Changes are coming to the availability of tax deductions for stock options in Canada.
Back in June 2019, the Canadian federal government proposed tax changes that would limit the availability of a 50% employee stock option deduction for high-income individuals employed by large corporations, and at the same time serve to maintain the deduction for employees of emerging companies.
For various reasons, the proposed legislation stalled until recently. Then, in November 2020, the Canadian government announced that it will move forward with a proposed $200,000 annual deduction limit on option grants that qualify for the employee stock option deduction.
Here are answers to your most pressing questions about this change.
Under present rules, there is no tax when an employee is granted stock options from their employer or from a company related to their employer.
However, when an employee exercises stock options of non-Canadian Controlled Parent Company (“CCPC”) shares, such as public-company shares, they are subject to tax on the amount by which the fair market value (FMV) of the shares at the time of exercise exceeds the the exercise price. The associated income is considered employment income.
The employee can generally claim a deduction equal to 50% of the employment income from the exercise of the options if they meet specific requirements:
the exercise price is not less than the FMV 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 currently no limit on the number of stock options that can be granted to any employee. This can result in situations where a significant amount of stock option employment income is taxed at a very favorable rate.
Due to the current stock option deduction, this rate is 50% of the rate that would otherwise apply to that income, with no cap.
Where the employee is taxed at the highest tax rate, their combined marginal tax rate would range between 44.5% and 54%, depending on their province or territory of residence (based on 2020 individual tax rates).
Under the current rules, the income from stock options is taxed at a top rate of between 22.25% and 27% when the 50% stock option deduction applies.
Beginning July 1, 2021, employees receiving stock options from corporations that are not CCPCs or other exempted companies, will be impacted by a $200,000 annual limit on grants that may qualify for the employee stock option deduction.
Under the new rules, the stock option deduction will be limited to $200,000 of employee stock options that vest in a given calendar year.
If the agreement does not specify a vesting schedule, the proposed legislation states that options are considered to vest on a pro-rata basis over the term of the agreement, up to a maximum five-year period.
Under the proposed rules, employers will be responsible for tracking this limit and notifying both the employee and the Canada Revenue Agency (CRA) within 30 days of the date of grant as to whether options granted are eligible for the stock option deduction.
BDO Canada provides an example of how to calculate the $200,000 limit on an annual basis:
The Department of Finance provides the illustration of Henry, a highly compensated executive with a large and established company, who receives a stock option grant after July 1, 2021, for 200,000 shares that vest in a schedule of 50,000 options per year in each of 2022, 2023, 2024, and 2025.
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. See the Appendix below for a more detailed analysis of this example.
Employers that are Canadian controlled private corporations (CCPCs) or are considered “smaller employers” (i.e. generally those with annual gross revenues of $500 million or less, determined at the highest level of consolidation for employers in a corporate group) are excluded from the changes.