TaxMatters@EY – May 2021

Alan Roth, Toronto

Proposed changes to the income tax treatment of security option benefits will take effect on July 1, 2021. The changes are intended to restrict the preferential tax treatment of security options for employees of large, established corporations while continuing to provide full tax benefits to employees of Canadian-controlled private corporations (CCPCs) and smaller non-CCPCs.

The proposed amendments to the Income Tax Act (Canada) (the Act) will limit the availability of the 50% employee security option deduction to an annual maximum of $200,000 of security options that vest (become exercisable) in a calendar year, based on the fair market value of the underlying securities on the date of grant. The proposed rules will generally not apply to employees of CCPCs or non-CCPC employers with annual gross revenues not exceeding $500 million. Otherwise, they will be effective for security options granted by other corporations (for the purchase of shares), or mutual fund trusts (for the purchase of units of a mutual fund), on or after July 1, 2021 (other than qualifying options granted after June 2021 that replace options granted before July 2021¹). The existing rules will continue to apply to security options granted before then.

Background

If you’re an employee and acquire securities under an employee security option plan, the excess of the fair market value of the securities under the option plan on the date you acquire them (by exercising the option) over the amount you paid for the securities is included in your income from employment as a security option benefit.²

When the employer that issued the option is not a CCPC, the benefit is generally included in your income under subsection 7(1) of the Act in the taxation year you acquire the securities under the option.³

If the employer is a CCPC, the benefit is included in your income under subsection 7(1.1) in the taxation year that you dispose of (or exchange) the shares acquired under the option, subject to certain conditions.

Half of the option benefit included in income generally qualifies as a security option deduction under paragraph 110(1)(d) of the Act,⁴ provided:

• The amount you paid to acquire the securities under the option (the exercise price) is not less than the fair market value of the underlying securities on the date you were granted the option (minus any amount you paid to acquire the option).
• The securities have the general characteristics of common shares⁵ (if they are shares of a company that is not a CCPC), or units of a widely held class of units of a mutual fund trust.
• You have been dealing at arm's length with your employer (and with each entity not dealing at arm's length with the employer) immediately after the option was granted.

The security option deduction results in the employee security option benefit being taxed effectively at the same rate as a capital gain.

The federal government has been seeking to limit the availability of this deduction because, in its stated view, the benefits of the deduction accrue disproportionately to a small number of high-income individuals employed by large, established corporations. Therefore, the government stated in the 2019 federal budget that proposed amendments would be introduced that would apply to security options granted to employees of “large, long-established, mature firms,” but would not apply to security options granted by CCPCs, or to security options granted to employees of “startups and rapidly growing Canadian businesses.”

In its fall economic statement delivered on November 30, 2020, together with corresponding updates to previously introduced proposed legislative amendments, the federal government provided further details on the proposed rules, confirming that they would take effect for security options granted on or after July 1, 2021 (other than qualifying options granted after June 2021 that replace options granted before July 2021) and would generally not apply to employees of CCPCs or non-CCPC employers with annual gross revenues not exceeding $500 million.

See EY Tax Alert 2020 Issue No. 57, Income tax measures from the 2020 federal Fall Economic Statement, and Issue No. 59, Stock option proposals reintroduced, for further details on these proposals. In addition, see EY Tax Alert 2019 Issue No. 26, Proposed changes to employee stock option rules (June 2019 update), and No. 14, Federal budget 2019-20: proposed changes to the stock option deduction.

The proposals

As noted above, the proposed amendments will impose a $200,000 annual limit on the amount of employee security options that vest in a calendar year that may qualify for the 50% security option deduction. The proposals contain rules to:

• Ensure this limit will apply to all security option agreements an employee has with an employer and the corporations that do not deal at arm's length with the employer
• Determine the order in which options will qualify for the deduction when the $200,000 limit is exceeded, and the vesting year when it is not clear in which year the options vest.

With respect to the second point, if an employee has a number of identical security options and some qualify for the existing tax treatment while others are subject to the proposed limit, the employee would be considered to first exercise the security options qualifying for the existing tax treatment. In addition, the determination of when an option vests will be made at the time the option is granted. If the year in which the option vests is not clear, the option will be considered to vest on a pro-rata basis over the term of the agreement, up to a five-year period.

The $200,000 annual limit will not apply to options granted by CCPCs and non-CCPC employers with annual gross revenue of $500 million or less. Gross revenue for this purpose is the revenue reported in an employer's most recent annual financial statements prior to the date the options are granted (or, in the case of a corporate group, the ultimate parent's consolidated financial statements), prepared in accordance with generally accepted accounting principles.

