Canada Tax: Canadian federal budget 2010 - Significant changes announced regarding the taxation of employee stock options

On March 5, 2010, the Canadian government released the 2010 Federal Budget ("2010 budget"). Of note, the 2010 budget announced significant changes in the taxation of employee stock options with respect to three areas:

- Taxation of options that are "cashed-out";
- The tax deferral of stock option benefits; and
- Employer withholding obligations.

The changes proposed in the 2010 budget will be effective retroactively to March 4, 2010, 4:00 p.m. EST (the "effective time"), whenever the budget proposals are ultimately enacted into law.


Taxation of stock option "cash outs"

In Canada, it is possible to structure employee stock option agreements in such a way that the employee will have the right to either:
- Exercise an option to acquire shares of the employer, or
- "Surrender" (i.e. dispose of) the option in exchange for a cash payout from the employer equal to the fair market value of the underlying shares on the date of surrender less the exercise price.

Where an employee chooses to surrender his or her stock options, the cash proceeds are treated as taxable income to the employee, and characterized as a stock option benefit. In the case of employee stock options, where certain conditions specified by the Income Tax Act (Canada) (the "Act") are met, an employee may reduce the taxable income realized at exercise by 50% by claiming a deduction on his or her personal tax return (the "reduction in taxable income"). Prior to release of the Canada's 2010 budget, surrendered stock options were also eligible for this 50% reduction in taxable income. Further, employers were permitted to claim a corporate tax deduction for their entire cash outlay.

With respect to surrendered or "cashed-out" stock options, the 2010 budget proposes to amend the Act so that the 50% reduction in taxable income will be available only to those employees whose employer forgoes the otherwise available corporate tax deduction and provides certain documentation to that effect. For these purposes, "employer" includes any person who does not deal at arm's length with the employer. The employer must provide evidence, in writing, to the employee that no corporate tax deduction is being claimed with respect to the cash payment made in conjunction with the employee's surrender of his or her options, and the employee must submit this written evidence with his or her personal tax return for the applicable tax year.

Based on the wording of the amendment, it appears that an employer's election to forgo the corporate tax deduction may be made with respect to each individual employee. However, it is not clear whether the employer's election can be made prior to the date the employee surrenders his or her options (e.g. at grant if the award permits a surrender/cash-out). It is also not clear whether a separate election can or must be made in respect of each option award granted to a particular employee.

This change in tax treatment appears to apply to all options disposed of for cash after the effective time. However, it is uncertain if "grandfathering" will be permitted for existing options (i.e. whether options granted prior to the effective time but are cashed out after the effective time will still qualify for the 50% reduction in taxable income and the employer will not have to forgo the corporate tax deduction).

It is important to note that this proposed amendment to the Act 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 his or her stock options with instructions for the broker to immediately sell the acquired shares on the open market to satisfy payment of the exercise price and any applicable income tax withholding.


Tax deferral of stock option benefits

Prior to release of the 2010 budget, employees were able to defer taxation of the stock option benefit arising in respect of options to acquire publicly listed shares until the year the employee sold the underlying shares or was otherwise deemed to have disposed of the shares (e.g. at death). The employee must have filed an election before January 16th of the year following the year in which the shares were acquired. The amount that may be deferred cannot exceed the stock option benefit arising on C$100,000 worth of options that vest in a particular year (based on the value of the underlying shares at the time of grant), and the option holder must have been eligible to claim the 50% reduction in taxable income.

However, in the year the employee sold the shares, the employee was liable to pay the income tax arising 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 value has declined to the point where the total value of the underlying shares at sale is actually less than the tax liability that arose on the stock option benefit at exercise.

