The Canadian government introduced plans last month to change the taxation of employee stock options. The proposal is designed to align taxation with proposed changes to the taxation of capital gains also presented in the federal budget. These rules would apply for transactions on or after June 25, 2024, even if the changes are not approved by Parliament until later this year.
This move will make stock options somewhat less attractive from a tax perspective. However, the change will likely have less impact on future long-term incentive (LTI) plan design than the changes that the government introduced in 2021, which included:
Under the April 16, 2024 budget proposals, the capital gains inclusion rate for corporations and trusts will increase from 50% to 66.67%. For individuals, the inclusion rate also will increase to 66.67%; however, the current 50% inclusion rate will continue to apply to amounts up to a $250,000 annual threshold.
For options that qualify for preferential tax treatment under the current rules – the 2021 rules noted above – the 50% deduction will apply up to an annual limit of $250,000 per employee. That limit is based on the combination of option exercise gains and capital gains realized by the employee from all sources in the same taxation year.
For option gains above the $250,000 annual limit, the stock option deduction will apply to 33.33% of the gain, leaving 66.67% of that portion of the gain taxable. This is in line with the proposed changes to capital gains taxation. See Table 1 for an example.
| Portion of gain [A] | Stock option deduction [B] | Taxable amount [A – B] (at the marginal tax rate) |
|---|---|---|
| Amounts up to $250,000 e.g., $250,000 |
One half of gain $125,000 |
$250,000 - $125,000 = $125,000 |
| Amounts above $250,000 e.g., $300,000 - $250,000 = $50,000 in the case of a $300,000 total gain |
One third of gain $16,667 |
$50,000 - $16,667 = $33,333 |
In making stock options less attractive from a tax perspective, these changes – combined with other factors such as the mandatory expensing of stock options and investor and proxy advisor preference for performance-based LTI plans – will further the general decline of stock option use in Canada.
As such, it is worthwhile to revisit the tax efficiency and the risk/reward relationship among various LTI vehicles to determine the optimal incentive mix relative to your organization’s business strategy and share price expectations.
We anticipate that the proposed changes will add administrative complexity. For example, how will tax withholding adapt to the new requirements? Employee capital gains as well as stock option gains will have to be considered when determining the stock option deduction.
Employees should review the potential impact of the proposed capital gains and option tax changes with their tax advisors. For transactions scheduled to occur in 2024, it might be beneficial to complete them before June 25 to ensure the full 50% deduction is accessible. For employees with vested options with in-the-money value greater than $250,000, exercising before June 25 will generate tax savings.
We will continue to monitor developments in Canada’s stock option tax changes and provide updates as they are finalized.
