Relief for those burned by plummeting stock options

National Post


After years of painstaking lobbying, some relief has finally emerged for many employees who exercised employee stock options and deferred their tax obligations until the date of sale of the underlying shares, only to find that the price of the shares has since plummeted in value.

The relief contained in Thursday's federal budget is available to all affected employees.

Under Canadian tax law, if you purchase shares though either an employee stock purchase plan or by exercising an employee stock option, your taxable employment benefit (and thus your tax liability) is based on the difference between the price you paid for the shares and the fair market value of shares on the date you receive them.

A stock option benefit deduction equal to 50% is available to tax the stock option at capital gains-type rates, even though it's still classified as taxable employment income.

While the value of the taxable benefit is fixed when the shares are acquired, the benefit can generally be deferred until the year you sell the shares.

That turned out to be a major problem for many employees, whose shares subsequently declined in value below the price at which they received the shares. The resulting loss was considered to be a "capital loss" which could only be used to offset capital gains and could not be deducted against the taxable employment benefit that arose upon acquisition of the shares.

It is this mismatch of capital loss against employment income that has sparked intense lobbying by various employee groups, especially in the high-tech sector, who face massive tax bills on money they never "received."

Thursday's budget proposed a number of measures directed at this issue.

First, to deal specifically with individuals who elected to defer paying tax on their stock option benefits until the year of sale, the government introduced a new special elective tax treatment to ensure that the tax liability on a deferred stock option benefit won't exceed the fair market value of the shares being sold.

Under this proposal, individuals can elect to pay a special tax equal to the proceeds of disposition of the optioned shares instead of the normal tax owing on the deferred stock option.

This relief is available to any employee who sold shares acquired upon option before 2010, provided the election is filed before the 2010 filing deadline (generally April 30, 2011). It will also apply to individuals who have not yet disposed of their optioned shares as long as they dispose of them before 2015 and elect by the filing deadline for the year of disposition.

Secondly, the government has eliminated the tax deferral election effectively immediately such that an employee can no longer defer paying tax on the stock option benefit until the year of sale.

Finally, to insure it collects its taxes when such options are exercised, the government will now insist on collecting the required income tax withholding when the options are exercised. Employers will be required to withhold tax at source for the period in which the employee exercised the option.

In a somewhat related budget announcement, the government is also cracking down on employee stock option plans that permit employees to dispose of their stock option rights for a cash payment from their employer.

Currently, the employer can deduct the cost of such cash payments while employees are entitled to the 50% stock option benefit deduction.

Under new proposals, for employees to be able to get this 50% deduction, their employer will have to file an election promising to forgo its deduction for the cash payment. If they don't, employees will be fully taxable on the value of such cash-out payments.