Written by Anu Nijhawan, Blake Haarstad and Hennadiy Kutsenko
For many public corporations, employee stock options have historically represented the "holy grail" of equity-based employee compensation. While providing an opportunity for employees to share in their employer's growth in a way similar to shareholders, stock options have also offered tax preferential treatment from the employee's perspective. Here we focus on legislative proposals which will fundamentally alter this tax treatment for certain options granted by large public corporations (having consolidated annual revenues above $500 million) after June 30, 2021. The legislative proposals were released as part of the Canadian Government's 2020 Fall Economic Statement, although the legislation itself has not yet been introduced to Parliament.
Under existing tax rules, upon the exercise of an option by an employee, the employee realizes a taxable benefit equal to the difference between the fair market value of the shares acquired and the exercise price paid (the option benefit). If certain conditions are satisfied, including that the exercise price under the option be at least equal to the fair market value of the underlying shares at the time the option is granted, the employee is entitled to deduct 50% of the option benefit (referred to as the 50% deduction), effectively allowing the employee to benefit from tax rates equivalent to capital gains rates. There is currently no maximum limit on the option benefit which can qualify for the 50% deduction. This preferential tax treatment will, however, be altered for options granted by large public corporations after June 30, 2021.
In particular, the proposals:
- Impose a $200,000 annual vesting limit per employee (based on the fair market value of the shares underlying the option on the date of grant) that can qualify for the 50% deduction. The result is that the tax rate applicable to stock option benefits above the $200,000 cap will double.
- Subject to certain conditions, permit the employer corporation (which may be the public corporation itself or a subsidiary) to deduct an amount equal to any option benefit that cannot benefit from the 50% deduction. As is the case under current rules, employers will not be permitted a deduction in respect of options where the employee is eligible for the 50% deduction.
- Subject to certain conditions, permit corporations to whom the new regime is applicable to elect to "opt-in" to the new regime even for options below the $200,000 annual cap (such that a corporate level deduction may be claimed).
The proposals are, however, more complex than they appear and create complexity for public corporations where options are granted to employees of both the public corporation and of its subsidiaries. In particular, the rules provide for increased compliance obligations both for public corporations which grant options and for the subsidiary corporations which employ the individuals granted options.
The New Regime
The new regime stems from the Liberal Party's platform during the 2015 federal election, and is premised on the notion that the current stock option rules are not sufficiently well-targeted and the preferential tax treatment provided to optionholders accrue disproportionately to a small number of high-income individuals employed by large established corporations. Legislative proposals were previously released in 2019, but their implementation was deferred based on concerns raised by various stakeholders. The new rules, which differ in some ways from the previous proposals, are now expected to be effective for all options granted after June 30, 2021. Options granted prior to that date (and options granted in a tax-deferred exchange in consideration for pre-July options) will continue to be governed by the current regime.
Under the new regime, employees will only be entitled to the 50% deduction for options representing underlying shares having a fair market value of up to $200,000, with the $200,000 limit being determined based on the value of shares underlying options that vest in a particular calendar year. Where the fair market value of shares that an employee can acquire under an option exceeds $200,000 in any given year, the 50% deduction will not be available in respect of the stock option benefit realized on the acquisition of shares above that threshold (referred to as Non-Qualified Securities).
The $200,000 annual limit applies by reference to the fair market value of the shares underlying the option—determined at the time the option is granted—and based on the vesting year of the particular options. Generally, an option is considered to have vested in the employee when the employee is able to exercise it and acquire the underlying shares. Under the new rules, if the particular option agreement specifies the calendar year in which the right to acquire a share first becomes exercisable, the vesting year will be that calendar year (and the $200,000 limit will be applied accordingly). If the option agreement does not specify a particular year, then the options will, for the purposes of these rules, be considered to vest on a pro-rata basis over the term of the option, up to a 60-month period (which begins the day following the day on which the agreement is entered into). The latter scenario is expected to apply where, for example, options vest solely based on performance-based vesting criteria.
The draft legislation also includes ordering rules which generally provide that options which qualify for the 50% deduction are considered to be exercised before options for Non-Qualified Securities.
To use an example, suppose an employee is granted a right to acquire 50,000 common shares of an employer corporation at an exercise price of $10 per share (being equal to the value of the shares at the time of grant), where the option vests immediately. In this circumstance, the employee is able to acquire $500,000 worth of shares, which is 2.5 times the annual cap of $200,000 (meaning that only 40 percent of the underlying shares will be eligible for the 50% deduction and the remaining 60 percent will be Non-Qualified Securities). If the shares increase in value to $20/per share and the employee acquires all 50,000 shares, the employee will recognize an option benefit of $500,000 (50,000 shares @ $20 value less $10 exercise price). Under the proposals, the 50% deduction can be claimed on the first $200,000 benefit but the remaining $300,000 will be taxed as regular employment income.
