Navigating the New ESOPs Deduction Under the Revised Capital Gains Regime

Posted on January 24th, 2025 in Domestic Tax

Executive summary:

Recent revisions introduced in the Federal Budget 2024, particularly the increase in the capital gains inclusion rate (CGIR) from 50% to 66.67%, have introduced new changes to taxpayers utilizing employee stock option plans (ESOP). These changes impact employees by introducing a new deduction framework under paragraphs 110(1)(d.4) and section 38.01, creating potential for significant tax benefits or, in some cases, tax pitfalls. Detailed scenarios below illustrate how the new rules interact to affect the taxation of ESOPs and capital gains. Despite the increased complexity of the revised framework, taxpayers can take advantage of these changes through proactive and strategic tax planning.

Employee stock option plans (ESOPs) are widely regarded as an effective tool for remunerating and incentivizing employees, particularly in fostering long-term alignment with corporate goals. From a tax perspective, ESOPs have historically provided distinct advantages for employees, including the ability to claim deductions on taxable benefits arising from stock option exercises and, in some cases, to defer tax liabilities to a future date.

However, recent changes introduced in the Federal Budget 2024, particularly the increase in the capital gains inclusion rate (CGIR) from 50% to 66.67%, have introduced new complexities and challenges for taxpayers utilizing ESOPs. Of particular concern is the overlap between the deferral of stock option benefits for Canadian-controlled private corporation (CCPC) ESOPs and the realization of capital gains in the same year, which may make it difficult to optimally utilize the $250,000 annual deduction limit, turning what is often seen as a beneficial rule into an unexpected trap. These amendments alter the tax landscape for employees and introduce new considerations for tax planning. For individual taxpayers, the decision to delay certain dispositions or exercises can create possible tax savings or, in some cases, tax pitfalls.

It is important to note, however, that Prime Minister Justin Trudeau announced his resignation, pending selection of a new Liberal Party leader, and requested that Parliament be prorogued until March 24. As a result, it is possible that the proposed amendments discussed below may not be passed.

Taxation of ESOPs: Existing rules and new regime

Under the current rules, when an employee exercises a stock option, the difference between the stock’s Fair Market Value (FMV) and its exercise price (stock option benefit) is included in the employee’s income as a taxable benefit. For employees of CCPCs, taxation of the stock option benefit is deferred until the shares are ultimately disposed of or exchanged. This deferral provides an advantage by allowing employees to delay the income recognition and the associated tax liability.

Historically, the taxation of ESOPs in Canada mirrored the taxation of capital gains, with employees being eligible to claim a stock option deduction equal to 50% of the stock option benefit. This effectively reduced the net income inclusion of the stock option benefit to 50%.

Changes effective June 25, 2024

Effective June 25, 2024, the CGIR has increased from 50% to 66.67%. Additionally, the stock option benefit deduction under paragraphs 110(1)(d) to (d.3) has been reduced from 50% of the taxable benefit to 33.33%, aligning the net stock option benefit with the new CGIR. Individual taxpayers will be able to maintain the 50% CGIR on their first $250,000 of capital gains annually, which must be shared with any stock option benefits for the year. This provision provides an avenue for individual taxpayers to manage their taxable income more efficiently while still adhering to the revised rules.

Introduction of paragraph 110(1)(d.4)

To accommodate the $250,000 annual limit, paragraph 110(1)(d.4) has been proposed. This provision enables an additional deduction equal to 1/6^th of the stock option benefit up to $250,000, provided a deduction is claimed under any of paragraphs 110(1)(d) to (d.3). In effect, this allows taxpayers to claim a cumulative deduction equal to 50% on the first $250,000 of stock option benefit (33.33% under paragraphs 110(1)(d), (d.1), (d.2) or (d.3) and 1/6^th under paragraph 110(1)(d.4)). Additionally, new section 38.01 has been introduced, allowing for a deduction of 1/6^th of the capital gain for the first $250,000 capital gains annually. However, this deduction is ground down by six times the deduction taken under paragraph 110(1)(d.4). These new paragraphs collectively ensure that taxpayers can achieve a reduced CGIR of 50% for the first $250,000 of combined stock option benefits and capital gains.

Example

The following example models how these deductions interact.

A taxpayer has an ESOP with a public corporation that was issued out-of-the-money for 50,000 shares. The taxpayer has $200,000 of other capital gains realized on the disposition of marketable securities. Consider the following three scenarios (all exercises occur on or after June 25, 2024):

• Scenario I: The ESOP has an exercise price of $10. The taxpayer exercised the option while the FMV of the shares was $20. At the time of sale, the FMV of the shares was $25.
• Scenario II: The ESOP has an exercise price of $10. The taxpayer exercised the option while the FMV of the shares was $12. At the time of sale, the FMV of the shares was $18.
• Scenario III: The ESOP has an exercise price of $10. The taxpayer exercised the option while the FMV of the shares was $10.50. At the time of sale, the FMV of the shares was $11.

