The tax treatment of stock options granted to employees has been well established by the Income Tax Act (Canada) (the “ITA“) and related commentary. In particular, Section 7 of the ITA contains the taxation rules for stock options granted to employees. However, these rules do not apply in the context of stock options granted to independent contractors.[1] As a result, the unique tax treatment of stock options granted to independent contractors is often overlooked.
Subsection 9(1) of the ITA provides that a taxpayer’s income for a taxation year from a business, is the taxpayer’s profit from that business for the year. Therefore, in a case where a stock option is granted in respect of services rendered pursuant to an independent contractor relationship, the Canada Revenue Agency’s (“CRA”) position is that the fair market value (“FMV“) of such stock option will be included in a taxpayer’s business income under subsection 9(1) in the year of the grant.[2]
The entire FMV of the stock option granted may not be subject to an immediate income inclusion if all or part of the stock option does not vest on the date of the grant. The CRA has not opined on vesting conditions directly. However, certain jurisprudence has supported the position that vesting or the fulfillment of conditions precedent are pre-conditions to an income inclusion.[3] Based upon this, it is the author’s view that the business income inclusion should be limited to the number of options that vest in a particular year. Upon vesting, the FMV of such options would then be included in the business income of the independent contractor in such year.
The determination of the FMV of a stock option is a question of fact. However, the CRA’s position is that the value of a stock option is the greater of:
- The trading value of the rights received; and
- The amount by which the FMV of the shares subject to the option at the time of the option’s distribution exceeds the exercise price provided in the option.[4]
Based upon the above valuation mechanism, the CRA has accepted that where there is no market for the options and the exercise price is equal to or greater than the FMV of the shares at the time of the grant, then there is no benefit.[5] The CRA seemed to accept that this could be accomplished by ensuring that the stock option plan only granted stock options at times when the exercise price was above the FMV of the shares:
It is possible that no amount would have been included in Corporation’s income when the options were issued. Indeed, it is possible that the FMV of these options at the time of issue was zero, taking into account the restriction in the plan that states that the exercise price may not be below the FMV of common shares at the time of issue.[6]
There may be an additional taxable event at the time the stock options are exercised. The CRA’s position is that, at the time of exercise, the independent contractor will be required to include in its income the difference between (i) the FMV of the shares at the time they are acquired, less the aggregate of (ii) the exercise price paid for the shares and (ii) the FMV of the stock option included in taxable business income at the time of the grant.[7] It is a question of fact whether this incremental value should be recognized as business income or a capital gain.[8] However, the CRA has noted that if the incremental value represents part of the consideration received for services rendered, then it should be included as taxable business income unless it can somehow be shown that the independent contractor was holding the option as capital property.[9] The CRA has also drawn a distinction between options granted for services previously rendered and options granted for services to be rendered. In the former case, upon exercise of the option then subsection 49(3) will apply to deem the exercise of the option to not be a disposition of property and the cost of the option will be added to the adjusted cost base of the shares acquired.[10]
It is arguable that where a portion of the stock options does not vest until a later date, that part of the consideration being granted to the independent contractor is for the rendering of future services. The CRA has noted that in these circumstances, it may take the view that the difference between the FMV of the shares and the exercise price at the time of exercise, or a portion thereof, is consideration received for such services rendered and included in taxable business income.[11] On the other hand, if the stock options expire without being exercised, the independent contractor may take a deduction for the amount previously included in their income.[12]
In summary, the ITA does not provide for a comprehensive set of rules on the tax treatment of stock options granted to independent contractors. Rather, the tax treatment has been established by a series of CRA positions and technical interpretations. The CRA has cautioned that the tax treatment of stock options granted to independent contractors is dependent upon the particular facts of the situation. As such, while the above provides a general overview and analysis of the application of the ITA, jurisprudence and the CRA’s positions, further analysis would be required to ensure proper tax treatment in relation to a particular fact pattern.
Should you have any questions or concerns, please feel free to reach out to a member of Miller Thomson’s Corporate Tax group.
[1] Section 7(5).
[2] See CRA Views, TI, 2000-0006935 – Stock options – employees and contracts. See also CRA Views, TI, 1999-0013915 – Stock options to independent contractors and CRA Views, TI, 2003-0054581E5 – Stock option for independent contractors.
[3] See Robertson v. The Queen, [1990] 1 C.T.C. 114 (Federal Court of Appeal) and Lockwood Financial Ltd. v. The Queen, 2020 TCC 128.
[4] See CRA Views, TI, 1999-0013915 – Stock options to independent contractors. See also IT-96R6 – Options Granted by Corporations to Acquire Shares, Bonds, or Debentures and by Trusts to Acquire Trust Units at para. 3.
[5] See CRA Views, TI, 2002-0151247 – Stock options issued to non-employees.
[6] See CRA Views, Interpretation, 2013-0513221I7-T – Stock options at Footnote 1.
[7] See CRA Views, TI, 1999-0013915 – Stock options to independent contractors.
[8] See CRA Views, TI, 2000-0032675 – Stock options granted independent contractors.
[9] See CRA Views, TI, 2003-0054581E5 – Stock option for independent contractors. See also CRA Views, Conference, 2004-0087041C6.
[10] See CRA Views, TI, 2002-0151247 – Stock options issued to non-employees.
[11] See CRA Views, TI, 2002-0151247 – Stock options issued to non-employees.
[12] See CRA Views, TI, 1999-0013915 – Stock options to independent contractors.
