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    Technology Futures

By Michael Volker

Stock Option Headache for Entrepreneurs

In the Federal Budget that was tabled on March 4th, there was a very detrimental rule change regarding taxation on stock options that hardly anyone has noticed.

Get this: When you exercise a stock option and buy shares in the company* you work for, CRA (Canada Revenue Agency) wants you to pay tax immediately (no more deferrals as in the past) on any unrealized "paper" profit even if you haven't sold any shares. Furthermore, CRA now wants your company to withhold the tax on this artificial profit. (*If the company is public or a non-CCPC.)

But, since there is no real gain, it means that unless the company wants to give you a loan, you will have to sell at least some of your shares right away to cover the tax.

This process is not only an accounting nightmare for you and the company - it's also fundamentally wrong in that CRA is making your buy/sell decisions for you.

It is also wrong in that stock options will no longer be an attractive recruiting inducement. Emerging companies will find it much harder to attract talent.

It will also be a major impediment to private companies that wish to go public. In the going-public process, employees usually exercise their stock options (often to meet regulatory limits on option pools). This could result in a tax bill of millions of dollars to the company. Also, it won't look good to new investors to see employees selling their shares during an IPO even though they have to.

Before the March 4th budget, you could defer the tax on any paper profit until the year in which you actually sell the shares that you bought and get real cash in hand. This was a big headache for those who bought shares only to see the price of the shares drop.

The stories you may have heard about Nortel or JDS Uniphase employees going broke to pay tax on worthless shares are true. They exercised options when shares were trading north of $100, giving them huge paper profits and substantial tax liabilities. But when the shares tanked, there was never any cash to cover the liability - nor was there any offset to mitigate the pain. The only relief is that the drop in value becomes a capital loss but this can only be applied to offset capital gains. In the meantime, though, the cash amount required to pay CRA can bankrupt you. 

CRA argues that the new rule will force you to sell shares right away, thereby avoiding a future loss. (Aren't you glad that they're looking after you so well?) But, that's only because the stupid "deemed benefit" is taxed in the first instance.

Example: You are the CFO of a young tech company that recruited you from Silicon Valley. You have a 5-year option to buy 100,000 shares at $1.00. Near the expiration date, you borrow $100,000 and are now a shareholder. On that date, the shares are worth $11.00. Your tax bill on this is roughly $220,000 (50% inclusion rate X the top marginal tax rate of 44%X $1 million in unrealized profit) which you must pay immediately (and your Company must "withhold" this same amount). Unless you've got deep pockets, you'll have to sell 29,000 shares to cover your costs - 20,000 more than if you did a simple cashless exercise. So much for being an owner! In this example, if the company's shares drop in price and you later sell the shares for $2.00, you'll be in the hole $120,000 ($200,000 less $320,000) whereas you should have doubled your money! Sure, you have a capital loss of $9 (i.e. $11 less $2) but when can you ever use that?  

As part of the March 4 changes, CRA will let the Nortel-like victims of the past (i.e. those that have used the previously-available deferral election) file a special election that will limit their tax liability to the actual proceeds received, effectively breaking-even but losing any potential upside benefit. I guess this will make people with deferrals pony up sooner. The mechanics of this are still not well defined.

The rules are somewhat different for private and public companies. Private companies do have somewhat more flexibility in what medicine they can take for this headache.

For example, private companies could award options that have a very long (or no) expiration date. That way, there's no pressure on an employee to exercise options.

But, then there's another problem: option agreements usually terminate 30 or 60 days after employment ceases. In these cases, an employee who exercises his options can defer the benefit but what is that benefit? Who determines the fair value for tax purposes? (another headache!). Of course, options could vest - much the same as shares do - and when an employee leaves, he could still hang on to his options. I can just see a company struggle with a capitalization table that shows 30-50% in options - another headache when investors try to figure out their real ownership percentages.

Oh, and here's another glitch: the life-time capital gains exemption of $750,000 is a wonderful bonus for entrepreneurial achievement. Investors and employee shareholders in Canadian private companies pay no tax on the first $750,000 in capital gains provided that they've held their shares for at least two years. This means that employees would have to take on a tax liability at least two years before being able to enjoy this tax perk! Does that make any sense at all?

