Proposed limits on employee stock option deductions

Introduction

The long-standing tradition of using employee stock options to reward and retain employees in Canada is expected to change for some employees due to limits proposed by the federal government to the current advantageous tax treatment available to employees in certain circumstances. Generally, these proposals will not impact Canadian-controlled private corporations; they will impact all corporations (including non-Canadian controlled private corporations and public companies) and mutual trust funds that have annual gross revenues in excess of $500 million.

Currently, subsection 7(1) of the Income Tax Act (Canada) affords favourable tax treatment to employee stock options if certain conditions are met. One such condition is that the exercise price, at the time the option is granted, is at least equal to the fair market value of the subject shares at the time of the grant. The favourable treatment entitles an arm’s length employee to deduct one-half of the taxable benefit that is realized at the time of exercise, effectively taxing the benefit similar to a capital gain.

On November 30, 2020, the Fall Economic Statement (“FES”) clarified changes to the employee stock option tax regime proposals that were introduced in the 2019 Federal Budget and a Notice and Ways and Means Motion (“NWMM”) released in June 2019. The NWMM invited stakeholders to provide input through a public consultation period that was conducted from June to September 2019. The FES reflects stakeholder input from the public consultation and revises the NWMM proposals to provide certainty on several aspects of the original proposals that impact both employees and employers affected by the proposed legislation.

Summary of the Proposed Changes

• The FES confirms the previously announced proposal to restrict the availability of the 50% stock option deduction based on a $200,000 annual vesting limit. The $200,000 limit is based on the fair market value of the underlying shares to which the stock option relates when the option is granted.
• The FES confirms the previously announced proposal to allow the employer to deduct the amount of the stock option benefit that is not eligible for the employee’s 50% stock option deduction, provided certain conditions are met.
• The FES proposes that the vesting year of the option will either be the calendar year in which the right to acquire first becomes exercisable or, if unclear from the option grant, the option will be considered to vest on a pro-rata basis over the term of the agreement up to the earlier of a 60-month period or the last day the option could be exercised.
• The proposed changes will not apply to Canadian-controlled private corporations; the proposed changes will apply to all corporations (including non-Canadian controlled private corporations and public companies) and mutual trust funds if their annual gross revenues (on a consolidated basis, if applicable) exceed $500 million.
• Employers subject to the new rules can choose whether to grant options under the current tax treatment, up to $200,000 per employee, or whether to grant all options under the new proposed tax treatment (i.e., with the stock option benefit being ineligible for any employee stock option deduction, but eligible for an employer deduction).
• The proposals will apply to options granted on or after July 1, 2021; however, in certain circumstances, options issued after June 2021 in exchange for options issued before July 2021 will not be subject to the proposed changes. Existing options are not affected.

Proposed Stock Option Deduction Limit

The 2019 Federal Budget introduced a $200,000 annual limit on the amount of employee stock options that may vest in an employee in any calendar year and be eligible for the stock option deduction. The $200,000 limit is based on the fair market value of the underlying shares to which the stock option relates when the option is granted. The annual limit applies to all stock option agreements that an employee has with an employer or any corporation that does not deal at arm’s length with the employer. However, where an employee is employed by a number of arm’s length employers, the employee has a separate $200,000 annual limit in respect of each employer.

The proposals provide for certain ordering rules if the amount of the stock options that may vest in a calendar year exceeds $200,000 (first in, first to qualify for the stock option deduction).

For stock options that exceed the $200,000 limit, an employee will be denied a stock option deduction in respect of the taxable benefit associated with those options. This will result in 100% of the stock option benefit being taxed as employment income, rather than 50% under the current rules.

The FES adopts these measures while clarifying how the vesting year of options is to be determined. The NWMM specified that the option vests in the calendar year in which the right to acquire the option becomes exercisable, as specified by the option grant and provided that if the vesting year was not specified or unclear from the option grant, the option would be considered to vest in the first calendar year in which the option “can reasonably be expected to be exercised.” In light of the residual uncertainty created by the phrase “can reasonably be expected to be exercised,”  FES now clarifies that when the vesting year is unclear from the option grant, the option would be considered to vest on a pro-rata basis from the day the grant was entered into until the earlier of:

i) 60 months after the day the agreement is entered into; or

ii) the last day the right to acquire the option could be exercisable under the option grant.

This change provides clarity that was lacking in the initial proposals.

The $500 Million Revenue Threshold

The 2019 Federal Budget indicated that the proposals would not apply to Canadian-controlled private corporations or “start-up, emerging, and scale-up companies”, but provided no details on the criteria distinguishing a “start-up, emerging, and scale-up company” from a “large, long-established, mature firm”. During the course of the public consultation, comments from stakeholders included that the Department of Finance ensure that this distinction be clear, rational, and understandable in order to ensure certainty for the tax treatment of stock options, even for entities that transition from a “start-up, emerging, and scale-up company” to a “large, long-established, mature firm”.[1]

With these comments in mind, the FES now clarifies that for the purpose of these proposals start-up, emerging, and scale-up companies will be considered non-Canadian controlled private corporations or mutual trust funds with annual gross revenues of $500 million or less. The  FES specifies the manner in which such revenue threshold is computed. For members of a corporate group that prepare consolidated financial statements, gross revenue should be reported as it appears in the most recent consolidated annual financial statements presented to shareholders before the stock option is granted. For employers that are not members of corporate groups, gross revenue should be reported as found in the most recent annual financial statements prepared in accordance with the generally accepted accounting principles and presented to shareholders before the stock option is granted.

