Budget 2010 – Op Ed

In his speech accompanying the country’s 2010 budget, Canadian Finance Minister Jim Flaherty said: “We are building Canada’s reputation as an investment-friendly country.” And to well-deserved accolades, Budget 2010 did indeed remove the arcane “Section 116” taxes that have been a perennial thorn in the side of Canadian entrepreneurs trying to entice venture capitalists and other investors from outside Canada to invest in their businesses.

But the extension of rules around withholding taxes on the exercise of stock options is drawing significant attention to the inherent flaws in these rules in the first place, and to the administrative complexities forced upon employers to try to comply with these rules, undermining many of the benefits of resolving the 116 issues.

Ironically, Budget 2010 provided relief to employees who in the past got very badly hurt by inherently flawed stock option taxation principles. But instead of addressing and curing the underlying inequities that drove the need for this retroactive relief, Budget 2010 institutionalizes the unfairness with upfront withholdings to ensure that the deemed taxes on unrealized income are fully paid, with the employer being held responsible, regardless of what happens to the employer’s share price in future. Budget 2010 is silent on how an employer is supposed to come up with these non-existent funds to withhold, or on how or why an employee – that may be subject to lock-ups or blackouts – is supposed to sell enough shares to cover the tax on these mythical profits.

The fundamental problem is that employees are deemed to have windfall – and taxable – profits when they exercise stock options. But the act of exercising options is not a disposition; it is simply an increase in investment, in order to maintain their existing ownership stake in the business. Compounding the problem, these deemed profits on unrealized income are taxed as “employment income”, while any subsequent losses – on actual realizations – are treated as capital losses in the event of a decline in their employer’s share price, so that employees can and often are effectively taxed at rates of 100% or even infinite rates on “profits” on sales of shares that they never see.

Fundamentally, the tax treatment of stock option “gains” needs to be symmetrical with the treatment of any subsequent share price losses, and taxes need to be levied only on realized net gains. This is not seeking special treatment; rather, this is no different than every other asset class from art to real estate to stock purchase warrants or other securities – or even founding shareholders of the company, or partners in professional firms – none of whom are taxed on the unrealized appreciation in the value of their ownership positions. Nowhere else in the tax system do people get taxed differently on gains and losses with no ability to offset losses against gains – let alone taxed on unrealized income in the first place. Why do “employees” deserve to be singled out for this draconian and patently unfair treatment?

Stock options – and the associated employee ownership – are an absolutely fundamental, powerful economic tool for driving innovation and prosperity in this country. Start-up technology company employees work extraordinarily long hours – for the thrill of creating something special and “game-changing” – but also to share in the economic rewards.

But for option programs to achieve their motivational benefits and potential, they must be fair, they must be simple for all employees to understand (even if you don’t have a degree in accounting), they must not arbitrarily force employees to reduce their ownership in the business simply to pay taxes on unrealized income, and they must be reasonably easy for the employer to administer.

Here’s the employee’s perspective, as per Budget 2010: Jane, with an option to purchase 50,000 shares at $2.00 that was granted 5 years ago and is now about to expire, has to go to the bank, family or wherever they can to scrape together $100,000. After exercise, she owns 50,000 shares with precisely the same economic value of the options the day before, plus the $100,000 that she has now invested. Where is the realized “income” or “gain” in that? Yet, under the option tax rules, if the share value at the time of exercise is (say) $12, she ALSO immediately owes CRA about $110,000 (with her employer also liable). So the cost of exercising her options – just to maintain her existing ownership stake in the business – has more than doubled! And that is supposed to be motivational?

It is even worse in many respects for private companies, because in the example above, if her employer were to subsequently fail, she would not only lose the $100,000 she invested on exercising the options, but she would be permanently on the hook for $110,000 in “taxes” to CRA – without ever having had the opportunity to sell a single share.

Symmetry of treatment up and down, and taxation only on realized net gains – like everything else that moves and gets taxed in this country – solves everything. It’s really quite simple. And it’s the only thing that’s even close to fair. And most of all, it is critical to fostering equity capital formation in Canada’s struggling technology sector. As significant side benefits, fair tax policy on options would, like RRSPs, even create a nice legacy of future tax revenues for the country as employee shares continue to grow in value and someday get sold, and simple taxation of net realized gains on sale of shares would result in a huge reduction in Income Tax Act complexity on all bases – CCPC, public, etc – and for CRA, employers and employees.

In the absence of this direct approach to taxing net realized gains, investors will see these tax policies and recognize that rather than options being the powerful motivational tool that they were intended to be, Canadian tax policy turns them into the Sword of Damocles over employees’ heads – most of whom are ill-equipped to understand the nuances of tax jargon and contingent liabilities. All the employees want to do is own – and retain – a stake in their business, just the way the founders and investors get to do – until it is time to sell. Everyone is happy to pay their fair share of taxes – when they sell. But investors with a choice of investing in a properly motivated workforce South of the border, or a demoralized – and even terrorized – one North of the border, will choose accordingly.

Budget 2010 goes the other way, and enhances its pre-existing flawed option tax policies with a withholding tax sledgehammer.