Dealing with Stock Options in Corporate Acquisitions Navigating the Labyrinth

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1 Dealing with Stock Options in Corporate Acquisitions Navigating the Labyrinth Precis In a transaction involving the purchase and sale of shares of a corporation, there may be outstanding employee stock options held by Canadian employees of Target. Gloria Geddes examines different methods of dealing with options without triggering unexpected and negative tax consequences for these option holders. She notes that it is generally in the best interests of all parties to safeguard the most beneficial tax treatment possible for the holders in dealing with their options. It is often the case that the option holders will continue to be employed in senior management positions by Target or by a corporation resulting from a post-closing business combination with Target. Preserving favourable tax treatment for option holders may be key to the future employment relationship with these individuals. Achieving the best tax result requires an understanding of the complex income tax rules applicable to stock options and the existing stock option plan and agreements, and the effect of the terms of the purchase and sale transaction on the tax treatment of those options. Introduction In general, there are four ways that in-the-money options 1 of a corporation that is being acquired ( Target ) may be dealt with in a manner that does not trigger adverse tax consequences for the Canadian option holders: (1) the options may be surrendered by the holders in consideration for a payment from Target that is equal to the difference between the exercise price and the share purchase price. This may be accomplished without a loss of favourable stock option tax treatment, provided that the conditions of paragraph 110(1)(d) of the Income Tax Act 2, and proposed subsection 110(1.1) 3 are satisfied; (2) the options may be exercised and the shares acquired tendered by the holder to the offer of the purchaser; (3) if the intention is that Target will continue to exist after the acquisition, the options may survive the transaction and continue under the existing option plan or be exchanged for new options of Target on a tax-deferred rollover basis under subsection 7(1.4) of the Act; or 1 The term in-the-money option refers to an option having an exercise price that is less than the value of the underlying share at that time. 2 R.S.C. 1985, c. 1 (5 th Supplement), as amended, hereinafter referred to as the Act. Unless otherwise stated, statutory references in this article are to the Act. 3 See Government of Canada release August 27, 2010: Draft Legislation re: Budget Proposals and Other Previously Announced Income Tax Measures ( hereinafter referred to as the Tax Proposals )

2 (4) the options may be exchanged under subsection 7(1.4) for new options of the purchaser corporation on a tax-deferred rollover basis. As discussed below, the most tax effective method will depend upon the circumstances. The treatment of the option holders of Target needs to be carefully considered well in advance of the closing date of the acquisition. When left until the eleventh hour, the closing of the transaction may be delayed and patchwork solutions to deal with the options may trigger adverse tax consequences for the option holders. Options With a Fair Market Value Exercise Price Most stock option plans of Canadian public corporations and many private corporations are structured to satisfy the conditions in paragraph 110(1)(d). If these conditions are met, the option holder (the Holder ) is allowed a deduction of one-half of the amount of the employment benefit arising under section 7(1)(a) at the time of exercising the option and acquiring the underlying shares (the One-half Deduction ). In addition to the requirement in paragraph 110(1)(d) that the exercise price must not be less than the fair market value of the underlying share on the date the option is granted, the underlying shares must be prescribed shares at the time the option is exercised (or surrendered). To be a prescribed share, a number of conditions set out in section 6204 of the Income Tax Regulations ( Regulation 6204 ) must be met at the time of exercise (or surrender) of an employee stock option. Certain of these prescribed share requirements can be problematic and must be carefully considered in the context of an acquisition of Target, as further discussed below. Exercise or Surrender of Options A stock option plan may provide for the acceleration of the vesting 4 of outstanding options immediately before a change of control or an offer by a third party purchaser (the Purchaser ) to acquire the outstanding shares of Target. Consequently, the Holders are in a position to exercise their options and acquire shares of Target that will be sold to the Purchaser. If a Holder holds a large number of options with a significant exercise price, it may be difficult for the Holder to come up with the cash to pay the exercise price. In these circumstances, the parties may want to consider: (1) a cash-out of the options, where the Holder is paid the difference between the exercise price and the value of the underlying shares in cash; (2) a disposition of the options where the Holder is paid the difference between the exercise price and the value of the underlying shares in kind with shares of Target; or (3) a form of cashless exercise, where the Holder is advanced an amount by the Purchaser equal to (a) the exercise price; and (b) the tax and any other source deductions that must be withheld and remitted by Target from the taxable benefit to the Holder on the exercise of the options. The amount advanced by the Purchaser is delivered directly to Target on behalf of the Holder. On the purchase of the shares by the Purchaser from the Holder, the amount that was advanced to the Holder is settled by way of offset against the proceeds of sale of those shares. 4 Vesting, as it applies to employee stock options, is not a defined term for purposes of the Act. It generally happens at the time the holder of the option has an unconditional right to exercise that option and acquire shares. Vesting may be time based (e.g. over a three year period) or performance based (e.g. upon the achievement of specified targets).

