Employee stock options: New tax withholding requirements create new challenges

  • July 17, 2014
  • Michael Friedman and Mariam Al-Shikarchy

Employee stock option plans (“ESOPs”) have long represented a popular means for companies to attract, compensate, and retain key employees. Under the Income Tax Act (Canada) (the “Tax Act”)1, a special set of rules govern the federal tax treatment of employees that are granted, and subsequently exercise, options under an ESOP (the “Stock Option Rules”).

In highly simplified terms, the Stock Option Rules generally provide that an employee that is granted a stock option under an ESOP is not considered to have realized an immediate taxable benefit at the time of the grant of the option. Instead, subject to certain relieving rules that apply in respect of select options granted by “Canadian-controlled private corporations” (“CCPCs”), where an employee exercises an option granted under an ESOP, a taxable benefit is generally deemed to be received by the employee in the taxation year in which the option is exercised. The amount of the deemed taxable benefit that is required to be included in the income of the employee for tax purposes is generally equal to the difference between the fair market value of the acquired shares on the date of their acquisition and the exercise price paid by the employee (plus any amount paid by the employee to acquire the relevant stock option).2Provided certain conditions are met, the employee may be eligible to claim a deduction equal to 50% of the stock option benefit when computing his/her taxable income.3

The 2010 federal budget introduced significant changes to the tax treatment of employee stock options.4 One important element of the proposed changes related to the tightening of the tax withholding requirements in respect of stock option benefits. At a high level, the amended Stock Option Rules (i) eliminate the ability to rely on “undue hardship” as a basis for the reduction of required tax withholdings in respect of stock option benefits, and (ii) “clarify” that employers are generally responsible for satisfying the applicable withholding requirements in respect of all stock option benefits realized on or after January 1, 2011.5

This article aims to provide a brief summary of the changes to the tax withholding requirements relating to stock option benefits that were introduced in the 2010 federal budget and identify steps that employers may wish to consider as a means of satisfying future tax withholding obligations in respect of employee stock options.

Characterization of stock option benefits

Sincestock options constitute a form of remuneration under the Tax Act, a taxable benefit that arises upon the exercise of a stock option gives rise to obligations of an employer to withhold and remit tax to the Canada Revenue Agency (the “CRA”). The Tax Act generally provides that tax must be withheld and remitted upon the exercise of stock options granted by non-CCPCs as if the resulting stock option benefit was paid as a bonus. 6

The 'undue hardship' exception

The requirement for an employer to remit tax in respect of the taxable benefit arising on the exercise of a stock option can have burdensome consequences, particularly where the amount of the stock option benefit is significant or where the relevant employee’s cash remuneration for the applicable period is relatively small. Prior to the 2010 federal budget, the CRA was generally open to requests to reduce the amount of required tax withholdings in circumstances that would otherwise give rise to “undue hardship.”7

The amended Stock Option Rules resulting from the enactment of the 2010 federal budget proposals now provide that the CRA may not reduce required tax withholdings in respect of stock options that have been exercised solely because the benefit is received as a non-cash benefit.8

Methods of funding remittance requirements

In light of the more stringent tax withholding and remittance requirements now applicable in respect of stock option benefits, employers and employees alike must consider how future tax withholding and remittance obligations will be satisfied, particularly in cases where the taxable benefit arising on the exercise of a particular stock option will trigger a tax withholding/remittance obligation that exceeds the cash remuneration otherwise to be paid to the employee during the relevant period. The discussion below highlights some possible means of ensuring that future tax remittance obligations are satisfied.

1. Cash payment by employee on exercise of a stock option

The ESOP could stipulate that stock options may not be exercised unless the employee remits sufficient funds to the employer to allow for any resulting tax remittance obligations to be satisfied. Such an approach may be attractive to employers because it helps to relieve the financial risk associated with having to manage potentially sizeable tax remittance obligations in the absence of sufficient cash remuneration from which tax withholdings may be made. On the other hand, the relevant employee will have the responsibility to set aside or borrow the amount necessary to fund the relevant tax remittances. Such an arrangement may not be feasible where the employee does not wish (or have the capacity) to incur debt or use his/her limited cash resources to satisfy the tax remittance obligation.

