Canada: Stock Options

Reprinted from A Director’s Guide to Executive Compensation, Issue 2, May 2006.


Increasingly criticized yet still popular, stock options currently occupy a position of controversy in executive compensation. Companies and executives favour options because they are a well-established and recognized form of incentive that continues to provide optionholders with favoured tax treatment under Canada’s taxation regime. In the last few years, institutional investors and governance organizations have led the charge to replace options with whole share compensation. Concerns over options are based on, among other things, lack of correlation with the optionholder’s performance and the inability to motivate the optionholder at all stages in a company’s growth. In response, companies are supplementing options with other forms of remuneration and altering option plans to address identified shortcomings. The following provides an overview of stock options, their tax treatment, common design flaws and solutions.

What Are Options?

A stock option is a right, but not an obligation, to acquire a specified number of shares at a certain price (the "exercise price") during a predetermined period of time. The exercise price is almost always set at not less than the fair market value of the share at the date of the option grant. Stock options generally vest, or become exercisable, after a specified time. Once the options vest, the optionholder has the right to purchase the underlying securities.

When the exercise price exceeds the grant price, the option is said to be "in-the-money." When the grant price exceeds the exercise price, the option is said to be "underwater." When an option is in-the-money, the value created is an incentive for the option recipient to remain employed with the option grantor on a long-term basis. When underwater, the option represents no value to the optionholder.

How Are Options Taxed?

A stock option grant that meets the requirements of section 7(3)(a) of Canada’s Income Tax Act is not taxable at the time of grant, vesting or exercise of an option. Rather, the employee is taxed when disposing of or transferring the shares acquired when exercising the option. The increase in share value over the exercise price is usually taxed at capital gains rates. This means that one-half of the gain is included in taxable income. However, the employer is not entitled to deduct the value of the shares issued to the employee from its income.

Where an option is granted with a tandem share appreciation right, the employee will generally be entitled to the same tax treatment on exercising the share appreciation right as if he or she exercised the option. Further, the employer is generally entitled to a deduction in respect of the cash payment made to satisfy the share appreciation right.

Problems with Option Plans and Potential Solutions

Part of the difficulty with stock options is that they are a form of leveraged compensation. This type of compensation rewards executives only for the increase in the value of the company’s shares. The share value may increase as a result of inflation, market conditions or other factors unrelated to the company’s or executive’s performance. Companies may modify the options to respond to some of these concerns. For example, options may provide for annual increases in the exercise price, for periodic increases in the exercise price to correspond with the performance of peer companies, for vesting only on the achievement of specified performance targets or for the decrease or elimination of initial awards or options where performance targets are not met.1

Option plans are criticized for failing to improve the executive’s long-term role in a company’s growth and development. With careful attention to option plan design, companies can use options to help motivate and reward executives who achieve successful landmarks. For example, plans should have clauses that motivate key employees to remain with the company for a reasonable time after an initial public offering or a sale of a business. Compensation packages, including the grant of options, can be made contingent upon an executive’s agreeing to non-solicitation and non-competition obligations. Lastly, vesting schedules can be made longer, providing incentives for the executive to remain with the company for a longer period of time and to make business decisions that take into account the long-term health of the company.


From Options to Whole Share Compensation

Increasingly companies are focusing on whole share awards rather than leveraged awards such as stock options. Whole share compensation includes share grants, deferred, restricted and performance share units and share grants. This type of compensation increases and decreases in value in direct relationship with changes in share value and continues to provide an incentive to executives even when the share value decreases below the original grant value. Common forms of alternatives to options are summarized below.

1. Restricted Share Units

A restricted share unit (RSU) is a right to receive the full value of a share at a future time. RSUs are generally funded by converting a portion of the executive’s bonus compensation into RSUs. The number of RSUs is generally determined by dividing the compensation amount by the fair market value of a share at the date of a grant. At the end of the relevant period, the employee receives either one share of the company for each RSU or an amount of cash determined by multiplying the number of RSUs by the fair market value of a share at the end of the period.2In some cases, the incentive plan will allow the executive to choose to settle in cash or in shares. RSUs generally are redeemed no later than three years after date of grant to avoid the salary deferral arrangement rules under Canada’s Income Tax Act.

2. Performance Share Units

A performance share unit (PSU) is similar to an RSU and is the right to receive the full value of a share at some future time. However, a PSU generally vests on the achievement of performance criteria, rather than on the passage of time. PSU plans will generally provide for either cash settlement or share settlement, although some plans allow the executive to choose to settle in either cash or shares. PSUs provide incentive regardless of the share price.

