Employee Stock Options Tax Treatment: Canadian Tax Lawyer’s Guide

Introduction – Employee Stock Options

Certain corporations offer stock options to their employees as a form of compensation. Employee stock options give employees the right to purchase shares of their corporate employer for a fixed price during a set time period. If the value of the shares exceeds the fixed option price then the employee can exercise the option and purchase the corporate employer’s shares at the fixed option price. Immediately after the share purchase, the employee can sell the shares in which case he or she will realize a profit. This article provides tax guidance related to employee stock options.

Employee Stock Options and Section 7 of the Income Tax Act

Pursuant to section 7 of the Income Tax Act, an employee is deemed to have received a taxable benefit where the option is granted, unless the corporation is a Canadian-controlled private corporations (CCPC) dealing with an employee at arm’s length in which case the taxable benefit is recognized when the shares are sold. Employees must account for the benefit acquired from exercising their employee stock options when computing their income for the relevant tax year. The benefit inclusion equals the fair market value of the shares at the time when the employee stock option was exercised (minus) the option price and any amount that the employee paid to purchase the option. As previously mentioned, where the employee stock option benefits are those of a CCPC, an employee is not required to account for the benefit until he or she sells the shares. In this context, the employee will have time between the point in time when they purchased the shares to the time which they sell those shares and will presumably have the funds to pay the tax.

Employee Stock Options and paragraphs 110(1)(d) and 110(1)(d.1) of the Income Tax Act

Subsection 110(1) of the Income Tax Act allows certain employees to report only one half of the benefit derived from exercising the employee stock option. Under paragraph 110(1)(d) of the Income Tax Act, employees of a CCPC may deduct one half of the employee stock option benefit when computing their taxable income if the employee: (1) received common shares upon exercising the employee stock option; (2) deals with the CCPC at an arm’s length, and (3) the employee stock option price (including any amount paid to acquire to the employee stock option) was not less than the fair market value of the shares at the time that the option was granted. Pursuant to paragraph 110(1)(d.1) of the Income Tax Act, employees receiving CCPC shares is deemed to have received an amount equal to half of the amount of the benefit provided that the employee: (1) held the shares in the CCPC for at least 2 years, and (2) he or she did not claim any other stock option deduction in association with the benefit.

Capital Gains Implications Associated with Employee Stock Option

As previously mentioned, the benefit acquired from receiving an employee stock option forms part of the employee’s taxable income. However, the acquired shares are a capital property and might give rise to capital gains once the employee sells those shares. To avoid double taxation, the amount of an employees’ benefit from exercising his or her employee stock option also increases the tax adjusted cost base of the acquired shares. In context of employee benefits, the fair market value of the underlying shares at the time he or she exercised the employee stock option (minus) option price = total (minus) ½ subsection 110(1) amounts = employee benefit. In context of capital gain for employees, the stock option benefit is also added to the tax adjusted cost base of the acquired shares. As such, the tax adjusted cost base of the acquired shares is computed as follows: option price (+) employee benefit. The sale triggers a capital gain – price at which the employee sells the shares (minus) tax adjusted cost base of acquired shares – and half of the capital gain is taxable.

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Changes to Employee Stock Options Rules

In 2019, Canada’s federal government proposed changes to the rules governing the taxation of stock option benefits. The purposed changes aim to limit the availability of the 50% stock option deduction for high income earners receiving employee stock options from corporations that are not CCPCs and to preserve such deduction for employees of small businesses and start-ups.

As of July 1, 2021, employees receiving employee stock options from corporations that are not CCPCs will be subject to a $200,000 limitation on the amount of stock option deduction that can be claimed. In particular, the new rules limit the annual benefit on employee stock options to $200,000, which can vest in a given calendar year. However, employee stock options granted by CCPCs are not subject to the above-noted $200,000limit. In addition, under the new rules, employees who donate shares acquired under an employee stock option in excess of the $200,000 limitation will be eligible for the Charitable Tax Credit (as is the case under the current rules) but not the employee stock option deduction. Further, the new changes permit employers to choose whether to grant their employee stock options subject to the new tax treatment or grant stock options that are eligible for the tax deduction in computing the taxable income. This notification must be made in writing within 30 days after the options are granted. Moreover, employers are also required to notify the Canada Revenue Agency (CRA) whether, or not, they will grant employee stock options that are subject to the new rules. It is uncertain whether these measures will achieve their intended purpose.

Pro Tax Tips – Employee Stock Options

An employee can not deduct capital losses against other source of income. As such, if an employee acquires shares under an employee stock option and those same shares later drop in value and the employee sells them at a capital loss – the employee cannot offset their employee stock option benefit using those losses. An employee may decide to acquire shares this calendar year but defer reporting and paying the tax on any capital gains by selling the shares in the following calendar year. Yet, in this context the employee runs the risk whereby those shares could potentially lose value. Employee stock options are a complex area of law that requires detailed analysis and advice from an experienced Canadian tax lawyer. Both employees and employers should consider their compensation choices and the tax implications associated with employee stock options. If you have questions about whether the taxation changes to employee stock option rules impact you or your business, contact our Certified Specialists in Taxation Canadian tax lawyer for appropriate tax guidance.

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