Q: What are the tax implications of issuing stock options to employees?
A: Stock options are a great way to attract and retain employees - especially for high-growth technology businesses. There are several advantages to offering employee stock options, however, businesses should be aware of the tax implications for the employer and the employee. If you are considering offering stock options to your employees, here are a few things you should know.
There are varying implications, depending on whether or not you are a Canadian-Controlled Private Corporation (CCPC).
For a company that is a CCPC
- Stock options granted to arm’s length employees by CCPCs have an advantage - upon exercise, the taxable benefit associated with the spread between the exercise price and the FMV at the time of exercise is deferred until the option shares are sold.
- Options can be granted with any option exercise price, including zero. However, options should be granted with an exercise price at or above the fair market value (FMV) of common shares at the time of grant in order to give flexibility in realizing preferred tax treatment.
- The taxable benefit (the spread as noted above) is included in the employee’s income as a stock option taxable benefit at the time of sale of the shares. In general, if the options were granted with an option exercise price equal to the FMV of the underlying shares at grant, the employee would receive a stock option deduction reducing the taxable benefit to one-half of the original amount, effectively treating the stock option taxable benefit as a capital gain.
- If the stock options are granted with an exercise price below FMV, the stock option deduction is still available, but the employee must hold on to the stock option shares after they are exercised for a period greater than two years.
- As the stock option benefit is a taxable employment benefit, the employer in normal circumstances is required to withhold and remit source deductions including any employee health taxes.
- However, stock options issued by CCPCs are not subject to withholding and remittance of source deductions (except EHT). The employer is required to report the taxable benefit on the employee’s T4 for the year of sale, which remains in effect even if the employee leaves the company.
- If there is a desire to withhold and remit source deductions, the employer would need to seek approval from the employee and obtain a waiver from CRA, which could be facilitated through an updated TD1 form.
There are different options available to determine FMV, and each provides a different level of evidence to support your FMV:
- perform a recent funding activity,
- complete an analysis of share value at the time of the grant and exercise, or
- perform a formal valuation (in certain situations).
For a company that is not a CCPC
The rules differ slightly when you’re not a CCPC. When the stock option is exercised, the employee will be taxed on the stock option benefit in the year of exercise and not deferred until the time the stock option shares are sold. In certain circumstances, the employee could be eligible for a stock option deduction. Unlike a CCPC, the employer is responsible to withhold and remit source deductions in addition to reporting the stock option benefit on the employee’s T4.
In addition to this, there are further restrictions with respect to significant amounts of options granted in large non-CCPC companies. Where a company with gross annual revenues in excess of 500 million dollars (on a consolidated basis) granted options to an employee that exceeds a 200,000 dollars annual vesting limit, a portion of those options will not be eligible for the stock option deduction on exercise. There are also additional reporting obligations that the company needs to comply with. For more details, please see this article on the proposed changes to stock option benefit rules.
For additional questions or further information on this topic, contact:
Paul Walker, Partner, Transaction Tax and Canadian Tax Services
Marie Neill, Senior Manager, Expatriate Tax Services