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2026-11-03

Montminy, 2017 FCA 156: employees who exercised options and sold the shares the same day still qualified for the stock option deduction

2017 FCA 156 · Federal Court of Appeal

Provisions

ITA s. 110ITA s. 7

Text

Author: Sas Tullo

This is an income tax appeal about the 50 per cent deduction for employee stock option benefits. Seven employees of a private company exercised options they had held for six years and sold the shares to the employer’s parent company the same day, under an obligation to redeem negotiated weeks earlier. The Tax Court denied the deduction because the employees had never borne the risk of holding shares. The Federal Court of Appeal allowed the appeals: the regulation defining a prescribed share directs that such an obligation be ignored, and the employees had borne an investor’s risk while they held the options. Anyone with an option plan in a private company will want to know where the risk requirement sits.

Facts

In December 2001, 9178-4488 Québec Inc., known as Cybectec, a Canadian-controlled private corporation, granted stock options to the appellants; the plan allowed exercise only on a public offering or a sale of all of Cybectec’s shares (para 6). In 2007 Cybectec received an unsolicited offer from Cooper Industries (Electrical) Inc. for the bulk of its assets, and on January 10, 2007 the plan was amended to make such a sale a trigger for exercise; at the same time the appellants committed to sell their shares and Cybectec undertook to ensure that its parent company would redeem them on issuance (para 7). Cooper acquired the assets on January 26, 2007; two days later the appellants were issued shares at the 20 cent exercise price and sold them the same day to the parent company for $1.2583 per share (para 8). They claimed the deduction under paragraph 110(1)(d) of the Income Tax Act on the resulting benefit (para 9), and the Minister disallowed it on the ground that they had not incurred the necessary risk (para 10).

The Tax Court judge, D’Auray J., held that the shares were not prescribed shares because paragraph 6204(1)(b) of the Income Tax Regulations applies where the share can reasonably be expected to be redeemed within two years, and the appellants knew on issuance that redemption would follow the same day (para 12). She accepted that the obligation to redeem existed to provide a market for the shares, so that the exception in paragraph 6204(2)(c) applied to subparagraph 6204(1)(a)(iv), but held that the exception did not reach paragraph 6204(1)(b) for want of a logical connection (paras 13-14, 31), reasoning that employees incur no risk until they exercise their options (para 15). Her finding that the 20 cent exercise price equalled fair market value at grant was not challenged on appeal (para 17).

Issues

The question was whether the obligation to redeem could ground a reasonable expectation of redemption under paragraph 6204(1)(b) despite the direction in paragraph 6204(2)(c) that such an obligation be disregarded (para 34), together with the appellants’ point that the Tax Court had overlooked the risk they bore while holding the options (para 2).

Holding

The appeals were allowed with costs in the lead appeal, and the seven assessments were remitted to the Minister for reassessment on the basis that the appellants were entitled to the deduction for 2007 (para 62). Paragraph 6204(1)(b), like subparagraph 6204(1)(a)(iv), must be applied without reference to the obligation to redeem (para 60), and the risk requirement is met through the characteristics of a prescribed share and the minimum exercise price, not through a holding period (para 56).

The court’s reasoning

Noël C.J., writing for a unanimous panel, characterized the question as one of statutory interpretation reviewable for correctness under Housen v. Nikolaisen, 2002 SCC 33 (para 34), and applied the textual, contextual, and purposive approach from Canada Trustco Mortgage Co. v. Canada, 2005 SCC 54 (para 35).

On the text, the Court held that the Tax Court’s reading contradicted paragraph 6204(2)(c), which applies “[f]or the purposes of subsection 6204” and requires that the determination be made “without reference to [an] obligation to redeem” (para 39). The Tax Court had not considered the connection that runs from paragraph 6204(2)(c) through subparagraph 6204(1)(a)(iv) to paragraph 6204(1)(b) if the latter is an anti-avoidance provision protecting that subparagraph, which its wording shows it to be (paras 40-41). Read that way, the two provisions complement one another, and the words of paragraph 6204(2)(c) cannot be ignored (paras 42-43).

