CROSS-BORDER EXECUTIVE COMPENSATION

CROSS-BORDER EXECUTIVE COMPENSATION September 14, 2010 Gloria J Geddes GOWLING LAFLEUR HENDERSON LLP Barristers & Solicitors Suite 1600-1 First Canadian Place 100 King S Canada M5X 1G5 Tel: 416.369.4583 E:mail: gloria.geddes@gowlings.com

1. STOCK OPTIONS AND TANDEM SARS... 2 1.1 Canadian Taxation of Stock Options... 2 1.2 Taxable Event... 2 1.3 One-Half Deduction of the Stock Option Benefit... 2 1.4 No Deduction For the Employer... 4 1.5 Cashless Exercise... 4 1.6 Withholding Tax... 5 1.7 U.S. Taxation of Stock Options... 5 1.8 Tandem SARs... 7 1.9 Canadian Taxation of Tandem SARs... 7 1.10 Cash Payment - Deduction for the Employer... 7 1.11 Payment of the Option Spread with Shares... 8 1.12 U.S. Taxation of Tandem SARs... 8 2. RESTRICTED STOCK AWARDS... 8 2.1 Restricted Stock Awards... 8 2.2 U.S. Taxation of Restricted Stock... 8 2.3 Canadian Taxation of Restricted Stock... 9 2.4 Potential Adverse Tax Consequences... 9 2.5 When Restricted Stock is Suitable for Canadians... 10 3. RESTRICTED SHARE UNITS (RSUS)... 10 3.1 Restricted Share Units... 10 3.2 Canadian Taxation of RSUs... 10 3.3 SDA Rules... 10 3.4 Exemptions From SDA Rules... 10 3.5 Payout in Cash... 11 3.6 Payout in Shares Issued From Treasury... 11 3.7 Payout in Shares Purchased on the Market... 11 3.8 U.S. Taxation of RSUs... 11 4. DEFERRED SHARE UNIT (DSUS) PLANS... 11 4.1 Deferred Share Units... 11 4.2 Canadian Taxation of DSUs... 12 4.3 DSU Plan Structure... 12 4.4 Winding-up a DSU Plan... 12 4.5 U.S. Taxation of DSUs... 13 5. APPRECIATION RIGHTS PLANS... 13 5.1 Appreciation Rights... 13 5.2 Canadian Taxation of Appreciation Rights Plans... 13 5.3 Issues Related to Vesting of SARs and PARs... 15 5.4 U.S. Taxation of SARs and PARs... 15 Page 1

6. CROSS BORDER EMPLOYMENT... 15 6.1 Cross-Border Compensation Plans... 15 6.2 Timing of Income Recognition... 16 6.3 Income or Capital Gains... 16 6.4 Exemption Under the Canada-U.S. Tax Convention (the Treaty )... 16 6.5 Allocation of Stock Option Benefits... 17 6.6 Withholding, Reporting and Transfer Pricing Tax Issues... 18 7. EMPLOYEE TRANSFERS TO CANADA... 18 7.1 Cross-Border Transfers... 18 7.2 Moving and Relocation Expenses... 18 7.3 Equalization Payments... 19 7.4 Receiving Bonus Payments Before Becoming a Resident of Canada... 19 7.5 Stock Incentives... 19 Page 2

INTRODUCTION At the 2009 G-20 London Summit, shortcomings in risk management practices, including executive compensation arrangements that created incentives for excessive risk-taking was identified as a significant driver of the recent global recession.. The G-20 report adopted the Financial Stability Forum ( FSF ) Principles for Sound Compensation Practices, published April 2, 2009, which focus on aligning compensation practices and risk outcomes. As a consequence of the scrutiny of governments, shareholders and the public, major corporations are attempting to create and maintain incentive plans that align compensation with corporate performance and avoid unnecessary and excessive risk. However, plans that incorporate measures sensitive to performance are necessarily complex with technical formulas that may be incomprehensible to the executives who will be participating in the plan and the shareholders who have a say on pay. There has also been a trend to greater diversification of compensation plans and packages for executives, of which stock options may be only one component. Equity based compensation is intended to link the interests of senior management to the longterm interests of the shareholders, by giving senior employees an interest in the performance of the corporation s stock. These plans provide for the acquisition of actual shares, either as outright share grants or stock options. However, stock options dilute the shareholders interests and no deduction is available to the employer in respect of the benefit conferred by the issuance of shares. Prior to March 4, 2010, one method of dealing with dilution and the denial of a deduction for Canadian stock option benefits, was to attach tandem stock appreciation rights ( Tandem SARs ) to new or existing stock options. As further discussed below, changes introduced in the 2010 Federal Budget now require employers to make a choice between a deduction for the employer and beneficial tax treatment for employees who exercise Tandem SARs. Restricted stock plans provide for a grant of shares with restricted rights. The restrictions apply until vesting conditions are met. Restricted stock plans are common in the U.S. but, as discussed below, a restricted stock award may have adverse tax implications for Canadian employees. Restricted share unit plans grant rights to receive cash payments measured by the value of shares in the form of units allocated to participants. They have been gaining in popularity as an alternative to stock option plans in the U.S. and in Canada. In order to avoid adverse Canadian tax implications, these plans generally provide for payout within three years after the end of the year in which they are granted Deferred share unit plans are often used to provide long term incentives to directors and executives based on share value and are not limited to a three year term before payout. There can, in fact, be no payout to an employee until death, retirement or termination of employment. Page 1

