Should you change your employee stock option plan given the new Canadian income tax rules?

The federal government recently tabled Bill C-30, which would implement various measures outlined in Budget 2021, including updated rules that will limit the current preferential income tax treatment of employee stock options. These proposed changes were first mentioned during the 2015 Canadian federal election campaign, and later announced in the 2019 federal budget. Draft legislation was released in June 2019 for public comment and an updated draft was released in November 2020. The proposed amendments contained in Bill C-30 have changed slightly from the prior draft, but remain broadly the same as were initially released in 2019 and will:

• Place a $200,000 annual limit (the annual vesting limit) on the value of shares¹ that may vest in a calendar year and still be eligible to receive the current 50% employee stock option deduction.
• Provide a deduction for employers for the amount of employee stock option benefits when the employee is not eligible for the 50% stock option deduction, subject to certain requirements.
• Impose additional reporting and tracking requirements for employers for each employee stock option grant.

If implemented, these proposals will apply to employee stock options granted on or after July 1, 2021, subject to certain exceptions for stock options issued after June 2021 in exchange for stock options issued before July 2021. 

The proposed amendments only apply to "specified persons," which excludes all Canadian-controlled private corporations (CCPCs) and non-CCPC corporations or mutual fund trusts with gross revenue determined based on the last prepared financial statements of $500 million or less determined on a consolidated basis where applicable. 

It should be noted that the enabling legislation has not yet been passed. 

Current rules

Under the existing stock option rules in the Income Tax Act (Canada) (the Tax Act), when an employee exercises an employee stock option, the difference between the fair market value of the shares at the time of the exercise and the amount paid by the employee to acquire the shares (the stock option benefit) is treated as a taxable employment benefit. 

However, where certain conditions are satisfied, the employee can claim a deduction equal to 50% of the stock option benefit (the stock option deduction). The effect of the stock option deduction is that the stock option benefit is taxed at the same effective rate as a capital gain, thereby giving capital gains-like treatment to the exercise of the employee stock option. While not always available, most stock option plans are carefully drafted so that the stock option deduction is available to employees.

New rules – impact to employees

The proposed amendments will limit the availability of the stock option deduction for employees upon exercise of a stock option by introducing the $200,000 annual vesting limit. Any stock option benefit realized on the exercise of an employee stock option in excess of the new annual vesting limit will be fully included in an employee's income without the benefit of the stock option deduction. 

While Bill C-30 defines the securities received on the exercise of employee stock options and not the options themselves, the proposed amendments effectively create two types of employee stock options:

• an option to acquire a "non-qualifying security" (a non-qualifying option), which will be subject to the new tax rules; and
• all other employee stock options (a qualifying option), which will be subject to the current tax rules.

Shares acquired upon exercise of an employee stock option over the $200,000 annual vesting limit (as determined at the time of grant), or shares acquired upon the exercise of an option the grantor designates as a non-qualifying option at the time of grant (even if under the $200,000 annual vesting limit), are referred to as "non-qualified securities." It does not matter whether a non-qualified security is issued or sold to employees upon exercise of an option, or if such employees surrender their options for cash – the stock option deduction will not be available for non-qualifying options. 

The $200,000 annual vesting limit is calculated by multiplying the fair market value of the underlying shares to which the stock option relates when the option is granted by the number of options that vest in the particular year, with any options granted in excess of that limit being non-qualified options. 

For example, an employee is granted options to acquire 25,000 shares with a fair market value of $10 per share on the date of grant. If all the options vest in year 1, the options to acquire 20,000 shares would be considered qualifying options and therefore eligible for the stock option deduction (20,000 x $10 = $200,000), while the options to acquire the remaining 5,000 shares would be treated as non-qualifying options and not eligible for the stock option deduction. The full amount of the stock option benefit realized on the exercise of the non-qualifying options and the acquisition of the non-qualified securities will be included in income without the benefit of the 50% deduction, regardless of when the options are exercised.

