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Fixing Canada Revenue Agency’s stock option rules

I got the following note in email from Ragui Kamel, who's trying to raise awareness of a nasty gotcha in Canadian taxation rules for stock options.  We discussed it in email yesterday, and will be having a Special Edition Squawk Box call on Friday afternoon.  Anyone who cares to join is invited, but especially those who live in Canada.  The call is hosted on Facebook.  If you don't have a Facebook account, please email me personally and I will send contact details. 

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From: Ragui Kamel 

Subject: This shouldn't happen in Canada – Please support 

Did you know that CRA taxes people on income they never received?
 
The situation arises due to an anomaly in the tax act when you exercise and hold stock options.  When you exercise the options, you are deemed to have an employment benefit on the value of the shares on the day of exercise.  But, if you hold onto the shares and they crash, as many did in the bubble, your loss of selling these same shares is a capital loss.  Here is the tricky bit:  the capital loss cannot be used against the employment benefit so you are taxed … even though in reality you may have lost money!  This is a tax on phantom income.  As a simple example, an employee exercises stock options at $15 when the stock is at $115. He is deemed to have an employment income of $100. He then holds onto the shares and sells them, as the stock tanks for $15. He now has a capital loss of $100 but he cannot use that to offset the employment income so he ends up being asked to pay tax on $100 he never made!

I was personally caught in this and had to send CRA a sizeable cheque … but at least I could afford it.    

I recently became aware of and joined Canadians for Fair and Equitable Taxation (www.cfet.ca), a group of people caught in the same technical tax trap and was horrified by the human impact of this quirk in the tax law.  Some examples

  • A single mother of two children who sold her options stock for $2000 and was taxed $50,000
  • A couple working on the assembly line, each making roughly $35K a year who got hit with a tax liability in excess of $50K
  • A software developer who had to cash his RRSPs and re-mortgage his house to pay the $80K in taxes he owed on phantom income.
  • A 68 year old retired engineer from Nortel who already has given the bulk of his savings to CRA and, because he deferred some option "benefit" is living in fear that Nortel is sold and the benefit triggered.  He would have to give all his retirement savings and, given his age, cannot remortgage his house.  In his words: "I pray I die before Nortel is sold"  

Clearly taxing people on phantom income is unfair and un-Canadian.  But it is shocking that 7 years later and, while they are well aware of the human impact, politicians have done little to fix matters.    

In the US, a similar situation is being fixed as we speak through a Kerry/Lieberman bill … but, two suicides have been attributed to the issue.  Are deaths what is needed for our politicians to act??  

On behalf of the thousands of impacted Canadians, I am asking for your support to make this issue more prominent and to push for its resolution.  Please do three things

  1. Sign the online petition at http://www.ipetitions.com/petition/cfet/signatures-1.html
  2. Write to your MP and to the minister of finance expressing outrage that this situation should occur in Canada.  Feel free to borrow from this email or from the material on www.cfet.ca
  3. Forward this note to others to raise awareness of this issue.  

Canada is a great country with a reputation for fairness and compassion.  This issue is a blemish on Canada.  Please help get it fixed

{ 36 comments… add one }

  • Duane Storey April 1, 2008, 11:22 am

    This is a really old problem, and many people in the dot com era in Canada got burned by it. Bad news is that yes, you do have to pay tax on gains you never received. Good news (if you can call it that) is that it's a capital loss and can be used to offset future capital gains.

    But it still sucks, and needs to be changed.

  • Don't agree April 1, 2008, 11:56 am

    I agree with the tax rules. If you are scared of the tax liability, only exercise your options when you are ready to sell. Options are a taxable benefit. Why can't people understand this? If the stock drops like a rock, you should have been working harder at your job instead of worrying about these clear and simple tax rules. Now get back to work.

