Equity-Based Employee Compensation. Canadian Bar Association Tax Specialists South Section

Transcription

1 Equity-Based Employee Compensation Canadian Bar Association Tax Specialists South Section February 27, 2006 Anu Nijhawan Bennett Jones LLP

2 Structuring Objectives Tax Considerations GOAL #1: Ensure employee is not subject to tax until benefit under the Plan is received GOAL #2: Obtain tax deduction for employer

3 Goal #1: Defer Employee Tax Main issue is to avoid salary deferral arrangement (SDA) rules If plan is an SDA, employee will be subject to immediate tax (6(1)(a) and 6(11)) on date of grant of benefit and thereafter on an accrual basis even if no benefit has yet been received Result: prepayment of tax liability Para. 8(1)(o) permits employee deduction when SDA entitlement forfeited but timing issue remains

4 Goal #1 - SDA Definition SDA defined broadly in subsection 248(1) any plan or arrangement (whether funded or not) employee has right to a payment in a future year in respect of services rendered in current or past year includes rights subject to conditions, unless there is a substantial risk that conditions will not be satisfied where it can reasonably be considered that one of the main purposes is to postpone tax

5 Goal #2 - Obtain Employer Deduction Section 9/ Para. 18(1)(a) and (b) incurred for the purpose of earning income Section 67 reasonableness Para. 20(1)(oo) deduction for amounts included in employee s income as SDA amounts Section governs timing and quantum of deductions for contributions to EBP Para. 7(3)(b) deduction prohibited where employer sells or issues shares (whether from treasury or not) to employee

6 Common Plans Stock Option Plans (with and without Tandem SARs) Phantom Plans Stand Alone Stock Appreciations Rights (SARs) Restricted Stock Units (RSUs) Performance Stock Units (PSUs) Deferred Stock Units (DSUs) Employee Stock Purchase Trusts

7 Stock Option Plans Description Employee is granted right to buy shares of employer corporation at a specified exercise price Can be granted by corporations and mutual fund trusts For MFTs, individuals must be employed by a corporation controlled by MFT Typically rights vest over time Tandem SARs - Plan is often structured so that employee has the right to surrender option in exchange for in-themoney payment

8 Stock Option Plans (continued) Basic Rules If shares acquired under option, no deduction for employer (7(3)(b)) Employee not subject to tax until option is exercised 7(3)(a) overrides SDA definition Upon exercise, taxable benefit equals value of shares acquired less exercise price paid (7(1)(a)) Employee can elect to defer benefit until disposition pursuant to subsection 7(8) if 110(1)(d) deduction available and certain other conditions are met

9 Stock Option Plans (continued) Basic Rules So long as exercise price FMV of underlying stock at the time the agreement was made, employees generally entitled to ½ deduction (110(1)(d)) capital gains-like treatment shares acquired under option must be prescribed shares under Reg (usually ordinary common shares) Tandem SARs So long as employee has choice to cash out, employee can still obtain 50% deduction and employer can deduct amount of cash-out payment Ensure Plan is a true stock option plan and not a disguised bonus plan

10 Stock Option Plans (continued) Recent Trends Criticism: not appropriate for MFTs where main benefit of unit ownership is income stream Response: Each time a distribution is paid, the employees is granted an additional option to purchase units for a nominal exercise price ($0.01) Tax Treatment: Same as ordinary stock options but capital gains-like treatment not available on the additional options since the FMV test will not be met

11 Stock Option Plans (continued) Recent Trends Criticism: Vesting is not subject to performance criteria - share price may reflect market factors and not employer performance Response: Number of shares subject to the option fluctuates based on employer performance Performance Warrants

12 Stock Option Plans (continued) Tax Treatment: Issue is availability of 110(1)(d) 50% deduction - exercise price must = FMV at time agreement is made Performance factor may be a condition precedent Definition: an uncertain event upon which the obligations of performance by both parties are dependent If performance factor outside control of both parties, neither party has any liability under an agreement until time condition is satisfied CRA View: agreement is not made until time employer is obligated to issue a specific number of shares at a specified price

