Potential changes to beneficial tax treatment on stock options
The Canadian government recently released proposed legislation that could limit access to beneficial tax treatment for stock options granted by certain companies after 2019. The proposals would introduce an annual limit on the amount of options that qualify for the beneficial treatment but would conversely allow a corporate deduction for the non-qualifying benefit. Companies should understand how the proposed legislation could affect them and their employees and if they may wish to accelerate stock option grants into the current year as a result.
Under current legislation, when a company that is not a Canadian-controlled private corporation (CCPC) grants a stock option to an employee, the employee is taxed when they exercise the option on the difference between the fair market value (FMV) of the shares at exercise and the exercise price payable for those shares.
If certain conditions are met (generally the exercise price equals the FMV of the shares at the option grant date and the options are over common shares of the company), the employee is only taxed on half of the taxable stock option benefit. This is known as the “50% deduction”.
Employers are generally unable to claim a corporate deduction where shares are issued to employees through a stock option.
The proposed rules state that employees granted stock options after 2019 in non-CCPC corporations will be subject to an annual vesting limit on the amount of the 50% deduction that can otherwise be claimed.
The limit imposed on the deduction will apply if the value of options that vest in a year is more than CAD 200,000. The value of the shares to be used for this test is the FMV of the shares at the grant date.
Henry is granted 100,000 stock options in 2020 that vest equally over a 4 year period (25,000 options per year). The FMV (and exercise price) at the grant date is CAD 15.
Each year, the value of the options that vest is CAD 375,000 (25,000 x CAD 15). The 50% deduction is therefore only available in respect of the exercise of 13,333 options that vest each year (CAD 200,000/CAD 15). The benefit arising on the exercise of the remaining 11,667 options that vest each year would be taxable in full.
To ensure compliance with the CAD 200,000 limit, the proposals will require employers to notify employees in writing whether the limit applies when options are granted. Employers will also be required to notify the Canadian tax authorities if options are granted that fall under the new rules.
However, a welcome change in the proposed rules is to allow an employer to claim a tax deduction when an employee is denied the 50% deduction as a result of the annual vesting limit.
Exclusions from the proposed legislation
As previously mentioned, the above rules would not apply to options granted in a CCPC. In addition to this, the government has recognised that many start-up, emerging or scale-up companies are not CCPCs and has indicated that the proposed legislation is not intended to apply to such companies either.
Public consultation is currently taking place regarding the definition of these companies and further details should be released in due course.
If the proposed legislation is enacted, employers will have an increased administrative burden to review whether stock option grants are subject to the annual vesting limit and notify employees. For smaller (non-CCPC) companies that may fall under the prescribed exclusion it will therefore be key to watch for further commentary from the authorities.