IBA 2001 CANCUN COMMITTEE NP STRUCTURING INTERNATIONAL EQUITY COMPENSATION PLANS CASE STUDY

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1 IBA 2001 CANCUN COMMITTEE NP STRUCTURING INTERNATIONAL EQUITY COMPENSATION PLANS CASE STUDY CANADIAN APPROACH BY ALAIN RANGER FASKEN MARTINEAU DuMOULIN LLP Stock Exchange Tower Suite 3400, P.O. Box Place Victoria Montreal, Québec H4Z 1E9 Tel: (514) Fax: (514) Vancouver Toronto Montréal Québec New York London

2 STRUCTURING INTERNATIONAL EQUITY COMPENSATION PLANS* A CANADIAN APPROACH Remuneration of employees through an equity compensation plan has become increasingly popular in recent years in the context of multinational corporations and Canadian employers and employees have been active participants in this phenomenon. Canadian corporations have expanded their activities abroad in the past ten years like never before and have established operations or subsidiaries in various countries. Similarly, during the same period, foreign corporations have discovered Canada as a new market and an increasing number of Canadian corporations have been the object of take-overs so that many Canadian employees have now become part of international groups. As a result of that globalization, Canadian practitioners have been faced with several tax, legal and other issues arising either in helping Canadian corporations and their subsidiaries to implement equity compensation plans for their Canadian and foreign employees, or in adapting foreign equity compensation plans to the Canadian tax and legal framework. Notwithstanding these developments and recent amendments, the Canadian tax system dealing with equity compensation has remained, in comparison with other countries, a very limited and simple structure. This paper will deal with the principal Canadian income tax and other legal aspects of international equity compensation arrangements affecting Canadian employees of foreign corporations rather than the rules applicable to Canadian corporations with regards to their foreign employees. 1 In the first part, we will summarize the principal rules applicable to stock option arrangements and other forms of equity compensation. The second part will address in greater detail the various questions raised by the case study. Part I Canadian Perspective on Equity Compensation Plans 1. Income Tax a) introduction As a preliminary remark, it is worth mentioning that residence, by opposition to citizenship for example, is the basis of assessment under the Canadian tax regime. An individual who is subject * The author would like to thank Thomas Copeland for his precious collaboration and Daniel Yelin for his comments. 1 The term employer used in the paper refers to a Canadian corporate employer which is an affiliate of the foreign issuer and the term employee refers to a Canadian participant in an equity compensation plan. Such a plan is referred to herein as an arrangement.

3 to tax in Canada will be taxed at graduated rates, i.e. the rate of tax increases in proportion to the annual income of the taxpayer. In addition to the tax payable to the Canadian federal government, individuals residing in Canada are subject to provincial income tax, which is based on the province of residence of the individual at the end of a calendar year. Historically, the provincial income tax has generally been calculated as a percentage of the Canadian federal tax. However, the province of Quebec, which has its own income tax legislation, establishes the income of an individual under its own rules (in most instances, these rules are similar to the federal rules) and levies tax at its own gradual rates. Other provinces are now beginning to adopt their own income tax rules and rates as well. In 2001, an individual residing in Canada is taxable on his or her income (including employment income) at a maximum rate that ranges between approximately 39% to 48.6% depending on the province of residence at the end of the year. An individual residing in Canada in any given year is liable to pay tax in Canada on his or her worldwide income, including his or her income for the year from each office and employment. An individual s income for a taxation year from an office or employment is composed of the salary, wages and other remuneration, including gratuities, received by the individual during the year. For purposes of the Income Tax Act (Canada) ( ITA ), an employee includes an officer. Furthermore, the definition of office at subsection 248(1) of the ITA provides that this term includes the position of a corporation director and adds that officer means a person holding such an office. b) taxation of employment benefit - general The taxation of an employment benefit pursuant to an employee stock option arrangement is provided for under section 7 of the ITA, which constitutes a system of taxation in and of itself within the broader section of the ITA dealing with employment income. 2 The rules of section 7 apply to both domestic and foreign arrangements with respect to shares issued or sold by a Canadian or a foreign employer, or by any corporation with whom the employer does not deal at arm s length. Therefore, section 7 determines the income tax consequences for an employee participating in a domestic stock option arrangement or an international stock option arrangement 3. Given the definitions of employee and office found in the ITA 4, the rules of 2 Where the conditions of application of section 7 are met, paragraph 7(3)(a) states that, except as provided by section 7, an employee is deemed to have neither received nor enjoyed any benefit under, or because of, the stock option arrangement. 3 Section 7 applies where a particular corporation has agreed to sell or issue its own securities or securities of another corporation with which it does not deal at arm s length to one of its employees or to an employee of a corporation with which it does not deal at arm s length. The Canada Customs and Revenue Agency ( CCRA ), the agency responsible for the administration of the ITA, gives a broad meaning to the word agree and takes the position that section 7 also applies to shares issued under a bonus plan or without any formal written agreement. 4 Supra, section a). 2

