Mike Brown has been in the venture capital business for 45 years, with experience in privately funded, early-stage technology companies.
Encouraging employees of private companies to buy shares in their companies must be a crucial part of any federal innovation policy. However, Canada's taxation of options detracts from efforts to stimulate the innovation economy. The recent decision to increase taxes on the exercise of employee stock options is a good opportunity to take a holistic look at these taxes to ensure we get it right.
An employee stock option is the right to purchase a share in the company where the person is employed, some time in the future, at a price that's fixed the day the option is granted. The rules rightly require that this exercise price cannot be less than the fair-market value of the shares when the option is granted, so there is no benefit as measured between these two prices.
The employee really realizes a benefit only when the company prospers, shares increase in value and become liquid, and are sold. None of this is a sure thing. I believe that fewer than 20 per cent of private company options ever get to be "in the money." Moreover, most of the time, shares in private companies are not liquid.
In Canada, the rules are that if employee options are exercised, this always gives rise to what the Income Tax Act defines as an "employment benefit," which is the excess of the deemed value over the exercise price. This means the employment benefit occurs when the shares are bought, not when they are sold.
That employment benefit is treated as taxable employment income. There is no other circumstance in Canada where a taxpayer pays income tax when a share is purchased. Yes, under the proposed new rules, up to $100,000 per annum of this employment benefit is taxed at 50 per cent of standard rates, but it's taxed as income, not as capital gain.
Gains should be taxed only when the shares are sold, as capital gains, the same as an investment in any other shares – where half the gain is taxed.
All employee options have an expiry date, which can be anywhere from five to 10 years after the original option is granted (known as the "exercise period"). When an employee leaves a company or dies, or if the exercise period is expiring, the employee might exercise the option even if the shares are unsaleable.
It would be helpful to get an explanation why there is a "benefit" when the employee buys the shares. Or why this is fair. Or why it helps Canada. But in the real, private world, investment risk is a risk no matter how you measure it. Buying any security involves a risk. Shares from options are not automatically valuable just because they are bought.
Governments, institutions and other companies attract employees by using pensions, with their contractual and often indexed retirement benefits. Most small companies have no pension plans. Employees are not taxed when the employer contributes to the pension plan. Consistency in tax treatment would recognize that an employee who exercises a stock option has received no benefit, just like employees who receive pension contributions from their employers. In both cases, the real benefit occurs only when they receive cash – either from a pension payment or from a gain when they sell the shares. Let's be consistent.
There's another damaging problem built into the current taxation regime. Under the Income Tax Act, capital losses can be offset against capital gains – but not against income. Over the years, I've known many instances where an employee has paid income tax on the employment benefit, but then the company goes into decline or fails. The shares become worthless. But that loss is deemed to be a capital loss, and cannot be offset against income. This negative ratchet leaves those employees with tax bills on worthless shares. Is this fair? When a company fails and employees lose their pension benefits, they don't have the insult of paying taxes on the injury of not receiving the pension payout.
Employees and investors understand this unfair tax treatment. Companies use an option scheme as an incentive to attract and reward employees, reducing cash outflow while the company is still young and cash-constrained. If options have little appeal, employees seek more cash compensation. Young companies ask their investors for more cash, adding to their already difficult capital challenges.
American venture capitalists just shake their heads. In the United States, employees are taxed when they sell the shares. Tax regimes drive investor behaviour, with investors motivated to move the good companies south.
Canada needs an integrated innovation policy, complete with the incentives of a fair and competitive taxation plan. Options should be in any employment package for those entrepreneurial souls who have the nerve to work for the very companies we need. Can Finance Minister Bill Morneau pause, canvass the affected parties and put the government on the right track?