  • Alec April 1, 2008, 12:06 pm

    I'm not scared by the tax liability, Don't. I am saying it's easy to get trapped by the tax liability. CRA should make the capital gain from the option taxable at the time of exercise or make the capital gain taxable at the time that the stock which is held is sold. For ordinary folks, who aren't tax savvy, this is a ticking time bomb.

  • Keith Quan April 1, 2008, 12:34 pm

    Alec:

    So it sounds like the tax rules are the same in the US and Canada. The issue of stock options and the sale of stock are treated as separate transactions, both subject to tax. It's just that the IRS collects the tax at the time the option is exercised, whereas the CRA relies on the individual to declare the income on his tax return and pay the applicable taxes when he files.

    I agree the IRS way is better since is prevents ordinary folks, unfamiliar with tax law, from taking the double hit that Ragui is describing.

  • matt roberts April 1, 2008, 1:04 pm

    Essentially, you guys are calling for a sorta withholding tax on Exercised Option Gains or more accurately an Immediate forced sale of the taxable gain amount the from value the options. Why is this a good idea?

    This of course makes alot of sense if the stock options
    A) are not restricted on when you can exercise them
    B) You believe the stock is going to go down after exercise them (because with this new withholding tax you have to sell a bunch of your shares immediately to cover the tax.)

    I would be royally pissed off if i was forced to exercise my options (because they were expiring) in feb, forced to sell 30 % at the feb price and the stock doubled between march and December. So I've essentially lost out on 30% of the stock upside. Today, the government lets me decide on the risk I'm willing to take.

    Personally, I believe many of those that held their shares did so in the belief the stocks would go up. Perhaps a withholding tax would save people from this, but I don't particularly believe the system is broken or unfair. People should, when coming into large amounts of money always contact a tax specialist, and decide how comfortable they are with the risks they are taking on.

  • Steve April 1, 2008, 2:01 pm

    Alec, yes I agree however I believe the CRA rules are different for public and private companies, due to the illiquid nature and subjective valuation of private company shares. The scenario you describe above, where someone takes options in lieu of cash sounds much more like a private startup and in this case the income tax exposure is triggered when the shares are sold.

    In the case of public companies, it seems to me that there is a major onus on the employer to clearly inform employees of the general tax consequences of their options programs and strongly encourage employees seek their own personal tax advice. As for the senior public company execs, the ones with the big comp plans and huge options packages… I guess I have much less sympathy for them, and they generally do qualify as "sophisticated investors."

  • Alec April 1, 2008, 3:45 pm

    The tax code is really stupid on this one, Duane. CRA should tax the option holder at the time the gain is actually realized.

  • Keith Quan April 1, 2008, 4:10 pm

    Actually, the tax code isn’t all that stupid. (And, no, I’m don’t work for CRA.)

    CRA treats the two transactions separately. The first is the issue of stock options by the employer. This is deemed to be employment income. The second is the sale of the stock by the employee, or stockholder. This is deemed a capital gain or loss.

    Look at it this way: If the employee gives you options at $15 and you exercise at $115, it’s the same as the employer paying you $100 in cash. If he were to do the latter, CRA would tax that $100 at your marginal tax rate, leaving you with some amount less than $100… let’s say $70. Then, with your $70, you purchase stock at current market rates ($115) and it plummets to $15. You would then write off a capital loss of $100 per share purchased.

    What Ragui Kamel is complaining about is purchasing stock using before tax dollars and then having to pay the tax on those dollars after he sells the stock at a loss – effectively giving him a “double hit”. What he should have done is exercise the options, sell off enough stock to cover the tax bill, and then hold the remaining stock, which would be subject to capital gains/losses when he sells.

  • Alec April 1, 2008, 4:18 pm

    Keith, having lived in the US, I think that the way that the IRS taxes options more sense. What they do is collect tax at the time the option is exercised. There is no possibility for the option holder to defer taxation. Sophisticated investors have been known to use margin accounts, when the spread is large enough, in order to be able to exercise and hold, but ordinary employees tend to exercise and sell.

    It’s the same end result as you’ve described, but ordinary folks tend to take the less risky option.

