How about a rational...

HOW ABOUT A RATIONAL TAX RATIONALE
A commentary on a taxable benefit law that severely punishes
Canadians who fail to take a potential gain when the opportunity arises.
By Victor Drummond ©
June 2008

Imagine yourself as an employee of a High Tech Corporation back in 1985.

Your work performance is outstanding and your employer corporation is growing by leaps and bounds.

Demand for your employer’s products far exceed the corporation’s production capacity
and competing corporations are hiring head-hunters to lure key employees to change from one employer to another.

Competing corporations -- Canadian, American and Foreign -- are offering more money; more perks; and fully paid moving expenses to people they want to hire.

To battle this attack -- on their most valued employees -- your corporation is now offering you, among other key employees, the opportunity to acquire corporation stock under an Employee Share Purchase Plan, (ESPP).

In order to illustrate the insidious nature of the defective “taxable benefit” legislation -- applicable to these plans -- this commentary will set real variables -- in this example scenario -- that would not necessarily be found in this combination -- for any one actual ESPP contract and/or applied by any one specific tax victim. Never-the-less each element of this example is valid for the typical events described.

This particular illustrative plan allows participants to vest, (order), 1000 shares per year, over a 15 year term, with paid-up shares to be exercised, (delivered), one year after each vesting.

The basic cost, per share, to plan participants -- is fixed by the Fair Market Value, (FMV), as of the date of the initial vesting, less 15%. In this instance the given FMV -- at the time the initial ESPP contract is signed on July 30th 1985 -- is $1.00 per share.

Therefore the basic cost -- to plan participants -- is fixed at $0.85 per share at the time of each vesting, i.e. each lot of 1000 shares have a basic cost of $850.00, per year, over the 15 year term of this ESPP contract. (1985 through 2000)

The basic cost per share, however, becomes inflated when the buyer is charged a brokerage fee, (commission), for buy and sell orders and/or levied taxes on any increase in the shares. FMV – which is greater than their ACB – at time of exercise.

If you do not sell any shares --at time of exercise -- you are still levied tax on the potential paper profit the shares FMV represent at that time even though you have not yet actually received any monetary return on your investment.

For sake of simplicity -- in this example scenario -- the bottom line Income Tax percentage is set at 38 although the range would actually vary according to the years federal, and provincial rates set, and the level of your taxable income.

For illustrative purposes’ the share FMV increase is fixed at $10.00, per year, and you are going to sell 100 shares each year, from 1988 to the year you taxable benefit tax equals 50% of your gross real income, to offset Taxable Benefit and Capital Gains taxes levied against your real and theoretical gain from year to year.
i.e. July 30th FMV per share:- !986 = $10.00, 1987 = $20.00, 1988 = $30.00 ….. 2000 = $150.00
Then the tech market bubble burst and the shares FMV on July 30th 2001 = $10.00

To clearly reveal the insidious aspect of the taxable benefit legislation – as it is applied to Employee Share Purchase Plans, (ESPP’s) and Employee Options (ESO’s) plans your actual “Earned” income -- and the tax it generates – is not included in this illustration.

Therefore the tax amounts shown here are purely the taxes levied as a product of the ESPP transactions. At the point where your ESPP generated tax depletes your REAL GROSS INCOME by 50% you will begin to apply the tax deferment option by completing form T1212 each year to defer taxes that exceed your real income by 50%.

At this stage you can no longer sell any of your ESPP shares as this would nullify the tax deferments.

In order to identify when that point has been reached in the on-going tax events your initial gross salary in the year 1985 is set at $35,000 with fixed annual increases of 2.5% per year from 1986 through 2000.

When you begin using the tax deferment option the hidden tax trap is set and it is triggered when the tech market crash begins in July of the year 2000.

The cost per share of the first shares exercised was $0.85 and the law states shares transactions must operate on a First In – First Out, (FIFO) basis.