Appreciation rights plans can be structured to provide executives with the opportunity to participate in the appreciation in the value of a business based on measurable financial components. The criteria are generally those observed to be directly impacted by the executive s performance, as opposed to the corporation s share price which is subject to external market fluctuations. Appreciation rights plans may be used to provide longterm incentive plans for employees of partnerships. 1. STOCK OPTIONS AND TANDEM SARS 1.1 Canadian Taxation of Stock Options: The rules in section 7 of the Income Tax Act (Canada) (the ITA ) govern the tax consequences for both the employee and a corporate employer (or a corporation with which it does not deal at arm s length) that has agreed to sell or issue shares of the corporation to the employee. 1.2 Taxable Event: Neither the grant nor the vesting of stock options is a taxable event under Canada s tax laws. A stock option benefit is included in an employee s income in the year the options are exercised and the employee acquires the underlying shares. The benefit is equal to the difference between the exercise price (plus the amount paid for the options, if any) and the fair market value of the shares on the date the shares are acquired. In the case of options granted for shares of a Canadian-controlled private corporation, the benefit is calculated at the time the shares are acquired by the employee, but tax is generally not payable until the employee disposes of the shares. 1.3 One-Half Deduction of the Stock Option Benefit: There is a significant tax advantage for employees, if the benefit realized on the exercise of the stock options qualifies for a deduction under paragraph 110(1)(d) or paragraph 110(1)(d.1) of the ITA. Under these provisions, the employee is entitled to deduct one-half of the stock option benefit (the difference between the exercise price and the fair market value of the share on the date it is acquired) in computing the employee s income. The availability of this deduction is fundamental to stock option planning. A number of conditions must be satisfied for the one-half deduction under paragraph 110(1)(d) (the One-half Deduction ) to be available. These conditions include the requirement that the exercise price (the amount payable by the employee to acquire the shares) cannot be less than the fair market value of the shares at the time the options were granted. Another requirement is that the share must be a prescribed share at the time it is acquired. A different one-half deduction under paragraph 110(1)(d.1) of the ITA is available only where a Canadian-controlled private corporation agrees to sell or issue shares to its employees (or employees of a non-arm s length Canadiancontrolled private corporation) and the shares acquired on the exercise of the option are held and not disposed of (other than as a consequence of the employee s death) for at least two years. (a) One-Half Deduction: Fair Market Value Test Page 2

The classic meaning given to the expression fair market value is the highest price an asset might reasonably be expected to bring if sold by the owner in the normal method applicable to the asset in question, in the ordinary course of business, in a market not exposed to any undue stresses and composed of willing buyers and sellers dealing at arm s length and under no compulsion to buy or sell. Fair market value is a question of fact. For shares traded on a stock exchange, the closing stock market price on the date of grant is an appropriate test of fair market value, provided the market is not spasmodic or ephemeral or suffering the effect of a transient boom or a sudden panic. 1 If an option is granted with a discounted exercise price, there is authority for the proposition that the amendment of the exercise price to increase it to fair market value on the date of grant will not, in and of itself, result in the disposition of the option. The One-half Deduction will be available, provided that the new exercise price is not less than the fair market value of the shares on the date the options were granted and the other conditions of paragraph 110(1)(d) of the ITA are satisfied. 2 Seemingly innocent provisions in a stock option plan can result in a loss of the One-half Deduction for employees. For example, reload options provide that new options, equal to the number of options exercised, are granted to employees who exercise existing options. CRA is of the view that a portion of the exercise price paid relates to the acquisition of the reload option, so that the amount payable for the shares may be less than the fair market value of the shares at the time of grant and the One-half Deduction is not available. 3 (b) One-Half Deduction: Prescribed Share Tests Generally, a prescribed share meets the following conditions: (i) (ii) (iii) the amount of the dividends payable is not limited or fixed; the amount receivable on the winding-up of the corporation is not limited or fixed; the share cannot be converted into a share that is not a prescribed share; 1 2 3 Steen v. The Queen, 86 DTC 6498 (F.C.T.D.), aff d 88 DTC 6171. Amirault v M.N.R., 90 DTC 1330 (T.C.C.) See CRA Views, document no. 2001-0071485, September 18, 2001. Page 3

(iv) (v) the issuing corporation must not have a right or obligation to redeem, acquire or cancel the share for an amount, other than an amount that approximates the fair market value of the share or a lesser amount; and the issuing corporation or a specified person in relation to the corporation cannot reasonably be expected to redeem, acquire or cancel the share within two years after the share is issued or sold to the employee. A specified person is defined in subsection 6204(3) of the Income Tax Regulations and is generally any person or partnership with whom the corporation does not deal at arm s length. There is a carve-out in that definition that provides relief from the prescribed share rules in the context of a take-over offer, but steps must be taken to ensure that the options are exercised or surrendered before the offeror has taken up more than 50% of the shares of the corporation. It is fairly common for U.S. stock option plans to provide that an employee can use shares acquired on the exercise of an option to pay the exercise price to acquire shares under another option (a Swap ). CRA s view is that shares acquired under one option that may be used under a Swap to acquire additional shares may not qualify as prescribed shares. 4 It is also problematic if the option plan contemplates that shares acquired on the exercise of options may be withheld and redeemed, acquired or cancelled by the corporation to satisfy withholding tax obligations. 1.4 No Deduction For the Employer: By virtue of paragraph 7(3)(b) of the ITA, no deduction is available to the issuer or any other person in respect of the benefit conferred on an employee by the issuance of shares, whether the shares are unissued shares or treasury stock that has previously been issued and reacquired at a cost to the issuer. Where a parent corporation grants stock options to employees of its subsidiary and a recharge agreement is entered into (whereby the subsidiary agrees to pay an amount equal to the stock option benefit enjoyed by the subsidiary s employees) subsection 7(3)(b) applies and the subsidiary cannot deduct the amount of the recharge payment. CRA has issued rulings that, provided the payment by the subsidiary to the parent is in respect of services rendered by employees to the subsidiary for options granted after the date of the recharge agreement (or for the increase in the stock option benefit that arises after the date of the recharge agreement on pre-existing options) the payments will not be included in the parent corporation s income as 4 2005. See CRA Views, document no. 2001-0071485, September 18, 2001; and 2 5-014984117, October 25, Page 4

