Employee stock options were first given preferential tax treatment in the Income Tax Act (Canada) (the “Act”)[1] in 1977 under the leadership of the Right Honourable Pierre Elliott Trudeau, Prime Minister of Canada, and Donald Macdonald, Finance Minister.[2] The public policy rationale for such treatment was (and continues to be) to support smaller and particularly newer companies that find it difficult to attract and retain employees because they lack financial resources and significant profits to match the higher salaries provided by larger, more mature companies.[3]
Pre-Budget 2019: Employee Stock Option Tax Rules
To put younger and growing Canadian businesses such as start-ups on more competitive footing in the market consistent with this public policy, the Act has provided the following regime for employees who are remunerated with stock options and for the companies that issue these options:
- Stock option income inclusion: When a corporation grants a stock option at a certain price to an employee, the employee is not taxed immediately at that time. Instead, the employee must include an employment benefit in his or her income for tax purposes in the year he or she exercises the option to acquire the shares unless an exception applies. The employment benefit is equal to the difference between the fair market value of the shares acquired at the time the employee exercises the options and the price that the employee actually paid to acquire the shares.[4]
- Exception to the stock option income inclusion: If the corporation that issued the stock option is a Canadian-controlled private corporation (“CCPC”), then the exercise of stock options crystallizes the amount of the employment benefit but the benefit is not actually included in the employee’s income until the year in which the employee disposes of the shares.[5] Therefore, the timing of the income inclusion depends on the type of corporation issuing the stock options.
- Stock option deduction: An employee may deduct in computing his or her taxable income an amount equal to one-half of the employment benefit (that is required to be included in income) so long as certain conditions are met.[6] Where an employee meets all of the conditions to take this deduction, the result is that only 50% of the employment benefit is taxable to the employee, which effectively means that the benefit is preferentially taxed at one half of the normal personal tax rate, equivalent to capital gains treatment.
- Employer deduction restriction: Employers cannot deduct the costs of granting employees stock options.[7] Although employers can deduct cash payments for settling stock options, doing so precludes the employee from claiming the stock option deduction, so in most cases the employer will forego this deduction.[8]
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