Taxation of employee stock options

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Stock options are a popular form of employee compensation that allows employees to participate in future growth. This article discusses the tax rules your clients should know if they receive stock options from their employers.

Taxation of stock options

When stock options are granted to your client, there is no immediate tax implication on the grant date. When the options are exercised, the difference between the fair market value of the shares and the amount paid to acquire the shares (i.e., the exercise price under the option agreement plus the amount paid to obtain the stock options) is treated as an employment benefit for tax purposes.

If the employer is a publicly traded corporation, the employment benefit is taxable in the year the options are exercised. If the employer is a Canadian-controlled private corporation (CCPC), the employment benefit is only taxable in the year your client sells the shares acquired under the options.

Tax-preferential treatment of the employment benefit is available, but the rules vary depending on corporation type.

If the employer is a non-CCPC, a tax-preferential treatment is available when:

the fair market value of the underlying shares is not greater than the exercise price at the time stock options are granted;
your client deals at arm’s length with the employer immediately after the option is granted (i.e., the client does not own a controlling interest in the employer corporation); and
options are granted for “prescribed shares,” such as participating common shares with no special guarantees, rights or features.

When the above conditions are met, 50% of the employment benefit can be deducted from income in the same year, so only half the employment benefit would be taxed. Keep in mind that this taxable portion of the benefit would also be subject to source deductions by your client’s employer.

If the employer is a CCPC, the 50% deduction is available when your client deals at arm’s length with the employer and shares acquired under the options are not sold for at least two years.

The adjusted cost base (ACB) of the shares acquired will equal the price paid to acquire the shares plus the employment benefit triggered from exercising the stock options.

To illustrate, let’s say Manuel received stock options from his employer, PublicCo, in 2022 that gave him the right to purchase 1,000 PublicCo shares at an exercise price of $25 per share. When the stock options were granted, PublicCo shares were valued at $20 per share on a designated stock exchange. Manuel decides to exercise the stock options in 2023 when PublicCo shares have risen to $35 per share.

In this situation, no taxable income was included in Manuel’s 2022 income, which was when the stock options were granted. When Manuel exercises the stock options to purchase 1,000 shares in 2023, an employment benefit arises of $10,000 (i.e., FMV of $35 per share – exercise price of $25 per share × 1,000 shares). Manuel met the criteria for the tax-preferential treatment, so he would qualify for the 50% deduction, which means his taxable income for 2023 would increase by $5,000. The result for Manuel is that he receives similar tax treatment as a capital gain, since only 50% of the benefit is taxable. Importantly, though, it is not a capital gain, and thus capital losses cannot be used to reduce the taxable employment benefit.

Going forward, Manuel’s ACB of PublicCo shares would be $35,000 (or $35 per share), which is the total of the amount Manuel paid to acquire the shares ($25,000) plus the employment benefit from exercising the stock options ($10,000).

When the shares are later sold, Manuel will be taxed on the capital gains calculated as the fair market value at the time of sale less the ACB calculated above.

Restriction to tax-preferential treatment

For non-CCPC employers who earn more than $500 million in gross revenue annually, the tax-preferential treatment (i.e., 50% deduction) discussed above is only available for stock options granted up to the annual vesting limit of $200,000. This limit is based on the fair market value of the underlying shares on the grant date and generally applies to options granted after June 2021. The vesting limit is generally applied based on the calendar year in which the options become exercisable. If the calendar year of vesting is not specified in the stock option agreement, the stock options would be assumed to vest on a pro-rata basis over the period between grant date and last date the option could become exercisable.

The employer that grants non-qualified stock options (i.e., options that exceed the $200,000 annual vesting limit) is required to notify the employee in writing within 30 days of the stock option agreement date. This notification can help your client in determining whether the stock options would qualify for the tax-preferential treatment.

Donation of stock options

If the shares acquired under the options are listed on a designated stock exchange and your client donates the shares to a registered charity in the same calendar year and within 30 days of exercising the stock options, they can benefit from another 50% deduction against the employment benefit. This would eliminate all employment benefit triggered from exercising the stock options. Either way, your client will still receive a donation tax receipt for the fair market value of the shares donated.

For any non-qualified stock options discussed above, this additional 50% deduction would not be available. Such donations would only qualify for the donation tax credit based on the amount of donation.

Alternative minimum tax (AMT)

As AMT is calculated on adjusted taxable income, the tax-preferential treatment available for stock options can result in AMT payable for your clients. Under the current rules, the adjusted taxable income allows for a deduction of only 20% of the employment benefit as opposed to the 50% deduction allowed under regular tax calculations. As per 2023 federal budget proposals, 100% of the employment benefit would be subject to AMT, beginning in the 2024 tax year.

In addition, currently the adjusted taxable income includes no employment benefit when shares acquired under the options are subsequently donated as discussed above. The 2023 federal budget proposed to include 30% of the employment benefit on these donated options to calculate AMT.

As the tax implications associated with stock options can be very complex, it is important for your clients to consult their tax advisors.

Vivek Bansal, CPA, CA, is director of tax and estate planning with Mackenzie Investments. He can be reached at vibansal@mackenzieinvestments.com.