How to stick­han­dle stock op­tions with­out end­ing up off­side with the tax­man

National Post (Latest Edition) - - FINANCIAL POST - Jamie Golombek Tax Ex­pert Jamie.Golombek@cibc.com Jamie Golombek, CPA, CA, CFP, CLU, TEP is the Man­ag­ing Di­rec­tor, Tax & Es­tate Plan­ning with CIBC Fi­nan­cial Plan­ning & Ad­vice Group in Toronto.

Em­ployee stock op­tions con­tinue to be a pop­u­lar form of in­cen­tive re­mu­ner­a­tion among a va­ri­ety of com­pa­nies, es­pe­cially in the tech­nol­ogy, ju­nior min­ing and ex­plo­ration and cannabis in­dus­tries. While stock-op­tion plans can be help­ful to at­tract, re­tain and re­ward key em­ploy­ees, it’s im­por­tant for op­tion re­cip­i­ents to fully con­sider the tax con­se­quences of both the ex­er­cise of an em­ployee stock op­tion and the sub­se­quent sale of the un­der­ly­ing stock. As we’ll see, this is par­tic­u­larly im­por­tant should the price of the stock de­cline in value af­ter you ex­er­cise your op­tion.

A re­cent court de­ci­sion demon­strates ex­actly what can go wrong in such a sit­u­a­tion. Be­fore re­view­ing the facts of the case, let’s re­view the gen­eral tax rules as­so­ci­ated with em­ployee stock op­tions.

THE LAW

If an em­ployee pur­chases a share of her em­ployer un­der an em­ployee stock-op­tion plan, the dif­fer­ence be­tween the fair mar­ket value of the shares at the time the op­tion is ex­er­cised and the ex­er­cise price is treated as a tax­able em­ploy­ment ben­e­fit. In most cases, the em­ployee is then en­ti­tled to the “stock-op­tion de­duc­tion,” which is equal to 50 per cent of the em­ploy­ment ben­e­fit. The net re­sult of the de­duc­tion is that stock­op­tion ben­e­fits gen­er­ally get taxed at ben­e­fi­cial cap­i­tal gains-like tax rates and thus pro­vide busi­nesses with an at­trac­tive tool to at­tract and re­tain highly-skilled em­ploy­ees. The key point to re­mem­ber, how­ever, is that the stock op­tion ben­e­fit is not ac­tu­ally a cap­i­tal gain but rather is clas­si­fied as em­ploy­ment in­come.

THE PROB­LEM

This can later be­come a prob­lem for an em­ployee whose shares sub­se­quently de­cline in value be­low the fair mar­ket value of the shares when the em­ployee ex­er­cised the op­tions and re­ceived the shares. If those shares are sold, the re­sult­ing loss, equal to the dif­fer­ence be­tween the new, lower fair mar­ket value of the shares and the fair mar­ket value of the shares on the date of op­tion ex­er­cise, is con­sid­ered to be a “cap­i­tal loss.” A cap­i­tal loss can only be used to off­set other cap­i­tal gains and can­not be de­ducted against the tax­able em­ploy­ment ben­e­fit that arose upon ac­qui­si­tion of the shares through the op­tion ex­er­cise.

It is this mis­match of cap­i­tal loss against em­ploy­ment in­come that has caused se­ri­ous tax prob­lems in the past for em­ploy­ees of var­i­ous stock plans when the tech bub­ble burst in the early aughts. In­deed, you may re­call the much-pub­li­cized case of the em­ploy­ees of B.C.-based SDL Op­tics, Inc. (later ac­quired by JDS Uniphase, now Vi­vai So­lu­tions) who re­ceived com­pany stock only to have the value of their shares sub­se­quently plum­met. It ul­ti­mately led to the fed­eral gov­ern­ment grant­ing two re­mis­sion or­ders in 2007 and 2008, for­giv­ing both the in­come taxes and ar­rears in­ter­est of 45 for­mer em­ploy­ees of the com­pany that arose from par­tic­i­pa­tion in the com­pany’s stock pur­chase plan.

