Understanding Employee Stock Option Plans in Canada
What Is An Employee Stock Option Plan?
An Employee Stock Option Plan (ESOP) is a type of compensation structure that allows employees to become partial owners of the company they are working for. Employees will earn the right to purchase shares of the company for a set price during a specified timeframe.
By owning shares of company stock, employees are incentivised to align with company goals, as they will be rewarded for the success of the company they work for.
In comparison to a predetermined salary for example, ESOPs may increase workplace morale and company culture by rewarding employees for their performance, which is also beneficial to the employer.
A traditional ESOP can be a useful tool for retirement planning because the allocated stock can be held without tax consequences until the employee sells the shares, however there are different types of ESOPs as we’ll discuss momentarily.
How Does An Employee Stock Option Work in Canada
ESOPs give employees the opportunity to purchase company stock.
As set out in an ESOP contract, the employer grants stock options to an employee as a form of compensation or incentive.
Let’s look at an example:
You start a new position at a fintech startup, and are given stock options for 4,800 of the company shares. The first date you need to be aware of is the cliff date. Known as a vesting cliff, this is the period of time when you cannot purchase (exercise) any of your stock options, i.e. convert the options into shares. This is generally one year, and is an insurance method used by your employer to make sure you work there for at least a year, before you can purchase shares.
These options will vest over a predetermined time frame, known as the vesting period. Let’s assume your new employer has set out a six year vesting period, you will have to wait six years before you can purchase all 4800 of your shares. Your stock options will vest on a monthly or on an annual basis during the vesting period, meaning 800 of your options will vest annually, allowing you to purchase them after they have vested.
Types Of ESOP In Canada
There are different types of ESOPs in Canada.
A Direct Stock Purchase Plan (DSPP) allows employees to use their own personal after-tax money to directly purchase shares of the company they work for.
With a DSPP, employees are able to eliminate brokerage fees by purchasing directly from the company they work for. There may be a discount offered to employees as part of their benefits package, for larger purchases, or as a performance bonus. These are NOT options, but rather actual equity ownership shares in the company.
Restricted Stock Units are a form of employee compensation that grant employees the ability to earn shares of their company after fulfilling certain requirements, such as working for a certain amount of time or achieving performance targets.
RSUs are issued through a vesting plan, or commonly referred to as a distribution schedule. Upon being vested, the employee receives the company shares at fair market value, and does have the right to sell them, subject to any restrictions in a shareholders’ agreement.
Phantom Stock may be awarded to employees in instances such as reaching performance targets. Phantom stock offers similar benefits to share ownership, without legally issuing company shares; this compensation plan is usually a cash bonus correlated to the value of a specific number of shares.
Although this is a cash bonus, in certain cases, the phantom stock may be converted to actual shares.
With Stock Appreciation Rights, employees may be compensated based on how much their company’s stock has appreciated in a given period of time.
Essentially, the employee would receive the net amount of the stock price increase in cash (or in equivalent value of shares of company stock), per amount of shares set out in the contract.
Non-Qualified Employee Stock Options (NQSOs)
Similar to our previous example, a Non-Qualified Employee Stock Option (NQSO) gives employees the right to purchase a designated number of company shares, at a fixed price, during a specific time period. Assuming that the company share price increases over time, it allows the employee to purchase shares at a ‘discounted’ price.
At the grant date of an NQSO, the price is set at the current fair market value of the shares. Although the price is set, if the fair market value of the shares increases during the vesting period, employees will have to pay taxes on the difference between the grant price and the exercise price. This is the reason why it’s a ‘non-qualified’ stock option, as it doesn’t qualify for preferential tax treatment.
NQSO Taxation
With a NQSO, the employee pays taxes on the difference between the exercise price and the fair market value of the shares. Employees are required to report an NQSO as a taxable employment benefit, and this would be taxed as regular income.
For example, if an employee purchases 500 NQSOs for $50 per share, when the fair market value at the time is $75 per share, the taxable benefit is ($75 - $50) x 500 = $12,500. This amount is added to the employee’s taxable income.
