A recent technical interpretation issued by the Canada Revenue Agency, Technical Interpretation 2011-0393411E5, provides that under Article XV of the Canada-U.S. Income Tax Convention, that after 2008, when a U.S. resident employee of a Canadian resident corporation acquires shares of the corporation on the exercise of employee stock options, the Canada Revenue Agency (CRA) would disallow that the income from the taxable amount would qualify for exemption from Canadian income tax under the Canada-U.S. Tax Treaty, even if the employer was not present in Canada for more than 183 days. The rationale of the CRA is that the income realized from the exercise of the Canadian stock option was "paid" to the employee by the Canadian resident corporation in applying Article XV(2)(b) of the Treaty.
Under the Canadian tax law, in general, the fair market value of the share of stock acquired by exercise of a compensatory stock option in excess of the amount paid to acquire the option is treated as income from employment. This is essentially the same result that is produced under Section 83 of the Internal Revenue Code and in particular, in accordance with Treas. Reg. §1.83-7 (non-qualified stock options not having a readily ascertainable fair market value on grant). ITA, ¶7(1). The basis of the acquired shares, referred to as the "adjusted cost base", is equal to the amount paid for the option, plus the strike price and the excess of the value of the shares acquired over the employees’s cost basis to acquire the stock. ITA, ¶53(1)(j). With respect to a nonresident employee, the spread between the value of the stock acquired by exercise of a compensatory option must be related to services rendered or performed of an employment in Canada. ITA ¶¶115, 2(3)(a). Unlike the deduction reported by the employer-issuer under IRC §83(h), in Canada the issuing corporation is not permitted to deduction the amount of the compensatory element of the exercised employment option. ITA, ¶7(3)(b).
Article XVof the Treaty provides:
- Subject to the provisions of Articles XVIII (Pensions and Annuities) and XIX (Government Service), salaries, wages and other remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State. If the employment is so exercised, such remuneration as is derived therefrom may be taxed in that other State.
- Notwithstanding the provisions of paragraph 1,remuneration derived by a resident of a Contracting State in respect of an employment exercised in the other Contracting State shall be taxable only in the first-mentioned State if: (a) Such remuneration does not exceed ten thousand dollars ($10,000) in the currency of that other State; or (b) The recipient is present in that other State for a period or periods not exceeding in the aggregate 183 days in any twelve-month period commencing or ending in the fiscal year concerned, and the remuneration is not paid by, or on behalf of, a person who is a resident of that other State and is not borne by a permanent establishment in that other State.
The language under Article XV is fairly clear and unambiguous. Generally, income from services received by a resident of the U.S., for example, is not taxable in Canada unless the employment is exercised in Canada and then is taxable in Canada to the extent so derived. So much for XV(1). Then in XV(2) , and in particular, XV(2)(b), income for services rendered by a U.S. resident for employment exercised in Canada is only taxable in the U.S. where the service provider is present in Canada for a period(s) of time not exceeding 183 days for a 12 month period commencing or ending in the relevant fiscal year and the compensation is not paid by, or on behalf of a person who is a resident of Canada and is not economically borne by a permanent establishment of a nonresident employer situated in Canada.
The question present in the newly issued TI was whether the position the CRA previously took in TI 2002-0126537, was still the position of the CRA in light of the fifth protocol to the Treaty that was signed and entered into force in 2008 with respect to Article XV(2)(b). In Technical Interpretation 2002-0126537 the CRA opined that a resident U.S. for the purposes of the treaty who was employed in Canada for the purposes of the ITA and earned income from that employment under section 7 of the ITA would not be subject to Canadian tax on that income by virtue of Article XV(2)(b) of the treaty if: (1) the resident was not present in Canada for more than 183 days in the tax year; and (2) the stock option benefit was not available to the employer as a deduction in computing taxable income of either a Canadian resident employer or the permanent establishment of a nonresident employer.
In Technical Interpretation 2011-0393411E5, the CRA revised its position from the position taken in 2002. In particular, the CRA opined that under the new provision, the compensatory element of the exercise of a stock option realized by a U.S. resident that is included in the employee’s income under the Canadian ITA for a tax year beginning on or after January 1, 2009, as income from an office or employment will be exempt from tax in Canada per Article XV(2)(b) provided: (i) the U.S. resident is not present in Canada for more than 183 days in any 12-month period commencing or ending in the particular tax year; (ii) the stock option remuneration is not paid by, or on behalf of, a person who is a resident of Canada under the treaty; and (iii) the stock option remuneration is not borne by a permanent establishment in Canada. Remuneration is borne by a permanent establishment in Canada if the compensatory element is deductible in the computation of income attributable to the permanent establishment under Canadian ITA. Stock option compensation derived by a U.s. resident is not exempt under the Treaty where it is paid by, or on behalf of, a resident of Canada even where the compensatory element is not deducting in computing the income of the Canadian resident employer.
What seems to be controversial about the CRA’s position is that in light of the Fifth Protocol to the Treaty (2008), when a U.S. resident employee of a Canadian resident corporation acquires shares of the corporation on the exercise of employee stock options, the CRA would deny an exemption from Canadian tax under the treaty, even if the employer was not present in Canada for more than 183 days, since the amount of any resulting stock option remuneration will be paid to the United States-resident employee by the Canadian-resident corporation for the purposes of Article XV(2)(b). This result may produce discontinuities in the cross-border treatment of non-qualified stock options (NQSOs) and incentive stock options (ISOs). This is due to the fact that as to incentive stock options, the bargain element on exercise is not included in taxable income for regular tax purposes only for alternative minimum tax purposes. Instead, capital gain is realized when the stock is sold provided the sale occurs more than 2 years after the date of grant or 1 year after exercise. IRC §421(a)(1).
It is certain that this new TI issued by the CRA will generate some controversy and that the issue will ultimately by posited with the Canadian tax courts for review and interpretation.