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Implications to stock options when the fifth protocol of the US Canada Tax Treaty is ratified

Originating in 1980, the US Canada Tax Treaty has previously undergone four major revisions or "Protocols" (1983, 1984, 1995, 1997) and as of September 21, 2007, the Fifth Protocol was signed by US and Canadian representatives. The new amendments will come into effect once ratified by both nations and when each has been formally notified of completed government procedures by the other. Canada completed the required legislative steps on December 14, 2007.

The fifth Protocol to the Canada-US Tax Treaty is about looking ahead and being innovative.

- Jim Flaherty Canadian Finance Minister
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In this highly competitive global economy, we need to continually explore ways to grow, expand and compete," explained Canadian Finance Minister Jim Flaherty. "Further improving and refining our relationship with the United States, our largest trading partner, is essential. The fifth Protocol to the Canada-US Tax Treaty is about looking ahead and being innovative. Amongst key measures contained in the fifth Protocol (which includes cross-border tax withholding and measures to avoid double taxations) is clarification on the taxation of stock options for internationally mobile employees. Previously there was no specific rule as to taxation procedures for options that were given in one country and then exercised by the employee in the other country. The fifth Protocol clarifies that the stock option benefit is considered to have been derived in the country to the extent which it was the employee’s principle country of residence from the date of the stock option grant to its exercise date.

For example if an employee is granted stock options while employed in the US, transfers to Canada one year later and then exercises those options three years following the transfer (four years from grant date), 25% of the income is determined to have arisen while in the US and subject to American tax guidelines and the remaining 75% falls under Canadian regulations. Taxation of the benefit will be subject to the same percentage of time residing in each country. This ensures the source of the benefit is clear and double taxation does not occur.

While some provisions of the fifth protocol become effective at various times subsequent to the date it enters into force, the issues regarding stock option taxations are effective immediately upon ratification.

US Canada Tax Treaty with Protocol Five amendments

Canadian Department of Finance – Summary

US Department of Treasury – Statement

http://www.treas.gov/press/releases/hp569.htm

SAB 110 allows smaller companies continued use of simplified expensing methods…for now

On December 21, 2007 the Securities and Exchange Commission (SEC) released Staff Accounting Bulletin (SAB) 110. This effectively extends the ability of eligible public companies to use a simplified method for determining the value of “plain vanilla” stock option grants for income statement purposes.

Three years ago, SAB 107 (March 2005) permitted companies to use the average of the time to vest and the full term of the option to determine the expected term of an option grant. This would be used in models such as Black-Scholes to calculate the amount of expense expected from stock option compensation. Use of this simplified method had an initial deadline of December 31, 2007 due to the expectation that reliable data regarding exercise behavior would be available by then. It was determined in SAB 110 that if sufficient historical information on employee exercise behavior is still unavailable, the simplified model could continue to be used past this deadline. This mainly benefits smaller companies where such data is still unavailable. Once reasonable historical data is compiled, use of the simplified option will no longer be allowed.

The simplified method:

• can be used only by companies lacking sufficient historical exercise data. This can be due to the brevity of the plan, recent significant changes to the option plan or changes to the business structure or procedures that could effect historical trends
• is for use with "plain vanilla options" which have these
  characteristics (from www.sec.com):
• The share options are granted at-the-money;
• Exercisability is conditional only on performing service through the vesting date;
• If an employee terminates service prior to vesting, the employee would forfeit the share options;
• If an employee terminates service after vesting, the employee would have a limited time to exercise the share options (typically 30-90 days); and
• The share options are nontransferable and nonhedgeable.
• if used, must be disclosed as such on financial statements along with reasons for its usage

For more information refer to U.S. Securities and Exchange Commission bulletin
http://www.sec.gov/interps/account/sab110.htm

The CRA solidifies its position towards withholding taxes on stock option exercises

The Canada Revenue Agency (CRA) recently clarified its position relating to two procedures of withholding tax for stock option exercises. This is not a policy change by the CRA but rather a solidification of administrative position and practices.

The employer is responsible to ensure the appropriate taxes are withheld and failure to do so may result in the company being liable for the taxes not withheld as well as any associated interest or penalties. The tax withholding process can be easily managed through Solium Shareworks’ tax withholding capabilities. To learn more about this functionality, please contact Solium Capital or your Account Manager.

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The backlash of stock option backdating

As the wake of the stock option backdating investigations of the past two years begins to subside, attention is now turning to the financial repercussions arising from the SEC’s rulings. The backdating options scandals involved altering the grant dates for stock options to give recipients a head start to paper profits. Although it's not illegal to grant options at a discount, it must be properly disclosed to regulators, investors and tax authorities.

A study conducted in November 2006 by Randall Heron (Kelley School of Business) and Erik Lie (Henry B Tippie College of Business) estimated that “18.9% of unscheduled, at-the-money option grants to top executives during the period 1996-2005 were backdated or otherwise manipulated” and that 29.2% of the 2,270 companies examined had at some point manipulated stock option grants.
http://www.biz.uiowa.edu/faculty/elie/Grants-11-01-2006.pdf

Examples of recent repercussions to executive for backdating options:

Apple Computers

• $150,000 fine
• Agreed to return $3.5 million in stock gains

Converse

• No fine
• Agreed to return $2.4 million in options gains

Integrated Silicon Solutions

• $125,000 fine
• Agreed to return $414,830 in gains

Maxim Integrated Products

• $800,000 in disgorgement, interest, and penalties
• $150,000 civil penalty

• Case currently in litigation

United Health Group

• $7 million in civil fine
• $12.7 million return of "ill-gotten gains"
• $448.3 reimbursed to United in options and cash
• $468 million total

• $20.6 million in stock-option gains and $3m in unexercised options

Brocade Communications Systems Inc.

• Both convicted August 2007 of conspiracy, falsifying corporate records and other charges (sentencing schedule for March 12, 2008
• Face up to 20 years in prison each
• Brocade paid $7 million in SEC fines

Other investigated companies

Source: Wall Street Journal database http://www.biz.uiowa.edu/faculty/elie/wsj1.htm

The HR Key to the ESOP Vault

Employee Stock Option Plans (ESOPs) are integral in ensuring the recruitment and retention of employees as well as adding to their motivation, dedication and the promotion of an involved and invested corporate culture…but is your plan realizing its full value? A recent (2007) study conducted by Farrell, Krische and Sedatole attacked that very subject and overwhelmingly, the answer is no.

Using a 'true-value' Black-Scholes figure as a benchmark, the researchers compared subjective employee feedback to determine if the costs of an ESOP are producing the benefits for which it is intended. With 76% of employees valuing their plan lower than the black book value, it is clear that this is not the case. Peripheral factors such as the amount of previous investment in the company, vesting time, tax rates and faith in the future of the company’s stock price influenced the perception of an ESOP’s value but the true value of the plan remained locked away.

The answer, however, is not to seek alternative incentive initiatives but rather to educate employees and demonstrate to them the inherent value contained within their plan. After completion of a stock option education program that informed participants of the functionality of their plan and the Black-Scholes value associated with their options, 84% of those who undervalued their options before the program had an increase in how they subjectively viewed their plan’s value.

Effectively communicating to participants the value locked in an ESOP can significantly increase the plans perceived value and benefit, which in turn, fosters the intended corporate impact to employee retention, recruitment and motivation. Solium offers communication services packages to help you effectively communicate to you participants.

When looking at corporation’s choices for employee incentive programs, ESOPs popularity has been steadily on the rise in the US.