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Deferred share unit ("DSU") plans are a form of equity-based compensation for employees, directors, or officers. If structured correctly, DSUs are exempt from the salary deferral arrangement ("SDA") rules in the Income Tax Act (Canada) ("ITA") and are therefore not taxed until they are cashed-out. DSUs are a valuable tool for retaining and rewarding talent but the underlying plan must be carefully drafted to ensure compliance and avoid unwanted tax consequences, especially when including dividend equivalents.
This article will provide an overview of DSUs, and pitfalls to avoid when granting dividend equivalents.
DSUs
To comply with the ITA, and to ensure tax is deferred until the DSUs are cashed out upon the death or retirement of the employee, DSU plans that are not structured to fit into the employee stock option regime must:
- be created in writing;
- defer payment until the earlier of the death of the employee or the cessation of the office or employment;
- be paid out no later than the end of the calendar year commencing after the death or cessation of office or employment;
- depend on the fair market value of shares of the granting corporation (or a related corporation), at a time within the period beginning one year before the triggering event and ending on the triggering event; and
- not protect participants from a reduction in the value of the underlying shares.
When a plan meets each of these requirements, employees will not owe any tax on DSUs until the DSUs are either cashed out or, where the DSUs may be settled by issuing shares of the granting corporation, converted to shares. This tax deferral is the principal tax benefit of DSUs for employees.
Dividend Equivalents
Dividend equivalents are amounts credited to an employee's DSU account when a corporation declares dividends. Dividend equivalents are important to DSU holders because the payment of dividends, in theory, decreases the value of the shares of the granting corporation and therefore the value of the DSUs. This potential reduction in value requires a mechanism to ensure that the DSU holders are not prejudiced. Dividend equivalents are this mechanism, and can reinforce the alignment between plan participants and the shareholders of the granting corporation.
The CRA has accepted that, when dividends are paid by an employer to shareholders, an amount equal to the dividends paid can be credited to an employee's DSU account as additional DSUs without the SDA rules applying. The additional units must be subject to the same terms as the original DSUs, i.e., that no amounts may be received until the earlier of the employee's death or cessation of employment.
The CRA has also opined that dividend equivalents paid in cash, or on a rolling basis over the term of employment, do not comply with the SDA rules. If dividend equivalents were paid in this manner, the plan would no longer meet the requirements for DSU plans prescribed in the Income Tax Regulations and there could be an immediate income inclusion for the employees. Accordingly, dividend equivalents should be credited in the form of additional DSU units to comply with the CRA's administrative positions.
Conclusion
Dividend equivalents can be economically important, but they add complexity to DSU plans. Employers should ensure that DSU plans featuring dividend equivalents are properly drafted to avoid unanticipated adverse tax consequences for both employers and employees.
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
