One of the measures in Budget 2010 (Pages 356 to 358) will be of special interest to Ottawa-area residents who elected to defer taxes on stock options. Some taxpayers who took advantage of tax deferral on stock options experienced financial difficulties when the value of the stock they received when exercising stock options declined in value. Budget 2010 proposes a special elective treatment to ensure that the tax liability on a deferred stock option benefit does not exceed the proceeds of disposition of the optioned securities taking into account tax relief resulting from the use of capital losses on the optioned securities against capital gains from other sources.

For example, let’s say you exercised options in 2001 to buy ABC at $50 and your strike price was $10. You elected to defer the taxes on the stock option benefit of $40 to the future. Your ABC stock only worth $5. If you sell ABC today, you’ll owe a tax on the stock option benefit of $40 but you’ll also have a capital loss of $45. Budget 2010 will allow you a deduction equal to the stock option benefit ($40). You’ll also declare an amount equal to half of the lesser of the stock option benefit and the capital loss on the optioned securities (1/2 of the lesser of $40 or $45) in your income as a capital gain. Essentially, the capital gain will wipe out the capital loss on the optioned securities.

If you disposed your optioned securities before 2010, you have to make an election for this special treatment on or before April 30, 2011. If you have not disposed of optioned securities before 2010, you must do so before 2015. Also, the Government has repealed the tax deferral election effective today.

This article has 24 comments

  1. Is it limited to Ottawa-area residents?

  2. Canadian Capitalist

    @Potato: Not at all. The Government earlier had provided relief to *some* JDS employees. The Budget extends it to everyone who was affected by the deferral.

  3. I saw the same thing and wrote about it. If it is what it appears to be, I’m very happy. What I’m not sure of is whether I can make this election before filing my 2009 income taxes. And if I can, how is this done? It seems unlikely that QucikTax, UFile and others will have this incorporated soon, but who knows?

  4. Seems like a lot of people didn’t understand their tax liabilities when they made the deferral election. Very lucky for them, the government has bailed them out when they knowingly or unknowingly took on substantially more risk than they should have. Talk about a major free pass when they screwed up on both the investing and taxation sides.

    Imagine you only messed up the investment side…

    Consider the posted example with an employee did not make the tax deferral and held onto the exercised shares. They paid taxes upon exercise at $50, the stock went down to $5 and they sold low. They’re left with $5, a $45 capital loss, and paid taxes on 50% of $40 some time (possibly years) earlier.

    Similarly, an employee paid in restricted shares instead of options would have paid taxes on 100% of the $40 upon receiving the shares. Bigger loss. No bailout.

    And what about the person who buys the shares at $50 using after tax dollars and rides it down to $5???

  5. P: I agree with you that people didn’t understand the risk they were taking. However, I definitely don’t see this as a case of the government bailing them out. The government set a trap with crazy tax policy and then decided to (partially) let people out of the trap. I don’t see this as a bailout. It is more recognizing bad policy and applying a patch that helps in the most egregious cases. I still think it makes no sense to have someone make X dollars and lose X dollars and owe money in taxes because they are considered different categories of income.

  6. P: In the other cases you mentioned, the investor actually has (or had) the money to pay the taxes owing. All of the capital gains and losses will work themselves out over time. In the stock option deferral case, the investor must pay taxes on cash that never existed. The taxes owing can be many times more than the amount of money the investor ever handled. In theory, the capital gains and losses will work themselves out over time here as well, but in the immediate term, the investor is ruined.

  7. I don’t think this was an intentional trap by the government, but certainly a policy with very unintended consequences that both the government and employers should have spelled out more clearly to the employees. My understanding is that the original goal was to allow people to retain ownership of exercised stock and not be forced to sell a portion immediately in order to pay taxes.

    In my examples, yes the investor uses outside cash to pay for taxes. Your implication though, is that a person with the money to pay the taxes at the outset should be penalized relative to someone with an identical benefit who chooses to defer the tax payment for whatever reason (no liquid cash to pay the taxes, no desire to pay taxes immediately, is betting the stock will go up etc). Both people can afford the taxes at the outset because they have the stock at the point of exercise and are free to sell at the market price which is the price the taxes are based on.

    Having cash or having stock in your name worth the same amount is more or less identical in a liquid market (trading fees, day to day fluctuations aside). The employees actively put their money at risk in the stock market. To say that the cash “never existed” or that the taxes are based on paper profits is simply untrue. It’s like saying that Bill Gates isn’t a multi-billionaire because most of his assets are in “stock” and never realized as “cash”. The policy is clear that taxes are owing based on the difference in share vs option price at the time of exercise, not some some peak share price at an arbitrary time. It’s similar to restricted shares where you pay tax on their value at the time they vest even though they aren’t in a “cash” form.

