REASONS
FOR JUDGMENT
Lafleur J.
A. overview.
[1]
This appeal concerns the determination of the
proper income tax treatment of various Cash Settlement Payments (as defined below)
made by the Appellant, Mr. James S.A. MacDonald, in partial and
final settlement of a Forward Contract (as defined below) under the Income
Tax Act, RSC, 1985, c. 1 (5th supp.), as amended (the “Act”), during the 2004, 2005 and 2006 taxation years. Mr. MacDonald
treated the Cash Settlement Payments made pursuant to the Forward Contract
totaling $9,956,837 as being on income account under subsection 9(1) of
the Act and claimed business losses in the aggregate amount of $9,936,149. The
Minister of National Revenue (the “Minister”)
reassessed Mr. MacDonald on the basis that these payments were made on
account of capital, and, therefore, resulted in capital losses. Also, as a
result of the reassessment for the 2005 taxation year, the Minister reassessed
Mr. MacDonald for the 2007 taxation year to delete a minimum tax
carryforward credit on the basis that such carryforward was no longer
available.
[2]
The Appellant contended that the Forward
Contract was an adventure or concern in the nature of trade, being a pure
speculation. The Forward Contract was a bet against the price of the Bank of
Nova Scotia (the “BNS”) common shares (the “BNS shares”).
Furthermore, the Forward Contract could only be cash settled and did not
involve the transfer of shares. Accordingly, any payment made under the Forward
Contract was on income account and the resulting losses were business losses.
It is only if the Forward Contract was considered a hedge of a capital asset
that the Cash Settlement Payments and the resulting losses could be converted
into a capital payment and capital losses for Mr. MacDonald. However, it
is clear that Mr. MacDonald’s intention in entering into the Forward
Contract was to profit in the short-term in the decline of the price of the BNS
shares and was not to hedge his BNS shares. Furthermore, there are no links as
to both timing and quantum between the Forward Contract and the BNS shares or
any other capital assets owned by Mr. MacDonald. Accordingly, the Cash
Settlement Payments were on income account and the resulting losses were
business losses to Mr. MacDonald.
[3]
The Respondent submitted that Mr. MacDonald
entered into the Forward Contract to hedge the BNS shares held by him since the
Forward Contract was sufficiently linked to the BNS shares, the Forward
Contract being a partial same asset hedge. As the BNS shares are capital assets
to Mr. MacDonald, the Cash Settlement Payments will also be considered as
being made on account of capital, resulting in capital losses to Mr. MacDonald,
within the meaning of sections 38, 39 and 40 of the Act. Furthermore, the
Respondent submitted that the Cash Settlement Payments were not deductible on
income account because they were capital expenditures within the meaning of
paragraph 18(1)(b) of the Act.
B.
the facts.
[4]
By the time this appeal reached trial, the
parties had come to an agreement on many of the relevant facts in a Partial
Statement of Agreed Facts, attached as Appendix A to these Reasons for Judgment.
[5]
Mr. MacDonald testified. He was a very
honest and straightforward witness. I found him to be a credible witness
and I do not doubt the truth of the facts he testified about.
[6]
Each party also called an expert witness: for
the Appellant, Mr. John Kurgan, a futures and commodities specialist
at RBC Dominion Securities and for the Respondent, Mr. Peter Klein,
Professor of Finance at the Beedie School of Business at Simon Fraser
University. Both witnesses were qualified as experts in the areas of financial
services, forward contracts, derivatives and hedging and their reports and
rebuttal reports were filed with the Court as expert reports.
[7]
Mr. MacDonald has over 40 years of
capital markets and corporate finance experience, starting at the brokerage
firm McLeod Young Weir (“MYW”) in 1969, and when MYW
was purchased by the BNS in 1988, he continued his career at Scotia McLeod Inc.
As a result of BNS acquisition of MYW in 1988, Mr. MacDonald acquired 183,333
common shares of BNS in exchange for shares that he held in MYW.
[8]
In 1994, Mr. MacDonald invested in VFC Inc.
(“VFC”), an automobile finance company that engaged in
non-prime automotive credit financing. He was VFC’s Chairman and owner of
963,004 shares of VFC. In 2003, VFC shares were publicly offered. In 2006, the
Toronto-Dominion Bank (“TD Bank”) acquired all the
shares of VFC and Mr. MacDonald received approximately $13 million
worth of common shares of TD Bank in exchange for his shares of VFC.
[9]
In March 1997, Mr. MacDonald left
Scotia McLeod Inc. and created Enterprise Capital Management Inc. (“ECM”), which managed funds for Canadian institutional
investors and high net worth individuals and which raised and invested funds in
a variety of companies.
[10]
In the late 1990s, Mr. MacDonald
anticipated, on the basis of his view of certain world financial events that
the BNS shares he held could decline in value in the short term, despite his
optimism about their long-term potential value. Such events included the 1997
Asian Debt Crisis, the collapse of the Thai Bhat, the October 1997
mini-crash of the New York Stock exchange, the Russian Debt Crisis in 1998 and
the 1998 collapse of the Long Term Capital Management hedge fund. Mr. MacDonald’s
negative short-term outlook stemmed from concerns he had about these adverse
developments in international markets; in addition, in his view, BNS was the
most internationally exposed to such events of all of the Canadian banks.
[11]
Mr. MacDonald approached TD Securities Inc.
(“TDSI”) to discuss a forward contract to speculate
against the trading price of the BNS shares. Mr. MacDonald entered into a forward
contract (the “Forward Contract”) with TDSI on the
trade date of June 26, 1997, the terms of which were set out in a
confirmation letter dated July 2, 1997, (the “Confirmation”),
with a forward date of June 26, 2002, (the “Forward
Date”). The Forward Contract could only be cash settled. There was no
entitlement to elect physical settlement (i.e. delivery of BNS shares) of the Forward
Contract. The cash settlement provision was very important to Mr. MacDonald
as he had no intention of selling the BNS shares. The Confirmation contained
optional early termination provisions pursuant to which Mr. MacDonald
could elect to terminate the Forward Contract prior to the Forward Date. The
Confirmation required a securities pledge agreement between Mr. MacDonald
and TDSI as credit support for purposes of the Forward Contract. However, no
copy of that agreement was produced at trial. Mr. MacDonald had testified
that he did not have a copy of said document.
[12]
Mr. MacDonald made cash settlement payments
under the Forward Contract as follows: $2,204,065 in his 2004 taxation year,
$5,855,329 in his 2005 taxation year and $1,897,442 in his 2006 taxation year
(the “Cash Settlement Payments”). The Cash
Settlement Payments were paid from Mr. MacDonald’s chequing account with
TD Bank.
[13]
Pursuant to the Confirmation:
(a) Mr. MacDonald agreed to pay TDSI the
amount by which the “Reference Price” (the official
closing price of the BNS shares on the Toronto Stock Exchange (“TSX”) on the Forward Date) exceeded the “Forward
Price” (as defined in the Forward Contract as being $68.46), multiplied
by the number of “Reference Shares”, being the number
of BNS shares subject to the Forward Contract (165,000 BNS shares); and
(b) TDSI agreed to pay Mr. MacDonald the amount
by which the Forward Price exceeded the Reference Price, multiplied by the
number of Reference Shares.
[14]
The Forward Contract was subsequently amended
and extended several times to either adjust the Forward Price (to reflect
changes to the quarterly dividend on the BNS shares) and the number of
Reference Shares (to reflect a split of the shares and a stock dividend), or to
extend the Forward Date and to substitute TDSI for TD Global Finance (In these
reasons for judgment, I will refer to TDSI and/or TD Global Finance as
TDSI). The Forward Contract was terminated on March 29, 2006.
[15]
On June 6, 1997, TD Bank offered a
credit facility to Mr. MacDonald which was accepted by the latter on July 7, 1997,
(the “Loan”). Mr. MacDonald also entered into
a securities pledge agreement with TD Bank (the “Securities
Pledge Agreement”), pursuant to which he pledged 165,000 BNS shares and
the Confirmation as collateral security for the Loan. Also, as collateral
security for the Loan, Mr. MacDonald pledged to TD Bank all amounts which
may become payable to him by TDSI pursuant to the Confirmation. The Loan made
available up to $10,477,480, subject to a maximum of 95% of the spot price of
the BNS shares multiplied by the number of BNS shares under the Securities
Pledge Agreement. The Securities Pledge Agreement also refers to an
Inter-Creditor Agreement between TD Bank and TDSI, as the pledged securities
(the BNS shares, the Confirmation and amounts payable by TDSI under the
Confirmation) would be pledged to both of TD Bank and TDSI.
[16]
Mr. MacDonald borrowed $4,899,000 under the
Loan in 1997, which proceeds were used for the purpose of investing in
Enterprise Capital Limited Partnership (part of the group of ECM) and other
various securities. The funds were borrowed before the taxation years under
reassessment in this appeal, and substantially all of the borrowed funds had
been repaid before the commencement of the relevant taxation years. On January 1, 2004,
the balance outstanding under the Loan was $554,485. Mr. MacDonald
testified that he considered the Loan terminated when it was fully repaid by
him on November 5, 2004.
[17]
Mr. MacDonald testified that he considered
the Loan to be ancillary to the Forward Contract — he viewed the Loan as a “by-product” of the Forward Contract. He claimed that he
entered into the Loan because it was offered to him on very favorable terms.
