Hi, this is Ruthann. I'm going to talk now about ITA 7, Employee Stock Options. This is an interesting topic because many people do get stock options from their employers and we want to look at the income tax implications of that. I'm doing a separate recording for this topic so that it gives you a chance to isolate it and work through the details of the calculations. Stock options are a benefit provided to an employee by an employer that allows, but does not require, the employee to purchase a specified number of shares for a specified period of time at a specified acquisition price, usually granted at or above fair market value can be lower.
Let's say, for example, if the shares are currently trading for $30 per share, and you are given options to purchase the shares at $35. And you think, well, now what good is that? Why would I buy shares for $35 when I could buy them on the open market for $30?
But the thing about that $35 option price is that it's locked in, where the market price will fluctuate. And suppose the market price goes up to $40. you can still buy at 35 according to your option certificate.
So now there is a benefit to them. So stock options given to employees in hopes to motivate the employee to work hard and in hopes of retaining the employee, that the employee will stay with the employer and wait for those options to become valuable. So what this happens then is that a taxable benefit. is created for the employee, but not generally a tax deduction for the employer. Now, employee stock options are also discussed in 3361. So many of you may have taken 3361 already, or you may be taking it now or in the future.
And in 3361, we talk about employee stock options and the importance in recording and reporting them for financial statement purposes. The shareholders of the company are very interested in knowing how much the company has issued in employee stock options. The options are also discussed in 4471, the advanced management accounting, where we talk about the motivational side of giving employee stock options, that hope that the employee will stay with the employer and will work hard for that employer. so that the company will prosper. Here in 3362, what are we interested in here?
We're interested in how does this end up on a tax return? Now you may have seen options in other courses as well, maybe in finance or other things that you've studied, maybe in 2257, but this is what our focus is here. The accounting for stock options is a bit complicated and it's because it depends on whether the company is publicly traded or a CCPC and depends on whether the options are granted at fair market value or higher or lower than fair market value. Here I'm going to talk about employee stock options. for a public company.
I'm going to assume that the fair market value for the company at $40 and that options were granted for $45 allows the employee to buy shares of the company at $45 and we're in this situation the option price is equal to or greater than the market price when the options were granted. A separate scenario may be that the options are less than fair market value at the time they are granted. So we'll talk about these two different possibilities. In either case, at the time options are granted, no action is required. However, when the option is exercised by the employee, then a stock option benefit occurs.
The benefit is the number of shares times the fair market value on the exercise date minus the exercise price. So suppose the shares go up in value to $50 and the employee decides to exercise their option at $45 and they have a $5 benefit per share times the number of shares. This amount is added to income.
when the option is exercised. Then we consider, does the employee qualify for a stock option deduction? If, when the options were originally granted, they were above fair market value, then a stock option deduction is permitted, 50% stock option deduction. So you'd have $5 added to income minus $2.50 as a stock option deduction.
If, on the other hand, the options had been lower than market when granted, no stock option deduction permitted. So when exercised, employment income. Later, when the shares are sold, you've bought the shares. When you sell them, you may have a taxable capital gain. And here, if the proceeds of your sale are greater than your cost, then you have a taxable capital gain.
Just a note here, that paying tax when options are exercised here can be difficult for employees. In order to exercise your options, you have to come up with the cash to buy the options, and you have to pay tax on the benefit. of those options.
Here's an example. An executive receives options to acquire 1,000 of his employer's common shares at an option price of $25 per share. At this time, the common shares are trading at $25 per share, so there's no immediate benefit to him.
The price that he could buy under the option is the same as market, but he exercises the options later when the shares are trading at $40 per share. Then in the following year, he sells the shares for $50 per share. Now assume that the employer is a public company and that the employment income inclusion is recognized when the options are exercised.
The tax consequences for the year of exercise is as follows. We have the 3A income, the increase of $15 per share when he exercises the options. And so he's got a $15,000 amount that is included in his net income.
Then after calculating net income, there's the 50%. stock option deduction. It reduces the amount that he has to pay tax on. And here we're calculating taxable income.
So back when we were in chapter one, we stopped at net income. But now we're starting to learn that there's more that comes after net income. After net income, the stock option deduction, if qualified.
Then later, in the next year when the shares are sold there's the taxable capital gain it's one half of the increase between the forty dollars market price when sold and the amount or market price when purchased purchased when he purchased the shares at forty dollars now sold them for fifty dollars there's that increase times a thousand shares and that capital gain 50% of a capital gain is a taxable capital gain. For an employee in this situation, it can be expensive exercising the options because they need to come up with the money to buy them. As well, they need to come up with the money for the tax on them.
