Strategies for Executive Compensation: Design and Tax Issues for a Turbulent Environment. Tuesday, April 10, 2012

Transcription

1 Strategies for Executive Compensation: Design and Tax Issues for a Turbulent Environment Tuesday, April 10, 2012 MONTRÉAL OTTAWA TORONTO CALGARY VANCOUVER NEW YORK CHICAGO LONDON BAHRAIN AL-KHOBAR* BEIJING SHANGHAI* blakes.com *Associated Office Blake,Cassels & Graydon LLP

2 SEMINAR INDEX TAB STRATEGIES FOR EXECUTIVE COMPENSATION: DESIGN AND TAX ISSUES FOR A TURBULENT ENVIRONMENT TUESDAY, APRIL 10, WELCOME LETTER 2. AGENDA 3. INCENTIVE AND STOCK COMPENSATION ARRANGEMENTS FOR PRIVATE EQUITY TRANSACTIONS ELIZABETH BOYD AND JEREMY FORGIE 4. INCENTIVE COMPENSATION ISSUES IN CORPORATE TRANSACTIONS DAVID CRAWFORD AND BILL SUTHERLAND 5. LONG TERM INCENTIVE PLAN CLAWBACKS: DESIGN, TAX AND OTHER LEGAL ISSUES KATHRYN BUSH 6. UPDATE ON CANADA REVENUE AGENCY POSITIONS ON LONG TERM INCENTIVE PLAN CONVERSIONS AND CROSS BORDER CASH BASED INCENTIVE PLANS ELIZABETH BOYD 7. TOWER WATSON PROFILES DAVID CRAWFORD BILL SUTHERLAND

3 April 10, 2012 Strategies for Executive Compensation: Design and Tax Issues for a Turbulent Environment As hosts, we welcome you to today's session. This morning you will be hearing Speakers from the Blakes Pensions, Benefits and Executive Compensation Group and the Towers Watson Executive Compensation Group review and consider various issues relating to the design and taxation of executive compensation arrangements, with a particular focus on private equity and mergers and acquisition transactions. We are particularly pleased to be joined for this morning s session by David Crawford and Bill Sutherland of Towers Watson. Each of the presentations, as well as additional related materials, is available electronically by visiting Profiles of the Blakes presenters and other lawyers in the Blakes Pensions, Benefits and Executive Compensation Group are available on our website at For your convenience profiles for David Crawford and Bill Sutherland are included in our booklet. This morning s presenters will be available during breakfast and at the end of the session to meet with you. Thank you for taking the time to join us this morning. Enjoy the seminar.

4 SEMINAR AGENDA 7:30-8:00 A.M. BREAKFAST INTRODUCTION 8:05-8:40 A.M. INCENTIVE AND STOCK COMPENSATION ARRANGEMENTS FOR PRIVATE EQUITY TRANSACTIONS ELIZABETH BOYD AND JEREMY FORGIE 8:40-9:15 A.M. INCENTIVE COMPENSATION ISSUES IN CORPORATE TRANSACTIONS DAVID CRAWFORD AND BILL SUTHERLAND 9:15-9:35 A.M. LONG TERM INCENTIVE PLAN CLAWBACKS: DESIGN, TAX AND OTHER LEGAL ISSUES KATHRYN BUSH 9:35-9:50 A.M. UPDATE ON CANADA REVENUE AGENCY POSITIONS ON LONG TERM INCENTIVE PLAN CONVERSIONS AND CROSS BORDER CASH BASED INCENTIVE PLANS ELIZABETH BOYD 9:50-10:00 A.M. Q & A AND CLOSING REMARKS

5 Incentive And Stock Compensation Arrangements For Private Equity Transactions Presented by: Elizabeth Boyd Jeremy Forgie April 10, 2012 Overview of Presentation Types of Private Equity Transactions Corporate Governance Considerations Participation of Target/Portfolio Company Management Exit Strategies and Investment Horizons Key Design Considerations and Commonly Used Incentive Arrangements 2 Overview of Presentation (cont d) Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules Share purchase loans Cash Based Long Term Incentive Plans and the SDA Rules Non-Portfolio Company Incentives Focus on employee-level tax issues corporate tax considerations may also affect compensation design 3 1

6 Types of Private Equity Transactions The structure of the transaction and objectives of the principal investors will have a significant impact on design of incentive compensation arrangements resulting in differences from public company equity and incentive compensation arrangements 4 Types of Private Equity Transactions (cont d) Most common are leveraged buyouts of target (or portfolio company), often with the participation of management Transaction may be structured as a takeover bid, court-approved plan of arrangement, amalgamation or sometimes as an asset sale 5 Types of Private Equity Transactions (cont d) In some cases, a private equity fund or firm will take a minority equity position in the portfolio company or invest in debt of the company with the possibility of taking a longer-term equity stake Sources: Getting the Deal Through: Private Equity 2011, David I. Walker, Executive Pay Lessons from Private Equity, Boston Law Review May 2011 (survey of 144 U.S. portfolio companies) and September 2011 Blakes Study Recent Developments in Canadian Private Equity and Private Equity: 2012 Trends 6 2

7 Types of Private Equity Transactions (cont d) After initial investment by private equity fund or firm in portfolio company, there will often be follow-on investment that is intended to raise further capital to facilitate additional growth of the portfolio company s business 7 Types of Private Equity Transactions (cont d) The private equity fund will also often recapitalize the business of the portfolio company by re-leveraging and taking out invested funds - those funds can then be distributed to investors in the private equity fund, deployed by the fund to make new investments or even redirected to other portfolio companies in which the private equity fund invests 8 Corporate Governance Considerations Private equity fund or manager will often prefer to be the majority shareholder so that it retains ultimate decision-making power over the portfolio company 9 3

8 Corporate Governance Considerations (cont d) Where there are minority shareholders (including management and other institutional investors) following the transaction, the shareholders agreement will typically dictate the manner in which the target company is governed, including any negotiated veto rights for minority shareholders and special liquidity events for shareholders including management 10 Participation of Target/Portfolio Company Management A private equity fund will often regard management of the portfolio company as being critical; for example, where the portfolio company is in an industry that is not familiar to the private equity fund or where the portfolio company s existing management team was a significant factor in the attractiveness of the investment 11 Participation of Target/Portfolio Company Management (cont d) From the perspective of the private equity fund and other investors, the objective will often be to emphasize retention and improvement in the portfolio company s business and downplay compensation tied to the closing of the transaction 12 4

9 Participation of Target/Portfolio Company Management (cont d) Often there will be employment contracts with key management and target financial performance hurdles that may be incorporated into equity and other incentive compensation arrangements 13 Participation of Target/Portfolio Company Management (cont d) Bearing in mind (particularly in a take-over bid) disclosure requirements relating to proposed management incentive compensation arrangements, it is quite common for there to be negotiation between members of key management and the private equity fund of different (and, in some cases, enhanced) salary, bonus and incentive compensation arrangements compared to what existed when the company was still a public company 14 Exit Strategies and Investment Horizons Due to the additional debt that is incurred by the portfolio company, leveraged buyouts can present greater potential risk to equity investors 15 5

10 Exit Strategies and Investment Horizons (cont d) The private equity firm or fund will usually develop a strategy that is intended to result in adding value to the portfolio company s business with the objective of realizing on its investment in the portfolio company as soon as is practical 16 Exit Strategies and Investment Horizons (cont d) The mechanism for realization (i.e., the exit strategy) may be a private sale or initial public offering together with subsequent secondary offerings 17 Exit Strategies and Investment Horizons (cont d) The time horizon for a liquidity event or exit can vary significantly for example, the private equity fund may have a longterm investment strategy with the objective of recouping its investment along with a return 18 6

