“it is desirable to minimize the employment benefit and increase the potential capital gain.”
Generally, there is no immediate tax implication when a stock option is granted to an employee. The timing and amount of any eventual taxable benefit will be based on the nature of the issuing corporation and the relationship between the exercise price (“strike price”) and the fair market value (“FMV”) of the shares when the stock option is exercised.
An employment benefit is calculated as the difference between the FMV of the shares at the time the option is exercised and the strike price. However, the time at which the employment benefit becomes taxable differs based on the status of the corporation issuing the stock options. If the corporation that grants the stock option is a Canadian-controlled private corporation (“CCPC”), the recognition of the employment benefit is deferred until the shares acquired under the stock option are sold. If the granting corporation is not a CCPC, the benefit is generally taxable in the year that the options are exercised.
A capital gain will be realized if the shares are sold for proceeds greater than the FMV of the shares when the option was exercised. If the proceeds are lower than the FMV when the option was exercised, the employee will have a capital loss that cannot be used to offset the employment benefit.
Subject to our comments below, the entire amount of the employment benefit is taxed at the employee’s marginal tax rate, whereas only one-half of a capital gain is taxed at the marginal rate.
The rest of this tax tip will deal with stock options issued by a CCPC.
In most CCPC scenarios, the strike price is nominal even if the shares have a high FMV. Where the employee deals at arm’s length with the CCPC and the employee holds the shares for at least two (2) years after exercise, one-half (1/2) of the employment benefit may be deducted from the employee’s income. This 50% deduction effectively allows the employment benefit to be taxed at capital gains tax rates even though the amount is employment income (not eligible for the capital gains exemption).
Even though the employment benefit can be taxed at the same effective tax rate as a capital gain any capital loss from the sale of the shares cannot be deducted against the employment benefit. Accordingly, it is desirable to minimize the employment benefit and increase the potential capital gain.
In order to:
- minimize the employment benefit;
- start the two (2) year hold period required for the 50% deduction; and
- allow more of the growth in FMV to be treated as a capital gain
employees should consider exercising their stock options early. If the strike price is nominal, there is little downside to this strategy and potentially large tax savings. Where the strike price is more than nominal the decision as to when to exercise the stock options is more complicated.
You should consult with your TSG representative if you have any questions relating to the taxation of stock options.
TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.
The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.