Particulars		Scenario I	Scenario II	Scenario III
Calculation of employment benefit
FMV on exercise	(A)	$ 20.00	$ 12.00	$ 10.50
Option price	(B)	$ 10.00	$ 10.00	$ 10.00
Stock option benefit per share	(C) = (A) – (B)	$ 10.00	$ 2.00	$ 0.50
No. of shares	(D)	50,000	50,000	50,000
Total option benefit	(E) = (C) x (D)	$ 500,000.00	$ 100,000.00	$ 25,000.00
Stock option deduction under 110(1)(d)(1)	(F) = (E) x 1/3	$ 166,666.67	$ 33,333.33	$ 8,333.33
Taxable employment benefit	(G) = (E) – (F)	$ 333,333.33	$ 66,666.67	$ 16,666.67
Calculation of taxable capital gains
Proceeds of Disposition	(H)	$ 25.00	$ 18.00	$ 11.00
FMV on exercise	(I)	$ 20.00	$ 12.00	$ 10.50
Capital gain per share	(J) = (H) – (I)	$ 5.00	$ 6.00	$ 0.50
No. of shares	(K)	50,000	50,000	50,000
Capital gain on ESOP shares	(L) = (J) x (K)	$ 250,000.00	$ 300,000.00	$ 25,000.00
Unrelated capital gains – assumed	(M)	$ 200,000.00	$ 200,000.00	$ 200,000.00
Total capital gains	(N) = (L) + (M)	$ 450,000.00	$ 500,000.00	$ 225,000.00
Total taxable capital gains	(O) = (N) x 2/3	$ 300,000.00	$ 333,333.33	$ 150,000.00
Calculation of new 110(1)(d.4) deduction
3 x deduction under 110(1)(d) or (d.1)	(P) = (F) x 3	$ 500,000.00	$ 100,000.00	$ 25,000.00
1.5 x Amount deducted under (d.01)	(Q)	$ 0	$ 0	$ 0
Lesser of $250,000 and difference of the above	(R) = Lower of 250k & (P) – (Q)	$ 250,000.00	$ 100,000.00	$ 25,000.00
110(1)(d.4) deduction	(S) = (R) x 1/6	$ 41,666.67	$ 16,666.67	$ 4,166.67
Calculation of CG reduction under 38.01
250,000 – 6 x 110(1)(d.4) deduction	(T) = $250,000 – ((S) x 6)	$ –	$ 150,000.00	$ 225,000.00
1.5 x taxable capital gains	(U) = (O) x 1.5	$ 450,000.00	$ 500,000.00	$ 225,000.00
38.01 deduction – 1/6 times the lesser of the above	(V) = 1/6 ( lower of (T) & (U))	$ –	$ 25,000.00	$ 37,500.00
Total net stock option income inclusion	(W) = (G) – (S)	$ 291,666.67	$ 50,000.00	$ 12,500.00
Total taxable capital gains	(X) = (O) – (V)	$ 300,000.00	$ 308,333.33	$ 112,500.00

Implications for CCPC ESOPs

Notably, the stock option benefit deferral for CCPC ESOPs under subsection 7(1.1) can inadvertently create difficulties in optimally utilizing the $250,000 annual limit. Since the deferral delays the income recognition of the stock option benefit to the year the individual disposes of the shares, both the stock option benefit and the associated capital gain are realized in the same year. This overlap necessitates careful planning, as the combined income inclusions may exceed the $250,000 threshold, reducing the effectiveness of the deductions under paragraph 110(1)(d.4) and section 38.01. In contrast, taxpayers holding shares outside a CCPC ESOP may have more flexibility in timing their stock option exercises and capital gains realizations.

Key takeaway

The introduction of a new deduction framework for ESOPs under the revised capital gains regime reflects an effort to balance the increased CGIR with targeted relief for individual taxpayers. While the changes introduce new complexities, they also present opportunities for strategic tax planning, particularly for taxpayers able to optimize their use of the $250,000 annual limit.

By understanding the nuances of paragraphs 110(1)(d.4) and section 38.01, and leveraging these provisions effectively, taxpayers can navigate the revised rules while minimizing their overall tax liability. As the tax landscape continues to evolve, proactive planning and adherence to best practices will be key to ensuring compliance and maximizing benefits under the new regime.

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This article was written by Chetna Thapar, Daniel Mahne and originally appeared on 2025-01-21. Reprinted with permission from RSM Canada LLP.
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