a shareholder benefit or taxable reimbursement. There are, however, published comments of CRA indicating that this position is subject to a review of all of the facts related to the specific situation. 1.5 Cashless Exercise: A cashless exercise arrangement, whereby shares acquired by an employee are sold on that employee s behalf by an independent broker and a portion of the proceeds delivered to the issuer to satisfy the exercise price, would generally not affect the status of shares as prescribed shares. The concern with a cashless exercise is the calculation of the benefit, being the difference between the fair market value of the shares on the date they are acquired and the exercise price. CRA has generally taken the position that the date of acquisition is the settlement date (when all steps have been completed). However, in Benham v. The Queen, 5 the Tax Court of Canada determined that the benefit should be computed by reference to the stock price on the date the employee gave notice of his intent to effect a cashless exercise, notwithstanding that the cashless exercise mechanism resulted in a delay of several days before all requisite steps were completed. 1.6 Withholding Tax: There is no exemption from withholding tax for stock option benefits. In general, tax is withheld and remitted in respect of the net benefit realized for Canadian tax purposes on the exercise of the options (taking into account the One-half Deduction). Since it is not possible to withhold from an issuance of shares (unless the shares are sold on the market on the employee s behalf to generate the amount of required withholding tax) withholding in respect of the exercise of an option would generally be from other cash remuneration paid to the employee. CRA s published administrative position has been to encourage employers to withhold from other remuneration to the extent possible without imposing hardship on the employee. It has also been CRA s administrative position that, where there is no cash remuneration, withholding is not required. This would apply, for example, where a non-resident parent corporation grants options to employees of its Canadian subsidiary, no other remuneration is paid by the parent corporation to the employees, and the Canadian subsidiary does not reimburse the parent corporation in respect of the stock option benefits. The March 4, 2010 Federal Budget introduced measures that override CRA s administrative positions and require withholding tax to be remitted on the stock option benefit. to the same extent as if the amount had been paid in money as a bonus (taking into account the One-Half Deduction). These measures apply to the acquisitions of shares on the exercise of options in 2011 and subsequent years. This is to give employers time to adjust their compensation arrangements 5 [2002] 3 CTC 2461 (T.C.C.). Page 5

and payroll systems before January 2011 to provide for the new tax remittance obligations. The 2010 Federal Budget tax remittance measures do not apply to an amount to which subsection 7(1.1) of the ITA applies. Subsection 7(1.1) applies where options to acquire shares of a Canadian-controlled private corporation are granted to arm s length employees. Subsection 7(1.1) provides that the benefit in respect of the acquisition of the shares is not deemed to be received until the year the employee disposes of or exchanges the acquired shares. The new withholding and remittance measures do not apply at the time these shares are acquired or at the subsequent time when they are sold.. 1.7 U.S. Taxation of Stock Options (a) Nonqualified Stock Options Nonqualified stock options ( NQSOs ) are not taxed at the time of grant, but at the time of exercise under the Internal Revenue Code (the IRC ) section 83. The spread between the fair market value of the underlying stock at the time of exercise and the exercise price is taxed as ordinary income to the employee. The company also receives a tax deduction at the time of exercise equal to the amount of ordinary income the employee recognizes. Whenever the employee sells the underlying stock, the employee will be taxed at the capital gains tax rates on any appreciation in the stock since the time of exercise. The company does not have any tax ramification at the time of grant or when the employee sells the underlying shares. If a NQSO is granted with an exercise price less than the fair market value of the stock at grant (a discounted stock option), the optionee will be taxed under IRC section 409A. Under section 409A, the optionee will be taxed at vesting, and in addition, will be subject to an additional 20 percent excise tax plus interest at the underpayment rate plus 1 percent. Incentive Stock Options Qualified stock options under section 422 of the IRC (also referred to as incentive stock options or ISOs) provide preferential tax treatment to employees. As long as all of the requirements stipulated in section 422 of the IRC are satisfied, ISOs are not taxed at the time of grant or at the time of exercise, but when the employee sells the underlying shares. The employee is taxed at the capital gains rate based on the stock appreciation from the time of grant. The company never receives a tax deduction unless the employee does not satisfy the holding period requirements (discussed below). The following requirements among others must be satisfied for preferential tax benefits under IRC section 422: ISOs must be granted within 10 years from the earlier of: (i) the date the ISO plan is adopted; or (ii) the date the plan is approved by shareholders. Page 6

The terms of the ISO must not allow for exercise after 10 years from the date of grant. An ISO s exercise price must equal, or exceed, the fair market value of the underlying stock on the grant date. ISOs must not be transferable (except at death). Stock acquired from the exercise of ISOs must not be disposed of within two years from the date of grant and the stock must be held for at least one year from the date of exercise ( Statutory Holding Period ). If the stock is disposed of during the Statutory Holding Period, then a disqualified disposition has occurred; therefore, the option holder is not entitled to the preferential tax treatment. The value of employer stock (under all plans of the employer corporation and its parent and subsidiaries) that can be exercised for the first time in any one year under an ISO may not exceed $100,000. The value of the employer stock is based on the fair market value of the stock on the date the ISO is granted. To the extent that the aggregate fair market value of stock exceeds $100,000, such options will be treated as nonqualified stock options. Although regular income tax liability is not levied at the time of exercise for an ISO, the spread between the fair market value of the stock at the time of exercise and the exercise price is subject to the alternative minimum tax (AMT). 1.8 Tandem SARs: One potential way to limit the dilution resulting from the issuance of shares to employees is to attach Tandem SARs to new or existing stock options. A Tandem SAR allows an employee to elect to take cash equal to the spread between the exercise price of the option and the fair market value in lieu of receiving shares. CRA has ruled that the addition of Tandem SARs to an existing stock option plan will not result in a taxable disposition of option rights by employees. 6 If the options are exercised, the attached Tandem SARs are automatically cancelled. If the Tandem SARs are exercised, then the options are cancelled. 1.9 Canadian Taxation of Tandem SARs: The exercise by an employee of a Tandem SAR and the receipt of a cash payment is treated for Canadian tax purposes as a disposition by the employee of the stock option. Paragraph 7(1)(b) of the ITA governs the tax treatment. If the conditions of paragraph 6 See CRA Views, document no. 2002-0131133; document no 2003-008513; and document no 2004-0073821R3. Page 7

