Options are the part of a private company’s capital structure nobody looks at until the letter of intent is signed. Then they surface at once: a key employee with a one-page grant from six years ago, a plan that never contemplated a sale, and a benefit Income Tax Act section 7 treats as employment income, not a capital gain. What follows covers the parts of section 7 a private Canadian sale actually meets; the section is considerably longer.
Key takeaways
SECTION 01 OF 09
Subsection 7(1) applies “where a particular qualifying person has agreed to sell or issue securities… to an employee”. Subsection 7(7) keeps it narrow: a qualifying person is “a corporation or a mutual fund trust”; a security of a corporation is “a share of the capital stock of the corporation”.
Two subsections wall it off. Under 7(3)(a) the employee is deemed “to have neither received nor enjoyed any benefit under or because of the agreement” except as the section provides; under 7(5) it “does not apply if the benefit… was not received in respect of… the employment”.
Paragraph 7(1)(a) taxes exercise: the securities’ value when acquired, less what was paid for them and for the right. Paragraph (b) taxes a disposition of the rights at arm’s length; (b.1) the same where they go back to the employer. And 7(4) keeps ex-employees in, applying “as though the person were still an employee”.
SECTION 02 OF 09
Subsection 7(1.1) applies where a Canadian-controlled private corporation agreed to issue a share to an employee dealing at arm’s length with it “at the time immediately after the agreement was made”. The mechanism is one read-in: “the taxation year in which the employee acquired the securities” becomes the year “the employee disposed of or exchanged the securities”.
The amount is unchanged, measured at exercise; only the year moves. Treadstone Law’s CCPC explainer gives the reason: without it “an employee could owe tax on paper gains from shares they can’t yet convert to cash”. That page covers the idea but cites neither 7(1.1) nor 110(1)(d.1).
The CRA’s withholding table follows suit: on a non-cash CCPC benefit the employer withholds no income tax, no CPP and no EI. Nothing happens until a disposition — which is why nobody has thought about it in years.
SECTION 03 OF 09
A share sale disposes of the shares, so for anyone holding shares acquired under 7(1.1) the closing is the event the deferral waited for. Treadstone Law on timing: the benefit “can be deferred until the year you actually dispose of the shares”. The whole spread, measured back at exercise, is income of the year of sale.
Where options were never exercised and are simply bought out, the character is the same. That payment, Treadstone Law notes on a buyout before exercise, “is generally treated as employment income at that point”. The CRA names the same pattern: rights disposed of “as part of a transaction that results in an ownership change in the corporation”.
Hence the pain: the holder expected a capital gain with an exemption in reach, and what arrives is employment income on a T4 in a year their rate is already at the top. Only growth after acquisition is a gain, because paragraph 53(1)(j) adds the section 7 benefit to their cost base.
SECTION 04 OF 09
Paragraph 110(1)(d) allows “1/2 of the amount of the benefit deemed by subsection 7(1) to have been received”. A 2024 proposal would have cut it and (d.1) to one third; the CRA records that “On March 21, 2025, the Government of Canada announced that they will not proceed with the proposed change.”
The conditions are cumulative: the exercise price “not less than” fair market value “at the time the agreement was made”; arm’s-length dealing immediately after it was made; and a prescribed share. Treadstone Law lists the same three.
Paragraph 110(1)(d.1) is the CCPC-only alternative, and the trap. It requires that the taxpayer “has not disposed of the share… or exchanged the share within two years after the date the taxpayer acquired it”. Exercise at the closing table, sell the same day, and it is gone — leaving everything to how the grant was priced.
SECTION 05 OF 09
Regulation 6204 defines the prescribed share and tests it “at the time of its sale or issue” — at exercise, not at grant. The holder must not be able to “cause the share to be redeemed, acquired or cancelled”, and the corporation must have no right to reacquire it other than “for an amount that approximates the fair market value”.
Ordinary private-company drafting offends both. A put right for a departing employee, a buy-back at a fixed multiple of earnings, a capped dividend entitlement — each routine, each able to take the share outside 6204 and the deduction with it.
The relief in 6204(2)(c) is narrow: it ignores the redemption right where the holder is at arm’s length and the purpose is loss protection at cost, or “to provide the holder with a market for the share” at fair market value — but withdraws it where the price is “directly determinable by reference to the profits”. A buy-back at six times EBITDA fails.
