This article was originally published on Feb. 21 2019 by The Lawyer’s Daily (www.thelawyersdaily.ca), part of LexisNexis Canada Inc.

Tech startups often compensate independent contractors or vendors with equity, such as stock options or restricted stock. Businesses can acquire needed services without dipping into their coffers, and contractors can make an investment with minimal cash and potentially realize significant returns.

A barter exchange is simple, right? No so fast! Lawyers with clients who own or provide services to tech startups should know that there are many considerations for both the business and contractor that are often overlooked when structuring equity-based compensation plans. In fact, participation in such plans can have unforeseen tax consequences.

Equity plans such as stock options are designed to incentivize employees. In Canada, when an employee is granted stock options, there are no tax consequences until the option is exercised. Also, under the right circumstances (i.e., the shares are “prescribed shares” or the employee deals at arm’s length with the option grantor), employees may be eligible to claim a deduction equal to 50 per cent of the stock option benefit.

The Income Tax Act provisions that address the favorable tax treatment apply to employees, not independent contractors. Independent contractors must recognize the value of the option as business income that is 100 per cent taxable when the option is granted. This means the tax cannot be deferred to the time when the options are exercised. Furthermore, the preferable 50 per cent security option deduction also applies to employees only.

Stock options held by independent contractors that have increased in value since grant must recognize the growth from the date of grant as either ordinary income or as a capital gain. The classification of business income or capital gain must be determined on a case-by-case basis. Adding insult to injury, the income recognized as business income at grant and vest is also subject to HST. Applicable sales tax varies by province.

Another issue is establishing fair market value. In the case of options being granted to an independent contractor, both parties must agree on the value of the underlying stock and the value of the goods or services rendered. The issue for contractors is that fair market value of startups is no exact science. However, this is the value that will be subject to income and sales taxes.

Independent contractors are, in general, a highly mobile workforce. This is especially true between Canada and the U.S. Unfortunately, when it comes to equity compensation for contractors, tax complexities are increased when the option holder works in multiple countries.

A common U.S. trap is the punitive salary deferral rules of s. 409A of the Internal Revenue Code (IRC) that impose an additional 20 per cent tax on income being deferred. For example, stock options granted with an exercise price less than the fair market value of the underlying stock at the time of grant are subject to 409A treatment in the U.S. The company must complete a 409A valuation — a formal report that sets the current value of a company’s stock and the price to purchase that stock — to ensure the option does not result in punitive taxation.

In Canada, equity incentives such as restricted stock awards (RSAs), restricted stock units (RSUs), stock appreciation rights (SARs) and phantom stock plans may be subject to salary deferral rules. For example, an RSA would fall into this category if the vesting period exceeds three years. This means that the income must be taxed on a current basis regardless of when the income is actually paid, effectively negating the tax deferral.

A trap for Canadian taxpayers holding U.S. equity incentives involves the timing recognition for calculating income tax. In the U.S., one recognizes taxable income resulting from RSAs when there is no longer a substantial risk of forfeiture and the vesting conditions are met. In Canada, however, income is recognized at the time of grant. The difference in the timing of taxable events between the two countries can result in a double-tax situation where the use of foreign tax credits isn’t possible. Imagine a 60-to-70 per cent tax rate on the income!

All is not lost though. Independent contractors who must file Canadian and U.S. tax returns should consider IRC s. 83(b) election for U.S. tax purposes. It allows for income from RSAs to be recognized at the time of grant, matching the Canadian treatment and timing.

Overall, receiving equity awards as part of a business transaction is not a recommended tax strategy. The implications are even worse for incorporated contractors. Formal compensation plans should always consider the risk incurred by the contractor in the form of a risk premium (i.e., valuing services rendered higher than market value, granting the options at a discounted price, or a combination of both). While the contractor could experience a windfall when the options are vested, one could also have a shortfall.

Finally, while all this highlights tax consequences for the independent contractor, the issuing company (i.e., the employer) should perform its due diligence to ensure it is not negatively impacted by the award.

 

Code Section 965 of the Tax Cuts and Jobs Act requires some US shareholders to pay a one-time transition tax on the untaxed foreign earnings of certain specified foreign corporation (“SFC”) as if those earnings had been repatriated to the US. Very generally, section 965 of the Code allows taxpayers to reduce the amount of such inclusion based on deficits in earnings and profits with respect to other SFCs.

On January 15, 2019, the final regulations of the transition tax under Section 965 were released. The final regulations are fundamentally the same as the proposed regulations (with some modifications) and apply to the last taxable year of a specified foreign corporation (“SFC”) beginning before January 1, 2018 with respect to a US shareholder.  For 2017 calendar year SFCs, the transition tax is calculated in 2017, and for fiscal year SFCs ending in 2018, the transition tax applies to the 2018 tax year.

It is important to note the anti-abuse provisions of the transition tax, which also remain similar to the proposed regulations, with some modifications.  Under the anti-abuse provisions, a transaction is disregarded when determining the “section 965 element” if each of the following conditions are met:

  1. Any part of the transaction occurs on or after November 2, 2017;
  2. The purpose of the transaction is to change the amount of a “section 965 element” of the US shareholder; and
  3. The transaction, in fact, changes the amount of the section “965 element” of the US shareholder.

The final regulations define “section 965 element” as any of the following amounts:

  1. The US shareholder’s section 965(a) inclusion (i.e. reduces earnings or increases a deficit) amount with respect to the SFC;
  2. The aggregate foreign cash position (i.e. reduction to cash position) of the US shareholder; or
  3. The amount of the foreign income taxes (i.e. increase in foreign taxes paid) of a SFC deemed paid by the US shareholder under the provisions of Sec. 960 as result of the section 965(a) inclusion. The deemed foreign tax credit is only available to US corporate shareholders that own at least 10% of a SFC and is not applicable to individual US shareholders.

According to the regulations, the transactions that may change the “section 965 element” include accounting methods, entity classification elections, specified payment and double counting rule, and certain cash reduction transactions.

Due to higher Canadian tax rates, one option is for individual US shareholders to create excess foreign tax credits in the year after the transition tax year that are sufficient enough to carryback to the previous year and offset the transition tax.  For US tax purposes, a foreign tax credit for Canadian taxes paid can be carried back one year.

For example, a significant bonus can be paid in 2018 for a 2017 transition tax year (or 2019 for a 2018 transition tax year for fiscal year SFCs), a dividend distribution can be taken, or some combination of both. However, any Canadian tax paid on a dividend distribution to reduce previously taxed income (i.e. income inclusion for transition tax purposes) is subject to a reduction in foreign tax credits that is equal to the ratio of the participation exemption deducted against total earnings and profits subject to transition tax. The participation exemption is the amount of exclusion that is applied against the earnings and profits.

It is not clear if the payment of a salary would also be subject to a reduction in foreign tax credits if it reduces pre-taxed cumulative earnings and profits.

In summary, we believe that increasing the foreign tax credit for carryback to recoup the transition tax is not within the scope of the anti-abuse provisions of the regulations.