Employee stock option deduction limits to take effect January 1, 2020
On June 17, 2019, the federal Minister of Finance tabled a Notice of Ways and Means Motion that would limit the availability of deductions with respect to shares issued under certain employee stock options granted starting January 1, 2020. This follows an announcement in the 2019 federal budget in which the government signaled its intention to limit the use of the current employee stock option tax regime for employees of large, established companies (as discussed in the March 2019 News & Views).
New $200,000 deduction limit for employee stock options
Provided certain conditions are met, employees are currently permitted to claim a deduction for 50% of employee stock option benefits when they exercise the option, which effectively results in the employee stock option benefit being taxed at half of the normal income tax rate (i.e., the same rate as capital gains).
The motion would put a $200,000 annual limit on the value of the employee stock options that may vest in a year and continue to qualify for the stock option deduction. This limit will be calculated based on the fair market value of the underlying shares at the time the option is granted. With respect to the portion of the stock option that exceeds the above limit, upon exercise the difference between the price paid and the fair market value of the stock will be treated as a taxable employment benefit, with no 50% deduction.
The limit will apply to all stock options granted by the employer and any non-arm’s length corporation or mutual fund trust, so multiple option agreements with the same employer or options from two nonarm’s-length corporations that vest in the same year will count towards a single $200,000 limit. However, employees with multiple arm’s-length employers will enjoy a separate $200,000 limit for each employer.
The cap will not apply to options granted by Canadian-controlled private corporations (CCPCs), and non-CCPCs that meet prescribed conditions, such as start-ups, emerging or scale-up companies.
The stated purpose of the proposal is to limit the preferential tax treatment of options for employees of large, long-established and mature firms while still allowing younger and growing companies to continue to use stock options to attract talent. However, it remains to be determined what will constitute “start-ups, emerging or scale-up companies.” The government will be accepting input on what characteristics will be used to define this category until September 16, 2019.
Employer deductions of amounts exceeding the prescribed limit
When an employee exercises an option for an employee stock option grant that exceeded the $200,000 limit, the employer may deduct the amount exceeding the limit for the year in which the employee exercised the option, provided certain conditions are met. In other words, the employer will be entitled to a deduction in respect of the stock option benefit that was included in the employee’s income. The securities to be issued under such stock option grants will be termed “non-qualified securities”.
Employers that are subject to the new employee stock option rules will be permitted to designate shares granted under employee stock options as ineligible for the 50% employee stock option deduction. Under certain conditions, the employment benefit generated with respect to those ineligible shares will be deductible to the employer. Employers that are not subject to the new rules will not be able to opt-in in order to designate shares as non-qualified.
Employers will be required to notify their employees in writing upon the grant of a stock option for nonqualified securities, as well as the Canada Revenue Agency in a prescribed form filed with the employer’s income tax return for the grant year.
The proposed limits on the preferential tax treatment of employee stock benefits could have a significant impact on the appeal of employee stock options as a compensation vehicle for executives. Some organizations may wish to consider alternative forms of incentive-based compensation beginning in 2020 when the new regime comes into force, either on their own or in conjunction with stock option grants falling below the annual limit. Morneau Shepell’s compensation consulting practice, with its extensive experience in incentive program design and stock option administration, can assist clients in updating incentive programs to achieve their goals.