With Parliament set to be recalled on Dec. 3, the new Liberal majority government has indicated that the first item on its fiscal agenda will be “lowering the tax rate for middle-class Canadians” and “raising the tax rate on those who make more than $200,000” with the presumable goal to have both of these changes in place for Jan. 1, 2016.
But another tax change included in the Liberals' election platform was to limit the benefits of the stock option deduction by placing a cap on how much can be claimed. The Liberals quoted a Department of Finance estimate that 8,000 “very high-income Canadians deduct an average of $400,000 from their taxable incomes via stock options.”
Let's take a deeper look at how the stock option deduction works, what might be changing, when, and what you can potentially do to proactively save some tax.
Under the tax rules, when a stock option is exercised, the difference between the exercise price and the fair market value of the share is included in income as an employment benefit. For “qualifying” options, an offsetting deduction equal to one-half the benefit may be claimed, which allows the stock option benefit to be taxed like a capital gain. For an option on shares of a public company to qualify, the exercise price can't be less than the fair market value of the underlying shares at the date the options are granted. The tax result is to effectively tax employee stock options like capital gains, although they are still considered to be employment income and thus qualify as “earned income” for RRSP contribution room purposes and, because they are not actually capital gains, you can't offset the income inclusion with capital losses you may have.
If an employee of a “Canadian-controlled private corporation” (CCPC) exercises stock options, the deduction is available as long as the shares are held for at least two years. In addition, CCPC stock option benefits aren't taxable when the options are exercised but rather at the time the underlying shares acquired upon exercise are sold.
The Liberals' electoral platform stated that it is their intention to cap the amount that can be claimed under the stock option deduction. The Liberals did acknowledge that stock options are a “useful compensation tool for start-up companies” and stated that they “would ensure that employees with up to $100,000 in annual stock option gains will be unaffected by any new cap.”
While it's unlikely the proposed $100,000 cap and the technical legislative amendments required to effect such a change will be introduced into law in the government's first fiscal bill next month, employees with significant stock option gains on vested employee stock options may wish to take immediate action, as it's possible that such a change could be effective as of the announcement date, with no grandfathering.
Exercising in-the-money, qualifying employee stock options this week, for example, could pretty much guarantee you the 50 per cent stock option deduction. Furthermore, if doing so brings your income over $200,000, exercising your options right now may also save you the additional four per cent federal tax hike coming for top-income earners. Of course, this assumes that both these tax changes won't be applied retroactively, which, while unpopular, can't be ruled out completely.