STOCK OPTION CASH OUTS
Under employee stock option plans, an employee does not always end up holding securities when they exercise their options. Instead, some plans are structured to allow the employee to dispose of their stock option rights for a cash payment from their employer or some other in-kind benefit. From a tax perspective, this provided a benefit to both the employee and employer.
Under the stock option rules, a taxable employment benefit will result if the employee exercises their options to purchase securities. Where certain conditions are met, a stock option deduction equal to 50% of the benefit will be allowed. For options granted to purchase publicly listed securities, the primary condition is that the exercise price cannot be less than the fair market value of the security at the time the option is granted. For Canadian-Controlled Private Corporation securities, generally a stock option deduction will be allowed provided a two-year holding test is met. The deduction effectively allows the benefit to be taxed at the same rate that applies to capital gains.
The income tax rules also prevent employers from claiming a tax deduction for the issuance of securities under stock options plans. However, where a plan allowed for a cash payment instead of the issuance of securities, the cash payment was fully deductible to the employer, while the employee could generally benefit from the 50% stock option deduction.
By allowing stock option benefits to be taxed at rates that normally apply to capital gains, the tax rules provide preferential tax treatment to employees. However, it was not the government’s intention to provide a benefit to employers by allowing them to deduct the cost of such benefits. As a result, the government proposed a change in the federal budget to prevent both an employee from claiming a stock option deduction and an employer from claiming a tax deduction related to the same taxable employment benefit. The stock option deduction will continue to be available to employees who receive securities where current conditions are met. As well, employers will continue to be allowed to structure employee stock option plans that allow employees to receive cash and be eligible for the 50% stock option deduction, but only where the employer elects to forgo the deduction for the cash payment. If a deduction is claimed by the employer, then the option benefit will be 100% taxable.
The draft wording of the rules indicate that the employer would file an election with the CRA to forgo the deduction. The employer would also provide the employee with written evidence of the election to not claim a deduction for the payment made to the employee. The employee would then be required to file this written evidence along with their tax return in which they claim the 50% stock option deduction. This measure will apply to dispositions of employee stock options that occur after 4pm EST on March 4, 2010.
It will be important for employers to consider current employee stock option plans that allow for cash outs to determine the impact of these rule changes. As well, employers will need to determine if this type of plan is feasible on a go forward basis, due to the loss of the employer deduction where preferential tax treatment continues to be available to their employees — or if other compensation strategies make more sense. Consult with your BDO advisor on the implications of these changes.
Next section: Withholding Requirements on Stock Option Benefits are Changing
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