Equity to Employees
Employees who are being given minor amounts of equity will usually obtain it by way of stock options.
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 option rights may be deferred for some period of time and will usually only vest if the individual is still employed by the corporation.
There should be a written 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 option and for keeping the shares. In the event of a departure from employment the shares are usually reacquired by the corporation on some basis.
If the shares of the corporation are publicly traded then the employee will be permitted to keep his shares even after his employment is terminated. However, he will usually be unable to exercise options to acquire any additional shares after leaving 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.
Most stock option plans are limited to management but some plans are made available to all employees of the organization. In that case there will usually be a different plan for management and for non-management employees.
Another 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 shares at fair market value, the corporation actually receives funds. Payments are only required by the corporation if dividends are declared.
The issuance of stock options has tax implications which vary depending on whether the corporation is private or public and also depend on how long the shares are held after exercise.
However when an employee is being provided with a significant percentage of the business, a reorganization of the capital of the corporation may be undertaken.
This reorganization is similar in principle to that undertaken in an estate freeze utilizing section 86 of the Act. Typically the existing shareholder will convert his shares into a class of special shares with the same value as the existing common shares. Thereafter he and the employee will be able to subscribe for new common shares of the corporation for a nominal amount.
A reorganization under section 86 has no immediate adverse tax consequences to the entrepreneur if carried out properly. One class of shares with an existing adjusted cost base and paid up capital will be converted into one or more other classes of shares of the same corporation with a total cost base and paid up capital equal to that of the shares being given up. The employee is then free to subscribe for new common shares of the corporation for a nominal amount with no tax implications to him.
When stock options are given without a reorganization, and a benefit is conferred on the employee, the 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 option was granted created considerable uncertainty in determining the value of benefits derived from unexercised options. The Act resolves the uncertainty by specifying both the method of valuation and the time for inclusion of the benefit in 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. Nor is the issuance of stock by virtue of the individual’s office (such as a directorship) taxable under these rules.
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 entrepreneurs, 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.
There are two special rules in respect of stock option plans. 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 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 CCPC with which the employer does not deal at arm’s length.
An employee may defer recognition of any benefit derived from stock options issued by a CCPC until disposition of the shares. Upon disposition of the shares, the employee is taxable on only 3/4 of the value of the benefit derived.
The employee benefits by deferring any 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 CCPC 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 his employer’s corporation or in a corporation with which the employer does not deal at arm’s length. An employee is taxable on only 3/4 of the value of any benefit derived from such a plan. 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.