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Dealing with Employee Stock Options in Corporate Acquisitions – Navigating the Labyrinth
In a transaction involving the purchase and sale of shares, there may be outstanding employee stock options held by employees of the target corporation ("Target"). It is generally in the best interests of all parties to safeguard the most beneficial tax treatment possible for the holders in dealing with those stock options. The option holders may continue to be employed in senior management positions by Target or by a corporation resulting from a post-closing business combination with Target. In these circumstances, preserving favourable tax treatment for option holders may be key to the future employment relationship with these individuals. Taxand Canada identifies the steps to achieve the best tax result that requires an understanding of the relevant country's income tax rules applicable to the stock options, a review of the existing stock option plan and agreements, and careful consideration of the impact of the terms of the purchase and sale transaction on those options.
Canada's Tax Rules Applicable to Employee Stock Options
Most stock option plans of Canadian public corporations are structured to satisfy conditions that allow an offsetting deduction by the employee of one-half of the amount of the employment benefit arising at the time of exercising the option and acquiring the underlying shares. To obtain this beneficial tax treatment, the exercise price must not be less than the fair market value of the underlying share on the date the option is granted and the underlying shares must be "prescribed shares" at the time of exercise (or surrender) of the stock option. Under Canada's tax laws, an employer is not entitled to an income deduction in respect of shares issued on the exercise or surrender of a stock option.
Dealing With In-the-Money Options in a Corporate Acquisition
There are essentially four ways of dealing with options of Target in a manner that does not trigger adverse tax consequences for Canadian option holders:
- the options may be surrendered by the holders in consideration for a payment from Target that is equal to the difference between the exercise price and the share purchase price, to be paid in cash or "in kind" with shares of Target that can be tendered to the offer of the purchaser
- the options may be exercised and the shares tendered by the holder to the offer
- if the intention is that Target will continue to exist after the acquisition, the options may survive the transaction and continue under the existing option plan or be exchanged for new options of Target
- the options may be exchanged for new options of the purchaser corporation on a tax-deferred rollover basis.
The most tax effective method will depend upon all of the circumstances.
Issues with Prescribed Share Rules on Exercise or Surrender
The one-half deduction of the benefit will be lost if the shares are not "prescribed shares" at the time of the exercise or surrender of the options. In the context of a corporate acquisition, it is easy to inadvertently and unintentionally fall off-side of these complex rules. For example, if the options are exercised or cashed-out at, or after, the time that the purchaser acquires a controlling interest in Target, the favourable tax treatment for the option holders will generally be lost.
Withholding Tax on the Surrender or Exercise of Options
Under Canada's tax laws, for 2011 and subsequent years, there is no exemption from withholding tax for stock option benefits. Withholding from a cash payment on the surrender options is relatively straightforward. On the issuance of shares, withholding tax may be funded by a sale of the shares on the market on the employee's behalf; withholding from other remuneration; or by requiring the employee to fund the withholding tax as a condition of the issuance of the shares. Any arrangement involving a repurchase by a Canadian corporation of its shares should be avoided, as it may cause the employee to lose the entitlement to the one-half deduction and may also give rise to a deemed dividend.
Exchange of Options
If certain conditions are satisfied, the exchange of options may be accomplished on a "rollover" basis. The new options are deemed to be the same options and a continuation of the old options. If the new options are issued by the purchaser corporation, it will be deemed to be the same person, and a continuation of the person (Target) that granted the old exchanged options.
The treatment of the option holders of Target needs to be carefully considered well in advance of the closing date of the acquisition. When left until the "eleventh hour", the closing of the transaction may be delayed and patchwork solutions to deal with the options may trigger adverse tax consequences for the option holders.
In a transaction involving the acquisition of a corporation, it is generally to the benefit of all parties to deal with outstanding stock options in a manner that preserves the most favourable tax treatment for the option holders and is appropriate to the structure of the overall transaction. There is no "one-size fits all" solution. Unexpected issues can and do arise. For example, where option holders are resident in Canada, avoiding unexpected adverse tax consequences for those option holders requires a careful navigation of the labyrinth of prescribed share rules. Understanding the potential issues early in the negotiations may be vital to dealing with them in a timely and appropriate manner.
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