    Consider this scenario:

    An employee is given a bonus of $40 cash and due to government program A, is only required to pay taxes on half the amount (awesome!). Additionally, government program B is available whereby the employee can invest the $40 bonus with $10 of their own money into company stock and defer the tax payment until the stock is sold.

    As fas as I can tell, this is functionally equivalent to what’s happened. The difference is that the employee gets “cash” first and immediately converts it into stock instead of simply getting stock directly.

    I still consider this a bailout. Due to the collosal scale of the mistakes made (at least in the selected examples I’ve seen reported by the media) and the resultant financial hardship, the policy provides substantial upside monetary benefit (elimination of taxes owing) to a select group of employees over other investors or even similar employees who made different taxation decisions (but possibly similarly poor investment decisions). There are no penalties beyond the loss of the investment which in these cases I assume is worthless or near worthless anyways. Relief could have been provided where taxes owing were set at a non-zero value but in a manner that did not result in excessive financial hardship.

  8. P: I’m not concerned whether this trap was intentional. It was predictable, which makes it bad policy from the start.

    It’s true that the people being “bailed out” had the opportunity to sell enough stock to pay the taxes immediately. But they didn’t. In all your (first set of) examples, the investor was made to pay tax at a time when he had the money. This is the important difference. In the stock deferral case, a person may have paid $10,000 for stock, sold it for $10,000 and owe $500,000 in taxes. It serves no useful purpose to drive this person into bankruptcy and cheerfully tell him that he’ll get all of his money back over time using his now massive capital loss.

    I see no problem with demanding taxes on paper gains in some cases as long as the taxes are owing immediately. To wait a decade is just asking for trouble. The issue isn’t whether investors have done something foolish. They have. The question is what to do with the ones whose foolish action has lead to financial devastation.

    I do consider Bill Gates to be a billionaire, but if Microsoft were to go bankrupt today (and assuming he has less than a billion dollars in other assets), I would no longer consider him to be a billionaire.

    Viewed in a different way, the “bailout” the government is allowing is actually a bad deal for some people. They have to forfeit the amount they got for selling shares in the form of a special tax, and they have to give up the large capital loss. If they manage to generate enough capital gains in the future that they could have made use of the capital loss, they are out the amount of the special tax. When this special tax amount is actually significant, this “bailout” is only useful to someone whose finances were otherwise going to be so decimated that future capital gains are unlikely.

    In my own case, I’m being spared about 60% of the taxes owing. For this I have to forfeit 100% of the capital loss. Taking the government’s deal is for me an exercise in reducing uncertainty going forward, but it could easily turn out to be a poor choice if I have good financial fortune in the future.

    I agree with you that in cases where the shares are worthless (like Nortel), this does let people completely off the hook. I’m not opposed to this because I think that the stock option gain was essentially a capital gain anyway. What I’m not happy about is how investors are treated differently based on the residual value of shares being confiscated by the special tax. But this new policy eliminates the driving of people into bankruptcy, which was the only important goal.

  9. Canadian Capitalist

    IIRC, the stock option tax deferral was demanded by employees and employers in technology companies. It is hard to characterize this as an intentional trap set by Government. Perhaps, they did not think through the unintended consequences but I don’t think this was a sin of commission.

    That said, I’m less concerned whether this is a bailout or not (To clarify, I don’t personally benefit from this relief. Whenever I exercised options, I immediately sold the shares and paid the tax). I’m more concerned that this relief was provided to selected taxpayers but not all. The Budget at least makes the relief available to everyone affected.

  10. Is the trap permanently removed, or is this just temporary legislation to free everyone who is currently in the trap?

    The reason I ask is that I hold options to a very small private US corporation. It might sink, or it might get bought out for a handsome price. Executing the options now could be very profitable if the corp eventually gets bought out, but fear of the trap has kept me from doing this. Am I protected now?

  11. CC: When I first noticed the trap, I spoke to a high-tech lobbying group and they were surprised. The high tech people I met who were savvy enough to understand the deferral issue believed that any capital loss on shares could be used to offset the stock option gain. The trap isn’t the entire deferral policy, but just that portion of it that treats the two types of income separately so that they can’t offset each other. This part of the tax policy was a surprise to all the high tech people I explained it to. I have no idea what was in the mind of CRA at the time or whether the trap was intentional or whether it was seen as some way to prevent certain types of abuse. High tech industry did ask for deferral, but they didn’t ask for the “trap” part of the legislation.

