Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: 1. The explanatory notes to the definition of "derivative forward agreement" provide two fact patterns under the heading "Example - Exchangeable Shares". Can the CRA confirm that an exchange right in the terms of an exchangeable share is not an "agreement" for purposes of the derivative forward agreement ("DFA") rules?
2. Can the CRA confirm that, in the context of an exchangeable share the terms of which permit a taxpayer to exchange its shares with the issuer for shares of another company, whether ancillary rights enabling such taxpayer to put its shares to another person for the shares of the other company in the event the issuer is unable to effect the exchange will not, in and of themselves, be considered an agreement for purposes of the definition of DFA?
3. Is the answer to 1 or 2 affected by whether the property is a share or a partnership interest? In particular, as a partnership interest is contractual in nature, will an exchange right be viewed as embedded (and not a separate agreement) such that the same result as set out in the explanatory notes in the exchangeable share example above applies to exchangeable partnership interests?
4. How will the CRA apply (c)(ii) to the right to exchange shares for securities (the "second securities") of another entity (a) that holds only interests (directly or indirectly) in the entity that issued the exchangeable shares or (b) that holds interests (directly or indirectly) in the entity that issued the exchangeable shares as well as other property?
Position: 1. The CRA cannot confirm that the rationale underlying the example in the explanatory notes is that an exchange right embedded in a share is not a DFA for purposes of the DFA definition.
2. The CRA cannot confirm whether ancillary rights will be considered to be an agreement for purposes of the DFA definition.
3. The answers to 1 and 2 apply equally to exchangeable partnership interests.
4. The CRA will compare the opportunity for profit and risk of loss of the exchangeable shares to the opportunity for profit and risk of loss of the second securities.
Reasons:
1. The reason why the first fact pattern in the explanatory note example does not give rise to a DFA and the second fact pattern does give rise to a DFA relates to subparagraph (c)(ii) of the DFA definition. An analysis of all the portions of the DFA definition needed to be undertaken regardless of whether the exchange right was an agreement because the call right in the example was an agreement.
2. We would require further information regarding the nature and form of these rights to make a determination.
3. The reasons given for questions 1 and 2 apply equally to partnership interests.
4. The legislation requires this comparison. Consistent with the explanatory notes, many standard exchangeable share transactions will not be DFAs as a result of the application of (c)(ii) of the DFA definition because the risk of loss and opportunity for profit associated with the exchangeable shares will be generally very similar to the risk of loss and opportunity for profit associated with the second securities.
CTF Annual Tax Conference
CRA Round Table December 2, 2014
Question 1 Derivative Forward Agreement
1. The explanatory notes to the definition of "derivative forward agreement" provide two fact patterns under the heading "Example Exchangeable Shares". Can the CRA confirm that the first fact pattern is not a DFA because the exchange right embedded in a share is not an agreement?
Response
The DFA rules are a set of anti-avoidance rules colloquially referred to as the "character conversion rules" that are intended to address certain structures that have the effect of transforming income into capital gains.
The heart of these rules is the definition of "derivative forward agreement" in subsection 248(1) of the Act.
The CRA cannot confirm that an exchange right embedded in a share is not an "agreement" for purposes of the DFA definition.
The reason why the first fact pattern in the explanatory note example is not a DFA and the second pattern is a DFA relates to subparagraph (c)(ii) of the DFA definition, as discussed further below. An analysis of the other portions of the DFA definition needed to be undertaken regardless of whether the exchange right is an agreement because the call right is an agreement.
2. Can the CRA confirm that in the context of an exchangeable share the terms of which permit the taxpayer to exchange its shares with the issuer for shares of another company ancillary rights enabling such taxpayer to put its shares to another person for the shares of the other company in the event the issuer is unable to effect the exchange will not, in and of themselves, be considered an agreement for purposes of the definition of DFA?
Response
No, the CRA cannot confirm this. We would require further information regarding the nature and form of these rights to make a determination.
3. Is the answer to 1 or 2 affected by whether the property is a share or a partnership interest? In particular, as a partnership interest is contractual in nature, will an exchange right be viewed as embedded (and not a separate agreement) such that the same result as set out in the explanatory notes in the exchangeable share example applies to exchangeable partnership interests?
Response
The answers to 1 and 2 apply equally to a partnership interest. As discussed further below, we would expect that, depending on their terms, many exchangeable partnership interests would not be DFAs as a result of subparagraph (c)(ii) of the DFA definition.
4. How will the CRA apply (c)(ii) to the right to exchange shares for securities (the "second securities") of another entity (a) that holds interests (directly or indirectly) in the entity that issued the exchangeable shares or (b) that holds interests (directly or indirectly) in the entity that issued the exchangeable shares as well as other property?
Response
The CRA will compare the opportunity for profit and risk of loss of the exchangeable shares to the opportunity for profit and risk of loss of the second securities.
Consistent with the explanatory notes, many standard exchangeable share transactions will not be DFAs as a result of the application of (c)(ii) of the DFA definition because the risk of loss and opportunity for profit associated with the exchangeable shares will generally be very similar to the risk of loss and opportunity for profit associated with the second securities.
Lara Friedlander
2014-054670
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