The 2020 Federal Fall Economic Statement (the “2020 Economic Statement”) proposes¹ amendments that will limit, in certain circumstances, the favourable tax treatment (i.e. quasi-capital gains treatment) that may be afforded certain recipients of employee stock options under the current rules of the Income Tax Act (Canada) (the "Tax Act").

Current Rules

Employee stock options (“Options”) are governed under section 7 of the Tax Act. Generally, Options are taxed as follows:

1. the grant of an Option to an employee is not taxable to the employee;
2. the employee is taxable when the Option is exercised (other than for certain Options granted by “Canadian-controlled private corporations” (“CCPC”), as defined in the Tax Act, which may be taxable when the underlying shares are sold);
3. the taxable benefit is calculated as the amount, if any, by which the fair market value (“FMV”) of the securities² issued pursuant to the Option exceeds the exercise price paid for such securities (and any amount paid for the Option);
4. the taxable benefit may be reduced by 50% (the “50% Deduction”) under paragraph 110(1)(d) of the Tax Act where the issued securities are plain vanilla common shares, the Options were not “in-the-money”³ on the grant date and the issuing corporation and the employee deal with each other at “arm’s length” for tax purposes;⁴ and
5. the issuer is not entitled to deduct, in calculating its income, any amount in respect of the Options.

Proposed Amendments

The 2020 Economic Statement proposes to place a limit on Options of a particular employee that may be eligible for the 50% Deduction (referenced above). In particular, the 50% Deduction will not be available to an employee in respect of Options, the underlying securities of which are “non-qualified securities”. Where the 50% Deduction is no longer available to the employee because the securities acquired are non-qualified securities, the employer may be entitled to deduct, in calculating its income for the year the Options are exercised, the amount of the denied 50% Deduction.

Non-qualified securities are securities that may be acquired under an Option in the same vesting year and whose aggregate FMV exceeded $200,000 at the time the Option was granted. A vesting year is the calendar year specified in the Option agreement in which the Option first becomes exercisable. If no vesting year is specified, the Option is considered to vest on a pro-rata basis over the term of the agreement, not exceeding 60 months. Non-qualified securities will also include securities designated by the employer as non-qualified securities when the Option is granted. The employer is required to notify the employee and the Minister of National Revenue in the year the Option is granted if the underlying securities include non-qualified securities.

The $200,000 limit will apply to all Options granted to the employee by his or her employer (or a qualifying person that does not deal at arm’s length with the employer). If an employee has Options that may vest in a year that include non-qualified securities, the Options granted first will be the first to qualify for the 50% Deduction. If the Options have identical rights and some qualify for the 50% Deduction and others do not, the employee will be considered to have exercised the Options that qualify for the 50% Deduction first. An employee with two or more arm’s length employers will have separate $200,000 limits for each of those employers.

The existing Option rules will continue to apply to (i) all Options granted before July 1, 2021 and (ii) those Options granted on or after July 1, 2021 by a CCPC or by a non-CCPC who, alone or together with a group that prepares consolidated financial statements, has annual gross revenue or consolidated group revenue not exceeding $500 million, as the case may be. In other words, Options granted on or after July 1, 2021 by a non-CCPC whose annual gross revenue is $500 million or more, are subject to the $200,000 limit.

Example

Ms. T is an employee of Big Public Co. (“BPC”), a non-CCPC with annual gross revenues in excess of $1 billion. On July 1, 2021, BPC grants Ms. T Options to acquire 100,000 shares of BPC at $25 per share with 20% of the Options vesting over a five-year period starting on January 1, 2022. The FMV of the shares on July 1, 2021 is $16 per share.

On July 1, 2022, the FMV of BPC’s shares is $30 per share. Ms. T exercises her Options to acquire 20,000 shares of BPC.

In 2022, Ms. T will include a benefit equal to $100,000 (20,000 shares x ($30 - $25)) in her income from employment.⁵

Of the 20,000 shares that vest in 2022, 7,500 shares are deemed to be non-qualifying securities, determined as follows:

Accordingly, Ms. T is only entitled to the 50% Deduction in respect of 12,500 of the shares she acquired on the exercise of her Options. Ms. T may therefore deduct $31,250 (12,500 shares x ($30 - $25) x 50%) from her $100,000 taxable benefit⁶ under paragraph 110(1)(d) of the Tax Act.

Recommendations

Before these new Option rules take effect, employers may wish to revisit their employee compensation plans. In particular, companies may wish to consider accelerating the issuance of any new Options before July 1, 2021 so employees may take advantage of the current rules.

When the new Option rules are in effect, employers will be able to control the extent to which they may take a deduction in respect of Options granted. Specifically, employers may designate all shares underlying Options as non-qualified securities, even if their FMV falls below $200,000 when the Options are granted. In this case, employers may be entitled to a full deduction in respect of the issued securities. Of course, this would come at the expense of the 50% Deduction for the employees.

Employers should consider the tax effectiveness of Option plans as well as other compensation plans, such as stock options not governed by section 7 of the Tax Act, restricted share units (RSUs), deferred share units (DSUs), stock appreciation rights (SARs), performance securities and employee profit share plans (EPSPs). 

1. Originally proposed in the 2019 federal budget, with draft legislation released on June 7, 2019, and to have taken effect on January 1, 2020, but delayed on December 19, 2019. ↩
2. These rules may also apply to trust units issued by a mutual fund trust. ↩
3. Generally, the Option exercise price was not less than the FMV of the underlying securities on the grant date. ↩
4. For Options granted by a CCPC, the 50% Deduction is available (under paragraph 110(1)(d.1)) even if the shares acquired have special terms and the Options are “in-the-money” on the grant date, but the employee must hold the shares for at least 2 years. ↩
5. Pursuant to paragraph 7(1)(a) of the Tax Act. ↩
6. Pursuant to paragraph 7(1)(a) of the Tax Act. ↩