Consequently the shares ACB will remain fixed at $0.85 per share until the first 1000 shares exercised are all sold even though the ACB of each years 1000 share vesting will be altered by the taxes levied and/or broker’s commissions charged.

The corporation, per share price in 1975 per the Initial Public Offering was $0.10.

To arrive at the July 30th 1985 FMV of $1.00 the publicly traded shares -- in your Employers Corporation -- have double in value and even tripled in value since the company became incorporated as a multi-national organization.

You feel comfortable working for your present employer. Your annual salary is adequate and the working conditions are comparable to most other corporations.

You bought a home nearby and this location has shopping, schools, transportation, good neighbours, and entertainment within easy walking distance.

Therefore you are not inclined to change employers if a change of residence would be involved.

Although you have no prior experience -- in stock market transactions and minimal knowledge of stock market operations -- the opportunity to own a part of your employer’s corporation appeals to you and would no doubt enhance your standing with your employer.

Furthermore the corporation’s track record appears to offer a solid guarantee you will make money if you buy the corporations shares. So you sign on.

As the corporation shares have been averaging consistently higher value for years the FMV looks good and the ESPP allows you to purchase your shares at a 15% discount below the calculated FMV. So you are in the money (theoretically), right from the day you vest, (order), your shares.

Not only that -- but you can order your quota of shares under a payroll deduction scheme which facilitates payment without depleting your savings account or paying interest on borrowed money.

There are other peculiar aspects to buying your shares via this ESPP.
For example you can not just go to a broker and pick up the shares you ordered, and paid for. The shares ordered are held in some form of escrow until the plan next delivery date, (exercise date).

In the time between the date of order, (vesting date), and the date you take control of your shares, (exercise date), you have no control over the latest block of shares you have ordered and paid for.

In this case the time between your initial vesting date and first exercise date is one year.

At first exercise date, July 30/86 you receive 1000 shares of your employers stock and the price you paid per share compared to the current trading price gives you a potential gain of $9,150.00, i.e. (1000 x 10) – 850 = $9,150.00

A very nice paper profit for a first go at the stock market. Of course you do not take this profit as the shares have gained $9.00 each in the past year alone and there is no end in sight.

Your 1986 “Income Statement” (T4) -- the year you first received your allotted ESPP shares -- reports your “Earned Income” as being some $4,575.00 greater than you calculated it should be from your pay slips.

This inflated “income” discrepancy is explained to you as being the addition of the taxable benefit portion of the theoretical gain -- you haven’t yet actually realized – created by the difference between the price you actually paid for your vested shares and their FMV at the time of exercising, (delivery).

The math goes like this:- On July 30th 1986 when your initial 1000 shares were exercise you had a paper profit of $9,150.00 as noted above. The Capital Gains inclusion rate for 1986 is 50%

Therefore your employer was obliged -- by law -- to add 50% of your paper gain, (9150 x 0.5) = $4,575.00 to your real income.

You then paid an additional “income tax of:- 4575 x 0.38 = $1,738.50
(What? Taxes on a purely paper gain?) (Yes, and you haven’t yet realized one cent of that paper profit.)

This tax is a real cost of acquiring the next 1000 shares and consequently the Adjusted Cost Base, (ACB) of the 1000 shares exercised, (delivered) on July 30th 1987 is: - (850 + 1738.50) / 1000 = $2.5885 per share.
But you can not claim this higher cost against the shares you sell until the initial 1000 shares exercised have all been sold.

So on July 31 1987 you sell 100 of the first 1000 shares, to offset the taxable benefit tax levied on the shares delivered on July 30th 1986.

Consequently you incur a Capital Gain on July 31/1987 of:- (100 x 20) – (100 x 0.85) = $1,915.00 which you will report on your 1987 tax return in April 1988.

As the CG inclusion rate in 1987 is again 50% you will be taxed another (1915 x 0.38) = $727.70 on those same shares.

Because a CG tax may be offset by past and/or future CG losses this tax does not inflate your ESPP shares ACB.

