The Taxation of Employee Stock Options and Proposed Changes
Background on the Taxation of Employee Stock Options
Under the Income Tax Act (the “Act”), employee stock option benefits are treated differently than other forms of remuneration from employment. Most forms of remuneration, including non-cash remuneration, are fully included in the employee’s income from employment in the year in which the cash or property is received. In the case of non-cash compensation, the fair market value of the property is included in income.
On the other hand, the receipt of an employee stock option does not generate an income inclusion or other taxable event for the recipient employee (the rationale relates to issues with valuation and liquidity, particularly in the case of options in shares of private corporations). The recognition of the stock option benefit is deferred and included in income in the year in which it is exercised (subsection 7(1)), or, in the case of options issued by Canadian-controlled private corporations (“CCPCs”), the year in which the shares are disposed of (subsection 7(1) with reference to subsection 7(1.1)). More significantly, owing to a deduction of one-half of the benefit allowed in computing taxable income under either paragraph 110(1)(d) or (d.1), typically only one-half of the stock option benefit is subject to taxation.In other words, employee stock option benefits are taxed preferentially, at the same rate as capital gains and with a built-in deferral, even though they are considered employment income and not capital gains. The preferential taxation of stock option benefits is a tax expenditure—in this case, government spending for the benefit of certain employees through the tax system.
Many countries tax employee stock options preferentially, but Canada has one of the most generous stock option tax regimes in the world. Under the Act, the one-half taxation rule can apply regardless of the amount of the stock option benefit, the size of the employer corporation, and generally without regard to the holding period of the shares. Furthermore, the one-half taxation rule can still apply if the underlying shares decline in value before the option is exercised and the option exercise price is reduced accordingly (subsection 110(1.7)). The downside, from the employer’s perspective, is that a deduction is not allowed in respect of the stock option benefit in computing the employer’s income (paragraph 7(3)(b)).
In the United States, statutory “qualified stock options” are taxed preferentially but they carry significant monetary and trading restrictions. As a result, most employee stock options in the United States are issued as “non-qualified stock options”, the benefits from which are fully included as employment income. In other words, most employee stock options benefits do not receive a tax preference under the US tax system. In states such as California and New York (apparent “brain drain” destinations for certain Canadian individuals), the highest income earners are typically taxed at a rate of around 50% on employee stock option benefits, compared to a rate of about 24% to 27% in Canada, depending on the province. However, unlike Canada, the corporate employer is allowed a corresponding deduction in computing its income.
Proponents of the employee stock option tax preference often contend that stock options motivate employees and improve their performance and align their interests with shareholders, such that their use should be encouraged under the tax system. Stock options are therefore viewed as valuable tools to attract and retain highly-skilled workers.
On the other hand, many tax policy experts argue against a tax preference for recipients of employee stock options. They argue that there is no reason why the government should subsidize a decision to issue stock options if it is sound from a business perspective (that is, without tax considerations). On the flip side, if firms choose the stock option route that is not worth the risk from a business perspective but may be worth the risk after accounting for the tax considerations, the tax preference subsidizes a bad business decision.
Tax policy experts at the Organisation for Economic Co-operation and Development (the “OECD”) have provided a detailed study on the taxation of employee stock options, which is available on the OECD website. The authors concluded that, as a benchmark, an efficient tax treatment of employee stock options would provide no tax preference to either increase or decrease the number of employee stock options and would be neutral with respect to the choice between granting stock options and paying salary. The benchmark would therefore tax stock option benefits in full and allow a deduction for the employer. The authors also conclude that the fact that stock options may have desirable characteristics is not sufficient to justify preferential tax treatment. They do, however, concede that a tax preference may be warranted for certain start-up firms that wish to attract talented employees but cannot afford to pay large cash salaries. These firms may lack collateral or a proven track record that prevents them from raising cash to cover their employment costs, and potential employees may balk at accepting stock options in the absence of a tax break.
The current federal government seems to agree, to a large extent, with the OECD study and the critics of the stock option preference. In the 2019 Federal Budget, the Department of Finance announced that it would be restricting the one-half taxation rule for employee stock options. The budget proposal indicated that the current one-half rule could apply in respect of benefits arising from up to $200,000 of shares—the value determined at the time of the grant—for each year in which the options vest. Options reflecting shares worth more than the $200,000 amount would not qualify for the one-half deduction and the option benefits would therefore be fully included in income. A major exception, where the current one-half tax rule would continue to apply, would be to stock options granted by CCPCs and other small start-up corporations to be prescribed under the Regulations to the Act.
The main rationale for the government’s decision to restrict the stock option preference is one of fairness. The 2019 Budget papers note that the current treatment disproportionately benefits high-income earners and therefore makes the income tax system less progressive. Interestingly, the Budget papers further indicate that the restriction will move toward aligning Canada’s employee stock option tax treatment with that of the United States. This latter point is interesting as it is rare that a Canadian government does away with a tax preference in order to align itself with the United States. More commonly, governments of all stripes and at all levels rationalize a reduction of our taxes in order to be more competitive with the United States (in this context, “competitive” always means lower taxes). Ironically, in the 2000 Federal Budget (released by a previous Liberal government), the introduction of a deferral for benefits in respect of options on publicly-traded shares (a tax break) was rationalized as assisting “corporations in attracting and retaining high-calibre workers and [making] our tax treatment of employee stock options more competitive with the United States.”
