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Share Unit Plans Offer New Approach

By: Christina Medland

Until recently, stock options were the most popular form of share-based compensation in Canada. However, their use is now under re-evaluation. Christina Medland, of Torys, looks at Restricted Share Plans, a new approach to compensation now under consideration.

The crash of tech companies and the collapse of Enron have prompted a re-evaluation of the use of stock options as a form of executive compensation.

As well, the recent and proposed changes to the Canadian accounting treatment of options have made options less attractive from a corporate financial reporting perspective.

One result of this is that restricted share unit plans are being suggested as a substitute for stock options. However, the Canadian tax system does not provide advantageous tax treatment for restricted share units. Accordingly, the replacement of stock options by restricted share units should be approached cautiously.

Until recently, stock options were the most popular form of share-based compensation in Canada. Until the recent changes to the accounting treatment of options, share appreciation rights were commonly awarded with options. Recently, deferred share unit plans have become the favoured form of share-based compensation for nonexecutive directors. The popularity of stock options and deferred share units has been driven in large part by the favourable tax and accounting treatment they receive. Options have also been popular with senior management as they give executives an upside participation, but no downside exposure to changes in share price.

Shareholders have been asking companies to re-evaluate their stock option practices because options are thought to:

Concerns about stock options have led to the widespread consideration of restricted share unit plans. This appears to be a development that has moved north from the United States, where such plans receive more favourable tax treatment than they do in Canada.

However, given the Canadian tax limitations, the better approach may be to properly design stock option plans to correct the problems associated with options, rather than abandon them for restricted share units.

How Restricted Share Unit Plans Operate

Restricted share unit plans can be established in one of three ways: treasury issuance, market purchase, or phantom. The value generated under each type of plan is the same and is determined as follows:

A treasury issuance plan must be approved by the TSX (for TSX-listed shares) and usually must be approved by shareholders of the company as well. Under a market purchase plan, shares are purchased by an independent trustee on the open market. This type of plan generally does not require shareholder approval, but does require the company to make a cash payment to fund the market purchase of shares in order to satisfy the requirement that each restricted share unit be redeemed for a common share. If, for business reasons, a company determines not to implement a treasury issuance plan, then a market purchase plan will be preferred over a phantom plan only if the company wishes to impose a long-term share ownership requirement. Otherwise, the administrative costs of having the independent trustee make the market purchases are not justified.

Taxation Of Restricted Share Unit Plans

To understand why the tax treatment of restricted share units is less favourable than the taxation of stock options, it is important to understand the tax treatment of stock options and their more favourable income tax treatment. Paragraph 7(3)(a) of the Income Tax Act (Canada) (the Tax Act) provides that the grant of a stock option is not a taxable event for an employee. The employee is taxed only on the exercise of the option or the transfer or disposition of his or her rights under the plan. Recent changes to the Tax Act allow employees of public corporations to further defer income on options in respect of $100,000 of shares each year, until the year in which the employee disposes of the shares. Where options are granted with an exercise price equal to, or greater than, the fair market value of a share at the time of grant, paragraph 110(1)(d) of the Tax Act allows a deduction of one-half of the amount ultimately included in income. This allows such options to receive “capital gains treatment” for increases in value during the time options are held by the employee. Stock options issued by Canadian-controlled private corporations (CCPCs) receive even more favourable treatment.

Restricted share unit plans do not receive tax treatment that is as favourable to the holder as the treatment of stock options. Individuals are generally taxed on a cash basis and so do not pay tax on amounts until amounts are paid or payable to them. Where an amount is not paid or payable to an individual, but it is reasonable to consider that one of the main purposes for delaying payment is to postpone tax that would otherwise be payable on salary or wages, the salary deferrable arrangement rules under the Tax Act will require that the amount be included in income in the year in which the deferral occurs. Clearly, a restricted share unit plan granted in lieu of a bonus would come within this definition.

