Backgrounder: Proposed Changes to the Tax Treatment of Employee Stock Options

Employee stock options, which provide employees with the right to acquire shares of their employer at a designated price, are an alternative compensation method used by businesses to attract and engage employees, and encourage growth. Many smaller, growing companies, such as start-ups, do not have significant profits and may have challenges with cash flow, limiting their ability to provide adequate salaries to hire talented employees. Employee stock options can help these companies attract and retain talented employees by allowing them to provide a form of compensation that is linked to the future success of the company.

Employee stock options, which provide employees with the right to acquire shares of their employer at a designated price, are an alternative compensation method used by businesses to attract and engage employees, and encourage growth. Many smaller, growing companies, such as start-ups, do not have significant profits and may have challenges with cash flow, limiting their ability to provide adequate salaries to hire talented employees. Employee stock options can help these companies attract and retain talented employees by allowing them to provide a form of compensation that is linked to the future success of the company.

To support this objective, the tax rules provide employee stock options with preferential personal income tax treatment in the form of a stock option deduction. This effectively results in the benefit being taxed at a rate equal to one-half of the normal rate of personal taxation – the same rate as capital gains.

A review of employee stock option deduction claims reveals that the tax benefits of the employee stock option deduction disproportionately accrue to a very small number of high-income individuals – resulting in a tax treatment that unfairly benefits the wealthiest Canadians.

In 2017, 2,330 individuals, each with total annual incomes of over $1 million, claimed over $1.3 billion in employee stock option deductions. In total, these 2,330 individuals, representing 6 per cent of stock option claimants, accounted for almost two-thirds of the entire cost of the deduction to taxpayers.

The public policy rationale for preferential tax treatment of employee stock options is to support younger and growing Canadian businesses. The Government does not believe that employee stock options should be used as a tax-preferred method of compensation for executives of large, mature companies.

It is for this reason that Budget 2019 announced the Government's intention to limit the use of the current employee stock option tax regime, and to move toward aligning it more closely with that of the United States for employees of large, long-established, mature firms.

Today's Notice of Ways and Means Motion takes the next step toward establishing a fairer employee stock option tax regime.

Current Treatment

When an employee acquires a share under an employee stock option agreement, the difference between the fair market value of the share at the time the option is exercised and the amount paid by the employee to acquire the share (including the strike price and any amount paid to acquire the option) is treated as a taxable employment benefit (an "employee stock option benefit"). No corporate income tax deduction is available in respect of an employee stock option benefit.

A stock option deduction equal to one-half of the employee stock option benefit is available to the employee, resulting in the employee stock option benefit effectively being taxed at the same rate as capital gains. The deduction is available to the employee provided certain conditions are met, including:

• the employee deals at arm's length with the employer at the time the option is granted;
• the amount payable by the employee to acquire the share is not less than the fair market value of the share at the time the option is granted; and
• the acquired share is a prescribed share (typically a common share).

In the case of an employee stock option granted by a Canadian-controlled private corporation (CCPC), the stock option deduction is available even if the acquired share is not a prescribed share or the amount payable by the employee to acquire the share is less than the fair market value of the share at the time the option was granted, provided the employee holds the acquired share for at least two years.

The employee stock option benefit is typically taxable in the year the option is exercised. However, in the case of an option granted by a CCPC, the taxation of the employee stock option benefit is deferred until the year in which the employee disposes of the acquired share.

Where an employee disposes of a stock option for a cash payment (or other in-kind benefit) from their employer rather than exercising the option, the employer is entitled to a corporate income tax deduction in respect of the cash payment and the stock option deduction is not available to the employee. However, if the employer elects to forgo its tax deduction in respect of the cash payment, the employee is eligible for the stock option deduction.

Proposed Treatment

$200,000 Limit

For employee stock options granted by employers that are subject to the new rules, there will be a $200,000 limit on the amount of employee stock options that may vest in an employee in a year and continue to qualify for the stock option deduction. An option vests when it first becomes exercisable. The determination of when an option vests will be made at the time the option is granted. For the purpose of determining the amount of options that may vest in any calendar year, the value of those options will be the fair market value of the underlying shares when the options are granted.

