Employee Stock Options
Employee stock options give employees the right to purchase a specified number of shares of a company at a specified price. Employees can derive financial and tax benefits from these stock options if they exercise their options when the market purchase price of the stock is greater than the purchase price specified by the option. They can then sell the stocks they own. However, there are important tax rules that must be understood when an employee exercises their options, and also when those stocks are sold.
Employee Stock Option – Public Companies and Tax Benefits
The following analysis is for stock options granted by public companies.
Under paragraph 7(1)(a) of the Income Tax Act, employees are taxed on the difference between the amount they pay to purchase their option and the fair market value of the stock at the time they exercise the option. The way in which employees are taxed on employee stock options is similar to the way in which they would be taxed on a bonus.
For example, if an employee is given an option to purchase stock for $1,000 and, at the time the employee exercises the option, the fair market value of the stock is $2,000, then the employee will be taxed on the $1,000 difference between the exercise price and the fair market value. This will be counted as employment income in the year the option is exercised.
The way in which employees are taxed on the exercise of their stock options creates the possibility for double taxation. Usually, when an employee sells stock purchased with an employee stock option, the gain incurred from the sale is taxed as a capital gain. In this case, and using the above example, the $1,000 option purchase price would be the cost base for the stock, while the $2,000 fair market value of the stock would be the price of disposition (assuming that the stock is sold for fair market value). The $1,000 difference would be the taxable capital gain. Double taxation can arise here because the employee could be taxed twice: once when the employee exercises the option, and again when the employee sells the stock.
Fortunately, paragraph 53(1)(j) of the Act provides that the difference between the exercise price and the fair market value is to be added to the cost base for the stock. This means that, for the above example, the $1,000 difference between the employee’s exercise price and the stock’s fair market value would be added to the $1,000 cost base on the sale of the stock. Now, with a $2,000 cost base, there would be a $0 difference between the cost base and the price of disposition. The employee’s taxable capital gain would be cancelled out.
Employee Stock Option – Canadian Controlled Private Corporations
If options are provided by a Canadian-controlled private corporation (“CCPC”), and those options are exercised, the taxable benefit mentioned above will only be added to the employee’s income when the stock is actually sold. This is the benefit of exercising options that were granted by a CCPC, you don’t pay any of the taxes until you actually sell.
These shares may also be eligible for the lifetime capital gains exemption. There are specific rules and conditions that must be met before being eligible for this exemption so please consult a tax lawyer.
Employee Stock Options – Tax Deferral
The Income Tax Act provides other mechanisms for the preferential treatment of employee stock options. Under paragraphs 110(1)(d) and (d.1), only half of the difference between the exercise price and the fair market value is taxable. This preferential treatment is, however, limited to certain circumstances: employees must deal at arm’s length with their employer, must generally receive prescribed stock on the exercise of options (rather than generally receiving cash), and, on the date the option is granted, the purchase price specified by the option must be greater than or equal to the fair market value of the stock. Also, if the employer granting the option is a CCPC, the employee must hold the stock for at least two years.
Employee stock options are useful for attracting and retaining employees. For CCPCs especially, employee stock options can act as tax subsidies because they can offer potential employees tax-deferred compensation in exchange for cash investment in the stock of the corporation. If a CCPC is strapped for cash, and if markets are rising, employee stock options can be an ideal means of taking advantage of such circumstances. If you have questions regarding employee stock options, or if you are interested in learning how to use them to your advantage, call us today!
This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in this article. If you have specific legal questions you should consult a lawyer.