Published: January 30, 2025
Background: The Failed Capital Gains Hike & The CRA’s Decision to Enforce
Back in April 2024, Canada’s federal government presented the 2024 federal budget, which included a proposal to increase the capital gains inclusion rate. Canada currently taxes capital gains at a 50% inclusion rate—that is, only half of a capital gain is taxable. The 2024 federal budget proposed to increase the capital gains inclusion rate to 67% for any capital gains exceeding $250,000. This meant that if an individual taxpayer realized a $1 million capital gain, then $627,500 of that million-dollar gain would be taxable at the taxpayer’s marginal tax rate. (To compare: The pre-proposal tax rules subjected only $500,000 of the million-dollar gain to tax.)
The Canadian government’s proposed tax rate hike drew fierce criticism. But what’s more, the government’s logistics perplexed not only Canadian taxpayers but also their Canadian tax lawyers and other tax advisors.
In particular, the government’s rollout of the proposed tax rules made it impossible for Canadian tax lawyers and other tax advisors to formulate an adequate tax plan for their clients. For example, although the proposed tax rules were slated to take effect on June 25, 2024, Canada’s Liberal Party, which designed and proposed the tax rules, didn’t produce a draft of the legislation until June 10, 2024, when the Liberal Party introduced the Ways and Means motion containing a cursory draft of the proposed legislation.
Also, according to the Department of Finance, Canadian taxpayers wouldn’t see the finalized initial draft of the legislation itself until July 2024, when it was slated to be introduced in the House of Commons for a first reading. Yet, because Canada’s Parliament generally takes a 2-month break in the summer, Canadians would need to wait until late 2024 before they or their tax advisors had a decent idea of what the final draft of the legislation would look like and of how exactly the rules would work.
That was the plan, anyway. By the end of 2024, the Liberal Party had imploded. On December 16, 2024, Chrystia Freeland resigned from her post as the minister of finance hours before she was scheduled to table the Trudeau government’s Fall Economic Statement. And on January 6, 2025, Prime Minister Justin Trudeau announced that he’d resign after his party selected a new leader. Trudeau also prorogued Parliament. Prorogation basically terminates the parliamentary session, and it essentially kills any legislative bill that hadn’t been formally enacted beforehand.
Prorogation had, therefore, killed the bill, increasing the capital gains inclusion rate. If the government wanted to implement those tax rules, then the government would need to reintroduce the bill in the House of Commons, and the bill would need to begin the legislative process from scratch. Granted, even this seemed unlikely. Acutely aware of dwindling support from voters, the Liberal Party now seems uninterested in hiking the capital gains tax.
Despite all this, the Canada Revenue Agency confirmed that, for the purposes of administering Canadians’ 2024 tax returns, the CRA will proceed as though the increased capital gains inclusion rate had taken effect as of June 25, 2024. In other words, even though the legislation never received Royal Assent and was therefore never enacted, and even though the legislation now seems unlikely to ever be enacted, the CRA will still enforce the increased capital-gains-inclusion rate.
The Department of Finance Canada apparently supports the CRA’s decision. The Finance Department points to the parliamentary convention that the CRA must treat tax proposals as though they’ve taken effect as soon as the government tables a notice of Ways and Means motion, which it had already done.
Hence, according to the Finance Department, until Canadian Parliament resumes and until the government confirms that it won’t proceed with the capital gains tax hike, the CRA should proceed to administer the proposed tax rules as though they’ve received Royal Assent.
Litigation has already begun. On January 24, 2025, the Canadian Taxpayers Federation filed a judicial review application challenging the Canada Revenue Agency’s decision to apply the increased capital gains inclusion rate without legislative authority.
The judicial review application asks Canada’s Federal Court to bar the CRA from collecting capital gains tax at the higher inclusion rate. In particular, the application seeks an order “restraining the CRA from taking any further steps to administer the new inclusion rate until and unless the new inclusion rate is authorized by Parliament by way of duly enacted legislation.”