Employers will be able to claim an income tax deduction on the portion of employee security option benefits that do not qualify for the security option deduction as a result of these proposed rules (non-qualified securities),but would have otherwise qualified for that deduction. Employers will also be able to designate securities to be issued or sold under a security option agreement as non-qualified securities for purposes of these rules. If this designation is made, employees will not be entitled to the security option deduction even if they would otherwise be eligible, but the employer will be entitled to a deduction equal to the value of the benefit received by employees.⁶

Employers will be required to notify employees in writing no later than 30 days after the day the security option agreement is entered into for non-qualified securities, and to report the issuance of security options for non-qualified securities in a prescribed form on or before the filing-due date for the employer’s income tax return for the taxation year that includes the date that the agreement is entered into. Employers will also be required to track which options are qualified for purposes of income tax withholding and T4 (Statement of Remuneration Paid) reporting. The tracking exercise will be more complex in situations where employees receive multiple option grants.

Example

Productco is a manufacturing corporation whose common shares are publicly traded on the Toronto Stock Exchange.

On August 1, 2021, Productco granted its executive officers stock options on its common shares. Productco did not designate the underlying securities as non-qualified securities under the option agreement. Each officer was granted 15,000 options to purchase 15,000 common shares of the company for $100 per share, equal to the fair market value of the common shares on that date.

Under the option agreement, 5,000 options will vest in each of 2022, 2023 and 2024. Productco’s most recent financial statements prior to the granting of the options reported gross revenues of $735 million for the year.

On August 1, 2022, each of the officers exercised 5,000 options to purchase 5,000 shares of Productco. The fair market value of the securities on that date was $120 per share.

Each of the officers will recognize a security option benefit of $100,000 (5,000 x ($120 - $100)). The proposed amendments will apply to the options granted by Productco since the company is not a CCPC and its gross revenues exceeded $500 million for the year, according to its financial statements for its last fiscal year that ended before the options were granted.

For each of 2022, 2023 and 2024, only 2,000 of the 5,000 options that may be exercised by each officer will qualify for the security option deduction because the fair market value of the shares represented by those 2,000 options on the grant date equals the $200,000 annual limit (2,000 x $100 per share).

Therefore, in 2022, each of the officers will be able to claim a security option deduction of $20,000 (50% x 2,000 x ($120 - $100)). Productco will be able to claim a corporate income tax deduction of $60,000 in respect of the security option benefit realized by each officer, since this is the amount of the benefit that does not qualify for the security option deduction under the proposed rules (3,000 x ($120 - $100)).

If Productco issues another 15,000 options on October 1, 2022 under the same vesting terms (i.e., 5,000 options vest in each of 2023, 2024 and 2025) and the share price returns to $100 on this grant date, then none of the options granted in 2022 that vest in 2023 or 2024 would qualify for the security option deduction because the qualified options would have been "used up" for those years, as a result of the options previously granted in 2021 that vested in 2023 and 2024. So 2,000 options would qualify for the deduction in respect of the 2025 vesting year, with the remainder being non-qualified.

Conclusion

The proposed amendments may have significant implications for employees of large established corporations that are not CCPCs who receive security options as part of their compensation package. To the extent an employer is planning on granting new options in 2021, consideration should be given to granting them prior to July 2021 to ensure employees can benefit from the existing rules.

For employers, the proposals will impose significant new tracking obligations since they will be required to identify which options do not qualify for the security option deduction at the time of grant, to notify employees and the Canada Revenue Agency, and to ensure correct reporting on the employee's T4 statement.

For additional information on these proposals and their potential impact on you, consult your EY tax advisor.

Brittany Rossler, Toronto, Winnie Szeto, Toronto, and Gael Melville, Vancouver

In this Tax Court of Canada case, an executor was assessed under section 160 of the Income Tax Act in respect of funds received from her mother’s registered retirement savings plan (RRSP) when her mother died. The main point at issue was whether the executor could be liable for the full amount of the RRSP proceeds and the Court had to consider, among other things, whether instructions left by the deceased led to the creation of a trust.

Facts

The taxpayer was appointed executor of her late mother's estate. The only significant asset of the estate was the mother's RRSP. The mother appointed the taxpayer as the designated beneficiary of the RRSP on the explicit understanding that the taxpayer would use the proceeds of the RRSP to pay for specific expenses such as funeral costs, estate administration costs, and travel costs for the family to visit the mother on her deathbed and to attend her funeral. The taxpayer was then to divide the remainder of the estate among herself and her two sisters.

After her mother's death, the taxpayer received $76,616 in net proceeds from the RRSP and distributed the funds in accordance with her mother's wishes.

The CRA assessed the taxpayer under subsection 160(1), which allows the CRA to hold the recipient of a transferred amount liable for the tax debt of the transferor where the following requirements are met:¹

1. There is a transfer of property either directly or indirectly, by means of a trust or by any other means whatever.
2. The transfer was made by a person who owed an amount under the Income Tax Act (the Act).
3. The transfer was made to a non-arm’s-length person.
4. The transfer was made for less than fair market value consideration.

If these criteria are met, the transferee is liable to pay an amount equal to the lesser of the amount owing to the CRA by the transferor and the shortfall in consideration. In Goldman, the CRA assessed the taxpayer for the full amount of the transfer to her from the estate.

