Background

Employee Stock Options (ESOs) are a popular form of compensation that companies may offer to attract and reward good employees. These options help create an ownership culture by aligning the goals of the employees with the goals of the company. Employees can participate in the future growth of the company, which can increase their performance, and in turn improve the profitability of the firm and increase the company’s share price.

ESOs provide an employee with the right, but not the obligation, to purchase shares of the employer’s company at a set price within a defined timeframe. The terms are documented in a contract and include the number of shares, exercise price, and timing (vesting schedule and expiry date).

Exercising Employee Stock Options

Stock options that are granted to an employee are often ineligible for exercise until a specified future date, known as a vesting period. These options provide employees with the right, but not the obligation, to purchase shares. If the exercise price is equal to or greater than the market price, the employee would simply leave the options unexercised. On the other hand, if the market price exceeds the exercise price (and the option is vested), the employee can purchase shares at the exercise price, subsequently sell them at the higher market price, and realize a profit. The difference between the market price and option exercise price is known as the intrinsic value. The possible methods for exercising ESOs will vary by company and potential options include:

Cash-Out of Stock Options

An employer may provide employees with the option to receive a cash payment (instead of shares). The payment would be based on the intrinsic value of the options at the time.

Make a Cash Payment

This method requires the employee to provide the capital to exercise the options at the exercise price. If the company is a not a Canadian-controlled private corporation (CCPC), employees may also be required to provide the value of source deductions that the employer is obligated to withhold and remit to the CRA. The employer may instead fund this withholding tax by other methods, such as withholding an additional amount from an employee’s regular salary or instructing a broker to sell a portion of the issued shares.

Cashless Exercise of Stock Options

A cashless exercise involves short selling the underlying shares to generate cash which is then used to pay the cost of exercising the options. The resulting shares are then used to close the short position.

Income Tax Implications

Employees need to pay tax on the benefit derived from the ESO in the form of a security options benefit. The tax may be payable in either the year the options are exercised or the year the resulting shares are sold and is dependent on whether or not the shares are of a Canadian-controlled private corporation (CCPC).

Canadian-Controlled Private Corporations (CCPCs)

In the case of shares of a Canadian-controlled private corporation (CCPC), Canada’s tax system recognizes the potential market forces and liquidity issues shareholders of private companies may face when selling shares. As a result, the taxable event is deferred until the resulting shares are sold. When the shares are eventually sold, any gains (or losses) are broken down into two components.

1) A security options benefit that’s equal to the fair market value (FMV) of the shares (at time of exercise) minus the exercise price and any additional amount the employee paid to purchase the option. While this security options benefit is taxable as employment income, the employee may qualify for a security options deduction equal to 50% of the benefit. This deduction effectively results in the benefit being taxed at capital gains tax rates.

2) A capital gain or loss that’s equal to the FMV at the time of sale minus the FMV at the time of exercise.

Non-CCPCs

Employees with ESOs from a non-CCPC must account for the security options benefit in the year that the ESO is exercised. Non-CCPC companies are typically public companies with shares trading openly on a stock exchange. It’s therefore assumed that shares of these companies can be sold without much resistance or liquidity concerns.

ESOs granted by non-CCPC employers may also be eligible for a security options deduction. This deduction is subject to slightly more stringent (but similar) eligibility criteria as ESOs granted by a CCPC. However, unlike CCPCs, the deduction an eligible employee receives may be limited so that the amount taxed at preferential tax rates is capped at $200,000. This limit is applicable to ESOs granted on or after July 1, 2021, by employers with annual gross revenues over $500 million.

The FMV at the time the ESOs are exercised generally becomes the cost base of the shares. When the shares are sold, the change in price will result in a taxable gain or loss (unless they are held in a registered account). A key consideration is that a capital loss from selling shares that have decreased since the exercise date, cannot be used to offset the tax owed on the security options benefit. While the security options benefit may have been taxed at a preferential rate that’s effectively equivalent to capital gains tax rates, it is not a true capital gain and therefore cannot be offset by capital losses.

Other Considerations

Other factors that may require consideration include foreign exchange, tax planning with registered accounts, alternative minimum tax, and estate planning implications. There are also additional rules that govern company insiders. It’s recommended to work with a qualified professional tax advisor to understand and adhere to the tax implications that are relevant to your situation.

This article is meant to provide a general overview and is not intended to provide tax or legal advice. You should consult with professionals to ensure that your own unique circumstances have been considered and any action taken is based on the latest information available.

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