409a valuation in Canada
In this article, we explain what a 409A valuation is, and whether or not you need a 409A valuation in Canada.
Canada has been the biggest hub for the import and export industry in the world. Canadian companies, no matter big or small, meet a lot of challenges due to compliances with their securities, tax and employee regulation. One such compliance is a 409A valuation.
Canadian Companies in the U.S.
To conduct business in the United States, Canadian companies may choose to form a U.S. corporation. Domestic corporations involve U.S. citizens and are therefore subject to U.S. taxation on their international profits. Various companies in the U.S. are based outside of Canada. Their head branch is in Canada, and their co-branches are in the U.S..
Overview of the Canadian companies and business with the US
The relationship between Canada and the U.S. is special. Shared geography, comparable ideals, mutual interests, deep personal relationships, and powerful, multi-layered economic links bind Canada and the U.S. together. These countries have the world’s largest trading partnership. Both countries’ economic competitiveness and prosperity are dependent on a secure and efficient flow of products and people across the border. When Canada and the U.S. cooperate, they improve security and speed up the movement of lawful people, commodities, and services.
Important US tax issues to know
- 83(b) election – The Internal Revenue Code’s (IRC) 83(b) election allows an employee or startup founder to pay taxes on the complete fair market value of restricted shares at the time of grant. The 83(b) election is for equities that have a vesting period. The 83(b) election instructs the IRS to tax the elector for stock ownership at the time of gift rather than when the stock vests.
- ASC 718 – Employee stock-based compensation is expensed on an income statement in accordance with ASC 718. Equity awards are a type of compensation that is subject to a set of accounting regulations known as ASC 718 that corporations must adhere to. Expense accounting was previously known as FAS 123(r), but it is now governed by ASC 718.
- ISO 100k – In contrast to Non-qualified Stock Options (NSOs or NQSOs), Incentive Stock Options (ISOs) receive preferential IRS treatment. The key advantage is that when the option is exercised, the spread between the fair market value (FMV) and the initial exercise strike price is not subject to ordinary income tax. Ordinary income tax is withheld on the spread by NSOs at the time of exercise. ISOs, on the other hand, are nevertheless subject to the Alternative Minimum Tax (AMT) in order to prevent affluent persons from hiding all of their income in this method. Another IRS rule designed to prevent the ISO program from being utilized as a tax shelter is the $100K Limit (100K ISO Limit).
- Form 3921 & 3922 – The IRS has issued two forms (and instructions) for reporting ISO workouts and ESPP share purchases: Form 3921 for ISO exercises and Form 3922 for ESPP share purchases. For each workout or purchase made during the calendar year, a new form must be completed and filed. As an example, if an employee used many ISO awards over the course of a year, in a calendar year, the employee must receive a copy of Form 3921 for each exercise, and the corporation must receive a copy of Form 3921 for each exercise, will be required to file numerous tax returns with the IRS.
- Internal Revenue Code Section 409A – A 409A is an impartial evaluation of a private company’s common stock, or equity reserved for founders and workers, at fair market value (FMV). It is used to calculate the fair market value (FMV) of your company’s common stock which a third-party valuation firm usually does. The cost of purchasing a share is determined by this valuation.
409a Valuation & Canadian Companies
There are various forms by the Canadian companies that exist along with the 409a valuation. The taxation is based on the fact that it is imposed in Canada itself.
Understanding IRS 409a valuation
A 409A valuation in Canada determines a company’s common stock, which is necessary when issuing stock options to employees. A 409A valuation in Canada is required for any corporation issuing stock options. The strike price for options granted to employees, contractors, advisors, and anyone else who receives common stock is determined by 409As.
When is a 409a valuation required for a Canadian company?
