Canada: Employee Stock Options Tax Planning – Vancouver Tax Lawyer Commentary

Last Updated: May 4 2016

Employee Stock Options- Introduction

The income tax planning for the structure of a stock option plan requires the income tax law and corporate law expertise that our experienced Vancouver tax lawyers bring to all client tax issues. In a stock option plan, the employee is given or earns the right to acquire shares of the corporation, usually at some fixed period of time in the future. Sometimes the employee acquires certain shares at the inception of the stock option plan with rights to acquire additional shares in the future. The vesting of the stock option rights may be deferred for some period of time and will usually only vest if the individual is still employed by the corporation.

Employee Stock Option Agreement- Requirements

There has to be a written stock option agreement which specifies how the employee earns rights to additional shares, the price to be paid for those shares and requirements for vesting. For privately held corporations continued employment with the corporation is generally a prerequisite for exercising the stock option and for keeping the shares. In the event of a departure from employment, even if the employee is fired, the shares are usually reacquired by the corporation on some basis since a closely held corporation does not want shareholders who may have adverse interests. Our top Vancouver tax lawyers are experienced in tax planning for the structuring and drafting of stock option agreements.

If the shares of the corporation are publicly traded then the employee will generally be permitted to keep the shares even after employment is terminated. However, he or she will generally be unable to exercise stock options to acquire any additional shares after leaving employment with the corporation.

Stock option plans are one of the proverbial “golden handcuffs” since the employee’s rights are limited or terminated in the event of termination of employment, so proper income tax planning and business planning is essential in structuring the terms and conditions of the plan.

Most stock option plans are limited to management but some stock option plans are made available to all employees of the organization. In that case there will usually be a different stock option plan for management and for non-management employees.

Another tax planning advantage to stock option plans from a corporate point of view is that there is no cash outflow to the corporation. On the contrary, if the employees are required to buy the optioned shares at fair market value, the corporation actually receives funds. Payments are only required by the corporation if dividends are declared.

Employee Stock Option Plans- Taxation

The issuance of stock options has Canadian income tax implications that vary depending on whether the corporation is private or public and also depend on how long the shares are held after exercise of the stock option and our Vancouver tax lawyers have the experience to properly advise you.

When stock options are given without a tax reorganization, and a benefit is conferred on the employee, the Tax Act has special provisions that are applicable.

Stock option benefits are taxable as employment income because they are, in effect, an alternative to cash compensation.

The common law rule that stock option benefits arose in the year in which the stock option was granted created considerable uncertainty in determining the value of benefits derived from unexercised stock options. The Canadian Income Tax Act resolves the uncertainty by specifying both the method of valuation and the time for inclusion of the benefit in taxable income.

An individual is taxable on the value of stock option benefits derived by virtue of employment. The benefit is determined by reference to the shares actually acquired pursuant to the stock option plan.

The first question is: Was the benefit conferred by virtue of the employment relationship? Issuance of stock for other considerations (for example, as a gift or in return for guaranteeing a loan) does not give rise to a benefit from employment. The tax definition of “employment” includes employees, and Officers are included in the tax definition of “employees”. Case law supports the idea that a director is an officer of a corporation; therefore, directors are bound by these provisions in almost all circumstances. An exception to this rule occurs when the benefit received by the director was not conferred by virtue of the employment relationship.

The triggering event for the recognition of stock option benefits is the acquisition of shares at a price less than their value at the time the shares are acquired. The time of acquisition is determined by reference to principles of contractual and corporate law.

Except in special cases (discussed below), the value of a stock option benefit can be determined only at or after the time the stock option is exercised, that is, when the shares are acquired. The value of the benefit is the difference between the cost of the option to the employee, any amount paid for the shares, and the value of the shares at the time they are acquired from the plan. Shares are considered to be acquired when the option is exercised.

“Value” means “fair market value”. In the case of publicly traded securities, stock market prices will usually be considered indicative of fair market value. Since listed stock prices inherently reflect the value of minority shareholdings, there is no need to further discount their value for minority interest.

The value of shares of a private corporation, which will be the case with owner-manager entrepreneurs and closely held businesses, is more difficult to determine. Shares of private corporations are generally valued by reference to estimated future earnings and the adjusted net value of assets. The pro rata value of the corporation is then adjusted to reflect a discount for minority interests, lack of market, etc.

When it comes to income tax planning for stock option plans there are two special income taxation rules. One applies to options issued by Canadian-controlled private corporations (“CCPC”) and the other to acquisitions of prescribed equity shares. These rules are incentive provisions intended to stimulate equity participation in Canadian corporations.

Shares acquired from a CCPCs stock option plan in an arm’s length transaction receive preferential treatment if they are held for at least two years. This is so whether the shares are issued by the employer corporation or by another Canadian-controlled private corporation with which the employer does not deal at arm’s length.

An employee may defer income tax recognition of any benefit derived from stock options issued by a Canadian-controlled private corporation until disposition of the shares. CCPC employees are also able to deduct 50% of any stock option benefits received from CCPC’s  under s. 110(1)(d.1) of the income tax act on the condition that they have not disposed of or exchanged shares for two years after the acquisition date. Upon disposition of the shares, the employee is taxable on the benefit amount less the deduction and the taxable portion of any capital gains realized on disposition.

The employee benefits by deferring any income tax liability which would otherwise arise upon acquisition of the shares through an “ordinary” stock option plan and by converting what would normally be fully taxable employment source income into income that is, in effect, taxable at a lower rate. The portion of the benefit that is taxable to the employee is not a capital gain but income from employment, taxed at the same rate as a capital gain.

An employee who disposes of shares in a Canadian-controlled private corporation within two years from the date of acquisition is taxable in the year of disposition on the full value of any benefit derived from their acquisition.

There is also a special rule for stock option plans under which an individual acquires prescribed equity shares in an employer’s corporation or in a corporation with which the employer does not deal at arm’s length. Under these special rules, It is also possible to receive a 50% deduction. The benefit, however, is taxable on a current basis.

The following conditions must be satisfied in order for a stock option plan to qualify for this special tax treatment:

  • The shares must be prescribed at the time of their sale or issuance
  • The employee must purchase the shares for not less than their fair market value at the time the agreement was made; and
  • The employee must have been at arm’s length with the employer and the issuing corporation at the time the agreement was made.

Employee Stock Option Plans- Vancouver Tax Lawyer Assistance

An employee stock option plan can be an important part of a corporation’s compensation package and has benefits to both employer and employee. Tax planning, structuring and drafting such an employee stock option plan requires advice from one of our experienced Vancouver tax lawyers. If you require tax help or advice with your employee stock option plan contact our Vancouver tax lawyer firm.

The information is thought to be current to date of posting. Income tax law changes frequently and content may no longer reflect the current state of the law. This document is not intended to create an attorney-client relationship. You should not act or rely on any information in this document without first seeking legal advice. This material is intended for general information purposes only and does not constitute legal advice. If you have any specific questions on any legal matter, you should consult a professional legal services provider.

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