Stock option plans are quite often an integral part of an employee’s compensation package to create long term capital use in retirement. Companies implement these plans to attract, reward and retain highly skilled employees.
What is a stock option?
A stock option allows the employee to purchase a certain number of shares at a specified price (‘the option price’) for a specified period of time. Often there is a holding period during which the employee cannot exercise the option. Once this holding period is over, the option is considered ‘vested’ and the employee can exercise the option any time thereafter until the expiry date, if any.
This article will review the different tax rules associated with option plans for Canadian-controlled private corporations (CCPCs) and non-CCPCs i.e. Canadian public corporations.
Taxation of stock options from Canadian public companies
While there are no tax consequences when such stock options are granted, at the time the employee exercises the option they trigger an ‘option benefit’. This benefit is equal to the difference between the market value of the stock and the ‘option price.’ This benefit must be included in the employee’s income from employment in the year in which the option is exercised. The employee can claim a tax deduction equal to one-half of the ‘option benefit’ if the shares are common shares and the exercise price, at the time the options were granted, was equal to the fair market value of the shares.
- You have options to acquire 3000 common shares of ABC
Company at $30 per share (equal to the fair market value of the shares on the date the options were granted).
- Current market value of ABC’s common shares is $75.
- All options are vested.
- If all 3000 shares are exercised, the taxable ‘option benefit’ is $67,500 ($75-$30 = $45 x 3000 shares x 50%).
Taxation of stock options from Canadian controlled private corporations
Employees of CCPCs do not need to include the ‘option benefit’ in income until the year in which the employee disposes the shares. As with non-CCPC shares, the option benefit may be reduced by one-half as long as the exercise price at the time the options were granted was equal to the fair market value of the shares. If it does not meet these criteria, an employee may be able to access another one-half deduction as long as the shares have been held for at least two years at the date of sale.
Deferring the ‘Option Benefit’
The 2000 Federal budget introduced a deferral of the ‘option benefit’ for non-CCPCs until the employee sells the shares, or is deemed to have disposed of the shares on death or on becoming a non-resident of Canada. This deferral applies to options exercised after February 27, 2000, regardless of when the options were issued.
The amount that may be deferred is limited to the benefit arising on $100,000 worth of stock options vested in a particular year. While the $100,000 amount is based on the fair market value of the shares at the time the option is granted, the actual benefit that can be deferred can be much greater.
This can best be illustrated by example:
In January 2000, an employee received 10,000 qualifying shares at an option price of $25 per share equal to the fair market value at the time of grant.
Of the 10,000 options, 5,000 vested in January 2001 and the
remaining 5,000 in January 2002.
On December 1, 2002, all options were exercised. The fair
market value of the shares on that date was $60.
In 2004, the employee sells all 10,000 shares at a fair market value of $65 per share.
2002 Tax Calculation:
Step One – Calculate the number of shares that can be deferred.
The $100,000 maximum deferral is based on the $25 fair market value. Therefore the income benefit that the employee can defer in our example is based on 4,000 shares per vested year ($100,000 / $25).
Step Two – Calculate the income deferral.
(Number of shares * benefit per share)
2001 deferral = $140,0000, (4,000 shares * $35 ($60-$25))
2002 deferral = $140,0000, (4,000 shares * $35 ($60-$25))
Total deferral – $280,000
Step Three – Calculate the income benefit.
2001 income inclusion = $175,000, (5,000 x ($60-$25 = $35))
2002 income inclusion = $175,000, (5,000 x $60-$25=$35))
Total income before deferral – $350,000, less deferral (from Step Two) = $280,000
Total income reported in 2002 = $70,000
Of this $70,000 only 50% is taxable at the employees marginal tax rate.
2004 Tax Calculation
The employee now pays the tax on the $280,000 option benefit that was deferred and the gain on the shares from 2002 to 2004 ($65-$60 x 10,000 shares = $50,000). The total
income reported when the shares are sold is $215,000 ($330,000 x 50%)
Note: If the value of the shares have declined when you eventually sell, you will realize a capital loss but still be liable for the tax on the option benefit.
An employee who receives stock options for a public company and elects to defer the taxable benefit of up to $100,000 per annum (under subsection 7(8) of the Canadian Income Tax Act) until the shares are disposed of must report the taxable benefit (receipt of the stock option) at the time of disposition (on form T1212) and must pay Canadian income tax at that time.
Note: The above article is for information purposes only and should not be construed as offering tax advice. Individuals should consult with their personal tax advisors before taking any action based upon the information in this article.