There is still uncertainty as to how employers should manage tax withholding on stock option income (i.e., apply a 1/2 or 1/3 exemption), given they would not be in a position to know whether the combined limit has been reached by the employee and how the employee has chosen to allocate the exemptions. Further technical changes in the legislation are expected to be introduced at the end of July 2024 that may provide additional clarification on this point. For now, it may be reasonable for employers to assume that only 1/3 of the stock option income is exempt and withhold taxes accordingly, and leave it up to the employees to claim the 1/2 deduction (if available) when they file their individual tax returns.
Key takeaways
Companies will need to decide immediately how to calculate withholding taxes on stock option exercises on or after 25 June 2024, to the extent the options generally qualify for the stock option deduction. If a decision is made to withhold on 2/3 of the option income, employees should be informed accordingly and educated that they may be able to claim a refund to the extent they were in fact entitled to the 1/2 deduction.
In general, companies should inform employees of the changes impacting any outstanding stock options and shares. To the extent companies provide tax information to employees (e.g., as part of the plan prospectus), such information should be updated.
Background
Stock options have been historically subject to favorable tax treatment in Canada, allowing employees to reduce the taxable amount at exercise (i.e., the difference between the fair market value (FMV) of the shares at exercise and the exercise price) by 1/2 (for federal tax purposes as well as provincial tax purposes, except in Quebec where the deduction generally is reduced to 1/4), provided certain requirements are met, including the option was granted at an exercise price of at least 100% of the FMV of the shares at grant, and the shares subject to the options qualified as prescribed shares.
As described in one of our earlier client alerts, for stock options granted on or after 1 July 2021, a CAD 200,000 limit applies to the amount of employee stock options that may vest (i.e., become exercisable) for each employee in each calendar year and continue to qualify for the employee stock option deduction. The CAD 200,000 limit is determined by reference to the FMV of the underlying shares at the time of grant. Options granted in excess of the CAD 200,000 limit are “non-qualified” and cannot benefit from the deduction.
Similarly, for shares sold, individual taxpayers generally could exclude 1/2 of the capital gain (i.e., the difference between the sale proceeds and the adjusted cost base of the shares) from taxation.
Update
Budget 2024 proposed to increase the inclusion rate for individuals to 2/3 (from 1/2) on the portion of capital gains realized in the year that exceed CAD 250,000. For the employee stock option deduction, a 1/3 basic deduction of the taxable benefit is provided to reflect the new capital gains inclusion rate, but the individual would be entitled to a deduction of 1/2 the taxable benefit up to a combined limit of CAD 250,000 for both employee stock options and capital gains. Updated draft legislation that may add further technical changes is expected to be introduced at the end of July 2024.
The proposed changes under Budget 2024 became effective on 25 June 2024, meaning the deduction available for stock option income and capital gains will be reduced from 1/2 to 1/3, once an individual taxpayer's annual combined limit of CAD 250,000 has been reached. Generally, once an individual taxpayer has recognized stock option income and capital gains that total CAD 250,000 during the tax year (that mirrors the calendar year), any stock option income and capital gains recognized after reaching the limit can benefit only from a 1/3 deduction. If the limit has been reached and the taxpayer has recognized both stock option income and capital gains during the year, the taxpayer can decide how to allocate the preferential tax treatment available up to the CAD 250,000 limit between stock option income and capital gains.
For example, if the taxpayer has recognized CAD 200,000 in stock option income and CAD 200,000 in capital gains, the taxpayer could decide to apply the 1/2 deduction to the full CAD 200,000 of the stock option income, and to CAD 50,000 of the capital gains. In this case, the remaining CAD 150,000 of the capital gain would benefit only from the 1/3 exemption.
The new annual CAD 250,000 limit does not impact the application of the CAD 200,000 cap that applies to options granted on or after 1 July 2021. If options generally qualify for the stock option deduction after application of the cap (which, as noted, is determined by reference to the FMV of the shares at grant), the option income recognized from such qualified options will count towards the CAD 250,000 limit. By contrast, the option income recognized from non-qualified options (i.e., options granted in excess of the CAD 200,000 cap) cannot benefit from the stock option deduction at the outset (neither the 1/2 nor the 1/3 deduction) and, consequently, does not count towards the CAD 250,000 limit.
Remaining issues
One unresolved challenge related to the new legislation is the employer's tax withholding obligation at exercise of stock options that generally qualify for the stock option deduction. Under the old rules, the employer has been able to ascertain whether the 1/2 deduction applied at exercise and could calculate withholding taxes accordingly. As the individual's CAD 250,000 limit is comprised of stock option income and capital gains, the employer would not be in a position to determine if and when an employee's CAD 250,000 limit is reached, because the employer would not have visibility into capital gains recognized by an employee (which could result from any shares or investments held by the individual, not just shares of the employer or a parent company of the employer). Further, the employer would not know how a taxpayer decides to allocate the preferential treatment between capital gains and stock option income, if the CAD 250,000 limit has been reached.
It is possible that the legislator will provide clarification on this point when it adopts updated draft legislation with further technical changes that is expected at the end of July 2024 or that the Canada Revenue Agency may publish further guidance eventually.
Until then, employers should discuss with their advisor how to calculate withholding taxes on option income recognized on or after 25 June 2024. Conservatively, employers may calculate withholding taxes on 2/3 of the option income for any exercise of options (that generally qualify for the deduction) on or after this date. If the employee has, in fact, not yet reached the CAD 250,000 limit, they may be able to claim a refund to reflect that only 1/2 of the option income was taxable.