Your second order of 1000 shares, (vested July 30th 1986), is exercised on July 30th 1987.
The paper profit on this date is:- (1000 x 20) – (1000 x 2.5885) = 20,000 – 2,588.5 =
$17,411.50

The Capital Gains inclusion rate for 1987 is still 50 percent. Therefore your “Earned Income” is inflated by (17411.5 x .500) = $8,705.75 which at the bottom line tax rate of 38% produces a taxable benefit tax of:- $3,308.19

This tax increases the ACB of the shares vested in 1988 to:- (850 + 3,308.19)/1000 = $4.1582 per share.

The Capital Gains Tax on the 100 shares sold in 1988 is:- (1915 x 0.5000)x 0.38 = $363.85 which can only be offset by past, or future, Capital losses.

It appears that holding your shares past their date of exercise is the wise thing to do because the shares in your employer’s corporation are averaging a higher and higher price every week.

If things keep going -- the way they have in the past two years -- you will be a multi-millionaire by the time your initial ESPP contract expires on July 30 2000.

Things really look rosy as of July 31st 1988 as you are currently holding 2,700 shares which are now trading at $30.00 per share -- producing a gross paper value of $81,000.00

Along the way, however, you have paid out real expenses to build this $81,000 paper castle in the air, i.e.

(1) You have paid $850 shares cost per year for 3 years for a total basic outlay of: $2,550.00

(2) You have paid real taxable benefit taxes for two years, and are set-up to pay for year three * in April 1989.
(3) You have paid $363.85 in Capital Gains Tax, (1988)

Therefore your total real cost, to date, is:- 2,550.00 + 1,738.50 + 3,308.19 + * 6,545.93 + 363.85 = $14,506.47 by the time the 1988 Income * taxable benefit tax is paid.

*i.e. (1988 ESPP tax.) = ((1000 x 30) – (1000 x 4.1582) x 0.666) x 0.38) = ((30,000 – 5,257.90) x 0.666) x 0.38 = $6,545.93

You have sold 300 shares, to date, to realize a gross CG of:- (100 x 10) + (100 x 20) + (100 x 30) = (1000 + 2000 + 3000) = $6,000.00

Your actual, ESPP operations, tangible Profit/Loss balance, as of July 31 1988 is:-
Credits = $6,000.00 and Debits = $14,,506.47 for a net deficit of $8,506.47

Based upon a database spreadsheet – with the ESPP parameters from 1985 through 2003
-- your Taxable benefit tax exceeds 50% of your real gross income in the year 1995.

Therefore on July 31 1995 you sell the last 100 shares of your initial vested 1000 share allotment and begin to apply the T1212 request to defer the 1995 and future years taxable benefit taxes. (The trap is now set.)

To this point you have paid a total of:- $121,681.38 in accumulated Taxable Benefits tax and $$14,947.60 in accumulated Capital Gains Tax but have only actually received $54,150.00 in real accumulated returns from the sale of your first 1000 ESPP shares.

At this stage your ESPP -- P&L Balance sheet is:- Credits = $54,150.00 and Debits = $121,681.38 for a net deficit of $67,531.38

By July 30th 2000 the tech market boom has peaked and shares in your ESPP which had been trading at $150.00 each are losing value almost daily. No one seems to know if the market will recover, stabilize or continue it’s downward trend.

Based upon faith in the management skills of your employer plus hope and past market performance you decide to hold your ESPP shares for one more year. You decide not to order (vest) your year 2001 shares allotment and stand pat with the 2001, 1000 shares delivery.

As of July 30th 2001 You now have accumulated ESPP deferred taxes of:- $$168,162.35 which will lose deferment status as soon as you sell, trade or dispose of any of your 15,000 ESPP shares.
Or if your employer corporation ceases operations, due to bankruptcy and/or take-over by another company.

