Bill Morneau gave high-income executives a holiday gift when he deferred stock option tax changes
By Allan Lanthier
In late December, Finance Minister Bill Morneau announced that changes to the tax rules for stock option benefits were being deferred pending further study regarding how to distinguish established businesses, which would be subject to new limitations, from early-stage ventures, which would not.
Although high-income executives will graciously accept the year-end gift it is difficult to understand why the government can’t get its act together. The proposal was included in the 2015 Liberal party platform and was the subject of extensive consultations in 2019.
Here’s an example of how stock options work. Sonia is a senior executive of a large Canadian public company (Canco). In 2020, Canco grants Sonia an option to acquire 50,000 shares in 2025. Her option price is $10 a share, the trading value of the shares today.
In 2025, the shares are trading at $30. Sonia exercises the option, acquires the shares from Canco and sells the shares on the stock market. With a gain of $20 a share, Sonia is left with a tidy cash profit of $1 million. Under existing rules, she is only taxed on one-half of the profit, the same as for a capital gain.
The perceived mischief is that Sonia’s stock option is simply a technique that allows executive compensation to be taxed at preferential rates. Had Canco paid Sonia a bonus of $1 million (even a bonus based on the value of the Canco shares) she would have been taxed at ordinary rates.
In its March 2019 budget, the government said employees would be subject to an annual cap of $200,000 for stock options eligible for preferential tax rates. This was followed by draft legislation in June, applicable to options granted on or after Jan. 1, 2020.
Stock options are important to early-stage businesses that may not have sufficient cash flow to pay salaries that will attract the brightest and the best
Under the new rules, Sonia would still benefit from reduced taxes on $400,000 of her $1 million profit. This is because the annual cap is based on the option price, not on the sales proceeds. For 2025, Sonia’s annual cap of $200,000, at her option price of $10 a share is equal to 20,000 shares, so her gain of $400,000 on those shares (a gain of $20 a share) is eligible for preferential rates.
Stock options are important to early-stage businesses that may not have sufficient cash flow to pay salaries that will attract the brightest and the best. With this in mind, the draft legislation exempts employees of “Canadian-controlled private corporations” (CCPCs) from the $200,000 annual limit. With respect to non-CCPCs, the government initiated a three-month consultation period on how best to distinguish “large, long-established, mature firms” from “startup, emerging, and scale-up companies.” Employees of the latter would also be exempt.
In December — still undecided on how to define an early-stage business — the government announced that the entire legislative package was being deferred. It will continue its review and provide details in the 2020 budget on how it intends to proceed.
It is unclear exactly how tax legislation can distinguish startups, scale-ups and emerging growth companies from mature, established businesses. In fact, it may not be possible to do so. Metrics might be used such as number of employees or annual revenue, profitability or cash flow. But any of these would be arbitrary and of uncertain application. So here is a much simpler idea: the new cap should apply only to employees of a non-CCPC if its shares (or those of its parent company) are publicly traded on a recognized stock exchange, whether in Canada or elsewhere.
This bright-line test would ensure simplicity, both from a legislative and compliance viewpoint. It would encourage non-CCPCs without publicly-listed shares or robust cash flows to offer employee stock options with more permanent share ownership conditions. And it would be consistent with the exception that has already been provided for CCPCs, irrespective of how large or profitable the CCPC may be.
The Department of Finance may be gun-shy following the controversy that erupted in 2017 after it issued tax proposals to discourage income splitting and passive investments in private corporations and was forced to retreat. But the stock option issue is not nearly as difficult. It is time to stop dithering.
Allan Lanthier is a retired senior partner of a Big Four accounting firm and has been an adviser to both the Department of Finance and the Canada Revenue Agency.