Section III: Typical Forms of Equity Compensation Awards

This section further discusses the most common equity-based compensation plan and award designs.

1. Stock Options

1.1 General Principles

Section 7 of the Income Tax Act (ITA) applies where a corporation or mutual fund trust agrees to sell or issue its securities or the securities of a corporation or mutual fund trust with which it does not deal at arm’s length (such as a domestic or foreign parent or wholly-owned subsidiary) to one of its employees or an employee of a non-arm’s-length corporation or mutual fund trust. The most common type of arrangement that falls within section 7 is the traditionally understood “stock option” (although the ITA does not use this term), pursuant to which the employee is granted a right to purchase shares for a set exercise price. For simplicity, this section will focus on section 7 arrangements that relate to shares of a corporation, although, as noted above, section 7 can also apply to units of a mutual fund trust (for example, certain real estate investment trusts).

As noted in Section 2.1: What Is an SDA and What Are Its Tax Consequences?, if section 7 applies to an arrangement, it will not be subject to tax under the “salary deferral arrangement” (SDA) rules. In fact, absent any other contractual expiry date, the ITA, in theory, permits a stock option to be deferred indefinitely. Moreover, if section 7 applies to an arrangement, no tax obligations arise prior to the holder exercising an option or otherwise agreeing (or being deemed to agree) to its settlement for consideration. In other words, there is no income inclusion at the time of grant or when the options “vest,” or become exercisable. Upon option exercise, the employee will crystallize a taxable employment benefit at the time of settlement (Stock Option Benefit) equal to the difference between the fair market value (FMV) of the shares acquired and the total amount paid by the employee to acquire them. This includes both the exercise price and any amount paid to acquire the option itself, although in practice, employees rarely pay anything for an equity award other than by providing services. This Stock Option Benefit will be subject to immediate income tax withholding and Canada Pension Plan (or Quebec Pension Plan) contributions (but not Employment Insurance premiums, except where the option holder surrenders their options for a cash payment), as well as tax reporting in the year of settlement, unless the option was originally granted by a Canadian-controlled private corporation (CCPC), which generally is a private corporation controlled by one or more Canadian residents. The rules applicable to section 7 awards granted by CCPCs are described in Section 1.3: CCPCs.

For an arrangement to fall within section 7, Canadian courts have confirmed that there must be a legally binding agreement compelling the employer or non-arm’s-length corporation or mutual fund trust to sell or issue a security. An arrangement under which an employer has no contractual obligation to sell or issue a security and may instead settle the arrangement through cash will generally not constitute an “agreement” to sell or issue securities, and thus section 7 will not apply (and, by extension, the SDA rules may apply).

In contrast, if an arrangement binds the employer to sell or issue a security but provides the employee with the right to elect to receive a cash equivalent instead, the arrangement will usually still constitute an “agreement” to sell or issue securities (as it relates to the employer) notwithstanding this employee cash-out right. Accordingly, in structuring awards to which section 7 is intended to apply, care needs to be taken to ensure that any cash-out rights or features rest with the employee and not the employer or other non-arm’s-length issuer.

As noted above, stock options are the most common form of arrangement falling within section 7. Moreover, properly structured stock options can offer substantial Canadian income tax advantages to employees, provided that certain conditions are met.

1.2 Employee Deductions Available

1.2.1 The 50% Option Deduction

If a stock option meets certain criteria, then the taxable Stock Option Benefit on exercise will be eligible for a 50% deduction (50% Option Deduction) (although if the employee-option holder is employed in Quebec, the deduction may only be 25% on the Quebec portion of the taxes payable on the Stock Option Benefit), which is to say, an effective tax rate akin to a favourably taxed capital gain. While many equity-based incentives can be structured to defer the timing of the taxable employment income inclusion, the 50% Option Deduction is the only provision of the ITA that reduces the effective tax rate applied to incentive compensation, which is otherwise fully taxable at marginal tax rates.

