In general terms, an employee stock option is an option granted by a corporate employer to an employee to purchase shares in the corporation (or a related corporation). The option gives the employee the ability to purchase shares at a preset price (the exercise price) over a set period of time (the term of the option). Typically, the employee will exercise the option at a time when the value of the shares is greater than the exercise price, so that the employee will make a gain or profit on the exercise.
Employee stock options are normally taxed preferentially under our income tax system. As discussed below, they are typically only half-taxed; more precisely, only half of the stock option benefit is included in taxable income.
The grant of a stock option by an employer to an employee is not itself a taxable benefit. Instead, the Income Tax Act employs a “wait and see” approach, under which the amount of the employment benefit is determined when the option is exercised and the underlying shares are acquired – or, in some cases, where the shares are later sold.
At the time of exercise, the amount of the benefit is the value of the acquired shares at that time in excess of the option exercise price. If the employee paid an amount for the option (this is rare), that amount reduces the benefit.
The amount of the benefit is added to the adjusted cost base of the shares, to prevent double taxation on a later sale of the shares.
John exercises an employee stock option with an exercise price of $10 per share, when the shares are worth $15 per share. His employment benefit is $5 per share ($15-$10). The $5 is added to the cost of the shares along with the $10 purchase price, so that his adjusted cost base becomes $15 per share. Thus, if he subsequently sells the shares for, say, $17 per share, he will have a capital gain of $2 per share (rather than $7 per share, which would occur if the benefit were not added to the cost of the shares).
Note that the full $5 benefit is added to the cost of each share, even if John qualifies for the one-half deduction in computing taxable income, described below.
In most cases, the benefit is included in employment income in the year of the exercise of the option and acquisition of the shares. However, if the employer is a Canadian-controlled private corporation (CCPC), the benefit is deferred and instead included in the year in which the shares are sold. (This recognizes that the value of the shares is not known at time of exercise, because the shares are not publicly traded.) In general terms, a CCPC is a private corporation that is resident in Canada that is not controlled by any combination of non-residents or public corporations.
As noted, typically only half of the benefit is included in the employee’s taxable income. This is done by including the full benefit as income and therefore in “net income”, and then deducting half of the benefit under section 110 of the Income Tax Act, in computing “taxable income”. This deduction is available in either of two scenarios:
- Generally, if the shares are prescribed shares (common shares or certain shares with similar attributes), the value of the shares at the time the option was granted was not greater than the exercise price under the option, and the employee deal’s at arm’s length with the employer; or
- In the case of a CCPC, the shares are held for at least two years by the employee (or if the employee dies within the two years still owing the shares).
Applied to the above example, assuming John qualifies under criterion 1) or 2) above, he will include in taxable income only $2.50 per share. His capital gain on the sale of the shares for $17 each would remain $2 per share (only half of which is included in income).
Stock option “cash-outs”
In some cases, an employer may agree to “cash out” an employee’s stock options. Typically, this means the employee will give up the stock options for a cash payout without ever acquiring shares in the corporation.
In this case, the employee does not normally qualify for the one-half deduction in computing taxable income. However, if the employer elects that it will not claim a deduction for the cash payment made to the employee, then the employee is eligible for the one-half deduction in computing taxable income, if the criteria under 1) above are met.