Taxation of Stock Options
Employee stock options are commonly provided by employers to compensate employees without a cash outlay, and to incentivize employees to remain at the company and take part in the future growth. Stock options can potentially be advantageous to you depending on this future growth and may receive preferential tax treatment when certain criteria are met.
A stock option plan allows you to purchase shares of the company at a fixed price. This price is commonly referred to as the strike price. The options typically become available to purchase over a set period known as the vesting period. For example, your employer may grant 3,000 total options to you which allow you to purchase shares of the company at a price of $10 per share. These 3,000 options will vest equally over the three-year period for total vested options of 1,000 per year. The taxation of these options depends on a few factors, such as the type of company you work for, the fair market value of the company’s shares at the time the options are granted and exercised, the time of exercise, and the length of time you hold the shares.
There are no income tax implications to you at the time the options are originally granted. The stock option benefit is calculated at the time the options are exercised and you purchase the shares. The fair market value of the options exercised less the strike price and any other amount paid to acquire the option is taxable to you. In the example above, if the fair market value of the shares has increased to $20 and you exercise 1,000 options, the stock option benefit is calculated as follows: ($20—$10) x 1,000 = $10,000. This benefit is included in your employment income and reported on your T4 slip in either the year of exercise or the year you sell the shares depending on the type of company you work for. Employees of Canadian-controlled private corporations (CCPCs) do not report this income inclusion until they sell the shares. Employees of non-CCPCs, such as public companies or private companies that are controlled by non-residents of Canada, report this income inclusion immediately at the time of exercise.
You may be entitled to a 50% deduction of the employment income inclusion if certain conditions are met. This deduction is intended to approximate the preferential 50% inclusion rate that capital gains receive. Employees of all corporations, including both CCPCs and non-CCPCs, may be eligible for the 50% deduction under paragraph 110(1)(d) of the Income Tax Act. The conditions of this paragraph include:
The shares must be of a prescribed class of shares. Generally, this refers to common shares of the company.
The options cannot be “in the money” at the time they are granted. This means that the strike price of the options plus any amount paid to acquire the options must be greater than the fair market value of the shares at the time the options are granted. This ensures the employee cannot receive an immediate benefit from the options.
The employee must be dealing at arm’s length with the employer. Employees who are related to the controlling shareholders of the employer generally cannot benefit from the deduction.
Paragraph 110(1)(d.1) provides another set of criteria for the 50% deduction which is only available to employees of CCPCs. The 50% deduction is available if the employee holds the shares for at least two years after the options are exercised. A deduction can be taken under either paragraph 110(1)(d) or 110(1)(d.1), but not both.
Historically, there have been no limitations on the annual stock option deduction that could be claimed. Employees could exercise any amount of options available to them and claim the 50% deduction on the entire benefit if they met the criteria above. Options granted after June 30, 2021 may be subject to an annual limit. This limit applies to non-CCPCs with annual revenue of at least $500 million in their corporate group. The stock option deduction is limited if the fair market value of the underlying shares for the options which vested during the year exceeds $200,000. The calculation is complex, but this could significantly impact employees of large, public companies who receive a sizable portion of their compensation by way of stock options. CCPCs are not impacted by these new rules, and all options granted prior to July 1, 2021 remain eligible for the full deduction.
The fair market value of the shares at the time of exercise becomes your adjusted cost base in the shares. This amount will be used to calculate your capital gain or loss upon disposition. If the shares subsequently decline in value after exercising, the loss on disposition cannot be applied against the stock option benefit recognized. It must be recognized as a capital loss which can only be applied against capital gains.
Stock option plans are a commonly used tool that can potentially benefit both the employer and employee. The taxation of these options requires careful analysis and has become more complicated by the recently enacted changes.
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