The Income Tax Act sets out a detailed set of rules governing the taxation of stock options granted to employees, directors and officers. In general, these rules treat the value inherent in the option (measured at time of exercise) as an employment benefit, but often subject to a deferral and a special deduction that effectively taxes the benefit at capital gains rates.
None of these rules apply to options granted to independent contractors. The interpretation of jurisprudence in this area by the Canada Revenue Agency ("CRA") has been that the option benefit represents 100% taxable business income to an independent contractor, and that this benefit may have to be quantified and included in income at time of grant, on exercise, or potentially both. Compared to the potential deferral and capital gains tax rates often available to employees, directors and officers, this has put independent contractors at a significant disadvantage.
The landscape here may be changing as a result of the recent Federal Court decision in Henley(2008 DTC 6017).
Henley is not a decision dealing with independent contractors, but it does deal with an issuance of warrants to an individual outside the normal scope of the employee stock option rules in the Income Tax Act, and in that sense it may be analogous to the circumstances of independent contractors. This decision was significantly in favour of the taxpayer.
Based on certain principles now enunciated in Henley and general principles under the Income Tax Act, in most cases it may now be appropriate to take the following approach to the taxation of stock options granted to independent contractors for future services:
- Any value inherent in the stock option at time of grant represents fully taxable business income to the contractor. However, if an option is granted with a fair market value exercise price, the inherent value of the option at the time of grant may be minimal or at least low, even if a Black-Scholes valuation is applied (and in the past, CRA has not insisted on a Black-Scholes valuation).
- Share sale proceeds received following the exercise of the option should not be considered business income as payment for services but may, depending on all the circumstances, yield capital gains treatment.
If CRA follows the principles in Henley and the Department of Finance does not respond by amending the Income Tax Act to impose additional restrictions, many of the significant tax impediments to issuing options to independent contractors can be largely eliminated and that is a sensible and welcome development. Pending clarification of any response by the government, it is prudent to consult with a tax advisor before implementing such options.