11 Exit Strategies and Investment Horizons (cont d) On the other hand, there could be other factors which make a faster exit attractive including opportunistic events such as a particular buyer (or type of buyer) becoming interested in the portfolio company due to a variety of different factors including tax, regulatory or competition law considerations 19 Exit Strategies and Investment Horizons (cont d) Portfolio company shareholder agreements often contain provisions dealing with anticipated liquidity events such as merger, sale to another corporation or initial public offering and, where there is an initial public offering, ensuring that shareholders, including management, have freely trading shares in the event of an IPO 20 Key Design Considerations and Commonly Used Incentive Compensation Arrangements Plan governance compared to public companies (board reacting to management proposals), in many cases, compensation decisions such as approval of management contracts, equity grants and other incentive compensation plans require only approval of principal investors 21 7

12 Key Design Considerations and Commonly Used Incentive Compensation Arrangements (cont d) Performance objectives because of significant leveraging, promoting cash flow and debt service are often important objectives which impact on plan design incentive compensation plans may be designed, for example, to reward management s contribution to control of discretionary costs, improving productivity, strategic repositioning and growth of the business that exceeds the rate of return assumed by the principal investors 22 Key Design Considerations and Commonly Used Incentive Compensation Arrangements (cont d) Importance of equity-based incentives studies noted above suggest that for portfolio companies: equity-based incentives for key management often represent 65% to 70% of total compensation opportunity 23 Key Design Considerations and Commonly Used Incentive Compensation Arrangements (cont d) providing a piece of the total appreciation in value of the portfolio company is a main driver as opposed to competitive equity grants relatively large up-front equity grants for key management most often in the form of stock options, a portion of which may be subject to timebased vesting and a portion subject to performancebased vesting, including measures such as EBITDA and internal rate of return (IRR) 24 8

13 Key Design Considerations and Commonly Used Incentive Compensation Arrangements (cont d) expectation that key management (e.g., CEO) will make a significant personal equity investment in the portfolio company at the outset and investment in the company following the liquidity event 25 Key Design Considerations and Commonly Used Incentive Compensation Arrangements (cont d) Equity grants will often be reserved for key management and principal investors may be reluctant to authorize increase in available option or equity pool provision in original pool for additional grants to employees promoted into key management roles and new hires 26 Key Design Considerations and Commonly Used Incentive Compensation Arrangements (cont d) Equity grants may not be available for management beneath the top key management tier, in which case, cash-based long-term incentive plans can be important, including appreciation rights, cash-settled restricted share units (RSUs), cash-settled performance share units (PSUs) and sometimes even cash-settled deferred share units (DSUs) which incorporate vesting provisions 27 9

14 Key Design Considerations and Commonly Used Incentive Compensation Arrangements (cont d) Private equity fund often wants to limit ability of portfolio company executives to liquidate their equity holdings prior to an IPO or other defined liquidity event. Sometimes, there will be an exception for shares already acquired by the executive as opposed to outstanding stock options or in some cases for certain narrowly defined events (e.g., death or disability). 28 Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules Employee stock options and other equity awards granted by a Canadian-controlled corporation (CCPC) have preferential Canadian income tax treatment: - taxable employment benefit arises when shares are disposed of (subsection 7(1.1) of Income Tax Act (Canada) (ITA)) the exercise of the stock option or the issuance of shares under a stock bonus or share-settled restricted share unit is not a taxable event 29 Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules (cont d) the employee may claim a 50% deduction (paragraph 110(1)(d.1)) against the taxable employment benefit (e.g., in-the-money amount when the option was exercised or in the case of a stock bonus, the fair market value of the share at the time it was issued) provided: 30 10

15 Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules (cont d) the employee does not dispose of the share (other than because of death) or exchange the share within 2 years of the date the employee acquired the share the employee has not claimed the regular stock option deduction under paragraph 110(1)(d) Alternatively, employee may be able to claim the 50% deduction under paragraph 110(1)(d) that is also available for ordinary non-ccpc options 31 Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules (cont d) Unlike with publicly traded companies subject to stock exchange rules, there is no requirement that private company options be issued at fair market value provided that when shares are issued they are fully paid in cash, past services or a combination Fully paid requirement can be an issue with stock bonuses or immediately exercisable discounted options for new employees or employees of a new entity 32 Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules (cont d) For some CCPCs, employee may be able to claim capital gains exemption for qualified small business corporation shares (sections 110.6(1) and 110.6(2.1)) although this is subject to various restrictions where the taxpayer has cumulative net investment losses (CNIL) and allowable investment business losses (ABIL) and claiming the deduction may trigger alternative minimum tax (AMT) 33 11

16 Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules (cont d) The determination of whether the portfolio company is a CCPC is not always straightforward A CCPC is a Canadian corporation (generally a corporation resident in Canada constituted under the laws of Canada or a province) that is not controlled by a publicly listed corporation or by one or more non-residents 34 Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules (cont d) In determining CCPC status control in the ordinary sense is not required where the shares of a corporation are widely held by nonresidents and/or publicly listed corporations such that none of those shareholders controls the corporation, the corporation will not be a CCPC if it would be controlled by one person if that person owned all of the shares held by such non-residents and publicly listed corporations 35 Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules (cont d) By ordinary stock options, we refer to an agreement by a particular corporation that is not a CCPC (or mutual fund trust) to sell or issue its shares (or trust units) to an employee or an employee of a corporation (or mutual fund trust) with which the particular company does not deal at arm s length General stock option tax treatment: (i) no tax on grant; (ii) tax on benefit arising on exercise; (iii) benefit equals excess of fair market value of shares acquired under the option over the exercise price (i.e., the in-the-money amount) 36 12

17 Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules (cont d) Employee can claim a 50% deduction under paragraph 110(1)(d) against the taxable benefit arising on the exercise of the options if the following conditions are met: the exercise price is at least equal to the fair market value of the shares at the time the options were granted the employee deals at arm s length with the corporation granting the option and the employee s employer (if different from the grantor of the option) the shares are prescribed shares under Regulation Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules (cont d) paragraph 110(1)(d) deduction can apply to ordinary options or to CCPC options where deduction under paragraph 110(1)(d.1) does not apply threshold question is there an agreement to sell or issue shares of the employer or a corporation with which the employer does not deal at arm s length? query whether there is such an agreement where option provides that it can only be exercised on a liquidity event and will be automatically cashed out fair market value exercise price can also be a challenge to establish in a private company context fair market value is not a defined term under the ITA and CRA generally does not provide rulings on valuation issues 38 Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules (cont d) Arm s-length requirement generally, employees, including senior management, are considered at arm s length from their employer but where management is part of control group, arm s-length requirement for paragraph 110(1)(d) deduction would not be met 39 13

18 Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules (cont d) Prescribed shares under Regulation 6204 where dividends or liquidation entitlements are limited to a maximum or fixed at a minimum, shares will not be prescribed shares where shares can be reacquired by issuer or person with whom the issuer does not deal at arm s length, this may preclude shares being prescribed shares conversion rights can also be problematic 40 Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules (cont d) some exceptions to repurchase restrictions if price does not exceed fair market value and/or to provide a market or protect employee from loss relevant dividend, liquidity and repurchase provisions can be in share terms or under an agreement in respect of a share or its issue, which could include shareholders agreement, credit agreement, etc. prescribed share test is at time shares are issued (or would have been issued in the case of a cash-out) 41 Stock Options Rules for Canadian-Controlled Private Corporations and Ordinary Stock Option Rules (cont d) paragraph 110(1)(d) deduction will not be available on an option cash-out unless company that granted option files election under subsection 110(1.1) to forego any deduction of cash-out amount subsection 110(1.1) election is made on employee s T4 for the year in which the option is cashed out where options cashed out on exit event, purchaser will control company at time T4s are prepared commitment from purchaser to cause election to be made can be included in purchase agreement but employees may not be parties 42 14

