The 2010 Federal Budget tightens stock option rules for companies and their employees by:
- removing employee choice to defer payment of tax on stock option benefits for publicly listed shares until those shares are sold;
- tightening employer obligations to withhold tax from employee cash remuneration when employees exercise options; and
- forcing employers to choose between the continuing favourable stock option treatment for employees on the cash-out of options and deductibility of cash payment as an expense for the employer.
While Budget 2010 purported to encourage growth in the Canadian economy with various incentives and programs, it also turned its sights on employee stock options. Steps were taken to make equity-based compensation less attractive in some circumstances. Equity compensation is often an essential component in executive recruitment and retention and there is a global trend towards requiring executives to hold stock so that they are exposed to the same losses as shareholders in the event of poor performance. As such, it seems counterintuitive that the Department of Finance would remove the tax deferral for public company shares which encourages the early exercise and holding of shares. The Budget 2010 proposals further encourage the immediate sale of public company shares by requiring full payroll withholding on non-cash equity compensation without administrative relief. This means that shares acquired on the exercise of options must either be sold to provide the funds to pay the tax or the funds must be found elsewhere, such as deductions from cash remuneration. The 2010 Budget has also made changes that require an employer to choose between a favourable tax result for employees and a tax deduction for the employer, to the detriment of one or the other of them and the benefit of a third party, namely the Canadian government.
1(a) Elimination of Tax Deferral for Public Company Shares
Until the high tech bubble, only option holders in Canadian-controlled private corporations ("CCPCs") had the advantage of deferring the payment of tax on the taxable benefit realized on the exercise of their stock options and acquisition of shares, until those shares were sold. In 2000, this deferral was extended to option holders in public companies, within certain limits. This deferral for options to acquire shares of publicly listed companies is being eliminated.
The policy reason behind the deferral of tax for CCPC shares is to address the liquidity problem associated with holding shares of a CCPC. Unlike shares of a public company, shares of a CCPC are not freely tradeable. Consequently, the taxable event is deferred until an actual disposition occurs, at which time the taxpayer should be placed in funds and be able to address the tax liability. The deferral of tax on the exercise of options and acquisition of CCPC shares continues and is not impacted by Budget 2010.
Since 2000, complex rules have provided a deferral of tax on the benefit that arises on the exercise of options and acquisition of public company shares, provided that the stock option deduction is available and certain other conditions are satisfied. See item 3 below for further explanation. There is an annual limit of $100,000 based on the year in which the options become exercisable and the value of the shares when the options were granted. The deferral for public company shares has now been repealed by the 2010 Budget for shares acquired on the exercise of options after 4:00 pm EST on March 4, 2010.
When the deferral of tax on public company shares was introduced, the expressed policy was to attract and retain high-calibre workers and make the tax treatment of employee stock options more competitive with the United States. However, it has not been clear what this deferral has actually accomplished. Given the long option periods for employee stock options, if there is no tax deferral, employees will generally hold unexercised options until they need the cash from selling the underlying shares and exercise and sell on the same day. Unless required to hold a certain number of shares under an employment contract or equity investment policy of the company, it makes sense for the employee to sell them on the market immediately and limit his/her exposure to tax liability.
There is the potential for gain but also the potential risk of loss when a decision is made to hold shares. As noted above, this risk is considered appropriate for compensation governance reasons. However, under Canada's tax laws, in addition to the potential risk of loss in value, there is also a risk of adverse tax consequences. The tax risk occurs because it is always the case on the exercise of stock options, whether CCPC shares or public company shares, that the stock option benefit is calculated at the time the shares are acquired. For public company shares, the deferral is only available if the exercise price is equal to the fair market value of the underlying shares at the date the options are granted. Employees who exercise options and defer the tax on shares that subsequently decrease in value below the exercise price will not only lose that value, they have to pay tax based on the higher value at the time of exercise. When the shares are disposed of, there will be a capital loss equal to the decrease in value. This capital loss cannot be offset against the stock option benefit included in income.
This potential detrimental tax consequence may have motivated the elimination of the tax deferral for public company shares. The Budget has also introduced a special relieving provision from this adverse tax consequence for dispositions before 2015.
