Proposed changes to the tax treatment of stock options
How will your support payments be affected?
INSIGHT ARTICLE |
Federal Finance Minister Bill Morneau tabled his fourth budget this past March, which may impact the tax treatment of your employee stock options (ESOs). If you pay child or spousal support, you may be wondering how these changes will affect your payment obligations. Although your taxable income will increase significantly, your support calculations should remain largely unaffected.
Under current legislation, a corporation can grant ESOs to an employee at fair market value (FMV). When an employee exercises these options, the difference between the exercise price and the FMV will be considered income. However, section 110(1)(d) of the Income Tax Act provides a stock option deduction. When you exercise or dispose of your ESOs, only half of the benefit will be taxed at your marginal rate.
If you work at a “large, long-established, mature firm,” the proposed amendments will limit the stock option deduction available to you. The stock option deduction will be limited to an annual cap of $200,000. The value of your options will be assessed based on the FMV of the shares on the date they were granted. If this value is less than $200,000, the current legislation will continue to apply.
These changes will not affect employees who work at start-up companies or rapidly growing Canadian businesses. In addition, these changes will not apply to ESOs granted prior to the amendments. Further detail on the parameters of what companies will qualify for the exception have been tabled for now as the government sorts out what it hopes to achieve.
What will happen if the value of your options exceeds the cap?
Let’s consider the following scenario:
Ms. Jane Doe is an employee at a long-established firm. She is given permission to acquire ESOs in the amount of 10,000 shares at $80 per share. On the date of grant, the FMV of the shares is $800,000 (10,000 x $80). This value exceeds the $200,000 cap. Therefore:
- The first 2500 ($200,000/$80) shares will receive preferential tax treatment; and
- 7500 shares will be included in her income and fully taxed at her marginal rate.
It is important to note that the $200,000 exception (2500 shares) may be grossed up but the remainder (7500 shares) will not have the same problem as there is no tax advantage to the remainder. “Grossing up” is a means of calculating a person’s assigned income if they receive income taxed at a lower marginal rate than normal. The grossed-up income represents the amount of “taxed income” they have to earn in order to have a net income equivalent to their present income.
Ms. Doe decides to exercise her ESOs. The exercise price is now $100 per share. Of the $200,000 benefit ($100-$80 x 10,000), $50,000 ($100-$80 x 2500) will be subject to the current stock option deduction and $150,000 ($100-$80 x 7500) will be considered income and taxed accordingly. Therefore, only $25,000 will escape tax liability.
Presently, half of the total benefit would escape tax liability. Therefore, $100,000 would be considered income for tax purposes as opposed to $175,000.
The important takeaway is if the amendments are approved and you decide to dispose of your ESOs, the amount of taxable income present on your tax return may surprise you.
No change to the taxation of Restricted Stock Units (RSUs)
Employee RSUs are set to remain fully taxable on the value of the benefit. However, the proposed budget refers to a corporate tax deduction. This deduction may apply to your employer if your ESO remain fully taxable. The budget does not state whether this deduction will encompass RSUs.
How will the ESO tax change effect your support obligations?
According to section 16 of the Federal Child Support Guidelines, child support is calculated based on “Total Income” as displayed on the T1 General Form issued by the Canada Revenue Agency. Since the value of taxable ESOs are reflected in your total income, the proposed changes will increase this number. This suggests that the pool of money used to calculate support will increase. However, this is not the case.
Schedule III of the guidelines indicate that the entire capital gain should be considered for support purposes, irrespective of the taxable value. Since ESOs are treated as capital gains, the entire benefit will be considered. In Ms. Doe’s case, child support will be calculated based on the $200,000 benefit, regardless of the legislative change. Therefore, the taxable income upsurge will not affect your support calculations.
Upon spousal separation, a Net Family Property (NFP) calculation will be performed to enable equalization of assets. ESOs and RSUs are included in this calculation based on their value at the date of separation. When assessing value, future tax liability is considered. The new tax changes are sure to increase the estimated liability for ESOs! Therefore, the ESOs will be valued at a lower rate, decreasing the NFP and spousal equalization value.
You may be wondering why equalization matters. If your ESOs or RSUs have not been disposed of at the time of separation, they may reappear as income on a future tax return. Accordingly, your income may reflect assets that have already been equalized. Luckily, the recurring assets are usually removed from support calculations. Otherwise, this would be considered “double-dipping”.