  • Steve April 1, 2008, 4:33 pm

    I am always sympathetic to anyone who suffers a catastrophic financial loss. After discussing this situation with a tax accountant, however, it seems the reasoning behind CRA’s rules are at least based on a principle that is not easy to argue against.

    Using the example above, Mr A exercises his options and pays only $15 in after tax savings to *own* stock that is in fact worth $115. At the same time Mr B, out of his after tax savings, buy shares in the same company and also pays $115. (Note: Mr. B had *already paid income tax* in order to have the “savings” to buy at $115.) Both shareholders then *choose* not to sell until the the shares reach $15.

    How then could it be fair for Mr. A to be treated preferentially, avoiding the income tax on his share purchase “benefit” when Mr. B had already had to pay income tax to become an identical shareholder?

    Oh yeah…, whether for an individual stock or the market as a whole, the next time you hear talking heads providing blanket advice to “buy and hold” and “not to panic”, recognize that:
    1) At that very moment, they and the institutions they represent, are almost always selling as fast as they can; and
    2) Knowing what & when to sell is as important as knowing what & when to buy.

    Taxes suck. F*cked companies suck more.

  • Alec April 1, 2008, 5:05 pm

    Steve — the thing which is often overlooked is that otherwise unsophisticated investors have now taken a stock option in lieu of cash compensation. Mr. A obviously shouldn’t be treated preferentially. My argument is, in fact, with the rule that allows the ordinary individual to defer tax. It’s a ticking time bomb that will catch that unsophisticated investor in a financial trap.

  • Alec April 1, 2008, 5:27 pm

    Matt — I think we can agree on “contact a tax specialist”. 😉 I also don’t think the solution of taking a margin loan as they do in the US is a bad solution. It still gets you nearly all of the upside, but it also forces reflection on how much risk you’re really willing to take.

  • Alec April 1, 2008, 6:45 pm

    Steve, I think the situation where options were given in lieu of cash was, while not explicitly stated, at least implied through much of the 1990’s even at public companies. I remember my own situation going to Microsoft. My salary was a little less than I might have expected elsewhere, but stock options were there. My hiring manager referred to them as ‘gravy’. ie. they might not ever be worth anything.

  • matt roberts April 1, 2008, 7:21 pm

    :-) First thing i did was contact a tax specialist, when my options bounced up in price.

    I would point out that most organizations. made these available to their employees during the last bubble. The vast majority of people chose to take the gamble. One example from my memory was the Mess for the Extreme Packets team after PMC-Sierra took them out back in 2000/01. The options transferred into PMC Options which were in lock up, but I believe were considered a taxable gain. The stock subsequently tanked but left a significant tax liability for some people. with the shares falling many were forced to sell quickly to clear out their tax debts.

  • Alec April 1, 2008, 9:03 pm

    Brutal. I’ll bet the Extreme Packets folks wished they had just cashed their options out and paid the tax man. PMC should have issued new options rather than exchange them.

  • matt roberts April 2, 2008, 11:48 am

    I believe the majority of the issues came about from PMC being listed in the States. (Extreme Packets may very well have been incorporated in Delaware) the employees of course were all in Canada so had to navigate the two jurisdictions.

  • ragui April 2, 2008, 1:20 pm

    K … since I started this, time I joined the debate. Four points to make

    1. Creating a tax liability when you buy stock via options is the only event in the personal tax code where you create a liability for buying something. No wonder people are confused … and that includes accountants and tax lawyers

    2. What you are buying is stock .. you are buying it at X and its value is Y. This should be clearly a capital gain (it is even calculated as a capital gain) … so why the silliness of treating as other than a capital gain?

