Copyright 2010, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Pension & Employee Benefits, March 2010
The federal budget, announced on March 4, 2010, includes significant changes to the taxation of employee stock options. This bulletin primarily focuses on the proposed changes to the Income Tax Act (Canada) (the ITA) relating to employee stock options. Our March 2010 Blakes Bulletin on Tax: 2010 Federal Budget (http://tinyurl.com/yamcneh) reviews other key income tax proposals, including some significant changes to the previously proposed Non- Resident Trust (NRT) rules that will be of interest to sponsors and administrators of many deferred income plans and other tax-exempt entities. In particular, the proposed exemption from the NRT rules is being extended to all persons exempt from tax under section 149 of the ITA including registered pension plan trusts, elected master trusts and various tax-exempt pension corporations. It will be interesting to see whether the draft legislation also deals with taxable intermediaries including certain trusts in which the beneficiaries are all registered pension plans or other tax-exempt persons. Various letters provided by the Department of Finance (including, for example, the April 28, 2008 letter addressed to the Pension Investment Association of Canada) suggested that such entities might also be included in the general exclusion from the NRT rules.
The remainder of this bulletin addresses the proposals in the Budget relating to cash-out rights provided under employee stock options, the elimination of the stock option benefit deferral election and a tightening of the income tax withholding rules relating to the exercise of stock options. A number of these changes will have immediate effect (4 p.m. Eastern Standard Time on March 4, 2010) (the Announcement Time).
STOCK OPTION CASH-OUT RIGHTS
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.
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 to either 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. A number of advance tax rulings were issued by the Canada Revenue Agency (CRA), in which the CRA ruled that an employer could, as a general rule, claim a deduction for the full amount of the cash payment paid to an employee upon exercise by the employee of a cash-out right, although it is understood that the availability of such a deduction in the context of certain corporate transactions is unclear.
Under the Budget proposals, the employee will be denied the 50% employee stock option deduction unless the employer elects 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. Although not entirely clear in the Notice of Ways and Means Motion that accompanied the Budget, we have been advised by the Department of Finance that 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. The Budget indicates that the employer's election must be filed with CRA by the employer and evidence of the election must also be filed by the employee when the employee files his or her return claiming the 50% deduction. In addition, it appears that the election must apply to all of the employee's options under a particular option agreement, although possibly not under all option agreements with a particular employer.
This proposal 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 or whether cashout rights should be eliminated on outstanding options and not provided with new options. In the case of outstanding options, the employer will also need to consider whether the cash-out right could be eliminated through an amendment or conversion of an existing option.
REPEAL OF DEFERRAL ELECTION
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. The deferral election is to be repealed immediately with the result that the election will not be available for any stock option exercised after the Announcement Time.
According to the Department of Finance, one of the reasons for the repeal of the deferral election was to address the circumstance where an employee elected to defer taxation of the stock option benefit and continued to hold shares that dropped in value to the point where, for example, the value of the shares fell below the amount of the employee's tax liability resulting from the exercise of the options. The stock option employment benefit and corresponding tax is crystallized on the date of option exercise and any subsequent loss on the securities is, typically, a capital loss to the employee and cannot offset any portion of the stock option employment benefit. Some employees found themselves in a situation where the ultimate proceeds of disposition of the acquired securities were insufficient to pay the tax on the stock option employment benefit.
The Budget proposes to provide relief to individuals who took advantage of the deferral election and find themselves in that situation. In brief, under the proposal, 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. 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 2010 (typically April 30, 2011).
The repeal of the deferral election may create a greater incentive on the part of the employee to dispose of his or her shares acquired through the 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).
The Budget proposes changes to the rules relating to an employer's obligation to withhold and remit tax in connection with the exercise of stock options after 2010. The withholding rules are to be amended to require an employer 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. Employees who have options on publicly traded shares may be able to sell their shares immediately upon exercise to fund the tax withholding.
The proposals do not address what would happen if the amount of the employee's cash remuneration is not sufficient to fund the withholding obligation. Moreover, the proposals also stipulate that the Minister of National Revenue will not be entitled to consider the fact that the benefit arose as from the acquisition of shares as the basis for a discretionary reduction in withholdings. The changes to the withholding requirements will not apply to stock options granted by Canadian-controlled private corporations, nor do they 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) includes a written condition restricting disposition of shares acquired through exercise of the options. The proposals may require some employers to review their current withholding arrangements for stock options including reliance on various statements made by the Canada Revenue Agency suggesting that withholding against other remuneration might be reduced where withholding at ordinary rates would impose hardship or where the stock option is granted by a non-resident corporation and the employee receives no cash remuneration from the non-resident corporation that grants the stock option. Employers should review the terms of their stock option plans and grant agreements to determine if provision is made for funding of the withholding requirements.
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.