The Stock Option Deduction and Prescribed Shares

The 50 percent deduction for stock option gains under paragraph 110(1)(d) is available only if the shares acquired on the exercise of the options are "prescribed shares," as defined in regulation 6204. The purpose of this restriction is to ensure that the shares are subject to price risk and are not just a form of disguised salary. The definition includes a requirement that the corporation issuing the stock option and persons not at arm's length with the corporation cannot reasonably be expected to redeem, acquire, or cancel the shares within two years of their issuance (regulation 6204(1)(b)). In Montminy v. Canada (2017 FCA 156; rev'g. 2016 TCC 110), the FCA held that the market-making exception in regulation 6204(2)(c)—namely, that an obligation to redeem, acquire, or cancel a share ("obligation to acquire") can be disregarded when the obligation's purpose is to create a market for the sale of the shares—could apply to this requirement. The decision clarifies to some degree the interpretation of the prescribed share rules.

In Montminy, the taxpayers held stock options granted by their employer, Cybectec. In response to an unsolicited offer to acquire most of Cybectec's assets, Cybectec undertook to ensure that its parent company would purchase the underlying optioned shares shortly after their issuance. Following the exercise of their options, the taxpayers sold their newly acquired shares to Cybectec's parent. The taxpayers claimed a deduction equal to 50 percent of the taxable benefit received pursuant to paragraph 110(1)(d).

The TCC found that the two-year reasonable-expectation test in regulation 6204(1)(b) was not met because the taxpayers knew that the shares were to be acquired by Cybectec's parent immediately following their issuance. The TCC held that the market-making exception in regulation 6204(2)(c) did not apply to regulation 6204(1)(b) because the two paragraphs were not logically connected. According to the TCC, this conclusion was supported by the context of the promulgation of paragraph 110(1)(d) and regulation 6204(1)(b), which was to ensure that employees subscribing to stock option plans were subject to a certain amount of risk. In the TCC's view, the employees did not incur any risk until they exercised their stock options.

The FCA reached a different conclusion: it found that when the market-making exception applied, the reasonable-expectation test in regulation 6204(1)(b) should be read without reference to an obligation to acquire. The FCA accepted the taxpayers' argument that regulation 6204(1)(b) was an anti-avoidance provision meant to prevent the abuse of regulation 6204(1)(a)(iv). The FCA said that
[s]ince subparagraph 6204(1)(a)(iv) and paragraph 6204(1)(b) share the same objective, the "logical connection" which the TCC judge could not establish with paragraph 6204(2)(c) is present in both cases. It follows that paragraph 6204(1)(b), like subparagraph 6204(1)(a)(iv), must be applied "without reference to" the obligation to redeem.
Discussing the notion of risk incurred by the employees, the FCA agreed that the policy objective behind the paragraph 110(1)(d) deduction is to ensure that employees are subject to risk and that stock option plans are not used to pay disguised salaries. The FCA disagreed with the TCC's suggestion that the taxpayers had not incurred sufficient risk. According to the FCA, the taxpayers were exposed to risk throughout the time between the granting and the exercise of the options. The FCA also found that the risk element was ensured not by the holding period, but by the characteristics of the shares and the minimum price at which the option must be exercised.

The FCA's conclusion in Montminy is welcome because it provides guidelines regarding the qualification of prescribed shares in situations where a stock option plan includes an obligation of a corporation to acquire such shares in order to create a market for their sale.

Alexandra Carbone
Blake Cassels & Graydon LLP, Montreal
alexandra.carbone@blakes.com

Canadian Tax Focus
Volume 7, Number 4, November 2017
©2017, Canadian Tax Foundation