Photo: National Post
This story featured prominently on CBC news last night, although I didn’t have any time to comment on it then. I meant to gather some more information about it today, but it appears that only the CBC is carrying this surprising story. According to the article, there are thousands of Canadian workers who purchased stock options from their employers before the economy went into the tank, but Revenue Canada is expecting them to pay taxes on the full value of the stock at the time they were purchased.
Income taxes are applied to stock options, which many Canadians purchase or receive from their company at a reduced price of the stock value. But while options can be an asset when a company is surging [think about all those original Wal-Mart employees], it’s a bankrupting liability during a downturn like this where practically everybody has lost their shirts in the market.
Called “phantom income” because the taxes are paid on the market value of the stocks when they are issued, there are thousands of Canadians who have to pay thousands, if not hundreds of thousands of dollars, on income they never even received. In fact this loophole in the tax system is so ruthless that it’s a kind of double-edged sword. It cuts the stockholder with the lowered value of their options, selling them for a pittance of the original value, thus losing their renumeration for services in the company; it then makes the person pay the value of the non-existent stock as though they had made money on the asset.
It isn’t just people losing a few bucks on the stock market either, but people actually losing their life savings, their homes, in order to pay off a tax bill from a glitch in the system that is entirely fixable. Even if the employees hold the stock, or defer remittance, they still have to pay the tax bill, and that never changes or goes away.
But while Ottawa is busy working on a brand new $50 billion deficit for fiscal 2009-2010, Finance Minister Jim Flaherty indicated no plan to change the system to fix the error:
“I won’t hold out any hope of any tax exemptions. The tax laws apply to all of us equally. There are some remedies that are available through hardship cases, but the reality is that those stock option situations are not uncommon and apply to a large number of Canadians. So, I can’t and I won’t hold out any hope of any tax exemptions in respect to that.”
It’s interesting how a taxpayer getting shafted by a glitch in tax laws can be a “hardship” case, but the failing automotive industry requiring billions of dollars isn’t. Paying taxes on income never received is a law that applies to everyone equally; blaming the global economic downturn for a $50 billion deficit is somebody elses problem.
With the confusion and loopholes and agony that is our progressive tax system, there has never been a better time to pitch a simple, manageable, and flat tax system in Canada. As Neil Reynolds of the Globe and Mail explains on his article about Christine Elliott’s bold vision for Ontario, the federal government has four different tax rates that are “riddled” with exemptions and deductions. The estimated “deadweight” cost of our absurdly complex tax code, writes Mr.Reynolds, is nearly $30-billion, a figure that should sound familiar to those who have seen the budget numbers. A simple tax that calculates money earned divided by the flat rate, and no more “phantom income”. How hard could that possibly be?
May 27, 2009 at 8:33 pm
Wrong.
They did not purchase the stocks but took them instead of wages, big big difference.
If they had bought the stocks they would be taxed at market value but as a wage option they are taxed at the purchase value which reflects the wage that would have been taxed.
Everybody that does not make out like bandits is not a victim.
May 27, 2009 at 8:45 pm
It’s still not income, Durward.
May 28, 2009 at 4:06 am
This situation is being misrepresented. An employee is awarded a stock option. This option will allow the employee to purchase stock from the company’s treasury at the pre agreed price any time up to an expiry date. If the option is excercised, the option price is paid for the stock certificates. If at the time of the acquisition of the stocks the market price exceeds the option price there is a deemed income for the diference. Revcan permits the employee to defer the tax liability until the stock is actually sold.
From the moment the option is exercised the employee is speculating in the value of the stock. If they sell it they must include the net amount in their current taxation year. If they choose to hold the stock they risk not only losing value, but will still have to pay the original tax amount.
This is entirely fair and in fact generous of Revcan.
May 28, 2009 at 4:54 am
Again, media talking out of their asses and not knowing anything about which they speak.
Ralph, these are income, just like my car, my parking space and if I were truly honest, the Aeroplan miles I earn while flying on business (not that I could ever cash those in).
Compensation in any form is taxable when you get it. Full stop. An option is no different. If you monetized it the day after you received it then you would have the cash to pay the tax.
The big updside, which has built quite a few big houses here in Calgary, is holding onto the option as the underlying securities keep going up, and up, and up – you get the idea.
However, as all of the dot-gone and Crooked E paper millionaires learned a decade ago, options don’t count for much when the company is broke or the shares are worthless.
So like the sub-prime mortgages, this is another case of people being greedy and looking at the upside only and not the downside. They should have asked a few more questions and planned for the downside.
So get paid in cash, pay your bills, live within your means – boring but it works. Unless some sobbing spendthrifts or incompetents get the Government to expropriate the fruits of your labour and good planning to ease their self-inflicted pain.
May 28, 2009 at 5:36 am
Bill,
I don’t see what’s so very difficult about calculating the taxable income on the dividend when it’s paid out. How can you pay taxes on the speculated price? I’m not saying that’s not what happens, I’m saying it’s a poor system.
May 28, 2009 at 6:01 am
It is not a dividend. The value of a publicly traded stock is calculated as the closing price on the day the option was excercised. That number is not speculative. It is the result of the market activity for that day.
It is not a poor system. A poor system would be what happens when you die. There is a DEEMED dispossession at the market price and the tax liability is triggered immediately.
