Introduction – Income Tax for Canadians who hold Employee Stock
Options
Many employers opt to compensate their Canadian employees with
options to purchase shares in the business at a discounted price. A
CCPC employee stock option (ESO) gives the
employee the right to purchase shares in the employer’s
corporation at a fixed price during a set period. Should the value
of the shares later exceed the option price, the employee may
exercise the option and thereby purchase those shares at the
bargain option price. The employee can then sell the shares and
immediately realize a profit.
From an employer’s perspective, employee stock options can
be an attractive means of compensating employees. First, employee
stock options may provide employees with an incentive to work
harder, contribute to the employer’s bottom line, and therefore
increase the value of the corporation and its shares. And through
the use of vesting periods, the employee stock option provides an
incentive for the employee to stay with the corporation. In
addition, by offering ESOs as part compensation, the employer
incurs minimal risk should the company perform poorly. In this
case, the value of the employer’s shares will fall below the
option price, and the employees will presumably abstain from
exercising their options.
Canadian employees, however, may not fully understand the
Canadian income-tax implications of ESOs. While some Canadian
employees may appreciate the Canadian income-tax implications of
exercising an ESO and selling the underlying shares, very few
understand the Canadian tax implications of transferring, selling,
cancelling, or redeeming the unexercised ESO rights.
This article examines the income-tax implications for Canadian
employees who transfer or sell their unexercised employee stock
options and the income-tax implications for Canadian employees
whose employers cancel or redeem the employees’ unexercised
ESOs. We first review the basic Canadian income-tax rules
concerning ESO benefits. Afterwards, we discuss the income-tax
consequences for a Canadian employee who disposes of the
unexercised rights under an employee stock option. We then discuss
the availability of an ESO tax deduction under subsection 110(1) of
Canada’s Income Tax Act. The article concludes by
offering pro tax tips for Canadian employees and businesses from
our expert Canadian tax lawyers.
Canadian Income-Tax Implications of Employee Stock Options
A Canadian employee doesn’t incur any tax liability when the employer grants the
stock options. Rather, the Canadian income-tax consequences arise
either (1) when the employee exercises the options, thereby
acquiring the shares, or (2) when the employee disposes of
unexercised options. Although each case gives rise to an employee
benefit, which the employee must report as employment income under
subsection 7(1) of Canada’s Income Tax Act, the
applicable tax rules alter the timing of the income inclusion. And
in the case where the employee exercises the ESOs, the legislation
also adjusts the tax cost of the shares that the employee acquired
under the option. The following sections first discuss the
income-tax consequences of exercising the ESOs and then discuss the
tax effect of disposing of unexercised ESOs, whether by transfer,
sale, or cancellation.
Income-Tax Implications of Exercising an Employee Stock Option:
Taxable Employee Benefit & Tax-Cost Adjustment
An employee who exercises ESOs must account for the resulting
benefit by reporting the value of the benefit as taxable employment
income. The amount of the employee benefit equals the result of the
formula A minus B, where:
- A is the fair market value of the shares at the time the
employee exercised the employee stock options; and - B is the option price plus any amount that the employee paid to
purchase the option.
For example, suppose the following: An employee receives
employee stock options granting the right to buy 150 shares for
$10. The employee paid nothing to acquire the ESOs. The employee
later exercises the options when 150 shares in the company are
worth $20.
The amount that the employee must report as a taxable employee
benefit is $10 (i.e., $20 value of shares upon exercising options -
$10 option price). The employer is typically also required to
withhold payroll tax on the benefit and report the benefit on the
employee’s T4 slip for the relevant tax year.
The tax year in which the employee must report the benefit as
taxable income depends on whether or not the ESO shares were those
of a Canadian-controlled private corporation (CCPC). If the ESO
shares are those of a Canadian-controlled private corporation, the
employee need not report the resulting employee benefit until he or
she sells the shares. If, however, the shares acquired under the
ESOs were those of a non-CCPC-i.e., a public corporation or a
foreign corporation-the employee must report the resulting employee benefit as taxable income for the
year in which the employee exercised the employee stock options and
acquired the shares.
