A stock option is a security granting the option holder the right, but not the obligation, to purchase shares of the granting company at a fixed price (the “exercise price”) on a future date. The term “employee stock option” describes stock options granted to employees of a company under an employee stock option plan (“ESOP”). An ESOP is the written plan of the employer company setting out the rules governing the options in question (e.g. how many options may be granted by the company, when options expire if the employee’s employment is terminated, etc.). An employer company must have an ESOP in place before it can grant employee stock options.
Employee stock options have long represented a popular means for companies to attract, compensate, and retain key employees. Under the Income Tax Act (Canada), a special set of rules govern the federal tax treatment of employees who are granted, and subsequently exercise, employee stock options.
The granting of an employee stock option does not create a taxable event for the employee, but a taxable employment benefit is triggered and added to the employee’s income when the employee exercises the option and acquires shares of the employer company. In general, the benefit is the difference between the fair market value (“FMV”) of the shares at the time the option is exercised and the exercise price of the option.
Once the option is exercised, the employment benefit is added to the adjusted cost base (“ACB”) of the shares for tax purposes so the employment benefit is not taxed again when the shares are sold. When the employee sells the shares, a resulting gain or loss is calculated and taxed under the general capital gain and loss rules.
Offsetting Deduction under the General Rule
An employee who exercises a stock option and acquires shares is entitled to an offsetting deduction equal to one-half the amount of the employment benefit if certain conditions are met. This results in the employment benefit being effectively taxed as if it were a capital gain. Importantly, the one-half deduction does not result in any reduction to the employee’s ACB of the acquired shares.
Here are the conditions that must be met for the employee to be able to deduct one-half of the stock option employment benefit:
Exception to the General Rule – Stock Options of CCPCs
There is an important exception to the general tax rule which taxes the employee on the stock option employment benefit in the taxation year stock options are exercised. In the case of options on shares of a Canadian-controlled private corporation (“CCPC”), taxation of the stock option employment benefit can be deferred until the taxation year in which the shares are sold by the employee. A CCPC is defined as a Canadian corporation whose shares are not listed on a designated stock exchange, and which is not “controlled” - directly or indirectly - by one or more public corporations or non-resident persons. The tax policy behind this exception recognizes the limited marketability of CCPC shares in many cases.
An offsetting deduction for one-half of the employment benefit is available for CCPC stock options: unlike the general rule, there is no requirement that the exercise price must be less than the FMV of the shares at the time the option was granted. As long as the employee has held the shares of the CCPC for at least two years before selling the shares, the employee may claim the offsetting deduction.
Although stock option benefits are included in an employee’s income from employment, the employer is not permitted to claim a deduction in respect of those benefits. Where the ESOP 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 one-half deduction on the employment benefit amount at the same time unless the employer files an election to forego the deduction on the cash payment.
Public company stock options
The rules are different where the company granting the option is a public company. The general rule is that the employee must report a taxable employment benefit in the year the option is exercised. This benefit is equal to the amount by which the FMV of the shares (at the time the option is exercised) exceeds the exercise price. When certain conditions are met, a deduction equal to one-half the taxable benefit is allowed.
The information in this blog post is for educational purposes only and does not constitute legal advice.