3 Whichever method is used, care must be taken, as discussed below, to ensure that it does not adversely impact any existing entitlement to the One-half Deduction. Cash-Out of Options In general, the One-half Deduction will be available under paragraph 110(1)(d) on a cash-out of options provided that: (i) the Holder deals at arm s length with Target; (ii) the shares would have been prescribed shares if they had been issued at the time the employee disposes of the options; (iii) the exercise price of the options is not less than the fair market value of the shares at the time the option was granted; and (iv) Target files a prescribed election under proposed subsection 110(1.1) as described in more detail below. Some stock option plans and agreements include tandem stock appreciation rights ( Tandem SARs ) that permit a Holder to exercise the Tandem SAR, surrender the related option, and receive a cash payment in lieu of exercising the option and acquiring shares. Prior to March 4, 2010, if the One-half Deduction was available on the exercise of the option, it would also generally be available in respect of the benefit realized on the surrender and disposition of the option in consideration for a cash payment. Proposed subsection 110(1.1) of the Act provides that, effective from March 4, 2010, the One-half Deduction from the benefit realized by an employee on a disposition of the stock option will only be available if the employer files a prescribed election in respect of all of the options granted to the employee under the relevant stock option agreement. Under the election, the employer will state that neither the employer (nor any person who does not deal at arm s length with the employer) will deduct the cash payment received by the employee as consideration for the disposition of those options. Proposed subsection 110(1.1) does not specify a time for the filing of the election. However, evidence of the election must be provided to the employee and filed by the employee with his or her tax return for the year in order for the employee to benefit from the One-half Deduction. This has the effect of imposing a time limit. As a practical matter the election will be filed by the employer before the T4 slips are issued to the employees for the year. In that way, written evidence of the filing of the employer election can be delivered by the employer to the Holder together with the T4 slip reporting the benefit. Until such time as there is a prescribed election form, the current practice is for the parties to a corporate acquisition transaction involving a cash-out of options, to agree that Target will advise Canada Revenue Agency ( CRA ) in writing of the intention to make the election, and to further agree that the prescribed form of the election will be filed by or on behalf of Target when it becomes available. For dispositions of options that occur at a time after the election form has been prescribed, Target may prepare the election and file it with CRA before the time of the disposition of the options. If the stock option plan and related option agreements do not provide for Tandem SARs, the question arises as to whether the One-half Deduction is preserved on a unilateral cancellation by Target of the outstanding options for consideration. It has become standard practice to amend option agreements in the context of a take-over bid to provide for a right of Holders to voluntarily surrender options for a cash payment. The practice stems from statements of CRA in IT-113R 5 that, if the employer has the right to pay cash instead of shares, the employer has not agreed to sell or issue shares for purposes of section 7 and the cash payment is employment income for which there is no One-half Deduction. If, on the other hand, the employee has the right to choose cash or shares, CRA considers that paragraph 7(1)(b) will apply and the Onehalf Deduction in paragraph 110(1)(d) will be available, provided the conditions of that provision 5 Interpretation Bulletin IT-113R Benefits to Employees Stock Options, dated August 7, 1996.

