1.0 INTRODUCTION

Specific provisions of the Income Tax Act (Canada) (the “ITA ”) make stock options a very attractive form of employee remuneration. Often the tax burden may be deferred and will be half that which it would otherwise be if the remuneration were paid by way of salary.

Employee stock options warrant consideration and pragmatic analysis. Part of the analysis is what the after tax return will be relative to other forms of remuneration. Only in an environment of continuously falling market prices will employee stock options never make financial sense.

The purpose of this booklet is to describe the tax consequences associated with the exercise of employee stock options and to discuss potential planning opportunities. Towards the end of this booklet we have used examples to illustrate the tax workings (including some tips and traps).

As with all booklets of this nature, we must add the usual disclaimer that the information contained in this booklet should not be relied upon or acted upon without first receiving legal advice. Not all employee stock options are the same and the tax dollars involved can be significant.

2.0 RULE S FOR EMPLOYEES

Employees vs. Independent Contractors

Where a person receives a benefit in kind rather than cash, the value of the benefit will generally be required to be included in income. The grant of a stock option is a benefit in kind.

For an employee (including a director or officer), the ITA contains special rules dealing with stock options that are received by virtue of the employee’s employment (and not for some other reason such as being a shareholder). The stock option rules for employees are generally more favourable than those for independent contractors (such as most consultants).

The determination as to whether a person is an employee or an independent contractor is not always easily made. One key indicator is whether the person was working for his or her own profit by providing services to more than one business, in which case the person will more likely be viewed as an independent contractor. In this booklet we describe only the special ITA stock option rules for employees.

General Scheme (Income Inclusion and Not a Capital Gain)

The general technical tax treatment of an employee stock option benefit must be understood in examining employee stock options. Although the employment benefit associated with stock options is often thought of as being taxed like a capital gain because the numerical tax result will in many cases be the same, the employment benefit is not a capital gain.

For a capital gain, 50 percent of the capital gain is included in computing income. Technically speaking, for employee stock options 100 percent of the benefit is included in computing income. One of two 50 percent deductions may then be claimed by the employee where certain conditions are met (these conditions are discussed in greater detail below).

How employee stock options are technically treated under the ITA is important for a number of reasons. First, the 50 percent deductions depend upon a number of statutory requirements and involve some complex tax language being satisfied. Second, the ITA generally allows capital losses to be carried back three years and ahead indefinitely against capital gains (technically speaking, net capital losses may be applied only against taxable capital gains). However, because a stock option benefit gives rise to an income inclusion and not a capital gain, capital losses may not be applied to offset the income inclusion (such capital losses include those suffered upon a subsequent disposition of the shares acquired under the stock option).

Timing

In order to more easily understand the stock option rules, three distinct times must be kept in mind.

The three times are:

  1. when the option is granted;
  2. when the option is exercised
  3. when the shares received under the option are disposed of (usually sold).

The general scheme of the stock option benefit rules varies depending upon whether or not the employee was an employee of a “Canadian-controlled private corporation” (a “CCPC”) at the time the option was granted. In general terms, a CCPC is a corporation incorporated in Canada that does not have over 50 percent of its voting shares held by any combination of non residents or public corporations.

Where the employee was an employee of a CCPC at the time of the grant of the stock option, the amount of the income inclusion (benefit) is computed at the time the option is exercised but is not included in income until and for the taxation year in which the employee disposes of the shares received under the option agreement. If after the grant of the option the CCPC loses its status as a CCPC, the deferral is not affected.

The advantage of a deferral of the income inclusion (which as noted above is computed at the time of exercise) to the taxation year of disposition can be significant. For example, if an option is exercised in 2008 but the shares are not sold for twenty-five years, the tax liability associated with the income inclusion will only need to be paid for the 2033 taxation year.

Where there is no deferral of the income inclusion to the year of disposition, the tax consequences may create cash flow difficulties for the employee because the employee will be required to pay tax associated with the income inclusion. The employee may be forced to sell shares in order to satisfy the tax liability. In some cases, the employee may not be able to sell the shares received to raise cash to fund the tax liability because a ready market may not be available. For example, where the corporation is a private corporation controlled by non-residents, a deferral will not be available and there will likely not be a ready market for the shares.

Other than some special rules for some publicly listed shares, where the employee was not an employee of a CCPC at the time of the grant, the amount of the income inclusion is also computed at the time the option is exercised but is included in income for the taxation year in which the employee exercised the option.

