Many readers are likely aware how these employee stock options work.
In general terms, if you are an employee and are granted a stock option from your employer corporation, you have the right (but not an obligation) to exercise the option and acquire shares in your employer’s corporation at an “exercise price”.
The exercise price is simply the amount you can pay, if you choose, to buy the shares. Depending on the terms of the stock option agreement, you could have 1, 2 or more years to exercise the option.
Obviously, you will not exercise the option if the shares are worth less than the exercise price. For example, if the exercise price is $20 per share and the shares are currently worth $16 per share, you will not exercise the option and buy the shares for $20, since you could just buy the same shares for $16 on the market. But if the shares are currently worth $25 per share, you might exercise the option, or maybe wait to see if they go up even more in value.
If the option expires because you choose not to exercise it, there are no tax consequences.
Assuming you do eventually exercise the option, the following is a summary of the relevant tax rules.
First, when the option is granted to you, no amount is included in your income for tax purposes. This is an exception to the normal rules that say if you receive a non-cash benefit from your employer, the value of the benefit is included in your income (there are other exceptions). Although not entirely clear, the reason for this likely stems from the difficulty, especially for private corporations, of valuing the option at the time of the grant.
When you exercise the option and acquire the shares, there is an employment benefit included in your income. Normally, the benefit is included in the year you acquire the shares. However, if your employer is a Canadian-controlled private corporation (CCPC), the inclusion is deferred to the year you sell the shares.
The amount of the benefit is the fair market value of the shares when you acquire them in excess of the exercise price. For example, if the exercise price is $20 per share and the shares are worth $25 per share when you acquire them, the benefit is $5 per share, which is recorded as employment income on your tax return.
However, in many cases you get a one-half deduction in computing your taxable income, which means the benefit is normally only half-taxed, similar to the taxation of capital gains. (There is a $200,000 threshold for this one-half deduction that applies in certain cases, discussed below.)
The one-half deduction rule, subject to the $200,000 threshold, applies if:
- The shares are common shares, or shares that are substantially similar to common shares (there is a complex definition under the Income Tax Regulations);
- The exercise price was not less than the value of the shares at the time the option was granted; and
- You deal at arm’s length with the employer corporation, basically meaning that you are not related to the corporation for income tax purposes (such as if you, or you together with family members, control the corporation).
Furthermore, if the employer is a CCPC, you get the one-half deduction even if you do not meet the above criteria, as long as you own the shares for at least two years before selling them.
If you exercise the option, such that the benefit is included in your income, then the amount of the benefit is added to the adjusted cost base of the shares. This rule ensures that you are not double-taxed when you sell the shares.
I am granted an employee stock option with an exercise price of $20 per share. I exercise the option when the shares are worth $25 each.
Later, I sell them for $28 each.
I have a $5 per share employment benefit, which is cut in half in computing taxable income assuming I meet the criteria discussed earlier.
My adjusted cost base of the shares becomes $25 (the $20 exercise price plus the benefit included in my income). So when I sell the shares for $28, I have a capital gain of only $3 per share, half of which is included in my income as a “taxable capital gain” (the normal rule for taxing capital gains).
Conversely, if I sell the shares for $22 per share, I would have
a capital loss of $3 per share, and half of that would be an allowable capital loss (generally claimable only against taxable capital gains).
The $200,000 threshold
For options granted after June 2021, there is a restriction on the one-half deduction. When the restriction applies, the full amount of the stock option benefit over the $200,000 limit is included in taxable income, rather than one-half.
The restriction limits the one-half deduction to employee stock option benefits reflecting $200,000 worth of shares per year for options granted in the year, based on the value of the shares at the time of the grant of the option. Employee stock option benefits over that limit are fully included in the employee’s taxable income. However, for the amount fully included for the employee, the employer will normally be allowed a deduction in computing its income.
As a simple example, say you are granted an option in August 2022 to acquire shares in your employer corporation, which is not a CCPC. At the time of the grant, the shares that are subject to the option are worth $500,000. You exercise the option and acquire the shares in December 2022. Since the limit regarding the one-half deduction is $200,000, the first $200,000 should be eligible for the one-half deduction. The remaining $300,000 will be fully included in your taxable income.
There are significant exceptions, where these restrictions do not apply and the one-half deduction continues to apply for the employee regardless of the $200,000 threshold.
First, the restrictions do not apply to stock options covering CCPC shares. In other words, any CCPC, regardless of size, can issue employee stock options and the employees can benefit from the one-half deduction.
Second, the restrictions do not apply to stock options offered by other (non-CCPC) employers, generally if their gross revenue for accounting purposes for their most recent fiscal period is $500 million or less (if the corporation is part of a group of corporations that prepares consolidated financial statements, the amount report for gross revenues of the group must be $500 million or less). Certain other conditions apply for these purposes.
In summary, employee stock option benefits continue to enjoy preferential tax treatment, subject to the $200,000 rule.