4 the ITA dealing with employee stock arrangements apply to ordinary employees as well as to officers and directors. Under section 7 of the ITA, the benefit deemed to be received pursuant to a stock option arrangement is calculated at the time of exercise of the option and acquisition of the securities (or at a later date in certain circumstances 5 ), and not at the time at which the rights are granted under the stock option arrangement. 6 As a general rule, paragraph 7(1)(a) provides that if the employee has acquired shares under the arrangement, the employment benefit is equal to the difference between the fair market value ( FMV ) of the shares at the time they are acquired by the employee and the aggregate of (i) the amount paid, or to be paid, for the shares at the time the employee acquired them and (ii) the amount, if any, paid by the employee to acquire the right to acquire the shares. Additional rules exist in order to deal with various changes in ownership of the stock option 7. For instance, paragraph 7(1)(b) of the ITA states that if the employee has transferred or otherwise disposed of rights under the stock option arrangement in respect of some or all of the shares to a person with whom the employee was dealing at arm s length, a benefit is deemed to be received by the employee because of his or her employment in the taxation year in which the disposition occurred. The value of the deemed employment benefit is equal to the excess of the value of the consideration received for the disposition of the rights over the amount, if any, paid by the employee to acquire the rights. If, however, the rights of the employee under the arrangement have, by one or more transactions between persons not dealing at arm s length, become vested in a person other than the employee who has acquired shares under the arrangement, paragraph 7(1)(c) establishes that a benefit, equal to the excess of the FMV of the shares at the time of their acquisition by the non-arm s length person over the sum of (i) the amount paid, or to be paid, to the issuer by the non-arm s length person for the shares and (ii) the amount, if any, paid by the employee to acquire the rights to acquire the shares, is deemed to have been received, in the taxation year in which the 5 Infra, section c). 6 Special rules are applicable to arrangements that provide for the issuance of shares of a Canadian-controlled private corporation where the benefit is generally taxable in the year of disposition of the shares rather than in the year of exercise of the option. Given the scope of this paper, these rules will not be reviewed. 7 Subsection 7(1.4) of the ITA allows for some changes in the ownership of the stock options on a tax-deferred basis. In general terms, where an employee exchanges his option to acquire shares of a particular issuer for an option to acquire shares of the same issuer, of a corporation with whom the issuer does not deal at arm s length after the exchange, of a corporation formed on the amalgamation or merger of the issuer and one or more other corporations or of a corporation with whom such amalgamated or merger corporation does not deal at arm s length immediately after the exchange and the FMV of the new option is not greater than the FMV of the old option, the employee is deemed not to have disposed of the old option and not to have acquired the new option and such new option is deemed to be the same option and a continuation of the old option. 3

5 non arm s length person acquired the shares, by the employee because of his or her employment. If the employee is deceased at the time of the acquisition of the shares by the non-arm s length person, the employment benefit is deemed to have been received by the non-arm s length person in that year as income from an employment performed by such person in that year in the country in which the deceased employee primarily performed the duties of his employment. Paragraph 7(1)(d) states that if the rights of the employee under the arrangement have, by one or more transactions between persons not dealing at arm s length, become vested in a particular person who has transferred or otherwise disposed of rights under the arrangement to another person with whom the particular person was dealing at arm s length, a benefit, equal to the excess of the value of the consideration for the disposition over the amount, if any, paid by the employee to acquire those rights, is deemed to have been received, in the taxation year in which the particular person made the disposition, by the employee because of his employment. Again, if the employee was deceased at the time of the acquisition of the rights by the arm s length person, the employment benefit is deemed to have been received by the non-arm s length person in that year as income from an employment performed by the non-arm s length person in that year in the country in which the deceased employee primarily performed his or her employment duties. Finally, if an employee who has died owned, immediately prior to his or her death, a right to acquire shares under an arrangement, paragraph 7(1)(e) provides that a benefit, equal to the amount, if any, by which the value of the right immediately after the death exceeds the amount, if any, paid by the employee to acquire the right, is deemed to have been received, in the taxation year in which the employee died, by the employee because of his or her employment. Subsection 164(6.1) of the ITA will provide relief, in certain circumstances, where the value of the stock option decreases after the death of the employee. More particularly, if the right to acquire the shares is exercised or disposed of by the employee s legal representative within the first taxation year of the estate of the employee and the representative so elects on or before a prescribed day and in the prescribed manner, the amount by which (i) the amount of the benefit deemed to have been received by the employee in respect of the stock option exceeds (ii) the amount by which the value of the right immediately before the time it was exercised or disposed of exceeds the amount, if any, paid by the employee to acquire the right 8, is deemed to be a loss of the employee from employment for the year in which he or she died. This means the deemed employment loss can be used to reduce the employment benefit otherwise calculated for the taxation year of the employee s death. c) deferral of recognition of the benefit 8 The ITA provides certain adjustments to the amount of the employment loss where the employee was entitled to a deduction with respect to the employment benefit in the year of death (infra, section d)), as well as to the cost of the rights for the estate. 4

6 While the general rule is that the employment benefit is taxable in the year the employee exercises the option and acquires the shares, a recently introduced exception 9 allows for the deferral of taxation of a portion or the full amount of the employment benefit from the date the option is exercised to the date at which the shares acquired pursuant to the stock option are sold or exchanged. More particularly, the taxable benefit may be deferred until the earlier of the year in which the employee disposes of the shares 10, the year in which the employee dies 11 or the year in which the employee becomes a non-resident of Canada 12. However, certain conditions are prescribed in order to benefit from that deferral: (i) (ii) (iii) (iv) the shares acquired under the stock option must be at risk, i.e. they must be ordinary common shares without guarantee, retraction or redemption features; the amount payable by the employee to acquire the shares under the arrangement is not less than the excess of the FMV of the shares at the time the stock option is granted over the amount, if any, payable by the employee to acquire the right to acquire the shares; the employee must deal at arm s length with the employer or any other corporation granting the stock option immediately after entering into the option arrangement; immediately after the grant of the option, the employee must not be a specified shareholder (i.e. a person that owns, directly or indirectly, at least 10% of the issued shares of any class of the capital stock of a particular corporation or a related corporation) of the entity granting the option, the employer or the entity whose shares could be acquired under the option; and 9 The deferral is available for shares acquired after February 27, 2000, without regard to the date the option relating thereto was granted or when it vested. It is therefore generally available for stock options existing on and after February 27, Subsection 7(1.5) of the ITA provides for a deferral of the employment benefit where a disposition of shares occurs as part of a corporate reorganization or capital restructuring as long as the employee does not derive an economic benefit. Subsection 7(1.5) applies in situations similar to those in which subsection 7(1.4) applies (supra, footnote 7). 11 Subject to one limited exception, a taxpayer is deemed to dispose of all of his or her capital property immediately before his or her death at the FMV of the property immediately before the taxpayer s death (infra, section h)). 12 Where an individual ceases to be resident in Canada, he or she is deemed to dispose of his or her capital property for proceeds of disposition equal to their FMV at that time. 5

