Private companies inherently understand the benefits of issuing equity compensation awards. Not only does it help you attract top talent, but it fosters a culture of ownership – creating an incentive for employees to drive company success. But in some countries, equity awards can come with hidden barbs that can put an unexpected tax burden on your staff.
Not so in Canada. In fact, employees in Canada who receive options from certain private companies are eligible for preferential tax treatment. There is, however, a caveat: those tax benefits only apply to awards issued by a Canadian controlled private corporation (CCPC).
Tax deferral and lower rates with CCPC
Although the tax rules that apply to options issued by CCPCs are complex (they’re tax rules!), there are two main benefits employees enjoy with CCPC equity awards.
First, no tax applies when the options are issued. Tax doesn’t even apply when the options are exercised, as long as certain conditions are met. Taxes are only triggered once employees sell their underlying shares, which means they can defer taxes so long as they meet the criteria and hold the shares. Where certain conditions are met, employees can also avail themselves of preferential tax treatment where they will only be required to pay tax on one-half of the benefit realized on exercise of the options.
Second, any gain realized on the subsequent sale of their shares is taxed at a preferential rate. What happens is that only half the gain is included in the employee’s income, meaning they pay tax on only 50% of the gain rather than on the full amount.
Employers benefit too
Beyond the advantageous tax treatment, they can offer their employees CCPCs that issue stock options also benefit in other ways.
For instance, unlike with other private companies, CCPCs do not need to establish the fair market value of their employee grants before issuing equity compensation awards. This frees them up to value their grants at zero, potentially increasing the gain their employees will realize over time. This applies to all forms of treasury-based equity compensation plans.
Additionally, CCPCs can issue stock options without facing any payroll tax implications. The employer only needs to report the income when employees sell their underlying shares.
Traps for the unwary
Although the rules at a high-level sound fairly straightforward, they can get quite complex in practice. For instance, employees only get preferential tax treatment on the benefit realized on exercise of the option if the option exercise price wasn’t below the shares’ fair market value at the time of grant, the shares were common shares and the employee was dealing at arm’s length with the employer. If the fair market value condition isn’t met, the preferential tax treatment may still be available as long as the employee holds the underlying shares for at least two years from acquisition date.
Things also get complicated if the CCPC goes public before those underlying shares are sold. According to Canada’s tax rules, an employee will be deemed to sell their shares acquired from a CCPC award on a first in first out basis before any non-CCPC shares. So, let’s say an employee is issued free-trading shares as part of the IPO and decides to sell them. If that employee also holds underlying shares from when the company was still a CCPC, they’ll be deemed to have sold their CCPC shares first – which attract differential tax treatment.
Then there’s the fact that employers need to rely on employees to alert them when they sell their underlying shares so the company can record the income. That’s one thing while the company remains private and there are limited avenues for selling the shares such as a liquidity event. It’s a whole other thing once the company goes public and finds itself having to track down former employees to find out if they’ve sold their shares.
Structuring for success
There are certain steps CCPCs can take in advance to avoid the pitfalls associated with issuing equity compensation, while still reaping the rewards. For example, you should make sure that:
- You’re still a CCPC when you grant the awards. A lot of funding for Canadian private companies now comes from US venture-backed firms, which can affect their CCPC status.
- You properly code your grants as CCPC awards so that, on exercise, employees won’t have to pay taxes and you won’t have to withhold taxes. Shareworks can help by setting the taxable compensation parameters on your options.
- Your employees understand the rules around CCPC-issued equity awards. Failure to communicate critical details, such as the holding requirement for the underlying shares, could result in the employee paying more tax than anticipated. For more tips on communication for private company equity compensation, take a look at this article.
- You provide proof of the value of your options if you do assign a grant price to them. Even though CCPCs aren’t required to provide a formal 409A valuation, like in the US, it’s good practice to back up any value you set so employees understand what they’re paying for.
To learn more about issuing equity compensation as a CCPC, or discuss how Shareworks can help, get in touch.