[18]
Mr. MacDonald also testified that he felt
that he was able to take advantage of a downturn in the market as well as of a
downturn in the price of the BNS shares and that his intention was to achieve a
profit on an anticipated decline in the value of the BNS shares based on “storm clouds” he saw on the investment horizon. He stated
that his intention was not to hedge and he was very clear on that point.
[19]
Mr. MacDonald explained during his
testimony that not realizing a gain on the Forward Contract in or around 1998
when the market was down was, in hindsight, a major error and that he
compounded the error by continuing to wait to settle under the Forward
Contract.
[20]
Mr. MacDonald explained that, during the
relevant period, he had the financial latitude to absorb the losses arising
under the Forward Contract. Mr. MacDonald testified that the aggregate
income reported on his T1 personal tax returns from 2002 through 2006 was
approximately $28.5 million, even after deducting any losses sustained under
the Forward Contract.
[21]
Mr. MacDonald testified that he did not
sell his BNS shares to offset the losses arising under the Forward Contract and
the BNS shares that he did sell during the relevant taxation years, were sold
by him for the purpose of rebalancing his investment portfolio. After the
acquisition of VFC by TD Bank, Mr. MacDonald acquired a significant
shareholding in TD Bank. In order to reduce his position in Canadian financial
institutions, Mr. MacDonald sold some of his BNS shares over time.
[22]
Notwithstanding the sale of some BNS shares over
the years, Mr. MacDonald testified that he maintained a positive long-term
outlook with respect to BNS. He explained at trial that, presently, the BNS
shares are his largest share investment, the “cornerstone”
of his investment portfolio, amounting to approximately 15 percent of his
total share portfolio. He has no intention of selling the BNS shares and
intended to keep them indefinitely.
C. the issue.
[23]
The issue in this appeal is whether the Cash
Settlement Payments made by Mr. MacDonald under the Forward Contract
during the 2004, 2005 and 2006 taxation years were on income account and
resulted in business losses for Mr. MacDonald or whether said payments
were on capital account and resulted in capital losses for Mr. MacDonald
under the Act.
D. the position of the parties.
1.
The Appellant’s Position.
[24]
The Appellant submitted that I should first
determine whether the Forward Contract was, in and of itself, an adventure or
concern in the nature of trade as a speculative instrument. If I conclude
that the Forward Contract was an adventure or concern in the nature of trade,
then I have to determine whether the Forward Contract was sufficiently linked
(both in terms of timing and quantum) with an underlying capital asset so as to
convert the payments on income account made by Mr. MacDonald under the
Forward Contract as payments on capital account, resulting in capital losses to
Mr. MacDonald. If I conclude that the Forward Contract was not an
adventure in the nature of trade, then, according to the Appellant, I should
dismiss the appeal.
[25]
According to the Appellant, the Forward Contract
was an adventure or concern in the nature of trade and the Cash Settlement
Payments were therefore fully deductible on income account for the purposes of
the Act, under subsection 9(1). The Forward Contract, by itself, cannot be
viewed as an income producing capital asset as it did not generate a current
yield. The Forward Contract did not involve an exchange, sale or delivery of
any BNS shares. Furthermore, the Forward Contract was a speculative instrument
and gave rise to profit or loss solely by virtue of fluctuations in the value
of the contract itself and more particularly, it could only give rise to gain
or loss by virtue of the fluctuations in the price of the Reference Shares
(that is the BNS shares) on its cash settlement. It is clear that the Forward
Contract was itself the sole source of income. At the time Mr. MacDonald
entered into the Forward Contract, it was uncertain whether the stock price of
the Reference Shares would exceed or be exceeded by the Forward Price on the
Forward Date. Mr. MacDonald’s sole purpose and intention in entering into
the Forward Contract was to speculate on, and profit from, an anticipated
decline in the trading price of the BNS shares.
[26]
In order to succeed in this appeal, the
Respondent must establish that the Forward Contract was a hedge against a
capital asset, such that the Forward Contract is treated as a capital asset,
with the result that any gains or losses resulting from its settlement will be
on capital account. In this appeal, the requirements pertaining to a hedge are
not made out as Mr. MacDonald had no intention to hedge when entering into
the Forward Contract and there was no linkage between the Forward Contract and
any capital assets owned by Mr. MacDonald, including the BNS shares, in
terms of both quantum and timing. According to the Appellant, the Forward
Contract did not hedge any capital asset and, therefore, the losses on income
account were not converted into losses on capital account.
2.
The Respondent’s Position.
[27]
The Respondent took issue with the approach
taken by the Appellant. According to the Respondent, as the Minister is taking
the view and had reassessed on the basis that the Cash Settlement Payments were
payments made on capital account since the Forward Contract was a hedge of the
BNS Shares (which are capital assets to Mr. MacDonald), then my analysis
should start with a discussion as to whether the Forward Contract was a hedge.
If I answer in the affirmative, then I will have to determine the
nature of the assets being hedged so as to qualify the Cash Settlement
Payments, whether as payments made on income or on capital account. If I conclude
in the negative, I will have to determine whether Mr. MacDonald was
engaged in a business, which, by definition, under subsection 248(1) of
the Act, includes an adventure or concern in the nature of trade. If I do conclude
that Mr. MacDonald was engaged in a business, the Cash Settlement Payments
will then be considered as payments made on income account resulting in
business losses for Mr. MacDonald.
[28]
According to the Respondent, the Forward
Contract was not an adventure or concern in the nature of trade; the Forward
Contract was “property” and “capital property” as defined under the Act.
[29]
According to the Respondent, Mr. MacDonald’s
primary intention in entering into the structured arrangement, including the
Forward Contract, was “to lock-in an economic gain on the
underlying BNS shares pledged and the Forward Contract, and to protect the
value of the BNS shares”. By entering into the Forward Contract, Mr. MacDonald
had locked-in a gain as if the BNS shares had been sold by fixing the price
(the Forward Price) and by virtue of the Loan, he had gained access to funds
similar to the amount that would have been obtained if the BNS shares had been
sold in the spot market instead.
[30]
Mr. MacDonald was exposed to no risk of
loss from the structured arrangement and was not a speculator on the Forward
Contract. According to the Respondent, Mr. MacDonald would have made a “multimillion-dollar profit” from his position under the
Forward Contract from August 1997 to May 2000 as the world financial
crisis grew and the BNS shares price fell; however, he did not act on it.
[31]
Furthermore, Mr. MacDonald’s secondary
intention was to benefit from the disparity flowing from the reporting of the
losses on the Forward Contract on account of income and the reporting of the
gains on the disposition of the BNS shares on account of capital.
[32]
The Respondent took the position that Mr. MacDonald
had hedged the BNS shares. The Forward Contract was a partial same asset hedge
for Mr. MacDonald’s long-term investment in the BNS shares, i.e. a forward
contract under which the underlying assets (or delivery assets) and the
Reference Shares were the BNS shares. Consequently, the linkage between the BNS
shares and the Forward Contract was clear. Since Mr. MacDonald reduced his
overall exposure to price fluctuations in the BNS shares and the number of BNS
shares comprising the delivery assets never exceeded the number of BNS shares
owned by Mr. MacDonald, Mr. MacDonald had hedged the BNS shares.
[33]
Furthermore, as the Forward Contract is a
partial same asset hedge, there was no need for the original purchase of the
BNS shares to be contemporaneous with the entering into of the Forward
Contract. The Respondent also pointed to linkages between the Forward Contract,
the Loan and the Securities Pledge Agreement, which I will review later in
these reasons for judgment.
E.
discussion.
1.
The Legal Framework.
[34]
Until 2013, the Act did not address directly the
taxation of financial derivative instruments. Therefore, basic tax principles
should apply as to the issue of whether payments made under a financial
derivative instrument are on income or capital account and the case law will provide
guidance as to how to apply the Act to that type of instrument.
[35]
As mentioned above, the parties took differing
approaches with respect to the appropriate legal framework that I should
use for my analysis in this appeal. For the reasons below, I am of the
view that the Appellant’s approach should be used as it is in accordance with
the structure of the Act. Therefore, I should first determine whether the
Forward Contract was, in and of itself, an adventure or concern in the nature
of trade for Mr. MacDonald, so as to be a source of income that is a “business”
under paragraph 3(a) of the Act. If I conclude that the
Forward Contract was, in and of itself, an adventure or concern in the nature
of trade for Mr. MacDonald, then the Cash Settlement Payments will be
considered payments from a source, namely the Forward Contract, which was a
business and will be on income account provided the Forward Contract was not a hedge of a capital asset, which later issue should be examined as a second step to my analysis. In my view, this approach is in accordance with the
principles for ascertaining profit under subsection 9(1)
of the Act developed by the Supreme Court of
Canada in Canderel Ltd v Canada, [1998] 1 SCR 147,
[1998] SCJ No 13 (QL) [Canderel], that “[i]n
seeking to ascertain profit, the goal is to obtain an accurate picture of the
taxpayer’s profit for the given year” (para. 53).