19 Share Purchase Loans Management investment can be facilitated through a share purchase loan, as loans generally not included in income unless forgiven Where employee is a shareholder, need to consider shareholder loan tax rules, in particular, subsections 15(2) and 15(2.4), as well as section 80.4 which provides for a taxable benefit where employee receives a low interest or interest-free loan as a consequence of his/her office or employment 43 Share Purchase Loans (cont d) Under s. 5(2), the amount of a loan received by a shareholder of a corporation from the corporation, a related corporation or a partnership of which the corporation or related corporation is a member, is included in the shareholder s income for the year in which the loan was received, subject to certain exceptions: 44 Share Purchase Loans (cont d) S.15(2.4) provides that s.15(2) will not apply where the loan is provided to an individual who is both an employee and a shareholder of the lending corporation or of a related corporation to enable the individual to acquire newly issued shares of the lending corporation or a related corporation where: it is reasonable to conclude that the loan was provided because of the individual s employment and not because he/she is a shareholder at the time the loan is made, bona fide arrangements were made for repayment within a reasonable time 45 15

20 Share Purchase Loans (cont d) Requirement for bona fide arrangements for repayment within a reasonable time does not require all of the loan terms be commercial, e.g., would not preclude an interest-free loan and may not require specific contractual repayment terms, but does require that arrangements for repayment exist when the loan is granted and the loan be repayable within a reasonable time Requirement for repayment on termination of employment, sale of shares or other event, the timing of which is uncertain, is unlikely to constitute bona fide arrangement for repayment within a reasonable time 46 Share Purchase Loans (cont d) Interest-free loans and loans at an interest rate below the prescribed rate for employee loans will result in a taxable benefit under s Essentially, benefit equals difference between the prescribed rate and amount of interest actually paid by the employee for the year and not later than 30 days after year-end 47 Share Purchase Loans (cont d) S applies to loans provided because of or as consequence of an individual s previous, current or intended office or employment Taxable benefit under s is deemed under section 80.5 to be interest for purposes of paragraph 20(1)(c), which may allow employee to deduct interest benefit (provided shares can be said to have been acquired to earn income) 48 16

21 Cash-Based Long-Term Incentive Plans and the SDA Rules Where real equity reserved for key executives, other employees typically receive cash-based long-term incentives, including: restricted share units performance share units unitized awards not based on shares values appreciation rights 49 Cash-Based Long-Term Incentive Plans and the SDA Rules (cont d) Salary deferral arrangement (SDA) rules will be relevant Components of SDA definition right to receive an amount after the year in respect of an amount on account of salary or wages for services in the year or a preceding year 50 Cash-Based Long-Term Incentive Plans and the SDA Rules (cont d) Components of SDA definition (cont d) must be reasonable to consider that one of the main purposes is to postpone tax includes a right subject to conditions unless there is a substantial risk one such condition will not be satisfied 51 17

22 Cash-Based Long-Term Incentive Plans and the SDA Rules (cont d) There is virtually no jurisprudence relating to the SDA rules Deferred compensation plans generally designed to minimize CRA assessing risk Commentary to date suggests the following about CRA s position with respect to the SDA rules time-based vesting is not sufficient to create a substantial risk of forfeiture 52 Cash-Based Long-Term Incentive Plans and the SDA Rules (cont d) Share unit plans that pay out by the end of the third year following the year in which the relevant services are rendered should fall within the paragraph (k) exception to the SDA definition applicable to bonuses and similar payments Share appreciation rights should not result in an SDA provided payments occur promptly following vesting 53 Cash-Based Long-Term Incentive Plans and the SDA Rules (cont d) Where awards subject to genuine, reasonably stringent performance conditions, there may be a substantial risk that one of the conditions will not be satisfied such that no SDA arises In private equity context, may want to tie settlement/vesting to liquidity event to retain employees and limit cash drain 54 18

23 Cash-Based Long-Term Incentive Plans and the SDA Rules (cont d) Where incentive is based on appreciation rights model, some concern that CRA may challenge if share value is based on a formula that reflects financial measures (e.g., EBITDA, sales etc.) but not necessarily a commercial fair market value or where appreciation not based on share values at all but on increases in a notional unit, although favourable rulings have been granted in the past 55 Non-Portfolio Company Incentives Private equity incentives sometimes provided at holdco level Common where holdco is U.S. LLC to provide employees with profits interests in LLC LLC not specifically recognized under ITA but CRA position to date seems to be that LLCs will generally be treated as corporations, while in U.S. they are considered to be a flow-through entity akin to a partnership 56 Non-Portfolio Company Incentives (cont d) Profits interests share in increases in the value of the LLC only after the agreed upon value is allocated to other LLC units Profits interest should be a security under Canadian securities laws so in principle should result in same tax treatment as acquisition by employee of any other security as a result of employment 57 19

24 Non-Portfolio Company Incentives (cont d) If LLC is a corporation for Canadian tax purposes, profits interest may be a share for purposes of section 7 of ITA Regardless of whether section 7 applies, if profits interest granted to employee, it appears that fair market value at grant would be taxable benefit of employment 58 Non-Portfolio Company Incentives (cont d) Profits interests generally have no intrinsic value at grant since if LLC liquidated at that time holders of profits interest would receive nothing In U.S., current tax rules allow profits interests to be granted at zero value (i.e., no income inclusion on grant) and any increase to be taxed as a capital gain 59 Non-Portfolio Company Incentives (cont d) Would expect profits interests to have some positive fair market value for ITA purposes, but can be difficult to establish Appears to be no published CRA commentary on taxation of profits interests granted to employees as a form of incentive compensation 60 20

25 Non-Portfolio Company Incentives (cont d) Where holdco or opco is actually a partnership for ITA purposes, this may affect available forms of incentive compensation In particular, partnerships cannot grant options on partnership units under section 7, although CRA s published statements indicate that employees may still benefit from section 7 where options granted by partners that are corporations Not clear how CRA s position applies with multi-tiered partnerships or structures involving trusts; sometimes see separate management holdco established which grants options subject to section

26 Incentive Compensation Issues in Corporate Transactions David Crawford Bill Sutherland April 10, Towers Watson. All rights reserved. Introduction A thorough assessment of incentive compensation programs is often overlooked during corporate transactions At times, a thorough assessment does not get completed until well after the transaction has been completed Our discussion today will aim to highlight some of the issues that can materialize for organizations that put themselves in play and for organizations looking to make an acquisition towerswatson.com 2 1

27 Acquirer (Buyer) Priorities in a Corporate Transaction Specific focus related to incentive compensation includes: Identifying and quantifying key issues that could impact the value of the transaction or the profitability going forward Identifying key issues that could impact business sustainability Identifying and quantifying any potential reputational risks Retaining key resources required to ensure success Limiting distractions towerswatson.com 3 Acquirer (Buyer) Perspective A full review of the compensation programs needs to be completed concurrent with all other assessments during the due diligence phase, The goal is to identify key issues that could impact the value of the transaction or the profitability going forward. Personal terms/contracts Formal plan documentation review Quantify the Potential financial impacts Who has contracts? What are the separation liabilities that will be triggered as per change of control agreements, or as a result of future departure scenarios? Are all long-term incentive awards immediately accelerated as a result of the transaction? Does the plan include roll-over provisions? What have the historical incentive payments/awards been? What is the value of all outstanding equity holdings? What are the financial obligations owed - in aggregate and for key executives? towerswatson.com 4 2

