The world of executive compensation is a strange one. Not only does it operate at the intersection of corporate, employment, securities and tax law, but the tax rules which apply are vague, have not kept pace with globalisation and other pressures of a changing world, and are designed to give very little comfort that an executive compensation arrangement will be compliant.
Essentially, executive compensation arrangements fall into one of two possible camps and must fit within the relevant rules – those that apply to agreements to issue securities to the employee, such as stock option plans1, and those where there is no such agreement. Where an executive compensation arrangement does not involve an agreement to issue securities, the employer will usually want it to avoid characterisation as a salary deferral arrangement (SDA). The tax rules that provide exemptions to such characterisation are few, poorly drafted and largely dependent on the Canada Revenue Agency's (CRA) interpretations. This leaves employers, who wish to incent executives, to deal with executive compensation professionals who are at the mercy of and must continuously sift through and review CRA pronouncements on the subject, and to requesting advance income tax rulings (Rulings) from CRA when appropriate.2 It is an expensive way to do business.
Two such recent pronouncements by the CRA illustrate the precariousness of common executive compensation structures.
Now You Convert, Now You Don't
An SDA is defined at subsection 248(1) of the Income Tax Act (Canada) as:
"a plan or arrangement ... under which any person has a right in a taxation year to receive an amount after the year where it is reasonable to consider that one of the main purposes for the creation or existence of the right is to postpone tax payable ... in respect of an amount that is, or in on account or in lieu of, salary or wages ... for services rendered ... in the year or a preceding taxation year..."
Exemptions to the SDA rules appear in the remainder of the definition of SDA, two of the most utilized of which are set out in paragraphs (k) and (l) of that definition. Paragraph (k) refers to:
"a plan or arrangement under which a taxpayer has a right to receive a bonus or similar payment in respect of services rendered by the taxpayer in a taxation year to be paid within 3 years following the end of the year,"
The paragraph (k) exemption is often referred to as the "three year bonus exemption". Although there are other types of plans designed to fit within the three year bonus exemption, one common type is the "restricted share unit' or "RSU" plan. Under an RSU plan, the eventual payment to the employee tracks the fair market value of the employer's shares.
Paragraph (l) refers to "a prescribed plan or arrangement". The prescribed plans are set out section 6801 of the Income Tax Regulations, and subsection 6801(d) refers to a plan or arrangement where deferred amounts cannot be paid before termination of employment and must be paid by the end of the calendar year following the year of termination, and must depend on the fair market value of the employer's shares (which limit such arrangements to employers that are corporations). Plans that are designed to fit within this exemption are typically referred to as "deferred share unit' or "DSU" plans.
A few years ago, the CRA ruled that RSUs could be converted into DSUs without infringing the SDA rules. For example, in Ruling number 2005-0144541R3, the employer proposed to give participants of an RSU plan the right to exchange their RSUs for an equal number of DSUs by irrevocably electing to do so prior to the date on which the RSUs were to vest. The RSUs were to be cancelled and a number of DSUs equal to the number of cancelled RSUs were to be granted on or after the RSU vesting date.3 Presumably, the theory behind such a conversion was that it gave the employees greater flexibility without infringing the spirit of the rules if not their actual wording (since the rules do not explicitly permit such conversions.)
A number of employers took comfort from these Rulings, and structured RSU and DSU plans with a conversion feature, without seeking a Ruling of their own. However, at the November 2015 CTF Annual Roundtable, the CRA reversed its position. It stated that:
"When considering the conditions that must be satisfied under paragraph (k) of the definition of SDA and paragraph 6801(d), a conversion of rights under a 3-year bonus plan to rights under a DSU plan, or vice versa, will not satisfy the conditions under either paragraph (k) or 6801(d). In such circumstances, the conversion of rights under what was a 3-year bonus plan could effectively permit the payment of an amount after the third calendar year, and the conversion of rights under what was a DSU plan could result in the payment of an amount prior to death, retirement or termination of employment. Accordingly, we are of the view that the operation of these provisions does not permit the terms of a plan to provide a taxpayer with the flexibility to subsequently convert those rights under a paragraph (k) plan for rights under a paragraph 6801(d) plan or vice-versa. Therefore, the terms of a plan cannot under any circumstance provide a taxpayer with conversion rights."4
In other words, the CRA now interprets conversions as a means to extent the RSU payment date beyond three years and pay DSUs before termination of employment.
