Tax characterization of derivative contracts

Jul 08, 2020
Business tax Derivatives & hedging Regulatory compliance

Who doesn’t like to eliminate risk? Particularly during these unstable times, taxpayers may turn to derivatives to manage risk and protect themselves from market fluctuations such as pricing or foreign exchange rate volatility.

Determining whether amounts arising from derivative contracts should be considered on account of income or capital from a tax perspective has been a longstanding concern. In March 2020, the Supreme Court of Canada (SCC) released its decision in MacDonald v. Canada, which was a welcome clarification on how to treat derivative contracts for tax purposes. The decision provided a two-step linkage approach in determining whether a derivative contract can be considered as a hedge.

Relevant facts

James S. A. MacDonald owned 183,333 common shares of the Bank of Nova Scotia (the BNS shares) since 1988. The shares were capital property to him. In 1997, Mr. MacDonald availed a credit facility for up to $10.5 million from Toronto-Dominion Bank. As per the terms of the credit facility, Mr. MacDonald was required to pledge the BNS shares and to purchase a forward contract as part of the pledge. Under the forward contract, MacDonald would make payments to TD bank for the excess, if the value of the BNS shares exceeded the forward price. Similarly, in the event the value of the BNS shares falls below the forward price, TD bank would make payment to MacDonald for the excess. Such payments made pursuant to the forward contract were called as cash settlement payments.

During the life of the forward contract, the BNS shares increased in value and MacDonald made cash settlement payments totaling approximately $10 million to TD bank. In computing his income, MacDonald claimed these payments as income losses deductible against income from other sources on the basis that he was speculating with the forward contract, and has not used it for hedging purpose.

The Canada Revenue Agency reassessed the taxpayer on the basis that the forward contract was entered to hedge the BNS shares, being capital property of the taxpayer, and thus the taxpayer should have claimed the payment as capital losses.

The primary issue is whether the losses realized by the taxpayer on the forward contract should be treated on account of capital or on account of income. The issue turned onto whether the forward contact was considered a hedge or speculation.

Hedge vs. speculation

A hedge is a transaction, which mitigates risk from market fluctuations, while speculation is the taking on of risk with a view to earning a profit. Gains and losses from the hedge transaction take on the character of the underlying asset being hedged. Thus, if the underlying asset is capital asset for the taxpayer and the transaction constitutes a hedge, the losses would be treated as capital losses. On the other hand, gains and losses from the speculation are characterized on their own terms, independent of an underlying asset. 

TCC’s ruling

The TCC held that the taxpayer’s sole intention in entering into the forward contract was to speculate on the price of BNS shares, not to hedge. The contract could only be settled in cash and there was no option for physical delivery of the BNS shares. This further boosted the position that the forward contract was speculative in nature. The TCC also found that there was no linkage between the forward contract and the BNS shares because the taxpayer treated both contracts, the loan and the forward, as separate instruments. Therefore, the purpose of forward contract was speculation and losses on the cash settlement payments were not affiliated with the BNS shares. The losses were thus on account of income and properly characterized by the taxpayer.  

FCA overturned the TCC’s decision

The FCA overturned the TCC’s decision and held that an intention to hedge was not a condition precedent for hedging. A hedging exists if the assets owned by the taxpayer are exposed to market fluctuation risk, when the derivative contract is entered into and such contract has the capacity to neutralize or mitigate this risk. A transaction to sell or settle the underlying asset or liability (via cash or physical delivery) is not required for a hedge to exist.  

In MacDonald, the BNS shares were exposed to risk of price fluctuation and the risk was mitigated by the forward contract that MacDonald entered into with TD bank. As a result, the transaction constituted a hedge and the losses on the cash settlement payments were thus capital losses.

SCC upheld FCA decision

In an 8-to-1 majority decision, the Supreme Court of Canada confirmed that MacDonald’s forward contract was a hedge and the losses on the cash settlement payments constituted capital losses. In the decision, the SCC held that whether a derivative contract is a hedge, it is mainly decided by the purpose of the contract. The SCC described that the purpose must be determined objectively by examining the link between the derivative contract and any underlying asset using two-step linkage analysis.

The first step is to identify an underlying asset, liability or transaction that exposes the taxpayer to financial risk. The second step requires assessing the extent to which the derivative contract mitigates or neutralizes the risk identified in first step. The SCC held that more effectively the derivative contract mitigates the risk associated with the underlying asset, the closer the link between the two, the stronger is the inference that the purpose of the derivative contract was hedging. However, a perfect link is not a pre-requisite for such conclusion.

The SCC identified that when seen along with the loan and pledge agreements, it is obvious that the purpose of the forward contract was to hedge. The forward contract had the capacity to mitigate the financial risk associated with the price fluctuation of the BNS shares held by Mr. MacDonald. Therefore, there is substantial linkage between the forward contract and MacDonald’s BNS shares.

Since the shares were held by MacDonald on account of capital, it is clear that the purpose of the forward contract, held by MacDonald, was to protect against market price fluctuations of the BNS shares. Hence, the SCC upheld the FCA’s decision that MacDonald’s forward contract constituted a hedge of BNS shares and the losses arising therefrom, must be treated as capital losses.

Being a well-informed taxpayer

The SCC’s decision confirms that the two-step linkage test is broad and that the taxpayer’s purpose in entering into the instrument is dominant. Documenting purpose as well as considering the surrounding facts that support the purpose will be instrumental in establishing the appropriate tax characterization of a derivative. 

If you have questions about how this ruling may impact your business contact us, or your tax professional today.

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