Canadian Tax: Recent Changes to the Employee Stock Options Rules

Overview

Generally, pursuant to subsection 7(1) of the Income Tax Act (Canada) (the “Act”) where an employer has agreed to sell securities of its capital stock to an employee, the employee is deemed to have received a taxable benefit from employment equal to the value of the securities at the time the employee acquired them, minus the total of the amount paid by the employee for the securities.

Timing of Benefit Inclusion

The point in time when the deemed taxable benefit has to be realized by the employee varies. The general rule is set out in subsection 7(1) of the Act which requires that the deemed taxable benefit is included in employment income by the employee in the taxation year in which the securities are acquired; however, prior to the 2010 Federal Budget there were two main exceptions to this general rule:

1. provided certain conditions were met, subsection 7(8) of the Act provided  an employee with a deferral on the realization of the deemed taxable benefit until there was a disposition or exchange of the securities; and
2. subsection 7(1.1) of the Act provides that if the employer is a Canadian-Controlled Private Corporation (“CCPC”) dealing at arm’s length with the employee, the employee can defer recognizing the deemed taxable benefit in income until the employee disposes of the securities. ¹

One-half Deduction

An employee who is deemed to have received a taxable benefit under subsection 7(1) of the Act may be entitled to an offsetting deduction equal to one-half of the taxable benefit, provided certain conditions are met on the grant of an option. The one-half deduction is intended to ensure that the employee’s taxable benefit is taxed at rates equivalent to capital gains rates. Provided the employee is taxed at the highest marginal tax rate in Ontario the one-half deduction reduces the employee’s taxable benefit from approximately 46% to 23%.

Proposed Changes Pursuant to the 2010 Federal Budget

Stock Option Cash Outs

Although an employee has to include the benefit in income either upon the acquisition of the securities or upon the disposition or exchange of the securities, the employer is generally not entitled to a deduction for the benefit included in the employee’s income.² Nevertheless, prior to the proposed changes introduced by the 2010 Federal Budget, a stock option plan could be structured in a way that would maximize both the employee’s and the employer’s tax position. This was achieved by allowing the employee the opportunity of “cashing out” his or her options for a cash payment, as opposed to purchasing the underlying shares, with the result that the employee would be allowed the one-half deduction and the employer could be entitled to a deduction equal to the cash payment made to the employee depending on the circumstances. The proposals of the Budget will eliminate the deduction by both the employee and the employer.

Pursuant to the Budget proposals, in order for the employee to qualify for the one-half deduction under either of paragraphs 110(1)(d) or 110(1)(d.1) of the Act, the employee either has to acquire the securities of the employer, in which case the employer would not be entitled to a deduction, or the employer must make an election to forgo the deduction for the cash payment made to the employee. It is interesting that the Budget makes reference to the paragraph 110(1)(d.1) deduction since in order to qualify for that deduction the employee has to have acquired the share and, as such, the cashing out alternative does not appear to apply to such an employee. Nevertheless, the proposed requirement under the Budget applies to both CCPCs and non-CCPCs where the employee would like to claim a deduction under paragraph 110(1)(d) of the Act.

The Department of Finance has indicated that the election to forgo the deduction for the cash payment made to the employee can be in respect of each agreement to issue stock options (i.e., the agreement with each employee) and does not have to apply to all options granted under the plan.

If the employer makes the election to forego the corporate deduction, the employee can claim the one-half deduction and have the stock option benefit amount taxed at approximately 23%. If the corporation does not make the election, the employee will be taxed at a rate of 46% on the amount of the stock option benefit while the corporation may be entitled to claim a deduction, provided such amount is not considered to be a capital expenditure.

Special Relief for Tax Deferral Elections

The current rules allow employees of public corporations and non-CCPCs to postpone the deemed taxable benefit on $100,000 per year of qualifying stock options (the “Deferral Election”). If the Deferral Election is made, the taxation of the benefit is deferred until the year when the shares are sold instead of when the shares are acquired or the option is exercised. The Budget eliminates the Deferral Election for stock options exercised after March 4, 2010, and provides special relief to employees that have filed the Deferral Election in circumstances where there is a decrease of the fair market value of the underlying securities to an amount less than the deferred tax liability. Hence, the purpose of the new proposed provision set out in the Budget is to limit the tax the employee has to pay to the proceeds of disposition on the sale of the shares.

Optional Election

Pursuant to the Budget, if the employee so elects (the “Optional Election”), then he or she will receive the following tax treatment:

1. The deduction available under paragraphs 110(1)(d) and 110(1)(d.1) of the Act is equal to 100% of the deemed benefit included in the employee’s income.
2. Capital gain inclusion equal to ½ of lesser of
   1. deemed benefit inclusion; and
   2. capital loss
3. Special tax equal to proceeds of disposition of the securities (payable in the year the deduction is claimed).

Accordingly, the Optional Election is only beneficial if the proceeds of disposition of the underlying shares are less than the outstanding tax liability on the benefit inclusion. Put another way, if the one-half deduction is available then the proceeds of disposition have to be less than the amount that is 46.4% multiplied by one-half of the benefit, and if the one-half deduction is not available then the proceeds of disposition have to be less than the amount that is 46.4% multiplied by the benefit, based on the top Ontario marginal tax rate.

Source Deductions

Pursuant to paragraph 153(1)(a) of the Act, an employer is required to withhold income tax on salary, wages and other remuneration. The definition of “salary and wages” is broad and includes all taxable employment benefits including employee stock option benefits taxable under section 7 of the ITA.  ³

The Budget clarifies that the withholding requirement pursuant to paragraph 153(1)(a) of the Act provides that an employer must remit to the Receiver General an amount in respect of an employment benefit that is taxable under subsection 7(1) of the Act, but not subsection 7(1.1) of the Act (which provides a deferral of the benefit inclusion until the time that the share is disposed of as opposed to acquired), as if the amount of the benefit had been paid to the employee in money and if the requirements of the one-half deduction are met by the employee the amount of the benefit is reduced by one-half.

The Budget states that withholding on the benefit is to the same extent as if the benefit were a bonus payment and as such compliance with the proposed withholding requirement may be difficult for an employer since there is no actual cash payment made to the employee but rather the employee is provided with securities. Hence, the employer may want to establish a procedure whereby upon the employee’s exercise of the stock option agreement an adequate amount of securities will be withheld and liquidated by the employer in order to fund the amount to be withheld. In addition, employers should examine their current stock option plans and agreements and may have to revise them in order to be able to satisfy this proposed withholding obligation.

 

¹ The amount of the benefit is added to the adjusted cost base of the securities when the securities are acquired.
² See subsection 7(3) of the Act.
³ Prior to the 2010 Federal Budget an employer did not have to withhold on employee stock option benefits where the benefit was deferred pursuant to subsection 7(8) and 7(15) of the Act. The 2010 Federal Budget proposes to repeal subsection 7(8) and 7(15).