Employee Stock Options of Public Companies

February 25, 2010 Employee Stock Options of Public Companies This article discusses the taxation of employee stocks options of public company shares. An overview of stock options Many companies offer employee stock options as part of their executive compensation package. Employee stock options give you the right to purchase a fixed amount of the company s shares at a predetermined price, called the exercise price or strike price. Employers typically set vesting periods for options, meaning you must work at the company for a specified period of time before you can exercise the options. For example, your employer may grant you 1,000 options in 2008, stipulating that you can exercise only 250 options in the years 2009, 2010, 2011 and 2012. Vesting periods give employees more incentive to work for their employer for a longer period and hopefully benefit from the increase in the share price. Taxation of stock options Stock options of public and private companies are taxed differently. This article focuses on the taxation of public company stock options (Canadian or foreign public companies). Generally, there is no tax implications when the stock options are granted to you; however, you may be taxable when you decide to exercise them. The taxable amount is the difference between the fair market value (FMV) of the shares at the time you exercise the options and the amount you paid for them (your exercise or strike price). The difference is considered an employment benefit, which must be reported on your T4 slip as a security option benefit, along with your salary, bonus and other income. Generally, the employment benefit is taxable to you in the year you exercise the options, regardless of when they were granted to you or when you decide to sell the shares. The adjusted cost base (ACB) of the shares received on the exercise of your stock options is equal to the FMV of the shares at the time of exercise of the stock options (i.e. the exercise price plus the security options benefit). Therefore, any capital gain/loss realized on the future disposition would only include the growth or decline in the value of the shares since acquisition. Professional Wealth Management Since 1901

Example #1 You are granted an employee stock option to purchase 100 shares of public XYZ Co. at $15 per share. At the time of grant, the FMV of the shares was $14 per share. On the date of exercise, the FMV of the shares was $20 per share. Therefore, you would have a security options benefit (reported on your T4) of $500 [($20-$15) x 100] that would generally be taxable in the year of exercise. The ACB of your shares would be $20 per share. Deferring the tax If you decide to exercise the options and hold on to the shares, as long as certain criteria are met, you may be able to defer the tax on the security options benefit to a future year when the shares are actually sold or deemed to be sold. Keep in mind that deferring this tax does not change the actual amount of the security options benefit that is subject to tax, even if the shares decrease in value. In fact, there is a risk that an employee will exercise the stock options, hold the shares, defer the tax; and then there will be a large enough decrease in the value of the shares that, by the time they decide to sell the shares, the proceeds of the sale won t even cover the cost of the deferred taxes. The stock option deferral rules are complex. Nevertheless, we have provided an overview of the rules below. However, we urge you to consult your professional tax advisor before exercising any options if you wish to defer any of tax on the security options benefit. Where an arm s length employee receives a stock option for common shares listed on a prescribed Canadian or foreign stock exchange, and the option is exercised after February 27, 2000, regardless of when the options were granted, you may elect to have the tax deferred until the shares are disposed of or are deemed by Canadian tax rules to be disposed of, but only if the conditions below are met. Prescribed stock exchanges include most Canadian, American and world markets. To qualify for the deferral, the total amount paid to acquire the share including the exercise price and any amount paid to acquire the option must be not less than the FMV of the share at the time the option was granted. The deferral is only available if you are an eligible employee at the time the option was granted. An eligible employee is an employee who deals with the company at arm s length and is not a specified shareholder. Generally, a specified shareholder is anyone who holds, directly or through related persons, 10% or more of any class of shares of the corporation or a corporation related to it. The deferral is only available if you are a resident of Canada at the time the option is exercised. There is a $100,000 annual limit on the options which will be eligible for deferral; for options above that limit, the employment benefit is taxable when the options are exercised. The $100,000 annual limit is the maximum specified value of stock options that vest in the employee s hands each year and that would be eligible for deferral. An option vests when it becomes exercisable. Specified value is normally the FMV of the underlying share at the time the option is granted; however the specified value should be adjusted to take into account any exchanges of options or if the underlying shares have split or been consolidated.

Example #2 On January 1, 2008 Jeff, an employee of a public corporation, was granted employee stock options from his employer. The employee stock options enabled Jeff to acquire 10,000 shares of the company. Of these employee stock options, half vested immediately and the remainder vested January 1, 2009. The exercise price and the FMV of the stock are both $18 per share on the grant date. The FMV of the shares was $50 on January 1, 2009. a) The FMV at the time the employee stock options were granted = $18 per share. b) The number of options that vest each year is 5,000. Therefore, (a) x (b) = $18 X 5,000 = $90,000 (specified value that vested on January 1, 2008) Also, (a) x (b) = $18 X 5,000 = $90,000 (specified value that vested on January 1, 2009) Since the specified value of the vested employee stock options are below the $100,000 threshold in both 2008 and 2009, Jeff was able to defer the full employment benefit when he exercised these employee stock options. If Jeff exercised all of his employee stock options on January 1, 2009 he would have the following expenditures and tax related considerations: $180,000 [10,000 shares @ $18] needed to exercise the employee stock options, $320,000 [10,000 shares x (FMV of $50 - exercise price of $18)] employment benefit that can be deferred until the securities are disposed of rather than at the time of exercise. Example #3 Jennifer works for a public company that has offered her employee stock options. These employee stock options will allow Jennifer to acquire 100,000 shares. At the time that these employee stock options are granted the exercise price is $4 per share and the FMV of these shares is also $4. On January 1, 2012 assume the FMV of these shares is $20 per share. Jennifer is permitted to exercise employee stock options for 20,000 shares on January 1, 2010, employee stock options for 60,000 shares on January 1, 2011 and employee stock options for the remaining 20,000 shares on January 1, 2012. The specified value of the stock options is calculated as follows: January 1, 2010: (20,000 shares x $4 per share = $80,000) January 1, 2011: (60,000 shares x $4 per share = $240,000)** January 1, 2012: (20,000 shares x $4 per share = $80,000) Based on the above calculation Jennifer will have to include in income a portion of the employee stock option benefit when she exercises the employee stock options that vest on Jan. 1, 2011 because the $100,000 specified value would be exceeded in 2011.

