Companies that offer stock option plans to their employees may have to quickly re-evaluate these arrangements following significant changes to the tax treatment of stock options announced in the 2010 federal budget. Many of these changes are effective for stock options exercised after 4:00 pm (EST) on March 4, 2010.
These measures change the tax treatment of stock option cash-outs and eliminate the opportunity to defer tax on the employment benefit resulting from exercising qualifying stock options in public companies and private companies that are non-Canadian controlled private corporations (non-CCPCs). The budget measures also require employers to withhold tax on benefits from employee stock options exercised after 2010.
For employees with underwater stock options, the budget measures may provide some welcome tax relief. This relief may be available for stock option benefits going as far back as 2001.
Background — Tax treatment of stock options
A stock option plan is an arrangement whereby a corporation gives an employee the right (an option) to purchase its shares at a given price. The price may be above or below the market price at the time the option is granted.
When the employee exercises the option to acquire the shares, the difference between the price the employee pays for the shares and their market value is treated as a taxable benefit to the employee.
If certain conditions are met, the employee can claim a deduction of one-half of the taxable benefit. The effect of this deduction is to tax the employment benefit at the same rate as a capital gain.
Generally, public company employees may qualify for the deduction if:
- The shares are normal common shares (not preferred shares)
- The exercise price is at least equal to the fair market value of the shares at the time the option was granted
- The employee deals at arm’s length with the corporation.
Before the 2010 federal budget, public company and non-CCPC employees were allowed to postpone the taxation on the benefit on $100,000 per year of qualifying stock options to when the shares were sold instead of when the options were exercised.
Stock options in Canadian controlled private corporations (CCPCs) are treated differently. As long as the employees deal at arm’s length with the corporation, the taxable benefit is reported when the employees sell the stock option shares, rather than when they exercise their options and acquire the shares. The 2010 federal budget does not affect these rules for CCPCs and their employees.
Stock option cash-outs
Some stock option plans have a “stock appreciation right” attached to them. Such plans allow the employee to receive a cash payment equal to the value of the options instead of purchasing the shares. In other words, the employee can “cash out” the options.
Before March 4, 2010, the same tax consequences for the employee resulted from the cash payment as from the issuance of shares — the employment benefit was included in income and the related one-half deduction was available if the required conditions were met. The employer could claim a deduction for the full amount of the cash payment.
The 2010 federal budget proposes to change these rules such that employees who receive a stock option cash-out can only claim the deduction of one-half of the employment benefit if the employer elects to forgo the deduction for the cash payment. If the employer does not make this election, it will be entitled to a corporate tax deduction for the payment but the employees must pay tax on the full value of the employment benefit. This change is effective for all stock options that are cashed out after 4:00 pm (EST) on March 4, 2010, regardless of when the options were issued.
The Department of Finance has not provided any grandfathering relief for stock option cash-out arrangements that were in place before the proposed changes to the rules in the 2010 federal budget. As such, employers and employees will need to reconsider the implications of any cash-out arrangements in place prior to March 4, 2010 before completing the transactions.
Finance has confirmed that an employer’s election to forgo the deduction for the cash payment when an employee cashes out his or her stock option rights can be made separately for each employee. In other words, it does not necessarily have to apply to all the employees in the stock option plan.
Finance has also indicated that the policy reason for not allowing employers to claim a deduction for a stock option cash-out payment is to preserve symmetry in the tax treatment of stock-based compensation. (When an employee exercises stock options and acquires shares, the employer does not get a deduction because it does not pay out cash.) This policy change also achieves more consistency with the U.S. tax treatment of stock options.
Example of new tax treatment of stock option cash-out
The following analysis illustrates the effect of the change by comparing the after-tax cost of stock option cash-outs to employees and employers under the old pre-budget rules and the new post-budget rules.
As the table shows, the employee’s after-tax proceeds of a $100 cash-out payment can remain the same pre- and post-budget at $77 (columns 1 and 2). However, the pre-budget regime caused the CRA to effectively lose a total of $7 in tax revenue per $100 of benefit, rather than receiving $23 in tax revenue from the employee. The reason for this tax revenue difference is the employer’s tax savings of $30 from claiming a deduction for the $100 cash payment to the employee.
