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Tax & Trusts e-LERT: Employers Urged to Review Stock Option Plans Before 2011 as a Result of New Draft Legislation - TSX Provides Guidance for Listed Issuers

Published: 11/23/2010

By Tom Koutoulakis, Christopher B. Norton, Janice Vohrah

Recent legislative proposals to amend the Income Tax Act (Canada) (“ITA”) address the changes to the stock option rules (and to unit options of a mutual fund trust) that were announced in the March 4, 2010 Federal Budget and discussed in our previous e-LERT Employee Stock Options and the 2010 Federal Budget.

Background to New Rules

The Budget “clarified” that after 2010, employers will be required to deduct and withhold tax on the amount of the taxable benefit realized on the exercise of an employee stock option as if the value of the stock option benefit had been paid to the employee as a cash bonus. Previously, employers relied on administrative concessions of the Canada Revenue Agency not to require withholding on such transactions.

The draft legislation confirms that the withholding requirement will apply to all stock options exercised after December 31, 2010, other than certain stock options granted by Canadian-controlled private corporations (“CCPCs”). Withholding only applies to the amount of the net taxable benefit upon exercise of such options after deducting the 50% deduction generally available where the exercise price is not less than the fair market value of the securities at the date of grant.

Limited transitional relief is available for stock option benefits arising from rights granted pursuant to a written agreement that was entered into before March 4, 2010 under which the employee was prohibited from disposing of the securities acquired under the agreement for a period of time after exercise.

Impact of New Rules on Employers and Employees

Public companies, mutual fund trusts and privately held non-CCPCs should review their existing option plans to determine if adequate provision has been made for funding this new withholding requirement. Some existing, broadly drafted withholding provisions may be sufficient to allow the employer to satisfy the withholding obligation by requiring an employee to fund the obligation or by permitting the employer to sell a portion of the securities issued on the exercise of the option, but likely many plans should be amended. Since these tax proposals are to be effective for 2011, it would be best to review and possibly amend any existing plans before 2011.

Companies should also inform optionees of these changes before they are implemented, since the changes may have a significant impact on the employee’s cash flow.

Where an employee holds other securities identical to those issued under the option and chooses to sell a portion of the securities to fund the withholding obligation, the employee may sell the securities acquired on the exercise of the option without being required to average the adjusted cost base of such securities with the adjusted cost base of the identical securities already owned by the employee. The employee would need to identify the optioned securities in his or her tax return to avoid the deemed averaging which would otherwise apply. This rule would allow the employee to avoid realizing a capital gain which might otherwise arise on the sale of the optioned securities. Employees should be advised to consult their tax advisers regarding the exercise of any options and sale of optioned securities.

Stock option plans of public companies (and possibly related agreements) may include general terms that permit directors or board committees to prescribe amendments in order to comply with applicable laws and regulations, new or otherwise. Some plans may also include specific provisions governing how withholding requirements are administered. 

From an administrative point of view, the adoption of available alternatives depends on a number of factors, including the ability of optionees to fund their portion of the withholding obligation and the number of participants under a company’s plan. For public companies, such amendments would generally trigger shareholder approval requirements under stock exchange rules if not permitted under the existing amendment provisions of an issuer’s plan or agreement. In this regard, the TSX has confirmed in Staff Notice 2010-0002, dated November 12, 2010, that it will generally consider amendments to option plans and agreements resulting from these rules to be of a “housekeeping” nature. The guidance by the TSX confirms that tax-related amendments, where necessary, may generally be made under existing provisions that allow the board or a board committee to make amendments to option plans or agreements of a “housekeeping” nature without shareholder approval. The TSX also confirmed that if an option plan does not contain general amendment provisions, it will still allow companies to amend their option plans and agreements to comply with these rules if:

1. the amendments relate only to changes necessary in order to comply with the Income Tax Act
2. the company also adopts proper general amendment provisions in its plan and
3. the amendments are submitted for security holder approval at the company’s next meeting
4. Public companies will also still be subject to the provisions of Section 613 of the TSX Company Manual, which includes pre-clearance by the TSX and disclosure in proxy circulars.

Public companies will also still be subject to the provisions of Section 613 of the TSX Company Manual, which includes pre-clearance by the TSX and disclosure in proxy circulars.