The 2010 budget proposes to amend the stock option deferral rules in two respects. First, individuals will be able to make an election to limit the tax liability on the deferred stock option benefit to the ultimate sale proceeds received. The elective relief will be adjusted to take into account the capital losses arising from the disposition of the shares at sale and the employee's ability to apply these losses against capital gains realized from other sources in the same year. This election will be available for shares sold before 2015 (including shares sold before the 2010 budget; the 2010 budget language does not specifically provide any restriction with respect to when the shares were actually acquired prior to 2010). For those shares sold before 2010, individuals will have to file the election by the filing due date for their 2010 personal tax return (typically April 30, 2011). For shares sold after 2009, the individual will have to file the election by the filing due date for their personal tax return for that year.

Second, with respect to employee stock option awards where the underlying shares are those of a publicly listed employer, no deferral of taxation will be allowed where the employee acquires the underlying shares after the effective time. However, employees receiving stock options where the underlying shares are those of a Canadian-controlled private corporation ("CCPC") retain the ability to defer taxation to the point of sale.


Employer withholding obligations

Traditionally, many employers have relied on the Canada Revenue Agency's (CRA) administrative position of "undue hardship" as the basis for not withholding income taxes at source on stock option benefits. Under the CRA's undue hardship policy, employers were not required to withhold income taxes in respect of stock option benefits if the employer believed that doing so would result in financial hardship to the employee. Where employers did choose to operate income tax withholding on an employee's stock option income, the Canada Revenue Agency permitted the employer to take into account the 50% reduction in taxable income when calculating the amount of tax to be withheld. In addition, where an individual made a valid election to defer taxation, the Act exempted employers from having to withhold income tax at exercise.

Recently, the Canada Revenue Agency clarified that their administrative position of undue hardship did not apply to stock options exercised by non-resident employees or to cashless exercise programs. The 2010 budget eliminates the ability of employers to rely upon the Canada Revenue Agency's administrative position of undue hardship with respect to all stock option income. Further, it appears that the fact that the tax arose on a stock option benefit may no longer be considered a sufficient basis for an individual to apply to Canada Revenue Agency for a formal waiver to reduce tax withholding by his or her employer under subsection 153(1.1) of the Act.

While the 2010 budget is generally retroactive to March 4, 2010, for options exercised on or after January 1, 2011, income tax will have to be withheld on stock option income as if the amounts had been paid to the employee in cash, subject to the following exceptions:

- If the stock option benefit qualifies for the 50% reduction in taxable income, the amount of the tax required to be withheld can be reduced to reflect this reduction (e.g. if the gross stock option benefit was $50,000 and the options qualified for the 50% reduction in taxable income, tax withholding would be calculated on $25,000 of income);

- No tax withholding is required where the individual must retain the shares for a period of time, provided that:
     - The options were granted before 2011 pursuant to a written agreement entered into before the effective time; and
     - The agreement, at the time it was entered into, included a written condition that restricts the employee from disposition of the shares for a period of time after the option exercise.
- No tax withholding is required where taxation of the stock option benefit is deferred under the stock option rules pertaining to CCPCs.


Quebec taxation of stock options

The province of Quebec has its own income tax legislation (the Taxation Act) and tax administration. The 2010 budget does not affect Quebec provincial taxation of stock options. It remains to be seen whether the Quebec government will adopt similar measures.


Action

- 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 costs to the corporation of the foregone corporate tax deduction where employees are to benefit from the 50% reduction in taxable income.
     - Employers should evaluate other compensation approaches. It should be noted that stock options, even with a cash settlement feature, will continue to be exempt from the salary deferral arrangement rules and, consequently, may still offer tax advantages in comparison to a cash bonus plan.

- Stock option deferrals
     - Employers should communicate to employees that it will no longer be possible to defer taxation on the stock option benefit after they exercise their option awards and acquire the underlying shares.
     - Employers should advise their employees of the opportunity, where share value has fallen between the time of exercise and the time of sale, to limit taxation of the deferred stock option income to the proceeds received at sale.

- Employer withholding obligations
     - Employers must review their current procedures for withholding on stock options. It will be important for the Canadian entity and its foreign parent company to develop a coordinated withholding process.
     - Other equity programs that are governed by the Act, such as employer stock purchase plans, may be subject to the new withholding rules and will have to be included when developing a tax withholding process.