Tax Court decision

The main focus of the Court’s decision related to the taxpayer’s liability under section 160 of the Act.

The Court found that there were five distinct transfers of property that needed to be considered because subsection 104(2) of the Act deems a trust to be a separate individual from the trustee. As a result, if the trust owes a tax debt, then that debt is a debt of the trust and not of the trustee personally.² The five transfers the Court identified were as follows:

1. The transfer of the RRSP proceeds from the mother to the taxpayer in trust
2. The distribution of part of that trust to the taxpayer as beneficiary
3. The payment of executor fees to the taxpayer from the trust
4. The unexplained distribution of certain amounts from the trust
5. The payment of the taxpayer's legal fees from the trust

Existence of a valid trust

The Court found that the three elements for creating a trust — commonly referred to as the "three certainties" — were met:

• The object of the trust was the deceased’s daughters, as beneficiaries
• The subject was the RRSP proceeds
• The mother’s intention was clearly to settle a trust

As a result, the mother’s instructions to her daughter had the result of creating a trust and the taxpayer received the RRSP proceeds in trust. The Court's analysis focused on the third certainty (i.e., the certainty of intention) due to certain obiter comments in the Livingston case.

It is well established by case law that the intention of the transferor to avoid tax is irrelevant for the purposes of subsection 160(1). However, in Livingston, the Federal Court of Appeal seemingly contradicted itself by stating both that intention was irrelevant and that it was an important factor.

In Goldman, the Tax Court reasoned that while the transferor's intention is irrelevant for determining liability under subsection 160(1), the transferor’s intention to defeat their creditors may be inconsistent with an intention to settle a trust. For example, if an individual transfers an amount to their spouse on the understanding that the spouse will return those funds back to the individual, the individual cannot be said to have intended to create a trust. The CRA can therefore look at the transfer between the spouses and assess the transferee for the full amount.

On the other hand, where the transferor has a genuine intention to create a trust, as was the case in Goldman, then the Court must look at the transfer to the trust first and then the transfer from the trust to the beneficiaries. In this case, the mother did not intend to defeat the CRA and retain a beneficial interest in the trust proceeds, which distinguished the case from Livingston, where no valid trust was established. While the mother may have intended to avoid paying the CRA, the Court found that this was entirely consistent with her intention to create a trust for the benefit of her daughters, and therefore did not prevent such a trust from existing.

Liability under section 160 for the transfer to the trust

Having found that a valid trust had been created, the Court then considered who was liable under subsection 160(1) for the amount of the RRSP proceeds transferred to the trust. The question was whether the trustee was liable in her personal capacity.

The Court held that the taxpayer could not be held liable for the full RRSP proceeds transferred into the trust because she only acquired legal title to those amounts as a trustee. If the CRA wanted to hold the taxpayer liable as a trustee for the unpaid tax debt of the trust, then the CRA should have issued an assessment under subsection 159(3),³ which it did not do.

Liability for other transfers

Although the taxpayer was successful in defending the CRA’s assessment against her for the RRSP proceeds transferred to the trust, she was unsuccessful with respect to some of the other four transfers the Court identified.

First, the taxpayer was liable in her personal capacity for amounts she received from the trust as a beneficiary. Subsection 160(1) captures transfers made "by means of a trust," where the beneficiary deals at non-arm's length with the settlor and the settlor owed tax when they transferred property to the trust. In this case, the taxpayer dealt with her mother at non-arm's length, the mother owed tax when she transferred the RRSP proceeds to the trust, and the taxpayer did not give any consideration in exchange for the amounts she received as beneficiary. As such, the taxpayer was liable for the lesser of the amount that was transferred to her for no consideration and the amount of her mother’s tax debt.

Further, the taxpayer was also liable for the unexplained distributions because she provided no evidence to prove that the distributions were not made to her and that the CRA’s assessment was incorrect. Finally, the Court held that the taxpayer was not liable for the executor fees she received out of the trust because she gave consideration for those fees by administering the estate. The result was a significantly lower liability under subsection 160(1).

Lessons learned

One lesson we can take from this case is that it may not always be clear when a trust has been created. The trust in this case was governed by the law of Ontario, which does not require a trust to be created in writing (except if the trust is in respect of land). The deceased individual in this case may not even have realized that she had created a trust by directing her daughter how to distribute her estate.

Taxpayers should seek legal advice when drafting their wills and when drafting any codicils to make sure they understand the implications of the documents.

The case is also a reminder that a deceased individual may have outstanding tax debts that the executor is unaware of, and so it is important to follow the procedures in section 159 before making any distributions. As the Court pointed out, if the CRA wanted to assess the taxpayer in her role as a trustee, it could have used subsection 159(3) to do so, because she had not obtained a clearance certificate before distributing the RRSP proceeds.

Finally, this case is a good reminder that taxpayers should be careful when accepting gifts from non-arm’s-length parties because they can be held jointly and severally liable for the transferor’s tax debt regardless of whether the transferor made the transfer to avoid their tax liability.

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