7 (v) the shares must be shares of a class of shares listed on a prescribed Canadian or foreign stock exchange. 13 The deferral, which is elective 14, is subject to an annual Cdn$100,000 limit on the value of all qualified options vested (i.e. when they first become exercisable) in a particular calendar year with respect to the employee. 15 This $100,000 limit will generally be based on the FMV of the shares subject to the arrangement at the time the option was granted. 16 Any portion of the $100,000 limit available in any given year that is not used by the employee (for example, because the FMV of the shares acquired pursuant to an option that vested in the year was less than $100,000 at the time the option was granted) cannot be carried forward to another year. For example, let us assume that an employee has an option to acquire 8,000 shares of the capital stock of his or her employer s parent corporation and that the exercise price is $20 a share, a price which corresponds to the FMV of the shares at the time the option is granted. Half of the option vests in 2002 and the other half in If the employee exercises his option in 2005 at a time when the shares have a FMV of $120 each, the employment benefit of $800,000 (8,000 x ($120 $20)) could be deferred, at the option of the employee, from 2005 to the year of disposition of the shares. Hence, since the value of the shares which were subject to the option that vested in 2002 was $80,000 (4,000 x $20) at the time that the option was granted, the $100,000 threshold for a particular year has been met with respect to the option vested in Similarly, the $100,000 threshold has been met for the option vested in If, however, the arrangement had been designed such that the option for all 8,000 shares had vested in 2002, the 13 The prescribed foreign stock exchanges include most of the American, European and Asian stock exchanges. 14 The election must be filed by the employee, in prescribed form and manner, before January 16 of the year following the year in which the acquisition of the shares occurs. Practically speaking, the employee must submit a letter to the person designated to report the employment benefit (usually the employer) containing a confirmation that (i) the employee was a resident of Canada at the time of the acquisition of the shares, (ii) the Cdn$100,000 annual vesting limit has not been exceeded and (iii) the amount of the benefit relates to shares purchased under an arrangement after February 27, Since an employee may receive options from more than one employer, or more than one corporation in a group, the employee has the responsibility to ensure compliance with the limit and has to keep track of whether the Cdn$100,000 annual vesting limit has been exceeded. However, the CCRA expects that, upon request, the employer will be able to provide assistance in furnishing the employee with information relevant to the limit. Furthermore, the CCRA is of the view that when an employer accepts the election from an employee, the employer must be satisfied that the conditions for a valid election have been met. Unless the employer has reason to believe otherwise, the CCRA is of the view that it is reasonable for an employer to rely on the certification made by the employee that the Cdn$100,000 annual limit has not been exceeded and that the employee was a resident of Canada at the time of the share acquisition. Finally, it should be noted that an employee may revoke an election already filed by filing a written notification to this effect with the person (likely the employer) with whom the election was filed. As for the election, the deadline for filing the revocation is January 15 of the year following the year in which the shares are acquired. 16 When a stock option is valued in a foreign currency, the exchange rate in effect at the date the option is granted must be used. 6

8 employee would have been able to use the deferral only for a portion of the shares acquired in 2005 since the total value of the shares for the vesting year 2002 would have exceeded $100,000 (8,000 x $20 = $160,000). d) reduction of employment benefit The benefit realized under a stock option arrangement is fully taxable as income from employment. However, the ITA allows for a 50% deduction of the deemed employment benefit in computing the employee s taxable income to the extent that the conditions described in (i), (ii) and (iii) in section c) above are met. 17 Consequently, the 50% deduction of the benefit otherwise established is available only to the extent that the price paid by the employee to acquire the option and the shares pursuant to the stock option arrangement is at least equal to the FMV of the shares on the date the stock option is granted. 18 While Canadian equity regimes do not generally provide for a reduction or a discount of the stock option price (i.e. the option price is generally equal to the FMV of the shares at the time the option is granted 19 ), a discount is often granted under foreign equity compensation arrangements. Generally, these discounts will have a negative impact on the Canadian employees. Because of the importance of the 50% deduction available to employees under the Canadian tax regime, an exception to the discount principle will often be suggested with regards to Canadian employees. For example, let us assume that an employee has an option to acquire shares of his employer s foreign parent corporation at a 10% discount of the FMV at the time the option is granted. The FMV of the shares at that time is $100 and the shares are worth $200 at the time the employee exercises the option and acquires the shares. While the employee would need only $90 to acquire the shares, there will be a taxable benefit of $110 and the employee will have to pay approximately $55 in tax (assuming a 50% rate of tax). Therefore, while the employee saves $10 on the purchase price (in comparison with the FMV of $100 at the time the option is granted), he or she suffers a tax of $55, i.e. a net outlay of $45. If the stock option price had been set at $100 initially, the taxable benefit would have been $100, subject to a reduction of $50. The $50 taxable benefit would have created a tax liability of $25 (assuming a 50% rate of tax). As a consequence, while each share costs $10 more to the employee upon acquisition, he or she only pays $25 of tax for an aggregate cost of $35 rather than $45. In 17 Since only one-half of the capital gain (the taxable capital gain) is subject to tax under the ITA, the 50% deduction of the deemed employment benefit, when applicable, has the effect of taxing the stock option benefit as if it were a capital gain. The regime that exists under the ITA for employees of Canadian-controlled private corporations provides for less onerous conditions in order to obtain the 50% deduction. 18 It should be noted that the exercise price under an employee stock option arrangement is to be determined without reference to changes in the value of a foreign currency relative to Canadian currency after the option is granted. 19 The option price is generally the average trading price over a specific period of time. Where the employee had to pay an amount to acquire the right to acquire the shares, the amount payable for the shares must be at least equal to the excess of the FMV of the shares at the time the option is granted over the amount paid to acquire the right. 7

