Many companies offer long-term incentive schemes in the form of equity compensation to various employees or consultants with a goal of retaining talent and allowing participants of these Plans to share in the growth of the company. These equity compensation plans may include Restricted Share Units, Restricted Share Awards, Stock Option Plans, or sometimes Share Appreciation Rights.
While these compensation items may attract participants, it is important to ensure that both the company and participants are aware of the nuances related to the taxation of these items, especially since taxation is closely dependent on the terms and conditions of each Plan. No one single Plan is identical to another, and a change of one single clause in the Plan has the power to significantly alter the resulting tax implications.
SARs are not explicitly defined in Canada’s Income Tax Act, but they are commonly known as phantom plans that entitle the participant to receive an amount equal to the appreciation in the value of the underlying shares from the date that the SAR is granted until the date that it is exercised.
Typically, where certain conditions are met, SARs are considered to have no value at grant, and its value is considered dependent on future services to be rendered. Therefore, where certain conditions are met, taxation of SARs typically arise at the time of vest, when the participant has fulfilled the required vesting conditions and are eligible for payout of the appreciation in value.
However, where the Plan entitles a participant to a dividend-equivalent prior to time of vest, where the value and timing of this dividend-equivalent is dependent on the actual dividend payments made to shareholders of the underlying shares, taxation of the Plan may be accelerated to the time that the participant becomes entitled to receive the first such dividend-equivalent.
This acceleration in timing of taxation is a result of the Salary Deferral Rules in Canada, where deferred amounts are taxed currently as earned and not upon receipt at vest. Once these Salary Deferral Rules have been triggered, any appreciation under the Plan must be reported as income on an annual basis, instead of reported once in aggregate at time of vest.
Still, this does not imply that dividend-equivalents are not recommended and should never appear in Plans. Situations may arise where a dividend-equivalent is present in the Plan but does not cause acceleration of the timing of taxation. The terms and conditions of the Plan is key, and care must be taken to ensure that the wording of the Plan allows for favourable taxation.
Nevertheless, as the terms and conditions of each Plan vary, it remains pertinent that a Plan is reviewed prior to the initial issuance so that the Plan may be modified, as necessary, to ensure favourable taxation where possible. Where issuances have already been granted under the Plan, the review may still offer insight into any taxation concerns and offer recommendations for future issuances.
Where a company wishes to have absolute guarantee on the taxation of a Plan, an official Advance Tax Ruling would need to be requested with the Income Tax Rulings Directorate at the Canada Revenue Agency. These official rulings may take 90 days or longer to process, and therefore would need to be initiated early if the company hopes to obtain an official ruling prior to the first issuance under the Plan.
Contact us for more information to see how BDO can assist in reviewing an existing or proposed Equity Compensation Plan and how BDO can offer recommendations for favourable taxation.
Debra Moses
dmoses@bdo.ca
Marie Neill
mneill@bdo.ca
Anita Wu
anwu@bdo.ca