Capital-gains budget change for employee stock options bites lower-level execs, not CEOs

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The proposed changes to capital-gains taxes in the 2024 budget will make little difference to top Canadian executives who make millions a year from their stock options, but will hit harder for those with smaller gains.

Why? There’s a limit to the number of employer-granted stock options that can benefit from a tax break under current law – the tax break the government proposes to cut back as part of its capital-gains changes.

A big fish who gets millions of dollars’ worth of stock options doesn’t get much of a break because of that limit – and they won’t be hurt much as the benefit diminishes, as the government proposes.

But more junior executives might have received an option grant small enough to get the benefit on every option they receive. So cutting back that benefit will hurt them far more, proportionally.

To get how all of this works, you’ll need to understand how employee stock options qualify for a tax benefit and how they’re taxed once they do.

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An option is the right to buy a share of stock at a set price, and it gets more valuable as the stock goes up. Buying a share for $20 when it’s currently worth $50 sure sounds like a healthy capital gain.

Except it’s not a capital gain. Canadian tax law considers all profits from options issued by your employer as ordinary employment income instead. That minimizes the impact of the potential changes to capital-gains taxation.

In the proposed 2024 federal budget, businesses and individuals will pay income taxes on two-thirds of their earnings from capital gains each year, up from one-half. For individuals, the increase applies only to capital gains in excess of $250,000. The government has said these measures, set to come into effect June 25, will generate $19.4-billion in revenue over five years.

While profits on employer-issued stock options are considered ordinary income, there is a provision in current tax law that mimics the capital-gains rules.

Employees can deduct half of their option profits from their income at tax time – which means you’re only taxed on half of your option profits. The 2024 budget will cut that deduction to one-third of profits – meaning you’ll pay tax on two-thirds of option profits. The tax increase only applies to profits above $250,000, a change designed to make option taxation match the new capital-gains rules.

The ability to use this deduction was severely limited, however, by a 2021 revision to tax law that set a ceiling on the amount of options that qualify for the profit-deduction rules.

These options are, appropriately, called “qualified.” Even though the tax benefit comes when the option is exercised, the company makes the determination of qualified versus non-qualified when it makes the grant. Only $200,000 worth of options per year that vest – or become usable by the recipient – can be considered qualified. The remainder of the options do not.

A qualified option, when exercised, qualifies for the deduction. A non-qualified option, when exercised, does not.

This means the tax impact of the 2024 changes will be small for top executives, and larger on executives who received smaller option grants.

“Probably there’s a lot of employees who have these stock options that would definitely not exceed that $200,000 limit” for annual qualified vesting, says Jill Winton, a tax lawyer at Stikeman Elliott LLP. “I don’t know that stock options are limited, generally, to the wealthiest people – sometimes it could just be regular employees in the back office who happen to be lucky and get options on the ground floor.”

To illustrate the impact, The Globe and Mail developed two scenarios, adapting from examples crafted by Hugessen Consulting Inc., a company that specializes in executive compensation. The Globe asked tax lawyers from Gowling WLG Canada LLP; Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, PC; and Stikeman Elliott to review the examples. (These rules largely apply to large publicly traded companies; smaller public companies and private companies tend to have more favourable treatment.)

Consider a senior executive who gets a grant the company values at $1-million: 200,000 options with an exercise price of $20, which is the market value of the underlying share of stock at the time. They vest in four annual chunks of 50,000.

The federal government’s calculation of qualified versus non-qualified is based on the share price at the time of the grant. So, in this example, the $200,000 limit divided by $20 equals 10,000 qualified shares per year. The remaining 40,000 vesting shares are non-qualified and ineligible for the deduction.

Let’s say the company has done extraordinarily well: its shares have jumped to $50 apiece on the Toronto Stock Exchange by the time the options have all vested. So the executive exercises all 200,000 at once.

Of those, 40,000 options, with a profit of $1.2-million, are qualified. Currently, $600,000 of that profit, or 50 per cent, can be deducted. The 2024 budget proposal reduces the deduction to $441,667. (That’s a 50-per-cent deduction, or $125,000, on the first $250,000 of gains and a one-third deduction, or $316,667, on the remaining $950,000 profit.)

The remaining 160,000, with a profit of $4.8-million, are taxed as ordinary income, with no deduction benefit and no new taxes from the 2024 budget changes.

At the combined federal-Ontario income tax rates, the executive loses $158,333 in deductions, which translates to $84,708 in extra taxes, increasing the tax bill on $6-million of option profits by 2.9 per cent.

The numbers look different, however, for executives or managers whose option grants are much smaller. Because they stand to gain less than the big dogs, much or all of their option profits may be qualified. That means that much or all of their profits will see increased taxes under the new rules.

Consider a lower-tier executive at the same company who gets a grant valued at $100,000: 20,000 options with an exercise price of $20. They vest in four annual chunks of 5,000.

In this example, $200,000 divided by $20 equals 10,000 qualified options per year – the limit is higher than the 5,000 options that are vesting. Therefore, all the options are eligible for the deduction.

The 20,000 shares have a profit of $600,000 in our scenario. Currently, $300,000 of that profit, 50 per cent, can be deducted. The 2024 budget proposal reduces the deduction to $241,667. (That’s a 50-per-cent deduction, or $125,000, on the first $250,000 of gains and a one-third deduction, or $116,667, on the remaining $350,000 profit.)

The executive loses $58,333 in deductions, which translates to $31,208 in extra taxes, increasing the tax bill on $600,000 in option profits by 19.4 per cent.

A jump from $20 to $50 in four years is an extraordinary gain of 150 per cent, providing ample profits in a relatively short amount of time. If the stock instead gained a more modest 30 per cent to 60 per cent, there would be no new taxes from the proposed 2024 changes for the senior executive and lower-level executive, respectively, in these examples. That’s because their total profits would be $250,000 apiece: They would still get the full 50-per-cent deduction and have no profits subject to the tax changes.

“Taken as a whole, the 2021 changes and the 2024 proposal really take a bite out of the preferential treatment for options,” says Paul Carenza, a tax lawyer at Gowling WLG Canada LLP. “If the optionee is a C-suite executive in a large company, then the impact of the 2024 proposal may be modest. In other cases, it is quite impactful.”

This leads to two different pieces of potential advice. For top executives with big profits, the tax savings may not be big enough to rush to use options before June 25, says David Crawford, a partner at Hugessen. For executives with smaller portfolios, however, the tax impact may be big enough to justify exercising options before the changes come into effect in late June.

“After all,” he says, “to use an option is to forfeit future gains if the stock continues to rise.”

Editor’s note: A previous version incorrectly said that reducing the deduction to $241,667 meant a deduction of $125,000 on the first $250,000 of gains and $16,667 on the remaining $50,000. This has been corrected.