Boards of directors seek to hire and retain talented, qualified and experienced executives and senior management. In the middle market, such leaders are ambitious and passionate about contributing to the success of the company and often find themselves in high demand. Boards of directors may offer compensation packages consisting of base salaries, bonuses, long-term incentives, benefits and other rewards designed to attract and retain top talent and motivate performance.
Employee Stock Options (ESO)
An ESO plan agreement is an agreement that grants executives rights to acquire specific numbers of shares at a predetermined, fixed price, at some future date. Generally, options subject to ESO plans will vest and become exercisable upon fulfillment of certain conditions. These conditions could be based on tenure, or performance or valuation metrics. ESO are subject to an expiry date. On exercise, the executives pay the strike price to acquire the shares of the company. For example, an executive receives 1,000 ESO on Jan. 1, 2015, when the FMV was $10 per share. The exercise price is $10 per share with a three-year vesting period. On Jan. 1, 2018, the FMV of the shares equals $40 per share. The executive then acquires 1,000 company shares with a FMV of $40,000 (1,000*$40) by paying $10,000 (1,000*$10). It is common for executives of a private company to delay the exercise of their ESO until the occurrence of a liquidity event, such as a sale of a company. This is because the executives may need to accumulate funds to finance the income tax liability that occurs on the exercise of the ESO and/or there may be no or a limited market to sell the shares of the company to be able to pay the income tax liability, as explained further below.
One important commercial advantage of ESO is that the executives, as owners, have a stake in the strategic and growth plans of the company and therefore are motivated to ensure its success. They may also have voting rights that could influence decision-making.
A disadvantage of ESO is that the executives may need to finance the purchase price to acquire the shares of the company. Further, as owners, the executives’ wealth may be closely tied to the company’s value, such that any fluctuation in company value could impact the executives’ net worth. Also, on exercise of the ESO, new shares may be issued from treasury (rather than repurchased from the market), thereby diluting existing shareholders’ interests in the company. Finally, every time the company issues stock options, it is required to value the company to determine the value of the ESO, making ESO plans costly to implement.
CANADIAN INCOME TAX TREATMENT OF EMPLOYMENT INCOME
Generally, employment income is subject to tax in the year of receipt. Employment income could consist of salary, bonus and other remuneration. It could also include the value of any benefits that an employee receives or enjoys by virtue of being an employee of the company such as the use of employer provided vehicles. There are exceptions to the general rule of including amounts from employment in income in the year of receipt. Two common exceptions are the salary deferral arrangement and ESO.
A salary deferral arrangement is an arrangement whereby the employee has a right to receive salary or wages in a future year for services rendered in the year or a previous year and it is reasonable to conclude that one of the main reasons for this right is to postpone tax. Salary deferral arrangement may exist even where the right is subject to one or more conditions. In arrangements where the right is subject to substantial risk that the deferred amount would be forfeited then the arrangement may fall outside the scope of a salary deferral arrangement. Where an arrangement constitutes a salary deferral arrangement, an amount equal to the deferred amount is considered to be a benefit in the year such benefit is received and subject to income tax in that year. As such, the employee is taxed on a deferred amount in the current year if it is considered to be a salary deferral arrangement. Correspondingly, the employer is allowed a deduction in the year that the employee is subject to tax on the deferred amount.
Where, pursuant to ESO plans, a company has agreed to sell or issue its shares or shares of a related company to its employees or the employees of a related company, and the employees deal at arm’s length with the company or the related company, there are specific rules that govern the income tax treatment of the benefit that arises on the issuance of these shares. The income tax treatment is slightly different depending on the classification of the issuer i.e., whether the company is a non-Canadian controlled private corporation (“non-CCPC”) such as a public company or a Canadian controlled private corporation (“CCPC”) as this will impact the Canadian income tax treatment of the benefit.
TAX TREATMENT INVOLVD PRIVATE CORPORATION ISSUERSING NON-CANADIAN CONTROLLE
Where a company that is non-CCPC issues an ESO to its executives, there are no immediate tax implications on the grant of the ESO. An employment benefit arises on the exercise date, equal to the excess of the FMV of the shares acquired at the time of exercise over the amount the executive paid to acquire the shares. In the above example, an employment benefit of $30,000 (($40 - $10) * 1,000) arises at the time of exercise. Since the ESO is issued by a non-CCPC, the employment benefit is taxable in the year the ESO is exercised by the executive.
The executive may receive a deduction equal to half the employment benefit if generally the following conditions are satisfied:
- The exercise price of the ESO is equal to or greater than the fair market value of the share at time the ESO is granted
- Immediately after the ESO is granted, the executive must be dealing at arm’s length with the company granting the option
- The shares issued are prescribed shares. A common share of a company would generally qualify as a prescribed share
The effect of the one-half deduction, if available, is to tax the employment benefit at a rate that is equivalent to the capital gains inclusion rate. In the example above, a one-half deduction of $15,000 is available and the net employment benefit of $15,000 is subject to income tax at the executive’s marginal tax rate.