3. Deferred Share Units

A deferred share unit (DSU) is a right very similar to an RSU, except that to meet requirements under the Income Tax Act (Canada), the holder may not redeem the DSU until cessation of employment or, in the case of a director, at the end of the term of office. The plan will generally provide for either cash settlement or share settlement, and in some circumstances may permit the executive to elect between the two settlement options.


Directors’ Approval of Stock-Based Plans

Directors and, in particular, compensation committee members reviewing stock option plans must consider shareholder as well as executive interests. Under the Toronto Stock Exchange Company Manual rules, in addition to the approval of each of a majority of the issuer’s directors and a majority of the issuer’s unrelated directors, shareholder approval is required in respect of certain security-based compensation arrangements.3 In Canada, institutional investors such as pension funds, mutual funds and independent money managers have significant ownership positions in publicly traded corporations. Directors will need to consider the preferences and attitudes of institutional investors when making decisions involving incentive plan design.

Stock options are one of a myriad of topics canvassed in the detailed proxy voting guidelines developed by institutional investors to establish specific standards that determine how shareholder votes are exercised. Below are a number of option plan design elements and the corresponding view of institutional investors that directors should keep in mind when contemplating proposed option plans or option plan amendments.

1. Link to Performance or Ownership

Many stock option plans currently base rewards on general market or sector performance rather than on individual company out-performance of the market or sector.4 The Canadian Coalition for Good Governance emphasizes that stock options are more effective vehicles for aligning executive and company interests when they are linked to performance objectives or share ownership guidelines. When linked to share ownership, the purpose of the option grants is to facilitate share ownership since it is expected that a large part of the after-tax gains on options would be held as stock in the company.5 When linked to performance objectives, option vesting and grant schedules are more effective when contingent upon the executive or company achieving performance targets.6

2. Provide for Corporate Change

Executive compensation arrangements sometimes provide that a change of control is a triggering incident, leading to an acceleration of vesting or additional entitlements. While change of control provisions may be desirable in some circumstances, the scale of the value provided to the executive on a change of control may be disproportional to the value provided to shareholders.

Institutional investors are unlikely to approve stock option plans with change of control provisions that allow optionholders to receive more value than shareholders receive. Institutional investors also emphasize the importance of setting out the change of control entitlements of executives prior to the actual change of control. This approach ensures that options are linked to long-term growth rather than attempting to retain executives in a hostile situation of corporate change where unreasonable demands may be made. Option plans that are instituted during a time of corporate change may also reflect rewards based on factors that are divorced from the executive’s performance. As a result, institutional investors have taken the position that they will not support change of control arrangements developed in the midst of a takeover fight, specifically to entrench management.7

3. Avoid Concentration of Option Grants

Institutional investors are also concerned about concentration of option grants, particularly where provided disproportionately to senior management. Institutional investors are likely to vote against plans or grants of a concentration of more than 20%–25% of all the available options. Further, total potential dilution of ownership should ideally be less than 5% and should never be more than 10%. Institutional investors prefer that the number of options granted in a given year expressed as a percentage of shares outstanding (known as the "burn rate") is restricted to less than 1% of the shares outstanding.8

4. Avoid Discretionary Grants of Options

Institutional investor guidelines do not favour option plans that give the board of directors broad discretion in setting terms of grants. Shareholders and other stakeholders are better able to assess the appropriateness of a proposed option plan that provides set schedules for vesting and grants. Generally, vesting schedules of no more than about five years are preferred. This length of time provides ample opportunity to motivate executives on a long-term basis, but also allows for reasonable cost projections to be made. At the other end of the spectrum, immediate vesting is also not favoured because the long-term quality of the option as a form of remuneration is eroded. Uncertainty resulting from "evergreen", or "reload", option plans is also considered undesirable, since shareholders cannot reasonably assess the potential dilution of option grants (for more information, see below "Evergreen Plans").9

5. Provide for Current Recognition of Expenses

Shareholders require a high level of scrutiny and disclosure for option plans. Disclosure of option grants and their treatment in financial statements should be clearly and carefully laid out on an ongoing basis. This requires public companies to expense the value of the stock options granted during the year. Failure to properly account for options may cause companies to be less concerned with the true cost of granting options and steer them toward granting more options than would be appropriate under a true accounting of their costs.


The Toronto Stock Exchange rules prohibit companies from setting the exercise price for an option at a market price that does not reflect undisclosed material information. In reminding companies of this prohibition, TSX staff recently cautioned listed issuers about "granting options during a blackout period, whether or not the blackout period is directly related to the material undisclosed event."