28 Transaction Scenarios Acquisition A purchases B Sale/Divestiture A sells part of its business to B Merger A and B combine Joint Venture A and B create C IPO Go Private Acquired company s incentive compensation plan tends to disappear May include a standstill agreement that leaves plans unchanged for a period of time Acquired business tends to see its incentive plans disappear or, at the very least, significantly modified to align with the new culture Incentive plans can take on a yours, mine, or ours mindset Provides an opportunity to take the best-of Can lead to dramatically different reward cultures and pay philosophies Highly focused/customized incentive plans created opportunity to experiment Bigger executive role Anticipate pay disclosure and governance scrutiny New ownership Equity focused on deal price towerswatson.com 5 Company In-Play or Reviewing Strategic Alternatives Implication for management: May have Winners and/or Losers Bigger Job, Same Job, Smaller Job, No Job Security / Protection Understanding termination benefits can foster significant retention for atrisk positions. Formalize/clarify understanding of severance protection. Program Treatment Providing clarity around the equity treatment could provide a strong incentive to retain key talent particularly if potential value is meaningful. Important to also ensure responsible treatment to allow for retention beyond transaction. Additional Retention Incentives May require the creation of retention programs to ensure that critical talent is retained and key executives are acting in the best interests of the desired transaction efforts. Need to ensure that any amounts are responsible in the context of the entire pay package. towerswatson.com 6 3

29 Program Treatment Equity Compensation (LTI) Consider the following principles: A technical change-of-control (COC) should not result in automatic vesting. If there is an ongoing share price and/or company performance can still be reasonably measured, there is no need to automatically vest or wind down the plans Participants should not be penalized If the plans cannot, from a practical point of view, continue (e.g., no share price available or acquiring company does not want the equity continuing), full value should ultimately be settled. A participant whose employment is terminated as part of the COC should receive the full benefit of the LTIP awards (i.e., fully vested) towerswatson.com 7 Stock Option in Transaction 3 types of treatment for stock options on a change-in-control: 1. Accelerate vesting and settle on transaction price; 2. Accelerate vesting and exchange options for those of the acquiring company (maintaining the option holders economic value); or 3. Maintain vesting and exchange options for that of the acquiring company (maintaining the option holders economic value). The 3 rd treatment is preferable with acceleration only if: The participant is actually or constructively terminated, or It is not practical to exchange the options (e.g., no publicly-traded share is available). towerswatson.com 8 4

30 Stock Option Rollover Maintaining Economic Value Assumptions Pre-Transaction Price [P1] $50.00 Post-Transaction Price $20.00 Exchange Ratio [P1 / P2] OPTIONS Pre Exchange Exchange Adjustment After Exchange Exercise Price $ / 2.5 $ Options 10,000 x ,000 Exercise Cost $300,000 $300,000 Underlying Market Value $500,000 $500,000 In-the-Money $200,000 $200,000 Combined Exercise Price Adjustment x 0.4 Combined Number of Shares Adjustment x 2.5 towerswatson.com 9 No Reason to Accelerate RSU/PSU Payment (Vesting) Share Price NewCo RSUs RSU Grant Transaction RSU $ Value No Share Price $ Payment Withheld Grant Year 3 towerswatson.com 10 5

31 Dollar Amount Converted to RSUs/DSUs Company in black-out, or Company anticipating IPO Grant Year 3 Remain Cash Settle $ Denominated Retention Convert to RSUs Settle Convert to DSUs Continue towerswatson.com 11 Key Points Ensure a complete review of all contracts and plan terms Understand the financial obligations triggered as a result of the transaction Understand specific program treatment Immediate vesting is not always a requirement Pay particular attention to retaining key talent towerswatson.com 12 6

32 Long Term Incentive Plan Clawbacks: Design, Tax and Other Legal Issues Presented by: Kathryn Bush April 10, 2012 Introduction Since 2008, substantial growth of the use of clawbacks in Canada Blakes Bulletin: Clawbacks Coming to Canada dealing with securities and corporate law aspects Current public examples Design issues Canadian tax issues 2 U.S. Statutory Clawbacks Sarbanes-Oxley Act of 2002 (SOX) negative revision of financial results executive misconduct material non-compliance in the financial results any incentive payments and entire payment 1-year period CEO and CFO enforced by SEC 3 1

33 U.S. Statutory Clawbacks (cont d) Dodd-Frank Wall Street Reform & Consumer Protection Act (DFW) applies in wider circumstances and to more employees than SOX any material non-compliance that results in a financial restatement all current and former executives 4 U.S. Statutory Clawbacks (cont d) 3-year look back absolute liability excessive portion of the award enforced by the Issuer 5 Financial Stability Board Principles FSB co-ordinating national financial authorities Bank of Canada, OSFI and federal Ministry of Finance are FSB members Principles for Sound Compensation Practices - Implementation Standards 6 2

34 Financial Stability Board Principles (cont d) OSFI best practices for Canadian financial institutions Canadian issuers which are subject to SEC listing requirements 7 Contractual Clawbacks in Canada and the U.S. Executive misconduct or bad behaviour Joining a competitor Movement to absolute liability 8 Type and Relative Prevalence of Clawbacks in the U.S. and Canada 450 public companies surveyed by Hay Group > 50% use clawbacks 82% of Fortune 100 companies use clawbacks clawbacks used in annual incentives stock options RSUS 9 3

35 Type and Relative Prevalence of Clawbacks in the U.S. and Canada (cont d) less frequent in Canada except top-tier banks and insurance companies are almost 100% now typical 2 or 3-year look back 10 Three Major Categories of Clawbacks Bad faith (including breach of noncompete) Fraud, negligence or intentional misconduct resulting in a financial result revision Any restatement of financial results (growing in prevalence) 11 Three Major Categories of Clawbacks (cont d) Paper includes 9 examples of U.S. and Canadian clawback provisions in 2011 proxies 12 4

36 Canadian Taxation Clawback in current year poses no difficulty Clawback in later year creates problems due to section 8 of Income Tax Act (Canada) 13 Potential Tax Relief for Later Year Clawbacks Filing an Amended Tax Return Armstrong - CRA discretion 14 Potential Tax Relief for Later Year Clawbacks (cont d) Mistake If the parties base their contract on a fundamental error about the assumptions supporting their agreement, and neither party agrees to bear the risk of the assumption turning out be false, the contract can be held void on the basis of the doctrine of common-law mistake. procedural and jurisdictional hurdles - Fradette 15 5

37 Potential Tax Relief for Later Year Clawbacks (cont d) Remission The Governor in Council may, on the recommendation of the appropriate Minister, remit any tax or penalty, including any interest paid or payable thereon, where the Governor in Council considers that the collection of the tax or the enforcement of the penalty is unreasonable or unjust or that it is otherwise in the public interest to remit the tax or penalty no public record of such a remission order having ever been granted in the case of a clawback 16 Potential Tax Relief for Later Year Clawbacks (cont d) Unjust enrichment enrichment without juristic reason 17 Potential Tax Relief for Later Year Clawbacks (cont d) Rectification In order for a party to succeed on a plea of rectification, he must satisfy the Court that the parties, all of them, were in complete agreement as to the terms of their contract but wrote them down incorrectly. It is not a question of the Court being asked to speculate about the parties intention, but rather to make an inquiry to determine whether the written agreement properly records the intention of the parties as clearly revealed in their prior agreement. 18 6

