Giving Your Employees the Option

Encouraging employees to acquire ownership in their employer company has long been a popular way to motivate and retain key people. Equity participation is more common among publicly traded entities, but many non-public companies have followed this path as well. In this and the next issue of Tax Alert, we will examine some of the equity participation strategies available to Canadian-controlled private corporations (CCPCs).   

Issuing shares to employees

Plans to issue shares to employees can include many variations, depending on the particular objectives. Following are some of the key questions typically considered in designing such a plan:

• Will a separate class of shares be created for employees? Will they be voting or non-voting shares? A separate share class can offer certain tax advantages since the paid-up share capital of the majority owner(s) and the employee group can be segregated. This may assist future transactions to reorganize capital or repurchase shares of either class. If broad voting rights are included, consider what types of corporate acts and resolutions will require approval of the minority employee shareholders.
• Will employees be granted existing equity value, or merely participate in future growth? Issuing stock to employees at a discount provides greater immediate value compared to an option granted at market value that will only become valuable if the share price increases.
• Does the company expect to raise capital from the employees? This may be desirable when other financing sources are limited. Further, employees arguably become more invested in the company's success when they have their own funds at risk. On the other hand, the company may wish to maximize the benefit to the employee by minimizing the employee's cost and risk.
• How much administration will the plan require? Stock ownership plans usually require periodic equity valuations, computation and reporting of tax benefits, and more complicated financial accounting disclosures.
• How will the value of the shares be determined? Assistance of a business valuator may be prudent to establish a reasonable method to estimate values when shares are issued or reacquired.
• Will employees surrender their shares when their employment ends? What mechanism will provide a tax-effective reacquisition?
• Finally, are there other tax features that can improve the benefits of a particular plan? The tax rules for equity plans are complex. A few of the principal considerations are described below. However, each plan and circumstance will require a review of the particular costs and benefits.

Taxation of stock options - employees

Employee incentive stock plans are governed by special tax rules that determine the amount and timing of taxable benefits. An employee can be granted an option or other rights to acquire shares under a plan (all such rights are referred to herein as "stock options," though these rules also can apply to other arrangements under which an employee acquires shares).  Ordinarily, no taxable benefit will arise until the employee disposes of the shares, transfers the rights to an arm's-length person, or still holds the rights at the time of the employee's death.

On exercise, a stock option benefit is measured as the excess of the value of the shares at the acquisition date over the employee's cost to acquire the shares or the option. Arm's-length employees of CCPCs, however, receive an important advantage.  For such employees, stock option benefits are not included in their income until the year they dispose of the shares. Persons related to the CCPC, including controlling shareholders, are deemed not to be at arm's-length.  

The employee may qualify for a deduction of 50% of the taxable benefit if the shares are held for at least two years before disposition. Some confuse this half-taxation as being a capital gain, but the amounts continue to be employment income. Such income cannot, for example, be sheltered by the lifetime capital gains exemption or by capital losses.    

The adjusted cost base of the shares acquired, for capital gains purposes, will include the cost, if any, of the option right, the exercise price paid for the shares, and the full amount of the employment benefit. There is no reduction of the cost base for the 50% deduction.

Taxation of stock options - corporations

Corporations generally are not permitted a deduction for stock option benefits provided to employees. In some cases, it may be preferable for the corporation to pay a cash bonus to the employee and have the employee purchase the shares with the after-tax proceeds.  This strategy provides the corporation with a deduction and provides the employee with full cost base in the shares.

One exception to this general rule applies where the employee has the right to choose to receive cash for the option gain in lieu of acquiring shares under the option. If the employee opts to take the cash, the Canada Revenue Agency takes the view that the corporation will ordinarily be permitted a deduction for the payment. This can result in half-taxation of benefits to the employee while the employer gets a full deduction. Care must be taken to ensure the 50% deduction is obtained for the employee. Since no shares are acquired, the option exercise price must be at least equal to the share value at the grant date, and the option to take cash or shares must be solely at the discretion of the employee.  

This edition of Tax Alert introduced the issues that need to be examined when designing and implementing an employee equity participation plan for a CCPC and the income tax considerations related thereto. The next edition of Tax Alert will review the use of share purchase loans, RRSPs, and indirect plans like phantom shares and stock appreciation rights in allowing employees to access share ownership.

If you have questions about implementing an employee stock ownership plan, or about your existing plan, please contact your Collins Barrow advisor.

Dean Woodward is a tax partner in Collins Barrow's Calgary member firm.