Alternative compensation strategies to attract and retain talent

Alternative compensation strategies to attract and retain talent

Considering the significant expense of recruiting and training employees, employers are increasingly motivated to structure compensation incentives that will not only attract top candidates, but retain them for the long term.

Strategies such as providing a supportive onboarding process, pairing new employees with mentors, conducting regular performance reviews, showing appreciation by acknowledging hard work and encouraging work‑life balance are all important elements.

But in today’s competitive market for talent, it is essential to also consider the optimum financial compensation strategy. Here, we look at a few value‑focused ways employers can compensate potential hires beyond high base salaries and benefits.

Equity‑based compensation

While smaller companies are limited when it comes to paying higher salaries, they can offer employees attractive alternative opportunities to participate in the company’s future. These are generally equity participation plans with no tangible value until they are vested. Large companies often find stock‑based plans to be an effective tool in motivating their employees, as it aligns the employee’s interests with those of the company, and the value of their efforts can be readily measured.

There are many variations in equity‑based compensation plans. These include the vesting schedule, definition of liquidity events, what happens if an employee leaves the company after options have vested and before the liquidity event, as well as other considerations. The appeal of the different plans may depend on the tax implications to both the employee and employer.

Equity‑based compensation has become commonplace as such compensation is based on an increase in the company’s share value, thereby incentivizing employees to put in greater effort to increase this value.

Stock options and warrants

Stock options or warrants are the most common non‑cash compensation plan. An employee is given the right to buy or sell the company’s stock within a certain timeframe for a specific price.

A call warrant or option grants the right to purchase shares at a specified strike price. A put warrant or option grants the right to sell the shares back to the company at a predetermined price. Each type has its own strategic implications and can be valuable, depending on the employer’s and employee’s outlook on the company’s future performance. While options and warrants have technical and legal differences, the tax implications may be similar if they are in essence received by virtue of employment.

When an employee exercises a call option, the benefit is taxable to the employee as employment income if the employee is given the right to purchase shares of the employer or a non‑arm’s length party. The benefit is also deemed to have been received if the employee transfers or disposes of rights under the agreement.

The taxation of the benefit will depend on:

  • The value of the shares at the time the options are granted;
  • The value of the shares at the time the options are exercised;
  • Amount paid by the employee for the shares (i.e., the strike price); and
  • Amount, if any, paid by the employee for the option

Generally, the employee is considered to have received a taxable benefit when the employee exercises the option and acquires the shares. The taxable benefit is the difference between the value of the shares when the employee acquired them and the amount paid for the shares, including any amount paid for the right to acquire the shares. The employee may deduct half (one‑third after June 25, 2024) of the taxable benefit if:

  • The share issued is a common share
  • The value of the share when the options are granted did not exceed the exercise price, and
  • The employer and employee are dealing with each other at arm’s length at the time the option agreement is entered into.

There is a limit of $200,000 annually of options that have vested if the employer group has revenues exceeding $500 million.

If the employer is an arm’s length Canadian‑controlled private corporation, the taxable benefit is deferred until the employee disposes of the shares. The half deduction is available if the employee holds the shares at least 2 years before selling. The stock option deduction is one‑third of the benefit if the stock option is exercised on or after June 25, 2024, or in the case of a Canadian‑controlled private corporation, when the share is sold. The deduction may be increased to half on up to a combined $250,000 for employee stock option benefit and capital gains. If the total combined employee stock option benefit and capital gains exceed $250,000, the employee may choose how to apply the $250,000.

If an employee has realized a capital gain of $125,000 and stock option benefits of $200,000 in 2025, the amount taxable at two‑thirds will be $83,333 of capital gain and $133,333 of stock option benefits.

The employee may elect to claim $200,000 of stock options and $50,000 of capital gain to be taxable at half deduction, or claim $125,000 of capital gain and $125,000 of stock options to be taxable at half deduction

An employee may receive cash instead of the shares in exchange for the option. The employee can claim the half (one‑third after June 25, 2024) deduction if eligible, or the employer can claim the cash payment as an expense, but not both.

If the employer chooses not to claim the cash‑out as an expense, the employer must elect to do so under subsection 110(1.1) of the Income Tax Act by entering this amount under code 86 ⁠–⁠ “Security options election” ⁠–⁠ in the “Other information” area of the T4 slip. This allows the employee to claim the deduction under paragraph 110(1)(d). The amount you report under code 86 may differ from the taxable benefit you must include in the employee’s income in box 14 and under code 38. If code 86 of the T4 is not entered, this indicates the employer chose to claim the expense, prohibiting the employee from claiming the deduction under paragraph 110(1)(d).

Restricted stock units

Restricted stock units (RSUs) are issued to employees through a vesting plan and distribution schedule after certain performance or service milestones are met. For example, an employee of a startup company may not receive shares as RSUs until and unless the company issues its initial public offering. Normally, no discretion or cash payment is required by the employee. RSUs are considered income once the conditions for vesting are met. Often, a number of the vested shares (if publicly traded) will be sold to cover the tax bill and the employee will only receive the balance of the shares.

Phantom stock plans

Phantom shares are a type of compensation where employees receive notional shares in the company on an established vesting schedule. Unlike RSUs, they do not provide ownership rights of actual shares. Instead, the value of the phantom stock units are tied to the company’s share value and, when vested, will be paid out in cash. For example, if an employee is awarded 100 shares when the share value is $10, and the value of the shares becomes $40 per share when vested, the benefit received is $4,000.

Stock appreciation rights

Stock appreciation rights (SARs) give employees the right to receive an amount equal to the increase in value of a set number of shares without owning them. The employee will receive a payout equal to the increase in share value. This is similar to a phantom stock plan, except it provides the right to the monetary equivalent of the increase in value of a specified number of shares over a specified time period. Using the same values as above, the employee can expect a benefit of $3,000 [($40 ‑ $10) x 1,000] at vesting.

Salary deferral arrangement

In planning equity‑based compensation arrangements, it is important to understand the salary deferral arrangement (SDA) rules. An SDA is a plan or arrangement under which an employee has a right to receive an amount in a future year where it is reasonable to consider one of the main purposes of the right is to postpone tax payable on salary or wages for services rendered by the employee in the year or a preceding taxation year. Under an SDA, the employee is taxed in the year the amount is earned.

Wondering which compensation strategy is right for you? Segal’s experts can help determine the best plan to implement, ensuring it meets the objectives of both your business and your employees.

It pays to understand compensation

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