38 Design Alternatives to Avoid Adverse Canadian Tax Consequences 3-year bonus exclusion from the Definition of Salary Deferral Arrangement a plan or arrangement under which a taxpayer has a right to receive a bonus or similar payment in respect of services rendered by the taxpayer in a taxation year to be paid within 3 years following the end of the year, downside delayed receipt by executive 3-year limit 19 Design Alternatives to Avoid Adverse Canadian Tax Consequences (cont d) Employee loan taxable benefit with respect to interest may result downside cumbersome must be repaid if clawback operative 20 Design Alternatives to Avoid Adverse Canadian Tax Consequences (cont d) Use of a trust s. 7 income inclusion by s. 8(12) deduction if clawback occurs downside immediate tax without cash unless a loan is also used trust needs to be established securities compliance 21 7

39 Conclusion Clawbacks in Canada seem to be growing in prevalence and scope Canadian tax result likely to be harsh unless there is planning at the time of the relevant award 22 8

40 Long Term Incentive Plan Clawbacks: Design, Tax and Other Legal Issues Kathryn Bush Partner Blake, Cassels & Graydon LLP Barristers, Solicitors 199 Bay Street Suite 4000, Commerce Court West Toronto, ON Canada M5L 1A9

41 Long Term Incentive Plan Clawbacks: Design, Tax and Other Legal Issues Kathryn Bush, Blake, Cassels & Graydon LLP 1. INTRODUCTION In recent years, particularly since the global financial crisis, the use of clawback provisions in executive compensation plans has become more widespread in Canada. Basically, clawbacks are arrangements under which an employee s compensation that has previously been awarded is forfeited or clawed back. Canadian public companies listed in the United States are subject to statutory clawbacks for certain employees. As well, certain Canadian financial institutions regulated by the Office of the Superintendent of Financial Institutions ( OSFI ) have adopted clawbacks as an OSFI-recommended best practice. Other Canadian public companies are not required to adopt clawbacks, but may choose to do so by agreement with affected employees. The increasing use of these provisions in Canadian employment contracts raises a series of interesting and potentially difficult issues that should be kept in mind when designing executive incentive plans. A potentially problematic example is the income tax consequences of compensation clawbacks in the context of the Canadian income tax laws. As will be discussed, the potentially harsh tax treatment of the clawed back amounts in Canada is an added layer of complexity that should be taken into account, particularly when using existing U.S. policies as a source for drafting Canadian clawback provisions. As explained in the Blakes Bulletin Clawbacks Coming to Canada, clawback provisions can take a variety of forms and be triggered by different types of events. 1 They may apply to vested and unvested awards, affecting different forms of compensation from annual bonuses to long term incentive awards of equity and non- The author acknowledges the assistance in the preparation of this paper of Atbin Dezfuli, Articling Student.

42 - 2 - equity compensation. Triggers range from fraudulent misconduct to bad faith behaviour and even the mere occurrence of a negative restatement of financial results. 2. U.S. STATUTORY CLAWBACKS Specific types of clawbacks are statutorily mandated under the U.S. Sarbanes-Oxley Act of 2002 ( SOX ), and Dodd-Frank Wall Street Reform and Consumer Protection Act ( DFW ). These measures are relevant for Canadian corporations which are foreign private issuers under U.S. securities laws. These provisions are also of more general interest since the concepts introduced and developed in the U.S. statutory clawbacks are widely adopted by both US and Canadian issuers in drafting their contractual clawback policies. The clawback provisions in SOX adopted the basic notion, incorporated in most current clawback policies, that executive bonuses based on materially inaccurate financial results that are subsequently subject to a negative revision should be forfeited. The forfeiture, or clawback, is conditioned on a finding of executive misconduct that has resulted in the material non-compliance in the financial results. These provisions apply to any incentive payments, covering both cash and equity awards, in the one-year period following the issue of the financial results that later had to be restated. The clawback is mandatory for U.S. public companies but only applies to the CEO and the CFO. However, the misconduct required to trigger the provision is not required to be that of the CEO or the CFO. 2 The DFW introduced bigger and better clawbacks that apply in a wider set of circumstances to a wider base of employees. Under these provisions, any material non-compliance with reporting requirements that necessitates a restatement of financial results triggers a clawback mechanism that applies to incentive awards received by all current or former executives. There is a three year look-back period, which means that incentive awards handed out during the three years preceding the date of restatement 1 J. Tuzyk, Blakes Bulletin on Securities Clawbacks Coming to Canada?, November 2011, available at

43 - 3 - are subject to recoupment. It is significant to note the absolute-liability nature of these provisions in that there is no misconduct requirement for the DFW clawbacks to be triggered. DFW measures apply in addition to the already in place SOX provisions discussed above, yet they are in one aspect narrower: DFW clawbacks only apply to the excessive portion of the award that was received by the executive based on inaccurate financial results, whereas, under the SOX, the entire payment may be subject to forfeiture. This is probably an appropriate policy choice in light of the no-fault nature of DFW clawbacks. Also unlike SOX, which tasks the SEC with enforcing the clawbacks by litigation, the DFW provisions are required to be enforced by the issuer, who should disclose its policies for doing so as part of its securities reporting requirements FINANCIAL STABILITY BOARD ( FSB ) PRINCIPLES AND CANADIAN ADVISORY POLICIES The FSB is an international organization co-ordinating national financial authorities of countries such as the U.S., and Canada. Bank of Canada, OSFI and the Federal Ministry of Finance are members of FSB, which has issued FSB Principles for Sound Compensation Practices Implementation Standards. The Principles espouse the basic notion that executive incentives based on inaccurate financial results that are subsequently subject to downward revision should trigger some form of recoupment or clawback mechanism. Further, unvested portions of deferred compensation should also be clawed back based on the actual performance of the business in the year of vesting. There are no regulatory or statutorily mandated clawbacks in Canada. However, Canadian issuers which are subject to SEC listing requirements are subject to clawback provisions, and clawbacks following the general guidelines of FSB Principles are recommended by OSFI as a best practice to the Canadian financial institutions that it 2 Ibid 3 Ibid

44 - 4 - regulates. As the OSFI-regulated entities are not subject to a specific legislative provision in this regard, there is no prescribed form of clawback as in the U.S CONTRACTUAL CLAWBACKS IN CANADA AND THE U.S. The Canadian clawback is therefore primarily a contractual measure. In drafting contractual provisions, Canadian companies have tended to follow the U.S. precedent, which has a longer and more established history of using such provisions. The historical use of U.S. contractual clawbacks has been directed at executive misconduct or bad behaviour, a common example being situations where employees left to join competitors. Following the example of U.S. lawmakers, however, clawback provisions are increasingly being used to address a much more far reaching set of issues, going beyond bad behaviour to include absolute liability-type situations where a negative restatement leads to disgorgement regardless of executive fault. This signals a new understanding of clawbacks as a risk-management mechanism and more generally a corporate governance tool to deter management from taking actions that could potentially harm the company s financial position TYPES AND RELATIVE PREVALENCE OF CLAWBACKS IN U.S. AND CANADA According to the HayGroup report, a survey conducted over 450 US public companies with revenues over $4 billion showed (i) more than half of them adopting some form of clawback; (ii) this figure is at 82% for Fortune 100 companies; (iii) clawbacks are applied to annual incentives as well as unexercised stock options and restricted stock/share units (RS/RSU), (iv) clawbacks are a much less frequent sight in Canada overall, apart from top tier banks and insurance companies which have been almost unanimous in adopting some form of recoupment policy since 2009, and (v) as in the 4 supra note 1 5 HayGroup, Executive Briefing Canada, Issue 1, March 2011