110(1)(d) of the ITA are satisfied, and the employer makes an election to forego any deduction for the cash payment, the One-half Deduction will be available and tax will be payable by the employee on one-half of the cash payment. In order to preserve the One-half Deduction on the exercise of a Tandem SAR, the right to elect to take cash in lieu of shares must be a right of the employee. If the employer corporation has the right to pay cash in lieu of issuing shares, CRA takes the position that the One-half Deduction is not available and the full amount of the cash payment will be included in the employee s income. 7 1.10 Cash Payment - Deduction for the Employer: If a cash payment is made to an employee on the exercise of a Tandem SAR in the ordinary course of business, the employer is generally entitled to deduct the cash payment in computing its income for Canadian tax purposes. 8 However, measures were introduced in the March 4, 2010 Federal Budget, that deny the One-Half Deduction to the employee who receives the cash payment, unless the employer elects to forego its deduction. Thus, either the employer can claim the deduction for the cash payment or the employee can claim the One-Half Deduction on the benefit realized on the surrender of the options, but not both. This employer election must be filed with CRA and evidence of the election provided to the employee. The employee files the evidence of the employer election with his or her tax return in which he or she claims the One-Half Deduction. 1.11 Payment of the Option Spread with Shares: If the payout of the Tandem SAR is in the form of shares issued from treasury, the benefit equal to the full fair market value of the shares will be included in the employee s income and there is no deduction by the issuer or any other person in respect of that benefit. The One-half Deduction should be available to the employee provided the conditions of paragraph 110(1)(d) are satisfied. 9 1.12 U.S. Taxation of Tandem SARs: Tandem SARs are taxed in the same way as traditional SARs for U.S. tax purposes (please see section 5). However, the following additional requirements exist when SARs are issued in tandem with ISOs: The SAR must expire no later than the expiration of the underlying ISO; 7 8 9 Interpretation Bulletin IT-113R4 Benefits to Employees Stock Options, August 7, 1996. The availability of a deduction in the context of a take-over or other corporate acquisition is unclear. Income Tax Technical News No. 19, dated June 16, 2000. Page 8

The SAR benefit may not exceed the difference between the fair market value of the employer s stock at the exercise date and the exercise price of the ISO (at least fair market value on the date of grant); The SAR is transferable only when the underlying ISO is transferable and under the same conditions; The SAR may only be exercised when the underlying ISO may be exercised; and The SAR may only be exercised when the market price of the stock exceeds the exercise price of the ISO. If a SAR is granted with an exercise price less than the fair market value of the stock at grant (a discounted SAR), the optionee will be taxed under IRC section 409A. Under section 409A, the optionee will be taxed at vesting and, in addition, will be subject to an additional 20 percent excise tax plus interest at the underpayment rate plus 1 percent. 2. RESTRICTED STOCK AWARDS 2.1 Restricted Stock Awards: A restricted stock award is an award of shares in which the recipient employee s right to transfer the share is restricted during a specified period of time until the shares vest. Once the vesting requirements are met, the restrictions lapse. If the employee ceases to be employed by the corporation before the vesting requirements are met, the shares are generally subject to forfeiture. 2.2 U.S. Taxation of Restricted Stock: Specific U.S. tax rules govern the tax treatment of restricted stock. A U.S. employee receiving a restricted stock award is not taxed at the time of grant unless an election is made under IRC section 83(b). Instead, the employee is taxed at vesting, when the restrictions lapse. The amount of income subject to tax is the difference between the fair market value of the shares at the time of vesting less the amount paid for the shares, if any. The company receives a tax deduction equal to the same amount included in the employee s income. The effect of the election under section 83(b) of the IRC is to include in income the fair market value of the stock at the time it is transferred to the employee (less any amount paid for the shares) as compensation. The company also takes a corresponding tax deduction at the time of the inclusion of compensation. If the election is made, no tax is imposed at vesting. The employee receives capital gains treatment on any subsequent stock appreciation from grant when the shares are sold. 2.3 Canadian Taxation of Restricted Stock: Unlike the United States, Canada does not have specific tax rules for restricted stock awards. There will be an immediate income inclusion for Canadian employees equal to the value of the Page 9

shares at the time of grant, even though the restricted shares remain subject to forfeiture prior to vesting. CRA treats restricted shares as being acquired when the Canadian employee acquires the incidents of beneficial ownership of the shares. 10 The risk of forfeiture of shares in the event of termination or other default may be considered to be more in the nature of a condition subsequent rather than a condition precedent to beneficial ownership. While restrictions on the right to transfer the restricted share does not derogate from beneficial ownership, the fair market value of the share at the date of acquisition may be discounted to reflect the restriction. Subsequent gains or losses in the shares would be capital gains or losses (assuming the shares are held as a capital asset). A capital loss realized on a disposition of a restricted share that has decreased in value can only be used to offset capital gains realized by the employee. It cannot be applied to offset the income inclusion of the Canadian employee in the previous year when the restricted share was acquired. 2.4 Potential Adverse Tax Consequences: Since taxes are generally payable when the restricted stock is granted, the employees must find the funds to pay the tax on the income inclusion equal to the value of those restricted shares. If the share value declines after the date of grant, there is a risk that the tax paid at the time of grant will exceed the proceeds received on the subsequent sale of the shares. Plans that provide for forfeiture of restricted shares on a departing employee can be particularly harsh for Canadian employees. The immediate income inclusion of the employee in the year the restricted stock was granted, cannot be offset by the capital loss on forfeiture. To avoid adverse tax implications, the Canadian taxation of the awards should be considered before a restricted stock plan is implemented in Canada. 2.5 When Restricted Stock is Suitable for Canadians: If the common shares of the corporation have a nominal or very low value at the time of grant, because the business is in the start-up phase or there has been a freeze of current value in preferred shares of the corporation, or the restrictions substantially reduce the value of the restricted stock, there may be advantages to the issuance of restricted stock. The immediate tax liability for the employees at the time of grant would be low in these circumstances and future increases in value would be taxed as capital gains when the shares are sold. Restricted stock may also be appropriate for issuance to employees of Canadian-controlled private 10 In general, the three incidents indicating ownership of a share are the right to receive dividends, the right to vote and the right to a return of capital in the event of the corporation s dissolution. The right to receive payment of a dividend is an important criteria in determining when a Canadian employee has acquired rights as a shareholder, as the definition of shareholder in the ITA includes a member or other person entitled to receive payment of a dividend. Page 10

