The public policy rationale for the preferential tax treatment of employee stock options is “to support younger and growing Canadian businesses.” That being said, the government “does not believe that employee stock options should be used as a tax-preferred method of compensation for executives of large, mature companies.”
To this end, draft legislation was introduced that would set a $200,000 annual cap on the amount of employee stock options that may “vest” for an employee in a year and continue to qualify for the stock option deduction. An option is said to vest when it first becomes exercisable. Employee stock options granted on or after January 1, 2020 would be subject to the new rules.
For example, let’s say Jay is an executive at Plumbing Co., a large, mature Canadian public company, who is awarded 20,000 stock options in 2020. The exercise price is $10 (which is equal to the share price when the options are issued) and the options expire in ten years (in 2030) and vest after three years, in 2023.
For the purpose of determining the amount of options that vest in any calendar year, the value of those options will be the fair market value of the underlying shares when the options were granted. Since Jay’s options were granted in 2020 when the price was $10, then all of Jay’s 2020 options, which vest in 2023, would be eligible for the stock option deduction since the total amount of options that vest in 2023 is $200,000 (in other words, 20,000 X $10).
This holds true regardless of the price of Plumbing Co. shares when Jay exercises the option. So, if Jay exercises the options in 2025 when the shares have tripled in price to $30, then Jay’s entire stock option benefit of $400,000 (20,000 X ($30 – $10)) would be eligible for the 50 per cent stock option deduction and Jay would pay tax on $200,000 in 2025 at his marginal tax rate.
If an employee exercises an employee stock option that exceeds the $200,000 limit in a particular vesting year, the difference between the fair market value of the share at the time the option is exercised and the exercise price paid by the employee to acquire the share will simply be treated as employment income and be 100 per cent taxable, making it consistent with the treatment of other forms of employment income such as salary, wages and a bonus. In other words, the employee won’t be entitled to the stock option deduction on the exercise of these options.