Cross-Border Counselor

For an employee who is a U.S. taxpayer, both the employer and the employee are liable for a portion of Social Security taxes and Medicare taxes (collectively referred to as “FICA” taxes) on the employee’s compensation. Employers are liable for withholding and remitting both the employer and the employee portions of FICA taxes, which typically occurs at the time the compensation is received by the employee, which his known as the “General Timing Rule.” However, when dealing with awards of nonqualified deferred compensation (“NQDC”) to U.S. taxpayers, a Special Timing Rule (outlined in Treas. Reg. §31.3121(v)(2)-1) may apply.  Under the Special Timing Rule, FICA taxes are owed when the employee becomes vested in the NQDC, whether or not the NQDC is actually paid at that time. If a Canadian company is unaware of this Special Timing Rule, it could result in the employer withholding and reporting incorrect FICA amounts as well as the employee overpaying FICA taxes. What is Nonqualified Deferred Compensation? A NQDC arrangement is really any kind of compensation that has been earned by an employee in one tax year, but that the employee will not receive until a later tax year. This could be as simple as a bonus earned in one year and payable in a later year, or as complex as equity-based awards, such as Restricted Stock Units, phantom stock, or a supplemental executive retirement plan (to name a few). However, this Special Timing Rule generally does not apply to stock options. What is the Special Timing Rule for FICA? As mentioned above, under the Special Timing Rule, FICA taxes are due on NQDC on the later of: (1) when the employee provides the related services, or (2) when the compensation is no longer subject to a substantial risk of forfeiture (i.e., when the amounts vest). In other words, FICA taxes could be due before the NQDC is actually paid to the employee. For a typical employer contribution-based cash plan or phantom stock plan, this rule means that FICA taxes will be due in the year when any deferred compensation (and any earnings) vest. This can become complex to track when there is an extended vesting schedule to ensure that the appropriate amount of FICA taxes are paid by the employer and employee when each tranche of the compensation (and earnings) vest. For a plan where employees are deferring salary or bonus, FICA taxes will be due in the year when the employee makes the deferral. To help ease some of the administrative complexity, there is a “rule of administrative convenience.”  The rule allows FICA taxes to be withheld and remitted as late as December 31 of the same tax year, with the amount of wages subject to FICA adjusted to reflect the value on December 31 (or an earlier date if payment is made earlier) after interest or earnings on the benefit are applied. This rule can be helpful if amounts under a plan vest at numerous times during a year. There are additional rules that can be utilized to help manage this complex issue. What are the Consequences of not Complying with the Special Timing Rule? The Special Timing Rule, although a bit administratively complex, is typically advantageous to the recipient of the NQDC. If FICA taxes are paid when the NQDC vests (but is not paid out), then FICA taxes will not be owed when the NQDC is paid (to avoid double taxation). This generally means that any interest or accruals on the amounts that have already been subject to FICA taxes, will not be subject to FICA taxes at all. On the flip side, the Special Timing Rule can occasionally be disadvantageous if NQDC is never paid, as regulations do not allow employees to recover FICA taxes paid on NQDC amounts that are never received. Unfortunately, many employers forget, or are not aware of the requirement, to include NQDC in income for FICA tax purposes at the time of contribution or vesting. If FICA taxes are not paid in accordance with the Special Timing Rule, the issue may be corrected if caught in time to amend withholding returns; otherwise, FICA taxes are due when payments are actually (or constructively) received and become taxable for income tax purposes (likely resulting in more FICA taxes due overall). The correction process is complex, as it involves determining open tax years for which correction is available, amending prior returns and issuing corrected W-2s. Therefore, employers should be careful to understand their nonqualified deferred compensation plans, and how tax withholding works under those plans.

