Is the buyer responsible for withholding tax when employee stock options are cashed out on a sale?

The rule

Paragraph 7(1)(b) covers exactly this transaction: where an employee “has transferred or otherwise disposed of rights under the agreement in respect of some or all of the securities to a person with whom the employee was dealing at arm's length,” a benefit equal to the payment received “shall be deemed to have been received… by the employee because of the employee's employment.” Because it is employment income, it comes with the ordinary consequences of a payroll payment, source deductions and remittance obligations, and it is a transaction expense of the target company, not a carve-out of the per-share merger consideration paid to shareholders.

When this changes

The mechanical consequence is that the option cash-out reduces equity value available to shareholders through the debt-free, cash-free purchase-price bridge, rather than being paid pro rata out of the headline per-share price the way it would be modelled if it were shareholder proceeds. Whether any individual employee can also claim the fifty-per-cent stock option deduction under s.110(1)(d)/(d.1), which would roughly halve their personal tax on the benefit, is a separate question with its own conditions, and does not change who withholds or when.

Where this played out — from the Case Files

• • The buyer treated the option cash-out as purchase price; the CRA treats it as employment income — the file this rule comes from: 240,000 vested options cashed out for $1,752,000 on a British Columbia software acquisition, modelled as shareholder proceeds and recharacterized as payroll

Sources

• • Income Tax Act, s.7(1)(b) — the change-of-control cash-out deemed to be employment income.
• • Treadstone Law — do I owe tax on stock options if my private company is bought out before I exercise them?.
• • Not verified here: s.110(1)(d)/(d.1) (the fifty-per-cent stock option deduction) and s.110(1.1) (employer election). No net after-tax figure for an employee is asserted; verify those conditions independently before relying on one.