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While income earned from stock options is deemed to be ordinary income under our tax laws, a special deduction was created in 1984 which allows individuals to deduct 50 per cent of the income derived from exercising stock options.

Lindsay Tedds is an Assistant Professor in the School of Public Administration at the University of Victoria. Daniel Sandler is a law Professor at Western University. Ryan Compton is an Associate Professor in the Department of Economics at the University of Manitoba

As part of its 2011 election platform, the Liberal Party of Canada released " Your Family. Your Future. Your Canada." This platform document included two proposals to increase fairness in our tax system. One, the cancellation of the Harper government's corporate tax cuts, received a significant amount of media attention during the election.

The other received no attention at all, which is surprising given the current interest in increasing tax revenues received from wealthy individuals. The ignored Liberal proposal called for limits on the application of paragraph 110(1)(d) of the Income Tax Act that provides for the preferential tax treatment of stock options. A government that says its committed to balancing the budget should give serious consideration to the elimination of this deduction.

Some employees receive a portion of their employment compensation in the form of stock options. A stock option provides the right to buy stock of a corporation within a stated period of time at a specified price. Stock options are used as part of an employment remuneration package in situations where there is a desire to link compensation to company performance. The more the company then grows, the more their stock options are worth.

Stock options have become the single largest component of compensation among CEOs and senior executives at large publicly traded companies in Canada. Executives like stock options because they have made them extremely wealthy, irrespective of the individual or collective managerial acumen.

In Canada, the income earned from stock options is granted preferential tax treatment when compared to other forms of employment remuneration. Under Canadian tax law, stock option recipients do not incur a tax liability on stock options until the options are exercised. The amount that must be included in income from employment on exercise is equal to the difference between fair market value of the stock on the date the option is exercises and the strike price.

While income earned from stock options is deemed to be ordinary income under our tax laws, a special deduction was created in 1984 (paragraph 110(1)(d)) which allows individuals to deduct 50 per cent of the income derived from exercising stock options. That is, only half of the employment benefit from stock options is subject to tax.

As an example, let's say the CEO of WidgetCo earns an annual salary of $500,000, and for this fiscal year also received a bonus of $400,000. Given this income level, the CEO faces the highest marginal tax rate on any additional income. We will assume a combined federal and provincial marginal tax rate of 45 per cent.

On March 1, the CEO elects to exercise previously awarded options. The company's stock is currently trading at $20. She exercises 100,000 options and sells the obtained shares from the exercise on the same day (more than 90 per cent of executive stock options are exercised and sold on the same day) which were granted with a specified (exercise) price of $15. The exercised shares are valued at $1.5-million (100,000 options at $15 a share) and the sale is valued at $2-million (100,000 options at $20 a share). The CEO then derives an employment income benefit valued at the difference of these two amounts, which is $500,000.

If the full $500,000 was taxed, as it should be, she would pay $225,000 in taxes leaving her with after tax income from the stock options of $275,000. But because of the special deduction, she only pays tax on $250,000 of the income benefit for a total of $112,500. That is, with the special deduction, the CEO pays $112,500 less in tax than she would otherwise.

Let's be clear: This $500,000 is not a capital gain. A capital gain only accrues if shares are bought and then held because there is an element of risk associated with the holding the shares. By buying and selling the shares on the same day, she is simply realizing the income benefit that had been attached to the awarded stock options. It is simply deferred employment compensation.

The purpose of paragraph 110(1)(d) was to encourage more widespread use of employee stock option plans. However, no clear causal link has been established between the increasing use of stock options and the existence of the tax deduction. That is, there is no evidence the deduction achieved its stated goals.In the United States, the use of stock options has increased much faster and have risen to a far higher level than ever witnessed in Canada, despite a more limited tax preference.

The Liberals are proposing to limit the deduction to the first $100,000 in annual employment income benefit from stock options, for a projected total increase in tax revenues of approximately $300-million a year. While the Liberal proposal is a step in the right direction to address unfairness in our tax system, our research ( here, here, and here) clearly demonstrates that the entire deduction should either be eliminated (by repealing paragraph 110(1)(d) of the Income Tax Act) or a holding period should be attached to the exercised shares in order to qualify for the deduction, as is the case in the United States.

Making this simple change to our tax system would ensure that wealthy Canadians are paying their fair share of taxes. It would also make a significant dent in the government's efforts to balance the budget and restore fairness and progressivity to our tax system.

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