2010 Federal Budget Commentary: Employee Stock Options and Section 116 Relief
Following the resumption of Parliament, the minority Harper government released its fifth Budget on March 4, 2010 (Budget 2010). The focus of Budget 2010 is to continue to support economic growth, jobs, infrastructure and industry. Budget 2010 recognizes the effects of the global recession, but contains a measure of optimism balanced with uncertainty about the strength and depth of the economic recovery.
Unlike certain recent budgets, Budget 2010 includes scores of tax measures, many of which will be welcomed by industry and taxpayers. As contemplated in the Throne Speech, which referred to closing "loopholes," a number of measures are intended to maintain the revenue base for the country and will tighten or eliminate structures which are perceived by the Government to be inconsistent with tax policy.
We have reproduced two of the highlights of the budget below dealing with significant changes to employee stock option rules and measures to streamline the Section 116 withholding and reporting regime. For a more detailed discussion of Budget 2010, please view our full publication by clicking here. On March 4, 2010, McCarthy Tétrault and Thomson Reuters hosted a live Webinar on the 2010 Federal Budget. To view it, click here.
Employee Stock Options
Budget 2010 proposes a number of measures associated with the taxation of employee stock options.
While one of the measures is relieving in nature, in aggregate the measures are expected to increase federal tax revenues by almost $1.7 billion by the end of the 2015 fiscal period principally through (i) the denial of a deduction to either the employee or the employer where a stock option is "cashed out," and (ii) the elimination of an employee’s ability to defer the taxable benefit arising on the exercise of public company stock options.
Stock Option Cash-Outs
If, in the course of employment, an employee acquires a security of his or her employer under a stock option agreement, the difference between the fair market value of the security at the time the option is exercised and the aggregate of the amount paid by the employee to acquire the security and the cost of the option is treated as a taxable employment benefit. Where certain conditions are met, the employee is entitled to a deduction from income equal to one-half of the employment benefit (the stock option deduction), resulting in the taxation of the benefit at capital gains rates.
If securities are issued under such stock option agreements, employers are generally prevented under the Income Tax Act (the "Act") from claiming a deduction from income in respect of the issuance of the securities. However, currently, where an employee elects to receive cash, which is usually equal to the "in-the-money" amount of the options, and to essentially "cash out" his or her rights under the stock option agreement instead of acquiring securities of the employer, the employer is normally able to deduct the amount of the cash payment even though the employee is still entitled to the stock option deduction.
Budget 2010 proposes that the ability of both the employer and the employee to claim deductions on a "cash out" be eliminated in respect of employee stock options disposed of after 4:00 p.m. EST on March 4, 2010. Employees will be entitled to the stock option deduction (under paragraph 110(1)(d) or (d.1) of the Act) on exercise of employee stock options only where:
- they exercise their options by acquiring shares of their employer; or
- they exercise a right to cash out their options and the employer makes an election to forego the deduction for the cash payment made by it.
Non-Arm’s Length Disposition of Employee Stock Options
While the Government believes that the disposition of rights under a stock option agreement to a non-arm’s length person results in an employment benefit under the Act at the time of disposition (including where the rights are cashed-out), Budget 2010 proposes to amend the Act (effective at 4:00 p.m. EST on March 4, 2010) to expressly provide for this result.
Tax Election Deferral and Remittance Requirement
The taxable benefit arising when an employee acquires securities under a stock option agreement is treated as employment income under the Act. Changes in value of the securities after their acquisition generally give rise to capital gains or losses on the disposition of the securities.
Where certain conditions are met, the Act permits an employee of a publicly traded company to elect to defer the recognition of the employment benefit for tax purposes until the disposition of the securities. Budget 2010 proposes to repeal the tax deferral election in respect of publicly traded securities (but not the somewhat similar deferral available in respect of employee-stock options for employers that are Canadian-controlled private corporations). The repeal will apply to employee stock options exercised after 4:00 p.m. EST on March 4, 2010.