A 409a valuation is required by the company when it doesn’t know the value of the stock it is keeping. For example, If you want to sell a table but don’t know how much it’s worth, you sell it to anyone. Using the same analogy, a 409a becomes vitally important if a firm intends to offer equity. It’s impossible to sell shares if you don’t know how much they’re worth. A 409a valuation is required if your company is:
US Holding company with the Canadian subsidiaries
Companies from the United States routinely explore doing business in Canada. Sometimes a US corporation contemplates purchasing shares in a Canadian company, while other times, a US company wants to expand its own operations into Canada. A limited liability corporation (LLC) is one of the most common business vehicles in the United States. This business is considered as a flow-through entity for US tax purposes, which means that the LLC’s revenue or loss is assigned to its shareholders, and the amounts are taxed in their hands. This is advantageous to US taxpayers since it eliminates the problem of a lack of integration between corporate and personal taxes in the United States.
Canadian Holding company with US subsidiaries
Canadian companies with minority US shareholders are considered subsidiaries. According to the United States’ constructive regulations, which were implemented as part of the United States tax reform. Canadian entities with minority US shareholders should consider whether they have new controlled foreign corporations in their groups with the Canadian companies discovering that their subjects to be expanded to US tax laws; each US shareholder that owns 10% or more of the value will have to file a US tax return directly.
Canadian companies with US employees (Offering ESOPs/Other Incentive Programs)
Employee share plans have long been a feature of the remuneration packages offered to employees of Canada-listed companies. Employers can provide stock plans to all employees (all-employee plans) or senior executives and executive directors on a case-by-case basis. Companies use staff incentive schemes for various reasons, including meeting or exceeding sales objectives, increasing production goals, raising employee morale, and rewarding exceptional employee performance, all of which contribute to the company’s success. Employees are rewarded for their accomplishments, and a sense of success is created. Simple rewards, such as gifts, plaques, or trophies, to monetary prizes, such as profit sharing, bonuses, or travel incentives, are all examples of incentives.
Other situations for 409a valuation
A third-party valuation provider is often employed to estimate the fair market value (FMV) of your company’s common shares under 409A in Canada. The strike price for options granted to employees, contractors, advisors, and anyone else who receives common stock is determined by 409As. When two countries do a stock exchange, there might be some situations that may occur.
- ESOP Plans in Canada (Share equity plans, Stock option plans, Equity Value Plan (EVOP™)) – Employee stock ownership plans, or ESOPs in Canada, allow employees to own stock in a company, increasing employee buy-in and investment while also encouraging accountability and a sense of ownership. Stock options, stock purchases, phantom stock ownership, or a combination of these options may be used.
- Share Equity Plan – Employers create business equity programs to promote a link between your job and the firm’s performance. These programs may give you access to equity through stock purchases or offer you the possibility to buy equity at a later date through stock options.
- Stock Option Plan – Employees can have access to company shares even if the company is privately owned through corporate equity plans. Once granted, stock option plans provide qualifying employees with the opportunity to purchase the company’s stock after a specified period of time (the vesting period) and for a set amount of time until they expire.
- Equity Value Plan – Value Plans are tailored to meet the needs of both beginner and experienced traders and investors. For a period of 360 days, each Equity Value Plan includes free delivery volume. Furthermore, even after the plan’s validity has expired, you will benefit from ultra-low brokerage prices.
- Canada Revenue Agency (CRA) and Valuation – Fair market value, according to the Canada Revenue Agency (CRA), “is usually the maximum dollar value you can achieve for your property in an open and unrestricted market, between a willing buyer and a willing seller who are competent, informed, and operating independently of one another. The highest monetary value.” Even if the thing being valued does not appear to have a “price”, fair market value is a financial amount (for example, if it is a rare and personal collection donated by the owner). The phrase “highest dollar value” implies that the fair market value equals the item’s retail price. “A market that is open and unfettered”. Fair market value must be assessed in an open market setting, which means that there are many vendors and buyers vying for items to buy and sell. The maximum price a willing seller may get for an item from a willing buyer is the fair market value. However, in rare cases, a professional appraiser or valuator may be required to determine the fair market value.
