Changes are coming to the tax treatment of employee stock options courtesy of this week’s federal budget. Whether you’ll be affected or not, however, will depend on what type of company you work for and the amount of stock options you receive. Let’s begin with a review of how employee stock options are currently taxed and then take a look at what’s being proposed.
Current rules
Under current tax rules, when an employee stock option is exercised, the difference between the exercise price and the fair market value of the share is included in income as an employment benefit. For qualifying options, you can claim an offsetting deduction (the “stock option deduction”) equal to one-half the benefit, so that only 50 per cent of the stock option benefit is included in your income and taxed at your marginal rate.
The tax result is to effectively tax employee stock options like capital gains, although they are still considered to be employment income and thus qualify as “earned income” for RRSP contribution room purposes. And, because they are not actually capital gains, you can’t offset the income inclusion with capital losses you may have.
The proposed rules
You may recall that one of the promised tax changes included in the Liberals’ 2015 pre-election platform was to limit the benefits of the stock option deduction by placing a cap on how much can be claimed. At the time, the Liberals quoted a Department of Finance estimate which found that 8,000 “very high-income Canadians deduct an average of $400,000 from their taxable incomes via stock options.”
In the budget document released this week, the government shared data from Canadians’ 2017 tax returns which showed that in 2017 (the latest tax year for which data is publicly available) 2,330 individuals, each with a total annual income of over $1 million, claimed over $1.3 billion of employee stock option deductions. In total, these 2,330 individuals, representing six per cent of stock option deduction claimants, accounted for nearly two-thirds of the entire $2.1 billion “cost” of the deduction to taxpayers.
In response, this week’s budget announced that the government will be moving forward with legislative amendments, to be introduced before the summer, that will cap the amount that can be claimed under the stock option deduction for some option holders. While the 2015 proposal was to set the cap at $100,000, the 2019 budget doubled the soon-to-be-introduced cap to $200,000, “aligning Canada’s employee stock option tax treatment with that of the United States.” The $200,000 annual cap on employee stock option grants will be based on the fair market value (“FMV”) of the underlying shares at the date of grant.
According to the budget documents, the proposed cap will only apply to limit the stock option deduction for individuals employed at “large, long-established, mature firms,” a vague, as-of-yet undefined term, that gives the government some time to come up with an appropriate definition. (Cue the lobbyists!) Startups and “rapidly growing Canadian businesses” would not have any caps imposed on their employee stock option benefits.
It’s important to note that any changes would only apply on a go-forward basis and will not apply to employee stock options granted prior to the future legislative announcement. As law firm McCarthy Tétrault cautiously suggested in their post-budget commentary: “Consideration may be given to the viability of making significant grants of stock options prior to legislative proposals being announced.”
Here are three simple examples, adapted from the budget document, that will help to explain how various employees may or may not be affected by the upcoming cap.
Example 1 — Mature firm — senior executive
Sarah is a senior executive of a large, long-established, mature company with an employee stock option plan. Sarah’s employer grants her stock options to acquire 100,000 shares at a price of $50 per share (the FMV of the shares on the date the options are granted), with all of the options vesting in some future year. Since the FMV of the underlying shares at the time of grant ($50 X 100,000 = $5 million) exceeds the $200,000 limit, the amount of Sarah’s stock options that can receive preferential tax treatment will be capped.
In this example, Sarah’s stock option benefits associated with 4,000 ($200,000 ÷ $50) of the options can continue to receive preferential tax treatment; however, the benefit associated with the remaining 96,000 options will be included in Sarah’s income and fully taxed at ordinary rates when exercised.
If the price of the shares has increased to $70 at the time that Sarah chooses to exercise her options, $1,920,000 {($70 – $50) X 96,000)} of the employee stock option benefit will be included in Sarah’s income and taxed at ordinary rates without being eligible for the stock option deduction. Only $80,000 {($70 – $50) X 4,000)} of the stock option benefit will be eligible for the stock option deduction, so Sarah will be taxed on 50 per cent of the $80,000 benefit.
Example 2 – Mature firm – manager
Isaac is a manager at the same large, long-established, mature company, which grants him employee stock options to acquire 3,000 shares at the same price of $50 per share. Since the FMV of the underlying shares at the time of grant ($50 × 3,000 = $150,000) is within the proposed $200,000 cap, all of Isaac’s stock option benefits associated with these options will continue to receive preferential tax treatment when exercised.
So, if the price of the shares increases to $70 at the time Isaac exercises his options, he will only be taxed on half of his stock option benefit of $60,000 {($70 – $50) × 3,000} in the year of exercise.
Example 3 – Startup employee
Jake is an employee of a startup company that also has an employee stock option plan. Jake’s employer grants him stock options to acquire 300,000 shares at a price of $1 per share. Since Jake received these options from a startup, all of the stock option benefits associated with the ultimate exercise of his options will continue to receive preferential tax treatment.
If the price of the startup shares doubles to $2 at the time that Jake exercises the options, his stock option benefit of $300,000 {($2 – $1) × 300,000} will continue to receive preferential tax treatment so he will be taxed on 50 per cent of the stock option benefit at his marginal rate.