Post-budget, the elimination of the employer’s tax deduction results in the CRA receiving $23 per $100 of benefit (when the employer elects to forgo the deduction (column 2)). If the employer does not elect to forgo the deduction (column 3), the CRA receives $16 in tax (compared to $23) but the net after-tax proceeds to the employee fall to $54 because the employee cannot claim the stock option deduction.
|Tax Results of Pre- and Post-Budget Employee Cash-Outs|
|Employer Cash Paid||$100||$100||$100|
|Tax Savings @ 30% (C)2||30||–||30|
|Net After-Tax Cost to Employer||$ 70||$100||$ 70|
|Employee Cash Received||$100||$100||$100|
|Less Stock Option Deduction||50||50||–|
|Tax thereon @ 46% (P)3||(23)||(23)||(46)|
|Net After-Tax Proceeds to Employee||$ 77||$ 77||$ 54|
|CRA perspective: Net tax
revenue lost (received) (C –
|1) The employee and employer will get the same tax result as the cash-out with election if
the employee acquires the shares instead of taking the cash-out.2) Assuming a 30% corporate tax rate, $100 deduction equals $30 in tax savings.3) Assuming a combined federal/provincial top marginal personal tax rate of 46%.
The table illustrates that the cash-out without the employer election to forgo the deduction may be the least appealing, even though less tax is paid initially, because the employee is significantly worse off.
If the employer did not elect to forgo the deduction (column 3), the employee would get a better result (from a tax point of view) by acquiring the shares instead of taking the cash-out option. The employee could then sell the shares to achieve the same cash position as the cash-out option with the employer election to forgo the deduction.
Accounting implications of tax changes
In situations where employees holding options to acquire shares under an employee stock option plan are entitled or can choose to receive cash in lieu of shares and they elect to receive those cash payments, these cash-settled grants were generally classified in the financial statements as a liability.
For Canadian GAAP purposes, transactions settled in equity instruments are generally classified as equity-settled awards and other transactions are classified as liability (cash-settled awards).
For these cash-settled awards, the company may have recorded a future tax asset on the basis that it will receive a deduction when the employee ultimately elects to receive cash payments and the cash payment is made. The proposed budget changes may require the company to review its accounting treatment of its future tax asset.
In addition, as a result of the proposed budget changes, companies may choose to modify the terms of their existing stock option agreements such that their existing liability classified stock option awards are reclassified as equity-settled awards. In these cases, they need to carefully consider the accounting treatment for the change in terms and conditions.
Deferral of stock option taxable benefit
Before the 2010 federal budget, public company employees who exercised stock options could generally defer tax on the related taxable benefit on up to $100,000 of annual qualifying employee stock options until the shares were actually sold. The budget proposes to eliminate this deferral, effective for stock options exercised after 4:00 pm (EST) on March 4, 2010.
As such, employees who exercise stock options after 4:00 pm (EST) on March 4, 2010 will not be able to defer tax on any of their employment benefit.
Employer withholding tax requirements
The budget states that, for benefits arising on the issuance of securities after 2010, employers must withhold tax on a stock option employment benefit from the employee’s pay. The amount of the withholding can be reduced for the 50 percent stock option deduction if the employee qualifies for the deduction.
As a result, employees who exercise stock options after 2010 will effectively have to pay the tax right away, rather than when they file their tax return for the year.
This tax withholding measure does not apply to options granted before 2011 under a written agreement entered before 4:00 pm (EST) on March 4, 2010, if the agreement includes restrictions on the optioned shares’ disposition.
Before the budget, employers were technically required to withhold tax on the employment benefit at the time of exercise. However, if the employee was not paid any cash, the CRA administratively waived the tax withholding requirement on the benefit for Canadian resident employees.
The budget does not provide details on how the employer will, as a practical matter, withhold the appropriate tax on the employment benefit when the employee does not receive any cash compensation on the exercise of the stock option.
Presumably, the employee will have to provide cash to the employer so that the employer can remit the required employee withholding tax to the CRA. Non-CCPC private companies will unfortunately place their employees in a difficult position where no market in which to sell the shares is available to the employee. Amendments to such plans will likely be necessary.
Employees who exercise stock options will need to keep in mind when considering whether to sell any of the shares that they will effectively need to have funds to pay a tax liability as soon as they exercise their options.
Underwater stock options
Shares purchased through a stock option plan are usually expected to increase in value. However, some employees who exercised stock options and did not sell the shares right away may have seen the shares’ value fall since the day they exercised their options.
Depending on how much the shares’ value has fallen, employees with these “underwater” stock option shares who deferred the taxable benefit when they exercised their options (as described above) could end up with a deferred tax liability greater than the value of the shares. The budget proposes a special election that the employee can make to ensure that any tax liability on the deferred stock option benefit, when realized, does not exceed the proceeds from the shares’ disposition.
Effectively, the election mechanism converts the taxable employment benefit from the employee’s income into a deemed taxable capital gain. In exchange, the employee pays a special tax equal to the actual proceeds received on the sale of the shares. By making the election, the employee applies the capital loss realized on the disposition of the shares to the deemed taxable capital gain, thereby using allowable capital losses that otherwise must be applied to taxable capital gains.
