A backlash is growing in the business community over a provision in the federal budget that forces employees to pay tax on stock options as soon as they exercise them - but before they cash in the shares.
Until last week, many employees exercising options on public company shares worth less than $100,000 were allowed to defer the tax they owe on the difference between the trading price of the stock, and what they paid for it. That "in-the-money" gap is considered employment income, although only half of it is taxed, in the same manner as capital gains.
In essence, anyone getting $100,000 worth of options, or less, didn't have to pay the tax until the year in which they sold the stock and actually received some cash.
From now on, they will not be allowed to wait. They'll have to pay the tax themselves - or their employer will have to send in the withholding tax - as soon as the options are exercised.
It is unfair to levy tax on a gain that has not taken place, says Jim Fletcher, chairman of Vancouver-based Vision Critical Communications Inc. "There is no cash being realized anywhere in the process of exercising options, but a whopping tax bill is being levied on the [theoretical gain]" The tax should be levied only when the employee sells his or her shares, he said.
Mr. Fletcher's company - a digital marketing offshoot from Angus Reid's polling group - is considering an initial public offering of shares, and this tax change is a discouraging factor that could weigh against going public, he said. Any options issued as a private company do not draw the immediate tax when they are exercised, but once the company is public there will no tax deferral on any new options.
John Hutson, a tax specialist with Deloitte & Touche LLP in Toronto, agrees that the change in tax rules will discourage companies from offering stock options.
Option plans are supposed to provide an incentive for companies to grow and create jobs, but Ottawa's move "has neutered that to some extent," he said.
Mr. Hutson said the budget provisions will force some employees to sell their stock as soon as they exercise their options, as they will have a large, instant, tax liability. That's "counterintuitive to what an option plan is all about," he said. "You want the employees to buy in and then to hold the shares."
A further complicating factor is that companies issuing options must submit the withheld taxes to Ottawa on behalf of the employee as soon as stock options are exercised. If the employee does not have enough income to pay this tax immediately, the firm will have to submit it for them, generating a potentially large liability if a number of employees are in the same boat.
Kelly Kerr, chief financial officer at MegaWest Energy Corp. in Calgary, said the change in rules will cause headaches for many companies in the oil patch where there is a widespread use of options. "It is going to cause some administrative issues at the very least," he said.
Vision Critical's Mr. Fletcher is also concerned with the way options are taxed in general. While the benefit from exercising a stock option is taxed at capital gains rates, that money is considered employment income. If the stock is subsequently sold at a lower price, the employee can declare a capital loss, but that loss can not be used to reduce that employment income.
"No where else in the tax system do you get this asymmetry where they nail you on the way up as employment income, and then give no credit if it craters after the fact."
This is unfair, he says, and generates a strong disincentive from using options to motivate employees. Finance Minister Jim Flaherty may say he is making the tax system more investment-friendly, but that's not the case, Mr. Fletcher said. "It's investment-unfriendly."
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HOW RULE COULD HURT
Here is an example of how the new stock option rules might work in one situation:
An employee, Bill, has been granted stock options by his company, Acme Technology Inc., which allows him to buy 100,000 shares at $1 each.
As the expiry date approaches, Bill exercises the option and buys Acme shares for $1 each, even though the current share price is $3. His paper gain of $200,000 is considered employment income, and he must pay tax on that - although at the 50-per-cent rate that applies to capital gains.
Acme must send the withholding tax to the federal government immediately.
Bill had to raise $100,000 to buy the shares, and he will have to come up with tens of thousands more to pay the tax even though he still holds the shares and has not sold them.
If, some time later, the stock falls to 50 cents and Bill sells at that price, he will have a capital loss that he can use to reduce his capital gains, if he has any. But he cannot use the capital loss to reduce his employment income, which was boosted by the earlier paper gain.
Richard Blackwell