The tax on Employee Stock Purchase Plans (ESPP) has two components: the difference between the offering price and the fair market value (FMV) of the stock is treated as employment income and the difference between the FMV and the selling price is treated as capital gains or losses.
For example, let’s say that shares in your employer ABC Inc. was offered to you at a price of $10 on September 15th and on that day, the stock closed at $12. As you had contributed $5,000 towards the purchase of company stock, 500 shares ($5000/$10 per share) were deposited in your brokerage account. The $1,000 benefit (500 shares x ($12 – $10)) is treated as employment income and will be taxed at your marginal tax rate. Starting in 2011, the Canada Revenue Agency requires employers to withhold and remit income taxes on employee stock benefits. Therefore, ABC Corp. will withhold $460 as income tax and remit it to the CRA. At the end of the financial year, ABC Corp. will include $1,000 in Box 14 (Employment Income) and $460 in Box 22 (Income tax deducted) of your T4 slip.
The employee is required to keep track of the adjusted cost base of the shares issued under the Employee Stock Purchase program. If we assume that you did not previously own any shares in your employer and you decided to sell the ESPP stock issued to you, you’ll also have to declare capital gains or losses in Schedule 3 (Capital gains or losses) for the year in which the shares were disposed. In our example, let’s say ABC Corp. came out with an earnings surprise soon after the ESPP shares were deposited in your account. The stock is trading at $15 and you decide to sell. You will have a capital gain of $1,500 (500 shares x ($15 – $12)) that you should declare in Schedule 3 of your tax return for the year.
The peculiarities of the tax treatment of ESPPs underline the risks inherent in holding on to company stock. If you were offered shares at $2 when the company stock is trading at $20, you are on hook for income tax on the difference, irrespective of what you finally sold the stock for. If the stock tanked and you finally sold at $2, you’ll have capital losses of $18 that can only be used to offset capital gains elsewhere in your portfolio, not the original employment benefit.
This post was updated on May 23, 2012 to reflect recent changes in taxation of ESPP benefits. The tax information presented in this post applies to both stock purchase plans offered by Canadian employers and ESPP programs typically offered by US employers.
The post was again updated on Oct. 29, 2013 with a graphic explaining how Employee Stock Purchase Plans are taxed.