Draft legislation released in August 2010 by the Canadian Department of Finance proposes changes that are expected to cause companies that grant stock options to review carefully their current stock option plans and perhaps look to alternative methods to compensate their employees.
The draft legislation follows the announcements made as part of the 2010 Canadian budget and incorporates changes which are expected to affect employee stock options in at least three ways. These are considered in turn below.
Stock option benefits – tax deferral
Currently, Canadian employees may elect to defer (at least in part) the charge to income tax that would ordinarily arise on the exercise of their stock options until the earliest of (i) the year that the resulting shares are sold, (ii) the year the employee dies, or (iii) the year the employee ceases to be resident in Canada for Canadian tax purposes. One of the notable disadvantages of this arrangement is that the tax liability will always be assessed by reference to the market value of the stock under option at the time of exercise. Consequently, if an employee elects to defer recognition of the employment benefit and the value of the stock subsequently decreases, the employee may not have sufficient proceeds from the sale or other disposal of the securities to satisfy his or her tax obligation.
The revised legislation introduces a special elective tax treatment for tax payers who have elected to defer tax, which will ensure that the tax liability on a deferred stock option benefit does not exceed the proceeds of sale of the underlying option securities following exercise, taking into account tax relief resulting from the use of capital losses on the option securities against capital gains from other sources.
Any year in which the tax payer is required to include in income a qualifying deferred stock option benefit, the tax payer may elect to pay a special tax for the year equal to the proceeds of the sale, or other disposal, of the option securities (in the case of residents of Quebec, the special tax will be two thirds of such proceeds). In applying these new rules it should be noted that only stock option benefits for which an election to defer taxation has already been made will qualify for the special elective tax treatment. It should also be noted that:
(i) individuals who disposed of their stock before 2010 will have to make an election for the special treatment on or before 30 April 2011 i.e. the expected filing due date for the 2010 taxation year; and
(ii) individuals who have not disposed of their stock before 2010 must do so before 2015, they will then have until their filing due date for the taxation year of disposition to make an election for the special treatment.
Finally, in relation to tax deferral, no deferral elections may be filed for publicly listed shares acquired after 4pm EST on 4 March 2010.
Stock option benefits – cashed out options
The tax rules currently ensure that when an employee acquires securities under a stock option agreement, only one deduction (at the employee level) is provided. This is because employers are, in this context, prevented from claiming a tax deduction for the issuance of a security. However, where employee stock option rights are not exercised but, instead, exchanged for a cash payment from the employer i.e. “cashed out”, the cash payment is fully deductible by the employer and, at the same time, the employment benefit received by the optionholder may still also be eligible for the existing stock option deduction (i.e. a deduction equal to one half of the employment benefit).
In line with the 2010 budget announcements, the revised legislation proposes to prevent employees and employers from both securing tax deductions for the same employment benefit. In addressing the situation, the stock option deduction will generally only be available to employees in situations where they exercise their options and acquire securities rather than giving up their rights in exchange for a cash equivalent. An employer may continue to allow employees to cash out their stock option rights without affecting their eligibility for the stock option deduction but, in these circumstances, the employer must make an election to forgo the deduction for the cash payment (and file copies of this election with the Canada Revenue Agency (CRA)).
As a consequence of these legislative proposals there are a number of actions which employers may wish to take to the extent that existing option plans have been, and may continue to be, operated on a cashed-out basis, including:
- carry out an assessment of the likely costs to the employer as a result of the foregone tax deduction if elections are to be made;
- consider the impact on share “headroom” if all options are now to be exercised in full rather than cashed-out;
- check that there are no contractual rights, or other policy restrictions, which would impact the employer if employees are prevented from a tax deduction if their options are cashed-out; and
- consider the impact that the loss of a deduction may have for financial reporting purposes.
The pre-budget position
Employers have frequently utilised the “undue hardship” provision allowed for by the CRA and not withheld income tax at source on stock option benefits from other cash payments for those employees who would experience undue financial difficulty as a result. The CRA allowed a 50% reduction on any of the employee’s taxable income for employers to take account of when they decided to activate income tax withholding.
The proposed position
“Undue hardship” will no longer apply where employers issue securities under an employee incentive plan. An employee will also not be allowed to apply to the CRA for “undue hardship” to reduce the liability for tax through withholding solely because the benefit was received as a non-cash bonus. For securities issued on or after 1 January 2011, any withholding income tax will need to be treated as if the employee had received the benefit as a cash-paid bonus. It will be important for employers to consider the current measures they employ when withholding tax on options.