By J. Sturgeon | Financial Post | 05. 25. 2009
Richard Smith gave the biggest part of his working life to Nortel Networks Corp.' s telecommunications services unit.
As division director, he witnessed and contributed to the Canadian technology company's rapid growth into a global titan in the 1980s and 1990s. Like other employees of the firm, which filed for bankruptcy protection in January, Mr. Smith was compensated in part with company-granted options on stock.
For many, it was a dream. They exercised their options and sold the shares for a handsome profit at the height of the dot-com boom, when Nortel was the toast of the Toronto Stock Exchange with a share price well above $100.
Yet for an untold number, emotional turmoil has been their only return, and now, as the enervated telecom firm faces a possible dissolution, those optioned shares threaten them with financial ruin.
The reason is a little-known amendment to federal income-tax laws made at the beginning of the decade on options allotted as part of employees' pay that allows for a tax deferral on optioned stock until it is disposed of.
The effect has left current and former Nortel workers such as Mr. Smith saddled with colossal tax liabilities on paper profit they never realized.
"It's been a nightmare," says Mr. Smith, who's name has been changed at his request. "I have to come up with $200,000."
The 68-year-old retiree's ordeal began in the mid-1990s when he was awarded the right to purchase Nortel shares at a discount set by the company.
Times were never better for Nortel. It was selling fibre-optic cable and other network components in spades as the Internet mania was in full flight. The stock was soaring, eventually inflating to occupy a full third of the market value of the entire Toronto exchange.
Mr. Smith retired in 1999 with options on about 13,000 shares, which he exercised in the fall of 2000. He spent about $90,000 of his savings to acquire shares worth $900,000. He could have sold, paid his tax obligation on the profit and still had enough to live in relative comfort for the rest of his life.
But he didn't.
Instead, he thought the stock would go higher still, so he held on. He also deferred the taxes owed to the Canada Revenue Agency (CRA), which were assessed at the time he optioned.
The deferral amendment had just been written into the Income Tax Act through that spring's federal budget. Wary of losing top tech talent (among other sectors) to U. S. companies then offering lucrative stock-option plans, Canadian legislators passed measures allowing for the payment delay on exercised options until the point of disposal.
What was not amended was when the tax assessment is made, which remained -- and still does -- at the point of exercise.
"It created a tax risk," says Ken Snider, a senior tax lawyer at Toronto-based Cassels, Brock & Blackwell LLP. Like a capital gain on an investment, taxes charged on optioned shares are punishing. The CRA applies the same policy it does on capital gains to shares awarded through options to employees -- 50% of the profits at the individual's tax rate.
What no one seemingly saw at the time was a scenario in which a stock collapses, obliterating employees' equity stakes while leaving them with a tax burden from an assessment made when a company's share price was through the roof.
"That is the trap," Mr. Snider says. "If the value of the shares dropped significantly, the proceeds of the sale would be insufficient to pay the tax liability."
Mr. Smith assumed his shares at $104 apiece. After nearly a decade of watching with dread as Nortel's stock price crumbled, his shares are now worth about 2¢ each, accounting for reverse stock splits. His tax liability is about $204,000, he says.
"This is my all-encompassing issue. It's been nine years and it's grinding me down."
Nortel, which declined comment for this story, filed for creditor protection on Jan. 14, succumbing after years of distracting accounting scandals and poor operating results. The filing has bought Nortel -- still North America's largest telecom-equipment maker -- time to restructure into a viable company.
That is clearly the most agreeable outcome for Mr. Smith and others in his position. If Nortel survives, he'll simply keep his shares and defer the tax perpetually.
Failing that lies some "horrific" scenarios. If Nortel sells itself, the acquirer could take it private, cancelling the public float and trigger his tax liability. If Nortel cannot find a suitor, liquidates and ceases to exist as a corporation, the tax will again come due.
The financial recourse for Mr. Smith, who lives with his wife on a $30,000 annual pension (which is also at risk because of Nortel's misfortunes) and old-age security, is to sell his home or empty out his retirement savings.
Nortel employees are not alone. A group called Canadians For Equitable Taxation (CFET) estimates thousands of Canadians share Mr. Smith's misfortune. Many are unwilling to come forward out of embarassment or fear they'll draw the eye of the CRA, says Gary Hawe, a spokesman.
In a rare instance that cast light on the issue, 35 former Canadian employees of California tech giant JDS Uniphase Corp. received a federal reprieve or "remission order" on their obligations in 2006 after lobbying their local Member of Parliament, Gary Lunn, then the natural resources minister.
Since then, awareness has grown. In late April, CFET, a group of several hundred, met with the federal finance committee to ask for a change to the rules. How far did discussions go? In short, nowhere.
The CRA argued its bound to administer the law so long as it is in place, says committee member John McKay, Liberal MP for Scarborough-Guildwood. Meanwhile, Jim Flaherty, the Minister of Finance, is "refusing to take on the issue."
Each side is "blaming the other for this problem and in between the crossfire there are a lot of dead taxpayers," Mr. McKay says.
Mr. McKay says the rules have created unintended consequences and need to be corrected. "It is an anomaly and it's wrong. You shouldn't tax people on phantom income."
"The best thing that could happen to me," Mr. Smith says, "is that the shares remain worthless and that's it. Then I can sleep at night."
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