corporations where the tax liability on the benefit is deferred pursuant to subsection 7(1.1) until the future sale or other disposition of the shares. 3. RESTRICTED SHARE UNITS (RSUs) 3.1 Restricted Share Units: RSUs typically form part of the executive s mid-term incentive compensation. The executive is granted notional units that represent a right to receive a payment on vesting equal to the fair market value of the corporation s shares. RSU plans are often referred to in Canada as phantom stock plans. The notional units represent a proxy for common shares and tie the executive s interests to shareholder returns without additional shares being issued. Payment may be in cash or in the form of shares. 3.2 Canadian Taxation of RSUs : RSU plans that provide for payment in cash generally provide for payment to be made within three years following the end of the year in which the RSUs are granted, in order to ensure that the salary deferral arrangement ( SDA ) rules do not apply. If the SDA rules apply, the employee will have an income inclusion in the year the RSUs are granted equal to the current value of the rights granted under the plan. If the plan provides for payment in the form of shares, the stock option rules apply and the value of the shares is included in income in the year the shares are received. 3.3 SDA Rules: An SDA is a plan or arrangement under which an employee has a right in a taxation year to receive an amount after the year on account of, or in lieu of, salary or wages for services rendered in the year or a preceding year. The SDA rules apply even if there are conditions attached to the right, such as a risk of forfeiture if employment is terminated. There is an exception from the SDA rules, if none of the main purposes of the plan is to defer tax. If there is, in fact, a deferral of tax, then CRA may presume that tax deferral is one of the main purposes of the plan. Given the potentially harsh consequences of the SDA rules and CRA s position, it is not advisable to rely solely on the none of the main purposes qualification in setting up deferred compensation plans. 3.4 Exemptions From SDA Rules: CRA takes the position that the SDA rules apply to plans based on the full value of the corporation s shares on the date of grant, even when there is a risk of forfeiture if employment is terminated and the value on the payment date may be less than the value of the corporation s shares on the date they were granted. However, certain statutory exemptions can be relied upon to ensure that the SDA rules do not apply. There is a specific exemption from the SDA rules for deferred share unit ( DSU ) plans, which are structured to fit within the prescribed rules in regulation 6801(d) of the Income Tax Regulations ( Regulation 6801(d) ), as further discussed below. RSU plans are generally structured to fit within another specific statutory three-year bonus exemption from the SDA rules. To fit within the three-year bonus exemption, the plan must provide for payout of RSUs within three years after the year in which the RSUs are granted. The stock option rules in section 7 of the ITA take precedence over Page 11

any other tax provisions (including the SDA rules) that could apply to tax a benefit that comes within the scope of section 7 of the ITA. 3.5 Payout in Cash: If the payout of RSUs is in the form of cash the employee will have a full income inclusion in the year of receipt equal to the cash received and the employer corporation will be able to take a deduction for the cash payment. 3.6 Payout in Shares Issued From Treasury: If the payout of the RSUs is in the form of shares issued from treasury, the employee will have a full income inclusion in the year of receipt equal to the value of the shares received under section 7 of the ITA. The One-half Deduction is not available to the employee and the employer corporation will not be able to take a deduction in respect of the benefit conferred on the employee. 3.7 Payout in Shares Purchased on the Market: If immediately before the time of payout of settlement of the RSUs, the employer corporation pays an amount equal to the purchase price of shares to an account maintained by a broker for the employee and these funds are used by the broker to pay the purchase price of shares of the corporation purchased on the open market and delivered to the employee, the rules in section 7 of the ITA would not apply. CRA has ruled that, in these circumstances, paragraph 7(3)(b) would not deny a deduction for the amount paid by the corporate employer to the broker to purchase the shares on the market. The amount paid to the broker (or a reimbursement of that amount) would be deductible by the corporation in computing its Canadian income. 3.8 U.S. Taxation of RSUs: Under U.S. tax law, RSUs are not taxed at grant or at vesting, but at receipt of the underlying shares. The value of those shares when received is taxed as ordinary income to the employee and the company receives a corresponding tax deduction for the same amount. Unlike restricted stock, an 83(b) election is not available for RSUs because RSUs are not considered property under section 83(b) of the IRC. RSUs are often used to delay timing of U.S. tax liability by including a proper deferral election. RSUs must be carefully drafted to comply with section 409A of the IRC. 4. DEFERRED SHARE UNIT (DSUs) PLANS 4.1 Deferred Share Units: DSUs can be issued to any employees as a long-term incentive, but DSU plans are often set up for directors of the corporation. For purposes of the ITA, a director is an officer and an employee. Participants in a DSU Plan are generally granted notional units, the value of which is directly related to the fair market value of the corporation s shares. Like RSUs, the notional units are a proxy for shares of the corporation. Upon retirement, death or termination of service, the participant will be entitled to receive a cash payment equal to the value of those units. Because payments cannot be made under a DSU plan prior to the occurrence of any of those events, DSU plans are used to provide a long-term link between directors and officers and the success of the corporation. Page 12