From the employee’s perspective:

• For the purposes of ordering the exercise of employee stock options, if an employee has an option to acquire a security pursuant to an agreement under which the employee could acquire both non-qualified securities and securities that would qualify for the stock option deduction, the employee will be considered to have acquired the qualifying securities before he or she acquires the non-qualified securities. 
• The annual vesting limit applies to all stock options that would otherwise be eligible for the stock option deduction that an employee receives from an employer or any corporation that does not deal at arm's length with the employer. 
• However, if an employee (which includes a director for tax purposes) has stock options from multiple arm's length employers, the employee has a separate $200,000 annual vesting limit for each employer.
• Bill C-30 specifies that the stock option will be considered to vest in the calendar year in which the right to acquire the underlying share becomes exercisable, as specified by the option grant. Where the vesting year is not specified in the option grant or is unclear, the option will be considered to vest pro-rata from the day the grant was entered into until the earlier of (i) 60 months after the day the agreement is entered into; or (ii) the last day the right to acquire the share could be exercisable. 

New rules – impact on employers

Provided an employer complies with certain requirements, the stock option benefit realized by an employee that does not qualify for the stock option deduction (solely because the options were non-qualifying options) will generally be deductible by the employer. As in the US, the proposed amendments also enable employers to elect that all stock options granted will be non-qualifying options, effectively denying the employee the 50% stock option deduction on options that do not exceed the $200,000 annual limit. 

From an employer's perspective, treating all stock options as non-qualifying options eases the administrative burden otherwise associated with tracking and complying with the annual limit.

Specifically, an employer will be entitled to deduct the amount of the stock option benefit realized by an employee upon exercise of a non-qualifying option where: 

• the employer is a "specified person"; 
• the employer employed the individual at the time the option was issued; 
• the amount is not claimed as a deduction in computing the taxable income of another qualifying person; 
• the employee would have been entitled to claim the stock option deduction if the share were not a non-qualified security; 
• if the employee was not a resident of Canada throughout the year, the employment benefit deemed to have been received by the individual must have been included in computing his or her Canadian taxable income for the year; and 
• the employer notifies:
  • the employee in writing, no later than 30 days after the option grant date, that a share acquired upon exercise of the option will be a non-qualified security; and
  • the Canada Revenue Agency in writing, on or before the employer’s filing due date for the year in which the option was granted, that a share acquired upon exercise of the option will be a non-qualified security. 

These obligations will require an employer to carefully track stock option grants to enable the employer to calculate the $200,000 limit for each employee for each vesting year, and to ensure proper withholding rates are applied upon exercise of the option. It is also important to note that the employer (and not the stock option issuer) is subject to the notification requirements mentioned above. Since giving timely notice is a precondition for any corporate tax deduction, this will require subsidiaries (including Canadian subsidiaries of foreign parents) to be aware of options granted to their employees by the parent and to ensure that the required notification is given in a timely manner.

Even if the other requirements are met, an employer that fails to provide a timely notification to an employee and the Canada Revenue Agency that an option is a non-qualifying option, will not be entitled to deduct the amount of the stock option benefit realized by the employee upon exercise of the non-qualifying option, in addition to any other consequences that may arise for the employer under the Tax Act for failure to comply with the notification requirements.  The critical considerations from the perspective of the employer and/or issuer of the option (if other than the employer) under the new regime are to:

• decide whether to grant options on or prior to June 30, 2021;
• decide whether to designate any options below the $200,000 annual vesting limit as non-qualifying options; 
• notify employees in writing within 30 days after the option is granted (but preferably at the time of and in their grant documents) of any options that are options to acquire non-qualifying securities (i.e., options that exceed the $200,000 annual vesting limit or options below the annual vesting limit that have been designated as options to acquire non-qualifying securities);
• implement new processes to:

• determine whether and when to designate option grants as non-qualifying options;  
• track the status of an option as a qualifying option or a non-qualifying option as well as the grant and exercise of the stock options;
• ensure that appropriate payroll tax withholdings are calculated upon exercise of the stock options and proper reporting of the stock option benefit and stock option deduction in the employee's T4 slips; 
• track the quantum of the stock option benefit that is eligible for a corporate tax deduction; and
• notify the Canada Revenue Agency (in the annual corporate income tax return) of any stock options issued in the year that are options to acquire non-qualifying securities.

