Significant changes to the taxation of employee options
Canadian Tax Alert, September 14, 2010
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The 2010 federal budget announced significant changes to the taxation of employee options with respect to three areas:
- The taxation of options that are “cashed out”;
- The tax deferral of stock option benefits; and
- Employer withholding obligations.
On August 27, 2010, the Department of Finance released draft legislative proposals for consultation.
Taxation of option “cash outs”
Prior to the 2010 federal budget, it was possible to structure option agreements to give an employee the right to either exercise an option to acquire shares or units or to surrender the option for cash proceeds equal to the fair market value of the shares or units on the date of surrender less the exercise price. In the latter situation, the cash proceeds were taxed to the employee as an option benefit eligible for the 50% stock option deduction (25% for Quebec) on the same basis as if the employee had exercised the option and acquired the shares. Further, the employer was permitted to claim a tax deduction for the cash outlay.
Under the draft legislation, the employee will generally be unable to claim the stock option deduction on the disposition of an option to acquire shares or units unless the entity that has agreed to sell or issue the shares or units files an election that neither it nor any person not dealing at arm’s length with it will claim a deduction other than one related to certain expenses in respect of hedging contracts with independent third parties. This change applies to option dispositions after 4 p.m. (EST) on March 4, 2010 (the Effective Time).
If the election to forgo the deduction is made, copies of the election must be provided to the Minister. Evidence of the election must be provided to the employee. The employee must file such evidence with his or her return for the year in which the options are surrendered.
Based on the wording of the draft legislation, it appears that the employer election is made in respect of each award made to individual employees. This will enable employers to select which employees will retain the ability to cash out their options on a tax effective basis. We anticipate that many employers will not attach cash surrender rights to option awards granted after the Effective Time unless the employer intends to relinquish the deduction.
Eliminating or restricting the cash surrender rights will accelerate depletion of the share pool available to cover options issued to employees. It may also exacerbate the dilution concerns of existing shareholders. As a result, we anticipate that many employers will review the suitability of other equity based compensation programs.
It is important to note that this proposed amendment does not apply to “cashless exercise” programs. Under a cashless exercise program, the employee does not surrender the option; rather, the employer arranges with a broker for the exercise price to be advanced to the employee and the employee exercises the options with a direction to the broker to immediately sell the shares on the open market to satisfy payment of the exercise price and any applicable tax withholdings.
Tax deferral of stock option benefits
Prior to the 2010 federal budget, taxation of at least a portion of the benefit arising upon exercise of options to acquire publicly listed shares or units could be deferred until the year in which the employee sold the securities or was otherwise deemed to have disposed of them (e.g., on death).
However, in the year in which the employee sold the securities, the employee was liable to pay the tax owing on the stock option benefit regardless of the value of the shares at the time of sale. In recent years, this lingering liability has been a significant problem for many individuals where the share or unit value has declined to an amount that is less than the tax liability on the option benefit.
The draft legislation proposes to amend the option deferral rules in two respects.
First, individuals will be able to make an election to limit the tax liability on the deferred option benefit to an amount equal to the ultimate sale proceeds received. For Quebec residents, the deemed liability will be reduced to 2/3 of the ultimate sale proceeds received as a result of the reduced deduction that Quebec residents may claim to reduce taxation of the option benefit. The elective relief will be adjusted to take into account the capital losses arising from the disposition of the shares and their application against capital gains from other sources. This election will be available for shares sold before 2015 (including shares sold before the federal budget announcement). For shares sold before 2010, individuals will be required to file the election by the filing due date for their 2010 personal tax returns.
However, the election can only be made where the individual elected to defer taxation of the benefit arising from the exercise of options to acquire shares or units that were traded on certain stock exchanges. Shares acquired through the exercise of options to acquire Canadian-controlled private corporation (CCPC) shares will not qualify for this relief.
Further, the draft legislation provides that while the tax deferral of the stock option benefit arising on the exercise of options to acquire CCPC shares remains, no deferral elections may be filed for publicly listed shares acquired after the Effective Time unless the options initially qualified as CCPC options and, in the case of an option exchange, this status was retained.
Employer withholding obligations
Traditionally, many employers have relied on the Canada Revenue Agency’s (CRA’s) administrative position of “undue hardship” as the basis for not withholding income taxes at source on stock option benefits. Under the undue hardship policy, an employer was not required to withhold income taxes in respect of stock option benefits from other cash remuneration if the employer was satisfied that to do so would result in financial hardship to the employee. The CRA also administratively permitted the employer to take into account the stock option deduction in determining the taxes to be withheld at source. In addition, where an individual made a valid deferral election, the Act exempted employers from the requirement to withhold income taxes at source in respect of the deferred stock option benefits.
Recently, the CRA clarified that its administrative position of undue hardship did not apply to stock options exercised by non-resident employees or to cashless exercise programs. The proposed legislation extends this position and eliminates the CRA’s administrative policy of undue hardship with respect to securities issued by the employer under employee incentive plans. Further, a tax liability that arises as a result of a stock option benefit will no longer qualify as grounds for a formal reduction of tax withholding under the undue hardship provision of the Income Tax Act.
