On September 28, 2010, the Minister of Finance released draft legislative proposals that would, if enacted, implement amendments to the Income Tax Act (Canada) (the "Act") announced in the March 4, 2010 Federal budget, including the proposed changes to the tax treatment of employee stock options. These proposed changes were discussed in an earlier Bulletin dated April 1, 2010 entitled "Important Changes to Tax Rules Governing Employee Stock Options: Should You Change Your Stock Option Plan?"
As discussed below, these changes may require amendments to stock option plans. Employers should review their plans and consider what approvals are required in order to implement the amendments, as some of the changes are effective as of budget day (March 4, 2010) or beginning January 1, 2011. If board or shareholder approvals are required, the time required to obtain approvals must be considered.
Withholding on Stock Option Benefits
Under the Act, an employee stock option is generally not taxable to the employee until the option is exercised.[i] At such time, the employee is generally deemed to receive a taxable employment benefit equal to the difference between the fair market value of the security at the time of exercise and the amount paid by the employee to acquire the security (the "stock option benefit").[ii] Furthermore, the Act imposes a general requirement on employers[iii] to make payroll withholdings in respect of all taxable employment benefits, including stock option benefits. However, the Act provides the Minister with discretion to reduce the withholding otherwise required where such withholding would cause the taxpayer undue hardship. As an administrative concession, the Canada Revenue Agency has also not enforced withholding where it would impose actual hardship or where the employee's entire remuneration is paid in non-cash benefits.
The proposed amendments "clarify" the employer's withholding and remittance obligation in respect of options to acquire shares of a publicly-listed corporation by requiring the employer to make withholdings as though the stock option benefit were a payment of a cash bonus. As a result, the same detailed withholding rules applicable to bonuses under the Act are also applicable to employee stock option benefits. This generally would require that the full remittance be made in the remittance period following the period in which the option was exercised.
Carved out from the withholding obligations are the following amounts: (i) amounts deemed to have been received as an employment benefit on the disposition of securities of a Canadian-controlled private corporation ("CCPC"); (ii) certain amounts deductible by the employee in respect of proceeds of the sale of shares donated to a charity; and (iii) the portion of the stock option benefit subject to the 50% deduction discussed below.
In addition, a new provision to the Act provides that a non-cash stock option benefit is not to be considered as a basis for determining whether an employee would face undue hardship as a result of the withholding. As a result, the Minister's ability to provide discretionary relief from withholding will be limited.
These changes apply after 2010, other than with respect to options granted before 2011 under an agreement entered into in writing before March 4, 2010 at 4:00 p.m. Eastern Standard Time that included at that time a written condition prohibiting the taxpayer from disposing of the optioned securities for a period of time after execution. Note that to be entitled to "grandfathering", the option itself (and not other agreements, such as employment contracts or corporate share ownership policies) must prohibit the disposition.
This enforcement of withholding requirements may have significant consequences for both employees and employers. Public companies will likely be required to amend their option plans to either require or allow employees to elect to have shares purchased on the exercise of an option sold on the market to fund the remittance obligation or to provide other mechanisms to fund withholding. However, where there is no readily available market to dispose of the optioned securities, as is generally the case with private companies or thinly traded public companies, employees may be placed in a difficult financial position as a result of withholding on other cash remuneration. In such situations, where an employee has insufficient cash remuneration from which to withhold (for example, where the stock option benefit is large compared to cash compensation), it is unclear how employers are to comply with their withholding obligation. An employer that fails to withhold could be held liable for the tax owing plus interest and penalties and, if the employer is a corporation, this liability may extend to the directors of the employer on a joint and several basis should the employer later become insolvent.
If shares acquired by an employee pursuant to a stock option agreement are identical to shares already owned by the employee, and the employee chooses to sell the newly acquired shares to fund the employer's withholding obligation or otherwise, the employee should consider making a special election regarding the disposition of newly acquired securities. Provided certain requirements are met, this election deems the newly acquired shares to be the shares that are disposed of (as opposed to the "old" shares owned by the employee) and also deems such shares to not be identical to the other shares owned by the employee. This ensures that the adjusted cost base of the shares acquired on the exercise of the stock option is not reduced as a result of the adjusted cost base averaging rules under the Act that generally apply to identical properties. Accordingly, the employee would be able to avoid a capital gain on the disposition of the stock option shares that may have otherwise been realized in the absence of the election.
Stock Option Cash-Outs
Under the Act, an employee may be entitled to claim a deduction (the "stock option deduction") in computing taxable income equal to one-half of the stock option benefit, provided that certain conditions are met.[iv] The purpose of the stock option deduction is to tax employees on the stock option benefit at the same effective tax rate as is applicable to capital gains (which are also subject to a 50% inclusion rate). The same rules generally apply where an employee elects to "cash out" his or her option rights (i.e., dispose of the option for an amount of cash equal to the increased value of the underlying security instead of exercising the option to acquire the securities). In some cases the right to cash out an option is referred to as a "tandem stock appreciation right" (or a "tandem SAR").
Employers are not entitled to a deduction in computing income when selling or issuing shares to an employee under a stock option agreement. However, the Act does not prohibit a deduction to the employer if the employee elects to cash out options instead. As a result, it has been possible to structure employee stock option agreements so that, if an employee elects to cash out his or her stock option rights, the benefit is eligible for the stock option deduction by the employee, while the cash payment is fully deductible by the employer. The federal government now considers this result to be improper in part because the aggregate tax borne by the employee and employer under a cash-out is less than the total amount of tax paid under other forms of compensation, such as exercised stock options and cash bonus payments.