9 addition, as more fully described in section c) above, the discount will have the effect of denying the elective deferral of the recognition of the employment benefit. e) cost of shares In order to avoid double taxation, the cost of the securities acquired by an employee under a stock option arrangement is increased by the amount of the deemed employment benefit. Since the difference between the FMV of the shares at the time they are acquired and the price paid by the employee is already taxable as regular employment income (subject to the 50% deduction discussed above), an adjustment is made to the cost of the shares for the employee so that the same value will not be subject to tax on the actual disposition of the shares. The basis for calculating the capital gain (or capital loss) on a subsequent disposition of the shares is therefore the aggregate of three amounts: (i) the amount, if any, paid by the employee to acquire the rights under the arrangement; (ii) the amount paid by the employee to acquire the shares; and (iii) the employment benefit. The fact that the employee may be entitled to a 50% deduction of the employment benefit in computing his taxable income is not relevant for the determination of the cost of the shares for capital gain purposes. In the past, an additional problem occurred when an employee owned other shares of the issuer that had been acquired in the open market. When computing a capital gain, section 47 of the ITA requires that the cost of identical properties of a taxpayer be averaged. As a result, each of the properties have the same adjusted cost base and, therefore, the same potential capital gain or capital loss on the disposition of any one of them. This led to unfair results in circumstances where the employee acquired shares under a stock option arrangement and disposed of such shares immediately thereafter. If such shares were the only shares owned by the employee, no capital gain was realized on the disposition given the increase in cost allowed by the ITA to take into account the employment benefit. However, if the employee had similar shares that had been acquired in the open market, the average cost base rule would usually have reduced the cost of the shares acquired under the stock option arrangement and the immediate disposition of the shares would have resulted in the realization of a capital gain by the employee In the Income Tax Technical News No. 19, issued on June 16, 2000, the CCRA had stated that where it would seem obvious to conclude that the particular shares acquired under a section 7 arrangement are in fact the shares that are being disposed of by the employee, the ITA would be administered so as to permit the employee to identify the shares acquired under the arrangement as those being disposed of. However, in order to support specific identification, the CCRA insisted that the employee show the correlation between the particular acquisition and disposition of shares. For instance, where the number of shares acquired under a section 7 arrangement was equal to the number of shares disposed of and the disposition occurred immediately after exercise of the option, the CCRA stated that it would accept the employee s identification of the particular shares acquired under the arrangement as being the shares disposed of. Consequently, only the adjusted cost base of the particular shares acquired under the arrangement was relevant for computing any capital gain or loss on the disposition of such shares. However, it was clearly stated that this interpretation would not apply where the employee acquired additional shares subsequent to the acquisition of the shares under the arrangement but before the disposition. The rules for averaging the cost base would apply to spread the increase in the adjusted cost base resulting from the employment benefit over all of the identical properties held by the taxpayer. 8

10 To remedy this situation, the ITA was amended to exempt certain shares acquired after February 27, 2000 from the cost averaging rule by deeming such shares not to be identical to any other shares acquired by the employee. However, a particular share must satisfy the following conditions for the employee to benefit from this exception: (i) (ii) the share must be acquired under an employee stock option arrangement for which a deferral in the year of taxation of the employment benefit is available (supra section c)); 21 and the share acquired under an employee stock option arrangement must be designated by the employee to be a share that is subject to a disposition of identical shares occurring within 30 days after acquisition. The effect of the new rule is that the share will be exempted from the cost averaging rule and the capital gain or loss on its disposition will be determined without regard to the adjusted cost base of any other identical shares owned by the employee. As a final observation, the adjusted cost base of the shares acquired by an employee must be determined in Canadian dollars and the proceeds from an eventual disposition of the shares must also be calculated in Canadian dollars. f) taxation of dividends Canadian employees will be taxable on dividends received on shares acquired through a stock option arrangement. For the purposes of the ITA, a dividend includes a stock dividend. Therefore, a stock dividend received from a non-canadian corporation will also be included in the calculation of the employee s income when received, whether or not the employee has the choice of receiving a stock dividend or a cash dividend. The amount of the stock dividend constitutes the adjusted cost base of the shares for the purposes of calculating the capital gain or capital loss on a subsequent disposition of the shares (subject to the averaging rule for identical properties discussed in section e) above). In addition, there may be a non-resident withholding tax on the dividend paid by a non-resident corporation to a Canadian resident which the Canadian resident may claim as a foreign tax credit under the detailed rules of the ITA. Dividends received from foreign corporations will not be eligible for the favourable treatment afforded to dividends received from Canadian corporations to take into account tax already paid at the corporate level, i.e. subject to a gross-up inclusion in income and a tax credit. g) disposition of shares In Canada, capital gains (capital losses) are subject to a 50% inclusion (deduction) in computing a taxpayer s income. To the extent that the shares acquired under a stock option arrangement are 21 Shares acquired in exchange for such shares under one of the rollover provisions of the ITA are also eligible. 9