4 are otherwise met. Another purpose in amending stock option agreements to add voluntary rights of surrender of options, has been to support a claim by Target for a deduction for the cash payment. 6 However, for cash payments made after March 4, 2010, the One-half Deduction will not be available to Holders, if Target claims such a deduction. Based on recent case law, a deduction may not be available to Target in any event. 7 Based on the case law and subsection 7(1.7) of the Act (which was added after IT-113R was published), it does not appear to be necessary to amend stock option agreements to provide for surrender rights in order to preserve the One-half Deduction for Holders. In Dundas v. Minister of National Revenue, 8 the Federal Court of Appeal found that, at the time the terms of the amalgamation were being negotiated, Mr. Dundas, the president of Canadian Reserve Oil and Gas Ltd. ( Canadian Reserve ) and other senior officers, had agreed to accept payments for the cancellation of options in accordance with a formula set out in the amalgamation agreement. The Court held that Mr. Dundas had disposed of his rights under his option agreements and that payment he received was taxable under paragraph 7(1)(b). In Buccinni v. The Queen, 9 Mr. Buccinni was an employee of Canadian Reserve, but unlike Mr. Dundas, he did not take part in the settlement negotiations and did not consent to the termination of his options in accordance with the amalgamation agreement. The Federal Court of Appeal found that there was a unilateral repudiation of Mr. Buccinni s rights and he could not be found to have later disposed of those same rights under section 7(1)(b) when his claims for damages were settled. In those circumstances, the Court held that the payment was damages for a breach of contract of employment and was not taxable. Subsection 7(1.7) was introduced to overrule the decision in the Buccinni case. As amended in the Tax Proposals, it provides that, for purposes of subsection 7(1) and 110(1)(d), a Holder will be deemed to dispose of options, if the Holder receives amounts in respect of options ceasing to be exercisable, and the cessation would not otherwise constitute a transfer or disposition of those options. As long as the stock option agreement provides for the sale or issue of shares by Target on the exercise of stock options, the unilateral cancellation of the options so that they cease to be exercisable should not cause the cash payment to the Holders to fall outside of the rules in section 7. Amounts received by the Holder will be taxable under paragraph 7(1)(b) and the One-half Deduction under paragraph 110(1)(d) should be available, provided that the other conditions of paragraph 110(1)(d) are satisfied and the election in proposed subsection 110(1.1) is filed in respect of the cash payment received by the Holder as consideration for the cancellation of those options. 6 In The Queen v. Kaiser Petroleum Ltd, [1990] 2 C.T.C. 439 #2 (F.C.A.), the Federal Court of Appeal held that, in the context of a take-over offer, a cash payment by Target company to option holders on the cancellation of its stock option plan was not deductible because there was a direct impact on the capital structure of Target corporation. A subsequent decision in Imperial Tobacco Canada Ltd. v. The Queen (sub nom. Shoppers Drug Mart Limited v. The Queen), [2008] 1 C.T.C (T.C.C.), dealt with a payment by Shoppers Drug Mart ( Shoppers ) to its parent, Imasco. The payment was made to reimburse Imasco for its cost of cashing out Imasco stock options held by employees of Shoppers, in the context of a reorganization of capital of Imasco. Mr. Justice Bowman held that the payment was deductible by Shoppers, noting that there was no change to Shopper s capital structure. Another significant distinction from Kaiser Petroleum was a provision in Imasco s stock option plan that the corporation could offer an option holder a right to elect to surrender an option, at the option holder s discretion, and receive a cash payment 7 In a recent case that arose out of the same going private transaction, Imperial Tobacco Canada Limited v. The Queen, heard October 20, 2009 [2010 TCC 648], the cash payment for the surrender of options was made to employees of Imasco. Mr. Justice Bowie concluded that he was bound to apply the decision in Kaiser Petroleum and deny the deduction for the cash payment made to the Imasco employees. He stated that the sole distinction from Kaiser made by Mr. Justice Bowman in the Shoppers Drug Mart case was that the reshaping of the structure was that of Imasco, not Shoppers. Mr. Justice Bowie held that that distinction did not exist in the case before him and, the cash payments to the employees of Imasco on the surrender of options were not deductible by Imasco. 8 [1990] 2 C.T.C (TCC)l aff d [1993] 1 C.T.C. 398 (F.C.T.D.); affi d [1995] 1 C.T.C. 184 (FCA). 9 [2001] 1 C.T.C. 103 (Federal Court of Appeal).

