What is a stock option?

Transcription

1 F A L L T HE I N S A N D O U T S O F S TO C K O P T I O N S I N T H I S I SS UE 1 The Ins and Outs of Stock Options 6 Flow-Through Shares Tax-Assisted Financing in the Resource Sector 7 Deductibility of Website Development Expenses Many companies, public and private, large and small, have found that it is almost impossible to attract and retain their talented workforce without offering an employee stock option plan. Nowhere is this more evident than in the fast-growing technology sector. This article discusses the federal tax rules associated with stock options. It does not address the provincial tax treatment of options. 1 What is a stock option? Simply put, a stock option is a right granted to an employee that a l l ows the employee to purchase a certain number of shares in a corporation at a specified price (the Option Price ) for a specified period of time. The corporation is usually either the employe r corporation or a member of the same corporate group (such as a parent corporation). Often there is also a holding period during which the employee cannot exercise the option. When the holding period is ove r, the option is said to vest, and the employee can exercise the option at any time thereafter until the designated expiry date, if any. The taxation of stock options is a complex area which has been the object of a number of proposed changes in Employees who deal at arm s length with the corporation and receive options on account of their employment (and not for any other reason) must include the value of the benefit they receive in their incomes for tax p u r p o s e s. Howe ve r, the amount of tax and the timing of the tax depends upon a number of factors as discussed below. 1 Note that the 2000 Ontario budget proposes the creation of a special stock option deduction for employees of corporations that carry on business through a permanent establishment in Ontario and directly undertake scientific research and experimental development in Ontario.

2 2 F A L L There are two sets of rules associated with option plans: one for Canadian-controlled private corporations ( CCPCs ) and one for non-ccpcs (generally corporations which are, or are controlled by, public corporations or non-residents of Canada). Where mutual fund trusts grant options for trust units to employe e s, the non- CCPC rules for public corporations apply. Non-CCPC Ru l e s If the corporation is not a CCPC, the employee must include the difference between the fair market value of the shares at the time the option is exercised and the Option Price plus any consideration paid for the option in his or her income. This difference is often referred to as the Option Benefit and is taxable to the employe e in the year of exercise or in the year the option rights are disposed of, whichever is earlier. The Option Benefit may be reduced by one-half (announced in the October 18, 2000 Federal Economic Statement and Budget U p d a t e ) 2 if the following conditions are met (the General D e d u c t i o n ): ( 1 ) the underlying share is an ordinary common share; ( 2 ) the total of all amounts payable (Option Price plus any amount paid for the option itself) is not less than the fair market value of the shares at the time the option is granted; a n d 2 The February 27, 2000 federal budget announced an increase in the General Deduction from one-quarter to one-third of the Option Benefit. The General Deduction was further increased to one-half of the Option Benefit by the October 18, 2000 federal budget update.

3 3 T A X L A W (3) at the time the option is granted the e m p l oyee is at arm s length to the employe r and the issuing corporation. The General Deduction results in the Option Benefit being taxed at the same effective tax rate as a capital gain. The Option Benefit is normally added to the cost base of the acquired shares for purposes of computing any capital gain or capital loss on the ultimate disposition of the s h a r e s. The February 27, 2000 federal budget introduced a proposal deferring the timing of the Option Benefit income inclusion for shares of public corporations and units of mutual fund trusts. There is a $100,000 annual limit on the amount of options that can be granted to and vest in an e m p l oyee in any one year and that will be eligible for the deferral. The deferral is only ava i l- able in circumstances where the General Deduction applies. In addition, it is not ava i l- able to shareholders holding more than 10% of the shares of any class of the stock of the issuing corporation or of the employer corporation. The deferred Option Benefit will be included in income at the earlier of: (1) the year the e m p l oyee dies, (2) the year the employe e becomes a non-resident of Canada, or (3) the year the employee sells the shares. CCPC Ru l e s E m p l oyees of CCPCs need not include the Option Benefit in income until the year in which the employee disposes of or exchanges the s h a r e s. As with non-ccpc shares, the Option Benefit may also be reduced by one-half if the General Deduction applies. If the General Deduction is not available (as would be the case, for example, if the Option Price were lower than the fair market value of the shares at the time the option is granted), an employee may be able to access another one-half deduction if the following conditions are met (the CCPC Deduction ): ( 1 ) the employee received the shares upon the exercise of an option granted to the e m p l oyee by a CCPC; and ( 2 ) except in the case where the employee dies, the shares are not disposed of or exchanged within two years of the date the employe e exercises the option and acquires the shares. If either the General Deduction or the CCPC Deduction is ava i l a b l e, the effective tax rate on the Option Benefit will be the same as for capital g a i n s. Howe ve r, an employee is not entitled to double dip and access both the General Deduction and the CCPC Deduction. Further, the employee will not be entitled to access his or

