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David Rotfleisch on Employee Stock Options: An Analysis of the Tax Consequences for Canadian Employees

posted 1 year ago

Introduction – Canada Employee Stock Option

Some companies choose to provide their employees the opportunity to buy shares of the company at a reduced price as a form of compensation, particularly for high-tech start-ups and, more lately, marijuana start-ups. An employee has the right to purchase shares of the employer organization at a specified price for a particular period of time under the terms of an employee stock option (ESO). Upon exercising the option, the employee would be able to buy the shares at the discounted option price even if the shares’ value rose above the option price in the future. Following that, the worker can sell the shares and make a profit right away.

Employee stock options are a popular kind of employee compensation that some businesses find to be appealing. First, it is believed that employee stock options will encourage workers to put in more effort, improve the employer’s bottom line, and ultimately raise the company’s stock value. In addition, an employee stock option (ESO) offers a way of payment with less risk to the employer in the event that the business performs poorly. The value of the Employer’s Shares will not be greater than the Option Price in this situation, and the Employer’s Employees will probably decline their Options. The employee stock option also offers an incentive for the employee to remain with the company through the usage of vesting periods.

Employee Benefit under Section 7(1) of the Income Tax Act: Income-Tax Consequences of Exercise of Employee Stock Options

When the employee obtains the option, there are no tax repercussions; instead, they only occur when the employee exercises the option, acquiring the shares granted by the employee stock option.

When calculating his or her earnings for the year, the employee must take into account the benefit received from exercising the option. The benefit inclusion is equal to the fair market value of the shares at the time the employee stock option (ESO) was exercised, less the option price and any other fees the employee may have paid to acquire the option. For instance, the employee paid $10 to purchase the employee stock option, the option price is $20 for 30 shares, and the employee exercised the option when the price of the 30 shares was $40. Benefit inclusion for the employee is $40 – $20 – $10, which is $10. Whether the shares covered by the employee stock option (ESO) are those of a Canadian-controlled private corporation (CCPC) determines the tax year in which the employee must include the benefit. The employee does not have to account for the benefit until the shares are sold if the employee stock option (ESO) shares are those of a Canadian-controlled private corporation (CCPC). The employee must account for the benefit in the year that the employee stock option was exercised and the shares were purchased, however, if the employee stock options shares are those of a non-CCPC (i.e., a public business).

Due to market dynamics and liquidity problems that Canadian-controlled private corporation (CCPC) owners frequently encounter, Canada’s tax system defers tax for people who purchase shares of a Canadian-controlled private corporation (CCPC). The market for shares in a Canadian-controlled private corporation (CCPC) is often more constrained and narrower than the market for shares in a public company. If employees were compelled to pay tax while buying shares they couldn’t easily sell, they would run into liquidity issues. Therefore, these employees are exempt from reporting the employee benefit until the year they sell their shares and, as a result, are likely to have the funds necessary to pay the applicable taxes. On the contrary, when trying to sell their shares on the stock exchange, employees who purchase shares in a public company typically don’t run into many difficulties. As a result, they must file an employee benefits tax return and pay the related fine in the same year that they purchase the shares they obtained through an employee stock option.

Amount Deducted for Employee Benefit from Exercise of Employee Stock Option: Sections 110(1)(d) and 110(1) (d.1)

Only half of the benefit from exercising the employee stock option may be reported by the employee under the Income Tax Act section 110(1). For instance, if the employee had the option to purchase 30 shares at $20 each, they would have exercised it if the price of 30 shares had increased to $40. Benefit inclusion for the employee is $40 – $20, or $20. In accordance with paragraph 110(1), the employee may report only $10 of the total $20 employee benefit from executing the employee stock option if they meet the requirements (see the list of requirements below).

There are two sets of requirements for the one-half benefit deduction in subsection 110(1). The first is generally applicable, while the second set less onerous requirements on employees purchasing shares of a Canadian-controlled private corporation (CCPC).

If the following conditions are met: (1) the employee received common shares upon exercising the employee stock option; (2) the employee dealt with the employer at arm’s length; and (3) the employee stock option (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 the option was granted, the employee may deduct half of the employee stock option (ESO) benefit when calculating taxable income under paragraph 110(1)(d).