** The maximum number of shares for which the deferral would be permitted is 25,000 shares (25,000 shares x $4 = $100,000). Therefore, 35,000 shares (60,000-25,000 shares) will create an immediate taxable event once the employee stock options are exercised. The employment benefit to be included in income once the employee stock options are exercised is calculated as follows, assuming that Jennifer exercises all of the options on January 1, 2012. $400,000 (100,000 shares X exercise price of $4) in funds are required to exercise all the employee stock options to acquire the shares $1,600,000 [(100,000 shares X ($20-4)] employment benefit The employment benefit on the 20,000 shares that vest in 2010 and 2012 can be deferred; but the deferral of the employment benefit related to the shares that vest in 2011 is limited to only 25,000 shares: $1,040,000 [65,000 shares X ($20 4)] of the employment benefit can be deferred. This amount of the employee benefit will become taxable once Jennifer disposes of her shares or they are deemed to be disposed of. $560,000 [(35,000 X ($20-4)] of the employment benefit cannot be deferred and will be taxable immediate on exercise of the options. Example #4 January 1, 2007 Jamie s employer granted her options to acquire 10,000 company shares; the exercise and FMV price is $10. The shares vest on February 15, 2009. February 10, 2008 the employer offers Jamie another 10,000 options; the exercise price and the FMV was $5. These options vest December 10, 2009. Jamie exercised all of the $10 options on February 15, 2009 when the FMV was $100 and all of the $5 options on December 10, 2009 when the shares were trading at $150. To determine the amount of employment benefit that Jamie can defer, we must calculate the specified value that vested in 2009. In other words, did she receive more than the allowable $100,000 worth of specified value in 2009? The specified value is equal to the FMV of the security at the time the option was granted MULTIPLIED by the number of options that VESTED in the year. The $10 options: ($10 x 10,000 = $100,000) vested in 2009 The $ 5 options: ($5 x 10,000 = $50,000) vested in 2009 The total specified value of the options that Jamie exercised in 2009 is $150,000. Since the total specified value of the options that vested in 2009 exceeds the $100,000 threshold, Jamie would not be able to defer all of the employment benefit. Jamie may choose which options to elect to defer in order to minimize the amount of employment benefit for 2009.

Employment benefit = (FMV at exercise exercise price) x number of shares exercised. $10 options: ($100-$10) x 10,000 = $900,000 employment income benefit ($90 per share) $5 options: ($150-$ 5) x 10,000 = $1,450,000 employment income benefit ($145 per share) Since the $5 options generate a larger employment benefit, Jamie should elect to defer all (10,000 shares) of the $5 option and half (5,000 shares) of the $10 options. The 10,000 shares of the $5 options generate a specified value of $50,000 [10,000 shares x $5 (exercise price)] and 5,000 shares of the $10 options generate a $50,000 specified value [5,000 shares x $10]. This combination of options that equal a specified value of $100,000 will give Jamie the maximum deferral in 2009. However, Jamie still has 5,000 shares of the $10 options that CANNOT be deferred and must be included in income in 2009. The employment benefit on these shares is $90 per share. Hence, ($90 x 5,000 shares) = $450,000 will have to be included in income in 2009. In summary, Jamie will have deferred an employment benefit of $1,900,000, taxable when the shares are disposed of, and a $450,000 employment benefit taxable immediately in 2009. Once you dispose of your shares the deferred employment benefit must be included in your income in the year of disposition. Besides the actual disposition of your shares, there are situations where you might be deemed to have disposed of your shares under the income tax rules. Some of the other situations may include (but is not limited to): On death On becoming a non-resident (with exceptions) On transfer of the shares to a registered plan On transfer of the shares to another individual (including a spouse) On transfer of the shares to a corporation (even if done on a rollover basis using subsection 85(1) of the Income Tax Act) On transfer of the shares to a trust Reporting the deferred option benefit To defer the taxation of a stock option benefit, you must file a deferral election with your employer. The filing deadline is January 15 of the year following the year in which the options are exercised. The January 15 deadline allows the employer time to file the appropriate T4 slip showing the deferral. The tax rules require that the deferral election be in prescribed form. This means that the election must be in the form of a letter from the employee to the employer containing the following information: 1) a request to have the deferral provisions apply; 2) the amount of the stock option benefits, related to qualifying shares acquired after February 27, 2000, that are being deferred;

