The federal government’s 2019 budget proposed changes that could affect the viability and attractiveness of stock options as a recruitment and retention tool for certain employers even as it gives these employers a tax break for shares issued pursuant to these options.
On the one hand, the budget proposed imposing an annual cap of $200,000 on employee stock options eligible for the stock option deduction under the Income Tax Act. On the other hand, the budget hinted options not eligible for the deduction in the hands of the employee (those in excess of the cap) may become deductible for the employer.
As things stand, an employee who exercises an option realizes a taxable benefit equal to the difference between the option price and the market price for the stock, at the time of purchase. In certain conditions, the employee can claim a deduction that results in a preferential tax rate that matches the rate applicable to capital gains.
From the employer’s perspective, the granting of the option and the exercise of the shares by the employee have no tax impact. The $200,000 cap would be based on the shares’ market value when the option is granted. The value of shares beyond that cap won’t be eligible for the preferential tax rate.
The impact on recruitment and retention strategy is potentially significant.
“The proposals could have a material impact on the use of stock options,” says Dov Begun, a partner at Osler Hoskin & Harcourt LLP. “But there are other ways in which employers can make things attractive for employees or recruits, such as share-settled restricted or performance share units.”
From an employer’s perspective, although companies typically issue new shares to satisfy the stock options they’ve granted, longstanding income tax rules preclude corporate level deductions for these shares — unlike salaries or bonuses, which are normally deductible expenses.
The budget hinted at a significant policy change here, one that would allow an employer a deduction for that portion of the stock options that exceeds the cap — the portion that’s not eligible for the preferential tax rate.
The kicker is that the proposal for the deduction seems more or less a throwaway, appearing only in a single sentence in the budget at the end of an illustrative example of how the cap would affect employees’ tax position.
But the federal Ministry of Finance has told tax lawyers the reference isn’t a mistake and it intends to enact the proposals. “Indeed, the proposed deduction aligns with the budget’s stated intention to align our treatment of stock options with the treatment accorded them in the U.S.,” says Begun. “There, the regime takes away some deductions for employees and allows more or less matching corporate-level deductions.”
What’s unclear is just whom the proposals will affect. In the words of the budget, the cap will apply only to employees of “large, long-established, mature firms,” a phrase the budget didn’t define.
“They’re aimed mostly at public companies,” says Chris D’Iorio, a senior manager and executive compensation specialist at PwC Canada in Toronto.
But that doesn’t mean they wouldn’t apply to others. “It’s not clear, for example, whether the proposals would apply to a two-year-old private startup that has $100 million in revenue,” he says.
What seems clear is the proposals are meant to affect a relatively small population. “They budget is explicit that they won’t apply to ‘startups and rapidly growing businesses,’” says Begun.
As it turns out, the Liberals’ 2015 election platform proposed a cap of $100,000. But, according to Begun, the government never followed through because startup companies complained they don’t have a lot of cash with which to recruit and reward employees, so the $100,000 restriction would adversely affect their recruitment and retention.
Otherwise, the budget is clear the new measures would apply only prospectively and not to stock options granted before the announcement of the legislative proposals. Further details are expected this summer by way of a detailed proposal or draft legislation, followed by a consultation process.