The net employment benefit received by the executive is considered a form of remuneration that is subject to payroll source withholding as if it were a bonus for the taxation year. Accordingly, the company is required to withholding CCP and income tax on the net benefit received by the executive but withholding will not apply in respect of one-half of the employment benefit that is deductible.
The executive’s adjusted cost base of the shares for income tax purposes is equal the purchase price paid plus the full employment benefit. In this case, the executive’s adjusted cost base of the 1,000 shares would be $40,000 ($10,000 + $30,000).
TAX TREATMENT INVOLVING CANADIAN CONTROLLED PRIVATE CORPORATION ISSUERS
An executive of a company that is a CCPC will be subject to similar income tax implications as discussed above for non-CCPC issuers except in a few specific respects.
First, the taxation of the employment benefit is deferred to the year the executive sells the shares. Therefore, on the exercise of an ESO of a CCPC, there are no immediate tax consequences to the executive on exercise of the ESO.
Second, the executive may also receive a deduction equal to one-half of the employment benefit, similar to the executive of a non-CCPC, provided the conditions discussed above are met. Where the executive is granted ESOs, and the exercise price of the option is less than the fair market value of the shares at the time it is issued, the one-half deduction may still be available to the executive if the executive holds the CCPC shares for at least two years (from the date of acquisition), before selling the shares.
Also of note, if the company is no longer a CCPC at the date of exercise, the executive may still defer the taxation of the employment benefit to the year of disposition of the shares. For example, if the ESO were granted by a CCPC prior to becoming a public company or being acquired by a non-resident purchaser, the executives would retain the one-half deduction tax benefit otherwise afforded to CCPC ESO holders (subject to the conditions described).
Further, the payroll source withholdings are not required if the net employment benefit arose on the exercise of the ESOs to acquire shares of a CCPC. This reflects the fact that the employment benefit on the disposition of CCPC securities is not recognized until the securities are sold or exchanged, so withholding may not apply appropriately in such situations.
CASH IN LIEU OF SHARES
Executives may have the option to choose to receive cash instead of shares of the company. Where the executive elects to receive cash on exercise of the ESO, the employment benefit is equal to the cash received less the amount the executive paid to acquire the rights. The employment benefit is taxable in the year of exercise. The executive may be eligible for the one-half deduction if the conditions discussed under the Non-CCPC above are met. However, if the employer i.e., the company, elects to pay cash instead of issuing shares of the company, the employment benefit is fully taxable to the executive. Further, the executive may not be eligible for the one-half deduction, unless the company forgoes claiming the deduction for the cash paid (as explained below).
The company should not be entitled to claim any deduction for the issuance of the shares pursuant to an ESO arrangement.
However, in the case where the company has elected to pay cash instead of issuing its shares or shares of a related company to the executive, the company may take a deduction for the cash paid to the executive. Alternatively, the company may elect to forego the deduction and allow the executive to claim the one-half deduction provided the conditions for the deduction are met.
2019 Budget Proposal
The recent 2019 Federal Budget proposes to align Canada’s ESO tax treatment with that of the Unites States by applying a $200,000 annual cap on any ESO grant that is currently eligible for tax-preferred treatment, and that is made to employees of “large, long-established, mature firms”. The cap is based on the fair market value of the underlying shares at the time that the ESO is granted. For example, assume that an employee of a large, long-established, mature company is granted an option to acquire 100,000 shares at a price of $50, the fair market value at the time the option is granted and that the share price is $70 when the option is exercised. In this situation, 4,000 (200,000 / $50 = 4,000) of the options would qualify for the current preferential tax treatment and the remaining 96,000 options would be fully taxed at the ordinary rates. As a result, $1,920,000 (($70 -$50) x 96,000) of the ESO benefit would be fully taxed while one-half of the remaining $80,000 (($70-$50) x 4,000) stock option benefit would be taxed at the rate that is equivalent to the capital gains rate. This would result in an overall income inclusion of $1,960,000 ($1,920,000 + ($80,000 / 2)), as compared to $1,000,000 under existing legislation.
The budget proposes to maintain the current preferential tax treatment for start-ups and rapidly growing businesses.
Further details on the new ESO regime is expected to be released before the summer of 2019. Any changes would apply prospectively and would not apply to employee stock options granted prior to the announcement of the legislative proposals to implement the new regime. It is imperative that Canadian business considering granting ESO to their employees to do so as soon as possible, before any proposed stock option legislation is tabled by the Ministry of Finance.