[36]
The basic rules for determining the income of a
taxpayer are found in section 3 of the Act, the relevant part of it reads
as follows:
|
3 Income for taxation year — The
income of a taxpayer for a taxation year for the purposes of this Part is the
taxpayer’s income for the year determined by the following rules:
(a) determine the total of all amounts each of which
is the taxpayer’s income for the year (other than a taxable capital gain from
the disposition of a property) from a source inside or outside Canada,
including, without restricting the generality of the foregoing, the
taxpayer’s income for the year from each office, employment, business and property,
(b) determine the amount, if any, by which
(i) the total of
(A) all of the taxpayer’s taxable capital gains for the year
from dispositions of property other than listed personal property, and
. . .
(ii) the amount, if any, by which the taxpayer’s allowable
capital losses for the year from dispositions of property other than listed
personal property exceed the taxpayer’s allowable business investment losses
for the year,
. . .
|
3 Revenu pour l’année d’imposition — Pour déterminer le revenu d’un contribuable pour une année
d’imposition, pour l’application de la présente partie, les calculs suivants
sont à effectuer :
a) le calcul du total des sommes
qui constituent chacune le revenu du contribuable pour l’année (autre qu’un
gain en capital imposable résultant de la disposition d’un bien) dont la
source se situe au Canada ou à l’étranger, y compris, sans que soit limitée
la portée générale de ce qui précède, le revenu tiré de chaque charge,
emploi, entreprise et bien;
b) le calcul de l’excédent
éventuel du montant visé au sous-alinéa (i) sur le montant visé au
sous-alinéa (ii) :
(i) le total des montants suivants :
(A) ses gains en capital imposables pour l’année tirés de la
disposition de biens, autres que des biens meubles déterminés,
[…]
(ii) l’excédent éventuel de ses pertes en capital déductibles
pour l’année, résultant de la disposition de biens autres que des biens
meubles déterminés sur les pertes déductibles au titre d’un placement
d’entreprise pour l’année, subies par le contribuable;
[…]
|
[37]
The Supreme Court of Canada explained in Friesen
v Canada, [1995] 3 SCR 103 at 111, [1995] 2 CTC 369, 1995 CanLII 62 [Friesen] that
section 3 of the Act:
. . . recognizes two basic categories of income:
“ordinary income” from office, employment, business and property, all of which
are included in s. 3(a), and income from a capital source, or
capital gains which are covered by s. 3(b). The whole structure of
the Income Tax Act reflects the basic distinction recognized in the
Canadian tax system between income and capital gain.
[38]
In accordance with paragraph 3(a) of
the Act, income derived from a source that is a business, including an
adventure or concern in the nature of trade, will be included in the income of
a taxpayer under the Act. Therefore, gains and losses from the settlement of a
forward contract will be considered on income account provided they are income
from a source that is a business, including an adventure or concern in the
nature of trade. On the other hand, gains and losses from the settlement of a forward
contract will be considered on capital account provided they are income from a
source that is a capital or capital property.
2.
The Forward Contract: an adventure or concern in
the nature of trade or capital property?
2.1 The Appellant’s position:
[39]
According to the Appellant, the Forward Contract
is the “quintessential adventure or concern in the nature of
trade” as it is highly speculative in nature, involves great risks, was
isolated and non-recurring and was not used by Mr. MacDonald to “lock-in” any gain on his BNS shares. The Forward Contract
could only be profitable if the trading price of the BNS shares upon settlement
was less than the Forward Price. When Mr. MacDonald entered into the
Forward Contract, it was uncertain whether he would be required to make
payments to TDSI or whether he would receive an amount from TDSI.
[40]
Furthermore, the Forward Contract cannot be
viewed as an income‑producing asset in the traditional sense, since it
does not, by itself, generate a current yield; it will give rise to gain or
loss by reference to the trading price of the BNS shares on the settlement
date. The Forward Contract cannot be considered “property”
or “capital property” because “it is a
tree that bears no fruit”. On maturity of the Forward Contract, there is
no exchange, sale or delivery of the BNS shares and there is no capital asset
separate from it that is being bought or sold. The Forward Contract is the sole
source of income for Mr. MacDonald.
The BNS shares, being the Reference Shares under the Forward Contract, are not
the source of income.
[41]
Given the nature of the cash-settled Forward
Contract and Mr. MacDonald’s stated intention at the time he entered into
the Forward Contract that he expected to profit from an anticipated fall in the
trading price of the BNS shares, the Forward Contract was “a
pure speculation” or an adventure or concern in the nature of trade.
2.2 The Respondent’s position:
[42]
According to the Respondent, a forward contract
is “property” within the meaning of subsection 248(1)
of the Act, a word so broadly defined that it includes a “right
of any kind whatever”, and is “capital property”
within the meaning of subsection 248(1) and section 54 of the Act.
The Respondent cited Friesen, supra, a case decided by the Supreme
Court of Canada (at para 42), for the proposition that there are only two
classes of property under the Act, inventory and capital property, and argued
that a derivative instrument can be either a capital property or inventory.
According to the Respondent, the Forward Contract at issue in this appeal is
capital property.
[43]
The Forward Contract is not an adventure or
concern in the nature of trade. The Respondent submitted that in order for
there to be an adventure in the nature of trade, there must be a scheme for
profit-making which does not include anticipated tax advantages, which was what
Mr. MacDonald was trying to obtain (Canada v Loewen (CA),
[1994] 3 FC 83 at 93,
[1994] 2 CTC 75 [Loewen]).
[44]
According to the Respondent, a series of facts
do not establish that Mr. MacDonald
had a scheme for profit-making; I will review these facts below.
[45]
Furthermore, the Respondent pointed to the
following factors that are relevant to determine whether a transaction is on
income or capital account: i) the nature of the property sold; ii) the length of the period of ownership; iii) the
frequency or number of similar transactions; iv) the work done to put the property into
marketable condition during the ownership period; v) the
circumstances responsible for the sale; vi) the motive at the time of acquisition and,
if there was a secondary intention at the time of purchase, to resell (Belcourt
Properties Inc v The Queen, 2014 TCC 208 at paras 30-31, 2014 DTC 1182).
2.3 Discussion.
[46]
For the following reasons, I am of the view
that the Forward Contract was, in and of itself, entered into by Mr. MacDonald
as an adventure or concern in the nature of trade as a speculative instrument.
[47]
A forward contract is a type of financial
derivative instrument. The Supreme Court of Canada in Placer Dome Canada Ltd
v Ontario (Minister of Finance), 2006 SCC 20, [2006] 1 SCR 715,
at para 30 [Placer Dome], generally describes a forward contract as
“a contract that obligates one party to buy, and another party
to sell, a specified amount of a particular asset at a specified price, on a
given date in the future”. The Supreme Court states that the obligation
under a forward contract is two-sided, that is both parties have an obligation
to perform. The Supreme Court also notes that, as commonly understood under
generally accepted accounting principles (“GAAP”),
financial derivatives are contracts whose value is based on the value of an
underlying asset, reference rate, or index (para 29).
[48]
Similarly, Dr. Klein generally described a
forward contract as an agreement between a seller and a buyer to exchange a
certain number of units of a “Delivery Asset” at a
future “Delivery Date” for a pre-agreed “Delivery Price”. He also explained that, in this case, it is
evident that Mr. MacDonald was the “seller” under
the Forward Contract notwithstanding the fact it is not certain until the date
of settlement which party will be required to transfer economic value. In other
words, until the spot price of the Reference Shares (i.e. the current market
price) on the date of settlement was known, it was unclear whether Mr. MacDonald
would pay TDSI or whether he would receive a payment from TDSI.
[49]
As mentioned above, the definition of the word “business” in subsection 248(1) of the Act includes an “adventure or concern in the nature of trade”. However, that phrase
is not defined in the Act and we must turn to the common law to ascertain its
meaning.
[50]
A “scheme for profit-making”
is the first requirement for an adventure or concern in the nature of trade and
must be present in the intention of the taxpayer. The courts have focused on
the intention of the taxpayer at the time of entering into the transaction.
[51]
In determining whether a transaction is an
adventure or concern in the nature of trade, the Exchequer Court of Canada in MNR
v James A Taylor, [1956] CTC 189, 56 DTC 1125
[Taylor], stated that all of the circumstances of the transaction must
be considered and that no single criterion can be formulated in reaching this
determination (Taylor, supra at 1139). In that case, the
Exchequer Court of Canada noted that the nature and quantity of the subject
matter was a relevant consideration as to whether a transaction is an adventure
in the nature of trade; in addition, the fact that a transaction is isolated or
unique is not a test as to whether it is an adventure in the nature of trade:
indeed, it may be, on the contrary, “a very important factor” (Taylor,
supra at 1137). The Exchequer Court cited with approval a statement
of Lord Carmont in Reinhold (Commissioners of Inland Revenue v
Reinhold, (1953) 34 TC 389) “that there are
cases “where the commodity itself stamps the transaction as a trading venture” (Taylor,
supra at 1139).
[52]
In Canada Safeway Limited v Canada, 2008 FCA 24,
2008 DTC 6074 [Canada Safeway], the Federal Court of Appeal
opined that although the courts have used various factors to determine whether
a transaction is an adventure in the nature of trade or a capital transaction, the
most determinative factor is the intention of the taxpayer at the time of
acquiring the property and if that intention reveals a scheme for
profit-making, then the transaction will be an adventure or concern in the
nature of trade (para 43). In assessing whether a scheme for profit-making
exists, the courts have to determine whether the taxpayer had “a
legitimate intention of gaining a profit from the transaction” (Friesen,
supra at para 16). However, if the taxpayer intended to hold the
property for the purpose of producing income or to be used in the production of
income, it will be considered a capital property (Canada Safeway, supra
at para 78).
