Watch Out for Restricted Stock Award Plans in Canada!

by Jim Yager and Tom Nicolopoulos, KPMG LLP, Toronto
(KPMG LLP in Canada is a KPMG International member firm)

Employers considering Restricted Stock Award (RSA) arrangements for employees should keep in mind that the Canadian tax consequences of these plans may make other options more attractive for Canadian employees.

The benefits of such awards can include enhancing the company's ability to recruit and retain talented employees. RSAs also can provide flexibility to the employer, since RSAs may be granted to specific individuals in different amounts and subject to different terms and conditions, enabling the company to better align its compensation plans to corporate objectives. However, RSAs have one significant disadvantage in Canada: they are taxed to the employee at grant even though the grant provides no cash to the employee to pay the tax.

In many countries, such as the United States, RSA plans are generally taxed when they vest, which can be many years after they are granted. For an individual subject to tax in Canada and another country, double taxation may result since the tax in Canada at grant may not be creditable in the other jurisdiction when the plan vests. Moreover, if the international assignee is covered by a tax equalization program, under which the employer bears the cost of higher foreign taxes, this additional tax cost may exponentially increase the employer's assignment-related costs.

This article provides a basic discussion of RSAs and Restricted Stock Unit (RSU) plans and primarily examines the implications for Canadian taxpayers of participating in RSA and RSU plans. It also compares, briefly, the situation for RSA participants in the United States versus Canada.

Canadian Tax Treatment May Make RSAs Less Popular than Elsewhere

Although RSAs have the disadvantage of being taxed at grant in Canada, the subsequent capital gain realized on the sale of the shares is subject to beneficial Canadian capital gains tax rates, under which capital gains are effectively taxed at half the rate of compensation income. If the share value substantially increases, the employee can ultimately pay less Canadian tax than if the RSA were taxed at normal tax rates at vest.

Due to this tax treatment in Canada, RSAs are less popular in Canada and tend to be more popular in the many other countries where they are typically taxed at ordinary income tax rates at vest, when the shares are no longer subject to a substantial risk of forfeiture and the employee can sell some or all of the shares to pay the tax liability.

In the U.S., the employee has the best of both worlds since the employee has the opportunity to elect tax treatment similar to the Canadian rules if the share price is expected to increase substantially. If the employee makes this election (known as the "83(b) election"), the employee will be taxed at ordinary income tax rates on the value of the shares at grant. No additional tax consequences arise when the shares vest and the employee receives capital gains treatment on the sale of the shares. In Canada, there are no such elections available that would alter the timing of the taxation of RSAs.

Restricted Stock Award and Unit Plans

Under a RSA plan, an employee receives an award of stock subject to either a vesting requirement or a restriction on disposing of the shares. The employee is considered an owner of the shares with an entitlement to receive dividends and exercise voting rights. If the vesting requirement is not met, the employee normally forfeits the shares to the company. The vesting of the shares may be based on performance goals or continued service over a specified period of time (e.g., three years). Generally, the employee will be awarded the stock at no cost.

RSU plans can be designed to provide similar economic benefits to the employee as RSA plans, though with different tax consequences. Under a unit plan, an employee will obtain an entitlement or opportunity to receive stock or cash at some specified future date if certain conditions are met, such as achieving a certain level of performance or simply continued employment. However, the employee does not actually receive shares of stock or cash when the RSU is granted. Unit plans are commonly referred to as "phantom share" plans since the units represent shares the employee does not actually own during the term of the plan.

Some plans may also confer rights to receive amounts equal to dividends on the stock over the period from grant to vest. These "phantom" dividends may either be paid at vest or paid over the vesting period.

Canadian Individual Income Tax Implications of RSA Plans

Canadian income tax law provides that an employee must include in income the value of benefits of any kind received or enjoyed in the year in respect of, in the course of, or by virtue of an office or employment. Thus, when an employer grants a RSA to an employee that has either a vesting period or a period when the shares cannot be transferred, the employee still recognizes compensation income equal to the value of the shares in the year of the grant.

According to the Canada Revenue Agency, the value of the taxable benefit from a RSA is the fair market value of identical shares at the time of acquisition that have no trading restriction, less an appropriate discount for the restriction. These provisions apply if the employee has beneficial ownership of the shares (based on factors such as voting and dividend rights and right to return of capital). The calculation of the discount is subject to valuation, which may take into account factors such as the volatility of the stock price and dividend payouts.

If the employee forfeits the stock before it vests, the employee can claim a capital loss for his or her tax base (the amount previously included in income plus any amount paid for the shares). Generally, no deduction against other compensation income is permitted. However, a deduction is allowed to the employee upon forfeiture, if an employer issued the restricted shares upon grant to a trust rather than directly to the employee.

After the shares vest, the eventual sale of the shares will produce a capital gain or loss. The tax base for calculating the capital gain or loss is the amount included in income at grant plus any amount paid for the shares. Consequently, the discount that was used to reduce the employment benefit is converted to a capital gain if the shares are ultimately sold at a gain. Dividends paid on restricted shares during the restriction period are taxed to the employee as dividend income.

When share prices are rising, RSAs generally provide a greater after tax benefit to employees than RSUs since a greater portion of the benefit is taxed at beneficial capital gains rates.

Conclusion

When designing and implementing a global equity compensation award, the employer should consider the tax implications to the employee in each jurisdiction. Frequently, an international company desires consistency in the tax treatment of compensation globally. While many jurisdictions defer the taxation of employees who receive RSAs until the shares vest, Canada taxes the employees when the awards are granted. Therefore, an employer may prefer to choose a RSU plan for its Canadian employees to keep their tax treatment comparable with their co-workers in other countries and avoid the adverse consequences of taxation at grant.

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.