A new provision of the Act (the "Deduction Denial Rule") will deny the employee the 50% stock option deduction unless: (1) the employer elects in prescribed form to forgo the deduction in respect of the cash-out payment;[v](2) the employer files the election in prescribed form with the Minister; (3) the employer provides the employee with evidence of the election; and (4) the employee files such evidence with his or her tax return for the year in which the stock option deduction is claimed. The employer's election to forgo its deduction in respect of the cash payment would apply to all options granted to a particular employee under a particular option agreement. Generally, the "agreement" would be the document under which the employer grants specific options to the employee (i.e., the option grant) and not the option plan itself. Accordingly, the employer may choose to elect to forgo the deduction in respect of some option grants but not others.
The Deduction Denial Rule would have the effect of preventing an employee and his or her employer from claiming a "double deduction" in respect of the same stock option cash-out. In other words, either the employee can claim the 50% deduction in computing his or her income or the employer can claim a deduction for the cash-out payment.
The Deduction Denial Rule does not specify when this election is to be made. The election could conceivably be made at any time between the time of entering into the stock option agreement (generally, the date the options are granted) and the time the employee elects to cash out. It could, perhaps, also be made up to the date the employee is required to file the relevant tax return.
To ensure that the deductibility of an amount paid to a third party to hedge the employer's liability with respect to a stock option cash-out is not affected by the employer's election to give up deductions for payments made to employees, the proposed amendments define a "designated amount" carve-out. In other words, an employer can deduct a designated amount with respect to an employee's disposition of rights under a stock option agreement. In order to qualify as a designated amount, the amount must fulfill the following three conditions:
- the amount must otherwise be deductible in computing the income of the employer in the absence of the Deduction Denial Rule;
- the amount must be payable to a person that deals at arm's length with the employer and is not an employee of the employer nor of a person that deals at non-arm's length with the employer; and
- the amount must be in respect of an arrangement entered into for the purpose of managing the employer's financial risk associated with a potential increase in value of the securities under the stock option agreement.
These changes will apply in respect of acquisitions of securities and transfers of dispositions of rights occurring after 4:00 p.m. Eastern Standard Time on March 4, 2010.
Employers whose stock option plan includes a "cash-out" option should seriously consider the following alternatives:
- maintain the status quo for the time being and decide later when options are actually exercised whether the election should be made;
- amend the plan to remove the "cash-out" option;
- amend the plan to include an undertaking on the part of the employer to make the new election.
Employers should keep in mind that if they decide to maintain a "cash-out" feature without undertaking to make the new election, their employees may be reluctant to avail themselves of the "cash-out" feature if they do not know in advance whether their employer will make the new election. Employers should review the terms of their plans to determine if they provide sufficient flexibility to make the desired amendments, and the authority to make the necessary elections and notifications.
Tax Deferral Election
Holders of employee stock options granted by CCPCs are generally not required to include a stock option benefit in income until the shares acquired on the exercise of the option are sold, provided certain conditions are met. Holders of options to acquire shares of non-CCPCs are generally required to include the stock option benefit in income in the year the option is exercised, subject to a limited deferral election.
In general terms, the election permits certain holders of non-CCPC employee stock options (including employees of Canadian public corporations and employees of Canadian subsidiaries of foreign public corporations) to defer recognition of the stock option benefit in respect of publicly-listed securities until such time as the acquired securities are sold. This election is available for benefits in respect of up to $100,000 of the employee's qualifying stock options vesting in a particular year.
The proposed amendments would repeal the current deferral rules regarding stock options in respect of non-CCPCs with the result that employees will no longer be allowed to defer the recognition of the stock option benefit in respect of publicly-listed securities. The proposed amendment is meant to provide relief to certain employees who have encountered financial difficulties as a result of making the election to defer tax payable on the stock option benefit. In particular, this problem has arisen where the value of the optioned securities has fallen following the exercise of the option to the point that the proceeds realized on the sale of the optioned securities is less than the tax liability in respect of the stock option benefit that was deferred as a result of making the election.
This proposal is not restricted in its scope, and thus will equally impact employees who would otherwise be able to pay the deferred tax liability and employees whose optioned securities increase in value. The repeal of the tax deferral election will apply to employee stock options exercised after 4:00 p.m. Eastern Standard Time on March 4, 2010.
Special Relief for Tax Deferral Elections
The proposed amendments provide relief to taxpayers who took advantage of the tax deferral election on stock options described above. Specifically, the amendments provide an election to ensure that the tax liability on a deferred stock option benefit does not exceed the proceeds of disposition of the optioned security.
In order to qualify for the new election: (1) the taxpayer must have made an election under the former rules to defer tax liability on a stock option benefit; (2) the taxpayer must dispose of the securities before 2015; and (3) if the taxpayer disposed of the particular securities before 2010 the election must be filed on or before the taxpayer's 2010 filing-due date and, in any other case, on or before the taxpayer's filing-due date for the year of disposition of the particular security.
Under the proposed amendments, qualifying taxpayers may generally elect to pay a special tax equal to the amount of the proceeds of disposition of the optioned securities (2/3 of the amount of the proceeds for employees who are residents of Quebec). This election would relieve the employee of his or her obligation to pay tax otherwise payable on the difference between the fair market value of the security at the time of exercise and the amount paid by the employee to acquire the security. In addition, electing taxpayers will be deemed to realize a capital gain designed to offset the benefit of any capital loss actually realized on the disposition of the optioned securities.
This is welcome relief for many taxpayers whose optioned securities have significantly declined in value as a result of recent economic turmoil. However, it should be noted that depending on the amount of the stock option benefit of an employee and the proceeds of disposition of his or her shares, there could be circumstances where the employee would be better off not paying the special tax, even if the value of his or her shares has gone down significantly since the time of the exercise of the option. For example, it may not be advantageous to make the new election if the employee is able to utilize the resulting capital loss immediately. The decision to make the new election and to pay the special tax should therefore be made only after a careful review of each employee's situation.