Background
The federal budget of April 2024 proposed increasing the capital gains inclusion rate for gains realized on or after 25 June 2024. This new inclusion rate was set at 66.67%, up from the previous 50%, for gains exceeding a combined annual limit of CAD 250,000 for both employee stock option income and capital gains.
Despite draft legislation having been published to enact this change, no bill was ever introduced to the Canadian Parliament. On 6 January 2025, the Canadian Parliament was prorogued (i.e., suspended) until 24 March 2025. When the Canadian Parliament resumes after prorogation, bills can be reintroduced at their previous stage under certain conditions. However, since the capital gains proposals never advanced beyond the notice of ways and means motions stage, they would need to be reintroduced as new proposed legislation.
Following the prorogation of the Canadian Parliament, the Department of Finance had initially confirmed that the Canada Revenue Agency (CRA) would proceed with implementing the changes to the capital gains inclusion rate effective 25 June 2024.
However, given the deferral of the entry into force of the proposed changes, CRA may no longer administer the changes as if in effect as of 25 June 2024.
Implications of the announcement
When a stock option qualifies under section 7 of the Canadian Tax Act, and an employee exercises the stock option, the difference (or spread) between the fair market value of the shares issued at exercise and the exercise price is included in the employee's income as an employment benefit. Subject to certain conditions, such spread has been treated like a capital gain, with 50% of the spread deductible from income.
The proposed legislation to increase the capital gains inclusion rate also proposed to revise the deduction amount on the exercise of stock options to align with the increased capital gains inclusion rate. Consequently, employees exercising stock options could only benefit from a 33.33% deduction of the taxable spread for stock options exercised on or after 25 June 2024, for option income exceeding a combined annual limit of CAD 250,000 for both employee stock option income and capital gains. Similarly, at sale of shares, 66.67% of the capital gains would be included in income if the combined CAD 250,000 limit was exceeded.
The announcement from the Canadian Minister of Finance and Intergovernmental Affairs clarifies that the taxable spread realized from exercising stock options giving right to qualified securities should, when applicable, continue to be subject to a 50% deduction in computing the employee's taxable income, rather than a 33.33% deduction, until 1 January 2026, irrespective of the total gains/option income realized during the year.
Actions to consider
Given that the proposed increase to the capital gains inclusion rate should no longer be administered by CRA as currently in effect until 1 January 2026, companies should consider the following actions for 2024 and 2025:
- For 2024, T4 reporting should be completed to reflect the actual withholdings and deduction rates applied to employee stock options. In other words, if an employer applied the 33.33% inclusion rate, this should be reported on Form T4. Reporting on this basis ensures that employees are able to properly calculate their taxable income and obtain refunds of income tax amounts if the employer over-withheld. Companies that applied the 33.33% inclusion rate may consider communicating to their employees that refunds may be available due to the continued application of the 50% inclusion rate during 2024.
- For 2025, where applicable, the 50% stock options deduction should be applied for Canadian income tax withholding and T4 reporting purposes.
In general, companies should consider updating information provided to employees regarding the tax treatment of stock option income and capital gains.
