As promised in the 2019 Federal Budget, draft legislation restricting the preferential treatment afforded to employee stock option plans was released on June 17, 2019. Currently, the preferential treatment, which is provided to all corporations, is a 50 per cent reduction in the taxable benefit to the stock option holder, provided specific criteria are met.
The draft legislation, if it becomes law, will take effect January 1, 2020, for stock options granted on or after that date. But the looming federal election on October 21, 2019, presents an obstacle to the draft legislation becoming law. It is unlikely that the Liberal government will divert resources from the campaign trail to pass the bill prior to the election, and what will happen after the election is anyone’s guess at this point.
When making financial decisions while facing such uncertainty, it is best to analyze the potential outcome based on the presumption that the draft legislation will become law.
The overall objective of the draft legislation is to restrict the preferential tax treatment afforded to holders of employee stock options to situations approved by the Department of Finance. This objective was accomplished as follows:
No restrictions – status quo:
- Canadian-controlled private corporations (CCPCs)
- non-CCPCs that are not considered mature companies1
- non-CCPCs that do not exceed the vesting limit
New restrictions – non-qualified securities:
- all other corporations exceeding the vesting limit
All CCPCs, along with select non-CCPCs that meet currently undefined criteria, will be exempt from the proposed restrictions. For all other corporations, the preferential treatment of the 50 per cent deduction will be restricted to securities based on an annual $200,000 vesting limit.2 The draft legislation provides a formula for calculating the proportion of securities under a stock agreement that are deemed to be non-qualified securities. The deduction for employees under paragraph 110(1)(d) is not available for securities deemed to be non-qualified securities.
The result of the draft legislation will be to shift the tax burden3 from the corporation issuing the stock on the exercise of the option to the individual stock option holder. This is accomplished by fully taxing (no 50 per cent deduction) the stock option benefit on the non-qualified securities while allowing the company to deduct the respective benefit associated with the non-qualified security. Although the tax burden has shifted, the overall tax revenue to the federal government remains relatively unchanged as the decrease in corporate taxes approximates the increase in personal taxes.
Employers that fall under the new restrictions must also be aware of three time periods affected by the legislation:
- Reporting period of the employer – The employer is responsible for designating or calculating the number of non-qualified securities at the time the agreement is executed. Any non-qualified securities, either designated or calculated, must be reported to the Canada Revenue Agency in prescribed form with the return of income for the taxation year that includes the day on which the agreement is executed.
The employer must also notify the employee of any calculated non-qualified securities resulting from exceeding the annual vesting limit. The notification must be made to the employee in writing on the day the agreement is executed. The employer is not required to notify the employee in situations where the security is designated as a non-qualified security in the agreement itself because the employee would already have this knowledge as a party to the agreement.
- Annual vesting period – The actual determination of non-qualified securities is calculated by the employer at the time the agreement is executed, which coincides with the reporting period. But the number of securities to consider for each annual vesting limit calculation is based on the year the securities actually vest to the holder.
- Taxation period of the holder – The taxation period of the stock option holder would be the year in which the stock options are exercised.4 The period could coincide with the vesting period, or it could be subsequent to the vesting period. The employer must calculate the taxable benefit resulting from exercising the stock option and report the amount to the Canada Revenue Agency on a T-4 by February 28 of the following year.
For employers that are subject to the restrictions, the tax burden will shift from employer to employee for agreements entered into after 2019. Employees will have less net compensation due to the increased tax burden, while employers will have greater cash flow due to the ability to deduct the respective benefit on non-qualified securities.
The proposed legislation, if passed, will apply to agreements executed after 2019, providing employers and employees a short window of opportunity to enter into agreements prior to the proposed implementation date. Alternatively, negotiations may need to take place between employers and employees to make stock option benefits more lucrative to compensate for the shifting tax burden.
In addition, employers should be aware that stock options in excess of the annual vesting limit will also result in additional administrative duties to calculate, report and track the non-qualified securities in order to properly determine the tax consequences to the stock option holders.
1 The 2019 Federal Budget stated that the government wished to carve out certain non-CCPCs, referred to as start-up, emerging and scale-up companies, from the new restrictions, thus limiting the new restrictions to mature non-CCPCs. The Department of Finance is seeking input on what characteristics would best represent start-up, emerging and scale-up companies. The deadline for providing comments to the Department of Finance is September 16, 2019.
2 This limit is based on the fair market value of the underlying shares at the time the options are granted.
3 Under current legislation, the company cannot deduct the stock option benefit.
4 For stock options issued by CCPCs, if certain criteria are met, the taxation of the resulting taxable benefit may be deferred until the shares are actually sold. Since the proposed restrictions do not apply to CCPCs, we will focus on the taxation period of non-CCPCs.
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