Proposed Draft Legislation on Taxing Stock Options

July 2019

Companies that will not be subject to this new limit:

  • CCPC (Canadian Controlled Private Companies): private companies controlled by Canadian residents, with various related qualifications
  • “Start-up, emerging, and scale-up companies”: the Government is seeking stakeholder input on the characteristics of companies that should be considered start-up, emerging, and scale-up companies for purposes of the prescribed conditions.

All other companies would be subject to the new limit

A revised effective date:

As currently drafted, the new rules would apply to grants made after December 31, 2019. Note that this differs from the timing set out in the Federal Budget, which cited an effective date coincident with the timing of the draft legislation, expected before the Summer of 2019. The new proposed timing may raise questions for many companies, especially given the uncertainty of implementation depending on the outcome of this fall’s Federal election.

What we know (so far) about the $200,000 limit:

  • The limit is based on the market value of the shares being optioned at the date of grant. An illustration:
    • A grant of 100,000 options at a market and exercise price of $20 would have an underlying market value of $2 million (100,000 options x $20 price)
    • The current “capital gains” type deduction will still apply to 10,000 of the options granted (10,000 options x $20 = $200,000 limit)
    • For clarity, the $200,000 limit is not related to the compensation or “grant date” value (e.g., Black Sholes or binomial valuation) that would be disclosed in the proxy
    • The grant noted above, with an underlying market value of $2 million may have a compensation value of $400,000 (e.g., 100,000 options x $20 share price x 20% Black Scholes value)
  • The determination of which options would qualify for the preferred tax treatment is based on the vesting year set out in the grant agreement (not the grant year or the exercise year)
  • In situations where multiple grants vest in a given year, the older grant would be used first to meet the $200,000 limit. Using the same 100,000 option grant example:
    • Assuming this grant vests ¼ per year over four years, this grant would presumably “take up” the limit for these four years, independent of whether any subsequent option grants would produce a higher gain
  • A fair degree of complexity and uncertainty remains with respect to treatment on items such as performance vesting, cliff versus gradual vesting, and termination or retirement scenarios
    • For instance, in a scenario where a 2020 option grant “cliff vests” in 2023 (with no gradual vesting before this), the recipient would not be able to access the $200,000 limit for 2021 and 2022 that would otherwise have been available if the award had gradual vesting  

Non-qualified stock option - corporate deductibility and employer designation:

Under the proposed new rules, employers will be able to claim a tax deductible expense equal to employees’ fully taxable gains on stock options. Put simply, in situations where the employee does not receive the full beneficial tax treatment, the company would receive the tax deductible expense. In fact, companies will be able to designate stock option grants that would otherwise qualify for the beneficial tax treatment (up to $200,000) as “non-qualifying stock options.” This would remove the $200,000 “allowance” for preferential tax treatment for award recipients and allow the company to receive the full corporate deductibility. This could be done as a result of tax analysis having a lens towards corporate vs. individual preferred treatment, or perhaps in response to a stakeholder or societal issue.

Issues to consider:

While the legislative amendments still have to go through the consultation phase as well as the post-election government process, as currently outlined there are a number of significant issues that boards and management teams will need to consider including:

  • The concept of accelerating the timing of the next stock option grant to prior to the effective date will likely be top-of-mind for some issuers (e.g., in December 2019 instead of January or February 2020 which is more common for calendar year companies). This would effectively be “an off-cycle grant,” which can often draw significant shareholder and proxy advisor scrutiny
  • Some issuers may feel pressured to make adjustments for perceived “advantages or disadvantages” among recipients and issuers that the tax change may be viewed as creating
    • For example, some companies will continue to qualify for the preferred tax treatment, while others will not
    • As another example, for non-qualifying issuers (e.g. companies that are deemed “established” for whom the adjusted rules would apply), there may be some pressures to consider whether to adjust the number of options granted to reflect the transfer of tax benefit from the executive to the employer (recognizing that the employer will pay less tax while the employee will pay more tax on the options received)
  • In any case, we see a potential for shareholder, stakeholder, and societal pressures on Boards not to facilitate preferred taxation or to adjust for losses of preferred taxes for senior executives.

The above issues, together with others that will certainly arise, will require careful consideration by boards and management teams for each company that may be affected by the change. Stock options will likely continue to be an important element of broader compensation programs, in spite of the changes to the after-tax benefits for recipients. It will be important to start considering the implications of these proposed changes sooner rather than later. Given the short timeframe towards implementation (January 1, 2020), these factors may play into year-end decision making and compensation planning for the next fiscal year.

We are working with our clients to address the complexities that arise from the proposed rules. Please reach out to a Hugessen consultant for further information, or for support with addressing the unique circumstances of your organization.