Canada and the US both tax employees who receive benefits from options they are granted to acquire shares in their employer or a related entity. This article will focus on the Canadian tax implication of employee stock options (“ESO”), and how these rules apply in certain Canada-US cross-border situations.
As a general rule, stock options benefits are taxed under section 7 of the Income Tax Act (“the Act”). No taxation results at the time that the ESO is granted-rather taxation results at the time the ESO is exercised. The amount taxable will be equal to the excess of the fair market of the stock at that time over the exercise price.
In cases where the ESO was not “in the money” at the time of grant (i.e. exercise price no less than fair market value of shares at that time), an offsetting deduction for 50% of that amount is allowed. Hence, only 50% is included in taxable income [1].
The cost base of the shares for capital gains purposes effectively winds-up being the fair market value at the time of exercise [2], so the benefit does not get taxed a second time when the shares are sold.
What happens, however, if there is a Canada-US cross-border aspect to the situation? The following comments will deal with the most common situations.
Canadian Resident Exercising ESOs for Shares in US Company
As long as the options relate to employment, whether by a Canadian subsidiary, or the US parent itself, the same Canadian taxation rules as discussed above will apply.
In addition, even if the Canadian resident was a non-resident when the ESO’s were granted, the rules above will still apply.
Assuming that the Canadian resident is not a US citizen, no amount should be taxable in the US except to the extent that it relates to employment in the US.
US Resident Exercising ESO for Shares in Canadian Company
To the extent that the options relate to employment in Canada, the same Canadian taxation rules as discussed above will apply [3].
It should be noted that these rules will apply even if the US resident is no longer an employee of the Canadian company at the time the ESO is exercised [4].
Canadian Expat Exercising ESO While US Resident
Under Canada’s domestic tax law, a Canadian expat who exercises an ESO while resident in the US could be subject to Canadian tax on the resulting income even if such income does not relate to employment in Canada. That will be the case as long as the income relates to a period during which the expat was resident in Canada [5].
However, it is arguable that the Treaty would preclude Canada from taxing such income if it does not relate to employment in Canada [6].
Related to Employment in Both Canada and US
What if there has been employment in both Canada and the US for the relevant employer (or affiliate) between the time that the ESO was granted and when it was exercised? The Treaty contains a special apportionment rule that may be applied for the purposes of determining the extent to which the related taxable amount is considered to be derived from employment in Canada or the US. This rule, which is found in Article 6 of “Annex B” to the Diplomatic Notes to the 2007 Protocol, states as follows:
“For purposes of applying Article XV (Income from Employment) and Article XXIV (Elimination of Double Taxation) of the Convention to income of an individual in connection with the exercise or other disposal (including a deemed exercise or disposal) of an option that was granted to the individual as an employee of a corporation or mutual fund trust to acquire shares or units (“securities”) of the employer (which is considered, for the purposes of this Note, to include any related entity) in respect of services rendered or to be rendered by such individual, or in connection with the disposal (including a deemed disposal) of a security acquired under such an option, the following principles shall apply:
(a) Subject to subparagraph 6(b) of this Note, the individual shall be deemed to have derived, in respect of employment exercised in a Contracting State, the same proportion of such income that the number of days in the period that begins on the day the option was granted, and that ends on the day the option was exercised or disposed of, on which the individual’s principal place of employment for the employer was situated in that Contracting State is of the total number of days in the period on which the individual was employed by the employer; and
(b) Notwithstanding subparagraph 6(a) of this Note, if the competent authorities of both Contracting States agree that the terms of the option were such that the grant of the option will be appropriately treated as transfer of ownership of the securities (e.g., because the options were in-the-money or not subject to a substantial vesting period), then they may agree to attribute income accordingly.”
The effect of this rule is generally that taxable benefit is apportioned based on the period of time during which the principal place of employment is in the US or Canada during the period between grant and exercise.
Endnotes
[1] Paragraph 110(1)(d) the Act-all subsequent statutory references are to the Act. However, with the recent election of a Liberal government, the availability of this deduction may be limited.
[2] Paragraph 53(1)(j)
[3] Subparagraph 115(1)(a)(i); Article XV(1) of the Canada-US Tax Convention (“the Treaty”)
[4] Subsection 7(4)
[5] Subparagraph 115(1)(a)(i)
[6] Article XV(1) of the Treaty would seem to only allow Canada to tax a US resident on income derived from employment in Canada.
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