Proposed changes to the taxation of employee stock options

In the months since the Federal Budget was tabled in April 2024, there has been much discussion and speculation about the proposed changes to the taxation rate applicable to capital gains. However, there has not been nearly as much attention given to the proposed changes to the taxation of stock option benefits, applicable to stock options exercised after June 24, 2024.

Prior to these recent proposals, employee stock option benefits were fully taxable as employment income and employees could claim a deduction of 50% of the benefit, provided certain conditions are met. As a result, the tax treatment of employee stock options is generally aligned with the taxation of capital gains in terms of the amount of the capital gain or stock option benefit that is taxable.

With the recent proposal to increase the capital gains inclusion rate from 50% to 66.7% for capital gains realized after June 24, 2024, the stock option deduction will be reduced from 50% to 33.3%, and effectively 66.7% of the employee stock option benefit will be taxable. Individuals will have a $250,000 combined annual limit for employee stock option benefits and capital gains, meaning that the increased inclusion rate will apply only when the combined employee stock option benefits and capital gains for the year exceed the $250,000 threshold.

This article focuses on the income tax implications of the proposed reduction of the stock option deduction for employees who exercise qualifying public company stock options and are not subject to vesting restrictions.

How are employee stock options taxed?

Under the general employee stock option rules, when employment stock options are exercised, employees must include in their income the difference between the fair market value of the stock at the date of exercise and the exercise price paid (which is usually the fair market value of the stock at the time the option was granted). This difference is referred to as the stock option benefit. When the stock option is in respect of a share of a Canadian-controlled private corporation (CCPC), the inclusion is deferred until the year the employee disposes of or exchanges the shares.

Prior to the recent proposals, an employee could claim an offsetting deduction of 50% of the stock option benefit, provided certain qualifying conditions are met. As mentioned, the net impact is that 50% of the stock option benefit is taxable, similar to a capital gain. Since 2021, a $200,000 annual vesting limit applies on certain stock options that can qualify for the stock option deduction.

The value of the options to be used for this test is the fair market value of the underlying shares at the date of grant. When an employee is denied the stock option deduction because of the vesting limit or when the employer makes an election, the employer can claim a tax deduction in computing its taxable income, subject to certain conditions.

These vesting rules do not apply to CCPCs or corporations that are not CCPCs that have annual gross revenues of less than $500 million on a consolidated basis. Note that the recent proposal to reduce the employee stock option deduction does not affect the vesting rules.

Proposal to reduce the employee stock option deduction

For individuals, 66.7% of capital gains realized after June 24, 2024 that are more than the $250,000 annual limit will be included in taxable income for the year. Capital gains realized up to the threshold will continue to be included in taxable income at 50%.

To preserve the tax treatment of stock options so that it continues to align with the taxation of capital gains, the employee stock option deduction is reduced from 50% to 33.3% for stock option benefits realized after June 24, 2024 that exceed the $250,000 annual limit. As a result, stock options are effectively taxed at a 66.7% inclusion rate as well.

It's important to understand that the $250,000 annual limit is a combined limit for both capital gains and employee stock option benefits. This means that individuals may claim the higher employee stock option deduction of 50% only to the extent they do not exceed the combined annual limit of $250,000 for both capital gains and employee stock option benefits. When the total capital gains and employee stock option benefits exceed the $250,000 threshold, the individual can choose how to allocate the limit.

The income tax impact before and after the changes take effect: A practical example

Let's look at an example of an employee, who is a resident of Ontario, subject to the top marginal tax rates, and realizes an employee stock option benefit of $500,000 in 2024. Assume they do not have any capital gains in the year and all their stock options qualify for the stock option deduction.

This simple scenario shows that the proposals have the negative impact of a reduced employee stock option deduction, which increases taxable income and income taxes payable. In this example, the employee can claim a deduction of 50% of the stock option benefit up to the $250,000 threshold. However, the remaining stock option benefit of $250,000 can only be partially offset by a lower 33.3% stock option deduction. In this case, the employee's effective tax rate increased by almost 4.5%.

If, on the other hand, the employee realized capital gains of $250,000 during the year and utilized the full annual limit to access the lower capital gains inclusion rate, then they can only claim a deduction of 33.3% of their stock option benefit.

In this latter scenario, the employee's effective tax rate on their employee stock option benefit would be approximately 9% higher than with a 50% stock option deduction. The increase in the capital gains personal tax rates resulting from the increase in the inclusion rate ranges from 7.4% to 9.1% depending on the jurisdiction. The same tax rates can be used to compare the increased rate of tax on eligible employee stock option benefits.

For information on the capital gains tax rates at both the 50% and 66.7% inclusion rates, refer to our 2024 top personal marginal tax rates publication for all jurisdictions.

Transitional rules for 2024

In 2024, special transitional rules will apply to the taxation of capital gains that are realized in both the period of the taxation year that is before June 25, 2024, and the period of the taxation year that is after June 24, 2024. These rules can result in the inclusion rate being averaged rather than being strictly 50% or 66.7%.

The transition rules do not apply to the taxation of stock option benefits. The rate of taxation of qualifying employee stock option benefits in 2024 is either 50% or 66.7% depending on the period of the year that the option was exercised – before or after June 25, 2024—and how the $250,000 exemption is allocated.

What employers should know

Even with the recent proposals, employee stock options can still be a tax-efficient compensation strategy. However, the proposed changes bring uncertainty regarding the amount of the employer's withholding tax obligation on stock option benefits realized after June 24, 2024.

Under the proposals, determining whether the employee's stock option deduction is at 50% or 33.3% depends on if the individual has reached the $250,000 annual limit and how it is allocated between capital gains and employee stock option benefits.

Employers will not be able to determine this information at the time the withholding obligation arises, as the allocation will not be known until the employee files their income tax return. As such, it's unclear if employers should withhold taxes on stock option benefits realized after June 24, 2024 at the higher 66.7% benefit inclusion rate. It is possible that changes to the draft legislation and/or guidance will be released that will clarify this issue.

BDO can help

If you have any questions about the proposed changes to the employee stock option deduction or setting up employee stock option plans, please contact us.