The key criteria for the 50% Option Deduction are:

• at the time the stock option is granted, the employee and the employer (and, if different, the issuer) deal at arm’s length
• the exercise price under the option is not less than the FMV of the underlying share on the date the option was granted (i.e., the option is not granted “in-the-money” and is instead granted “at-the-money” (most commonly) or even “underwater”)
• the shares underlying the option meet prescribed requirements, which can be complex, but generally require the shares to be plain-vanilla voting or non-voting common shares with no fixed or special dividend rights, redemption rights or liquidation preference
• the shares subject to the option are not “non-qualified securities” (as discussed below)

The ITA was amended to impose an annual cap on the availability of the 50% Option Deduction for options granted after June 30, 2021. The cap applies to options granted by a “specified person,” which is generally defined as a corporation or mutual fund trust that reported more than C$500-million in gross annual revenue (on a consolidated, worldwide basis) in its most recent financial statements presented to shareholders and unitholders (or a member of a group that prepares consolidated group financial statements where the annual total consolidated group revenue exceeded such threshold) and that, in the case of a corporation, is not a CCPC. Note that by virtue of the gross annual revenue test, an issuer that is not otherwise a CCPC could be a specified person in one period and not another, depending on whether its most recently reported gross annual revenues exceed the C$500-million threshold.

Under the cap, for each vesting year of an option, the shares underlying the option that would become available for purchase in that vesting year valued in excess of C$200,000 (valued as of the date the option agreement is made, which generally will be the date of grant) are deemed to be non-qualified securities, whether or not those shares are actually acquired in that particular vesting year. The 50% Option Deduction will not apply upon the acquisition of non-qualified securities. Conversely, the acquisition of shares whose value comes within the C$200,000 per-vesting year cap (for simplicity referred to as “qualified securities,” although this is not a statutory term) will be eligible for the 50% Option Deduction if these shares meet the other requirements for such deduction, as noted above.

A “vesting year” is defined as the year in which the option is first exercisable according to its terms (whether actually exercised or not). If the option specifies that it will only be exercisable upon an event the timing of which is not reasonably foreseeable at the time of grant, for example a future change of control, a special deeming rule will instead apply to deem the option to vest pro rata over a period beginning on the date of grant and ending on the earlier of its 60-month anniversary or the date that the option otherwise expires in accordance with its terms (and, in effect, deeming the option to have multiple vesting years for purposes of the cap).

If a particular option could be exercisable for both non-qualified securities and qualified securities, the ITA deems them to be exercised for qualified securities first. 

1.2.2 Deductions Available to Employers

Generally, the ITA precludes both the employer and any other person (including a corporate parent) from claiming an employee compensation-related deduction for Canadian income tax purposes as a result of the grant of a stock option or the issuance of shares upon the exercise of a stock option. However, an employee-option holder’s employer is entitled to a deduction equal to the Stock Option Benefit included in the employee’s income in relation to the acquisition of non-qualified securities discussed in Section 1.2.1: The 50% Option Deduction for the taxation year in which the option is exercised, subject to certain conditions, including that the 50% Option Deduction would have been available to the employee in respect of the Stock Option Benefit but for the application of the ITA’s non-qualified securities rules. Importantly, only the employee-option holder’s employer is eligible for the deduction, even if the stock options and subject shares are granted and issued by another person.

The ITA allows specified persons to designate shares subject to stock options that otherwise would qualify for the 50% Option Deduction as non-qualified securities (that is, shares that may otherwise fall under the C$200,000 per vesting year FMV threshold). As a result of this designation, the Stock Option Benefit realized by the employee would not qualify for the 50% Option Deduction, but a corresponding deduction equal to the Stock Option Benefit would be available to the employer on exercise.

