Meaning
Statutory rules governing the taxation of employee stock options represent a major component of equity compensation design. In Canada, income tax act section 7 establishes that the benefit derived from the exercise of an option is treated as employment income rather than a capital gain. This provision defines both the timing of the tax event and the calculation of the taxable benefit.
Value Calculation
The taxable benefit is determined by subtracting the exercise price from the fair market value of the shares at the time the option is exercised. Employers must report this amount on the employee tax slip for the year of exercise.
Rate Deduction
Taxpayers may qualify for a specific deduction that reduces the effective tax rate on their stock option benefit. Under related provisions, if the option exercise price is not less than the share value at the grant date and the shares are common shares, the individual can deduct one half of the taxable benefit. This reduction aligns the taxation of the option benefit with the preferential rate applied to capital gains.
It provides a direct incentive for long term employment and holds value for recruits joining early stage startups that cannot afford high cash salaries.
Timing Variance
Public and private corporation employees face different tax deferral opportunities under the legislation. For employees of Canadian controlled private corporations, the tax payment is deferred from the year of exercise to the year of the sale of the shares. Employees of public companies must pay the tax in the year of exercise, regardless of whether they sell the shares.
