Forward contract was a hedge, not speculation, so losses were capital losses
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 today in a decision that is in “the national public interest,” says one tax law expert.
“The heart of the issue, and the principle that will have enduring value and which will determine future conduct and influence the bodies, … is the fact that you have to determine intention in an objective manner based on the facts and not simply ex post declaration by the taxpayer” as to whether the taxpayer was speculating or hedging in a particular derivatives contract, says Vern Krishna, a professor of law at the University of Ottawa, and Of Counsel at TaxChambers LLP.
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 the bank. MacDonald took the position that he took a forward derivatives contract with TD Securities as speculation.
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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.
In the appellant’s agreement with TD Securities in 1997, if the value of the shares that he had pledged as security against his loan increased, he would pay the difference between the share price at the future date specified in the forward contract, and the price specified in the contract. If the value of the shares decreased, however, the bank would pay him the difference, and the money the appellant received would be used as extra security for the loan.
The price of the shares increased, and the appellant made cash settlement payments to TD Bank of over $10 million under the forward contract.
The appellant 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 Income Tax Act recognizes two categories of income: i) ordinary income, such as from employment and business; and ii) 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 Minister of National Revenue disagreed with the appellant, finding 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, not as income losses. MacDonald filed an objection.
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 of 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 are therefore properly characterized as income losses, the Tax Court found.
But 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.
The hedge was on the other side of the transaction, says Krishna. 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.
“So now he’s covered,” Krishna says. “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 today’s majority ruling, written by Justice Rosalie Abella, “The Cash Settlement Payments arising from the forward contract derive their income tax treatment from the underlying Bank of Nova Scotia shares, which the parties agree were held by Mr. MacDonald on account of capital. When considered in its full and proper context, it is clear that the purpose of the forward contract was to hedge against market price fluctuations that Mr. MacDonald’s Bank of Nova Scotia shares were exposed to.”
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; 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 got money from TD Securities under the forward contract, the money 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. So all of these activities -- the loan agreement, the pledges and the forward contract – were 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 Justice 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 by reviewing the taxpayer’s subjective statements of intent and objective manifestations of intent. MacDonald’s intent was to speculate, and not hedge, Justice Côté found.
In an email sent to Canadian Lawyer, the appellant’s lead counsel, Elie Roth of Davies Ward Phillips & Vineberg LLP in Toronto, wrote that “While we are disappointed with the result in the case, we note 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.
“The Court clarified that the existing case law continues to be relevant,” said Roth, “and rejected the application of a test based entirely on foresight of risk. However, the decision leaves open the question of the level of sufficient linkage required to characterize what would otherwise be a speculative derivative instrument as a hedge.
“The majority’s reasons suggest that the analysis as to whether there is a hedge of an underlying risk should be determined predominantly based on the economic linkage between the derivative instrument and the risk, which will inform the purpose of the transaction, even if that risk is theoretical in nature. Justice Côté’s dissent provides helpful guidance with respect to a number of the issues left open by the majority’s reasons for judgment and will be relevant in applying the test set out by the Court in future cases.”