1.3 CCPCs

The ITA’s taxation rules for stock options or other awards subject to section 7 granted by a CCPC differ somewhat. In particular, where an employee stock option has been granted by a CCPC to an arm’s-length employee, the exercise of the option crystallizes a taxable Stock Option Benefit, but taxation of the benefit is deferred until such time as the employee disposes of the shares. Thus, tax on the Stock Option Benefit on exercise of a CCPC Option may be deferred to a subsequent tax year, whenever the employee ultimately disposes of the shares. When the deferred benefit becomes taxable, no employer withholding obligations arise, although the benefit must still be reported, which can be administratively burdensome if the individual is no longer employed by the issuer. If the employee subsequently disposes of the share for proceeds greater than the Stock Option Benefit, the employee will become taxable both for the crystallized and tax-deferred Stock Option Benefit as well as for a capital gain in respect of the excess of the proceeds of disposition of the shares over their adjusted cost base. Alternatively, the employee may be eligible to claim a capital loss where the share has declined in value since exercise. Capital losses may be used in the year of realization to offset capital gains in that year. Capital losses that cannot be fully applied against gains in the year in which the capital losses are realized can be carried back up to three years or used in a future year to offset capital gains in those other years. Capital losses may not be used to reduce ordinary income, including a Stock Option Benefit.

An alternative 50% deduction is available to the employee in respect of the CCPC stock option benefit (or benefit in respect of any other CCPC equity award taxed under section 7 of the ITA) if the employee holds the shares acquired upon CCPC option exercise for at least two years (50% CCPC Deduction). While the effect of the 50% CCPC Deduction is similar to the 50% Option Deduction, the 50% CCPC Deduction does not require the CCPC section 7 award to have been granted at-the-money or underwater (in-the-money grants may still be eligible), nor does it require the share underlying the award to be a “prescribed share”. Consequently, a CCPC section 7 award that relates to preferred shares or shares that otherwise have fixed or special dividend rights, redemption rights or liquidation preferences can still qualify for this 50% deduction. The deferral of the Stock Option Benefit and the potential availability of the 50% CCPC Deduction depend on the issuer’s status as a CCPC at the time of grant and not on its CCPC status at the time of exercise or other settlement of the award.

A CCPC stock option can also be eligible for the 50% Option Deduction, so long as it is structured to meet the required criteria for the 50% Option Deduction. Having both the 50% CCPC Deduction and the 50% Option Deduction generally available provides helpful flexibility for a CCPC issuer regarding the structuring of an award. As noted above, a CCPC is not a specified person for purposes of the ITA’s stock option rules and so shares subject to CCPC options will not be non-qualified securities. Accordingly, for such shares, the potential for a 50% deduction (either the 50% CCPC Deduction or, if applicable, the 50% Option Deduction) will be uncapped.

1.4 Comparison of the Timeline of Taxation and Availability of Deductions for CCPCs vs. Non-CCPCs 

The following table compares when a Stock Option Benefit will be included in the employee’s income for CCPC versus non-CCPC options.

1.5 Disposing of Options

Generally, if the employee-option holder surrenders stock options to an arm’s-length person, including the employer or option issuer, the ITA considers the employee to have disposed of the options. The value of the consideration for the disposition (less any amounts paid by the employee-option holder to acquire the option) will be included in the employee’s taxable employment income in the year in which the option surrender occurs. A disposition for tax purposes can take multiple different forms, including a settlement of the options in cash for the in-the-money value of the options, a net exercise where the employee-option holder only receives the net number of shares subject to the options (commonly referred to as “net settlement”), or a fundamental change to the option (which is discussed under Section 1.6: Amendments to and Exchanges of Options.

If the 50% Option Deduction had applied had the option been exercised, it may also be available where the option holder disposes of the option. This generally requires that the issuer of the option files an election under subsection 110(1.1) of the ITA in the relevant year, whereby it (and any other person not dealing at arm’s length with the issuer) elects to forgo a corporate deduction in respect of the consideration (cash, shares or such other form of consideration) paid for the disposition of the option. There is an exception to this requirement for an election that applies in the context of an option award that is made by a specified person where the option holder surrenders for consideration options over shares that are qualified securities, i.e., options over shares that do not exceed the C$200,000 per-vesting year cap. In this case, subsection 110(1.44) of the ITA automatically facilitates the 50% Option Deduction for such options, such that a subsection 110(1.1) election is not required.

