Unlike some recent budgets, the 2010 Canadian federal budget (Budget 2010) contains scores of tax measures, including some that may impact tech companies. Two highlights include significant changes to the employee stock option rules and measures to streamline the Section 116 withholding and reporting regime. The latter proposal will come as welcome news to venture capitalists and other investors from outside Canada who have invested or are looking to invest in Canadian tech companies. While one of the employee stock option proposals is relieving in nature, the others may come as an unpleasant surprise for certain tech companies with employee stock option plans.
Employee Stock Options
Stock Option Cash-Outs
When an employee exercises an employee stock option, the positive difference between the fair market value of the share at that time and the sum of the option strike price and the cost of the option is treated as a taxable employment benefit. Where certain conditions are met, the employee is entitled to a deduction from income equal to half the benefit (the stock option deduction). This effectively results in the taxation of the benefit at capital gains rates.
If shares are issued when an employee exercises an option, the employer generally cannot claim a deduction from income in respect of the issuance of the shares. However, currently, where the employee elects to receive cash instead of shares, the employer is normally able to deduct the amount of the cash payment and the employee can claim the stock option deduction.
Budget 2010 proposes to eliminate the ability for both the employer and employee to claim deductions on a "cash-out." The employee will only be entitled to the stock option deduction if his or her employer makes an election to forego the deduction for its cash payment.
Tax Deferral Election
A stock option benefit is usually triggered at the time the options are exercised. Currently, where certain conditions are met, an employee holding options of a publicly traded company can elect to defer the recognition of the stock option benefit until he or she disposes of the shares. Budget 2010 proposes to repeal the tax deferral election in respect of publicly traded shares.
The deferral rule in respect of employee stock options granted by Canadian-controlled private corporations (CCPCs) is unaffected by Budget 2010.
Budget 2010 proposes to clarify withholding requirements to ensure that the employer remits the tax in respect of the employment benefit when an employee stock option is exercised. Where the stock option deduction is available, it will be taken into account in computing the amount required to be remitted. Budget 2010 also proposes that the fact that the employment benefit arose on the acquisition of shares not be considered a basis on which the Canada Revenue Agency (CRA) may administratively reduce the required remittance. These changes to remittance requirements will apply to shares issued after 2010 to give employers time to change their compensation arrangements and payroll withholding systems.
Special Relief for Past Tax Deferral Elections
Some employees who took advantage of the tax deferral election have experienced financial difficulties where the shares have declined in value. In some cases, the value of the shares is less than the deferred tax liability.
Budget 2010 proposes to introduce an election that would generally create a deduction sufficient to offset the previously recognized taxable employment benefit and would instead subject the individual to a special tax. The election is intended to ensure that the tax liability does not exceed the proceeds of disposition of the shares.
Streamlining the Section 116 Withholding and Reporting Regime
Subject to the provisions of an applicable tax treaty, Canada taxes non-residents on their gains from the disposition of "taxable Canadian property." The purchaser of such property is generally obliged to withhold and remit part of the purchase price unless the vendor obtains a Section 116 clearance certificate from the CRA.
Historically, all unlisted shares of Canadian corporations were subject to these Section 116 withholding and reporting obligations. In certain circumstances, listed shares and shares of non-Canadian corporations were also subject to that regime. Recent proposals in 2009 alleviated these obligations to a degree. Generally, Budget 2010 should now relieve those obligations entirely for non-resident investors, except where the shares (or equity interests) derive their value principally from Canadian real property, Canadian resource property, or timber resource property at any time in the 60-month period prior to the relevant disposition, or where certain deeming rules are applicable. This proposal will come as welcome news to non-residents who have invested, or are looking to invest, in Canadian tech companies.
For a more detailed discussion of Budget 2010, read our firm's federal budget commentary.
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