    DG: I’m no tax expert, especially with tax issues with crossing borders, but you don’t appear to have a problem with this trap if you’re still holding options rather than actual shares. The trap is now removed, and you can avoid this particular problem if you sell the shares you get from exercising your options immediately after you get the shares. I have no idea what other issues you might run into, though.

    • Canadian Capitalist

      @Michael: I find it incredible to believe any lobby group can claim that they did not know stock option gains were treated as employment income (all they had to do was ask their accounting department; it’s spelled out clearly in T4 slips). It has always been the case and back in the late 1990s, IIRC, there was even demand that stock option gains should be treated as capital gains that could be used to offset capital losses. That demand leads me to believe that any lobby group that says it was surprised is rewriting history. The Government allowed tax deferral but it never changed the way stock option gains were treated.

      I don’t know how anyone can say they are surprised. It is spelled out clearly in black and white that stock option gains (and ESPP gains for that matter) are treated as earned income. What I can believe is that folks who opted to defer taxes on their stock gains did not think through the scenario where they sell their stock for less than the FMV on the day of exercise. IMHO, ignorance of tax law is never a valid defense.

  12. Michael: Everything would be taxed as income in that case. I want to execute my option now while the share price is currently low so that future gains can be taxed as capital gains. I would accept paying $X of income tax now if I know I could get about $X back as a deduction if the company sinks.

    This is starting to sound too good to be true; perhaps I’ve answered my own question. 🙂

  13. DG: If the share price is currently low, and you can afford to pay tax on the current value in the future even if the shares ultimately go to zero, then I don’t think you have a problem.

    CC: What people should have known is a matter of opinion that I’m happy to sidestep other than to say that we often see things much more clearly in hindsight that we do beforehand.

    When the rules changed so that the stock option employment gain was taxed at the same rate as capital gains (50% instead of 100%), most people simply didn’t think about what might happen with deferred gains if stocks tanked. Among the few who did think about it, they just assumed that since stock option gains were being treated similar to capital gains, and that amounts could offset. I thought this initially. In 2000 I discovered my mistake. When I talked to my management and accounting people, they were all surprised (and some realized that they had personal exposure). I then took my findings to a high tech lobby group and encountered surprise from everyone there. Maybe they should have known better, but they didn’t. It could be that there were people around who understood all this from the beginning, but I didn’t encounter any such people.

    I agree that ignorance of the law can’t be allowed as a valid defense. But this fact isn’t a good reason for having bad laws. I think shutting down stock option gain deferral is the right thing to do here. The only reasonable choices were to either have deferral and treat all gains and losses as capital gains and losses, or have no deferral at all. The midway solution containing a trap for the unwary just made no sense.

    CC, your interest and aptitude for sifting though information about taxes and other financial matters is easily in the 99th percentile. It’s hardly surprising to me that others could come to understand this entire issue incorrectly.

  14. Canadian Capitalist

    @Michael: Actually, way back in 2001 when I cashed in some options, I was warned by colleagues to sell immediately because the gains were counted as employment income. I wasn’t all that savvy about finances back then and can claim so special insight that this was a disaster waiting to happen.

    I do completely agree with you that the tax deferral was a bad tax policy to begin with and that those who are affected by it probably did not think through the implications. I am also sympathetic to giving them a break in this budget because this quirk has caused undue hardship to a lot of people.

    But I do think there is a valid reason for treating stock option and ESPP gains as employment income and not capital gains. It is to prevent the ability to offset capital losses in investment accounts.

  15. Canadian Capitalist

    @DG: You have two choices. (1) Hold on to the options (2) Exercise the options and hold on to the shares.

    I guess you are asking about (2). Let’s assume that your strike price is $X, the FMV is $Y (since the company is private, you’ll have to ask accounting what the FMV is). If you exercise now, you’ll have to come up with $X to pay your employer for the shares. You’ll owe taxes at 50% on $Y – $X. You can’t defer the taxes anymore, so you’ll have to come up with the cash to pay CRA.

    So your cost will be $X + 20% of ($Y – $X). The question you have to ask yourself is: Is my investment today worth the risks of (a) owning illiquid shares in a private company (b) owning stock in my employer? Your answer would likely depend on what your outlay is compared to your net worth and portfolio value.

