There has been a lot of speculation that the taxable capital gain inclusion rate may be increased in the next Federal Budget to be tabled on March 22, 2017 from the current 50% rate to possibly 66 2/3% or 75% as was the case starting in 1988 and during the 1990’s.
It is unknown at this time whether any changes in the next Budget will, if implemented, be retroactive to January 1, 2017, or be effective as of the day of the Budget; however, when changes were introduced in the year 2000, such changes were effective as of the particular Budget day, resulting in one of three different rates being applicable for transactions arising in that year.
What has not been given a lot of attention is the fact that if the taxable capital gain inclusion rate is increased by the Budget, history has shown that a consequential reduction will also be made to the employee stock option benefit deduction.
Currently the stock option benefit deduction for “qualifying stock options” is 50% of the taxable benefit amount. A “qualifying stock option” is an agreement granted by an employer corporation to its employee to acquire shares at a price not less than the fair market value of the shares at the time the agreement was made. Generally, public company stock options are “qualified stock options.”
The stock option benefit deduction mechanism mirrors the taxable capital gain inclusion rate, that is, the taxable portion of the stock option benefit is the same percentage of the total benefit as is the portion of a capital gain that is taxable. In the year 2000, the taxable capital gain inclusion rate was decreased and the stock option benefit deduction was correspondingly increased.
Any pre-Budget planning will mostly be applicable to situations when individuals hold stock options to acquire public company shares, which stock option arrangements qualify for the 50% deduction. The taxable benefit income inclusion and the 50% deduction arises when the option is exercised and the stock is acquired.
If the Budget increases the taxable capital gain inclusion rate to 66 2/3% or 75% then the portion of a stock option benefit that will be taxable will be the similar 66 2/3% or 75% portion, which means that the stock option benefit deduction will decrease as follows:
|– Capital gain inclusion rate||50%||66 2/3%||75%|
|– Stock option benefit deduction||50%||33 1/3%||25%|
The reduction in the stock option deduction will increase the tax on the stock option benefit significantly, for example for an individual resident in Alberta in the top personal tax bracket the tax would be:
|– Currently at 50% stock option deduction||24%|
|– At 33 1/3% stock option deduction||32%; 1/3 more tax (8% increase)|
|– At 25% stock option deduction||36%; 50% more tax (12% increase)|
Individuals who have unexercised vested stock options that they are considering exercising in the near future may want to consider exercising the options before the next Budget to take advantage of the higher 50% stock option benefit deduction.
In order for the favourable 50% stock option benefit deduction to be available before the March 2017 Budget date, the stock option has to be exercised, that is, the stock needs to be acquired, issued and paid for before the March 2017 Budget date.
For individuals who utilized the annual $100,000 stock option benefit deferal rules prior to March 5, 2010, the realization of the taxable benefit arises when the subject shares are sold, at which time the 50% stock option benefit deduction can be claimed. If a sale of the subject shares is being contemplated, such individuals may want to consider accelerating the sale of the shares acquired pursuant to the stock option benefit deferral rules before the next Budget to take advantage of the higher 50% deduction. The amount of an individual’s deferred security option benefit carried forward to the 2016 taxation year would have been reported on the individual’s 2015 Notice of Assessment or Reassessment and on Canada Revenue Agency’s prescribed form T1212 – Statement of Deferred Security Options Benefits, filed with the individual’s 2015 personal income tax return.
As is the case with all public company stock options, the potential reduction in the stock value after the exercise date needs to be carefully considered on account of the risk that if the share value drops, the taxable benefit amount is still based on the value of the shares at the exercise date. As such, the question of whether or not the stock option should be exercised before the next Budget should not be based solely on tax considerations but primarily on investment considerations.
For stock options granted by a Canadian-Controlled Private Corporations (“CCPC”) the taxable benefit income inclusion and the 50% deduction arises not when the shares are acquired, but when the shares are sold. The stock option deduction applies if the CCPC stock option is a “qualified stock option” or the private company shares purchased on the exercise of the stock option have been held for at least 2 years prior to the sale. As the taxable benefit is not recognized until the shares are sold, it will likely not be practical or beneficial to plan to prepay income tax if a sale of the CCPC shares is not being contemplated in the near future.
Our comments outlined above only take into consideration the Canadian tax implications arising from the exercise of employee stock options.