45 - 5 - U.S., a wide range of incentives are subject to disgorgement in Canada, with a typical look-back period of two to three years. 6 Clawback provisions have been commonly categorized into the following three major categories: (1) the first category covers bad faith conduct which includes the breach of non-compete policies, and more generally conduct that is not in good faith and goes against the best interests of the company. (2) The second major category covers fraud, negligence or intentional misconduct, where the employee has unearned income as a result of fraudulent or negligent conduct leading to financial results that need to be revised at a later point. (3) The third major categories are clawbacks that are triggered directly by a restatement of financial results, with no need for the company to show a causal link between the negative revision and employee misconduct. Companies may adopt a combination or all of these measures in their clawback policies, and the following examples will demonstrate that companies may adopt language that is not clearly caught by these categories. Overall, it seems however, that the inclusion of strict restatement clawbacks is increasingly common, particularly in Canadian entities that adopt such provisions. 6 Ibid

46 EXAMPLES OF U.S. AND CANADIAN CLAWBACK PROVISIONS IN 2011 PROXIES (a) (i) U.S. Public Issuers Clawbacks; DEF 14A forms available on EDGAR General Motors Company GMC s initial clawback policy was adopted in response to TARP measures and covered fraud, negligence and intentional misconduct. More recently, the board has expanded the recoupment policy to cover material inaccuracy in financial statements, applying to any SEO and the next top 20 earners of the company. The policy however adds a knowledge condition for recoupment which separates it from the absolute-liability type provisions: Recoupment Policy on Incentive Compensation On September 8, 2009, our Board reaffirmed and expanded our policy regarding the recoupment of incentive compensation paid to executive officers in situations involving financial restatement due to employee fraud, negligence, or intentional misconduct and posted it on our website, consistent with the requirements for TARP recipients. Our recoupment policy now provides that if our Board or an appropriate committee thereof has determined that any bonus, retention award, or incentive compensation has been paid to any SEO or any of the next 20 most highly compensated employees of the Company based on materially inaccurate misstatement of earnings, revenues, gains, or other criteria, the Board or Compensation Committee shall take, in its discretion, such action as it deems necessary to recover the compensation paid, remedy the misconduct, and prevent its recurrence. For this purpose, a financial statement or performance metric shall be treated as materially inaccurate with respect to any employee who knowingly engaged in providing inaccurate information or knowingly failed to timely correct information relating to those financial statements or performance metrics. We will continue to

47 - 7 - review our policy to assure that it is consistent with evolving best practices and SEC and NYSE requirements. 7 (ii) CISCO Systems, Inc. Clawbacks in CISCO are limited to the cash incentives for restatement triggered provisions, going back to July, The proxy however also mentions possible forfeiture of equity awards for detrimental activities and termination for misconduct: Since March 2008, Cisco has maintained a recoupment policy for cash incentive awards paid to executive officers under Cisco s annual cash incentive plan, the EIP. In the event of a restatement of incorrect financial results, this policy would enable the Compensation Committee, if it determined appropriate and subject to applicable laws, to seek reimbursement of the incremental portion of EIP awards paid to executive officers in excess of the awards that would have been paid based on the restated financial results. This policy also was applied to the discretionary cash incentive awards paid to executive officers for fiscal Cisco s variable cash incentive and long-term, equitybased incentive award plans also generally provide for forfeiture if a named executive officer participates in activities detrimental to Cisco or is terminated for misconduct. 8 Cisco has adopted a senior executive compensation recoupment policy. This policy is: In the event of a restatement of incorrect financial results, the Compensation and Management Development Committee (the Compensation Committee ) will review all cash incentive awards under the Executive Incentive Plan ( bonuses ) that were paid to executive officers (within the meaning of Rule 3b-7 of the Securities Exchange Act of 1934, as amended) for performance periods beginning after July 28, 2007 which occur during the restatement period. If any such bonus would have been lower had the level of achievement of applicable financial performance goals been calculated based on such restated financial results, the Compensation Committee will, if it determines appropriate in its sole discretion, to the extent permitted by governing 7 DEF 14A filed

48 - 8 - law, require the reimbursement of the incremental portion of the bonus in excess of the bonus that would have been paid based on the restated financial results. 9 (iii) Dell Inc. Dell s clawback is a straightforward restatement-based policy that applies to all awards made in the restatement period: Recoupment Policy for Performance-Based Compensation If Dell restates its reported financial results, the Board will review the bonus and other awards made to the executive officers based on financial results during the period subject to the restatement, and, to the extent practicable under applicable law, Dell will seek to recover or cancel any such awards which were awarded as a result of achieving performance targets that would not have been met under the restated financial results. 10 (iv) Exxon Mobil Corporation Exxon s recoupment policy is a straightforward restatement-triggered clawback that applies only to cash awards. The look-back period and the employees to whom the clawback would be applied are not made clear in the proxy: The annual bonus and retirement benefits also align the interests of senior executives with the priority of long-term, sustainable growth in shareholder value. Specifically, 50 percent of the annual bonus payout is delayed based on earnings performance, as described in the CD&A, and the entire annual bonus is subject to recoupment. In addition, pension values are highly dependent on executives remaining with the Company for a career and performing at the highest levels. (...) 8 DEF 14A filed available at 10 DEF 14A filed

49 - 9 - Cash and Earnings Bonus Unit payments are subject to recoupment in the event of material negative restatement of the Corporation s reported financial or operating results. Even though a restatement is unlikely given ExxonMobil s high ethical standards and strict compliance with accounting and other regulations applicable to public companies, a recoupment policy was approved by the Board of Directors to reinforce the well-understood philosophy that incentive awards are at risk of forfeiture and that how we achieve results is as important as the actual results. 11 (v) Qwest Communications International Inc Qwest s restatement clawback, adopted in 2005, applies to performance based awards made in the restatement period to executives: Our Board has adopted a policy whereby, in the event of a substantial restatement of previously issued financial statements, our Board will review all performance-based compensation awarded to executives that is attributable to performance during the time periods restated. Our Board will determine whether the restated results would have resulted in the same performance-based compensation for the executives. If not, the Board will consider: Whether the restatement was the result of executive misconduct; the amount of additional executive compensation paid as a result of the previously issued financial statements; our best interests in the circumstances; and any other legal or other facts or circumstances our Board deems appropriate for consideration in the exercise of its fiduciary obligations to us and our shareholders. If our Board then deems that an executive was improperly compensated as the result of the restatement and that it is in our best interests to recover the 11 DEF 14A filed

