As foreshadowed in the 2019 federal budget (Budget 2019), on June 17, 2019, the Department of Finance released draft legislation to limit the beneficial tax treatment generally available to employees on an exercise or cash-out of their stock options (the Stock Option Proposals). The federal government stated in Budget 2019 that the proposed changes would become effective upon the release of the legislative proposals. However, the Stock Option Proposals provide that the proposed changes will only apply to stock options granted on or after January 1, 2020. This resolves uncertainty regarding the effective date of the new measures.
The Stock Option Proposals will not apply to employee stock options granted by Canadian-controlled private corporations (CCPCs) or other employers that satisfy certain yet-to-be-specified "prescribed conditions". The prescribed conditions are intended to exempt non-CCPCs that are "start-ups, emerging, or scale-up companies". The Department of Finance has requested input from stakeholders on what such "prescribed conditions" should include.
This summary describes the June 17, 2019 Stock Option Proposals. For our summary of the tax measures announced in Budget 2019, please see: www.mccarthy.ca/en/insights/articles/2019-canadian-federal-budget-commentary-tax-initiatives.
Current Rules
Generally, under the current rules, an employee is only taxed on one-half of the employment benefit that he or she recognizes on the exercise or cash-out of employee stock options, provided that:
- the options have an exercise price at least equal to the fair market value (FMV) of the underlying shares on the date of grant, and
- the underlying shares are, or would be, "prescribed shares" (generally, plain vanilla common shares) at the time that the options are exercised or cashed-out.
The amount of the employment benefit is equal to the excess of the FMV of the shares on the exercise date over the exercise price thereof or, in the case of a cash-out of options, the amount received by the employee on the cancellation of the options. The beneficial tax treatment results in employees being taxed at a rate equivalent to the rate on capital gains.1
In order for an employee to obtain the beneficial tax treatment described above on a cash-out of options, the employer must expressly elect to forego any otherwise available tax deduction. An employer is generally not entitled to a tax deduction where an employee exercises stock options to acquire shares.
The Stock Option Proposals
The Stock Option Proposals, if enacted as proposed, will limit the beneficial tax treatment to circumstances where the current conditions for such treatment are met and at least one of the following two conditions is met:
- the stock options being exercised or cashed-out are within a $200,000 annual vesting limit; or
- the employer is not a "specified person".
As noted above, the Stock Option Proposals will only apply to employee stock options granted on or after January 1, 2020.
Where an employee is denied the beneficial tax treatment as a result of the Stock Option Proposals, the employer will generally be entitled to a tax deduction equal to the amount of the employee's employment benefit. In addition, employers that are subject to the new rules will be able to designate options that would otherwise fit within the $200,000 annual vesting limit as ineligible for the beneficial tax treatment so that the employer will be entitled to a tax deduction in respect of such options upon the employment benefit being realized.
- Annual Vesting Limit
Where the employer is a "specified person" (as described below), the beneficial tax treatment will only be available on an exercise or cash-out of stock options up to a $200,000 annual vesting limit. The number of options that qualify for the annual vesting limit will be determined based on the FMV of the underlying shares on the date the options are granted and the number of options that vest in a particular calendar year. Where options are subject to vesting conditions other than time-vesting, the options will be subject to the annual vesting limit in the first calendar year in which the right to acquire the underlying shares can reasonably be expected to be exercised.
For example, assume that on January 2, 2020 an employee is granted 30,000 options to acquire shares that have an FMV at that time of $10 per share. If all 30,000 options vest in 2023, the beneficial tax treatment will only be available on the first 20,000 options (i.e., $200,000/$10 (FMV of shares on the date of grant)). If instead 20,000 options vest in 2023 and 10,000 options vest in 2024, the beneficial tax treatment will be available in respect of all 30,000 options, as the $200,000 annual vesting limit will not be exceeded in respect of either 2023 or 2024.
- Non-Specified Person
Where the employer is not a "specified person", the beneficial tax treatment will generally be available on an exercise or cash-out of stock options, provided the conditions under the current rules described above are satisfied. A "specified person" is defined in the new rules as any employer, other than:
- a CCPC; or
- an employer that meets "prescribed conditions".
The "prescribed conditions" referred to in 2 above have not yet been determined, and the federal government is seeking input from stakeholders on this aspect of the Stock Option Proposals. In the backgrounder to the Stock Option Proposals, the Department of Finance states:
"Further in recognition of the fact that some non-CCPCs could be start-ups, emerging, or scale-up companies, those non-CCPCs that meet certain prescribed conditions will also not be subject to the new rules. The Government is consulting on what the prescribed conditions should be for this purpose."
The deadline for submissions to the Department of Finance on the prescribed conditions is September 16, 2019 (which is also the date on which the House of Commons is set to resume sitting after the summer recess). Given this timeline, it is unlikely that the Stock Option Proposals will be enacted before the 2019 Canadian federal election.
Footnote
1 Under the current rules, beneficial tax treatment may also be available to an employee in respect of the exercise of options to acquire shares of a CCPC that do not meet the conditions described above, provided the employee holds the shares for at least two years after the exercise of the options. The Stock Option Proposals do not amend this aspect of the current rules.
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