Federal Liberal Government Proposes Changes to Stock Option DeductionWednesday, December 16, 2015
The newly-elected federal Liberal government indicated in its electoral platform that it intends to make certain changes to the tax treatment of stock options, in particular to cap the deduction which may be claimed at $100,000 per year. The exact nature and timing of any amendments to the Income Tax Act (Canada) (the “ITA”) remain uncertain.
The Stock Option Deduction
A stock option is a right, often granted to employees as compensation or a performance incentive, to purchase shares of the employer corporation at a given exercise price. The granting of an option is not a taxable event. The employee receives a taxable benefit if the fair market value of the share at the time of exercise is greater than the exercise price of the stock option. For public companies, stock option grants are often generally regulated by the stock exchange on which the shares underlying the stock options are listed. The stock exchange often particularly regulates the exercise price of stock options. An exchange may permit the exercise price to be above, at or below the market price of the shares at the time the option is granted.
When an employee acquires shares pursuant to the exercise of a stock option, the amount by which the fair market value of the shares at the time of exercise exceeds the exercise price is treated as a taxable benefit to the employee under the ITAin the year of exercise.
Employees of all corporations can deduct 50% of the benefit from taxable income if:
(a) the stock option shares are common shares;
(b) the exercise price for the shares was at least equal to the fair market value of the shares at the time the option was granted; and
(c) the employee deals at arm’s length to the corporation.
These tax rules also apply to what is commonly referred to as the “cashless” option – where the option is exercised using funds loaned from a broker, who immediately resells the shares (thereby foregoing the need for the holder of the stock option to raise the funds required to exercise the option).
Where the option is exercisable for shares of a Canadian-controlled private corporation (“CCPC”), the above benefit to the employee is recognized in the year the employee sells the shares received upon exercise of the stock options, rather than in the year the employee exercises the options and acquires the shares. In addition, if the employee has held the shares acquired pursuant to the exercise of the stock option for at least two years, the 50% deduction from taxable income is available to the employee when the shares are sold.
Treatment to the Employer
Employers are not permitted to deduct from income for tax purposes the amount of the taxable benefit to an employee upon the exercise of stock options, in contrast to cash compensation. Exceptionally, the employer can elect to claim as a deduction for tax purposes the amount of the taxable benefit realized by the employee, but where this occurs, the employee will not be entitled to a 50% deduction. Few, if any, employers take advantage of this deduction since it is disadvantageous to their employees.
Their minimal cost of issuance and unlimited potential economic upside make stock options an attractive form of compensation for start-up initiatives in industries with significant up-front costs and delayed profitability, such as the technology resources, and biotech sectors.
Proposed Changes in the Liberal Platform
What the Liberal Party seems to have proposed is that the 50% deduction from taxable income will be amended so as to apply only to a maximum of $100,000 of a stock option benefit realized annually. On November 20, 2015, Finance Minister Bill Morneau clarified that any new rules would only apply to stock options granted from the date the changes were announced. Stock options issued, granted, and handed out before the date of the changes will be grandfathered into the new regime, even if such options have not vested as of the announcement date.
The Liberal election platform did not distinguish between the deduction on common shares of public companies, and the rules relating to CCPC stock options. It is possible that both deduction regimes may be amended in this manner.
The exact nature and timing of any amendments to the ITA remain uncertain. In the meantime, employers who grant stock options to their employees may wish to consider the following issues:
(a) accelerate granting of options – employers may wish to consider granting options now before the new stock option regime becomes effective to take advantage of grandfathering rules;
(b) consider other forms of compensation – employers may consider other forms of employee compensation such as a deferred share unit plan (sometimes referred to as a phantom stock plan) or performance stock unit plan. However, unlike a stock option plan, these plans do not allow employees to choose the timing for triggering the taxable benefit;
(c) potential employer deductions – benefits received by employees under stock option plans cannot currently be deducted by the employer, unlike cash compensation. It is unclear whether the government plans to change this. An employer deduction may change the costs and benefits of issuing stock options, depending on the situation of the employer and the employee; and
(d) impact on financial statements – employers need to consider the implications on the financial statements of the business of any actions they take to change the terms of their stock option plans.
Before updating the terms of their stock option plans, employers should review the existing terms of their plans, and may wish to consider the consequences of any changes for both the employer and its employees.
This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.
If you would like further information regarding the issues discussed in this update or if you wish to discuss any aspect of this commentary, please feel free to contact us.