Copyright 2010, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Tax/Pension & Employee Benefits, October 2010
On August 27, 2010, the Department of Finance released draft legislative proposals for the Income Tax Act (Canada) (the ITA). Related Explanatory Notes were made available on September 10, 2010 and additional draft legislative proposals, addressing many of the same provisions of the ITA as the August 27 proposals, were released on September 28, 2010. If enacted, many of these proposals will take effect as of 4:00 p.m., Eastern Standard Time, March 4, 2010 (the Announcement Time). For a discussion of the stock option amendments as announced earlier this year, please see our March 2010 Blakes Bulletin: Canadian Federal Budget Announces Changes to Employee Stock Option Rules.
These legislative proposals include significant tax changes with respect to employee stock options. These proposed tax changes mean that some corporations and mutual fund trusts that provide employee security options (generally referred to in this bulletin as "stock options") may need to amend existing option plans and/ or grant agreements before December 31, 2010. These tax changes were first announced in the March 4, 2010 Federal Budget (the Budget) and include:
- the requirement, commencing in 2011, for the withholding and remittance of tax in respect of an employment benefit realized by an employee exercising a public company stock option;
- the requirement that on a cash-out of a stock option right, the employer must elect to forego a tax deduction of the cash-out amount for the employee to be subject to capital gains equivalent tax rates in respect of the cash-out amount; and
- the repeal of the election which allowed employees exercising public company stock options to defer including an amount in income until the shares were sold.
Grantors of stock options should review their option plans and grant agreements to determine whether amendments should be made prior to 2011 in light of the proposed changes to the ITA. If a grantor of options determines that amendments to its stock option plan or grant agreements are advisable, it should review the amending and other provisions of its plan or grant agreements, as the case may be, and the requirements of any stock exchange on which its securities are listed. Of particular concern for public companies is that, in certain circumstances, board and/or securityholder approval may be required to effect the amendments. The timeline for obtaining such required approvals should be considered in light of the changes to the ITA becoming effective as of January 1, 2011.
MANDATORY WITHHOLDING ON STOCK OPTION EXERCISE
Under the ITA, an employee stock option is generally taxable to the optionholder at the time the option is exercised. When an employee exercises the option, there is a deemed employment benefit equal to the in-the-money value of the exercised option (essentially the difference between the exercise price paid by the employee and the fair market value of the shares at the time of exercise). Provided certain conditions are met, the employee can claim a 50% deduction against the amount of the deemed employment benefit, effectively resulting in the stock option benefit being taxed at capital gains rates.
The proposed amendments include significant changes to the rules relating to the obligation of a person providing a stock option benefit to withhold and remit tax in connection with the exercise of stock options after 2010. Under the proposed changes, a person conferring a stock option benefit on an employee will be required to make withholdings from the employee's remuneration determined on the hypothetical basis that the deemed employment benefit that arises as a consequence of the exercise of the options is paid to the employee as a cash bonus. The person conferring the option benefit may be the direct employer of the option holder, but could also be a parent or affiliate of the employer. For these purposes, if the 50% stock option deduction in paragraph 110(1)(d) is available, the amount of the benefit subject to withholding may be reduced by one-half. The proposed amendments to the ITA do not address what would happen if the amount of the employee's cash remuneration available to the person conferring the stock option benefit to withhold from was not sufficient to fund the withholding obligation. Moreover, as announced in the Budget, the proposed legislation expressly provides that in granting discretionary relief from withholding under subsection 153(1.1), the Canada Revenue Agency (the CRA) will not be entitled to waive a withholding requirement in respect of a deemed benefit under subsection 7(1) solely because it is received as a non-cash benefit.
