1. Executive Compensation: Employment Considerations How CRA Taxation Rules Impact Stock Option Plans
Éric Lévesque, Partner (Tax)
Stephanie Weschler, Partner (Employment & Labour)
Stikeman Elliott LLP

2. Executive Compensation
I. Employment Considerations – Establishing the Proper Plan II. Primer of Tax Issues Related to Executive Compensation
©2018 Baker & McKenzie LLP

3. I. Employment Considerations – Establishing the Proper Plan 1
I. Employment Considerations – Establishing the Proper Plan 1. Factors to consider in determining executive compensation packages 2. Components of compensation packages 3. Constructive dismissal 4. Entitlements upon termination of employment

4. 1. Factors to consider in determining executive compensation packages
Executive retention v. company interests
Compensation philosophy- principles and guidelines
Pay-for-performance
Compensation v. financial performance of company
Performance based on key business metrics
Benchmarking
Assessment of compensation packages

5. 2. Components of compensation packages
Base salary
Short-term incentives
Long-term incentives
Enhanced retirement allowance (SERP)
Supplemental benefits and perquisites (health benefits, car allowance, club memberships, etc.)

6. 3. Constructive Dismissal
Unilateral modification to compensation plans or grants under existing plans
Trigger termination entitlements
Consideration v. sufficient notice

7. 4. Entitlement upon termination of employment
Contractual entitlements (employment agreement and plan documents)
Termination without cause
Legal entitlements – Reasonable notice
Contractual limitations

8. II. Primer of Tax Issues Related to Executive Compensation

9. Stock Option Plans
General stock option tax treatment (under s. 7 of the Income Tax Act (“ITA”)):
no tax on grant (s. 7(3)(a) of the ITA);
tax on benefit arising on exercise (s. 7(1)(a) of the ITA) (deferred until sale of shares only if CCPC at grant– s. 7(1.1) of the ITA) or upon arm's length sale of options (s. 7(1)(b) of the ITA), including surrender of the options to the issuer for cash.
To fall within s. 7, the plan/agreement must provide for the sale or issuance of a security to the employee. CRA has taken the position that where the employer has the discretionary right to cash settle the employee instead of issuing the shares, agreement does not fall under s. 7 of the ITA (50% deduction then not applicable)(IT-113R4).
Phantom stock units not eligible for s. 7 treatment for same reasons.
Employees having, at the discretion of the employee, the right to surrender the options for cash instead of exercising for shares should still be under s. 7 of the ITA.
Amount included into income for employee equals the fair market value (“FMV”) of the securities upon exercise less the exercise price. If an employee is prohibited from selling a share acquired pursuant to an agreement to sell or issue securities for a period of time, the FMV of the share for purposes of determining the option benefit can reflect an appropriate discount (usually small).

10. Stock Option Plans Types of securities covered by s. 7:
Shares of the capital stock of a Canadian corporation;
Shares of the capital stock of a foreign corporation;
Units of a mutual fund trust (trust must resident in Canada).
Can be securities of the employer or person not dealing at arm’s length with employer;
Potential double tax: If issuer repurchase shares from employee that were acquired under a stock option, a deemed dividend under subsection 84(3) of the ITA may arise. In such a case, the employee may effectively be subject to double taxation in respect of the s. 7 benefit and the subsection 84(3) deemed dividend, and ultimately have a capital loss that cannot offset neither the dividend nor the stock option benefit. Distinction between open market purchase by the corporation and substantial issuer bid.

11. Stock Option Plans Exchanges of options—on a rollover basis if:
Employee disposes of rights to acquire shares or units;
Employee receives no consideration other than new options to acquire shares or units of:
the same corporation or trust;
a corporation or trust with whom the original issuer is not dealing at arm’s length immediately after the exchange;
amalgamated or merged corporation, or of a corporation or trust not dealing at arm’s length with the amalgamated or merged corporation immediately after the exchange;
mutual fund trust to which s (1) applies.
In the money value of new rights does not exceed in the money value of old rights.
Reduction of strike price – permitted in limited circumstances (i.e. reorg. exception would have applied).

12. Stock Option Plans
ACB step-up to FMV of shares upon exercise. Future increase/decrease in value is generally capital gain or loss.
No ACB averaging rule for shares sold within 30 days after exercise, subject to certain conditions.
Benefit is taxable income for employee, so corporation must remit income taxes on the benefit. Typically plans provide that employee must pay strike price and other arrangements can be made if more cash necessary to cover withholding. CRA allows 110(1)(d) deduction to be taken into account to calculate amount to be remitted.
Broker can be used to facilitate transaction (i.e. cashless exercise) instead of employee paying the strike price.

