The Income Tax Act (Canada) (the “Act”) provides employee optionholders with a potential 50% federal tax deduction (the “50% Deduction”) vis-à-vis the taxable gain realized on the exercise of a stock option (typically equal to the fair market value (“FMV”) of the share at the time of exercise minus the exercise price). In general, the 50% Deduction is available for stock options granted with an exercise price equal to or in excess of the FMV of the underlying share at the time of grant, where the share underlying the option is a typical common share without preferential dividend or redemption rights.
Currently, there is no cap on the 50% Deduction, which can make employee stock options a valuable incentive and retention tool.
The uncapped availability of the 50% Deduction may, however, be about to change. Proposals originally introduced in 2019 and formalized with draft legislation published on November 30, 2020 (the “2020 Proposals”) will amend the Act to introduce a new annual limit on the 50% Deduction. The 2020 Proposals will apply to options granted on and after July 1, 2021. However, as of writing, the 2020 Proposals have not been tabled in Parliament, and so whether they ultimately pass in their current or a modified form remains to be seen.
Specifically, the new rules will impose an annual limit on the 50% Deduction for each “vesting year” of an underlying option agreement, which will be defined as the year in which the option agreement specifies the option is first exercisable.
The per-vesting year limit is capped at CAD 200,000 (approximately USD 160,000) of the underlying securities to which the options relate, by FMV, as of the time the stock option agreement is made. In other words, the limit generally tracks, by vesting year, the first CAD 200,000 worth of securities valued as of the agreement date. Employers will generally have flexibility to maximize the 50% Deduction by structuring options to vest over multiple years. For example, an option in respect of shares with an FMV of CAD 1 million (as of the grant date) could preserve the 50% Deduction for all shares subject to the option by vesting in 20% tranches over five years (CAD 200,000 X 5 = CAD 1 million).
The 2020 Proposals exempt from the new cap options issued by a Canadian-controlled private corporation (“CCPC”) and non-CCPCs with annual gross revenues that do not exceed $500 million (a carveout intended to capture startup and emerging companies). If the entity issuing the security is part of a group that prepares consolidated financial statements, the $500 million threshold will apply on a group basis.
Finally, shares in respect of stock options that exceed the CAD 200,000 per-vesting year threshold will be considered “non-qualifying securities”. The 2020 Proposals include a new deduction for an employer equal to the gain realized by the employee on the exercise of an option for non-qualified securities. The employer will also be permitted to designate, in writing, securities that otherwise would be eligible for the 50% Deduction (even under the new limits) to be non-qualified securities, such that the sale or issuance of these securities to the employee will be deductible to the employer and no longer eligible for the 50% Deduction.
- Mark Firman, Stikeman Elliott LLP (Canada) 
 This article has been adapted from Stikeman Elliott’s December 2, 2020 blog post “Further Update on Employee Stock Options”: https://www.stikeman.com/en-ca/kh/tax-law/Further-Update-on-Employee-Stock-Options.