[53]
The courts have consistently emphasized that
adventures in the nature of trade are speculative trading ventures and they
involve great risk (Continental Bank of Canada v Canada, [1998] 2 SCR 358,
98 DTC 6501; Aviva Canada Inc formerly CGU Group Canada Ltd v The
Queen, 2006 TCC 57, [2006] GSTC 8).
[54]
In Ethicon Sutures Ltd v The Queen, 85 DTC 5290
(FCTD), [1985] FCJ No 436 (QL) (FCTD), the Federal Court stated
that “where the transaction is a speculation made in the hope
of profit, it will be treated as an adventure in the nature of trade . . .”
(page 5293).
[55]
The Appellant referred this Court to the Canada
Revenue Agency (the “CRA”) Interpretation Bulletin IT-459
(September 8, 1980) (now archived) as support for the proposition
that all of the circumstances of a transaction must be considered when
determining whether it is an adventure or concern in the nature of trade. In
this document, the CRA reiterated the principal tests for determining whether a
transaction is an adventure or concern in the nature of trade, which are
derived from the case law:
i) whether the
taxpayer dealt with the property acquired by him in the same way as a dealer in
such property ordinarily would deal with it;
ii) whether the
nature and the quantity of the property excludes the possibility that its sale
was the realization of an investment or was otherwise of a capital nature, or
that it could have been disposed of other than in a transaction of a trading
nature; and
iii) whether
the taxpayer’s intention as established or deduced, is consistent with other
evidence pointing to a trading motivation.
[56]
Applying the doctrine propounded in Canada
Safeway, supra, to this case, the most important factor to consider
answering the question as to whether the Forward Contract was, in and of
itself, an adventure or concern in the nature of trade is the intention of Mr. MacDonald
at the time of entering into the Forward Contract.
[57]
Clearly, a forward contract can be used to hedge
or to speculate (Placer Dome, supra at para 29). Thus, the
type of derivative instrument used has no bearing on Mr. MacDonald’s
intention. Further, it cannot be inferred from the terms and conditions of the
Forward Contract, the Loan and the Securities Pledge Agreement that there was a
speculative intention, or not. In other words, these agreements do not state
that the purpose was to hedge or to speculate.
[58]
The Respondent argued that Mr. MacDonald’s
primary intention by entering into that structured arrangement, including the
Forward Contract, was to lock-in an economic gain on the BNS shares pledged and
the Forward Contract, and to protect the value of the BNS shares. He therefore was
exposed to no risk of loss from the structured arrangement. Furthermore, according
to the Respondent, Mr. MacDonald did not show a scheme for profit-making
and did not act as a dealer or trader would act. I do not agree with the
Respondent.
[59]
I am of the view that Mr. MacDonald’s
sole purpose and intention in entering into the Forward Contract was to
speculate on and profit from, an anticipated decline in the trading price of
the BNS shares; his testimony was credible and reliable, and he was himself a
very credible witness. In addition, I am not satisfied that there was a
change of intention over the years, even where Mr. MacDonald stated that
he continued holding the Forward Contract because he wanted to cut his losses,
since a change of intention must be clear and unequivocal (Edmund Peachey
Ltd v The Queen, 79 DTC 5064 at 5067 (FCA), [1979] FCJ No 2
(QL) (FCA)).
[60]
In order for there to be an adventure in the
nature of trade, there must be a scheme for profit-making and I am of the
view that a scheme for profit-making was present in this case. The facts showed
that Mr. MacDonald had a legitimate intention of gaining a profit from the
Forward Contract. When he entered into the Forward Contract, it was uncertain
as to whether he would be required to make a payment to TDSI or whether he
would receive an amount from TDSI. The Forward Contract afforded Mr. MacDonald
an opportunity to speculate on the outcome that the price of the BNS Shares
would drop in the short term and that he could profit from that anticipated
drop. His testimony was uncontradicted and the surrounding facts supported his
testimony.
[61]
I agree with the following arguments raised
by the Appellant. Mr. MacDonald entered into a Forward Contract that could
only be cash settled. Hence, the Forward Contract did not involve an exchange,
sale or delivery of any BNS shares. The Forward Contract was pure speculation
since Mr. MacDonald had to deal with the Forward Contract to get income
from it, i.e. he had to terminate it or partially terminate it to get
any income; the Forward Contract did not, by itself, yield income. The Forward
contract could only be profitable if the trading price of the BNS shares at the
maturity date was lower than the Forward Price and only if Mr. MacDonald
dealt with the Forward Contract, i.e. if he terminated it or partially
terminated it. Furthermore, the Forward Contract itself stamps the transaction
as a trading venture as it was highly speculative in nature, it involved great
potential for risk and reward, it was isolated and non-recurring, and was not
used to lock-in any gain in the BNS Shares. As to whether Mr. MacDonald
would receive or be required to make payments under the Forward Contract was
entirely dependent upon the future movement in the market price of the BNS
Shares on the TSX.
[62]
Although there were cross-references between the
various agreements (the Forward Contract, the Loan, the Security Pledge
Agreement), the evidence showed that Mr. MacDonald did not consider the
Loan as being part of the Forward Contract. He considered the Loan to be a
by-product of the Forward Contract, and testified that since the terms and
conditions were so advantageous, he accepted the credit offered by TD Bank. The
evidence showed that Mr. MacDonald treated the Loan and the Forward
Contract as two separate instruments. Only a small percentage of the loan
credit offered was borrowed by Mr. MacDonald. In addition, in November 2004,
the Loan was repaid in totality; but the Forward Contract remained in place.
The fact that Mr. MacDonald invested the amount borrowed in ECM and other
publicly listed securities is not relevant with respect to that determination.
[63]
What I have to examine is the intention of
Mr. MacDonald at the time of entering into the Forward Contract as
confirmed by the execution of the Confirmation. The Confirmation was executed
on July 2, 1997; the Forward Contract has a trade date of June 26, 1997.
I am of the view that, on balance, the evidence showed that Mr. MacDonald’s
intention at the time of entering into the Forward Contract was to gain a
profit by speculating that the market price of the BNS shares would drop in
value because of the storm clouds he foresaw coming in the financial markets
and which he referred to in his testimony: the 1997 Asian Debt Crisis, the
collapse of the Thai Bhat, the October 1997 mini-crash of the New York
Stock Exchange, the Russian Debt Crisis in 1998 and the 1998 collapse of the
Long Term Capital Management hedge fund. In his own words, Mr. MacDonald’s
intention “was to achieve a profit on an anticipated decline
in the value of Bank of Nova Scotia shares based on the storm clouds that [he]
saw in the investment horizon”. It is clear from Mr. MacDonald’s
testimony that his intention was to speculate — he wanted to profit from a
potential decline in the value of the BNS shares in the light of the state of
the financial market around the time he entered into the Forward Contract.
[64]
An important factor supporting my conclusion as
to the intention of Mr. MacDonald is that when Mr. MacDonald entered
into the Forward Contract, he did not know whether he would be making a payment
to TDSI or whether he would receive a payment from TDSI. According to Mr. MacDonald’s
testimony, which I found credible and reliable, his unfavourable short
term outlook stemmed from concerns he had about these adverse developments in the
international markets and because, in his view, BNS, of all of the Canadian
banks was the most internationally exposed to such events. His belief was based
on the vast experience he had gained during the numerous years he had worked in
the financial market and the critical information he had of BNS specifically.
Mr. MacDonald’s testimony was clear as to what his intention was in
entering into the Forward Contract. As a very well-informed person in the world
of finance, he saw storm clouds on the horizon. Also, because he worked at a
very high level position at the BNS for many years, he was able to reasonably
conclude that the BNS was the most exposed of the Canadian banks to the foreign
market turbulence.
[65]
The Respondent argued that Mr. MacDonald’s
self-serving statements alone cannot be determinative of his intention. However,
I am not guided solely by Mr. MacDonald’s statements (i.e. by his
subjective intention) and I must look for objective manifestations of
purpose, which is a question of fact to be decided from all of the
circumstances (Symes v Canada, [1993] 4 SCR 695 (at 736),
[1994] 1 CTC 40; Swirsky v Canada, 2014 FCA 36,
2014 DTC 5037 at para 8). As mentioned in the previous
paragraph, the facts and surrounding circumstances showed that the testimony of
Mr. MacDonald was credible and reliable.
[66]
Another very important fact to take into account
in this particular case is that Mr. MacDonald did not intend to ever sell
his BNS shares and he wanted to hold on to them for the very long term. The
facts also supported his testimony in that respect as Mr. MacDonald only
sold only a small number of BNS shares throughout the years to rebalance his
portfolio. In 2003 and 2004, he did not sell any BNS shares (he donated 400 BNS
shares in 2004). In 2005, as VFC was becoming quite successful, Mr. MacDonald
sold 273,000 BNS shares, representing 37% of his shareholding. The reason given
by Mr. MacDonald for selling the BNS shares was credible: as he was one of
the founders of VFC, it would not look good if he were to sell VFC shares.