As such, employees who deferred the taxable benefit on a stock option exercise and who dispose of the shares for proceeds less than the taxable benefit can elect to pay tax equal to the proceeds of disposition instead of paying tax on the taxable benefit. To take advantage of the election, the employee must make the disposition before 2015.
In assessing whether they should take advantage of the special relief, employees should keep in mind that the election reduces the potential for tax relief from using the capital losses otherwise available on the underwater shares against capital gains realized from disposing of other property.
Relief available as far back as 2001
The budget proposes to allow these elections for the previous 10 years (which goes beyond the normal three-year assessment period). Thus, it may be possible for employees to go back as far as 2001 to obtain relief for a deferred employment benefit that was realized on shares that were sold before the March 4, 2010 budget announcement.
To take advantage of this tax relief, employees must make the special election on or before their tax return filing due date for 2010 (generally April 30, 2011). For dispositions after 2010 but before 2015, the deadline for making the election will be the tax filing due date for the year the disposition occurs.
Example of underwater stock option election
The following example illustrates the tax consequences of making the underwater stock option election.
Assume that Mr. X is granted a stock option by his public company employer (Pubco) in 2008, when the fair market value of the Pubco shares equals the exercise price of $1,000. Mr. X exercises the option in 2009, when the fair market value of the shares has increased to $10,000. Thus, Mr. X has a taxable employment benefit of $9,000 in 2009 ($10,000 fair market value minus $1,000 exercise price). Mr. X chooses to defer the $9,000 employment benefit until he disposes of the shares. However, by 2010, the fair market value of the shares has declined to $1,000. Mr. X chooses to dispose of the shares in July 2010.
The following table illustrates the results of Mr. X making the underwater stock option election. This analysis assumes that Mr. X is subject to a combined federal/provincial top marginal tax rate of 46%.
|Tax Consequences of Underwater Stock Option Election|
|Employment Benefit 2010||$9,000||$9,000|
|Stock Option Deduction||(4,500)||(9,000)|
|Deemed Taxable Capital Gain1||–||4,500|
|Allowable Capital Loss2||–||(4,500)|
|Taxable Income||$4,500||$ –|
|Tax @ 46%||2,070||–|
|Special Tax (Proceeds of Disposition)||N/A||$1,000|
|1) Deemed capital gain equals ½ of the lesser of the employment benefit
and the capital loss (both $9,000 in this example).2) Allowable capital loss realized offsets deemed capital gain.
As the table shows, by making the election, Mr. X will reduce his normal $2,070 tax liability to $1,000. With the election, he claims a $9,000 deduction to remove the entire employment benefit from his income but instead he has to include in his income a deemed taxable capital gain of $4,500 ($9,000 benefit × 50% capital gain inclusion rate). He is then able to use his allowable capital loss of $4,500 ($10,000 cost base of the shares – $1,000 proceeds = $9,000 × 50%) to offset the deemed capital gain of $4,500. Thus, no capital loss remains for carryover.
Making this election completely eliminates Mr. X’s regular tax liability for the employment benefit/capital gain and uses up his capital loss. He is then left with paying the special tax equal to his proceeds of disposition of $1,000. This results in a current tax savings of $1,070 ($2,070 – $1,000).
However, if Mr. X expects to realize capital gains that he could use his allowable capital loss of $4,500 to offset, he may be better off not making the special relief election. In this situation, he would carry over the $4,500 capital loss and apply it against $4,500 in taxable capital gains to realize tax savings of $2,070 ($4,500 × 50%). Doing this would completely offset the $2,070 tax cost of the employment benefit while allowing him to keep the $1,000 proceeds from disposing of his underwater shares.
Generally, to make the special relief election worthwhile, an employee would have to see a significant drop in the value of the stock option shares (e.g., a loss of at least 80 percent of the stock’s value in our example) and not be able to use the related capital losses to reduce tax on other gains.
Also, depending on the exercise price, even if the shares significantly decline in value, an election may not be beneficial if the proceeds of disposition of the stock option shares are high in relation to the taxable employment benefit.
If the shares’ sale proceeds exceed the tax on the deferred taxable benefit, the election is not helpful.
Non-arm’s length employees’ stock options
The 2010 federal budget proposes to amend the income tax rules to clarify that the disposition of rights under a stock option agreement to a non-arm’s length person results in an employment benefit at the time of disposition (including cash out). Although the government considered that these benefits were taxable in these circumstances under existing tax rules, it also believed that clarification of these rules was warranted.