Updated on November 23, 2015
As seems to be the case when a new party takes power in Ottawa, things change fast. On Friday we released our predictions for the tax changes that may come in December of this year after the Throne Speech. In particular, we warned the employee stock option deduction may be capped at $100,000 as this was a Liberal campaign promise. At almost the same time we sent out our predictions, the new Finance Minister Bill Morneau was delivering his first fiscal update. In the press conference that followed, Minister Morneau apparently sought to quell speculation about changes in the employee stock option deduction by commenting, “any options in effect will be subject to the taxation framework prior to that date”. Put another way, if an employee has employee stock options now, the new rules will not apply. We are sure that is welcome relief for many employers and employees because rushing to exercise an employee stock option for tax reasons may result in bad investment decisions. Unfortunately, it means a new batch of issues. For example:
1) We have no idea how the new employee stock option rules will apply to unvested employee stock options that will not vest before new employee stock option tax rules come into effect. If an employer has unvested employee stock options and it is possible to accelerate the vesting, that employer may wish to consider immediate vesting. Before changing the employee stock option vesting rules, the employer needs to consider the business/motivational reasons for the vesting. The employer may determine it is more important to maintain the vesting arrangement as is rather than to give the employee access to the employer stock option deduction in excess of $100,000. On the other hand, unvested employee stock options may not be affected by the new employee stock option rules.
2) Changing the vesting provision to the employee stock option plan may result in other negative tax changes to the plan that need to be considered before any change is made.
In our November 20, 2015 email to you, we noted it will be a bumpy ride. This remains the case.
Our predictions released Friday, November 20, 2015 (see update to Employee Stock Option Deductions above):
We have just finished the longest Federal election campaign in modern Canadian history. The Liberals were elected and Justin Trudeau appears committed to keeping his many election promises. We now know Parliament will be called back on December 3, 2015, there will be a Throne Speech December 4, 2015 and that Parliament will sit for slightly more than a week so the Liberal Government can introduce into law the promised “middle class tax cuts”, which means tax increases for those not deemed “middle class”. We have very little time to get ready for what may be coming in December.
Capping the Employee Stock Option Deduction at $100,000
One of the planks in the Liberal election platform is to cap the employee stock option deduction at $100,000. To our clients with employee stock options, this may be the biggest and harshest tax change under the Liberals.
An employee who is granted an option to acquire shares of his or her employer will have a taxable benefit equal to the difference between the option price and the fair market value of the shares on the date the option is exercised (the date the shares are acquired). Depending on the structure of the employee stock option plan, an employee may be eligible for a deduction equal to 50% of the taxable benefit, making the tax rate on the employee stock option benefit equal to the capital gains rate. If the employee stock option deduction is capped at $100,000 as the Liberal’s promised in their election campaign, a lot of employees are going to pay a lot more income tax.
We believe there is a substantial risk the Liberal Government will introduce the $100,000 cap on the employee stock option deduction in December.
We caution that the tax change to the employee stock option deduction is speculation on our part. We do not know if the new tax law to cap the employee stock option deduction at $100,000 will go forward, and if it does, we do not know if it will apply effective January 1, 2016, or at the date the legislation is proposed. Neither do we know if the new tax law will apply differently to employee stock options in private companies or public companies. Lastly, we do not know if the new tax law will apply to existing unexercised employee stock options, or only to employee stock options issued after the new law comes into effect.
What should you do if you are an employee with in-the-money stock options and you are currently entitled to the 50% deduction? Realizing no one predicts what the future holds, and understanding your investment risk, becomes real only when you exercise a stock option. Therefore, you need to first decide whether it is a wise investment decision to exercise your employee stock option before the possible change in tax law in December 2015, or wait until some better time in the future. You must factor into this investment decision the possible imposition of a $100,000 cap on the employee stock option deduction. If you think it is a wise investment decision to exercise your employee stock options before the possible change in tax law, you then need to decide if you should wait until the potential December 2015 announcement by the Federal Government to cap the employee stock option deduction at $100,000, or exercise your options now and take the chance that the tax change does not happen. The tax risk of waiting for the announcement is the possibility that the tax change comes into effect at the date the announcement is made (meaning the 50% deduction on the employee stock option benefit is gone immediately).
Those who decide to exercise their employee stock options in anticipation of the expected December 2015 tax changes need to consider the cash required to fund the acquisition and the tax withholdings. Income tax withholdings on the taxable employment benefit (net of any 50% deduction as applicable) will be triggered with the exercise of the option. However, those with employee stock options in an arm’s length Canadian-controlled private corporations (CCPC) will have their taxes deferred until the shares are sold.
Reducing the Tax-Free Savings Account (TFSA) Annual Contribution Limit
Given the vociferousness of Justin Trudeau’s objections to the Conservative Government’s pre-election goodie that increased the TFSA annual contribution limit from $5,500 to $10,000 per year commencing in 2015, we think it is very likely the Liberal Government will move quickly to bring the limit back to $5,500. This may include limiting the unused 2015 TFSA contribution room being carried forward to 2016 to $5,500. For this reason we suggest you consider making your full $10,000 TFSA contribution for 2015 to the extent you are able before the December tax changes; otherwise, you risk losing the additional $4,500 TFSA contribution room for 2015.
4% Increase in the Federal Top Marginal Personal Income Tax Rate
During the election, the Liberals promised they would increase the personal income tax rate on Canada’s top 1% (defined as those with personal taxable income in excess of $200,000). You do not need a crystal ball to predict that the Liberal Government will be increasing the Federal personal income tax rate on taxable income over $200,000 by 4%.
We have been expecting the top marginal personal income tax rate for B.C. residents to decline in 2016 from 45.8% to 43.7% as a result of the elimination of B.C.’s 2.1% temporary special personal income tax on taxable income in excess of $151,051. For this reason, many people have planned to defer income until 2016. The federal tax rate increase means the tax rate for a B.C. resident with taxable income in excess of $200,000 will increase from $45.8% in 2015 to 47.7% in 2016. Whether the B.C. Government will be like other provincial governments and take this opportunity to increase its personal income tax rate on income over $200,000 is anybody’s guess. In any event, the decision to defer income to 2016 should be revisited if the reason for the deferral was tax savings.
Will the December 2015 Tax Changes Apply Retroactively?
Many times the courts have ruled that the government has the power and authority to make retroactive tax changes. Will the Liberal’s expected December 2015 tax changes apply retroactively to January 1, 2015? It could happen, but we think it is unlikely. The Liberals might be a new government, and Justin Trudeau may be an inexperienced Prime Minister, but the Liberals have to know a retroactive tax change for anything other than to shutdown an abusive tax loophole will create outrage amongst taxpayers, court challenges and uncertainty with business.
As the bus driver in Harry Potter said, “It’s going to be a bumpy ride”. He was not talking about the upcoming tax change, but he may as well have been.
To find out more about these potentially significant tax changes in December 2015 contact us today.