Public Companies Should Consider Amending Stock Option Plans Prior to 2011 to Reflect Income Tax Withholding Requirements
The 2010 Federal Budget includes provisions affecting employee stock option plans. One such budget provision "clarifies" that after 2010, employers will be required to make source deductions in respect of employee stock option benefits to ensure that an amount on account of tax on the value of the taxable benefit associated with the issuance of securities is remitted to the government by the employer. Amendments to the Income Tax Act will provide that, for the purposes of the withholding requirement, the employment benefit realized by an employee on the exercise of a stock option must be determined as if it were paid as a cash bonus.1 This amendment will apply to benefits arising on the issuance of securities after 2010, which delay was said to provide time for businesses to "adjust their compensation arrangements and payroll systems."2
The amendment potentially will impact not only Canadian employers, but also non-Canadian companies that have stock option plans under which Canadian employees (for example, of a subsidiary company) participate.
The precise implications to public companies of this remittance requirement have been unclear pending release of draft legislation and explanatory notes by the Department of Finance. On August 27, 2010, the Department of Finance issued draft legislation to implement certain 2010 Federal Budget proposals and, on September 10, 2010, issued explanatory notes in respect of the draft legislation. These materials indicate that the transitional relief in respect of the new remittance measures will allow employers time to adjust their employee stock option plan provisions, if necessary, to allow a sufficient quantity of the related securities to be sold at the time of exercise of an employee stock option in order to satisfy the income tax withholding and remittance obligations.
Some stock option plans may include general tax withholding or compliance with law provisions that may be broad enough on an exercise of options to (i) permit the employer to require an option holder to pay any required withholding amount; or (ii) permit the company to sell, in the market, a portion of the securities issued and to use the proceeds to satisfy the required withholding. In other cases, however, option plans may not contain appropriate provisions and should likely be amended.
Absent appropriate provisions in the option plan, employers could, commencing January 1, 2011, face the dilemma of being required to withhold and remit an amount to the CRA in respect of the taxable benefit to an employee as if the benefit were cash, without there being any or a sufficient cash payment to the employee from which to fund the remittance. In such cases, the employer may have to determine whether it has a legal right to impose, as a condition of the options being exercised, an additional funding requirement on the employee, or a right to sell a portion of the underlying securities on behalf of the employee. In addition, the company may need to consider potential implications of any provisions in the plan requiring consent of affected option holders if their rights might be prejudiced or impaired.
Employers should review and, if necessary, amend, the terms of their stock option plans to include express provisions to address the increased withholding requirements. This, in turn, likely will require a review of the provisions of the plan to determine whether the plan can be so amended without security holder approval. In many cases, plans will provide authority to the Board of Directors to make amendments. For public companies that are subject to the requirements of the Toronto Stock Exchange, if the option plan does not contain amending provisions empowering the Board (or a delegated committee) to make specific amendments, it may be necessary to obtain security holder approval for the amendment.3 Even if such an amendment can be achieved by Board approval, companies may not have many Board meetings scheduled prior to December 31, 2010, and should not delay attending to this action.
An appropriate amendment to the stock option plan and related documentation may be to include broad income tax withholding language, including provisions specifically requiring an option holder to (i) pay to the employer, in addition to the exercise price, sufficient cash to permit the required tax remittance; (ii) authorize the employer, on behalf of the holder, to sell in the market a portion of the securities being issued to realize cash proceeds to be used to satisfy the required remittance; or (iii) make other arrangements acceptable to the employer to fund the required remittance.4 The first alternative might be preferable for the employer, but would require the option holder to provide additional funds up front. The second alternative would likely require the employer to make and coordinate administrative arrangements with a broker regarding the sale of securities.5
If a stock option plan provides for the sale of a portion of the underlying shares acquired on the exercise of an option, and the employee owns other identical securities, the employee may wish to consider whether he or she is eligible to make a designation under Section 7(1.31) of the Income Tax Act, such that the employee is considered to have disposed of the shares acquired on exercise of the options rather than other identical shares owned by the employee. As the shares acquired on exercise of the options will generally have a cost equal to their fair market value on acquisition, this designation can prevent that cost from being averaged down where identical shares with a lower adjusted cost base are owned by the employee.
We have considerable expertise in advising public companies regarding stock option plans and amendments thereto, and regarding income tax withholding requirements, as well as in advising as to the implications to employees of option exercises. We would be pleased to assist and advise you in reviewing and revising your security-based compensation arrangements and in respect of required tax withholdings.
For other commentaries regarding the 2010 Budget, please see our firm’s 2010 Federal Budget Commentary and our article "2010 Federal Budget — Implications for Tech Companies."
1 Prior to the Budget change, many employers have been relying on administrative positions published by the Canada Revenue Agency (the "CRA") (including in relation to the "hardship" provisions under section 153(1.1) of the Income Tax Act on the basis that the benefit is a non-cash benefit), and have not been withholding or remitting taxes at the time of option exercises in certain circumstances. Other employers have been withholding and remitting taxes in respect of the stock option benefit from cash remuneration paid throughout the year.
2 The proposed remittance measures will not apply in respect of options granted before 2011 pursuant to an agreement in writing entered into before 4:00 p.m. EST on March 4, 2010 where the agreement included, at that time, prohibitions on the disposition of the underlying securities for a period of time. In addition, the measures will not apply in situations where the employee benefit is deferred for tax purposes in the case of certain options granted by Canadian-controlled private corporations. However, the amount required to be withheld and remitted in respect of an exercise of options can be reduced by certain deductions available under the ‘equivalent to capital gains’ deduction or the deduction permitted for certain charitable donations in respect of securities acquired on exercise of the options.
3 It is possible that, in such circumstances, the Toronto Stock Exchange might be willing to agree to concessions or variations to its standard requirements for security-based compensation agreements, but this should be confirmed.
4 If the employer is prepared to be temporarily out-of-pocket in respect of the withholding obligation, a possibility may be to provide for the holder to agree that the funds required may be deducted from subsequent cash compensation payable to the holder. If this alternative is to be considered, the parties should carefully consider potential ramifications, including possible labour and employment issues.
5 This may give rise to issues that need to be addressed, including potential requests for "know your client" paperwork from employees and determining who should be responsible for the brokerage fees (including sales commissions), particularly if the employer has not otherwise made or coordinated these type of arrangements (for example, in connection with an employee share purchase plan).