Private company incentive compensation for a cross-border workforce: key considerations

Stock options

Stock options are contractual rights to purchase a specified number of shares of a company, subject to the satisfaction of certain vesting conditions, at a fixed exercise price. Stock options are commonly used by privately held companies because both Canada and the U.S. provide preferential tax treatment, and they are relatively simple to administer.

In both jurisdictions, when structured properly, a participant may defer the recognition of tax until the date of exercise. In Canada, participants may be eligible to receive capital gains-like treatment, with additional tax deferrals available for participants of companies that qualify as Canadian-controlled private corporations. In the U.S., options that qualify as “incentive stock options” are eligible for preferential capital gains treatment when the shares underlying the options are disposed. For tax reasons, stock options are typically granted to cover common shares with no preference or caps as to dividends or liquidation entitlements, put rights, or certain call or exchange rights.

It is possible to grant options with an exercise price that is below the fair market value of the underlying shares at the time of grant in both jurisdictions. However, such options may not be eligible for capital gains-like treatment in Canada and must be structured to comply with U.S. tax rules that impose limitations on when the options can be exercised. As a result, care should be taken to avoid promising a specific date of grant or a set exercise price in any employment offer letter or otherwise.

Profits interests

Profits interests are equity interests that may be granted by a partnership in exchange for services and are typically subject to vesting, forfeiture and repurchase provisions. Profits interest holders are generally entitled to participate in distributions from the partnership above a certain hurdle amount based on the liquidation value of the partnership at the time of grant.

Generally, profits interests are the most tax-efficient equity award for U.S. taxpayers because (i) they are considered to have zero value for tax purposes at the time of grant; (ii) ordinary income tax would not be owed at the time of vesting; and (iii) distributions made in respect of the profits interests would generally be taxed at the preferential capital gains rate.

However, profits interests are less commonly used in Canada because profits interests are generally taxable on the date of grant unless purchased for fair value. Privately held companies generally engage third-party valuation firms to complete a valuation of the profits interests (taking into account any discount associated with restrictions on transfer and forfeiture provisions). If the profits interests are later forfeited, any capital loss recognized by a Canadian taxpayer cannot be used to offset any employment income inclusion on the date of grant.

Since profits interest holders are partners of the partnership on the date of grant, this presents some potential complexities for privately held companies with a cross-border workforce. If the entity issuing profits interests to Canadian taxpayers is a U.S. limited partnership or U.S. limited liability company, those Canadians taxpayers would become subject to U.S. tax filing obligations. Further, under U.S. federal tax law, an individual cannot be classified as both a partner and an employee of a single entity. Therefore, holders of profits interests cannot be employed by the partnership that is issuing the profits interests. For these reasons, companies wishing to use profits interests for their cross-border workforce should consult their legal and tax counsel to ensure that profits interests have the desired outcome under both jurisdictions.

Phantom equity

Phantom equity awards are effectively contractual rights to receive a cash payment in the future where the amount of the payment is determined by reference to the value of a share or equity interest that is being tracked. Similar to stock options and profits interests, phantom equity may be subject to certain vesting conditions. Phantom equity can also accommodate bespoke arrangements that may not be available with stock options or profits interests.

For Canadian taxpayers, a phantom equity award must generally be paid by the end of the third year following the service year in respect of which the award is granted. For U.S. taxpayers, a phantom equity award must generally be paid by March 15 of the calendar year following the calendar year in which the award becomes vested, so as to qualify for the short-term deferral exemption; otherwise, the award must be paid on one of the permissible payment events (such as a separation from service, death, disability, or a change of control of the company) or on a pre-determined payment date or schedule.

Companies should be aware that it may not be possible to design identical phantom equity arrangements for their cross-border workforce due to the different tax constraints. There may also be additional drafting and operational complexity regarding dual taxpayers.

Other considerations

Other factors to consider when providing equity incentive plans to a cross-border workforce are as follows:

• Companies should consider which limitations and restrictions should apply to shares underlying equity awards if its employees are eligible to become shareholders.
• The use of an “Employer of Record” may create complexity and prohibit participants from enjoying the tax advantages that are otherwise available under the equity incentive plan.
• For companies with participants who are working in Québec, there are differences in employment standards legislation, and the Charter of the French Language imposes certain translation requirements that should be taken into account.
• There is no public market to trade securities of privately held companies. This not only constrains the ability of participants to liquidate their securities, but also impacts the valuation of those securities.
• In order to ensure participants can appreciate the potential value of the awards, equity incentive plans should not be overly complicated.