In Canada, the taxation of employee stock options is governed by s. 7 of the Income Tax Act (Canada): see Rogers Estate v The Queen, 2014 TCC 348 at paragraph 38. The basic rule in s. 7 (modified in limited cases) is to tax, as employment income, the difference between two amounts: (1) the value of the shares at the time the employee actually acquires them, and (2) the total of the amount paid for the shares acquired plus the amount (if any) paid to acquire the option itself. In Ferlaino v. The Queen, 2016 TCC 105, a former Canadian tax director (Employee) of a Canadian subsidiary in a US-controlled group was granted stock options in 2000 and 2002 to acquire shares of the US parent company. The (future) exercise price at the time of the option grant was expressed in US dollars. The Employee exercised the options in 2010 and 2012, at which times the Canadian dollar had significantly strengthened as against the US dollar from the date of the grant: i.e., the Canadian dollar was roughly at par (1 to 1) with the US dollar in 2010 and 2012, compared to roughly 1.5 to 1 in 2000 and 2002. The option was exercised using the “cashless exercise” procedure, whereby the shares of the US parent were issued to a broker and immediately sold. From the US dollar sale proceeds, the exercise price for the shares was paid to the US parent and the balance was remitted to the Employee.
The Employee and the CRA agreed that the value of the shares should be converted into Canadian dollars at the exchange rate prevailing on the date the Employee actually acquired those shares. However, the Employee argued that his “tax cost” of those shares, for purposes of s. 7, should be determined as the US dollar exercise price for the shares translated into Canadian dollars at the exchange rate prevailing on the date the option was granted (i.e., at 1.5 to 1) – and not at the rate prevailing on the date the shares were actually acquired (i.e., at 1 to 1). This had the obvious effect if increasing the Canadian dollar tax cost of his shares acquired, and thereby reducing his Canadian dollar taxable employment benefit under s. 7. The Tax Court of Canada did not agree with this argument. The wording of s. 7 is plain and clear – the cost of the shares is the amount paid for the shares at the time they are acquired. Thus the date the shares were actually acquired was the relevant date on which to convert the US dollar acquisition price paid into Canadian dollars (i.e., at an exchange rate of 1 to 1). The date the option was granted was completely irrelevant on this point. The statutory context, s. 261(2)(b), and the purpose of s. 7 all supported this plain reading of s. 7.