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.

Tax-Qualified Plans – Blessing or Curse?

When granting equity awards, one of the most important questions is the tax effect of such awards.  Granting awards that have a negative tax impact on the employee or the company is counter-productive and should lead companies to consider other ways to incentivize their employees.  On the other hand, should companies maximize the availability of favorable tax treatment for equity awards in certain countries?  This is not an easy question to answer.

Favorable Tax Treatment – The Company vs. the Employee

When we talk about favorable tax treatment, it can mean different things depending on the country and the qualified-tax plan.  The most basic distinction is whether the treatment is favorable for the employee, the company, or both.

  • For employees, favorable treatment often means that taxation can be deferred (usually until the shares are sold), the taxable amount can be reduced or characterized more favorably (e.g., as capital gain, rather than employment income), social taxes can be mitigated or avoided, or a combination of the foregoing.
    For the company, favorable treatment usually means that employer social taxes can be reduced or avoided, tax withholding/reporting obligations can be eliminated, or a tax deduction becomes available.
  • Companies will need to consider which of the above are most important to them.  In my experience, it is usually a combination of employer social tax savings and employee tax savings that prompt companies to implement a tax-qualified plan.

The prime example for this is France, where a tax-qualified plan can reduce the very high employer social taxes (up to 46%) that are due on non-qualified awards, but also allow for a tax deferral and potential tax savings for employees.  Of course, French-qualified awards are famously complex, due to the many changes the French legislator has adopted over the last few years (described in more detail in my prior blog post here).

By contrast, in Israel, a trustee plan (Israel’s version of a tax-qualified plan) benefits almost exclusively the employee, but has become so common that companies are almost forced to adopt one, due to competitive pressures. More recently, however, several of our clients have adopted trustee plans in Israel for the main reason of obtaining a local tax deduction, which has become more important in the wake of the Kontera decision, so there is now also a dual reason for such plans in Israel.

The Cost-Benefit Analysis

Before companies decide to implement a tax-qualified plan, they should undertake a careful cost-benefit analysis.  In working with private companies, I have observed that they tend to almost reflexively adopt a tax-qualified option plan in the UK or a French-qualified plan.  This is usually based on advice from local advisors who claim that these plans are common place for companies offering awards in their jurisdiction and that, to remain competitive, awards have to be granted under these plans.

While it is true that tax-qualified plans in these countries can be especially beneficial for private companies and their employees, this advice often omits the administrative burden and cost of maintaining such plans.  Virtually all tax-qualified plans (with France and the UK being no exception) come with various special conditions (such as minimum vesting and holding period requirements) and ongoing filing obligations (such as special annual reporting requirements).  And while the initial preparation and implementation of the tax-qualified plan can be handled by an outside advisor, ensuring that the special conditions are met and completing the ongoing filings typically falls on the company which, in the case of many private companies, may not have sufficient resources to deal with these issues.

Another important consideration is the treatment of qualified awards in a corporate transaction.  This is again especially relevant for private companies which are more likely to be acquired before awards can first be exercised or vest.  If an acquisition disqualifies the awards from the favorable treatment, the qualified plan essentially would have been implemented for naught.

Of course, companies don’t have a crystal ball and whether or not an award could be disqualified depends on the type of acquisition, the treatment of the awards in the acquisition, whether holding periods have been satisfied at the time of the acquisition and many other factors.  Still, dealing with qualified awards in an acquisition is usually cumbersome and, in many cases, it will be necessary or advisable to obtain tax rulings to preserve the qualified status of awards.  For example, in Israel, it seems that any modification of an existing award granted under a trustee plan requires the approval from the Israeli Tax Authority to maintain trustee plan status.

Embarking on a New Tax-Qualified Plan? Answer These Questions First!

As companies decide whether or not to implement a tax-qualified plan in a particular jurisdiction, they should ask themselves the following questions:

  • What is the benefit of the tax-qualified plan?  If the benefit is purely, or mostly, for the employee, how does this affect employees in other countries who may not be able to receive the same tax benefits?  Are the employer social tax savings significant enough to warrant the implementation and maintenance cost of the plan, as well as the administrative burden?
  • Has everyone weighed in on the decision to implement a tax-qualified plan?  Operating a qualified plan will most likely have a significant effect on the stock plan administrator who will need to administer special terms, such as holding periods, and comply with ongoing requirements.  It can also have corporate tax and accounting consequences which should be socialized with the right people within the organization.
  • Who should pay for the implementation and maintenance of the plan?  If the main benefit of the plan is employer social tax savings, perhaps it is appropriate to allocate the cost to the local entity.
  • Do we have the administrative capacity to administer the qualified plan?  In this respect, it is important to understand all of the requirements and any ongoing filing requirements.  I would also consider creating a detailed checklist that can be used to track the requirements and obligations, which can be especially useful if there is turn-over at the company.
  • What does the future hold?  If a company is about to implement a new equity incentive plan, does it make sense to implement a qualified plan under the “old” plan, given that most qualified plans are tied to the parent plan and have to be re-done when a new plan is adopted?  If a corporate transaction is probable, what is the impact of such a transaction on a qualified plan?

At the end of the day, as always seems to be the case with global equity awards, the answer of whether a tax-qualified plan should be implemented is highly fact-specific and depends on the particular circumstances of each company.  The best advice is to not jump into implementation of a qualified plan, but carefully consider all of the benefits and requirements and seek input from multiple stakeholders.

To Learn More

In case you are planning to attend the 2017 GEO National Equity Compensation Forum in Rancho Palos Verdes from September 13-15, I invite you to attend the presentation on this topic that I will participate in, together with Jennie Anderson from Microsoft and Wendy Jennings from Cisco.  Jennie and Wendy are among the most experienced stock plan administrators in the industry and will no doubt have great tips when it comes to tax-qualified plans!  If you have not registered yet, please see our invitation here for a special discount offer.

The Go-To Guide to 2016-2017 Filing / Reporting Requirements for Global Employee Share Plans

2016-2017

It is almost the end of the calendar year, and in addition to wrapping up gifts and holiday parties, it is time for multinational companies to consider the necessary tax and regulatory filings for global stock plans triggered by the close of 2016. As you consider the steps your company may need to take to start the new year right, please see our Global Equity Services Year-End / Annual Equity Awards Filing Chart, which contains key filing and reporting requirements for 2016 and 2017.

Happy Holidays from Baker McKenzie – wishing you prosperity in the New Year and favorable equity regulations around the globe!

Brave New World: Withholding in Shares After Changes to ASC 718

brave-new-world

Many companies are considering changing their tax withholding practices after FASB modified the accounting rules for share-based awards (ASC 718). For most companies, the modified rules become mandatory for accounting periods starting after December 15, 2016, although companies are able to voluntarily implement the revised rules earlier.

The changes to ASC 718 were mainly intended to facilitate tax withholding for equity awards granted to employees outside the U.S., but have also raised questions for taxes withheld for U.S. executives. Continue reading