Employee Stock Options in Canada | Ontario Business Central

Introduction

Stock option programs have been a standard part of compensation packages for years. Stock options were a big attraction for top talent to new tech companies during the dot-com bubble of the late 1990s.

By providing their employees with a percentage in the company’s growing stock, start-ups were able to provide lower pay packages to their employees (while maintaining their capital investment). But then the dot-com crash happened, and many of these firms went bankrupt, leaving executives with useless stock options.

Stock options benefits are also a part of many businesses’ compensation packages today. They are, however, usually used as a bonus rather than a substitute for a competitive wage. Furthermore, employee stock options are no longer limited to executives but are instead available to a wide range of employees at companies of all sizes.

What Are Employee Stock Option Plans?

Employee stock options (ESOs) are a form of equity compensation provided by businesses to their workers and executives. Rather than issuing shares of stock, the company instead offers derivative options on the stock.

These incentives are similar to standard call options in that they offer the employee the right to purchase the company’s shares at a pre-determined value for a pre-determined amount of time. The terms of the employee stock options and how they apply to the employee stock can be set out in-depth in an option agreement.

It Is Typically Used as an Incentive

A stock option is an incentive offered by companies that allow their workers to buy a decided number of the organization’s shares at a fixed price (usually less than market value) by a certain date. The employee is not obligated to buy any of the shares specified in the option. Rather, they have the option to buy the stock at any time between when the offer is made and when the last exercise date is reached.

Employees with these types of stock options may turn a portion of their entire future compensation plan into taxable income for taxation purposes.

Used as Compensation by Many Startups

Stock options are a common benefit associated with emerging startups or scale-up companies. They can grant these companies the opportunity to compensate early workers if and when the company goes public. Some fast-growing businesses give stock options out to motivate their employees to work toward the projected value of the company’s shares.

Employees can also be offered stock options as an incentive to remain with the company. When an employee leaves before the options vest (before they are available to buy), their optioned stocks are forfeit. There are no dividends or voter rights in ESOs.

Types of Employee Stock Options

Employee Stock Option Plans can be offered by a company as a form of corporate benefits to any or all their employees. These programs are well-known for offering monetary compensation in the form of stock options. ESOs give employees the freedom to purchase underlying shares of the company they’re working for.

Other forms of equity compensation include the following:

Restricted Stock Grants

These grants offer employees the ability to buy or earn stock after fulfilling certain conditions, such as working for a certain amount of years or achieving performance goals.

SARs (Stock Appreciation Rights)

SARs give an employee the right to an appreciation in the prices of a certain amount of shares, which you can get in cash or company shares.

Phantom Stock

This pays an employee a potential cash bonus tied to the total of a specified number of shares. There is normally no legal transition of equity ownership, but the phantom stock can be converted to actual shares if certain incidents occur.

Employee Stock Purchasing Plans

These plans allow workers to buy stock options at a discounted price.

All of these equity compensation programs have one thing in common: they provide employees and stakeholders with an opportunity to help develop the business and partake in its success.

What Is a Non-Qualified Stock Option (NSO)?

A non-qualified stock option (NSO) is a form of employee stock option in which the disparity between the grant price and the price at which you exercise the option is taxed as regular income.

Non-qualified stock options offer workers the ability to buy a specific number of shares of their company’s securities at a fixed price within a set period. These options can be used as an alternate method of compensation for employees and a way to reward their commitment to the organization. When the business makes these options open, also known as the grant date, the value of these stock options is usually the same as the securities market price.

Taxation of a Non-Qualified Stock Option

Consultants and advisors receive non-qualified stock options (NSOs), while employees only receive incentive stock options (ISOs).

When you exercise your options, you incur ordinary income taxes, and when you sell the stock, you pay taxes on capital gains.

When you sell ISOs, you only pay taxes on regular income or capital gains, based on how long you owned the shares before selling them.

Some Key Terms

Option Pool

The Option Pool is a holding account for a portion of the company’s stock that can be provided to employees as future options. An Employee Stock Option Plan defines the number of shares in the Option Pool and the form of shares that will be included in the account.

Employees would profit from the company’s success without having to vote on top management because an Option Pool is almost always comprised of non-voting stock.

Option Award Agreement

The official arrangement between the corporation and the employee seeking options is called the Option Award Agreement. Although the ESOP is a company-wide stock options document, the Option Award Agreement is tailored to each employee’s options.

The number of options being granted to the employee and the Exercise Price the employee would ultimately have to pay to obtain shares will be included in the Option Award Agreement.

Issue Date

This is the date when the employee stock options are granted to you or signed in to your contract.