3) confirmation that you were a resident of Canada when the options are exercised; and 4) confirmation that the $100,000 annual vesting limit has not been exceeded. You must also complete and file form T1212 (Statement of Deferred Security Options Benefits) in the year of deferral and for every year in which you continue to hold the shares. This form must be filed annually regardless of whether or not you have deferred any stock option benefits in the year or disposed of any securities in the year where you had previously elected a deferral. Form T1212 is used to track deferred stock option benefits and requires you to report the purchase and sale of stock option shares. If you wish to revoke your original election, you will have to file a notice in writing with your employer. The deadline for filing a revocation is the same as for filing the election to defer. 50% stock option deduction In many instances you may be able to claim a stock option deduction equal to 50% of the employment benefit relating to the exercise of your employee stock options. The shares must qualify in order to receive this preferential treatment. An employee stock option will be considered to qualify for the 50% stock option deduction, if the following criteria are met: 1) the employer corporation is the seller or issuer of the shares; 2) the employee stock option is in respect of common shares; 3) at the time the employee stock option is granted the exercise price is not less than the FMV of the shares; and 4) you must be dealing at arm s length with your employer Example #5 Charley is granted employee stock options to purchase 100 shares of public XYZ Co. which qualify for the 50% stock option deduction and which vest on December 15, 2008. The exercise price of the XYZ Co. option is $15 per share and the FMV of the shares when the option was granted is $14 per share. Charley exercises his options in February 2009, when the FMV of the XYZ Co. shares are trading at $20 per share. Therefore, Charley will have a $500 [($20-$15) x 100] employment benefit in 2009. Since the options qualify for the 50% stock option deduction, Charley will be entitled to a deduction of 50% of the $500 employment benefit or $250. The net inclusion on Charley s 2009 return will be $250 ($500-250). By taking a 50% stock option deduction, you pay tax at your marginal tax rate on only half of the stock option benefit, which is similar to how capital gains are taxed. (In Quebec the stock option deduction is only 25%; thus the overall effect is not the same as a capital gain.)

The key distinction between stock option benefits and capital gains is that, although the stock option benefit is taxed at the same rate as a capital gain, it is reported on your tax return as employment income and not capital gains. Therefore, you cannot use it to offset your capital losses only capital gains can offset capital losses. Note that where you have deferred the employment benefit to a year where the shares are disposed or deemed to be disposed, the 50% stock option deduction would be claimed at that time if the shares qualified. Future appreciation of the shares Although the stock option benefit is taxed as employment income, if you hold the shares and do not sell them immediately after exercising the options, any future appreciation of the shares after the exercise date will be taxed as a normal capital gain or loss. Your adjusted cost basis of the shares is the FMV of the shares at the time you exercise the options. Let s look at an example to see how this works. Assume your employer granted you 1,000 options of company stock at an exercise price of $5 per share, which was the FMV of the shares when the options were granted. A few years later your options become fully vested and the current share price is $12 per share. At this time, you decide to exercise all of your stock options and hold the shares. You pay your employer the exercise price of $5,000 ($5 x 1,000) in exchange for 1,000 shares. Two weeks later, the share price increases to $13 and you decide to sell all 1,000 shares on the market for $13,000. The following table summarizes the tax implications: Stock option benefit added ($12 FMV at time of exercise $5 exercise or to your T4 employment income strike price) x 1,000 shares $7,000 50% stock option deduction $7,000 x 50% ($3,500) Net increase in taxable employment income $7,000 $3,500 $3,500 Taxable capital gain on the ($13 FMV $12 ACB) x 1,000 shares $1 per share gain x 50% capital gains inclusion rate $500 Additional taxable income $3,500 + $500 $4,000 Your additional taxable income would be only $4,000 ($3,500 employment income and $500 taxable capital gain) half of your $8,000 true profit ([$13 sale price $5 price you paid] x 1,000 shares).

Charitable donation of employee stock options If you donate your public company shares directly to a charity in the same year of exercise and within 30 days of exercising them, you could receive an additional 50% deduction on the stock option benefit, on top of the normal 50% stock option deduction, for a total deduction of 100%. If you are interested in donating shares you receive through your stock option plan, please ask your advisor for more details. This publication is not intended as nor does it constitute tax or legal advice. Readers should consult their own lawyer, accountant or other professional advisor when planning to implement a strategy. The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. The examples provided in this article are for illustration purposes only and are not indicative of future returns; fees and commissions are not included in these calculations. This information is not investment advice and should be used only in conjunction with a discussion with your RBC Dominion Securities Inc. Investment Advisor. This will ensure that your own circumstances have been considered properly and that action is taken on the latest available information. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. *Member CIPF. Registered trademark of Royal Bank of Canada. RBC Dominion Securities is a registered trademark of Royal Bank of Canada. Used under licence. Copyright 2010. All rights reserved.