To slightly alter this example, assume that the employee can acquire the same 50,000 common shares at $10 per share, but the right to acquire the shares vests over the course of a four year period (instead of vesting entirely in the year of grant). That means that, in each year, the employee can acquire only 12,500 shares. Pursuant to the option agreement, the value of shares that an employee can acquire in Year 1 (and for that matter, Years 2, 3 and 4) is $125,000 and therefore below the $200,000 limit. Accordingly, the employee should be entitled to the 50% deduction in respect of the entire option benefit realized on the acquisition of the shares (provided all the other criteria for the 50% deduction have been met).
The proposals do, however, provide a benefit for employers. Where the rules apply to deny the 50% deduction in respect of an employee's acquisition of Non-Qualified Securities, the corporation that employs the employee (which may be the public corporation or a subsidiary) is permitted to claim a corporate level tax deduction in computing its taxable income equal to the option benefit not subject to the 50% deduction. As is the case with the current rules, the corporation is not entitled to a deduction where the employee can benefit from the 50% deduction. The employer corporation's deduction, if any, arises in the taxation year of the employer that includes the day on which the employee exercised the option and acquired the Non-Qualified Securities.
There are a number of conditions that must be met in order for an employer corporation to be entitled to this deduction under the proposed new rules. Generally, (i) the options in question must have qualified for the 50% deduction in the employee's hands but for the proposed new rules; (ii) the corporation claiming the deduction must be the employer of the employee; (iii) the amount cannot be claimed as a deduction against income of any other corporation or mutual fund trust; (iv) if the option was granted to a non-resident employee, that employee must be subject to tax in Canada in respect of the option benefit; and (v) the employer of the employee satisfies the notification requirements described below.
It is interesting to note that the proposals provide the benefit of the corporate level tax deduction to the employer corporation—which may well be an entity different from the public corporation which actually grants the option.
Designating Non-Qualified Securities
Under the proposals, large public corporations will also have the ability to "opt-in" to the Non-Qualified Securities regime. Under this mechanic, a public corporation can designate options as being for Non-Qualified Securities, which serves to disallow the employee from claiming the 50% deduction but also permits the corporation a corporate level tax deduction. As currently worded, however, the proposals appear to limit this ability to apply only in respect of options granted by the corporation to individuals employed directly by it—as opposed to employees of an issuer's subsidiaries. Such a result was presumably unintended and it remains to be seen whether it will be remedied in the final legislation.
The entity that is the employer of an option holder who is granted an option for Non-Qualified Securities is, under the proposals, responsible for notifying employees in writing, no later than 30 days after the day an option is granted, if any underlying shares (or a proportion thereof) are a Non-Qualified Security and also to notify the Minister (in a form to be prescribed but not yet available), if any underlying shares (or a proportion thereof) are a Non-Qualified Security. The notice to the Minister must be provided on or before the filing-due date for the taxation year of the particular employer that includes the time that the agreement to issue securities is entered into.
The proposed new rules provide a dramatic shift in the tax treatment of stock options. The following key take-aways emerge:
- As the new regime applies only to stock options granted after June 30, 2021, public corporations may wish to consider granting stock options prior to that date so as to benefit from the grandfathering. Disclosure and related issues will need to be considered. As a practical point, given the coming into force of these proposals, it is expected that most 2021 annual grants are excluded from the new regime.
- For options granted after June 30, 2021, a public corporation granting options will need to decide whether, and what portion, of shares underlying options will be designated as Non-Qualified Securities. Such a designation will be adverse to employees (since the option benefit will no longer qualify for capital gains-like treatment), but beneficial to the corporation which will be entitled to claim a tax deduction.
- Corporations may wish to consider whether, and to what extent, the benefit of any corporate-level tax deduction should be shared with employees—whether by way of increased stock option grants or otherwise.
- Stock option plans and grant agreements may need to be amended to accommodate the designation of Non-Qualified Securities and the notice requirements under the proposed rules. As demonstrated by the example above, care will need to be taken in establishing the vesting periods for options, so as to potentially limit the stock option benefit realized in any particular taxation year to less than the $200,000 proposed cap.
- Employers will need to track any options granted to their employees (even where such options are actually granted by a related corporation) in order to ensure that their notification obligations are satisfied. This may require information sharing between human resources groups and internal tax groups.
- Employers may need to update payroll processes to ensure that tax and other source withholdings are properly applied having regard to options which qualify for the 50% Deduction and those which do not.
- Where a significant number or proportion of a corporation's employees may be subject to full taxation on stock options, consideration should be given to other forms of equity-based incentive awards, including phantom stock or share appreciation rights.
The Bennett Jones Tax and Employment Services groups have a wealth of experience in implementing equity-incentive plans and would be pleased to collaborate with employers in understanding the implications of the proposed new rules for 2021 and designing any amendments to equity-based incentive programs which may be desirable in the circumstances.