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Taxation and innovation: Striking the right balance

Author(s): Amanda Heale, Dov Begun, Mark Longo, Geoffrey Taber

Dec 9, 2015

A new Liberal majority government was elected federally in 2015 following a campaign that included a pledge to finance certain campaign commitments, in part by increasing taxes for the wealthiest Canadian individuals. A key challenge for the government will be to strike a fair balance between increasing revenues and redistributing income, on the one hand, and creating appropriate and effective incentives for innovation and productivity on the other.

The Liberals’ campaign included two key tax commitments – a promise to increase taxes on individuals with incomes in excess of $200,000 with a new top federal marginal tax rate of 33% and a promise to reduce the ability of high income individuals to obtain tax-preferred stock option benefits by imposing a cap that would apply to employees with over $100,000 in annual stock option gains.

Stock option rules in Canada currently compare favourably with those in our largest neighbour (and competitor for tech talent), the United States. Under existing Canadian tax rules, an employee who acquires shares upon the exercise of an employment stock option is allowed a tax deduction of 50% of the employment benefit (this benefit is calculated as the difference between the fair market value of the share acquired over the exercise price paid by the employee to acquire the share), provided that certain other conditions are met. The effect of this deduction is to tax the stock option benefit at the rate applicable to capital gains – which is one-half of the rate that would otherwise apply to ordinary employment income.

The new Liberal government proposes to change these rules. Although the government’s November 20, 2015 “Update of Economics and Fiscal Projections” did not provide any formal guidance or proposal, the Honourable Bill Morneau, Minister of Finance, stated that details of the proposal remain to be developed “in the next few months.” He did provide some comfort, however, that any changes to the tax rules relating to employment stock options would only affect stock options granted after the government has settled upon a course of action in this regard. Employment stock options granted prior to that time will remain subject to the current taxation regime and should not be affected by the government’s proposal.

Employee stock options are frequently used as part of a compensation package in the technology sector, particularly in start-up companies that are cash-constrained and might otherwise struggle to attract the top talent they need to advance their business. The new government should carefully consider the potential impact of the proposed changes to the taxation of stock options on tech companies’ ability to attract and retain the best talent.