The use of stock options to attract and retain talent in a very competitive marketplace is becoming increasingly commonplace in Canada. As a result, the taxation of stock options has been the focus of much attention recently as businesses and government officials are concerned about Canada's ability to remain competitive vis-à-vis its U.S. neighbour. In his latest federal budget, released on February 28, 2000, the Minister of Finance, the Honorable Paul Martin, proposed changes to stock options taxation in Canada. Due to the changes, stock options will become one of the few items of income that can result in a lower tax burden for Canadians than for U.S. taxpayers. This article discusses, in general, how stock options are currently taxed in Canada, the proposed changes, and how those changes may affect U.S. expatriates currently on assignment in Canada. For a broader discussion of the current and proposed rules related to Canadian stock options, please see the related article, "A, B, C's of Canada's New Employee Stock Option Regime."

Current Canadian Rules

The Canadian Income Tax Act (ITA) taxes Canadian public company and foreign company stock options in a two step process. First, the exercise of a stock option gives rise to a taxable employment benefit in the year of exercise. The benefit is equal to the difference between the taxpayer's cost and the fair market value of the shares at the time of exercise. The taxpayer's cost is equal to the cost of both the shares and the options to acquire them. This is similar in nature to how the United States' Internal Revenue Code (IRC) taxes non-statutory stock options, also referred to as non-qualified stock options (see IRC Section 83). In both countries, therefore, the full amount of the benefit is initially brought into income.

Provided certain conditions are met, Canada then may allow a 25 percent (33 percent under the proposed rules) reduction in the benefit in determining taxable income. The conditions are twofold. Firstly, the underlying shares must be common shares. Secondly, the fair market value of the underlying shares at the time of grant must be less than or equal to the exercise price. This provision essentially means that the net benefit is taxed at the same rate as a capital gain. For 2000 (prior to the proposed changes), the maximum effective tax rate for capital gains for a resident of Ontario was 35.9 percent (31.9 percent with the proposed changes) as compared to the maximum rate, for other employment income, of 47.9 percent.

For a public or a non-Canadian private company there was previously no ability for the recipient to defer the taxation of the benefit. In the case of Canadian-controlled private corporations (CCPCs), however, the taxable employment benefit is generally not included in income until the year of disposition of the share acquired under the option.

The Proposals

The budget proposes to extend the ability to defer the income inclusion to options on publicly traded shares. Employee stock options granted by CCPCs are not affected by the proposed changes. The proposals will apply to any option exercised after February 27, 2000, irrespective of whether the options were awarded before, on, or after that date. In order for the benefit on publicly traded shares to be deferred, the options must meet the following conditions:

• The taxpayer must be an eligible employee. Eligible employees are those who, at the time the option is granted, deal at arm's-length with the employer (and any related corporation) and are not specified shareholders. A specified shareholder is any individual who owns 10 percent or more of any class of shares.
• The option must be an eligible option. An eligible option is one under which:
  • The share to be acquired is an ordinary common share
  • The share is of a class of shares traded on a prescribed Canadian or foreign stock exchange
  • The total of all amounts payable to acquire the share, including the exercise price and any amount payable to acquire the option, is not less than the fair market value of the share at the time the option is granted (this is the same test used to determine whether an individual is entitled to the stock option deduction described above).
• There will be a $100,000 annual limit on the amount of options that an employee can be granted which will be eligible for deferral. (All dollar figures expressed are Canadian dollars except where otherwise noted.) The limit will apply to the value of the stock options that vest (first become exercisable) each year. The value of the stock option is the fair market value of the underlying share at the time the option is granted.

• Monitor compliance with the $100,000 limit
• Report the related employment benefit and stock option deduction on an information slip in the year the share is disposed.

How Changes May Affect Expatriates

The proposals appear to copy a number of the requirements dealing with U.S. Incentive Stock Options, or ISOs (see IRC Section 422). In fact, supplementary information released with the budget draws a direct comparison with the U.S. stating that "The proposed rules are generally similar to those for Incentive Stock Options in the United States."

The proposed changes primarily impact those U.S. expatriates who hold ISOs. Under the old rules, when a U.S. taxpayer, who was a resident of Canada, exercised an ISO, an unexpected consequence arose. The exercise of the ISO, which was tax deferred for U.S. purposes, was a taxable event in Canada. This led to a significant mismatch in the timing of foreign tax credits. The problem was compounded for the employer: where the employee was covered by a tax equalization policy, the hypothetical U.S. tax calculation would not include the benefit resulting from the exercise in hypothetical income, but the actual foreign (Canadian) income would. The resulting foreign tax was thus significantly higher than the hypothetical U.S. tax resulting in a larger equalization payment.

The proposals (currently pending enactment) act to alleviate this problem. The income inclusion from an exercise of an ISO treatment will be deferred, in both countries, until such time as the underlying shares are sold. However, two caveats apply: first, the available deferral in Canada is up to $100,000 (at the 1999 average exchange rate of 1.4898, this translates into USD67,123, which is obviously less than the USD100,000 limit allowed for ISOs); second, the employment benefit is considered a tax preference item for U.S. alternative minimum tax purposes (see IRC Section 56 (b)(3)).

Thus an individual may be subject to alternative minimum tax (AMT) in the year the options are exercised even though no regular U.S. tax will arise. Depending on the sourcing of the benefit arising on the exercise of the options, on the U.S. return, and the mix of the individual's income, this may have not been an issue in the past. If the employment benefit was sourced foreign, a foreign tax credit (FTC) could be claimed against AMT income. As the exercise would have been taxable in Canada, Canadian tax would have arisen on the exercise. The increased foreign taxes could then be used to offset any U.S. AMT liability subject to the 90 percent limitation for AMT FTCs.

With the change, the possibility exists that double tax may now arise. Although it is still possible to offset 90 percent of U.S. minimum tax with FTCs, there is a possibility now that there may not be sufficient Canadian tax to reduce U.S. minimum tax because generally the exercise of ISOs will no longer be taxable in Canada. Therefore, a potential for double tax may still exist if the sale of the underlying shares does not occur in the same year as (or within two years of) the exercise of the ISOs — this is assuming that the employee does not have the means to absorb the AMT credit in the future.

In general, the U.S. expatriate would be entitled to claim a foreign tax credit on his or her U.S. tax return for any Canadian income tax associated with the disposal of the ISO stock. The character of the deferred income would be included on the U.S. return and treated as a capital gain. The character on the Canadian return, however, will still be employment income. Although the character of the income is different for the countries, the Canadian taxes associated with the stock option benefit should be attributable to the capital gain reported on the U.S. return (see Reg. 1.904-6(a)(1)(i) and 1.904-6(a)(1)(iv)).

Conclusion

With proper planning, the proposals should reduce the overall tax costs associated with U.S. expatriates accepting short-term assignments in Canada. The stated goal of the Department of Finance was to "assist corporations in attracting and retaining high-caliber workers" and to quell the so-called "brain drain" to the U.S. in the high technology sector. Not only will these proposals act to level the playing field with respect to Canadians thinking of leaving Canada in order to pursue employment opportunities in the U.S., but they should also help make the acceptance of an expatriate assignment to Canada more palatable.

Post-script

On October 18, 2000, the Honourable Paul Martin, Minister of Finance, released a "mini-budget." One of the items Mr. Martin announced is that the capital gains inclusion rate would be lowered to 50 percent, effective October 18. The employment benefit stock option deduction would also be increased to 50 percent, for post-October 17 benefits, to ensure that the effective inclusion rate for stock options, which qualify for the deduction, is also 50 percent.