Not So Fast: Tax Deduction For Share-Based Awards in Canada

After discussing the issues for a tax deduction for share-based awards in Israel in my last blog, I wanted to revisit another tax deduction conundrum, this time in Canada.

In the past, the Canada Revenue Agency (CRA) generally has not allowed a local tax deduction for the cost of share-settled awards (other than under very narrow circumstances).  However, based on a technical interpretation released on April 12, 2017, the CRA updated its position such that a company should be entitled to a tax deduction for the cost of awards if:

  • it retains the discretion to determine whether the award will be settled in cash or shares;
  • it does not commit to delivering the shares at any time before settlement;
  • it actually delivers shares upon settlement; and
  • where the award is granted by a non-Canadian parent company, the Canadian entity reimburses the parent for the cost of the award.

Based on this interpretation, most companies should be able to obtain a tax deduction in Canada for (time-based or performance-based) RSUs granted under the above conditions.  By contrast, it would be more difficult to structure an option or purchase rights granted under an ESPP as being able to be settled in cash or shares.¹

But even for RSUs, companies will need to consider two issues before restructuring their awards to be settled in cash or shares to obtain the tax deduction.

First, companies will need to confirm with their accountants whether retaining the discretion to settle the award in cash or shares will subject the award to liability accounting, i.e., mark-to-market accounting (rather than (fixed) equity accounting).  Liability accounting can introduce greater volatility for the balance sheet, but depending on the number of awards granted in Canada, this may not be material for most companies.

Second (and probably more importantly), if the award can be settled in cash or shares, it will be subject to the salary deferral rules, which is Canada’s version of Section 409A (sort of).   If an award runs afoul of the salary deferral rules, it is taxed at grant, and not only when the shares are issued, which is obviously a very undesirable outcome.

An exemption to the salary deferral rules exists, but is often described incorrectly as applying if an award is fully vested at least by the third anniversary of the grant date.  Therefore, it is assumed that awards that vest pro-rata over a three-year period from the grant date or awards that cliff-vest on the third anniversary of the grant date are fine.

However, the three-year vesting exemption from the salary deferral rules is a bit more nuanced.  In particular, it applies only if the award is fully vested within three years after the end of the year in which the services were rendered for which the award is granted.  For example, if a company grants an award in February 2017 (at least partially) for services rendered in 2016, the award would have to be fully vested by December 31, 2019 to avoid taxation at grant (i.e., less than three years from the grant date).

The question then becomes if or when awards are granted in consideration for services rendered before the grant date.  For new hire awards, it should be relatively easy to argue that the awards are not granted to reward past performance, in which case it will be sufficient if the awards are vested by the third anniversary of the grant date.  However, for refresh grants, this argument is more difficult to make, and there is an inherent assumption that awards made to existing employees are made to, at least in part, reward past performance.  This becomes even more clear if a company determines the size of the refresh grant (again, at least in part) based on prior year performance.

Consequently, granting awards that can be settled in cash or shares to obtain a tax deduction in Canada may require additional changes to the award terms to avoid running afoul of the salary deferral rules, i.e., shortening the vesting schedule (in some cases, quite significantly).

Given the above, before rushing into relying on the CRA interpretation to take a tax deduction in Canada, companies should carefully consider if retaining the discretion to settle the award in cash or shares makes sense in light of the challenges posed by the salary deferral rules.


¹  For options, it is also important to point that, even if companies are able to retain discretion to settle the option in cash or shares, such discretion will eliminate the 50% tax exemption that otherwise applies to options.  Therefore, going this route for options is hardly going to be popular with employees.