MacDonald – Supreme Court of Canada affirms that a cash-settled forward “objectively” was a capital share hedge notwithstanding no matching share sale
In 1997, an individual with a significant long-term holding in common shares of a public company (BNS) entered into a cash-settled forward which had the effect of establishing a short position against a portion of his BNS shareholding. Over several years starting in 2004, he closed out the forward at a loss. At the time of entering into the forward, he also monetized about half of his BNS shareholding through a loan from a bank (TD Bank) affiliated with the forward counterparty to which he pledged his shares and the forward contract – but then repaid the loan in 2004. The Tax Court had accepted the taxpayer’s testimony that he had intended to profit from the anticipated decline in the value of the BNS shares under the forward contract but nevertheless retained ownership of the shares based on his belief that they would perform well in the long term.
In affirming the Federal Court of Appeal’s decision to reverse this decision on the basis of objective indications that the forward sales hedged the taxpayer’s BNS holding, Abella J stated:
The forward contract had the effect of nearly perfectly neutralizing fluctuations in the price of [the] shares held by Mr. MacDonald, pointing to a close linkage. The purpose of the forward contract as a hedging instrument is most apparent when one considers the forward contract alongside the loan and pledge agreements between Mr. MacDonald and TD Bank. Seen in this light, there was considerable linkage between the forward contract and Mr. MacDonald’s … shares.
In the course of arriving at this conclusion, she indicated that:
- A derivative contract is a hedge if its purpose is to “hedge exposure to a particular financial risk such as the risk posed by volatility”.
- “Purpose is ascertained objectively … . [T]he primary source of ascertaining a derivative contract’s purpose is the linkage between the derivative contract and any underlying asset, liability or transaction purportedly hedged.”
- “The absence of a synchronous transaction used to offset gains or losses arising from a derivative contract is not equivalent to the absence of risk and is not, by itself, determinative of the characterization of a derivative contract”, so that “The fact that Mr. MacDonald did not sell his … shares immediately to offset his losses under the forward contract does not sever this connection”.
- “[C]ash settled forward contracts and forward contracts settled by physical delivery are economically equivalent and treating them differently for tax purposes would create ‘an unjustified artificial distinction’.”
- Options (along with forwards) were “one of the “two basic types of derivatives”, so that the principle that “Gains and losses arising from hedging derivative contracts take on the character of the underlying asset, liability or transaction being hedged … . [whereas] speculative derivative contracts are characterized on their own terms, independent of an underlying asset or transaction” also applied to options.
The dissenting reasons of Côté J indicated that the majority’s decision meant that “a derivative instrument that shorted shares in TDB was a hedge of the BNS Shares regardless of the taxpayer’s intentions.”
Neal Armstrong. Summaries of MacDonald v. Canada, 2020 SCC 6 under s. 9 – Capital gain v. profit – Futures/Forwards/Hedges and General Concepts – Purpose/Intention.