Still, unless the Federal Court decides upon this judicial review application within the next few weeks, Canadian taxpayers must contend with the confusion arising from the Canada Revenue Agency’s decision to enforce the increased capital gains inclusion rate as they start to file their 2024 T1 income tax returns.
The CRA’s administrative position has especially caused uncertainty for Canadian employees who exercised employee stock options and for their employers who need to withhold payroll tax on the resulting ESO benefits. After discussing these problems, this article provides pro tax tips from our expert Canadian tax lawyers for Canadians on preparing their 2024 tax filings in light of the Canada Revenue Agency’s decision to enforce the unenacted capital gains proposals.
The CRA’s Decision Raises Unique Challenges for Employee Stock Options & Payroll Source Deductions
Some businesses, especially tech start-ups, opt to compensate their employees with options to purchase shares in the business at a discount price. An employee stock option (or ESO) grants an employee the right to purchase shares in the employer corporation at a fixed price during a set period. Should the value of the shares later exceed the option price, the employee may exercise the option and thereby purchase those shares at the bargain option price. The employee can then sell the shares and immediately realize a profit.
Subsection 7(1) of Canada’s Income Tax Act requires the employee to include the employee stock option benefit when calculating taxable income. The ESO benefit equals the amount by which the value of the underlying shares at the time that the employee exercised the employee stock option exceeds the option price.
For example, suppose that an employee receives an option to acquire the employer’s shares for $100, and the employee exercises the option when the shares are worth $400. Under subsection 7(1) of Canada’s Income Tax Act, the employee must report the $300 difference as employment income.
But qualifying employees may claim a 50% deduction under subsection 110(1) of Canada’s Income Tax Act. Subsection 110(1) gives two sets of criteria for the one-half benefit deduction. The first applies generally; the second places less stringent demands on employees who acquire shares in a Canadian-controlled private corporation (or CCPC). Under the general rule in paragraph 110(1)(d), the employee may deduct 50% of the ESO benefit when computing taxable income if:
- the employee received common shares upon exercising the employee-stock option;
- the employee dealt at arm’s length with the employer; and
- the ESO option price (including any amount paid to acquire the ESO) equalled or exceeded the fair market value of the underlying shares at the time that the option was granted.
For employees who receive CCPC shares, paragraph 110(1)(d.1) grants the same 50% deduction but with fewer constraints—in particular, the employee may claim the deduction so long as the employee held the shares for at least 2 years.
Although these ESO tax rules pertain to the tax obligations of the employee who exercised the employee stock option, the employer must also take these tax rules into account because the net ESO benefit is subject to payroll tax withholdings. That is, the employer must calculate the employee’s net ESO benefit so that the employer can determine the amount of payroll tax to withhold from the employee’s salary and remit to the Canada Revenue Agency.
The problem is that, back in April 2024, when Canada’s federal government proposed to increase the capital gains inclusion rate, the government also proposed a corresponding reduction to the ESO deduction available under subsection 110(1).
According to the proposal, the 50% deduction would no longer apply to the entire ESO benefit. Instead, if the deduction applied, only the first $250,000 of the ESO benefit would be deductible at 50%, and anything exceeding $250,000 would only qualify for a 33% deduction.
The Canada Revenue Agency’s plan to enforce these proposals has left Canadian employees uncertain about how to calculate and report their income from employee stock options, and it’s left their employers uncertain about how to administer payroll tax deductions and prepare T4 slips. Some employers—worried about penalties and interest—have even demanded that their employees repay the payroll tax that the employer “under-withheld.”
Pro Tax Tips: What Are the Alternatives for Canadian Employees and Employers?
When deciding how to prepare their 2024 tax filings, Canadian employees and employers may find it helpful to consider the potential forms of liability that an employer may face under Canada’s Income Tax Act. The employer’s liability—or lack thereof—may shed some light on a course of action that employees and employers find mutually acceptable.