  16. Michael: You highlight a good point with reference to your own personal situation that’s particularly shocking about this proposed remedy. At the extreme behaviour where the employee holds the investment to the point of it being wiped out (ie. took the maximum risk), the resulting tax liability becomes zero and the investment is worthless. The person comes out with no cash in hand but no additional taxes owing. If the employee sold the shares earlier at a lesser loss, there a particular share price where the tax liability equals the value of the shares and the person also comes out with no net cash and has paid maximum taxes (though they can carry forward a capital loss, there’s no guarantee of future gains to cancel them out). Basically beyond a particular threshold, the larger your investment loss, the larger your tax benefit is!! The scale of this proposed remedy is completely backwards. What kind of investing style is the government encouraging here? Clearly one that rewards taking on substantial investment risk, being ignorant of tax law, and lobbying the government when things go sour.

    @CC: IMHO, this is still providing selective benefit, but not in the way you are thinking. It specifically provides benefit to employees who chose to defer tax payment. It does not provide remedy for employees with identical benefit who did not defer taxes (ie. through a reduction/elimination of previously paid taxes). It provides relief that is disproportionate for employees who incurred smaller losses relative to ones with a substantial or complete losses. The structure of the policy, it’s discrimination between normal investors and different classes of employee investors, and the lack of any meaninful penalties for either ignorance or willful disregard for tax law is absolutely galling to me.

    We now have a situation where people have effectively been allowed to invest pre-tax dollars where the tax bill is wiped out on an extreme loss, and where profits (had there been any, there certainly were for some people but not those doing the lobbying) would have been reduced by 50% for taxation purposes (both the income and cap gains parts). Imagine if the government did that for everyone’s RRSP investments.

  17. Canadian Capitalist

    @P: I perfectly understand your point. I’m not disputing that this is selective treatment, just that I’m not terribly fussed about it because our tax code is riddled with preferential treatment. I wasn’t fine with it when tax relief for deferrals were available to some select taxpayers but not everyone, which is far more odious IMHO.

  18. CC: I worked hard in 2000 to educate people about this issue within my company, among my friends, and through CATA (Canadian Advanced Technology Alliance) and other groups my boss was connected with. This included sending letters to Paul Martin (then Minister of Finance). So, it’s possible that I played a small role in spreading the word that eventually made it to you in 2001. Unfortunately, many people had already made the critical mistake by the time my efforts began.

    • Canadian Capitalist

      @Michael: I did not make all that much from stock options. Like so many tech workers, I waited until 90% of it became worthless 🙂 Nevertheless, thank you for your efforts. I’m sure it would have helped a lot of people avoid this whole mess.

  19. How far back can it apply? If I experienced this situation (my tax owning > value of stock) in 2001, can I recover the tax paid to CRA now?

    CC nice post but can you post more details such as above?

    • Canadian Capitalist

      @Hank: Did you file for deferral back in 2000 and sell your shares in 2001? The budget document says that the relief is available for past years, so it might apply to you.

  20. Just found this article. Thx for the overview. Not clear on one aspect though. If you don’t have capital gains from some other position (i.e. your only gains and losses are on the options you exercised on one stock), is the new relief limited to taxes owed can’t exceed proceeds from sale?

    I deferred in 2000. With the stock’s performance and the FX (it’s a US listed stock), the proceeds today would barely cover the taxes owed. As the stock provides dividends, keeping it is preferable to selling it and turning over the proceeds to CRA. But if there was some relief available beyond that, I’d consider selling the stock and paying a reduced tax bill to CRA. That’s mostly because I don’t have any confidence in the long term prospects of the company. If I’m right about that, seems like it would be good for CRA as well as me to get something versus nothing. Anyway, any clarification appreciated and thanks again for the article.

  21. I was Hi-Tech employee in the year 2000 unfortunately I exercised options and I triggered taxable benefit. I was able to defer tax payment submitting T1212. I was participating ESPP plan as well and again bad luck I never sold my shares. I had to pay large tax on ESPP Taxable benefit there was no deferral possibility on ESPP.
    Now by budget 2010 I can elect form RC310 (Tax relief on deferral Election) and I am selling shares. All proceeding belongs to government.
    How will I differentiate “deferred” shares vs. ESPP if I sell at once? I have my records but Form RC310 is asking to declare all proceedings from Schedule 3 Column 2 to be on the last line but that is not right, I should include just “deferred share proceedings” that is less than my total proceedings. I paid taxes on ESPP (phantom gain) once, than now is just loss. To simplify I am selling all my shares and how to properly report “Deferred” vs. ESPP