4.2 Canadian Taxation of DSUs: DSUs are designed to fit within the specific rules in Regulation 6801(d) that exempt qualifying arrangements from the SDA rules, which would otherwise apply to include the deferred amounts in the participant s income at the time the DSUs are granted. The following is a summary, in very general terms, of the rules: (a) (b) (c) There is a prescribed window of time during which amounts have to be received under a DSU plan. All such amounts can only be received after the employee s death, or retirement from, or termination of, service and no later than the end of the first calendar year commencing after such an event. The amount that can be received under a DSU plan must depend upon the fair market value of the shares of the corporation (or a related corporation) at a time within the period that commences one year prior to the time of the death, retirement or termination of service and ends at the time the amount is received during the prescribed window. There cannot be any guaranteed minimum amount. Specifically, there can be no entitlement of the participant (or a person not dealing at arm s length with the participant) to any amount or benefit for the purpose of reducing the impact of any reduction in the fair market value of the shares of the corporation. If the DSU plan complies with the prescribed rules in Regulation 6801(d), the participant will be taxed in the year that amounts are received out of the DSU plan. Payments cannot be spread over more than a two year period because of the limited payout period described above. The corporate employer is permitted a deduction in the year the amount is paid out of the DSU plan. 4.3 DSU Plan Structure: A DSU plan is often used to replace all or a portion of fees paid to directors. Generally, to avoid constructive receipt concerns, the director makes irrevocable elections before the end of a calendar year to choose fee entitlements for the following year in cash or DSUs. If the director chooses all or a portion of fee entitlements to be paid in DSUs, the DSUs are recorded in a notional account maintained by the corporation and are valued based on the fair market value of the corporation s shares. Following the director s termination of service, the credited DSUs may be paid out in cash to the director. Alternatively, the corporation could pay cash to a broker or other third party (acting on behalf of the director) to purchase the corporation s shares on the open market. In these circumstances, the directors are subject to tax in the year the DSUs are paid out and the cash payments made by the corporation to the director (or the broker) should be deductible by the corporation in the year the payments are made. 4.4 Winding-up a DSU Plan: As a consequence of the rule that payments cannot be made to participants prior to their retirement, death or termination of service, a DSU plan cannot be easily or quickly wound-up. CRA, in a recent technical Page 13

interpretation, took the position that participation under a DSU plan could not be terminated and effectively converted into participation under an employee stock option plan as this would result in an amount being received prior to the employee s death, retirement or termination of employment. CRA took the position that this would cause the DSU plan to fail to comply with the rules in paragraph 6801(d) and, as a result, the plan would be an SDA and taxed accordingly. 11 4.5 U.S. Taxation of DSUs: Deferred share units are often referred to as phantom stock in the United States. Under U.S. tax rules, phantom stock is taxed at the ordinary income tax rates at the time of payout assuming the amounts are not considered constructively received pursuant to IRC Section 451. The company also receives a tax deduction for the same amount of income recognized by the employee at the time of payout. DSU Plans must be carefully drafted to comply with section 409A of the IRC. 5. APPRECIATION RIGHTS PLANS 5.1 Appreciation Rights: Appreciation rights plans may be in the form of standalone stock appreciation rights ( SAR s) with future payouts based on the increase in value of shares, if any, or performance appreciation rights ( PARs ) with future payments based on the corporation achieving specified financial performance and business goals that contribute to shareholder value, such as earnings growth rate, return on capital and cash generated by the underlying business. 5.2 Canadian Taxation of Appreciation Rights Plans There is no specific statutory exemption from the SDA rules for appreciation rights plans. These plans are structured to avoid the SDA rules by ensuring that the rights of employees to receive amounts under the plan relate only to future services rendered after the time the SARs are granted. Unlike RSUs and DSUs the holder of a SAR unit is not entitled to the value of the underlying shares but only to the appreciation, if any, in the value of those shares after the date of grant. CRA accepts that any such increase in value relates to services provided after the date of grant and, therefore, until such time as the employee has a right to cash in the SARs, the SDA rules do not apply. (a) Stand-Alone SAR Plans 11 CRA Views, document no. 2006-0178881E, January 16, 2007. Page 14

Unlike RSUs and DSUs the holder of a SAR unit is not entitled to the value of the underlying shares but only to the appreciation, if any, in the value of those shares after the date of grant. Under a stand-alone SAR plan, the executive is granted units which have no current value. At a later specified date, the executive may exercise the SAR and receive a payout in the form of cash or shares equal to the increase in value of the shares, if any, between the date of grant and the specified date of exercise. CRA s long-standing position is that such increase in value relates to services provided after the date of grant and, therefore, until such time as the employee has a right to exercise and cash in the SARs, the SDA rules do not apply. 12 If the payout of the SAR is in the form of cash or shares purchased on the employee s behalf on the open market, the employee will have a full income inclusion in the year of receipt equal to the amount received and the corporation will be entitled to a deduction for the amount paid to the employee. If the payout is in the form of shares issued from treasury, the employee will have a full income inclusion in the year of receipt equal to the value of the shares received. The employer will not be able to take any deduction. (b) PAR Plans Like a SAR plan, PARs are structured to avoid the SDA rules by ensuring that the rights of employees to receive amounts relate only to future services rendered after the time the PARs are granted. Unlike SARs, appreciation for a PAR is not valued by reference to share value. PARs are measured by selected financial criteria, such as increases in the value of an underlying business and/or earnings, positive cash flow, and return on capital and, in some cases, comparators with competitors in the same industry. CRA has issued a ruling that, where the measure of appreciation was based on the consolidated income of a parent corporation before deducting certain items, the appreciation rights-type plan was excluded from the SDA rules. The exclusion was available on the basis that, like a SAR, the plan could be considered a payment for future services since the eventual payout is based on the future performance of the parent group of companies. 13 CRA issued a similar favourable ruling in respect of a share-appreciation rights plan based on the value of the company determined as a percentage of EBITDA adjusted for certain debts and cash (and cash equivalents) and distributions to shareholders. CRA referred to this plan as 12 Question 26 of the 1988 Revenue Canada Roundtable; CRA Views, document no. 9307455, June 1, 1993; and document no. 9422835. 13 CRA Views, document no. 2005-0118901R3, Date: 2006. Page 15