Suppose that, for the purposes of determining the correct amount of payroll tax to withhold from an employee, the employer calculated the employee’s net employee stock option benefit by using the 50% deduction that subsection 110(1) permits. This means that, according to the current provisions of Canada’s Income Tax Act, the employer withheld the correct amount of payroll tax from the employee’s salary, but according to the unenacted capital gains proposals, the employer undercalculated the employee’s income and therefore failed to withhold enough payroll tax.
Three potential sources of liability might concern the employer:
- Liability for the tax itself;
- Liability for interest and penalties on the under-withheld payroll tax; and
- Director’s liability.
None of these should trouble an employer who withheld the correct amount of payroll tax from the employee’s salary according to the current provisions of Canada’s Income Tax Act but who, according to the unenacted capital gains proposals, undercalculated the employee’s income and therefore failed to withhold enough payroll tax.
First, liability for the tax itself ultimately falls on the employee, not the employer. Indeed, no provision of Canada’s Income Tax Act renders an employer liable for the tax that the employer failed to withhold from a Canadian resident employee.
Subsection 227(8.4) of the Income Tax Act imposes derivative tax liability on an employer who failed to withhold payroll tax from a non-resident employee—i.e., an employee who is a Canadian non-resident for income tax purposes. But that subsection doesn’t impose derivative tax liability on an employer who failed to withhold tax from an employee who is a Canadian resident for income tax purposes.
In MacLeod v The Queen, [1999] 4 CTC 2223, 1999 CanLII 512 (Informal Procedure), the Tax Court of Canada clarified that “if the employer does not withhold from a resident employee, the employer is not liable for the tax that should have been withheld.” In other words, if an employer fails to withhold payroll tax from a Canadian resident employee, the CRA will pursue the employee for that tax, not the employer.
Although Canada’s Income Tax Act doesn’t impose derivative tax liability on the employer for under-withheld payroll tax, it does impose penalties and interest on the employer.
In particular, the employer may be liable for penalties and interest under subsections 227(8) and 228(2.3). That said, these subsections impose penalties and interest for any amount that the employer did not withhold “as required by” the tax laws pertaining to payroll tax withholdings.
Because the capital gains proposals never received Royal Assent, the corresponding withholding obligations were never “required by” any provision of the Income Tax Act. Hence, the employer shouldn’t incur penalties or interest under subsections 227(8) or 228(2.3).
Moreover, even in the unlikely scenario where the CRA assesses the employer for penalties and interest because the capital gains proposals managed to receive Royal Assent with retroactive effect, the employer should qualify for at least partial relief by means of a taxpayer-relief application—also known as a fairness application. (For more information, read our article about the taxpayer-relief provisions.)
Finally, in situations like the one described above, the employer will likely avoid liability under the director’s liability provisions in section 227.1 of Canada’s Income Tax Act. Section 227.1 is a tax collection tool. It essentially expands the CRA’s ability to collect a corporation’s unremitted source deductions when efforts to collect against the corporation prove futile.
In particular, if a corporation collected payroll tax from its employees yet failed to remit those source deductions to the Canada Revenue Agency, subsection 227.1(1) renders derivative tax liability on “the directors of the corporation at the time the corporation was required to remit.”
Each director thereby becomes “jointly and severally, or solidarily, liable, together with the corporation, to pay” the amount that the corporation collected but failed to remit. A key requirement, however, is that section 227.1 applies only if the employer corporation collected the payroll tax but failed to remit the amount to the Canada Revenue Agency. It doesn’t apply if the employer failed to collect the payroll tax in the first place.
As a result, it shouldn’t apply to a situation like the one described above—where the employer didn’t withhold the amount of payroll tax required by unenacted capital gains proposals.
In summary, Canada’s Income Tax Act doesn’t provide the Canada Revenue Agency with any viable means of punishing employers who didn’t withhold payroll tax according to the unenacted capital gains proposals. Thus, employers need not demand that their employees repay payroll tax that the employer “under-withheld.”
