Employees who receive some of their compensation through stock options are eligible (with some conditions) for special tax treatment of their compensation. Lindsay Tedds wrote a great backgrounder on the taxation of employee stock options. I’m going to assume you’ve all read that piece and skip over the technical rudiments that Lindsay so capably described. I’d like instead to pick up and expand on one item Lindsay mentions at the end–the treatment of options for corporate taxes. This is a central issue because it potentially has big implications on the revenue expectations coming out of any change in option taxation.

Right now at the personal tax level, income from exercised options can be partially exempted from taxation using the 110(1)(d) special tax measure. At the corporate level, these options are not deductible by the firm for corporate tax purposes. So, this income is effectively taxed at the corporate level instead of the personal level. In contrast, consider how regular wage compensation is treated. Firms get to deduct the compensation and it is taxed fully in employee hands. It is taxed only once.

About $750 million in taxes were relieved using this 110(1)(d) exemption in 2014, according to the Department of Finance. However, that $750 million estimate is heavily dependent on the first caveat to the estimates listed in the Department of Finance publication. Here’s the assumption:

The estimates and projections are intended to indicate the potential revenue gain that would be realized by removing individual tax measures. They are developed assuming that the underlying tax base would not be affected by removal of the measure.”

There is good reason to expect that assumption does not hold for the case of stock options.

Imagine we removed the 110(1)(d) personal exemption. The key question is what that would happen at the corporate level in response.There are two choices.

First, the government could do nothing on the corporate side. In this case, compensation in the form of options would be taxed at the corporate level as well as the personal level. With this double taxation, it is very likely that employees and employers would find other ways to arrange for compensation.

The attractive alternatives would be those taxed only at one level or the other–not both. Who would choose a form of compensation that is taxed on both sides of the deal? The answer: not as many as happens right now with 110(1)(d) in place–and that means that some part of the full $750 million in potential revenue would dissipate. In fact, many argue that alternatives such as Restricted Share Units (RSUs) and Deferred Share Units (DSUs) are already more tax efficient, and therefore a better choice than traditional stock options.

The second choice would be to allow a deduction at the corporate level, so that option taxation is treated symmetrically with other forms of compensation. However, if this choice is made, corporate tax would go down since firms would now get a tax deduction.

I think updating the taxation of employee stock options is a good policy initiative. All forms of compensation should be taxed as similarly as possible. There are challenges with the case of options because of questions about when to tax them (at issuance? at vesting?) and also how to value them before exercise. But I think we can do better than the current 110(1)(d) treatment.

But, no matter which choice is made, revenue is almost sure to be lower than the full $750 million estimated in the Department of Finance publication.

This revenue shortfall matters for the debate about budgets in the current election campaign. In their 2011 platform, the Liberals introduced the idea of repealing the 110(1)(d) exemption. In March of this year, the NDP also committed to the idea of 110(1)(d) repeal. Since the start of this election campaign, I don’t believe either party has confirmed a repeal of 110(1)(d) will be part of their final 2015 platform. When and if those commitments appear, it is worth paying attention to how the corporate side of stock options is handled, and whether revenue expectations have been adjusted appropriately.

(Update: According to the Ottawa Citizen in the evening of September 1st, the NDP mentioned options taxation as a revenue source, citing the full $750 million.)

My disclosure statement is here.

Kevin Milligan
Kevin Milligan is Professor of Economics in the Vancouver School of Economics at the University of British Columbia, and is also a Scholar-in-Residence with the C.D. Howe Institute and a Research Associate of the National Bureau of Economic Research. Since 2011, he has served as Co-Editor of the Canadian Tax Journal. His research spans the fields of public and labour economics, with a focus on how the Canadian tax and transfer system affects the decisions and wellbeing of individuals and families.

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