The changes are in – What you need to know about stock option taxation

On June 29, 2021, Bill C-30 reached royal assent, bringing the long-discussed $200,000 deduction limit to stock option tax deductions into effect for all options granted on and after July 1, 2021.

In the 2019 budget, the purpose of these amendments to the Income Tax Act was to limit tax benefits related to employee stock options for “large, long-established, mature firms”, in an effort to align tax treatment with U.S. practices and address the growing amount of tax deductions claimed by executives and other high-income individuals.

Since these amendments were first proposed, the Federal government has clarified certain details surrounding the types of organizations whose options would be subject to this limit. This article outlines:

1.     What is the tax deduction available for income from stock options if your organization is not subject to the new regulation?

2.     How does the new limit work, and who does it affect?

3.     What are the tax implications for options granted by affected companies?

4.     How does this new limit impact your compensation plans?

What is the tax deduction available for income from stock options if your organization is not subject to the new regulation?

Employee income from stock options granted by a Canadian company that is unaffected by the new regulation is eligible for a 50% deduction of the taxable income amount (similar to the capital gains tax rate), provided that certain conditions are met.

Example – Deductions for unaffected stock options:

Stephen received 100,000 options from a company unaffected by the deduction limit on July 1, 2021 with an exercise price of $25, all of which vest on June 31, 2023, when the stock price is $30.

If Stephen chooses to exercise his options on that day and sell the resulting stock, the monetary gain he receives upon exercise is ($30-$25) * 100,000 = $500,000.

With the 50% deduction, the taxable income at ordinary rates from these options would $500,000 * 50% = $250,000.

How does the new limit work and who does it affect?

Under the new limit, a $200,000 cap will be applied to the 50% tax deduction as described above. This will be applied to all options vesting (as opposed to granted) during the year in question, based on the fair market value of the underlying shares at the time of grant (not the fair value of the option itself or the actual monetary gain).

This limit applies to any options granted by non-CCPCs with annual gross consolidated revenues of more than $500 million.

What are the tax implications for options granted by affected companies?

Let’s go back to our previous example of 100,000 options at an exercise price of $25, assuming that the options are now affected by the new limit.

The 50% deduction will now only apply to $200,000 / $25 = 8,000 options under this new system, while the rest of the options are taxable at ordinary rates. This means that only 8,000 x ($30 - $25) = $40,000 is eligible for the 50% deduction (out of the $500,000 monetary gain).

Now the tax-exempt income from these options is $40,000 x 50% = $20,000, while the taxable income at ordinary rates is the remaining $480,000. Significantly higher than before the new regulation.

Example – Deductions for affected stock options:

In this scenario, $480,000 / $500,000 = 96% of the option benefit is taxable at ordinary rates, as opposed to the current 50%.

How does this new limit impact your compensation plans?

Using the fair value of the underlying security as the basis for a limitation may seem simple at first glance, but you may find that the deduction is far more limiting than it appears.  Options are not valued purely based on the underlying share price for compensation purposes. One option is almost always worth less than one share – after all, an option is the right to purchase* a share at the exercise price, and not the share itself.

*For compensation purposes, all options granted are call options as opposed to put options (which allow the holder to sell a share at the exercise price).

Typically, methods such as the Black-Scholes model or the Binomial model are used to estimate the true fair value for the option itself. In brief, these models account for the potential increase (or decrease) in the price of the underlying security during the life of the option.  If you want to ensure your long-term incentive (“LTI”) plans have the same fair value at grant, you must award a larger number of options than shares to achieve the same fair value.

Given that option values are often less than 30% of the share fair value for large publicly-traded companies, limiting the tax deduction to $200,000 of share fair value significantly increases the number of options that are subject to higher taxes.

Historically, options were viewed as a tax-advantageous method of compensation, but this new limit levels the playing field with other compensation methods. Without the full 50% deduction, preference for a specific LTI vehicle will hinge on risk tolerance, and the highly leveraged upside of an option versus more certainty from  a share-based award.

We highly advise consulting your tax advisor regarding your individual tax calculation.

For illustrative purposes, here is an example where the new taxation rules could negatively impact the after-tax payout from your LTI plan:

In this scenario, we will assume that the target dollar amount of your long-term incentives is $500,000, and compare the difference between the after-tax income from an option award and an equivalent award of restricted share units (“RSUs”), which are taxed as ordinary income upon vesting:

At this point, we can see that stock options result in lower pre-tax income. However, there is a significant difference in after-tax income under the current taxation rules and the new taxation rules:

In this scenario, a previously-advantageous tax situation now becomes unfavourable once the new limit is applied.

The future of stock options

Will stock options become a rare sight among top TSX issuers?

While grants of stock options might be smaller and less common, they are unlikely to disappear completely from long-term incentive plans at larger companies. Organizations with a strong positive outlook on future growth may decide that their expected growth will outpace the loss of after-tax income and continue to issue options. Other organizations without easily-identified performance indicators may use options to act as a pseudo-performance requirement, as the payout of a stock option inherently requires share price growth. Others may grant more options in an attempt to increase compensation to pre-limit levels, though such tactics by publicly-traded companies may draw the ire of outside stakeholders.

What might be the best replacement for stock options?

One potential replacement is performance-based share units (“PSUs”), which are full-value share-based awards with performance conditions attached that can affect the number of share units paid out to the executive. PSUs are taxed similar to RSUs and result in similar after-tax income (provided that the executive reaches their performance targets), in addition to being considered part of good governance practice. PSUs are highly preferred by shareholders, proxy advisors (such as ISS and Glass Lewis) and the Canadian Coalition for Good Governance (CCGG) for their direct ties to corporate performance.  That said, they are not simple to design or for executives to understand.

How can we help?

Compensation Governance Partners specializes in executive compensation matters (including long-term incentive plan design), and we can help you determine the most appropriate course of action when it comes to your executive compensation plan. To learn more about how we can assist you, please contact us.