The changes to the withholding requirements will not apply to stock options granted by Canadian-controlled private corporations, nor will they apply in connection with certain charitable donations of proceeds arising from the sale of securities acquired pursuant to an option. In addition, under transitional rules contained in the draft legislation, the new withholding requirements will not apply to "grandfathered" options granted before 2011 provided the options were granted pursuant to a written agreement that (i) was entered into before the Announcement Time, and (ii) included a written condition prohibiting disposition of shares acquired through the exercise of options, for a period of time after exercise. We note that the Budget proposals referred to an agreement that "restricts" not "prohibits" disposition. In addition, under the draft legislation, the relief from withholding appears to apply only if the prohibition on disposition is contained in the option agreement itself. This would seem to mean that provisions in other documents, such as corporate share ownership policies, employment agreements, lock-up agreements with underwriters, etc., that could prohibit or restrict the sale of shares acquired under an option would not result in the application of the grandfathered tax withholding treatment.
Implications for Employers and Employees – Employers Need to Consider How Withholding will be Funded
Commencing in 2011, corporations and mutual fund trusts that provide employee stock options will not be entitled to rely on various statements made by the CRA suggesting that withholding in respect of stock options may not be required or may be reduced. The proposals offer no guidance as to how to satisfy the withholding obligation. In practice, employees receiving large stock option benefits may have to immediately dispose of shares in order to pay the tax. However, this may not be viable where the shares are not publicly traded.
Corporations and mutual fund trusts that grant options will need to review their current withholding arrangements for stock options and their stock option plans and grant agreements to determine if provision is made for funding of the withholding requirements.
Changes to stock option plans and related documents that may be advisable include provisions requiring an employee who is exercising an option to:
- remit sufficient cash to the person conferring the option benefit to fund the withholding obligation;
- elect to have a portion of the shares that are acquired by the employee on the exercise of the stock option deposited with a broker who is directed to sell the shares on behalf of the employee and remit sufficient proceeds to the person conferring the option benefit to fund the withholding obligation; or
- make other acceptable arrangements to fund the withholding obligation.
Where employees will have the ability to elect to deposit shares with a broker to be sold, it may also be advisable for the stock option plan or related documents to include details regarding the process by which any shares will be sold and the obligations of the parties involved, including provisions relating to the timing and price of any sale and protections for the person conferring the option benefit and possibly the broker in the event of a delay or other complication in selling the shares.
If a grantor of employee stock options determines that amendments to its option plan or grant agreements are advisable, it should review the amending and other provisions of its plan and/or grant agreements and the requirements of any stock exchange on which its securities are listed. In certain circumstances, board and/or securityholder approval may be required to effect the amendments. The timeline for obtaining such required approvals should be considered in light of the changes to the ITA becoming effective as of January 1, 2011.
If an employee elects to sell a portion of the shares acquired on the exercise of a stock option and the employee also owns other shares, the employee should consider whether to make an election under subsection 7(1.31). Where this election is available, making the election will ensure that it is the share acquired on the exercise of the stock option that is considered to be sold (rather than another share owned by the employee) and that the adjusted cost base (ACB) of the share that is sold is not averaged with the ACB of any other shares owned by the employee, as averaging could result in a reduced ACB and an unintended capital gain from the sale of the shares.
STOCK OPTION CASH-OUT RIGHTS
A number of employee stock option plans provide cash-out rights (also sometimes referred to as "tandem stock appreciation rights" or "tandem SARs") whereby the employee can elect either to exercise the option in the ordinary course and receive the shares or receive a cash payment equal to the in-the-money amount of the option. The 50% deduction (capital gains rate taxation) is also generally available where the employee exercises the cash-out right provided the option itself qualifies for the 50% deduction. Historically, the CRA took the position that an employer generally could claim a deduction for the full amount of the cash payment paid to an employee upon exercise of a cash-out right even if the employee qualified for the above-noted 50% deduction, although it is understood that the availability of the employer deduction in the context of certain corporate transactions is unclear.
Under the proposed amendments, the employee will be denied the 50% employee stock option deduction unless the employer elects, in prescribed form, to forego a deduction in respect of the cash-out payment. In effect, either the employee can claim the 50% deduction or the employer can claim a deduction on the cash-out payment, but not both. This measure will immediately and retroactively apply to all options exercised (or cash-out rights exercised) after the Announcement Time, regardless of the date the underlying option was granted. In order for the employee to claim the 50% deduction, the employer's election to forego a deduction must be filed with the CRA by the employer, evidence in writing of this election must be given to the employee, and this evidence must be included by the employee with his or her income tax return for the year in which he or she claims the deduction. In addition, the election must apply to all of the employee's options under a particular option agreement, although not necessarily under all option agreements with a particular employer. While the draft legislation refers to the election being in "prescribed form", to date no guidance has been provided by the Department of Finance or the CRA as to what that prescribed form will be.
