Moore
November 2018 Newsletter

Employee stock options have specific rules that are different from the tax rules that apply to other options as discussed in the article above.

Generally, an employee stock option refers to an option granted to an employee of a corporation that entitles the employee to buy shares in the employer (or a related corporation) at a set price over a set term. In other words, the option is basically a call option for the employee on shares in the employer (or related corporation).

The grant of the option is not a taxable event for either the employee or employer.

Instead, the Income Tax Act provides a “wait and see” approach, under which the employee has tax consequences only if the employee exercises the option and acquires the shares. If the employee does not exercise the option, it simply expires with no tax consequences. (In the rare case where the employee paid something for the option, the amount paid will constitute a capital loss for the employee if the option expires. But generally employees do not pay for these options − they receive them as an employee benefit.)

 

Exercise of option

If the employee exercises the option and acquires the underlying shares, the employee will include in employment income a benefit equal to the difference between the option exercise price and the fair market value of the shares when they are acquired.

The timing of the inclusion will depend on whether the employer corporation is a Canadian-controlled private corporation (CCPC) or not. If it is not a CCPC, the benefit is included in income in the year in which the shares are acquired. If it is a CCPC, the benefit is included in the year in which the employee sells the shares. In other words, the CCPC stock option provides a potential deferral for the employee. (This recognizes that the market value of shares in a CCPC is usually unknown until shares can actually be sold. For shares of a public company, in contrast, the value can easily be determined.)

The amount of the benefit is added to adjusted cost base of the shares for capital gain / capital loss purposes, so as to prevent double taxation. 

One-half deduction

In most cases, if you exercise an employee stock option, you will be allowed a deduction of one-half of the benefit in computing your taxable income. In other words, similar to capital gains, in most cases only one-half of employee stock option benefits are subject to tax.

You are allowed the one-half deduction in either of the following two scenarios.

First, you get the deduction if:

  • The option exercise price was not less than the fair market value of the shares when the option was granted (in colloquial terms, the option was not “in the money” when it was granted to you);
  • The shares were common shares (or prescribed shares with similar characteristics to common shares); and
  • You deal at arm’s length with the employer.

Alternatively, you can get the deduction if the employer is a CCPC and you hold on to the shares for at least two years before selling them.

Example

In 2015, you were granted an option to acquire common shares in your employer at an exercise price of $20 per share. At the time of the grant in 2015, the shares were trading at $18 per share. Your employer is a public company and thus is not a CCPC. You deal at arm’s length with your employer.

In 2018, you exercise the option and acquire the shares when they are worth $30 per share. In 2019, you sell the shares for $35 per share.

Results: In 2015, there is no tax effect on you, since you have not yet exercised the option.

In 2018, you include a benefit of $10 per share ($30 − $20) in your employment income. However, in computing your taxable income, you will be allowed to deduct half of that amount, or $5 per share. The initial $10 benefit amount is added to the cost of each share, which becomes $30.

In 2019, you will have a capital gain of $5 per share ($35 − $30), and half of that will be included in your income as a taxable capital gain.

Note that if you sold the shares in 2019 for, say, $25, you would have a capital loss of $5 per share. However, this capital loss cannot be used to offset the employee stock option benefit, since capital losses can only offset capital gains, and the stock option benefit is considered employment income.

Last modified on November 19, 2018 12:00 am