For securities issued after 2010, income taxes will be required to be withheld on the benefits as if a bonus had been paid to the employee in cash, subject to the following exceptions:
- If the stock option benefit qualifies for the stock option deduction, the amount of the tax required to be withheld can be reduced to reflect this deduction (e.g., if the gross stock option benefit for a taxpayer outside of Quebec was $50,000 and the options qualified for the 50% stock option deduction, tax withholdings would be calculated on $25,000).
- No tax withholding is required where the individual must retain the shares for a period of time, provided:
- the options were granted before 2011 pursuant to a written agreement entered into before the Effective Time; and
- the agreement, at that time, included a written condition that restricts the employee from disposing of the shares for a period of time after the option exercise.
We anticipate that these criteria will rarely be satisfied.
- No tax need be withheld where taxation of the stock option benefit is deferred under the stock option rules pertaining to CCPCs.
Action steps to consider
These proposals will require Canadian companies, as well as non-Canadian companies who grant options to employees of their Canadian affiliates, to carefully review their employee stock options plans.
Stock option cash outs
- Employers should evaluate existing plans with respect to “in the money” options that could be surrendered for cash to determine the cost to the corporation of the forgone tax deduction and the dilution impact on existing shareholders if employees no longer surrender their options for cash.
- Employers will be required to determine how important it is, as a matter of compensation policy, to maintain preferential individual tax treatment in the form of the stock option deduction in light of the forgone corporate tax deduction.
- Existing stock option plans should be reviewed by legal counsel to determine whether there is any language that would compel the employer to provide the stock option deduction to employees who elect to surrender their options for cash proceeds.
- In the future, it will be necessary for employers to be significantly more strategic in granting options that can be surrendered for cash.
- Employers should consider the accounting impact of the loss of the deduction on their financial reporting.
- Employers should evaluate other compensation alternatives. It should be noted that stock options, even with a cash settlement feature, will continue to be exempt from the salary deferral arrangement rules, which can accelerate employee taxation of benefits, and, consequently, may still offer tax advantages in comparison to a cash bonus plan. However, many stock based compensation programs can be designed to avoid triggering the salary deferral arrangement rules.
- These proposals will also impact corporate acquisitions where the purchaser requires outstanding options to be cancelled as part of the acquisition.
Stock option deferrals
- Employers should communicate to employees that it is no longer possible after the Effective Time to defer taxation on the stock option benefit where they exercise the option and hold the shares.
- Employees should also be advised of the opportunity to limit taxation of the deferred stock option benefit to the proceeds received on the actual sale of their shares where the share value has declined.
- In certain situations, employers will be required to track CCPC options. For example, in the high tech industry, it is not uncommon for employees to receive options prior to an IPO and then convert their options to those of the publicly traded company. With the abolition of the deferral election for publicly traded shares, retaining the CCPC status of exchanged options will be critical. Further, tracking the “converted” options that continue to be held by individuals will be very important where the converted options maintain their CCPC status and continue to qualify for the tax deferral.
Employer withholding obligations
- Employers must review their current procedures for withholding on stock options. Note that the definition of “employer” under the Income Tax Act is very expansive and includes non-resident employers who pay remuneration to Canadian resident employees and non-resident employees who perform employment services in Canada. Where a parent company grants stock options to employees of its Canadian affiliate, the parent company is responsible for withholding and reporting of the stock option benefit unless the costs are recharged to the Canadian entity. In practice, the Canadian entity typically reports the stock option benefit and assumes the withholding obligation (subject to the CRA’s former administrative policy of undue hardship) and the CRA has administratively accepted this practice. However, in light of the new withholding obligations, it will be important for the Canadian entity and its parent company to develop a co-ordinated withholding process.
- Employers should consider establishing a “cashless exercise” program in order to ensure that their tax withholding obligations are met. However, the mechanics of the cashless exercise must be reviewed carefully to ensure that they conform with Canadian tax requirements.
- Employers will be required to track the option exercises of former employees and may wish to consider mandatory language requiring former employees to automatically sell a portion of the shares to cover the applicable withholding taxes.
- With respect to existing option grants, employers should consider whether the employees are required to hold the shares for a certain period of time following exercise, thereby meeting the exception to the withholding obligation. It may be possible that certain restricted shares would meet the exception such that no withholding would be required. Unfortunately, it appears that corporate share ownership guidelines that require senior executives to maintain a certain level of shareholdings will not qualify as an agreement that restricts the employees from disposing of the shares. Consequently, the new withholding obligations may force senior executives to dispose of a portion of their shares to satisfy tax withholdings, contrary to the corporate compensation and governance policies of their employers.
- Employers may wish to consider making loans to executives to cover tax withholdings where not prohibited from doing so under corporate governance policies or securities regulations. However, such loans must be structured carefully and the tax implications of the loan for the employer and executive should be reviewed.
- Other equity compensation programs that are governed by the employee option provision of the Income Tax Act, such as employee stock purchase plans, will be subject to the new withholding rules and should be considered when developing a tax withholding process.
This publication is produced by Deloitte & Touche LLP as an information service to clients and friends of the firm, and is not intended to substitute for competent professional advice. No action should be initiated without consulting your professional advisors. Your use of this document is at your own risk.