On November 30, 2020, the Department of Finance ("Finance") released its 2020 Fall Economic Statement which included draft legislation (the "2020 Proposals") refining previous proposed amendments to the taxation of employee stock options. The changes had been anticipated, and are based on previous draft legislation released on June 17, 2019 (the "2019 Proposals"), summarized in more detail in our update of June 27, 2019. Finance had announced on December 19, 2019 that the 2019 Proposals, which were to be effective January 1, 2020, would be delayed. The 2020 Proposals reintroduce them with some notable modifications and clarifications.
If the 2020 Proposals are passed in their current form, they will apply to employee stock options (a term inclusive of options to acquire units in a mutual fund trust) granted on or after July 1, 2021. The 2019 Proposals, by contrast, were to become effective January 1, 2020.
Importantly, the 2020 Proposals would preserve treatment under the current rules for option agreements made on or after July 1, 2021 that result from an exchange of options (originally granted prior to July 1, 2021) to which subsection 7(1.4) of the Income Tax Act (Canada) (the "Act") applies.
Generally, under the current stock option rules in sections 7 and 110 of the Act, employees are eligible for a 50% deduction (the "50% Deduction") on the gain realized on the exercise of an employee stock option (typically equal to the fair market value of the security at the time of exercise minus the exercise price). The 50% Deduction is available in respect of employee stock options that are granted with an exercise price equal to or in excess of the fair market value ("FMV") of the underlying security at the time of grant, where, if the security is a share, the share underlying the option is a vanilla common share without, among other things, preferential redemption rights.
Under the current rules, stock option vesting (whether time-based or otherwise) is not addressed in the Act and is largely left to the employer and employee as a matter of contract.
New Annual Limit on the 50% Deduction
As in the 2019 Proposals, the new 2020 Proposals will introduce new rules that do track vesting and therefore introduce a vesting concept into the Act.
Specifically, the new rules will impose an annual limit on the 50% Deduction for each "vesting year" of an underlying option agreement, which is defined as the year in which the option agreement specifies the option is first exercisable.
In a change from the 2019 Proposals, if no vesting year is specified, the 2020 Proposals will deem the options to vest pro rata over a period equal to the lifetime of the stock option agreement or, if shorter, over the five-year period beginning on the grant date.
The per-vesting year limit is capped at $200,000 of the underlying securities to which the options relate, by FMV, as of the time the stock option agreement is made. In other words, the limit generally tracks, by vesting year, the first $200,000 worth of securities valued as of the agreement date. The 50% Deduction is otherwise unlimited if the securities appreciate by a significant margin.
A similar annual limit will apply to the Act's separate deduction for publicly listed securities donated to charity within 30 days after the exercise of an option. That deduction, which could, in combination with the 50% Deduction, eliminate any taxable income inclusion to the employee, will similarly be capped at $200,000 by FMV (at the grant date) per vesting year.
Exception for CCPCs and Other Companies
As with the 2019 Proposals, the 2020 Proposals exempt options issued by a Canadian-controlled private corporation ("CCPC").
The 2019 Proposals had also provided for exceptions for "start-up, emerging or scale-up" companies, but the criteria to qualify as one of those entities was to be later prescribed. In this respect, the 2020 Proposals will instead exempt non-CCPCs with annual gross revenues that do not exceed $500 million. If the entity issuing the security is part of a group that prepares consolidated financial statements, the $500 million threshold will apply on a group basis.
Securities in respect of stock options that exceed the $200,000 per-vesting year threshold will be considered "non-qualifying securities". As with the 2019 Proposals, the 2020 Proposals include a new deduction for an employer equal to the gain realized by the employee on the exercise of an option for non-qualified securities. In addition, the 2020 Proposals continue the ability for the employer to designate, in writing, securities that otherwise would be eligible for the 50% Deduction (even under the new limits) to be non-qualified securities, such that the sale or issuance of these securities to the employee will be deductible to the employer and no longer eligible for the 50% Deduction.
The sale or issuance of securities subject to stock options that would otherwise not meet the criteria for the 50% Deduction (even assuming no limit applied) will continue not to be deductible to the employer. Therefore, share-settled awards (such as certain share-settled stock units with no exercise price) and options granted in-the-money will not be deductible to the employer.
New Notification Requirements
The 2020 Proposals will require the employer to notify an employee within thirty days of a stock option agreement which securities underlying the option are non-qualifying securities. In addition, the employer will be required to notify the Canada Revenue Agency ("CRA") on or before the issuer's filing due date for the tax year in which the agreement is made which securities are non-qualifying securities. The notification must be done in prescribed form, further details of which have not yet been released.
Although the 2020 Proposals are not yet in force and subject to passage in Parliament, they do clarify some areas that the 2019 Proposals had left unclear.
In addition, the new July 1, 2021 effective date should give issuers and employers some time to consider amendments to existing plans, potential grants under the current rules (up to and including June 30, 2021) and new internal processes and compliance calendars to track post-June 2021 option grants by vesting year to ensure that the new limits on the 50% Deduction are respected and that the requisite notices are provided to employees and the CRA by the applicable deadlines.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.