From the supply side, the question is what motivates a firm to grant a backdated option, and from the demand side, what motivates an executive to demand (or, at the very least, accept) a backdated option?
Both sets of motivations arise from the quantitative and qualitative benefits, costs, and risks of issuing and receiving backdated options. Certain AMT may be carried forward and applied to reduce the general tax payable in subsequent years (to the extent that the general tax exceeds the tentative alternative minimum tax liability for the subsequent year).
If an employee exercises options that are otherwise qualified as ISOs but then disposes of the shares within one year of exercise or within two years of when the options were granted, the employee stock option benefit (as determined above for a NSO) is not included in income until the time of sale of the shares and the difference between the sale proceeds and the fair market value of the shares at the time of exercise is taxed as a short-term capital gain. Short-term capital gains are taxed at the individual’s ordinary income tax rate. However, if the shares decline in value between the time of exercise and the time of sale, then the employee benefit is limited to the difference between the sale proceeds and the strike price under the option. Prior to the introduction of § 409A to the Code in late 2004, if the fair market value of an NSO was not readily ascertainable at the time of grant, no income was recognized for tax purposes until the option was exercised, regardless of whether or not the options were in-the-money on the grant date. In either case, upon exercise, the amount included in income (and subject to tax at normal tax rates as compensation income) was equal to the difference between the strike price and the fair market value of the stock on the date of exercise. This amount was also added to the basis of the stock for capital gains purposes. Any further taxation was deferred until the underlying shares were sold, when the gain or loss—i.e., the difference between the sale price and the fair market value on the exercise date—was taxed as a capital gain or loss. If the shares were held for one year or less, the gain was taxed as a short-term capital gain (taxable at regular marginal rates) whereas if the shares were held for more than a year, the applicable rate was the long-term capital gains rate, which is currently fifteen percent. This tax treatment remains applicable to options provided that they are not in-the-money at the grant date. § 409A provides in part: (a) Rules relating to constructive receipt (1) Plan failures (A) Gross income inclusion (i) In general.—If at any time during a taxable year a nonqualified deferred compensation plan— (I) fails to meet the requirements of paragraphs (2), (3), and (4), or (II) is not operated in accordance with such requirements, all compensation deferred under the plan for the taxable year and all preceding taxable years shall be includible in gross income for the taxable year to the extent not subject to a substantial risk of forfeiture and not previously included in gross income.
Following corporate and accounting scandals such as Enron, Tyco, and World Com, the American Jobs Creation Act of 2004 added § 409A to the Code, which radically changed the taxation of deferred compensation, including discounted stock options. I. (ii) Application only to affected participants.—Clause (i) shall only apply with respect to all compensation deferred under the plan for participants with respect to whom the failure relates. § 409A applies to a broad range of deferred compensation, although it also provides a number of exceptions, including employee stock options that are granted not-in-the-money. However, in-the-money options (including backdated options that appear to be not-in-the-money options) are caught by the section.
In particular, the relevant personal income tax rules in the two countries are compared and contrasted to demonstrate the role these rules may play in determining the demand for backdated options in the two countries. As will be shown, this is potentially an important component in the decision of executives to accept backdated stock options and may provide an additional incentive for executives to demand them in Canada.
The taxation of stock options varies significantly between Canada and the United States. In this part we summarize the differences, focusing on backdated options and incorporating a discussion of recent U. changes regarding the taxation of discounted stock options enacted in 2004 on the heels of the Enron, World Com, and Tyco scandals.
All employee stock options share the same general tax treatment in two areas. annual salary or bonus income), which is taxable in the year it is received, there are no tax consequences when stock options are granted or when they vest; rather, under subsection 7(1), a tax liability does not arise until the time the option is exercised, at the earliest. The amount that must be included in income from employment upon exercise (or later, if certain conditions are met) is equal to the difference between the fair market value of the stock on the date the option is exercised and the strike price. A., the taxable portion is calculated as one-half of the capital gain or capital loss. There are, however, several exceptions to the general rules described above that affect both the amount and timing of the inclusion.
This paper contrasts the post-tax returns of backdated at-the-money options to currently-dated in-the-money options (with the same strike price as the backdated options) and demonstrates that a Canadian executive can earn a significantly larger after-tax return from backdated options compared to a US executive.
This article considers in detail the potential role of personal income taxation in influencing demand for backdated options in Canada relative to the United States.