NOTE: The new tax rules for employee stock option plans take effect on July 1, 2021. Learn more at Limited Options: New Employee Stock Option Tax Rules Effective July 1, 2021.

Employee stock option plans, like all equity compensation plans, can be a valuable and versatile tool for corporations (particularly startups), to attract, incentivize and retain talent. The value of employee stock option plans can, however, be impacted by their tax treatment – and right now, the tax treatment of employee stock options is in limbo.

In Budget 2019, the federal government proposed changes to the tax rules applicable to employee stock options. The Department of Finance released the details of the proposed changes on June 17, 2019: intended to take effect January 1, 2020, stock options granted before January 1, 2020 would have been subject to the current (more favourable) tax rules, and options granted on and after January 1, 2020 would have been subject to the new (less favourable) tax rules. On December 19, 2019, however, the Finance Department announced it has postponed implementation of the new tax rules for employee stock option plans, with no indication of a new effective date. While it’s still expected the new rules will, in some form, ultimately be implemented on a future date, it won’t be January 1, 2020. In the meantime, employee stock option grants remain subject to the current – and more favourable – tax rules. And that means that, at least for now, employers (or prospective employers) contemplating employee stock option grants still have the option of doing so under the current tax rules. But best to do so sooner rather than later: it might not be an option for long.

Current Rules. For Canadian-controlled private corporations (CCPCs) dealing at arm’s length from the employee, the employee stock option benefit is taxable in the year in which the shares are disposed of. Otherwise, the benefit is generally taxable in the year in which the employee acquires the shares (in other words, when the employee exercises the option). Under the current rules, there is a deduction equal to one-half of the benefit, effectively resulting in capital gains treatment. This deduction is available if certain conditions are met, including all of the following:

• The share is a “prescribed share” (generally a common share).
• The amount payable by the employee to acquire the share is not less than the fair market value of the share at the time the agreement is made (that is, when the option is granted).
• The employee was dealing at arm’s length with the employer at the time the option was granted.

For CCPCs, if an employee holds the shares for at least two years, this deduction is available even if it’s not a prescribed share or the amount payable by the employee to acquire the share is less than the fair market value of the share at the time the option was granted.

Proposed Rules. On June 17, 2019, the federal government tabled proposed new rules for the tax treatment of employee stock options, including:

• Annual limit. A new annual limit of $200,000 on the amount of employee stock options that may vest in any calendar year(based on the fair market value of the optioned shares when the options are granted) that can qualify for the deduction.

• Limit exemptions. This annual limit won’t apply to employee stock options granted by CCPCs. Recognizing some non-CCPCs could be “start-ups, emerging or scale-up companies”, it won’t apply to non-CCPCs that meet certain criteria set out in the new rules. But to date, there’s not yet any definition of a start-up, emerging or scale-up company to which this exemption would apply, a significant reason why the implementation of the new rules is postponed.

• Over limit. If an employee exercises stock options in excess of the annual $200,000 limit, the difference between the fair market value of the share at the time the option is exercised and the amount paid by the employee to acquire the share will be treated as a taxable employment benefit.

Implementation Timing. It’s not known when the now postponed proposed changes to the employee stock option tax rules will take effect. However, the government has stated it will introduce revisions to the proposed rules with Budget 2020. It’s likely these will include an effective date that will give individuals and businesses time to review and adjust to the new rules. The government announced the postponement in implementing the new rules after hearing from affected businesses on the proposed changes to the rules. Specifically, the government had requested feedback on what should qualify as a startup or emerging company for the purpose of qualifying for the proposed preferred tax treatment. Until the new rules take effect, however, employers and employees can continue to take advantage of the existing tax benefits of issuing stock options to compensate employees.

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Please contact your McInnes Cooper lawyer or any member of our Tax Law Team @ McInnes Cooper to discuss this topic or any other legal issue.

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