CHANGES TO THE TAX DEFERRAL ON PUBLICLY TRADED COMPANY STOCK OPTIONS
Stock options are a common form of compensation provided by employers to their employees. For income tax purposes, there are specific rules that apply to tax the benefits employees receive from their stock options. A benefit will arise when an employee exercises their options and this will be taxed as employment income. This benefit is generally equal to the difference between the fair market value of the securities at the time the option is exercised and the amount paid by the employee to acquire the securities. If the employee chooses to hold the securities, a capital gain or loss will be realized when the securities are later sold. However, where a capital loss is realized, it can’t be used to reduce the taxable employment benefit.
Tax Deferral for the Taxable Employment Benefit
The tax rules generally require that the taxable employment benefit be included in income at the time the options are exercised. An exception applies to options granted to purchase securities of a Canadian-Controlled Private Corporation (CCPC) where certain conditions are met. Where this exception applies, the benefit is instead included in income when the securities purchased under the options are sold. In 2000, the deferral on the timing of the benefit inclusion in income was extended to publicly traded company options. To take advantage of the deferral, certain conditions applied including the filing of an election. The deferral on public company options was introduced at a time when stock markets were strong, and stock option plans were popular and benefited employees well.
However, not long after the extension of the deferral to public company securities, we saw large declines in the stock markets, largely in the technology sector. More recently, we have seen significant declines in the value of numerous companies with the recession that had hit us. Unfortunately, due to these market declines, many employees that made the election to defer the taxation of their taxable employment benefit now owe more tax on that benefit than the proceeds they will actually receive from the sale of their securities. As mentioned, capital losses realized on the sale of these securities can’t be used to reduce their employment benefit. So the ability to defer has not served many employees well and in certain cases, employees have found themselves in financial difficulty.
Elimination of the Deferral and Special Tax Relief Proposed
In the 2010 federal budget, the government proposed to eliminate the deferral on publicly traded company securities effective for employee stock options exercised after 4pm EST on March 4, 2010. The deferral of stock option benefits for most CCPC options will continue to be allowed.
The government also proposed to provide tax relief to employees who have taken advantage of the deferral on publicly traded company securities, but who have found themselves in the unfortunate position of owing more tax on their benefit than the proceeds they will receive (or have received) on the disposition of their securities. This tax relief will be provided on an elective basis and will ensure that the tax liability on a deferred stock option benefit does not exceed the proceeds of disposition of the optioned securities, taking into account tax relief resulting from the use of capital losses on the optioned securities. Where an employee elects to apply this special tax treatment to their optioned securities, the employee will:
- Pay a special tax for the year equal to the proceeds of disposition they receive on the sale of the securities. For residents of Québec, the special tax will be equal to 2/3rds of the proceeds. (Québec will harmonize with the federal change, except that the Québec tax will be 50% of the proceeds);
- Be able to claim an offsetting deduction equal to the amount of the taxable employment benefit that has been deferred; and
- Include in income as a taxable capital gain, an amount equal to half the lesser of the taxable employment benefit and the capital loss that will result on the sale of the securities. This taxable capital gain may be offset by the allowable capital loss on the optioned securities, if that loss is not used to offset other taxable capital gains realized by the employee.
The special elective tax treatment will only be available for stock option benefits on publicly traded company securities where a deferral election was made. It will apply for employees who dispose of their optioned securities after 2009 and before 2015, by making an election by the filing due date of their personal tax return for the taxation year of disposition of the securities. It will also apply retroactively for employees who disposed of their optioned securities before 2010. In this case, employees will be required to make the election for special tax treatment on or before their filing due date for the 2010 taxation year.
To illustrate how this special elective measure will work, the following example provides a comparison of the regular tax treatment of a deferred benefit arising from stock options and using the special elective tax treatment.
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Example
An employee was granted options to purchase 100 shares of ABC Company. The exercise price was $50 per share (equal to the fair market value of the shares at the date the options were granted). The employee exercised the options on March 15, 2005 and the fair market value of the shares on that date was $200 per share. The employee elected to defer the taxation of the benefit of $15,000 (fair market value of $20,000 less cost on exercise of $5,000). The employee sold their shares on March 30, 2010, when the fair market value had declined to $25 per share, resulting in a capital loss of $17,500 (proceeds of disposition of $2,500 less the adjusted cost base of $20,000). Assume the taxpayer pays tax at 46% and is not a resident of Québec.
As can be seen from the chart above, in this situation the tax liability will be less if the employee chooses the special elective tax treatment. However, the remaining net capital loss balance available to apply against other taxable capital gains will also be less as a portion of the allowable capital losses has been used to provide tax relief under the special calculation.
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Where the proceeds received on the sale of the optioned securities exceed the tax liability on the deferred benefit, this election would not be made. As well, if an employee has realized significant capital gains in the past three years or expects to do so in the future, it may be more beneficial to forgo the election and have a higher net capital loss balance that can be used to offset the realized or potential capital gains. In the example above, the net capital loss that was lost under the election ($7,500) would produce a tax saving of up to $3,450 if used to offset a future gain. Ignoring the time value of money, this could bring the tax cost of the election up to $5,950. Note also that if this election is available to be used retroactively on securities already disposed of, consideration will need to be given to the capital loss balance still available in 2010.
If you have deferred benefits on publicly traded company options, contact your BDO advisor to find out if you should take advantage of this special tax relief.
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