Taxation of Stock Options

Stock options are a popular way for companies to attract and retain key employees.  So what happens when an employee is granted stock options by a Canadian-Controlled Private Corporation (“CCPC”)?

  • There are no tax consequences to the employee when the stock options are granted or when the options are exercised by the employee.
  • When the shares are sold, the employee may have to include an amount in income equal to the amount, if any, by which the fair market value of the shares at the time the employee acquired them exceeds the exercise price for the shares.  This income will be considered employment income.

However, the employee may be entitled to a deduction of 50% of this employment income if the following conditions are met:

1.         The employee held the shares for at least two years prior to selling them; or
2.         The exercise price was greater or equal to the fair market value of the shares at the time the options were granted.

If the employee qualifies for this deduction, they will be taxed on this income at capital gains rates (i.e. only 50% taxable).  However, the income is still considered “employment income” and the employee cannot use the $800,000 Capital Gains Exemption (“CGE”).

When the employee sells the shares to someone other than their employer, the employee may also realize a capital gain equal to the amount by which the sale proceeds exceed the cost of the shares.  The cost of the shares is the fair market value of the shares at the time they were acquired by the employee.

However, the employee may be able to claim the CGE to offset all or some of this capital gain if the shares meet a number of conditions.  One of these conditions is that the share must be owned by the employee for at least 24 months prior to the sale.  Therefore, employers should consider a plan which encourages employees to exercise the options early.

Because of the varying tax results for employees, care should be taken when preparing a stock option plan to ensure it provides the best tax result for the employees.  The availability of the 50% deduction and/or CGE will depend upon the terms of the plan and could change the ultimate after-tax benefit for the employee.

Please note that the tax implications can vary significantly depending on your tax situation, therefore, you should consult with your tax advisor before entering into a stock option agreement.