Prepare for a tax hit from stock purchase plans

National Post

2004-04-17



Much attention has been given in recent days to the report that former JDS
Uniphase employees, among thousands of other former high-tech employees, could
lose their life savings, their homes and even face potential bankruptcy as a
result of huge tax bills they owe from their participation in employee stock
purchase plans -- tax on money they never "received" after stock prices
plummeted in 2000.

Some have blamed the problem on a "bizarre technicality" in tax law. Quite
the contrary -- it's the result of conscious government tax policy, best
understood and debated by an example.

Jack, an employee of ABC HiTech Ltd., was able to purchase 1,000 shares of
ABC at $2 per share through the company's stock purchase plan when the
then-current market price of shares was $302. Under Canadian tax law, Jack has
received an employment benefit equal to the difference between what he paid and
what the stock was worth, or $300,000.

That this amount should be taxable as employment income is not the issue, as
presumably XYZ HiTech Co., a competitor of ABC which did not offer a similar
plan, would have had to pay a higher cash salary or other benefits to be able to
entice and attract employees such as Jack to its company.

After the tech crash, the shares of ABC drop back down to $2 and Jack sells
his shares realizing a capital loss of $300,000 ($2,000 - $302,000). The tax
problem comes from the fact that this loss is considered to be a capital loss
and thus can only be offset against other capital gains and not against the
employment benefit of $300,000 reported on his 2000 T4 slip. It is this mismatch
of employment income against capital loss that has created the harsh economic
reality for employees who face massive tax bills on money they never "received."

So far, the government has been unsympathetic. According to the Canada
Revenue Agency, "the tax system reflects the result that, at the point of
acquisition, those employees who hold their shares have chosen to accept a
market risk, as an investor, in the expectation of a return on that investment,
including the future appreciation in the value of those shares. Thus, they are
subject to the same general income tax rules respecting capital gains and losses
on the underlying shares as other investors."

This would include, for example, employees of XYZ, who, if they were to
purchase shares of ABC on the open market, would not be allowed to deduct their
capital losses from employment income.

How can this situation be avoided in the future? Employees could set aside
money (perhaps by periodically selling some shares) to fund the tax liability
come year-end. The amount of the benefit is known with certainty at the time of
acquisition and by applying an employee's own personal marginal tax rate, he or
she could know how much to save in anticipation of this liability.

Another solution could be to force employers to deduct the tax from the
employee's pay throughout the year, leaving no surprises at year-end.

Finally, one does wonder if the current rule is indeed good tax policy. After
all, relaxing the rules to encourage employee stock ownership would ultimately
benefit all Canadians.