While many have blamed the prob­lem on a flaw in the tax law, the real is­sue is that once an em­ployee de­cides to ex­er­cise her op­tions and not im­me­di­ately sell her newly ac­quired stock, she steps out of the shoes of an em­ployee and into the shoes of an in­vestor. As the Canada Rev­enue Agency has stated, “The tax sys­tem re­flects the re­sult that, at the point of ac­qui­si­tion, those em­ploy­ees who hold their shares have cho­sen to ac­cept a mar­ket risk as an in­vestor, in the ex­pec­ta­tion of a re­turn on that in­vest­ment, in­clud­ing the fu­ture ap­pre­ci­a­tion in the value of those shares. Thus, they are sub­ject to the same gen­eral in­come tax rules re­spect­ing cap­i­tal gains and losses on the un­der­ly­ing shares as other in­vestors.”

THE CASE

In the re­cent case, an Al­berta ex­ec­u­tive was de­nied a re­mis­sion or­der for the tax he owed af­ter the shares he re­ceived upon ex­er­cis­ing his stock op­tions plunged in value. He went to Fed­eral Court seek­ing a ju­di­cial re­view of the gov­ern­ment’s re­fusal to rec­om­mend re­mis­sion of his 2007 tax li­a­bil­ity.

In 2004, the tax­payer was granted an em­ployee stock op­tion al­low­ing him to pur­chase 75,000 shares of his em­ployer’s stock at a cost of $0.95 per share. On March 22, 2007, the tax­payer ex­er­cised his op­tion and ac­quired the 75,000 shares at that price when the shares were worth $13.70 per share. As a re­sult of pur­chas­ing the shares at less than their fair mar­ket value, the CRA as­sessed a tax­able em­ploy­ment ben­e­fit for the 2007 tax year in the amount of $956,250, or $12.75 per share.

The tax­payer ob­jected to the assess­ment and ul­ti­mately filed an ap­peal to the Tax Court, ar­gu­ing that since the shares ac­quired were sub­ject to nu­mer­ous black­out pe­ri­ods and he was con­sid­ered an in­sider of the com­pany, he was re­stricted from sell­ing the shares im­me­di­ately and the as­sessed value of the shares should be re­duced. The Canada Rev­enue Agency agreed to re­duce his em­ploy­ment ben­e­fit by 30 per cent to $648,000.

But the tax­payer’s tax prob­lem oc­curred when he ul­ti­mately sold his shares in 2011 for $3.05 per share or $228,750 in to­tal, thereby re­al­iz­ing a cap­i­tal loss of $419,250. But the cap­i­tal loss could not be used to off­set the $648,000 ben­e­fit. As a re­sult, the tax­payer was li­able to pay in­come tax on the tax­able em­ploy­ment ben­e­fit.

The tax­payer then ap­plied for a re­mis­sion of the re­sult­ing in­come tax and in­ter­est. To sup­port his re­quest, he cited the two re­mis­sion or­ders pro­vid­ing re­lief to SDL em­ploy­ees who were un­able to off­set tax­able em­ploy­ment ben­e­fits with a sub­se­quent cap­i­tal loss on the sale of em­ployee stock pur­chase shares.

The gov­ern­ment re­fused the tax­payer’s re­mis­sion re­quest, on the ba­sis that his cir­cum­stances were not the same as those of the other tax­pay­ers, since they had par­tic­i­pated in a stock pur­chase plan rather than a stock op­tion plan and there were no ex­ten­u­at­ing cir­cum­stances that could war­rant re­mis­sion, as the tax­payer’s de­ci­sion to pur­chase, hold and sell the shares were all de­ci­sions within his con­trol.

The Fed­eral Court judge had to de­cide whether the gov­ern­ment’s de­ci­sion not to grant a re­mis­sion or­der was un­rea­son­able. The judge re­viewed the facts of the case and com­pared them to the facts and cir­cum­stances of the SDL em­ploy­ees and con­cluded that the gov­ern­ment prop­erly ex­er­cised its dis­cre­tion not to is­sue a re­mis­sion or­der.

In the 2010 bud­get, the gov­ern­ment changed the law to en­sure it col­lects its taxes when op­tions are ex­er­cised. Em­ploy­ers are now re­quired to with­hold tax at source for the pe­riod in which the em­ployee ex­er­cises a stock op­tion. Em­ploy­ees still need to be mind­ful that if they con­tinue to own the stock, and it drops in value, they may be left with a cap­i­tal loss that can only be used against cap­i­tal gains.

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