A, B, C’s of Canada’s New Employee Stock Option Regime

by KPMG LLP, Toronto

(KPMG LLP in Canada is a KPMG International member firm)

If you are an employee holding stock options in your employer company, an understanding of the new rules will help ensure you make the most of the related tax incentives. And if you are an employer seeking ways to attract and retain skilled employees in today’s heated labour market, particularly in the high-technology sector, employee stock option plans are an increasingly popular route. Beyond the tax benefits, share ownership plans can offer flexibility in developing attractive remuneration packages, while at the same time motivating employees and fostering their long-term commitment to your company.

Canada’s 2000 federal budget proposes tax breaks for employees who exercise stock options in shares of qualifying public companies. Employee options in shares of Canadian-controlled private corporations (CCPCs) already receive preferential tax treatment.

The rules governing the taxation of employee stock options are complex and may trigger unintended tax consequences to employees if plans are not properly designed. This article summarizes the current tax rules applying to employee stock options and highlights the new rules for options in public company shares.

Benefits from Employee Stock Options

A stock option plan is an arrangement whereby a corporation gives an employee the right (an option) to invest in its shares at a given price. The price may or may not be less than the market price at the time the option is granted.

Before discussing the new tax breaks for employee options in public company shares, let’s look at a simple example of the general rules. Suppose you work for a public corporation whose stock trades at $20 (all dollar figures expressed are Canadian dollars unless otherwise noted). In 2000, you are given an option to buy up to 1,000 shares at $20, which you can exercise when the options vest in 2001. In 2001, when the stock is trading at $30, you decide to exercise the option and buy 1,000 shares for $20,000. In 2002, the shares increase to $40 and you decide to sell them.

The general rule for stock options is that you are considered to receive a benefit from employment, not when the option is granted (in 2000 in the above example), but when you exercise it (in 2001). The taxable benefit is the difference between the price you pay ($20,000) and the value of the shares when you exercise the option ($30,000). As such, you would normally report a taxable benefit of $10,000 in your employment income for 2001.

Generally, you may be able to claim a deduction against the taxable benefit for 2001 if:

The shares are normal common shares (not preferred shares) The exercise price is not less than the fair market value of the shares at the time the option was granted You deal at arm’s length with the corporation.

If each of these conditions is met, you can deduct one-third of the amount of the taxable benefit (or one-quarter for options exercised before February 28, 2000). The effect of this deduction is to tax the employment benefit at the same two-thirds inclusion rate as a capital gain.

The cost base of your shares will be $30,000, the sum of the option price plus the amount of the benefit that has been included in your income. When you sell the shares for $40,000, in 2002, your capital gain will be $10,000 ($40,000 — $30,000), of which two-thirds will be taxable.

Stock Options in CCPCs

As noted, special tax treatment is available for employee stock options in CCPCs. If your employer is a CCPC that you deal with at arm’s length, the employment benefit arising on the exercise of your stock options in your employer’s CCPC is not taxed until you sell the shares.

If you have held the shares for at least two years at the date of sale, you can claim a tax deduction for one-third of the benefit realized in the year the shares are sold (one-quarter for shares sold before February 28, 2000) without having to meet the first two requirements for regular stock options outlined above. This exception is designed to stimulate employee participation in ownership of small businesses. It also acknowledges that valuation of shares in a private company may be difficult.

New Rules for Stock Options in Public Companies

Recognizing the increasing importance of share ownership and stock option plans for recruiting and retaining key employees, the 2000 federal budget proposes to postpone the taxation on $100,000 per year of qualifying employee stock options for publicly-listed shares. Instead of taxing the benefit in the year of exercise, it will be taxed when the shares are sold. In the above example, this change would enable our employee to defer tax on the $10,000 benefit until 2002, the year the shares are sold.

The new rules are similar to the U.S. rules governing Incentive Stock Options (ISOs) and are in part designed to ensure Canadian companies are able to compete on even ground with their U.S. rivals.

Employees of public companies must meet several conditions to qualify for this treatment. Among other things, you must deal at arm’s length with your employer and you must not be a specified shareholder (i.e.. generally, you must not own 10 percent or more of the company’s shares). The shares to be acquired must also be ordinary common shares, which are traded on a prescribed Canadian or foreign stock exchange.

Additionally, the total of all amounts payable to acquire the shares, including the option price and any amount payable to acquire the option, cannot be less than the share’s fair market value on the date the option was granted. If these conditions are met, the stock option benefit on the qualifying stock options will be included in income in the year that the shares are sold.

$100,000 Annual Limit

The $100,000 annual limit on the fair market value of options available for the deferral applies to the year of vesting — the year the employee gains the right to exercise the options under the terms of the option agreement — and not to the year in which the option is actually exercised. As a result, the vesting period can dramatically change the amount of the benefit that may be deferred. All stock option plans of the employer and related corporation must be included when determining if the annual limit will be exceeded in year of vesting.

For example, say an employee is granted options for 20,000 shares with an exercise price of $10 per share ($200,000 in total), which is their fair market value at the time the options are granted. All of the options vest in Year 1 and the employee exercises the options in that year when the share price is $25 per share ($500,000 in total).

In this case, the employee’s potential benefit is $300,000 ($500,000 — $200,000). But the deferral is only available for 10,000 shares due to the $100,000 limit, so only half of the total benefit ($150,000) can be deferred. The additional $150,000, will be taxed under the general rules as employment income in Year 1 (subject to the one-third employee stock option deduction).

But what if we change the facts so the vesting period for the 20,000 shares is spread equally over Years 1 and 2 (i.e.. 10,000 each year) and the employee exercises the options in Year 2? In this case, tax on the entire $300,000 benefit can be deferred because the fair market value of the 10,000 shares attributable to options vesting each year does not exceed the $100,000 annual limit.

The table below summarizes the tax results of both scenarios. In practice, employees will generally only exercise their options if they plan to sell the shares. Most employees will probably not pay the exercise price if they can simply hold the options and exercise them at a future date. So it seems that the employees who will benefit the most from this measure are those whose options would otherwise expire before they might plan to sell the shares. For example, an employee may have options that vest with a short expiry period (i.e.. years four and five of a five-year option plan) or may be leaving the company with a short period of time to exercise any vested options.