Imagine a Canadian company adopts a deferred share unit plan (DSU Plan) for its directors.  At the time the plan is adopted, the company does not have the plan reviewed by U.S. counsel, because none of their directors reside in the U.S.  It is not until several years later that the company learns that one of its directors, despite living in Canada, has dual citizenship with the U.S.  Because the typical form of Canadian DSU Plan will not comply with U.S. tax laws governing deferred compensation, particularly U.S. Internal Revenue Code Section 409A (Section 409A), the company has quite a mess on its hands.  You can read our prior articles on common payment timing issues with DSUs here and common election deferral issues with DSUs here. It is because of scenarios like the above that it is crucial to consider whether any of your employees or non-employee directors are U.S. taxpayers.  Unlike most other countries, U.S. taxpayers are taxed on worldwide income, regardless of where they reside.  U.S. taxpayers include: (i) U.S. citizens regardless of residency; (ii) legal permanent residents (“green card” holders); and (iii) non-citizen, non-green card holders who have a “substantial presence” in the United States under the U.S. income tax laws (but exceptions to this category apply – careful analysis of the facts and applicable tax treaties is required). Section 409A is so broad that it covers most nonqualified deferred compensation arrangements, unless a specific exception applies, and it imposes specific timing, election and distribution requirements on covered arrangements.  If a nonqualified deferred compensation arrangement fails to comply with the requirements of Section 409A, deferrals are includible in income at vesting (even if they are not paid out) and subject to a 20% additional tax.  In some circumstances, an underpayment interest penalty will also apply. Because of the broad definition of Section 409A, it is easy to overlook that employment agreements, change-in-control agreements, and severance agreements with U.S. taxpayers frequently contain provisions that subject them to Section 409A.  Because the failure to comply with Section 409A can result in such onerous tax penalties, if a Canadian company has U.S. taxpayers participating in its equity plans or if the company is entering into any type of compensation arrangement with a U.S. taxpayer where such arrangement promises to pay compensation in a future taxable year, the company should consider having the terms of any such plan or arrangement reviewed by U.S. counsel.

A Canadian company adopting a deferred share unit plan (DSU plan) for its directors must consider U.S. tax implications for U.S. taxpayers.  It is important to remember that U.S. citizens and U.S. residents for tax purposes (including green card holders) are taxed on worldwide income, regardless of where they reside.  As such, participation by a U.S. director, including an expat or holder of dual citizenship, could result in significant adverse tax consequences under Section 409A of the Internal Revenue Code, as a typical Canadian DSU plan often runs afoul of Section 409A.  In a prior article, DSU Plans Require Careful Review to Avoid Adverse U.S. Tax Treatment, common payment timing violations of U.S. tax laws governing deferred compensation were discussed (as well as tips for properly identifying U.S. taxpayers).  While payment timing is one common violation of Section 409A, it is also important to consider the timing of elections to defer compensation. In order to avoid a violation of U.S. deferral election timing rules, a Canadian company should consider both the general deferral election timing rules under Section 409A, as well as the exceptions permitting more lenient timing.  Generally, deferral elections must be made by the end of the taxable year before the year in which the services giving rise to the compensation that will be deferred are performed.  For instance, for any amounts earned in 2023, the election to defer should be made no later than December 31, 2022.  Once a deferral election is made, payment may not be accelerated, unless a specific exception applies, and payment may not be further deferred, unless strict second deferral election rules are obeyed. While compliance with the general deferral election timing rule is always the simplest and least risky approach, there are exceptions to this general rule that provide greater leniency in some situations.  One of the most common exceptions is for initial eligibility.  Section 409A provides that a deferral election may be made within 30 days following the date that a service provider (e.g., a director) is first eligible to participate in the plan, provided that the election may only apply to compensation earned following the date of the election (and provided the service provider does not participate in another deferred compensation plan required to be aggregated with such plan under Code Section 409A).  There are additional exceptions to the general deferral election timing rules for payments conditioned on continued service for a period of at least 12 months as well as for performance-based compensation.  However, compliance with these exceptions can be rather tricky, and the consequences for failing to comply are severe, so these exceptions should be discussed with legal counsel proficient in U.S. tax law. Where a U.S. director fails to make a timely deferral election within the meaning of Section 409A, the value of the DSUs as of December 31st of the year in which the DSUs vest (i.e. the year in which the DSUs are awarded for the majority of DSU plans) will be included in the U.S. director’s income for that year, regardless of whether actual payment of the DSUs is deferred. In addition, a 20% penalty tax will be imposed on the U.S. director. Advanced planning is crucial to ensure compliance with the above-mentioned deferral election timing rules in order to avoid the adverse tax consequences described above.  A Canadian company with U.S. directors should have any such DSU plan reviewed by counsel proficient in U.S. tax law prior to implementation.  However, even where review prior to implementation is not possible, a review after implementation would still be advantageous, as early correction may avoid or minimize certain adverse tax consequences.  We work regularly with Canadian tax counsel to ensure compliance and/or to correct violations.

