Friday, March 5, 2010

Budget Brings Big News for Stock Option Victims

The usual Friday feature of short takes will have to wait until Monday because the 2010 budget appears to have a provision to finally help people caught in a stock option trap. I’m in this situation along with people I used to work with at both Entrust and Nortel.

Canadians generally think of stock options as financial lottery tickets given to CEOs and other company bigwigs to make them rich. There is a lot of truth to this. But during the technology boom in the late 1990s, even working level employees often received a few stock options not realizing their potential for financial harm.

When stocks rise and employee stock options become valuable, we usually say that so-and-so “cashed in his options” and now the jerk is rich. However, this glosses over the fact that it is really a two-step process. For example, a Nortel employee first had to exercise the stock option by paying its strike price. Then the employee received Nortel shares and could sell them in the stock market for a higher price than the option strike price.

This sounds a lot like many scams where you’re promised great riches if you just send in a small fee now. With scams, there are no real great riches to come later. Unfortunately, that’s the way it worked out for some people as we’ll see.

Exercising stock options and selling the resulting shares are often done all on the same day so that it is like a single transaction. But, for various reasons, some employees choose to pay the option strike price but then hold onto the shares, sometimes for years.

The problem comes if the share price is high when the option is exercised, but drops before the shares are sold. Canada Revenue Agency (CRA) expects people to pay taxes on the paper gain from when the shares were high. For employees of Entrust and Nortel, the income tax owing usually far exceeds the pittance they get when they sell their shares. The Nigerian prince didn’t come through with the promised fortune, and CRA still wants their cut of the fortune anyway.

Minister Flaherty has ridden to the rescue with a compromise of sorts. As long as Canadians are willing to forfeit the proceeds from the sale of the shares in the form of a special tax, it appears that they won’t have to pay tax on the huge paper gain. I say “it appears” because I base this on my own (possibly flawed) interpretation of pages 357 and 358 of the 2010 budget document:
“In any year in which a taxpayer is required to include in income a qualifying deferred stock option benefit, the taxpayer may elect to pay a special tax for the year equal to the taxpayer’s proceeds of disposition, if any, from the sale or other disposition of the optioned securities. Where such an election is made:

– the taxpayer will be able to claim an offsetting deduction equal to the amount of the stock option benefit; and

– an amount equal to half of the lesser of the stock option benefit and the capital loss on the optioned securities will be included in the taxpayer’s income as a taxable capital gain. That gain may be offset by the allowable capital loss on the optioned securities, provided this loss has not been otherwise used.”
A big area of uncertainty is how taxpayers can make this election to pay the special tax and how they subsequently fill out their tax forms. It appears that this election can be made even if the shares were sold before 2010:
“Individuals who disposed of their optioned securities before 2010 will have to make an election for this special treatment on or before their filing-due date for the 2010 taxation year (generally April 30, 2011).”
I’m certainly hoping that I can make this election before filing my 2009 taxes. This provision will save me more than the amount of my first mortgage. I don’t want to have to come up with this money by the end of April and hope to get it back later somehow.


  1. I believe your interpretation is correct. Let us know how it goes, and I hope I'm not being premature by saying congratulations!! :)

  2. It's similar to anything else: If you don't know what you are doing, trouble looms.

    These options were not intended to be exercised and held.

    Similarly leveraged ETFs are not designed to be held.

    But people do both, not understanding the rules of the game. It's really sad that those who gave out the options were not obligated to warn their employees about the dangers.

  3. Preet: Thanks!

    Mark: Interestingly enough, when I first figured out the potential problem, I told the company about it and wrote a letter to a high-tech lobbying group about it. Their initial reaction was to say that I was crazy and that the tax rules couldn't possibly work this way. So, not only did the company not warn people, but management didn't even understand it themselves.

  4. Michael,
    Unlike most other tax measures, CRA cannot administer tax refunds on the basis of a Way and means motion, so CRA will be unable to process refunds for amended previous year returns or new returns until the Budget Implementation Bill becomes law.

  5. Anonymous: Thanks for the information. I don't much about the matters you're talking about. In my case, there is no need to refile an old return because my shares were sold in 2009. If CRA isn't able to take into account the new measure before the end of April, I may be in a position of having to file my 2009 taxes under the old rules and then refile them later. If you have any insight into which way this is likely to go, I'm interested.

