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The Liberal government is changing what it calls “highly regressive” rules governing the taxation of employee stock options by imposing a cap on preferential tax treatment.

Rules to be introduced this summer will impose a $200,000 annual cap on employee stock option grants taxed effectively at the capital gains rate. The change targets executives at large companies who are compensated with stock options currently taxed at the preferential rate.

The rules will apply “for employees of large, long-established, mature firms” but will not change for “start-ups and rapidly growing Canadian businesses.”

The budget did not define those terms. The $200,000 limit will be based on fair market value of the underlying shares.

Employee stock options are used to increase employee engagement and promote entrepreneurship and growth, helping smaller companies and start-ups with limited cash for salaries to attract talent. For this reason, they’re taxed at the same rate as capital gains or one-half of personal income, the budget says.

“The public policy rationale for preferential tax treatment of employee stock options is to support younger and growing Canadian businesses,” the document says.

In 2017, 2,330 people who all earned more than $1 million claimed more than $1.3 billion in employee stock option deductions. While they only represented 6% of stock option deduction claimants, the budget says, they accounted for nearly two-thirds of the total deductions.

“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 budget says.

Details of the plan will be released before this summer, and changes will apply on a go-forward basis, therefore not affecting employee stock options granted before the legislative proposals for the new rules are announced.

Bruce Ball, vice-president of taxation at CPA Canada, said every company would have to consider how it approaches the new threshold.

“They may want to see if there are other ways of doing incentives other than stock options because there won’t be any inherent tax benefit anymore,” he said.

Firms could offer compensation based on the increase of a company’s value, for example, without using stock options. There wouldn’t be a tax advantage, though, he said.

“You’re incenting the same thing but it’s simpler if it’s going to be fully taxed,” he said.

Ball also said Finance would need to consult on “the dividing line” between a growth company and a mature company.

Under the proposed regime, an executive of a large, mature company granted stock options to acquire 100,000 shares at $50 per share—fair market value of $5 million—would only be taxed at the capital gains rate on 4,000 of those shares ($200,000 divided by $50), an example in the document says. The remaining 96,000 options would be included in income and taxed at ordinary rates.

If share prices increased to $70 by the time the employee exercised the options, $1.92 million ($70 x 96,000 minus $50 x 96,000) would be included in income. Only $80,000 of the benefit ($70 × 4,000 minus $50 × 4,000) would be taxed at the capital gains rate.

That compares to current rules, where the employee would get a $1 million employee stock option deduction on the $2 million benefit, the budget says.

At large firms, the “vast majority” of employees who receive employee stock option benefits wouldn’t be affected, the document says. An employee at a startup who received options exceeding the $200,000 threshold would still be taxed at the capital gains rate.

The new rules would align with tax treatment of large firms in the U.S., the budget says.