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David Rotfleisch: The Employee Stock Option and its Tax Implications – Know What your Canadian Lawyer Has to Say

posted 2 years ago

What is Employee Stock Option?

The employee stock option (ESO) allows employees to avail themselves of corporate shares fixed at a price offered by the employers in a specific period of time. Some start-up companies offer this scheme, giving employees the privilege to acquire business shares at affordable rates. If employees choose to purchase shares at a later date and in that period, such holdings increase in value, the discounted price applies, and the employees have the option of selling their share with all the profits realized therefrom.

Employee stock options are a desirable form of employee compensation for some firms. First, it is believed that giving employees stock options will motivate them to put in – more effort, boost company profits, and ultimately raise the stock and company value. Additionally, an ESO offers a way of payment with little risk to the employer in the event that the business performs poorly. The value of the employer’s shares won’t be greater than the option price in this scenario, and the employees are likely to forego their options. There are also vesting periods set where employees may receive incentives through employee stock options as a way to encourage them to stay in the company.

How do Employees Benefit and Get Taxed From ESO?

No tax repercussions result from the employee receiving the option; instead, they occur when the employee exercises it – i.e. when acquiring the shares granted by the employee stock option.

When calculating his or her salary 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 was exercised, less any purchase fees and the option price. For instance, the employee paid $12 to purchase the shares, the option price is $40 for 36 shares, and the employee exercised the option when the 36 shares were worth $65. Benefit inclusion for the employee is $65 – $40 – $12 = $13.

Whether the shares covered by the employee stock option are those of a Canadian-controlled private corporation (CCPC) determines the tax year in which the employee is required to include the benefit. If the ESO shares come from a Canadian-controlled private corporation, the employee is exempt from reporting the benefit until the shares are sold. However, if the shares obtained through an employee stock option are those of a public corporation rather than a CCPC, the employee must account for the benefit in the year that the employee stock option was exercised.    

Different tax treatment is given to purchasers of CCPC shares under the tax system of Canada, which include the deferment of tax, a policy point of view due to market-related issues and valuations. Also, there are more market restrictions imposed given the limited circulation of shares in CCPC as compared to the public ones. As a result, employees who are holders of CCPC shares could be confronted with liquidity issues if obliged to pay taxes for shares bought but cannot be easily sold. Accordingly, these employees are exempt from reporting the employee benefit until the year they sell their shares and, consequently, are likely to have the funds necessary to pay the applicable taxes. In contrast, the employee-holders of public shares have fewer worries about selling their shares anytime they want, so they will be required to report their profit and pay the corresponding tax for the shares acquired in that year through the employee stock option.

Lawful Deductions Arising from the Exercise of ESO

The Canadian Income Tax Act provides how deductions may be made in the instance of exercising an employee stock option, and these are Subsections 110 (1), 110 (1)(d), and 100 (1)(d.1).

The first provision allows the reporting of an employee of only half of his or her benefit accrued from the employee stock option. Two sets of requirements are listed in subsection 110(1) for the one-half benefit deduction. The first is generally applicable, whereas the second imposes softer requirements on employees who buy CCPC shares. Using the same example, there is a $40 option price for 36 shares, and the employee exercised the option when such shares were worth $65. Then the benefit the employee gets is $25 after deducting the option price ($40) from the fair market value ($65) of the shares. Using the criteria expounded in Subsection 110 (1), the employee may be allowed to report only $12.5 instead of $25.

Paragraph 110 (1)(d.1) discusses the scope of applicability of present deduction in computing an employee’s income tax:

  1. If the shares received by an employee in the exercise of the employee stock option  are common shares;
  2. If there is an arm’s length agreement between employer and employee; and,
  3. If the option price and the amount paid for the employee stock option are not below the fair market shares value when the option was allowed.

The same provision applies to employees with CCPC shares but with minor limitations. The employee who availed of the employee stock option may enjoy the half deduction in CCPC shares if he or she is the holder of shares for 2 years at the minimum.

Capital Gains on Sale of ESO Shares: How They are Computed?

The benefit received by an employee from exercising an employee stock option becomes part of that employee’s taxable employment income. However, the acquired shares are a capital asset that may result in a capital gain in Ontario if sold by the employee.

The employee may be exposed to double employee stock options taxation if there are no adjustments in the tax liability for the acquired shares to incorporate the benefits previously taxed. As a preventive measure, the amount an employee would get from ESO adds up to the tax imposed on acquired shares, as can be gleaned from paragraph 53 (1)( j) of the Income Tax Act of Canada.

It should be noted that if the employee qualified for the one-half benefit deduction under paragraph 110(1)(d) or paragraph 110(1)(d.1), paragraph 53(1)(j) does not increase the adjusted cost base of the acquired shares. The tax cost computed based on the ESO shares still includes the total benefit cost despite the allowance of half deduction as explained in paragraph 110 (1) of the tax act.

Assume a worker exercises an employee stock option with a $40 option price. The underlying shares were worth $65 when the employee exercised the ESO. Later, the worker sells the shares for $75.

On the employee benefit:

The employee receives a benefit from executing the employee stock option of $65 minus $40 = $25 – ½ under subsection 110(1) = $12.50. If the employee purchased CCPC shares, she would include the benefit either in the year she sold the shares or in the year she executed the employee stock option.

On the capital gain:

Although subsection 110(1) lowered the employee’s employee stock option benefit to $12.50, the full ESO benefit will be added to the tax cost of the acquired shares under paragraph 53(1)(j). The tax cost of the acquired shares would then be $65 ($40 + $25). That sale produces a $10.00 capital gain, of which half is taxed.               

Handling of Capital Losses and Gains from ESO Made Easy

To put it clearly, the benefits received from employee stock options by an employee are income from employment, and the profit realized after selling respective shares is a capital gain. This explains that capital losses are not deductible from other income sources. Hence, there can be no offsetting of ESO profit using the capital loss when the value of shares acquired decreases.

In case you prefer to defer the expected capital gain on the sale of shares, it is best to sell such shares in the succeeding year. For example, if you purchased some shares this 2022, wait until the early part of 2023 in selling your shares to defer the reporting and paying of tax in the form of capital gains. The reason for this is simply that if you sell your shares in 2022, your capital gain tax liability will be due on April 30, 2023, while if you dispose of the shares on January 15, 2023, you have until April 30, 2024, to pay your taxes from the benefits of your shares.

The downside, however, can be the possible loss of value if you plan to defer the sale of shares. In this instance, you will opt to offer out your stocks immediately after accepting the employee stock option and its terms. Another consideration is the expiration of some options at the end of the year.

It is then more practical to avail yourself of the ESO later in the current year which gives you an ideal opportunity to sell the acquired shares early in the consecutive year. This move will allow you to enjoy all at the same time the deferment of capital gain tax liability, enjoyment of the option before the offer concludes, and lesser risks of losing the value of shares.

In case you are in need of expert legal advice as an employee planning to avail an employee stock option, or as an employer exploring other ways to compensate your employees, a tax lawyer in Canada can easily be approached especially in devising the most appropriate strategies and forms in tax planning.


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