Are employee stock options taxed in a buyout before they are exercised?

Whether a buyout triggers tax on stock options depends on what the deal does with them. Section 7 of the Income Tax Act lists when the employment benefit is treated as received. A grant is not one of those moments. Acquiring the securities is one, and so is transferring or otherwise disposing of the rights, the category a cash-out at closing generally falls into.

When the benefit is treated as received

Under paragraph 7(1)(a), an employee who acquires securities under the agreement is treated as receiving, because of employment, the amount by which the securities’ value then exceeds what the employee paid for them and for the right to acquire them. The benefit falls in the taxation year of the acquisition, so exercising before closing creates it in that year, subject to the private-company rule below.

A cash-out is a disposition of the rights

Paragraph 7(1)(b) treats a transfer or other disposition of the rights to a person the employee was dealing with at arm’s length as a benefit in the year it happens, and paragraph 7(1)(b.1) does the same for a disposition to the company that made the agreement, or a qualifying person not at arm’s length with it, when the employee was not dealing with it at arm’s length. Either way the benefit is the value of the consideration for the disposition, less anything the employee paid to acquire the rights. The Act’s definition of disposition includes any transaction or event entitling a taxpayer to proceeds of disposition, so a cash payment for giving up unexercised options generally fits.

When the tax can be deferred or reduced

For shares of a Canadian-controlled private corporation, subsection 7(1.1) can move the taxable year from the year of acquisition to the year the employee disposes of or exchanges the shares, if the employee dealt at arm’s length with the corporations involved immediately after the agreement was made. Subsection 7(1.4) can treat an exchange of old options for new ones as no disposition, where the only consideration is rights under an agreement with the same company or another person the subsection lists, and the new option does not widen the gap between value and price. Paragraph 110(1)(d) allows a deduction in defined cases.

Withholding is a separate question

Subsection 153(1.01) treats the benefit as remuneration paid as a bonus for withholding purposes, with exceptions. Who withholds when options are cashed out covers the payer. The CRA says a business being sold must close its payroll account if it has employees, and its remittance guidance includes a final remittance when a business is changing.