By Rick Schubert and Chris D'Iorio
Currently, many corporations are scrutinizing all of their operations with a view to determining how they can reduce cash outlays and other profit and loss expenses. One area that has not traditionally been examined is the structuring of directors' compensation.
Most of the deferred equity-based compensation paid to directors takes the form of deferred share units (DSUs), taxable only upon settlement. However, DSUs are actually less tax-efficient than an alternative vehicle: Restricted Shares, which constitute a taxable benefit upon grant. This may seem counter-intuitive, but it results from different tax rates between capital gains and dividends and regular employment income. The corporation can use the superior tax-efficiency of Restricted Shares to save cash without impairing the delivery of net reward to the directors.
A Restricted Share is a share of a corporation having restrictions placed on its disposition by the shareholder (in this case, a director). Upon grant, the shareholder/director obtains all of the regular rights of a shareholder, such as entitlement to dividends, the ability to vote the shares and rights upon dissolution, and continues to enjoy these entitlements throughout the restriction period. Unlike DSUs, which can only be paid out under the very limited specific circumstances articulated in paragraph 6801(d) of the Regulations to the Income Tax Act (Canada), the restrictions placed upon a Restricted Share can be set to whatever circumstances best achieve the objectives of the corporation's deferred compensation program. The restrictions could replicate those of DSUs (i.e. not disposable until termination of office) or be based on other events, performance achievements and/or a fixed time period.
Ditching the DSU
The difference between Restricted Shares and DSUs in tax efficiency is much more significant in the context of today's deeply depressed share prices. This is because of the Restricted Share's superiority in terms of taxation of increases in value and the potential for future value increase in the eventual recovery of a depressed market. While all income received under a DSU program is tax-deferred until eventually paid out, all is taxed at full employment income rates upon receipt.
In contrast, while Restricted Shares are taxed upon grant, all increases in share value from that point until the time of disposal are taxed at half the rate applicable to DSUs because they constitute capital gains. Additionally, the taxable inclusion with respect to a Restricted Share is less than — in some cases much less than — the fair market value (FMV) of an identical unrestricted share.
This reduced FMV constitutes the taxable benefit of the grant to the director and also the adjusted cost base of the share at disposition. The value of this discount is also received at capital gains tax rates, assuming the share has at least retained its grant FMV at the time it is eventually disposed of. Finally, actual dividends are received on a real-time basis from Restricted Shares and, if the shares are those of a qualifying Canadian corporation, the dividends will also be taxed at capital gains rates.
As a result of the greater tax efficiency inherent in Restricted Shares, corporations can provide the same net remuneration to directors at a substantially reduced cost.
An example of how Restricted Shares are better
Suppose the goal was to provide the same net benefit to the directors at the point of full recovery in share price to the previous high of $100, and that the current share price is $60. Further, assume that a valuation determines the discount to FMV of a share with the restrictions applicable to the shares in question is 20%. The FMV of a Restricted Share here is currently, therefore, $48.
Now assume the share price eventually returns to $100 at the time the DSUs are to be settled. Also assume the director receiving a $100 payout under the DSU, pays $46 in tax (approximately the top Ontario rate) and, therefore, nets $54. The director holding the Restricted Share would have paid 46% tax on the $48 FMV of the Restricted Share, or $22.08 and 23% on the capital gain of $52 ($100 - ACB of $48) or $11.96 for a total of $34.04 in taxes. This is $11.96 less tax on the Restricted Share. In order to produce the same net payout as the DSUs, approximately 30% fewer Restricted Shares would be required.
Corporate tax and accounting
DSUs constitute a liability and therefore an expense that must be recognized at grant and be adjusted "mark-to-market" each reporting period until settlement. While this adds an element of volatility to the financial statements, it would usually be immaterial given the quantum involved in directors' DSU plans. The expense is finalized upon settlement and is equal to the value of the settlement. Because the expense recognition commences upon grant and the tax deduction does not occur until settlement, there is usually a period of years during which the expense recognition is not offset by a tax deduction. DSUs are commonly settled in cash, which is a fully tax deductible outlay when made.
In the case of Restricted Shares, the compensation expense is fully recognized in the year of grant. The compensation expense to be recognized is equal to the discounted FMV of the Restricted Shares. The tax deduction is equal to the cash outlay to purchase the shares (assuming the shares are purchased on the open market) and is available in the year of grant.
Companies should consider amending their compensation plans to include Restricted Shares, since it's a way to reduce compensation costs.