On June 17, 2019, the Department of Finance released draft legislation reflecting the 2019 budget tax proposals. The draft legislation is scheduled to apply to options issued after 2019. Whether it will be passed into law remains to be seen, and likely depends on the results of the upcoming October federal election. If the current governing Liberal party wins the election, one would expect the proposals to be implemented. If another party wins, we will have to wait and see.
Under the draft legislation, the one-half deduction under paragraph 110(1)(d) for employees is not allowed for stock option benefits deemed to be received under subsection 7(1) in respect of “non-qualified securities” under an agreement for each “vesting year” of those securities. This new restriction does not apply to benefits under options granted to employees by CCPCs, and other employers who meet prescribed conditions, who are not “specified persons” (subsection 110(0.1)) and whose issued securities therefore cannot constitute “non-qualified securities” (see subsection 110(1.3)). In other words, such options will remain eligible for the one-half deduction. Interestingly, the exception for options issued by a CCPC applies regardless of the size or capitalization of the CCPC.
Generally, when dealing with one option agreement, subsection 110(1.31) provides that non-qualified securities for a vesting year under the agreement mean those securities whose fair market value (“FMV”) at the time the agreement was entered into (the “relevant time”) exceeds $200,000. For example, if the FMV of the securities at the relevant time in 2020 was $300,000, and the vesting year was 2021, one-third ($100,000 / $300,000) of the securities would be non-qualified securities regardless of their value in 2021 or when they were acquired. The other two-thirds would remain eligible for the one-half deduction under paragraph 110(1)(d).
Although the $200,000 amount is determined as of the relevant time, the determination of whether the securities are non-qualified securities is made in respect of each vesting year. For example, if the FMV of the securities under an agreement at the relevant time was $500,000, and half of the securities had a vesting year of 2021 and the other half had a vesting year of 2022, one-fifth of the securities vesting in each of 2021 and 2022 would be non-qualified securities ($250,000 – $200,000 / $250,000), while any benefit from the remaining securities would remain eligible for the one-half deduction.
An ordering rule in subsection 110(1.31) applies where securities under more than one agreement have the same vesting year, and the aggregate FMV of the securities at their respective relevant times exceeds $200,000. In such case, the FMV of securities under earlier agreements are counted before those under later agreements in order to determine which securities exceed the $200,000 limit and are therefore deemed to be non-qualified securities.
The $200,000 limitation per vesting applies to securities that may be issued to an employee by the employer and those that may be issued by specified persons who do not deal at arm’s length with the employer. Therefore, the limit cannot be circumvented by having stock options issued to one employee by multiple non-arm’s length parties.
“Vesting year” of a security to be issued under an agreement is defined in subsection 110(0.1). If the agreement specifies the calendar year in which the employee’s right to acquire the security first becomes exercisable (otherwise than as a consequence of an event that is not reasonably foreseeable at the time the agreement is entered into), that calendar year is the vesting year. If the agreement does not specify the calendar year in which the employee’s right to acquire the security first becomes exercisable, the vesting year is the first calendar year in which “the right to acquire the security can reasonably be expected to be exercised”, which, depending on the facts, may be difficult to determine. In its explanatory notes to the provision, the Department of Finance provides the example where the right becomes exercisable in a year as a consequence of the attainment of certain goals based on sales, hours, or performance.
Another ordering rule in subsection 110(1.41) applies where an employee exercises a right under an agreement to acquire shares, where some of the shares under the agreement are not qualified securities and others are qualified. The employee is deemed to acquire the qualified securities before the non-qualified securities, which could be beneficial if the former are eligible for the one-half deduction under paragraph 110(1)(d).
The benefit relating to non-qualified securities, although not eligible for the one-half deduction for the employee, may be deductible for the employer in computing taxable income under paragraph 110(1)(e). The deduction for the employer is allowed only if, among other things, the employee otherwise would have been eligible for the deduction under paragraph 110(1)(d). Owing to the deduction for employers, the additional tax revenues resulting from the full taxation for the employees may be largely, if not completely, offset by the tax savings for employers. But, as noted, these changes were meant to address a perceived tax unfairness relating to employee stock options, and not necessarily to increase tax revenues. It is also interesting that the employer’s deduction does not reduce its income under Division B of the Act, but rather reduces its taxable income under Division C. Deductions under Division B are typically justified under a “technical” tax regime in measuring income, whereas deductions under Division C are typically of a special category such as that of a tax expenditure.
Subsection 110(1.9) provides that where securities to be issued or sold are non-qualified securities under subsection 110(1.31) (see above), the “specified person” must notify the employee in writing that they are non-qualified securities on the day that the agreement is entered into and file a prescribed form with the CRA for the taxation year that includes that day. The “specified person” for this purpose is the employer, or non-arm’s length entity, that sells or issues the securities under the agreement (which can include either securities of that specified person or of a non-arm’s length specified person). A specified person is defined to exclude a CCPC, or a corporation or mutual fund trust that meets prescribed conditions. As noted earlier, we await the release of the prescribed conditions.