    3. Regardless, this technicality (and it is a technicality) has caused misery to lots of people … many of whom are being ruined. How about the $14/hr assembly worker who finally thought she would have a little cash only to find a tax liability that causes her to lose her home. Let's transcend legalistic arguing about a flawed law and show some compassion

    4.The US had an analogous situation but have the wisdom to be fixing it via a John Kerry/Joe Lieberman bill currently going through congress. We are Canadians who pride ourselves on traditions of fairness and compassion and we can't fix it? Makes me want to move

  • Larry April 2, 2008, 1:52 pm

    "Look at it this way: If the employee gives you options at $15 and you exercise at $115, it’s the same as the employer paying you $100 in cash."

    Keith: Whether this is or not the SAME is pretty much a subjective debate. I do not think it is the same. There was never any cash layout by the employer in the transaction. The employee purchase the share at $X when its value was determined by market participants at $Y. The different is capital gain by any definition.

    Today, many homes are sold or bought at below appraised or assessed value. Should the buyers of these homes be deemed to have received a benefit or income and thus forced to pay a tax on such difference between purchase price and appraised/assessed value of the purchase?

    In the Canada, the ESO benefit is taxed like capital gain. Why is that? Because the authority clearly recognized that it is nothing but capital gain. For some reason, such capital gain is "deemed" to be income. On what basis was this "deeming" justified?

  • Alec April 2, 2008, 2:08 pm

    Cross border option navigation is not for the faint of heart. It means accountants and lawyers on both sides of the border.

  • Peter Childs April 2, 2008, 2:59 pm

    I have a more general concern – whenever governments ‘deem’ value on something where the value is actually set by the market they always introduce inequity and distortions.

    Two places where this is a distinct problem is marketvalue assesment for houses and stocks. Neither of these items actually establishes its real value until their is a transaction – as the price elasticy for stocks post 2001 and current US realestate housing clearly demonstrate.

    For stocks the isses is even worse because market analysis often impune the value of a company by multiplying current stock value by all shares – but unless the company is drastically undervalued AND central bank policies have encouraged cheap money – no one would buy all the shares at the market price. It’s generally a fiction that the value of a company = stock price * all shares.

    The CCRA position is a travisty.

  • Peter Childs April 3, 2008, 4:03 am

    To echo Larrys comment – which at it's heart questions whether an unexcersised option is a capital gain – I'd just ask:

    If the option is locked in, and if it could be sold, would it be sold at a discount.

    And of course the answer is Yes – because their is risk associated with future value.

    That's exactly the same process that applies to locked in bonds – where the faith in the underlying companies ability to meet it's obligation and the time until the bond becomes due strongly factor into it's present value.

    Locked in options are worse because the stock market in much more volitie than the bond market, so present value is much harder to determine.

    I raise this because I believe if you are going to change the law you have to start where the discrepancies are greatest – and determining the value of a locked in options is that place.

    Next step is to deal with the cases where options were included as a standard part of the employement package – ie the employee did not elect to purchase but was obligated to.

    Then move to the case where the employee is given the right to buy options as part of their compesation at a discounted rate off the current stock price. Here I would argue that where the option is locked in the employees decision includes two components – the delta between the current value and a discount to address risk that future value will not be the same as present value. I'd go further and agrue that where the delta is large that both the employee and the employer beleive the risk that future value will change is substantial.

    It's not hard to argue this when one looks at the P/E of many of the companies that offer options.

    While it's a nice tax grab it doesn't jive with either the government own practice or fundamental economic behaviour – and for that reason it's unreasonable to call an excersised option a capital gain.

  • matt roberts April 3, 2008, 12:38 pm

    Some Options and shares are locally traded by employees who have transfer rights – there's abit of an underground economy in them.

    Larry: Options in the US are now expensed as a cash expense on corporate books. While I don't believe they are in Canada, there has been a hit to shareholder equity on the books . SO in many way there is an Expense to the employer and the owners. Just cause its not profit sharing (physical Cash) doesn't mean its not considered capital.

  • Larry April 3, 2008, 1:22 pm

    Options in the US are now expensed as a cash expense on corporate "books."