Strike Price

The Option Exercise Price (also known as a “Strike Price”) is the price an employee will pay in the future to buy shares. Even though it will not be charged at that moment, the price must be fixed in the Option Award Agreement.

Exercise Price

Deciding the exercise price can be tricky. A low Exercise Price would profit employees the most. However, the Exercise Price cannot be too low. It must represent the stock’s fair value when the options were granted (not when the shares are actually purchased).

Vesting

Vesting is the predetermined timetable and set of guidelines for when you will be able to use all of your stock options. In layman’s terms, this means that vesting is the time it will take for you to exercise your options.

Vesting Cliff

The Vesting Cliff is the period during which you are not permitted to exercise any of your stock options — typically lasting one year. Employers use vesting cliffs to guarantee that their employees work at least a year for the company before exercising their options and acquiring shares.

Expiration Date

Stock options do not last indefinitely. A vesting period generally lasts one to five years, but certain employees can have a vesting period of up to ten years. An employee usually has about 90 days to use their options if they quit the company for some reason, whether due to a furlough, resignation, or retirement.

It’s probably time for action if you’re within a couple of weeks of the expiration date and the stock is selling above the exercise price. It is best to have exercised the option then let years of hard work go to waste.

How Do Employee Stock Options Plans Work?

Let’s look at a quick example to help you understand how stock options function. Let’s say you get a position at a scale-up company and are given stock options for 4000 of the company’s shares as part of your job incentive. You and the company would need to sign a document specifying the stock option provisions—this could be included in your employment agreement.

The Grant Date

The grant date, or the day your options start to vest, will be stipulated in the contract. When a stock option vests, it becomes available for you to utilize – that is, purchase – the option.

The Vesting Period

Unfortunately, you will not obtain all of your options when you first start working for a company; instead, the options will vest over a period—defined as the vesting period.

Let’s assume the options have an eight-year vesting duration and a one-year cliff in this situation. An eight-year vesting period means that you’ll have to wait eight years to be able to exercise all options.

The silver lining is that since your stock options will vest steadily over the duration of this vesting era, you will be able to exercise any of them until the eight years are up.

In this example, over the duration of the eight-year vesting period, one-quarter (500) of your options are likely to vest annually. So, by the second year of your career, you’ll have the right to exercise 1000 options.

What to Do When the Vesting Period Is Over

The unfortunate thing is that none of the options can vest until a certain amount of time has elapsed. This is where the one-year cliff enters the picture: it ensures that you must work for the company for at least one year to obtain any of your options. You will have no choice if you leave a job before the one-year mark has passed.

What Are the Regulations for Buying Stock Options in Canada?

The Precedence

The Canadian government announced in the Federal Budget 2019 that it plans to restrict the use of the existing employee stock options tax regime to make it clearer and more equal for Canadians while guaranteeing that start-ups and new Canadian companies generating jobs can continue to grow and develop.

CPA Canada claims it is in the interest of the public to restrict stock option benefits. However, as reported in a May 2019 proposal to the Department of Finance Canada, it is equally critical that the comprehensive proposals provide transparency, certainty, and impartiality in their implementation.

Regulations for Canadian Businesses

CCPCs, or Canadian Controlled Private Corporations, have a range of advantages over other corporate entities, and ESOs are another field where CCPC status is advantageous, usually in terms of tax treatment. In essence, a CCPC is a Canadian business that is not owned by non-residents or government corporations.

In general, neither the employee nor the employer faces any tax repercussions when an employee’s stock option is granted. Since no tax gain exists, the employee is not eligible for payroll inclusion, and the employer is not entitled to a similar deduction.

Taxing stock options is something every organization must keep in mind. Employees who redeem issued stock options must submit tax on the variance between the stock’s value and the compensation price charged under the new employee stock option provisions in the Income Tax Act.

The employee can obtain an offsetting deduction equal to half of the business expense if certain requirements are met. This essentially decreases the employee’s tax burden by half, resulting in substantial tax benefits. This preferential treatment currently has no monetary cap.

The 2020 Government Revision to Policy

The Canadian government implemented revised draft laws to adjust to the proposed amendments presented the preceding year. This revision will limit the availability of the stock option deductions in the Fall Economic Statement for 2020.

Employees that receive stock options from companies that are not CCPCs or any other excluded corporations after July 1, 2021, will be subject to a cap on the number of stock options deductions they can assert under the new rules.

