Overview of s. 126(4.5) (pp. 10:41-42)
[S]ubsection 126(4.5) affects a taxpayer's holding period for purposes of applying...subsection 126(4.2), a rule that aims to discourage taxpayers from acquiring shares or debt obligations for the purpose of generating foreign tax credits in respect of foreign withholding taxes imposed on dividends or interest paid on such securities. Subsection 126(4.2) limits the foreign tax credit in respect of dividends or interest on a share or a debt obligation held on income account if the period that began at the time the taxpayer last acquired the security and ended at the particular time is one year or less. Where it applies, new subsection 126(4.5) generally changes to a later date the time of the last acquisition of the share or debt obligation for purposes of subsection 126(4.2), in effect shortening the taxpayer's holding period and thereby potentially causing subsection 126(4.2) to apply in respect of a security that, but for the SDA rules, would have been held for over a year. Subsection 126(4.5) applies if a taxpayer has entered into an SDA with respect to a share or debt obligation owned by the taxpayer and the synthetic disposition period is 30 days or more. Like its counterpart in the dividend stop-loss rules (subsection 112(8)), new subsection 126(4.5) will not apply if, prior to the particular synthetic disposition period, the taxpayer owned the security for a one year period (uninterrupted by a prior synthetic disposition period) prior to the commencement of the particular synthetic disposition period.
Targeted mutual fund forward sale agreements (p. 10:2)
Many mutual funds (both mutual fund trusts and mutual fund corporations…) used forward agreements (both forward sale transactions and forward purchase [or pre-paid forward] transactions) to provide investors with an economic return based on the performance of a reference portfolio that would generate ordinary income while having that return taxed as a capital gain….In the case of a forward sale agreement, the mutual fund would enter into an agreement with a counterparty (often a financial institution) to sell the Canadian securities portfolio for a purchase price based on the performance of the bond portfolio to which the mutual fund was seeking to gain exposure. Each time the mutual fund would settle the forward agreement physically (that is, sell Canadian securities to the counterparty under the forward agreement), the mutual fund would realize gains and losses on capital account, and, by virtue of the forward agreement, such capital gains and losses would reflect a return based on the performance of the bond portfolio.
Targeted mutual fund forward purchase agreements (p. 10:2-3)
An alternative structure would be where a mutual fund would enter into an agreement to acquire a portfolio of Canadian securities. The mutual fund would prepay its obligation to purchase the portfolio of Canadian securities upon entering into the agreement. The value of the Canadian securities to be delivered on settlement of the agreement would be determined by reference to the performance of, for example, a bond portfolio (as in the forward sale example described above). Each time the mutual fund physically settles the forward agreement, the counterparty to the forward purchase agreement would deliver Canadian securities with a value based on that of the bond portfolio and the mutual fund would then immediately sell the Canadian securities for cash. The Canadian securities would generally be listed, non-dividend paying shares of Canadian public corporations that would be sufficiently liquid to allow for an immediate sale by the mutual fund.
Application of s. 248(10) to "series" (p.10:5)
The DFA definition applies to a single agreement with a term that exceeds 180 days, as well as a series of agreements where the term of the series exceeds 180 days. It is arguable that the concept of "series of agreements" concept is covered by subsection 248(10), which provides that "the series shall be deemed to include any related transactions or events completed in contemplation of the series". [fn 9: See Michael Kandev, Brian Bloom, and Olivier Fournier, "The Meaning of ‘Series of Transactions’ as Disclosed by a Unified Textual, Contextual, and Purposive Analysis" (2010) 58:2 Canadian Tax Journal 277-330, at note 6, where the authors state that "[w]e are of the view that the application of subsection 248(10) is not limited only to those instances where the exact expression 'series of transactions or events' appears in the Act. Significantly, this expression is the broadest of the 'series' references in the Act and should be seen to include the narrower references in other provisions. In this regard, see the decision of the Federal Court of Appeal in OSFC...where Rothstein J stated, at paragraph 37, 'I read subsection 248(10) to apply whether a series is a series of transactions, a series of events, or a series of transactions and events.' Also consider that subsection 248(10)...is intended to clarify the meaning of the word "series" and not the meaning of the words 'transaction' and 'event.' Therefore, subsection 248(10) should apply to all 'series' references in the Act"] If subsection 248(10) applies to modify the concept of series of agreements, a taxpayer's intention regarding the term of an agreement on entering into an initial agreement with a term of 180 days or less is unlikely to be relevant if a subsequent agreement or subsequent agreements, when combined with the term of the initial agreement, results in a series of agreements with a term in excess of 180 days….
Distinction between ACB and cost/proceeds and sale price (p. 10:12)
[P]aragraph 49(3)(b) provides that the cost to the purchaser of the property under an option includes the adjusted cost base to the purchaser of the option itself….
[P]aragraph 49(3)(a) provides that the proceeds of disposition to the person disposing of property on the exercise of an option include the consideration received by that person for the option (i.e., the option premium)….