1.6 Amendments to and Exchanges of Options

The Canada Revenue Agency (CRA) takes the position that a fundamental change to the terms and conditions of a stock option may trigger a taxable disposition. The CRA has not exhaustively defined the term “fundamental change,” and what is or is not fundamental is likely ultimately to depend on the facts. However, there is case law that supports the view that a change in the exercise price of an option is not a “fundamental change”. This view is reflected in special rules in the ITA permitting a reduction of an option’s exercise price without triggering a disposition, so long as the aggregate in-the-money value of the options immediately following the repricing does not exceed their aggregate in-the-money value immediately prior to the repricing. For purposes of the ITA, negative underwater values are deemed to be zero. These rules could, for example, permit repricing of the exercise price of underwater options to make them at-the-money, subject to other legal considerations, including any applicable securities law restrictions and whether the terms of the plan under which the options were granted permit such a reduction. 

The ITA also provides special rules for the tax-free exchange of options. Similar to the rules governing repricing, where options are exchanged for new options of the employer or another person with whom the employer does not deal at arm’s length and specified criteria are met, the options are deemed not to have been disposed of, and the new options are deemed to be continuations of the original options (at least for purposes of section 7 of the ITA). The two key criteria are that the aggregate in-the-money value of the new options immediately following the exchange does not exceed the aggregate in-the-money value of the old options immediately prior to the exchange, and that the employee receives no consideration for the exchange other than the new options. The ability to effect a tax-free exchange of options is frequently relied on in mergers, acquisitions and other business combination transactions, whereby the options of a target corporation may be exchanged for options of a resulting merged corporation or other corporate acquirer of the target’s shares. Some business transactions may involve situations in which the issuer of the new options deals at arm’s length with the issuer of the original options, either immediately following the transaction or at all times before and after the transaction. In these cases, a tax-free exchange may be unavailable, and a risk could arise that the exchange is found to be a taxable disposition of old options for new options. Accordingly, it is recommended that in any business transaction context in which employee stock options will be exchanged, legal advice is obtained to assess the availability of the tax-free rollover, as well as ensuring compliance with applicable exemptions from prospectus requirements under securities laws.

2. Restricted Share Units and Performance Share Units

2.1 Share Units Generally

The ITA does not contain specific statutory rules governing phantom share rights, or what are commonly referred to both within and outside Canada as Restricted Share Units (RSUs) and Performance Share Units (PSUs). Generally, RSUs represent a contingent right on the part of an employee to receive shares of the employer or the cash equivalent following one or more contractually defined vesting periods, usually but not always requiring, as vesting criteria, the passage of time and continued employment in good standing. In contrast, PSUs by their terms typically tie vesting to the satisfaction of defined performance criteria, either measured over a contractually defined performance period or upon the occurrence of a specified event, as well as continued employment. While PSUs are, like RSUs, linked to underlying reference shares, the ultimate payout may be based on a multiplier that is greater or less than one (where one ties to the FMV of a reference share), depending on the degree of satisfaction of the performance criteria. Again, since the ITA does not provide specific rules for RSUs and PSUs, the principles described in this section can broadly apply to similar phantom units linked to something other than a share (including another reference security, such as a trust unit) or to another value identifier. Section 7 of the ITA, discussed in Section 2.2: SDA Rules, will also apply to RSUs and PSUs, but only where the RSU or PSU can only be settled in shares of a corporation or units of a mutual fund trust (in either case, provided that such shares or units are newly issued, i.e., from treasury, and that the RSU or PSU meets the other criteria for section 7 to apply, as described under Section 1.1: General Principles). This guide discusses only share units for simplicity.

