The 2024 federal budget introduced several proposed changes that will impact Canadian taxpayers. One of the most significant changes is the proposed increase to the capital gains inclusion rate. This article will focus on the similar but lesser-known impact of the budget: the effect of these changes on the treatment of stock option compensation. Understanding these changes is crucial for anyone receiving stock options as part of their compensation package.
What is an employee stock option?
Companies often reward employees with compensation tied to their own stock rather than regular cash compensation. This form of equity-based compensation has become increasingly common in many industries. It is most notably important in the technology industry and, in general, even more so in startups and early-stage companies. There are many different forms of equity-based compensation; this article will focus on employee stock options.
An employee stock option gives the employee the right, but not the obligation, to buy a share in the employer at a future point in time at a pre-determined price.
As a simple example I will outline a hypothetical timeline which will be used throughout the article. An employee might be given the right to buy shares in ABC company for $10. This $10 is called the grant price, and the date on which it is granted is called the grant date). The employee will likely need to wait a certain period before they are allowed to exercise that right, referred to as the vesting period.
Once these options have passed their vesting date, the employee may choose to exercise their right to buy the shares for the set grant price, and in turn receive the actual shares of ABC co. at what their market value (in my example below they are worth $50 at the time of exercise). The employee then faces another decision; do they sell the shares immediately, or continue to hold the shares to sell them at a later date?
How are employee stock options taxed?
There are two types of taxes one might owe on a stock option. The growth in price between the grant price and exercise price is referred to as a Stock Option Benefit and it appears on a T4 slip, very similar to regular employment income. Under current tax legislation, some amount of this income qualifies for an offsetting deduction of 50% of the benefit. This means that only half of the income is taxable. In most provinces, this preferential tax treatment ends up looking very similar to the second type of tax an employee may be subject to: capital gains.
Capital gains tax will be levied on any increase in the market price of the shares between[TF1] the time the employee exercises the options and the time they eventually sell the shares. Again, under current legislation, only one half of this income is taxable.
In my timeline from earlier, this tax breaks down as follows:
| Stock Option Benefit | $40.00 | $50 less $10 |
| Stock Option Deduction | ($20.00) | ½ of the Stock Option Benefit |
| Gross Capital Gain | $50.00 | $100 sale less $50 |
| Non-Taxable Capital Gain | ($25.00) | ½ of the Capital Gain. |
| Taxable Income | $45.00 | This income would be taxed at the employee’s marginal tax rate. |
| Taxes owing | $24.08 | Assumes the top combined marginal tax rate in Ontario of 53.53% |
| After-Tax Proceeds | $75.92 |
What are the proposed changes?
I mentioned earlier that some options qualify for preferential tax treatment by way of a 50% deduction. Options granted before June 30, 2021 are fully qualified, while options granted after July 1, 2021 are qualified up to an annual vesting limit of $200,000.[1] The employment benefit arising from non-qualified options is taxed as regular income. The proposed changes in the budget apply only to qualified options (those receiving preferential tax treatment).
The 2024 budget proposes to reduce the employee stock option deduction to one-third (33.33%) of the stock option benefit. This mimics the new capital gains inclusion rate which is proposed to increase to two thirds (66.67%) inclusion. The employee would be entitled to receive the current, more favorable, treatment of one-half the stock option benefit up to a combined limit of $250,000 per year. This $250,000 limit is shared by capital gains and stock option income. [2]
If an employee’s stock option benefit combined with capital gains is below $250,000 in a given tax year there are no changes to the tax treatment.
If an employee’s stock option benefit combined with capital gains exceeds $250,000 in a given tax year the current tax treatment will apply on the first $250,000 of income and all income above this amount will be included at 66.67%.
Example of the Tax Treatment on a Stock Option Benefit exceeding the $250,000 personal allowance:
| Stock Option Benefit | $40.00 | $50 less $10 |
| Stock Option Deduction | ($13.32) | 1/3rd of the Stock Option Benefit |
| Gross Capital Gains | $50.00 | $100 sale less $50 |
| Non-Taxable Capital Gain | ($16.67) | 1/3rd of the capital gain. |
| Taxable Income | $60.01 | This income would be taxed at the employee’s marginal tax rate. |
| Taxes owing | $32.12 | Assumes the top combined marginal tax rate in Ontario of 53.53% |
| After-Tax Proceeds | $57.87 |
What is the impact?