At least with the options you have the right to control when you pay the tax. This at least leads to some tax planning options.
May 28, 2009 at 8:42 am
Raphael – this only happens if the employee figures he is getting a deal; i.e., the current share price is sufficiently higher than his option price for him to pay any fees and still make a profit. No one exercises an option if the option price is above the price the stock is actually trading at. The problem arises if the employee does not sell the shares immediately.
As an example, I work for XYZ Corp and have been granted an option to buy 10 shares at $10 each. On the day I exercise my option, the shares are worth $20 each. So I hand over my $100 and get the shares. Because they are worth $20 each, I have an employee benefit of $100 which will show up in box 14 of my T4 as well as box 38 (security options benefits) at the bottom of my T4. As well, because of the favourable tax treatment of this particular benefit, there will also be an amount in either box 39 or 41 (security options deduction) equal to have the amount in box 38 (in my example, $50).
If I choose, as many employees do, to sell immediately, I get the $200 (less any brokerage fee). Assuming the fee is zero, I’m $100 ahead, exactly the amount in box 38 of my T4 and also the amount that was added to my regular wages in box 14. When I do my taxes, my box 14 amount shows up on line 101 and becomes part of my taxable income. That’s the same treatment as any other employee perk (provincial health care premiums, employee use of company vehicle, etc., etc.). However, I also take the $50 from box 39 or 41 and put it on line 249. This reduces my taxable income by $50, or half the stock option benefit.
To summarize, I am $100 ahead because of the stock option I exercised and sold, but I only have to pay taxes on $50 of that gain because of the special tax treatment on this particular employee perk. I am paying taxes on this perk as if I had bought the shares on the open market back when they were $10 each and sold them at $20 each, making a capital gain.
The problem arises when I think the stock is on its way up and decide to hold and make even more money. I have my 10 shares with an ACB (adjusted cost base) of $20 each. I also elect to defer paying tax on the first $100 I made until I actually sell the shares. If all goes well, the shares go up to $30 each and I sell. Again neglecting any fees, I have made an additional $100. This is a regular capital gain so I report it on Schedule 3 and am taxed on $50 (half the actual capital gain of $100).
I have done well. I bought at $10 and sold at $30, making $20 per share and, because of the tax treatment of options, am paying taxes on only $10 per share.
The problem arises if I hold too long, and the market goes due south. My shares are now only worth $15 each and I bail out. I have lost $5 per share. However, because I have sold my shares, I now have to report the original employee perk of $10 per share, though I still only have to pay taxes on $5 per share. The sale is reported on Schedule 3, proceeds of disposition of $15 per share ($150), ACB of $20 per share ($200), and a capital loss of $5 per share ($50). Because capital gains are taxed at 50%, capital losses are deducted at 50%, so I have a net capital loss of $25. However, net capital losses can only be deducted against taxable capital gains, so I cannot deduct my loss against the gain I reported via my T4. I can only deduct it if I have actually made money on the stock market in that year or the prior three years. Otherwise, I must carry that net capital loss forward indefinitely or until I die, at which time I can finally deduct it against other income.
It’s not rocket science. People in this bind were gambling that the share prices would rise and they would make even greater profits. They lost. Where the ‘unfairness’ arises is that they can’t deduct the net capital loss against the income they reported on their T4.
I hope this clarifies things.
May 28, 2009 at 10:26 am
Raph,
Frances has provided a pretty good explanation of the situation.
I think what you need to keep in mind, is that there is more than one transaction or event in play here.
Once you exercise your options, you have a gain (and you would only exercise them when your options are in-the-money). That gain is taxable. It doesn’t matter what you do next, nothing can change the fact that at this moment, you have made money, and owe tax on your profits. You could sell the stock today, take part of the proceeds to pay the tax, and pocket the remainder.
It’s what happens after this that can cause people some grief. If you cash out, end of story, as Frances explained. If you decide to hold the stock, it’s no different than if you just went out into the market to buy a stock at the current market price. If it drops, you will lose money. The people described in the CBC sob story are not paying tax on a losing situation. They are simply paying the taxes they elected to defer when they originally exercised their options.
This is not an unfair tax treatment (well, no more unfair than any other tax rule), it’s simply the loss on a bad investment.
Perhaps if the government forced people to pay the tax on their options at the time they exercised, this wouldn’t happen. It may have forced people to sell some of their holdings upon exercise. But then, the current rules actually give you the freedom of choice here, which I believe is preferable. Nobody forced people to defer the tax until later. The problem is people deferred the tax, likely fortetting they owed it, or just figured that they would gamble and somehow make enough money in the markets to cover their already owing, though temporarily deferred, tax debt.
These people are not victims of a heartless tax system. They are victims of making poor investment choces. That can happen to any of us. While unfortunate, that happens, and it’s nobody elses fault.
May 28, 2009 at 2:59 pm
Frances,
What a great detailed answer. You really made me understand things clearly. Sometimes when I blog I try to get balanced opinion and information, but because I only had the CBC article I was going mainly on one source of knowledge.
Maybe I can contact you when I have financial questions for articles in the future?
May 28, 2009 at 3:50 pm
Thanks for the complements, Raphael. I’d be glad to help if I can.