Taxation of Deferred Compensation Arrangements

• Author: Andrew J. Freedman
• Pages: 291-306

Taxation

of

Deferred

Compensation

Arrangements

Andrew

J.

Freedmari

A.

INTRODUCTION

As

a

general rule,

from

an

income

tax

perspective, compensation usually

in the

form

of

salary

or

benefits

is

included

in an

individual's income

in

the

year that

it is

received

by the

employee. When calculating income

for

tax

purposes

or

when

calculating income

pursuant

to the

Federal

Child

Support

Guidelines1

the

amount

of

employee compensation will

be

con-

firmed

by the

employer

in the

form

of a 14

Information Slip setting

out

the

amount

and

year

of

receipt. This amount will also

be

identical

to

what

is

reported

in an

individual's personal

tax

return.

In an

effort

to

provide additional incentive

to

employees, companies have developed

arrangements

or

plans that have

the

effect

of

rewarding employees

in

one

year

but

deferring

the tax

consequences

and

cash receipt

to a

future

period. These arrangements

are

usually

referred

to as

deferred

compen-

sation plans

or

arrangements. Over

the

years they have become both

sophisticated

and

complex and,

as a

result,

the

income

tax

rules relating

to

these

plans

have taken

on

similar attributes.

*

Andrew

J.

Freedman,

CA,

IFA, CBV, ASA, Partner, Cole

&

Partners

in

Toronto,

i

SOR/97-175

[Guidelines].

For a

comprehensive review

of the

impact

of

deferred

compensation

on

determining

Guidelines

income,

see the

paper

prepared

by

Aaron

Franks

for

this program.

291

292

ANDREW

J.

FREEDMAN

Although

tempting,

this

paper will

not

focus

on the

valuation issues

related

to

these plans,2 which

are

relevant because

the

value

of

these

plans would

find its way

into

the

calculation

of an

individual's

net

fam-

ily

property.

The

subject

will

be

approached,

for the

most part,

from

an

income

tax

perspective

in

that various arrangements will

be

described

along with

the

related income

tax

implications. There

is a

section

on

employee termination payments that, although

not

exactly

on

topic,

de-

serves attention when

deferral

of

compensation

is

discussed.

The

following salary

or

income deferral arrangements

are

reviewed:

•

employee stock options

•

performance

share

units

(PSUs)

•

deferred share units

(DSUs)

•

stock appreciation rights

(SARs)

•

deferred

salary leave plans

(DSLPs)

•

termination payments

There

are

others

and

companies continue

to find new

names

for a

particular

type

of

plan.

The

basic concepts

of all of

these plans will,

for

the

most

part,

fit

into

one of the

above.

From

an

income

tax

perspective,

any

amounts received

from

any of

the

above

are

included

in an

individual's income

—

the

question

to be

answered

is,

When?

B.

EMPLOYEE

STOCK

OPTIONS

Stock

options

are

securities that represent

the

right,

but not the

obliga-

tion,

to

purchase

(call

option)

or

sell (put option) shares

in a

company

at

a

given price (strike price

or

exercise price)

on or

before

a

specified

ex-

piry date.

The

option holder

can

exercise

his

right

to

purchase

or

sell

the

underlying shares

any

time until expiry. Sometimes

a

certain amount

of

time must pass

or

certain goals must

be

achieved

before

the

option

becomes exercisable.

The

period

of

time during which

the

holder

is not

permitted

to

exercise

the

option

is the

vesting

period.

The

date

the op-

tion becomes exercisable

is the

vesting date.

The

focus

here will

be on

options

to buy

stock,

not

options

to

sell

stock.

Throughout this paper,

references

to

options

refer

only

to

call

op-

tions.

2

Valuation

concepts

relating

to

stock

options

and

termination

payments

are

briefly

reviewed.