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With the global economic crisis still in the news, executive
compensation remains a hot topic of discussion. Many corporations
spend more than necessary to deliver net incentive dollars to their
executives. At the same time, these organizations often tie up tens
of millions of dollars more than necessary in hedging equity-based
compensation obligations.
Currently, share unit plans are designed in such a way that all
income eventually paid to participants (whether in respect of value
existing at the time of grant or that which accrues as a result of
post-grant increases in share price) is taxed at regular employment
income rates. This applies to restricted share units (RSUs),
performance share units (PSUs), deferred share units (DSUs) or
combinations thereof. In Ontario, for example, this would generally
translate into taxation at the top marginal rate of 46.21%. There
is a design modification available, a hybrid approach (hybrid) that
reduces the tax rate in respect of increases in the unit value to
half that of current levels1.
The benefit of this increase in tax efficiency can deliver
substantial cash savings to the corporation without reducing the
net payout under the plan to the executives. It can also deliver a
greater net benefit at a reduced cash cost. Furthermore, if the
plan obligation is hedged, as many are, this results in the ability
to release up to 30% of assets held in the hedge pool. With
broader-based plans, this can mean the release of tens of millions
of dollars into working capital or debt retirement.
All of this can be accomplished without modifying the existing
incentive structure, corporate tax deductibility or accounting
treatment while delivering the same or a greater net benefit to the
plan participants.
The hybrid involves two features:
Capping all share units at today's depressed share values
(the payout value of a capped share unit can only reflect any
decrease in the value of the underlying share)
Pairing a percentage of those capped share units (CSUs) with
tandem stock options2, designed to be eligible for the
50% deduction under the Income Tax Act (Canada).
This results in the entire benefit of all post-grant share price
increases being captured within the tandem options rather than the
share units, thereby reducing the tax rate in respect of that
portion of the incentive compensation to half of what it would have
otherwise been.
Conclusion
The increase in the use of share units as a key element of
executive and senior management incentive compensation, coupled
with current depressed share prices, gives rise to an excellent
opportunity to significantly reduce the cost of paying and hedging
share unit plan obligations. Such plans can be amended to use
hybrids that reduce the tax rate applicable to post-amendment share
unit value increases to half of what it would otherwise be with
much or all of the benefit of that increased tax efficiency
benefiting the corporation and its shareholders by way of decreased
cash costs and increased working capital.
Footnotes
1. In all provinces other than Quebec. The tax rate in
respect of the Quebec portion of the taxes would be reduced by
25%
2. A tandem option is a regular option paired with a
cash-settled share appreciation right, which effectively offers the
option holder the choice of exercising the option or accepting a
cash payment equal to the intrinsic or "in-the-money"
value of the option. Both forms of settlement are eligible for the
50% deduction allowed to the option holder in respect of the
benefit under the Income Tax Act (Canada). If the option
holder elects to receive the cash settlement, as is commonly the
case, the cash payout is tax deductible to the corporation when
made. From an accounting perspective, tandem options are treated as
a cash liability, as are cash-settled share units, thereby
resulting in the same accounting treatment in this respect as would
have been the case had the cash-settled share units in their prior
form not been modified.
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.
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