Example of distinction between ACB and cost (p. 10:13)
[A] taxpayer has an option to purchase a share that would be held as capital property in 200 days. The taxpayer paid an option premium of $3, the strike price of the option is $105, the fair market value of the share at the time of acquiring the option is $100, and the fair market value of the share at the time of exercising the option is $107.
The fair market value of the property delivered on settlement of the agreement is $107. If the amount paid for the property is the strike price of $105, the difference of $2 appears to be wholly attributable to the change in the fair market value of the property over the term of the agreement (an increase of $7). Accordingly the exception in subparagraph (b)(i) of the DFA definition in subsection 248(1) should apply, and the exercise of the option to purchase would not be a DFA.
However, if the amount paid for the property includes the option premium, the difference between the fair market value of the property delivered on settlement of the agreement and the amount paid for the property becomes -$1. On the basis of this interpretation, the difference between $108 (the amount paid for the property) and $107 (the fair market value of the property delivered on settlement of the agreement) should not be considered to be wholly attributable to the $7 increase in the fair market value of the property over the term of the agreement. Accordingly, the option would be considered to be a DFA in this case….
Exclusion for purchase options (p. 10:13)
In the case of a call option...the exception in subparagraph (b)(i)...should apply, provided that the difference between the fair market value of the property delivered on settlement and the amount paid for the property is wholly attributable to changes in the fair market value of the property over the term of the agreement. This reasoning applies where the change in the fair market value of teh property over the term of the agreemetn is equal to or greater than the difference beween the fair market vlaue of the proeprty delivered on settlement and the amount paid for the properyy.. .
Exchangeable securities – exclusion for embedded exchange rights? (pp. 10:15-16)
When dealing with exchangeable shares…the Department of Finance's view in the technical notes is that the taxpayer would retain sufficient economic exposure to the shares of the Canadian corporation such that the agreement to sell those shares would not be a DFA….
The reason for [this conclusion]…is not immediately evident. It is possible that the reason that exchangeable shares with an exchange right embedded in the share terms would not be a DFA is because the price for the shares of the Canadian corporation corresponds to the inherent value of those shares by virtue of the share terms. It is also possible, however, that the presence of the exchange right in the share terms does not constitute an agreement to sell capital property….
[B]ased on the Department of Finance's conclusions with respect to exchangeable shares and the policy regarding retention of economic exposure stated above, it is worth considering whether a right embedded in any security, regardless of that to which the right relates, would exclude the security from the DFA Rules in all cases….
Currency forwards as potential DFAs (pp. 10:h18-19)
[T]he calculation of the forward price under a currency forward agreement takes account of: (i) the spot exchange rate at the time the forward agreement is entered into, (ii) the interest rate in the base currency, (iii) the interest rate in the secondary currency and (iv) the term of the agreement. …
[A] taxpayer may choose to sell forward USD$100 in a year to hedge its exposure to the US dollar. Assume for these purposes that the one year forward rate results in the taxpayer receiving CAD$110 in one year in exchange for USD$100 to be paid on the one year maturity date and that, based on the current spot rate, USD$100 has a fair market value of CAD$105 at the time that the forward agreement is entered into. In this case, the sale price of the property is fixed at CAD$110 and the fair market value of the property at that time is CAD$105, resulting in a difference of CAD$5 for purposes of subparagraph (c)(i) of the definition of DFA…
[S]ince the sale price of CAD$110 is based on the forward rate (which is based in part on the interest rate differential described above), the difference between the sale price of the property and the fair market value of the property at the time the agreement is entered into (i.e., CAD$5) is attributable in part to a rate (i.e., an interest rate). This difference has been fixed at the time of entering into the agreement with the result that the exception in clause (c)(i)(A) is not available in this example. The exception in clause (c)(i)(B) is also not available in this example as the sale price of US dollars is denominated in Canadian dollars….
[A]n analysis should be completed of the transaction as a purchase agreement of that same taxpayer as well….Since the purchase price for the Canadian currency in this case is denominated in US dollars, it is possible that the exception in subparagraph (b)(ii) could apply. In any event, if the currency forward transaction would be a DFA under the analysis in paragraph (c), it is arguable that an exclusion under paragraph (b) would not be sufficient to conclude that the currency forward transaction would not be a DFA. …
[G]iven that the common law principles as to whether currency transactions should be on capital account are well-established, and the fact that the intent of a currency forward transaction does not fit within the description of the type of transaction being targeted by the DFA Rules, presumably the underlying intent of the DFA Rules is not for all currency forward agreements to be DFAs….
