Corporate Tax

Worker Inventory Choices: Adjustments To Tax Therapy Now In Pressure – Company/Industrial Regulation

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The amendments to the Income Tax Act (Canada) (Tax Act)
that restrict the amount that employees are entitled to deduct in
respect of stock option benefits (Stock Option Rules) for employee
stock options granted on or after July 1, 2021 have now been
enacted as part of Bill C-30, An Act to implement certain
provisions of the budget tabled in Parliament on April 19, 2021 and
other measures (Bill C-30). In this bulletin, we discuss the
new Stock Option Rules.

What you need to know

  • The Stock Option Rules cap the availability of the 50% employee
    deduction (50% Deduction) for certain stock option benefits based
    upon a $200,000 annual vesting limit. In addition, employers can
    designate certain stock options as ineligible for the 50%
    Deduction.
  • The Stock Option Rules apply to employee stock options granted
    by employers that have annual gross revenue in excess of $500
    million or by employers that are members of a group that prepares
    consolidated group financial statements where the annual total
    consolidated group revenue exceeds $500 million.
  • However, the Stock Option Rules generally do not apply to
    employers that are Canadian-controlled private corporations
    (CCPCs).
  • The Stock Option Rules permit the employer to deduct amounts in
    respect of employee stock option benefits where the stock options
    are ineligible for the 50% Deduction.
  • The Stock Option Rules apply in respect of employee stock
    options granted on or after July 1, 2021.
  • Employers will need to comply with onerous tracking,
    administration, and notification requirements in connection with
    their stock option grants.

Introduction

The Stock Option Rules were enacted as part of Bill C-30 on June
29, 2021 and generally take effect for employee stock options
granted on or after July 1, 2021.

The Stock Option Rules generally restrict the 50% Deduction that
may otherwise be available to the employee on the exercise or cash
out of employee stock options for securities that are non-qualified
securities for the purposes of the Stock Option Rules. The
underlying securities are deemed to be non-qualified securities if
the $200,000 Annual Vesting Limit is exceeded. The underlying
securities can also be designated as non-qualified securities by
the grantor if certain conditions are met.

Where the employee is denied the 50% Deduction because the
underlying securities are non-qualified securities, the employer is
generally eligible to deduct the amount of the stock option benefit
if certain conditions are met.

The Stock Option Rules generally apply to employee stock options
granted by employers that have annual gross revenue in excess of
$500 million or by employers that are members of a group that
prepares consolidated group financial statements where the annual
total consolidated group revenue exceeds $500 million.

Employee stock options granted by CCPCs are generally not
subject to the Stock Option Rules. However, as described in more
detail below, there are certain situations where employee stock
options granted by CCPCs may be affected.

With the enactment of the Stock Option Rules, employers now need
to comply with onerous tracking, administration and notification
requirements in connection with their stock options granted on or
after July 1, 2021. Both employers and employees should consider
the implications of these new measures on their long-term
compensation arrangements.

We provide a detailed discussion regarding the application of
the Stock Option Rules from the perspective of both employees and
employers below.

1. Limit on employee deduction

The Stock Option Rules deny the 50% Deduction for stock option
benefits realized in respect of the exercise of employee stock
options to acquire non-qualified securities. Generally, stock
options will be subject to the Stock Option Rules if the following
three conditions are satisfied:

  • the stock options are granted by an employer that is a
    “specified person”;
  • the underlying securities are “non-qualified
    securities”; and
  • the stock options are granted on or after July 1, 2021.

Under the Stock Option Rules, employers have an obligation to
notify the employee and the Canada Revenue Agency (CRA) if the
securities underlying a stock option are non-qualified
securities.

(A) Employers who are specified persons

The Stock Option Rules apply to employee stock options granted
by an employer that is a “specified person” as defined in
the Stock Option Rules.