2.2 SDA Rules

Many share units are structured to permit the employer to elect, at its discretion, to settle a vested share unit in shares (which could be new shares issued from treasury or, alternatively, previously issued shares acquired for delivery in settlement of the share unit (Secondary Market Shares)), the cash equivalent or a combination thereof. Since this type of share unit does not, by its terms, require the employer to sell or issue a treasury share, it would not fall within section 7 of the ITA, and thus may not avoid application of the SDA rules. However, as further discussed in Section 2.1: What Is an SDA and What Are Its Tax Consequences?, if payment is subject to one or more conditions and there is a substantial risk that one or more of these conditions will not be satisfied, then the arrangement will not meet the definition of an SDA, although, depending on the facts, whether or not a substantial risk of non-satisfaction exists could be contested as between the employer/employee on the one hand and the CRA on the other. As with any deferred remuneration, taking care to avoid or minimize the potential application of the SDA rules to share units is an important structuring consideration. In this context, the 3-Year Bonus Exception to the SDA rules has particular importance, which applies if amounts paid (whether in shares or cash) in settlement of the share unit can be considered a bonus or similar payment, and such amounts are payable (and actually paid) on or before the end of the third calendar year following the first service year to which this award relates (as further discussed under Section 2.2: Exceptions to the SDA Rules).

2.3 Potential Application of Section 7

The ITA’s section 7, discussed in Section 1: Stock Options in the context of stock options, will apply to RSUs or PSUs that, by their terms, require the employer to settle the share units in shares issued from treasury (or, where settlement could comprise a full or partial cash equivalent, the cash equivalent is at the sole election of the employee, rather than at the election of the employer). As commonly understood, RSUs and PSUs do not require the employee to pay an exercise price to receive a share at settlement. As such, an RSU or PSU subject to section 7 would not be eligible for the 50% Option Deduction, although it could be eligible for the 50% CCPC Deduction if the RSU or PSU were granted by a CCPC and the employee held the resulting shares for at least two years. Furthermore, in the case of a CCPC share unit, while a taxable benefit would crystallize at the time of share unit settlement, taxation would be deferred until such time as the employee ultimately disposed of the shares. As with stock options, the ITA would preclude a compensation-related corporate tax deduction for any treasury share issuance to settle an RSU or PSU that is taxable under section 7, although if the terms and conditions of the award permitted the employee to elect, and the employee did elect, to receive cash, a compensation-related corporate deduction for any cash paid may be supported. One advantage for an employer in structuring an RSU or PSU to fall within section 7 would be to avoid the potential application of the SDA rules. As the ITA imposes no maximum on the term of a section 7 arrangement following grant, a “section 7 share unit” could contemplate contractual vesting and settlement periods exceeding the timeline under the 3-Year Bonus Exception. 

2.4 Dividend Equivalents

The ITA does not expressly address the payment or crediting of dividend equivalents regarding share units. CRA generally permits the crediting of dividend equivalents in respect of an underlying share unit if the dividend equivalents are converted into additional underlying share units with the same terms and conditions, including vesting conditions, but does not have a similar policy of broadly accepting cash dividend equivalents. While the ITA does not preclude fractional share units, employers who have granted share units that are intended to be subject to section 7 will generally need to anticipate how fractional share units will be addressed, given case law’s broader guidance that section 7 awards should not contemplate unilateral employer cash-out rights. Various strategies may be available, and legal advice is recommended.

