Stock-option taxation―what changes are in the works?

May 14, 2019

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In the 2019 federal budget, the government announced an intention to limit the current, favourable taxation rate on stock-option benefits. Until the government provides further information and draft legislation, we can only comment generally on what this may mean for Canadian businesses and other businesses operating in Canada. However, the government has indicated that the revised law will be modelled on certain U.S. stock-option rules.

The proposal

The federal government announced it will release changes restricting Canada’s beneficial employee-stock-option tax treatment by applying a $200,000 annual cap on employee-stock-option grants that qualify for the current tax treatment. The $200,000 cap will be based on the fair-market value of the underlying shares at the time of the grant. The proposed change could affect any employee in Canada who receives stock-option benefits as compensation, including employees of Canadian companies, employees of foreign companies operating in Canada, and employees of Canadian subsidiaries of foreign corporations.

The government asserts that this approach will not adversely affect employees at startups and rapidly growing Canadian businesses who receive employee stock options. However, there is concern within Canadian business, and in Canada’s technology community particularly, that the announced changes will make Canada a less-competitive destination for employees and interfere with businesses’ ability to attract top talent. The current Canadian tax rates on stock-option benefits help to balance out Canada’s high personal tax rates (as compared to personal tax rates in the U.S.).

The budget announcement also stated that the government believes employee stock options should not be used as a tax-preferred method of compensation for executives of large, mature companies. They indicated the public policy rationale for the preferential tax treatment of employee stock options is to support growing Canadian businesses. Under current law, the rules for the tax treatment of employee stock options differ between private and public company stock options, but there is no differentiation of tax treatment based on size of corporation. Consequently, these government comments have caused confusion about how proposed changes to stock-option rules will affect any given business.

Current rules

Under current rules, 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 fair-market value 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. If the stock options meet specific requirements, then the employee can claim a deduction equal to 50% of the employment income that arose on exercise of the options. The requirements are generally that:

  • the exercise price is the fair-market value 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, consequently, 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 top 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 tax rates known to date. With the 50% stock-option deduction, stock-option income will be taxed at a top rate of between 22.25% and 27%.

Examples of proposed changes

Budget documents provide examples of how the proposed changes will work. Two of these examples provide the basis for our illustrations:

 

(A)

(B)

(A)x(B)

(C)

(D)

((D)-(B))x(C)=(E)

(F)

(E)-(F)=(G)

 

Number of stock options granted in year one

Fair-market value of underlying shares at date of grant

Value of shares in stock-option grant when granted

Number of stock options exercised in year three

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 year three

Henry

100,000

C$50

C$5,000,000

 

C$70

     

Treatment under proposals

Option grants that qualify for stock-option deduction

4,000

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

96,000

C$50

 

96,000

C$70

C$1,920,000

Nil (Note 1)

C$1,920,000

Total taxable income in year of exercise

             

C$1,960,000

Treatment under current law

Option grants that qualify for stock-option deduction

100,000

C$50

 

100,000

C$70

C$2,000,000

C$1,000,000

C$1,000,000

Additional taxable income under proposed changes

         

C$960,000

Note 1: No deduction because value in stock options at date of grant is greater than C$200,000

                 

Amanda

100,000

C$1

C$100,000

 

C$6

     

Treatment under proposals

Option grants that qualify for stock-option deduction

100,000

C$1

C$100,000

100,000

C$6

C$500,000

C$250,000

C$250,000

Option grants that do not qualify for stock-option deduction

Nil (Note 2)

             

Total taxable income in year of exercise

             

C$250,000

Treatment under current law

Option grants that qualify for stock-option deduction

100,000

C$1

 

100,000

C$6

C$500,000

C$250,000

C$250,000

Note 2: All stock-option grants qualify for 50% deduction as the value in stock options at the date of grant is less than C$200,000

 


Under the proposed system, Henry, a highly compensated executive with a large, established company, will be worse off than under the current system. This is because his stock-option grant represented $5 million in stock value when 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 $960,000 more in taxable income compared with the current tax system for the same value received from stock options.

Conversely, Amanda, employed by a startup company, has a stock-option grant that does not exceed a value of $200,000 in the year of grant, and therefore will not be adversely affected in the taxation of her stock-option benefits.

From comments in the budget-document examples, it appears that the change in taxation of stock-option benefits is intended to limit the personal tax benefit to the recipient of the income received through stock options, but it may also change the corporate tax position regarding a deduction when a stock option is exercised. An example in the budget papers suggests that a corporate tax deduction may be available for stock-option benefits on which the employee is fully taxed. This needs to be confirmed when draft legislation is released.

Uncertainties

Our examples are based on government-provided information. As draft legislation has not yet been released, and may not be released before Canadians go to the polls in October, further analysis is difficult at this time. However, the government has been clear that any changes will apply only on a go-forward basis and will not apply to employee stock options granted prior to the announcement of legislative proposals to implement this change.

If you have questions regarding how the proposed stock-benefit taxation changes may affect your business, please contact your BDO representative.


The information in this publication is current as of April 29, 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.