Canadian Tax Issues for ESOPs

Written by

The Canadian tax deadline is May 1st and as we all know only two things in life are certain – death and taxes. And for a lot of people doing taxes is a death defying experience.

ESOPs or Employee Share Ownership Plans have special tax related issues. There are three types of ESOPs in Canada.

  1. The one most widely known as an ESOP is a share equity plan. Share equity plans are the transfer of legal title of an ownership percentage in the company and can include voting or non-voting shares.
  2. Stock option plans are based on a company promise to the employee to allow them the right to buy shares at some time in the future but at today’s price.
  3. An Equity Value Plan (EVOP™) is a unit of ownership that mirrors the rights and value of an actual share. It has no legal status but is governed by the unit holder agreement.
Each of the three types has different tax issues and the issues change depending on whether the company is publicly held or privately held. Focusing on the most popular ESOP – the Share Equity Plan – the major tax benefits are related to privately held companies. An employee investing in a qualified small business, as defined in the Income Tax Act, can be eligible for a lifetime capital gains exemption. This means that that upon the sale of the shares to a third party there is no income tax payable on the capital gains portion. The exemption is currently about $835,000 and it changes yearly with inflation adjustments. Other than a person’s personal home, this is the only tax free exemption available for Canadians. In addition interest incurred to finance the investment may be deductible against other income thus reducing the personal income payments of the employee.

Another potential benefit is in the area of bonuses. A company can pay employees in shares in lieu of cash. If the company qualifies, then the employee pays no income taxes on the shares until they actually sell those shares. There are several important restrictions on this benefit as well as some down sides from a tax perspective. Therefore, it’s important that the employee have a full understanding of the pros and cons of this method before using bonuses as a means of funding an ESOP.

Tax is a complex issue that requires the employee to fully understand the implications. After all, with a federal tax rate as high as 40%, what becomes important is not what you gain but what ends up in the employee’s pocket after the government takes its cut.