    Matt: How will this new development affect the taxation of ISO in the US? As I read the from the IRS website (2007), the IRS considers the granting and exercise of ISO non-taxable event. Will this new development change this? If so, how will the value of the ISO at the time of grant be determined? Previously, it was deemed to have a value of $0 since there is no market for such options, and the strike price is set at the FMV of the underlying stock at the time of grant.

  • Isalexus April 29, 2008, 2:07 pm

    How can it be fair to tax someone when there is actually no money earned or made? How can it be fair if one is forced to immediately sell “shares” from a stock option just to protect one self from taxation of “PHANTOM” earning?

  • Brad July 22, 2008, 3:53 pm

    WRONG – This entire discussion does not have all the facts. In Canada if an option holder exercises his/her options they can defer the taxable benefit until they actually sell the shares. It requires notifying your employer by the end of the tax year so that they get the T4 information correct and you also have to complete a separate disclosure for CRA identifying the amount deferred as part of your tax return. This came into law about 5 years ago to specifically fix the problem identified at the start.

  • Albert October 6, 2008, 3:44 pm

    READ BELOW, YOU ARE ALLOW TO DEFER REPORTING THAT TAX BENEFIT WHEN YOU ECERSICE YOUR OPTIONS UNTIL THE DATE YOU DISPOSE OF THEM, I HOPE THIS IS USEFULL
    CHEERS

    Line 101 – Security option benefits A security option benefit occurs when you are allowed to buy securities through your employer at a pre-established price which is less than the fair market value of the securities.

    If your employer is a Canadian controlled private corporation (CCPC), which you deal with at arm’s length, you only have to include this taxable benefit on your tax return for the year you sell the securities. If your employer is not a CCPC you may have to report taxable benefits you received in (or carried forward to) the year you exercise your stock option.

    However, you may be able to choose to defer reporting these benefits if you have not yet disposed of those securities.

    To defer reporting those benefits, you have to confirm certain information in writing with your employer (or the person who would be required to file an information return about your acquisition of securities). You also have to attach, every year, Form T1212, Statement of Deferred Security Options Benefits, with your paper return. For more information, see Guide T4037,Capital Gains, or contact us. Your Notice of Assessment or Notice of Reassessment will show the remaining balance of your deferred amounts.

    To claim a deduction on your stock options, see line 249 – Security options deductions

  • Wendy November 19, 2008, 12:41 pm

    Argh! I have no sympathy for those people. They were just greedy. They should have sold enough shares to cover their tax debt and hold the rest if they want to. The stock market is like gambling. Not too mention you can’t have it both ways. People want capital gains treatment when there is a gain but want income treatment when they have a loss. It just doesn’t work that way.

  • S. Kumar Agarwal January 24, 2009, 3:16 pm

    I want to know how Deferred Stock Options Benefit would be treated if
    Nortel goes bankrupt?
    Does anybody know it?

    Thanks.

  • Tom March 18, 2009, 5:53 am

    There is still confusion if the employee’s company was a Canadian-controlled private corporation. Unlike a public company, there is generally no way to sell the shares that the employee has received as there is no market (stock exchange) to establish a truly fair market value. There is no way to value these shares other than what the company tells their employees, which will generally be higher than reality. Further, any attempt to sell the shares privately or back to the company could not be done without the employer’s knowledge. This would be looked upon very negatively by management – likely risking the employee’s advances or employment within the company, and it risks receiving favorable references if the employee is no longer with the company. The employee/shareholder is forced to hold onto them and hope for the best.

    If you exercise options for stock in a CCPC, I truly don’t believe you even receive a firm monetary benefit until you are able to sell them (i.e. the company goes public or is purchased by another company). Unlike a public company, you cannot simply turn around and sell the shares at the time you receive them – or take the chance from that point forward that there will be a capital gain or loss. The recent tax laws make holding onto the shares easier to swallow if it is a public company, but I don’t think there is a real need to worry about it if it is a CCPC.

