The long-standing tradition of using employee stock options to reward and retain employees in Canada may change due to limits proposed by the federal government to the current advantageous tax treatment available to employees in certain circumstances.
Currently, subsection 7(1) of the Income Tax Act (Canada) affords favourable tax treatment to employee stock options if certain conditions are met. One such condition is that the exercise price at the time the option is granted is at least equal to the fair market value of the subject shares at the time of the grant. The favourable treatment entitles an arm’s length employee to deduct one-half of the taxable benefit that is realized at the time of exercise, effectively treating the benefit like a capital gain.
On March 19, 2019, the Federal Budget proposed to change the employee stock option tax regime. Through a Notice and Ways and Means Motion (“NWMM”), the Department of Finance Canada has now released details of the proposed changes.
Summary of Proposed Changes
- The NWMM proposes to restrict the availability of the 50% stock option deduction based on a $200,000 annual vesting limit.
- The NWMM proposes to allow the employer to deduct the amount of the stock option benefit that is not eligible for the employee’s 50% stock option deduction, provided certain conditions are met.
- The proposed changes will not apply to Canadian-controlled private corporations or start-up, emerging and scale-up companies.
- Public consultation is being sought before September 16, 2019, on the characteristics of companies that should be considered start-up, emerging and scale-up companies.
- The proposals will apply to options granted on or after January 1, 2020. Existing options are not affected.
Proposed Stock Option Deduction Limit
The proposals introduce a $200,000 annual limit on the amount of employee stock options that may vest in an employee in any calendar year and be eligible for the stock option deduction. The $200,000 limit is based on the fair market value of the underlying shares to which the stock option relates when the option is granted. The annual limit applies to all stock option agreements that an employee has with an employer or any corporation that does not deal at arm’s length with the employer. However, where an employee is employed by a number of arm’s length employers, the employee has a separate $200,000 annual limit in respect of each employer.
The proposals provide for certain ordering rules (first in, first to qualify for the stock option deduction) if the amount of the stock options that may vest in a calendar year exceeds $200,000. The Department of Finance provides numerical examples of how it intends these rules to apply.
For stock options that exceed the $200,000 limit, an employee will be denied a stock option deduction in respect of the taxable benefit associated with those options. This will result in 100% of the stock option benefit being taxed as employment income, rather than 50% under the current rules.
Potential Tax Deduction for the Employer
The proposals provide an employer with a deduction in respect of the stock option benefit associated with non-qualified securities. Non-qualified securities include those securities that are in excess of the $200,000 annual vesting limit, as well as, options that the employer opts to designate as only being subject to the new rules.
The amount of the deduction available to the employer is equal to 100% of the stock option benefit realized by the employee, which is equal to the difference between the fair market value of the underlying securities at the time of exercise and the established exercise price. These new proposals are effectively providing for a 100% corporate deduction (for a non-cash outlay) in respect of which a 50% stock option deduction is being denied to the employee. At best, these proposals are tax revenue neutral from the federal government’s perspective. In simple terms, assuming a combined corporate tax rate of 26.5% and a personal marginal tax rate of 53.53%, a $100 stock option benefit deduction to the corporation yields a $26.50 corporate tax savings, while the denial of the $50 stock option deduction creates an additional tax of $26.76 to the employee. While these proposals may be promoted as “the next step toward a fairer tax system” by effectively redistributing the tax benefit of the stock option deduction away from highly-compensated executives to a broader group of corporate shareholders, as a result of the corporation deduction, it would be incorrect to regard them as being a tax-revenue generator for the federal government.
To claim the corporate tax deduction, certain conditions must be met including:
- the employer was the employer of the individual at the time the stock option was granted;
- the stock option deduction would have been available to the employee if the underlying securities were not non-qualified securities; and
- the employer provided:
- notice in writing to the employee on the date of the grant that the securities would not be eligible for the stock option deduction; and
- notice to the Canada Revenue Agency of any non-qualified securities by filing a prescribed form with its income tax return for the year in which the stock options were granted.
Based on the above, the corporate deduction is not available in respect of options issued by a person, such as a parent or subsidiary company, dealing at non-arm’s length to the employer, notwithstanding that an individual may realize a stock option benefit in respect of securities issued by an employer or a person dealing at non-arm’s length to the employer. Subsequent draft legislation may provide clarification as to whether or not this was intentional.
Impact to Charitable Donations
Under the current rules, in addition to the stock option deduction that is available to employees, as described above, an additional 50% stock option deduction (the “charitable deduction”) is available to an employee who exercises a stock option in respect of a share of a publicly listed company and gifts the share to a “qualified donee” (i.e., a registered charity) within 30 days. Consequently, under the current rules, an employee may acquire a share on the exercise of the stock option and donate it to a charity without any corresponding income inclusion. The new proposals limit not only the availability of the stock option deduction but also the charitable deduction in respect of non-qualified securities, so that the taxable benefit associated with the exercise of the stock options is fully included in the income of the taxpayer. However, the capital gains exemption that is currently available to taxpayers in respect of the donation of publicly-traded securities to a qualified donee is not impacted by the new proposals.
Although the new legislative proposals will only apply to employee stock options granted on or after January 1, 2020, affected employers should consider:
- the timing of granting stock options and other stock-based awards prior to these new rules coming into effect; and
- the notice requirements, including an appropriate method to notify employees of non-eligible securities.
Of course, if the federal Liberals do not form the government after the federal election in October, these proposed changes may not be enacted into law. Nevertheless, employers and employees should consider the proposed changes in current discussions or planning for new employee stock options.