Canada’s tax system delays the tax liability for employees
who acquire CCPC shares because of the market forces and liquidity
issues that those shareholder-employees often face. The market for
shares in a Canadian-controlled private corporation is typically
restricted and far smaller than that for shares in a public
corporation. If employees acquiring CCPC shares were required to
pay tax when acquiring shares that they couldn’t readily sell,
they’d face a liquidity issue. So, these employees need not
report the employee benefit until the year that they sell their
shares and thus presumably have the cash to pay the tax. Employees
acquiring shares in a public corporation, on the other hand,
don’t generally encounter much resistance when attempting to
sell their shares. They can access eager buyers on the stock
exchange that lists their employer’s company. Those employees
must therefore report the taxable employee benefit as income for
the year in which they exercised the ESOs and acquired the
shares.
In any event, the resulting employee benefit is calculated in
the same way, and it forms a part of that employee’s taxable
employment income. The only difference is the timing of the income
inclusion.
Canada’s Income Tax Act also adjusts the tax
attributes of the shares that the employee acquired under the ESO.
The employee may realize a capital gain when selling the shares.
Yet if the tax cost of those shares were not adjusted to account
for the already taxed employee benefit, the employee would suffer
double taxation. To prevent that, Canada’s tax rules increase the tax cost
(a.k.a. adjusted cost base or ACB) of the acquired shares by the
amount of the taxable employee benefit that the employee must
report as income.
For example, suppose that an employee exercises employee stock
options allowing the employee to purchase 100 shares at an option
price of $10. At the time the employee exercised the ESOs, the
underlying shares were worth $15. The employee subsequently sells
the shares for $17.
In this case, the amount of the taxable employee benefit from
exercising the employee stock option is: $15 – $10 = $5. (In some
circumstances, the benefit can be reduced by half under subsection
110(1), which we discuss in more detail below.) As mentioned above,
the employee reports the taxable employee benefit as employment
income, either for the taxation year in which she exercised the
employee stock option (non-CCPC shares) or for the taxation year in
which she sells the shares (CCPC shares).
The $5 employee benefit is then added to the tax cost of the 100
shares that the employee acquired upon exercising the ESOs. In
other words, the $5 employee benefit is added to the $10 that the
employee paid to acquire the ESO shares. The employee’s tax
cost for the 100 shares is therefore $15. When the employee sells
the shares for $17, it results in a capital gain of $2.00, half of
which is the employee’s taxable capital gain.
Income-Tax Implications of Transfers, Dispositions, Buyouts
& Cancellations of Unexercised Employee Stock Options
The previous section discussed the tax consequences for an
employee who exercises the employee stock options and disposes of
the acquired shares. This section focuses on the income-tax
consequences that arise when an employee disposes of ESOs that
remain unexercised. This situation might come about if, for
instance, the employee transfers or sells the ESO rights without
exercising them, or if the employer cancels the options, paying out
the employee instead.
These situations fall under paragraphs 7(1)(b) and 7(1)(b.1) of
Canada’s Income Tax Act. These paragraphs apply when
an employee “has transferred or otherwise disposed of rights
under” the ESO agreement between the employee and employer.
That is, they cover situations where the employee has transferred
the options themselves. Specifically, paragraph 7(1)(b) applies
when the employee transfers the ESO rights to a person with whom
the employee dealt at arm’s length, and paragraph 7(1)(b.1)
applies when the employee transfers the ESO rights back to the
employer that granted them or transfers the ESO rights to a
corporation with whom the employer does not deal at arm’s
length (e.g., the employer’s parent company).
In each case, the employee will realize a taxable employee
benefit, which equals the result of formula A minus B, where:
- A is the value of the employee’s consideration for
disposing of the ESO rights; and - B is the amount, if any, that the employee paid to acquire the
ESO rights.
The resulting amount is deemed to be a taxable employee benefit
that the employee received in the taxation year during which the
employee transferred or disposed of the ESO rights.
To illustrate: Suppose that, in 2021, an employee received
employee stock options granting the right to buy 150 shares for
$1,000. The employee paid nothing to acquire the ESOs. In 2022, the
employer’s parent company cancelled the ESOs, which the
employee never never exercised, and paid $3,000 to the
employee.
The result, under paragraph 7(1)(b.1), is that the employee is
deemed to have received a $3,000 taxable employee benefit, which
the employee must report as employment income for the 2022 taxation
year. (The employer may also be required to withhold payroll tax on
the $3,000 and report the benefit on the employee’s T4 slip.)