  6. CC: You're definitely right that this new policy meets the fairness test much better than when the government just forgave the tax bills of some JDS employees. Any quibbles I have with the new policy are quite minor compared to what it does achieve which is to stop driving the unwary into bankruptcy pointlessly.

    1. The comment above is a reply to Canadian Capitalist's comment:

      Like I mentioned on my blog, I think this is a welcome move. It is certainly far better than offering relief to a small group of individuals.

  7. Anonymous: My earlier comment should have said "I don't know much about ...". The missing word may have left the impression that maybe I "don't care much about ...". I definitely care. Even though this is my site, I don't seem to have the power to edit my own comments after submitting them.

  8. Michael,
    CRA can process your 2009 tax return under the new Budget rules, allowing you to elect to pay the special tax rather than the baseline liability. Since you sold the optioned securities in 2009 and assuming that you have not already remitted tax, CRA can process your return immediately. For those claiming refunds however, CRA will not pay out refunds until the new rules are law.

  9. I'm sympathetic to your tax loss, but are you really a "victim"? Comparing this to Nigerian prince scams is a little over the top I think. When you sold your options didn't you choose not to sell at least enough to cover the taxes? It sounds like you could have locked in enough to buy a house or two or diversify, but you chose to hold the bulk of your liquid assets in the same company you depended on for a paycheck. And you are a victim because nobody told you that there was a tax liability?

    I would be interested in the various reasons why individuals chose to hold onto shares after exercising stock options. The only reason I can imagine is the options were expiring and it looked like there was a lot more money to be made in the stock.

  10. 2nd to last Anonymous: Thanks for the CRA information. You seem to be ahead of my MP who is still trying to find out how this will work. If you have any information about who I need to contact to arrange the make my election and file my 2009 income taxes, I'm interested.

    last Anonymous: I would have to say that "victim" is the right word. However, the financial harm that I was facing is less severe than many other Canadians, some of whom were completely wiped out.
    They are true victims. Their punishment is far out of proportion with their mistakes.

    Most people in this situation didn't sell enough to cover the tax liability because it never occurred to them that the tax liability would not take into account capital loss if the stocks lost value. Considering that both types of income are taxed at the same rate, not allowing the gains and losses to offset is nuts.

    You may not think much of the financial planning ability of people caught in this situation, but how harshly do they deserve to be punished for it? I don't blame people for not being sympathetic to CEOs, but in some companies most employees received options. These people are not financially savvy.

    The main reason employees at my company exercised options to get stock was because the mechaism the company offered to do it all in one step was bad. You had to commit to a sale a day or two in advance by sending in a fax, that often got lost. Once holding shares and waiting for an opportune time to sell, momentum can set in. Then if the shares dropped in value before the investor learns about the tax treatment, he is left praying that he isn't hit by a forced disposition. In my case, I sold a few shares per year to slowly defuse the bomb.

  11. I still have a tough time understanding how people were burned by this. I worked at Nortel in the mid 90's, band 6, early thirties, and nobody I knew was talking about getting stock options then. It sounds like everybody was getting options by mid '96, enough that they'd have 4000 vested by the peak in the summer of '00 to exercise for a gain of $100 per share. OK, with splits it was originally only 500 shares I suppose. But that seems like the scenario that would be required to rack up a mortgage sized tax liability in the $100k range.

    Didn't people get T slips by March while the exercised shares could still cover the tax liability? T slips and doing taxes should have made it pretty clear that stock option gains were income. The taxes would be due, wouldn't they?

    It seems like the only way to get burned would be to exercise at the top in '00 and then not believe what taxes were telling in April '01 latest.

    Though I don't agree that people affect were victims in that they given a opportunity to make an extraordinary amount of money and then seem to have ignored/disbelieved the implications of their actions over long periods of time, I guess I can't disagree that the punishment was pretty severe.

  12. Anonymous: In my case the options were with Entrust rather than Nortel. The grants to working level people at Entrust were genrally higher than they were at Nortel. I do have many friends who worked for Nortel because I used to work there. They were not all given the same number of options, even if they were in the same band. Some were given additional options more than once per year. The size of option grants is much more variable than salaries. So, the potential size of problems (and rewards) varied significantly.

    I can't say how aware these people were of their potential future problems after their T slips came out. No doubt it varied. some would have been aware of the risk they were taking and others not. Either way, though, the punishment is severe.