Cannabis and tech employees beware: Stock options can lead to massive tax bill if shares go south
In a decision released this week, the Federal Court of Appeal ruled that an executive who exercised employee stock options only to see the price of the underlying stock subsequently plummet, was not entitled to a remission of the tax owing on his stock-option employment benefit. The decision sends a strong message to employees, especially in the tech and cannabis sectors where stock-option awards are common and share prices are volatile, that if they choose to exercise their options and hold on to the shares, the tax man, and the courts, will have little sympathy should things go south.
Before reviewing the facts of the recent case, here’s a brief refresher on the employee stock-option rules. Under the current rules, if an employee exercises an employee stock option, the difference between the fair market value of the shares at the time the option is exercised and the exercise price is treated as a taxable employment benefit. In most cases, the employee is then entitled to the “stock-option deduction,” which is equal to 50 per cent of the employment benefit. The net result of the deduction is that stock-option benefits generally get taxed at beneficial capital gains-like tax rates but are still considered to be employment income.
This is an important distinction because it can lead to a mismatch problem later on for an employee who exercises her options, acquires the shares and then sells them at loss. This loss, equal to the difference between the sale price and price of the shares on the date of option exercise multiplied by the number of shares sold, is considered to be a “capital loss,” which can only be used against capital gains.
The mismatch of capital loss vs. employment income has caused tax problems in the past for various tech employees in the early 2000s. The situation became so bad for some employees of B.C.-based SDL Optics, Inc. (later acquired by JDS Uniphase, now Vivai Solutions) that the government granted remission orders in 2007 and 2008, forgiving both the income taxes and arrears interest of 45 former employees of the company that arose from participation in the company’s stock-purchase plan.
So, what exactly is a remission order? In its internal guide, the Canada Revenue Agency describes a remission order as “an extraordinary measure that allows the government to provide full or partial relief from a tax or penalty, or other debt, under certain circumstances, when such relief is not otherwise available under the existing laws.” Each remission request is considered “on its own merits to determine whether collection of the tax or enforcement of the penalty is unreasonable or unjust, or if remission is in the public interest.” To assist CRA officials in making that assessment, guidelines have been developed as to when remission may be granted. These include cases of extreme hardship, incorrect action or advice on the part of CRA officials, financial setback coupled with extenuating factors, or unintended results of the legislation.
If the CRA denies your request for a remission order, you can apply for a judicial review of its decision by the Federal Court of Canada. If that appeal is unsuccessful, the matter can be further appealed to the Federal Court of Appeal.
And that’s where our recent case landed. The taxpayer is an Alberta executive who was denied a remission order for the tax he owed after the shares he received upon exercising his employee stock options dropped in value.
In 2004, the taxpayer was granted employee stock options allowing him to purchase shares of his employer’s stock at a cost of $0.95 per share. On March 22, 2007, the taxpayer exercised his options and acquired the shares when the price was $13.70 per share. As a result of purchasing the shares at less than their fair market value, the taxpayer was required to pay tax on an employment benefit of $648,000.
Fast forward to 2011. The taxpayer sold his shares that year for $3.05 per share, realizing a capital loss of $419,250. The capital loss could not be used to offset the $648,000 employment benefit.
The taxpayer applied for a remission of the resulting income tax and arrears interest, arguing that he should be treated the same as the SDL employees who had received remission orders forgiving their tax and interest. The CRA refused the taxpayer’s remission request on the basis that his circumstances were not the same as those of the other taxpayers, since the SDL employees had participated in a stock-purchase plan rather than a stock-option plan and there were no extenuating circumstances that could warrant remission, as the taxpayer’s decision to purchase, hold and sell the shares were all decisions within his control.
In 2018, the lower Federal Court concluded that the government properly exercised its discretion not to issue a remission order. At the appellate court, the taxpayer argued that the CRA’s decision to deny a remission order was “unreasonable because the (taxpayer) was similarly situated to employees of SDL” and that the CRA’s decision to distinguish the two situations was “arbitrary and unreasonable.” The taxpayer “legitimately and reasonably expected that he would be provided the same process considerations as the successful SDL … employees.”
The appellate court disagreed, concluding that the two situations were not the same since a stock-option plan provides “greater flexibility to employees” than a stock-purchase plan. The taxpayer had the option “to purchase, or not purchase, shares at a designated price for a specified period of time regardless of shifts in market value during that period.”
In dismissing his appeal, the court wrote: “The (taxpayer) acquired the shares with knowledge that the related employee benefit was to be included as taxable income in that taxation year. The decisions to exercise the option to purchase the … shares and to hold those shares were within the (taxpayer’s) control.”