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April 17, 2007
Tax Alert |  Tax Advisory | 

Giving Your Employees the Option - Part II

In our last issue of Tax Alert, we considered employee equity participation in private corporations, including issuing stock and granting stock options. This article follows up with more ideas on involving employees in ownership.   

Share purchase loans

Instead of issuing options or stock at a discounted price, some employers prefer to lend a key employee the subscription funds to purchase shares at their full value, often with the idea that repayments will be made out of the employee's future bonuses. A share purchase loan to an arm's length employee need not bear interest, but a taxable benefit will arise to the extent actual loan interest is below the interest rate prescribed by the CRA. However, this typically has no net tax effect since the benefit is deemed to be interest paid, allowing the employee to claim an offsetting investment interest deduction.   

If the shares appreciate in value and are sold, the employee will have capital gains and can presumably repay the loan from the proceeds. But problems often arise if the share value declines. Does the company expect to require repayment of the loan if the shares have lost value? Many private corporation employers do not wish to enforce collection on key employees when business is down and the stock price suffers. Such employers might try to limit the employee's downside risk, for example by agreeing to limit repayment of the loan to the value of the underlying shares. This might save the employee from the cost of an "underwater" loan, but not necessarily from the tax consequences.  The employee will ordinarily have a taxable benefit equal to the unpaid balance of the loan. Solving that tax cost is difficult. One option is simply to pay deductible bonuses to employees, to fund either repayment of the loan or payment of the incremental tax. These issues make share purchase loans less popular for private corporations.

Indirect plans

Other alternatives include "phantom shares" and "stock appreciation rights." Phantom shares grant employees notional shares under which they may become entitled to payments from the corporation equivalent to any dividends declared on the underlying class of shares, as well as "proceeds" on a future disposition of the rights. Stock appreciation rights are similar plans, except the employee is granted rights that are valued only on future appreciation in the underlying stock. These rights can be combined with traditional options. For example, an employee may be able to choose to exercise an option, or alternatively exercise appreciation rights for cash.

For tax purposes, these plans are essentially deferred bonus plans, with amounts calculated on a formula that includes share value. Since a quoted market price is not available, the share value might be independently appraised, or determined by way of formula from book earnings and net assets. The employee typically has none of the legal rights of a shareholder, which is a principal attraction of these plans for majority owners. Plans are typically designed such that benefits are taxable to the employee when payments are received. This requires that the rights granted have no immediate value when issued, and the employee is guaranteed no minimum payment, among other conditions.  Payments are generally deductible to the employer. This can actually provide greater overall tax efficiency than a stock option plan, where the employee is taxed on one-half of the benefit but the corporation generally gets no deduction. Combining appreciation rights and options can potentially deliver the best of both worlds – full deduction to the employer and 50% taxation to the employee, if the employee opts for cash. 

There are complex rules governing deferred employee compensation that must be respected in structuring these plans, but the CRA has ruled favourably on several such plans.  Proper planning is essential to their use, and a tax ruling might be prudent where significant amounts are involved.  

Issuing shares to Registered Retirement Savings Plans

Another strategy allows employees to acquire shares using funds held in RRSPs. This approach usually arises when the company requires additional capital and the employee does not otherwise have sufficient cash to invest. Tax rules prevent controlling shareholders and related persons from acquiring Canadian-Controlled Private Corporation (CCPC) shares in RRSPs. Those rules also limit the subscription amount to less than $25,000 for any shareholders who end up with 10% or more of any class of stock after the purchase.     

While attractive on the surface, the RRSP strategy has several drawbacks. Dividends and gains realized on the shares are tax-deferred, but will be fully taxed when funds are ultimately withdrawn from the RRSP.  Where shares are held outside the RRSP, dividends qualify for the dividend tax credit and capital gains are only 50% taxable. Moreover, gains realized by individuals on shares of CCPCs that meet certain tests can be sheltered by the now $750,000 lifetime capital gains exemption. This benefit will be lost where the shares are held within an RRSP. 

RRSPs as shareholders can also complicate a sale of the company. For example, if a sale of the company included deferred sale proceeds to be paid in years hence, the amount receivable is not a qualified investment for the RRSP.

Finally, the involvement of RRSPs creates increased administration requirements, not the least of which is the need to confirm to each RRSP trustee that the shares meet the requirements initially to qualify as an RRSP investment.

Equity participation by employees can be a complex matter. Your Collins Barrow advisor can help you design the plan that best suits your needs and objectives.

Dean Woodward is a tax partner in Collins Barrow's Calgary member firm.

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Information is current to April 17, 2007. The information contained in this release is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.