A consulting company (“Serviceco”) received stock options (the “Options”) on the shares of the parent (“Parentco”) of its arm’s length client (“Opco”). Serviceco had agreed with its employee (“Employee”) to pay Employee a fixed salary plus a percentage of the Options. Accordingly, Serviceco transfers 6,000 Options to the Employee in Year 1, who exercises them in Year 2 just prior to Parentco making an initial public offering of its shares, and Employee then disposes of the Parentco shares in Year 3.
After noting that the s. 7 rules did not apply, CRA stated:
[T]he Employee received the 6,000 Options in Year 1 as compensation for services rendered to Serviceco as an employee. Accordingly, the FMV of the Options, determined at time the Employee received the Options, will be included in the Employee’s income for Year 1 under subsection 5(1) and paragraph 6(1)(a). … It is the CRA’s view that the intrinsic value of an option is not reflective of its FMV; rather, a valuation method that is appropriate in the circumstances should be used to determine the FMV.
The tax consequences that result from the Employee’s exercise of the Options in Year 2 and the disposition of the optioned shares in Year 3 will depend on the facts. For information, refer to Interpretation Bulletin IT-479R, Transactions in Securities.