Budget 2010 - Op Ed

In his speech accompanying the country’s 2010 budget, Canadian Finance Minister Jim Flaherty said: “We are building Canada’s reputation as an investment-friendly country.” And to well-deserved accolades, Budget 2010 did indeed remove the arcane “Section 116” taxes that have been a perennial thorn in the side of Canadian entrepreneurs trying to entice venture capitalists and other investors from outside Canada to invest in their businesses.

But the extension of rules around withholding taxes on the exercise of stock options is drawing significant attention to the inherent flaws in these rules in the first place, and to the administrative complexities forced upon employers to try to comply with these rules, undermining many of the benefits of resolving the 116 issues.

Ironically, Budget 2010 provided relief to employees who in the past got very badly hurt by inherently flawed stock option taxation principles. But instead of addressing and curing the underlying inequities that drove the need for this retroactive relief, Budget 2010 institutionalizes the unfairness with upfront withholdings to ensure that the deemed taxes on unrealized income are fully paid, with the employer being held responsible, regardless of what happens to the employer’s share price in future. Budget 2010 is silent on how an employer is supposed to come up with these non-existent funds to withhold, or on how or why an employee – that may be subject to lock-ups or blackouts – is supposed to sell enough shares to cover the tax on these mythical profits.

The fundamental problem is that employees are deemed to have windfall – and taxable – profits when they exercise stock options. But the act of exercising options is not a disposition; it is simply an increase in investment, in order to maintain their existing ownership stake in the business. Compounding the problem, these deemed profits on unrealized income are taxed as “employment income”, while any subsequent losses – on actual realizations – are treated as capital losses in the event of a decline in their employer’s share price, so that employees can and often are effectively taxed at rates of 100% or even infinite rates on “profits” on sales of shares that they never see.