An ACB adjustment is unnecessary here because the employee never
exercised the options and therefore acquired no shares.
Tax Deduction for Taxable Employee Benefits: Paragraphs
110(1)(d) and 110(1)(d.1)
The previous sections demonstrated that Canadian employees may
need to report taxable employee benefits if they exercise ESOs,
sell shares acquired under ESOs, or transfer ESO rights. Although
the taxable employee benefit is reportable as employment income,
subsection 110(1) of Canada’s Income Tax Act allows a
qualifying employee to report only one-half of the ESO benefit.
This deduction effectively reduces the ESO-benefit tax rate to the
capital-gains tax rate.
Paragraph 110(1)(d) lays out the general criteria for the ESO
tax deduction. Under paragraph 110(1)(d), the employee may deduct
half of the ESO benefit when computing taxable income if: (1) the
employee stock options entitled the employee to receive common
shares; (2) the employee dealt at arm’s length with the
employer; and (3) the option price (including any amount paid to
acquire the ESO) equaled or exceeded the value of the underlying
shares at the time that the option was granted. An employee may
also qualify for this deduction if the employee disposes of the
rights to an unexercised ESO, but this deduction is unavailable if
the option price was less than the share value at the time that the
option was granted.
For example: Assume that the option price was $10 for 15 shares,
and that, at the time that the option was granted, the 15 shares
were worth $25. In this case, the employee cannot qualify for the
one-half ESO tax deduction because the share value exceeded the
option price at the time that the option was granted.
Employees who exercised ESOs and acquired CCPC shares can also
claim a deduction under paragraph 110(1)(d.1). For employees
receiving CCPC shares, paragraph 110(1)(d.1) grants the same
one-half deduction but with fewer constraints. If, under the
employee stock option, the employee receives shares in a CCPC, the
employee receives the one-half deduction as long as the employee
held the shares for at least 2 years and has not already claimed a
deduction under paragraph 110(1)(d).
Pro Tax Tips -Tax Planning & Tax-Audit Defence for
Canadians Holding Employee Stock Options
If you plan on selling the shares you acquire from exercising
your employee stock option, you can theoretically defer the
resulting capital gain by selling these shares the following year.
For instance, if you acquired your shares in 2022, you can defer
the need to report and thus pay tax on any capital gain by selling
the shares at the beginning of 2023. If you sold the shares in
2022, your tax liability for any resulting capital gain would arise
on April 30, 2023. But by selling the shares on, say, January 1,
2023, you delay that tax liability until April 30, 2024.
The risk, of course, is that, if you delay the sale, the shares
may lose value in the interim. Moreover, you unfortunately cannot
use that loss to offset the income relating to the ESO benefit. As
mentioned above, if an employee receives a taxable employee benefit
relating to employee stock options, that benefit is reportable as
employment income, yet any loss from selling the acquired shares is
generally reportable as a capital loss. You cannot deduct capital losses against other sources of
income. As a result, if you sell the ESO shares at a loss, you lose
not only monetarily but also taxwise, because you cannot offset
your taxable ESO benefit using that capital loss.
So, you generally want to sell the shares soon after exercising
your employee stock option and acquiring them. Moreover, the expiry
date for some ESOs aligns with the end of the calendar year.
One tax-planning option is for the Canadian employee to exercise
the employee stock options as late in the year as possible, which
ideally allows the employee to sell the shares shortly after
acquiring them yet still after the year end. The employee thereby
defers the Canadian tax liability on the resulting capital gain
while both exercising the option before it expires and reducing
exposure to the risk that the shares may lose value.
Whether you’re an employee who has received an employee
stock option or an employer considering potential compensation
packages, consult one of our expert Canadian tax lawyers for advice
on more sophisticated tax-planning strategies and structures.
Moreover, Canadians who have received, exercised, or transferred
employee stock options should gather and retain all supporting
documents in case the Canada Revenue Agency’s tax auditors want
to review your claim. You should, for instance, retain the option
agreement, your employer’s confirmation that the option price
equaled the value of the underlying shares, the cancellation
agreement (if any), a schedule showing exactly how your employer
calculated the benefit reported on your T4 slip, etc. Fortunately,
Canadian employees who have received, exercised, or transferred employee stock options can often avoid tax-audit problems through early
engagement of an experienced Canadian tax lawyer. Speak to our
Certified Specialist in Taxation Canadian tax lawyer today.