We have written about this in the past [here], but the message bears repeating each year. It is easy to overlook that employment agreements, change-in-control agreements, and severance agreements with U.S. taxpayers frequently contain provisions that subject them to U.S. Internal Revenue Code Section 409A ("Section 409A"), and failure to comply can result in onerous tax penalties. However, to the extent that rights under such agreements are not yet vested, it may be possible to correct them before year-end without penalty. Even if rights under an agreement are vested, in some cases correction is available with payment of reduced penalties under IRS correction programs. It is important to remember that U.S. residents, and U.S. citizens regardless of country of residence, are taxed on worldwide income. This means that compensatory arrangements for employees and directors who are U.S. citizens working outside the U.S. will be subject to U.S. federal income tax. If compensation arrangements have not been reviewed for Section 409A compliance, we recommend doing so now, especially with respect to arrangements that will or may become vested during 2019. For a more detailed explanation, see our Dorsey publication from October 6, 2015 here.

Canadian companies relying on Rule 701 under the Securities Act of 1933 to exempt their U.S. awards of stock options and other types of compensatory equity (such as RSUs and PSUs), need to track on an ongoing basis the amount of grants being made in the United States. If they anticipate that the aggregate dollar amount of the awards, calculated under Rule 701, will exceed US$5 million in any 12-month period, they must also prepare and deliver Rule 701-mandated disclosure documents. Just this month, the SEC announced a financial settlement with a privately-held fintech company, Credit Karma, Inc., relating to Credit Karma’s failure to provide stock option holders with the financial statements, risk factors, and other disclosures required by Rule 701 when its stock option awards exceeded US$5 million over 12 months. In the settlement, Credit Karma agreed that due to these disclosure failures, there was no valid securities exemption, and the company had violated the registration requirements of the Securities Act. This, notwithstanding that only a small fraction of the stock options were actually exercised. Failure to comply with Rule 701 can also subject a company to additional consequences, including state enforcement actions, rescission offers to investors, and, in extreme cases, criminal prosecution. While a company should always obtain advice from a knowledgeable securities lawyer, some key facts to know about calculating Rule 701 limits include: In the case of options, the sale is deemed to have been made at the time of the grant of the options, and the value is determined based on the exercise price of the options; In the case of other securities, the calculation is made at the time of sale, or in the case of a deferred compensation plan when the irrevocable election to defer is made, and the value is determined based on all of the consideration received or to be received by the company for the sale of the securities; and The SEC has taken the position that disclosure requirements are triggered by a company’s expectation that it will exceed US$5 million in a 12-month period, even if it has not yet exceeded US$5 million. Rule 701 imposes further restrictions on which advice should be obtained by companies making equity awards in the United States, including limits on the types of companies that can make an award, the types of persons who can receive an award, resale restrictions, and the aggregate maximum amount that can be awarded even if Rule 701 disclosures are provided.

We are frequently asked to review Canadian companies’ stock option, restricted share unit (RSU), performance share unit (PSU), deferred share unit (DSU), and other stock-based compensation plans for U.S. securities law purposes, because awards are expected to be made to U.S. residents. For companies that are cross-listed and file reports with the Securities and Exchange Commission (SEC), the intention is typically to register the underlying securities by filing a Form S-8 with the SEC. For companies that do not file SEC reports – whether publicly traded in Canada or privately held – the intention is typically to rely on the exemption provided by Rule 701 under the Securities Act of 1933 and exemptions under the securities laws of the states in which awards will be granted. Some of the most common U.S. securities issues we see in connection with Canadian stock-based compensation plans include: 1.  Defining the class of persons eligible to receive awards in a manner broader than is permitted under Form S-8 or Rule 701, especially: Allowing grants to consultants that are entities, or that are involved in investor relations or fundraising activities; Allowing grants to consultants’ employees; and In the case of Rule 701, allowing grants to employees of subsidiaries that are not majority-owned. 2.  Failing to realize when a plan is subject to U.S. securities laws and requires registration or an exemption, or the treatment of securities as restricted securities, especially: Plans that involve open market purchases or that otherwise involve the delivery of shares that were previously free trading, such as an open market employee share purchase plan (ESPP) or a trust funded with free trading securities; and Plans in which a participant elects to forego cash in exchange for a long-term investment that itself is ultimately settled in cash, such as an executive deferred compensation plan or a director DSU plan. 3.  Unqualified covenants of the company to take all steps necessary to comply with applicable law, which could be interpreted as requiring a non-reporting company to file an SEC registration statement and become an SEC reporting company if the company has inadvertently made U.S. awards that are not exempt from registration. 4.  Failing to include provisions required by U.S. state laws, when grants will be made in states that require the inclusion of specific terms in the plan. 5.  In the practical aspects of plan implementation and the making of awards, including: Making awards that do not comply with U.S. federal or state laws because such laws were not evaluated prior to the time of grant; and Using forms of award agreement that have not been tailored for U.S. residents.

