At a roundtable tax discussion I facilitated in an Ottawa boardroom this past week, it didn't take long for the talk to turn to Nortel employees, their disappearing pension and their tax predicament.
As reported this week, Nortel employees who received and exercised employee stock options face a looming problem called "phantom income." The company is under court protection from bankruptcy, and should the shares disappear or be sold, employees could face a massive tax bill this year.
While many have blamed the problem on a flaw in the tax law, the issue is not so simple.
Here's an example: Let's say Dick's employer has a stock option plan and he was granted the option to purchase 1,000 shares of his employer at $50 per share. Dick exercised that option when the market price of the shares was $80. Rather than sell the shares he decided to hang on to them. By filing an election in the year of exercise, Dick was able to defer paying tax on this benefit until he sold the shares.
The stock-option benefit deferred was $30,000, equal to the difference between what he paid ($50,000) and what the stock was worth when he exercised his option ($80,000).
The difference, while not a capital gain, is taxed at the same rate as a capital gain -- 50% of your marginal tax rate--but is considered to be employment income.
The problem arises when Dick decides to sell his shares which, given recent market conditions, have been pummelled and are now worth a mere $10 each. As a result, Dick will receive proceeds on the sale of $10,000 and realize a loss of $70,000 ($10,000 -$80,000). This loss is considered to be a capital loss and thus can only be used to offset other capital gains. This means it cannot be applied against the deferred employment benefit of $30,000, due in the year of sale, even though it was taxed at the same rate as a capital gain.
It is this mismatch of employment income against capital loss that has created the harsh economic reality for employees who face potentially massive tax bills on money they never received.
The government remains unsympathetic.
As the Canada Revenue Agency previously wrote: "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."
Asked last week about potential relief for affected shareholders, Jim Flaherty, the Finance Minister, essentially said not to hold their breath.
"The tax laws apply to all of us equally," Mr. Flaherty added. "There are some remedies that are available through hardship cases, but the reality is that those stock-option situations are not uncommon and apply to a large number of Canadians."
Mr. Flaherty was likely referring to the remission order granted in October, 2007, forgiving both the income taxes and arrears interest of 42 former employees of British Columbia-based SDL Optics, Inc. (since acquired by JDS Uniphase), who were part of the SDL stock purchase plan.
While some employees who can demonstrate hardship can try to get their own remission orders, those who exercise stock options in the future -- perhaps because they are expiring or they are leaving the company -- should consider selling at least enough shares to fund the future tax liability.