(b) Special Relief for Tax Deferral Elections
Just as we saw in the high-tech crash a decade ago, one consequence of the recent economic downturn, is that the shares acquired by employees who elected to defer tax on their stock options may have gone down in value after the shares were acquired. In some cases, the value may be less than the cost of the shares to the employee. This creates serious economic hardship on the employees affected. Budget 2010 proposes amendments that provide relief for employees in this situation. If an employee exercised an option and acquired publicly traded shares and elected to defer the tax, and the employee disposes of those shares before 2015 for proceeds of disposition that are less than the benefit included in income, the employee will be permitted to elect to instead pay a special tax that is equal to the proceeds of disposition. Where the election is made, the employee will be able to claim an offsetting deduction equal to the stock option benefit. An amount equal to one-half of the lesser of (i) the stock option benefit, and (ii) the capital loss, will be treated as a taxable capital gain that can be offset by the allowable capital loss.
2. Remittance Requirements
Since employee stock options give rise to deemed taxable benefits, even where the employer does not make any cash payment to the employee, questions often arise as to whether the employer must remit the withholding tax. In the past, to address special situations where full withholding and remittance would be problematic, the Canada Revenue Agency has provided administrative relief. For example, relief was provided when withholding from the stock option benefit would be an impossibility (where the issuance of shares is the only form of remuneration) or create hardship (for example, where the options are exercised near the end of the year and withholding from other remuneration would leave the employee with little or no cash remuneration).
Unfortunately, the Budget proposes that an amount must be remitted by an employer in respect of an employment benefit arising on the issuance of shares (other than on the exercise of options granted by a CCPC) and Canada Revenue Agency will no longer be permitted to reduce the amount to be remitted on the basis that the benefit arose from the acquisition of shares.
The withholding tax on the stock option benefit is not an additional tax. The employee would have to pay the tax on the net stock option benefit when filing the tax return for the year in which the shares are acquired (other than shares acquired on the exercise of CCPC shares). However, the upfront payment of tax may create cash-flow problems and hardship for an employee who is required to come up with both the exercise price and the tax, unless the employee is able to immediately sell all or a portion of the shares sufficient to fund the withholding tax.
There will also be administrative issues for employers required to remit the tax at the time of exercise, when there is no cash remuneration from which to withhold the tax. Companies that are not CCPCs and whose shares are not publicly listed and easily liquidated may have the greatest need for equity compensation arrangements and may not have sufficient surplus cash to pay the required payroll remittances on behalf of employees who are receiving primarily non-cash remuneration.
There is a relief from the withholding and remittance obligations in respect of the exercise of options granted before 2011, if the stock option agreement was entered into in writing before 4:00 pm EST on March 4, 2010 and the agreement included a condition that restricted the employee from disposing of the securities for a period of time (i.e., restricted shares).
3. Elimination of "Win-Win" Situation on Stock Option Cash Outs
Before the Budget, both employers and employees could benefit from cashing out employee stock options. Where the employee had the right to surrender options for a cash payment, the employer could deduct the cash payment and, in some circumstances, the employee could take a deduction and obtain capital-gains-equivalent treatment for the cash received. This structure benefited the after-tax positions of both the employer and employee. As a result of the proposed Budget changes, the employer will now have to choose between itself and the employee as to who will be able to take a deduction.
The basic rule is: when an employee exercises an option and acquires shares, a benefit equal to the difference between the exercise price and the fair market value of the shares, is included in the employee's income. Provided that certain conditions in the Income Tax Act (Canada) (the "Tax Act") are met, the employee is entitled to deduct one-half of the benefit realized at the time of exercise (the "stock option deduction"). However, the employer is denied a deduction in computing its income in respect of the benefit to the employee. The rationale underlying the denial of the employer deduction is that on the issuance of shares there is no cash outlay and, therefore, the employer is not "out of pocket".
Some stock option plans have attached tandem stock appreciation rights ("SARs") that allow an employee to elect to surrender a stock option, in lieu of exercising it, and receive a cash payment equal to the difference between the exercise price and the fair market value of the underlying shares. Prior to the Budget 2010 announcements, if all of the conditions for the stock option deduction were met at the time of the surrender, the employee was entitled to deduct one-half of the cash payment received in computing income, thereby obtaining capital-gains-equivalent treatment. Further, the employer was entitled to deduct the cash payment as an employment expense as there was an actual out-of-pocket cash outlay.