While the recently enacted U.S. tax reform legislation did not overhaul executive compensation to the extent proposed in early forms of the bill, Section 162(m) of the U.S. Internal Revenue Code was dramatically revised in a way that affects Canadian companies that file reports with the SEC and that employ, or may in the future employ, executives in the United States. Previously, Section 162(m) limited the amount of compensation that an SEC reporting company that was a “domestic issuer” for securities law purposes, or its subsidiaries, could deduct with respect to its most senior executives. Important for many of our Canadian clients, we believe that under the rule changes, U.S. tax deductions for compensation paid to key executives of any SEC reporting company, including foreign private issuers, and their subsidiaries, will now be subject to the limitations of Section 162(m). In addition, the rule changes eliminate a major exception for qualifying performance-based compensation. This article identifies the important changes to Section 162(m) and addresses the limited transition and grandfathering opportunities companies should now consider. Section 162(m), as amended, limits the amount of compensation an SEC reporting company can deduct with respect to its CEO, CFO, and the next three highest earners in the company’s controlled group to US$1 million per individual per year. As mentioned above, compensation paid to key U.S. executives of foreign private issuers likely no longer escapes the reach of Section 162(m). It appears that regulations that formerly exempted key employees from public companies that were not subject to SEC proxy statement requirements (i.e., were not obligated to file a summary compensation table) have been undermined by the revised Section 162(m). Included in Section 162(m)(3) is now a statement that covered employees, aside from the CEO and CFO, are determined without regard to whether the compensation of such employees is required to be reported to shareholders. Absent any future clarifying regulations from the U.S. Treasury to the contrary, foreign private issuers should take note that certain key employees will be considered covered employees under Section 162(m) going forward. To the extent that compensation paid to a covered employee was intended to be claimed as a compensation expense deduction on a corporation’s U.S. federal income tax return, it will be important to recognize that any such compensation in excess of US$1 million annually to a covered employee will not be deductible. A major exception that exempted qualifying performance-based compensation from the reach of this limitation has been removed effective in 2018. Therefore, whereas public companies had been able to deduct large compensatory payments above the basic US$1 million limit to key executives relating to the exercise of stock options and/or the issuance of stock awards payable because of the achievement of pre-set performance objectives, this exception will no longer be available going forward. Removal of the performance-based exception will disadvantage public companies that have intentionally structured their compensation to be predominantly performance-based in order to deduct key employee compensation to the greatest extent possible. However, the overall reduction in the U.S. corporate income tax rate from 35% to 21% in the tax legislation will more than compensate for any lost deductions in most cases. Once an executive is a “covered employee” of a company for purposes of Section 162(m), the executive now will remain a covered employee forever. As a result, compensation deductions for payments made after an executive is no longer among the company’s top earners, whether received as severance, or even paid to beneficiaries after an executive’s death, will be limited under Section 162(m). While there have been reports of some companies reacting to the loss of the performance-based compensation exception under Section 162(m) by shifting executive compensation formerly payable as performance-based to base salary, the impact on employers generally remains to be seen. We encourage companies to discuss with U.S. tax counsel how the revisions to Section 162(m) may impact the ability to deduct compensation paid to key officers who are covered employees. In particular, a transition rule under the new Section 162(m) rules exempts remuneration paid pursuant to written binding contracts in effect as of November 2, 2017, from the new rules, so long as such contracts have not been materially modified or extended. The transition rule may impact whether and to what extent a company decides to modify arrangements such as employment agreements, deferred compensation plans, and bonus plans. Understanding how the transition rules impacts a company’s existing arrangements will allow for planning opportunities to maximize compensation deductions and the tracking of disallowed compensation deductions going forward.