Budget 2010 also proposes to clarify withholding requirements to ensure that an amount in respect of the employment benefit associated with the issuance of a security is required to be remitted to the CRA by the employer. The employer will be required to remit tax in respect of the benefit, together with other employer remittances in respect of salaries and benefits, for the period that includes the date on which the security was issued or sold as if the benefit were a cash bonus. Where the stock option deduction is available, it will be taken into account in computing the amount of taxable benefit that is subject to withholding. This withholding measure will not apply, however, to options granted prior to 2011 pursuant to an agreement entered in writing prior to 4:00 p.m. EST on March 4, 2010 where the agreement included restrictions on the disposition of the optioned securities. Budget 2010 does not address whether the administrative relief for undue hardship will continue to be available.
Special Relief for Tax Deferral Elections
Some employees who took advantage of the tax deferral election in respect of securities of a publicly-traded company have experienced financial difficulties where the optioned securities have declined in value, in some cases to the point that the value of the securities is less than the deferred tax liability on the underlying stock option benefit.
Budget 2010 proposes to introduce a special elective tax for affected taxpayers who made the tax deferral election. This special election is intended to ensure that the tax liability on the deferred stock option benefit does not exceed the proceeds of disposition of the optioned securities, taking into account tax relief resulting from the use of capital losses on the optioned securities against capital gains from other sources.
In any year in which a taxpayer is required to include in income a qualifying deferred stock option benefit (i.e., where some of the optioned shares are disposed of), the taxpayer may elect to pay a special tax equal to the taxpayer’s proceeds of disposition (or two-thirds of such proceeds for residents of Québec, given the separate tax regime applicable to individuals resident in Québec) from the disposition of the optioned securities. Where this election is made:
- the taxpayer will be able to claim a deduction equal to the amount of the stock option benefit; and
- an amount equal to one-half of the lesser of the stock option benefit and the capital loss on the optioned securities will be included in the taxpayer’s income as a taxable capital gain. That gain may be offset by the allowable capital loss arising on the disposition of the optioned securities (provided that the loss has not otherwise been used).
To qualify for this elective special tax treatment:
- where the optioned securities were disposed of before 2010, the election must be made on or before the filing-due date for the 2010 taxation year (typically, April 30, 2011); and
- where the optioned securities were not disposed of before 2010, the securities must be disposed of before 2015, and the election must be made before the filing–due date for the taxation year of the disposition.
This measure should provide welcome relief to taxpayers who elected to defer the stock option benefit on publicly traded securities where the securities declined significantly such that on disposition their value was less than the tax liability deferred.
Section 116 Relief
Subject to the provisions of applicable tax treaties, Canada currently taxes non-residents on their income and gains from the disposition of "taxable Canadian property." The Act also imposes an obligation on a purchaser acquiring such property from a non-resident to withhold part of the purchase price and remit such funds to the government on account of the non-resident’s potential Canadian tax liability, unless the non-resident vendor obtains a "clearance certificate" from the CRA. To obtain a clearance certificate, a non-resident must remit an amount to the CRA on account of the non-resident’s potential Canadian tax liability, post security or satisfy the CRA that no tax will be due.
Budget 2010 proposes an important relieving measure to exclude from the definition of taxable Canadian property shares of corporations, and certain other interests, that do not at any time during the 60-month period prior to the determination time derive their value principally from real or immovable property situated in Canada, Canadian resource property or timber resource property. These measures will apply in determining after March 4, 2010 whether a property is taxable Canadian property of a taxpayer.
This measure will align the provisions of the Act more closely with Canada’s tax treaties and the domestic rules of various OECD countries including the United States. The measure also builds upon recent changes to the Act that eased compliance requirements on the disposition by a non-resident of taxable Canadian property where treaty exemptions were applicable.
The Act deems certain property to be taxable Canadian property in certain circumstances (e.g., under the provisions of paragraph 85(1)(i) and other reorganization provisions where the exchanged property was taxable Canadian property). Such provisions are generally to be amended such that the deeming rule will apply only for 60 months after the relevant disposition.