3. Deferred Share Units

3.1 Paragraph 6801(d) of Canada’s Income Tax Regulations

The ITA does not expressly use the term “deferred share unit” (DSU), but it does provide for two alternative sets of rules that can accommodate these arrangements as they are usually structured. Generally, DSUs, similar to RSUs and PSUs, represent a contingent right on the part of an employee to receive shares of the employer, or the cash equivalent, following termination of employment, directorship or office, or retirement, or death. Because the ITA considers directors and officers to be “employees” for tax purposes, and because directors and officers may also be “employees” as that term is more traditionally understood as a matter of employment law, the CRA has frequently expressed the view that termination of “employment” in this context describes the earliest date on which the DSU recipient ceases to be all of a director, officer or employee of the issuer and any non-arm’s length corporation. As in other jurisdictions, DSUs are more often awarded to non-employee directors, either in lieu of director fees or as a separate award, although sometimes executive employees are also eligible to receive DSUs. Where DSUs can be settled in shares or cash at the employer’s discretion, the ITA accommodates these arrangements and exempts them from application of the SDA rules if they satisfy the requirements of paragraph 6801(d) of Canada’s Income Tax Regulations (ITR).

In general, the statutory requirements are that:

• the arrangement is in writing with the employer (or a related corporation)
• pursuant to the arrangement, one or more amounts are payable to the employee (or, in the case of a deceased employee, their legal representative, dependent or relation), which amounts are paid following the employee’s termination of employment (including all directorships and offices) with the issuer and all non-arm’s length corporations, retirement or death and no later than the end of the calendar year following the year in which the termination of employment, retirement or death falls
• the amounts paid to the employee are based on the FMV of shares of the employer (or a related corporation) within the period commencing one year before the employee’s termination of employment and ending on the payment date
• there are no other arrangements in place to compensate the employee for a decline in the shares’ FMV

While the ITA permits a lookback period of up to one year prior to the employee’s termination of employment (or retirement or death) in determining the amount of the DSU payment, it is more common in practice for DSU arrangements to set this value as the reference shares’ FMV as of the settlement date. A DSU may contractually provide that it is settled in treasury shares, Secondary Market Shares, cash or any combination. Insofar as any of these settlement means are at the discretion of the employer or related corporation, a compensation-related deduction should be available to the employer. Amounts, whether in shares or cash, paid to settle DSUs remain subject to withholding. Since the DSU must be settled following termination of employment, retirement or death, the employer will generally want to ensure that appropriate arrangements are made to satisfy the withholding, particularly if the cash component of DSU settlement would not by itself be sufficient to fully settle the withholding obligation, and no other salary or wages are then owing to the employee from which withholding could be made.

The statutory criteria above, as interpreted by the CRA, strictly require settlement of the DSU to occur following the termination of all employment and, if applicable, directorships and offices. A termination of employment will not occur if the DSU holder remains employed or continues to hold a directorship or office with the employer or any non-arm’s length corporation, even in a part-time or other limited capacity. Accordingly, the ITA’s requirement of termination of employment may not coincide with the United States’ statutory concept of “separation of service.” This can make the design of cross-border DSU plans, or DSUs granted to holders who perform services in both Canada and the U.S., more complex. Legal advice from both Canadian and U.S. practitioners is recommended in these scenarios.

A DSU that conforms to the criteria above can be referred to as a “6801(d) DSU.”

3.2 Section 7 DSUs

Where a DSU contractually binds the employer or related corporation to settle the DSU through the issuance of treasury shares, the DSU can also be subject to section 7 of the ITA (Section 7 DSU). If the DSU is a Section 7 DSU, it would also fall outside potential SDA characterization (albeit by virtue of section 7 rather than paragraph 6801(d) of the ITR), which means that such award does not need to comply with the requirements noted above for 6801(d) DSUs. As with other section 7 agreements, the employer and any non-arm’s length corporation would be denied a compensation-related deduction for the settlement of the DSU with treasury shares; however, the DSU could contractually provide for a full or partial cash settlement right at the DSU holder’s election, in which case, the deduction may be available if the holder exercises such right. Section 7 DSUs are generally unusual because if an employer intends to grant a share unit award subject to section 7, it would more commonly grant RSUs, where permitted under the applicable incentive plan. However, as paragraph 6801(d) of the ITR applies only to DSUs issued by corporations, it is not uncommon for real estate investment trusts and other mutual fund trusts that wish to provide trustees or senior executives with equity awards that are deferred until termination of service to grant Section 7 DSUs.

