Taxation Of Employee Stock Options

Many businesses use stock options to attract and reward good employees. Stock options give employees the opportunity to share in the future growth of a company without reducing the company's cash flow. If the stock options are structured properly, the employee can enjoy the benefit on a tax-effective basis. 

Employees typically receive stock options, granting them the right to purchase shares of the employer corporation at a fixed price (the exercise price) on a future date. The granting of the stock option does not create an immediate tax event for the employee. A taxable employment benefit is triggered when the employee exercises the options and acquires shares of the company. The benefit is equal to the amount, if any, by which the fair market value (FMV) of the shares at the time the employee acquires them exceeds the amount paid by the employee for the shares (the exercise price). The employment benefit is also added to the employee's adjusted cost base (ACB) for tax purposes so the employment benefit is not taxed again on a subsequent disposition. 

The employee may also be entitled to an offsetting deduction equal to 50 per cent of the amount of the employment benefit if certain conditions are met. Generally speaking, the deduction is available if the shares acquired are prescribed shares (typically ordinary common shares), the exercise price was not less than the FMV of the shares at the time the options were granted, and the employee was dealing with the employer at arm's length. The deduction results in the employment benefit being effectively taxed as if it were a capital gain, notwithstanding that the benefit is income from employment. 

Although stock option benefits are included in an employee's income from employment, the employer corporation is not permitted to claim a deduction in respect of those benefits. Where the stock option plan provides an employee the choice to receive cash in lieu of shares, and the employee opts to receive cash, the employer is permitted a deduction for the cash payment. However, the employee may not claim the 50 per cent deduction on the employment benefit amount at the same time unless the employer files an election to forego the deduction on the cash payment. 

Canadian-controlled private corporation

The above rules are even more advantageous when the employer is a Canadian-controlled private corporation (CCPC), a private company that is not controlled by any non-Canadian residents or public companies. 

The timing of the taxation of the employment benefit is deferred to the taxation year in which the employee sells the shares, as opposed to the taxation year in which the employee acquired the shares. The employment benefit will be calculated as discussed above. Moreover, the employee may also claim the 50 per cent offsetting deduction as long as the individual holds the shares of the CCPC for at least two years before selling them. There is no requirement that the exercise price be at least equal to the FMV at the date of grant, nor any requirement that the shares qualify as prescribed shares in order to be eligible for the deduction. 

Consider, for example, a key employee, Bob, who is granted options in 2015 to acquire 1,000 common shares of his employer company at an exercise price of $10 per share, which is the current FMV. In 2016, the FMV increases to $20 per share and Bob exercises his options, purchasing 1,000 shares for $10,000. In 2018, the shares increase to $30 per share and Bob decides to sell his shares. The tax consequences for Bob depend on whether the issuing company is a CCPC or not:

If the issuing company is not a CCPC, Bob will pay tax on the employment benefit when he exercises his options and acquires the shares in 2016. Because the shares are ordinary common shares and the exercise price is not less than the FMV of the shares at the time the options were granted (Bob is dealing with his employer at arm's length), Bob may also claim a deduction of 50 per cent of the employment benefit, effectively taxing it at the same rate as a capital gain. Thus, Bob will have an employment income inclusion of $5,000 in 2016, and when he sells his shares he will realize a taxable capital gain of $5,000 in 2018. 

If the issuing company is a CCPC, Bob will not have to pay tax on the employment benefit until he disposes of the shares in 2018. Because Bob held the shares for more than two years after the options were exercised, he will also be able to claim a deduction equal to 50 per cent of the benefit. If Bob had held the shares for less than two years, he would still be able to claim the 50 per cent deduction of the employment benefit since the other conditions are met (i.e. the shares are prescribed shares, the exercise price was not less than FMV, and Bob was dealing with his employer at arm's length). 

Thus, Bob will have a total net income inclusion of $10,000 in 2018, comprising of the $5,000 employment income (related to the increase in the shares' value net of the 50 per cent deduction when he exercised his options in 2016), plus the $5,000 taxable capital gain realized on the disposition of the shares. 

Bob may be able to shelter the $5,000 taxable capital gain if the shares he sold are eligible for the capital gains exemption for qualified small business corporation shares. Individuals are entitled to a lifetime capital gains exemption of up to $813,600 (for 2015) on such shares. 

However, if the shares decline in value and Bob sells them in 2018 for $10,000 (less than their $20,000 value when he exercised the options), he will still have an income inclusion of $5,000 (the employment benefit after the 50 per cent deduction), which is subject to tax, and a $5,000 allowable capital loss (($10,000-$20,000) x 50 per cent). Although the employment benefit is afforded the same tax treatment as a capital gain, it is not actually a capital gain. Thus, the $5,000 allowable capital loss realized in 2018 may not be used to offset the employment benefit. 

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.