The new tax rules regarding the deduction of employee stock options are now in effect
Prepared by Andersen in Canada, Montreal Partner Patrick Coutu, Tax Director Danny Guérin and Tax Specialist Junior Leugoue
As of July 1, 2021, any grant of stock options of a corporation other than a Canadian-controlled private corporation (“CCPC”) made on or after that date will now be subject to the new rules provided for in federal Bill C-30, which received Royal Assent on June 29, 2021. These new rules apply to corporations other than a CCPC or a group of corporations with gross annual revenue in excess of $500 million in its most recent individual or consolidated financial statements in accordance with generally accepted accounting principles (“GAAP”).
To Better Understand The Impact of These New Rules, here are The Rules in Effect Prior to June 30, 2021.
When an employee is granted stock options by the company he works for or any other company related to it, there are no tax consequences. However, in the case of a corporation that is not a CCPC, at the time of exercising the stock options, the employee will have to pay tax on the amount of the fair market value (FMV) of the shares in excess of the exercise price.
However, the employee may, under certain conditions, claim a deduction equal to 50% of the difference between the FMV and the exercise price of the stock options under 110(1)(d) of the Income Tax Act (“ITA”). Simplistically, an employee will be entitled to this deduction to the extent that the share on which a call option right exists is a prescribed share (i.e. a single common share) and the exercise price is greater than or equal to the FMV of the shares at the time the options are granted.
The legislative provisions relating to the 50% deduction described above did not provide for any limit as for the number and value of options that may be granted to an employee (i.e. no limit on the deduction described above).
Proposed New Tax Rules
As of July 1, 2021, new tax rules limit at $200,000, per calendar year, the value of stock options granted by corporations other than CCPCs that may be deductible in the computation of the taxable income of employees to whom such options have been granted. To determine when an option is considered vested, reference should be made to the terms of the stock option agreement. Generally, an option will be considered vested in the year in which it first becomes exercisable. In the event that the stock option agreement does not specify when the option is considered to be vested, the new legislation clarifies that options will be considered vested on a prorated basis over the term of the agreement, up to a maximum of five years.
The new proposed limit on the stock option deduction will only apply if the value of the vested options exceeds $200,000 in a calendar year. To determine whether the value of the options exceeds the new limit, the FMV of the underlying shares on the date the options are granted must be used. If the value of the options vested in a given year is greater than $200,000, the stock options vested first will be the ones eligible for the deduction.
Stock Option Grants
The new provisions also apply where an employee makes a gift of a publicly traded stock acquired through a stock option agreement. The stock option deduction will be limited to the $200,000 limit, but any excess amount will still be eligible for the charitable donation tax credit.
Tax Treatment for Employers
It is important to note that the new rules do not change the taxation of stock options granted by CCPCs.
The proposed new rules now allow employers to designate one or more of the securities under the stock option agreement as “non-qualified” even if the $200K limit on the value of the underlying shares is not exceeded. This optional designation will prevent the employee from being able to claim a deduction of 50% of the benefit amount in the calculation of their taxable income, but will allow the corporation (the employer) to claim a deduction for the purpose of calculating its corporate taxable income. Obviously, to the extent that the $200K limit on the value of the underlying shares is exceeded, the employer may be able to claim a deduction equivalent to the amount of the benefit that was included in the employee’s income.
It will be the employer’s obligation to notify in writing all employees whose stock options exceed the $200,000 vesting limit or whose stock options the employer has elected to designate as non-qualified securities, leaving the deduction to the employer. As a result of this designation, the employer will be able to claim a deduction equivalent to the benefit the employee would have received. The employer will have to notify the employees in question within 30 days following the grant of the options and will also have to notify the Canada Revenue Agency (“CRA”), in a prescribed form, of any grant of options subject to the new rules.
Complexity of the Stock Option Monitoring Process
Companies will be responsible for tracking employees’ use of their $200,000 limit for each year in which options are vested in order to distinguish between eligible and non-eligible options. This task will be more complex in situations where employees are granted multiple stock options over several years. In addition, it will be the employers’ responsibility to withhold taxes when an option is exercised and to report the income on the appropriate employees’ forms.