Consider your options

There is a wealth of published analysis on the general application of the conditions necessary for qualified stock option status. Less well-understood, however, is the application of those conditions in the particular circumstances of options over the shares of a company subject to a pending corporate takeover. In this connection, it is important to note that some of the steps commonly considered by the parties to facilitate a takeover can inadvertently jeopardize the one-half reduction in the taxable stock option benefit. This article will address briefly some of the considerations to bear in mind in order to avoid such an unfortunate result for executive optionholders.

To begin with, in order to be eligible for qualified stock option status in the first place, the options must be governed by section 7 of the Income Tax Act. Amongst other things, this means that the company granting the options must in fact have committed to issue shares in satisfaction of vested options. A promise to pay the employee cash equal to the in-the-money value of the options is not sufficient for this purpose; rather, the most the company can do is to give the employee the choice of exercising the options for shares or surrendering the options for cash.
All of this is fine and well in the ordinary course. But when a company’s shares are about to cease their existence as a result of a pending takeover offer, the transaction parties may naturally be tempted to think that automatically cashing out all existing options would simplify the mechanics of the bid or the plan of arrangement by which the takeover is to be effected. That is, an automatic, across-the-board cash-out would eliminate the hassle of having employees exercise options for shares which they would then immediately turn around and sell to the acquiror. Wouldn’t that make life easier?

Unfortunately, such an automatic cash-out would almost certainly cost the options their qualified status, thereby doubling the tax burden on employees. While relatively recent amendments to the Income Tax Act might give optionholders a technical argument to the contrary, it would be far preferable not to have to rely on such argument. Accordingly, the safer position is to require optionholders to go through the rigamarole of exercising their options and then selling the optioned shares to the purchaser, or at least to have the optionholders themselves choose between cash and shares.

A second threat to qualified stock option status in the takeover context can sometimes arise as a result of the timing of any cash payments which are chosen by optionholders. One of the other criteria for qualified status is that the optioned shares constitute “prescribed shares” as defined in the federal Income Tax Regulations, or would be so prescribed if the options had been exercised and the shares actually issued. In most cases, one of the tests for prescribed share status is that the issuing corporation or certain other defined persons could not reasonably be expected to acquire the optioned shares within two years after their issuance.

The relevant rules in the Income Tax Regulations are structured so as to create an exception to this two-year requirement where the person making the cash payment or purchasing the shares is a potential acquiror in a takeover offer. However, optimizing the corporate tax position of one or both of the parties to the transaction sometimes initially militates in favour of a sequencing which could put the stock options offside this exception in the prescribed share rules, thereby once again jeopardizing the one-half reduction in the executive’s taxable benefit.

In most cases, solutions to these potential structuring problems can be found, which meet everybody’s legitimate tax requirements while preserving the one-half reduction. These solutions can often be quite complex, though, which results in a disproportionate amount of professional advisors’ time being spent on addressing this issue in the case of many M&A transactions. But it is far better to amp up transactional complexity and advisory effort than to double executives’ tax bills, especially when many of those same executives’ positions may be disappearing in the wake of the acquisition.