Similar U.S. constructive sale proposal (p. 10:26)
Even if one were to decide that 90 percent is generally an appropriate threshold in statutory provisions using a substantially all standard, in the case of risk of loss and opportunity for gain or profit in the SDA Rules one is left with the question: 90 percent of what? This issue was considered in the United States in commentary concerning an early version of the U.S. constructive sale rules, which were close cousins to the SDA Rules: [fn 47: The proposed constructive sale rule that was the subject of the cited commentary (Section 9512 of the Revenue Reconciliation Bill of 1996, which was not enacted in the form proposed) bore considerable similarity to the deemed disposition provision of the SDA Rules (subsection 80.6(1), read in conjunction with the SDA definition). The proposed U.S. rule would have deemed a taxpayer to have sold at fair market value an appreciated stock, debt instrument, or partnership interest when the taxpayer substantially eliminated both risk of loss and opportunity for gain for some period with respect to such appreciated security.]
- To illustrate the difficulty of measuring risk of loss and opportunity for gain, consider a taxpayer who owns a share of common stock that is currently trading at a price of $100. The maximum amount that a taxpayer could "lose" over any time period with respect to this share of stock is $100. Accordingly, one might initially conclude that if a taxpayer purchased a put option with an exercise price of, say, $90, the taxpayer has retained only 10% of the total risk of loss with respect to the share of stock. On closer examination, however, the analysis is significantly more complex, because the likelihood that the stock will trade between $100 and $90 is considerably greater than the likelihood that the stock price will drop close to zero during the term of the option. Accordingly, some element of probability should be taken into account in quantifying the risk of loss with respect to the stock.
The U.S. multi-factorial approach (p. 10:27-28)
[T]he multi-factorial approach (taking into account for example volatility, yield, and interest rates in respect of the property in question over the term of the arrangement) suggested by the Senate report, as well as a somewhat objective methodology like option pricing or other approaches involving mathematical financial models, should be considered in seeking to apply the substantially all test in the SDA Rules. Another such approach that has been considered in the United States as potentially helpful in addressing the above-mentioned challenge in the constructive sale rules is a so-called delta approach, which involves measuring the rate at which an offsetting position changes in value relative to an underlying asset. A perfectly hedged position under which the changes in value of the hedge are equal to the change in value of the underlying property would have a delta of 1.00….
[T]hese financial measures have been derived from the context of liquid public markets, where measurements of volatility of a security are meaningful. The SDA Rules, however, also apply to properties which are not publicly traded, where such approaches are inapplicable or unavailable….
Retroactive effect of one-year rule (p. 10:35)
Tax compliance conundrums can arise as a result of the fact that a taxpayer may not know at the time of entering into an SDA that the synthetic disposition period will turn out to be one year or more. For example, an executory contract of sale where the transaction takes far longer to close than anticipated could result in the taxpayer having to amend the return for the year in which the SDA was entered into in order to report a deemed disposition not then known to have occurred….
Example of interaction of SDA and DFA rules (pp. 10:35-36)
The interaction of the SDA Rules and DFA Rules may be illustrated by means of an example. [fn 69: The example is found in the technical notes, supra note 11, at 60-61.] A taxpayer who holds as capital property ABC Co shares with an adjusted cost base of $1 million and a fair market value of $10 million receives a five-year loan for $10 million from a purchaser (with interest of $2 million payable in five years). Under the arrangement, the taxpayer obtains a right to settle the loan (including accrued interest) in five years by transferring the ABC Co shares to the purchaser, and the purchaser obtains a right to acquire the shares from the taxpayer in five years for $12 million….The taxpayer would therefore be considered to have entered into an SDA…[and] there would be a deemed disposition for $10 million at the inception of the SDA, resulting in a $9 million capital gain,…
The difference between the $12 million sale price and the $10 million value when the "sale agreement" was entered into is attributable to something other than dividends on the ABC Co shares or changes in the value of such shares. Moreover, as noted above, the sale agreement is part of an arrangement that has the effect of eliminating a majority of the taxpayer's risk of loss and opportunity for gain or profit. Such a sale agreement is therefore a DFA, and, as a result, the $2 million difference between the $12 million proceeds of disposition and the $10 million value at the time the agreement was entered into would be included as ordinary income under subparagraph 12(1)(z.7)(ii)….
Legal form prevails for leases (p. 28)
[P]ursuant to paragraph 80.6(2)(c), subsection 80.6(1) will not apply if the SDA in question is a lease of tangible property or, for civil law purposes, corporeal property. According to the Technical Notes, the SDA Rules are not intended to displace the existing tax rules with respect to such leases. Apparently, and contrary to the general thrust of the synthetic disposition rules, this is an area of the law where legal form and not economic substance will continue to be determinative of tax consequences. [fn 66: See e.g. CRA, Income Tax Technical News no. 21… "…in the absence of sham…a lease is a lease and a sale is a sale."]
Example of over-one year SDA with disposition within one year (p. 10:38)
[W]here an "American-style" option (an option that can be exercised at any time during its term) is part of an SDA creating a synthetic disposition period of 400 days, but the option holder exercises the option after 180 days, at the outset this was an SDA with a period of more than one year such that subsection 80.6(1) would apply but for the exception in paragraph 80.6(2)(e). That exception would apply here because the property was disposed of as part of the arrangement or at least one component of the arrangement (the option).
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