Also, in 2006, Mr. MacDonald acquired TD Bank shares in exchange for his
shares of VFC and decided to sell some BNS shares and TD Bank shares to
rebalance his portfolio. In 2006, Mr. MacDonald sold 10,000 BNS shares,
representing only 2.2% of his shareholding. Mr. MacDonald’s testimony was
very clear: the BNS shares are the cornerstone of his investment portfolio,
representing approximately 15% of the value of his portfolio at the date of the
hearing. Accordingly, it is clear that Mr. MacDonald took an important
financial risk by entering into the Forward Contract. If the market price of
the BNS shares went up, he would have had to make a payment to TDSI. As he did
not want to sell the BNS shares and he did not, in fact, sell any BNS shares
when he made payments under the Forward Contract, it is evident that making
payments under the Forward Contract without selling any corresponding BNS
shares put Mr. MacDonald in a disadvantageous financial position.
Therefore, one cannot conclude that he had locked-in a gain by entering into
the Forward Contract. Furthermore, keeping in mind the important fact that Mr. MacDonald
testified that he wanted to keep the BNS shares for the very long term,
I do not see why Mr. MacDonald would have entered into the Forward
Contract with the intent of making a payment to TDSI, which would be to lose
money.
[67]
The Respondent emphasized in her submissions
that, at all times, the number of BNS shares owned by Mr. MacDonald was in
excess of the number of shares subject to the Forward Contract. According to
Dr. Klein’s testimony, in order to speculate, that is to increase one’s
exposure to risk, the number of shares under the contract must be greater than
the number of shares owned. Further, Dr. Klein concluded that there would
still be a hedge in respect of the number of shares owned. The Respondent invoked
Lamarre ACJ’s comments in George Weston Limited v The Queen, 2015 TCC 42,
[2015] 4 CTC 2010 [George Weston]: in order for a
transaction to be speculative, a derivative transaction must have a notional
value in excess of actual risk exposure (para 68). Also, in Placer Dome,
supra, the Supreme Court of Canada stated that for a transaction to be
speculative, the taxpayer must be exposed to something over and above its
actual exposure (para 29).
[68]
I do not agree with the Respondent’s
proposition. If the Respondent’s position is correct, then it will be
impossible to ever speculate using a derivative instrument while maintaining a
long position in an asset. As I have concluded above, Mr. MacDonald was
exposed to no risk by holding the BNS shares since he did not want to sell them
for the very long term. Accordingly, by entering into the Forward Contract, I am
of the view that he increased his risk, as he did not know if he would have to
make a payment to TDSI or whether he would receive a payment from TDSI.
[69]
My conclusion is reinforced by the cash
settlement feature of the Forward Contract which, as expressed by Mr. Kurgan,
is more likely to be used by a speculator. As mentioned above, Mr. MacDonald
cannot settle the Forward Contract by transferring any BNS shares; the only
method of settlement is by way of cash transfer. The sole source of income for
Mr. MacDonald is the Forward Contract. However, Dr. Klein was of the
opinion that the cash settlement feature of the Forward Contract was not
determinative of a hedge or speculation as they are economically equivalent. At
the hearing, Dr. Klein testified as to the economic equivalence between
cash settled and a physically settled forward contract. I agree with him
that he had made that demonstration. However, in tax cases, form matters and my
goal is not to determine the economic equivalence between two different
transactions but the tax consequences arising from a specific transaction and,
to that end, I must try to obtain an accurate picture of the income of a
taxpayer. I am of the view that the present case corresponds to the first
caveat referred to by the Supreme Court of Canada in Shell Canada Ltd v
Canada, [1999] 3 SCR 622, [1999] SCJ No 30 at
paras 39 and 45 [Shell]:
39 This Court has repeatedly held that courts must be
sensitive to the economic realities of a particular transaction, rather than
being bound to what first appears to be its legal form: Bronfman Trust, supra,
at pp. 52-53, per Dickson C.J.; Tennant, supra,
at para. 26, per Iacobucci J. But there are at least two caveats
to this rule. First, this Court has never held that the economic realities
of a situation can be used to recharacterize a taxpayer’s bona fide
legal relationships. To the contrary, we have held that, absent a specific
provision of the Act to the contrary or a finding that they are a sham, the
taxpayer’s legal relationships must be respected in tax cases. Recharacterization
is only permissible if the label attached by the taxpayer to the particular
transaction does not properly reflect its actual legal effect: Continental
Bank Leasing Corp. v. Canada, [1998] 2 S.C.R. 298, at para. 21,
per Bastarache J.
. . .
45 . . . Unless the Act provides otherwise,
a taxpayer is entitled to be taxed based on what it actually did, not based on
what it could have done, and certainly not based on what a less sophisticated
taxpayer might have done.
[Emphasis
added.]
[70]
Nevertheless, I am also cognizant of the
comments of the Supreme Court of Canada in Placer Dome, supra, “that, at least for the purposes of GAAP, the way in which a
derivative contract functions as a “hedge” is unaffected by the method by which
the contract is settled” (para 31). However, as also stated by the
Supreme Court in Canderel, supra, GAAP is not determinative of
tax treatment (para 36 and following).
[71]
The Respondent also argued that as the Forward
Contract was subject to an early termination provision that allowed Mr. MacDonald
to partially or wholly terminate the Forward Contract prior to the Forward
Date, Mr. MacDonald should have acted on it when the price of the BNS
shares fell in 1998 and throughout the mid-2000 and he would have made profits
in the multi-million figures. The Respondent argued that Mr. MacDonald did
not act like a dealer or speculator. Indeed, Mr. MacDonald admitted in
testimony that in 1998, he could have entirely terminated the Forward Contract
and could have made a substantial profit given the market price of the BNS
shares at that time. It does raise the question as to why Mr. MacDonald,
when faced with an opportunity to profit, did not even partially terminated the
Forward Contract during this period if his intention was to speculate using the
Forward Contract. But Mr. MacDonald gave a reasonable explanation: he
admitted that he made a mistake in not taking the profit.
[72]
It is not evident from the evidence if there
were other circumstances where Mr. MacDonald could have profited under the
Forward Contract. Aside from Mr. MacDonald’s admission regarding 1998, according
to the evidence available, there is only one period of time (between July 2, 1997,
and November 28, 1997, on the assumption the Forward Price under the
Forward Contract was not amended to be less than $67.854 in this period) where
the Reference Price was less than the Forward Price (in which case, TDSI would
be required to make a payment to Mr. MacDonald upon settlement). No
amended Confirmations are found in the evidence from between
November 28, 1997, and March 22, 2002; thus, I do not
have information about the Forward Price during this period. After
March 22, 2002, it appears that the Reference Prices were higher than
the Forward Prices as set out in the amended Confirmations (in which case, Mr. MacDonald
would be required to make a payment to TDSI upon settlement). While it appears
that Mr. MacDonald may have been “passive”
compared to a dealer or trader, I am of the view that this is not
sufficient to conclude that Mr. MacDonald was not acting as a dealer or
trader in respect of the Forward Contract. Furthermore, to ascertain in hindsight
the intention of Mr. MacDonald at a specific time is, in my view, to be
done with extreme caution. In hindsight, it is easy to say that, as the price
of the BNS shares went down in 1998 up to the mid-2000, Mr. MacDonald
should have settled the Forward Contract and would have made multi-million
dollars from the arrangement. As mentioned above, storm clouds existed back in
1997. Furthermore, as Mr. Kurgan testified, a bear market had started in
the mid-2000 and growing anxiety existed on the financial markets; the attack
on the twin towers in New York City on September 11, 2001, also generated
a lot of anxiety in the financial market.
[73]
The Respondent further stated that Mr. MacDonald
had no ability to make any profit or speculate under the Forward Contract as he
had pledged all payments to be made by TDSI under the Forward Contract as
collateral under the Loan and had assigned all of his rights under the Forward
Contract to TD Bank. Furthermore, Mr. MacDonald had also pledged the BNS
shares. I do not see the relevancy of these arguments. The fact that
collaterals are taken by banks is not relevant for determining whether a person
is engaged in an adventure or concern in the nature of trade. A creditor will
often require collaterals as a guarantee under a contract; this has no bearing
on the question of whether the debtor is engaged in an adventure or concern in
the nature of trade. More particularly, the fact that Mr. MacDonald had
pledged all payments to be made by TDSI under the Forward Contract and the BNS
shares as collateral under the Loan and had assigned all of his rights under
the Forward Contract to TD Bank is not relevant for determining whether Mr. MacDonald
was engaged in an adventure or concern in the nature of trade. The determinant
for whether Mr. MacDonald would receive a payment under the Forward
Contract was whether the Forward Price exceeded the Reference Price. It was not
necessary for Mr. MacDonald to sell or deal in his BNS shares in order to
profit using the Forward Contract. Further, while the amounts payable to Mr. MacDonald
by TDSI, if any, were pledged to TD Bank under the Securities Pledge Agreement,
Mr. MacDonald would still be entitled to such amounts (provided he did not
default under the agreements). I would also add that the fact that the BNS
shares were pledged was irrelevant for Mr. MacDonald as he had the
intention to keep the BNS shares for the long term and the evidence showed that
he effectively did.
[74]
The Respondent added that Mr. MacDonald had
no ability to deal with the Forward Contract while TD Bank’s commitment to lend
existed since the Loan required that he maintains the Forward Contract.
