Employee stock option plans can be an effective way for companies to attract, reward, and retain employees. Stock option plans are contracts between a company and its employees that grant employees the right to buy a specific number of the company's shares at a set price, often called the exercise price, within a specified time period. If the shares rise in value, the employee can exercise their option and purchase shares at the exercise price — thus acquiring company shares at a discount.

For an employer, stock option plans can be relatively inexpensive to set up and can encourage employee participation and loyalty. It is important for both companies and employees alike to understand the tax consequences of stock option plans.

When a company establishes a stock option plan, the exercise price is usually set at or above the fair market value of the shares when the option to purchase them is granted.

Normally, there are no immediate tax consequences when a company grants a stock option to its employees, but there may be tax implications when the option is exercised by an employee. Here's what you need to keep in mind before you do.

Stock options in public companies

For the employee who exercises a stock option, the difference between the fair market value of the shares and the exercise price is taxable as a stock option benefit. For example, if the options were granted with an exercise price of $1 per share, and the fair market value of the shares is $10 on the exercise date, the taxable benefit is $9 per share ($10 minus $1).

The resulting stock option benefit is taxable as employment income, but the tax can be reduced by claiming a special tax deduction where certain conditions are met, including:

  • The shares are issued by the employer, or a corporation that does not deal at arm's length with the employer (such as a parent corporation).
  • The exercise price is equal to or greater than the fair market value of the shares when the option was granted.
  • The shares are ordinary common shares, not preferred shares, and not subject to any unusual conditions or agreements regarding matters such as repurchase.

If the required conditions are met, the employee can claim a stock option deduction of 50 percent of the taxable benefit. To use the previous taxable benefit example, the employee could claim a deduction equal to $4.50 per share (50% of $9). In Quebec, the stock option deduction is capped at 25 percent for shares of public companies that do not have a significant presence in Quebec.

Stock options in a Canadian-Controlled Private Corporation (CCPC)

The tax treatment of stock options in public companies differs from the treatment of options granted by CCPCs. When a CCPC grants stock options to an employee, provided the employee deals at arm's length with the company, the taxable employment benefit is generally delayed until the shares are disposed of, rather than when the option is exercised.

Where an employee exercises their CCPC stock options, however, the taxable employment benefit is calculated in the same method as for a public company — and if the shares have been held for at least two years, the 50 percent tax deduction is generally also available.

The tax treatment of stock option plans can be complex, no matter the company type. If you are considering exercising options or disposing of shares from exercised options, consult with a qualified tax advisor to assess the impact on your tax situation.