TO BE OR NOT TO BE..

TO BE OR NOT TO BE “INCOME”
In what mysterious way does a corporation share change from
a capital investment to a taxable “benefit” income and back again to a Capital Loss?

A commentary on the Canadian government policy of declaring
the same equity to be morphed from not income, to taxable income, to a capital loss.
By Ken Thompson and Ragui Kamel with editing support by K.H. and G.H. CFET Members.
August 2009

Canadian Business Magazine On-Line , current as of August 1 2009, carries an interesting article by journalist Larry MacDonald titled: “Caught in a tax nightmare.” The article with comments may be viewed at:
http://blog.canadianbusiness.com/caught-in-a-tax-nightmare/comment-page-1/#comment-32962

It is a report about a Mr. Roy, (not his real name), a retired manager in the soon to be defunct Nortel, who was a participant in a Nortel’s Employee Shares Option Plan (ESO). When the option agreement he was holding was about to expire he elected to receive the underlying shares. To do so, he used his own after-tax dollars to exercise the options at the strike price of those options

By exercising the options and keeping the shares, Mr. Roy had a deemed paper profit of $250,000 which his employer added to his T4 Income reporting document, as “Earned Income”, in the “Taxable Benefit” category.

Mr. Roy had not sold any shares and had not realized one cent of tangible benefit from the purchase of those shares. Regardless, he was levied taxes on the “Earned Income” at the capital gains inclusion rate for that year.

This action brought Mr. Roy’s total “income tax” to a level exceeding his real, gross salary, for the entire year, by a wide margin. As the ESO transaction had not provided any real hands-on income Mr. Roy applied for a tax deferment per the conditions and restrictions provided by Canada Revenue Agency (CRA) form T1212.

Now that Nortel is disappearing, CRA is deeming Mr. Roy to have disposed of those shares (which are now valueless) and will come calling for the tax on the $250,000 paper profit, a profit Mr. Roy never materially received. To pay this tax, Mr. Roy will have to cash his RRSPs and perhaps sell the family home.

The excuse for taxing Mr. Roy into financial ruin is based on the CRA rationale that Mr. Roy, at the moment of exercising the options under his ESO agreement, had in reality received a taxable benefit equal to the calculated “Fair Market Value” (FMV) of those shares less their “Adjusted Cost Base” (ACB).

Although this rationale may sound plausible in isolation, it is not factually reasonable, consistent or fair minded. It is not in accordance with tax policy applied to all other Canadians who buy, sell, or hold corporation shares acquired apart from an ESO or an Employee Shares Purchase Plan (ESPP).

Using long established Canadian tax policy relating to an ordinary honest, hard-working Canadian who invests, speculates and trades all kinds of shares, shares options and Investment Certificates let us follow a typical equivalent pair of options transaction, executed by Mr. Roy and a fictitious Canadian a Mr. Jones.

Two years back Mr. Roy and Mr. Jones each acquired the ability, via an options contract to purchase 10,000 shares of company X in 24 months time at a fixed shares purchase (strike) price. As option holders they each have the right to acquire the underlying Company X shares at the fixed price before the option contract is about to expire. Or, if there is no profit, in acquiring the stock then they can allow the options to expire.

The only difference between Mr. Roy and Mr. Jones is that Mr. Roy received his contract from his employer via an ESO agreement whereas Mr. Jones, for a modest fee, bought a 24 month leap option from his broker.


Eventually the great day arrives: The shares of Company X are now trading at a level that could give each of them a $250,000 gain. Both men decide to exercise their option agreements … and both men decide to hold onto the shares acquired through that exercise

However, when the time comes to report tax, there is one colossal difference between the two and this is where the unfair tax policy kicks in. Although he has not sold the shares, Mr. Roy is deemed to have made $250,000 profit as employment benefit whereas Mr. Jones, who also has not sold his shares is deemed not to have made any money.

A while later, due to deteriorating market conditions, the stock value of Company X is reduced to half of what it was and both Mr. Roy and Mr. Jones sell.

Mr. Jones transaction is classed as “Capital” trading and he is only levied a tax if he actually took home a real gain. In spite of the $250,000 paper gain he made when he exercised his Company X options, he only ends up paying tax on the real $125,000 he received. Further, that gain is offset by any other capital losses Mr. Jones made that year, conceivably, he could end up paying no tax at all.

Mr. Roy, on the other hand, is taxed on the “employment benefit” of the deemed $250,000 profit he theoretically had at the moment of exercise. Since, unlike Mr. Jones, his benefit is not treated as capital gain, this tax is applied regardless of the fact that, in the end, he only made $125,000 and regardless of whether, overall, Mr. Roy’s bottom line investment transactions produced a loss for the year.

In addition Mr. Roy’s one ESO transaction is isolated, by the CRA tax policy on ESPP and ESO trades, so that it is “employment benefit” and immune from consolidation with any other investment transactions Mr. Roy may have completed during the tax year.

The crux of the difference is that Mr. Roy’s shares are taxed as a “employment benefit” and even if the shares are later sold at a loss, the CRA policy prevents him from applying this “capital loss” on the same equities against the so-called “taxable benefit” he never actually realized.

Although both Mr. Roy and Mr. Jones made a paper gain of $250,000 at option exercise, only Mr. Roy’s is taxed on that paper gain, regardless of his bottom line investment dealings for the year.

Sound Fair and reasonable to you? Is there any justification for classing one of these $250,000 paper gains as “employment income” and not the other?

To be justifiable and fair they should both be treated alike, i.e. as “capital” gains and each taxed only on the bottom line profit, if any, at the end of the trading year.

The Honourable James Flaherty, Canada’s Minister of Finance, has declared, on several occasions, that Canada’s tax laws are “fair” because all investors are treated alike. Not so, Mr. Flaherty and when they are treated alike you will have come much closer fulfilling your commitment to “fair” taxation.

Until Canada’s defective taxable benefit legislation has been corrected, as the U.S. Government has done (Ref: www.reformAMT.org), to put an end to taxing this phantom income, Canadians are not getting the fair and justifiable taxation they were promised and to which they are entitled.

Contact your local federal Member of Parliament and inform them you demand this outrageous tax on phantom income be corrected. Canadians are not second class Americans and are entitled to the same fair treatment regarding the taxing of phantom income.

Ken Thompson and Ragui Kamel (CFET members)