Changes to the taxation of stock options that were supposed to be implemented January 1, 2020, have been delayed. That means there’s more time for tax and compensation planning opportunities before these changes go into effect.
What is a Stock Option?
A stock option is simply the right to buy a share of a company at a designated price. It’s often used as a form of compensation. For example, a start-up company might offer stock options to attract and retain talented employees by offering future compensation that’s connected to the success of the company.
How Does Stock Option Taxation Work?
When a stock option is exercised, it’s essentially taxed at the same rate as capital gains. The difference in the current price of the share and the purchase price of the share is reported as an employee taxable benefit. (This includes the strike price as well as the price paid for the stock option.)
However, only half the income is taxed. There’s a stock option deduction awarded at one-half of the taxable benefit as long as three conditions are met:
1. the employee is at “arm’s length” of the employer when the stock option is exercised,
2. the amount payable is not less than the amount paid, and
3. the share is a prescribed share.
Why is Stock Option Taxation Being Reviewed?
The Government of Canada is mandated to grow tax revenue, and they have a pattern of targeting Canadians in the highest tax brackets.
Out of all the stock options implemented in 2017, 6 percent of Canadians exercised two-thirds of the stock options, equalling more than $1.3 billion. The perception is that stock option taxation unfairly benefits the wealthiest Canadians in its current form.
The Government of Canada plans to reserve preferential tax treatment for younger start-up companies that are growing and creating new jobs, while penalizing the larger, more-established companies. The Government of Canada says it wants to move toward fairer tax treatment, but I don’t know what their definition of fair is or who this is fair to. I guess time will tell.
What Are the Proposed Changes?
After January 1, 2020, any new engagements offering new stock options to employees fall under the new tax rules. However, we don’t know the exact date when the rules will change for those with existing stock options.
The new rules impose a $200,000 limit. The first $200,000 of stock options exercised in a year will fall under the old tax regime with the stock option deduction, as outlined above. Under the new rules, any stock options above the $200,000 limit are taxed at the full rate as any other personal income.
Therefore, you should consider exercising some stock options sooner rather than later to fall under the old tax regime.
We don’t know when the new rules will be implemented. We don’t know what kind of time limit the Government of Canada might impose when they change the rules. But, we do know the current taxation treatment. Weigh the current price of your stock options and how the changing tax treatment might affect you.
After the new rules are in play, you’ll want to plan out the time frame for exercising your stock options. If you exercise all your options in one day, the first $200,000 will fall under the old rules, anything above is under the new rules. But, if you’re able to stagger your option dates over a two- to four-year period, you would be able to take advantage of the $200,000 limit in each of those tax years. This could provide a huge tax savings.
Talk to your tax accountant and financial advisors and stay well-versed in the new rules to ensure you choose the most opportune times for exercising your stock options.