However, Mr. MacDonald testified that he considered the Loan to be a
by-product of the Forward Contract; a commitment to lend was offered to him by
TD Bank on very favorable terms and that is why Mr. MacDonald executed the
Loan. Furthermore, the evidence showed that he did not borrow the whole amount
offered to him under the Loan; he borrowed $4,899,000 out of $10,477,480, so
approximately 47% of the credit offered by TD Bank. He used part of these
loaned funds to invest in ECM and also purchased more publicly listed
securities. Since Mr. MacDonald is financially affluent, I am of the
view that if he had wanted to deal with the Forward Contract, he would have had
the means to repay the amount owed under the Loan and terminate the Forward
Contract at his convenience.
[75]
The Respondent noted that the first repayment on
the Loan (February 2003) was closely followed by the first Cash Settlement
Payment (June 2003) and part of the BNS shares that were pledged were
released back to Mr. MacDonald, thereby demonstrating that Mr. MacDonald
could not have traded. In my view, the Respondent errs in examining the BNS
shares and not the Forward Contract. Mr. MacDonald had stated that he did
not wish to sell the BNS shares; the question is whether he acted as a dealer
or trader in respect of the Forward Contract and not in respect of the BNS
shares. The question is not whether he had speculated with the BNS shares but
whether he had speculated when he entered into the Forward Contract. The same
could be said about the Respondent’s argument that if Mr. MacDonald was a
dealer or trader, he would have reported all transactions in securities on
income account. The question here is whether the Forward Contract was an
adventure or concern in the nature of trade; hence, I have to determine if
Mr. MacDonald was acting as a dealer or trader in respect of the Forward
Contract. I do not see the relevancy of how he dealt with publicly listed
securities to the question of whether Mr. MacDonald was engaged in an
adventure or concern in the nature of trade in respect of the Forward Contract.
[76]
Furthermore, according to the Respondent, there
is no evidence of an overall profit-making scheme or an opportunity for profit
by immediate realization as Mr. MacDonald entered into a single Forward
Contract, for 9 years, which was amended several times. In contrast, a
dealer or trader would have had multiple contracts. I am of the view that
this argument cannot be sustained as the Exchequer Court in Taylor, supra,
had concluded that the fact that a transaction is isolated or unique is not a
test as to whether it is an adventure or concern in the nature of trade (Taylor,
supra at para 48).
[77]
The Respondent assumed that Mr. MacDonald
had a secondary intention to obtain a tax benefit which cannot be considered as
a scheme for profit-making and referred to Loewen, supra, in
support of this argument, where the Federal Court of Appeal stated: “I do not think it can properly be said that a transaction
whose sole purpose is to reduce the tax otherwise payable by a taxpayer is, for
that reason alone, an adventure in the nature of trade” (page 95).
[78]
In Loewen, supra, the Federal
Court of Appeal clearly stated that the reduction of taxes cannot be the sole
factor to consider in the determination of whether an operation is an adventure
or concern in the nature of trade, and other factors must be present. In Mr. MacDonald’s
case, I am of the view that reducing the taxes otherwise payable was not
one of the purposes of his entering into the Forward Contract. Mr. MacDonald’s
testimony was clear: he did not want to ever sell the BNS shares and wanted to
hold to them for the very long term. The facts showed that that was, and
continued to be, his intention. Therefore, there could be no mismatch reporting
— namely business losses on the Forward Contract and capital gains on the sale
of the BNS shares as argued by the Respondent.
[79]
Finally, with respect to past practices, Mr. MacDonald
testified that, prior to 1997, he had not entered into a forward contract in
respect of a publicly traded security. He testified that he was in the practice
of writing call options against securities that he owned and these were
reported as income because he regarded them as speculative and he “thought it was best to have a consistent approach to both the
options and the forward contract”. The Respondent pointed out that
Mr. MacDonald treated some of the options as being on capital account. She
submitted that from 2003, Mr. MacDonald altered his reporting status for
BNS options trades and treated the options as being on account of income.
Mr. MacDonald testified that a “very minor number”
were “inadvertently” treated as capital. Therefore,
despite Mr. MacDonald’s practice of reporting other derivatives on account
of income, there does appear to be some inconsistency in respect of his
treatment of the call options. However, in this appeal, my concern is with the
Forward Contract and not the call options. Consequently, his inconsistency in
the treatment of the call options has no bearing as to whether or not the
Forward Contract was an adventure or concern in the nature of trade.
3.
Hedging.
[80]
The second step of my analysis consists in
determining whether Mr. MacDonald had hedged a capital asset when he
entered into the Forward Contract, and, in the affirmative, what is the capital
asset being hedged, so as to convert the Cash Settlement Payments from a
payment made on income account to a payment made on capital account. It is
clear from the evidence adduced at trial and the submissions of the parties
that the BNS shares held by Mr. MacDonald are the capital assets to be
considered in making that determination. For the following reasons, I am of the
view that Mr. MacDonald did not hedge the BNS shares: Mr. MacDonald did not
have a clear intention to hedge when he entered into the Forward Contract and
the facts of this case did not show a link both in terms of quantum and timing
between the Forward Contract and the ownership of the BNS shares or any
transaction in respect of the BNS shares. Furthermore, no other links had been
found.
3.1 Definition of a hedge.
[81]
There is no definition of a hedge in the Act. In
the Canadian Dictionary of Finance and Investment Terms, the word hedge is
defined as a strategy used to offset investment risk, where a “perfect
hedge is one eliminating the possibility of future gain or loss” (Jerry
White et al, Canadian Dictionary of Finance and Investment Terms, 2nd ed
(Hauppauge, NY: Barron’s, 2000) (Canadian Dictionary of Finance). The Black’s
Law Dictionary (10th edition, 2014) defines a hedge as follows:
To use two compensating or offsetting transactions to ensure
a position of breaking even; esp., to make advance arrangements to safeguard
oneself from loss on an investment, speculation, or bet, as when a buyer of
commodities insures against unfavorable price changes by buying in advance at a
fixed rate for later delivery.
[Emphasis
added.]
[82]
In his expert report, Mr. Kurgan described
a hedge as “simultaneously using one investment to offset the
risk of any adverse price movement in another investment”. Mr. Klein,
in his report, explained that a hedger seeks “to reduce or
eliminate their exposure to a source of risk to which they are already exposed”
and was in disagreement with the use of the term “adverse”
used by Mr. Kurgan, since a hedge offsets all price changes in the asset
being hedged.
[83]
According to Mr. Kurgan, linkage both in
quantum and time, is essential for a hedge. More particularly, an asset will
not be hedged unless there is a hedging instrument at the relevant time and the
amount of the hedge is directly linked to the amount of the underlying asset.
[84]
However, Dr. Klein did not agree that
hedging can properly be restricted in that way as there is no requirement for a
hedge to be in place for the entire amount of the asset being hedged as partial
hedges are common in the industry. Furthermore, according to Dr. Klein,
there is no need for the hedge to be terminated at the same time as the asset
being hedged is sold. The linkage both in quantum and time is not needed
provided that there is a sufficient linkage in other ways between the hedge and
the asset being hedged.
[85]
From the commercial definition of that word as
well as the experts’ testimony, I am of the view that an essential
component of a hedge is that the strategy used to hedge must result in an
offset of investment risk.
[86]
Furthermore, the case law referred to below holds
that the central indicia of a hedge are: (i) an intention to eliminate
risk (i.e. to hedge), and (ii) a hedging instrument that is directly
linked (or symmetrical) to the underlying asset that is the subject of the
hedge in terms of both quantum and timing (the “linkage
principle”) (Reference re: Grain Futures Taxation Act (Manitoba),
[1925] JCJ No 4 (QL), [1925] 2 WWR 60). Also, I am
of the view that a hedge requires both a clear intention to hedge as well as a close
linkage between the purported hedging instrument and the underlying asset or
transaction. The link in quantum and timing is very important because it locks in
either a gain or a price.
[87]
The Appellant cited Echo Bay Mines Ltd v
Canada (TD), [1992] 3 FC 707, 92 DTC 6437 [Echo
Bay], Placer Dome, supra, and Salada Foods Ltd v The Queen,
[1974] CTC 201 (FCTD), 74 DTC 6171 (FCTD) [Salada Foods],
as authorities that confirmed the requirement of an extremely close link
between the purported hedge and the underlying asset or transaction in order to
support a finding of a hedge for income tax purposes.
[88]
More specifically, in Echo Bay, supra,
the Federal Court of Appeal concluded that there was a sufficient
inter-connection and integration with the taxpayer’s business, i.e. the
production of silver, such that the gain from the closing out of the forward
sales contract was considered income from that business. In reaching its
conclusion, the court noted that finding a hedge “depends upon
assessment at the time forward sales contracts are concluded of capacity and
intention to produce product committed under those contracts . . .”
[1992] 3 FC 707 at 716).
[89]
In Placer Dome, supra, although
the Court was concerned with the definition of “hedging”
in the Ontario Mining Tax Act and further, the case did not bear on
income versus capital gain, the Supreme Court of Canada gave some helpful
comments about hedging, as commonly understood, as referring to transactions
that offset financial risk. In addition, the Supreme Court reviewed the meaning
of hedging as it is commonly understood under GAAP:
29 . . . As Professors Grottenthaler and
Henderson explain, there are essentially two reasons for entering into such a
contract — to speculate on the movement of the underlying asset, reference rate
or index, or to hedge exposure to a particular financial risk such as the risk
posed by volatility in the prices of commodities: see M.E. Grottenthaler and
P.J. Henderson, The Law of Financial Derivatives in Canada (loose-leaf),
at p. 1-8. This distinction between speculation and hedging is an
important one. A transaction is a hedge where the party to it genuinely has
assets or liabilities exposed to market fluctuations, while speculation is “the
degree to which a hedger engages in derivatives transactions with a notional
value in excess of its actual risk exposure”: see B.W. Kraus, “The Use and
Regulation of Derivative Financial Products in Canada” (1999), 9 W.R.L.S.I.
