Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.
Principal Issues:
1) The characterization for income tax purposes of a hedge transaction, which includes the purchase of exchangeable securities and the short sale of other securities.
2) The tax treatment of fees paid to short lender as compensation for distributions paid on trust units.
Position:
1) A short sale is generally on account of income. However, where shares are borrowed in order to hedge a taxpayer's position with respect to property held on account of capital, the gain or loss on the short sale would also be on account of capital.
2) Compensation payments in respect of a short sale on capital account are not a cost of the securities sold short.
Reasons: See IT-479R
XXXXXXXXXX 2001-008736
N. L. Storry
September 11, 2001
Dear XXXXXXXXXX:
Re: Short Sale Arrangement
We are writing in response to your correspondence of May 31, 2001, wherein you requested our views regarding the treatment of compensating payments made to a security lender by a security borrower and the characterization of the gain or loss to the borrower on the completion of a short sale.
The opinion you seek appears to relate to a specific proposed transaction and, therefore, we bring your attention to Information Circular IC 70-6R4 Advance Income Tax Rulings, dated January 29, 2001, issued by the Canada Customs and Revenue Agency. Confirmation of tax consequences with respect to proposed transactions involving specific taxpayers will only be provided in response to a request for an advance income tax ruling. However, we can provide you with the following general comments.
For ease of explanation and understanding, you have provided the following hypothetical example:
( The taxpayer acquires exchangeable shares of ABC Co. at $10 per share;
( The taxpayer holds the shares of ABC Co. on capital account;
( Holders of the exchangeable shares are entitled, at any time, to require ABC Co. to redeem the shares in exchange for certain other securities based on the exchange ratio determined;
( The other securities have a current market value of $10 per unit;
( Holders of the other securities are entitled to receive monthly distributions of $.20 per unit;
( In order to hedge the risk of fluctuation in the value in exchangeable shares of ABC Co., the taxpayer enters into an arrangement whereby he borrows a specified number of the other securities and agrees to return the same number of identical securities at a later date;
( The taxpayer immediately sells the other securities in the market for $10 per unit;
( In order to compensate the lender, the taxpayer is required to pay to the lender an amount equal to the total distributions, which the lender would have received had it not loaned the other securities to the taxpayer;
( The arrangement does not fall under the rules in section 260 of the Income Tax Act (the "Act") as the other securities are not "qualified securities" as defined in subsection 260(1) of the Act and accordingly the arrangement is not a "securities lending arrangement" as defined thereunder.
It is the Agency's position that the transfer of the securities by the lender to the borrower, under a short sale arrangement to which section 260 of the Act does not apply, generally results in a disposition of the securities by the lender at fair market value and an acquisition by the borrower at fair market value on the date the securities are transferred to the borrower. The consideration paid by the borrower is in the form of a right provided to the lender to reacquire an equal number of identical securities for no consideration other than the extinguishment of the right. The value to the borrower of the obligation to honor the right would equal the fair market value of the securities acquired. The disposition of the borrowed securities by the borrower to a third party immediately after they are borrowed would generally produce no gain or loss since the value of the borrowed securities will not have changed in the interim. When the right to acquire securities given by the borrower to the lender is settled, the borrower will purchase from a third party the number of securities it originally borrowed (the "new securities") and dispose of them to the lender in consideration for the settlement of its obligation under the right. As a result, the borrower will realize a gain or loss on the disposition of the new securities to the lender equal to the change in the value of the borrowed securities during the term of the arrangement.
As stated in paragraph 18 of IT-479R, the gain or loss on the "short sale" of shares is generally considered to be on income account, however, this position is a general presumption and is subject to a review of the facts. In this regard, we would consider a short sale entered into in order to hedge a taxpayer's position with respect to shares held on capital account to be a short sale that is on capital account. Accordingly, in the above case, the gain or loss to the borrower on the disposition of the new securities would be a capital gain or loss.
In the situation you described, the borrower agrees to pay the lender an amount ("compensating payment") equal to all distributions made by the issuer in respect of the loaned securities while they are on loan. There is no apparent reasonable basis for viewing the compensatory payments made by the borrower to the lender as forming a part of its cost of the new securities acquired from a third party. As a result, it is our view that such payments would not be included in the computation of the borrower's gain or loss on the disposition of the new securities. Moreover, as the transaction is on capital account, there is no basis for allowing a deduction for the purposes of computing income under the Act.
We trust these comments will be of assistance.
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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