An employee stock option plan (ESOP) may align the interests of a corporation’s1 employees with the interests of its shareholders and provide a method of compensating employees with minimal cash outlay. These plans may form a substantial part of an employee’s total compensation package and provide them with a valuable tax deferral.
In its 2019 budget, the federal government proposed changes to the taxation of ESOPs to target highly compensated employees of large companies. The draft legislation was introduced in Bill C-30 on April 30, 2021, and after being approved by Parliament, it received royal assent to become law on June 29, 2021.
This article looks at the impact of Bill C-30 on options granted before and after July 1, 2021.
Options granted before July 1, 2021
For options granted before July 1, 2021, there are no changes to the tax treatment. Where the requirements of Canada’s Income Tax Act (the Act) are met, an employee of a corporation other than a Canadian-controlled private corporation (CCPC) will generally be taxed on ESOP compensation as follows:
- On the option grant date, the employee will receive no taxable benefit;
- On the acquisition of the shares when the option is exercised, the employee will be deemed to receive an employment benefit on the amount by which the fair market value (FMV) of the acquired shares exceeds the amount paid by the employee to acquire them.
In general, where the ESOP is not granted “in-the-money” (i.e., if the exercise price of the option is not less than the FMV of the shares on the date the ESOP is granted), the employee will be entitled to a deduction equal to 50% of the benefit they receive in respect of the ESOP. As a result, employees will generally be taxed on only half of the ESOP benefit received.
For an employee of a CCPC who’s dealing at arm’s length with their employer, the benefit will generally be deferred until after the shares are disposed of (rather than when the shares are acquired). This means that the employee will be taxed at their marginal tax rate on 50% of the option benefit, provided that certain other requirements of the Act are met. This is considered employment income and not a capital gain, although the 50% employment income inclusion rate is the same as the capital gain inclusion rate.
The employer will be denied any deduction in computing income for tax purposes from the stock option benefit. This results in some integration—while an employee in the top marginal bracket might save about 27% in personal income tax because of the 50% stock option deduction, their employer will be denied a deduction, costing them roughly the equivalent amount (27%) in corporate income tax.
Options granted on or after July 1, 2021
The new rules apply to options granted on or after July 1, 2021, where the employer2 is a “specified person” that meets all of the following requirements:
- The employer is not a CCPC;
- The employer’s shares are “non-qualified securities”; and
- The employer has gross revenue in excess of $500 million on the most recent consolidated financial statements issued before the grant date (or, if consolidated financial statements are not prepared, they have gross revenue in excess of $500 million on their entity-level financial statements).
When consolidated financial statements have been prepared, the last consolidated financial statements presented to shareholders before the grant date will generally be used for the revenue test. For certain multinational groups, the consolidated financial statements used for this purpose will be the consolidated financial statements presented to the ultimate parent entity.3
What are “non-qualified securities”?
If ESOPs are granted by an employer that is considered a “specified person” to an employee, the ESOPs will be deemed “non-qualified securities” and the employee’s ability to claim the 50% deduction will be limited to an annual vesting limit of $200,000.
A calculation must be performed in each vesting year to determine the amount of non-qualified securities issued to the employee. The calculation of non-qualified securities must be made for each ESOP grant based on the formula (A + B - $200,000)/A, where:
- A is the total FMV of the shares included in the new ESOP granted to the employee in a given vesting year; and
- B is the lesser of:
- $200,000; and
- The total FMV of the shares included in any past ESOPs granted to the employee in a given vesting year4 (excluding the new ESOP grant and certain other factors).
The legislation includes two special ordering rules. The first rule applies to partial exercises; it deems that an employee must receive qualified securities before they may acquire non-qualified securities. The second rule is intended to address situations in which two ESOPs are granted to a particular employee at the same time; in such cases, the employer may designate the ordering of the agreements for the purpose of calculating the proportion of non-qualified securities granted.
In summary, an employee may claim the 50% option deduction on up to $200,000 of the ESOPs granted to them in each vesting year, based on the FMV of the underlying shares on each grant date.
By contrast, the employee cannot claim the 50% stock option deduction for the acquisition of non-qualified securities; however, the employer can claim a tax deduction for the amount of the employment benefit. In such cases, the employee will pay more personal income tax than under the old regime, but the employer will pay less corporate income tax (assuming they have sufficient income to use the deduction).
An employer can also choose to designate shares acquired by an employee under an ESOP as non-qualified securities, regardless of whether the employee meets the $200,000 FMV threshold. Doing so will allow the employer to realize a higher tax deduction and may simplify their recordkeeping in respect of non-qualified securities. Note, however, that employers that are not subject to the new regime, such as CCPCs and corporations with less than $500 million of gross revenues, cannot opt into the new regime to designate shares as non-qualified securities.
Employers must notify employees that granted options are non-qualified securities within 30 days of the grant date. Employers must also notify the Canada Revenue Agency (CRA) of any non-qualified securities granted in a given taxation year, and must do so by the corporate income tax return due date for that same year.
What employees and employers should do to prepare for the new rules
Employees of non-CCPC corporations with gross revenues in excess of $500 million should be aware that a grant made under an ESOP on or after July 1, 2021, with a value of more than $200,000 (based on the FMV of the underlying shares on the grant date) in a particular vesting year, may not be eligible for the 50% stock option deduction on a portion of this ESOP. Any employee who might benefit from the $200,000 annual vesting limit should also be aware that their employer could simply designate the entire ESOP as non-qualified securities, thereby eliminating the employee’s entitlement to the 50%-stock option deduction altogether.
Employers should track the value of ESOPs granted to employees, based on the FMV of the underlying shares on each grant date, to: a) determine whether non-qualified securities have been granted to employees in a particular vesting year, and b) enable them to make the required notifications to employees and the CRA on time. Employers should also consider whether it would be beneficial to designate any new ESOP grants as “non-qualifying securities.”
Additionally, employers should consider whether an adjustment to future ESOPs should be made to take into account the increased personal income tax that might be payable by employees—and the potential tax savings to the employer—under the new regime.
Alex Ha is a tax manager with D&H Group LLP in Vancouver, where he specializes in tax planning, corporate reorganizations, tax dispute resolutions, and COVID-19-related tax incentives.
This article was originally published in the March/April 2022 issue of CPABC in Focus.
Trusts that issue options to acquire their units follow similar rules; however, in this article, all references are to a corporation and its shareholders.
Where the ESOPs being issued are options to acquire shares of a corporation with which the employer does not deal at arm’s length, that other corporation is also included in the determination of whether the ESOP is a non-qualified security. For the purposes of this article, the ESOPs being issued are options to acquire shares of the employer.
Where consolidated financial statements have not been prepared, there are rules specifying which financial statements are to be used to determine the employer’s revenues.
Options granted before July 1, 2021, that vest after June 30, 2021, are excluded from the calculation of the annual vesting limit.