31, at p. 38. . . .
[Emphasis
added.]
The Supreme Court also concluded that the general principles
articulated in the Echo Bay, supra, had some relevance in the
situation under review and adopted a strict approach to the linkage principle:
35 Although I am mindful that Echo Bay Mines
concerned a different statute, one in which “hedging” is not a defined term, I conclude
that the general principles articulated in that case have some relevance here.
The central issue in Echo Bay Mines was whether gains and losses from
hedging were sufficiently linked to the underlying transaction, namely
the production and sale of silver, to constitute “resource profits” within the
meaning of the Regulations under the Income Tax Act. . . .
[Emphasis
added.]
[90]
In Salada Foods, supra, the
Federal Court upheld the Minister’s assessment that the profit from the
transaction was income from an adventure in the nature of trade. In that case,
the taxpayer, which owned a number of subsidiaries in the United Kingdom, had
anticipated a decline in the value of the pound sterling against the Canadian dollar.
The taxpayer sold forward a certain amount of pound sterling for delivery the
next year. The pound sterling did decline in value and the taxpayer closed out
its short position in the pound sterling realizing a substantial profit. The
taxpayer argued the profit was a capital gain on the basis that the transaction
was a hedge to protect its investments in the UK subsidiaries but the profit
was assessed as income from an adventure in the nature of trade. The Federal Court
upheld the Minister’s assessment by noting that the amount of pound sterling
sold forward bore no relationship and there was no link to the value of the UK
subsidiaries. The Federal Court concluded that the transaction was an adventure
in the nature of trade as it was carried out as a purely speculative
transaction with the intention and hope of profit:
In arranging the forward sale contract
the Plaintiff acted in exactly the same fashion as a dealer or speculator in
currencies would act. There was never any intention on the part of Salada that
the transaction be in any way an investment in its normal sense and, in fact,
it was acknowledged by the Plaintiff to be wholly speculative. The whole
success of the enterprise depended on purchasing the £500,000 at a lower price
than that at which it had contracted to deliver them six months before and the
necessity for so doing in turn arose, not because the Plaintiff knew the pound
was to be devaluated, but because it speculated that it would. It was not
investing idle capital funds nor was it disposing of a capital asset. What was
done was done because Salada was confronted with an abnormal situation from which
it hoped to gain an advantage, not matter what the motivating factor was for
desiring such an advantage. (pp.206-207)
[91]
Furthermore, the Appellant stated that, to his
knowledge, there are no Canadian tax cases whereby a hedge was imposed where
the taxpayer did not expressly have the stated intention to implement a hedge.
The Appellant referred to Saskferco Products ULC v Canada, 2008 FCA 297,
[2009] 1 CTC 302 [Saskferco], as authority for the
proposition that, in the absence of a direct linkage, a mere intention to hedge
on the part of the taxpayer is insufficient to find a hedge for income tax
purposes. In Saskferco, supra, the taxpayer argued that the
borrowing operation in US dollars was a natural hedge of its dollar-based
revenues. The Federal Court of Appeal, upholding this Court’s decision, held
that the primary purpose of the borrowing operation was to finance the
construction of a capital asset, notwithstanding the fact that it may have been
intended to hedge the foreign currency, and concluded that there was no
correlation between the loan and the asset said to be hedged, namely the US
dollar sales revenue, and therefore, there was no hedge for income tax
purposes.
[92]
Both parties also referred to George Weston,
supra, in support of their respective positions.
[93]
In George Weston, supra, George
Weston Ltd. (“GWL”) treated payments received in
respect of the termination of cross-currency basis swap contracts on account of
capital, and reported a capital gain. The Minister reassessed GWL on the
grounds that the receipts were on account of income. GWL was a Canadian
publicly traded corporation that held direct and indirect subsidiaries in
Canada and the United States. In 2001, GWL acquired a predominantly U.S.‑based
bakery business, Bestfoods Baking. The acquisition increased the corporate
group’s net investments in USD operations and was financed entirely by debt.
GWL argued that it entered into the swap to preserve its consolidated balance
sheet equity and to protect against foreign exchange fluctuations. The
respondent’s theory was that the receipts on closing out the derivative could
be treated as being on account of capital for income tax purposes only if it
could be established that the derivative transaction was linked to an
underlying transaction — such as the purchase or sale of a capital asset, the
repayment of a debt denominated in a foreign currency, or the investment of
idle capital funds. The respondent was of the view that it is not sufficient to
hedge the net investment through a hedge if the taxpayer has no intention to
sell the investment since there would be no offsetting position against which
the gains or losses arising from the contract could be matched.
[94]
Associate Chief Justice Lamarre noted that
the Supreme Court in Shell, supra, did not say that the gain or
loss on a derivative must necessarily be linked to a gain or loss on another
transaction and she opined that there is no legal basis to deny capital
treatment to proceeds earned from a hedging contract if there is no sale or
proposed sale of the underlying item being hedged. In finding that the swaps
were entered into as a hedge of the investment in the USD operations, Lamarre ACJ
considered GWL’s intention, the amounts of the swaps and the amounts of the USD
operations which were approximately equal as well as the timing of the
acquisition of the swaps which was fairly close to the acquisition of the USD
operations.
[95]
In my view, George Weston, supra,
confirmed the requirement to assess both the taxpayer’s intention and conduct
in determining whether a transaction is a hedge as well as the requirement to
apply the linkage principle. In that case, the amounts of the swaps matched the
value of the underlying U.S. assets that the taxpayer intended to hedge and
there was some contemporaneity as the timing of the swaps was sufficiently
close to the time the U.S. assets (the asset that was being hedged) were
acquired. It was clear that the taxpayer would not have entered into the
derivatives in the absence of the BestFoods acquisition and Lamarre ACJ
accepted that the intention was to hedge the investment. I agree with the
Appellant that, notwithstanding some comments suggesting that George Weston,
supra, broadens the circumstances whereby a hedge may be found, the law
still requires a close linkage between the purported hedging instrument and the
underlying asset.
3.2
Discussion.
Intention
[96]
Before examining the linkage principle, I have
to determine whether Mr. MacDonald had a clear intention to hedge against
his BNS shares. I am of the view that he did not have such an intention,
as I have found that he had speculated by entering into the Forward
Contract. As I have examined in detail the intention of Mr. MacDonald
at the time he entered into the Forward Contract in the previous section of
these reasons for judgment, I will not address that issue here.
Linkage
principle
[97]
Citing George Weston, supra, the
Respondent argued that the existing risk was Mr. MacDonald’s ownership of
the BNS shares and the potential for price fluctuations. She stated that the
Forward Contract reduced Mr. MacDonald’s exposure to price volatility. The
Respondent pointed out that her position is that the Forward Contract is
sufficiently linked to the ownership of the BNS shares so as to constitute a
hedge. It is not her position that the Forward Contract is linked to a
transaction that is the sale of the BNS shares or the reimbursement of the Loan.
[98]
The Respondent relied also on Dr. Klein
expert’s opinion. Dr. Klein was of the view that the Forward Contract was
a partial same asset hedge for Mr. MacDonald’s long term investment in the
BNS shares, namely a hedge where the Delivery Asset and the asset being hedged
is the same asset, namely the BNS shares, and therefore the link is very clear.
Accordingly, in this case, no other links are required to conclude that a hedge
exists. Dr. Klein expressed the opinion that the use of the words “Reference Assets” or “Delivery Assets”
were used interchangeably in forward contracts. As the number of Reference
Stock under the Forward Contract did not exceed the number of BNS shares owned
by Mr. MacDonald, that means that Mr. MacDonald hedged the BNS
shares. Furthermore, as the Forward Contract provided for a financial and
economic equivalence of an immediate sale, Mr. MacDonald had effectively
eliminated all risks related to price fluctuation and, therefore, there was a
hedge.
[99]
I do not agree with Dr. Klein. In my
view, the Forward Contract cannot be described for income tax purposes as a
partial same asset hedge of the BNS shares. The BNS shares are the Reference
Shares in the Forward Contract and are not the Delivery Assets. Mr. Kurgan
also testified that the Forward Contract is not a same asset hedge of the BNS
shares as the BNS shares are not the Delivery Assets but are the Reference
Shares under the Forward Contract. Mr. MacDonald cannot settle the Forward
Contract by transferring BNS shares to TDSI. The settlement under the Forward
Contract has to be satisfied by the exchange of cash.
[100] My conclusion is also based on the testimony of both experts to the effect
that a forward contract is a negotiated contract between the parties as opposed
to a future contract that is a standardized document. If the parties had wanted
the BNS shares to be the Delivery Assets, it would have been provided for in
the Forward Contract, but it was not.
[101] Furthermore, Dr. Klein’s opinion is based on a purely economic
and financial perspective. To follow the economic and financial model presented
by Dr. Klein at the hearing would lead this Court to speculate on what
could happen as opposed to concluding as to what did happen. This is not what
this Court should do when determining the tax consequences resulting from a specific
fact pattern (Shell, supra at para 45).
