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I need some help from someone who understands how employee stock purchase plans are taxed in Canada.

Glad to be of service!

(For example, Jan 1 = $100, July 1 = $120, I get the stock at either $85 or $100)

As far as I understand it, if I buy the stock at 85% of that lowest price, I get taxed (at purchase) on the difference between my price and the market price. Is that correct? is it income tax or capital gains tax?

Correct. Unfortunately, it's taxed as income tax. If you buy at $85 when the stock currently trades at $120, Revenue Canada (now CCRA) pretends that the company just gave you $35. If your payroll deductions added up such that you ended up buying 100 shares, you will have $3500 added to your T4 at the end of the year.

If I buy stock at 100% of the lowest price, I don't pay any tax until I sell the stock. Is that correct?

No. In your example, you're buying stock at $100 when it currently trades at $120. CCRA will pretend that the company just handed you $20. If your payroll deductions over the six month period accumulated to the point where you bought 100 shares, you will see $2000 added to your T4.

This would only be true if the stock declined over the six month period. Suppose the stock was $120 at the beginning of the six month period and was $100 at the end of the period. According to your ESPP, you will buy your company stock at $100 when it currently trades at $100. Thus, you have been given no income and will not be taxed. The only benefit you get is that you don't pay a brokerage commission if you had bought in the open market.

If instead you choose to buy at $85, then you would be taxed on the $15 gain for each share of company stock that you purchased.

Under what conditions is it favorable to choose one option over the other?

It should be clear that it is always better to buy at 85% of the lower price, even if you have to pay income tax on the gain. You will always come out ahead by buying your company stock at a discount.

These plans are ideal for people who aren't high risk takers and don't want to gamble in the stock market. If you keep buying at 85% of the lowest price and selling the entire position every six months, you get all the upside with very little downside risk. The only bad thing about it is that it is taxed by CCRA at your full marginal rate. If your stock climbs by a significant amount and you buy it really cheap, be prepared to pay a lot more income tax!

There is one more thing that you should know. Let's say that your company stock climbed from $100 to $120 over a six month period and you bought 10 shares at $85 at the end of the period. You've gained $35 per share. This will be taxed as income. On your T4, you will recognize $350 in additional income.

Because you've paid income tax on the difference between $85 and $120, the $120 price is now the cost basis of your stock purchase.

What is the cost basis? It is the price that CCRA considers your purchase price. Let's say you hold on to those shares that you bought for $85 but are worth $120 today.

Let's say, due to some great news announcements, that in a span of a month, your company stock climbs to $200. You decide to sell your 10 shares at $200.

You will have now just triggered a capital gain. The capital gain is based on the difference of the sale and the cost basis. In other words, you have triggered a capital gain of $200 - $120 = $80 dollars per share. Since you sold 10 shares, you have triggered a capital gain of $800, which you will owe tax on.

This is important because you have NOT triggered a capital gain of $200 - $85 = $115 per share. You have already paid tax (ordinary income tax, for that matter) on the difference between $85 and $120. The gain from $120 to $200 is taxed as a capital gain.

Similarly, if the stock declines from $120, you will have incurred a capital loss. So, for example, if your company stock drops from $120 to $100 by the time you've sold it, you will have incurred a capital loss of $20 per share. You will still end up paying the gain from $85 to $120 as ordinary income tax.

Hope this clears things up for you.
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