In the 2024 Federal Budget, the Department of Finance announced that capital gains realized by individuals on or after June 25, 2024 in excess of an annual $250,000 threshold will be subject to a two-thirds inclusion rate for purposes of calculating the individual's taxable income. Capital gains realized by individuals below the threshold will still be subject to a one-half inclusion rate. See our previous report on these changes (Upcoming changes to the capital gains inclusion rate: Planning opportunities to reduce the impact of the new rules) for more details.
Legislation to implement these changes was released on June 10, 2024. The proposed amendments to the Income Tax Act (Canada) (the "Tax Act") include amendments that will affect the taxation of employee stock options. The changes are anticipated to be effective retroactive to June 25, 2024. Employees, employers, and their advisors must be aware of these changes to ensure that they are in compliance with the new rules and to plan their tax affairs accordingly.
This article briefly highlights the changes to the deduction available in respect of stock option benefits.
Stock option benefits
When an employee exercises a stock option, they realize a stock option benefit (the "Benefit"), for income tax purposes, equal to the amount by which the fair market value of the security acquired exceeds: (a) the amount paid to acquire the security (i.e., the exercise price); and (b) the amount paid to acquire the stock option, if any.
The amount of the Benefit is included in the employee's income in the year the security is acquired. However, if an employee exercises a stock option of a "Canadian-controlled private corporation" ("CCPC") (as that term is defined in the Tax Act), the income inclusion is deferred until the employee disposes of the security.
Old stock option benefit deduction calculation
Although the full amount of the Benefit must be included in the employee's income, an employee is often entitled to a deduction equal to one-half of the amount of the Benefit, provided certain conditions are satisfied. This effectively results in capital gains treatment for the Benefit where the deduction is available.
New stock option benefit deduction calculation
Although there are no changes to the computation of the Benefit under the new rules, there are changes in how the amount of the deduction is determined.
In respect of stock options exercised on or after June 25, 2024 (or for a CCPC, securities disposed of on or after June 25, 2024), the employee may still be entitled to a deduction equal to one-half of the amount of the Benefit, but only up to the $250,000 threshold. If the Benefit is greater than $250,000 in a particular year (for example, $400,000), and provided all other criteria for the deduction are satisfied and the employee does not realize any capital gains in the year, the employee will be entitled to a deduction equal to one-half of the $250,000 portion of the Benefit ($125,000), plus one-third of the amount of the Benefit in excess of $250,000 ($50,000). Instead of a $200,000 deduction, the employee will only be entitled to a $175,000 deduction, resulting in an extra $25,000 of net taxable income.
Note that the $250,000 threshold includes both the amount of the Benefit and capital gains realized by the employee in the year. If an employee has an income inclusion from a Benefit and realizes a capital gain in the same year, and the sum of those amounts exceeds the $250,000 threshold, the allocation of the preferential treatment (i.e., the one-half inclusion rate) between the Benefit and the capital gains is up to the employee.
Where the security is a share of a CCPC, the Benefit and the capital gain realized on the sale of such share will generally be included in the employee's income in the same year. Where possible, employees should be mindful about the timing of such dispositions and consider managing the $250,000 threshold (e.g., sell over several years).
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.