Canada: Employee Stock Options: Tax Implications For Canadian Employees – A Canadian Tax Lawyer's Analysis

Last Updated: October 8 2018
Article by David Rotfleisch

Introduction – Employee Stock Options

Some businesses, especially high-tech start-ups, and more recently marijuana start-ups, opt to compensate their employees with options to purchase shares in the business at a discount price. An employee stock option (ESO) gives an employee the right to purchase shares of the employer corporation at a fixed price during a set period. Should the value of the shares later exceed the option price, the employee may exercise the option and thereby purchase those shares at the bargain option price. The employee can then sell the shares and immediately realize a profit.

Certain employers find employee stock options to be an attractive method of compensating their employees. First, employee stock options are thought to provide employees with an incentive to work harder, contribute to the employer's bottom line, and thus increase the value of the corporation and its shares. Moreover, an ESO affords a method of compensation with little risk to the employer should the company perform poorly. In this case, the value of the employer's shares will fail to exceed the option price, and its employees will presumably eschew their options. Also, through the use of vesting periods, the employee stock option provides an incentive for the employee to stay with the corporation.

Income-Tax Implications of Exercising an Employee Stock Option: Employee Benefit under Subsection 7(1) of the Income Tax Act

No tax consequences arise when the employee receives the option; they arise when the employee exercises the option—i.e., when the employee acquires the shares under the employee stock option.

The employee must account for the benefit garnered from exercising the option when computing his or her income for the year. The benefit inclusion equals the fair market value of the shares at the time the employee exercised the ESO minus the option price and any amount that the employee paid to purchase the option. For example, the option price is $10 for 15 shares, the employee paid $5 to purchase the employee stock option, and the employee exercised the option when the 15 shares were worth $20. The employee's benefit inclusion is $20 - $10 – $5 = $5.

The tax year in which the employee must include the benefit depends on whether the shares under the ESO are those of a Canadian-controlled private corporation (CCPC). If the ESO shares are those of a Canadian-controlled private corporation, the employee need not account for the benefit until he or she sells the shares. But if the employee-stock-option shares are those of a non-CCPC—i.e., a public corporation—the employee must account for the benefit in the year that he or she exercised the employee stock option and acquired the shares.

Canada's tax system defers tax for those acquiring shares of a CCPC due to the market forces and liquidity issues that those shareholders often face. The market for shares in a Canadian-controlled private corporation is often restricted and typically smaller than that for shares in a public corporation. Employees acquiring CCPC shares would therefore face liquidity problems if they were required to pay tax when buying shares that they couldn't readily sell. So, these employees need not report the employee benefit until the year that they sell their shares and thus presumably have the cash to pay the tax. On the other hand, employees acquiring shares in a public corporation generally don't encounter much resistance when attempting to sell their shares on the stock exchange. So, they must report the employee benefit and pay the resulting tax in the year that they acquired the shares under the employee stock option.

Deduction for Employee Benefit from Exercising an Employee Stock Option: Paragraphs 110(1)(d) and 110(1)(d.1)

Subsection 110(1) of the Income Tax Act allows the employee to report only half of the benefit derived from exercising the employee stock option. For example, the option price is $10 for 15 shares, and the employee exercised the option when 15 shares were worth $20. The employee's benefit inclusion is $20 - $10 = $10. If the employee qualifies (see below for criteria), subsection 110(1) permits the employee to report only $5 of the $10 employee benefit from exercising the employee stock option.

Subsection 110(1) gives two sets of criteria for the one-half benefit deduction. The first applies generally; the second places less stringent demands on employees acquiring shares of a CCPC.

Under paragraph 110(1)(d), the employee may deduct half of the ESO benefit when computing taxable income if: (1) the employee received common shares upon exercising the employee stock option; (2) the employee dealt at arm's length with the employer; and (3) the ESO option price (including any amount paid to acquire the ESO) wasn't less than the fair market value of the underlying shares at the time that the option was granted.

For employees receiving CCPC shares, paragraph 110(1)(d.1) grants the same one-half deduction but with fewer constraints. If, under the employee stock option, the employee receives shares in a CCPC, the employee receives the one-half deduction as long as the employee held the shares for at least 2 years.

Capital Gains Implications When Selling the ESO Shares

The benefit that an employee reaps from exercising an employee stock option forms a part of that employee's taxable employment income. The acquired shares, however, are a capital property that may give rise to a capital gain when the employee sells them.

The employee would suffer double taxation if the tax cost of the acquired shares were not adjusted to account for the already taxed employee benefit. To prevent that, the amount of the employee's benefit from exercising the ESO also increases the tax cost of the acquired shares.

This result comes from paragraph 53(1)(j) of the Income Tax Act. Notably, paragraph 53(1)(j) doesn't reduce the tax-cost bump of the acquired shares if the employee qualified for the one-half benefit deduction under paragraph 110(1)(d) or paragraph 110(1)(d.1). In other words, although the subsection 110(1) may allow the employee to deduct half the ESO benefit from taxable income, the tax cost of the ESO shares includes the full amount of the ESO benefit.

For example, an employee exercises an ESO with an option price of $10. At the time the employee exercised the employee stock option, the underlying shares were worth $15. The employee subsequently sells the shares for $17.

Employee benefit: The employee's benefit from exercising the employee stock option is $15 - $10 = $5 – ½ under subsection 110(1) = $2.50. The employee includes the benefit either in the year she exercised the employee stock option or, if she acquired CCPC shares, in the year that she sells the shares.

Capital gain: Although subsection 110(1) reduced the employee's ESO benefit to $2.50, paragraph 53(1)(j) adds the full ESO benefit to the tax cost of the acquired shares. So, the tax cost of the acquired shares is $10 + $5 = $15. The sale therefore triggers a capital gain of $2.00, half of which is taxable.

Tax Tips – Capital Losses and Deferring Capital Gains from ESO Shares

The benefit from exercising an employee stock option is employment income; the profit from selling the acquired shares is a capital gain. And you cannot deduct capital losses against other sources of income. As a result, if the shares that you acquired under an employee stock option later drop in value and you thereby sell them at a capital loss, you cannot offset your ESO benefit using that loss.

If you plan on selling the shares you acquire from exercising your employee stock option, you can defer the resulting capital gain by selling these shares the following year. For instance, if you acquired your shares in 2017, you can defer the need to report and thus pay tax on any capital gain by selling the shares at the beginning of 2018. If you sold the shares in 2017, your tax liability for any capital gain would arise on April 30, 2018. But by selling the shares on, say, January 1st 2018, you delay that tax liability until April 30, 2019.

Of course, by delaying the sale, you risk the possibility that the shares will lose value. So, you generally want to sell the shares soon after exercising your employee stock option and acquiring them. Moreover, the expiry date for some ESOs aligns with the end of the calendar year.

One alternative is to exercise your employee stock option as late in the year as possible, which ideally allows you to sell the acquired shares shortly thereafter yet in the following year. You thereby defer the tax liability on the resulting capital gain while both exercising the option before it expires and reducing your exposure to the risk that the shares may lose value.

Whether you're an employee who has received an employee stock option or an employer considering your choices for remuneration, you may wish to consult one of our expert Canadian tax lawyers for advice on more sophisticated tax-planning strategies and structures.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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