A Canadian company (the employer) historically has not issued equity-based awards to employees of its U.S. subsidiaries, but it now is considering doing so. Past posts have addressed potential U.S. income tax pitfalls and the need for careful review of the plan and award agreements prior to the grant of restricted stock units (RSUs) and deferred share units (DSUs) to individuals who are subject to U.S. federal income tax on compensatory income. You can read the DSU blog entry here and the RSU blog entry here. Let’s assume careful review and drafting have addressed potential U.S. tax issues in terms of the written documents. What are common mistakes that can arise in administering the U.S. awards? A common error with respect to RSUs awarded to U.S. employees is to overlook the correct timing of U.S. employment tax obligations (as distinguished from federal income tax withholding obligations). Confusion can arise when, for U.S. tax purposes, the substantial risk of forfeiture lapses earlier than the year in which the RSUs will be settled/paid out. For purposes of this discussion, when we use the term “vesting” it means the lapse of a substantial risk of forfeiture. Below are examples of how confusion can arise. Many RSUs provide for immediate settlement upon satisfaction of service-based vesting conditions. In such a case (and absent any “retirement vesting” provision as discussed below) federal income tax and FICA are due essentially at the same time, i.e. when the RSUs vest and are paid out. Some RSUs by their terms delay the income tax event by deferring the payment until an event or date that will occur later than vesting. However, in contrast to income tax withholding, which occurs when shares or cash in settlement of RSUs are actually or constructively received, the FICA tax event cannot be delayed. FICA tax is due for RSUs upon vesting, even if payment/settlement is delayed. One common oversight is failing to take into consideration the impact that “retirement vesting” in an RSU award will have on FICA tax timing. In the absence of retirement vesting provisions, an RSU that has a service-based vesting period frequently will be settled (shares delivered or cash settlement) immediately upon vesting. In such a case, both federal income and FICA withholding will apply at the time of vesting/settlement. In contrast, if an RSU award provides that it will not be forfeited if the individual retires prior to the scheduled vesting date, the RSU will be vested when the participant becomes eligible to retire (because there will be a lapse of the service-based substantial risk of forfeiture), notwithstanding that settlement of the RSU may not occur until the original settlement date. Even if the RSU will be settled on the earlier of the scheduled vesting date and the date of retirement, this will not solve the problem. This is because the risk of forfeiture lapses when the participant is eligible to retire, whether or not he or she in fact retires at that time. Thus FICA taxes will be due at grant if the individual already has met the criteria for retirement, or at the time during the vesting period that an individual first meets the criteria for retirement. This obligation to withhold and pay employment taxes before the RSUs are settled/paid out may be an unpleasant surprise for the employer and the participant. There are some alternative timing rules for FICA withholding that can provide some (but not complete) relief. We’ll discuss them in a future post. As a reminder, U.S. taxpayers are taxed on worldwide income, regardless of where they reside. U.S. taxpayers are: (i) U.S. citizens regardless of residency; (ii) non-resident aliens (“green card” holders); and (iii) non-citizens, non-green card holders who have a “substantial presence” in the United States under the U.S. income tax laws (but exceptions to this category apply – careful analysis of the facts and applicable tax treaties required).

