Underwater Shares

Jennifer Horner, Kitchener, and Jim Kahane, Toronto

As a result of the recession, many employees who had elected to defer the stock option benefit on the acquisition of shares of their public company employer were left holding shares that had significantly less value than when they were acquired and, in a number of cases, were worth less than the taxes deferred in the year of exercise and payable on the sale of the shares.

For these individuals, the 2010 federal budget proposed some relief if the shares are disposed of before 2015. Employees will be allowed to elect to effectively limit the tax liability relating to the stock option benefit to proceeds from the disposition of these shares. Specifically, employees who make the election will be required to pay a special tax equal to the proceeds from the disposition of the shares (or two-thirds of the proceeds in the case of Quebec residents) and will be entitled to a deduction equal to the amount of the deferred stock option benefit in computing their taxable income.

In addition, an amount equal to one-half of the lesser of the stock option benefit and the capital loss realized on disposition of the shares will be required to be included in their income as a taxable capital gain. This will effectively recharacterize all or a portion of the reduction to the stock option benefit as a taxable capital gain so that the employee will not also have the benefit of the capital loss that would otherwise arise when they have elected to pay a reduced tax liability.

There is no relief if the shares have declined in value, but proceeds are sufficient to pay the tax that was deferred when the shares were acquired. For such a taxpayer, a capital loss equal to the difference between the value of the shares at the time of exercise and the actual proceeds of disposition will continue to be available. Such capital loss can be carried back three years against capital gains, and carried forward indefinitely. And, in some cases, if this capital loss can be used in the current year, the prior three years or future years to reduce tax on capital gains, an employee is better off forgoing the election even when the tax on the employment benefit exceeds the proceeds.

To make this special election, employees must elect on or before their tax return filing deadline for the year in which they disposed of their shares.