Equity-based employee compensation plans are varied and sometimes confusing. They can either deliver securities or they can operate in a virtual world where the benefit is paid in cash based on the value of a reference security. They can provide benefits based only on the increase in the reference security or benefits based on the security’s original value, as well as any increase in value. Some of these plans are subject to securities law considerations, while others are not. Some are subject to vesting and performance criteria.
One thing that is common to all equity-based plans is the need to fit within the tax rules.
In designing and analyzing an equity-based plan, the most fundamental questions are whether and how the plan permits the deferral of amounts that would otherwise be brought into the employee’s income sooner. This article provides a summary of the comprehensive article written by Lorraine Allard available on our website describing various types of equitybased plans and the tax and other attributes of those plans.
Income Tax Act — Section 7 or Not
The first major determination to be made is whether the plan qualifies for income deferral treatment under Section 7 of the Income Tax Act (ITA). If it does not, then it may be caught by the salary deferral arrangement (SDA) rules, which are designed to prevent the postponement of tax.
All that is needed for a plan to fit within Section 7 is an agreement by a corporation or mutual fund trust to sell or issue to an employee its securities or those of a corporation or mutual fund trust with which it does not deal at arm’s length. A plan under which the employer must or may pay cash will not normally be considered an agreement to sell or issue securities, and will therefore not qualify as a Section 7 plan.
Section 7 plans
A Section 7 plan is any plan that fits within Section 7, even where no options are issued. Nonetheless, the most recognizable form of a Section 7 plan is a stock option plan.
Stock option plans do not give rise to income tax at the time of an employee’s entitlement to participate in the plan, nor upon the acquisition by an employee of an option under the plan. At the time of exercise of an option or the later disposition of option shares, the ITA requires the inclusion in the employee’s income of an employment benefit amount equal to the excess of the fair market value of the securities when acquired over the price, if any, paid to acquire them.
Stock option plans may be divided between those offered by Canadian-controlled private corporations (CCPCs) and those offered by other issuers. Where the securities are not shares of a CCPC, the employment benefit amount is included in income when the securities are acquired by the employee. These securities may be deferred for tax purposes until their subsequent sale – if certain conditions are met, including listing of the shares on a prescribed stock exchange and qualifying for the Section 110(1)(d) deduction. Where the securities are shares of a CCPC, there is an automatic deferral of the recognition of the employment benefit amount until the shares are sold.
In addition to the benefit of deferral, employees may also be entitled in the case of stock options to a partial deduction from the amount of the employment benefit, which will result in a more favourable rate of tax with respect to stock options.
An employee who acquires securities that are not shares of a CCPC will be entitled to a deduction from income, equal to one-half the employment benefit amount (which effectively equates the tax rate on the employment benefit amount to the capital gains tax rate) if certain conditions are met. These conditions include the exercise price of the options being no less than the fair market value of the securities at the time the agreement to sell or issue the securities is entered into. This is what is commonly referred to as the ‘110(1)(d) deduction,’ after the relevant provision of the ITA.
An employee who acquires securities that are shares of a CCPC will be entitled to an automatic deduction equal to one-half the employment benefit amount if he or she does not dispose of the relevant CCPC shares within two years of their acquisition. This is referred to as the ‘110(1)(d.1) deduction.’
Once the employee acquires the securities under a Section 7 plan, those securities belong to the employee. As with any other security, the employee may realize a capital gain equal to 50 per cent of the difference between the proceeds of disposition, net of reasonable costs of disposition, and the adjusted cost base in respect of the securities, and, for that purpose, the adjusted cost base increased by the full employment benefit amount.
When the employee elects to receive cash in lieu of shares, the employee will be required to include the amount of cash in the employee’s income, as income from employment, in the year received.
Under a stock option plan, a deduction is available to the employer in connection with the issuance of cash but not securities.
Non—Section 7 plans
If a plan is not a Section 7 plan, the plan will have to be designed to avoid the application of the SDA rules in order to achieve deferral of income inclusion. The SDA rules constitute an anti-avoidance measure that prevents the deferral of employment income by imposing a form of statutory “constructive receipt.” Generally, the SDA rules result in deferred amounts being added to the employee’s income in the year in which the right to receive the amount first arises. If a non-Section 7 plan is funded (in equity based plans, by means of employer equity), it will constitute an “employee benefit plan” (EBP) and be subject to its own tax regime under the EPB rules. Like the SDA rules, the EBP rules constitute an anti-avoidance measure.
Among the types of equity-based plans not subject to the SDA rules are properly designed appreciation rights plans, performance-based plans, so-called three-year deferred bonus plans and deferred stock unit plans.