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 Options on Options: Canada’s 2010 Federal Budget
1. Tax Deferral.
First some relief:
Following previous Canadian tax law, if you purchase shares by exercising an employee stock option, the taxable employment benefit is based on the difference between the price you paid and the fair market value of the shares on the date you sell them. A benefit deduction of 50% is available so that the stock options are taxed at capital gains-type rates, even though it is still classified as taxable employment income.
While the value of the taxable benefit is fixed when the shares are acquired, taxation of the benefit can generally be deferred until the year the employee sells the shares.
This all works fine unless the shares lose value between the time you acquire the shares and the time you sell them. There is a mismatch because the allowable capital loss cannot be used to offset the taxable employment benefit, but only other capital gains, and this results in a crushing tax burden for some employees when stock values drop hard and fast (e.g. post 2000).
To help with this problem, the government has introduced a new tax elective that lets employees pay a maximum tax bill equivalent only to the market value of the stock when it is sold. This removes the burden of having a higher tax bill than the shares are worth. No capital loss can be claimed at the same time, but at least the bottom doesn’t fall out completely.
On the other hand:
The above solution is only offered retroactively to stock options exercised prior to 2010. For public companies, the 2010 budget removes the opportunity for an employee to choose to defer tax until the shares are sold, thus removing the original problem altogether, at least from the CRA’s point of view. It is still possible for tax deferral involving shares of a Canadian Controlled Private Corporation (CCPC).
2. Withholding
Coupled with these changes in tax deferral, the government now requires that the employer must withhold income tax at source when the options are exercised; the employment benefit is treated as if it were a cash bonus during the period. Again, the withholding rules do not apply for CCPC’s; however, for public companies, there is a concern that this withholding requirement now means an open-ended, uncontrollable contingent liability for the company, especially for stock prices that rise substantially. Employers may need to create an administrative mechanism to ensure that when options are exercised, sufficient shares are sold immediately to cover the cash that needs to be remitted to the CRA.
3. Cash or No Cash
The third area of significance represents, essentially, the closing of a loophole. "Tandem" stock option plans permit employees to dispose of their stock option rights for a cash payment from their employer. Previously, employers were allowed to deduct the cost of the cash payment as an expense, and the employee was able to claim the 50% stock option benefit reduction as well.
This "double dipping" is no longer allowed and the employer now has to choose between taking the deduction or allowing the employee to receive the 50% deduction. If the employer takes the deduction, the employee will be liable for tax on the full value of the cash payment. There are several possible approaches, including eliminating the cash-out aspect of the plan, replacing the plan with full-value grants, or forgoing the employer deduction. For some employers, fixing this may be complex, as there will be accounting, disclosure and employment laws to take into consideration.
When all is said and done:
As always, the tax code is a work in progress. Benjamin Franklin famously told us that tax is one of the two things of which we can be certain – at least it helps to know which direction the code is pointing. If you have questions, feel free to contact the author, or better yet, talk to your accountant.
By Charles Brooks, Corporate Recruiters Ltd. Charles can be reached at charles@corporate.bc.ca
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