The table below shows the impact of the proposed changes for an Ontario taxpayer in the highest tax bracket. Other provinces will have a similar impact, but their own provincial tax rate would apply.
| Effect of New Rules on Ontario Taxpayers | ||||||
| Stock Option Benefit | Current Tax Liability | Effective Tax Rate | Tax Liability Under Proposed Legislation | Effective Tax Rate | Difference ($) | Difference (%) |
| 100,000.00 | 26,765.00 | 26.77% | 26,765.00 | 26.77% | – | 0.00% |
| 250,000.00 | 66,912.50 | 26.77% | 66,912.50 | 26.77% | – | 0.00% |
| 500,000.00 | 133,825.00 | 26.77% | 156,129.17 | 31.23% | 22,304.17 | 4.46% |
| 1,000,000.00 | 267,650.00 | 26.77% | 334,562.50 | 33.46% | 66,912.50 | 6.69% |
| 5,000,000.00 | 1,338,250.00 | 26.77% | 1,762,029.17 | 35.24% | 423,779.17 | 8.48% |
| 20,000,000.00 | 5,353,000.00 | 26.77% | 7,115,029.17 | 35.58% | 1,762,029.17 | 8.81% |
| * Highest combined tax rate in Ontario assumed (53.53%) | ||||||
| ** AMT is not considered | ||||||
| ***Capital Gains assumed to be nil. | ||||||
How should I plan around this?
First off, the $250,000 annual limit will result in many individuals not being impacted by these changes. Recall that only those who have combined capital gains and stock option benefits exceeding $250,000 in a given year will notice a change.
If you are an individual who is likely to exceed this limit and you are already planning to exercise a portion of your options in the near term for reasons other than tax planning, there could be a motivation to advance this timeline to before June 25th in order to avoid higher taxes if the proposed legislation is approved.
Choosing to advance your exercise date comes with a tradeoff, as you are advancing taxes that would otherwise be deferred. This video by my colleague Ben Felix explains this tradeoff in detail. The hidden cost of advancing the taxes depends on several items; primarily your time horizon of holding the asset and the expected return of this asset.
You should be aware of the difference in tax treatment of options granted by a Canadian Controlled Private Corporation (CCPC). If you hold options that were granted by a CCPC, the stock option benefit is not taxable when you exercise the options, but rather, when you eventually sell the underlying shares.[3] This means that if you wish to advance tax treatment of these options to before June 25th deadline, you would not only need to exercise the options but also sell the underlying securities.
Lastly, the 2023 Federal Budget proposed changes to the Alternative Minimum Tax (AMT) calculation that have yet to be approved but are proposed to come into effect as of January 1, 2024. These changes included an increase in the inclusion rate for employee stock options in the AMT calculation from 80% inclusion to 100% inclusion.[4] I will not go into the full details of AMT in this post, however an individual triggering a large stock option benefit before June 25th should be aware that the likelihood of triggering AMT is higher if the stock options benefit is triggered prior to June 25th. AMT can be recovered over a 7-year period, but this recovery may involve purposeful tax planning. If AMT is triggered and is not fully recoverable, the tax savings from advancing the stock option benefit declines substantially.
In conclusion, there is not a one-size-fits-all answer when it comes to this planning. I certainly do not recommend hastily advancing the taxation of your stock options in an attempt to capture more favorable tax treatment without carefully considering your specific tax situation. Furthermore, all the legislation discussed is still proposed and subject to change, adding another layer of uncertainty around this planning.
Given the complexity and nuance of the topic, I strongly recommend reaching out to your financial advisor or tax planner to discuss how you may be affected by the proposed changes. They will be able to review your unique circumstances, including your income level, the type of options you hold, and your long-term financial goals.
[1] Canada Revenue Agency. (n.d.). Option benefit deductions. Retrieved from https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/payroll/benefits-allowances/financial/security-options/option-benefit-deductions.html
[2] Canada. Department of Finance. (2024). Budget 2024: Fairness for Every Generation. Retrieved from https://budget.canada.ca/2024/report-rapport/toc-tdm-en.html
[3] Canada Revenue Agency. (n.d.). Option benefit deductions. Retrieved from https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/payroll/benefits-allowances/financial/security-options/option-benefit-deductions.html
[4] Canada. Department of Finance. (2023). Budget 2023: A Made-in-Canada Plan: Strong Middle Class, Affordable Economy, Healthy Future. Retrieved from https://www.budget.canada.ca/2023/home-accueil-en.html