For some publicly listed shares, subject to certain limitations, the ITA contains provisions that allow the deferral of the income inclusion arising at the time that the option is exercised to the year of disposition in cases where the shares acquired under the stock option agreement were, at the time of their acquisition, of a class of shares listed on a designated stock exchange if the employee’s acquisition of shares is a “qualifying acquisition”. The requirements and limitations in this regard are described in greater detail below under the heading “Deferral of Income Inclusion for Listed Shares”.

As an aside, an independent contractor is required to include in computing income the amount of any benefit in kind associated with the grant of a stock option for the taxation year in which the option is granted. As can be seen from the special rules for employees, an employee is generally not required to include any benefit in income until at least the year of exercise or the year of disposition depending upon which special rules are met.

Finally, it should be noted that further special rules apply where an employee, before exercising an employee stock option, either disposes of the stock option, ceases to be a Canadian resident, or dies.

3.0 CALCULATING THE INCOME INCLUSION

Whether or not the employee was an employee of a CCPC at the time the option was granted (or the publicly listed share rules apply), the calculation of the income inclusion resulting from the exercise of the stock option is the same. It is only the timing of the income inclusion (and the potential 50 percent deductions) that may differ.

The income inclusion is the amount calculated as follows:

A – (B+C)

where:

A = value of the shares at the time of the option is exercised B = the amount paid or to be paid for the shares (the exercise price) C = the amount, if any, paid to acquire the option.

In most cases the income inclusion will be the amount by which the value of the shares exceeds the exercise price of the option because employers generally do not require employees to pay for the grant of the option.

Where the shares are not publicly traded the determination of the “value” of the shares may not be straightforward and may be challenged by the Canada Revenue Agency (“CRA”). Similarly, where the shares (whether or not they are publicly traded) are subject to trading restrictions, the determination of the appropriate discount to reflect the trading restriction may give rise to a CRA challenge.

4.0 T HE 50 PERCENT DEDUCTIONS

Where an employee stock option benefit is included in income, the ITA provides for two separate 50 percent deductions. As the first type of deduction is available only in respect of the employee stock options granted by a CCPC, an employee who has received options in a CCPC may claim either (but not both) of the two 50 percent deductions, provided that the respective statutory conditions for the deductions are otherwise met. In all other instances, only the second of the two 50 percent deduction will be available (again, assuming the conditions for the deduction are otherwise met). Either deduction must be claimed for the taxation year in which the employment benefit is included in income.

For either deduction, the employee must have been dealing at arm’s length with the employer immediately after the option was granted.

Where the employee stock option was granted by a CCPC to an employee, the first 50 percent deduction will generally be available if the employee does not dispose of or exchange the shares within two years of acquiring of the shares under the stock option. As previously noted, the income inclusion for the benefit associated with shares acquired under an employee stock option granted by a CCPC is the year of disposition and not the year of acquisition. Consequently, in the taxation year of disposition the employee will report the income inclusion (based upon the value of the share at the time the option is exercised) and may claim a 50 percent deduction.

The second 50 percent deduction is available to employees whether or not the employee stock option was granted by an employer corporation that was a CCPC at the time of the grant. The key requirements for this 50 percent deduction are:

  1. the amount payable under the option agreement to acquire the shares must not be less than the amount by which the fair market value of the shares at the time of the grant of the stock option exceeds the amount, if any, paid to acquire the option; and
  2. the shares must be “prescribed shares” at the time of their acquisition by the employee.

As noted above, it is uncommon for employees to be required to pay for an employee stock option agreement. Accordingly, in most cases, the first requirement for this 50 percent deduction essentially means that the exercise price of the option must at least equal the fair market value of the shares at the time the option is granted.

As previously noted, where shares are not publicly traded it may be difficult to determine the fair market value of a share. Moreover, a CRA auditor with hindsight and seeing potentially large tax dollars in denying the 50 percent deduction may be tempted to challenge the parties’ determination of fair market value.

A further requirement for the second 50 percent deduction involves “prescribed shares”. “Prescribed shares” are shares with certain characteristics and which meet certain requirements as prescribed under regulations to the ITA. In general terms, the prescribed share definition appears intended to reflect “garden variety” common shares. That said, the definition is lengthy and contains significant complexity. For example, a right of first refusal in favour of the employer corporation will often cause the prescribed share definition not to be met. For commercial reasons, it is common for a private corporation to want a right of first refusal because it enables the corporation to keep its shares closely held and, in particular, held by its employees who will have a vested interest in the financial success of the corporation as a result of holding its shares.

