The taxation of stock options

As an incentive strategy, you may provide your employees with the right to acquire shares in your company at a fixed price for a limited period. Normally, the shares will be worth more than the purchase price at the time the employee exercises the option.

For example, you provide one of your key employees with the option to buy 1,000 shares in the company at $5 each. This is the estimated fair market value (FMV) per share at the time the option is granted. When the stock price increases to $10, your employee exercises his option to buy the shares for $5,000. Since their current value is $10,000, he has a profit of $5,000.

How is the benefit taxed?

The income tax consequences of exercising the option depend on whether the company granting the option is a Canadian-controlled private corporation (CCPC), the period of time the employee holds the shares before eventually selling them and whether the employee deals at arm’s- length with the corporation.

If the company is a CCPC, there won’t be any income tax consequences until the employee disposes of the shares, provided the employee is not related to the controlling shareholders of the company. In general, the difference between the FMV of the shares at the time the option was exercised and the option price (i.e., $5 per share in our example) will be taxed as employment income in the year the shares are sold. The employee can claim a deduction from taxable income equal to half this amount, if certain conditions are met. Half of the difference between the ultimate sale price and the FMV of the shares at the date the option was exercised will be reported as a taxable capital gain or allowable capital loss.

Example: In 2013, your company, a CCPC, offered several of its senior employees the option to buy 1,000 shares in the company for $10 each. In 2015, it’s estimated that the value of the stock has doubled. Several of the employees decide to exercise their options. By 2016, the value of the stock has doubled again to $40 per share, and some of the employees decide to sell their shares. Since the company was a CCPC at the time the option was granted, there’s no taxable benefit until the shares are sold in 2016. It’s assumed that the conditions for the 50% deduction are satisfied. The benefit is calculated as follows:

Employment income
Employment income ($20 – $10) × (1,000 shares) $10,000
Income deduction (50%) ($5,000)
Income inclusion $5,000
Proceeds of disposition ($40 × 1,000 shares) $40,000
Cost base ($20 × 1,000 shares) ($20,000)
Capital gain $20,000
Taxable capital gain $10,000

What if the stock declines in value?

In the above numerical example, the value of the stock increased between the time the stock was acquired and the time it was sold. But what would happen if the share value declined to $10 at the time of sale in 2016? In this case, the employee would report a net income inclusion of $5,000 and a $10,000 capital loss ($5,000 allowable capital loss). Unfortunately, while the income inclusion is afforded the same tax treatment as a capital gain, it isn’t actually a capital gain. It’s taxed as employment income. As a result, the capital loss realized in 2016 cannot be used to offset the income inclusion resulting from the taxable benefit.

Anyone in difficult financial circumstances as a result of these rules should contact their local CRA Tax Services office to determine whether special payment arrangements can be made.

Public company stock options

The rules are different where the company granting the option is a public company. The general rule is that the employee has to report a taxable employment benefit in the year the option is exercised. This benefit is equal to the amount by which the FMV of the shares (at the time the option is exercised) exceeds the option price paid for the shares. When certain conditions are met, a deduction equal to half the taxable benefit is allowed.

For options exercised prior to 4:00 p.m. EST on March 4, 2010, eligible employees of public companies could elect to defer taxation on the resulting taxable employment benefit (subject to an annual vesting limit of $100,000). However, public company options exercised after 4:00 p.m. EST on March 4, 2010 are no longer eligible for the deferral.

Some employees who took advantage of the tax deferral election experienced financial difficulties as a result of a decline in the value of the optioned securities to the point that the value of the securities was less than the deferred tax liability on the underlying stock option benefit. A special election was available so that the tax liability on the deferred stock option benefit would not exceed the proceeds of disposition for the optioned securities (two-thirds of such proceeds for residents of Quebec), provided that the securities were disposed after 2010 and before 2015, and that the election was filed by the due date of your income tax return for the year of the disposition.