Part 1 of this 3-part series explained the taxation of U.S. stock options. In this article we will discuss the tax implications of Canadian stock options.
The tax consequences resulting from Canadian stock options is differentiated by the type of company that is granting the option. This is because stock options grant by Canadian controlled private corporations (CCPC’s) enjoy additional special benefits that other corporations to not qualify for. CCPC’s are corporations that are residents of Canada, that are not controlled by non-residents or public corporations. In general, when any company grants a stock option to an employee there are no tax implications; however, a divergence arises between CCPC’s and other companies at the time of exercise.
Stock Options Issued by Other Corporations
When an employee of a non-CCPC company exercises their options, they incur a taxable benefit that is included in their taxable income as ordinary income. The amount of the benefit is equal to the difference between the fair market value of the shares at the time they are exercised, the amount paid by the employee to the corporation for the shares and the amount paid by the employee to acquire the right to acquire the shares.
When the shares are eventually sold the employee will incur a capital gain or loss that is calculated as the difference between the proceeds on the sale and the fair market value at the time they were exercised. Only 50% of a capital gain is taxable and a capital loss cannot be used to offset the taxable benefit previously incurred.
Example: Cindy is a Canadian resident that is employed by Dot.ca, a public company listed on the Toronto Stock Exchange. She was granted 1,000 stock options at no cost on Nov 1, 2018 with an exercise price of $1 per share. The fair market value of the shares at that time was $5 per share. On Nov 1, 2019 she exercised the options when the fair market value of the shares was $10 per share, and then sold the shares 2 week later for $12 per share.
There are no tax consequences in 2018 when the options were granted, however, she will incur a taxable benefit of $9,000 ($10,000-$1,000) in 2019 when she exercised her options. In addition, in 2019 she will incur a capital gain of $2,000 ($12,000-$10,000) of which 50% or $1,000 will be taxable.
Taxable Benefit Deduction
If the following criteria are met an employee can deduct 50% of the taxable benefit when the options are exercised:
- The shares are “prescribed” shares (equivalent to common shares)
- The option price was not less than the fair market value of the shares at the time that the option was granted
- The corporation is dealing with the employee at arm’s length
Example: Cindy is a Canadian resident that is employed as a manager by Dot.ca, a public company listed on the Toronto Stock Exchange. She was granted 1,000 stock options to purchase common shares at no cost on Nov 1, 2018 with an exercise price of $5 per share. The company was dealing at arm’s length with Cindy at the time the options were granted. The fair market value of the shares at that time was $5 per share. On Nov 1, 2019 she exercised the options when the fair market value of the shares was $10 per share, and then sold the shares 2 week later for $12 per share.
There are no tax consequences in 2018 when the options were granted, however, she will incur a taxable benefit of $2,500 (50% x ($10,000-$5,000)) in 2019 when she exercised her options. In addition, in she will incur a capital gain of $2,000 ($12,000-$10,000) of which 50% or $1,000 will be taxable.
Deduction Limit Change
The 50% deduction of the taxable benefit, discussed above, will be subject to limitations on stock options granted after June 30, 2021. After that date there will be a $200,000 limit to this preferential rate. This limit will be based on the fair market value of the underlying shares at the time the options are granted and is an annual per employee limit. These new rules will not apply to CCPCs, or non-CCPC employers with annual gross revenues of $500 million or less. Employees exercising stock options that exceed the $200,000 annual limit will no longer be eligible for the 50% stock option deduction.
Example: Cindy is a Canadian resident that is employed as a manager by Dot.ca, a public company listed on the Toronto Stock Exchange. She was granted 100,000 stock options to purchase common shares at no cost on July 1, 2021 with an exercise price of $5 per share. The company was dealing at arm’s length with Cindy at the time the options were granted. The fair market value of the shares at that time was $5 per share. On Nov 1, 2021 she exercised the options when the fair market value of the shares was $10 per share, and then sold the shares 2 week later for $12 per share.
There are no tax consequences when the options were granted. Because her options were granted after June 30, 2021, and the value of the underlying shares at the time the options were granted was $500,0000 she is not eligible for the 50% stock option deduction. In 2021, she will incur a taxable benefit of $500,000 ($1,000,000-$500,000. In addition, she will incur a capital gain of $200,000 ($1,200,000-$1,000,000) of which 50% or $100,000 will be taxable.
Stock Options Issued by CCPCs
When an arm’s length employee exercises stock options issued by a CCPC, the taxable benefit is deferred until the underlying shares are eventually sold. When the shares are sold the employee incurs a taxable benefit calculated as the difference between the fair market value when the option was exercised and the option price. In addition, they will also incur a capital gain or loss calculated as the difference between the proceeds and the fair market value of the shares when the option was exercised. If a capital loss is incurred it cannot be used to reduce the taxable benefit, however, it can be used to reduce other capital gains incurred.
Example: Cindy is a Canadian resident that is employed as a manager by Dot.ca, an CCPC. She was granted 1,000 stock options on Nov 1, 2018 with an exercise price of $1 per share. The fair market value of the shares at that time was $1 per share. On July 1, 2019 she exercised the options when the fair market value of the shares was $4 per share, and then sold the shares on January 1, 2020 when the value of the shares was $6 per share.
There are no tax consequences in 2018 or 2019 when the options were granted and subsequently exercised because the company is a CCPC. The $3,000 ($4,000-$1,000) taxable benefit is deferred until 2020 when she sold the shares. In addition, she will incur a capital gain in 2020 of $2,000 ($6,000-$4,000) of which 50% or $1,000 will be taxable.
Taxable Benefit Deduction
An employee of an CCPC can also deduct 50% of the taxable benefit if the following conditions are met:
- The employee is still dealing at arm’s length with the company in the year of disposition
- The shares are held for at least two years from the date they were acquired
Example: Cindy is a Canadian resident that is employed as a manager by Dot.ca, an CCPC. She was dealing at arm’s length with the company when the options were granted and when the options were sold. She was granted 1,000 stock options on November 1, 2017 with an exercise price of $1 per share. The fair market value of the shares at that time was $1 per share. On November 1, 2018 she exercised the options when the fair market value of the shares was $4 per share, and then sold the shares on November 30, 2020 when the value of the shares was $6 per share.
There are no tax consequences in 2017 or 2018 when the options were granted and subsequently exercised because the company is an CCPC. The $1,500 (50% x ($4,000-$1,000)) taxable benefit is deferred until 2020 when she sold the shares. In addition, she will incur a capital gain in 2020 of $2,000 ($6,000-$4,000) of which 50% or $1,000 will be taxable.
Part 3 of this series will discuss cross border taxation of stock options.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.