New rules – additional considerations

The proposed amendments will have a number of additional implications for employers, compensation committees and equity compensation practices, including the following: 

• Review Grant Documentation and Option Plans. Employers should review their existing stock option plans and grant documentation and consider whether any updates are required to give effect to the new tax rules, including whether updates should be made to distinguish between qualifying options and non-qualifying options and to reflect the ability to claim a corporate tax deduction. For issuers that use an electronic platform to administer stock option plans and option grants or grant agreements, it will be important to ensure updates are made to comply with the requirement to give written notice within 30 days that a share acquired upon exercise of the option will be a non-qualified security.
• Cliff Vesting. Employers that grant options that "cliff vest" (i.e., a significant proportion of the options vest in a single year) may wish to consider granting options that vest gradually over several years to better use the employee's $200,000 annual vesting limit, which is based on the vesting of options in a particular calendar year, rather than the year in which the options are granted or exercised. 
• Performance-Based Vesting. Where an employer grants options that vest based on performance or other non-time based criteria, the options will be considered to vest pro-rata over the period that begins on the day the agreement was entered into, and ends on the earlier of (i) 60 months after the day the agreement was entered into, and (ii) the last day that the right to acquire the share could become exercisable under the agreement. Employers will need to consider whether any of the particular options granted will be counted toward an employee's $200,000 annual vesting limit, whether the grants would be non-qualifying options and any reporting requirements that may be triggered. 
• Employer Deduction. Employers may decide that all employee stock options will be to acquire non-qualified securities to (i) avoid tracking the status of each employee's $200,000 annual vesting limit, and (ii) claim a corporate tax deduction for the stock option benefit (subject to satisfying the requirements outlined above). 
• Corporate Groups. A number of issues arise for corporate groups, including the following:
  • Employers whose employees receive stock option grants from another company in the corporate group will be able to benefit from the corporate tax deduction even though the stock option is granted by another member of the corporate group (such as a parent company or other non-arm's length party). Although the employer may benefit from the tax deduction, the issuer of the options must determine whether to proactively designate one or more of the shares to be acquired upon exercise of the option as a non-qualified security. 
  • It is the employer, not the issuer of the stock option, that has the responsibility to notify the employee that the shares received pursuant to the option will be non-qualified securities. For corporate groups, this will mean a significant amount of coordination will be required between the employer (who has to give notice that the option is a non-qualifying option) and the issuer of the stock options (who has to designate the option as a non-qualifying option) to ensure compliance with the new rules. 
  • Bill C-30 does not expressly require a Canadian employer that is not the issuer of the options to reimburse a parent company or other non-arm's length party for the costs associated with issuing shares upon exercise of options by employees of the Canadian employer in order to take a deduction for stock option benefits.  This is particularly interesting in the context of options granted by foreign corporations to employees of a Canadian employer since, where the requirements are otherwise met, the Canadian employer appears to be eligible to deduct the stock option benefit where it may not directly have an economic outlay for the costs associated with issuing the shares.   
• Grant More Options. Employers may consider granting more options after June 30, 2021, to compensate an employee for the increased tax burden on non-qualifying options. 
• Alternative Compensation Plans. Employers may consider using alternative forms of equity incentive compensation (i.e. performance or restricted share units, or share appreciation rights, etc.) in circumstances where employees are being fully taxed on a large proportion of their stock options. Even so, employers should also consider that while the new rules may result in employees losing the benefit of the stock option deduction, employee stock options can offer the benefit of tax deferral on incentive compensation beyond the three-year limit that certain other forms of equity-based incentive compensation may be subject to under the salary deferral arrangement rules.