FREQUENTLY ASKED QUESTIONS
Question: What is an employee stock option
(ESO)?
Answer: An employee stock option (ESO) grants
an employee with the right to purchase shares in the employer’s
corporation at a fixed price during a set period. Should the value
of the shares later exceed the option price, the employee may
exercise the option and thereby purchase those shares at the
bargain option price. The employee can then sell the shares and
immediately realize a profit.
Question: I exercised an employee stock option that was
granted by my Canadian employer. How much will I pay in Canadian
tax?
Answer: This information is insufficient to
determine your Canadian tax liability stemming from your ESOs. To
explain why, we should review the basic Canadian tax rules relating
to ESO benefits. An employee who exercises ESOs must account for
the resulting benefit by reporting the value of the benefit as
taxable employment income. The amount of the employee benefit
equals the result of the formula A minus B, where:
- A is the fair market value of the shares at the time the
employee exercised the employee stock options; and - B is the option price plus any amount that the employee paid to
purchase the option.
In addition, the tax year in which the employee must report the
benefit as taxable income depends on whether or not the ESO shares
were those of a Canadian-controlled private corporation. If the ESO
shares are those of a Canadian-controlled private corporation, the
employee need not report the resulting employee benefit until he or
she sells the shares. If, however, the shares acquired under the
ESOs were those of a non-CCPC-i.e., a public corporation or a
foreign corporation-the employee must report the resulting employee
benefit as taxable income for the year in which the employee
exercised the employee stock options and acquired the shares.
Furthermore, subsection 110(1) of Canada’s Income Tax
Act allows a qualifying employee to report only one-half of
the ESO benefit. This deduction effectively reduces the ESO-benefit
tax rate to the capital-gains tax rate. The availability of this
deduction depends on (amongst other things) whether the option
price equaled or exceeded the share value at the time that the
options were issued, and whether the options related to shares in a
Canadian-controlled private corporation.
As a result, we cannot determine your Canadian tax liability
without knowing (at the very least) the option price, whether you
paid anything to acquire the options, the value of the underlying
shares at the time that the options were issued and at the time
that the options were exercised, whether the options permitted you
to acquire shares in a CCPC, and whether you have since disposed of
any of the shares that you acquired under the ESO. Of course, we
also need to know which tax bracket you fall under. To discuss the
extent of your potential tax liability and whether any tax-planning
options are available to reduce the Canadian tax relating to your
ESOs, consult one of our expert Canadian tax lawyers today.
Question: I received ESOs from my employer a few years
ago. This year, my employer’s company was purchased by another
company, which will buy out my ESOs. I’ve never exercised any
of the ESOs. Does this mean that I need not report a taxable
employee benefit relating to my ESOs?
Answer: No. This situation will likely fall
under paragraph 7(1)(b.1) of Canada’s Income Tax Act.
This paragraph applies when an employee transfers the ESO rights
back to the employer that granted them or transfers the ESO rights
to a corporation with whom the employer does not deal at arm’s
length (e.g., a buyout by the employer’s new parent company).
In this case, the employee realizes a taxable employee benefit that
equals the result of formula A minus B, where:
- A is the value of the employee’s consideration for
disposing of the ESO rights; and - B is the amount, if any, that the employee paid to acquire the
ESO rights.
The resulting amount is deemed to be a taxable employee benefit
that the employee received in the taxation year during which the
employee transferred or disposed of the ESO rights.
Our knowledgeable Canadian tax lawyers can advise whether this
tax rule applies in your circumstances. We can also advise whether
any tax-planning opportunities are available.
Question: I must report taxable benefits relating to
employee stock options. Which supporting documents should I retain
in case I’m selected for a tax audit by the Canada Revenue
Agency?
Answer: You should retain, at the very least,
the option agreement, your employer’s confirmation as to
whether the option price equaled the value of the underlying
shares, the cancellation agreement (if any), and a schedule showing
exactly how your employer calculated the benefit reported on your
T4 slip. The relevant supporting documents will also depend on
whether you plan on claiming the 50% ESO tax deduction under
subsection 110(1) of Canada’s Income Tax Act. For
advice on how to audit-proof your claim, speak to our Certified
Specialist in Taxation Canadian tax lawyer today.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.