Timing and amount of Income Inclusion
In essence there are 3 important dates to remember when determining the taxability of stock options:
a) The day the option was granted. ("Grant date")
b) The day the option was exercised. ("Exercise date")
c) The day the shares were sold. ("Sale date")
Grant date – No income inclusion
Exercise date – No income inclusion as long as the corporation remains a CCPC for tax purposes
Sale date – Income inclusion – The income inclusion is as follows:
Employment income – Difference between the exercise price and the value that the shares were worth when the option was exercised.
50% deduction (also known as the 110(1)(d) deduction) – The employee will get a 50% deduction of the above mentioned employment income if certain conditions are met.
Capital gain or loss – There will be a capital gain or loss on the date of sale calculated as the difference between the sale price and the exercise price. (Note not the price option price).
Bob is granted options to purchase 1,000 common shares of ABCD Corp. on January 1, 2013 at $5.00 per share.
On June 1, 2013 Bob exercises his options and purchases the shares for a total of $5,000. (On this date the fair market value of ABCD's shares is $8 per share).
On December 31st, 2015, Bob sells his shares in ABCD for $20 per share.
The following is what Bob will report on his 2015 tax return:
Employment income = $3,000 ($8-5 x 1,000 shares)
Less: 50% deduction =($1,500) ($3,000 x 50%)
Net employment income = $1,500
Proceeds from disposition of shares = $20,000
Adjusted cost base of shares = $8,000
Capital Gain = $12,000
Taxable capital gain = $6,000
Note, there is further planning available that can be done to eliminate the $12,000 in capital gains by utilizing Bob's lifetime capital gains exemption. (As long as the sale is to someone other than the company itself and the shares are held for 2 years)
In order to qualify for the 50% deduction mentioned above one of the 2 conditions need to be met as well as the "cash out option":
a) The employee does not dispose of the shares he has acquired by way of an option for 2 years.
b) The option price is not below the FMV of the corporation's shares at the grant date and the shares must be "Prescribed shares"
Prescribed shares generally mean your normal "garden variety" common shares. There is a CRA commentary that a right of first refusal agreement would disqualify shares from being prescribed shares.
Also at no time can an employee own more than 10% of the company for this to apply.
Cash out option
Generally a stock option grant and exercise is not deductible for tax purposes by the corporation as it is an equity transaction, however, if the employee were to "cash out" his options for a cash payment in lieu of actually purchasing the shares the corporation would be entitled to a deduction as a salary expense while the employee would still get the above mentioned treatment, the 2010 budget made significant changes to these rules whereby now in order to claim the 50% deduction mentioned above the following needs to be done:
a) The employee has to actually purchase the shares. Or,
b) If the employee does exercise a cash out option the employer has to file an election with CRA certifying that the employer will not claim a deduction for the cash out option, also evidence of this election has to be given to the employee who exercised the cash out option and filed with their tax return.
Finally, note valuation of the shares of the corporation are extremely important and should be clearly documented at the grant date, exercise date and the sale date.