The one-half deduction is given to employees who receive Canadian-controlled private corporations (CCPC) shares under paragraph 110(1)(d.1) with fewer restrictions. When an employee acquires shares in a Canadian-controlled private corporation (CCPC) as a result of an employee stock option, as long as the employee kept the shares for at least two years, they are eligible for the one-half tax deduction.

Consequences of Capital Gains on the Sale of employee stock option (ESO) Shares

The advantage that an employee receives from executing an employee stock option is included in the employee’s taxable employment income. However, the obtained shares are a capital asset, so when the employee sells them, there could be a capital gain.

In the absence of an adjustment to reflect the already taxable employee benefit, the employee would be subject to double taxation on the shares they bought. In order to avoid this, the employee’s ESO benefit amount also raises the cost of the acquired shares’ tax liability.

This outcome is a result of the Income Tax Act’s paragraph 53(1)(j). It should be noted that if the employee qualified for the one-half benefit deduction under paragraph 110(1)(d) or paragraph 110(1), paragraph 53(1)(j) does not diminish the tax-cost increase of the acquired shares (d.1). To put it another way, even though paragraph 110(1) may permit the employee to offset half of the employee stock option (ESO) benefit from taxable income, the tax cost of the employee stock option (ESO) shares includes the full amount of the employee stock option (ESO) advantage.

Take the instance of an employee who exercises an employee stock option (ESO) with a $20 option cost. The underlying shares had a $30 value at the moment the employee exercised the employee stock option. In the end, the employee receives $34 for selling the shares.

Employee advantage: According to section 110(1), the employee receives $5 in compensation for exercising their employee stock option worth $30 less $20 ($10 minus 1/2). If the employee purchased Canadian-controlled private corporations (CCPC) shares, she must include the benefit in the year she sells the shares, or in the year she exercised her employee stock option, whichever comes first.

Capital gain: Even though paragraph 53(1)(j) contributes the full employee stock option (ESO) advantage to the tax cost of the acquired shares, subsection 110(1) lowered the employee’s ESO benefit to $5. As a result, the acquired shares’ tax cost is $30 ($20 + $10). As a result, the sale results in a $4.00 capital gain, of which half is taxed.

Tax Advice: employee stock option (ESO) Shares: Capital Losses and Deferring Capital Gains

Employee stock option exercise results in income from employment; selling the shares you’ve bought results in a capital gain. Additionally, you are unable to offset capital losses with income from other sources. As a result, you cannot use a loss to offset your employee stock option (ESO) benefit if you sell shares that you purchased through an employee stock option at a loss after they later decrease in value.

If you intend to sell the shares you obtain as a result of exercising your employee stock option, you can delay the capital gain by doing so the next year. For instance, if you purchased your shares in 2018, you can delay the requirement to disclose and subsequently pay tax on any capital gains by selling the shares at the start of 2019. If you sold the shares in 2018, your tax obligation for any capital gain would become due on April 30, 2019. However, if you sell the shares on, say, January 1, 2019, you can postpone that tax burden until April 30, 2020.

obviously, you run the risk of the shares declining in value if you delay the sale. Therefore, after exercising your employee stock option and purchasing the shares, you should usually sell them as soon as possible. In addition, the end of the calendar year coincides with the expiration date for some ESOs.

One approach is to activate your employee stock option as late in the year as you can, ideally enabling you to sell the acquired shares soon after, still in the following year. By exercising the option before it expires and lowering your exposure to the risk that the shares may decrease in value, you are able to delay the tax payment on the ensuing capital gain.

If you’re an employer evaluating your options for compensation or an employee who has received an employee stock option, you may need to contact one of our knowledgeable Canadian tax lawyers for guidance on more complex tax-planning methods and structures.


“Only general information is provided in this article. Only as of the publishing date is it current. It hasn’t been updated, therefore it might no longer be relevant. It cannot or ought not to be relied upon because it does not offer legal advice. Each tax circumstance is unique to its facts and will be different from the instances described in the articles. You should contact a lawyer if you have specific legal inquiries.”


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