Demystifying 409A Valuations for Canadian Companies

Authors: Thassiane Gossler & Karan Menon

409A valuations are gaining prevalence within the Canadian startup ecosystem. This appraisal of the fair market value (FMV) of a company’s common stock, carried out by an independent third party, holds the key to tax-deferred compensation and regulatory compliance. In this blog post, we will demystify 409A valuations, exploring its purpose, implications, and applicability for Canadian companies.

Determining the Exercise Price for Stock Options

A stock option essentially confers the right to purchase a share at a predetermined price, commonly referred to as the exercise price. This price may align with the FMV at the time of grant, ensuring that the employee or recipient solely benefits from the growth post-grant. Alternatively, it could be set at a discount.

Determining the exercise price is a critical step. Typically, options are granted with an exercise price set at the FMV on the date of grant, although this is not always the case, especially for Canadian Controlled Private Corporations (CCPCs), which offer more flexibility, and which we will discuss in another post.  Establishing FMV often involves obtaining a valuation, which is particularly relevant for companies granting options to US taxpayers, who may face adverse tax consequences if the exercise price is not aligned with FMV.

The Purpose of a 409A Valuation

At its core, the primary purpose of a 409A valuation is to ensure that stock options granted to employees are issued at FMV on the date of grant. The United States Internal Revenue Code (IRC) Section 409A governs the treatment of nonqualified deferred compensation, such as stock options, for tax purposes.[1] To qualify for tax-deferred compensation, two key requirements must be met:

1) The option must be for the company’s common stock.

2) The strike price must be equal to the FMV of the underlying stock on the grant date.

Failure to meet these criteria can have serious consequences. If a company sets the strike price below what is considered FMV on the grant date, the IRS might classify the stock option as “current income.” This, in turn, could trigger immediate tax liabilities, penalties, and interest for the employee. The company could also face penalties for failing to withhold taxes correctly and could potentially face employee lawsuits.

To avoid these consequences, a provision known as the “safe harbor” was established to enable privately held companies to determine the FMV of their common shares in a manner acceptable to the IRS. The most widely adopted method for meeting Section 409A safe harbor requirements is to engage a qualified, independent valuation provider to perform the 409A valuation. This helps ensure that the FMV of the common stock is viewed as accurate and reasonable by tax authorities. While the IRS can still challenge the valuation, the burden shifts to the IRS to demonstrate that the valuation method is grossly unreasonable.

Applicability to Canadian Companies Hiring US Employees

Canadian companies that employ US taxpayers are not exempt from the 409A valuation requirements. US citizens are required to report their worldwide income to the IRS. Therefore, any nonqualified deferred compensation, such as stock options, received from a Canadian employer by an employee who is a US citizen is subject to Section 409A of the IRC, even if this employee resides in Canada.

This means that Canadian companies expanding to the US or hiring employees who are US taxpayers must navigate the same 409A valuation process to ensure their stock options and compensation plans comply with US tax regulations. Whether your business operates in Canada or the United States, understanding the implications of 409A valuations is vital to avoid potential pitfalls and protect both your employees and your company’s financial health.

Final Thoughts

409A valuations are a critical component of the regulatory landscape for private companies and their employees. Ensuring that stock options are issued at FMV on the grant date is one of the key components to qualifying for tax-deferred compensation and avoiding the adverse consequences of noncompliance with respect to US employees. Canadian companies employing US taxpayers should be aware of the reach of Section 409A of the IRC, which extends to nonqualified deferred compensation even when the employer is based in Canada and ensure their Stock Option Plans are designed to comply with 409A. To learn more about stock option considerations and how they apply to your business, please contact Thassiane Gossler at tgossler@oziellaw.ca.

DISCLAIMER: This publication is intended to convey general information about legal issues and developments as of the indicated date. It does not constitute legal advice and must not be treated or relied on as such.

[1] I.R.C., S 409(a).