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Global Governance Advisors

Canadian Federal Government Announces Updates to Proposed Stock Option Taxation Rules

Posted by Paul Gryglewicz on Aug 5, 2019 9:00:00 AM
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By: Paul Gryglewicz & Peter Landers

Canadian stock option tax reform is on the horizon with no thanks to the Federal Liberal government.  Where Canada has historically held a competitive advantage in the area of after-tax earnings for employees, executives and directors who receive stock options, this advantage is about to be neutered in Canada.  In the global war for executive talent, Canada is about to place itself into a disadvantaged position in the arena of compensation. 

On June 17, the Liberal government provided further clarification on changes proposed to current stock option rules from the 2019 Canadian Federal Budget. If you recall, the proposed new rules will cap the value of stock options that option holders can benefit from under Capital Gains equivalent tax treatment at an annual vesting limit of $200,000. The Capital Gains tax limit is applied based on the total fair market value of the underlying shares on the date a stock option is granted that has the same vesting year.  Any underlying shares in excess of the $200,000 annual vesting limit are deemed to be non-qualified securities and the 50% deduction is not available with respect to those options. When multiple stock option grants vest in the same year, the rules will effectively apply the limit based on the order in which the grants were made with older grants counting towards the limit first. This will have a material impact on the value of after-tax compensation that executives and employees at Canadian corporations can hope to earn from stock options, meaning that further guidance from the federal government on how this will be implemented is high.

The June 17 announcement provides some, but not full clarity on how these proposed changes will be implemented. From a timing perspective, it was shared that the new taxation rules will only apply to stock options granted on or after January 1, 2020 so there will be no retroactive application of the new rules to grants previously made to executives and employees before this date. This will provide companies with additional time to digest the impact of the proposed new rules and determine any changes they would like to make, if any, to their compensation programs.

What is interesting is that as part of the proposed changes, employers will now be able to deduct the amount of stock option benefit that does not qualify for the Capital Gains-equivalent tax treatment for non-qualified securities, assuming certain conditions are met such as:

  1. Making sure the employer was the employer of the individual at the time the stock options were granted;
  2. The 50% deduction would have been available to the executive or employee if the securities were deemed not to be non-qualified securities; and
  3. The employer has complied with specific notification requirements that include notifying the executive or employee in writing on the date of grant of any securities that are deemed to be non-qualified securities because of the $200,000 annual vesting limit and notifying the Canada Revenue Agency of any securities that are non-qualified securities (including those that are designated as such by the employer) in a prescribed form filed with the employer's income tax return for the year in which the stock options are granted.

Companies can also designate all of the underlying shares to be non-qualified securities in the stock option grant agreement to further take advantage of the employer deduction, but we do not expect companies to do so beyond what is required under the $200,000 annual vesting limit.

The government has also clarified that the proposed changes will not apply to Canadian Controlled Private Corporations (“CCPCs”) or to start-up, emerging and scale-up companies. However, the specific characteristics that define what a start-up, emerging or scale-up company is have yet to be defined by the government, which is the biggest area of uncertainty surrounding the proposed legislation. GGA has illustrated the potential impact the change in stock option taxation can have on different-sized companies in the table below.

Example: Grant of 200,000 options with a $50.00 exercise price realizing a 150% premium upon exercise

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Example: Grant of 200,000 options with a $5.00 exercise price realizing a 150% premium upon exercise

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As you can tell, companies with higher share prices will see their executives impacted more on an after-tax basis under the proposed rules than those with lower share prices.

The federal government has indicated that they are seeking stakeholder input on the characteristics that should be considered when determining a start-up, emerging and/or scale-up company with submissions being accepted by the Department of Finance until September 16, 2019. Should company size, industry sector or stock exchange listing be considered? What should determine size? Is it Revenue, Assets, Market Cap, number of employees? These are all answers that will need to be provided to make sure Boards and executive teams fully understand the potential impact, if any, of the proposed taxation changes on their companies.

Potential impact of proposed changes on compensation decisions

While there are still some unknowns relating to the final rollout of the proposed tax changes, this is not the government’s first attempt at removing the tax benefit from stock options and we at Global Governance Advisors (“GGA”) have been evaluating reasonable and shareholder friendly alternatives to help keep executive’s after tax earnings similar to current levels.  We have highlighted a few alternatives below and look forward to speaking with our clients and prospective clients interested in learning more of the benefits this year.