Notwithstanding the clarity provided by the revenue thresholds, they are not without some deficiencies. Generally, the exclusion from these proposals for “start-up, emerging, and scale-up companies” allow them to compete for new talent by offering stock options in comparison to large corporations that can more easily compensate employees with cash.  However, the use of revenues as the distinguishing criteria may have a disproportionate effect on large employers if they operate in an industry that demands a high degree of research and development and consequently, have lower profits and cash available to use for employee compensation. Furthermore, the revenue threshold does not address situations where a corporation or mutual fund’s revenue is close to, but does not meet the revenue threshold. If the bright-line test is $500 million, a company with revenue that falls just short of this amount may be excluded from the proposed measures. Although such a corporation may have greater profits and cash flow to compensate employees in comparison to another corporation that is at or above the revenue threshold, the corporation below the revenue threshold will receive the advantage of qualifying for the proposed deductions. It remains to be seen whether administrative policy will emerge to address certain anomalous situations on a case-by-case basis, to ensure that the proposed measures achieve their intended result.

Employer Tax Deduction

The proposals will provide an employer with a deduction in respect of the stock option benefit associated with non-qualified securities. Non-qualified securities include those securities that are in excess of the $200,000 annual vesting limit, as well as options that the employer opts to designate as only being subject to the new rules.

The amount of the deduction available to the employer is equal to 100% of the stock option benefit realized by the employee, which is equal to the difference between the fair market value of the underlying securities at the time of exercise and the established exercise price. These proposals are effectively providing for a 100% employer deduction (for a non-cash outlay) in respect of which a 50% stock option deduction is being denied to the employee. At best, these proposals are tax revenue neutral from the federal government’s perspective. While these proposals are being promoted as “the next step toward a fairer tax system” by effectively redistributing the tax benefit of the stock option deduction away from highly compensated executives to a broader group of corporate shareholders, as a result of the employer deduction, they are not expected to be a tax-revenue generator for the federal government.

For an employer (or non-arm’s length person to the employer to whom the proposals apply) to  claim a deduction in respect of the stock option benefit associated with non-qualified securities, certain conditions must be met. These conditions include that:

• the employer is a corporation (or a mutual fund trust);
• the employer was the employer of the individual at the time the stock option was granted;
• the amount being claimed as a deduction is not claimed as a deduction by another corporation (or mutual fund trust);
• the stock option deduction would have been available to the employee if the underlying securities were not non-qualified securities;
• in the case of an employee not resident in Canada throughout the year, the stock option benefit was included in the employee’s taxable income earned in Canada for the year; and
• the employer provided:
  1. notice in writing to the employee within 30 days after the option agreement was entered into that the securities is a non-qualified security; and
  2. notice to the Canada Revenue Agency of any non-qualified securities by filing a prescribed form with its income tax return for the year in which the stock options were granted.

These proposals provide employers with the choice to opt-in to the new measures when the options exceed the $200,000 limit in a year, or to elect that all options granted be non-qualifying securities under the proposed rules, effectively denying the employee the 50% deduction even though the options satisfy requirements for the employee stock option deduction in respect of amounts that do not exceed the $200,000 annual limit.  From an employer’s perspective, the ability to treat all issued options as non-qualifying securities eases the administrative burden otherwise associated with tracking and complying with the annual limit.

Impact on Charitable Donations

Under the current legislation, in addition to the stock option deduction that is available to employees, as described above, an additional 50% stock option deduction (the “charitable deduction”) is available to an employee who exercises a stock option in respect of a share of a publicly listed company and gifts the share (or cash proceeds from the sale of such shares) to a “qualified donee” (i.e., a registered charity) within 30 days of exercise of the option.  Consequently, under the existing rules, an employee may acquire a share on the exercise of the stock option and donate it to a charity without any corresponding income inclusion.

The FES proposals provide that if an employee donates publicly listed shares (acquired upon the exercise of a stock option that is in excess of the $200,000 limit), the employee will not be eligible for any of the additional charitable deduction, but will continue to remain eligible for the charitable donation tax credit associated with the donation. However, the capital gains exemption that is currently available to taxpayers in respect of the donation of publicly traded securities to a qualified donee is not impacted by the FES proposals.

Looking Forward

The new legislative proposals will apply to employee stock options granted on or after July 1, 2021, in most cases. The proposals will not apply where options have been issued after June 2021 in exchange for options issued before July 2021 under subsection 7(1.4) of the Act. In these situations, the options will not be subject to the new rules and thus will not be considered to have been issued after June 2021.

In either case, affected employers should consider:

• the timing of granting stock options and other stock-based awards prior to these new rules coming into effect; and
• the notice requirements, including an appropriate method to notify employees of non-eligible securities.

As stakeholder input has been received and revisions have been made, the proposed legislation is expected to be enacted into law. Employers and employees should consider the proposed changes in current discussions or planning for new employee stock options and are encouraged to reach out to a Miller Thomson tax advisor to better understand how the proposed changes may apply to their particular circumstances.

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[1] Stakeholders comments include those from The Joint Committee on Taxation The Canadian Bar Association and Chartered Professional Accountants of Canada, May 14, 2019.