Repealing the Employee Stock Option Deduction and Unanswered Questions

As you all know, the federal NDP announced on Friday it would repeal the employee stock option deduction and reallocate the savings to support low and middle income earners. I have long been writing about this deduction and would like to think this policy idea is founded, at least in part, on my work (work that is joint with Daniel Sandler who wrote the book on venture capital and tax incentives). If it is, it makes me feel at least someone is listening at least some of the time.

I thought I would give you some background information in this area and allow you to form your own thoughts. I certainly understand that not everyone has a good grasp on this very technical issues. I’ll go right back to basics so even those of you without any knowledge in this area can get informed. As a result, this will be a long post and is based on a number of papers that I have coauthored in this area.

In addition, I have some question for the NDP that do indeed need to be answered.

What is an Employee Stock option?

A stock option is a financial instrument which provides the holder the right, but not the obligation, to buy or sell stock of a corporation within a stated period of time at a specified price, commonly referred to as the “strike price”.

There are a number of significant differences between employee stock options and standard stock options that you can trade in the open market.

• Unlike standard stock options, employee stock options are not traded publicly on an exchange, but rather are granted pursuant to a private contract with the board of directors or compensation committee of the firm serving as the writers of the option and the executive (employee) acting as the holder of the option.
• Employee stock options must often be held for a pre-specified vesting period before they can be exercised (usually 3 -5 years during which time the employee cannot sell or transfer the options), which is not present in standard stock options.
• The option period of an employee stock option can be quite lengthy (e.g., ten years), which is longer than standard stock options. The option period is the period of time that the holder has the right to buy stock of the corporation.
• Fourth, the option period of an employee stock option is often curtailed in the event that employment is terminated or the employee dies.
• Employee stock options are usually (and often required to be) granted at-the-money, meaning that the strike price of the option equals the market price of the underlying stock on the day of the option grant, whereas a traditional stock option is issued out-of-the-money, meaning that the strike price of the option exceeds the market price of the underlying stock.

It is important to understand that employee stock options are a form of compensation. Rather than be paid in bonus or salary, employees forgo these forms of immediate compensation in exchange for future compensation (at least that is true for stock options granted either at or out-of-the money) that comes from stock options. Stock options have become the single largest component of compensation among senior executives at large publicly traded companies in North America.

What is the Canadian Tax Treatment of Stock Options?

Compared to most countries, the personal income taxation of employee stock options in Canada is notably less complex and more generous from the employee’s perspective. Since 1972, all employee stock options share the same general tax treatment in two respects.

• Unlike other employment income (e.g. annual salary or bonus income), which is taxable in the year it is received, there are no tax consequences when stock options are granted or when they vest. Rather, under subsection 7(1) of the ITA, a tax liability does not arise until the year the option is exercised. The amount that must be included in income from employment upon exercise is equal to the difference between the fair market value of the stock on the date the option is exercised and the strike price.
• Upon the sale of the stock acquired pursuant to the option, the difference between the proceeds of disposition of the stock and the fair market value of the stock on the date the option is exercised is taxed as a capital gain or capital loss, as the case may be. Under section 38 of the ITA, the taxable portion of a capital gain or capital loss is one-half of the capital gain or capital loss.

For options issued by a public corporation (employee stock options can also be issued by a Canadian-controlled private corporation (“CCPC”) and the taxation history and treatment of these options differs from those issued by a public corporation. I do not consider the tax treatment of options issued by CCPCs in this blog post), there were two significant tax changes to this base tax treatment: the changes made in 1984 and 2000. The employee stock option deduction is related to the 1984 change.

In order to encourage the use of stock options as a compensation mechanism, the 1984 federal budget introduced paragraph 110(1)(d) of the ITA. Under paragraph 110(1)(d), if a Canadian public company grants stock options to an employee, and the strike price is at least equal to the fair market value of the underlying share on the day the option was granted, the employee receiving the options is able to deduct 50 percent of the stock option benefit. The application of the deduction means that the income benefit obtained from stock options is taxed at the same rate as capital gains (and thus at a lower rate than that applicable to ordinary income).

Motivating the 1984 federal tax change was the desire “to encourage more widespread use of employee stock option plans” (1984 Budget Plan, p. 7). Employee stock options are generally believed to assist in the alignment of incentives of company executives and workers with that of company shareholders. By aligning the incentives of employees with shareholders, employees have a stake in increasing their company’s value (and hence, share price) and must be entrepreneurial and innovative to do so. (This is actually the exact motivation for Gordon Gekko’s Greed is Good Speech). By increasing the productivity and ultimately growth of their company, the hope would be for overall higher rates of economic growth and prosperity.