Paragraph (k) of the definition of “salary deferral arrangement” under the Tax Act provides an exemption to the salary deferral arrangement rules where the employee is to receive a bonus (or similar payment in respect of services rendered) to be paid within three years. The taxation of bonus compensation can be deferred for up to three years, so plans will typically allow for vesting (and payout or redemption) to occur in the third year after the year in which the restricted share units are granted. It is important to note that where the restricted share units represent the payment of a bonus, withholding for CPP, EI, and income tax will have to be made on the amount paid.

Restricted share unit plans, because they do not typically have an exercise price, are not eligible for the deduction under paragraph 110(1)(d) of the Tax Act which permits capital gains treatment. However, where the shares being issued to the employee under a restricted share unit plan are shares of a CCPC, the employee is entitled to a deduction of one-half of the amount to be included in income, provided that the employee holds the shares for at least two years from the date of issue.

There is no deduction available to the employer for shares issued under a restricted share unit plan.

If a corporation awards restricted share units for purposes other than bonus payments or payments of salary, the three-year restriction would not apply. This kind of a plan could allow for the restricted share units to be held indefinitely before vesting, without triggering an income inclusion since the “salary deferral arrangement” rules would not apply.

Restricted Share Unit Plan Pitfalls

Restricted share unit plans are ‘shoehorned’ into the three-year bonus exemption under the salary deferral arrangement rules and so, if not carefully designed, can result in the restricted share unit plan not having the desired tax treatment.

Most importantly, the restricted share plan of a U.S. employer should not be extended to Canadians. In U.S. restricted share plans, the shares are issued to the employees immediately, but they are subject to certain conditions or vesting restrictions that prevent the employee from dealing with, or disposing of, the shares until a certain time has elapsed. Under this style of plan, the shares would be taxed when issued and so there would be no tax benefit except a small discount from fair market value to account for the vesting restriction. The fact that in a Canadian restricted share unit plan, employees are issued units (representing shares to be issued in the future) instead of the shares themselves, is crucial to the deferral of tax.

A restricted share unit plan may allow the employer to set conditions on the eventual granting of the shares under the plan. However, if the conditions relate to services rendered by the employee outside the year in respect of which the bonus is granted, then the entire bonus will become subject to the salary deferral rules, and will not receive the three-year deferral. This is because the three-year bonus exemption is only available for bonuses in respect of services rendered within a particular taxation year. The addition of a condition for delivery that relates, or could relate, to services outside that year could put the plan offside of this requirement. The simplest such situation is where the number of units granted varies with respect to performance benchmarks calculated over a number of years – for example, a plan that calls for an employee to receive 2,000 restricted share units if the employee maintains a certain level in the employee’s performance review for two consecutive years. Equally, where units are granted for one taxation year, but the delivery of the shares in three years’ time is conditional on the maintenance of a certain performance benchmark, those units will be subject to the salary deferral rules.

Replacing Stock Options With Restricted Share Units

From a tax perspective, restricted share unit plans make a poor substitute for stock options. The holder of stock options benefits from a generous tax framework, including section 7 treatment, deferral of the section 7 benefit until disposition of the shares, the paragraph 110(1)(d) deduction, and provincial tax relief in certain circumstances. Certain research employees in Ontario qualify for a new tax refund on Ontario tax payable on their Section 7 benefit, under section 8.7 of the Income Tax Act (Ontario). Other than section 7 treatment, these tax advantages are not available to the holders of restricted share units. Instead, in order not to be taxed at the time of grant, restricted share units must fit within the exemption for bonuses under the salary deferral arrangement rules and, even then, there is only a three-year deferral available.

From a tax policy perspective, restricted share unit plans fall between two well-understood poles. They are not like options, because they are paid in lieu of bonuses and do not carry the same incentive appeal as options. At the same time, they are not like bonuses or salary, because they provide an element of capital “interest” in the employer’s shares (as a result of the enforced “holding period”), which is more like an option.

Christina Medland is with Torys LLP.

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