On context, the Court accepted that employees must bear some risk and that option plans must not become disguised salary, but held that the Tax Court erred in deriving a two-year holding period from paragraph 6204(1)(b) and in neglecting the risk the appellants bore from 2001 to 2007 while holding their options (paras 44-46). Paragraph 110(1)(d.1) applies only to CCPC shares and secures risk through a two-year holding period after acquisition (para 48). Paragraph 110(1)(d) addresses risk through the share and the exercise price: the share must be a “plain vanilla” common share under paragraph 6204(1)(a), and the exercise price must be at least the fair market value of the share when the option is granted (paras 49, 52). Because the Cybectec options were granted at fair market value, their growth from 20 cents to $1.2583 was attributable solely to the growth of the company, placing the appellants in the same position as an investor (para 53), and they could have claimed the deduction by selling their options to Cybectec under clause 110(1)(d)(i)(B) or the shares to Cooper under subsection 6204(3) (para 55). The Court concluded that “it is not the imposition of an holding period that ensures the existence of a risk element, but the particular characteristics of a prescribed share and the minimum price at which the option must be exercised” (para 56).

The two-year reference in paragraph 6204(1)(b) was explained as a time limit on an anti-avoidance rule that extends subparagraph 6204(1)(a)(iv) to informal or unenforceable redemption arrangements (paras 58-59). Since the two provisions share one objective, both are subject to paragraph 6204(2)(c), and because subparagraph 6204(1)(a)(iv) was not avoided, paragraph 6204(1)(b) could not be used to deny the deduction (paras 60-61).

Practical implications

The decision settles that a redemption right or obligation that meets the conditions of paragraph 6204(2)(c) is disregarded for every part of subsection 6204(1), including the reasonable expectation test. A private company that arranges a liquidity event for employee shareholders on a sale of the business does not, by that arrangement alone, forfeit the deduction for its employees, even where the shares are issued and sold on the same day.

In my view, the more durable contribution of the reasons is the distinction between paragraphs 110(1)(d) and 110(1)(d.1): the Court locates the investor’s risk in the period during which the option is held at a fair market value strike, not in a period of share ownership. The Minister did not respond to the appellants’ arguments (para 30), so the reasons say little about cases where the exercise price is below value or the redemption arrangement serves another purpose.

Paragraph 110(1)(d) has been amended since the decision: the consolidated text on the Justice Laws website, current to September 30, 2026, lists amendments in 2017, 2018, 2021, and 2026, and the paragraph now excludes “non-qualified securities”, while the deduction remains one half of the benefit. Section 6204 of the Regulations has also been amended, most recently by SOR/2024-231, but the wording of paragraphs 6204(1)(b) and 6204(2)(c) considered by the Court remains. Whether an appeal was taken is not verified here.

For employees and advisers, the takeaway is that the paragraph 110(1)(d) deduction depends on the terms of the option and the nature of the share, not on how long the shares are held after exercise. Where a buyer or parent company is to acquire the shares immediately on exercise, the documents should record that the arrangement exists to provide a market for the shares, and the grant-date exercise price should be supportable as fair market value.

This comment is general information, not legal advice. The law may have changed since the decision; check the current text in the tax wiki.

Montminy v. Canada, 2017 FCA 156, judgment dated July 14, 2017, Noël C.J., Scott J.A., and Boivin J.A.; reasons by Noël C.J. (Federal Court of Appeal, lead docket A-180-16, with dockets A-181-16 to A-186-16; English translation of French reasons; the court’s site notes a correction made on April 16, 2018). Reasons on the Federal Court of Appeal’s site. Also on CanLII. The decision under appeal is Montminy v. The Queen, 2016 TCC 110, whose facts and reasoning are set out in the appeal reasons at paragraphs 6 to 17 and 31 to 33 and are summarized above from that source.