Hopefully, the Canadian Taxpayers Federation’s recent judicial review application will encourage (or force) the CRA to accept that it cannot enforce tax rules that democratically elected lawmakers haven’t enacted. Until then, employers who seek to maintain staff morale and retain valuable employees should withhold payroll tax and prepare T4 slips in accordance with the current provisions of Canada’s Income Tax Act.
Frequently Asked Questions
Back in April 2024, Canada’s federal government proposed to increase the capital gains inclusion rate from 50% to 67%. This rule was supposed to take effect on June 25, 2024. What’s the current status of the capital gains tax hike?
The legislation was never officially enacted. On January 6, 2025, Prime Minister Justin Trudeau prorogued Parliament. Prorogation basically terminates the parliamentary session, and it essentially kills any legislative bill that hadn’t been formally enacted beforehand. Prorogation had, therefore, killed the bill increasing the capital-gains-inclusion rate.
If the government wants to implement those tax rules, then the government will need to reintroduce the bill in the House of Commons, and the bill will need to begin the legislative process from scratch. But this seems unlikely.
Despite all this, the Canada Revenue Agency confirmed that, for the purposes of administering Canadians’ 2024 tax returns, the CRA will proceed as though the increased capital gains inclusion rate had taken effect as of June 25, 2024. In other words, even though the legislation never received Royal Assent and was therefore never enacted, and even though the legislation now seems unlikely to ever be enacted, the CRA will still enforce the increased capital gains inclusion rate.
The Canadian Taxpayers Federation now seeks to challenge the Canada Revenue Agency’s decision in Federal Court. On January 24, 2025, the Canadian Taxpayers Federation filed a judicial review application challenging the Canada Revenue Agency’s decision to apply the increased capital gains inclusion rate without legislative authority.
The judicial review application asks Canada’s Federal Court to bar the CRA from collecting capital gains tax at the higher inclusion rate. In particular, the application seeks an order “restraining the CRA from taking any further steps to administer the new inclusion rate until and unless the new inclusion rate is authorized by Parliament by way of duly enacted legislation.”
Why does the CRA’s decision to enforce the capital gains proposal have an effect on payroll tax withholdings?
Back in April 2024, when Canada’s federal government proposed to increase the capital gains inclusion rate, the government also proposed a corresponding reduction to the employee stock-option deduction available under subsection 110(1) of Canada’s Income Tax Act.
Subsection 110(1) allowed qualifying employees to deduct 50% of the ESO benefit that subsection 7(1) required them to report as employment income. But according to the government’s proposal, the 50% deduction would no longer apply to the entire ESO benefit. Instead, if the deduction applied, only the first $250,000 of the ESO benefit would be deductible at 50%, and anything exceeding $250,000 would only qualify for a 33% deduction.
The Canada Revenue Agency’s plan to enforce these proposals has left Canadian employees uncertain about how to calculate and report their income from employee stock options, and it’s left their employers uncertain about how to administer payroll tax deductions and prepare T4 slips. Some employers—worried about penalties and interest—have even gone as far as demanding that their employees repay the payroll tax that the employer “under-withheld.”
Can the Canada Revenue Agency punish employers who withheld the correct amount of payroll tax from the employee’s salary according to the current provisions of Canada’s Income Tax Act but who, according to the unenacted capital gains proposals, undercalculated the employee’s income and therefore failed to withhold enough payroll tax? What should employers do if they’re in this situation?
Canada’s Income Tax Act doesn’t provide the Canada Revenue Agency with any viable means of punishing employers who didn’t withhold payroll tax according to the unenacted capital gains proposals. Thus, employers need not demand that their employees repay payroll tax that the employer “under-withheld.”
Hopefully, the Canadian Taxpayers Federation’s recent judicial review application will encourage (or force) the CRA to accept that it cannot enforce tax rules that democratically elected lawmakers haven’t enacted. Until then, employers who seek to maintain staff morale and retain valuable employees should withhold payroll tax and prepare T4 slips in accordance with the current provisions of Canada’s Income Tax Act.
DISCLAIMER: This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.
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