11 eventually sold at a loss, the loss will generally be characterized as a capital loss. The allowable capital loss (which is equal to 50% of the capital loss otherwise determined) can only be applied against taxable capital gains and cannot be used to reduce the employment benefit. For example, let us assume that an employee has acquired one share of the capital stock of his or her employer at $60 under a stock option arrangement at a time when the FMV of the share was $110. An employment benefit of $50 must be included in computing the employee s income and the employee is (or is not, depending on the circumstances) entitled to a 50% deduction of the employment benefit in computing his taxable income. Since the employment benefit resulting from the exercise of the option is $50 and the price paid for the share is $60, the adjusted cost base for computing the capital gain or capital loss on a subsequent disposition of the share is increased to $110. If the employee sells the share when it has decreased in value to $60, he or she will realize a capital loss of $50, 50% of which will be the allowable capital loss than can only be applied against taxable capital gains. Therefore, while the employee has an income inclusion of $50 (or $25 as the case may be), he will not be entitled to use the allowable capital loss of $25 to reduce the deemed employment benefit even though, in economic terms, no actual gain or profit was realized in the year from the stock option arrangement. Given the recent experience of the stock markets, particularly in the new economy sector, this deficiency in the system has led to major difficulties for a certain number of employees, especially in 2000 (and inevitably in 2001). The benefits that had to be reported by a number of employees were exceptionally large because the value of their employer s shares had increased significantly by the time the employees exercised their options but had decreased dramatically shortly thereafter. This has left many employees in a position of having to pay tax in respect of employment benefits that were no longer reflected in the value of the acquired shares. In many instances, employees did not have the resources to pay the tax because of the decreased value of the acquired shares. Since the ITA does not provide for relief in such circumstances, the CCRA has raised the issue with officials of the Department of Finance, which has undertaken a review of different alternatives aimed at alleviating this problem. h) death tax and administration issues As mentioned in section b) above, when an employee dies without exercising his options, an employment benefit equal to the amount by which the value of the right immediately after death exceeds any amount paid by the employee to acquire the right will be deemed to have been received by the employee because of his employment in the taxation year in which the employee died. The 50% deduction of the taxable employment benefit will be applicable as long as the prescribed conditions are fulfilled (supra, section d)). The ITA also provides relief, in certain circumstances, where the value of the options decreases after the death of the employee. Where options have been exercised prior to the employee s death and shares have been acquired, the employee will be deemed to have disposed of the shares and to have received proceeds of disposition equal to the FMV of the shares immediately before the employee s death, potentially realizing a capital gain. If a capital gain is realized, 50% of that capital gain will be included in the employee s calculation of income for the year of death. Subject to certain conditions, if an 10

12 employee bequests his shares to his or her spouse or to a qualifying spousal trust, resident in Canada, the employee will be deemed to have disposed of the shares for an amount equal to the adjusted cost base of the shares immediately before the death. The spouse or qualifying spousal trust will be deemed to have acquired the shares at the time of death at a cost equal to the deemed proceeds of disposition. The tax consequences arising upon death can thus be deferred until the earlier of the disposition of the shares or the death of the last surviving spouse. Administrative consequences resulting from the death of an employee will depend upon the terms of the arrangement and the policies of the arrangement administrator. Each province and territory in Canada has procedures for validating a will (probate, letters probate or appointing an administrator) or an intestacy. In the province of Quebec, the liquidator of an estate will be required to provide a Declaration of Heredity establishing his power to exercise in the name of the estate. In the other provinces, there is a probate process whereby the executor or the administrator may be required to obtain Letters Probate or Letters of Administration (the terms differ in the different provinces). There may be delays in obtaining declarations of probate, which could last several months. The probate tax imposed varies for each province and, for the most part, is determined based on the value of the assets of the deceased passing through the estate (including stock options). In the province of Quebec, there is a flat fee charged, that is not based on the FMV of the assets. There are mechanisms that could shelter stock options from probate tax. These include transfer of bare legal title to a nominee corporation or designating a beneficiary under the arrangement. Consideration should be given to providing flexibility in the arrangement to allow for such planning. i) withholding and reports The CCRA takes the position that the employment benefit realized on the exercise of a stock option constitutes salary and wages subject to regular reporting requirements and to salary withholding with regard to income tax and the payment of most social security taxes. As a result, a corporation with an establishment in Canada will be required to report the employment benefit arising from the acquisition of shares pursuant to an employee stock option arrangement and make the required withholding. The issuer corporation is required to report an employee stock option benefit to Canadian tax authorities for each employee receiving such benefit prior to the end of the month of February following the year in which the employee stock options are exercised. To the extent possible, withholding should be made from an employee s regular remuneration. The CCRA has taken the administrative position that the benefit may be prorated over the remaining pay period of the year. Furthermore, the CCRA will not require withholding if it would result in undue hardship. For instance, if the benefit is the only remuneration received by the employee from the payer, if it arises late in the year or if it is very large in proportion to the 11

