Navigating Executive Compensation in M&A

Many legal and financial challenges related to executive compensation can arise from leadership transitions during mergers and acquisitions (M&A). Companies must decide how to treat equity incentives, navigate complex tax implications and manage employment law considerations.

Here are five key factors to consider when handling executive compensation in M&A transactions:

1. Stock Option Taxation. If properly structured, the optionholder’s tax obligations will be deferred until the options are exercised or otherwise settled. The optionholder may also claim a tax deduction of up to 50% on the option benefit if certain requirements are met. However, material changes to Canada’s tax deduction rules in 2021 and proposed harmonization with the new capital gains tax rules may complicate the available deduction (if any). Companies should consider these rules on grant, settlement and, where applicable, exchange of options.
2. Prescribed Share Requirements. To qualify for the employee stock option deduction, underlying shares must meet the “prescribed shares” criteria per Regulation 6204 of Canada’s Income Tax Act (ITA) when such shares are issued or sold. In M&A deals, parties that intend to settle all outstanding options must carefully consider the prescribed share requirements, especially where an existing shareholder plans to acquire the remaining shares in the target company.  
3. U.S. Structures. The ITA does not provide for tax-deferred rollovers of stock options into, or rights to acquire, U.S. partnership units. However, a rollover of stock options into options over LLC units is generally possible. In U.S. private equity deals, profits interest units are a common form of go-forward equity-based compensation. Understanding the differing tax consequences of issuing profits interests to Canadian and U.S. employees is important, and companies can explore structuring options to more closely align compensation outcomes on both sides of the border.
4. Restrictive Covenants. In M&A, imposing new employment restrictive covenants generally requires fresh consideration, and Ontario law prohibits non-competition covenants in most employment agreements. The scope of employment restrictive covenants must be narrow in time, geography and restricted activities to maximize the likelihood of enforceability. It may be prudent for companies to enter into “overlapping” commercial and employment restrictive covenants with employees who receive sale proceeds.  
5. Terminations. Under the Canadian common law, executives dismissed without cause can be entitled to significant reasonable notice or pay in lieu thereof. The Supreme Court of Canada affirmed in Matthews v. Ocean Nutrition Canada Ltd. (2020) that employees are generally entitled to damages in lieu of equity-based compensation that would have vested during the notice period, subject to an unambiguous contracting out of this obligation in the plan documentation. Companies should consider these issues when planning terminations during M&A.

Have more than five minutes? Watch our seminar on this topic or contact any member of our Pensions, Benefits & Executive Compensation or Employment & Labour groups to learn more.