Taxation of Stock Options

Taxation of Stock Options

Stock options are beneficial to employees, allowing them to purchase shares in their employer corporation (or related company) below fair market value. Stock options can be a useful way to remunerate key employees when a company has a cash shortage (and the options would actually bring cash in when an employee exercises them), although this would also dilute the existing shareholders’ ownership of the company. Employees granted company stock options are not taxed; however, employees who exercise the stock option and purchase the shares are considered to have received a benefit. How and when that benefit is taxed depends on who the employer is and whether the stock option price is below the fair market value of the shares at the time the option is granted.

Public company employers

If the option price is below the fair market value of the shares at the time the option was granted by a public company employer, the employee is deemed to have received a benefit that is included in their employment income when they exercise the option to purchase the shares. The amount of the benefit is equal to the difference between the fair market value of the shares at the date of purchase and the option price the employee paid. If the employee sells those shares at a future date, they would recognize a capital gain or loss equal to the difference between the sale price and the fair market value at the time the option was exercised.

For example, assume Pub Co. granted an option in 2019 to a key executive named Sarah to allow her to purchase 1,000 shares at $10 per share when the fair market value of the shares was $12. Sarah exercised those options in 2020 when the fair market value was $14 per share, and she sold them in 2021for $15 per share. Sarah’s fully taxable employment income in 2020 would be $4,000 [1000 shares × ($14-$10)]. She would also report a capital gain in 2021 of $1,000 [1000 shares × ($15-$14)], half of which is taxable.

Note that if Sarah had exercised the option in 2019 when it was granted, her employment income would have been $2,000 [1000 shares × ($12-$10)] in that year, and the 2021 capital gain would be $3,000 [1000 shares × ($15-$12)]. While the total income over the three-year period would be the same as in the first scenario, her total taxable income would decrease by $1,000, since a greater portion is a capital gain and only half of that is taxable.

If a public company employer grants stock options that do not have an immediate benefit to the employee (i.e., the option price is equal to, or greater than, the fair market value of the shares at the time the option is granted), the employee can deduct half the employment income benefit when the options are exercised as a “stock option deduction.” This leaves half the benefit taxable in the year that the option is exercised – similar to the way that capital gains are taxed.

If Sarah’s employer had set the option price at $12 (the fair market value of the shares at the time the option was granted) instead of $10, her 2020 employment income addition would have been $2,000 [1000 shares × ($14-$12)], but she would have been able to deduct $1,000 from her taxable income in that year as a stock option deduction.

Canadian-controlled private corporation (CCPC) employers

If the employer is a CCPC, the employment benefit is not taxable until the shares are sold, rather than when it is exercised. If the employee owns the shares for two years after the acquisition, half of the employment income addition can be deducted from taxable income as a stock option deduction. If the employee does not hold the share for two years, then they can claim the stock option deduction only if the option price is equal to, or greater than, the fair market value of the shares at the date the option was granted.

Note that although the effective tax rate for stock options that qualify for the stock option deduction is similar to that of capital gains, they are not considered capital gains (i.e., you cannot use them to offset any capital losses).

Federal budget changes for 2019

The original purpose for the preferential tax treatment of stock options was to assist the growth and development of small businesses (in the preliminary stages when cash flow may be limited) and compete with larger, higher paying companies to attract and retain talent. However, the government became increasingly concerned that stock options were often used to provide preferential tax treatment on the compensation paid to employees of large, mature companies.

The Budget proposed to cap the amount of stock options for which employees of “large, long-established, mature firms” could claim the stock option deduction at $200,000 per year. These changes are not intended to affect employees of CCPCs or “start-ups and rapidly growing Canadian companies.” The $200,000 cap is determined for shares that become vested in a calendar year (generally the first year in which they can be exercised) and is based on the fair market value of the shares at the time the options are granted. The cap will be applied separately for employers that deal at arm’s length.

Essentially, the Budget proposed that there be qualified options, which are subject to the current tax regime outlined above, as well as non-qualified options. While the employee is not entitled to the stock option deduction for non-qualified options, the employer can deduct the total option benefits recognized by the employee from the corporation’s taxable income if certain conditions are met. In such cases, non-qualified options would be treated the same as any other employment income. At the time the options are granted, employers who are not CCPCs or “start-ups, emerging or scale-up companies” can take the options that meet the conditions to be qualified and designate them as non-qualified instead. These changes will not apply to stock options granted before 2020.

The characteristics of “start-ups, emerging or scale-up companies” will be defined by regulation following a stakeholder consultation period, which ended in mid-September 2019. Given the October election results, it is important that affected employees and employers continue to monitor and assess the potential impact of these changes.