Employee stock options and tax-free savings accounts: A tax planning opportunity

11 minute read
01 June 2009

Part I: Tax-Free Savings Accounts

Commencing in 2009, individuals resident in Canada who have reached the age of 18 are entitled to contribute up to $5,000 per year to a trust governed by a tax-free savings account ("TFSA").1 Such contributions are to be made out of the after-tax funds of the individual; in other words, unlike registered retirement savings plans ("RRSPs"), the individual will not be entitled reduce his or her taxable income by the amount of the contribution. However, similar to RRSPs, income earned or capital gains realized in a TFSA will not be subject to tax, provided the TFSA holds qualified investments that are not prohibited investments. 2 Unlike RRSPs, however, withdrawals from a TFSA are not subject to tax. Furthermore such TFSA withdrawals may be added to the individual’s TFSA contribution limits going forward.3

At first glance, the potential tax savings offered by TFSAs are fairly pedestrian, especially in the first few years when total contribution limits are low. For example, if an individual contributed $5,000 to his or her TFSA on January 1, 2009 and earned a 10% return in the first year, the individual would have effectively sheltered only $500 of investment income from tax. Additionally, if an individual contributed $5,000 to his or her TFSA at the beginning of each year for 10 years and earned a 10% return annually, after 10 years his or her TFSA would have accumulated $37,656 of tax-free investment income. If done for 20 years, an individual's TFSA would have earned $215,012 of tax-free investment income.

As the value of a TFSA increases the potential tax savings increase as well. As such, to the extent one can increase the value of his or her TFSA sooner rather than later, the potential tax savings can increase dramatically, even exponentially.

Part II: Employee Stock Options

Employee stock options ("Options") granted by a public corporation (or an income trust) to its employees, giving an employee the right to acquire shares (or units) ("Option Shares") of the corporation (or the income trust), may be a way in which an employee can increase the value of his or her TFSA and realize significant tax savings.

Options are taxable pursuant to section 7 of the Tax Act. Generally, an employee will not realize a taxable benefit ("Option Benefit") in the year Options are granted, but instead will realize an Option Benefit in the year the Options are exercised and the Option Shares acquired.4 The Option Benefit may be deferred in certain circumstances to the year in which the Option Shares are actually disposed of, pursuant to subsection 7(8) of the Tax Act and subject to the limitations therein. The amount of the Option Benefit will be calculated as the difference between the fair market value of the Option Shares on the date they were acquired and the Option exercise price.5 The Option Benefit may be reduced by 50% pursuant to paragraph 110(1)(d) of the Tax Act. To the extent the employee holds the Option Shares as capital property and the proceeds of disposition received on the Option Shares exceeds (or is less than), generally, the fair market value of the Option Shares on the exercise date, the employee will realize a capital gain (or capital loss).6 If the employee realizes a capital loss on the disposition of the Option Shares, the allowable portion of such capital loss will not be claimable against the Option Benefit.7

Part III: Interaction of Options and TFSAs

Generally, where a share is qualified to be held in a TFSA, an option to acquire the share is also qualified to be held in a TFSA.8 A share of a public corporation (or a unit of an income trust) is usually a qualified investment for a TFSA.9 As such, an option to acquire a share of a public corporation (or a unit of an income trust) is also usually a qualified investment for a TFSA.

According to published Canada Revenue Agency policy and relevant case law, non-publicly-traded, under-water Options (e.g. where the exercise price of the Options exceeds the fair market value of the Option Shares) have little or no value.10 As such, subject to the terms of the relevant stock option plan and applicable securities regulatory and stock exchange requirements, an employee may transfer his or her Options to his or her TFSA while using up little, if any, of his or her annual $5,000 TFSA contribution limit.

On the exercise of Options that are held in an employee's TFSA, the employee will be required to include in his or her income the Option Benefit and may still be entitled to the 50% deduction referenced above.11 However, the Option Benefit deferral referenced above would not be available to the employee.12

On the sale of the Options Shares that are held in a TFSA, neither the holder of the TFSA nor the TFSA itself would be subject to tax on any resulting capital gain. Furthermore, such proceeds may be withdrawn from the TFSA tax-free. As a result of this treatment, the value of an employee's TFSA may be increased dramatically.

Part IV: Review of Stock Option Plan

The relevant stock option plan will have to be reviewed to ensure that the Options may be transferred into an employee's TFSA. Furthermore, to the extent the TFSA does not have sufficient funds to pay the exercise price on the Options, consideration should be given to amending the stock option plan to permit the employee to elect to receive cash in lieu of Option Shares on the exercise of the Options. Otherwise the TFSA may have to undertake a "cashless exercise" of the Options.13

Part V: Illustration

Assume Jane has non-publicly traded Options to acquire 100,000 Option Shares for $1.00 per share and the current fair market value of such shares is $0.75 per share. Because the Options are under-water, and assuming the relevant stock option plan would permit it, Jane should be able to transfer the Options to her TFSA without using up any of her $5,000 annual contribution limit.