The $200,000 limit on the amount of employee stock options that may vest in any calendar year will generally apply to all stock option agreements between the employee and the employer or any corporation that does not deal at arm's length with the employer. If an individual has two or more employers who deal at arm's length with each other, the individual would have a separate $200,000 limit for each of those employers.

If the amount of stock options that may vest in a year exceeds $200,000, those employee stock options granted first will be the first to qualify for the stock option deduction. Where an employee has a number of identical stock options and some qualify for the existing treatment while others are subject to the new rules, the employee will be considered to exercise the stock options qualifying for the existing treatment first.

Examples of how the new limit will operate are provided in the Annex.

Employers subject to the new rules will be able to choose whether to grant employee stock options subject to the current tax treatment, up to the $200,000 limit per employee, or whether to designate employee stock options that would otherwise be subject to the current tax treatment as being subject to the new rules.

Employers will need to ensure compliance with respect to the $200,000 limit. This will include a requirement that an employer notify its employees in writing whether options granted are subject to the new rules at the time the options are granted. In addition, employers will be required to notify the Canada Revenue Agency if they issue securities subject to the new rules.

The new rules will apply to employers that are corporations or mutual fund trusts. Employers that are CCPCs will not be subject to the new rules.

Further, in recognition of the fact that some non-CCPCs could be start-ups, emerging, or scale-up companies, those non-CCPCs that meet certain prescribed conditions will also not be subject to the new rules. The Government is consulting Canadians on what the prescribed conditions should be for this purpose.

As noted in the news release with which this Backgrounder was issued, in establishing the prescribed conditions, the Government will be guided by two key objectives. First, that the employee stock option tax regime becomes fairer and more equitable for Canadians. Second, that start-ups and emerging Canadian businesses that are creating jobs can continue to grow and expand.

In this regard, the Government would be interested in the views of stakeholders with respect to the characteristics of companies that should be considered start-up, emerging, and scale-up companies for purposes of the prescribed conditions. The Government would also be interested in stakeholder views on the administrative and compliance implications associated with putting such characteristics into legislation.

Employee Tax Treatment

Where an employee exercises an employee stock option that exceeds the $200,000 limit, the difference between the fair market value of the share at the time the option is exercised and the amount paid by the employee to acquire the share will be treated as a taxable employment benefit. The full amount of the employment benefit will be included in the income of the employee for the year the option is exercised, consistent with the treatment of other forms of employment income. The employee will not be entitled to the stock option deduction in respect of this employment benefit.

Charitable Donations

Under the current tax rules, if an employee donates a publicly listed share (or the cash proceeds from the sale of a publicly listed share) acquired under an employee stock option agreement within 30 days of the exercise of the option to a qualified donee, such as a registered charity, the employee is eligible for an additional deduction equal to one-half of the employee stock option benefit. As a result, where both the stock option deduction and the additional deduction in respect of a qualifying donation are available, the entire employee stock option benefit is effectively excluded from income. Donations of shares of private corporations are not eligible for the additional deduction.

If an employee donates a publicly listed share acquired under a stock option that is subject to the new tax rules, the employee will not be eligible for a tax exemption on any associated employee stock option benefit. Any capital gain that has accrued since the share was acquired under the stock option agreement will continue to be eligible for the full exemption from capital gains tax, subject to existing rules.

Employer Tax Treatment

For employee stock options granted in excess of the $200,000 limit, the employer will be entitled to an income tax deduction in respect of the stock option benefit included in the employee's income. The deduction may be claimed in the taxation year that includes the day on which the employee exercised the stock option.

Employers subject to the new rules will be entitled to a deduction for income tax purposes where the employee would have been entitled to the stock option deduction had they been granted under the existing rules.

Generally, employers that are subject to the new rules will also be able to designate employee stock options as ineligible for the employee stock option deduction (and instead eligible for a deduction for corporate income tax purposes) under the terms of the stock option agreement.

Corporations that are not subject to the new rules will not be permitted to opt in to the new employee stock option tax rules.

Coming into Force

Employee stock options granted on or after January 1, 2020 will be subject to the new rules.

