Employee Stock Options — Proposed Changes to Canada's Preferential Tax Treatment
Article by Christopher Ross, Kevin Fritz & Alexandre Lamoureux
On June 17, 2019, Canadian Federal Finance Minister Bill Morneau released draft legislation that will impact on the preferential tax treatment of employee stock options (“Proposals”). The Government initially announced its intention to introduce these measures in the Federal Budget released on March 19, 2019.
Stock options give employees the right to acquire shares of their employer at a designated price as an alternative form of compensation and are currently given preferential tax treatment in Canada.
According to the Government, the policy objective for this preferential tax treatment is to help “smaller, growing companies” (such as start-ups) attract and retain talent, since these companies may not have significant profits or may have cash flow challenges that affect their ability to offer competitive salaries. The Government’s concern is that this preferential tax treatment is being used by “large, mature companies” to provide executives a tax-preferred form of compensation. It should be noted that this is a new policy objective of the Government, as the preferential tax treatment of stock options has been in place for decades without any consideration of the size or maturity of the employer corporation.
The Proposals purport to address this concern by imposing a $200,000 (CAD) per employee limit on the amount of employee stock options granted by certain employers that will continue to qualify for the current preferential tax treatment.
The key features of the current tax treatment of employee stock options are as follows:
- the employee is considered to have received an employment benefit equal to the fair market value of the underlying share when the option is exercised less the amount paid for the share (and the option, if any);
- the employment benefit is fully taxable either (i) in the year the share is acquired (in the case of a share of a corporation that is not a “Canadian-controlled private corporation” (“CCPC”)), or (ii) in the year the share is disposed of (in the case of a share of a corporation that is a CCPC);
- provided certain conditions are met, the employee is entitled to a deduction equal to one half of the employment benefit (“Stock Option Deduction”), which means that the employment benefit is effectively taxed at the preferential capital gains tax rate (i.e. the amount is 50% instead of 100% taxable); and
- the employer is not entitled to a deduction in respect of the employment benefit.
The key features of the proposed tax treatment of employee stock options under the Proposals, which apply to options granted on or after January 1, 2020, are as follows:
- if the employer is subject to the new rules, there will be a $200,000 (CAD) limit on the amount of employee stock options that may vest in the employee in the year and continue to qualify for the current preferential tax treatment (i.e. the Stock Option Deduction); and
- the employer will be
- entitled to a deduction in respect of the employment benefit associated with employee stock options that are either above the $200,000 (CAD) limit or designated by the employer as ineligible for the Stock Option Deduction, and
- required to report employee stock options granted in excess of the $200,000 (CAD) limit or designated as ineligible for the Stock Option Deduction to the (i) employee in writing on the day the agreement is entered into, and (ii) CRA in prescribed form with its tax return for the taxation year in which the option is exercised.
The new rules will apply to every employer that is a “specified person”. A “specified person” is defined as any corporation (or mutual fund trust), except a corporation (or mutual fund trust) that:
- is a CCPC; or
- meets prescribed conditions.
A CCPC is generally a Canadian resident private corporation that is not controlled by one or more non-resident persons or public corporations.
The exception for an employer that is a CCPC appears consistent with the Government’s objective of preserving the current preferential tax treatment for employee stock options granted by “smaller, growing companies”, and the exception for an employer that meets prescribed conditions is stated to be in recognition of the fact that not every “smaller, growing company” is a CCPC.
The Proposals do not specify what these prescribed conditions are, and the Government is seeking stakeholder input on the characteristics of companies that should be considered “smaller, growing companies” and therefore continue to qualify for the current preferential tax treatment. The deadline to submit stakeholder input is September 16, 2019.
The $200,000 (CAD) limit applies to the amount of employee stock options that may vest in an employee in a particular year, based on the fair market value of the underlying shares when the option is granted. An option is generally considered to vest in an employee when it first becomes exercisable by the employee. The $200,000 (CAD) limit applies to all stock option agreements between the employee and the employer (and any corporation (or mutual fund trust) that does not deal at arm’s length with the employer).
One of the key questions is how the target of these measures - i.e. “large, mature companies” - is defined. The Proposals do not answer this question other than by exception - i.e. a “large, mature company” is not a CCPC or a corporation (or mutual fund trust) that meets prescribed conditions. In other words, every employer is potentially caught by the new rules, unless it qualifies for an exception.
This type of broad legislative drafting can impose a significant compliance burden on the taxpayer, since the taxpayer will be caught by the new rules, unless it can establish that it qualifies for an exception. This determination should be straightforward for an employer that is a CCPC, which is a welcome bright line test. The key then will be the drafting of the “prescribed conditions”, which we can presumably expect sometime after the consultation period ends on September 16, 2019.
Given that the Proposals apply to employee stock options granted on or after January 1, 2020, employers that may be affected should consider granting stock options before then.