The Best Way for Canadian Startups to Compensate Employees

Summary: Your main choices are

1. Salary
2. Cash bonus
3. Contractor including overseas contractor
4. Stock options
5. RSUs.

 

The usual startup recipe is salary for core roles, measured bonuses for results, contractors for true projects, stock options for upside, and RSUs mainly once you are later stage or public. But make sure to keep SR&ED in view at every step.

Small businesses are a huge employer in Canada, so most candidates still expect a salary anchor. As of 2022, small businesses employed 46.8% of the private labour force.

1) Salary

What it is?
A set payment amount paid on each pay run. The employee won’t receive the full amount. You typically have to deduct income tax, CPP, and EI on the salary and remit(pay) it to the CRA. There are also employer taxes.

Employee Impact
Generally, salary provides stability to the employee. It relieves them of stress of wondering how they will pay their bills. It is taxed as employment income which is the highest taxed form of income. But they are typically used to it.

Company Impact
The company pays the gross salary and employer taxes (employer CPP, employer EI, EHT). The startup can deduct the salary but if the startup has a loss, that deduction may not be very valuable.

Salary typically doesn’t incentivize employees the best as pay is fixed irrespective of performance. There are also other obligations you have once you have an employee (i.e. termination pay, accommodation, etc.). But most potential workers will expect it.

SR&ED impact
Salary has the best impact on SR&ED. Salary or wages for eligible R&D performed in Canada are allowable SR&ED expenditures, subject to the rules and your chosen calculation method. You also get to gross up the salary costs by 55% for the SR&ED credit meaning you can get back up to 60% of an employee wages.

2) Cash Bonus

What it is?
A one time payment (sometimes multiple times) each year for hitting goals. You withhold payroll just like salary despite common misconceptions. CRA has a specific method for calculating income tax on irregular amounts like bonuses.

Employee Impact
Bonuses can motivate and reward results much more than a salary does. They are taxed as employment income in the year paid. People often feel “taxed more” on bonuses because the extra income can push them into a higher bracket for that year. High performing candidates may be more attracted to a generous bonus program.

Company Impact
Similar to a salary, the company pays the gross bonus and pay also pay employer taxes. The startup can also deduct the bonus which is useful if they are profitable. Plan cash and approvals so payment happens on time. Bonus generally incentivizes employees more than salary.

SR&ED impact
A bonus tied to eligible R&D work can be included in SR&ED salary or wages. However, there is no 55% gross up like there is with salary.

3) Contractor in Canada

What it is?
You buy services from an incorporated vendor or sole proprietor instead of hiring an employee.

Employee Impact
They are not your employee. They report business income and handle their own CPP EI. They invoice you and may need to register and charge you for GST/HST.

Company Impact
There are no payroll taxes like CPP or EI. One of the biggest issues is misclassifying someone who functions like an employee. CRA doesn’t care if you call them a contractor if they act like an employee. CRA looks at control, ownership of tools, chance of profit, and risk of loss to decide status.

If you misclassify an employee as a contractor and don’t pay the necessary payroll taxes, CRA may come after you to collect these taxes along with interest and penalties.

SR&ED impact
R&D services performed in Canada on your behalf can qualify for SR&ED, but only 80% of the contract amount is a qualified SR&ED expenditure.

4) Contractor Overseas

What it is?
You hire a foreign individual or company to perform services entirely outside Canada.

Employee Impact
They are not your employee and handle their own local taxes.

Company Impact
Generally, there are no Canadian concerns for hiring them overseas. But you need to be aware of potential taxes in foreign countries. Foreign contractors are often said to cost less but their quality is usually worse than hiring Canadians.

SR&ED impact
Overseas contract R&D generally does not produce Canadian SR&ED credits for you.

5) Stock Options

What it is?
Stock options are right for an employee to buy shares later at a set price. If they choose to exercise the right to buy the shares and pay the startup that set price, then the ownership by the existing owners becomes diluted and the employee will then own part of the startup.

If they exercise that right or sell the shares, they may have to pay tax. The timing and withholding depend on whether you are a Canadian controlled company or not.

Employee Impact
Stock options are unique. However, a big issue with them is that employees don’t always understand how they work.

When a startup grants employee stock options to an employee, the employee does not have any tax consequences. However, if the startup increases in value the employee could then benefit from that increase. Initially, there is no real gain to the employee until the value of the shares increase.

It is a way for employees to be incentivized to grow the startup without actually paying any cash to the employee and without the employee being taxed immediately to participate in the growth.

Only when the employee exercises or sells the shares would there be tax consequences. The timing and the amount of tax depends on a) if they are Canadian controlled or not, and b) if the strike price was more than the value of the shares when they were granted.

Company Impact
There is generally no cash spent to grant stock options to employees which make it great for cash-strapped startups. It also incentivizes employees to grow the startup. But there are administrative costs to create a plan, get valuations, track options, and do proper payroll reporting. They could also dilute ownership of existing shareholders and owners.

SR&ED impact
Stock options benefits may still be treated as a eligible for the SR&ED credit if that the employee’s salary for the grant year was eligible for SR&ED.

6) RSUs

What it is?
Restricted Share Units (RSUs) are essentially a promise to pay someone in shares of the company (instead of cash) if they meet certain requirements. Meeting these requirements is called ‘vesting’. Vesting typically involves working a required amount of time. For example, an employee pay receive 30 shares vested evenly over 3 years meaning they receive 10 shares after each year they work (even if the shares triple in value).

Employee Impact
RSUs are simple to understand. The downside is tax at vest even if the shares are illiquid. Later, when shares are sold, there can be a capital gain or loss compared to the value at vest.

The employee generally pays tax based on the value at vesting. The employee is incentivized to increase the company’s value.

Company Impact
RSUs create a cash requirement at each vesting date to remit income tax, CPP and EI (this is often done by selling some shares of the employee to cover their deductions). There may also be a cash outlay for employer payroll taxes. It helps align motivations of the employee to grow the company. But it also dilutes ownership.

SR&ED impact
Share based awards like RSUs are not eligible for SR&ED.

Comparison Table: Options, Pros and Cons

 

Need help deciding on how to compensate employees? Contact CoPilot Tax today.