Now it's different if the employer is a CCPC. I'm going to use the same numbers as the previous example. fair market value of $40, option for $45, or option for $35.
So either the option is equal to or greater than market price or less than market price. Still, when the option is granted, no action required. So that's the same as with a public company. But this is different. When the option is exercised by the employee, you calculate an amount that needs to be added to employment income, but you don't add it yet.
You add that amount to employment income when the shares are later sold. The stock option benefit calculated, but not included in income. When the shares are sold, you add the amount to income as well.
Any taxable capital gains are added under 3B. Another difference for a CCPC relates to the stock option deduction. If the employer is a CCPC, then that 50% stock option deduction is allowed if the option price is greater than or equal to fair market value when the option was granted.
So that's the same as the public company, there's no immediate benefit, stock option deduction permitted. or second option only if it's a CCPC, if the shares were held for at least two years prior to being sold. So think about this situation.
Suppose the market price for the shares was $40 and the option price when granted was 35. Now there's an immediate benefit when those options are granted. In this case, the employee could immediately sell the shares and get a benefit. But if they don't, if instead they wait two years, hold those shares for at least two years, maybe the market price will go up even higher.
The stock option deduction will be permitted for the CCPC shares as long as the owner of those shares. waits at least two years before selling. And then when the shares are sold, then the taxable capital gain, half of the proceeds is calculated.
And the cost of the shares is the fair market value when the options are exercised when we calculate that taxable capital gain. Here's an example. Susan's employer is a CCPC. In year one, employee stock options are granted 500 shares at $22 per share.
At the time of the grant, the fair market value of the shares is $20.50. In this case, Susan's options are higher than market at time of the grant. In year two, all the options were exercised when the fair market value was $31.50. And then in year three, all the shares were sold for $38.75. So we want to look at the impact on Susan's income for tax purposes, year one, two, and three.
In year one, when the options are granted, there is no tax impact. In year two, when she exercises, because it's a CCPC, there is no tax impact. at the exercising of the shares in year three when she sells the shares there is a taxable impact and all of the different pieces come into her taxes in the year of sale 3a income the difference between the market when exercised and her option price times the numbers of shares she's got an income inclusion.
Then the increase from the 3150, the market at exercise and the market when sold, capital gain times one half taxable capital gain. So there's her net income inclusion related to the shares. She qualifies for the stock option deduction because the original shares at the time of grant. where the grant price was higher than market. So in the year of the sale, she'll have an income inclusion.
It seems very generous that the government would allow employees to receive income under a stock option plan that's only half taxable. that amount added to income, to 3A income, and then subtract half of it before paying taxes. And the reason that the government allowed that was so that small businesses that weren't able to afford to pay top salaries could give stock options to employees in order to attract good quality employees. However, over time, instead of stock options being used primarily by small startup companies to attract top quality employees, they're used extensively by large public companies to reward employees who already have high income.
If you already have a million dollars of income and you're going to get a raise, you might say, wait, you know, give me options instead because I only have to pay tax on half of it. the amount that I earn under options. So in 2020, the government dealt with this.
They were troubled by this for a long time, that high income people could shelter their income from tax by simply receiving it through stock options. So new legislation was proposed in the November 2020 fall economic statement became effective for any options granted after July 1st, 2021. And this provision limits the ability to claim a stock option detection for wealthy executives of large mature companies. This legislation does not apply to CCPCs or also does not apply to public companies with gross revenues of $500 million or less.
but employees of larger public companies are only able to claim the stock option deduction on an annual amount up to $200,000 per employer. If you have a stock option benefit more than $200,000, that additional amount does not qualify for the stock option deduction. Stock option shares are classified as either qualifying or non-qualifying. So these are options granted after July 1st, 2021, and the employer has to designate these are qualifying or non-qualifying based on the fair market value of the option shares at the time the option plan was granted. And employers are required to notify employees and the CRA whenever there are non-qualifying shares related to a SNOP.
option plan. So non-qualifying shares would be shares that do not qualify for the stock option benefit because they are in excess of a $200,000 benefit to the employee. It's a good example of how the government uses legislation to adjust to motivate, first of all to motivate companies to hire good quality employees. but then also to limit that benefit where they feel that it would not be fair to certain taxpayers or other taxpayers who aren't in the position to earn those high levels of income