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© Copyright 2000 Rogers Media. The following article first appeared in the April 2000 edition of
BENEFITS CANADA magazine.
Improving options
The new federal budget loosens tax rules for employee stock options. But it's debatable just how
much tax Finance Minister Paul Martin's proposal will actually defer.
By Gary Nachshen
The rumours cascaded out of Ottawa for months. The federal government was going to loosen the tax rules for
employee stock options in order to stem the alleged brain drain to the U.S. from the high tech sector.
Optimists dared to dream that Finance Minister Paul Martin would exempt up to $1 million of option income
from tax altogether. Instead, February's federal budget simply proposed to defer the taxable event for
certain stock options from the option exercise to the subsequent share sale.
Will this proposed deferral help all that much? Let's start addressing the issue by taking a look at some
historical background.
For decades, the Income Tax Act treated the exercise of employee stock options as giving rise to a taxable
benefit in the year of exercise, with the benefit equaling the entire spread between the exercise price and
the market price of the optioned shares on the exercise date. Beginning in the late 1970s, taxation of that
benefit was deferred until the year the shares were sold in the case of Canadian-controlled private
corporations (CCPCs).
In 1984, the Income Tax Act was amended to tax the benefit at a reduced rate equal to the capital gains
inclusion rate (lowered in the 2000 federal budget from three-quarters to two-thirds of the gain), so long
as the exercise price was no less than the fair market value of the optioned shares on the grant date, and
the optioned shares had certain attributes typical of common shares. A bit of tinkering aside, there the
rules stood until the most recent budget.
NEW PROPOSAL
Under the latest proposal, the deferral of the taxable event--available until now only for CCPC
options--will be extended to options on publicly traded shares as well as mutual fund trust units, subject
to several conditions summarized as follows:
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Where the options are granted over shares as opposed to mutual fund trust units, those shares must be
listed on a Canadian or foreign stock exchange. The optionholder cannot own 10% or more of any class of
shares of the employer corporation or the company granting the options or issuing the optioned shares.
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The optioned securities must meet the above-mentioned fair market value and common share attribute
tests set out in the Income Tax Act for reduction of the stock option benefit to the capital gains
inclusion rate.
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The value of the optioned securities (together with any related securities), which vest in any
particular year, cannot exceed $100,000 on the grant date.
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The employer or its agent must put a system in place to monitor the above-mentioned $100,000 annual
limit and report all sales giving rise to taxable benefits to both Revenue Canada and the employee or
former employee. The government is calling for consultations on the development of a satisfactory
reporting system, with a view to implementing it by the end of this year.
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The options must have been exercised after Feb. 27, 2000, irrespective of whether they were awarded
before, on or after that date.
U.S. ROLE MODEL
It's worth noting that Ottawa did resist some ill-advised early recommendations to restrict the deferral to
employees of high tech enterprises alone.
The actual proposal was described in the government's budget as being patterned after the U.S. Internal
Revenue Code treatment of incentive stock options, to the point of adopting the same $100,000 annual limit.
If a U.S. employee exercises an incentive stock option and holds the optioned shares until the later of two
years from the grant date and one year from the exercise date, the taxable event occurs upon the sale of
such shares, with the employee being taxed at the long-term capital gains rate on any realized gain.
What goes unmentioned, however, is that the $100,000 limit referred to in Ottawa's budget is expressed in
Canadian dollars, while the $100,000 limit for incentive stock options prescribed in the Internal Revenue
Code is, of course, in much more robust American greenbacks.
More fundamentally, the budget presents no empirical data (other than an estimated $75 million associated
annual tax expenditure) to demonstrate that the proposed deferral will actually stem the brain drain.
Indeed, insider trading reports filed with provincial securities commissions and other anecdotal evidence
suggests that most optionholders immediately flip their optioned shares. And since tax on stock option
benefits under current rules ordinarily becomes due and payable only in April of the year following
exercise, it is not an immediate tax bill which is motivating employees to dump their shares right away.
Rather, such employees are generally keen to avoid the risk of any subsequent decline in the share price,
as the resulting capital loss cannot be offset against the stock option benefit for tax purposes.