For these purposes, a “specified person” is a
“qualifying person” (which is defined to mean a
corporation or a mutual fund trust) that is not a CCPC and:

  1. where the qualifying person is a member of a group that
    annually prepares “consolidated financial
    statements”1, the total annual consolidated group
    revenue reflected in the last consolidated group financial
    statements presented to shareholders or unitholders of the ultimate
    parent entity for the group prior to the stock option grant exceeds
    $500 million; or
  2. in any other case, the qualifying person has annual gross
    revenue in excess of $500 million based on the amounts reflected in
    its annual financial statements presented to shareholders or
    unitholders for its last fiscal period preceding the stock option
    grant, or its second to last fiscal period preceding the stock
    option grant if financial statements have not been presented to
    shareholders or unitholders for its last fiscal period, or, where
    financial statements were not presented to shareholders or
    unitholders for either of those periods, the amounts that would be
    reflected in annual financial statements for its last fiscal period
    if such statements had been prepared in accordance with generally
    accepted accounting principles.

The exclusion for CCPCs from the definition of “specified
person” means that the Stock Option Rules should generally not
apply to stock options granted by CCPCs.

However, there are some circumstances where the Stock Option
Rules can apply to stock options granted by CCPCs. For example, the
Stock Option Rules will apply to stock options granted by a CCPC to
an employee of the CCPC where the underlying securities are
securities of another qualifying person that does not deal at
arm’s length with the CCPC and the other qualifying person is a
“specified person”. Similarly, the Stock Option Rules can
apply to stock options granted by a CCPC to an employee of another
qualifying person that does not deal at arm’s length with the
CCPC and the other qualifying person is a “specified
person”. These situations may be rare, but it is important to
recognize that CCPCs are not completely excluded from the
application of the Stock Option Rules.

The total annual consolidated group revenue or annual gross
revenue tests are a proxy for and address some of the uncertainty
surrounding what the Government considers to be large,
long-established, mature companies that the Government indicated
would be targeted in its initial announcement of these rules.

(B) Non-qualified securities

Securities underlying employee stock options granted by
specified persons will be “non-qualified securities” to
the extent that the Annual Vesting Limit is exceeded or if the
qualifying person designates the underlying securities to be
non-qualified securities in accordance with the Stock Option
Rules.

(i) Annual Vesting Limit

The Annual Vesting Limit will apply to an employee stock option
where the following three conditions are met (Conditions of
Application):

  1. the grantor (a qualifying person) grants an option over the
    grantor’s securities (or of another qualifying person with
    which the grantor does not deal at arm’s length) to the
    employee;
  2. at the time the stock option is granted (referred to as the
    relevant time), the employee is an employee of the grantor or of
    another qualifying person that does not deal at arm’s length
    with the grantor; and
  3. any of the following persons are specified persons at the
    relevant time: a) the grantor, b) the other qualifying person
    referred to in i) above, or c) the employer.

Where the foregoing Conditions of Application are met, the
proportion of the underlying securities to be issued under the
employee stock option that are deemed to be non-qualified
securities is determined by the formula A/B.

Variable A is itself determined by the formula C + D –
$200,000.

Variable B is the amount that is determined for C above.

Variable C is the total of all amounts each of which is the fair
market value of a security to be issued under the stock option
(determined as at the grant date of the stock option) that has the
same vesting year.

Variable D is the lesser of (i) $200,000 and (ii) the total of
all amounts each of which is the fair market value of a security
underlying other stock options having the same vesting year that
are granted to the employee by the grantor or by a qualifying
person that does not deal at arm’s length with the grantor,
other than: (a) securities designated as non-qualified securities
pursuant to the Stock Option Rules, (b) securities that are
“old securities” (within the meaning of subsection
7(1.‍4) of the Tax Act) with respect to an exchange of stock
options to which subsection 7(1.4) applies, (c) securities where
the right to acquire those securities is an “old right”
(within the meaning of subsection 110(1.‍7) of the Tax Act)
with respect to a reduction in the exercise price of the related
stock option to which subsection 110(1.7) applies, and (d)
securities in respect of which (A) the related stock option has
expired, or has been cancelled, before the relevant time, and (B)
the 50% Deduction is not available to the employee for any
year.