Blackout periods represent the approximate periods when a company might possess undisclosed material information. If the company is satisfied that no such information exists, the mere existence of a blackout period should not preclude granting options or establishing the exercise price.

However, the TSX has serious concerns about what it believes is a poor governance practice, and has put listed companies on notice that it will scrutinize these grants to ensure that no undisclosed material information existed at the time of pricing. The TSX may require the company to cancel or re-price options granted during these periods.

If some doubt exists about whether there is undisclosed material information, boards should consider delaying the grant of options until the blackout period has expired.


Omnibus Plans

Companies in the United States have been offering up "cafeteria-style" or omnibus plans to executives and senior management for some time. These plans consolidate all forms of mid-term and long-term incentives offered by a company into one plan. The plans generally allow broad discretion to the company to choose the form of incentive award. Canadian incentive plans are usually specific to the type of award (i.e., an option plan or RSU plan), each of which has its own limit on shares available for issuance.

In Canada, we have yet to see the emergence of omnibus plans; indeed, Canadian institutional investors are wary of omnibus plans and warn against their use. The Ontario Teachers’ Pension Plan clearly states in its proxy guidelines that it will not generally support omnibus stock option plans. Rather, shareholders should be provided with the option to accept or reject each type of compensation proposed by management, rather than considering incentives in an aggregate format.10 This criticism of omnibus plans stops short of an outright ban. Instead, institutional investors are likely to carefully scrutinize each element to determine whether the specific benefits being offered are at odds with other guidelines on incentive plan design.

Companies wishing to provide omnibus plans to employees will need to think carefully about both shareholders and employees. Shareholders may approve a plan whose specific elements meet the standards they demand of individual plans. For example, plan designs should continue to make links to performance and use longer-term vesting schedules for each type of incentive offered.

Evergreen Plans

The TSX in Ontario requires that option plans specify a maximum number of shares that can be subject to options, rights or entitlements.11 Since January 2005, the TSX has permitted that number to be expressed either as a fixed number or as a fixed percentage of outstanding shares. In the case of a fixed percentage, a "rolling maximum" allows the number of shares under an arrangement to increase automatically with increases in the total number of shares outstanding. As well, since January 2005, option plans may be "evergreen." Evergreen plans are plans under which shares that are subject to an option or right that has been exercised are reloaded into the available pool.12 These types of plans must be re-approved by shareholders every three years.

Institutional investors will not ordinarily support evergreen plans because of their dilutive effect.13 Further, evergreen plans do not allow shareholders to limit the extent of the dilution of shareholder interests in the future. Although evergreen plans are now permitted by the TSX, they are unlikely to become widespread because of the uncontrolled dilution they permit.


1. C. Medland and J. Sandford, "Tax Treatment of Share Based Compensation in the New Era" (Forthcoming, Taxation and Executive Compensation, Winter/Spring 2006).

2. Medland and Sandford, supra note 1.

3. Where more than 10% of the company’s shares are available for issuance under share-based compensation arrangements, securityholders who have limited or no voting rights will be entitled to vote on the plan in proportion to their equity ownership. Toronto Stock Exchange Company Manual, looseleaf ed. (Toronto: Toronto Stock Exchange, 1975) Rule 613.

4. Ontario Teachers’ Pension Plan, Good Governance Is Good Business: Corporate Governance Policies and Proxy Voting Guidelines (Toronto: Ontario Teachers’ Pension Plan, 2005) at 19.

5. Canadian Coalition for Good Governance, Good Governance Guidelines for Principled Executive Compensation (Canadian Coalition for Good Governance: June 2005) at 9.

6. Ontario Teachers’ Pension Plan, supra note 4.

7. Ibid. at 20.

8. For a complete list of Ontario Municipal Employees Retirement System guidelines, see OMERS, "Proxy Voting Guidelines," online: OMERS See also Ontario Teachers’ Pension Plan, supra note 4.

9. For a complete list of OMERS guidelines, see ibid.; see also Ontario Teachers’ Pension Plan, ibid.

10. Ontario Teachers’ Pension Plan, ibid. at 22.

11. Toronto Stock Exchange Company Manual, looseleaf ed. (Toronto: Toronto Stock Exchange, 1975), Rule 613.

12. Torys’ client memo no. 2004-29, Major Amendments to the TSX Company Manual, November 29, 2004.

13. Philips, Hagar and North Investment Limited, Proxy Voting Guidelines, December 22, 2005, at 8; Public Sector Public Investment Board, Proxy Voting Guidelines, February 6, 2002, at 3.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.