5 Disposition of Options for an In Kind Payment in Shares The tax treatment for the Holder should be the same, whether the payment on the disposition of options under paragraph 7(1)(b) is paid in cash or is paid in kind with issued shares having a total value equal to the amount of the spread between the exercise price and the fair market value of the shares that would have been acquired on the exercise of those options. The Onehalf Deduction under paragraph 110(1)(d) should be available, provided that the other conditions of paragraph 110(1)(d) are satisfied. 10 In these circumstances, the better view is that an election under proposed subsection 110(1.1) is not required, even though the shares are acquired on the disposition of the options rather than under the agreement pursuant to which the options were granted. No deduction will be available to Target in respect of the issuance of the shares, in any event. However, at this point in time there is no interpretation by a court or CRA on this point. Exercise of Options and Tendering Acquired Shares to the Offer A cashless exercise that preserves the One-half Deduction may be accomplished by arranging for the Purchaser to make an advance to the Holder equal to the exercise price and the withholding tax payable on the benefit realized at the time of exercise. The Purchaser will pay those amounts to Target, on behalf of the Holder. Target then issues the shares to the Holder and remits the tax to the Receiver General. On closing, the Purchaser will purchase the shares from the Holder and the amounts advanced by the Purchaser to the Holder to fund the exercise price and the withholding tax will be repaid by way of offset against the proceeds of sale to the Holder. Withholding Tax on the Disposition or Exercise of Options There is no exemption from withholding tax for stock option benefits. In general, tax is withheld and remitted in respect of the net benefit realized for Canadian tax purposes on the exercise of the options (taking into account the One-half Deduction). Withholding from a cash payment on the cash-out of options is relatively straightforward. Since it is not possible to withhold from an issuance of shares (unless the shares are sold on the market on the employee s behalf to generate the amount of required withholding tax) there must be a mechanism for funding the withholding tax. CRA s published administrative position has been to encourage employers to withhold from other remuneration to the extent possible without imposing hardship on the employee. It has also been CRA s administrative position that, where there is no cash remuneration, withholding is not required. This policy was applied when a non-resident parent corporation granted options to employees of its Canadian subsidiary, no other remuneration was paid by the parent corporation to the employees, and the Canadian subsidiary did not reimburse the parent corporation in respect of the stock option benefits. 10 If instead of a disposition of the options and a payment in kind, Target agrees to a form of net exercise where the original exercise price is effectively reduced to nil and fewer shares are issued, the Holder will generally lose the entitlement to the One-half Deduction under paragraph 110(1)(d). Although the economic result would effectively be the same as on a disposition of the options and a payment in kind described above, the legal form of a transaction or arrangement will govern its tax treatment under Canada s tax laws. The Holder may be considered to have paid zero exercise price - not an exercise price equal the fair market value of the shares on the date the options were granted.