For these purposes, the “vesting year” is the calendar
year specified in the stock option in which the stock option first
becomes exercisable (other than as a consequence of an event that
is not reasonably foreseeable at the time the stock option is
granted). However, if the stock option does not specify the vesting
year, then the vesting year is the calendar year in which the
option would become exercisable if the option specified that all
identical rights to acquire the underlying securities become
exercisable on a pro rata basis over the period that begins on the
day the stock option is granted and ends on the earlier of: a) the
day that is 60 months after the date of grant, and b) the last day
that the stock option could be exercised.

The Technical Notes provide an illustrative example of the
vesting year for a stock option that is granted on July 1, 2022 and
expires on June 30, 2029 (i.e., a seven-year period) and does not
specify the year(s) in which the rights to acquire the underlying
securities may first be exercised. In that case, 10% of the
securities would have a vesting year of 2022, 20% would have a
vesting year of 2023, 20% would have a vesting year of 2024, 20%
would have a vesting year of 2025, 20% would have a vesting year of
2026, and 10% would have a vesting year of 2027. The rule for
determining the vesting year for stock options that do not have a
specific time when they become exercisable addresses this
uncertainty in the Government’s initial announcement of the
Stock Option Rules.

It should be noted that the vesting year of an underlying
security is determined at the time the stock option is granted and
may be different from the year in which the stock option is
exercised.

The following example from the Technical Notes illustrates the
application of the Annual Vesting Limit.

Example:

Mckayla is an employee of Xco, which is a specified person. In
2022, Xco agrees to grant her 70,000 employee stock options to
acquire 70,000 shares of Xco, each with a strike price of $2 (the
fair market value of the underlying securities at the time the
options are granted). The first year Mckayla will be able to
acquire those securities is in the 2024 calendar year.

The proportion of those securities that are deemed to be
non-qualified securities is:

A/B

A = C + D – $200,000

where

C = $140,000 (i.e., 70,000 x $2)

D = is the lesser of

(i) $200,000; and

(ii) 0

A = 0 (i.e., $140,000 + 0 – $200,000)

B = $140,000

A/B = $0/$140,000

As a result, none of the securities in respect of which options
are granted in 2022 are non-qualified securities.

In 2023, Xco agrees to grant Mckayla another 50,000 options to
acquire 50,000 shares of Xco with a strike price of $2 (the fair
market value of the underlying securities at the time the options
are granted) with a vesting year of 2024.

The proportion of those securities that are deemed to be
non-qualified securities is:

A/B

A = C + D – $200,000

where

C = $100,000 (i.e., 50,000 x $2)

D = is the lesser

(i) of $200,000; and

(ii) $140,000 (i.e., the amount for C for the previous options
with the same vesting year)

A = $40,000 (i.e., $100,000 + $140,000 – $200,000)

B = $100,000

A/B = $40,000/$100,000

As a result, 20,000 (i.e., 50,000 x ($40,000/$100,000)) of the
50,000 securities in respect of which options are granted in 2023
are non-qualified securities.

To the extent that the underlying securities are non-qualified
securities as a result of the Annual Vesting Limit, the employee is
disqualified from claiming the 50% Deduction on the exercise of
stock options in respect of such non-qualified securities. However,
as discussed further in Part 2 below, the employer is eligible to
deduct an amount in respect of the stock option benefit in respect
of such non-qualified securities.

(ii) Ordering rules

The Stock Option Rules provide two different ordering rules to
assist in the determination of non-qualified securities under the
Annual Vesting Limit.

The first ordering rule provides that if the employee acquires
underlying securities on the exercise of a stock option and the
acquired securities could be securities that are not non-qualified
securities, then the securities are deemed to not be non-qualified
securities. According to the Technical Notes, this ordering rule is
intended to address circumstances where an employee exercises stock
options to acquire some but not all of the underlying securities
that the employee could acquire under the stock options (i.e., a
partial exercise), and the acquired securities may or may not be
non-qualified securities. This ordering rule deems the employee to
have acquired the securities that are not non-qualified securities
before acquiring any securities that are non-qualified
securities.

