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Fairness is in the eyes of the beholder. You might recall the story of Jérôme Kerviel, who was the "rogue" derivatives trader who worked at the Société Générale SA bank in Paris. Mr. Kerviel was convicted in 2008 for breach of trust, forgery and unauthorized use of the bank's computers, which resulted in losses to the bank of about $7.5-billion. Mr. Kerviel was fired, but he claimed the bank was being unfair.

When it comes to fairness, Canadian taxpayers have made it such a big issue that our government introduced "fairness rules" to give relief to taxpayers in certain situations. There is one situation that has come up over and over again, however, where Canadian taxpayers have cried foul but the taxman has refused to call the tax system unfair. A recent court decision sided with the taxman once again over the issue, and Canadians need to take heed. Let me explain.

The problem

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Picture this. You're employed by a company that offers a stock option plan. Under the plan, you're able to buy shares in your employer at $10 per share. Over the course of time, the value of the shares on the open market rises to be worth $200 per share. So, you exercise your options and buy 1,000 shares for $10 each. Your cost, then, is $10,000. The shares are worth $200,000 (1,000 shares at $200 each). You make a nice profit of $190,000 in the process.

The fact is, this exercise of your options is going to trigger some tax. You have just realized a benefit of $190 per share ($200 less $10), for a total benefit of $190,000. This will be taxable to you, not as a capital gain, but as employment income. The good news? Most stock option plans in Canada are structured to take advantage of a stock option deduction equal to 50 per cent of the taxable benefit. In this example, then, we'll assume that just $95,000 of the benefit (one half of $190,000) will be taxable. This will give rise to a tax bill of $44,090 for someone in a high tax bracket in Ontario in 2015.

But the story isn't over. Suppose that you hold onto your shares, and the shares drop to just $10 over a short time. You still owe the taxman $44,090 in taxes but your shares are now worth just $10,000 (1,000 shares at $10 each). Where are you going to get the money to pay your tax bill? If you sell your shares for $10,000, you'll realize a loss of $190,000 (your adjusted cost base is $200,000 – the value on the date you exercised your options – but you sell them for $10,000).

You might expect that your taxable stock option benefit could be offset by your $190,000 loss on the sale of your shares. Not so. The loss is considered to be a capital loss, whereas the taxable income was considered to be employment income. Capital losses can be applied against capital gains, but not generally other types of income. The result? You'll face tax on the stock options with no immediate relief from the loss.

The case

There have been a few court cases in the past on this issue. On Jan. 20, Mr. Bing Zhu, a Canadian taxpayer, was the most recent casualty of the courts (see Bing Zhu v. The Queen, 2015 TCC 16). Mr. Zhu had acquired 116,000 shares in his employer, Canadian Solar Inc. (CSI) and in September, 2008, exercised his options and acquired 53,150 shares in his employer. He had to report employment income of $1,667,070 (half of which was taxable due to the 50-per-cent stock option deduction) as a result of his stock options in 2008, but sold his shares in November, 2008, for a loss of $1,247,657. He tried to argue that his losses were not capital losses, but regular business losses, in an attempt to have his losses applied against his employment income. Didn't work. The court ruled against him. Even though it may not be fair to Mr. Zhu, the court had no authority to give relief based on an argument of fairness.

The solution

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To avoid the fate of Mr. Zhu and so many others, consider selling any shares acquired under a stock option plan as soon as possible. Otherwise, you run the risk of those shares dropping in value and leaving you with a tax hit and a capital loss that won't offset your taxable employment income. As a minimum, sell enough shares to raise the cash to pay your taxes.

Tim Cestnick is managing director of Advanced Wealth Planning, Scotiabank Global Wealth Management, and founder of WaterStreet Family Offices.

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