5.0 CAPITAL GAINS (LOSSES) AFTER THE TIME OF EXERCISE

Between the date of acquisition and the date of disposition of the shares, the shares will in all likelihood rise or fall in value and upon their disposition either a capital gain or capital loss will be triggered. The capital gain or loss will be calculated based upon a cost base equal to the value of the shares at the time of exercise under the employee stock option agreement (in other words, the cost base of the shares will be increased by the amount of the income inclusion arising at the time the option is exercised).

One half of any capital gain will be required to be included in computing the employee’s income (in some cases, the “$750,000 capital gains exemption” may be available to eliminate some or all of the tax liability that would otherwise arise). Generally, a capital loss can be used to offset a capital gain arising in the year. If there are no capital gains in the year, the capital loss may be carried back three years and ahead indefinitely to offset capital gains arising in those years.

An important point to note is that any realized capital loss cannot be applied to reduce the income inclusion (or otherwise provide a deduction) resulting from the acquisition of the shares under the employee stock option agreement. The inability to apply the capital loss against the income inclusion may trap an employee in the situation where he or she has a significant tax liability but never realized sufficient proceeds from the sale of the shares to fund the liability. The potential trap is illustrated in Example C at the end of this booklet.

6.0 DEFERAL OF INCOME INCLUSION FOR LISTED SHARES

Following announcements by the Minister of Finance in the February 2000 Budget, the ITA was amended to add provisions that enable employees to defer the income inclusion associated with acquiring publicly–listed shares under an employee stock option plan until the year in which the employee actually disposes of the shares subject to certain requirements and limitations. The deferral is available where an employee’s acquisition of shares is a “qualifying acquisition”.

The apparent purpose behind the Budget proposals was to align Canada’s tax treatment of employee stock options of publicly-traded corporations closer with the approach taken in the United States.

In general terms, an acquisition is a “qualifying acquisition” where:

  1. the shares are acquired after February 27, 2000;
  2. the employee would otherwise be entitled to the second 50 percent deduction described above, which generally means that:
    1. the exercise price must be equal to or greater than the fair market value of the share at the time of the grant;
    2. the employee must be at arm’s length with the employer;
    3. the share must meet the “prescribed share” definition (as noted above, generally speaking, a “garden variety” common share);
  3. the employee must not be a “specified shareholder” immediately after the grant of the option (a “specified shareholder” generally means a person who owns directly or indirectly at least 10 percent of the shares of any class); and d) the share is of a class of shares that at the time of acquisition is listed on a designated stock exchange (most major Canadian and foreign stock exchanges).

To obtain the benefits of deferral, the employee must satisfy the following conditions:

  1. the employee must file an election (usually with the employer) to defer the income inclusion in a prescribed manner and by a prescribed time (usually January 16 of the year following the year of acquisition);
  2. the employee must be a Canadian resident at the time of acquisition of the shares;
  3. the shares to which the election applies cannot exceed the $100,000 annual vesting limit.

The annual vesting limit is generally based upon the exercise price of the shares under an employee stock option plan that vest in a particular year. Vesting refers to the time at which the option becomes exercisable. Example F at the end of this booklet illustrates this vesting aspect.

7.0 ANCILLARY MATTERS

Discount Stock Purchase Plans

Employer corporations with shares actively traded on a stock exchange often give employees the ability to purchase treasury shares at a discount to the market price (often the lowest market price over a stated period of months).

Under such discount stock purchase plans the employee will be viewed under the ITA as receiving an employment benefit equal to the value of the discount. The employee will be required to include this amount in computing income in the year the shares are acquired. Neither a deferral nor the 50 percent deduction is available because the purchase price is less than the fair market value of the shares at the time of their acquisition.

RRSPs

An employee may be granted an employee stock option which may subsequently be transferred to his or her RRSP (an RRSP cannot receive the grant directly). Although it is possible for an RRSP to hold an employee stock option, it is usually not advisable to do so because there is the potential for double taxation resulting from the ITA’s technical workings.

Identical Property Rules

As a general rule, the cost basis of identical shares (shares of the same class) are averaged in order to determine the cost base of any particular share held. The ITA employee stock option rules provide a set of exceptions to this general rule.

Special rules exist with respect to shares acquired under an employee stock option plan arising from different vesting periods. Further rules serve to track shares acquired under an employee stock option plan separately from shares of the same class acquired by the employee otherwise than pursuant to an employee stock option plan.

Deductibility by Employers

The ITA specifically provides that the employment benefits associated with an employee stock option are generally not deductible by the employer (in some situations where an employer or employee may elect to pay or receive cash rather than shares, the cash payment is deductible).

Withholding by Employers

A general obligation is placed upon employers to withhold and remit the appropriate tax with respect to employment benefits received under stock option plans.