a typical SAR under which the employee has no right, conditional or not, to receive an amount. 14 Because appreciation for PAR plans are based on increases in the value of a business, rather than share value, they are often used to provide long-term incentive plans for employees of partnerships. 5.3 Issues Related to Vesting of SARs and PARs: The exercise and payout of a SAR or PAR does not have to be within three years of the date of grant. The performance period can extend out for any reasonable length of time. The payout date can be changed to an earlier time. However, the timing of payout must be in the same year the SAR or PAR becomes exercisable, to avoid the SDA rules. CRA takes the position that once an employee has a right to exercise a SAR and does not do so, the SAR may become a deferred amount for purposes of the SDA rules 15 For this reason, a SAR or PAR plan should not provide for exercise windows or any vesting provisions which may cause the right to become unconditional before the end of a performance period. 5.4 U.S. Taxation of SARs and PARs (a) Stock Appreciation Rights (SARs) SARs are not taxed at the time of grant, but at the time of exercise. The mployee is taxed at the ordinary income tax rates on the amount received at exercise which is based on the stock appreciation since the grant date. The company receives a corresponding tax deduction equal to the amount of ordinary income recognized by the employee. SARs may be settled upon exercise in stock or cash. The tax treatment is the same for both types of awards. However, for stock-settled SARs, the employee will also be taxed on the subsequent stock appreciation at the capital gains rate. If a SAR is granted with an exercise price less than the fair market value of the underlying stock at grant (a discounted SAR), the optionee will be taxed under section 409A. Under section 409A, the optionee will be taxed at vesting and, in addition, will be subject to an additional 20 percent excise tax plus interest at the underpayment rate plus 1 percent. (b) Performance Appreciation Rights (PARs) 14 15 CRA Views, document no. 2006-0201541R3, Date: 2007. CRA Views, document no. 9307455, June 1, 1993; document no. 9422835, September 14, 1994. Page 16

PARs are mostly commonly referred to as performance shares in the U.S. PARs are not taxed under U.S. tax rules at the time of grant, but at the time of payout. The cash received is taxed at the ordinary income tax rates for the employee and the company receives a tax deduction for the same amount upon payout. PAR plans must be carefully drafted to comply with section 409A of the IRC. 6. CROSS BORDER EMPLOYMENT 6.1 Cross-Border Compensation Plans: Executive compensation plans are often used in cross-border situations, with the intention of providing similar benefits to executives of a parent corporation and its subsidiaries. Cross-border tax issues also commonly arise where a U.S. resident provides services in Canada or a Canadian resident is a U.S. citizen and is subject to tax on the benefits in both Canada and the U.S. 6.2 Timing of Income Recognition: In situations where an employee provides services in different countries which impose tax based on an individual s residence, such as Canada and the U.S., the country in which the individual is resident will have the right to tax the entire benefit realized by that employee. The individual may also be subject to income tax in the source country in which he or she provided the employment services. In these circumstances, the country of residence should allow a foreign tax credit for the taxes paid in the source country. However, benefits derived from compensation plans may be taxed at the occurrence of different events and times in each country. For example, one country may impose tax on the value on the date of exercise of rights while the other country imposes tax at the time of vesting of those rights. If there is a difference in the timing of income recognition, there is a risk of double taxation. Canada does not allow foreign tax credits for taxes paid on employment income to be carried forward or back. 6.3 Income or Capital Gains: Inconsistencies may also exist between countries in determining which portion of a taxable benefit derived from share compensation should be treated as an income receipt and which should be treated as a capital gain. Double taxation can result where countries have different rules. 6.4 Exemption Under the Canada-U.S. Tax Convention (the Treaty ): As a general rule, where an employee resident in one country provides services in the other country (the source country ) the source country can impose tax on the remuneration derived from the employment exercised in the source country. There are limited exceptions in Article XV(2) of the Treaty. The fifth protocol to the Treaty (the Fifth Protocol ) made changes to Article XV(2)(b) effective for 2009 and subsequent years. In order to meet the current exception, the employee must: (i) not be present in the source country for more than 183 days in any 12 month period commencing or ending in the fiscal year concerned; and (ii) the employee s remuneration cannot be paid by, or on behalf of, a person who is a Canadian resident or borne by a permanent establishment in Canada. Page 17

Article XV(2)(b), as it currently applies, refers to remuneration that is paid by or on behalf of a person who is resident in the source country, as opposed to an employer. The Technical Explanation indicates that in certain abusive cases, substance over form principles may be applied to recharacterize an employment relationship. CRA has indicated that whether the word person or the word employer is used, the intention is to determine who, in fact, is exercising the functions of the employer. 16 This intention can be illustrated by two examples. In the first example, a Canadian company wishes to employ U.S. residents for one or more periods of less than 183 days. The Canadian company recruits the employees through an intermediary in the U.S. who purports to be the employer and hires the employee. Notwithstanding the intermediary, there is an employee-employer relationship established between the Canadian company and the U.S. resident employees. In these circumstances, the exemption in Article XV(2)(b) does not apply and the U.S. resident employees are subject to Canadian tax on their remuneration. In the second example, a Canadian company retains a U.S. company to provide services in Canada. The services are rendered by the U.S. company through its employees. In that case, there is no employer-employee relationship between the Canadian company and the employees. The exemption in Article XV(2)(b) would be available, provided the other conditions have been met. However, this situation may create significant Canadian tax issues for the U.S. company as it will be carrying on the business of providing services in Canada. The term borne by is used in the situation of a permanent establishment in Canada. Remuneration is borne by a person if that person is charged for the remuneration directly or indirectly, through a management or administration fee or otherwise, even if the employee continues to be paid from the U.S. 6.5 Allocation of Stock Option Benefits: If stock options are granted to a nonresident who provides services in both Canada and another country, the amount subject to Canadian tax on the exercise of the options will be the portion of the benefit that relates to employment performed in Canada in the year the options were granted (not the year of exercise). The diplomatic notes exchanged in connection with the Fifth Protocol contemplate an apportionment of the employment benefit between Canada and the U.S. in connection with the exercise of stock options granted while employed in one country but exercised or disposed of after moving to the other country to work for the same or related employer. The diplomatic notes state that the benefit is generally sourced on the basis of the number of days spent in each of the employee s principal places of 16 CRA Views, document #2008-0300571C6, dated December 9, 2008. Page 18

