Many employers utilize formula-based appreciation rights (Appreciation Rights) as a mechanism to attract, retain and incentivize key employees. Particularly common amongst private corporations, Appreciation Rights generally entitle a recipient employee to a future cash payment based on the increase in the value of a future-oriented financial measure, such as the value of the employer's shares or an increase in another performance metric, such as EBITDA, revenue, profit, or retained earnings, measured over the time the Appreciation Rights are outstanding. Such plans have been popular amongst employers that have sought to incentivize employees based on increases in value or profitability (similar to a stock option) but concurrently avoid many of the complexities that come from employees being entitled to acquire corporate shares. Payouts based on increases in profitability or revenue are also desirable in situations where share value is not easily determinable (e.g., where no market for the shares exists).

Once the commercial terms of an Appreciation Rights plan are determined, the efficacy of the arrangement, from a tax perspective, depends on ensuring that the employee will not pay tax in respect of the Appreciation Right until he or she receives the payment under the plan. This critical tax treatment has, however, been called into question by two recent pronouncements of the Canada Revenue Agency (CRA) (CRA Documents 2020-0850281I7 and 2020-0841961I7, both dated July 10, 2020, and published September 2, 2020). Given these pronouncements, employers should re-evaluate the grant of Appreciation Rights in their particular circumstances.


Unlike stock options, Appreciation Rights plans are not subject to an explicit taxing regime in the Income Tax Act (Canada) (ITA). To avoid an employee recipient being taxed in the year the grant of the Appreciation Right is made, it is critical that the ITA's "salary deferral arrangement" (SDA) rules do not apply to the Appreciation Rights.

An SDA is defined broadly by the ITA, and includes any plan or arrangement under which an employee has a right to receive an amount in a future year where: (i) it is reasonable to consider that one of the main purposes for the creation or existence of the right is to postpone tax payable under the ITA (the Purpose Test), and (ii) the amount is on account salary or wages of the employee for services rendered in the year or a preceding taxation year. The definition includes a right that is subject to one or more conditions unless there is a substantial risk that any one of those conditions will not be satisfied. Where the SDA rules apply, the employee is subject to tax on the grant of the incentive award, notwithstanding that he or she will not have yet received a payment.

Because incentive plans typically have several purposes, including, to some extent, tax efficiency, it is rare for a plan to rely on the Purpose Test to avoid the SDA definition. Rather, most incentive plans are implemented based on an explicit exception to the SDA rules, the most common being an exception for a bonus paid within 3 years following the end of the year in which the services respecting the bonus are rendered (typically used for restricted share unit plans). Reliance on this exception is sometimes not practicable, particularly given commercial imperatives to reduce the incentive to focus on short-term financial results. Appreciation Rights have thus evolved as an alternative way to offer incentive compensation beyond a 3-year incentive period.

Appreciation Rights plans have been widely implemented based a series of historical rulings issued by the CRA since the 1990s. The traditional view, supported by those rulings, has been that, since an Appreciation Right entitles an employee to a payment based on future increases in value, and thus has little or no intrinsic value when granted, it should be considered to be granted in respect of future services (not for services rendered in the year or a past year), such that the second requirement above of the SDA definition is not satisfied. In particular, the historical CRA rulings have indicated that an Appreciation Right should not constitute an SDA where the following requirements are satisfied:

  • Each Appreciation Right has a nil value at the date of grant;
  • Each Appreciation Right entitles the holder to receive the appreciation in respect of a particular metric from the date the Appreciation Right is granted to the date of payout; and
  • Payment is to be made at a fixed future date, with no ability for the employee to obtain payment at an earlier date.

The benefit of such characterization was that the term of an Appreciation Right could be virtually unlimited, thus providing a mid-to-long term incentive beyond the 3-years otherwise permitted under the SDA rules.

Unfortunately, the CRA's recent pronouncements call such position into question and suggest that there is a material risk in continuing to grant such Appreciation Rights unless restructured to fit within the revised CRA guidelines.

Revised CRA Position

In CRA Documents 2020-0850281I7 and 2020-0841961I7, the CRA indicates that it will no longer provide positive rulings on formula-based Appreciation Rights plans, unless the payout is based solely on the increase in the fair market value (FMV) of the employer's shares or unless the Appreciation Right is based on an explicit exception to the SDA rules (e.g., the 3-year bonus exception).

The CRA also clarified certain of the interpretative issues with respect to such plans, narrowing the potential scope of Appreciation Rights plans. The CRA's discussion is illuminating in several respects and reveals the following high-level principles:

  • Appreciation Rights plans must be reviewed annually, after all relevant facts are known, to determine if the SDA rules apply. The analysis cannot be done in advance.
  • Appreciation Rights plans should not be viewed as being in respect of only future service, even if such rights have no value as of the date of grant. In particular, in the first year that an Appreciation Right has a notional positive value (even if the employee has no right to a payout or the Appreciation Right is not yet exercisable), the employee holder could be considered to have a right to receive an amount that is, or is on account or in lieu of, salary or wages for past services. This would then trigger the SDA analysis.
  • Applying the CRA's views, the SDA rules are more likely to apply in certain circumstances, including:
    • If the formula used to determine the payout under an Appreciation Right "would likely result", based on the employer's history, in a positive payout, even if the employer's net earnings did not increase and remained stable. In other words, the SDA rules will be of particular concern if the Appreciation Rights plan is structured to nearly always have a positive value regardless of the employer's net earnings; or
    • Where the financial metrics that underlie a formula-based Appreciation Rights plan are particularly susceptible to manipulation. The CRA's concern is that such manipulation could be used to obfuscate the fact that a formula-based Appreciation Rights plan's underlying purpose is to defer tax, rather than act as a tool to incentivize employees by rewarding future performance.

What Now?

The CRA's positions are concerning, particularly coming as a reversal of a long-established administrative policy and in the midst of the current economic climate wherein employers are looking for innovative plans to attract and retain employees.

What is clear in light of the recent CRA pronouncements is that employers with Appreciation Rights plans should review those plans and their incentive compensation practices with their legal and tax advisors to ensure that the employees are not subject to adverse tax results.

In many cases, restructuring of an Appreciation Rights plan should be considered. While there is no "one-size-fits-all" approach, there are several potential alternatives:

  • The CRA will continue to exempt "standard" share appreciation rights plans as being exempt from the SDA rules. To qualify for this treatment, the Appreciation Right must have no intrinsic value at the date of grant, the value of the Appreciation Right cannot be guaranteed (and may have a negative value after the date of grant), and the value of the Appreciation Right at any particular time can be determined by subtracting the FMV of a share of the employer at the date of grant from the FMV of a share of the employer at that particular time. Employers who are able to quantify share value may wish to consider whether their respective Appreciation Rights plans can fall within this exemption.
  • The CRA has also noted that its revised position does not mean that all Appreciation Rights plans are SDAs, and that, in particular, many such plans will not be a SDA where the underlying formula used closely approximates the FMV of the shares of the employer over the duration of the Appreciation Right. Thus, where an employer wishes to continue to use a performance metric other than share value, care should be taken to ensure that growth in such metric closely approximates growth share value, and that it is not a metric which is subject to the manipulation concern evidenced by the CRA.
  • Where neither of the two above alternatives are of utility, an employer may wish to restructure their Appreciation Rights plan to be based on the 3-year bonus, or another explicit exception, to the SDA rules.

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.