What are the Impacts of Canada Revenue Agency’s Cap on Stock Option Tax Deductions? A Canadian Tax Lawyer’s Analysis

Introduction: CRA Introduces Cap on Stock Deductions for Employees

The government budget in 2019 revealed that Canada intends to cap stock option deductions for individuals because the stock option tax deduction was regressive. The government’s purpose for the stock option deduction was to allow corporations that were starting out to provide competitive salaries to desirable candidates. Start-up corporations are able to offer more competitive salaries based primarily in stock rather than cash. When the value of a stock option rises significantly and is exercised, the employees can take advantage of the stock option deduction reducing their tax payable.

After the Canada Revenue Agency(CRA) analyzed the data on the stock option tax deductions, it concluded that most of the tax benefits went to high income individuals receiving over 1 million dollars in yearly salaries. This proposed legislation seeks to cap the deductions to limit the tax benefits to the first $200,000 of income from stock options. The amounts that are above the $200,000 limit will be taxed at normal rates and not be allowed to take advantage of the preferred rate available for stock options.

What are the Current Stock Option Deduction Rules Under the Income Tax Act:

Under the existing stock option deduction rules, when an employee exercises a stock option, the difference between the strike price (a predetermined fixed price for which the owner of the option can buy the stock) and the fair market value of the option at the time it is exercised is included in the employee’s income as a taxable benefit.

However, employees can use preferential personal income tax treatment of qualifying stock options by claiming an offsetting deduction equal to one half of the benefit under paragraph 110(1)(d) of the Income Tax Act.

The rationale for the stock option deduction is to support young and growing Canadian businesses. There is currently no limit or cap on the stock option benefit under paragraph 110(1)(d) of the Income Tax Act, so employees that receive more than $200,000 in stock option benefits will be affected by the proposed legislation.

According to a CRA analysis, in 2017, $1.3 billion in deductions went to 6% of individuals by way of the paragraph 110(1)(d) deduction on employee-stock-option benefits—that is, 6% of taxpayers received almost two-thirds of the all deductions claimed under paragraph(1)(d) of the Income Tax Act in that year. In other words, under the current system, the Canadian government ceded significant potential revenue to a small group of high-income employees who received stock options of significant value. The Canada Revenue Agency therefore determined that the current stock option deduction rules were regressive. The downside to this new policy is that will discourage valuable employees from staying in Canada and encourage them to leave for more lucrative opportunities elsewhere.

The rationale of the proposed legislation is to prevent well-paid employees at mature businesses from taking advantage of the stock option deductions but to allow Canadian start-ups and other qualifying businesses to continue to offer competitive compensation packages to employees.

Which Companies Will Be Affected by the Stock Option Cap Draft Legislation:

The limitations being imposed will not affect all corporations. For example, Canadian controlled private corporations (CCPCs) and other corporations that meet a list of “prescribed conditions,” which are yet to be determined, will not be affected by the limitation of the proposed stock option deduction rules.

If a corporation meets the conditions, the corporation will be exempt from the legislation and the employees of the exempt corporation will not be limited by the proposed legislation on stock option deductions. So, those employees may claim the one-half deduction on the full amount of the benefit from exercising an employee stock option.

Yet a non-exempt company may still qualify for a corresponding corporate tax deduction equal to the employee’s stock option benefit. That is, if the employee’s one-half deduction is limited only to the first $200,000 of the stock-option inclusion, the corporate employer may qualify for a deduction in the amount of the stock option benefit. This is presumably meant to match the tax result if the employer had remunerated its employee by paying a salary rather than offering a stock option: the salary would be a deductible expense when the employer computed its own taxable income.

To qualify for the deduction, the employer must:

• Be a specified person;
• Have employed the individual at the time the employee-stock-option agreement was entered into; or
• Meet the notification requirements.

The Canada Revenue Agency has not yet clarified what constitutes a “specified person” nor how to meet the notification requirements.

Corporations can claim this corresponding corporate tax deduction for agreements to sell or issue securities that are entered into after 2019 if these conditions are met. Corporations and employees should seek the advice of an experienced Canadian tax lawyer to determine whether the corporation meets the necessary conditions to be exempt from the finance cap or if the corporation can take advantage of the corresponding corporate tax deduction.

CRA indicated that the cap is for large, long-established, mature companies and not for start-ups or fast-growing Canadian businesses. Finance is still seeking consultation, and the proposed legislation is not yet a tax bill. The consultation period for the bill ends on September 16, 2019; therefore, it is unlikely that further details on this bill will be released until fall of 2019.

Which Stock Options Qualify for the Stock Option Deduction if Multiple Stock Options Vest in a Year:

Multiple stock options per employee may vest in a year exceeding the $200,000 annual limit. The proposed legislation clarifies that the employee stock options that are granted first would be the first to qualify for the stock option deduction.

Additionally, an employee may have several identical stock options, and some may be eligible for the existing treatment and others subject to the new rules. In this situation, stock options qualifying for the current treatment will be considered to be exercised by the employee before the stock options subject to the new rules.

Tax Tip – The Importance of Planning Around the Stock Cap

Corporations that currently or plan on giving stock options as part of their compensation plans should seek the advice of an experienced Canadian tax lawyer because some corporations might be exempt, and others might be able to take advantage of a corresponding corporate income tax deduction.

Additionally, an experienced Canadian tax lawyer can advise whether companies may want to reconsider their compensation plans that are currently in effect because the proposed legislation will come into effect on January 1, 2020. Companies will want to consider the timing of the granting of stock options and stock-based awards. For example, companies may want to develop methods to analyze and track the different options eligible for stock option deductions that have been given to employees such that the cap is not surpassed and to prepare for new compliance requirements for reporting. Likewise, corporations may want to grant additional stock options before the new rules come into effect, or change compensation plans for employees to utilize the maximum stock option deduction under the new rules and consider plans vesting over the course of a few years to benefit from the $200,000 annual cap.

Our experienced Canadian tax lawyers can help corporations and employees assess the effect of the proposed stock option cap on their business plans and finances. Additionally, we can develop an optimal tax plan taking advantage of any tax benefits or easing the impact of corporate or personal taxes.

About the Author

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David J. Rotfleisch

David J. Rotfleisch, a leading Canadian tax lawyer, is not only a certified specialist in taxation but also a chartered professional accountant. Most recently, David is a pioneer in Canadian crypto taxation.

As of April 2020, he was one of 12 Ontario Certified Specialists In Taxation™.

Learn more about David J. Rotfleisch