6 Amendments to section 153 under the Tax Proposals effective for the 2011 and subsequent years override CRA s administrative positions. Withholding tax must be remitted on the amount of the stock option benefit realized on the exercise or disposition of options to the same extent as if the amount had been paid in money as a bonus (taking into account the One-half Deduction, where it is available). 11 If there is a disposition of options for a payment in kind of shares equal to the spread, consideration could be given to a partial cash payment by Target equal to the amount of the withholding tax requirement. This amount would be retained and remitted by Target to satisfy its withholding and remittance tax requirements. If a partial cash payment is made, the election in proposed 110(1.1) will need to be filed to preserve the One-half Deduction. Any arrangement involving a repurchase by Target of shares issued on the exercise of options to cover the withholding tax obligations should be avoided as it will generally cause the Holder to lose the entitlement to the One-half Deduction and may also result in a deemed dividend for the Holder. In the past, a common practice has been to withhold on the net benefit at the top marginal rate for the province of residence of the Holder. As a result of the amendments to section 153 under the Tax Proposals, the net benefit is deemed to be received as a bonus. The withholding rates for bonuses are determined by a formula that is set out in subsection 103(2) of the Income Tax Regulations. Prescribed Share Issues on the Exercise or Disposition of Options Traps for the Unwary In order for the One-half Deduction to be available on either: (a) the exercise of an option and acquisition of the underlying share; or (b) the disposition of an option for a payment in cash or in kind ; at the time of such exercise or surrender the underlying share must be a prescribed share. Section 6204 of the Income Tax Regulations ( Regulation 6204 ) sets out the prescribed share rules. There are a number of these rules, most of which are aimed at ensuring that the underlying shares are ordinary plain vanilla common shares. However, in the context of a corporate acquisition, it is easy to inadvertently and unintentionally fall offside of these rules, resulting in the loss of the One-half Deduction for the Holders. Issues with Dividend Lock-ups In the context of a corporate acquisition, the parties may agree that the directors of Target will be prohibited from declaring or paying any dividends prior to closing. This prohibition gives rise to a concern with Regulation 6204(1)(a)(i), which requires that the amount of dividends that the corporation may declare or pay on the share cannot, under any agreement in respect of the share or its issue be limited to a maximum amount. Arguments may be made that the purchase and sale agreement is not in respect of the shares and, as a matter of corporate law, does not override the articles of the corporation that provide for dividend rights. However, there is no certainty that these arguments would prevail. In a 2005 technical interpretation, CRA 11 These new remittance measures do not apply to an amount to which subsection 7(1.1) of the ITA applies. Subsection 7(1.1) applies where options to acquire shares of a Canadian-controlled private corporation are granted to arm s length employees. The benefit in respect of the acquisition of the shares is not deemed to be received until the year the employee disposes of or exchanges the acquired shares. The new withholding and remittance measures do not apply at the time these shares are acquired or at the subsequent time when they are sold.

7 considered the application of this rule to a loan agreement that contained a covenant that the corporation may not declare a dividend of greater than 50% of cumulative net income. In those circumstances, CRA was the view that the share in question was a share on which the dividend limitation was imposed; the loan agreement would be an agreement in respect of the share for purposes of Regulation 6204(1)(a)(i); and the share would not be a prescribed share. 12 To avoid putting Holders at risk of losing the One-half Deduction, the alternative is to provide in such an agreement that no dividends may be declared and paid by the board of directors of Target without the consent of the Purchaser. In this way, unexpected dividends will not be paid and Regulation 6204(1)(a)(i) should not apply to deny the One-half Deduction to the Holders on the exercise or surrender of their options. Purchaser cannot be a Specified Person Regulation 6204(1)(a)(iv) precludes a share from being a prescribed share where the holder can cause a specified person in relation to Target to acquire the share. Regulation 6204(1)(b) precludes a share from being a prescribed share where there is a reasonable expectation that a specified person will acquire the share within two years from the date of its issue. When options are exercised (or cancelled for consideration) in the context of an acquisition of the shares of Target, these prescribed share rules will result in the loss of the One-half Deduction for the Holders, unless steps are taken to ensure that, at the time of the exercise or cancellation, the Purchaser is not a specified person. For these purposes, a specified person is defined in Regulation 6204(3) in relation to Target, and means:..any person or partnership with whom Target does not deal at arm s length otherwise than because of a right referred to in paragraph 251(5)(b) of the Act 13 that arises as a result of an offer by the person or partnership to acquire all or substantially all of the shares of the capital stock of Target. Consequently, a Purchaser who has made an offer to acquire 90% or more of the shares of Target will not be a specified person until such time as the Purchaser has acquired sufficient voting shares to control Target (i.e., has taken up more than 50% of the voting shares). Timing of Exercise or Disposition of Options In order to preserve the One-half Deduction, the options must be exercised or cashed-out before the Purchaser acquires an actual controlling interest in Target and becomes a specified person. This may occur on the actual date of closing, as long as it occurs at a point in time before the Purchaser owns more than 50% of the voting shares. Offer to Purchase All or Substantially All of the Shares If the corporate acquisition does not constitute an offer by the Purchaser, then Regulation 6204(3) does not provide relief and the Purchaser will be a specified person as soon as the 12 CRA Views, Interpretation external E5 Regulation 6204, Date: March 7, Paragraph 251(5)(b) deems a person who has a right to acquire the share of a corporation to own the share for purposes of determining whether that person is related and deals at arm s length with the corporation. Regulation 6204(3) provides that this deeming rule will not apply for purposes of the prescribed share rules, provided that the person is making an offer to acquire all or substantially all of the shares of the corporation. However, once a person acquires an actual controlling interest (more than 50% of the voting shares), that person will have legal control by virtue of actual ownership and will be a specified person at that time, regardless of paragraph 251(5)(b) of the Act.

