Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 67-41

1967-1 C.B. 98

Sec. 425

IRS Headnote

Where the original terms of a qualified stock option provide that it is exercisable by the optionee only while in the employ of the grantor corporation, a change in the terms of the option to permit exercise while in the employ of a subsidiary corporation is a `modification' within the meaning of section 425(h) of the Internal Revenue Code of 1954.

Revenue Ruling 58-324, C.B. 1958-1, 214 clarified, and Revenue Ruling 59-68, C.B. 1959-1, 95, distinguished.

Full Text

Rev. Rul. 67-41

Advice has been requested whether a change in the terms of an employee stock option in the manner described below is a `modification' within the meaning of section 425(h) of the Internal Revenue Code of 1954.

X corporation granted qualified stock options to its employees at a time when it had no subsidiaries and contemplated no change in its corporate structure. The terms of each option included a provision that the option would expire upon termination of the optionee's employment with X .

After the date of grant, but prior to expiration of the options, X acquired several subsidiary corporations pursuant to a plan of expansion and diversification. The plan contemplated that some of X's employees would terminate their employment with X to become employees of the subsidiary corporations. X amended the terms of all the options previously granted to permit exercise by the optionees while employed by X or any one of its subsidiary corporations.

With certain exceptions not controlling here, section 425(h)(3) of the Code defines the term `modification' as any change in the terms of an option which gives the employee additional benefits under the option. For example, a change which provides more favorable terms for the payment for the stock purchased under the option is a modification. (See section 1.425-1(e)(5)(i) of the Income Tax Regulations.)

In the instant case, the amendment of the options granted by X to permit exercise of the options by the optionees while in the employ of a subsidiary corporation gave the optionees additional benefits because it gave them the right to exercise the options in a particular circumstance where the right previously did not exist. Consequently, this amendment is a `modification' within the meaning of section 425(h)(3) of the Code.

The facts in this case are distinguishable from those in Revenue Ruling 58-324, C.B. 1958-1, 214, which holds that an optionee who exercised his option while employed by a corporation which had become a subsidiary of the grantor corporation after the date of grant qualified for the treatment provided in section 421 of the Code. In that case, the terms of the option permitted exercise by an optionee while in the employ of a subsidiary corporation regardless of whether the subsidiary was created or acquired subsequent to the granting of the options.

Revenue Ruling 59-68, C.B. 1959-1, 95, holds that the employment relationship existing by reason of the particular agreement described in that case is not considered as having been terminated when the employee is directed by his employer to serve as an officer of an affiliated corporation. In effect, that holding gives recognition to the continuing employment of the optionee by the grantor corporation according to the terms of an agreement under which the grantor corporation continued to pay the optionee a salary and retained the right to direct and control his actions. The issue in the instant case is distinguishable in that it relates to the effect of the granting of an additional benefit to the optionee rather than to the question whether there is a continuing employment relationship under the terms of the option when granted.

Although the amendment of the terms of the options in the instant case is a `modification' within the meaning of section 425(h)(3) of the Code, it should be noted that section 425(h)(3)(A) of the Code provides that the term `modification' shall not include a change in the terms of the option attributable to the issuance or assumption of an option under section 425(a) of the Code.

Section 425(a) of the Code provides in part that the term `issuing or assuming a stock option in a transaction to which section 425(a) applies' means a substitution of a new option for the old option, or an assumption of the old option by an employer corporation, or a parent or subsidiary of such corporation, by reason of a corporate merger, consolidation, acquisition of property or stock, separation, reorganization, or liquidation, if (1) the excess of the aggregate fair market value of the shares subject to the option immediately after the substitution or assumption over the aggregate option price of such shares is not more than the excess of the aggregate fair market value of all shares subject to the option immediately before such substitution or assumption over the aggregate option price of such shares, and (2) the new option or the assumption of the old option does not give the employee additional benefits which he did not have under the old option.

Thus, if the subsidiary in the instant case assumed the options of X or substituted its own options and the conditions of section 425(a) of the Code and section 1.425-1 of the regulations were otherwise met, a change in the terms of the option solely to qualify under section 425(a) of the Code would not be a `modification' as defined by section 425(h)(3) of the Code. However, the change in the terms of the options in the instant case was not attributable to an issuance or assumption of a stock option under section 425(a) of the Code.

Accordingly, for the reasons indicated above, where the original terms of a qualified stock option provide that it is exercisable by the optionee only while in the employ of the grantor corporation, a change in the terms of the option to permit exercise while in the employ of a subsidiary corporation is a `modification' within the meaning of section 425(h)(3) of the Code.

Revenue Ruling 58-324, C.B. 1958-1, 214, is hereby clarified, and Revenue Ruling 59-68, C.B. 1959-1, 95, is hereby distinguished.