SECTION 06 OF 09
Treadstone Law’s article on options in a business sale names the four routes — “Acceleration, cash-out, rollover, and cancellation” — with cash-out holders paid “the deal price less the exercise price”. It is good on mechanics and leaves tax alone: no section 7, no deferral, no deduction.
The tax turns on an election most parties have never heard of. Subsection 110(1.1) grants the deduction on a cash-out only where the company “elects in prescribed form” that neither it nor a non-arm’s-length person will deduct the payment. The CRA: “Either you or your employee can claim a deduction, not both.” It is reported using Code 86.
Then payroll, a closing-day cash item. A cash-out is cash, so on the CRA’s table income tax, CPP and EI are all withheld — unlike a non-cash CCPC benefit. Treadstone Law on withholding confirms the duty to treat the benefit “like other employment income”, but covers neither the CCPC exception nor CPP and EI. Somebody funds and remits it; the agreement should say who.
SECTION 07 OF 09
Subsection 7(1.4) can make an exchange a non-event. The holder must receive “no consideration… other than rights under an agreement” with a designated person — a list including a qualifying person not at arm’s length with the issuer immediately after the disposition, and any “corporation formed on the amalgamation or merger…”.
Paragraph (c) is what gets breached: the new option may not be further in the money than the old was immediately before. Sweeten it with a lower strike or extra shares and the rollover fails and the whole spread is income. Where it holds, the new option “is deemed to be the same option as, and a continuation of, the exchanged option” — and 110(1)(d)(iii) then tests it against the original agreement, so a defective grant is not cured by a clean rollover, nor a good one spoiled by it.
SECTION 08 OF 09
Where employees exercised long ago and hold real shares, 7(1.5) does the same job for a share-for-share exchange: if the only consideration is new securities of the issuer, a non-arm’s-length person or an amalgamated corporation, and their value does not exceed the old, the new are “the same securities as, and a continuation of” the old. Take cash and it ends.
Cancellation falls under 7(1.7): where rights cease to be exercisable and the holder is paid, the taxpayer “is deemed to have disposed of those rights… and to have received the particular amounts as consideration”. Payment for a cancelled option is a section 7 benefit whatever it is called. The CRA’s untaxed mirror case is a merger leaving no corporation to exercise against and no replacement options.
A plan that was never an option plan sits outside all of it. With no agreement to issue securities, the CRA’s position is that “section 7 does not apply” and the employee “is not eligible for any security options deductions”; Treadstone Law agrees: “Because no shares change hands, phantom stock and SAR payouts generally don’t qualify for the special stock option deduction.”
SECTION 09 OF 09
None of it is discretionary at closing. The pricing test was settled at grant, the prescribed-share question by the share terms and the shareholders’ agreement, and the two-year clock has run or it has not. By the time the buyer asks for the option register, every variable deciding whether the holder keeps half the benefit or none is already history.
What remains open is narrow and worth real money: cash-out, rollover or cancellation; whether the company makes the 110(1.1) election or keeps the deduction; who funds the withholding and employer CPP and EI. The buyer inherits it: on a promise the seller made, “In a share purchase, generally yes… is your responsibility going forward”, while an asset purchase does not carry it unless assumed.
Section 7 is longer than this page: it also carries identical-property ordering rules, an emigrant rule, trustee rules and a death rule, and subsections 7(8) to (15) were repealed by S.C. 2010, c. 25, s. 3. The $200,000 vesting limit in 110(1.31) is outside a private sale by design: it bites only on a “specified person”, which under 110(0.1) “is not a Canadian-controlled private corporation” and has revenue “in excess of $500 million”. Treadstone Law agrees genuine CCPCs “are generally excluded from this cap altogether”. Where there is no plan at all, only an old letter, the outcome “depends entirely on your option plan and the deal’s change-of-control terms.”
At the sale itself. The CCPC deferral under subsection 7(1.1) moves the income inclusion to the year the employee disposes of the shares, so a share sale is that disposition, and years of accumulated benefit land as employment income in a single year, on a T4.
No, not on the option benefit itself. Section 7(3)(a) taxes the spread as employment income, not a capital gain, so it does not qualify for the capital gains exemption; only growth in value after the shares are acquired is treated as a capital gain.
Only if strict conditions are met. Under subsection 7(1.4), the rollover is a non-event only if the employee receives no other consideration and the new option is no further in the money than the old one was; sweetening the new grant breaks the rollover and makes the whole spread taxable.
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