8 share purchase agreement is signed. If a Holder exercises options and acquires shares or disposes of the options for a cash payment, at any time when the Purchaser is a specified person, the One-half Deduction will not be available to the Holder and he or she will pay tax on the full amount of the benefit realized on the exercise or surrender of the options. There is no apparent tax policy reason why Holders should be denied the One-half Deduction, where the form of the transaction (or series of transactions) does not, strictly speaking, constitute a contractual offer by the Purchaser to acquire shares of Target. In a 2006 ruling, 14 CRA considered a proposed plan of arrangement effecting in the sequence indicated, the cancellation of the options of Target for cash; and the acquisition by the Purchaser of 100% of Target shares. Although a plan of arrangement is not technically an offer, CRA ruled that, at the time the options were cashed out, the Purchaser was not a specified person pursuant to Regulation 6204(3). The other requirement of Regulation 6204(3) is that the offer is to acquire all or substantially all of the shares of Target. Generally the phrase all or substantially all is interpreted as 90 percent or more. If the Purchaser purchases something less than 90 percent of the shares of Target, for example only 51% of the voting shares, or purchases 100% of the voting shares but none of the preferred shares of Target, relief will not be available under Regulation 6204(3). There may be a concern if the Purchaser already owns more than 10 percent of the shares of Target and less than a controlling interest. In these circumstances, a reasonable interpretation of all or substantially all is one that would apply the 90 percent test to those shares not already owned by the Purchaser. In cases where there is uncertainty regarding whether or not the tests in Regulation 6204(3) will be met, and the preservation of the One-half Deduction is important, consideration should be given to providing that: (i) the options survive post-transaction; or (ii) are exchanged on a rollover basis under subsection 7(1.4) for options of the Purchaser. Exchange of Options If the terms of the existing stock option agreements of Target are fundamentally changed or the existing options of Target are exchanged for new options of another entity, and subsection 7(1.4) does not apply to that exchange, there will be a disposition of the existing options by a Holder for purposes of paragraph 7(1)(b) for consideration equal to the fair market value of the new options (less the amount, if any, paid by the Holder for the old options). CRA has expressed the view that the excess of the value of the new option received over the old option, while included in income in accordance with paragraph 7(1)(b), will not be added to the new option s cost. 15 CRA s view was that the cost of the new options for purposes of any subsequent application of section 7 and paragraph 110(1)(d), is equal to the value of the old options at the time of the exchange. Consequently, a portion of the benefit already included in income and taxed on the exchange of the options may be taxed again on the subsequent exercise or surrender of the new option. CRA considered that it is not clear that the provisions of 248(28) of the Act would apply to prevent such double counting. Where the conditions of subsection 7(1.4) are satisfied, there is no disposition of the old options for purposes of section 7 of the Act. The new options are deemed to be the same options and a continuation of the old options. If the new options are issued by the Purchaser, the Purchaser 14 CRA Views, Ruling R3 Prescribed shares/plan of arrangement, date See CRA Views, Tech Interp Exchange of employee stock options, dated January 21, 1998.

