Employee stock options at risk of crossborder double taxation

Canadian residents receiving employee stock options from an employer in the United States may wind up paying tax twice. And the government of Canada isn’t making things easier.

Last June, the feds announced coming changes to the taxation of employee stock options. According to a Department of Finance Canada news release, the changes will curb the use of “tax-preferred compensation for executives of large, mature companies” and ensure that smaller, growing companies benefit from stock options as intended.

My initial observation is that any perceived benefit diminishes when employees are not eligible for preferential tax treatment or must file income tax returns in multiple countries, which subjects them to double taxation.

Proposed changes include:

• A $200,000 annual limit on employee stock options that can receive tax-preferred treatment under current tax rules. Employee stock options granted by Canadian-controlled private corporations will not be subject to this limit.
• Start-ups, emerging or scale-up companies that are not Canadian-controlled private corporations and that meet certain conditions will also not be subject to the new limit.
• Employee stock options above the limit will be subject to new tax.

The new rules were scheduled to come into effect for employee stock options granted on or after Jan. 1. However, in late December 2019, the feds announced that they would delay the effective date. Still, no new date has been announced.

Employee stock ownership plans are benefit plans giving employees an ownership interest in the company and include employee stock options, employee share purchase plans, etc. Such plans can be beneficial to both employee and employer. The employee can gain financially over the long term and the compensation received through the plan is taxed at lower rates than regular wages, while the employer has a way to offer remuneration that isn’t cash money.

This is important for smaller start-up companies that have yet to see significant profits. Through employee stock options, employers can encourage a sense of ownership for employees that increases performance, thereby increasing share price.

The employee stock option grants employees the right to purchase shares of the company at a set price in the future when certain milestones are met. This is called “vesting.” Ideally, the value of the stock appreciates over time and employees pay a lower price to acquire the shares. The difference between this “exercise” price and the actual value on the date of the transaction is a taxable benefit and is taxed as ordinary income, while appreciation of the stock from the time of exercise to disposition is taxed as a capital gain.

But for cross-border employees, it isn’t that simple. This is because tax treatment in the United States and Canada do not always align. Both countries treat the taxable benefit recognized from the exercise of employee stock options as ordinary employment income, but there are differences in terms of how the IRS and CRA tax capital gains and how the two countries allow for tax deferral of the stock option benefit.

Look at capital gains. The U.S. capital gains on stock held longer than one year are taxed using preferential tax rates (zero per cent, 15 per cent or 20 per cent, depending on the taxpayer’s income tax bracket). Canada, on the other hand, taxes capital gains using standard income tax brackets. However, a portion of the capital gain is excluded from income tax based on the inclusion rate at the time of sale (currently 50 per cent but the rate is rumoured to increase with the next federal budget).

A further benefit of employee stock options is the tax deferral on the stock option benefit from the time of exercise to the time of the share sale. In the United States, the tax deferral is available to qualified or incentive stock options only, while in Canada, tax is deferred until the shares are sold only if the stock options are issued by a Canadian-controlled private corporation.

Another significant difference between the United States and Canadian tax treatment of employee stock options is the “security option deduction.” A deduction in Canada may be available that is equal to 50 per cent (linked to the capital gains inclusion rate) of the total taxable benefit.

What does this mean?

For U.S. persons who receive Canadian employee stock options or Canadians who receive U.S. employee stock options, there may be a significant timing mismatch of the stock option benefit. Having a timing mismatch is important because it may generate double-tax. Why?

The utilization of foreign tax credits will be compromised, thereby resulting in the stock option benefit being taxed once at exercise and again at sale if the shares are U.S. employee stock options or they are from a Canadian-controlled private corporation.

What’s the best advice? Review your employee stock option agreement to determine if you are eligible for preferential tax treatment. And talk to a trusted adviser who knows the rules in both countries in order to keep your options open.

This article was originally published on February 12 2020 by The Lawyer’s Daily (www.thelawyersdaily.ca), part of LexisNexis Canada Inc