The CRA has since proceeded to revoke the conversion Rulings with respect to units not yet credited as of the date specified in the revocation letter sent to the relevant employer. As concerns conversions for which a Ruling was not sought, the CRA indicated that it would continue to apply the positions in the Rulings to any units credited on or before November 24, 2015.
Are Additional Units in Respect of Dividends Next?
A mysterious technical interpretation surfaced recently which calls into question the common practice of providing, in RSU plans, "dividend equivalent rights".5 Such rights are typically structured in such a way that additional RSUs, equal in value to cash dividends paid on the shares on which the RSU value is based, are credited to an RSU plan participant's RSU account whenever cash dividends are, in fact, paid on the shares.
Since the document is only a technical interpretation, the situation having given rise to the enquiry is not clear. In particular, the technical interpretation refers to the RSU plan in question giving employees the right to be issued shares while the dividend equivalent rights would be paid in cash.6 Regardless of whether it is actually an agreement to issue shares or not, what the CRA says is of real concern for both types of structures:
"The notional crediting of dividend equivalents and subsequent cash payment to an employee in respect of vested dividend equivalents, would not, in our view, be excluded from the SDA definition by virtue of the paragraphs (a) to (l) exclusions. In particular, the exclusion under paragraph (k) of the SDA definition would not apply as a dividend equivalent payment is not in respect of an employee's right to receive a bonus or a payment similar to a bonus. Nor would the dividend equivalent cash payments fall within the parameters of section 7 of the Act. Accordingly, the dividend equivalent cash payments made to an employee in respect of vested RSUs may be a salary deferral arrangement, where one of the main purposes for the creation of the dividend equivalents is to postpone tax payable. Such a determination would be a question of fact.
This is an unexpected position and one that runs counter to the terms of many RSU plans.7 It is also unclear as there is no indication as to whether a dividend equivalent right would constitute an SDA if the payment is made at the time the dividend is paid to shareholders rather than when the RSUs are settled. RSU plans do not provide dividend equivalent rights to postpone tax. They do so in order that the plan participant, on payment, will be put in the same economic position as someone having held shares since the date the original RSUs were granted.
However, the "main purpose" test, which comes from the SDA definition, is "in the eyes" of the CRA until such time as a determination by the CRA that dividend equivalent rights constitute an SDA is successfully contested before the courts. Even then, a court decision would be fact-specific, and, in any event, RSU plan sponsors generally do not wish to take on the tax authorities, particularly over an executive compensation plan.
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Even a favourable Ruling is no guarantee that an interpretation of the tax rules is correct. One would have thought that there would be comfort in the Rulings where the CRA's review of RSU plans granting dividend equivalent rights was favourable, but one would have thought the same thing about the conversion Rulings. The only comfort that one can extract from the revocation of the conversion Rulings is that the CRA made its revised position know publicly and that it did not impact past conversions. A wholesale reversal of its tacit acceptance of dividend equivalent rights would likely be made in a similar fashion. Therefore, sponsors of existing and future RSU plans granting dividend equivalent rights should remain vigilant and ready to revisit that feature of their RSU plan if the tide ever turns against them.
Footnotes
[1] These will be governed by section 7 of the Income Tax Act (Canada).
[2] Redacted Rulings and CRA technical interpretation are accessible to the public.
[3] See also Rulings number 2003-0044483, 2004-0088601R3 and 2006-0210171R3.
[4] See document number 2015-0610801C6.
[5] See document number 2014-0526941E5.
[6] Although it is possible to structure an RSU plan that settles an employee's entitlement in shares rather than in cash, typically RSU plans pay cash and an RSU plan that may settle in shares is structured to avoid being characterized as an agreement to issue shares.
[7] Most of the RSU plans which were the subject of the conversion Ruling as well as other Rulings and technical interpretations dealing with other aspects of RSU plans provide for dividend equivalent rights.
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