The ITA contains provisions that exempt employers from the withholding requirement (although there will be a reporting requirement) with respect to shares qualifying for the publicly listed share deferral.

On an administrative basis, CRA will relieve employers from the withholding requirements where undue hardship may result in other cases. Undue hardship may be occasioned by the fact that the employment benefit (unlike salary) may not give rise to actual cash.

Cross-Border

Any cross-border aspect will usually invoke the workings of the tax systems of both countries and the relevant tax treaty (if any). Even the simple, common examples of an employee who performs services in two countries or is a citizen of one country (such as the U.S.) but a resident of another (such as Canada) typically require detailed analysis. Diplomatic notes that accompany proposed amendments to the Canada US Income Tax Convention will serve to simplify matters, at least somewhat, for many taxpayers.

Where an employee is a Canadian resident who performs services in Canada but receives employee stock options from a U.S. corporation, the calculation and timing of the income inclusion will usually be the same as described above in respect of options granted by Canadian corporations. In addition, the second of the 50 percent deductions described in this booklet (i.e., not the 50 percent deduction related to employee stock options granted by a CCPC) will also usually be available.

Donation of Option Shares to Charity

The ITA provides additional tax benefits for donations of certain securities to public charities. Subject to certain conditions, an employee who donates certain publicly traded option shares to a public charity may deduct one half of the income inclusion from income for the taxation year in which the income inclusion arises, provided that the shares are donated within the same year and within 30 days after the employee acquires the shares. In general, the income inclusion is calculated based on the lesser of the fair market value of the shares on acquisition and donation. In many cases, the net effect is that an employee will not be taxed.

8.0 CONCLUSION

Even in unpredictable times, the judicious use of stock options may yield significant after tax advantages. A successful employee stock option plan will often result in one half of the tax that would otherwise arise upon the payment of remuneration by way of salary. Moreover, in many cases, the obligation to pay the tax may be deferred for many years. In unpredictable times, a key risk for an employee is acquiring shares under an employee stock option and then subsequently selling them at a lower value. The capital loss arising upon the disposition will not be able to be used to reduce or otherwise offset the income inclusion triggered by the employee’s acquisition of the shares.

9.0 EXAMPLES

The following examples are for illustrative purposes only. In addition, a number of unstated assumptions have been made to the facts described (e.g., the employee has always been a Canadian resident and citizen and relevant tax laws remain unchanged).

EXAMPLE A

CCPC AND SHARES HELD FOR OVER TWO YEARS

Facts:

Stock Option Corporation (“SOC”) is a “Canadian-controlled private corporation”. An employee of SOC, Gary, is granted an option to acquire 1,000 common shares of SOC at $5.00 per share. Gary exercises the option in 2008 when the shares are worth $8.00 per share. Gary sells the shares in 2011 for $17.00 per share.

Answer:

  1. Amount of Income Inclusion – Gary must compute an income inclusion of $3,000 [($8/share - $5/share) x 1,000 shares] which represents the value of the shares at the time of exercise minus the amount to be paid for the shares.
  2. Timing of Income Inclusion – Because SOC is a CCPC the inclusion in income of the $3,000 employment benefit will be deferred to the taxation year in which the shares are disposed of (2011).
  3. 50 Percent Deduction – Because Gary did not dispose of the shares within two years of having acquired them and SOC is a CCPC, Gary will be able to claim a deduction equal to 50 percent of the income inclusion. As a result his net income inclusion will be $1,500 [$3,000-(50% of $3,000)] in 2011.
  4. Capital Gain (Loss) – In 2011 Gary will also realize a capital gain of $9,000 [($17/share - $8/share) x 1,000 shares]. One half of the capital gain ($4,500) will be required to be included in computing income.

If the requirements of the “$750,000 capital gains exemption” (technically, a deduction not an exemption) are met, the $4,500 inclusion may be offset by a $4,500 deduction. The rules relating to the $750,000 capital gains exemption are very complex. That said, in this type of situation, an employee such as Gary may be able to claim the “exemption”.

EXAMPLE B

CCPC AND SHARES HELD FOR LESS THAN TWO YEARS

Facts:

Same as Example A except the shares are sold in 2009. 

