Canada: Proposed Changes To Taxation Of Employee Stock Options Released, But Deferred

The Government released draft legislative proposals (Proposals) on June 17 to implement the changes to the employee stock option tax regime announced in the 2019 Federal Budget (Budget). The Budget proposed to cap the amount of employee stock options that can benefit from the 50% employee deduction. Our 2019 Federal Budget bulletin has further details. If passed, the Proposals will only apply to stock options granted on or after January 1, 2020. As a result, employers have some time to digest the Proposals and determine whether and to what extent changes to their compensation arrangements should be made. 

What you need to know

  • The Budget proposed to restrict the availability of the 50% employee deduction for certain stock option benefits. Draft legislation to implement this change was released on June 17.
  • The Proposals generally restrict the deduction based upon a $200,000 annual vesting limit.
  • The Proposals permit the employer to deduct the amount of the stock option benefit that doesn't qualify for the 50% employee deduction if certain conditions are met.
  • The proposals do not apply to CCPCs or to start-up, emerging and scale-up companies.
  • The Government is seeking stakeholder input on the characteristics of companies that should be considered start-up, emerging and scale-up companies.

Existing rules

Under the existing rules, where a corporation or mutual fund trust (each, a "qualifying person") grants a stock option to an employee of the qualifying person (or of another qualifying person with which the grantor does not deal at arm's length), the employee is taxed on the employment benefit derived from the exercise of the stock option. The employment benefit is generally equal to the difference between the fair market value of the underlying securities acquired on the exercise of the stock option and the exercise price. If certain conditions are met including that the exercise price at the time the stock option was granted equals or exceeds the fair market value of the underlying securities at that time (i.e., the stock option was not granted in-the-money), the employee is generally entitled to a deduction equal to 50% of the amount of the employment benefit. The general policy intent of the 50% deduction is to effectively mirror capital gains treatment. 

The proposals

$200,000 annual vesting limit

The Proposals implement the $200,000 annual cap announced in the Budget by excluding employee stock options to acquire "non-qualified securities" from being eligible for the 50% deduction. Non-qualified securities are those securities that exceed a $200,000 annual vesting limit. The limit is applied based on the aggregate fair market value of the underlying securities on the date the stock option is granted that have the same vesting year.  Any underlying securities in excess of the $200,000 annual vesting limit are deemed to be non-qualified securities and the 50% deduction is not available with respect to those securities. Where multiple stock option grants from the same employer (or non-arm's length qualifying persons that are not CCPCs or that do not meet prescribed conditions) vest in the same year, the rules effectively apply the limit based on the order in which the grants occurred, with older grants utilizing the limit first.

For these purposes, the vesting year is generally the calendar year specified in the stock option in which the employee's right to acquire the security first becomes exercisable. Otherwise, if the stock option does not specify the year when the employee has the right to exercise, the vesting year is the calendar year in which the employee's right to acquire the security can reasonably be expected to be exercised.

Apart from securities that are non-qualified securities as a result of the $200,000 annual vesting limit, the employer can designate the underlying securities to be non-qualified securities in the stock option grant agreement. An employer may do this to benefit from the employer deduction with respect to non-qualified securities discussed below.

The Proposals require the employer to notify the employee in writing on the date of grant of any securities that are deemed to be non-qualified securities because of the $200,000 annual vesting limit. The employer is also required to notify the Canada Revenue Agency of any securities that are non-qualified securities (including those that are designated as such by the employer) in prescribed form filed with the employer's income tax return for the year in which the stock options are granted.

Employer deduction

The Proposals also introduce a deduction for the employer in respect of those stock option benefits for which the 50% deduction is denied to an employee. The amount of the deduction is equal to the aggregate stock option benefit realized by the employee (i.e., the amount by which the fair market value of the underlying stock at the time of exercise exceeds the aggregate exercise price). The deduction is only available in respect of non-qualified securities the employer has agreed to sell or issue if certain conditions are met, including: (i) the employer was the employer of the individual at the time the stock option was granted; (ii) the 50% deduction would have been available to the employee if the securities were not non-qualified securities; and (iii) the employer has complied with the notification requirements set out above. Among other things, this implies the entity that grants the stock option must be the actual employer of the employee at the time the stock options were granted in order to be eligible for the employer deduction. 

Exclusion for CCPCs and start-ups, emerging and scale-up companies

The Proposals (including with respect to the employer deduction) do not apply to employee stock options granted by CCPCs or by qualifying persons who meet prescribed conditions. The Government is seeking stakeholder input on the characteristics of companies that should be considered "start-up, emerging and scale-up companies." In establishing the prescribed conditions, the Government states that it will be guided by two key objectives established in the Budget: to make the employee stock option tax regime fairer and more equitable for Canadians; and to ensure that start-ups and emerging Canadian businesses that are creating jobs can continue to grow and expand.

Stakeholders are invited to submit comments with respect to the prescribed conditions to the Department of Finance by September 16. It remains to be seen whether the prescribed conditions will be based upon size of the company, the business sector in which the company operates or other factors.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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