Why is a 409a valuation important?
Defining the fair market value of shares
A company’s post-money valuation, which is based on how much investors paid for their own position after fundraising, is often (but not always) different from its 409A valuation in Canada. Because preferred stock is given to investors, a post-money valuation is based on preferred stock price, but a 409A is based on the price of common stock. Preferred stock is frequently more valuable than regular stock due to particular characteristics.
The fair value of the company
A 409A is used to calculate the fair market value (FMV) of your company’s common stock, which a third-party valuation firm usually does. The strike price for options granted to employees, contractors, advisors, and anyone else who receives common stock is determined by 409As.
Safe harbor status
While companies frequently conduct their financial analysis to estimate FMV early in its lifespan, valuations grow more complicated as time goes on, requiring more knowledge and taking longer. Eqvista helps you in filing a 409a valuation and also ensures you get safe harbor protection.
Consequences for not complying with 409a while issuing equity
An independent company valuation is necessary for nonqualified deferred compensation (NQDC) plans that contain stock options and/or stock appreciation rights (SARs). The valuation determines the strike price at which the opportunities and SARs can be exercised.
The penalties of not complying with 409a can be severe for the company and the employees too. The sanctions will ruin your staff before they ruin your firm, but you can bet the two will happen in quick succession.
Noncompliance with section 409A in Canada can result in the following tax penalties for employees:
- Even if payment is made in the following years, employees must pay income tax and a 20% penalty on any deferred vested amounts under the NQDC plan as of the last day of the vesting year.
- Employees must pay a premium interest tax of 1% above the federal underpayment penalty rate on failed compensation from the vesting date forward. Employees may be required to pay additional penalties as a result of understating their income. Employees may also be subject to penalties imposed by the state.
Common Valuation Methods
The common valuation methods are those that their companies use to calculate and check the stored stock. There are three differences that have been used to analyze the value of the stock following the instructions mentioned in the 409a section.
- Asset approach – A company’s net asset value is the emphasis of an asset-based approach to business valuation. Total liabilities are subtracted from total assets to arrive at the net asset value. There is some space for interpretation when determining which of the company’s assets and liabilities to include in the assessment and how to measure their worth. Financial executives have a significant duty in determining and keeping awareness of a company’s value.
- Market approach – The market approach is a method for calculating an asset’s worth based on the selling price of similar assets. Along with the cost technique and discounted cash-flow analysis, it is one of three main valuation methodologies. In circumstances where there is a lot of data on similar transactions, the market method shines. Alternative procedures may be required if that data is not available.
- Income approach – The income technique estimates fair value based on the income generated by the property. The capitalization rate is divided by the net operating income to arrive at this figure. When it comes to business valuation, the income method reigns supreme. The majority of people start a business to make money. As a result, if someone is buying a firm, the amount of money they will generate in the future is the most important consideration in determining the purchase price. In simple terms, the income strategy is analyzing a company’s financial history in order to forecast future earnings.
Calculations for 409A Valuation in Canada
Let’s say there is a company, Smart Navigations Limited, which supplies global positioning systems (GPS) around the world. This company has some senior managers and executives who are expats and US citizens, who need to declare tax back in the US for their stock options they plan to exercise in the future. In order to determine the strike price on these options, Smart Navigations Limited decided to undergo a 409a valuation to find the value, and exercise price, for their ESOPs.
Here is a basic look at their Cap table:
After having their 409a valuation processed, the resulting value was calculated as:
With the total valuation of the company at $16,800,000 after the DLOM, and capital structure with 39,250,000 shares, after processing the value through a waterfall analysis, the final share price was calculated as:
$0.30 price per share
With this, Smart Navigations Limited was able to issue its stock options according to its ESOP plan at a strike price of $0.30 to its US staff.
Get a certified 409a Valuation Report for Your Company
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