Tax Insights: Will stock options continue to be an effective form of employee compensation?

Issue 2024-17

In brief

The 2024 federal budget proposed changes to the capital gains inclusion rate, which included increasing it from one half to two thirds, for the portion of capital gains realized by individuals after June 24, 2024 that exceed $250,000 annually. A corresponding reduction to the employee stock option deduction (from one half to one third of the stock option benefit, with a similar shared threshold) could reduce the benefit of granting stock options to employees. This Tax Insights discusses the relative effectiveness of stock options as a tool in employee compensation, in light of the proposed changes.  

In detail

Effective for the sale of shares that occur after June 24, 2024, two thirds of the portion of realized capital gains that exceed an annual $250,000 threshold will be included in an individual’s taxable income for the year (capital gains up to the threshold will continue to be included at the existing one half inclusion rate). This means that the portion of capital gains that exceeds $250,000 in any one year will be subject to tax at a rate that is two thirds – and not one half – of an individual’s applicable marginal tax rate. For an individual resident in Ontario and paying tax at the top marginal rate, this will result in a tax rate of 26.76% on capital gains up to $250,000 and 35.69% for the portion of capital gains that exceed $250,000. For comparative tax rates in other provinces and territories, see our Tax Insights “2024 Federal Budget: Supporting housing, rising taxes." 

To align with the higher capital gains inclusion rate, the employee stock option deduction will be reduced to one third (instead of the existing one half) of the taxable benefit realized after June 24, 2024. The deduction will remain at one half of the taxable benefit up to a combined annual limit of $250,000 for both employee stock options and capital gains.

The proposed changes to the stock option deduction do not affect any of the Annual Vesting Limit (AVL) rules introduced in 2021. The AVL rules apply at the time that options are granted and limit the number of options that will qualify for the stock option deduction. The actual percentage of the stock option deduction will only be determined at the time the options are exercised and will depend on both the amount of benefit realized and the employee’s personal circumstances (i.e. capital gains in the year of exercise).

Big picture impact

The table below illustrates how the proposed changes would impact an employee’s stock option benefit. It assumes that the employee:

• is a resident of Ontario and is subject to the province’s top marginal tax rate of 53.53%
• has exercised their stock options, resulting in a $1,000,000 taxable benefit

PwC observes

The reduced stock option deduction is intended to align with the new increased capital gains inclusion rate. While this may seem unfavourable, an employee’s stock options are still subject to a preferential tax rate and the employee is still better off than simply being paid cash. The net impact for an employee is that, for the amount of stock option benefit above the $250,000 threshold, they will pay approximately 8% to 9% more tax than they would have before the proposed changes (the exact increase depends on the employee’s province or territory of residence and assumes the employee is taxed at their jurisdiction’s top marginal tax rate). This generally aligns Canada with other countries that offer some form of tax preference for stock options – in many other jurisdictions, any preferential rate on stock options is generally limited to a certain amount.

For stock options that do not attract the stock option deduction, the proposed new rules do not impact the taxation of these options.

Are stock options now ineffective as compensation?

Paying employees with stock options is an effective compensation strategy (i.e. the employee will be taxed at a lower tax rate):

• if the employee can claim a one half stock option deduction and the company foregoes the corporate tax deduction representing the value of the benefit granted, and
• when the employee stock option benefit tax rate and the corporate tax rate are almost the same

However, with the proposed decrease in the stock option deduction, the employee’s tax rate on a stock option benefit above $250,000 will be higher than the corporate tax rate; accordingly, although stock options could still be an effective compensation strategy, it will be less tax efficient. In certain circumstances, it might make sense for an employer to offer a deductible cash bonus instead of granting stock options – with a “gross-up” to compensate for the additional tax payable in a cash (vs. stock option) scenario – for approximately the same net expense to the employer. For the employer, this would be a relatively small additional cost, and for the employee, an increased cash bonus can deliver the same net benefit without requiring the employer to issue shares.

