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Digital Policy #2: Taxing Talent Down the (Brain) Drain

by Randall on September 18, 2008 · 1 comment

Posted in: Entrepreneurism,Investing,Public Policy,Society,Startups

Source: ContactSingapore.sg    

 

 

 

 

Source: ContactSingapore.sg

The knowledge based economy is all about businesses finding, motivating and retaining the very best talent. And the quest for top talent goes way beyond the lofty C-suite and includes top developers, product managers, sales people, marketers — i.e. pretty well everyone in a knowledge-based company.

I personally view building talented teams as the number one determinant of business success

Technology startups tend to use stock-based compensation, mostly Employee Stock Option Plans, most liberally in part as a way to level the playing field in competing with larger companies in the talent search and in part because the “lift” in value as startups grow from zero to exit can be quite significant.

With that in mind, it is ironic that stock options were originally adopted as a key strategy in the Silicon Valley employed to leverage equity in cash-strapped startups and because of their tax efficiency. Today in the US, and even more so in Canada, they can also be a real headache as people negotiate the tax maze of CRA and IRS.

The labyrinth of unfair taxation problems relating to stock options is unbelievably complex, and more importantly, potentially punitive. And, it is important to note that this issue doesn’t just affect founders and senior management, but can cause real stress for all levels in a corporation. This issue is agnostic to level.

Typical problems are:

  • Option Gains Taxed at Employment Rate: Counterintuitively, the CRA taxes gains on stock options at the rate of employment income, rather than as a Capital Gain which is half the tax rate of employment income. There are special rules and exemptions which attempt to drop the tax rate down to be equivalent to a capital gain, but the the sheer complexity of the Income Tax Act means that this system fails far too often. You’d get a capital gain investing in the stock market, so why not in your own company?
  • Taxation on Phantom Income: It gets worse. There are numerous cases where, depending on the timing of a rise in stock price relative to stock option exercise with the actual redemption of the stock at a later date and lower price, an employee can be taxed on gains that they don’t actually receive. In other words, CRA demands tax on monies never received. One egregious example reports “a single mother of two children who sold her options stock for $2000 and was taxed $50,000.”
  • Cross Border Issues: There are many tax provisions that work in Canada, but completely break down when companies are structured across borders, such as between US and Canada, which is very common. Furthermore, cross border acquisitions, which are extremely common, are a real source of taxation headache, not to mention generating unnecessarily complex structuring costs.

For those interested in a deeper understanding of this issue, some sources containing extensive analysis and documentation of the anomalous world of unfair talent taxation are:

Clearly, such taxation is unfair. But, more importantly, it is an example of how a complex and inadequately debugged taxation system can put a significant brake on our future economic development. It is important to understand that this is not about people paying their fair share of tax. Instead, the issue stems from complex rules that create surprisingly unfair outcomes that, because they are codified in taxation law, must be enforced. Only governments have the power to fix these serious anomalies.

Future economic prosperity in Canada will be driven by successful knowledge based businesses, and thus we should be encouraging our top talent to be motivated to work long hours and provide the motor of the economic growth provided by knowledge based startups.

While it may never top of the charts in the current election campaign, in fact, this taxation issue might well be one of the most important for our government to address. Is anyone in Ottawa listening? The current election provides citizens a great time to engage and educate politicians of all parties in this issue.

About Randall

Randall Howard is a serial entrepreneur and long term technologist with a passion for social innovation.

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