Silicon Valley North #7 May'99

The Way I See Itů by Michael Volker

Optional way to pay tax man

The way I see it, employee stock option plans in Canada may not be the incentive that many people think they are. In fact, in Canada, stock options can easily embitter employees and backfire in their use as a carrot to lure and motivate good talent - thanks to Revenue Canada.

In Canada, unlike the USA, employees of public companies are taxed on their stock options in the year in which they exercise these options - even if they have not sold the shares acquired under an option plan.

I'm surprised that the high tech community has not been more outspoken about  this problem. It may explain why stock options are not used by Canadian firms to the same extent they are by American companies.

Here's why. If you work for a Canadian public company and you have an employee stock option to acquire shares, say 50,000 at $2.00 (the price when you joined the firm) over a 2-year period, you have to pay income taxes on the "deemed" profit, as calculated on the exercise date, regardless of whether or not you actually made a real profit, i.e. even if you decide to hang on to these shares as an investment in, and commitment to, your company.

If the shares are trading at $4.00 when you exercise your option, your company will file a T4 slip for you showing that you have made $100,000 of employment income (i.e. $2 profit per share X 50,000). Although you are allowed a 25% deduction on this $100,000 (Revenue Canada does this to make us believe that this profit is being taxed like a capital gain), you now have $75,000 of additional high marginal-rate income.

This might be acceptable if you actually made such a profit by selling all your shares right away at the $4.00 trading price. But, let's say you didn't. Then, when faced with this tax burden the following April, you may find yourself having to sell some shares just to pay the tax. If the shares have fallen back to $2.00, as is easily the case with emerging tech stocks, you are out-of-pocket not only the $100,000 you paid to acquire the shares but also the $39,000 tax bill (if you live in B.C.). Furthermore, the loss on the sale of these shares (your cost base in this example is the $4.00 acquisition price) can only be used to offset other capital gains.

Because of the potential negative impact brought about by acquiring and holding shares, employees are effectively forced into selling the shares immediately - i.e. on the exercise date - to avoid any adverse consequences. But, can you imagine the impact on the company's share price when five or six optionees "dump" hundreds of thousands of shares into the market? This does nothing to encourage employees to hold company shares.

In an ideal world, likely the one envisaged by Revenue Canada, shares can only increase steadily in value over time in which case the only negative impact on employees is that they pay some of their ultimate gains sooner than later.

But we all know that in tech markets, senior or junior, it is not uncommon for shares to trade over a 3:1 range in a 52-week period and show great price volatility. All it takes is a negative quarterly earnings report to knock more than half the value out of a stock. And that'll just be the time when you need to sell some of your holdings to pay your additional paper taxes.

This is yet another example of Revenue Canada's ridiculous and punitive tax measures which, even considering the best possible scenario, completely destroys the value of the highly touted employee stock option!



Michael Volker is a high technology entrepreneur and director of Simon Fraser U's University/Industry Liaison Office. He is a former executive director of the BC Advanced Systems Institute and is chair of the Vancouver Enterprise Forum. He may be reached at mike@risktaker.com.

Copyright, 1999.