4 4 F A L L her $500,000 super capital gains exemption relating to qualified small business shares in respect of the Option Benefit. Again, the amount of the Option Benefit is normally added to the cost base of the shares. If a corporation is a CCPC at the time the option is granted, the CCPC rules will usually continue to apply even if the corporation later ceases to be a CCPC prior to the exercise of the option. Upon exercise, the shares will also be deemed to fall under the CCPC rules. E x a m p l e M s. Jones receives an option from a non-ccpc to acquire common shares of the corporation at $ 100 per share. At the time the options are issued to Ms. Jones, the fair market value of the common shares is $200 per share. If Ms. Jones exercises the option she will have to include the $100 per share Option Benefit in her taxable income in the year of exercise of the option. The Option Benefit of $100 is not reduced by one half as the option price was less than the fair market value of the shares at the time the option was issued. Further, the $ 100,000 deferral will not be available because the General Deduction is not ava i l a b l e. If Ms. Jones sells the shares three years later for $50 0 per share, she will report a capital gain in the year of sale of $300 per share, one-half of which is taxable. If, in the above example, the corporation had been a CCPC, there would have been no tax liability in the year the option is exercised. In the year the shares are sold, Ms. Jones would report an option benefit of $50 per share (the $100 Option Benefit is reduced by one half under the CCPC Deduction if the shares were held for two years prior to disposition) and a capital gain of $300 per share, one half of which is taxable. Exchanges of Options and Shares Generally, if an employee sells or disposes of option rights, or the shares arising from the exercise of the options, he or she must include the value of the Option Benefit in employment income in the year of the sale or disposition. However, in circumstances where options are exchanged for new options, and the employee does not receive an economic advantage as a result of the exchange, the new options will generally be deemed to be a continuation of the old options and there will be no immediate tax liability. Therefore, a corporation may undergo restructuring or reorganization, or may put in place a new option plan that is not fundamentally different from the previous plan, without adversely affecting the employees. The option exchange rules apply to options of both CCPCs and non-ccpcs. Similarly, if an employee exchanges shares which were received as a result of the exercise of a stock option to which the CCPC rules apply and r e c e i ves in return new shares from either the

5 5 T A X L A W e m p l oyer or another non-arm s length corporation, the employe e s new shares will be deemed to be a continuation of the old shares, and no immediate tax will arise. The new shares will be deemed to have been issued under the stock option plan, and the employee may be entitled to access either the General Deduction or the CCPC Deduction at the time of the ultimate disposition. These share exchange rules apply only to shares that were received upon the exercise of options under the CCPC rules. New Tr e n d s Stock option plans are often combined with other compensation plans. For example, while stock option rules do not apply to cash-based i n c e n t i ve plans, such as bonus plans or phantom stock option plans (where the e m p l oyee receives a cash payment related to the increase in value of the corporation), it is possible to combine an option plan with a cash-based plan that qualifies under the stock option rules under certain circumstances. Multinational corporations often put in place one stock option plan for their employe e s wo r l d w i d e. These complex plans must be designed in accordance with the requirements of different jurisdictions in order to ensure that all e m p l oyees receive the most preferential tax treatment ava i l a b l e. M a ny employers structure stock based compensation plans in order to permit employees to have the potential to access the $500,000 super capital gains exemption for qualified small business corporation shares. From the employe r s point of view, the one major disadvantage associated with compensating employees by granting stock options is that the employer is not entitled to claim a deduction for any benefit granted to the employee in respect of the option. Howe ve r, as businesses compete for the same skilled wo r k f o r c e, stock option plans will become ever more important. With planning and creativity, employers may ensure that their plans are effective and costefficient compensation tools.