Canadian companies and their outside counsel occasionally ask about the ability to grant early exercise incentive stock options (“ISOs”) to limit the impact of the U.S. alternative minimum tax (“AMT”) to their U.S. employees. However, due to fairly counterintuitive U.S. federal tax regulations, structuring options in this manner may expose optionees to negative tax consequences in the event of a disqualifying disposition (defined below). This post reviews the tax effects of early exercise ISOs and compares the tax results to alternative structures. Early Exercise ISO Tax Consequences With any early exercise option, the optionee is permitted to initially exercise their entire stock option by paying the full option exercise price, but will receive back restricted stock with the same vesting schedule as the original option. Employees will usually file a Section 83(b) election as permitted within 30 days following the transfer of the restricted stock. In 2004, final ISO regulations clarified that Section 83(b) elections filed on restricted shares acquired via early exercise ISOs are only effective for AMT purposes and not for ordinary compensation tax purposes. In the best case where both ISO holding periods are met (the shares acquired via ISO are held at least two years from the date of grant and at least one year from the date of exercise, prior to sale), the entire spread between the sale price and the exercise price paid will be taxed as long-term capital gain. However, if either holding period is not met, a “disqualifying disposition” occurs. Assuming that an 83(b) election was timely filed within 30 days following exercise, then upon a disqualifying disposition, the difference between the fair market value of the shares on the date the underlying restricted stock vests less the exercise price paid for the shares is compensation income that will be reported on the employee’s Form W-2 in the year of sale (or if less, the amount realized in the sale less the exercise price).[1] In addition, the capital gains holding period will only begin on the date the underlying restricted stock vests.[2] To the extent the stock price increased or decreased from the date of restricted stock vesting, such change will be short-term or long-term capital gain or loss, as applicable. This tax result means that early exercise ISOs become risky to an optionee in the event of a disqualifying disposition. While reducing AMT income is a positive result, a disqualifying disposition results in a potentially large amount of compensation income and/or short-term capital gain. The optionee often has little control over whether a disqualifying disposition will occur, such as if all shares are sold in connection with an acquisition of the issuer or if the optionee’s shares are repurchased following termination from employment. Early Exercise NSO Tax Consequences As compared to an ISO, the exercise of a non-qualified stock option (“NSO”) is not a preference item for AMT purposes. If an optionee early exercises a NSO, an 83(b) election will be respected for compensation purposes and the optionee will only recognize compensation income equal to the fair market value of the shares on the date of exercise less the option’s exercise price. This income will be subject to applicable withholding for federal and state payroll taxes, including FICA. However, if the option is early exercised shortly following the option grant date, as is often the case, there is typically minimal (or zero) spread to recognize as compensation up front. The 83(b) election also starts the capital gains holding period. Thereafter, the vesting of the underlying restricted stock received upon the early exercise will not result in any further compensation income to the optionee. Upon disposition of the stock, capital gain or loss will be recognized in the year of sale, which will be long-term if the stock is held at least one year from the date of early exercise. Therefore, in contrast to early exercise ISOs, early exercise NSOs can reduce the exposure to gain being characterized as short-term capital gain to the one year after the early exercise, provided the 83(b) election is timely filed. In addition, by exercising and filing an 83(b) election shortly following grant, recognition of compensation income may be limited or eliminated. Early exercise ISOs have an overhang for up to two years following the date of grant where a disqualifying disposition could result in both compensation income and short-term capital gain recognition. For these reasons, as illustrated in the examples below, we find early exercise NSOs to be preferable to early exercise ISOs in most cases. This is especially true with respect to companies where (i) there is a possibility of acquisition within two years following the date of grant, (ii) the optionees have sufficient capital to early exercise the awards, and (iii) the optionees see a meaningful upside for the company at the time of early exercise (or the amount needed to early exercise is relatively small). Example 1 A startup company grants early exercise ISOs for 1000 shares to an employee at $0.05 per share on June 1, 2017, subject to a vesting schedule where 50% vests on June 1, 2018, and the remaining 50% vests on June 1, 2019.  Participant early exercises on June 5, 2017 while shares are still worth $0.05 per share and files an 83(b) election recognizing $0 in income, which is effective only for AMT purposes. Upon exercise, the participant receives restricted shares with the same two-year vesting schedule. When 50% of the shares vest on June 1, 2018, the fair market value has risen to $5 per share. On March 1, 2019, the company is sold via a stock purchase agreement for $10 per share. All unvested equity awards are accelerated and the shares held by the participant are sold in the deal, resulting in a disqualifying disposition, as both ISO holding periods were not met. Participant recognizes compensation income equal to the spread between FMV on the date the restricted stock vested less the exercise price paid: For the 500 shares that vested on June 1, 2018, 500 x $(5.00 - .05) = $2,475. For the 500 shares that vested in connection with the March 1, 2019, transaction, 500 x $(10.00 - .05) = $4,975. Total compensation income recognized due to disqualifying disposition is $2,475 + $4,975, or $7,450. The capital gains holding period begins on the date of restricted stock vesting. Because both tranches of restricted stock vested less than a year prior to the March 1, 2019, transaction, the $10,000 received in the stock sale less (i) $7,450 previously recognized as compensation income and (ii) $50 in total exercise price paid, or $2,500, is short-term capital gain. Example 2 Assume the same facts as Example 1, but with an early exercise NSO instead: The 83(b) election on June 5, 2017, results in $0 in compensation recognition and also begins the capital gains holding period. No compensation income is recognized with the vesting of the underlying restricted shares, as there is no disqualifying disposition concept applicable, and the 83(b) election was effective for compensation tax purposes. Upon the sale of the company on March 1, 2019, the entire $10,000 received minus the $50 amount paid in exercise price, or $9,950, will be recognized as long-term capital gain. Example 3 Assume the same facts as Example 1, but with a regular ISO grant (without the early exercise feature) that is exercised immediately prior to the March 1, 2019, transaction: No compensation income recognized at the time of exercise under the ISO rules. The March 1, 2019, sale of the shares will be a disqualifying distribution, characterizing the full $10,000 received minus the $50 amount paid in exercise price, or $9,950, as compensation income.   [1] U.S. Treas. Reg. Sec. 1.422-1(b), Ex. 2. [2] Id.

