Does stock-option taxation need a rethink?

The Liberal promise to change the taxation rate on stock options is getting pushback from business, primarily the innovation sector, who say the lowerrateencourages anentrepreneurial spirit.

In its electioncampaign last year, the Liberals proposed settinga $100,000 limiton the amount of stock-optiongains any individual could claim at a preferred tax rate.

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Citing Department of Finance numbers that show the tax break costs Ottawa $750 million a year, the Liberalspoint to 8,000 very high-income Canadians who deduct an average of $400,000 from their taxable incomes via stock options. Few Canadians would oppose a bigger tax billfor those very high earners.

Stock options are taxed as if they are capital gains, with half the difference between the option price and the market value of the share taxablein the year when an individual exercises the option. That's much lower tax than they'd pay if they were paid an equivalent salary or bonus.

The only thing that stock options are good for is executivesbad for companies, bad for shareholders, bad for workers, bad for prosperity and the country.- Roger Martin, former dean of the Rotman School of Management

The technology community, biotech startups and the junior mining sector are in full cry against any change.

"In many instances, the principals of these companies do not pay themselves," said Rod Thomas, president of the Prospectors & Developers Association of Canada.

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"In a perfect world, the options are there and, if you're successful, that's where you make your gains."

And while every cash-starved startup dreams of being the next Google, most of them will fail to grow that large. It's the nature of entrepreneurialism that encourages innovative people to hang on with a high-risk venture, planning for the big payoff.

'Part of the culture'

"It's something that we've had for a very long time. It's just part of the small company culture, really, because they can't pay large salaries they don't have the wherewithal to do that. Granting options is one way of compensating," Thomas said.

The CEO of Shopify, an up-and-coming Ottawa tech company, has told the federal government the proposal to change the rules would hurt innovation.

"It would have been harder to build Shopify with the taxation being the way that it's proposed," Tobi Ltke said.

Thomas said if the federal government insists on changes, it should consider treating large revenue-generating companies differently than small entrepreneurs.

"What you might consider doing is applying a cap to the large corporations. You could differentiate between the venture capital companies who are starved for capital and talent and have that as a separate class," he said.

"I don't think any government wants to stifle innovation in Canada."

Current system 'indefensible'

While some voices arearguing for the need for a rethink of the stock-option taxation proposal,there are other arguments to go ahead with a change among them evidence that stock-option compensation is not good for companies and may even lead to a risky management style.

The overwhelming majority of companies that give stock options are not junior miners or tech startups, but large, listed companies who can afford to pay their senior people in cash. And most of those who benefit are highly paid executives.

Not only are these top earners rewarded handsomely, they pay less tax on options than if they were to be paid in cash or a bonus.

Roger Martin, former dean of the Rotman School of Management at the University of Toronto, calls the current system for stock-option compensation "indefensible."

He said it ignores the public policy benefits of having a lower tax rate on capital gains.

"We wanted people to take their hard-earned money and rather than spend it, invest in a share of stock. We said, that's sufficiently good for the economy, that we want to reward people for doing that ,and we'll make the tax on it lower than it would otherwise be," Martin said.

"These executives are not taking money out of their pockets to invest in stock and then paying capital gains. This is plain and simple executive compensation."

'Bad for companies, bad for shareholders'

Martin has been, along with investor Warren Buffett, a prominent opponent of any kind of stock-based compensation for executives.

The idea that getting stock or stock options as compensation causes CEOs to align their interests with those of the company is just plain wrong, he argues. It hasn't resulted in better returns for companies.

The incentive for the CEO is to increase expectations about futurenot actualearnings so as to drive up stock prices and benefit from exercising the option, Martin says. That may mean talking up the company in the press, making new acquisitions or using aggressive accounting to inflate expectations.

But that's not the same as managing the company well.

"It's bad for companies. I'd like to see policies that discourage it for companies. The only thing that stock options are good for is executives bad for companies, bad for shareholders, bad for workers, bad for prosperity and the country," Martin said.

The idea that stocks and stock options were appropriate compensation for the top executives rose out of a single 1976 article that argued giving stock-based compensation aligned the interests of a company and itsupper management.

The idea caught on in the U.S. and by 2000, most of Canada's largest companies were awarding stock options. Martin says companies now do it because everybody does it.

Tax the executive, spare the company

Amin Mawani, a tax expert at York University'sSchulich School of Business, also believes Ottawa should change its approach.

He advocates taxing share options as if they were cash or bonus money, at the marginal tax rate of the person who receives them,but then allowing companies to deduct the cost of options as they do payroll costs.

"If the company gets the deduction, the company gets the benefit and can pass the cash to its employees," Mawani said.

That won't result in a benefit to federal government coffers. Mawani estimates Ottawa and the provinces would lose as much on the company deduction as they would gain on full taxation of the stock options in the hands of executives, give or take a few dollars.

It also won't be much use to junior mining companies or tech startups, as they still won't have the cash to pass on to anyone.

"The twist is that for startups, it won't be useful to them as they are taxed at a very low rate," he said.

Innovation Minister Navdeep Bains acknowledged the government has "heard concerns around stock options." But he promised an innovation agenda that would help startups thrive.

The timing of any changes is unclear. Though a budget will come down March 22, thefinance minister has not said whether that document will outline changes to stock-option taxation.