13 employee s regular salary, no withholding is required. Quebec tax authorities have adopted similar administrative positions. In cases of hardship, the tax associated with the employment benefit will have to be paid by the employee receiving the benefit by April 30 of the calendar year following the year in which the employment benefit was realized. There is no legal requirement in Canada obliging the employee to pay income tax withholding associated with the employment benefit at the time he or she exercises the options although a contractual requirement may exist. As a result of the administrative position regarding hardship, if an employee of a Canadian based subsidiary receives shares of the foreign parent corporation, the foreign parent corporation will generally be required to report the employment benefit to the CCRA but will probably not be required to make any withholding. If the Canadian subsidiary reimburses the foreign parent for the cost of the employee stock option arrangement, however, the CCRA takes the position that it is the Canadian subsidiary that provides the remuneration to the employees. When an employee wishes to take advantage of the tax deferral with respect to options that qualify for the annual Cdn$100,000 limit (based on the value of all qualified options vested in a particular calendar year), the employee must submit a letter to the person required to report the employment benefit (usually the employer) containing a confirmation that (i) the employee was resident of Canada at the time of acquisition of the shares and that (ii) the Cdn$100,000 annual vesting limit has not been exceeded. The letter must also provide the amount of the benefit related to the qualifying shares purchased under an arrangement after February 27, While the election must be filed at the latest on January 15 of the year following the purchase of the shares, it can be filed at the time of the share purchase, in which case the CCRA permits the employer to reduce the employee s income tax withholding by the amount of tax related to the benefit being conferred. The Canada or Quebec Pension Plan withholding can also be reduced. While the employee is responsible for filing the deferral election with the employer, the responsibility for reporting the stock option benefit and its tax deferral remains with the employer (or the corporation that granted the option or the corporation from whom the shares were purchased if they are not the same as the employer). The stock option benefit and the deferral thereof have to be reported on a prescribed form. As for the employee, he or she is required to file a prescribed form with his or her tax return for each year during which he or she has an outstanding balance of deferred stock option benefits. Among other withholdings, the exercise of the employee stock option will affect the contributions that the employer is required to make pursuant to the Canada or Quebec Pension Plan unless no other cash payment is made to the employee. When an employee acquires shares and realizes an employment benefit, the amount of the benefit will be included in determining the employer contribution per employee up to the annual contribution limit per employee. Contributions under private pension plans will depend on the definition of salary used by the particular plan. Additional contributions to employment insurance are not required. 12

14 j) consequences for employer Under paragraph 7(3)(b) of the ITA, the income for a taxation year of any person is deemed not to be less than its income for the year would have been if a benefit had not been conferred on the employee by the sale or the issue of the shares. Thus, an employer will generally not be permitted to deduct as an expense the costs incurred in providing the employment stock benefit to the employee. The CCRA has nevertheless taken the position that a Canadian corporation will be permitted to deduct the plan administration and implementation costs where these costs are reasonable. The prohibition at paragraph 7(3)(b) applies if the shares are issued or sold pursuant to an arrangement with the employer or a related corporation. If this condition is not met, a deduction will be available. Where the employee has the option to receive cash instead of shares, for example, the CCRA has taken the position that the employer will not be restricted in its deduction. 22 The reasoning is that no shares have been sold or issued under the arrangement in such circumstances. Similarly, it may be possible to structure an arrangement whereby shares are purchased on the open market subsequent to a contribution made by the employer. In this latter situation, the employer may also be entitled to deduct the amount of expenses relating to stock benefit arrangements. Where, in respect of the participation of Canadian employees in the stock option arrangement, the Canadian corporation reimburses the foreign parent corporation for the difference between the FMV of the shares on the date of exercise over the exercise price, the Canadian corporation is considered for Canadian tax purposes to be the corporation conferring the benefit on the employees and is not therefore entitled to any deduction (subject to the exceptions mentioned above). If not properly structured, there is a risk that Canadian tax authorities will consider that the reimbursements of such expenses by the Canadian corporation to its foreign parent corporation constitutes a shareholder benefit in favour of the foreign parent corporation. If this is the case, the amount would be considered to be a deemed dividend subject to withholding tax. k) phantom stock plan A phantom stock plan is intended to allow the employees to participate in the increase in value of the shares of their employer without actually being issued any shares. Under such a plan, an employee is issued notional units corresponding to a certain number of shares as negotiated with the employer. The plan is established for a definite period of time and at the expiration of the period, the employee is entitled to receive, as a cash payment, the increase in value of his or her units. The phantom stock plan is therefore more of a bonus mechanism than a real participation in the capital of a corporation. Since no shares are issued to the employee, he or she is not 22 It should be noted that if the employee (and not the employer) can choose between receiving shares or cash, the employee can still benefit from the 50% deduction of the employment benefit when the prescribed conditions mentioned in section d) above are satisfied. 13

15 entitled to any voting rights nor to any dividend payments (although in certain plans, the payment of dividends is taken into account in establishing the value of the units at the end of the period). Depending on the circumstances, a phantom stock plan regime may fall within the scope of the salary deferral arrangement provisions contained in the ITA. According to these rules, where an employee has a right to receive an amount after the end of a taxation year, such amount has to be included in the employee s income in the taxation year unless it has previously been included as income of the employee. The CCRA takes the position that a phantom stock plan may constitute a salary deferral arrangement and, as a consequence, an employee is required to include in his or her income on an annual basis the accruing gain in respect of his or her units to the extent that such gain has not been previously included as income. Since section 7 of the ITA only applies where a particular corporation has agreed to sell or issue its own securities or securities of another corporation with which it does not deal at arm s length, arrangements in which the issuance of shares is not contemplated by the parties are not governed by section 7. A phantom stock plan under which only notional units are created and issued to employees does not therefore qualify for purposes of section 7. l) savings contract Certain arrangements provide for the possibility for employees to deposit a portion of their salary in a trust account to accumulate an amount of money to purchase shares of their employer or their employer s parent corporation. Generally, these arrangements also provide that the employer will match the employees contributions. Any amounts deposited by an employer pursuant to a savings contract on behalf of an employee will be part of the employee s salary and will be taxable as employment income at the time of deposit in the name of the employee. Thus, the employer making the deposits will be required to make all regular withholdings with regard to the salary paid to the employee. An employee having a right in the savings contract will likely be required to make an annual income inclusion for interest that may accrue on the savings. Under the ITA, individuals that hold an interest in an investment contract are required to include in their income for the year the interest that accrued in respect thereof each year to the extent that such interest was not otherwise included in the taxpayer s income. An investment contract generally refers to a debt obligation. Subject to specified exceptions defined in the ITA, the term debt obligation is broad and generally applies where interest is payable on a sum. This regime will likely apply if a foreign bank pays interest on the amounts deposited. The term investment contract is subject to certain specified exceptions, including arrangements under an employee benefit plan. An employee benefit plan means an arrangement under which contributions are made by an employer (or by a non-arm s length person) to a custodian and 14

