Jay A. Lefton Senior Partner OPTIONS AND OTHER EQUITY-BASED INCENTIVES FOR EMPLOYEES AND OTHER SERVICE PROVIDERS: Tax, Corporate and Securities Issues OPTIONS AND OTHER EQUITY-BASED INCENTIVES FOR EMPLOYEES AND OTHER SERVICE PROVIDERS: Tax, Corporate and Securities Issues Presentation at the Sault Ste. Marie Innovation Centre September 15, 2009

2 Tax Framework: Taxation of Employment Income  Fundamental principle of the Income Tax Act (Canada) (“ITA”):  Remuneration and benefits generally taxed in year received  Exceptions:  Plans for employees governed by section 7 of the ITA  “employee” includes an officer and may also include a director where the agreement is entered in consideration for the individual's services as director.  “phantom” stock plans

3 Section 7 Based Plans  Common plans eligible for exemptions under Section 7 of ITA:  Stock option plans  A right, subject to certain conditions, to acquire:  A specified number of shares  At a specified price  For a specified period of time  Share appreciation rights (SARs)  Entitles the holder to take specified value (FMV – exercise price) either in cash or shares

4 Section 7 Based Plans (cont’d)  Common plans eligible for exemptions under Section 7 of ITA:  Stock Bonus Plans  A bonus payable in shares  Could be a one-time incentive or an ongoing program  Stock Purchase Plans  If sold at FMV, no taxable benefit  If sold at a discount to FMV, s. 7 benefit equal to FMV of share at purchase date less price paid

5 Section 7 Based Plans: General Rules  Three distinct times are relevant:  When the right is granted  When the right is exercised  When the shares received under the right are disposed of (usually sold)

6 Section 7 Based Plans: General Rules (cont’d)  No tax on entering into agreement  Employee generally taxed either:  When share acquired (subject to deferral discussed later), or  Disposition of share or rights under agreement  Employee generally taxed on difference between  FMV of shares at time acquired and  Option exercise price  Value of s. 7 benefit added to employee’s cost of share (to avoid double taxation)

7 Section 7 Based Plans: General Rules (cont’d)  Deduction for employee  Employee may be entitled to a 50% deduction from income if (i) employee is dealing at arm’s length with the corporation and (ii) certain requirements are met  General Requirements  Amount payable to acquire the security (i.e. exercise price) is not less than FMV at date of agreement, and  Underlying security is a “prescribed share”

8 Section 7 Based Plans: General Rules (cont’d)  Deduction for employee  Employee may be entitled to a 50% deduction from income if certain requirements are met  Alternative Basis for Claiming Deduction  Share acquired is of a “Canadian controlled private corporation (“CCPC”) (being a private corporation incorporated in Canada which is not controlled directly or indirectly by one or more non-resident persons, public corporations or any combination of these entities), and  Employee holds the shares for at least 2 years before disposing of them  Result  s. 7 benefit taxed at capital gains rates

9 Section 7 Based Plans: General Rules (cont’d)  Deferral of s. 7 benefit for CCPCs  s. 7 benefit not taxed until employee disposes of shares  Deferral opportunity for public company (non- CCPC) plans  If agreement to acquire certain publicly-listed shares, s. 7 benefit may be deferred until earliest of  Year shares are sold  Year employee dies  Year employee ceases to be resident in Canada  Availability of deferral subject to certain conditions and monetary limits

10 Section 7 Based Plans: Other Tax Issues  Federal Source Deductions  Generally, employers are obligated to withhold and remit income tax and CPP contributions (but not EI premiums) on s. 7 benefit  No withholding on non-CCPC options where election to defer  However, CRA generally does not require income tax withholding:  Where there is no cash payment at same time,  Section 7 benefit is large in relation to cash remuneration, or  Withholding would cause undue hardship.

11 Phantom Stock Plans  No shares are acquired under these plans, but payment is based upon value of a specified number of company shares  Phantom stock “awards” or “units” may be linked to performance targets set by employer  Can avoid the “Salary Deferral Arrangement” by fitting into one of two exceptions

12 Phantom Stock Plans (cont’d)  Exceptions to “Salary Deferral Arrangement” rules  Bonus payable within 3 years from date services rendered, or  “prescribed plan”:  Written agreement to receive cash amounts attributable to employment  Amounts receivable only following retirement, death or termination of employment, and no later than year following this triggering event  Amounts based on FMV of shares of employer (or related corporation) determined in the period between 1 year before termination date and the payment date  No downside protection (if a decrease in value)

13 Stock Options and Consultants  General rules:  A consultant is not an “employee”  Income inclusion in year of grant  Additional inclusion when exercised, either:  Business income, or  Capital gain  Exercise price and cost of option added to cost of share  Issuer not entitled to deduction for value of option  Issuer generally entitled to deduction for issuing or selling share, but amount of deduction is reduced by that amount FMV of share exceeds exercise price

14 Corporate Considerations: Stock Option Plans  A stand-alone grant or a “plan”  Considerations:  Maximum number of shares eligible  Exercise price  Permit cashless exercise?  Categories of recipients  Employees  Directors  Consultants  Ability to transfer to RRSPs of the foregoing?  “Vesting” conditions  Restrictions/Conditions of exercise, if any  Term (“expiration date”) of the entitlement

15 Corporate Considerations: Stock Option Plans (cont’d)  Considerations (cont’d):  Effect of a sale of the company (change of control) or amalgamation/merger  Automatic vesting?  Mandatory exercise of “in the money” options?  Effect on “under water” options?  Exchange of options for options of the acquiror?  Do option holders need to become parties to the acquisition agreement for the purposes of giving representations, or do they get to “play for free”?  “Jail time” considerations for options and underlying shares  A “reverse retention bonus”

16 Corporate Considerations: Stock Option Plans (cont’d)  Considerations (cont’d):  What happens if the recipient ceases to be involved with the company?  Effect on vested vs. unvested options  Terminated by the company “for cause”  Terminated by the company not “for cause”  Voluntary resignation by individual  Death or disability  Ability of the company to repurchase options and underlying shares?  At what price?  “Valuation” vs. formula vs. Board determination  Minority discount vs. proportion of overall value?

17 Corporate Considerations: Stock Option Plans (cont’d)  Considerations (cont’d) :  Consider that shareholders have rights!  Waive rights to financial statements?  Non-voting convertible shares?  Need to become party to a unanimous shareholders’ agreement?  Consider “drag-along” provisions  Voting rights?  Voting trust agreement?  Power of attorney?  Family Law considerations  Modification of the plan in the future  Method of approval  Effect on prior grants

18 Securities Law Issues  The grant or issuance of these rights (options/shares) are “securities” for the purposes of the Securities Act (Ontario)  Under National Instrument Rule , there are conditional exemptions available for trades to employees, executives, directors and consultants of issuer and affiliates  Participation must be voluntary  “Consultant” provides services under a written contract and “spends a significant amount of time and attention on the business of the issuer or a related entity”  Consider National Instrument  Resale of Securities

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