What to look for in new stock option legislation

By Melissa Shin | March 11, 2016 | Last updated on October 30, 2023
5 min read

It’s not a great time to be rich—at least from a tax perspective.

If your clients work for public companies that grant them stock options, they may have to pay more tax on income from those options after the 2016 Federal Budget.

Finance Minister Bill Morneau has 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.

Further details, however, are unknown.

We spoke with Ana-Luiza Georgescu, a tax partner with KPMG in Montreal, about what to expect. (This analysis does not apply to Quebec, where rules are different.)

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, says Georgescu. In our example, the taxable benefit is $70 per share.

Read: CRA stock options ruling a bonus for executors

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,” says Georgescu, “because it does give the same result overall.”

Conditions for stock option plans to receive favourable tax treatment

  • The options have to be granted by virtue of employment.
  • The employee must deal at arm’s length with the company.
  • The exercise price must be the same or higher than the fair market value of the stock at the time of granting.
  • The shares underlying the stock option have to be prescribed shares (e.g., common shares).

For more detail, see the CRA definition.

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.

She notes 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.

What to look for on Budget Day

“There are a lot of details that we’re expecting to be clarified,” says Georgescu.

On March 22, she’ll look for:

  • The effective date of the change. While Morneau has stated that options granted before the effective date will be grandfathered under the old rules, Georgescu is waiting to see actual legislation. Will the new rules apply to existing stock options that are exercised after the effective date, or only stock options that are granted after the effective date?
  • What the limit is. Again, Morneau has mentioned a $100,000 cap, but that could change. And how will the cap room be calculated? “Is it all or nothing? Once you’ve exceeded the limit, do you have no right to the deduction? And is the rest is included at 100%?” We also don’t know if the limit is annual or lifetime, she adds.
  • How the limit will be calculated. Let’s say the cap is $100,000. Is it $100,000 in income? Or is $100,000 the fair market value at grant? At exercise?
  • Whether there will be a corresponding corporate deduction (there isn’t one right now). At the moment, the corporation cannot claim an expense when issuing stock options.
  • How Canadian-controlled private corporations would be affected. Right now, an arm’s-length employee is only taxed when she sells the shares, not when she exercises her stock option.

What could happen if stock option rules change

Should employees with existing stock options exercise them before March 22? Not simply because of the possible new rules, says Georgescu.

“You need to balance the investment piece and the tax piece,” she says. Exercising right now would hedge against a rule change, but “you may be giving up on the increase in the share value. It’s a personal decision. It’s not necessarily tax-related.”

The employee would also need enough cash to buy the stock when she exercises the option, and the shares would have to be vested.

Read: Tax and estate issues with stock options

With potential changes to the capital gains inclusion rate, the decision becomes more complicated, Georgescu adds. If the employee exercises her option, does he hold the shares or sell them to get ahead of a capital gains change? “It’s not just tax,” she says. “It’s an investment decision.”

If the changes go through, companies may start granting or enhancing other awards to help manage the tax hit for employees. Other compensation tools include:

  • Restricted Share Units (RSUs): “[A] promise to deliver shares at a future vesting date (e.g., three years after grant) or the cash equivalent value,” as defined in a PwC report;
  • Performance Share Units (PSUs): “[S]imilar to RSUs, but with a performance multiplier based on company achievement,” says the report; and
  • Stock appreciation rights: “[S]imilar to a stock option, but designed to make a cash payment equal to the appreciation in stock value over a specified period.”

Notes Georgescu: “Historically, these did not qualify for the stock option deduction, but they have other objectives and corporate tax treatment that made them interesting.”

Public companies may still find stock options attractive if the new legislation allows them to be deducted from corporate net income, she says. “But if the corporate deduction is also not going to be allowed—same as currently—then that will make stock options less attractive than before. There will no favourable tax treatment at the employee level, and neither will there be a corporate deduction.”

Another wrinkle: if the changes happen, companies’ payroll departments will have to track options issued and exercised pre-budget and post-budget. “And there [would have] to be employee communication to manage expectations that the inclusion rate will change, and there will be corresponding payroll withholding, and/or additional tax liabilities with their returns.”

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Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.