employment between the grant date and the exercise or disposition. In determining whether income from the exercise or disposal of an option is subject to these rules, the days present and income earned tests of Article XV(2) are applied. However, these tests are applied with respect to the year in which the services are performed and not with respect to the year in which the stock options are exercised or disposed of. The Canadian and U.S. competent authorities retain an overriding right to attribute income in a different manner if it is more appropriate because, for example, the options were in the money at the time of grant or not subject to a substantial vesting period. CRA takes the view that the phrase principal place of employment means the country in which the employee was physically present while performing the employment on a particular day. CRA will apportion the stock option benefit over the period between the grant and exercise of the option using the following fraction 17 : Days employee physically present in Canada while exercising the employment in period Total number of days exercising the employment in the period If the employee was present in two countries in one day, rendering services in each country, CRA would look to the country in which the employee principally (more than 50%) rendered services on that day. 18 6.6 Withholding, Reporting and Transfer Pricing Tax Issues: Where employees perform services in both Canada and another country, compliance with reporting and withholding obligations can become complex and onerous. Consideration must be given to transfer pricing and how costs relating to cross border transfers should be allocated. Countries other than Canada may allow a corporation deduction for stock option benefits, which may provide planning opportunities for a group of related entities to maximize deductions outside of Canada. 7. EMPLOYEE TRANSFERS TO CANADA 7.1 Cross-Border Transfers: The cross-border transfer of an employee to Canada, whether on a short-term or permanent basis, gives rise to a number of Canadian tax implications. These tax implications should be addressed and appropriate tax planning done prior to the actual move in order to avoid unexpected adverse tax consequences that impact the financial position of the employee and the employment relationship. 17 CRA Views, doc. #2008-0300631C6, dated December 9, 2008. 18 Ibid. Page 19

7.2 Moving and Relocation Expenses: Moving expenses incurred by a nonresident moving from a foreign country into Canada are not deductible from taxable income earned in Canada. However, a reimbursement by the employer of actual, reasonable expenses incurred by the employee in moving the employee s family and house contents to Canada will generally not be included in the employee s income from employment for Canadian tax purposes and will be deductible by the employer. Reimbursements of amounts paid for the cost of financing or the use of a house are employment benefits, even though these costs are incurred coincident with, or as a result of, the move. Examples of taxable benefits include reimbursements of mortgage interest paid by an employer in connection with an employee s old residence and payments for bridge financing and mortgage insurance premiums for the new residence. Similarly, a reimbursement of a loss on the sale of the employee s old home in the foreign country would be considered a taxable benefit of employment. 7.3 Equalization Payments: Employees relocating to Canada may be faced with higher living expenses than in their home country. A cost of living adjustment payment made by the employer to compensate the employee for such increased costs will generally be included in the employee s income, as either an allowance for personal or living expenses or a taxable benefit of employment. Where an employee is transferred from a lower tax jurisdiction to Canada, tax equalization payments intended to put the employee in the same position for tax purposes, as if he or she had continued to be employed in the lower tax jurisdiction, will be treated as additional income from Canadian employment. An employer may want to compensate an employee for losses resulting from foreign exchange fluctuations. If the value of the Canadian dollar goes down, the employee will be compensated to reflect the remuneration he or she was intended to receive at the time of employment in Canada. The employee will be particularly concerned with foreign exchange issues, if he or she is required to make periodic payments in the home country, such as child support or mortgage or other loan repayments. Any compensation for a decrease in the value of the Canadian dollar will be employment income subject to Canadian tax. 7.4 Receiving Bonus Payments Before Becoming a Resident of Canada: Any foreign income earned and paid prior to an employee becoming resident in Canada will generally not be taxable in Canada. Once the employee becomes a resident of Canada, he or she will be taxable on his or her world-wide income received during the period of Canadian residence, even though the income was earned while a non-resident. For that reason, the employee may want to arrange to receive all remuneration due to the employee in respect of foreign employment before becoming a Canadian resident. A bonus in respect of employment services performed in another country and received prior to the transfer of the employee to Canada will generally not be subject to tax in Canada, as long as it is reasonable to conclude that the entire bonus relates to past services performed in that other country and not to the future services to be performed in Canada. Page 20

7.5 Stock Incentives: If an employee has participated in a stock option plan under which options were granted in respect of services performed outside Canada at a time when the employee was not a resident of Canada, consideration should be given to allowing the employee to exercise the options and acquire shares before the employee becomes a Canadian resident. Canada does not provide any relief from Canadian tax for benefits on options granted when the employee was a non-resident of Canada and exercised after the employee becomes a Canadian resident. If both Canada and another country impose tax in the year the option is exercised, the tax paid in the country of origin may be credited against the Canadian resident employee s Canadian tax. If Canada and the other country impose tax in different years, or on different amounts, there will be a mismatch of the foreign and Canadian tax for foreign tax credit purposes and the potential for double tax. Gloria Geddes is a partner, Toronto Office Group Leader, Tax and the National Leader, Executive Compensation Group at Gowlings. She may be contacted at (416) 369-4593 or by e-mail at gloria.geddes@gowlings.com 2010 Gowling Lafleur Henderson LLP This publication contains material of a general interest only and is not intended to provide legal advice or to replace a consultation with a legal professional on any particular matter. Page 21