Employee stock options and their associated tax treatment have recently been a hot topic for a couple of reasons.
First, new rules came into effect over the summer that limit the preferential tax treatment associated with certain employee stock options. Secondly, a recent federal court decision once again demonstrated the dangers of what can happen when an employee exercises their stock options, but doesn’t sell their newly acquired shares right away.
Let’s take a look at each new development.
The new stock option rules
An employee granted a stock option has the right to purchase company stock of their employer at a predetermined price. Under longstanding tax rules, the difference between the exercise price and the fair market value of the share is included in income as an employment benefit when an employee exercises a stock option.
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 per cent 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.
On July 1, 2021, however, these rules were modified for some employees. Under the new rules, a $200,000 annual cap was placed on the amount of employee stock options that may “vest” for certain employees and still 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.
Under the new rules, no stock option deduction is available if an employee exercises an employee stock option that exceeds the $200,000 limit. The difference between the fair market value of the shares at the time the option is exercised and the exercise price paid by the employee to acquire the shares will simply be treated as employment income and will be fully taxable. Employers are now required to notify employees when options granted will not be eligible for the 50-per-cent stock option deduction.
The good news is that these 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.
The federal case
The July 2021 case involved a Vancouver couple who exercised employee stock options only to see the price of the underlying stock subsequently plummet. They were in federal court seeking a remission order for the tax owing on their stock-option employment benefits.
This is a common issue that has plagued thousands of employees who similarly exercised their stock options, but did not immediately sell their newly acquired stock. The stock option benefits, while generally taxed like a capital gain at a 50-per-cent inclusion rate, are still considered to be employment income, which can lead to a mismatch problem later on for employees who exercise their options, acquire the shares and then sell them at loss. This loss is considered to be a “capital loss,” which can only be used against capital gains.
The mismatch of capital loss versus employment income has caused tax problems in the past for various tech company employees in the early 2000s. The situation became so bad for some employees of SDL Optics Inc. that the government granted remission orders in 2007 and 2008, forgiving both the income taxes and arrears interest that arose from 45 former employees’ participation in the company’s stock-purchase plan.
A remission order is, in the Canada Revenue Agency’s words, “an extraordinary measure that allows the government to provide full or partial relief from a tax or penalty, or other debt, under certain circumstances, when such relief is not otherwise available under the existing laws.” Remission can be granted in cases of extreme hardship, incorrect action or advice on the part of CRA officials, financial setback coupled with extenuating factors, or unintended results of the legislation.
The Vancouver couple were former employees of a company that offered a stock option plan and they exercised their stock options in 1997 and 1998. Unfortunately, the stock lost its value when the company ran afoul of the United States Securities and Exchange Commission, and trading of the stock was suspended.
The taxpayers were required to report the stock option benefit as part of their income for 1997 and 1998. The CRA assessed the couple’s income tax returns, resulting in tax, late filing penalties and interest, which, by 2020, combined with other amounts owing, had reached balances owing of a bit more than $48,000 for the husband and $268,000 for the wife.
The CRA began collection procedures against the couple in 1997, including registering judgments against their home in Vancouver and issuing requirements to pay to their financial institutions and employers, and would garnish the husband’s Canada Pension Plan benefits and proceeds from the wife’s mother’s estate if they didn’t pay.
In late 2017, the couple sent a joint letter to the CRA, applying for a remission of tax, interest and penalties, because of extreme hardship, extenuating circumstances and the “public interest.” In their submission, they explained that the only asset they had was their $1-million Vancouver home and argued that being forced to liquidate that asset would be “unreasonable and unjust.” They submitted that it was “not in the public interest to force them to liquidate their home, as it is express public policy to keep senior citizens in their homes when possible.”
The CRA disagreed and denied their request for a remission order, noting the couple had sufficient equity in their house to pay their outstanding tax liability, and that they had, in the past, refinanced their home, but had not used those funds to pay their tax debts. The CRA also noted that the potential for a sudden decline in value after acquiring shares is a “known risk.”
The couple subsequently liquidated their home and paid their tax debts, but nonetheless applied to the Federal Court for a judicial review of the CRA’s decision. At trial, the judge was tasked with determining whether the CRA’s decision was “reasonable.” The court found that it was, and dismissed the couple’s application.