Canada and Ontario Grant Tax Relief for Stock Options

According to recent studies, high taxation is at least partially to blame for Canada's much-debated brain-drain, especially that impeding growth in technology industries. In their most recent budgets, Ottawa and Queen's Park introduced measures that should bring some tax relief to high-earners holding stock options.

Canada has enjoyed a sustained period of economic growth fuelled in no small measure by the high-technology industry in recent years. With stock markets booming, employee stock options ' as an incentive ' are more popular than ever. In particular, the use of stock options has been embraced by the high-tech sector as an essential tool to recruit and retain knowledge workers in a competitive market. The value that can be delivered by stock options potentially far exceeds an employee's take-home pay.

For employees in public companies, however, the exercise of their options has always been a mixed blessing. Yes, they have bought shares worth much more than the purchase price (i.e. the stock option benefit). But the tax authorities want their share of that value immediately. Often, the only way of funding the tax liability on the stock option benefit is to sell the shares they have just bought.

Relief is here. In their spring budgets this year, both the federal and Ontario governments have heeded the call from Canadian companies to improve the tax treatment of employee stock options. The Ontario measures in particular target stock options granted by research-intensive companies. Here is a summary of the highlights of the federal and Ontario proposals.

The Federal Tax Deferral
The centrepiece of the federal budget measures for public-company stock options exercised after February 27, 2000 deferred taxation of the stock option benefit, up to $100,000 per year, to the year of sale of the shares.

Only eligible employees holding eligible stock options will qualify for the deferral. An eligible employee is one who, at the time the option is granted, deals at arm's length with the employer (and any related corporation), and is not a specified shareholder (specified shareholders generally own, directly or indirectly, 10% or more of any class of a company's shares). An eligible option is one under which:

• The share to be acquired is basically an ordinary common share;
• The share is of a class of shares listed on a prescribed Canadian or foreign stock exchange;
• The total purchase price is not less than the fair market value of the share at the time the option was granted.

In addition to this tax deferral, employees exercising stock options will benefit from the federal budget proposal to cut the capital gains inclusion rate from 75% to 66 2/3%, and to move the consequential change to the usual deduction for stock option benefits from 25% up to 33 1/3% ' to parallel the capital gains treatment. This means that, in the year the shares are sold, the stock option benefit will now be taxed at a lower rate while the gain from the date of exercise to the date of sale will also be taxed at a lower rate.

Ontario's R&D Stock Option Deduction
Some employees in research-intensive companies in Ontario can look forward to additional relief from their provincial government. Ontario's 2000 budget includes a generous proposal to permit employees involved in qualifying Ontario research and development activities to deduct for Ontario tax purposes up to $100,000 per year for income arising from qualifying stock options. Such income includes both the stock option benefit realized from the exercise of an eligible employee stock option and the capital gain realized from selling the shares.

An eligible stock option is an agreement by an eligible corporation to sell or issue its shares to an eligible employee where the employee is entitled to claim the federal one-third deduction from income under the federal rules. Only stock option agreements entered into after the enabling legislation is enacted will qualify.

In keeping with the R&D focus of this tax initiative, the benefit is available to employees (other than specified shareholders) who:

• Are employed as full or permanent part-time employees by an "eligible corporation" for at least six consecutive months;
• Spend at least 30% of their time directly undertaking, supervising or supporting the performance of R&D in Ontario in the year the option is granted;
• Are Ontario residents at the relevant times (i.e., the year of option grant and the year in which tax relief is claimed).

An eligible corporation is one that:

• Carries on business through a "permanent establishment" in Ontario in the year of the option grant;
• Directly undertakes R&D in Ontario in the immediately preceding year;
• Incurs R&D expenditures (that qualify for the existing Ontario R&D super allowance) of at least $25 million or 10% of its aggregate total revenue in the year before the year in which the stock option is granted.

Public companies throughout Canada with stock option plans will benefit from the federal tax initiatives, while the new Ontario stock option deduction will be a boon to Ontario's high-tech sector. These companies and their employees have cause to celebrate!