For most employees, the taxation of their employment income is straightforward, since their income is mainly comprised of salary and bonuses.
However, when an employee receives employment income through participation in equity-based compensation plans, this can create complications that may negatively impact their income, since the final amount of their compensation is tied to the performance of their employer’s shares.
Often, the compensation is not received until some future date. This uncertainty in amount of compensation and time of receipt creates difficulties for the taxation of this type of employment income. We’ve set out a general approach to taxing equity-based compensation. We discuss the taxation of Restricted Share Units (RSUs) to illustrate the approach.
How is employment income taxed?
Under the Income Tax Act (ITA), a taxpayer’s income from employment is all the compensation from employment—salary, wages and other remuneration—that is received in the year. The general rule regarding taxation of employment income is that it’s taxed when it is received or enjoyed.
This general rule is strengthened by the Salary Deferral Arrangement (SDA) provisions of the ITA. An SDA is a plan that gives an employee a right to defer the receipt or enjoyment of employment income. One of its main objectives is to defer taxation of the employment income by the exercise of that right.
The SDA provisions of the ITA are actually anti-deferral provisions. They deem a deferred amount under an SDA as immediately received and enjoyed by the employee, despite the exercise of the right to defer. Thus, the general rule applies to the deferred amount. Essentially, the SDA provisions take away the opportunity for an employee to defer taxation by deferring the receipt or enjoyment of employment income.
How is equity-based compensation taxed?
The definition of employment income is broad, and remuneration includes equity-based compensation received by an employee. As stated, an employee pays tax on employment income when he receives or enjoys it. Thus, the initial position is that equity-based compensation is taxed when it is received or enjoyed.
Are there exceptions to the immediate taxation of equity-based compensation?
In the context of equity-based compensation, two exceptions exist of particular note.
The first exception stems from the definition of an SDA. An SDA does not include a plan or arrangement under which an employee has a right to defer receipt of a bonus or similar payment for services rendered in a given year to another time (essentially an SDA) within 3 years.
For example, if your employer had such an arrangement, you could choose to receive this year’s equity-based compensation at any time prior to December 31, 2014. By doing so, you defer the taxation of the compensation to the year in which it is received. This exception is called the 3-year SDA.
The second exception is found in the stock option provisions of the ITA. These provisions are extensive and they set out a comprehensive scheme for taxing compensation received in the form of stock options. Effectively, the provisions oust the general rule.
Some important features of the stock option provisions are:
- Taxation occurs when an employee receives shares.
- No taxation occurs when an employee receives a right to obtain shares (option granted).
- If the company granting the stock is a Canadian-controlled private corporation (CCPC), taxation of the compensation occurs when the employee disposes of the shares, not when he or she receives them.
- A deduction is available to an employee if he pays an amount for the shares at their receipt (exercise price) that is not less than the fair market value of the shares at the grant of the options. Effectively, the deduction taxes as a capital gain the difference between the exercise price and the fair market value of the share when received.
These brief statements on the features of the stock option provisions are not comprehensive. A detailed review of the ITA provisions is necessary to meet their many conditions and qualifications.
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