50 performance-based compensation paid to that executive, our Board will pursue all reasonable legal remedies to recover that performance-based compensation. We have not been required to take any action under this policy since its adoption in January (b) (i) Canada; Proxies available on SEDAR Brookfield Asset Management Inc. Members of Brookfield s management committee are subject to clawbacks upon the occurrence of certain events. A material restatement leads to clawbacks for only the CEO and CFO. Other members of the management committee are subject to clawbacks for materially detrimental conduct after leaving the company, including breach of confidentiality agreements and defamation. The look-back period is two years: Reimbursement of Incentive and Equity-Based Compensation Specified executives, including all members of the Management Committee, are required to pay to the Corporation an amount equal to some or all of any Bonus or other incentive-based or equity-based compensation and the profits realized from the sale of securities of the Corporation upon the occurrence of certain events. The amount, if any, will be determined by the Compensation Committee which will recommend appropriate action to the Board and will take appropriate steps to ensure that such amount is recovered. In the case of a significant restatement of financial results, the Chief Executive Officer and the Chief Financial Officer may be required to make such a payment. In order to protect the Corporation s reputation and competitive ability, members of the Management Committee may be required to make such a payment if they engage in conduct that is materially detrimental to the Corporation after the cessation of their employment with the Corporation. Detrimental conduct includes participating in transactions involving the Corporation and its clients which were 12 DEF 14A filed

51 underway or contemplated at the time of termination, solicitation of clients or employees, disclosing confidential information or making inappropriate or defamatory comments about the Corporation or its clients. The policy relates to any amounts or benefits received within two years prior to the event giving rise to the claim and includes both monetary payments and shares received from exercise of options or redemption of RSUs and DSUs. 13 (ii) Nexen Inc. A material restatement of financial results may lead to clawback but only as required by law, and not as a contractual measure. Nexen identifies barriers in Canada for formally enacting US-type clawbacks, including employment, taxation, and enforcement issues. Reimbursement If, as a result of wilful misconduct, Nexen s performance results were restated in a way that would have resulted in lower incentive awards, the CEO and CFO would reimburse Nexen proportionately as required by law. While Nexen is aligned and committed to the US model for clawbacks, we are monitoring the development of proposed US requirements and are consulting with industry leaders and shareholder advisory groups to better understand the development of clawback policy models in Canada. Identified barriers to implementation include employment law, enforcement and tax issues. Nexen is working on a more formal solution that effectively addresses alignment of shareholder and executive interests by ensuring that compensation is not increased as a result of wilful misconduct. 14 (iii) Royal Bank of Canada RBC uses explicit risk-control language that goes beyond financial results to cover inappropriate or extreme risk-taking behaviour. The policy is applied to a wide range of 13 Proxy filed March 28, Proxy filed March 25, 2011

52 executives, and includes a financial restatement trigger as well as a broader misconduct trigger covering any failure to follow internal policies and procedures: Addresses situations in which individuals might profit from business activities that are conducted inappropriately or outside of approved risk limits and tolerances, or from financial results, financial reporting or financial statements that are erroneous or misstated. Applicability The CEO, members of the Group Executive, all executives of RBC and Capital Markets employees who participate in the RBC Capital Markets Compensation Program. Under the policy, the financial restatement trigger applies to the CEO and the CAO and CFO, and all other members of the Group Executive. Key features Allows RBC to recoup incentive awards that have been paid or vested and cancel unvested mid and long-term incentive awards in the event of misconduct, including failure to follow internal policies and procedures. A financial restatement trigger permits RBC to recoup incentive awards that have been paid or vested and to cancel unvested mid and long-term incentive awards in excess of the amount that would have been received under the restated financial statements, subject to the board s discretion. Additionally, performance-based incentive programs at RBC include provisions that would revoke certain awards to the CEO, members of the Group Executive, and other participants if their employment is terminated for cause. In the event of termination for cause and consistent with the law of the jurisdictions in which we

53 operate, the terminated participant would forfeit all previously awarded unvested mid and long-term incentive awards. 15 (iv) Sun Life Financial Inc. The clawback here applies to all employees, disgorging incentive payments made under inaccurate financial results with a two year look-back. Interestingly, the policy, adopted in 2010, includes instances of omission such as any failure to report or take action to stop misconduct of another employee that an employee knew, or ought to have known, about: New clawback provision for all employees The board adopted a new clawback provision that allows it to recoup incentive compensation if an incidence of misconduct led to an overpayment of incentive compensation. This new provision is consistent with emerging competitive practice and regulatory principles. Clawbacks Our CEO and CFO are required by law to reimburse their incentive compensation if there is an incidence of misconduct and we need to restate our financial statements. In 2010 the board approved a new clawback policy, allowing it to demand that former or current employees pay back any or all of the incentive the compensation they received or realized in the previous 24 months if: employee was involved in misconduct (such as fraud, dishonesty, negligence or non-compliance with legal requirements or Sun Life Financial s policies, any other act or omission that would justify termination of employment for cause, and any failure to report or take action to stop misconduct of another employee that an employee knew, or ought to have known, about), and the 15 Proxy filed February 6, 2012

54 misconduct directly or indirectly resulted in the employee receiving or realizing a higher amount of incentive or deferred compensation. 16 CANADIAN TAXATION From the Canadian tax perspective, a clawback occurring in the same taxation year as the receipt of the compensation should pose no difficulty. The employer and employee can adjust the compensation and the related source deductions, prior to making the required tax filings in respect of the year. The difficulty arises when the clawback occurs in a subsequent year. Limitations of Section 8 of the Income Tax Act The difficulty stems from subsection 8(2) of the Income Tax Act, (Canada) (the Act ) which reads as follows: Except as permitted by this section, no deductions shall be made in computing a taxpayer s income for a taxation year from an office or employment. The balance of section 8 of the Act provides for a number of express deductions in computing income from employment, including deductions for: the reimbursement of amounts included in income for periods during which no services were rendered (8(1) (n)). amounts previously included in income but forfeited under a salary deferral arrangement; (8(1) (o)) and expenses incurred by employees engaged in the selling of property or negotiating of contracts, which deduction may provide relief in respect of a clawback in limited circumstances. (8(1) (f)). (See CRA Document E5, where a commission salesperson was unable to make full 16 Proxy filed March 29, 2011

55 use of the provision where amounts had to be repaid to his former employer.) None of the deductions set out in section 8 expressly covers the scenario where a reimbursement or forfeiture of a bonus is required. Accordingly, relief would have to be sought elsewhere. Filing an Amended Tax Return The taxpayer subject to a clawback could simply file an amended return for the year in which the bonus was received. However, there is no general, statutory right to file an amended return as established in Armstrong v. The Queen, 2006 DTC 6310 (FCA). While the Act contains specific provisions that permit or mandate the filing of an amended return in specific circumstances, (See, for example, paragraph 164(6) (e), regarding the carry back of losses to a deceased s terminal year.) No provision expressly permits an employee to do so in the case of a clawback. Accordingly, relief would depend on the discretion of the Canada Revenue Agency ( CRA ) to assess on the basis of the amended return. The Law of Mistake A taxpayer may argue that the prior income inclusion ought to be reversed on the basis of a mistake of fact which rendered the agreement to pay the bonus void. A clawback would not seem to meet the Canadian definition of a mistake: If the parties base their contract on a fundamental error about the assumptions supporting their agreement, and neither party agrees to bear the risk of the assumption turning out be false, the contact can be held void on the basis of the doctrine of common-law mistake Bell v. Lever Bros. Ltd., [1932] A.C. 161, [1931] All E.R. Rep. 1 (H.L.).

