Upon the sale of the shares, the difference between the sale price and the exercise price under the option is treated as a capital gain, and since the shares must have been held for at least one year, the gain is taxed at the long-term capital gains rate of fifteen percent. An option award that does not, at the time of grant, meet the requirements of an ISO is taxed as an NSO. If an NSO has a readily ascertainable fair market value at the time of grant, the difference between the option’s value and the amount paid by the grantee is taxed as income in the year of the grant or in the year that the option is exercised, depending on the taxpayer’s election. However, in order for an option to have a readily ascertainable fair market value it must be either publicly traded or meet the following four conditions: (1) be transferable; (2) be exercisable in full on the grant date; (3) not be subject to any conditions that affect the value of the option (e.g., vesting and transferability restrictions); and (4) the fair market value of the underlying share must be readily determinable. Since NSOs are not generally publicly traded and fail to meet any of the first three conditions, most NSOs are not taxable at grant. If an employee exercises options that are otherwise qualified as ISOs but then disposes of the shares within one year of exercise or within two years of when the options were granted, the employee stock option benefit (as determined above for a NSO) is not included in income until the time of sale of the shares and the difference between the sale proceeds and the fair market value of the shares at the time of exercise is taxed as a short-term capital gain. Short-term capital gains are taxed at the individual’s ordinary income tax rate. However, if the shares decline in value between the time of exercise and the time of sale, then the employee benefit is limited to the difference between the sale proceeds and the strike price under the option. Prior to the introduction of § 409A to the Code in late 2004, if the fair market value of an NSO was not readily ascertainable at the time of grant, no income was recognized for tax purposes until the option was exercised, regardless of whether or not the options were in-the-money on the grant date. In either case, upon exercise, the amount included in income (and subject to tax at normal tax rates as compensation income) was equal to the difference between the strike price and the fair market value of the stock on the date of exercise. This amount was also added to the basis of the stock for capital gains purposes. Any further taxation was deferred until the underlying shares were sold, when the gain or loss—i.e., the difference between the sale price and the fair market value on the exercise date—was taxed as a capital gain or loss. If the shares were held for one year or less, the gain was taxed as a short-term capital gain (taxable at regular marginal rates) whereas if the shares were held for more than a year, the applicable rate was the long-term capital gains rate, which is currently fifteen percent. This tax treatment remains applicable to options provided that they are not in-the-money at the grant date. § 409A provides in part: (a) Rules relating to constructive receipt (1) Plan failures (A) Gross income inclusion (i) In general.—If at any time during a taxable year a nonqualified deferred compensation plan— (I) fails to meet the requirements of paragraphs (2), (3), and (4), or (II) is not operated in accordance with such requirements, all compensation deferred under the plan for the taxable year and all preceding taxable years shall be includible in gross income for the taxable year to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. S. It is important to understand the differences in these rules, particularly the extent to which these differences affect the after-tax return to a Canadian executive compared to a U. Part II considers these personal income tax rules in detail. For individuals, the exemption amount depends on whether the individual is married and filing a joint return (in which case the amount is ,000) or is a surviving spouse (,000) or is single (,750).
(ii) Interest.—For purposes of clause (i), the interest determined under this clause for any taxable year is the amount of interest at the underpayment rate plus 1 percentage point on the underpayments that would have occurred had the deferred compensation been includible in gross income for the taxable year in which first deferred or, if later, the first taxable year in which such deferred compensation is not subject to a substantial risk of forfeiture. Neither § 409A nor the final regulations issued to date under the statute specify the amount included in income (and the basis for the additional tax). The first example assumes that the individual exercises the options and sells the resulting shares on the same date, which is a common occurrence. The sale price of the shares on the date of exercise is $22.77.
