Canada Tax: Significant changes to taxation of employee stock options in 2010 Canadian federal budget

The 2010 Canadian federal budget, tabled on 4 March 2010, includes significant changes to the federal taxation of employee stock 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.

The proposed changes will generally be effective after 4 p.m. Eastern Standard Time (EST) on 4 March 2010 and will require Canadian companies, as well as non-Canadian companies that grant options to employees of their Canadian affiliates, to carefully review their employee stock options plans.


Taxation of stock option "cash outs"

Currently, option agreements can be structured to give an employee the right to either exercise an option to acquire shares or to surrender the option for cash proceeds equal to the fair market value of the shares on the date of surrender, less the exercise price. In the latter situation, the cash proceeds are taxed to the employee as a stock option benefit eligible for the 50% stock option deduction on the same basis as if the employee had exercised the option and acquired the shares. Further, the employer is permitted to claim a tax deduction for the cash outlay.

The 2010 federal budget proposes to amend the Income Tax Act (Canada) (Act) so that the 50% stock option deduction will be available to an employee who surrenders options for cash only where the employer forgoes the corporate tax deduction and certain documentation is provided. For these purposes, "employer" includes any person that does not deal at arm's length with the employer (e.g. a related company). The employer must provide evidence in writing to the employee that no deduction is being claimed in respect of the payment made to the employee for the disposition of his/her options and the employee must file this evidence with his/her personal tax return for the applicable tax year.

Based on the wording of the proposed amendment, it appears that the employer election is made in respect of individual employees. However, it is not clear whether the election can be made before the date on which the employee surrenders his/her options. For example, can the employer designate options with a cash-out feature at the time of grant as being options for which the employer will forgo the corporate deduction? It is also unclear whether a separate election can or must be made in respect of each option award for a particular employee.

The proposed change in the tax treatment appears to apply to all options disposed of for cash proceeds after 4 p.m. (EST) on 4 March 2010.

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, he/she arranges with a broker for the exercise price to be advanced to the employee and the employee exercises the option 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 withholding.


Action steps

- 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 determine how important it is, as a matter of compensation policy, to maintain preferential individual tax treatment in the form of the 50% stock option deduction in light of the forgone corporate tax deduction.
- 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 and, consequently, may still offer tax advantages in comparison to a cash bonus plan.
- 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 50% stock option deduction to employees who elect to surrender their options for cash proceeds.
- On a go-forward basis, it would be prudent for employers to expressly reserve in the plan the right to designate which options with a cash surrender right will be eligible for the 50% stock option deduction.
- These proposals will impact corporate acquisitions where the purchaser requires outstanding options to be
surrendered as part of the acquisition.


Tax deferral of stock option benefit

Taxation of the stock option benefit arising in respect of options to acquire publicly listed shares currently can be deferred until the year in which the employee sells the shares or is otherwise deemed to have disposed of them (e.g. on death). The employee must file an election before 16 January 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 CAD 100,000 worth of options that vest in a particular year (based on the value of the shares at the time of grant), and the option-holder must be eligible to claim the 50% stock option deduction.

However, in the year in which the employee sells the shares, the employee will be 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 value has declined to an amount that is less than the tax liability on the stock option benefit. The 2010 federal budget proposes to amend the stock option deferral rules in two respects:

1. 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 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 (generally 30 April 2011).

2. While the tax deferral of the stock option benefit arising on the exercise of options to acquire Canadian-controlled private corporation (CCPC) shares remains, no deferral elections will be allowed for publicly listed shares acquired after 4 p.m. EST on 4 March 2010, unless the options initially qualified for the deferral available in respect of CCPC shares and the options have retained this status.


Action steps

Employers should communicate to employees that it will no longer possible after 4 March 2010 to defer taxation on the stock option benefit where they exercise the option and hold the shares. Employees also should 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, tracking the "converted" options that continue to be held by individuals will be very important because, under the Act, the converted options maintain their CCPC status.


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 50% 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.

The Canada Revenue Agency recently clarified that its administrative position of undue hardship did not apply to stock options exercised by nonresident employees or to cashless exercise programs. The 2010 federal budget extends this position and eliminates the Canada Revenue Agency's administrative policy of undue hardship with respect to all stock options. Further, it appears that a tax liability that arises as a result of a stock option benefit may no longer qualify for a formal reduction of tax withholding under subsection 153(1.1) of the Act. For options exercised after 2010, income taxes will be required to be withheld on stock option benefits 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% 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 was CAD 50,000 and the options qualified for the 50% stock option benefit, tax withholdings would be calculated on CAD 25,000).
- No 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 4 March 2010; 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.
- No tax need be withheld where taxation of the stock option benefit is deferred under the stock option rules relating to Canadian-controlled private corporations (CCPCs).


Action steps

Employers should review their current procedures for withholding on stock options. In light of the new withholding obligations, it will be important for the Canadian entity and its parent company to develop a coordinated withholding process.

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. Many companies have corporate share ownership guidelines that require senior executives to maintain a certain level of shareholding. It is not clear whether such policies would qualify as an agreement that restricts the employees from disposing of the shares. However, it is possible that certain restricted shares would meet the exception such that no withholding would be required.

Other action steps to consider for employer withholding obligations include:

- Employers should consider establishing a "cashless exercise" program to ensure that their tax withholding obligations are met.
- 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.
- Certain other equity compensation programs, such as employee stock purchase plans, will be subject to the new withholding rules and should be considered when developing a tax withholding process.