It gets confusing when a company changes its status from being a CCPC (Canadian Controlled Private Company). This can happen, for example, when U.S. investors get involved. It means that the life-time capital exemption would no longer be available - another reason to exercise options earlier.

Stock Option exercises should not be taxed in the first instance until actual monetary benefits are realized – instead of taxing appreciated assets that haven’t been sold. (CRA's next move will be to tax appreciated artwork!)

Note: Warrants (similar to options) given to investors are NOT taxed until benefits are realized. Options should be the same. Investors get warrants as a bonus for making an equity investment and taking a risk. Employees get options as a bonus for making a sweat-equity investment and taking a risk. Why should they be treated less favorably?  

I don't understand how such punitive measures make their way into our tax system. Surely, no Member of Parliament (MP) woke up one night with a Eureka moment on how the government can screw entrepreneurs and risk takers. Such notions can only come from jealous bureaucrats who can't identify with Canada's innovators. What are they thinking?

You might wonder why we have options in the first place. Why not just give employees free shares just like the free shares that company founders get? Well, that's because CRA also regards shares given to employees (beyond the startup phase) as a taxable benefit. So, that is why stock options where created to get around this. If a company could easily give stock grants to employees, it would not have to give as many because of the intrinsic value of shares versus options. And, CRA should tax owners when they sell their shares - not when they receive them.

One argument given by the taxman is that stock options are an employment benefit and benefits are taxable. This is a strange interpretation of the word, "benefit". I thought a benefit was something that's good for you!

A common view is that large public corporations, while it creates more accounting work for them, aren't that upset about this tax. They do see it as a benefit and for them and their employees, it might be better to sell shares, take the profit and run. For smaller emerging companies - especially those listed on the TSX Venture exchange, the situation is different. For one thing, a forced sale into the market can cause a price crash, meaning having to sell even more shares. Managers and Directors of these companies would be seen as insiders bailing out. Not good.

The rules are complex and hard to understand. The differences between CCPCs, non-CCPCs, public companies and companies in transition between being private and non-private give you a headache just trying to understand the various scenarios. Even while writing this article, I talked to various experts who gave me somewhat different interpretations. Does your head hurt yet? What happens if you do this...or if you do that? It's messy and unnecessary.

The solution: don't tax artificial stock option "benefits" until shares are sold and profits are realized. For that matter, let's go all the way and let companies give stock - not stock option - grants to employees. 

I wonder how many MPs know about this tax measure? I wonder if any even know about it. It's a complex matter and not one that affects a large percentage of the population - certainly not something that the press can get too excited about. I'm sure that if they are made aware of it, they'd speak against it. After all, on the innovation front, it's yet another impediment to economic growth.

For another good article on the subject, please read Jim Fletcher's piece on the 2010 Budget on BootUp Entrepreneurial Society's blog.

It's about "TIME"

Simon Fraser University's TIME Centre in downtown Vancouver recently expanded to SFU's Burnaby campus (Discovery Park) to offer incubator offices to entrepreneurs at both locations.

TIME is an acronym for Technology, Innovation, Mentorship, and Entrepreneurship. It's more than just an incubator. Complete, ready-to-go furnished offices with high speed internet, servers, telephone and fax, printing, etc. are only the beginning.

New Ventures BC, the Vancouver Enterprise Forum, the Vancouver Greentech Exchange, the VANTEC Angel Network and WUTIF Capital all make TIME their home.

Within TIME there is also the TIME Business Centre (a little like an airport business lounge but without booze) that is open to technology entrepreneurs and business people to use as a drop-in downtown office facility. Need to plug-in? Make some calls? Do some work? Hold a meeting? There are some great facilities for holding your company's AGM. Why hang out at MacDonald's when you can work productively at the TIME Centre? Drop by and check it out! It is located at SFU's downtown campus at 515 West Hastings St. You won't believe the price! 

Check www.sfu.ca/time for info.  

Michael Volker, a technology entrepreneur, is Director of the Commercialization & Entrepreneurship Office at Simon Fraser University and President of the Western Universities Technology Innovation Fund and GreenAngel Energy Corp. He is a founder of the Vancouver Angel Network and past Chair of the Vancouver Enterprise Forum and past Chair of the B.C. Advanced Systems Institute. He owns shares in many of the companies he writes about. Copyright, 2010.

What Do You Think? Talk Back To Mike Volker

Contact: mike@volker.org

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