The ABCs of cashless exercise methods

How to create flexible option plans for your company, and tangible tax benefits for employees

By Paul Carenza

Accounting changes and corporate governance issues have dramatically affected the use of stock options by employers across Canada. However, option plans continue to represent a large component of overall compensation for many employers. Stock option plans continue to be popular because they allow companies to compensate employees without an outlay of cash. One drawback to employers is that they are unable to claim a deduction for shares issued when options are exercised. But from the employee’s perspective, a properly structured stock option plan is beneficial because of the preferential income tax treatment it receives compared to ordinary employment income.

Stock option agreements provide an exercise price that must be paid by the employee to acquire shares subject to the option. Generally, the exercise price will be an amount equal to the fair market value of the underlying share on the date the option is granted (a “fair market value option”). This is to satisfy one of the requirements of Canada’s Income Tax Act that sets the effective tax rate of an option at the same level as that of capital gains (the “option deduction”).

The practical effect of a fair market value option is that the employee must have sufficient funds to pay the exercise price. When the exercise price of the options is high and there are many options being exercised, an employee may not have the resources to exercise the options. It may also be impractical to arrange for daylight loans or other interim financing measures.

If possible, structuring the exercise of the option without an outlay of cash can be beneficial. It is important that cashless exercise methods don’t negate the option deduction benefit. There are several strategies to achieve a “cashless exercise” of options, each with their own benefits and potential pitfalls.

Broker’s short sale

In a broker’s short sale, the stock option plan provides employees the assistance of a broker. When the employee intends to exercise an option, he informs the employer and the broker that the cashless exercise method will be used. The employee authorizes the broker to short sell a number of employer shares equal to the number that will be acquired on exercise of the option. The broker sells the shares short and uses the proceeds to pay the employee’s option exercise price to the employer. Next, the employer issues the shares covered by the option and the broker sells the shares to cover its short position. The broker remits the balance of the proceeds from the transaction to the employee, net of any brokerage fees and charges.

Although this method is fairly well-established, there are a few drawbacks. First, this form of cashless exercise is only available for exchange-traded securities, as otherwise a short sale isn’t possible. Second, some funds will be spent on brokerage fees. Third, there is some debate about the date on which the employee is considered to have exercised the option and on which to compute the amount of the employment benefit.

Disposition of option rights

Perhaps the simplest method of cashless exercise is for the plan to permit the employee to elect to dispose of the option in consideration of a payment by the employer of an amount, in cash or shares, equal to the difference between the current fair market value of the share underlying the option and the exercise price of the option (the difference being the “in the money” amount). In many cases this right is built into the stock option plan in the form of a stock appreciation right (SAR). A SAR is a right entitling the holder to payment of an amount equal to the increase in share value over a period of time.

When the option is disposed of for cash, the cash payment is included in the employee’s income and, under current Canada Revenue Agency (CRA) administrative policy, the employee is entitled to the option deduction affording capital gains treatment. As no shares are issued by the employer, the employer is not subject to the prohibition on claiming a deduction for exercised options and may deduct the cash payment. Of course, this method requires that the employer agrees (at the outset or later) to settle the option in cash.

If the option is disposed of for shares, having a value equal to the in the money amount, the amount is included in the employee’s income and, under current CRA administrative policy, the employee is entitled to the option deduction affording capital gains treatment. As shares are issued by the employer in settlement of the option, the employer is prohibited from claiming a deduction for the shares.

This method is attractive because it’s available for private and publicly-traded company shares. In addition, it’s relatively simple to implement and administer. This method also either eliminates or reduces the number of shares issued under the option plan, thereby limiting the dilutive effect of stock option plans on the employer’s outstanding shares.

Exchange of the option

In an exchange of an option, an employee is issued a fair market value option in the normal course. However, rather than exercising the option and paying the cash exercise price, the employee can choose to exchange the option for a new right to acquire treasury shares (the “substituted right”). The substituted right entitles the employee to a number of shares that are of equal value to the in the money amount of the exchanged option on the date of the exchange, without the payment of any exercise price. On the exercise of the substituted right, the employer issues this reduced number of shares to the employee. The value of the shares issued is included in the employee’s income, resulting in the same income inclusion to the employee as if the original option had been exercised. The CRA administrative position is that the employee should be entitled to the option deduction. As shares are issued in settlement of the substituted right, the employer is not entitled to a deduction for these shares.

This method is available for private company shares as well as publicly-traded shares, is relatively simple to implement and administer, and reduces the dilutive effect on the employer’s outstanding shares. The most interesting feature of this method is its use of an exchange mechanism. This strategy relies on specific rules in the Income Tax Act to ensure that the exchange of the options for the substituted right occurs on a tax-deferred basis. In doing so, the employee maintains the ability to claim the benefit of certain other provisions that permit the employee to defer the inclusion in income of the option benefit from the taxation year in which the option is exercised or disposed of to the year in which the share acquired is disposed of.

The key to success is to structure the cashless exercise in a way that ensures the option deduction remains available. It is generally desirable to provide cashless exercise alternatives at the time an option plan is adopted. However, even if an option plan doesn’t provide for a cashless exercise, it is possible to provide employees with this ability prior to exercise, using one of the methods discussed above. Overall, providing a cashless exercise feature can provide flexibility to an employer and has tangible benefits to employees. 

Paul Carenza (pcarenza@ogilvyrenault.com) is a partner in Ogilvy Renault’s tax practice area.

Top