This article is part of a series on profit-sharing plans, an interesting alternative for companies wishing to improve employee retention within their ranks.
Over the past few months, our team of Canadian tax consultants has assisted a number of companies in the development and implementation of certain profit-sharing plans, and has decided to write articles on the subject in order to inform even more entrepreneurs keen to offer their employees the best possible working environment.
Find our other articles on profit-sharing schemes here.
In the previous articles, you were able to understand how the bonus plan works, as well as the freeze and new share issue strategies, two incentive plans that a company can decide to offer its employees.
Overview of the concept: what is a stock option?
The implementation of a stock option plan gives employees the opportunity to acquire company shares at a price equal to or less than the fair market value (“FMV”) of the shares, while benefiting from certain specific tax advantages.
Such a program therefore represents an interesting way of integrating key employees into the company’s shareholder base, fostering their retention over the medium and long term and, by the same token, encouraging them to be more productive and increase the company’s profitability.
How do employee stock option plans work?
Generally speaking, a stock option plan offers one or more employees the possibility of acquiring a specified quantity of the company’s shares at a given price (the option exercise price), which option may generally be exercised until a specific expiry date.
Since the employee can acquire shares at a fixed, predetermined price, it is possible that the exercise price of the options will be lower than the FMV of the shares at the time the options are exercised.
In such a case, the employee receives a financial benefit and must include in taxable income a taxable benefit equal to the difference between the FMV of the shares at the time the option is exercised and the price paid to acquire them.
The timing of the income inclusion of the taxable benefit depends on whether or not the corporation is a Canadian-controlled private corporation (“CCPC”).
Depending on whether or not the corporation is a CCPC, and whether or not the employee does not deal at arm’s length with the corporation, the taxable benefit must be included either in the year the options are exercised or in the year the shares are sold.
Considering all the potential tax impacts, an assessment of the company’s value is often necessary to determine the FMV of options and shares when the latter are not traded on the stock market, for example.
Possible tax deductions
Provided certain criteria are met, the employee may benefit from a deduction in calculating taxable income representing 50% of the value of the taxable benefit at the federal level and 25% in Quebec (although the Quebec deduction may exceptionally increase to 50% in certain specific circumstances).
The terms of the deduction will also vary according to the company’s status and qualification.
Other tax considerations
- The granting of stock options to employees, who will potentially exercise these options, implies that these employees become shareholders in their own right in the company, and therefore hold the rights and privileges attributable to minority shareholders.
Although the rights and privileges attributable to shares granted to employees do not usually involve voting rights, several other legal elements must nevertheless be considered. - When the shares acquired by the employees are subsequently sold, the employee will realize a capital gain, which is potentially eligible for the potentially eligible for the DGC.
This represents an advantageous tax treatment for the employee. - The adjusted cost base (“ACB”) of the shares used to calculate this gain for the employee is increased by the value of the taxable benefit calculated when the options were exercised.
- If the corporation whose shares may be acquired by the key employee is a CCPC at the time the options are granted, and the employee deals at arm’s length with the corporation, the stock option plan rules will be more advantageous than for other “types” of corporations.
- As of July 1, 2021, there are several restrictive rules applicable to a plan set up by a large non-CCPC with annual gross revenues in excess of $500 million.
These rules are not discussed in this text.
Accounting and financial statement presentation
With regard to the accounting and financial statement presentation of such a plan, the Canadian Accounting Standards for Private Enterprises (ASPE) stipulates that a company setting up a stock option plan for its employees must recognize in the financial statements a compensation expense equivalent to the fair value of the options granted.
In summary, the compensation expense is recognized over the periods during which services are rendered to acquire the right to exercise the options.
The fair value of options granted must be estimated using an option pricing model that takes into account :
- the exercise price;
- the expected term of the option (or the contractual term in certain cases);
- the current price of the underlying share;
- the expected volatility of the underlying stock;
- expected dividends on the share (with certain exceptions);
- the risk-free interest rate for the expected term of the option.
For a private company, calculating the fair value of options granted is complex, not least because the current share price underlying the option and the share’s expected volatility are not available on the stock markets.
They must therefore be estimated, at considerable cost.
Example: Case study and analysis
The company is an SME in the information technology sector.
As this sector of activity is highly competitive, the management team wanted to set up a profit-sharing plan that would have the effect of mobilizing their employees and fostering their sense of belonging to the company.
Following several discussions, management decided to set up a stock option plan that would be accessible to all their key employees.
After analyzing numerous considerations, the management team came to the conclusion that it was desirable for employees to have the opportunity to become minority shareholders in the company.
Although the company would have to take on additional management and administrative tasks, such as presenting financial statements to minority shareholders, documenting the company’s fair market value, calculating taxable benefits, etc., management was confident that implementing the stock option plan was the best way to achieve their objectives and encourage the retention of key employees.
As part of the plan’s implementation, the drafting of the stock option agreement and the terms and conditions relating to the exercise of options represented the most delicate and neuralgic element of the process.
In fact, the definition of the applicable value, the terms and conditions relating to the exercise of options and the repurchase or sale of shares, as well as the formulas and terms applicable to these operations had to be both attractive to key employees and sustainable and realistic for the founding shareholders.
After a few years, management has noted that the annual recurring costs associated with the plan remain high.
Nevertheless, they remain satisfied with the implementation of the stock option plan, notably because of the plan’s effect on the mobilization and loyalty of the employees who have signed up.
Don’t hesitate to contact a member of our team to discuss this further.