The recent 2010 Federal Budget included a number of significant changes to the tax rules under the Income Tax Act (Canada) (the "Act") applicable to employee stock options. These proposals are summarized below.
Under the Act, the granting of an employee stock option is not a taxable event for the company or the employee. Generally, on exercise of the stock option, or in the case of certain stock options granted by a Canadian-controlled private corporations (a "CCPC"), at the time the optioned shares are sold or the option is disposed of, the employee is required to include in his or her income for the year a taxable benefit equal to the difference between the fair market value of the optioned share at the time of exercise and the amount paid by the employee to exercise the option. Where certain conditions are satisfied, the employee is entitled to claim a deduction equal to 50% of the amount of the stock option benefit, resulting in the income effectively being taxed in the employee’s hands at capital gains rates.
Since 2000, employees in certain cases have been permitted to defer this inclusion of employment income realized in respect of options to acquire up to $100,000 of qualifying public company shares until the year of disposition of the shares. The Budget includes a proposal to repeal this deferral effective for stock options exercised after 4:00pm (EST) on March 4, 2010.
In certain cases, employees who have taken advantage of this deferral have suffered where the stock value has declined after the shares were acquired. The Budget proposes limited relief for such individuals by permitting qualifying employees to elect to pay a special tax equal to the full proceeds of disposition of such shares (2/3 of such proceeds for Quebec residents) instead of the tax otherwise payable in connection with the corresponding stock option benefit. This election will benefit an individual where the amount of the tax liability would otherwise exceed the proceeds from the sale of the shares and will apply where the shares are disposed of before 2015. Retroactive relief is also proposed for dispositions made in prior years where a public company option deferral election was made.
The Budget also included a proposal to prevent both an employer and its employee from claiming a deduction from income in situations where the employee "cashes out" the stock option rights after March 4, 2010 for a payment rather than exercising the option. Specifically, where an employee elects to receive a payment instead of exercising the option pursuant to the terms of the plan or receives a payment for cancelled options in respect of a takeover, the employee will not be permitted to claim the 50% deduction unless the employer files a prescribed form of election to forgo a deduction in respect of the cash-out payment and provides a copy of the election to the employee. In other words, either the employer or the employee can claim a deduction, but not both.
The Budget also clarifies that after 2010, employee source deduction withholding requirements arising on an employee’s exercise of a stock option must be computed and remitted as if the value of the stock option benefit had been paid to the employee as a cash bonus.