What?

That is all pretty technical so I think an example would be helpful. Employee A (most likely a CEO or VP) is employed at a publicly traded company in Canada and is the recipient of an option grant for 100,000 shares. The grant is dated as having been made on January 1 when the share price was $15 and that is set as the strike price. Assume that the individual faces a combined federal and provincial marginal tax rate of 45% and assume that the options vest after one year, meaning that the employee must hold the options for at least one year.

On January 2 the following year the employee elects to exercise these options just as the vesting period expires. The company’s stock is now currently trading at $20. The employee exercises 100,000 options and sells the obtained shares from the exercise on the same day (more than 90 per cent of executive stock options are exercised and sold on the same day) which were granted with a specified (exercise) price of $15. The exercised shares are valued at $1.5-million (100,000 options at $15 a share) and the sale is valued at $2-million (100,000 options at $20 a share). That is, the employee pays $1.5 million for shares that they then immediately sell for $2 million. The employee derives an employment income benefit valued at the difference of these two amounts, which is $500,000.

If the full $500,000 were taxed, as it should be because it is income, the employee would pay $225,000 in taxes leaving her with after tax income from the stock options of $275,000. But because of the special deduction, she only pays tax on $250,000 of the income benefit for a total of $112,500 paid in tax. That is, with the special deduction, the employee pays $112,500 less in tax than she would otherwise.

Let’s be clear: This $500,000 is not a capital gain. A capital gain only accrues if shares are bought and then held because there is an element of risk associated with the holding the shares. By buying and selling the shares on the same day, the employee is simply realizing the income benefit that had been attached to the awarded stock options. It is simply deferred employment compensation.

We have lots of forms of deferred employment income, mostly performance-based employment income that are taxed as regular income. So it is not the presence of the deferral that dictates this special treatment.

Did the Tax Change Do It Job?

The intent of 110(1)(d) was to encourage the use of employee stock option plans to promote economic growth and prosperity. Did it do this?

First the view that employee stock options drive productivity is not a view that is still widely held. There is no real evidence that employee stock options actually have any discernable effect on employee productivity. For example, Ittner, Lambert, and Larcker (2003) are unable to show that rapid growth of companies is due to employees working harder and more innovatively. Oyer and Schaefer (2005) demonstrate that option awards to non-executive employees are not only too small to provide any incentives but that few of these lower level employees have the necessary authority to make the types of decisions and affect the changes necessary to greatly increase productivity.

Second, while we know that stock option plans took off in the 80s and 90s, there is no reason to think that this was due to the deduction. Why?

• This tax regime favors the recipient, the employee, rather than the supplier, the company. It provides no direct impetus for a company to create employee stock option plans or increase the supply of stock options available under such plans which was the intent of the change. However, assuming the existence of a stock option plan, it does increase the after-tax value of stock options to the employee, particularly when compared to wage and salary income, and may lead to increased take up by employees.
• The use of employee stock options in the United States has increased at a much faster rate and risen to a far higher level than in Canada, despite a more limited tax preference in the United States. The most common type of stock option in the United States is a non-qualified stock option (NSO), which accounts for more than 95% of all employee stock options in the United States (Hall & Liebman, 2000), and these are taxed as ordinary income. It is often asserted that the key driver to the use of NSOs as a component of employee compensation has been the ability of the issuing company to deduct the expense even though the company is not out of pocket (Malwani, 2003, p. 1231). Canadian companies are not permitted such a deduction.
• The use of employee stock options throughout North America, particularly in ICT companies, is highly correlated with the large increases in the stock market during the 1990s. During this time, recipients could expect to more than offset the higher wages they would have earned without the option plan while employers reduced their compensation costs, which is a particular draw for companies with limited or negative revenues like many ICT companies at the time.

Unintended Consequences

Section 110(1)(d) rewards option manipulation practices, practices that have been shown to have been widespread at least in the US. In order for an individual to qualify for the deduction the employee stock option must be granted such that the strike price is at least equal to the fair market value of the underlying share the day the option was granted. This is, if the stock is trading at $15 on the day of the option grant, the exercise price of the stock option must be equal to or greater than $15. That is, there is a clear tax advantage to stock options that are granted not-in-the-money or at least reported as such.

Backdating is the act of using hindsight to select a date for a stock option grant after that date has occurred, and then claiming to have granted the options on that earlier date, in order to take advantage of the historical price performance of a company’s stock. In practice this would involve looking back to find a local low point for the underlying stock relative to the current day’s stock price and choosing that low point as the option’s grant date. Hence, the act of reporting options that are granted in-the-money as being not in-the-money, (i.e. backdating), is an act of tax evasion in Canada. In the context of employee stock options, Canada has devised a system that rewards risky and fraudulent behaviour.