A Canadian company that proposes to grant stock options or other types of equity compensation to persons in the United States must comply with the securities laws of the state in which the recipient is located, unless the type of equity being issued (e.g., the underlying common shares, in the case of options to purchase common shares) is listed on a “national securities exchange” such as the NYSE, Nasdaq, and NYSE MKT. This means that private companies, Canadian public companies that are not listed in the United States, and Canadian companies that are listed in the United States only in over-the-counter markets such as the OTCQX, OTCQB, or Pink Sheets, are required to comply with state securities laws. Canadian companies should not assume that because they have taken the requisite steps under U.S. federal laws, such as registering the underlying securities by filing a Form S-8 with the SEC or complying with an exemption from registration under SEC Rule 701, that no further actions are required. While some states’ laws do not require additional actions to be taken, many states impose requirements that differ from federal laws. For example, Some states require that an application for exemption be filed and accepted by the state, or another type of notice be filed, and a fee be paid, prior to making the first equity award in that state. Some states’ exemptions from registration requirements restrict the types of awards that can be made, the types of persons that can receive awards, and the types of companies that can rely on the exemption. For example, some states’ exemptions are unavailable for awards to consultants and non-employee directors, are subject to bad boy disqualifications, are available only for certain types of equity plans, or are unavailable for awards made on an SEC-registered basis. Some states have no specific exemption for equity-based compensation, and a company seeking to make equity-based awards in those states must either register the plan or comply with another type of exemption, such as an exemption that might be available for a private placement to a limited number of persons satisfying certain investment criteria. The State of California imposes substantive requirements on the plan itself, including terms related to the number of securities to be issued, minimum vesting criteria, minimum post-termination exercise periods, information delivery requirements, and shareholder approval requirements, in addition to the requirement to file a notice and pay a fee.