Lastly, subsection 110(1.4) allows an employer to designate one or more securities of the employer or a non-arm’s length entity (that could otherwise be qualified) to be issued under an agreement as non-qualified securities. The designated securities are then deemed to be non-qualified securities for the purposes of the rules discussed above.
|||Generally speaking, the deduction is allowed under paragraph 110(1)(d) if the exercise price is not less than the fair market value of the underlying shares at the time the agreement is entered into, the employee deals at arm’s length with the employer, and the shares are prescribed shares under Regulation 6204 of the Income Tax Regulations (the “Regulations”). The deduction is allowed under paragraph 110(1)(d.1) in the case of CCPC shares if they are held for at least two years.|
|||In its publication Rewarding Talent, the firm Index Ventures reviewed the employee stock option rules for 73 countries and ranked Canada second in terms of tax “friendliness” (Estonia was first). See the Index Ventures website at www.indexventures.com/rewardingtalent.|
|||Owing to the lack of monetary and other restrictions, non-qualified stock options “are the options making the news as creating large fortunes for officers and employees”; James M Bickley, Summary: Employee Stock Options: Tax Treatment and Tax Issues (Congressional Research Services, 2012).|
|||Interestingly, previous Department of Finance positions relied on these rationales to justify the preferential one-half inclusion of stock option benefits. For example, see Department of Finance, “Report on Federal Tax Expenditures—Concepts, Estimates and Evaluations 2018”, Part 3, at 124; and more generally the Department of Finance 1984, 2000, and 2010 budget papers.|
|||The arguments are set out in detail in Daniel Sandler, “The Tax Treatment of Employee Stock Options: Generous to a Fault” (2001) vol. 49, no. 2 Canadian Tax Journal 259, and Calvin Johnson, “Stock and Stock Option Compensation: A Bad Idea” (2003) vol. 51, no. 2 Canadian Tax Journal 1259.|
|||As noted by Sandler, ibid at 297-98, “No preferential tax treatment should be necessary in order to compel a corporation to do what is in its own best interests. In order to substantiate the provision of tax incentives for stock options, it would have to be shown that stock options are socially desirable, that the amount of employee stock options issued in the absence of a tax preference is suboptimal, and that a tax preference would increase the number issued to a higher level. This point has not been the subject of any rigorous study. Rather, it is assumed without proof of its validity.”|
|||More generally, some commentators in the business world criticize the business case for the use of employee stock options, aside from the tax considerations. Roger Martin, former dean of the University of Toronto Rotman School of Management, argues that employee stock options encourage executives to “pursue strategies that fatten their wallets at shareholders’ expense” (“Taking Stock” (2003) vol. 81, no. 1 Harvard Business Review 19) and are based on the “wrong-headed coupling of the real market (the business of designing, making and selling products and services) with the expectations market (the business of trading stocks, options and complex derivatives)” (excerpt from Fixing the Game: Bubbles, Crashes and What Capitalism Can Learn from the NFL, published at https://rogerlmartin.com/lets-read/fixing-the-game). Henry Mintzberg, business management professor at McGill University, savages the use of employee stock options and stock grants, arguing that they “represent the most prominent form of legal corruption that has been undermining our large corporations and bringing down the global economy. Get rid of them and we will all be better off for it” (“No More Executive Bonuses!” Wall Street Journal, June 14, 2012). Warren Buffett, chairman of Berkshire Hathaway, is also not a fan of employee stock options, arguing that they do not give executives the same stake as shareholders since the shareholders will suffer if the price declines whereas the executives will not (“Stock Options Are Faulted By Buffett” New York Times, March 11, 2002).|
|||“The Taxation of Employee Stock Options,” (2005) OECD Tax Policy Studies No. 11.|
|||Department of Finance, 2000 Federal Budget papers. The deferral was subsequently repealed in the 2010 Federal Budget.|
|||In its June 17, 2019 news release accompanying the draft legislation, the government states that the employers who meet prescribed conditions are intended to be “start-up, emerging, and scale-up companies” that are not CCPCs. Stakeholders were invited to submit comments with respect to the prescribed conditions by September 16, 2019.|
|||In contrast, other tax preferences in respect of CCPCs, such as the small business deduction and enhanced investment tax credits, are phased out if the CCPC’s taxable capital exceeds $10 million.|
|||Applying the formula in subsection 110(1.31), A would equal $100,000, and B and C would each equal $300,000.|
|||Applying the formula in subsection 110(1.31) for each year, A would equal $50,000, and B and C would each equal $250,000.|
|||The Department of Finance explanatory notes to the provision provide a useful example of this ordering rule.|
|||The Department of Finance explanatory notes also provide an example of this ordering rule.|
|||Employees in the highest federal tax bracket of 33% would see another 16.5% of tax added to their benefits, whereas non-CCPC employers subject to the 15% general corporate tax rate could save 15% of tax from their deductions. Provincial tax considerations would vary.|