The following example from the Technical Notes is
illustrative:

Example:

Andrew is an employee of Yco, a specified person. In 2022, Yco
grants Andrew options to acquire 300,000 shares with a strike price
of $2 per share (the fair market value of the underlying securities
at the time the options are granted) and a vesting year of 2023.
Yco does not agree to sell Andrew any other securities with that
vesting year.

Under subsection 110(1.31), 200,000 of those shares will be
non-qualified securities and 100,000 of the shares will be
qualified securities.

If Andrew chooses to exercise his right to acquire 150,000 of
those 300,000 shares in 2023, 100,000 of those shares could be
qualified securities. Thus, he is considered to exercise options to
acquire the 100,000 qualified securities first, with the remaining
50,000 shares being non-qualified securities.

The second ordering rule addresses the ordering of multiple
stock option grants at the same time. This rule provides that where
two or more stock options are granted by a qualifying person at the
same time and the qualifying person designates the order of the
grants, then for the purposes of variable D of the Annual Vesting
Limit discussed above, the stock options are deemed to be granted
in the order so designated. According to the Technical Notes, this
ordering rule is intended to ensure that one stock option agreement
does not preclude another from granting securities that are not
non-qualified securities2.

(iii) Designation as non-qualified securities

Apart from the Annual Vesting Limit, the underlying securities
will be non-qualified securities if the grantor designates the
underlying securities to be non-qualified securities. In order for
the grantor to be able to make the designation, the Conditions of
Application for the Annual Vesting Limit (discussed above) must be
met. Where the grantor designates the underlying securities as
non-qualified securities, the underlying securities are deemed to
be non-qualified securities. Such a designation disqualifies the
employee from claiming the 50% Deduction on the exercise of the
stock options in respect of such securities. However, as discussed
in further detail in Part 2 below, the employer is eligible to
deduct an amount in respect of the stock option benefit in respect
of such non-qualified securities.

(iv) Notification of non-qualified securities

Where the securities underlying a stock option are non-qualified
securities (either because the Annual Vesting Limit has been
exceeded or because of the designation of the securities as such),
the employer of the employee (which may not be the grantor) is
required to notify the employee and the CRA that the underlying
securities are non-qualified securities. The employer is required
to notify the employee in writing of the non-qualified securities
within 30 days after the date on which the stock option was
granted. The employer is required to notify the CRA, in prescribed
form, that the security is a non-qualified security on or before
the grantor’s filing due date for the taxation year in which
the stock option was granted.

(C) Stock options granter on or after July 1, 2021

The Stock Option Rules apply to employee stock options granted
on or after July 1, 2021. Stock options granted before July 1, 2021
which vest after June 30, 2021 will not be included in the
calculation of the Annual Vesting Limit. In addition, where, after
June 30, 2021, an employee exchanges stock options which were
granted before July 1, 2021 for new stock options, the new stock
options will also be excluded from the calculation of the Annual
Vesting Limit, provided the existing requirements under the Tax Act
for tax-deferred stock option exchanges under subsection 7(1.4) of
the Tax Act are satisfied in respect of such exchange.

2. New employer deduction

Historically, employers have not been entitled to claim a
deduction in respect of stock option benefits realized upon the
exercise of stock options. However, if certain conditions are met,
the Stock Option Rules permit an employer to deduct in computing
its taxable income for a taxation year an amount equal to the
amount of the stock option benefit in respect of employment with
the employer that is deemed under subsection 7(1) of the Tax Act to
have been received by an employee in the year in respect of the
exercise of an employee stock option for a non-qualified security
granted by the employer (or a qualifying person that does not deal
at arm’s length with the employer) to an employee.

