The Canadian federal budget (the “Budget”), announced and effective March 4, 2010, introduced some notable changes to the tax ramifications of employee stock options.
Employees that acquire shares of their employer pursuant to an employee stock option agreement (or a tandem stock appreciation right, settled in shares) are required to include as income the difference between the value of the security at the time the option is exercised and the amount actually paid by the employee on the exercise of the option as a taxable employment benefit. This continues to be the case. The changes made relate largely to the timing of the inclusion and the availability of a tax deduction, meant to reduce the value of the taxable benefit (in some cases) to mirror capital gains treatment.
Under the pre-existing regime, employees of publicly traded companies were entitled to defer recognition of the taxable benefit until the time at which the shares were sold where certain conditions were met. Under the Budget rules, this deferral would no longer be available in respect of options of publicly traded companies that are exercised after March 4, 2010. This change does not affect the deferral that is available for options in respect of Canadian-controlled private corporations.
That said, individual taxpayers who have previously elected to defer taxation of their stock option benefits until the year of disposition are able to take advantage of a special election which, broadly, limits their tax liability to the proceeds of disposition in respect of the optioned shares. This relief, which is meant to assist taxpayers that hold shares that are now worth less than their tax liability in respect of those shares, is available to employees who exercised their options before 2010, provided the election is filed before the tax filing deadline for 2010.
The federal budget also clarifies that the disposition of rights under an option agreement to a non-arm’s length party results in a taxable employee benefit at the time of disposition. This is meant to serve as a clarification of the existing law.
Stock appreciation rights (“SARs”) entitle an employee to elect to receive either shares in the employer or a cash payment. Under the pre-existing SAR regime, employees that elected to receive a cash payment were entitled to a deduction equal to 50% of the taxable benefit, while the employer was entitled to deduct the cost of the cash payment to the employee. Under the proposed rules, it will no longer be permissible for both the employer and the employees to obtain deductions in respect of the cash payment. Instead, in order for employees to deduct 50% of the taxable benefit, the employer will be required to file an election agreeing to forego the tax deduction that would otherwise be available to the employer in respect of the cash payment.
The federal budget further clarifies the rules in respect of withholding by an employer, requiring the employer to withhold at the source in respect of all stock option benefits granted in or after January 1, 2011, except where otherwise provided.