The proposed changes may limit the effectiveness of stock options as a tool in employee compensation in certain circumstances. For example, when a corporation has top executives who have been granted qualifying options with anticipated multi‑million dollar payouts. If the corporation is more sensitive to losing a corporate deduction compared to expending cash and having volatile earnings, stock options will be a less effective form of compensation. This is especially true if the employer is a private corporation that may also have reservations about minority shareholdings. However, if the employee demographic is broad-based and annual payouts will mostly occur either under or just over the $250,000 threshold, then there will be no change regarding the tax effectiveness of stock options.

It is also important that non‑tax reasons for using stock options should be considered (e.g. design flexibility, income statement and cash flow impact) in circumstances when a cash-based plan now offers a comparable net benefit without the need to issue shares.

What we do not know

The federal budget documents provided minimal details on the proposed stock option changes, so clarification is required in a number of areas, including whether:

• the reduced one third rate will apply to both the general stock option deduction under paragraph 110(1)(d) of the Income Tax Act and the Canadian‑controlled private corporation (CCPC)-only deduction under paragraph 110(1)(d.1)
• relief will be granted to employees who exercised a CCPC option before June 25, 2024 (or perhaps before the date of the budget [i.e. April 16, 2024]?); these employees have or will have a deferred taxable benefit with an associated risk that the share value of the stock may decline. These employees might have accepted this risk because a one half stock option deduction was available to them; however, changing the deduction “mid-stream” to one third seems highly punitive
• there will be any ordering rules for allocating the annual $250,000 threshold between capital gains and stock option benefits qualifying for the stock option deduction
• Québec will follow the federal government and reduce its 50% stock option deduction that is available to large Québec-headquartered or small or medium-sized innovative employers (the province has already announced that it will harmonize with the proposed federal capital gains inclusion rate)

Additional questions for reporting and/or withholding purposes will also require answers, such as how will an employer know whether the employee has reached the combined stock option/capital gains limit of $250,000? This concern applies to both CCPCs and non-CCPCs, since both must report the benefit for the year on a T4 Statement of Remuneration Paid (and Québec Relevé 1 (RL-1) Employment and other income) slip. To address this issue, employers must be allowed to either:

• estimate the amount, based on information from employees (this would be similar to the current withholding rules for Registered retirement savings plans contributions, where an employer is permitted to waive withholding based on “reasonable grounds”), or
• withhold on the full taxable benefit (i.e. not net of the deduction), although this would require withholding on amounts that exceed taxable income

Further, if there is no clear method for determining or assuming the application of the $250,000 limit, how will an employer report the stock option deduction on a T4/RL-1?

When should an employee exercise their options?

For stock option holders, the most important question is likely whether they should exercise their options before June 25, 2024, to lock in any gains at the lower effective option rate. However, if they exercise before June 25, 2024, they might lose any potential gains that may arise during the remaining stock option life (this assumes that other strategies are not used to compensate for the stock option gain).

When there is no expectation of other capital gain in the years before an option expires and if the in-the-money value of the option (current share price minus exercise price) is:

• ≤ $250,000 x the number of years left until the option expires, it is probably not beneficial to exercise before June 25, 2024, if the only reason is to take advantage of the current lower tax rate
• > $250,000 x the number of years left until the option expires, the decision to exercise depends on the expectations for the stock; an option holder may benefit from exercising sooner if they expect lower growth or have little time left. However, if the option still has “runway” before it expires, there is a higher chance that it could still grow, even with a smaller stock option deduction

The taxpayer’s total exercise price should also be factored into any analysis; in addition, any tax savings might be eroded if the taxpayer borrows funds to pay the exercise price when the option is exercised. 

The takeaway

With employee stock option inclusion rates rising, employers should look at their stock option plans to ensure they continue to serve their intended purpose. Some companies are still struggling to cope with the 2021 AVL changes and share unit plan deductibility, so these new rules will only add complexity to both day‑to‑day administration and stock option plan design going forward.

Employees should be aware of the upcoming rate changes and consider personal planning, to minimize their effective tax rate (subject to stock option plan restrictions).