2010 Federal Budget: Proposed Changes to Stock Option Rules

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Episode 16: 2010 Federal Budget: Proposed Changes to Stock Option Rules

Release date: March 16, 2010
Running time: 10:21 minutes

The 2010 Federal Budget proposed changes to tandem or "cash out" stock options that will have implications for employees and employers alike. In this podcast, we discuss the implications for employers, what planning alternatives exist, and what employers should do immediately to deal with the fallout from these changes.

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2010 Federal Budget: Proposed Changes to Stock Option Rules

You're listening to another episode of PwC's Tax Tracks at www.pwc.com/ca/taxtracks. This series looks at the most pressing technical and management issues affecting today's busiest tax directors.

Gerry Lewandowski: Here with us today is Rick Schubert, a senior member of PwC Canada’s human resource services tax practice based in Toronto. Rick is a specialist in tax structuring and accounting for executive compensation plans. Rick has been with PwC Canada for many years and provides Canadian executive compensation tax planning and accounting services to businesses of all sizes and in all industries. Rick is with us today to help us make sense of the new federal proposals around employee stock options and deal with next steps, particularly from the perspective of employers.

Thanks for joining us Rick.

Rick: You're most welcome.

Gerry: Rick, can you summarize the significant changes that were in the recent federal budget in connection with equity-based compensation plans?

Rick: Certainly, there were some very significant changes. The first one being the elimination of the tandem option. That is an option structure where the employee has a choice between a cash settlement and simply exercising the option. It used to be that both the employer and employee could obtain tax deductions in respect of the cash settlement. Now, it can only be one or the other. The employer has to make a decision as to whether it will take the deduction in respect of the cash settlement or the employee will be allowed to take the 50% deduction. Assuming they choose cash. If the employee simply exercises the option, they get the 50% deduction and the employer does not. There is no cash outlay – the employer does not get the deduction.

The second major change was the elimination of the ability to defer the payment of tax on a stock option benefit. This was a risky strategy that really, with the market decline, got a lot of employees in trouble where they ended up having a tax liability that exceeded the value of the shares, post market crash.

At the same time that they have eliminated the ability to defer they tax on payment of an option benefit, the budget proposes to provide relief for those affected in the way that I just described. They can essentially satisfy their tax obligation by turning over all the proceeds from the sale of those shares. So, if my tax liability is greater than the value of my shares, I can sell them and just hand that money over to the government and I will have satisfied my tax obligation.

The final one was the tightening up of withholding obligations. Post 2010 there is no more hardship exemption. There is a hard and fast rule that the employer must remit the tax exigible on a stock option benefit.

Gerry: Now let’s look at the changes to the tandem options in more detail. What are some of the key implications for employers who have tandem option plans?

Rick: Well, I think the greatest challenge is a decision has to be made fairly quickly as to whether or not the company is going to agree not to deduct a cash settlement. Whether it will, in fact, even maintain a tandem plan structure where an employee has a choice between exercising the option and choosing cash. A lot of employers went into these type of plans because they were averse to EPS dilution (diluting the stock holders), and/or really wanted the tax deduction.

That places them in an awkward position in terms of deciding what to do. If I don’t give my employees the 50% deduction on the cash side, and take my deduction, my tax deduction, employees will not chose the cash. They’ll chose to exercise and that’s going to dilute my shareholders. Conversely, if I chose not to get my tax deduction, I’m in a position where I’m paying out cash, and not getting a tax deduction. It’s not a very pleasant position to be in.

So decisions have to be made with respect of the plan design for future grants as well. They could maintain the status quo, they could go with share appreciation rights only, perhaps options only, perhaps switch over to a full value grant such as restrictive shares.

It’s a complicated decision that needs to made and there are a lot of moving parts that affect not only the tax side but also the accounting side.

Gerry: So Rick, as an employer, what immediate decisions will have to be made in respect of plans that offer cash payments in exchange for option rights?

Rick: Well, the most immediate need would be to clarify what their position is going to be through formal communication with employees. As an employee, not knowing what my employer’s decision is going to be in terms of the deductibility… Do I get the 50% deduction, or does the employer get the deduction for the cash outlay? I don’t know really which way to go. Is it still safe to take a cash settlement or should I exercise the share option in order to safeguard my 50% deduction? Employers, I think, need to communicate to their employees some type of a safe harbour type of position going forward. Until such time as the employer has made up its mind as to whether it will elect to forgo the tax deduction or not.

Gerry: It sounds like the implications of these tandem option plans flow across both tax and accounting. Does that mean a client would have to coordinate advice from two separate professionals?

Rick: Not necessarily. That is often the case. We have structured our practice at PricewaterhouseCoopers such that our equity compensation tax specialists work continually with our equity compensation accounting specialists. In fact, on my team, I have people both with law degrees, CA designations, CPA designations. We knit the two sides together and work in a cross-disciplinary basis so that we can coordinate the analysis of the tax and the accounting. When I change something on the tax side, it often, usually in fact, changes something on the account side. So I need to be cognizant of both impacts.

Gerry: What are some of the key implications of the elimination of the deferral election and the relief that is being provided?

Rick: Well, the main one to me, is that it will preclude employee from taking risks that perhaps a lot of them shouldn’t be taking, in terms of reducing or eliminating the ability to leverage at least through the tax system. Because I have to pay my tax up-front, I can’t defer that payment, I can never again be in a position where my share value is less than my tax obligation.

Gerry: Now, what are the key implications of the elimination of the hardship exemption in connection with withholding obligations?

Rick: As I mentioned, the reduction in employee risk from the employee perspective. But from the employer perspective, the main impact is going to be the necessity to put in place some kind of a mechanism that is going to sell shares, in sufficient quantities, to finance withholding remittance. I can no longer simply allow an employee to exercise their options and walk away with all the resulting shares. I have to ensure somehow that enough shares are going to be sold and someone, either me as the employer, or a third party administrator, is going to remit the tax that’s owing on that benefit.

Gerry: And, finally, Rick will you please tell us about PwC’s Human Resource Services practice pertaining to executive compensation?

Martin: Well, our model, if you will, is our strengths are tax and accounting and we stick to our knitting. We focus on that area and we work, often times hand-in-hand, with traditional compensation advisors. We don't really get involved in the determination of, for example, how much an executive should make. That is done by the traditional compensation consultants. They do it extremely well. What we see our role as being is coming in and once the determination of the size of the wallet has been made, we find the most efficient tax and accounting ways of structuring those payouts so that it reduces the expense to the company, eliminates whatever negative accounting impacts they might not want to see in it, and also maximizes tax efficiencies for both the recipient and the employer.

Gerry: Thank you, Rick, for your thoughts and insights into these recent proposed stock option rules. For additional information around reward and compensation, please visit our Human Resource Services webpage at pwc.com/ca/hrs.

Thank you for tuning into Tax Tracks at www.pwc.com/ca/taxtracks.

The information in this podcast is provided with the understanding that the authors and publishers are not herein engaged in rendering legal, accounting, tax or other professional advice or services. The audience should discuss with professional advisors how the information may apply to their specific situation.

Copyright 2010 PricewaterhouseCoopers LLP. All rights reserved. PricewaterhouseCoopers refers to PricewaterhouseCoopers LLP, an Ontario limited liability partnership, or, as the context requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is a separate and independent legal entity. For full copyright details, please visit our website at pwc.com/ca.

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Through interviews with prominent PwC tax subject matter professionals, Tax Tracks is an audio podcast series that is designed to bring succinct commentary on tax technical, policy and administrative issues that provides busy tax directors information they require.