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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. (B) Interest and additional tax payable with respect to previously deferred compensation (i) In general.—If compensation is required to be included in gross income under subparagraph (A) for a taxable year, the tax imposed by this chapter for the taxable year shall be increased by the sum of— (I) the amount of interest determined under clause (ii), and (II) an amount equal to 20 percent of the compensation which is required to be included in gross income. Under § 409A(a)(1)(A), the “compensation deferred under the plan” must be included in the employee’s gross income “for the taxable year to the extent not subject to a substantial risk of forfeiture and not previously included in gross income.” In addition to the income inclusion, § 409A(a)(1)(B) provides that the tax payable on such income is increased by “premium interest tax” plus an “additional tax” (commonly referred to as a penalty tax) equal to twenty percent of the compensation required to be included in gross income. Generally speaking, a taxpayer must include in income an amount attributable to a grant of in-the-money stock options in the year that the options vest and in every subsequent year up to and including the year of exercise (to the extent not included in income in a previous year). The question of demand requires consideration of what an executive receives in monetary value from a backdated option (i.e., an option that appears to be an at-the-money option with an earlier grant date but is, in fact, in-the-money on the actual grant date) compared to a currently dated at-the-money option.
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. The taxation of stock options varies significantly between Canada and the United States. In this part we summarize the differences, focusing on backdated options and incorporating a discussion of recent U. changes regarding the taxation of discounted stock options enacted in 2004 on the heels of the Enron, World Com, and Tyco scandals. Personal income taxation of stock options in Canada is notably less complex and more generous from the employee’s perspective than in the United States. The AMT rate for individuals is 26% of such amount up to 5,000 and 28% of any excess. This paper contrasts the post-tax returns of backdated at-the-money options to currently-dated in-the-money options (with the same strike price as the backdated options) and demonstrates that a Canadian executive can earn a significantly larger after-tax return from backdated options compared to a US executive. We tie this to the favorable Canadian tax treatment of executive options relative to their treatment in the United States.