Stock-option taxation―what changes have been proposed?

June 21, 2019

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The federal government announced an intention to limit the current, favourable taxation rate on stock option benefits in the federal budget released in March 2019. The Department of Finance released legislative proposals on June 17 that will apply to employee stock options granted on or after January 1, 2020. The government has allowed a consultation period until September 16, 2019 in respect of this draft legislation. The proposed rules will not apply to employee stock options granted by Canadian-controlled private corporations (CCPCs). It is not expected that this draft legislation will be passed before Canadians go to the polls for the federal election in October; therefore, it is unclear what will become of these proposed changes if there is a change in government.

Employee tax implications

The proposal - $200,000 annual vesting limit

The proposed rules state that employees receiving stock options after 2019 in 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 draft rules provide that the benefit of the stock option deduction will be limited by formula for shares that vest in a given taxation 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 2020 may vest in equal amounts over the next four years – 2,500 options per year in each of 2021, 2022, 2023 and 2024. If the agreement does not specify a vesting schedule, the draft legislation states that options are considered to vest in the first calendar year that the stock option can reasonably be exercised.

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 shares to be used for this test is the fair market value (FMV) of the shares at the date of grant.

Example

Henry receives a stock option grant in 2020 for 200,000 shares that vest in a schedule of 50,000 options per year in each of 2021, 2022, 2023, and 2024. 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.

Current rules

The current rules state there is no tax when an employee is granted stock options from their employer or from a company related to their employer. When an employee exercises stock options of public-company shares, they are subject to tax on the amount by which the 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 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 the FMV of the shares at the date the options were granted
  • 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. 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 of residence and based on 2019 personal tax rates in effect. Stock option income will be taxed at a top rate of between 22.25% and 27% with the 50% stock option deduction.

Employer tax implications

An important change in the proposed rules is to allow an employer to claim a tax deduction in computing its taxable income when the employee is denied the stock option deduction as a result of the proposed vesting limit. From a tax policy perspective, this will have the general effect of making these new proposals 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.

To ensure compliance with the $200,000 limit, the proposals will require employers to notify employees in writing to indicate whether the stock options are subject to the new rules when 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.

Application of proposals to stock options of early stage public companies and similar entities

The taxation of shares of CCPCs will not change under these proposals. The government also intends that the proposals to restrict the stock option benefit not apply to stock options of start-ups, emerging or scale-up companies that are not CCPCs (such as early stage public companies) where such companies meet certain prescribed conditions. In establishing the prescribed conditions, the government will be focusing on companies that are creating jobs and will continue to do so as they grow and expand. The government is seeking feedback with respect to what the nature of these prescribed conditions should be.

BDO Canada will be making a submission to the Department of Finance to reflect the concerns of our clients. We encourage you to contact your BDO tax advisor if you have questions as to how the proposed rules may apply to you or if you have direct suggestions with respect to the prescribed conditions you would like us to consider in our submission.


The information in this publication is current as of June 18, 2019.

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.