  1. Consideration of Performance Share Units to replace some or all Stock Option grants

Stock options have been increasingly scrutinized by shareholders as they have historically been viewed as all or nothing incentive vehicles and not viewed as being performance-based when referring to the traditional vesting schedule, where the vast majority of option grants vest solely on time. Performance Share Units (“PSUs”), while taxed at an executive’s full marginal rate, represent a higher degree of accountability when vesting, as the executive only realizes compensation when the company achieves pre-defined performance conditions.  There is a strong market prevalence currently with PSU plan designs, where most PSU designs incorporate a multiplier allowing the initial Target PSU grant to vest at 150% or 200% of the targeted number of shares granted in the event of superior performance.  Not only does this leverage provide the executive or employee holding the PSUs with similar windfall payout potential to that of stock options, but the taxation rate becomes more equal under the new rules. As for shareholders, superior performance (assuming performance is designed properly) will also mean superior returns for shareholders. Before, the preferred tax treatment of stock options made PSUs less competitive on an after-tax basis, similar to RSUs. Adding or increasing the weighting of PSUs within their annual LTIP grant mix has the added advantage of aligning closer to the expectations of groups such as ISS and Glass Lewis which should help in securing more favourable vote recommendations on compensation moving forward as these groups generally do not prefer the use of stock options. An illustration of how PSUs could become a more viable after-tax alternative to stock options is highlighted in the graphics below.

Example: Grants of an equivalent value of Stock Options and PSUs with 200% Performance Multiplier

(Options granted at ratio of 3 Options for 1 PSU)

Capture 8As can be seen in the graphic above, the proposed tax rules on stock options mean that share appreciation of approximately 180% to $140 is required to begin to provide more After-Tax value to the recipient than PSUs that vest at 200% of Target. This compares to share appreciation of approximately 80% to $90 under the Current rules (a $50 difference). PSUs become a lot more attractive in this case.

  1. Consideration of Stock Option Grant for 2020 being made before the end of 2019

With the updated guidance that stock options will only be subject to the new taxation rules starting with grants made on January 1, 2020 or later, we at GGA expect some companies to look to make one more Stock Option grant to executives and employees under the old tax rules before the end of the calendar year. This will allow them to provide a similar grant level to 2020, but allow eligible executives and employees to still benefit from the Capital Gains equivalent tax treatment for one more year. Most companies will then not provide any Stock Option grant for 2020 and most likely wait until 2021 to make a subsequent grant. Consider this as the “bid farewell” party to preferred stock option taxation amongst corporate Canada. While this has tax advantages for the executive or employee, it will present a disclosure issue for publicly-traded companies as the “Option-Based Awards” column of the Summary Compensation Table may look a lot higher in value for 2019 when compared to earlier years as an additional grant will have been made. This will make it important for companies that choose to follow such a granting strategy to clearly outline the rationale for making the extra Stock Option grant in 2019 and what their proposed approach to future grants will be moving forward.

How can you prepare for the potential new rules?

It is important that all companies potentially affected by the proposed new taxation rules consult a qualified tax accountant to ensure an adequate understanding of the impact, if any, of the rules on their organization. It is also important to have a stress test and scenario analysis conducted on your current compensation program with a particular emphasis on the long-term incentive plan strategy.  We have assisted organizations in quantifying the potential after-tax impact of proposed tax changes on their current long-term incentive structure and worked with companies to determine what an optimal after-tax structure might look like moving forward. If your company has never used share-based awards such as PSUs or RSUs and relied solely on Stock Options, then setting up an education session for your Board and executive team on the different long-term incentive vehicles available in the market along with the pros and cons of adopting such plans can allow you to properly plan ahead of your next Annual General Meeting to bring any new equity compensation plans forward for shareholder approval.

Conclusion

Material changes to the taxation of stock options are coming for the first time in many years in Canada. This will have a material impact at many Canadian companies who have relied on stock options as all or a part of their Long-Term Incentive Program. With these proposed changes provides the opportunity to explore new ways in which to compensate executives and employees that companies may have never considered before to provide more effective after-tax compensation and align closer to the views of ISS and Glass Lewis. It is critical that affected Canadian companies prepare for the proposed new rules before they come into effect on January 1, 2020 by conducting appropriate stress testing of different performance scenarios and the resulting after-tax outcomes. Preparation also includes gaining better understanding of what characteristics will be used to determine a start-up, emerging or scale-up company and provide a submission of your company’s views to the Department of Finance by the submission deadline. No one likes change, but by being properly prepared for the resulting impact companies can set themselves up for success in the new taxation environment in attracting, retaining and motivating the key talent it requires to achieve its long-term goals. 

Special thanks to Hemant Sud, Associate at Global Governance Advisors, for his contribution to the data analytics contained within this blog.

Topics: GGA, Canadian Federal Government, Stock Option Taxation