[102] Both experts also agreed that the fact that the Forward Contract had
the effect of an immediate sale has no bearing as to whether Mr. MacDonald
had hedged or not.
[103] Furthermore, I am of the view that the Respondent erred when
she said that the risk for Mr. MacDonald rested with his ownership of BNS
shares and the potential for price fluctuations, citing George Weston, supra.
The facts in George Weston, supra, are clear: the swaps were
entered into to protect GWL against a devaluation of the USD compared to the
Canadian dollar which would have had a negative impact on GWL’s financial
statements and on GWL’s debt to equity ratio. The risk in GWL was clear and, in
the absence of the swaps, GWL would have had suffered from the devaluation of
the USD as it would have had a direct impact on GWL’s financial statements and
a direct impact on its shareholders. When the risk was no longer present, GWL
terminated the swaps.
[104] However, I am of the view that the situation I am faced
with is entirely different as to the existence of a risk. In arguing as she
did, the Respondent did not take into account the actual facts of this case.
Mr. MacDonald testified that he wanted to keep the BNS shares for the very
long term. He sold only a small number of BNS shares over the years to
rebalance his portfolio. He owned the BNS shares for the past 30 years. He
entered into the Forward Contract, which was cash settled, confirming his
intention not to sell the BNS shares. I do not see how Mr. MacDonald
could have been exposed to a risk associated with the ownership of the BNS
shares since he did not want to ever sell the BNS shares and, in fact, he only sold
a small number of shares. As long as he did not sell the BNS shares, he suffered
no risk in holding the BNS shares and I do not see how price fluctuations
could have affected him.
[105] Accordingly, I am of the view that other links, both in terms
of quantum and timing, have to be present in order to find that the Forward
Contract had hedged the BNS shares and that the existence of an offsetting
transaction is a prerequisite to find a hedge in this particular case.
[106] According to the Respondent, Mr. MacDonald created an
opportunity to terminate the Forward Contract permanently by fully repaying the
Loan, since “otherwise he would have been required to ‘maintain
the Forward Transaction’”. As the Loan required the Forward Contract but
the Forward Contract did not require the Loan, it would make sense that when
you repay the Loan, you terminate the Forward Contract at the same time. Both
experts agreed that the Loan was irrelevant as to whether Mr. MacDonald
had hedged or not. I agree with them. The Loan was fully repaid in
November 2004. Mr. MacDonald did not borrow any amount under the Loan
in 2004, 2005 and 2006. Furthermore, Mr. MacDonald testified that the Loan
was ancillary to the Forward Contract. I cannot find any connection
between the amount borrowed under the Loan and the entering into, and the
settlement of, the Forward Contract.
[107] In the present case, there is no particular transaction that occurred
around the time Mr. MacDonald entered into the Forward Contract, which
could be considered as a triggering event. In George Weston, supra,
there was a related transaction — the Bestfoods acquisition — that triggered
the decision to enter into the swaps and to which the swaps could be linked in
timing. In this appeal, Mr. MacDonald owned the BNS shares for
approximately 30 years prior to entering into the Forward Contract. There
was a significant disparity between the entering into, and the settlements of,
the Forward Contract and Mr. MacDonald’s acquisition and disposition of
the BNS shares. Mr. MacDonald continued to own approximately 447,000 BNS
shares after the final settlement under the Forward Contract. I find that
there was no close linkage between the settlements of the Forward Contract and
the BNS shares. Specifically, the settlements were not based on any anticipated
sale of the BNS shares and the sale of BNS shares by Mr. MacDonald did not
occur in close proximity to the settlements.
[108] Indeed, the quantum of BNS shares under the Forward Contract is less
than the number of shares owned by Mr. MacDonald. This suggests that there
is no close matching in terms of the value under the Forward Contract and the
value of Mr. MacDonald’s ownership of BNS shares. Nevertheless, both
experts confirmed that one may enter into a partial hedge.
[109] The Respondent pointed out that, as Mr. MacDonald settled under
the Forward Contract, a corresponding number of BNS shares were released back
to him, such that there was perfect correlation as to quantum and timing. I am
not convinced by this argument. This simply seems like a logical result flowing
from the settlement of a forward contract.
[110] Furthermore, I am not convinced by Dr. Klein’s opinion to
the effect that the cash flows are a link between the Forward Contract and the
BNS shares. The schedule of expected dividends is arguably a standard component
of a forward contract. Furthermore, in his testimony, Dr. Klein specifically
said that schedule A would appear in a forward contract both for a hedger
and a speculator.
[111] The Respondent argued that since the terms of the Forward Contract
are certain, then there is a lock-in because Mr. MacDonald is certain to
get the Forward Price on the Forward Date of that delivery or reference stock
or underlying asset. However, in his testimony, Dr. Klein agreed that, in
the hypothetical situation where a person settles a forward contract with cash
and does not dispose of the underlying shares on the market at the same time as
he settles the forward contract, he will not have locked-in a gain on the
shares and will still be subject to a change of price on the shares the very
next day. I am of the view that the fact that Mr. MacDonald had sold
forward the BNS shares is irrelevant for determining whether he had hedged the
BNS shares or not. Both experts testified to that effect. Legally, Mr. MacDonald
remains the beneficial owner of the BNS shares; the shares were pledged.
Furthermore, I agree with Mr. Kurgan that the spot forward
equivalence under the Forward Contract is nothing more than a pricing mechanism
and is not indicative of a hedge. Until the Reference Price of the BNS shares
was determined, it was unclear which of the parties to the Forward Contract
would be required to make a payment.
[112] As the Forward Contract was to be cash-settled only, the only possible
manner for Mr. MacDonald to be protected from a loss under the Forward
Contract was to sell a certain number of BNS shares to cover the corresponding
loss on the settlement of the Forward Contract. But Mr. MacDonald never
sold any BNS shares at the same time, or in close proximity with, the
settlement of the Forward Contract. Accordingly, Mr. MacDonald only had an
unrealized gain on the BNS shares but an actual loss on the settlement of the
Forward Contract. I am of the view that without Mr. MacDonald having
sold BNS shares in very close proximity with the settlement of the Forward
Contract, one cannot conclude that Mr. MacDonald had mitigated or reduced
a risk. The evidence adduced at the hearing showed very clearly that Mr. MacDonald
did not sell any BNS shares in very close proximity to the settlement of the
Forward Contract.
[113] More specifically, the first partial settlement of the Forward
Contract occurred on June 16, 2003, and there were subsequent
periodic terminations occurring until March 29, 2006. Mr. MacDonald
donated a minimal number of BNS shares during this period; however, the first
sale of BNS shares occurred on January 19, 2005. Thus, the payment on
the settlement of the Forward Contract arose at different times from the
realized gains on the sales of BNS shares.
[114] The Respondent pointed out that Mr. MacDonald started VFC in 1994,
and, at incorporation, Mr. MacDonald owned 963,004 shares in VFC with an
adjusted cost base of about $1 each or a total cost of about $1 million,
and raised approximately $5 million. The Respondent added that, on March 19, 1997,
the Appellant incorporated and co-founded ECM and needed cash for this new
business venture and this reveals a link between the Forward Contract and the
BNS shares since the Loan was available. I fail to see that link.
[115] The Respondent submitted that other links are present in this case:
the amount of the Loan outstanding would have been reduced if the original
Forward Price was reduced; if the number of Reference Shares under the Forward
Contract were reduced, the credit facility available to Mr. MacDonald
under the Loan would also be reduced; the terms of the Loan also required Mr. MacDonald
to “maintain the Forward Transaction”; Mr. MacDonald
also pledged as collateral the payments from TDSI that he would be entitled to
receive under the Forward Contract as well as 165,000 BNS shares. I am of
the view that the above-mentioned links are not sufficient to call for a
finding of a hedge in this appeal.
[116] In Shell, supra, the Supreme Court of Canada rejected
the Crown’s argument that foreign currency contracts were so closely related to
money borrowed under debentures issued by the taxpayer that the two instruments
should be treated as one (para. 65). I acknowledge that in Shell,
supra, the various agreements were entered into between arm’s length
parties. Here, the parties with whom Mr. MacDonald contracted with are
banks or corporations within the same group. However, I am of the view
that, given the credible testimony of Mr. MacDonald and the absence of
links between the amounts of the Loan used by Mr. MacDonald and the value
of the BNS shares as Reference Shares in the Forward Contract, the same principle
applies in this appeal.
[117] Therefore, the only link between the Forward Contract and the BNS
shares was the fact that Mr. MacDonald entered into the Securities Pledge
Agreement, the Forward Contract and the Loan at approximately the same time.
This link is insufficient to call for a finding of a hedge in the present
appeal.
F.
conclusion.
[118] On the basis of the foregoing, I am of the view that the Cash
Settlement Payments are payments made on income account resulting in business
losses for Mr. MacDonald and therefore, the
appeal from the reassessments made
under the Act for the 2004, 2005, 2006 and 2007 taxation years is allowed, with
costs to the Appellant, and the matter is referred back to the Minister for
reconsideration and reassessment in accordance with these Reasons for judgment.
Signed at Montreal, Quebec, this 8th
day of August 2017.
“Dominique
Lafleur”
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