Optimizing claims for the new paragraph 110(1)(d.4) stock option deduction

Executive summary

With the proposed increase to the capital gains inclusion rate and revised stock option deduction, this article discusses how taxpayers can optimize their deductions and credits to potentially avoid any negative tax consequences.

This content was first published by the Canadian Tax Foundation in (2025) 15:1 Canadian Tax Focus / Focus sur la fiscalité canadienne. Republished with permission.

Draft legislation released September 22, 2024 (now announced to be effective January 1, 2026) will increase the capital gains inclusion rate from one-half to two-thirds on capital gains and taxable benefits from employee stock options (section 7) above $250,000. As mentioned in the explanatory notes, an individual may choose how to allocate their $250,000 threshold between capital gains and stock option benefits. The statutory implementation of this concept provides that claiming a deduction against stock option benefits under the new division C deduction in paragraph 110(1)(d.4) reduces dollar for dollar the new division B deduction (section 38.01). Forgoing or only partially claiming the paragraph 110(1)(d.4) deduction in order to increase the section 38.01 deduction is often advantageous, because it may decrease net income (while leaving taxable income unchanged). Individuals who realize net taxable capital gains in the same year as a stock option might benefit from this choice (which might occur, for example, if subsection 7(1.1) defers that stock option benefit inclusion to the year in which the shares are sold or exchanged).

To ensure that the new inclusion rate for capital gains also effectively applies to section 7 stock option benefits, amendments to subsection 110(1) reduce the stock option deductions under paragraphs 110(1)(d) to (d.3) from one-half to one-third of the taxable benefit. To provide an additional deduction on the first $250,000 of taxable benefit—paralleling a similar provision for capital gains, discussed below—an additional one-sixth deduction is provided in new paragraph 110(1)(d.4). The combined effect of these amendments is to provide for a cumulative deduction equal to 50 percent on this portion of the stock option benefit.

As discussed above, the amount deducted under paragraph 110(1)(d.4) also reduces the amount deductible under new section 38.01. The section 38.01 deduction is one-sixth of the lesser of (1) the amount by which $250,000 exceeds 6 times the amount claimed under paragraph 110(1)(d.4); and (2) 1.5 times the net taxable capital gains. The section 38.01 deduction reduces net income (paragraph 3(b.1)), so there is a tradeoff between the paragraph 110(1)(d.4) deduction and the section 38.01 deduction.

Table 1 shows that forgoing or reducing a paragraph 110(1)(d.4) deduction in order to claim a higher section 38.01 deduction can be worthwhile. In scenario 1, consider an individual who in 2026 has $100,000 of employment income, $300,000 of net taxable capital gains, $400,000 of net income before the section 38.01 deduction, and a deduction under paragraph 110(1)(d.4) of $40,000. This produces final net income of $398,333. However, scenario 2 shows that forgoing this $40,000 division C deduction increases the division B deduction in section 38.01 by an equal amount. Thus, the individual’s taxable income is unchanged, but net income falls by $40,000 to $358,333. If the individual is in the phase-out range for old age security (OAS) in both scenarios, this would save the individual $6,000 in federal income tax ($40,000 times the 15 percent OAS phase-out rate). Additionally, since the taxpayer’s total income (line 15000 of the T1 return) would also go down by $40,000, the amount paid for child support and spousal support may also decrease. Various refundable and non-refundable tax credits may also increase.

Table 1

Forgoing or reducing a paragraph 110(1)(d.4) deduction is not always beneficial. In scenario 3, the assumed paragraph 110(1)(d.4) deduction remains at $40,000, but the individual has no net taxable capital gains (and thus a lower net income [$100,000]) before the section 38.01 deduction. Since the section 38.01 deduction is a lesser-of calculation in which one of the elements is a multiple of net taxable capital gains, there can be no section 38.01 deduction. Hence, there is no benefit to be gained by forgoing the paragraph 110(1)(d.4) deduction (scenario 4): this increases taxable income without changing net income.