Published: March 25, 2020
Last Updated: October 13, 2021
Employee stock options (“ESO”) are a form of compensation that corporations often grant to certain employees in addition to a regular salary. An ESO grants the holder of the option a right, but not an obligation, to purchase shares of the corporation at a certain predetermined price. The idea behind an incentive stock option is to help align the employee’s interests with those of the corporation.
Canadian Controlled Private Corporations (“CCPC”) enjoy a number of special benefits over other corporations, and ESOs are another area in which CCPC status is beneficial with regards to tax treatment. Essentially, a CCPC is a corporation that is resident in Canada, which is not controlled by non-residents or public corporations. Whether a corporation qualifies as a CCPC can sometimes get complicated because of the various definitions of control, and falls outside the scope of this article.
In general, when an employee stock option is issued, there are no related tax implications for either the employee or the employer. A tax benefit has not arisen, and therefore the employee is not subject to an income inclusion and the employer does not claim a related deduction. However, when an ESO is exercised – that is, when the employee wishes to use the ESO to purchase company shares – a divergence arises between the tax treatment of a CCPC’s stock options and other corporate stock options.
Upon exercising the stock option, non-CCPC employees have incurred a taxable benefit and it must be included in their income. The amount of the benefit to be included is equal to the fair market value of the shares purchased minus the amount paid by the employee to the corporation for the shares, and minus the amount (if any) paid by the employee to acquire the stock options. So for example, an option is issued at no cost to the employee with an exercise price of $10 per share when the corporation’s shares were worth $10. The value of the corporation’s shares then rises to $15 per share. If the employee exercised the option, then the taxable benefit would be $5 per share (= $15 – $10). This amount is includable under section 7 Income Tax Act employment income. If the employee had to pay $1 to acquire the option, the taxable benefit would be $4 (= $15 – $10 – $1).
Conversely, a CCPC employee does not have to include any benefit amount in their income when exercising an ESO; the inclusion is deferred until the employee disposes of the shares. At that time, the CCPC employee must include the taxable benefit amount in their income, and must calculate any taxable capital gains, just as a non-CCPC employee would. The ability to defer is beneficial since no tax has to be paid at the time of exercise. Furthermore, the shares might then be sold at a time when there are capital losses to offset the capital gain.
Additionally, if certain criteria are met an employee can deduct 50% of the taxable benefit they would have had to include in their employment income arising from exercising their ESO.
This preferable tax treatment arises pursuant to the deduction under subparagraph 110(1)(d) of the Income Tax Act. This deduction applies if an employee meets four criteria:
- The employer or a corporation not dealing at arm’s length with the employer is offering ESOs
- The shares are “prescribed” shares (equivalent to common shares)
- The employee isn’t paying more for the ESO than the benefit gained
- The corporation is dealing with the employee at arm’s length.
CCPC status comes with various tax minimizing opportunities, including the preferential treatment of ESOs. If you require assistance with setting up a CCPC, drafting or implementing an employee stock option plan, or you would like advice on the current structure of your employee stock option plan, please contact one of our experienced tax lawyers.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."