Changes to the taxation of stock option benefits are coming this summer that will affect certain Canadian employees and their employers. While these changes have not yet been enacted into law at the time of writing, it is expected that they will apply to stock options granted on or after July 1, 2021. This article will provide an overview of these changes and the impact they may have on certain employees and corporations.
Timeline of proposed changes
Changes to the rules governing the taxation of stock option benefits were initially announced as part of the 2019 federal budget. These changes were intended to target certain high-income individuals receiving stock options from corporations other than Canadian-controlled private corporations (CCPCs). In June 2019, the Department of Finance released draft legislation that would apply these revisions to stock options granted on or after January 1, 2020. Following a consultation period in respect of this proposed legislation, the federal government subsequently decided to delay the implementation of these rules to provide more time to consider the feedback received.
As part of its Fall Economic Statement released on November 30, 2020, the federal government revisited this issue and announced that it will proceed with a revised version of the rules initially proposed in 2019. The proposed legislation that accompanied the Fall Economic Statement incorporated several important modifications to the measures initially proposed in 2019. These modifications were intended to provide additional clarity in response to issues raised by stakeholders during the consultation period that followed the release of the 2019 draft legislation.
This article will examine the changes to the stock option rules as proposed on November 30, 2020. Note that this article addresses situations where the employee deals at arm's length with the employer issuing the shares; other rules may apply where the employee does not deal at arm's length with the employer.
The current rules state that there is no tax when an employee is granted stock options from their employer or from a company related to their employer. However, when an employee exercises stock options of non-CCPC shares, such as public-company shares, they are subject to tax on the amount by which the fair market value (FMV) of the shares at the time of exercise exceeds the amount they need to pay to exercise the options (the exercise price). This income is considered employment income.
The employee can generally claim a deduction equal to 50% of the employment income that arose on exercise of the options if the stock options meet specific requirements:
- the exercise price is not less than the FMV of the shares at the date the options were granted; and
- the employer does not claim a deduction in calculating taxable income for amounts paid to the employee in cash in lieu of issuing shares on exercise of the option.
There is no limit in the Income Tax Act on the number of options that can be granted to any employee, and situations can arise in which a large amount of stock option employment income can be taxed at a very favourable tax rate. Due to the stock option deduction, this rate is 50% of the rate that would otherwise apply to that income. Where the employee is taxed at the highest tax rate, they would have a combined marginal tax rate of between 44.5% and 54%, depending on the province or territory of residence and based on 2020 personal tax rates. Under the current rules, stock option income will be taxed at a top rate of between 22.25% and 27% when the 50% stock option deduction applies.
Proposed tax rules
Under the proposed rules, employees receiving stock options after July 1, 2021, from corporations that are not CCPCs or certain other exempted corporations will be subject to a limit on the amount of stock option deduction that can be claimed.
The new rules provide that the benefit of the stock option deduction will be limited to $200,000 of employee stock options that vest in a given calendar year. Stock options vest in a given year if, under the stock option agreement, that year is the first year that stock options can be exercised. Often a stock option grant will vest over several years. For example, a grant of 10,000 stock options made in 2021 may vest in equal amounts over the next four years — 2,500 options per year in each of 2022, 2023, 2024, and 2025. If the agreement does not specify a vesting schedule, the proposed legislation states that options are considered to vest on a pro-rata basis over the term of the agreement, up to a maximum five-year period.
The limit imposed on the stock option deduction will apply if the value of options that vest is more than $200,000 in a given year. The value of the options to be used for this test is the FMV of the underlying shares at the date of grant. If the total value of all the options that vest in a given year were more than $200,000, then the options that were granted first would be the first to qualify for the stock option deduction.
The Department of Finance provides the illustration of Henry, a highly compensated executive with a large and established company, who receives a stock option grant after July 1, 2021, for 200,000 shares that vest in a schedule of 50,000 options per year in each of 2022, 2023, 2024, and 2025. The FMV of the shares underlying the options is $50 per share at the date of grant and this is also the exercise price. Henry can acquire 50,000 shares, at $50 each, for a total of $2,500,000 in each year of vesting. Only the first $200,000 of this value, represented by 4,000 options ($200,000/$50 per option), will receive the beneficial tax treatment of a deduction equal to one-half of the stock option benefit realized on the exercise of those options. This effectively results in taxing this benefit at tax rates that apply to capital gains. The stock option benefit is determined as the difference in FMV in the shares at the date of exercise and the exercise price. The stock option benefit arising on the exercise of the remaining 46,000 options that vest in the year will not be reduced by the stock option deduction and therefore will be fully taxable. See the Appendix below for a more detailed analysis of this example.
