The March decision on derivative contract is ‘in the national public interest,’ says one tax lawyer
A taxpayer’s forward derivative contract was a hedge, not speculative, and so the taxpayer’s losses were capital and not income losses, the Supreme Court of Canada ruled in March in a decision that is in “the national public interest,” says one tax law expert.
“Any decision of the Supreme Court in the tax area is going to have a profound ripple effect across the economy,” both for commercial and individual taxpayers, says Toronto tax litigator William Innes. That said, he notes “a subtle sea change in the way the Supreme Court is approaching business-type tax cases.”
Under former Chief Justice Beverley McLachlin, the Supreme Court maintained an “even keel” regarding business tax deductions, Innes says. “There was a careful balancing of interests, assisted by the presence on the court of Mr. Justice [Marshall] Rothstein; he was a real tax expert.” The absence of McLachlin and Rothstein on the bench “tells in this case,” says Innes, predicting the decision “will engender a broad level of uncertainty in the business/investment community.”
In MacDonald v. Canada, shares that the appellant James MacDonald had put up as security against a large bank loan were agreed to be capital assets by the appellant and by the bank. MacDonald took the position that he took a forward derivatives contract with TD Securities as speculation.
A forward derivatives contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. It can be used for hedging or speculation. A hedge is generally a transaction that mitigates risk, while speculation is the taking on of risk with a view to earning a profit.
If the contract is a hedge, any cash settlement payments required to be paid under the forward contract would be characterized as capital losses; if the contract is speculative, the losses would be treated as income losses.
Under the appellant’s agreement with TD Securities in 1997, when he launched his own business, if the value of the shares he had pledged as security against his loan increased by the future date set in the forward contract, MacDonald would pay TD the full amount of the increase. If the value of the shares went down, TD Securities would pay him, and the money MacDonald received would be used as extra security for the loan for his business provided by the TD Bank.
The price of the shares increased, and MacDonald made cash settlement payments to TD Bank of more than $10 million under the forward contract. He later claimed the cash settlement payments as income losses that would be deductible from his income from other sources on his tax returns for 2004, 2005 and 2006.
The Minister of National Revenue, however, found that the forward contract was a hedge of the appellant’s Bank of Nova Scotia shares and, therefore, characterized the cash payments to TD Securities as capital losses and not as income losses that could be deducted 100 per cent from taxes owing. MacDonald filed an objection.
The Income Tax Act recognizes two categories of income: ordinary income, such as from employment and business; and income from a capital source or capital gain. In Canada, income is taxed at 100 per cent, while capital gains are taxed at just 50 per cent.
The tax treatment of gains and losses that derives from derivative contracts — or contracts that have an underlying asset, such as shares or real estate — depends on whether the derivative contract is characterized as a hedge or as speculation. Gains and losses arising from hedge derivative contracts take on the character of the underlying asset; in this case, bank shares. Speculative derivative contracts are characterized on their own terms, independent of an underlying asset.
On appeal from the Canada Revenue Agency’s decision, the Tax Court agreed with the appellant that his intention was to speculate and that there was no linkage between the forward contract and MacDonald’s shares. Cash settlement payments were, therefore, properly characterized as income losses, the Tax Court found.
The Federal Court of Appeal allowed the Crown’s appeal. It found that MacDonald owned shares that were subject to market risk, and the forward contract had the effect of neutralizing that risk. The forward contract was, therefore, a hedge and the losses were capital losses.
If the Bank of Nova Scotia shares that had been pledged by MacDonald had gone down rather than up in value, TD Securities would have paid MacDonald the full amount of the decrease in value, says Krishna. “So now he’s covered. If the shares go up in value, he sells, he makes his money, pays off his loan, he’s happy. If the value of the shares goes down, TD Securities pays him. He’s hedged his bets.”
In the majority ruling, written by Justice Rosalie Abella, the court found that: i) it is the purpose of the derivatives contract that matters; ii) to look at purpose, one needs to look at the linkage between the purpose and the underlying asset; and iii) the full context is relevant, including the existence of other agreements working together.
In this case, there was the forward contract between McDonald and TD Securities and his loan from TD Bank. The 165,000 Bank of Nova Scotia shares pledged by MacDonald to get his loan were also the underlying assets of the forward contract with TD Securities. If MacDonald received money from TD Securities under the forward contract, it would be pledged as extra security for the loan with TD Bank. Maintaining the forward contract was also part of the condition for getting the loan, and so the loan agreement, share pledges and forward contract were all linked.
“As Noël C.J. observed, the combined effect of the forward contract, the loan agreement and the pledge agreement allowed for credit backed by collateral that was free from market fluctuation risk,” wrote Abella in her reasons.
In dissenting reasons, Justice Suzanne Côté found that the tax characterization of the forward contract turns on the taxpayer’s intent, which was determined here by reviewing the taxpayer’s subjective statements of intent and objective manifestations of intent. MacDonald’s intent was to speculate and not hedge, Côté found.
At the lower court levels, it “came as a surprise” that the Tax Court judge’s decision was reversed by Federal Court of Appeal Chief Justice Marc Noël, Innes says. “He decided the issue of MacDonald’s intent was irrelevant, [and] that changed the law in my view. I suspect it was why the Supreme Court granted leave, because that change in the law gave a certain discomfort to the investment community.”
Elie Roth of Davies Ward Phillips & Vineberg LLP in Toronto, who represented the appellant, told Canadian Lawyer that “both the majority and the dissent acknowledged the core principle advanced by the taxpayer on appeal, which is that intention, or purpose, is the central test to be applied in determining the characterization of a derivative instrument as on income or capital account.”
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