Annex: Examples of how the $200,000 limit will operate and how the new rules for taxing employee stock options could affect employees who are granted stock options

Example 1

Henry is an executive of a corporation that is subject to the new employee stock option tax rules. In 2020, Henry's employer grants him stock options to acquire 200,000 shares at a price of $50 per share (the fair market value of a share on the date the options are granted), with one-quarter of the options vesting in each of 2021, 2022, 2023 and 2024. Since the fair market value of the underlying shares at the time of grant in each vesting year ($50 × 50,000 = $2.5 million) exceeds the $200,000 annual limit, the amount of stock options that can receive preferential tax treatment will be capped. In particular, the stock option benefits associated with 4,000 ($200,000 ÷ $50 = 4,000) of the options in each vesting year can continue to receive preferential personal income tax treatment, while the stock option benefits associated with the remaining 46,000 options in each vesting year will be included in Henry's income and fully taxed at ordinary rates and deductible for corporate income tax purposes.

Henry exercises all of these options in 2024, by which time the price of the shares has increased to $70. This means that $3,680,000 (($70 - $50) × 184,000) of the employee stock option benefit will be included in Henry's income and fully taxed at ordinary rates (with a deduction to the employer), while only $320,000 (($70 - $50) × 16,000) of the benefit can receive preferential personal income tax treatment (with no deduction to the employer).

Example 2

Mckayla is an employee of a corporation that is subject to the new employee stock option tax rules. In 2020, her employer grants her employee stock options to acquire 12,000 shares at a strike price of $50 per share, the fair market value of a share on the date the options are granted. Options to acquire 3,000 shares vest in each of 2021, 2022, 2023 and 2024. Since the fair market value of the underlying shares in each vesting year ($50 × 3,000) does not exceed the $200,000 limit, all of the stock option benefits associated with these options will continue to receive preferential personal income tax treatment (with no deduction to the employer).

Mckayla decides to exercise all of these options in 2024, by which time the price of the shares has increased to $70. Her entire stock option benefit of $240,000 (($70 - $50) × 12,000) will receive preferential personal income tax treatment (with no deduction to the employer).

Example 3

Tobias is an employee of a corporation that is subject to the new employee stock option tax rules. In 2020, his employer grants him employee stock options to acquire 120,000 shares at a strike price of $4 per share, the fair market value of a share on the date the options are granted. All of the options are identical and vest in 2021.

50,000 ($200,000 ÷ $4 = 50,000) of the options will qualify for preferential personal income tax treatment (with no deduction to the employer), while the remaining 70,000 options will need to be granted under the new tax rules.

If Tobias exercises 20,000 options in 2021, all of these options will be considered to qualify for preferential personal income tax treatment because of the ordering rule for identical stock options. If the price of the share has increased to $5, his stock option benefit of $20,000 (($5 - $4) × 20,000) will receive preferential personal income tax treatment (with no deduction to the employer).

If Tobias exercises an additional 40,000 options later in 2021, 30,000 of those options will qualify for preferential personal income tax treatment and 10,000 will be subject to the new rules. If the price of the share is still $5 at this time, $30,000 (($5 - $4) × 30,000) of the stock option benefit will receive preferential personal income tax treatment (with no deduction to the employer), while $10,000 (($5 - $4) × 10,000) will be included in his income and fully taxed at ordinary rates (with a deduction to the employer).

Example 4

Venetia is an employee of a corporation that is subject to the new employee stock option tax rules. In February 2020, her employer grants her employee stock options to acquire 40,000 shares at a strike price of $4 per share, the fair market value of a share on the date the options are granted. The options vest in 2022. In July 2020, her employer grants her an additional 30,000 options with the same strike price ($4) and vesting date (2022).

All of the 40,000 employee stock options granted in February will continue to qualify for the preferential personal income tax treatment, as their total amount ($4 × 40,000 = $160,000) does not exceed $200,000. 10,000 of the options granted in July 2020 will qualify for preferential personal income tax treatment ($4 × 10,000 = $40,000 = $200,000 - $160,000). The remaining 20,000 employee stock options granted in 2020 will be under the new tax rules.

If Venetia exercises 50,000 options in 2022, all of these options will be considered to qualify for preferential personal income tax treatment. If the price of the share has increased to $6, her stock option benefit of $100,000 (($6 - $4) × 50,000) will receive preferential personal income tax treatment (with no deduction to the employer).

If Venetia exercises any additional options later in 2022, all of the stock option benefit on those options will be included in her income and fully taxed at ordinary rates (with a deduction to the employer).