Employees must report capital gains or losses on their tax return when they sell their shares, or as a deemed disposition upon death. The capital gain (loss) would be the difference between the exercised price and the price at time of disposition.
Incentive Stock Options (ISOs)
Incentive stock options (ISO) are a tax advantaged type of employee stock option. Once options are exercised, employees are able to sell them immediately.
As with an NQSO, ISOs have a predefined price at the grant date, which can be below the actual market stock price when the employee exercises the options.
Taxation Of ISO Stock Options
Unlike NQSOs, the difference in exercise price and current FMV (fair market value) does not need to be reported as income. However, the individual must report capital gains or losses on their tax returns when they decide to sell the shares, or as a deemed disposition upon death.
Please note that there are complex tax rules in certain cases that are beyond the scope of this article. For more information on Incentive Stock Options, and the general taxation of ESOPs, please reach out to us here at Parr Business Law.
Advantages Of Employee Stock Option Plan In Canada
Advantages For Employees
An ESOP gives employees the opportunity to earn more money and be rewarded for their dedication and hard work. When employees have an ownership stake in the company’s success, it allows them to be directly rewarded for their contributions. By taking initiative, being innovative, and even sacrificing personal time to assist the company grow, they will profit from this growth rather than be stuck on a predetermined salary.
There is opportunity for wealth accumulation. If the company’s stock increases over time, employees may be able to realize gains that are far greater than their regular salary. This can help fund their retirement, be added to their estate, or help them reach other financial goals in life.
In certain cases, the realized profits on ESOPs may be taxed as capital gains, this means that if ESOPs are offered in lieu of a larger salary, the employee may end up with more after-tax cash, as individuals pay less taxes on capital gains compared to employment income.
The capital gains inclusion rate is one-half (50%) of the capital gain up to $250,000. Every dollar of capital gain over $250,000, will be subject to a two-thirds (66.6%) inclusion rate.
If your total purchase price of your ESOPs are $400,000, and your total sale price is $1,000,000, your taxable capital gain on the $600,000 would be $358,333. Assuming you live in BC and made no other income that year, you would be paying $153,220 in taxes.
Previously, the capital gains inclusion rate was a flat 50% (which would have you saving $31,208 in the above example). However the recent federal government changes have increased the inclusion rate.
ESOPs are also a great retirement planning tool. Although specific rules may vary depending on the company, your ESOP balance will often be distributed to you over a number of years upon retirement. This helps to reduce taxes compared to a larger, lump sum payment and can make retirement planning simpler.
Advantages For Employers
Companies can use ESOPs to keep participating employees focused on company performance and appreciation of company stock. Since participating employees are also shareholders, these plans are meant to incentivize employees to act in the best interests of the company by providing them with an incentive to see the company's stock perform well.
ESOPs can help retain valuable employees by giving them partial ownership and opportunity for wealth accumulation. Vesting schedules also encourage employees to stay with the company so they can fully realize the benefits of ESOPs.
Stock options can also allow companies to offer lower salaries, as the appreciation of shares compensates for the lower cash salary. This may be advantageous in startups and early stage businesses, allowing the company to use their capital towards other investments rather than higher salaries.
Offering an ESOP can also make the company more attractive to talented individuals. Especially in competitive industries, ESOPs can make the employee benefits package more attractive, helping recruit top talent.
Conclusion
ESOPs are an employment benefit that allow employees to purchase shares of company stock. The price of the shares are set as the FMV at the grant date, and will remain the same during the vesting period. Amount of options, vesting period, grant dates and other information will be set out in contract prior to the beginning of the ESOP.
By owning shares of company stock, employees are now able to be directly rewarded for their contributions to the success of the company they work for.
There are many nuances to ESOPs, as well as various tax implications that are beyond the scope of this article. If you are interested in this topic, please reach out to us at Parr Business Law and we will assist you.