4. Share Appreciation Rights

A share appreciation right (SAR) is a type of phantom stock arrangement under which the employer agrees to pay the employee an amount equal to the increase in the FMV of a reference share from grant to settlement. While the ITA does not separately recognize SARs, the CRA has a long-standing administrative policy whereby such SARs will not be taxable to the employee at grant and will further be exempted from the SDA rules until settlement, so long as they are based on a formula of “A” minus “B,” where “A” is the FMV of the reference share at the time of settlement and “B” is the FMV at the time of grant (and consequently “A” minus “B” would yield zero if the calculation were carried out on the grant date), and the settlement occurs in the year the employee otherwise has the right to trigger payment under the SAR. On the basis that such SARs have no intrinsic (in-the-money) value at grant and the value continues to fluctuate until settlement with changes in the underlying share’s FMV, the CRA’s administrative position considers them to be remuneration for future services only and therefore exempt from the SDA rules until settlement. 

Where an employer wishes to replicate the economics of a stock option but preclude the employee from acquiring an equity stake, or otherwise where the employer wishes to incentivize performance tied to share price through a cash-based incentive that extends beyond the period permitted under the SDA rules’ 3-Year Bonus Exception, a SAR may be considered. 

In addition to traditional SARs that track the FMV of a reference share, employers may intend to grant formula-based SAR-type awards that track the appreciation of an equity interest that is not a share or a financial metric (e.g., EBITDA increase or earnings growth from grant). Caution should be exercised when considering such awards, as the CRA indicated in 2020 that it would no longer provide favourable rulings on these types of awards from an SDA perspective. The CRA did not say that all formula-based SAR-type awards will be SDAs, but careful structuring will be required and legal advice should be obtained.

4.1 Tandem Stock Appreciation Rights

A Tandem SAR is a SAR granted in conjunction with a stock option. Under such an arrangement, when the employee is granted a stock option, the corporation will grant a SAR at the same time. Tandem SARs are also often referred to as “cash-out rights.” The Tandem SAR entitles the employee to elect to receive the value of the option, measured by the excess of the FMV of the share at the date of exercise of the Tandem SAR over the exercise price stipulated in the option. The main appeal of a Tandem SAR is that it provides an alternative method of providing the value of the stock option to the employee, without requiring the employee to purchase shares under the option where the terms of the option do not otherwise permit “net settlement” as discussed above or a “cashless exercise” (sometimes referred to as “sell to cover”). Under a cashless exercise, an employee exercises the options without using personal out-of-pocket cash, but the employee directs a broker or the company to sell all or a portion of the acquired shares, on behalf of the employee, to cover the exercise price and, where contemplated by the applicable incentive plan or option agreement, applicable withholding taxes. The employee may exercise either the option or the related Tandem SAR. If the option is exercised, the Tandem SAR is cancelled for no consideration, and vice versa.

As with the cash-out of a stock option, discussed in Section 1.5: Disposing of Options, cash received in settlement of a Tandem SAR is eligible for the 50% Option Deduction if its tandem option would also have been eligible for the 50% Option Deduction if exercised, but the employer must file a subsection 110(1.1) election (except where the circumstances described in Section 1.5: Disposing of Options regarding options granted by specified persons over qualified securities apply) that neither the employer nor any other person not dealing at arm’s length with the employer will claim a deduction for the compensation-related expense of the cash-out.

5. Restricted Shares

Under an award of restricted shares (in some jurisdictions, more commonly called “restricted stock”), shares are issued or otherwise provided to an employee subject to contractual restrictions on the sale or other transfer of the shares for a specified holding period, which under the terms of the award may be called a “vesting period.” Under such an award, the shares are often subject to contractual provisions providing for forfeiture if certain conditions (such as continued employment) are not met.