The revised draft legislation is analogous to the proposals from 2019, but it adds some clarity. Employee stock options that are eligible for the Employee Stock Option Deduction will be capped at $200,000 per year, as announced earlier, and will include all stock option agreements between the employee and the employer or some other private corporation with which the employer does not have an arms-length relationship.

If an individual has two or more arms-length employers, each of those employers will be subject to a separate $200,000 limit.

The new draft law subjects employers’ rights to mark all granted stock options as non-qualifying.

What the New Regulations Mean for Canadian Corporations?

The new regulations would not apply to CCPCs, as mentioned in previous announcements. The updated draft legislation also determines which organizations would be called “big, long-established mature firms.”

Employers that have companies or mutual fund trusts with annual gross revenue of more than half a billion in the previous fiscal year will be subject to the new legislation. Employers with annual revenues of less than $500 million, on the other hand, would be exempt from the new regulations. The revenue test will be applied on a rotating annual basis and will be dependent on the employers or, where relevant, the corporate organization’s consolidated economic statement.

Employees

The new $200,000 cap will apply to each employer for each calendar cycle (but there will only be one $200,000 limit for options provided by multiple non-length arms’ employers). The stock option deduction will not extend to taxable benefit—realized on a similar portion of the options—if the share price to be purchased by options vested in a year by an individual exceeds $200,000.

The date on which the option becomes exercisable for the first time must be decided at the time of grant. This also means that:

The vesting year will be the calendar year in which the right to receive protection becomes exercisable for the first time (unless the vesting undergoes an incident that was not predictable when the grant was made).
The vesting year will be decided if the options become exercisable over the period if it does not define the annual year of vesting. This is determined between the option grant date and the last day the option can be exercised under the agreement; the duration is limited to five years.

Employers

The value of the deduction applicable to the employer is equivalent to 100 percent of the employee’s stock option gain, which is the gap between the fair market value of the underlying securities at the point of the exercise and the fixed strike price.

Employers would need to develop review systems to ensure that they check whether they will be compliant with the new regulations annually. Tax planning should also be done accordingly.

Employers who are part of a corporate entity must also consider financial statements, and employers with workers who receive employee stock options from another non-arms length company must ensure that the total vesting sum is taken into account.

Why Are Employee Stock Options Beneficial for Me?

Benefits of Employee Stock Options for Employees

Listed below are the main advantages of any type of equity incentive plan for the key employees of a company.

Through stock ownership, an employee will invest directly in the company’s performance.
Employees may feel driven to be efficient because they have a stake in the business.
They may provide a significant boost to the employee’s income.
Depending on the plan, the employee may save money on taxes when they sell or dispose of their shares.

Benefits of Employee Stock Options for Employers

Listed below are some advantages offered by an employer equity incentive package.

It is a critical tool for attracting the best and brightest minds in an increasingly integrated global economy where top talent is sought from all over the world.
By offering lucrative financial benefits, this package improves employee work motivation and economic well-being.
Employees are motivated to help the business grow and prosper so they will profit from it.
In some instances, this package may be used as a possible escape strategy by shareholders.

What Should I Do if My Job Offers Me Employee Stock Options?

On top of a good wage, employee stock options can be a pleasant bonus. However, they may be insufficient compensation for low wages.

Employee stock options are also sold by employers. These options can account for a significant portion of an employee’s pay. Sometimes, they can also account for the majority of the payout. We’ve all heard of some person who became wealthy solely because of their stock options.

If you’ve been granted options, you can closely review the company’s stock option contract, as well as the options agreement, to decide the rights and conditions that apply to an employee stock.

The grantee’s rights are detailed in the stock options agreement, which is approved by the company’s board of directors. The options agreement outlines the vesting schedule, how the ESOs will vest, the number of shares specified by the grant, and the strike price for your option grant.

How Can I Buy or Invest in Employee Stock Options?

You’ll be able to exercise your options after they’ve vested for a period of time, at the end of which they’ll be available for purchase. This means you will be able to buy stock in the company you work with.

The cost of these options has been defined in the contract you signed with your company when you first started your job. This price is often referred to as the grant price, strike price, or exercise price. This price will not change regardless of how well (or badly) the business performs.

When Should You Exercise Your Employee Stock Options?

A variety of variables can affect when and how you exercise your stock options. To begin with, you should probably wait until the business goes public to exercise your stock options. If you don’t wait and your employer does go public, your shares can be worth less than what you paid for them – or even nothing.

Second, you’ll want to exercise your options only when the stock’s market price increases past your exercise price after your company’s initial public offering (IPO). Consider the following scenario: your exercise price is $2 per share. When the market price is $1, it’s not a smart idea to exercise the options right away. You’d be safer off purchasing on the open market.