Provision is made for a "designated amount", to be carved out of the amount that the employer elects to forego deducting. A designated amount will, in general, be an amount paid to a third party to hedge the employer's liability with respect to the stock option cash‑out. Specifically, it is an amount that would:
- otherwise be deductible in computing the income of the employer in the absence of proposed subsection 110(1.1);
- be payable to a person with whom the employer deals at arm's length, who is neither an employee of the employer (nor of a person not dealing at arm's length with the employer); and
- be in respect of an arrangement entered into for the purpose of managing the employer's financial risk associated with a potential increase in value of the securities under the stock option agreement.
Implications for Employees and Employers
The inability of both employers and employees to take this previously enjoyed "double" deduction presents several immediate concerns.
First, employees will need to be aware that if they exercise a cash-out right, they may not qualify for the 50% deduction unless the employer elects to forego its deduction for the cash-out payment. Second, employers which provide stock options with cash-out rights will need to determine whether they are prepared to forego the deduction of the cash-out right, on some or all options, whether cash-out rights should be eliminated on some or all outstanding options and whether cashout rights should be provided with any new options. In the case of outstanding options, the employer may also wish to consider whether the cash-out right could be eliminated through an amendment or exchange of an existing option. If cash-out rights will continue to be included in a stock option plan and the employer might choose to forego a deduction of a cash-out amount to allow for preferential tax treatment to the employee, the stock option plan should be reviewed to ensure that the employer has the authority to make the required income tax elections and notifications. If there is any question on this matter, amending the stock option plan to specifically provide that the employer has the authority to make any elections permitted by the ITA would be prudent.
REPEAL OF DEFERRAL ELECTION FOR STOCK OPTIONS
Background and Tax Changes
The stock option rules under the ITA were amended in 2000 to permit an employee to defer inclusion in employment income of the stock option benefit relating to publicly traded shares until the year in which the employee sells the underlying shares. Similar to U.S. incentive stock options (ISOs), there are limits on the number of options and the options must meet certain criteria in order to qualify for the deferral election. This deferral election will be repealed with the result that the election will not be available for any stock option exercised after the Announcement Time.
The proposed amendments provide some relief to individuals who took advantage of the deferral election and find themselves in the situation where the tax payable by them exceeds the value of the shares. In brief, under proposed new Part I.1 – Tax In Respect Of Stock Option Benefit Deferral – an employee will be able to elect to pay a special tax equal to the full proceeds of disposition of such shares (two-thirds of the proceeds if the taxpayer is resident in Quebec) instead of the amount that would otherwise have been payable in connection with the exercise of the options. Should the employee elect to pay this tax, he or she will lose the capital loss resulting from the disposition (i.e., the employee will not be able to offset this loss against other capital gains). The special election is intended to apply to sales of optioned shares before 2015, including sales of optioned shares in previous years where a deferral election has been made. Where an employee wants to make the election for shares sold before 2010, the employee will be required to make the election on or before their filing due-date for the 2010 tax year.
Implications for Employees and Employers
The repeal of the deferral election, combined with the new withholding requirements, will create a greater incentive on the part of many employees to dispose of shares acquired through an exercise of the option in order to pay for the tax liability that arises from the exercise of the options. This could work against the objective of employers to promote minimum or target share ownership and in practice may be difficult where the shares are not publicly traded (or only thinly traded).
ADDITIONAL STOCK OPTION AMENDMENTS
The draft legislative proposals relating to stock options also clarify that the rules in subsection 7(1) apply in circumstances in which an employee disposes of rights under an agreement to sell or issue securities to the grantor of the options (or a qualifying person with whom the grantor does not deal at arm's length) and where a person with whom the employee does not deal at arm's length who has acquired the employee's rights under an option agreement disposes of those rights to a qualifying person with whom the person does not deal at arm's length.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.