(From the July 2021 Edition of eFORUM)
By Jamie Golombek and Debbie Pearl-Weinberg
On July 1, 2021, new stock option rules came into force to limit the preferential tax treatment associated with certain employee stock options.
Here’s a quick overview of how employee stock options work, the previous tax treatment, and the tax treatment for newly issued options granted as of July 1, 2021.
Previous Tax Rules
When granted a stock option, an employee has the right to purchase stock at a predetermined price. Under the tax rules, when an employee exercises a stock option, the difference between the exercise price and the fair market value of the share is included in income as an employment benefit. For qualifying options, the employee can claim an offsetting deduction (the “stock option deduction”) equal to one-half of the benefit, so that only 50% of the stock option benefit is taxed. The result is to effectively tax the benefit associated with the exercise of employee stock options as if it were a capital gain, although technically, the income is still considered to be employment income.
New Tax Rules
Under the new rules, for options granted by certain companies, a $200,000 annual cap will be placed on the amount of employee stock options that may “vest” for an employee in a year and qualify for the stock option deduction. An option is said to vest when it first becomes exercisable, and its value will be the fair market value of the underlying shares when the option was granted.
If an employee exercises an employee stock option that exceeds the $200,000 limit, no stock option deduction will be available. The difference between the fair market value of the share at the time the option is exercised and the exercise price paid by the employee to acquire the share will simply be treated as employment income and will be fully taxable. Employers are required to notify employees where options granted will not be eligible for the 50% stock option deduction.
The new tax rules only apply to employee stock options granted after June 30, 2021.
Stock options offered by Canadian controlled private corporations (CCPCs), and by non-CCPCs whose annual gross revenues do not exceed $500 million, are exempt from the new rules.
To illustrate, let’s say Art is an executive at Plumbing Co., a large, mature Canadian public company, and Art is awarded 20,000 stock options in July 2021. The exercise price is $10 (which is equal to the share price when the options are issued) and the options vest after three years, in 2024. The value of Art’s options that vest in 2024 is $200,000. Risa also works at Plumbing Co. Risa is granted 30,000 stock options in July 2021 on the same terms. The value of Risa’s options that vest in 2024 is $300,000.
All of Art’s 2021 options, which vest in 2024, would be eligible for the stock option deduction since their total value of $200,000 does not exceed the maximum amount in option value that may vest in a year to be eligible for the stock option deduction. This holds true regardless of the price of Plumbing Co. shares when Art exercises the options. So, if Art exercises the options in 2026 when the shares have tripled in price to $30, Art’s entire stock option benefit of $400,000 (20,000 X ($30 minus $10)) would still be eligible for the 50% stock option deduction and Art would pay tax on $200,000 (being 50% of $400,000) in 2026 at his marginal tax rate.
If Risa also exercises her options in 2026, only part of her stock option benefit will be eligible for the 50% stock option deduction since the total value of her options grants (30,000 X $10) is $300,000, which exceeds the $200,000 annual vesting limit. The stock option benefit of $400,000 on the first 20,000 options granted (20,000 X ($30 minus $10)) will be eligible for a $200,000 deduction, for a net income inclusion of 50% or $200,000. However, for the stock option benefit on the next 10,000 of options exercised, Risa will be subject to a full income inclusion of $200,000 (10,000 X ($30 minus $10)), since the 50% deduction will not be available.
If an employee donates a publicly listed share acquired under an employee stock option agreement to a registered charity within 30 days of the exercise of the option, they are entitled to a deduction of one-half of the stock option benefit, so long as the 50% stock option deduction described above is available. This deduction is also available if the employee directs a broker to immediately dispose of the share acquired, and to pay the proceeds to the charity. In these situations, by doing so, the entire employee stock option benefit is effectively tax free.
As of July 2021, if an employee donates a publicly listed share acquired under a stock option that is no longer eligible for the 50% employee stock option deduction (as described above), or donates proceeds from the sale of the stock by a broker, then this additional 50% deduction will also no longer be available, and the full stock option benefit would be taxable.
That being said, a donation tax credit will still be available. In addition, any capital gain that accrues subsequent to option exercise would continue to be eligible for the full exemption from capital gains tax.