13. Stock Option Plans
Under existing federal rules, employee can claim a 50% deduction (s. 110(1)(d) of the ITA) against the taxable benefit arising on exercise if:
the exercise price is at least equal to fair market value ("FMV") of the shares at the time options granted;
employee deals at arm's length with grantor; and
the shares are "prescribed shares" (generally, common shares).
Québec grants only a 25% deduction. However, stock options granted after February 21, 2017 on shares of a publicly traded corporation are entitled to 50% deduction if the corporation’s wages subject to contributions to the health services fund total $10 million or more for the calendar year in which the stock option agreement was concluded or in which the shares were acquired.
CRA position issued recently denies 110(1)(d) where corporation issues treasury shares to the employee equal to the intrinsic or in-the-money value of the stock option (different than short sale method).
No deduction for employer if shares are issued under an agreement (s. 7(3)(b) of the ITA—see Transalta for exception). Since 2010 budget, if options are surrendered for cash, employer (and non arm’s length persons) must forego the deduction and make an election under s. 110(1.1) of the ITA. Notification to employee made through T4 slip.

14. Cash-based LTIPs and the SDA Rules
If a plan is not subject to stock option rules, it is usually structured to avoid SDA rules in the Income Tax Act ("ITA").
If not for an SDA, executives are not taxed when rights are granted under the relevant plan, but rather when their employment income is received.
SDA rules act as an anti-avoidance measure to discourage deferral of employment income:
if there is an SDA, deferred amounts are added to the executive's income as of when the right to receive them arises (i.e., when they are earned), therefore creating cash flow issues for employees and employers (source deductions).
If any portion of a bonus is paid beyond three years, the entire amount is considered to be an SDA.
A discretionary issuance of shares, in order to satisfy bonus obligations, is not caught by the deductibility restrictions set forth in s. 7(3)(b) of the ITA [Transalta Corporation v. The Queen, [2012] 3 C.T.C (TCC)]. The CRA stated it did not appeal the decision in Transalta because it considered the case to be fact-specific, noting that in similar cases it will consider whether sufficient evidence exists to support that an “agreement” exists for the purposes of s. 7 of the ITA.

15. Employee Profit Sharing Plans ("EPSPs")
EPSPs allow employees to share in the cash profits of their employer's business.
Trust in favour of participant employees increases loyalty.
Inclusion in year of allocation not distribution.
No deductions at source on contributions, allocations or distributions (i.e., Canada Pension Plan and Employment Insurance).

16. Deferred Share Unit Plan ("DSUs")
Specifically excluded from SDA rules (Regulation 6801(d)).
Typically:
Used for directors of corporations (considered employees for tax purposes).
Grant of notional units, the value of which is directly related to FMV of the corporation's shares.
Payments are deferred to no later than the end of calendar year following termination of employment, retirement or death.
Redeemable for cash or shares purchased on the open market or from treasury.

17. Restricted Share Unit Plan ("RSUs")
Employees are granted notional units representing a right to receive payment on vesting equal to the FMV of the corporation's shares.
At the end of the vesting period, employees receive either one share per RSU or cash equal to: RSUs x FMV of share at that time.
In order for SDA rules not to apply, RSUs must provide for payment to be made within three years following the end of the year in which the RSUs are granted (i.e., the 'three-year rule').
No possibility of capital grain treatment.

18. Tax Positions re: RSU/DSU Plan
For employees:
If paid in cash, shares from treasury or shares in the open market, full income inclusion in the year of receipt equal to the cash received or value of shares received (no favourable deduction).
For employers:
If paid in cash or under a market purchase plan, they are generally deductible.
Usual source withholdings will apply (QPP, CPP etc.).

19. Restricted Stock Plan
Shares issued up front to employees, but share rights are subject to restrictions (e.g., vesting schedule).
Employees are unable to sell their shares of the corporation until restrictions are removed.
During this period, employees are normally unable to assign the shares.

20. Tax Positions re: Restricted Stock Plan
For employees:
The employees will be taxed when the shares are received.
FMV of the shares given to the employee less a discount for the restrictions imposed on the shares.
Disadvantage: taxed on grant. Employees are required to pay income taxes before access the value of the shares.
Restricted stock plans are not eligible for 50% deduction (except CCPC).
For employer corporation:
Amounts representing FMV of treasury shares issued are not deductible.
Usual source withholdings will apply.