To eliminate the tax advantage for one of the parties to the option agreement, the Budget 2010 proposes to deny the one-half deduction to the employee on the exercise of the SAR, unless the employer elects to forgo the deduction for the employment expense. The expressed policy rationale for this change is to close a "loophole" and "preserve symmetry" in tax treatment between stock based benefits. It is by no means clear that the entitlement of an employer to deduct a cash payment made to an employee on the exercise of a SAR is a "loophole". Arguably, symmetry would have been better achieved by allowing a deduction for the employer for the stock option benefit to the employee on the exercise of options and issuance of shares. On the exercise of an option, the issuer gives up an amount equal to the difference between the share price and the exercise price, because it could have sold the share to an outside investor at a higher price. The difference represents a cost to the issuer. In the United States and other countries, the income tax authorities allow this difference (the intrinsic value of certain options) to be treated as an operating expense. Canada is now extending its denial of a deduction to actual cash payments, unless the employees are denied the benefit of the stock option deduction. Employers concerned about relationships with their employees will most likely make the election to forego the deduction on the exercise of a SAR so that their employees are not negatively impacted.
The exercise of a SAR allows an employee to benefit from the stock option deduction without having to borrow or otherwise find the funds to pay the exercise price, which can in some cases be substantial. The result is similar, from the employee's perspective, to the more elaborate "cashless exercise". In a cashless exercise, the employee exercises the option and acquires the shares. The shares are immediately sold by a third party broker on behalf of the employee and the exercise price for these shares is paid to the employer out of the proceeds of sale. The difference with the cashless exercise is that the net cash received by the employee is from a third party, and there is no cash payment by the employer. The cashless exercise will only be a viable alternative to exercising a SAR, if there is a ready market for the shares.
The changes are applicable for "transactions" occurring after 4:00 pm EST on March 4, 2010. It is not entirely clear in the provisions, but discussions with the Department of Finance indicate that there will be no exception for SARs that have already been granted under a stock option plan. This seems harsh, considering that compensation terms may already have been established based on the existing tax implications.
The changes are being effected by introducing new conditions of eligibility for the stock option deduction. To benefit from the stock option deduction, the employee must acquire shares, unless: (a) the employer elects in prescribed form in respect of all "stock options issued or to be issued under the stock option agreement after 4 pm EST on March 4, 2010" that neither the employer (nor any person non-arm's length with the employer) will deduct any amount in respect of the payment, to or for the benefit of the employee, for the employee's disposition of the options, and that election is filed with the Canada Revenue Agency; (b) the employee is provided with evidence in writing of such election; and (c) the employee files that evidence with his or her tax return for the year in which the stock option deduction is claimed.
The Department of Finance has confirmed that, notwithstanding the wording, the election of the employer is intended to be available for all stock options regardless of whether they were issued before or after March 4, 2010 and have advised Canada Revenue Agency of that interpretation. It has also been confirmed that the election will have to be made with respect to each separate agreement to grant options to each employee and not to all options issued under the stock option plan.
Existing stock option plans and agreements will not have to be amended and the election of the employer will not have to be made, as long as employees in all cases exercise options and acquire shares. If: (i) the plan/agreement provides for SARs; (ii) the election has not been made by the employer in respect of the options issued to the employee; and (iii) the employee exercises a SAR, the employee will be denied the stock option deduction. Removing an existing enforceable SAR may create other difficulties. Consequently, if there are existing SARs in a stock option plan or agreement, the employer will have to either (i) make the prescribed election not to take any deduction; or (ii) inform employees that the stock option deduction is not available if they exercise the SAR.
SARs have not been as common as might be expected, because they can create cash flow problems, particularly for private company employers. Given that employers will not be able to deduct the cash payment, unless they are prepared to deny the employees the benefit of the stock option deduction, the SAR mechanism will become even less popular. SARs may still be utilized in a take-over situation where it is desirable to cash out option holders on a conditional surrender basis even though the payment is not deductible. Consideration in these particular circumstances will need to be given to the filing of the appropriate elections to ensure that upon the conditional surrender, option holders receive the stock option deduction.
4. Non-Arm's Length Dispositions of Options
Section 7 of the Tax Act is a complete regime that governs the treatment of stock options, including what happens on a disposition of those options. In general, a transfer of options to a person not dealing at arm's length with the employee, for example to a spouse or an RRSP, is not considered to be a taxable event. On the exercise of the option by the transferee while the employee is still alive, the stock option benefit would generally still be included in the income of the employee. Budget 2010 introduces a provision that confirms that these rules govern the disposition of rights under a stock option agreement to a non-arm's length person. The Supplementary Information indicates that this change "clarifies" that non-arm's length dispositions result in an employment benefit at the time of disposition.
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.