One principal tax objective in structuring equity‑based incentive compensation is to ensure that incentive amounts provided to employees are taxable to those employees no earlier than when shares or cash amounts are received. Canada’s Income Tax Act (ITA) generally imposes limitations on how long cash-based remuneration or equity-based remuneration, where the issuer retains discretion to elect a cash settlement, can be deferred, primarily through its salary deferral arrangement (SDA) rules, although, as will be discussed, there are many statutory and some administrative exceptions.
In addition to ensuring alignment between the time of settlement and the time of the employee’s tax inclusion (and the employer’s withholding obligation, if applicable), employers will generally also want to ensure preferential tax treatment to employees, where available. In this regard, certain types of equity-based incentive compensation can be preferable from the employee’s perspective over others. As discussed in Section III: Typical Forms of Equity Compensation Awards, there are several different forms of incentive compensation with distinct structuring considerations that affect income inclusion and potential tax deductions for employees and employers.
1. The Taxation of Canadian Employment Income
1.1 Taxed on Receipt
Under the ITA, employees are generally taxed upon receipt of employment income. Receipt in this context generally means “actual receipt,” except in circumstances where the doctrine of constructive receipt or the SDA rules apply (the latter are discussed in Section 2: Salary Deferral Arrangements). Usually, remuneration from employment takes the form of a cash salary, wages or cash bonuses. However, the fair market value (FMV) of any property or benefit received by an employee in respect of, in the course of or by virtue of employment will be taxable upon receipt unless a statutory exception applies. For example, employer-paid premiums for certain types of group health and welfare plans are statutorily exempted.
1.2 Constructive Receipt
The Canada Revenue Agency (CRA) has long taken the position that an employee (or former employee) “receives” a payment or other employment benefit on the earlier of the date the payment is made and the date the employee (or former employee) is considered to have “constructively received” it. The CRA has previously stated that employment income is therefore taxable in the earliest taxation year in which one of the following occurs:
- The employee receives the amount
- The amount is paid or transferred to another person for the benefit of the employee or such other person, at either the employee’s direction or with the employee’s agreement
- The amount is credited to an employee’s debt or account, set apart for the employee or otherwise available to the employee without being subject to any restriction concerning its use (“constructive receipt”)
The CRA has issued favourable advance tax rulings for arrangements under which employees are given the opportunity to elect to receive what might otherwise have been bonus or cash incentive payments in the form of phantom or deferred share units, provided the election is made on an irrevocable basis prior to the calendar year in which the employee starts earning the award — often the year of grant. Nevertheless, avoiding triggering a taxable income inclusion based on “constructive receipt” remains an important part of Canadian incentive design.
2. Salary Deferral Arrangements
One of the central tax considerations for an employer designing or Canadianizing an incentive compensation program involving awards that span multiple calendar years is avoiding the application of the ITA’s SDA rules. In short, when an arrangement is found to be an SDA, the “deferred amount” (see Section 2.1: What Is an SDA and What Are Its Tax Consequences? for further discussion), which is effectively the value of the applicable award at the relevant time, determined without regard for vesting conditions or other contractual restrictions, would be taxable to the employee in a year prior to the actual amounts becoming paid, and potentially as early as the end of the first year the particular incentive was granted. Any year-over-year increase in the value of an award which is found to be an SDA would become taxable in each subsequent year that the award remains outstanding. Where the SDA rules trigger a tax inclusion in a year earlier than the year of receipt, the employer would also generally have income tax and related social security withholding and remittance obligations at this earlier time. Both results are clearly far from ideal, as employee taxation and employer withholding would arise prior to any amounts being paid. Where an arrangement is found to be an SDA retroactively to an earlier year, and the relevant taxes were not appropriately withheld and remitted in such prior year, the employee and employer tax obligations will be overdue from such prior year, and penalties and interest may arise in respect of tax not paid or remitted from the original SDA inclusion date. Generally, the potential penalty for an employer who has failed to withhold is equal to 10% of the amount that should have been withheld in the first instance, and 20% for any repeat instance in the same calendar year or in circumstances of gross negligence. In extreme cases, failure to withhold could also result in personal liability for directors and even jail.
