ISOs capital management is allocating and managing a company’s capital to maximize shareholder value.
Percolating beneath the surface of the workplace environment resides an employer’s desire to find and retain top talent. On the flip side, employees seek forms of appreciation and recognition of their business contributions that enhance their usual forms of compensation.
In this article, we will focus on Incentive Stock Options (ISOs) capital management granted to key employees. In an era of remote employment, a firm understanding of the tax implications is critical where cross-border circumstances exist.
Summary and Takeaways
Incentivizing, rewarding, and reciprocating with employees to acknowledge their valuable contributions and retain top talent is essential. That’s where Incentive Stock Options (ISOs)can play a key role. But it’s important to understand the tax implications of ISOs, especially within a cross-border situation.
- To maximize tax efficiencies, the holder of the ISO must not sell the stock before the later of 2 years from grant date or 1 year from the stock exercise/purchase date.
- Comply with this holding requirement and the gains are taxed at long-term capital gains tax rates – and you avoid being taxed at the considerably higher ordinary income rate.
- Remote work has become more commonplace, so large numbers of Canadians who have been working for U.S. employers have reestablished Canadian residence.
- However, Canada taxes ISOs based on the exercise date, while the U.S. taxes them based on the sale date.
- Timing the purchase and sale within the same calendar year is vital for cross-border taxpayers in order to qualify for the foreign tax credit and avoid double taxation liability.
In its simplest form, an ISO allows the employee the right to purchase their employer’s stock at a specified grant price over a period of time (e.g., 10 years), unless separation from the company occurs during this period of time. Typically, the options vest over a few years, incentivizing the employee to remain with the employer, a “golden hand cuffs” proposition if you will. As the stock’s share price increases, the value of the ISO also appreciates, resulting in a mutual benefit, a win-win for both employer and employee.
By ISOs capital management has the potential for more preferential tax treatment. There are a couple key timeframes that must be accounted for:
- date on which the options were granted
- date on which the options were exercised and stock purchased
To maximize tax efficiencies, the holder of the ISO must not sell the stock before the later of 2 years from grant date or 1 year from stock exercise/purchase date. If the holder of the ISO satisfies this holding requirement, the gain between purchase and sale date is taxed at long term capital gains tax rates (currently 15% or 20% federally), contingent upon their income. It should be noted that the intrinsic value of the option at ISO exercise is considered an Alternative Minimum Tax (AMT) preference item. Therefore, if AMT is owed upon exercise, a tax credit for this AMT paid upon exercise should be accounted for in the year of stock sale. Unlike a Non-Qualified Stock Option (NQSO), the taxation of an ISO transpires at sale vs. exercise date (except for the inclusion for AMT purposes). If the ISO holding requirements are not met, the entire gain is taxed as ordinary income (currently up to 37% federally).
The majority of ISO holders receive the grant, exercise the option, and either hold or sell as a U.S. resident. In this case the aforementioned taxation rules apply. However, in an era of remote employment, many Canadians have returned to Canada while maintaining their employment status with a U.S.-based employer. Essentially, they’ve re-established Canadian tax residency as ISO vesting schedules continue to accrue. For them, it is critical to understand Canadian taxation laws relative to ISOs.
Unlike the U.S., Canada taxes an ISOs capital management on the date of exercise as opposed to the date of sale. There is potential for a foreign tax credit (FTC) mismatch if the purchase and sale are not performed within the same calendar year.
Example: An employer, XYZ Corporation, grants one of its key employees (Steve) 1,000 shares of XYZ Corporation at $50 per share over a 4-year vesting period. The grant date was July 1, 2019. On July 30, 2020, Steve exercised his right to purchase 250 shares of XYZ Corporation at $50 per share when the market price was $60 per share. As Steve now resides in Canada, the $10-per-share intrinsic value at purchase is taxed in Canada at ordinary income tax rates, with a potential 50% deduction if certain criteria are met, to effectively tax the intrinsic value at capital gains rates (also subject to grant limitations). The shares were then held until August 1, 2021, at which point those same shares were sold at $70 per share. Although Steve met the holding requirements for preferential long-term capital gain tax treatment in the U.S., he is essentially double taxed on the same income because the purchase and sale happened in separate calendar years.
One is left to wonder how to approach this FTC mismatch. The answer is to exercise and sell the ISO in the same calendar year. Since the gains are recognized in the same tax window, double taxation can be avoided through the matching of FTCs on the T1/1040.
ISOs capital management – It goes without saying that each situation can be unique; therefore, it’s best to speak with a cross-border tax and financial professional who is intimate with the ever-changing tax landscape. For a review of your specific cross-border scenario contact Cardinal Point.