The 2010 Federal Budget proposed several significant changes to the taxation of employee stock options which should be considered by both employers and employees.
Cashing-Out of Options
When an employee exercises an option and the employer issues a share in satisfaction of the option, the employee may be entitled to preferential, “capital gains-like” tax treatment in respect of the stock option benefit. However, the employer is not entitled to a deduction in respect of the issuance of the share. A practice developed whereby employers designed their stock option plans to permit an employee to dispose of, or “cash out”, their options in return for a cash payment from the employer equal to the “in the money” amount of the option. This practice permitted both the employer and the employee to obtain favourable tax treatment, as the employee maintained the entitlement to the preferential tax treatment while the employer became entitled to a tax deduction in respect of the cash payment to the employee.
Budget 2010 proposes to prohibit this “double benefit” by disentitling the employee to the preferential tax treatment unless the employee acquires the shares under the option or, if the employee “cashes out” the option, the employer files an election not to claim a deduction in respect of the cash payment to the employee. It appears an employer will be permitted to make such an election on a selective basis rather than being required to so elect in respect of all options issued under the employer’s stock option plan.
This change is effective for transactions occurring after 4:00 p.m. on March 3, 2010. The impact of this measure on existing and future stock option grants should be considered to ensure the expectations of both the employer and the employee are met. It may also be appropriate in certain circumstances to consider other methods of achieving a “cashless exercise” of stock options.
End to Deferral of Income Inclusion for Public Company Options
Generally, when an employee exercises a stock option and acquires a share, the employee will have a taxable employment benefit in the year the share is acquired. However, an employee of a publicly-traded company who exercised a stock option was permitted to defer the inclusion in income of the stock option benefit until the year the share acquired under the option was disposed of. This deferral gave rise to positive and negative outcomes. On the positive side, the deferral facilitated the aligning of employee and shareholder interests, by enabling an employee to satisfy the employer’s requirement to hold a certain number or value of shares, without the employee having to fund the tax associated with the stock option benefit from other sources of income. However, this deferral also gave rise to situations in which the shares declined in value following the exercise of the options to an amount below the deferred tax liability in respect of the option exercise.
Budget 2010 proposes to eliminate the ability to defer the income recognition to the year in which the shares are disposed of, effective for the exercise of options after 4:00 p.m. on March 4, 2010.
For employees of publicly-traded companies who previously exercised options, elected to defer the income inclusion and whose shares are now worth less than the deferred income tax liability, the Budget proposes to introduce elective tax relief. The relief is intended to ensure that the tax liability in respect of the stock option benefit does not exceed the sale proceeds of the shares and any capital losses in respect of the employer shares available to the employee.
The elimination of the deferral will likely require employers to reconsider requirements on employees to maintain a certain holding of employer shares, as to maintain such requirements may cause economic hardship to employees who will be obliged to fund the associated tax liability without being able to sell shares into the market. Alternatively, other arrangements may be required to fund the tax liability.
Employers that pay remuneration are required to withhold at source a prescribed amount and remit the withheld amount to the Canada Revenue Agency on account of the employee’s income tax liability for the year. As stock options are a form of remuneration, a benefit arising from the exercise or “cash out” of a stock option is subject to this withholding requirement. However, the Canada Revenue Agency administratively waived the withholding requirement in certain circumstances, permitting the employees to pay the associated tax on filing a tax return for the year.
Budget 2010 proposes to require withholding at source on all stock option benefits realized as of January 1, 2011, other than (a) benefits arising under a stock option agreement entered into before 4:00 p.m. on March 4, 2010 and which included a requirement for the employee to retain the shares so acquired for period of time, and (b) benefits in respect of the exercise of an option to acquire a share of a Canadian-controlled private corporation. It appears this measure is intended to address the situation in which the employee is unable to pay the associated tax due to a decline in the value of the shares between the date of exercise of the option and the filing of the employee’s tax return for the year.
Draft legislation has not yet been released on this proposal. However, we suspect employers and employees will have to reconsider the timing of the exercise of stock options, the number of options to be exercised at any one time and arrangements to fund the withholding requirement, such as selling a portion of the shares into the market .
Non-Arm’s Length Dispositions of Option Rights
When an employee’s rights under a stock option agreement have become vested in another person with whom the employee does not deal at arm’s length, the stock option benefit will generally be included in the employee’s income in the year in which the transferee acquires shares under the stock option. Budget 2010 proposes to clarify that where an employee disposes of such rights to a non-arm’s length transferee, the income inclusion to the employee will arise in the year the employee disposes of the stock option rights.