16 under which one or more payments are to be made to, or for the benefit of, employees or former employees. If the amount paid does not constitute interest or if the savings contract does not constitute a debt obligation, the employee will likely be required to include the amount imputed in the calculation of his or her income at the time that the amount is imputed. A foreign exchange gain or loss may arise because of the fluctuation of the foreign currency relative to the Canadian dollar amounts that are deposited pursuant to a savings contract. For the purposes of determining the benefit realized under the arrangement, the value of the shares acquired will be determined in Canadian dollars at the time the employee acquires the shares. 2. Securities Law Securities law in Canada is a matter of provincial/territorial jurisdiction. 23 Each province and territory has its own securities law, policies and rules, which can significantly differ. Securities law in each province and territory of Canada is administered by a regulator (a Securities Commission ). In addition, the various Securities Commissions in Canada have co-operated to issue National Instruments and Policies which, upon adoption by the local jurisdiction, are applicable in all provinces and territories of Canada. a) general As a general principle, securities may not be distributed in Canada except pursuant to a prospectus (the prospectus requirement ) and no trade of securities may be made without the involvement of a dealer registered in the particular jurisdiction for that purpose (the registration requirement ). It is also generally true that any act in furtherance of a trade of securities is considered a trade. Since it is not practical for an issuer to prepare and file a prospectus in the context of an equity compensation arrangement, the issuer must rely on exemptions available from these requirements. Many of the exemptions contain filing requirements (and fees). It should also be noted that if securities are issued pursuant to an exemption from the prospectus requirement, the securities may not be freely tradable in the jurisdictions and may be subject to the first trade rules. However, to the extent any discretionary relief described below has not been obtained from the relevant Securities Commissions prior to the time invitations are delivered to eligible employees, those invitations should include language to the effect that applications for such relief have been made or will be made and that an eligible employee s participation in the arrangement may be 23 The use of the term jurisdiction in this section relates to the Canadian provinces of British Columbia, Alberta, Ontario and Quebec only. 15

17 subject to certain conditions imposed by the Securities Commission in their respective jurisdiction. In each jurisdiction (other than Quebec), an exemption is generally available for the issuance of securities by an issuer to employees of the issuer or its affiliates without the use of a Canadian prospectus or the need to make the trade through a Canadian registered dealer (the employee exemption ). The employee exemption is available for employees that qualify as employees at the time of the trade in the securities. Canadian securities laws do not provide a definition of employee, but a person would generally be considered an employee if the details and method of work of the person is subject to the control and direction of the employer and whose income tax is deducted at source. However, the issuance or transfer of shares by an issuer on exercise of options is a distribution of securities under Canadian securities law (other than in Quebec, where such issuance or transfer is viewed as being part of the initial issuance) subject to the registration requirement and prospectus requirement. The employee exemption is generally available in the jurisdictions for the issuance or transfer of shares by the issuer on the exercise of options, but only if the participant is still an employee of the issuer or its affiliate at the time of exercise. However, since the employee exemption requires an annual filing (and fee) in certain jurisdictions (discussed below), another exemption may be more preferable to permit these exercises. Generally, such trades can be done pursuant to the exemption in each jurisdiction that permits the holder of a right to purchase securities in accordance with the terms and conditions of a previously issued security (i.e. an option), provided no commission or remuneration is paid or given in respect of the trade, other than for administrative or professional services, or services performed by a registered dealer (the exchangeable security exemption ). The exchangeable security exemption would also permit exercises of options by former employees and beneficiaries of deceased employees. (i) Quebec issues An application for discretionary exemptions from the registration and prospectus requirements will be required in Quebec with respect to the grant of options. Further relief may be required in this application if, for example, the exercise price of an option is at a discount in excess of a prescribed discount of the market value of the shares of the issuer at the time of the grant of the option (e.g. 10% if the shares trade at more than Cdn$5.00 per share) 24 or to allow an employee to exercise options after three months of termination of 24 Note our comments on the tax implications of a discounted exercise price in section 1. d) above. 16

