Withholding Obligations on Option Exercise Effective January 1, 2011 


November 2010

The 2010 federal budget first proposed significant changes affecting the tax treatment of employee stock options. These changes will be relevant to employers and employees alike. 
One of the most important elements is clarification that, commencing January 1, 2011, employers will be responsible for withholding and remittance of source deductions on the exercise of stock options. Exceptions will be available for Canadian private company options, and options granted by agreement in writing before the March 4, 2010 budget date (but only where the agreement included a written condition restricting the employee from disposing of the securities acquired under the option for a period of time after exercise). 
Most Canadian public companies will therefore be in the position of having to implement the withholding starting January 1, 2011. This withholding will apply at the time of exercise of the stock option – note that the special "$100,000 rule" for a public company option benefit deferral is no longer available. Administrative relief to address the withholding obligations will also no longer be available – the employee will not be allowed to claim "undue hardship". However, where the normal requirements are met, the special deduction that effectively taxes many option benefits at capital gains rates will still be available. The proposals will also impact non-Canadian companies with Canadian option plan participants.
The question not addressed by these proposals is how the withholding/remittance should be funded. As the withholding and remittance requirements will apply to public company options as of the time of exercise on the same basis as if the taxable benefit were the payment of a cash bonus to the employee, this will put the onus on the company to ensure sufficient cash becomes available in the course of the option exercise to allow the company to meet its remittance obligations. If these steps are not taken, it is expected that the public company will have to fund the remittance from its own cash resources.
Public companies should take steps to advise option holders that after January 1, 2011 they will not be permitted to exercise options unless the company has been provided with sufficient funds to cover the withholding/remittance obligations - if necessary by separate cheque from the option holder - or acceptable arrangements to provide such funds have been made. Implementation of such communications and steps should go hand-in-hand with a review of existing option plans, option grant forms or agreements, and adoption (where feasible) of the requirement that the option holder must fund the taxes.

Option plans or agreements could also accommodate a "cashless exercise" feature, where sale of optioned shares is coordinated through a broker who will remit sufficient cash to the company to allow it to fund the tax, or the addition of a "cash-out right" to allow the option holder to be paid any "in the money" component in cash, net of the applicable withholding.