Under the current rules, where an employee donates a publicly listed share that was acquired under an employee stock option agreement to a qualified donee within 30 days of being acquired, the employee may be eligible for an additional stock option deduction of 50%. As a result, any benefit realized by the employee on these options will be fully sheltered from tax. With the proposed changes to the rules, this additional stock option deduction will be limited to the $200,000 vesting limit. Where an employee donates shares acquired under a stock option in excess of the $200,000 limit, they should still be eligible for a donation tax credit but not for any stock option deduction.
Employer tax implications
The taxation of stock options granted by CCPCs will not change under the new rules. The new rules restricting the stock option benefit will also not apply to stock options of corporations that are not CCPCs where such corporations have annual gross revenues of less than $500 million on a consolidated basis.
An important change in the proposed rules is to allow an employer to claim a tax deduction in computing its taxable income, subject to certain conditions, when the employee is denied the stock option deduction because of the proposed vesting limit. From a tax policy perspective, this will have the general effect of making these new rules revenue neutral.
The current rules allow an employer to claim a deduction in respect of employee stock options only when they have made a cash outlay to the employee in respect of the options and under the option agreement.
Under the proposed rules, employers will also have the option to choose whether to grant stock options that are subject to the new tax treatment, or instead to grant options that are eligible for the tax deduction in computing its taxable income. To ensure compliance, the proposed rules will require employers to notify employees in writing to indicate whether any of the stock options exceed the $200,000 vesting limit or if they have chosen to designate the stock options as not being eligible for the stock option deduction (and instead a deduction will be available to the employer). This notification must be in writing and must be made within 30 days after the options are granted. Employers will also be required to notify the Canada Revenue Agency if they grant options in respect of securities that will be subject to the new rules. A prescribed form will be required for this purpose, which has yet to be released.
As noted above, stock options granted by a CCPC will not be subject to the $200,000 vesting limit or any of the other proposed changes to the rules.
In general, where stock options are granted by a CCPC, there is no immediate taxation of the stock option benefit that may arise when the stock options are exercised. Where the employee and the employer deal with each other at arm's length, the benefit will instead generally be taxable at the time the share acquired on the exercise of the option is eventually either disposed of or exchanged.
At that time, the employee may be eligible to claim a deduction equal to 50% of the benefit included in their employment income if they have:
- held on to the shares for at least two years from the date of acquisition (unless disposed of as a consequence of death); and
- not claimed any other stock option deduction in respect of the benefit.
These rules will continue to apply to stock options of a CCPC, regardless of when the options are granted.
While these proposed measures have not yet been enacted into law, it is not expected that the rules will change substantially from the draft legislation released on November 30, 2020. If you have questions about how the proposed stock benefit taxation changes may affect you or your business, please contact your BDO representative.
As noted in the Department of Finance example above, Henry is granted 200,000 stock options after July 1, 2021. The stock options are to vest evenly over a period of four years, with 50,000 options vesting in each of 2022, 2023, 2024, and 2025. The FMV of the shares underlying the options is $50 per share at the date of grant and this is also the exercise price. For the purposes of this example, assume that Henry decides to acquire 50,000 shares in 2022, at $50 each.
The following chart summarizes the tax implications of exercising these 50,000 stock options under both the current and the proposed rules:
|Number of stock options granted afterJuly 1, 2021||Fair market value of underlying shares at date of exercise||Value of shares in stock option grant when granted||Number of stock options exercised in 2022||Fair market value of underlying shares at date of exercise||Employment benefit recognized at date of exercise||Stock option deduction||Net income included as a result of stock option exercise in 2022|
|Treatment under proposed rules|
|Option grants that qualify for stock option deduction||C$50||C$200,000||4,000||C$70||C$80,000||C$40,000||C$40,000|
|Option grants that do not qualify for stock option deduction||C$50||46,000||C$70||C$920,000||Nil (Note 1)||C$920,000|
|Total taxable income in year of exercise||C$960,000|
|Treatment under current law|
|Option grants that qualify for stock option deduction||200,000||C$50||50,000||C$70||C$1,000,000||C$500,000||C$500,000|
|Additional taxable income under proposed changes||C$460,000|
|Note 1: No deduction because value in stock options at date of grant is greater than C$200,000|
Under the proposed system, Henry will be worse off than he would be under the current system. This is because the 50,000 of stock options that vested in 2022 represented $2.5 million in stock value at the time that the options were granted. Only the options representing $200,000 in stock value (or 4,000 options) when the options were granted will be allowed the current, beneficial stock option tax treatment. As illustrated, Henry will have $460,000 more in taxable income under the proposed rules, as compared to the current tax system, for the same value received from stock options.
The information in this publication is current as of February 15, 2021
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.