On June 17, 2019, draft legislation proposing changes to the taxation of stock options was tabled. These proposals follow the announcements in the 2019 Federal Budget introducing a $200,000 annual cap on the deductibility of employee stock option grants for employees of “large, long-established, mature firms.” The proposals are expected to apply to stock options granted on or after Jan. 1, 2020.
Existing rules on the taxation of stock options
As explained in RSM’s previous Tax Alert, generally employment income, including the value of any benefits that an employee receives by virtue of being an employee, is subject to tax in the year of receipt. However, qualifying employee stock options (ESO) are excepted from this rule. Instead, where a company issues an ESO, there are no immediate tax implications on the grant of the ESO. A taxable employment benefit arises on the exercise date of the option, equal to the excess of the fair market value (FMV) of the shares acquired at the time of exercise over the amount paid by the employee to acquire the shares. For Canadian controlled private corporation (“CCPC”) issuers, the taxation of the employment benefit is deferred to the year the employee sells the shares. Further, the employee may be entitled to receive a deduction equal to half the employment benefit if certain conditions satisfied.
In the news release accompanying the proposed changes, the government noted that:
[…] the public policy rationale for preferential tax treatment of employee stock options is to help smaller, growing companies such as start-ups—that do not have significant profits and may have challenges with cash flow—attract and retain talent.
However, as highlighted in Budget 2019, the current employee stock option deduction is not effective in meeting its intended goal. In many cases, it is being used to provide tax-preferred compensation for executives of large, mature companies. As such, its benefits are disproportionately going to a very small number of high-income individuals. In 2017, for example, just over 2,300 individuals, each earning more than $1 million in that year, were able to claim more than $1.3 billion in tax deductions on their employee stock options. In total, these individuals, representing six per cent of stock option deduction claimants, accounted for almost two-thirds of the entire cost of the deduction to taxpayers.
The draft legislation thus proposes the following main amendments:
- A $200,000 annual limit will apply on ESO grants that can continue to receive tax-preferred treatment under the current employee stock option tax rules. The $200,000 annual limit will be based on the FMV of the underlying shares at the time the options are granted.
- ESOs granted by CCPCs will not be subject to the new limit.
- In recognition of the fact that some non-CCPCs could be start-ups, emerging or scale-up companies, those non-CCPCs that meet certain prescribed conditions will also not be subject to the new limit.
$200,000 annual limit
For employee stock options granted by employers that are subject to the new rules, there will be a $200,000 limit 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.
The $200,000 limit on the amount of employee stock options that may vest in any calendar year will generally apply to all stock option agreements between the employee and the employer or any corporation that does not deal at arm's length with the employer. If an individual has two or more employers who deal at arm's length with each other, the individual would have a separate $200,000 limit for each of those employers.
Where an employee exercises an ESO that exceeds the $200,000 limit, the difference between the FMV of the share at the time the option is exercised and the amount paid by the employee to acquire the share will be treated as a taxable employment benefit.
For ESOs granted in excess of the $200,000 limit, the employer will be entitled to an income tax deduction in respect of the stock option benefit included in the employee's income. Where an employee is denied the beneficial tax treatment under the new rules, the employer will generally be entitled to a tax deduction equal to the amount of the employee’s employment benefit.
Employers subjected to proposals
The new rules will apply to employers that are corporations or mutual fund trusts. Employers that are CCPCs will not be subject to the new rules.
Further, in recognition of the fact that some non-CCPCs could be start-ups, emerging, or scale-up companies, those non-CCPCs that meet certain prescribed conditions will also not be subject to the new rules. In this regard, the Government is soliciting the views of stakeholders with respect to the characteristics of companies that should be considered start-up, emerging, and scale-up companies for purposes of the prescribed conditions.
Employers will need to ensure compliance with respect to the $200,000 limit. This will include a requirement that an employer notify its employees in writing whether options granted are subject to the new rules at the time the options are granted. In addition, employers will be required to notify the Canada Revenue Agency if they issue securities subject to the new rules.
Takeaways for middle market businesses
Given the proposed effective date of Jan. 1, 2020, it may be desirable for employers to issue ESOs by the end of the year to avoid the application of the $200,000 annual cap and enhanced compliance obligations. The ultimate ratification of the proposals may be delayed by the legislature’s upcoming summer recess and the fall federal election.