The backdating of options has become a significant policy issue due to its suspected prevalence. US research has shown that backdating was quite prevalent (e.g. Lie, 2005; Heron & Lie, 2007). Some estimates indicate that approximately 20% of executive stock option grants appear to have been backdated (Heron, Lie, & Perry 2007, p. 22) and at least 30% of companies that granted options to executives appear to have manipulated one or more of their grants (Heron & Lie, 2009). In addition, close to 200 companies (some Canadian) have been investigated by the SEC and the U.S. Justice Department (Collins, Gong, & Li, 2009, p. 403), many companies have had to restate earnings, a number of company executives have been forced to resign after admitting to backdating options, and criminal investigations have been launched against several key insiders.

Despite this data, only one Canadian company has undergone an investigation that resulted in information which the CRA used to reassess some employees that exercised suspicious stock option awards. In addition, at least four other Canadian companies have quietly announced that they found practices consistent with backdating, but it is not clear whether this has resulted in their employees being reassessed by CRA.

Questions for the NDP

Employee stock options are a poor, indeed perverse, form of executive compensation. The preferential tax treatment of options only exacerbates this problem. By getting rid of the deduction, we are eliminating this tax loophole that disproportionately benefits the wealthy elite and rewards fraudulent behaviour.

But eliminating the deduction under paragraph 110(1)(d) is not the end of this issue. Two questions that remain are:

• when the tax benefit from stock options should be reported, and
• Whether the employer should be permitted an offsetting deduction that is currently not allowed in Canada because of the presence of 110(1)(d)

Both of these questions need to be addressed by the NDP in their policy and I have not seen them discussed.

We could look to the accounting treatment of stock options for a way forward for taxing stock options. Until recently, Canadian and U.S. firms did not have to recognize a compensation expense for stock options that were granted not-in-the-money and were not performance-based because the options could be accounted for using the intrinsic value method. The intrinsic value of a stock option is the amount by which the price of the underlying stock exceeds the exercise price at the grant date. Provided that the option was granted not-in-the-money, it had no intrinsic value. When options were granted in-the-money, the intrinsic value of the options at the grant date must be amortized over the option vesting period. Therefore, firms that favoured compensation in the form of not-in-the-money stock options (or that least that were reported to be not-in-the-money) over cash remuneration reported higher book income.

In 1995, the U.S. Financial Accounting Standards Board (FASB) issued a statement encouraging but not requiring companies to use the fair value method. The fair value method requires that stock options be expensed based on their fair market value at the time of issuance (and amortized over the vesting period) even if the options are not-in-the-money. Option pricing models, such as a modified Black-Scholes or Binomial model, can be used to determine the fair market value of options on their grant date. A similar non-mandatory move was made by the Canadian Institute of Chartered Accountants (CICA) in late 2001. However, in the period following corporate scandals such as Enron, both Canada and the U.S. have made the fair value method mandatory. In Canada, firms have been required to use the fair value method for financial periods beginning on or after January 1, 2004 while the U.S. rule applies for financial periods beginning on or after June 15, 2005.

I do not think it would be inappropriate for the tax treatment of options to match the current accounting treatment: that is, taxing options at grant. Since employment income is taxed on a received rather than earned basis, an employee should not be required to include an amount in income prior to having an unconditional legal right to exercise the options: that is, when the options vest. On the day the options vest, the employee does indeed receive something of value; they have the unconditional legal right to that income making the vesting time to be appropriate for taxation. How do you value the options when they vest? Option pricing models are now sufficiently robust that they can determine an option’s value at that time with a reasonable degree of accuracy.

With respect to the corporate deduction, it is important to remember that employee compensation is a cost incurred by the company and section 110(1)(d) was used in lieu of the company deduction. If 110(1)(d) is repealed, the employer should instead be allowed to now take the deduction and that this deduction be incurred at the same time and for the same amount as the employee’s tax liability.

The final issue that remains for me is when will any policy makers, the securities regulators, or the CRA recognize the importance of the backdating issue and begin investigations into this practice and demanding the repayment of taxes owed as a result of this fraudulent behavior. Employees who receive backdated stock options should be reassessed not only to deny any deduction claimed under paragraph 110(1)(d), but also to include the full stock option benefit in an earlier year than that in which the employee reported the benefit for tax purposes. Such reassessment would also include interest, compounded daily at a relatively high rate. Furthermore, if the executive knew of the backdating, he or she may be subject to gross negligence penalties and could even be charged with tax evasion. It is time to get serious on this issue, even if the practices are in the past (a claim which I doubt).