13 Stock Option Plans (continued) Withholdings: Technically, employer should withhold from ordinary cash remuneration CRA Position: withholdings not required in cases of undue hardship (e.g. stock option benefit large in comparison to ordinary salary) New: undue hardship may not exist where cashless exercise

14 Phantom Plans Stand-Alone SARs Description Traditional: Employee given right to future payment which is measured by the appreciation in share value of employer Recent CRA Rulings: future payment can be measured by other attributes of employer (e.g. consolidated income or profitability targets)

15 Phantom Plans Stand-Alone SARs (continued) Tax Treatment Key concern is avoiding SDA rules CRA - so long as SAR has no value at time of grant, it is a payment in respect of future services and will not constitute an SDA (i.e. not in respect of current or past service) BUT, once SAR is vested, could be an SDA where purpose of employee s decision not to exercise is to defer tax Employee taxed, at income rates, at time of future payment no capital-gains like treatment Where future payment made in cash, employer entitled to deduction

16 Phantom Plans Restricted Stock Units Description 1 RSU = FMV of one share/unit of employer Value rises and falls based on the value of the employer s shares Typically, participant accounts are credited with additional RSUs as dividend equivalents On vesting, RSUs are redeemed and employer makes payment: cash market shares treasury shares

17 Phantom Plans RSUs (continued) Tax Treatment Key concern is avoiding SDA rules Specific exception in SDA rules (paragraph (k)): plan or arrangement under which employee has right to receive a bonus or similar payment in respect of services rendered in a particular year to be paid within 3 years following the end of the year Payment must be made by December 31st of the third year following date of grant maximum deferral period of 3-4 years

18 Phantom Plans RSUs (continued) Tax Consequences to Employee Employee taxed at time of payment at regular income rates Capital gains-like treatment not available Tax Consequences to Employer So long as payment made in form of cash or market shares, employer entitled to a deduction No deduction for treasury shares 7(3)(b)

19 Phantom Plans RSUs (continued) Example June 15, 2006 Employer declares bonus of $100 in respect of services in 2006 Employer share price at date of grant is $10 Employee is granted 10 RSUs (100/10) December 31, 2009 RSUs are redeemed Employer share price is $13 Employee is given $130 (less source withholdings) Note: if share price goes down (e.g. $8), employee still rewarded (with $80)!

20 Phantom Plans Performance Stock Units Description Operate in same manner as RSUs but vesting period is dependent on satisfaction of performance criteria Tax Treatment CRA - performance criteria which are out of direct control of employee may constitute a condition where there is a substantial risk of forfeiture and hence SDA rules will not apply Safer to rely on 3-year bonus exception to SDA rules

21 Phantom Plans Deferred Stock Units Description Operate in the same manner as RSUs and PSUs but can be used to defer tax on ordinary salary and on bonuses Based on a different exception to the SDA rules

22 Phantom Plans DSUs (continued) Tax Treatment Key concern is avoiding SDA rules Specific exception in SDA rules (Regulation 6801(d)): DSUs must be granted by a corporation not available to mutual fund trusts directly Entitlement to payment in respect of the DSUs must only arise after the employee's death, retirement, or loss of employment (entitlement event) Payment in respect of DSUs must be made by December 31 of first calendar year commencing after entitlement event; Amount of the payment must be determined based upon FMV of employer shares within one year of entitlement event; and No arrangement by which the employee is compensated for any reduction in FMV of the corporation's shares (i.e. no guaranteed minimum payment). Tax consequences on pay-out are same for RSUs

23 Phantom Plans DSUs (continued) Example 2006 Employee earns annual retainer fees of $1000 and elects to have 20% ($200) paid in DSUs Employer share price at date of grant is $10 Employee is granted 20 DSUs (200/10) 2015 Employee retires Employer share price is $20 December 31, 2016 DSUs are redeemed and Employee is given $400 (less source withholdings)

