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As the new year begins, many employees enjoy their year-end bonuses earned on top of their salary for a job well done. For these employees, bonuses come in the form of a straightforward cash payout. For other employees, especially those in the startup space, compensation may come with a strategic choice: receiving cash bonuses or employee stock options ("ESOs"). ESOs are rights conferred upon an employee to purchase a certain number of shares of a corporation at a fixed price during a certain period of time.
Tax treatment for cash bonuses is vastly different when compared to ESOs, and as such, merits careful consideration for whether taking ESOs is the financially correct decision for any given employee. Not only is tax treatment inherently different between the two, but the complexity of the tax regime for ESOs is arguably much higher and therefore can put off some employees from even considering them.
However, it would be prudent to know the pros and cons of either compensation structure before making a concrete decision as an employee. Choose wisely, and your wallet will thank you.
Division C Deductions on Taxable Income
Per section 2(2) of the Income Tax Act (the "ITA"), taxable income is calculated as your total income for the year plus additions (such as taxable capital gains) less deductions permitted under Division C of the ITA. One of those deductions, found in section 110(1)(d) or (d.1) , applies a deduction when qualifying ESOs are exercised. As a result, unlike bonuses, which are fully taxable, only 50% of the benefit gained from exercising the ESOs will be subject to taxation at the employee's progressive tax rate, effectively halving the tax payable.
Qualifying for a Deduction
In order to qualify for a deduction when exercising ESOs, several conditions must be met: the employee must deal at arm's length with the employer, meaning the parties are unrelated and act independently; the shares are "prescribed shares" as described in Regulation 6204 of the Income Tax Regulations (effectively a "normal" common share); and the stock option price is greater or equal to the fair market value of shares when ESOs were first given.
Amount and Timing of Benefit of ESOs
Section 7(1) of the ITA governs how ESOs are taxed when they are exercised. It is to be noted that section 7(5) stops claimants who did not receive the ESOs by virtue of employment, and instead, for example, received the benefit as shareholders, from utilizing section 7.
Initially, an employee will be presented with an ESOs contract, specifying their contractual right to purchase company shares at a fixed price. No taxation occurs at this point.
Strategically, an employee should exercise their stock options when the exercise price is lower than the fair market value of the shares. Any benefit received at this point must be reported on the employee's annual tax return, unless the employer is a Canadian-controlled private corporation ("CCPC"). At this point, a deduction may be applied to the benefit derived from qualifying ESOs. In other words, unless the employer is a CCPC, taxation of ESOs occurs when you exercise the option to buy the shares.
If the employee paid to receive the ESOs, the cost is deductible.
To illustrate with a simple example, assume an employee was granted ESOs to acquire 10 shares at a price per share of $10 when the fair market value of each share was also $10. The employee then exercises the ESOs when the fair market value of each share jumps to $20. The benefit is the difference between the fair market value of the shares at acquisition time, the amount paid by the employee to exercise the ESOs, and any price paid to acquire the ESOs by the employee, all multiplied by the amount of shares acquired. Thus, in this example, the benefit is $100 ($10 difference x 10 shares).
After holding the shares, an employee may later sell them for a capital gain or loss pursuant to the ESOs contract. A gain occurs if the shares are sold for more than what the employee paid to obtain them. To prevent the same shares from being taxed twice (because it was already taxed when the employee exercised their stock options), section 53(1)(j) provides a tax mechanism to avoid double taxation under the capital gain mechanisms.
Where an employee exercises stock options granted by a CCPC, they enjoy a tax deferral. The employee only reports the aforementioned benefit when the shares are sold, at which point the Division C tax deduction can be claimed. However, this can only be done if the employee holds the shares for a minimum of 2 years.
Cash Bonuses
Unlike ESOs, cash bonuses offer little flexibility in tax treatment and therefore do not provide any deduction. They are treated the same as all other income, subject to the same progressive tax income rates, as well as pension and employment insurance deductions.
Despite offering no deductions, cash bonuses do come with a special advantage: they can be directly deposited by the employer into an employee's registered retirement savings plan ("RRSP"), effectively bypassing the withholding taxes that would otherwise apply to RRSP contributions equal to the employee's progressive tax bracket, thereby allowing an employee to receive and invest the full untaxed amount of the bonus into their RRSP.
The real benefit to cash bonuses as compared to ESOs is simple: cash bonuses are money now. As such, cash bonuses can be seen as short-term gain, while ESOs are more long-term investments, and their viability for any given employee depends on risk tolerance and most importantly, patience.
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.