    Please feel free to correct me, but for a CCPC I think when you exercise you option to buy a share for say $1, that is simply equivalent to you buying the shares outright at that price. Even if management says it is worth $100 per share, it is meaningless since there is not true way to establish a fair market value. Later, if you sell at $10 then that is the time you claim a capital gain based on the sale price less the cost base (i.e. $10 – $1 = $9/share).

  • Braden April 2, 2009, 9:42 pm

    When this horrible tax law is corrected (or thrown out), the government needs to pay back the taxes unjustly taken from these people, with the interest or gains that this money might have otherwise made.

  • Braden April 3, 2009, 12:55 am

    Wendy: you have no sympathy for these people because it is clear you don’t actually understand their situation; consider this example: Mary has options to buy stock at $2 per share, and the market value of that stock is $20 per share. Her husband is unemployed, and they need to pay back the $20,000 loan borrowed against the equity in their home to pay the bills. They’ve run their loan dry and are out of cash, so she figures that this is the best time for them to exercise some of her vested stock options, so she instructs her investment broker to exercise enough shares to cover the loan, plus pay taxes based on her salaried tax rate. She instructs her broker to exercise and sell 1400 shares at a gain of $20-$2 = $18 per share, expecting to gross $25,200. So she gets a short term loan from the broker for $2,400 and her broker requests the approval to exercise of 1400 shares from her employer, receives a certificate of shares issued, and proceeds to probe the market for buyers. Meanwhile her employer’s stock plummets that day, and the broker is only able to find buyers at $19 for 100 shares, $12 for another 200, $8 for another 400, $5 for another 300, and $2 for the remaining 400. In total she receives a cheque for only $7,400 ($9,800 – $2,400 broker loan), far short of her goal. BUT she is now on the hook for tax on 1400 shares at $18 per share. How is this greedy and how is this deserved?

  • Braden April 3, 2009, 1:04 am

    To clarify my earlier post, I think I need to add that where the tax law is not fair and just is that it irrationally and illogically taxes the phantom gain of $25,200. A more rational and logical tax law would tax the actual capital gains, or allow a claim of capital loss if the market price dropped below the exercise price at the time of sale.

  • IP May 26, 2009, 8:49 am

    There is plenty of discussion as to how people get screwed when the stock value plummets. What happens if the stock skyrockets? CRA cannot afford to tax these exercised options as a capital gain at the time they are exercised and then held. If they did, would it then mean that the profits realized after the stock skyrocketed would be tax free because tha capital gains tax had already been paid at the time the options were exercised? How many times can they tax you for exercising your options?

    It appears to be a fair system until the anomolous situation where a stock's value plummets in a very short period of time while someone is attempting to excercise their options.

    Perhaps a better plan would be to lobby the gov't/CRA to modifiy the rules somewhat depending on what your intent is when you excercise your options. At the time of exercising, you declare your intention to hold or immediately sell. If you intend to hold, the taxes are due immediately based on the idea this is a taxable benefit and you are required to sell sufficient stock to cover the taxes and hold the rest. Anything you hold from that point on is taxed based on capital gains rules. If your declaration is to sell immediately, you are not taxed until the intended block is sold and you pay based on capital gains rules. That should keep it fair….however this will never happen as we all know that there is nothing fair when it comes to the CRA….

  • Patrick May 27, 2009, 7:49 am

    Let's abolish the CRA + all taxation. Let's make the funding of government voluntary. How is forcing people at gun point to pay for government compatible with a free-society?

  • Rodman June 11, 2011, 2:31 pm

    I've read all the comments above and am wondering if anything has changed WRT taxing of phantom income.

    In 2010 I exercised some options which were converted to shares. By the time the shares arrived and were sold the value had dropped by $10K. I now owe an $2500 in tax and have a capital loss of $5K that I will not be able to claim as I don't play the market.

    Has anyone recently challenged this with CRA?

    • asaunders June 11, 2011, 9:40 pm

      I haven't heard of any changes, but I don't track this very closely either.

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