Photo of Cameron MacCarthyBy Cameron MacCarthyMarch 26 2015
Business Law

Employee Compensation: Tying Compensation to Firm Performance

There are a number of potential benefits to tying employee compensation to firm performance. These benefits include maximizing shareholder returns, boosting overall employee morale, sending a signal to markets and strengthening brand awareness. 

However, studies have shown that there is almost no correlation between CEO compensation and firm performance at many leading North American firms.[i] So, while the idea of performance-based compensation gains traction, current practice suggests that employee compensation (especially top-tier management) remains unhinged from firm performance.[ii]

In the current economic climate, savvy firms (especially private issuers with cash flow constraints) will choose tax-efficient compensation structures that effectively tie employee compensation to firm performance rather than commit to guaranteed cash bonuses. 

This article highlights a creative use of stock options by a Canadian-controlled private corporation ("CCPC") as part of an overall compensation plan.

Equity Incentives

Equity incentives are an effective way to attract, retain and motivate employees. Equity incentives allow employees to participate in the long term success of the firm and promote a greater alignment of interest between owners and employees.  There are a number of different equity incentive plans that firms can utilize. It is important to carefully assess each plan from a commercial and tax perspective as some plans can create unintended issues.  

For example, a private issuer granting shares to employees will have to consider the dilution of current shareholders' interests and the implications of adding minority shareholders. A shareholders' agreement may be required to restrict the employee shareholders from transferring their shares to third parties and provide the firm with the right to repurchase the shares in the event the employee's employment is terminated.

Stock Options

Stock option plans incentivize employees by granting participants the right to purchase shares at a specific price once the option has vested. The employee then benefits from any increase in share price over the vesting period. Neither the grant nor the vesting of a stock option is a taxable event for an employee. The taxable event is deferred until the time the employee exercises the stock option. 

At the time of exercise, the employee is deemed to receive as taxable income the difference between the aggregate exercise price of the options (plus the amount paid for the options, if any) and the fair market price of the underlying shares on the date they are acquired. A more detailed summary of the taxation of stock options is available at our previous blog.

However, if the employer issuing options is a CCPC, then the employee's tax liability will be deferred even further. The employee will not have a taxable event until the underlying shares are disposed of. This matches the employee's tax liability to the moment cash is received.

Because "CCPC options" receive favourable tax treatment, they can be creatively utilized in designing employee compensation plans. For example, a CCPC employer could issue a stock option with an exercise price of $0.01 on a share with a fair market value of $1.00, allowing the employee to receive $0.99 in value without having to pay tax until the share is sold. If the employee is entitled to receive $10,000 of equity compensation in a year, the employee would be issued options to acquire 10,101 shares ($10,000 / $0.99) without triggering any tax liability.

Though tax is payable when the shares are sold, the taxable employment benefit to the employee is calculated at the time the shares are acquired by the employee. In the above example, the taxable benefit to the employee would be $0.99. If the employee holds the underlying shares for at least two years following the exercise of the option, she would be entitled to have the taxable benefit taxed at the capital gains rate. This means that only 50% of the $0.99 taxable benefit would be included in the employee's income.

While the taxable benefit is taxed at the capital gains rate, it is not eligible for the $800,000 "lifetime capital gains exemption". However a capital gain resulting from an increase in the value of the shares between the date the options are exercised and the date the shares are disposed of may be eligible for the exemption subject to certain conditions being satisfied.

In the above example, suppose the employee exercised all of her 10,101 options when the fair market value of the underlying shares was $1.00 per share, then sold the shares more than two years later when the fair market value of the shares had increased to $2.00 per share. The tax consequences to the employee would be as follows:

  • A taxable employment benefit of $5,000 ($0.99 * 10,101 * 50%)
  • An increase in the adjusted cost base of each share equal to $1.00 (the $0.01 exercise price plus the $0.99 benefit)
  • A taxable capital gain of $5,050.50 (the $2.00 proceeds of disposition less the $1.00 of adjusted cost base * 50%)
  • Assuming that all of the requisite criteria are satisfied, the $5,050.50 taxable capital gain may be eliminated if the employee utilizes a portion of her lifetime capital gains exemption.
  • Assuming that the employee is taxed at the highest marginal rate, she has received after tax proceeds of $18,252 for an outlay of $101 (exercise price of $0.01 * 10,101 options) and a continued commitment to the success of her firm.

Conclusion

Employers have a variety of options to choose from when designing a compensation structure for employees. Different plans offer different benefits in terms of liquidity, dilution, tax effects, retentive impact and ease of implementation. The right structure will depend on the needs of your firm and your employees.

Invitation for Discussion:

If you would like to discuss employee compensation or any business law matter, please do not hesitate to contact one of the lawyers in the Business Law group at Nerland Lindsey LLP.

Disclaimer:

Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.

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  • [i] Jay Lorsch & Rakesh Khurana, “The Pay Problem: Time for a New Paradigm for Executive Compensation”, Harvard Magazine (May-June 2010) online: Harvard Magazine https://harvardmagazine.com/; The Economist Online, “Executive Pay and Performance”, The Economist (7 February 2012) online:  The Economist Online .
  • [ii] Peter Eavis, “Executive Pay: Invasion of the Supersalaries”, The New York Times (12 April 2014) online: The New York Times .

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