Currently, employee stock options are taxed preferentially under the Income Tax Act relative to other forms of remuneration.
There is no taxable benefit to the employee when the stock option is granted. Instead, the inclusion of the stock option benefit is normally deferred to the year that the option is exercised and the underlying shares are acquired. However, if the employer issuing the shares is a Canadian-controlled private corporation (CCPC), the inclusion of the benefit is deferred further to the year that the shares are sold.
The benefit included in income is the amount by which the value of the shares at the time they are acquired exceeds the exercise price paid when they are acquired. If the employee paid something for the option (which is rare), the amount paid reduces the amount of the benefit.
The more significant tax preference – more important than the deferral − is the one-half taxation of the benefit. That is, although the benefit is included in income, a deduction of one-half of the benefit is normally allowed in computing taxable income.
As a result, the benefit is taxed at the same rate as capital gains, which are also only one-half taxed. However, as discussed below, the one-half deduction for employee stock options will be somewhat restricted, effective for options granted after June 2021.
In general terms, in order for the one-half deduction to apply to the stock option benefit, the following conditions must be met:
- The shares must be common shares, or “prescribed shares” that are similar to common shares;
- The employee must deal at arm’s length with the employer; and
- The value of the shares at the time the option is granted must not be greater than the option exercise price.
Alternatively, if the shares are CCPC shares, the one-half deduction can also be claimed if the employee holds the shares for at least two years. In such case, the above conditions do not have to be met. In general terms, a CCPC is a private corporation resident in Canada that is not controlled by non-residents or public corporations.
The amount of the benefit is added to the employee’s cost of the shares for capital gains purposes. This rule ensures that the employee will not be double taxed on the amount of the benefit.
Example
You were granted an employee stock option in 2019. The exercise price was $10 per share and covered 1,000 common shares. The value of the shares when they were granted was $10 per share. The employer is not a CCPC. You deal at arm’s length with the employer.
You exercise the option in 2020 when the 1,000 shares are worth $16 each. You sell the shares in 2021 for $20 each.
Results: In your 2020 tax return, you will report the benefit of ($16 – $10) x 1,000 shares, which equals $6,000. Based on these facts, you are eligible for the one-half deduction, so only $3,000 is included in your taxable income.
The cost of each share to you for tax purposes equals the $10 that you paid under the exercise price plus the $6 benefit per share, or $16. Since you sold them for $20 each in 2021, you will have a capital gain of $4 per share. This results in a capital gain of $4,000, half of which, $2,000, is included in your income as a taxable capital gain in 2021.
Note: If the employer had been a CCPC, both the taxable benefit and the taxable capital gain would be included in your 2021 tax return. Even though the shares were not held for 2 years, the deduction is available under the first rule described above.
Under current rules, the employer is not allowed a deduction in computing its income with respect to the stock option benefit. This rule is detrimental for employers compared to the payment of other forms of employee remuneration and compensation, which are generally deductible for the employer.
Upcoming changes
In the 2019 Federal budget, the government announced that it would be limiting the one-half deduction that applies to employees receiving stock option benefits. Draft proposals were released at the time, but the government delayed the implementation of the proposals pending further study.
Recently, in its Economic Statement on November 30, 2020, the government released the latest version of the proposals. They will apply to employee stock options granted after June 2021. The proposals do not apply to options granted before July 2021, even if they are exercised after that time.
Where they apply, the new rules will limit the one-half deduction to employee stock option benefits reflecting $200,000 worth of shares per year for options granted in that year (the value is determined at the time of the grant of the option). Stock option benefits over that limit will be 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 September 2021 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 $300,000. You exercise the option and acquire the shares in December 2021. Since the new limit regarding the one-half deduction is $200,000, only two-thirds of your resulting benefit will be eligible for the one-half deduction. The other one-third will be fully included in your taxable income.
There are two significant exceptions, where the proposals do not apply and the one-half deduction continues to apply for the employee.
First, the proposals 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 proposals do not apply to stock options offered by other (non-CCPC) employers, generally if their gross revenue for accounting purposes for the 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 reported for gross revenues of the group must be $500 million or less). Certain other conditions apply.