The conditions that must be met are the following:

  1. the employer is a qualifying person;
  2. the employee was an employee of the employer at the time the
    stock option was granted;
  3. the amount is not claimed as a deduction in computing the
    taxable income of another qualifying person;
  4. the 50% Deduction would have been available to the employee if
    the security was not a non-qualified security;
  5. if the employee is not resident in Canada throughout the year,
    the stock option benefit must be included in computing the
    employee’s taxable income earned in Canada for the year;
    and
  6. the employer must comply with the notification requirements (as
    discussed in Part 1 above) in respect of the non-qualified
    security.

The employer deduction is available in respect of the exercise
of employee stock options over non-qualified securities regardless
of whether the securities are non-qualified securities because the
Annual Vesting Limit is exceeded or because the securities have
been designated as non-qualified securities. This means that
employers can choose to designate the securities underlying an
employee stock option as non-qualified securities in order for the
employer to be able to deduct amounts in respect of the stock
option benefit realized by the employee (where the conditions for
the employer deduction described above are satisfied).

3. Consequential changes to the cash out of employee stock
options

The Stock Option Rules also contain consequential amendments to
the rules applicable on the cash out of employee stock options.

First, the Stock Option Rules provide a specific rule with
respect to the cash out of employee stock options where the
underlying securities are not non-qualified securities. This rule
applies where: i) the Conditions of Application for the Annual
Vesting Limit are met (as discussed above in “1. Limit on
employee deduction”), ii) the underlying securities are not
non-qualified securities, and iii) a payment is made to the
employee for the transfer or disposition of a stock option (i.e., a
cash out). Where this rule applies, the employee is eligible for
the 50% Deduction in respect of the cash out and, as discussed in
more detail below, no qualifying person is entitled to any
deduction in respect of the cash out payment3. Prior to
the enactment of the Stock Option Rules, in order for the employee
to be eligible for the 50% Deduction on a cash out of employee
stock options, the grantor had to make the election under
subsection 110(1.1) to forgo the deduction by the grantor (or any
non-arm’s length persons) in respect of the cash out payment
(other than for a designated amount). Whereas under the Stock
Option Rules, on a cash out of employee stock options over
securities that are not non-qualified securities to which this rule
applies, the 50% Deduction is automatic; it is not dependent on the
grantor making the subsection 110(1.1) election.

Second, another rule affecting the subsection 110(1.1) election
applies where the grantor designates securities underlying an
employee stock option as non-qualified securities. Where such a
designation is made, the grantor is precluded from making the
election under subsection 110(1.1) with respect to the deduction of
the cash out payment. As a result, where a grantor designates the
underlying securities as non-qualified securities, the employer is
eligible for the employer deduction in respect of the stock option
benefit, the employee is ineligible for the 50% Deduction and the
employer cannot then shift the 50% Deduction back to the employee
on a cash out of the stock options by making the subsection
110(1.1) election.

4. Other considerations

(A) Compensation adjustments

Employers that are impacted by the new Stock Option Rules should
consider exploring whether these changes merit any adjustment to
their compensation arrangements. Possibilities include
restructuring compensation arrangements for employees who are
negatively impacted by the new measures, structuring stock option
grants to ensure that the underlying securities are not
non-qualified securities (or, if the employer deduction is desired,
to ensure that the underlying securities are non-qualified
securities), or transitioning towards other share-based
compensation arrangements, such as restricted share units or
performance share units.

(B) Notifications and internal practices

Employers should take this opportunity to review their internal
administrative practices with respect to stock option grants. The
new measures will require employers to track stock options granted
by them and related corporations in respect of non-qualified
securities and to comply with the prescribed notification
requirements.

Footnotes

1 As defined in subsection 238.1(1) of the Tax
Act.

2 We note that subsection 110(1.42) as enacted in Bill
C-30 states “If two or more agreements to sell or issue
options are entered into at the same time…”
(emphasis added) It is not clear whether the reference to
“options” is intended say “securities”, which
would be more consistent with the context of these rules. If it is
meant to refer to “options” then this rule may have
limited impact as it is not typical for employers to sell or issue
options to sell or issue securities to employees.

3 Other than a deduction for a “designated
amount” as defined in subsection 110(1.2) with respect to
certain employee stock option hedging arrangements.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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