2.1 What Is an SDA and What Are Its Tax Consequences?
An SDA is a plan or arrangement (funded or unfunded), under which any person has a right in a current taxation year to receive an amount after that year (referred to in the ITA as a “deferred amount”) and:
- it is reasonable to consider that one of the main purposes for the creation or existence of the right to the deferred amount is to defer tax payable by the taxpayer on an amount that is, or is on account of or in lieu of, salary or wages for services rendered by the taxpayer in the given year or a preceding taxation year
- if the right to the deferred amount is subject to conditions, there is not a substantial risk that any one of those conditions will not be satisfied
- no prescribed exception applies
The deferred amount determined as at the end of a taxation year is the amount on which the employee’s tax inclusion (and the employer’s withholding obligation) for that year is based. The assessment of whether an award is an SDA is, to a large degree, a question of fact. Therefore, to avoid potential SDA risk, Canadian employers often seek to rely on a prescribed exception, if and to the extent available.
2.2 Exceptions to the SDA Rules
The SDA rules specifically exclude certain arrangements. These include:
- registered pension plans (traditionally understood, formally registered defined benefit or defined contribution pension plans)
- deferred profit sharing plans (a type of group savings plan to which only employers may contribute and which, despite the reference to “profit sharing,” is used primarily for retirement savings)
- employees profit sharing plans
- certain plans or arrangements established for the purpose of deferring the salary or wages of professional athletes
- an arrangement established primarily for non‑resident employees in respect of services rendered outside of Canada
- certain prescribed plans, which include share- or cash-settled deferred share units, payment of which is deferred until termination of employment (or termination of directorship or office) (for more information, see Section 3: Deferred Share Units)
- a bonus that is paid no later than three years following the year in which the employee first provided the services for which the bonus is remuneration (3-Year Bonus Exception)
The 3-Year Bonus Exception is one of the most relied on exceptions to the SDA rules for structuring deferred compensation for Canadian employees. It is particularly relevant to restricted share units, performance share units and similar phantom units if these are either exclusively cash settled or the issuer retains discretion to settle these in shares or the cash equivalent. These units are discussed in Section 2: Restricted Share Units and Performance Share Units.
In addition, an agreement to sell or issue securities pursuant to section 7 of the ITA, which notably would include a stock option (for more information, see Section 1: Stock Options), will not be taxable under the SDA rules by virtue of a special rule in paragraph 7(3)(a) of the ITA.
3. Employer Withholding Obligations on Equity-Based Compensation
An employer is required to deduct, remit and report source deductions on remuneration paid to employees.
Remuneration paid in cash or near-cash, including cash amounts paid to settle equity-based incentives, will generally be subject to income tax withholding, as well as employee Canada Pension Plan (national pension scheme) contributions and employee Employment Insurance (national, public unemployment insurance) premiums. Employers are required to make corresponding Canada Pension Plan contributions and Employment Insurance premium contributions, although these employer amounts are paid separately and are not withheld from employee remuneration. For employees employed in Quebec, a similar provincial pension scheme, the Quebec Pension Plan, is in place in lieu of the Canada Pension Plan. Quebec employees and their employers are required instead to contribute to this provincial scheme in respect of Quebec-based employment. As noted in Section 2: Salary Deferral Arrangements, an employer who fails to make the appropriate withholding deductions can be liable for penalties, interest and even director personal liability and jail.
The withholding obligation on share (or other non-cash-settled) incentives can create challenges, particularly where an employee’s parallel cash remuneration (such as salary and wages) is insufficient to fund the withholding obligation. In these circumstances, an employer and employee will need to plan ahead. Aside from the employee contributing their own additional funds to satisfy the withholding, other strategies exist, as discussed in this guide.