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Canadian Budget 2024 proposes changes to employee qualified stock option deductions, capital gains inclusion rate
July 2024
In brief
What happened?
Canada’s Budget 2024 introduces proposed changes to employee stock option deductions and the capital gains inclusion rate. While the existing CAD200,000 annual vesting limit for the 50% deduction measured at grant for qualified stock options would remain unchanged, the budget would introduce a new combined yearly cap of CAD250,000 covering both stock options and capital gains. Individuals with gains exceeding CAD250,000 from qualified stock options and capital gains would be eligible for only a 1/3 deduction.
While it is possible that changes may be introduced prior to the adoption of enabling legislation, if the effective date remains unchanged, these changes would apply to stock option exercises or sales of shares taking place on or after June 25, 2024.
Why is it relevant?
The proposed changes would affect employers with Canadian-resident option plan participants or non-residents subject to tax in Canada.
Action to consider
All companies are encouraged to adjust their stock option exercise withholding and reporting practices in accordance with draft legislation, as it is accepted practice in Canada to act on the basis of announced legislation. Companies that do not act on the proposed legislation and wait to comply until the legislation is formally approved risk underwithholding at stock option exercise and creating a liability for employees upon filing of their personal return to the extent of the excessive 1/6 deduction over the CAD250,000 limit.
The exposure for employers could include penalties and interest for failure to withhold (although the authority in the circumstances of proposed legislation is unclear) as well as, more significantly, potential liability for the actual tax due (including interest) when nonresident employees are involved. For employees, tax may be due upon filing their return if withholdings have been insufficient.
In detail
Under the new proposed legislation, employees would be eligible to receive only a 50% deduction on combined qualified stock option and capital gains totaling CAD250,000. For any amount above this threshold, the deduction would be limited to 1/3. Under the draft legislation, employers would be required to deduct 1/3 of the taxable benefit realized at qualified stock option exercise, in accordance with Income Tax Act paragraph 110(1)(d).
Employees would have the opportunity to claim the remaining 1/6 deduction on their individual tax returns. The deduction would be taken in the year of sale, for options on Canadian-controlled private corporation shares, or in the year of exercise for all other corporations or mutual funds.
What this means for employers
Employers are encouraged to update their processes for applying the deduction at the withholding level at the moment of stock option exercise for qualified securities. As a first step, for stock options granted after June 30, 2021, companies should determine how much of the spread at exercise is “qualifying,” as there is no deduction available for the non-qualifying part, not even the 1/3 deduction in excess of the CAD250,000 threshold. Under ITA 110(1)(d), employers now should apply only a 1/3 deduction when qualified stock options are exercised, leaving the employee responsible for claiming any additional deduction up to the CAD250,000 limit (the additional 1/6 deduction if available under ITA 110(1)(d.4)).
From a T4 reporting perspective (i.e., the Canadian equivalent of W-2 reporting), Code 39 likely now should reflect only a 1/3 deduction rather than the prior 50% (subject to any further guidance provided by the Canadian Revenue Agency). Codes 14 and 38 still should reflect the full stock option exercise gain; Code 86 should be used if applicable. Note that this applies only to options granted prior to July 2021 and qualified options granted after June 2021 subject to the annual CAD200,000 vesting limit measured at stock option grant.
What this means for employees
Under ITA 110(1)(d.4), employees now would be responsible for claiming the additional 1/6 deduction on option benefits under the CAD250,000 limit via their annual Canadian income tax return. To the extent employees elect to take the option deduction in a tax year, the capital gains inclusion rate of 50% would be increased to 2/3 in the same year. This effectively allows employees to choose to allocate this deduction either to the stock option or to their capital gains in that year. Once the employee reaches the CAD250,000 threshold, the deduction is limited to 1/3 and the employee cannot claim any additional amount on their tax return for stock options or capital gains.
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