However, the proposed regulations indicate that the amount to be included is the intrinsic value of the option on the last day of the employee’s taxation year in which the option vests and any subsequent year in which a vested option remains unexercised, and, in the year of exercise, the actual value on the exercise date. The income inclusion and penalty tax apply regardless of when (or if) the options are ultimately exercised. In effect, § 409A provides for income inclusion (and a corresponding penalty tax) in each year following the year in which an option vests, and until and including the year of exercise, depending on the value of the underlying shares on December 31 (or the date that the options are exercised in) of the subsequent year. Based on the above discussion, the most preferential compensation regime from an executive’s tax perspective in either Canada or the United States is one in which the options are granted not-in-the-money (or for our purposes, backdated to appear as such). To demonstrate the tax consequences of backdated options in each country, consider the following example. Table 1 summarizes the tax consequences of this example in Canada and the United States.  The AMT is a tax designed to ensure that no taxpayer—whether individual or corporate—may disproportionally benefit from certain tax preferences.
Both sets of motivations arise from the quantitative and qualitative benefits, costs, and risks of issuing and receiving backdated options. Certain AMT may be carried forward and applied to reduce the general tax payable in subsequent years (to the extent that the general tax exceeds the tentative alternative minimum tax liability for the subsequent year).
Most of the research to date has focused on supply side factors (e.g., accounting treatment, securities regulations, and corporate taxation), while there has been little discussion of demand side factors.
For options issued by a public corporation, one-half of the stock option benefit is deductible under paragraph 110(1)(d) if three conditions are met: (1) the option strike price is equal to or greater than the fair market value of the share at the time of the grant; (2) the optioned shares are “plain vanilla” common shares; and (3) the employee deals at arm’s length with the employer. In addition, for options issued by public corporations after February 27, 2000, and exercised prior to p.m. are met: (1) the recipient is a Canadian resident; (2) the underlying shares are traded on a Canadian or foreign prescribed stock exchange; and (3) the individual is entitled to the deduction under paragraph 110(1)(d). The deferral, however, is limited to the first $100,000 worth of options per year of vesting.
(EST) on March 4, 2010, the employment income benefit is deferred until the time the shares are sold if the following conditions, stipulated in subsections 7(8) to (16) of the I. In the United States, the taxation of employee stock options depends on their characterization as non-statutory stock options (“NSOs”) or statutory stock options, which includes incentive stock options (“ISOs”) and employee stock purchase plans (“ESPPs”). There is no difference in the treatment of options granted by a public corporation and a private corporation. In order for an option to be treated as an ISO, a number of requirements must be met including: (1) the exercise price must not be less than the fair market value of the stock at the time of the grant; (2) the exercised shares must be held for the longer of two years from the grant date or one year from the exercise date; and (3) the combined value, as determined by the fair market value of the underlying shares on the grant date, that can be acquired for the first time in any calendar year (i.e., in the year of vesting) cannot exceed US 0,000. For an ISO, there are no income tax consequences until the time the shares are sold, unless the Alternative Minimum Tax (“AMT”) applies. Thus, a taxpayer must pay the greater of (i) his or her regular tax liability or (ii) his or her tentative minimum tax liability, calculated under the AMT rules.
We therefore focus on the value at exercise (and eventual sale of the shares) and demonstrate the role the income tax regime plays in determining the after-tax value to the executive. The long-term capital gains rate remains applicable for AMT purposes; in other words, the reduced rate is not treated as a tax preference for AMT purposes.
This article considers in detail the potential role of personal income taxation in influencing demand for backdated options in Canada relative to the United States.
Following corporate and accounting scandals such as Enron, Tyco, and World Com, the American Jobs Creation Act of 2004 added § 409A to the Code, which radically changed the taxation of deferred compensation, including discounted stock options. I. (ii) Application only to affected participants.—Clause (i) shall only apply with respect to all compensation deferred under the plan for participants with respect to whom the failure relates. § 409A applies to a broad range of deferred compensation, although it also provides a number of exceptions, including employee stock options that are granted not-in-the-money. However, in-the-money options (including backdated options that appear to be not-in-the-money options) are caught by the section.