Recently we blogged about pitfalls and potential adverse tax consequences for U.S. taxpayers with respect to deferred share unit awards that pay out following the participant’s termination of services. Read that blog entry here. But what about restricted share units (RSUs) that are subject to vesting based on continued service and that are settled/paid out immediately after the scheduled vesting date(s)? If you only have a handful of employees in the U.S. who would receive RSUs under your existing RSU Plan, you may wonder whether review by U.S. tax counsel really is necessary. Common sense would suggest that there is no way such RSUs could run afoul of the U.S. tax rules related to deferred compensation (otherwise known as “Section 409A” of the U.S. Internal Revenue Code) because the intent is to pay out as soon as the RSUs vest and hence there is no “deferral” of compensation. Forget common sense. Given the significant adverse tax consequences (20% penalty tax) for the recipient if the RSU is neither exempt from, nor compliant with, Section 409A, the answer is yes, have the terms of the RSU Plan and RSU agreement reviewed by U.S. tax counsel before granting RSUs to U.S. taxpayers. A common problem with respect to RSUs awarded to U.S. taxpayers has to do with the “retirement” provisions in the RSU award. A company may believe that the RSUs will not be deferred compensation that is subject to Section 409A because the RSUs are subject to vesting based on continued service through stated “vesting” dates and they are paid out shortly after the scheduled vesting dates. The company believes the RSUs are exempt under the “short term deferral” exemption, and thus there is no risk of Section 409A penalties for noncompliance. However, many RSU awards have “retirement” provisions which state that upon a participant’s Retirement (as defined in the RSU Plan or RSU agreement), the RSUs will “continue to vest” as though the participant had continued employment or services with the company through the scheduled vesting dates. For U.S. tax purposes the substantial risk of forfeiture lapses once an individual becomes eligible to retire, even if the individual does not in fact retire. Thus, such an RSU awarded to an individual who is retirement eligible, or who will become retirement eligible during the vesting period, will not be subject to a substantial risk of forfeiture as soon as the individual is retirement eligible because the settlement/payout which will occur immediately following the scheduled vesting dates will be outside of the short term deferral period (i.e., the RSUs won’t be settled/paid out in all cases by March 15 of the year following the year in which the RSUs no longer are subject to a substantial risk of forfeiture). Since such RSUs will not be exempt from Section 409A, they must instead meet all of the 409A rules for documentary and operational compliance; hence the need to review the documents before grant in order to structure them to comply with Section 409A. Fortunately, through careful drafting and plan administration, RSU awards can be designed and administered to avoid these and other potential problems. We work regularly with Canadian tax counsel to ensure compliance. Tip: In thinking about whether any recipients of RSUs are U.S. taxpayers, remember that U.S. taxpayers are taxed on worldwide income, regardless of where they reside. U.S. taxpayers are: (i) U.S. citizens regardless of residency; (ii) non-resident aliens (“green card” holders); and (iii) non-citizens, non-green card holders who have a “substantial presence” in the U.S. under the U.S. income tax laws (but exceptions to this category apply – careful analysis of the facts and applicable tax treaties required).

A Canadian company is planning to adopt a deferred share unit plan (DSU plan) for its directors. Only one or two of its directors are U.S. citizens or U.S. residents (“U.S. Directors”). With only one or two U.S. Directors, you wonder whether it is important to consider U.S. tax implications. The answer is a resounding yes because the typical form of Canadian DSU plan will not comply with U.S. tax laws governing deferred compensation. Participation by a U.S. Director will result in significant adverse tax consequences for the U.S. Director under Section 409A of the Internal Revenue Code. Specifically, for U.S. federal income tax purposes, the value of the DSUs as of December 31st of the year in which the DSUs vest (i.e. the year in which the DSUs are awarded for the majority of DSU plans) will be included in the U.S. Director’s income for that year, regardless of whether actual payment/settlement of the DSUs is deferred until later termination of board service. In addition, a 20% penalty tax will be imposed. A typical Canadian DSU Plan runs afoul of Section 409A in two ways. First, such plans frequently allow the director to “redeem” the units following termination of services by electing a redemption date either during the year of termination or during the following calendar year. This violates section 409A because it allows the director to choose, at or after termination of service, which tax year the payment/settlement will occur. Since Section 409A requires both documentary and operational compliance, the mere inclusion of the problematic language in the document constitutes a 409A violation and triggers adverse tax consequences for the U.S. Director. In other words, you can’t simply postpone the U.S. tax review until later, figuring that you will fix it before the U.S. Director terminates board service. The second common Section 409A problem arises because most Canadian DSU plans are designed to comply with the requirements of Income Tax Regulation 6801(d), which provides a specific prescribed exception to the salary deferral arrangement rules for Canadian income tax purposes. However, the payment timing requirements under Section 409A upon the U.S. Director’s “Separation from Service” are in some circumstances inconsistent with the requirements of Income Tax Regulation 6801(d). Fortunately, through careful drafting and plan administration, a DSU plan can be designed and administered to avoid these problems. We work regularly with Canadian tax counsel to ensure compliance. Tip: In thinking about whether any of a company’s directors are U.S. taxpayers, remember that U.S. taxpayers are taxed on worldwide income, regardless of where they reside. U.S. taxpayers are: (i) U.S. citizens regardless of residency; (ii) non-resident aliens (“green card” holders); and (iii) non-citizens, non-green card holders who have a “substantial presence” in the United States under the U.S. income tax laws (but exceptions to this category apply – careful analysis of the facts and applicable tax treaties required).