6 6 F A L L F L O W- T HR O U G H S H A R E S - TA X - A S S I S T E D F I N A N C IN G I N T H E R E S O UR C E S E C TO R The oil and gas and mining sectors have always required considerable amounts of capital in order to find and exploit resource properties. By reason of the substantial risk associated with the significant costs, these sectors have often had difficulty raising the necessary capital. Would you invest millions of dollars in an exploratory test well in the Rocky Mountain foothills or off the coast of Newfoundland, knowing the odds are you will find nothing of value? Would you put money into a northern mineral exploration program knowing that there are literally thousands of failures for every mine brought into commercial production? Nevertheless, the resource industry in Canada is a cornerstone of our economy. In an effort to encourage investment in this key sector, the government of Canada has for many years allowed investors to obtain tax benefits not available in other industries. This is accomplished through the use of flow-through shares. A flow-through share is an ordinary common share of a corporation issued pursuant to a flow - through agreement. The flow-through agreement p r ovides that the corporation will incur qualifying expenses and renounce those expenses to the share s u b s c r i b e r. The effect of this renunciation is that the subscriber, rather than the corporation, is considered to have incurred the expenses and is entitled to the tax deductions associated with them. There are two types of expenses which can be renounced: (1) Canadian exploration expenses ( CEE ) which are deductible 100% in the year incurred or any subsequent year and (2) Canadian development expenses ( CDE ) which are deductible at the rate of 30% per year. As the names imply, CEE relates to costs of exploring for oil and gas or mineral reserves whereas CDE relates to the cost of developing reserves which have previously been found. Corporations generally have 24 months from the time the flow-through agreement is entered into to incur the qualifying expenses. However, if the corporation incurs the expenses by December 31 of the year following the year in which the agreement is entered into, then for most expenses, the renunciation can be made effective December 31 of the prior year so that the subscriber gets the deduction in the first year even though some of the expenses are not incurred until the following year. The corporation has to pay an interest component to the tax authorities to the extent the expenses are incurred after the end of February in the second year. As an additional incentive to small companies (those with less that $15 million in taxable capital) in the oil and gas sector, up to $1 million per year of most types of CDE can be renounced as

7 7 T A X L A W CEE thereby entitling the subscriber to a 100% deduction, even though the expenses in question are of the less risky CDE variety. Because the subscriber is entitled to write-off the cost of the flow-through shares via deductions for CEE and CDE, the shares are deemed to have a nil cost for tax purposes. As a result, the full amount of any proceeds must be brought into income (as a capital gain for most taxpayers) at the time of disposition. With record commodity prices in the oil and gas sector at this time, many corporations may be reluctant to issue flow-through shares because they will need to retain the tax deductions for the CEE and CDE for themselves. Nevertheless, the ongoing need for capital will no doubt cause some corporations in both the oil and gas and the mining sectors to seek to raise capital again this year through the use of flow-through shares. D E D U C T I B I L I T Y O F W E B S I T E D E V E LO PM E N T E X P E N S E S In recent technical interpretations, the Canada Customs and Re venue Agency (the CCRA ) has taken the position that the component parts of a website development should be categorized separately between income and capital accounts for income tax purposes. Although the CCRA recognizes that a website is not permanent, may be modified frequently and in some cases taken d own and rebuilt, it is of the view that certain components of the development costs are capital in nature and subject to amortization at the applicable capital cost allowance rates. In part i c u l a r, (1) any equipment required to operate the website is to be considered general-purpose electronic data processing equipment and thus capitalized as a Class 10 asset (30% CCA rate), (2) any equipment that is not general-purpose electronic process equipment should be included in Class 8 (20% CCA rate) and (3) sys t e m s s o f t ware should be included in Class 10 (30% CCA rate) whereas application software should be included in Class 12 (100% CCA rate). The Borden Ladner Gervais LLP Tax Law Update is necessarily of a general nature and cannot be re g a rded as legal advice. The firm would be pleased to provide additional details and to discuss the possible application of these matters in specific s i t u a t i o n s.

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