Proposed Legislative Changes to the Taxation of Employee Stock Options in Canada

In the 2019 Federal Budget, the Canadian government outlined its proposal to introduce a $200,000 annual limit on employee stock option grants for employees of “large, long-established, mature firms”. The government takes the view that the current regime of preferential tax treatment for employee stock options does not help to achieve the policy objective of supporting younger and growing Canadian businesses, but instead, disproportionally benefits executives of large, mature companies who take advantage of the rules as a preferred form of compensation. 

In an effort to provide further clarifications to the proposed new stock options rules, the Department of Finance released a Notice of Ways and Means Motionon June 17, 2019.

Current Regime

Under the current stock option rules, pursuant to subsection 7(1) of the Income Tax Act (Canada) (the “Act”), at the time when employee stock options are exercised by an employee, a taxable benefit is added to the employee’s taxable income to the extent the fair market value (“FMV”) of the underlying shares exceeds the exercise price specified in the option agreement. However, provided that at the time of the grant, the options are not in-the-money (i.e. exercise price is not less than FMV) and, generally, common shares are issued upon the exercise of the options, the employee is entitled to claim a deduction under paragraph 110(1)(d) in the amount of 50% of the taxable benefit determined under subsection 7(1).

New Proposed Amendments

The new draft legislative proposals, if enacted as proposed, would impose a $200,000 annual vesting limit on employee stock option grants (based on the fair market value of the underlying shares at the time the options are granted) that could be entitled to receive the 50% deduction allowed under paragraph 110(1)(d). 

Under the new regime, a vesting year in respect of an option agreement is determined by either: (i) the calendar year in which the employee is first able to exercise his or her option as specified in the option agreement; or (ii) if the option agreement does not specify a vesting time, the first calendar year in which the option can reasonably be expected to be exercised.

The new annual vesting limit would not apply to employee stock options granted by “specified persons” as defined in the Act to mean: (i) Canadian-controlled private corporations (“CCPCs”); and (ii) non-CCPCs that meet certain prescribed conditions (yet to be released).

In addition, the new draft legislative proposals introduce a tax deduction for an employer who enters into an option agreement with its employee to grant non-qualified securities. The amount of deductions the employer is entitled to claim against its taxable income for a taxation year would be equal to the amount of taxable benefit its employees realize under subsection 7(1) in respect of non-qualified securities.

An employer would be entitled to claim such deductions under circumstances where the following conditions are met: (i) at the time of entering into the agreement, the employer notifies the employee in writing that the security is a non-qualified security; (ii) the employer notifies the Minister of National Revenue that the security is a non-qualified security in prescribed form filed with the employer’s income tax return in the year the agreement is entered into; and (iii) the employer is a specified person and the employees would have otherwise been entitled to claim the deduction under paragraph 110(1)(d).

In order to be entitled to claim the tax deduction, it is critical that the employer designates the options that would have otherwise qualified for a deduction under paragraph 110(1)(d) as non-qualified securities by specifying this in the option agreement.

The new draft legislative proposals will apply to employee stock options granted on or after January 1, 2020.

The federal government is currently seeking input on the characteristics of companies that should be considered “start-up, emerging, and scale-up companies” for purposes of the prescribed conditions as well as views on the administrative and compliance implications associated with putting such characteristics into legislation. Submissions of any comments with respect to the prescribed conditions for the consideration by the Department of Finance are due on September 16, 2019.

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