Deemed Benefit and Tax under Section 7
Section 7 of the Income Tax Act[1] taxes an employee’s benefit derived from the exercise of rights under a legally binding agreement with an employer to sell or issue shares to the employee. Section 7 applies where a corporation has agreed to sell or issues shares to the employee. If there is no agreement, section 7 does not apply. Section 7 deems the benefit to be income from employment and identifies the time at which the income is deemed to have been realized (and, therefore, taxable).
The benefit is equal to the difference between the option price and the fair market value of the shares when they are acquired. The benefit is included in the income in the year the option is exercised. When certain conditions are met, the employee may deduct ½ of the benefit deemed to have been realized.
A benefit is deemed realized under subsection 7(1) when, inter alia, the following events occur:
- When the employee acquires any of the securities or when they are acquired by a person not dealing at arm’s length with the employee;[2]
- When the rights to acquire the securities are disposed of by the employee or by a person not dealing at arm’s length with the employee to a person with whom the employee or the other person is dealing at arm’s length;[3]
- On the death of an employee holding an unexercised right to acquire the securities under an agreement to which subsection 7(1) applies.[4]
Deferral of the Taxable Benefit for Canadian Controlled Private Corproations
Under subsection 7(1), the deemed benefit is realized when the shares are acquired by the employee. There is a deferral in subsection 7(1.1) where the shares are acquired by an arm’s length employee of a corporation and the corporation is a Canadian controlled private corporation (“CCPC”). If subsection 7(1.1) applies, the gain is deferred until the employee disposes of the shares acquires under the agreement. In order for 7(1.1) to apply, the following conditions must be met:
- A CCPC has agreed to sell or issue shares to an employee; and
- The employee must be arm’s length with the CCPC immediately after the agreement was made.
The ½ Deduction
When an employee realizes a benefit under subsection 7(1) they may be entitled to a deduction of ½ in calculating their taxable income under paragraphs 110(1)(d) or 110(1)(d.1). The deduction is meant to ensure that the employee’s benefit is taxed at rates similar to capital gains rates.[5]
Under paragraph 110(1)(d), the employee is entitled to the deduction where:
- A qualifying person (a corporation or mutual fund trust) has agreed to sell or issue a security under an agreement such that a benefit arises under subsection 7(1);
- The security was acquired under an agreement by the taxpayer;
- If the security is a share, it must be a prescribed share at the time of its issue or sale;[6]
- The amount payable to acquire the security under the agreement must not be less than the fair market value at the time the agreement grating the option was made (minus any amount paid for the right to acquire the security).[7]
In the case of a CCPC or startup, it may not be possible to rely on the deduction under paragraph 110(1)(d) if the taxpayer is allowed to acquire shares for a nominal amount (that would violate point 4 above). In the case of CCPCs, there is a corresponding under paragraph 110(1)(d.1), where:
- The taxpayer has not disposed of the share (except on death) or exchanged the share within two years after the date the taxpayer acquired the share; and
- The taxpayer has not deducted an amount under paragraph 110(1)(d) in respect of the benefit.
If the taxpayer is unable to claim the deduction under 110(1)(d.1) (for example, if the taxpayer disposed/exchanged the share within two years), the taxpayer may still be able to claim the deduction under paragraph 110(1)(d), provided that the conditions for that deduction are met.
Example
John Doe enters into an agreement with his employer, Acme Inc., a CCPC, where he agrees to purchase 100,000 common shares for $100. John and Acme deal at arm’s length. The agreement is dated January 1, 2018. John exercises the option and acquires the shares on March 1, 2018. On the date the shares are acquired they have a fair market value of $2,000,000.
Under subsection 7(1)(a), the benefit is realized and taxed in the year in which the shares are acquired (2018). However, John is able to rely on the exception in 7(1.1) and defer recognizing the benefit until the year in which the shares are disposed of. John is able to rely on the exception because Acme is a CCPC and has agreed to sell John shares and immediately after the agreement, Acme and John were dealing at arm’s length.
Further, John will only have to realize half the deemed benefit as income ($999,950) in the year in which he disposes of the shares if he does not dispose of them (otherwise than as a consequence of death) within two years and does not rely on the deduction in paragraph 110(1)(d).
In 2022, John’s shares increase in value to $40 per share ($4,000,000) and John sells the shares. In 2022, John will realize the income inclusion ($999,950) and a capital gain of $2,999,950 (4,000,000 – 999,950 [income inclusion] – 100 [cost to purchase shares]). Half the capital gain ($1,499,975) is included in income.
| Income Inclusion | |
| Option Grant Date – January 1, 2018
|
Non-tax event |
| Exercise Date – March 1, 2018
Employment benefit = 2,000,000 – 100 (which is added to ACB) Income inclusion = 1,999,900 / 2
|
Non-tax event |
| Disposition Date – 2022
Income inclusion Proceeds of disposition = 4,000,000 – 1,999,900 – 100 Capital gain = 2,000,000 Taxable portion = 2,000,000 /2
|
999,950
1,000,000 |
| TOTAL INCOME INCLUSION | 1,999,950 |
[1] RSC 1985, c 1 (5th Supp.). All statutory references are to the Income Tax Act, unless otherwise noted.
[2] 7(1)(a) and (c).
[3] 7(1)(b) and (d).
[4] 7(1)(e).
[5] The amount of the deduction has varied over time to be consistent with the variation in inclusion rates for capital gains.
[6] A prescribed share is defined in regulation 6204(1) and is, generally, an ordinary share.
[7] See paragraph 110(1)(d). There are some other restrictions which are too specific and technical to explain here.