Most owner-managers in the services business will attest to the fact that employees are their most important asset. At our firm, a large number of our clients are service-oriented: architects, engineers, designers, and asset managers, to name a few. Some of their companies are well-established and have built their brand, while others have recently incorporated and are in the midst of creating their vision and attracting new clients. No matter where they are in their business cycle, one thing is clear: these owner-managers are highly dedicated, motivated and have a wealth of experience in their respective fields. Most importantly, they need to attract and retain a similar caliber of employees. Employee compensation becomes an important tool in helping achieve this goal. The types of compensation methods can vary depending on the availability of cash flow and the desire to align the goals of the employees to those of the business.

Some companies use high base pay to attract talent while others use a lower base but use commission pay, profit sharing and bonuses to incentivize certain employee behaviour. One of my clients used stock options for some of their new hires this year. Their agreement stipulated that certain target dates and performance thresholds must occur before the employees can exercise their options, thus motivating the employees to stay with the company for the long haul and meet the desired targets. This required no cash outlay from the company, but rather a commitment to share in the equity of the company should the employees achieve their targets and choose to exercise their options. As it is an effective compensation strategy for companies that see a future of high growth, it is very important to consider the interesting accounting and tax considerations that arise.

Accounting Standards

For Audit and Review Engagements, financial statements are prepared using IFRS 2 (International Financial Reporting Standards - Share-based payment) or ASPE (Accounting Standards for Private Enterprises) Section 3870. Under these reporting standards, employee stock options must be accounted for at the grant date using an options pricing model (such as Black Scholes) that takes in to account many variables, some of which must be estimated and can be complex. Further accounting adjustments are required at the date of exercise of the options and there are certain minimum disclosures that must be addressed in the notes of the financial statements. These reporting and disclosure requirements can help the users of the financial statements to better understand and assess the impact of these underlying agreements.

Income Tax Considerations

As for the tax effect of employee stock options, there is no tax liability to the employee when the options are granted. At the exercise date, the difference between the fair market value at the date of exercise and the exercise price would be taxed as employment income (stock option benefit) with a 50% stock option deduction available if certain requirements are met. For companies that are CCPCs (Canadian Controlled Private Corporations), there is an added benefit in that the stock option benefit inclusion is deferred until the shares are sold and then reported on the employee's T4 slip in the year of sale. If the employee holds the shares for more than two years, the stock option benefit would be eligible for the 50% stock option deduction; if held for less than two years, the stock option benefit would still be eligible for the 50% stock option deduction unless the exercise price at the grant date was at an amount less than fair market value.

Once the options are exercised, the cost base of the shares is equal to the exercise price plus the stock option benefit (fair market value on date of exercise). An added bonus is that in the case of a CCPC, once the shares are sold, the employee may be able use their capital gains exemption, where they would not pay any tax on the first $824,176 (for 2016 disposals) of capital gains, as long as both the company and the employee meet the specified requirements. It is also important to keep in mind that there is no tax deduction for the company when using stock options, as there would if using salary, commission, profit sharing or bonus. The rules for non-CCPC employee stock options differ.

Summary

Any compensation method chosen by owner-managers will require a full analysis of its impact. Not only will they have to assess the possible behavioural outcomes of such strategies, but they will also have to involve their accountants and tax advisors in the process in order to obtain a full understanding of the accounting and tax issues that can arise. This cohesive strategy should provide a good head start in managing the company's most important asset: its employees.