No shortcuts when calculating RSUs

By Robert Mendenhall | October 1, 2011 | Last updated on October 1, 2011
5 min read

For most employees, the taxation of their employment income is straightforward, since their income is mainly comprised of salary and bonuses.

However, when an employee receives employment income through participation in equity-based compensation plans, this can create complications that may negatively impact their income, since the final amount of their compensation is tied to the performance of their employer’s shares.

Often, the compensation is not received until some future date. This uncertainty in amount of compensation and time of receipt creates difficulties for the taxation of this type of employment income. We’ve set out a general approach to taxing equity-based compensation. We discuss the taxation of Restricted Share Units (RSUs) to illustrate the approach.

How is employment income taxed?

Under the Income Tax Act (ITA), a taxpayer’s income from employment is all the compensation from employment—salary, wages and other remuneration—that is received in the year. The general rule regarding taxation of employment income is that it’s taxed when it is received or enjoyed.

This general rule is strengthened by the Salary Deferral Arrangement (SDA) provisions of the ITA. An SDA is a plan that gives an employee a right to defer the receipt or enjoyment of employment income. One of its main objectives is to defer taxation of the employment income by the exercise of that right.

The SDA provisions of the ITA are actually anti-deferral provisions. They deem a deferred amount under an SDA as immediately received and enjoyed by the employee, despite the exercise of the right to defer. Thus, the general rule applies to the deferred amount. Essentially, the SDA provisions take away the opportunity for an employee to defer taxation by deferring the receipt or enjoyment of employment income.

How is equity-based compensation taxed?

The definition of employment income is broad, and remuneration includes equity-based compensation received by an employee. As stated, an employee pays tax on employment income when he receives or enjoys it. Thus, the initial position is that equity-based compensation is taxed when it is received or enjoyed.

Are there exceptions to the immediate taxation of equity-based compensation?

In the context of equity-based compensation, two exceptions exist of particular note.

The first exception stems from the definition of an SDA. An SDA does not include a plan or arrangement under which an employee has a right to defer receipt of a bonus or similar payment for services rendered in a given year to another time (essentially an SDA) within 3 years.

For example, if your employer had such an arrangement, you could choose to receive this year’s equity-based compensation at any time prior to December 31, 2014. By doing so, you defer the taxation of the compensation to the year in which it is received. This exception is called the 3-year SDA.

The second exception is found in the stock option provisions of the ITA. These provisions are extensive and they set out a comprehensive scheme for taxing compensation received in the form of stock options. Effectively, the provisions oust the general rule.

Some important features of the stock option provisions are:

  • Taxation occurs when an employee receives shares.
  • No taxation occurs when an employee receives a right to obtain shares (option granted).
  • If the company granting the stock is a Canadian-controlled private corporation (CCPC), taxation of the compensation occurs when the employee disposes of the shares, not when he or she receives them.
  • A deduction is available to an employee if he pays an amount for the shares at their receipt (exercise price) that is not less than the fair market value of the shares at the grant of the options. Effectively, the deduction taxes as a capital gain the difference between the exercise price and the fair market value of the share when received.

These brief statements on the features of the stock option provisions are not comprehensive. A detailed review of the ITA provisions is necessary to meet their many conditions and qualifications.

How are the general rule and exceptions applied to equity-based compensation?

There are many forms of equity-based compensation or at-risk pay. Employers often modify these forms of compensation to offer incentives to their employees in a way that meets their objectives.

By way of illustration, we will look at Restricted Share Unit (RSU) plans and their taxation as it regards employees. In Canada, RSU plans are commonly referred to as phantom plans because, under an RSU plan, the employee initially receives notional units, not shares.

The units “represent a right to receive a payment on vesting equal to the fair market value of the company’s common shares,” explains Gowlings tax lawyer Gloria Geddes in “Executive Pay Packages: Compensation Planning in Light of Increased Scrutiny.”

By referencing the common shares of the company, the employee’s compensation is tied to an amount that a shareholder would receive when investing in the company’s shares. Finally, under an RSU plan, the payment can be made in cash or shares.

Does the general rule for taxation of equity-based compensation apply to RSUs?

The general rule, as discussed above, does apply and the ITA has no specific provisions for RSUs. Unless the RSU fits within an exception, an employee pays tax on an RSU when he receives a unit, the right to receive cash or shares as compensation.

Can an RSU be excepted from the general rule as a 3-year SDA?

Yes, the RSU can qualify under this exception to the general rule if the timing of the receipt of compensation is correct.

In fact, RSU plans that provide for payment in cash generally permit payment within three years following the end of the year in which the employee’s services are rendered. This ensures the SDA rules do not apply.

Remember that the compensation, regardless of whether in the form of cash or shares, must be received within three years of the end of the year the compensation relates to, not three years from the date the RSU is granted.

Can an RSU qualify to be taxed as a stock option?

It seems possible, but is not the normal course for RSUs. The RSU plan would need to provide that the compensation awarded pursuant to the RSU be shares only, not cash. However, the deduction that mimics capital gains taxation does not apply to RSUs.

Our usual classification of differing forms of equity-based compensation is not particularly helpful in determining how we tax the compensation. When determining how to tax equity-based compensation, there is no shortcut. Each plan granting this type of compensation needs detailed review. Then, the tax analysis must proceed through the provisions found in the ITA.

Robert Mendenhall is vice president of the Wealth & Estate Planning Team at Richardson GMP. This team of in-house experts and professionals provides coordinated support to advisors to ensure clients have complete and comprehensive wealth plans in place.

Robert Mendenhall