Let us assume that the Option Shares are trading at $5.00 in 2 years and Jane causes her TFSA to exercise the Options and acquire the Option Shares. If the TFSA has $100,000 it may use this amount to satisfy the Option exercise price.14 If the TFSA does not have $100,000 to pay the exercise price, it cannot borrow money to pay the exercise price. If the stock option plan permits it, Jane's TFSA could elect to receive cash in lieu of shares. Alternatively, Jane's TFSA could undertake a "cashless exercise" of the Options.15 If the TFSA used its own funds to pay the exercise price, it would have $500,000 worth of Option Shares. If the TFSA elected to receive cash instead of Option Shares or undertook a complete cashless exercise, the TFSA would have $400,000 of cash. Under both scenarios, the value of the TFSA has increased by a net amount of $400,000, which may be used to earn tax-free investment income in the future.

Continuing with the foregoing example, assuming Jane's TFSA did not have $100,000 to pay the exercise price and Jane withdrew $80,000 from her TFSA to pay the tax on her Option Benefit, the TFSA would have $320,000 with which to invest and earn tax-free returns. If the TFSA invested this $320,000 and realized a 10% annual return, in the first year it would earn $32,000 tax-free. If Jane's TFSA invested this $320,000 and earned a 10% annual return for 20 years, her TFSA would have earned $1,459,174 of tax-free investment income. Furthermore, Jane would, in addition to her $5,000 annual contribution limits, be able to contribute a further $80,000 to her TFSA at any time.

As illustrated by the foregoing example, the tax benefits of contributing under-water Options with little or no value to a TFSA could be significant. The only foreseeable potential downside of such a planning strategy is the unavailability of the deferral of the recognition of the Option Benefit from the year of exercise of the Options to the year of disposition of the Option Shares.16

1 Section 207.01 and 146.2 of the Income Tax Act (Canada) (the "Tax Act"). All further statutory references herein shall be to the Tax Act unless otherwise stated.

2 Subsections 146.2(4) and 207.04(1).

3 Subsections 207.01(1) "unused TFSA contribution room".

4 Paragraphs 7(3)(a) and 7(1)(a).

5 Paragraph 7(1)(a).

6 The amount of the taxable benefit calculated under paragraph 7(1)(a) is added to the adjusted cost base of the Option Shares pursuant to paragraph 53(1)(j).

7 Paragraph 111(1)(b).

8 Regulation 4900(1)(e).

9 Regulation 4900(1)(b).

10 See Alan Macnaughton and Amin Mawani, "Contributions of Employee Stock Options to RRSPs and TFSAs: Valuation Issues and Policy Anomalies," (2008) vol. 56, no. 4 Canadian Tax Journal 893-922; Stanley Ebel and Curtis Stewart, "Update on Employee Stock Options & Employee Benefits," in Report on Proceedings of the Fifty-Fourth Tax Conference, 2002 Conference Report (Toronto: Canadian Tax Foundation, 2003), 27:1-47; and Interpretation Bulletin IT-96R6, "Options Granted by Corporations to Acquire Shares, Bonds, or Debentures and by Trusts to Acquire Trust Units," October 23, 1996, paragraph 3. However, it has been reported recently that senior Canada Revenue Agency officials have now informally suggested that their previous published position in respect of the valuation of Options may not be applicable in respect of TFSAs. See Alan Macnaughton and Amin Mawani, "CRA: Employee Stock Options and TFSAs," (May 2009) vol. 17, no. 5 Canadian Tax Highlights.

11 Paragraphs 7(1)(c) and 110(1)(d).

12 Subsection 7(8) modifies the operation of paragraph 7(1)(a), not subsection 7(1)(c). When Options are exercised in a TFSA, paragraph 7(1)(c), not paragraph 7(1)(a), provides for the taxation of the employment benefit in the hands of the employee.

13 Under a cashless exercise of Options the employee will generally retain a broker to sell some or all of the Option Shares in conjunction with the exercising of the Options. Part of the proceeds received from the sale of the Option Shares is then used to pay the exercise price. Once the exercise price has been paid, the employer then issues some or all of the Options Shares to the broker who then transfers them to the purchaser. It has been expressed that there is some uncertainty as to the tax treatment of a cashless exercise of Options. (See CRA technical interpretation 2004-0070361E5, "Cashless exercise" of employee stock options (August 18, 2004).)

14 Paragraph 146.2(2)(f).

15 Supra note 13.

16 Supra note 12.

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