If the market price is $3 per share, on the other hand, you will profit from exercising your options and selling them. However, if the price is rising, you may want to hold off a bit before exercising your options. Your capital is invested in those shares until you exercise them. So why not hold off on selling until the stock price is where you want to be? You’ll be able to buy and sell with ease, making a profit without being out of money for a longer period.

How Do Taxes Work With Employee Stock Option Plans?

Taxes are a complex topic that varies depending on the financial situation of each organization and each employee. On the other hand, options are common in Canada—owing to their simplicity in terms of taxation. In a nutshell, options allow both the employee and the company to delay tax effects until a later date.

If an employee was compensated for their employment with equity rather than options, those shares would need to be allocated to the employee’s income per year to calculate how much tax would be owed. Employers usually withhold taxes only on regular compensation or benefits, so the value of the stock will result in a rise in the employee’s tax bill.

When it comes to taxation, options are a better choice than directly offering workers employee stock. The tax regime of an option does not occur immediately because it is simply an arrangement relating to a potential opportunity to buy shares.

Even if the employee exercises his or her options and buys stock from the firm, the tax consequences are typically minor. The employee’s tax implications are postponed until the stock is sold and the employee has received a return on the investment.

When your employer offers you the opportunity to purchase shares, it has no immediate impact on your tax situation. An option is a contract that allows you to purchase securities as options at a specific price. Shares of a corporation or units of a mutual fund trust are assets that the signed agreement can protect.

You would have a taxable profit earned from jobs if you exercise your option and purchase the securities for less than the fair market value (FMV). The disparity between what you paid for the shares and the FMV at the time you utilized your option is the taxable gain. Any amount you paid to purchase the option rights can be deducted from the reward amount.

Employee Stock Options for Emerging Startups and Scale-up Companies

Getting engaged early in a startup is a great way to advance your career and get connected with a business whose future success could result in a significant monetary benefit for you. Stock Option Plans make it possible to do the above.

An option is essentially the right to purchase shares of an organization’s stock at a set value in the future. Alternatively, options are how you can buy shares of stock in a startup. If the business develops and succeeds, your stock options will become extremely valuable.

What Are the Best Employee Stock Options Plans?

Many of the firms we deal with have a clear idea of what type of employee ownership strategy they want to adopt, which is typically focused on real needs and priorities.

If you’re deciding on a stock plan for a small business, the first question to answer is: what your expectations are for employee ownership.

There are a few popular responses to this question.

We’re a small business with many employees, and we’d like to use employee ownership to buy shares from one or more founders.
We are not looking to sell shares at this time, but we would like to give employee ownership to our employees as an incentive.
We are a new business and want to provide key staff with an equity interest in the company.

If the aim is to transform a company, an employee stock ownership plan is usually the best option due to its preferential tax treatment.

Where Startups Can Struggle

Employee stock ownership plans (ESOPs) are almost always sponsored by the company rather than the workers.

An ESOP may be too difficult to set up for some very small companies, while its rules may be unacceptable for others. Employees will then purchase the shares in the company. This is challenging to do and has negative tax implications, but it can work in some situations.

If you want to give everyone ownership but don’t want to sell, an ESOP might be the best option. You may finance the plan by making tax-deductible donations to the ESOP trust in the form of new or unissued stock.

If ESOPs don’t work for you or the expenses of setting up the scheme are too great, another alternative is to offer individual equity awards to workers through stock options, restricted stock, stock appreciation privileges, or “phantom” stock. These don’t offer any special tax advantages, but they are very versatile in terms of who gets how much and under what conditions.

Bottom Line

Employee stock options can be an important part of your wage subsidies, particularly if you work for a business whose stock has recently soared. Realizing the benefits of stock options can help you get the most out of your rights. However, make sure that you use them before they expire and recognize the tax consequences of your decisions.

When employed at a high-potential startup, stock options can be an ideal way to buy shares of stock at a low cost. Optimally, the value of the stock will increase as the company becomes more profitable, while the strike price of your options will stay the same. In other words, you can get a great deal on shares of the company as they become highly attractive!

We have provided an overview of employee stock options in Canada, it is always recommended to speak with a legal representative, accountant, financial advisor, or other financial experts to see what the best options are for you and your business.

Should you have any questions, please feel free to reach out to our staff for additional information and assistance.

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Ontario Business Central Inc. is not a law firm and cannot provide a legal opinion or advice. This information is to assist you in understanding the requirements of registration within the chosen jurisdiction. When you have legal or accounting questions, we recommend that you speak to a qualified professional.