56 Even if the clawback could meet the test of a mistake under Canadian law, which seems very unlikely, the taxpayer would have to navigate the procedural and jurisdictional hurdles. In Fradette v. The Queen, [20] the taxpayer mistakenly received approximately $26,000 from a provincial pension commission over a period of years, which was included in the taxpayer s income and subject to provincial and federal income tax. When the payer discovered the error years later, it required the taxpayer to repay the sums paid in error, which the taxpayer did. While Revenue Quebec agreed to reimburse the taxpayer for the provincial tax paid on the repaid amount, the CRA did not so agree, and issued a nil assessment for the year of the final repayment. The taxpayer s appeal to the Court was met with the Crown s motion to dismiss on the basis that no appeal lies from a nil assessment. The Crown s motion was successful. However, Mr. Justice Tardif made the following comments: This is a very special case which causes one to have great sympathy for the appellant, who must bear unaided the consequences of a mistake in which he had no part. Unfortunately, I have no jurisdiction to correct this injustice except that I would like to think that Parliament had such a situation in mind when it adopted the [Financial Administration Act]. Remission Remission orders are extraordinary measures that provide for complete or partial relief from taxes, interest or penalties. Remission orders are granted by the Governor General in Council, under the authority of subsection 23(2) of the Financial Administration Act: The Governor in Council may, on the recommendation of the appropriate Minister, remit any tax or penalty, including any

57 interest paid or payable thereon, where the Governor in Council considers that the collection of the tax or the enforcement of the penalty is unreasonable or unjust or that it is otherwise in the public interest to remit the tax or penalty. A remission order must be sponsored internally by the CRA and the procedure is timeconsuming. The CRA will generally require evidence of extreme hardship or incorrect action or advice from the CRA that led to additional tax. There is no public record of a remission order ever been provided in the case of a clawback. Unjust Enrichment Unjust enrichment is another remedy that might be considered. This equitable remedy requires an enrichment of one party, a corresponding deprivation of another, and the absence of any juristic reason for the enrichment. The remedy has been raised by taxpayers in a number of cases, with mixed results. One difficulty in raising the remedy is that it will often conflict with the legislation on which the particular assessment is based. In the British Columbia Ferry Corp. v. M.N.R., [2000] FCJ 227 F.C.T.D. in which the plaintiff sought a determination of whether it had overpaid taxes on fuel oil, the Court concluded that the Excise Tax Act constituted a complete code and excluded any equitable remedy that might otherwise have been available. Another difficulty with the remedy in the case of a clawback is that there may arguably be a juristic reason for the enrichment and deprivation, namely the operation of the Act as it applies to the receipt of employment income in a particular taxation year.

58 Rectification Rectification is another equitable remedy that has been used by taxpayers in a number of tax cases. In H.F. Clarke Ltd. v. Thermidaire Corp. Ltd., [1937] 2 OR 57, at (C.A.) the doctrine of rectification was described as follows: In order for a party to succeed on a plea of rectification, he must satisfy the Court that the parties, all of them, were in complete agreement as to the terms of their contract but wrote them down incorrectly. It is not a question of the Court being asked to speculate about the parties intention, but rather to make an inquiry to determine whether the written agreement properly records the intention of the parties as clearly revealed in their prior agreement. As rectification requires an error in the recording of an agreement, it would appear this would be of little use in the case of a clawback. DESIGN Based on the above, there does not appear to be a clear and certain way in which the negative tax impact of a clawback may be reversed. The following are some methods by which a clawback could be structured to take advantage of existing tax rules. (a) Three-Year Bonus An exception to the salary deferral arrangement definition in paragraph 248(1)(k) permits a bonus for services rendered in a year to be deferred for three years: salary deferral arrangement, in respect of a taxpayer, means a plan or arrangement, whether funded or not, under which any person has a right in a taxation year to receive an amount after the year where it is reasonable to consider that one of the main purposes for the creation or existence of the

59 right is to postpone tax payable under this Act by the taxpayer in respect of an amount that is, or is on account or in lieu of, salary or wages of the taxpayer for services rendered by the taxpayer in the year or a preceding taxation year (including such a right that is subject to one or more conditions unless there is a substantial risk that any one of those conditions will not be satisfied), but does not include... a plan or arrangement under which a taxpayer has a right to receive a bonus or similar payment in respect of services rendered by the taxpayer in a taxation year to be paid within 3 years following the end of the year,... The deferred bonus may be subject to conditions during the deferral period, which could include the absence of a financial restatement or wrongdoing. If such a condition materialized, the bonus would not be paid and there would never have been an income inclusion to reverse. Of course, the downside is that the employee does not have access to the bonus amount during the deferral period. Further, under this approach, the clawback period would have to be restricted to three years and the particular three years drafted carefully. Nevertheless, this is likely the easiest way to implement a taxneutral clawback under the current state of the law. (b) Employee Loan The employer and the employee could agree to arrange a loan, equal to the amount of the bonus, for a term equal to the duration of the desired clawback regime. During the term of the loan, the loan amount would not be included in the employee s income, the loan would be included in income if and when forgiven rather than repaid although a taxable benefit in respect of interest may result. (See Subsection 80.4(1) and subsection 6(9) of the Act.) This may not be a concern in the era of low interest rates and could be dealt with by grossing-up cash compensation. At the end of the term, the bonus is paid to the employee, which is used to repay the loan. If the bonus does not

60 become payable due to a clawback, the employee would repay the loan. While imperfect and slightly cumbersome, this method would avoid having to unwind an income inclusion in a prior year. Care will need to be taken to structure the loan such that it is clearly a loan and not, for example, a taxable advance, or in the case of an employee who holds shares, a shareholder benefit. (c) Use of a Trust The bonus could be structured using a trust to hold employer stock during the clawback period. Upon issuance of the stock to the trust, the employee would have an income inclusion (see Subsection 7(2) and paragraph 7(1)(a) of the Act). (It is assumed the deferral provided for in subsection 7(1.1) for shares of a Canadian-controlled private corporation would not be relevant in the context of clawbacks.) At the end of the clawback period, if the stock is released from the trust, the employee would not have an additional income inclusion and would be able to liquidate the stock. If the clawback was engaged prior to the release of the stock to the employee, and the arrangement provided for the stock to be returned to the issuing employer, the employee would be entitled to a deduction in computing income equal to the amount of the income inclusion in the prior year under Subsection 8(12) of the Act. Subsection 8(12) of the Act provides a deduction for an employee who forfeits rights to a share in certain circumstances. The deduction is available if the employee is deemed to have disposed of the share held by a trust pursuant to subsection 7(2) of the Act. The trust must have disposed of the share to the corporation that issued the share as a result of the employee failing to meet the conditions necessary for title to the share to vest in the employee. Furthermore, the corporation must acquire the share from the trust or redeem or cancel it for an amount no greater than the price paid to acquire the share from the corporation. If the foregoing conditions are satisfied, the employee may, in the year of forfeiture, deduct the excess of the amount of the benefit deemed to have been received by the

61 taxpayer under subsection 7(1) in respect of the share over the amount, if any, deducted under paragraph 110(1)(d) or (d.1) of the Act in respect of that benefit. Where a deduction is available under subsection 8(12), that subsection deems any gain or loss from the disposition of the share to be nil and provides that section 84 does not apply to deem a dividend to have been received in respect of the disposition. Clearly, this approach is not elegant. The employee would have additional taxable income in the year the bonus is awarded but would not have additional cash with which to pay the tax unless a loan as described above was employed. Securities law compliance issues would also have to be considered. However, this approach provides a clear way of achieving the deduction for clawed-back compensation. 7. CONCLUSION Some may hope for a specific amendment to the Act of dealing with the clawback issue although there may be very limited sympathy, and therefore political will, for such an amendment. Accordingly, structuring a clawback utilizing one of the three methods above may be the most prudent if there is a desire to ensure that the clawback is tax neutral

62 Update on Canada Revenue Agency Positions on Long Term Incentive Plan Conversions and Cross Border Cash Based Incentive Plans Presented by: Elizabeth Boyd April 10,