From the employer’s perspective, a restricted treasury share award can generally be expected to fall within section 7. Under other restricted share award designs, such as where the employer contributes amounts to a third-party trustee or agent to purchase Secondary Market Shares on employees’ behalf, this will not generally be the case. 

From the employee’s perspective, except in case of a restricted share award granted by a CCPC subject to section 7, the FMV of the restricted shares will generally give rise to a taxable employment inclusion at the time of receipt, which the CRA generally considers to occur when the indicia of share ownership (e.g., beneficial ownership, and voting and dividend rights) are first acquired by the employee. Under most restricted share arrangements, the indicia of share ownership are met at the time of award, albeit the contractual restrictions imposed by the award encumber what otherwise would be the employee-shareholder’s rights. In determining restricted shares’ FMV relative to an unencumbered share, the CRA has indicated that discounts from what otherwise would be the share’s FMV (or, for a publicly traded share, its market price) may be supportable. Since an award of restricted shares can be expected to give rise to an immediate tax inclusion for the employee, and since the transfer restrictions often imposed on restricted shares would not permit a portion of the shares to be immediately sold for proceeds to cover the withholding obligation, the employer and employee will generally need to make alternative arrangements. If it is not possible or desirable for the employee to provide out-of-pocket funds to cover the withholding or to arrange withholding on other remuneration payable to the employee, the parties may consider a loan, with the principal of such loan being equal to the taxes payable by the employee regarding the restricted share award. The loan would need to be genuine, with its terms requiring repayment within a reasonable time. Furthermore, the ITA imposes certain rules regarding interest on such loans. In addition, any employee loan for such purposes at a Canadian public company can be expected to require certain disclosures to be included in the company’s public, continuous disclosure record. For more information on employer loans, please contact any member of our Pensions, Benefits and Executive Compensation group.

Once the contractual restrictions lapse, no further employment income inclusion to the employee-shareholder arises, as they have already paid tax on the award upfront. Assuming the employee has not otherwise paid any amount for the restricted share, the initial tax inclusion would generally constitute the employee’s adjusted cost base of the share, and any subsequent appreciation in the share (including as a result of the lapse of contractual restrictions) would, on disposition, trigger a capital gain. If the employee forfeits the share because the contractual restrictions are not met, no corresponding deduction from employment income will arise to offset the initial upfront employment income inclusion. At most, the employee can be expected to realize a capital loss that could be offset to reduce other capital gains.

Because of the foregoing employee tax treatment, restricted share awards to Canadian employees are uncommon, particularly compared to jurisdictions in which the employee is not taxed at grant but only when the contractual restrictions lapse (which these jurisdictions may alternatively describe as the shares “vesting”).

6. Profits Interests

The ITA does not distinctly recognize what some jurisdictions, notably the U.S., describe as profits interests. Under these arrangements, employees receive equity interests in an investment vehicle, typically a non-Canadian formed limited partnership or limited liability company, which interests contractually provide for a share of a portion of the fund’s investment returns above a defined threshold. Because the ITA does not provide specific rules for profits interests (including to otherwise recognize these as a distinct category of interest), the taxation of such interests granted to a Canadian employee typically engages other, more general provisions of the ITA. In general, if an award of profits interest is being considered, legal advice is recommended, and alternative structuring for the Canadian workforce as compared to the U.S. participants is also possible.

7. Employee Share Purchase Plans

Employee Share Purchase Plans (ESPPs) can be structured in various ways; however, they are often structured as broad-based plans under which employees can make contributions over a period of time and then can purchase shares from the employer at a discount, or they involve matching contributions from the employer. ESPPs can involve both issuances of shares from treasury or purchases of Secondary Market Shares. This guide does not discuss the nuances of tax structuring for ESPPs, which would require specific advice tailored to a specific tax structure. However, various options are available, each with its own considerations and potential advantages and disadvantages.