Answer:

  1. Amount of Income Inclusion – Same as Example A.
  2. Timing of Income Inclusion – Same as Example A, except that the income inclusion is included in 2009 (the year of disposition in this example).
  3. 50 Percent Deduction – The 50 percent deduction described in the answer to Example A will not be available because the shares will not have been held for two years. However, the second 50 percent deduction may be available. If the $5/share exercise price is not less than the value of an SOC share at the time of the grant and the shares are “prescribed shares” (generally, garden variety common shares), Gary will be able to claim the second 50 percent deduction with respect to the income inclusion. Assuming the second 50 percent deduction can be claimed, the net tax result will be the same as in Example A except that the income inclusion and 50 percent deduction will be reported and claimed in the 2009 taxation year (the year of disposition in this example), as opposed to the 2011 taxation year.
  4. Capital Gain (Loss) – Same as Example A except the capital gain must be reported for the 2009 taxation year (the year of disposition) and the $750,000 capital gains exemption will not be available because the shares will not meet the exemption’s 24 month holding period requirement.

EXAMPLE C

CCPC AND SHARES SOLD AT A LOS

Facts:

Same as Example A except that Gary sells the shares for $3.50 per share.

Answer:

  1. Amount of Income Inclusion – Same as Example A.
  2. Timing of Income Inclusion – Same as Example A.
  3. 50 Percent Deduction – Same as Example A.
  4. Capital Gain (Loss) – Gary will realize a capital loss of $4,500 [($8/share - $3.50/share) x 1,000 shares]. The capital loss cannot be used to offset the net income inclusion of $1,500.

The overall effect is that Gary will have acquired the shares for $5/share and sold them at $3.50/share but will be required to pay the tax associated with the $1,500 net income inclusion (the income inclusion of $3,000 minus the 50 percent deduction of $1,500).

EXAMPLE D

A PRIVAT E CORPORAT ION (OTHER THAN A CCPC)

Facts:

Same as Example A except that SOC is not a CCPC but a private corporation controlled by non-residents.

Answer:

  1. Amount of Income Inclusion – Same as Example A.
  2. Timing of Income Inclusion – The timing of the income inclusion will not be deferred. Gary will be required to include the $3,000 employment benefit in computing income for the taxation year in which the option is exercised (2008).
  3. 50 Percent Deduction – The 50 percent deduction described in Example A will not be available because SOC is not a CCPC. The 50 percent deduction described in Example B will be available if the $5/share exercise price is not less than the value of an SOC share at the time of the grant and the shares are “prescribed shares” (generally, garden variety common shares).
  4. Capital Gain (Loss) – Same as Example A except that the $750,000 capital gains exemption will not be available because SOC, in this example, is not a CCPC.

EXAMPLE E

CORPORAT ION WITH LISTED SHARES

Facts:

Same as Example A except that SOC is not a CCPC but a corporation with shares listed on a designated exchange.

Answer:

  1. Amount of Income Inclusion – Same as Example A.
  2. Timing of Income Inclusion – Gary will be able to defer the income inclusion to the year of disposition by making an election in prescribed form within the prescribed time.
  3. 50 Percent Deduction – The 50 percent deduction described in Example A will not be available because SOC is not a CCPC. Assuming that the $5/share exercise price is not less than the fair market value of an SOC share at the time of the grant and the shares are prescribed shares (generally, garden variety common shares), the 50 percent deduction described in Example B will be available. The 50 percent deduction is claimed in the taxation year in which the employment benefit is included in income. Assuming Gary elects to defer the income inclusion, in our example the income inclusion and claim for the 50 percent deduction would be for the 2011 taxation year.
  4. Capital Gain (Loss) – Same as Example A except that the $750,000 capital gains exemption will not be available because SOC, in this example, is not a CCPC.

EXAMPLE F

CORPORAT ION WITH LISTED SHARES (VESTING ASPECTS)

Facts:

SOC is a corporation with shares listed on a designated stock exchange. Gary is granted an option in 2008 to acquire 30,000 shares at $5/share (the market price at the time of the grant). 15,000 shares vest in each of 2009 and 2010. Gary exercises the option with respect to the 30,000 shares in 2011 when the shares are trading at $80/share. Gary holds no other options or shares in SOC. Can Gary elect to defer the income inclusion arising from the exercise? If the options all vested in 2009 is the answer different?

Answer:

Assuming the other conditions required for the deferral for listed shares are met, Gary will be able to elect to defer the income inclusion of $2,250,000 [($80- $5) x 30,000 shares] to the year of disposition of the shares. The $100,000 annual vesting limit is determined based upon the year of the vesting and the exercise price for the vested options. In neither 2009 nor 2010 (the years of vesting) is the $100,000 annual vesting amount exceeded [$5/share x 15,000 shares = $75,000].

If all 30,000 shares vested in 2009, then Gary would not be able to defer the total income inclusion. Gary would only be able to elect with respect to 20,000 shares ($100,000 ÷ $5/share = 20,000 shares) to defer the income inclusion arising with respect to those shares.