After outcry over possible changes to the taxation of stock options, the Liberal government has left the existing regime in place — at least for now.

In the weeks leading up to the budget, Finance Minister Bill Morneau stated there would be a $100,000 cap on favourable tax treatment for stock options. He later said there would be grandfathering for options issued prior to Budget Day.

But the budget makes no mention of changes to the existing regime. Morneau says the government was listening to the objections of entrepreneurs, who compensate early employees with stock options in lieu of pay.

“I heard from many small firms and innovators that they use stock options as a legitimate form of compensation for their employees,” said Morneau. “So we decided not to put that in the budget.”

When asked if it would be in a future budget, he said: “It’s not in our plan.”

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The government is trying to stimulate innovation and economic growth, and stock options are a key part of attracting the talent needed for that, says Nancy Graham, portfolio manager at PWL.

“This isn’t just about somebody in a large, established, company getting stock options,” she says. “Even so, we still want [to incentivize] top talent in large established corporations.”

How things work now

Employers issue stock options as part of employee compensation packages. These awards give employees the right to purchase company stock at a pre-determined price on a future date. This benefits employees if the exercise price is lower than the trading price of the stock. For instance, if the exercise price is $100, and the stock is trading at $170, the employee makes $70 per share. (If the exercise price is above the trading price, the option is worthless.)

When employees exercise their options, they realize a taxable benefit equal to the fair market value minus the exercise price, Ana-Luiza Georgescu, a tax partner with KPMG in Montreal, told before budget day. In our example, the taxable benefit is $70 per share.

If the stock option plan meets certain conditions (and most Canadian ones are designed to meet them, notes Georgescu), only half the benefit is taxable—in our example, $35 per share. “That is often referred to as capital gains treatment,” said Georgescu, “because it does give the same result overall.”

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But the benefit is still considered employment income. “The fact that they’re getting this favourable inclusion rate doesn’t re-characterize the income as capital gains.” As such, “it’s subject to employer payroll withholding and reporting. There are separate boxes on the T4 [where the income is] identified as from stock options.”

The income is also subject to CPP withholding, provided the employee hasn’t reached the contribution limit already. CRA does not require EI to be deducted because stock options are viewed as non-cash compensation, to which EI does not apply.

Georgescu noted that the employee will be taxed again on any capital gains when he sells the stock itself (in this case, any gains above $170, which is the cost base for tax purposes). If he sells the shares immediately after exercise, he’d likely realize a small capital loss since transaction costs would be paid out of his holdings.

But, if he holds the shares and they increase in value, there’s potential for him to realize a large capital gain upon sale.