The Effect of CGIR on Employee Stock Options

Evelyn Jacks

Providing ESOPs is a way of helping start-up businesses to attract high-value employees despite their lack of capital to pay the larger salaries.  Because larger companies were using stock options as a form of compensation for higher-income employees effectively reducing the taxes paid by such employees, a limit was placed on the amount of stock options that were eligible for this treatment for employees of large companies. Now proposed changes to the Capital Gains Inclusion Rates (CGIRs) will make this even more complex.

Historical Background. In December 2019, after consulting with Canadians, tax changes were passed in Bill C-30 on June 29, 2021 on the taxation of ESOPs, and have been effective July 1, 2021. Specifically, the 2019 Federal Budget proposed an annual cap of $200,000 on stock options granted to employees by “large, long-established, mature firms,”  on the value of the shares at the time the options are granted. 

For example, if the share price is $25 per share, then the company cannot grant an option for more than 8,000 shares to any one employee.  If options are granted for more shares, the additional shares would not be eligible for the security options deduction on the personal tax return. In the November 30, 2020, Economic Update, the government announced that the new rules will apply to most corporations and mutual fund trusts.  The rules will NOT apply to:

• Canadian Controlled Private Corporations
• Non-CCPC employers with annual gross revenues below $500,000,000

Under these rules, the securities option deduction will only be available to the employee for the first $200,000 of stock options that become vested in the year from any one employer. The taxable benefit will remain equal to the difference between the value of the shares at the time the option is exercised, and the amount paid. However, where the value of the options vested exceeds $200,000, the securities option deduction will be limited to one-half of the benefit on the first $200,000 of the options exercised.

This tax treatment applies to options granted after June 30, 2021. Where multiple options that are granted after June 2021 are exercised in one year, the limitation on the securities option deduction will be applied based on the year the options are vested, not the year they are granted or exercised. Where an employee has identical options granted both before and after July 1, 2021, the older options are deemed to be exercised first so the old rules will apply to those options.

As you can see, these rules are complex; now we must deal with pre- and post-June 25, 2024 tax changes, in the absence of proposed legislation, at least at the time of writing. 

How the Tax Calculations Work. Before the proposed change in the capital gains inclusion rate scheduled for June 25, 2024, the treatment was fairly straight forward.  The company would grant a stock option to an employee, which allowed them, at some point in the future, to purchase the stocks at the current market price of the stock.  If the value of the shares increased, the employee could purchase the shares at the discounted (grant) price. 

The difference between the market value of the shares when the option was exercised and the amount paid (grant price) was a taxable benefit to the employee.  Although the taxable benefit was included in their income for the year that the option was exercised, they were eligible for a stock option deduction equal to 50% of the taxable benefit thereby reducing the amount subject to tax to 50% (equivalent to the taxation of capital gains). 

When the employee sold the stock, their cost base was the fair market value of the stock at the time they exercised the option (i.e. what they paid plus their taxable benefit).  That meant that any increase in value of the stock after purchase was another capital gain.

How we expect the rules to change is the subject of Part 2 – tune in next week for Employee Stock Options, anticipated tax calculations post June 24, 2024.

Excerpted from the Advanced Retirement and Estate Planning Course - now available.