DEFERRAL DILEMMA
In the absence of a further amendment to the Income Tax Act eliminating the option benefit/capital loss
mismatch, one may legitimately question how much of a change in optionholders' behaviour the proposal is
likely to cause. In other words, it's debatable how much tax will, in fact, be deferred.
Ultimately, the deferral will probably prove beneficial to those employees compelled to exercise options
which would otherwise expire, and to executives of corporations which expect management to maintain minimum
stock holdings. Others will not want to run the mismatch risk or part with the exercise price of the
options any sooner than they intend to cash out altogether, tax deferral or no tax deferral.
At one point, the budget refers to employers' use of both stock options as well as employee share purchase
plans. The terms of the proposal, though, preclude access to the new deferral for participants in discount
or open-market share purchase plans. Discount plans will not meet the fair market value condition for the
deferral, while plans in which shares are purchased on the open market, as opposed to being issued from
treasury, fall outside the scope of the Income Tax Act's option rules altogether.
Also, don't expect the new rules to open the door to expanded use in Canada of U.S.-style restricted stock
(i.e. stock subject to forfeiture by employees who fail to meet certain minimum employment period or other
conditions).
Restricted stock is usually free to employees who ultimately meet all the stipulated restrictions and,
therefore, fails to meet the fair market value condition for the deferral. Such stock will still be taxable
to employees up front, whether or not they ever lay their hands on it.
ACCESS TO THE DEFERRAL
Tax simplification aficionados may bemoan the fact that access to the new deferral will be contingent on
establishment of a satisfactory arrangement for T4 reporting of taxable benefits in the year the shares are
sold.
This requirement may well oblige employers to set up escrow-type accounts for optioned shares to keep track
of such shares' eventual sale by employees or former employees. At first glance, it's unclear why a
self-reporting system along the lines of that for capital gains could not have sufficed.
Tucked away in the budget is a brief reference to the impact of a departure on the new deferral. That is,
the cessation of an individual's status as a resident of Canada will be treated as a taxable event,
terminating the deferral on the optioned shares held at the time of departure. If the new deferral is a
carrot designed to keep high tech employees in Canada, this "toll tax" constitutes a stick.
At the end of the day, the greatest incentive to the enhanced use of stock options delivered by the budget
may well actually prove to be not the proposed deferral itself, but rather the lowering of the taxable
benefit on qualifying options from three-quarters to two-thirds of the exercise price/market price spread.
That change, strictly consequential on the lowering of the capital gains inclusion rate, will no doubt
increase the bias in many enterprises' employee remuneration policies away from cash compensation and
toward options.
Gary Nachshen is a partner with the law firm of Stikeman, Elliott in Toronto.
*** ***
More budget changes
The stock option tax deferral is not the only proposal in the federal budget of specific interest to plan
sponsors. Here are two other noteworthy items.
Since 1997, the Income Tax Act has encouraged charitable donations of certain types of property in kind,
stipulating a one-half reduction in the inclusion rate on capital gains realized as a result of such
donations. The budget proposes equal treatment for the stock option benefit on certain optioned shares
donated by an employee to specified types of registered charities shortly after the option is exercised.
Specifically, to the extent the stock option benefit would otherwise qualify for taxation at the new
two-thirds capital gains inclusion rate, the donation of the optioned shares will result in only one-third
of the spread being taxable. Note that the donation of the optioned shares has to be made before 2002. And
if the shares in question decline in value between the exercise date and the donation date, the reduction
in the taxable benefit will be carved back accordingly.
The budget also raises the old 20% limit on foreign property that pension plans, deferred profit sharing
plans, registered retirement savings plans (RRSPs) and registered retirement income funds may hold without
suffering penalty tax to 25% for 2000 and 30% for 2001. With the trust-tiering and derivatives structures
long available to pension plans and the clone funds recently developed for RRSPs, this proposal may be a
case of shutting the barn door well after the horses have crossed the border. The move should, however, at
least allow increased RRSP investment in shares of individual foreign corporations and other securities,
which the clone products do not duplicate.
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