2. Advance tax withholdings

The employer may make extra withholdings from an employee’s regular cash remuneration in the taxation year in which the exercise of a stock option by the employee is expected to occur. For this method to be effective, an employee must be able to forego a portion of his/her regular compensation. In addition, an estimated valuation of the relevant stock option benefit must be available to determine the amount of tax that ought to be withheld. Given that it is difficult to predict the quantum of any future stock option benefit before the relevant option is actually exercised, this method may fail to provide sufficient funds to satisfy the ultimate tax obligation. Conversely, if the relevant stock option is never exercised, it is possible that excess withholdings will ultimately be made from an employee’s remuneration in respect of the year and the employee will thereafter be required to wait until the following year to claim a tax refund.

3. Employer pays the withholding tax

The employer may pay the tax required to be remitted on the exercise of a stock option on behalf of an employee and then make arrangements with the employee for reimbursement. Such an approach could be implemented through the use of a promissory note or another form of loan agreement. However, among other issues, it would be critical to ensure that the terms of any such loan are commercially reasonable in order to avoid the characterization of such an arrangement as a taxable shareholder benefit or taxable benefit from employment.

4. Sale of optioned shares

The ESOP may provide an employee with a “cashless” exercise feature, whereby a broker sells a certain number of the optioned shares on behalf of the option holder to a third party in order to fund the required tax remittance. For this method to be effective, there must be a liquid market for the shares.

5. “Cash-out” rights

The ESOP may include a “cash-out” right. Such a right would permit the employee to “cash out” the stock option in return for a cash payment from the employer equal to the “in-the- money” amount of the stock option, net of the applicable withholding tax. (It is worthy of note that the 2010 federal budget introduced further legislative amendments that now preclude an employee from claiming the paragraph 110(1)(d) deduction (one of the so-called 50% deductions) where a stock option is exercised and a “cash out” payment is received, unless (i) the employer agrees to forgo the right to claim a deduction in respect of the “cash out” payment, and (ii) certain other conditions are satisfied.)

6. Payment of cash dividend

An employer could declare a cash dividend contemporaneous with the exercise of the stock option by the employee. The employee could then use the cash dividend received in respect of his/her newly acquired shares to satisfy the tax remittance requirement in respect of the stock option benefit. This method may not be attractive in many circumstances as it requires the employee to pay the associated tax on the dividend payment and to then use the net proceeds to pay the tax in respect of the stock option benefit. Cash flow challenges for the employer could also arise if the relevant shares are widely held, creating an obligation to declare a large aggregate dividend in order to provide a limited distribution to a select number of new shareholders.

The new stock option withholding rules raise a host of practical, administrative and economic issues for both employers that grant stock options and employees that are the beneficiaries of such grants. It will be prudent for both employers and employees to consider the means of satisfying future tax withholding and remittance requirements well in advance of any potential exercise of a stock option in order to preclude future difficulties. Employers should also review and reassess existing ESOPs to ensure that they operate efficiently and in a manner that will continue to provide sufficient motivation to employees.

1. R.S.C. 1985, c. 1 (5th Supp.).
2. Ibid. at section 7.
3. Ibid. at paragraph 110(1)(d).  
4. The relevant 2010 federal Budget proposals were enacted into law on December 15, 2010.
5.  Certain exceptions to this requirement apply in respect of (i) certain options granted by CCPCs; (ii) options that were granted before 2011 pursuant to a written agreement entered into before 4:00 p.m. (EST) on March 4, 2010 where the agreement included, at that time, a written condition which prohibited the employee from disposing of the securities acquired under the agreement for a period of time after the exercise of the options; and (iii) certain amounts that are deductible by the employee in computing taxable income.
6. Supra note 1 at subsection 153(1.01).
7. See, for example, CRA Technical Interpretation Letter #9233476 (12 January 1993).
8. Supra note 1 at subsection 153(1.31).

The foregoing provides only an overview and does not constitute legal advice.