Publication
Stock option plans are effective compensation when share prices are rising. However, in a climate of declining share prices, stock options often require "repricing" in order to maintain their incentive effect. Care must be taken, however, to ensure that the repricing does not negatively impact the employee's tax position.
The following paragraphs address some of the tax concerns generally relevant to public corporations with Canadian resident employees who hold options that have an exercise price greater than the fair market value of the shares.
Unexercised Options - "Repricing"
The Income Tax Act (Canada ) gives employees favourable treatment when the exercise price of the option is not less than the fair market value of the share at the time the option is granted. If this test is met - and certain other requirements are satisfied - then
- the employee will be entitled to a deduction equal to 50% of the income inclusion that arises on the exercise of the option (the "stock option benefit"); and
- the employee may be entitled to defer recognition of the stock option benefit until the shares acquired on the exercise of the option are sold;
If the fair market value of shares has fallen below the exercise price of the option, a simple "repricing" - i.e., amending the terms of the option to reduce the exercise price - may mean that the exercise price is less than the fair market value of the shares on the date of the option grant. Instead, the original options should be exchanged for new options that have an exercise price equal to the fair market value of the underlying shares on the date of the exchange. This exchange can be structured as a tax-deferred "rollover" of options provided, among other things, that the "in the money amount" of the new options is not greater than the "in the money amount" of the old options. Of course, the tax, securities and accounting implications of an exchange of options must be fully considered before any option exchange is implemented.
The Department of Finance recently announced, however, that it is considering an amendment to the Act that would avoid the necessity of exchanging options in these circumstances. The amendment under consideration would permit the 50% deduction in computing income (assuming it is otherwise available) where stock options are repriced where "the reduction in exercise price provides no immediate increase in the net benefit associated with the option". If adopted, the amendment will apply to repricings occurring after 1998. The Canada Customs and Revenue Agency (the "CCRA") has indicated that pending the publication of the proposed amendment it will not reassess taxpayers who have claimed the 50% deduction in these circumstances, except in cases of abuse.
Exercised Options
Another result of a decline in share price is felt by employees who exercised stock options, but did not sell sufficient shares to obtain the cash necessary to pay the tax on the stock option benefit. In the worst case scenario, the decline in share price is such that the tax liability is greater than the fair market value of the shares at the time the tax liability comes due. Furthermore, a sale of the shares will generally result in a capital loss, which generally can be used to offset capital gains, but not the taxable benefit resulting from the exercise of options, which is treated as income from employment.
We are advised that the CCRA is cognizant of the hardship many individuals are facing as a result of the 2000/2001 stock market declines. The CCRA is advising taxpayers in this position to report the stock option benefit or claim the deferral, where it is available. In cases of hardship, collections officers will work with taxpayers to establish payment schedules. We understand that this matter is also under review by the Department of Finance, but that it has not yet been determined what - if any - solutions may be forthcoming.
An employee who has deferred the recognition of a stock option benefit and who still holds the shares should consider planning for the ultimate disposition of the shares which will trigger payment of the tax liability. Ideally, the employee will be able to hold the shares until stock price increases provide sufficient cash, on a sale of the shares, to pay the tax. If the stock price does not recover, however, the employee may be in a difficult financial position. This situation may be addressed - to some extent - if the employee holds the shares until death. On death, he or she will be deemed to have disposed of the shares at fair market value immediately prior to death. This deemed disposition ends the deferral of the stock option benefit, and triggers a capital loss, 50% of which is the "allowable capital loss". To the extent the allowable capital loss cannot be used to offset taxable capital gains and certain other amounts, the loss can be applied to reduce the deceased employee's income from any source, including the stock option benefit. While this is not a perfect result, as only part of the stock option benefit can be reduced by the loss, the outcome is better than if the shares are disposed of prior to death. Additional insurance could be obtained to cover the projected deficiency. Of course, such planning must be done in contemplation of the overall estate planning objectives of the employee.
The purpose of this document is to provide information as to developments in the law. It does not contain a full analysis of the law nor does it constitute an opinion of Ogilvy Renault or any member of the Firm on the points of law discussed.
If you wish to correct your mailing information, please contact us by telephone at (514) 847-4859 or by fax at (514) 286-5474.
©OGILVY RENAULT 2002 -All Rights Reserved