9 will be deemed to be the same person, and a continuation of the person (Target) that grants the old exchanged options. This is particularly helpful where Target is a Canadian-controlled private corporation (a CCPC ) and the old options were eligible for the deferral in subsection 7(1.1) as discussed below. Section 7(1.4) and Canadian-Controlled Private Corporations ( CCPCs ) If Target is a CCPC, tax on the benefit that arises on the exercise of an option to acquire shares of the CCPC is deferred pursuant to subsection 7(1.1) until the sale or other disposition of the share. The benefit subject to tax is equal to the difference between the exercise price and the value of the CCPC share at the time the share was acquired. To the extent the share value has increased after it was acquired, the increase in value will be taxed as a capital gain when the shares are sold. If the share has decreased in value a capital loss will be realized on the disposition of the share. Regardless of whether or not the exercise price is equal to the fair market value at the date of grant and the other conditions of the One-half Deduction in 110(1)(d) are satisfied, if the employee holds the share for at least two years, only one-half of that benefit will be subject to tax at the time of the sale of the share, pursuant to paragraph 110(1)(d.1). On a corporate acquisition of a CCPC, an employee with unexercised in-the-money options will not be able to defer the payment of tax on the exercise and acquisition of shares that are immediately sold to the Purchaser. In addition, there will be no deduction under paragraph 110(1)(d.1) and the full amount of the benefit will be taxed, unless the conditions of the Onehalf Deduction under paragraph 110(1)(d) are satisfied. In these circumstances, it will generally be in the best interests of the employee holding CCPC options to exchange those options on a rollover basis under subsection 7(1.4) for new options to acquire shares of the Purchaser. The deferral of tax until disposition of the shares and the benefit of paragraph 110(1)(d.1) will continue to be available in respect of the new options, even though the Purchaser is not a CCPC. Conditions of Subsection 7(1.4) The conditions of subsection 7(1.4) on an exchange of options in the context of a corporate acquisition are generally as follows: (a) (b) (c) the Holder must receive no consideration for the old options other than the new options; the new options must be granted under an agreement with: (i) Target corporation that issued the old options; (ii) a corporation with which Target corporation does not deal at arm s length immediately after the exchange (which generally includes the Purchaser); or (iii) a corporation formed on the amalgamation or merger of Target and one or more other corporations; and the amount by which (i) the total value of the shares underlying the new options immediately after the exchange exceeds the total exercise price of such new options (the pre-exchange option value ), cannot exceed (ii) the amount by which the total value of the shares underlying the old options immediately before the exchange exceeds the total exercise price of the old options (the post-exchange option value ).

10 The no consideration other than the new options test will not be met if there is a cash payment or any other economic advantage provided to a Holder in addition to the new options. An issue may arise as to whether there is consideration in addition to the new options, if the terms of the stock option agreement under which the new options are granted are more favourable than the terms of the agreement governing the old options. The test in (b) above is not based on the actual value of the options, it is based on a comparison of the spread between the value of the underlying shares and the exercise price before and after the exchange. If the options of Target are exchanged for options of the Purchaser, the number of new options and their exercise price can be determined by a mathematical exchange ratio formula using the offer price for the shares of Target. However, an issue may arise if the exchange ratio for options is set at the date the share purchase agreement is signed, but the value of shares of the Purchaser increases prior to the closing date. To avoid the risk of not complying with this test, the terms of the option exchange should provide for an adjustment of the option exchange ratio to the extent necessary to ensure that the post-exchange option value does not exceed the pre-exchange option value. Conclusion In a transaction involving the acquisition of a corporation, it is generally to the benefit of all parties to deal with outstanding stock options in a manner that preserves the most favourable tax treatment for the option holders and is appropriate to the structure of the overall transaction. There is no one-size fits all solution. Unexpected issues can and do arise, particularly in navigating the labyrinth of the prescribed share rules. Understanding these issues early in the negotiations may be vital to dealing with them in an appropriate manner.