Principal Issues: [TaxInterpretations translation] Could subsection 7(1.31) and, consequently, subsection 47(3) apply in a situation where an employee who sold short a security held as capital property exercise a stock option on an identical security and cover his/her position within 30 days after the short sale?
Position: Possibly. However, the averaging rule in subsection 47(1) could still apply to the short sale.
Reasons: A short sale transaction includes two dispositions for tax purposes for the short seller. The first disposition occurs when the short sale is entered into and the security sold at that time is not a security acquired under a stock option agreement. However, subsection 7(1.31) could apply to the second disposition, which occurs when an identical security acquired under a stock option agreement is returned to the lender.
FINANCIAL STRATEGIES AND FINANCIAL INSTRUMENTS ROUNDTABLE, 7 OCTOBER 2021
2021 APFF CONFERENCE
Question 7
Employment-related share options and identical goods
Where a taxpayer acquires a security under an agreement referred to in subsection 7(1) and certain conditions are satisfied, subsection 7(1.31) and subsection 47(3) create an exception to the average cost rule found in subsection 47(1) and thereby minimize the tax consequences normally associated with the application of the general rules applicable to the disposition of identical properties. One of the conditions for the application of subsection 7(1.31) is that a taxpayer acquires, at a particular time, a particular security under an agreement referred to in subsection 7(1) and then disposes of a security identical to that security no later than the 30th thirtieth day after the day that includes the particular time.
Consider the example of a taxpayer (the “Employee”) who holds a stock option from the individual’s employer under an agreement referred to in subsection 7(1) (the “Option”). Prior to exercising the Option, the Employee makes a short sale of a security identical to the share that he may acquire under the Option.
To do so, the Employee borrows the identical security from a third party (the “Lender”) and then sells it in the market. When borrowing the security, the Employee undertakes to deliver to the Lender a security identical to the borrowed security. The exercise of the Option will allow the Employee to acquire the security for the purpose of delivering it to the Lender, thus enabling him to cover his position. The Employee proceeds with the short sale independently. It is not a cashless exercise under the employer’s plan. The short sale therefore has no impact on the computation of the benefit arising from the exercise of the Option, which will be determined pursuant to paragraph 7(1)(a). However, in the context of the short sale, the Employee disposes of the security before acquiring it by virtue of the agreement referred to in paragraph 7(1).
The Employee has made an election under subsection 39(4) in the past. Under that election, all Canadian securities (as defined in subsection 39(6)) held by the Employee (including the security of the Employer acquired pursuant to the exercise of the Option) are considered to be capital property of the Employee and dispositions of Canadian securities of the Employee are considered to be dispositions of capital property.
In addition, the Employee held a number of identical securities of the Employer, acquired in prior years, prior to the short sale. Other than the above transactions, the Employee does not dispose of any other securities of the employer during the period beginning on the day of the short sale and ending on the day the securities are delivered to the Lender.
Question to the CRA
Could subsection 7(1.31) and, consequently, subsection 47(3) apply in a situation where the Employee exercises the Option and covers his position by delivering to the Lender the security acquired following the exercise of the Option within a period of 30 days following the short sale?
CRA Response
The situation that you have submitted does not allow us to identify with certainty the legal relationships between the various parties involved and, consequently, the tax consequences related to this series of transactions. A detailed analysis of all the contracts and agreements would be necessary in order to definitively determine the tax consequences applicable to a particular situation. However, we are able to provide the following general comments, which may not be fully applicable in a particular situation.
Subsection 7(1.31) deals with the situation where a taxpayer acquires a security under an agreement referred to in subsection 7(1) ("Newly-acquired Security"). and the taxpayer disposes of a security identical to the Newly-acquired Security no later than 30 days after the acquisition of the Newly-acquired Security. Where all of the conditions of subsection 7(1.31) are satisfied, that subsection deems the Newly-acquired Security to be the security that was disposed of by the taxpayer. In summary, subsection 7(1.31) specifies the order of disposition of securities.
For the purposes of the average cost rule for identical properties rule in subsection 47(1), subsection 47(3) indicates, inter alia, that a security to which subsection 7(1.31) applies is deemed not to be identical to any other security acquired by the taxpayer. Consequently, the adjusted cost base ("ACB") of each of the securities to which subsection 7(1.31) applies will be calculated without reference to the ACB of any other security held by the taxpayer.
In order to determine whether subsection 7(1.31) may apply in the context of a short sale, it is necessary to understand certain tax consequences generally applicable to a short sale.
The CRA's position is that a short seller generally acquires the securities when it borrows shares for the purpose of a short sale, whether or not under a "securities lending arrangement" (as defined in subsection 260(1)). The acquisition cost to the short seller of the borrowed securities generally includes the FMV of the securities at the time the short lender transfers them to the short seller. On the short sale, it is the borrowed securities that the short seller is considered to have disposed of.
Where the short seller subsequently acquires identical securities and delivers them to the lender to cover its short position, it is the identical securities so acquired that the short seller is considered to have disposed of.
Thus, the CRA is of the view that a short seller generally makes two dispositions of securities in a short sale. Both dispositions must therefore be considered.
Generally, as stated in paragraph 18 of Interpretation Bulletin IT-479R (footnote 1), gains or losses on short sales of securities are considered to be on income account. However, whether the gain or loss on a particular transaction is to be taxed as income or as a capital gain or loss is a question of fact which can only be resolved after a full examination of all the facts relating to a particular situation. On the other hand, subject to subsection 39(5), it is possible that a taxpayer may be able to make an election under subsection 39(4) in respect of Canadian securities (as defined in subsection 39(6)) sold short. Indeed, for the purposes of the subsection 39(4) election, a Canadian security also includes a security described in subsection 39(6) that is sold short.
Where, in a taxation year for which an election under subsection 39(4) applies, a taxpayer makes a short sale, the two dispositions of securities (both the one that occurs at the time of the short sale and the one that occurs subsequently when the borrower delivers securities to the lender to cover its short position) are deemed to be dispositions of capital property to the short seller.
In the situation described, we are of the view that the Employee makes two dispositions that would be deemed to be dispositions of capital property. For purposes of calculating the capital gain or loss, if any, arising from these two dispositions, it would be necessary not only to determine the ACB of the Newly-acquired Security (the employer's security acquired pursuant to the exercise of the Option), which the Employee will dispose of by delivering it to the Lender, but also to determine the ACB of the security acquired by the Employee at the time of the borrowing and sold in the market on the short sale.
With respect to the first disposition, that of the security acquired on the borrowing, subsection 7(1.31) would not apply since that security would not have been acquired pursuant to an agreement referred to in subsection 7(1). Consequently, the average cost of identical properties rule in subsection 47(1) would apply to determine the ACB of the security acquired on the borrowing.
However, with respect to the second disposition, that of the Newly-acquired Security, subsection 7(1.31) could apply, provided that the Newly-acquired Security was delivered to the Lender by the borrower within the 30-day period following the day on which the Option was exercised and that the other conditions of subsection 7(1.31) were satisfied. If this were the case, the average cost of identical properties rule in subsection 47(1) would not apply to determine the ACB of the Newly-acquired Security pursuant to subsection 47(3).
Isabelle Brulotte
October 8, 2021
2021-089968
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 CANADA REVENUE AGENCY, Interpretation Bulletin IT-479R (archived), "Transactions in Securities", February 29, 1984.