24 Employee Stock Purchase Trusts Description Employer makes contribution to Trust and Trustees acquire shares May be structured as matching contribution where employee makes contributions through payroll deduction Shares acquired with employer s contribution vest over time All distributions/dividends paid to Trust Tax Treatment Characterization of the Plan depends on whether the Trustee acquires shares from the employer directly (e.g. treasury shares) or whether the shares are acquired on the open market

25 Employee Stock Purchase Trusts Treasury Shares Risk that subsection 7(2) will apply If a security is held by a trustee for benefit of an employee Whether absolutely, conditionally or contingently Employee deemed to have acquired share at time trust acquired it (7(2)(a)) Immediate tax - Prepayment of tax liability even though no benefit received If employee later forfeits entitlement to shares, subsection 8(12) may provide deduction in limited circumstances Employer denied deduction for contribution to Trust pursuant to 7(3)(b)

26 Employee Stock Purchase Trusts Market Shares Employee benefit plan (EBP) An arrangement under which employer makes contributions to a third-party Payments under arrangement to be made to or for the benefit of employees Trust not necessary but preferred from corporate governance perspective SDA definition takes priority over EBP definition Vesting conditions usually structured to fall within exception in paragraph (k) of SDA definition Employee has right to receive payment by December 31st of third year following the year in which it was earned

27 Employee Stock Purchase Trusts Market Shares (continued) Taxation of Employee Employee contributions are non-deductible and refund of such contributions is tax-free So long as SDA is avoided, employee subject to tax at time of constructive receipt (i.e. vesting) of all distributions from the Trust All distributions taxed as employment income regardless of original form as dividends Where shares are distributed by Trustee on satisfaction of vesting, employee will have income inclusion equal to FMV of shares at that time (6(1)(g)) and will be deemed to have acquired the shares at a cost equal to FMV (107.1(b)(ii))

28 Employee Stock Purchase Trusts Market Shares (continued) Taxation of Trust Trust is a taxpayer - all income earned in the Trust, including dividends on the Shares held by the Trust, that is not allocated and paid to a beneficiary of the Trust in the year in which it is earned will be taxed in the Trustee's hands (104(6)(a.1) and 122(1)) Amounts that are distributed to employees will be subject to tax in employee s hands Potential double tax!!! Trust must distribute all income in year it is earned To employees as income beneficiaries employee gets benefits of distribution To employer as income beneficiary employer could then use funds to declare a bonus which would be deductible

29 Employee Stock Purchase Trusts Market Shares (continued) Taxation of Employer Employer subject to tax on all income allocated to it from Trust (104(13)(b) and 12(1)(m)) No deduction at time of contribution to Trust (18(1)(o), 18(10), 32.1) employer has immediate funding cost but delayed deduction Employer deduction only at time that amounts distributed to employees (32.1(1)) or on wind-up of plan Deduction is the lesser of: Amount by which the total amounts distributed to employees in the year exceeds the income of the Trust and Aggregate amount of previously-undeducted contributions

30 Employee Stock Purchase Trusts Market Shares (continued) Potential mismatch between employer contribution, deduction and employee income inclusion Example June 15, 2006 Employer declares bonus of $100 in respect of services in 2006 Employer share price at date of grant is $10 Employer contributes $100 to Trust and Trustees acquires 10 shares December 31, 2009 Employees entitlement under Trust vests and shares are distributed Employer share price is $13 Employee has taxable income of $130 Employer has only $100 deduction

31 Summary Plan Employee Tax Employer Deduction Time of Payout Stock Options On exercise No - if shares issued Variable Capital gains-like treatment possible Yes if cash-out SARs On payout at income rates Yes if cash Variable RSUs On payout at income rates Yes- if market shares or cash 3 4 years PSUs On payout at income rates Yes if market shares or cash Variable DSUs On payout at income rates Yes if market shares or cash Termination of employment ESP Trust - Treasury Shares On grant at income rates No Variable ESP Trust -Market Shares On payout at income rates Yes 3 4 years