Employee stock options taxed in full
Normally, one-half of an employee stock option benefit is deducted in computing taxable income, which means that only half the benefit is taxable. However, certain conditions must be met in order to claim the one-half deduction. If the conditions are not met, then the entire stock option benefit is taxable.
For example, in general terms, the shares must be common shares, or shares with attributes that are similar to common shares. The fair market value of the shares at the time the option is granted cannot exceed the exercise price under the option. Also, at the time that the shares are issued, it must be shown that the employer or a person not dealing at arm’s length with the employer cannot reasonably be expected to redeem, acquire or cancel the shares within two years (the “two-year reasonable expectation” test).
(In some cases, CCPC shares qualify for the one-half deduction with less stringent requirements.)
This two-year reasonable expectation test proved fatal in the recent Montminy case. In this case, a corporation granted options to the taxpayer and other employees to acquire shares in the corporation. The taxpayer subsequently exercised the option and acquired the shares. On the same day, he sold the shares to the parent corporation of the employer.
The CRA assessed the taxpayer to deny the one-half deduction. On appeal, the Tax Court of Canada upheld the CRA assessment. The Court found that, at the time the taxpayer and other employees exercised their option and acquired the shares, the parent corporation had entered into an agreement under which it agreed to purchase those shares immediately. As a result, the two-year reasonable expectation test was not met. The entire stock option benefit was taxable to the taxpayer because the one-half deduction did not apply.
This decision is currently under appeal to the Federal Court of Appeal.