18 employment. In addition, beneficiaries of a deceased employee will not be able to exercise options beyond one year of the death of the employee unless relief is obtained. If there are over 50 eligible employees in Quebec, a French language Offering Notice (the Offering Notice ) summarising the stock option arrangement will be required to be filed with and approved by the Quebec Securities Commission in the form prescribed by regulation. The Offering Notice must then be sent to each employee resident in Quebec prior to any options being granted in Quebec. b) securities freely tradable The first trade of shares issued or transferred by an issuer pursuant to an exemption from the prospectus requirement (i.e. shares acquired on exercise of options) is often subject to the prospectus requirement unless they are sold (i) pursuant to another exemption from the prospectus requirement or (ii) pursuant to a discretionary exemption obtained from the relevant Securities Commission. In addition, unless an exemption is available, all subsequent sales of shares acquired on exercise of options are subject to the registration requirement (i.e. the sale must be made through a dealer registered in the jurisdiction in which the holder is resident). These first trade rules differ significantly in each of the jurisdictions. The Securities Commissions of all jurisdictions other than Quebec are scheduled to adopt a new multilateral instrument to harmonize the resale rules for securities initially distributed under an exemption. This instrument is expected to come into force on November 30, Under the new instrument, the first trade by an employee in shares of a non-reporting issuer in each jurisdiction acquired under a prospectus exemption will be exempt from the prospectus requirement if: (i) the issuer was not a reporting issuer in any jurisdiction at the distribution date; (ii) at the distribution date residents in Canada did not own more than 10% of the outstanding securities of the class of the capital stock of the issuer and did not represent more than 10% of the total number of owners, directly or indirectly, of securities of the class of the capital stock of the issuer; and (iii) the trade is made through an exchange or market outside Canada to a person or company outside Canada. Until this instrument comes into force, the following local rules will apply. (i) British Columbia The resale of shares acquired pursuant to an exemption from the prospectus requirement in British Columbia is subject to both the registration and prospectus requirements. An exemption from both the registration and prospectus requirements is available for such first trades if the 17

19 holder intending to resell was an employee at the time of acquisition of the shares on exercise of options. However, there is no exemption in British Columbia from the registration requirement for a person who was not an employee at the time of the acquisition of the shares on exercise of options. Consequently, unless discretionary relief is obtained from the British Columbia Securities Commission, the resale of these shares must be made through a registered dealer in British Columbia. To the extent relief is not obtained, the issuer should notify the employees in this regard at the implementation stage of the arrangement. (ii) Alberta The resale of shares issued or transferred on exercise of options by a holder in Alberta will be subject to the registration and prospectus requirements in Alberta unless an exemption order from the Alberta Securities Commission is obtained to allow such first trades without meeting the prospectus and registration requirements. (iii) Ontario The prospectus requirement does not apply to the first trade of shares by an Ontario resident (whether an employee, former employee or beneficiary of a deceased employee). The registration requirement will not apply on the first trade of shares by employees in Ontario. However, this exemption from the registration requirement is not available to a person in Ontario who is not an employee at the time of resale. Consequently, unless discretionary relief is obtained from the Ontario Securities Commission, the resale of these shares must be made through a registered dealer in Ontario. To the extent relief is not obtained, the issuer should notify the employees in this regard at the implementation stage of the arrangement. (iv) Quebec It is necessary to obtain a discretionary exemption from the resale rules in Quebec to allow shares acquired by Quebec residents on exercise of options to be resold without meeting the registration and prospectus requirements. This relief is typically requested concurrently with the exemption requests mentioned above. c) holding through nominee Shares may be held on behalf of an employee through a nominee provided that such activities do not constitute acts in furtherance of a trade under applicable Canadian securities laws. If this is not the case, discretionary relief must be obtained from the relevant Securities Commission as discussed above. In such circumstances, an employee would not appear on the issuer s shareholder register but he would nevertheless retain all rights (including dividend and voting rights) in relation to the shares as a beneficial holder thereof. d) registration of employer or participant in the arrangement 18

20 Any act in furtherance of a trade is regarded as a trade in many of the jurisdictions. Therefore, unless an exemption from the registration requirement is available, or unless discretionary relief from the relevant Securities Commission is obtained, an entity (i.e., an employing affiliate, plan administrator, savings carrier, nominee holding shares on behalf of employees or a foreign broker or dealer) assisting the issuer in the issue of options or the issue or transfer of shares to Canadian residents on exercise of options or assisting Canadian residents in the resale of shares may, depending upon the nature of the activities performed, be required to be registered as a dealer in the relevant jurisdiction. There are exemptions available in each of Ontario and British Columbia for the activities of an employing affiliate and an employee administrator, which would likely include the activities of a plan administrator, savings carrier, nominee holding shares on behalf of employees and a foreign broker or dealer acting on behalf of or for the benefit of employees of an issuer or its affiliates. In Quebec, relief will normally be requested in the application mentioned above. Where a third party administrator is involved in the arrangement, the application would have to specifically request relief for such third party administrator. If, however, the employee is no longer an employee of the issuer or its affiliate when the activities of the entity are performed, there would be no exemption available from the registration requirement in British Columbia and Ontario and discretionary relief would be required. To the extent the activities of these entities constitute acts in furtherance of a trade, there may not be exemptions available from the registration requirement in the other jurisdictions (whether the participant is still an employee or not). Some Securities Commissions in Canada have, however, taken the position in the past that acts in furtherance of exempt trades are exempt themselves. Discretionary relief should be applied for in this regard in these other jurisdictions and the Securities Commissions will indicate whether they would be willing to grant the relief requested. e) annual securities regulatory filings and fees Where an issuer is not a reporting issuer in a jurisdiction, there are no continuing obligations in respect of its arrangement, other than the annual filing requirements and fees described below and those that may be imposed by a Securities Commission in connection with any discretionary relief to be obtained as described above. There is currently a proposal before the Ontario Securities Commission that may substantially increase the filing fees that would be payable in Ontario for distributions of securities under a stock option arrangement. While it is unknown when, if at all, this proposal will be implemented in Ontario, it is expected that if implemented, the other Securities Commissions will follow by adopting a similar fee structure in their jurisdiction. (i) British Columbia 19

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