Furthermore the FMV of those shares has now fallen to $10.00 per share which you would be very fortunate to receive if you placed a sell order for that many shares. Even so the total proceeds of the sale would only return $150,000 which is $18,162.35 short of retiring the deferred taxes.

Surely the stock market has bottomed and there is nowhere for your ESPP shares to go but up – if you wait a bit longer. As the ACB of your ESPP shares now exceeds the FMV you will not incur additional taxable benefit taxes this year.

The hidden trap is now sprung and the noose around your neck is drawing tighter.

By July 30th 2002 the -- per share -- FMV has fallen to $5.00. This reduces the theoretical return on the sale of your 15,000 shares to $75,000 which is now short $93,162.35 of retiring your outstanding deferred taxes.
Your employer corporation is now beginning to reduce production costs by closing some production departments – consolidating other departments and retiring some senior employees.

For now your employment position appears safe and all should turn out well if the stock market would only recover some of its past glory.

On July 30th 2003 you receive the really bad news.

Your position has been removed from the corporate organization chart and you are being dehired effective August 30th 2003. Your separation package consists of 13 months pay including one month of unused annual vacation. Your total separation benefit will be $60,000.

To add insult to injury the FMV of your ESPP shares has dropped to its 1985 level of $1.00 per share. If you sold your 15,000 shares now – and added your separation package you could only compile a total of $75,000 which is still $93,162.35 short of retiring the deferred tax on money you have never actually received.

You have a $14,947.60 balance of accumulated CG taxes already paid but you can not recover any of that money unless you sell ESPP shares at a Loss and that would trigger the cancellation of your deferred taxable benefit axes.

Furthermore – so long as this tax remains unpaid you may not move out of Canada – regardless of anything the Canadian Charter of Rights and Freedoms may say.

The taxable benefit tax trap has sprung and you are scuppered.

Although this case history is hypothetical the transactions described herein are typical and there are thousands of honest hard-working Canadians who have found themselves facing taxation on huge amounts of potential ESPP/ESO benefits that they have never actually received.

Many of these tax victims have found it necessary to sell or mortgage their homes, and/or deplete their savings accounts and/or borrow large sums of money in order to pay this unjust, and unwarranted tax levy.

Most victims, who have used the appeal avenues provided, have had their appeals denied on the grounds that they conscientiously elected to gamble in the stock markets at their own risk.

At interesting rationale in view of the fact the government had not supplied any of the money involved in this series of transactions. This logic of having a claim to tax opportunity when no real profit has been realized is rather presumptuous and dangerous to Canadians as a whole.

This applied rationale is not rational and no agency should assume the right to demand a share of anyone’s money that only existed in theory.

How about treating all gambles in the stock market as Capital Investments and only taxing real gains and allowing this tax to be offset by past, (3 year) and/or future Capital Losses.

That is a rational system of taxation.

If you agree the legislation that produces huge taxes on purely potential profit is unfair, unjustified and unethical – then visit web page http://www.cfet.ca and sign the petition for Fair and Equitable taxation.

Furthermore use the link to E-mail your Member of Parliament and demand that they support correcting this legislation and properly compensating those who have already paid tax on purely phantom income.

Victor Drummond ©

Post Scrip:- The form T1212 did not become available until the year 2001 but for sake of illustrating the catch 22 a deferment created it is shown in this hypothetical instance as happening in 1995. That date for deferment beginning may also be valid if the taxpayer had defaulted on payment of taxable benefit taxes from or before that date.

Also the deferred amount of tax:- $168,162.35 is only the tip of the iceberg.
As of July 30th 2002 the P&L Account would be:-

Credits:- Income from ESPP shares sold to date = $54,150.00
Debits:- Capital Gains Taxes paid = $14,947.60
Debits:- Taxable Benefits Taxes,(Total) = $267,361.85 (of which $168,162.35 deferred)

Defecit = 54,150 - (14,947.60 + 267,361.85) = $228,159.45

The total taxes levied are 5.2 times the actual real income realized. Is that rational?