As you may be aware, Budget 2010 contained a number of changes relevant to stock options. The purpose of this note is to alert our corporate clients with existing stock option plans that special attention should be paid to two of the proposed changes in particular as they may necessitate changes to the company’s stock option plan terms and/or to certain of the company’s administrative practices.
Source Withholding Requirements: Up until now the Canada Revenue Agency (“CRA”) has shown considerable administrative flexibility regarding the withholding and remitting of tax by employers with respect to stock option benefits realized by their employees on the exercise of stock options. In recognition of the non-cash nature of stock option benefits, CRA has allowed for reduced withholdings in circumstances where making normal withholdings would result in undue hardship to the employee. This relief will generally no longer be available for options exercised after 2010. Instead, the employer’s tax withholding and remitting obligations with respect to stock options benefits will be the same as the obligations arising on a payment to the employee of an equivalent cash bonus, but taking into account any 50% deduction in respect of the option benefit that may apply.1 The change in rules will not impact options of Canadian-controlled private corporations since on the exercise of CCPC options payment of the tax is delayed until the shares are sold.
Given the non-cash nature of stock option benefits, this new position will pose challenges for some employers. In order to meet its withholding and remittance obligations, the employer will likely need to arrange for one of the following:
- require that the employee provide a cheque to the employer for the amount of the withholding;
- require that the employee make a same day sale of a portion of the shares acquired sufficient to fund the withholding and remit the proceeds to the employer; or (iii) if there is sufficient cash remuneration being paid to the employee, withhold the necessary amount from the cash remuneration payment. Employers should review the provisions in their stock option plans relating to source withholdings to determine whether the language will permit the employer to take such steps as are necessary in order for it to honour its withholding and remitting obligations under the new rules. Where the language is insufficient for this purpose, amendments should be considered. As well, employee communication materials (e.g. employee pamphlets or booklets) may require modifications.
Cash-Outs of Stock Options: Many stock option plans include a provision allowing an employee, in lieu of exercising the option, to elect to receive a cash payment equal to the in-the-money amount of the option, i.e. to cash out his/her rights instead of acquiring the underlying shares. Prior to Budget 2010, an employee could claim the 50% deduction on the cash payment (if the stock option otherwise satisfied the conditions for the deduction) and, as well, the employer was entitled to a deduction in respect of the cash payment Under the proposed rules, the 50% deduction will be denied to the employee (resulting in a full income inclusion of the cash payment) unless the employer elects that neither the employer, nor any person not at arm’s length with the employer, will deduct any amount in respect of the cash payment. In other words, either the employee obtains the 50% deduction or the employer deducts the cash payment, but not both.
Where a stock option plan includes a cash-out provision, the employer should consider what, if any, representations have been made by it to its employees regarding the availability of the 50% deduction on cash-out payments received. Where the employees are expecting to be able to avail themselves of the 50% deduction, the employer will need to carefully consider its alternatives, including (i) preserving the deduction for the employees by forfeiting its own deduction; (ii) preserving its own deduction and notifying the employees that they will no longer be eligible for the 50% deduction; and (iii) amending the plan to delete the cash-out option entirely. In making its decision the employer should take account of any relevant factors and circumstances. For example, in some cases the forfeiture by the employer of the deduction will have limited downside to it (such as where it is in a loss position), in which event making the election to preserve the deduction for the employees would clearly make sense. Depending on the approach decided upon by the employer, changes to employee communication materials and/or the plan may be required.