Release date: March 31, 2014
Guest: Vasu Krithigaivasan
Running time: 09:56 minutes
In this episode of our “Top global mobility issues facing Tax Directors” series, Vasu Krithigaivasan discusses equity charge-back agreements that commonly exist between a Canadian subsidiary and its foreign parent company in order to provide a framework for incentive compensation plans.
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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.
Chantal: Hello, it’s Chantal McCalla of PwC Canada. Welcome to another instalment in our PwC podcast series on the top issues for Tax Directors to think about. With us today is Vasu Krithigaivasan, a Senior Manager from the PwC Human Resource Services tax group. Vasu specializes in international assignments and expatriate tax management at PwC. He has been working in this field since 2000. Today he is going to discuss “Intercompany equity charge-back agreements”.
Vasu: Thank you Chantal.
Chantal: Now Vasu, it is my understanding that it is quite common for a number of Canadians who are employed by the Canadian subsidiary of a foreign parent company to receive incentive compensation in the form of “stock options” of the foreign parent company. Can you give us a brief description of the situation and the related issues?
Vasu: This is a very common scenario Chantal. In this podcast, I will primarily address the issue from an employer or corporate perspective. While there are other forms of equity compensation, this discussion will be restricted to stock options.
Here is a scenario that we come across very often.
Let’s say we have a company incorporated in Canada that is 100% owned by a foreign corporation. We will call the foreign company “the foreign parent”. The foreign parent company agrees to issue shares to an employee of the Canadian company as part of their incentive compensation plan. We will call the Canadian company “the Canadian sub”. This employee has only worked in Canada. When the shares are issued to the employee, the foreign parent company charges the Canadian sub for an amount equivalent to the value of the shares issued to the employee. Generally, there are agreements in place for charging such amounts. These are commonly known as “equity charge-back agreements”.
Chantal: Why should companies have equity charge-back agreements?
Vasu: If companies wish to treat the cost of the shares as an expense and claim a deduction on their corporate income tax return, then, they would need an equity recharge agreement in place to substantiate the payment. Also, if the reimbursement by the Canadian sub to its parent is not supported by an agreement, the payment could be considered a dividend payout to the parent.
Chantal: So, does this mean companies can claim a deduction on their tax return for reimbursements made in accordance with their equity charge-back agreements? Or are there other conditions to be met?
Vasu: That’s correct Chantal — it is not that simple. There are other conditions that need to be met for them to be able to take a deduction on their corporate tax return.
Chantal: Vasu, why is this such an important issue for companies?
Vasu: It is very important because it affects their bottom line. If they are able to deduct this expense on the tax return, it reduces the company’s overall tax cost. For a company that predominantly uses equity based compensation to reward its employees, the tax savings could be significant.
Chantal: Vasu, can you explain how companies pay out equity compensation?
Vasu: Sure. Generally, companies follow one of two methods to pay out equity compensation. The first method is to deliver shares to the employee. The second method is to settle in cash based on the value of the shares on the settlement date. While recharge may happen in both situations, the tax consequences to the company and the employee are not the same.
Chantal: Ok. What must companies do to be able to get a deduction on their tax return?
Vasu: The stock option plan of the company must give the option to the employee to choose between taking shares or cash. If the employee chooses to take cash, then the company will be able to get a deduction on its tax return for the amount of the cash settlement.
If the employee chooses to take shares, then the company will get a tax deduction only if the shares are purchased in the market and offered to the employee. Should the company issue new shares from treasury, the company will not be able to take a deduction on its corporate tax return. Generally, stock options are not settled with market purchased shares.
Some companies set up an employee benefit plan trust to facilitate the purchase of shares in the market. There are a number of rules that must be complied with for the company to be able to deduct amounts that are paid into this trust for the purchase of shares. Also, there are limitations as to how much and when such amounts that are paid into the trust can be deducted on the company’s tax return.
Where the employee has worked in more than one location during the vesting period of the shares, care must be taken to ensure that the Canadian sub is only charged for the time the employee worked in Canada. This is assumed to be the benefit that the Canadian entity received while the employee worked in Canada. The allocation is not as simple as it appears. You will need to consider transfer pricing rules before arriving at the amount that should be allocated to the Canadian sub.
Chantal: How does the method of payout impact the employee?
Vasu: If the employee receives shares and also meets the conditions set out in the “prescribed share rules”, then, the employee is able to claim a deduction for an amount equal to 50% of the income on his Canadian income tax return. This deduction is called the stock option benefit deduction. If the employee receives cash, the employee may not claim the stock option deduction unless the corporation makes an election to not claim a corporate tax deduction.
Chantal: Can you give us an example to illustrate the above rules?
Vasu: Sure Chantal.
Mr. X is a Canadian resident living in Toronto. He works for Canada subco which is a fully owned subsidiary of Foreign Parentco. The parent company granted options to issue 5,000 shares to Mr. X on January 1, 2010. The grant price was C$10.00 per share. The options became fully vested on January 1, 2013. During the vesting period, Mr. X worked for 2 years in a foreign location and 1 year in Toronto. The stock option plan of the parent offers employees to choose between accepting shares or cash once the shares become fully vested. The two companies have an intercompany equity recharge agreement.
Mr. X exercised the options on January 1, 2013 when the value of the share was C$20. He chose to receive the payout in cash rather than shares. Mr. X received C$50,000 in cash as settlement on exercise of the options.
Foreign Parentco charged its Canadian sub C$16,667 under the equity recharge agreement. This amount represents the time period Mr. X worked in Canada during the vesting period.
Canada subco may claim a corporate tax deduction for $16,667 on its tax return because the settlement for the stock options was made in cash and it did not make an election not to claim a corporate tax deduction. Since Mr. X did not receive shares on settlement, he is not entitled to claim the stock option deduction. The entire stock option benefit of $50,000 is subject to tax as employment income.
Chantal: Are there any other issues that companies need to consider?
Vasu: The method of accounting for equity transactions may be impacted by the settlement options offered. Therefore, companies need to take this into account and not deal with the issue of corporate tax deduction in isolation. Also, if the entity holding the shares for the Canadian resident employees is a non-resident trust, then, the recently enacted non-resident trust rules must be considered to ensure there are no negative tax consequences. For more information on these rules, please refer to PwC’s recent Tax Insights publication titled: Canada’s new non-resident trust rules: what they mean for global equity plans.
Chantal: It appears this subject is very complex and a lot of thought and planning is required to ensure there are no unintended tax consequences.
Vasu: You summed it up correctly, Chantal.
Chantal: Thanks for joining us today, Vasu. If people listening to this podcast have any questions pertaining to these types of agreements, Vasu’s contact details are listed on our PwC podcast website at www.pwc.com/ca/taxtracks.
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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.