In June, the federal government introduced draft legislation that will limit the preferential tax treatment associated with certain employee stock options. The new rules, which were originally introduced in the March 2019 federal budget, fulfil a 2015 Liberal party election platform promise to limit the benefits of the stock option deduction by placing a cap on how much can be claimed.
In the backgrounder accompanying the draft legislation, the government released data to show that in 2017, 36,630 Canadians claimed, in aggregate, nearly $2.1 billion worth of stock option deductions on their 2017 tax returns. Among these taxpayers, 2,300 individuals, each with a total personal annual income of over $1 million, accounted for nearly two-thirds of the $2.1 billion in stock option deductions claimed.
If you have clients who receive stock options as part of their executive compensation, you may want to brush up on the new rules before their effective date – January 1, 2020 – to help your clients understand how part of their compensation may be taxed going forward.
Current rules
Under current tax rules, when an employee stock option is exercised, the difference between the exercise price and the fair market value of the share is included in income as an employment benefit. For qualifying options, the employee can claim an offsetting deduction (the “stock option deduction”) equal to one-half the benefit, so that only 50% of the stock option benefit is included in income and taxed at the employee’s marginal rate.
The result is to effectively tax the benefit associated with the exercise of employee stock options as if it were a capital gain, although technically, the income is still considered to be employment income.
Proposed rules
The public policy rationale for the preferential tax treatment of employee stock options is “to support younger and growing Canadian businesses.” That being said, the government “does not believe that employee stock options should be used as a tax-preferred method of compensation for executives of large, mature companies.”
The June 2019 draft legislation would set a $200,000 annual cap on the amount of employee stock options that may “vest” in an employee in a year and continue to qualify for the stock option deduction. An option is said to vest when it first becomes exercisable. Employee stock options granted on or after January 1, 2020 would be subject to the new rules.
If an employee exercises an employee stock option that exceeds the $200,000 limit in a particular vesting year, the employee won’t be entitled to the stock option deduction on exercising these options. In these cases, the difference between the fair market value of the share at the time the option is exercised and the exercise price paid by the employee to acquire the share will simply be treated as employment income and be 100% taxable, making it consistent with the treatment of other forms of employment income such as salary, wages and a bonus.
Exempt companies
Stock option plans offered by Canadian controlled private companies (CCPCs) will be exempt from the new rules. In addition, some non-CCPCs classified as “start-ups, emerging, or scale-up companies” could also be exempt from the rules if they meet “certain prescribed conditions.”
To this end, the government launched a consultation process asking Canadians for input as to what, exactly, these prescribed conditions should be. In establishing the prescribed conditions, the government says it will be guided by two key objectives: that the employee stock option tax regime becomes fairer and more equitable, and that start-ups and emerging Canadian businesses that are creating jobs can continue to grow and expand. Specifically, the government is looking for submissions with respect to the characteristics of companies that should be considered start-up, emerging and scale-up for the purposes of the prescribed conditions.