2 March 2005 External T.I. 2004-0084891E5 - Securities lending arrangement

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues:

(a) Does CRA interpret the words in paragraph 260(1)(c) of the definition of a "securities lending arrangement" ("Definition") as meaning that a borrower of a qualifying security must have disposed of the security before a dividend is paid by the issuer in order to meet the dividend compensation payment criteria in the said paragraph?

(b) Are the words "amounts equal to ... all dividends, if any, paid on the security" in paragraph 260(1)(c) of the Definition interpreted by CRA as meaning the gross amount of a dividend paid by the issuer of the borrowed security or as meaning the net amount after, for example, deducting any applicable foreign taxes withheld at source from the dividend payment received
(c) Determine the tax consequences to the borrower upon the settlement of the right to acquire securities given by the borrower to the lender in the circumstances described in the letter.

(d) Are compensation payments made by a financial institution to a securities lender under a securities lending arrangement to which section 260 of the Act does not apply, where the financial institution has the borrowed securities on income account, deductible when paid pursuant to section 9 of the Act.

Position:

(a) Our general view is that a securities borrower is not required to have disposed of the borrowed security in order that the security lender meet the dividend compensation criteria in paragraph 260(1)(c) of the Definition.

(b) In our view paragraph 260(1)(c) of the Definition restricts the scope of application of subsection 260(1) to a share lending arrangement where, inter alia, the lender's opportunity for income in respect of the share is not changed as a consequence of the arrangement.

(c) General comments.

(d) General comments.

Reasons:

(a) Interpretation of the legislation.

(b) Interpretation of the legislation.

(c) Question of fact.

(d) Question of fact.

XXXXXXXXXX 						2004-008489
P. Diguer, CGA
March 2, 2005

Dear XXXXXXXXXX:

Re: Securities lending arrangements

We are writing in response to your facsimile dated July 08, 2004 in which you request our views on the application of section 260 of the Income Tax Act (Canada) (the "Act") in circumstances where a Canadian financial institution borrows and on-lends shares of a foreign issuer.

In particular you describe a situation where:

1. A Canadian financial institution ("Finco") maintains an actively-traded portfolio of debt and equity securities, including securities of foreign issuers. The foreign debt and equity securities in question are "mark-to-market properties" as defined in subsection 142.2(l) of the Act;

2. A typical trading transaction would involve the borrowing and on-lending of foreign securities by Finco under the terms of a lending arrangement;

3. The targeted benefit to Finco in intermediated transactions of this type includes the earning of rebate interest on the cash collateral posted with the lender of the securities which exceeds the rebate interest paid to Finco on cash collateral received from the ultimate borrower of the securities;

4. Alternatively, borrow fees earned by Finco from the ultimate borrower might exceed borrow fees paid by Finco to the lender.

5. Additionally, foreign securities are also borrowed by Finco in the course of executing various programme trading strategies involving short sales to hedge offsetting positions in the same securities or exposures to different securities the price movements of which are expected to exhibit some correlation with that of the securities sold short.

6. On one or more occasions Finco has borrowed a foreign security (the Borrowed Security) and before disposing of the Borrowed Security it received an amount paid by the issuer of the Borrowed Security for which Finco was obligated to make a compensation payment to the lender of the Borrowed Security.

7. On other occasions involving Borrowed Security, Finco was under the terms of the arrangement (you suggest that this is "standard" language in similar securities lending documentation) obligated to pay a cash compensation payment equal to the distribution received by Finco net of any applicable foreign taxes withheld at source.

8. A typical trading transaction would then include the acquisition of identical foreign securities by Finco and the transfer of the said foreign securities by Finco to the lender under the terms of the lending arrangement.

You ask

(a) With respect to amounts received by Finco on the Borrowed Security as described in paragraph 6 above, how are the following words in the definition "securities lending arrangement" (the "Definition") in paragraph 260(1)(c) of the Act being interpreted by the CRA:

... the borrower is obligated to pay to the lender... compensation for all dividends, if any, paid...that would have been received by the borrower if the borrower had held the security throughout the period...

Specifically, does CRA interpret these particular words as meaning that a borrower of a qualifying security must have disposed of the security before a dividend is paid by the issuer in order to meet the dividend compensation payment criteria in paragraph 260(1)(c)?

(b) With respect to compensation payments described in paragraph 7 above, are the words "amounts equal to ... all dividends, if any, paid on the security" in paragraph 260(1)(c) of the Definition interpreted by CRA as meaning the gross amount of a dividend paid by the issuer of the borrowed security or as meaning the net amount after, for example, deducting any applicable foreign taxes withheld at source from the dividend payment received by Finco?

(c) That CRA confirm your understanding of our technical interpretation letter (our file # 2001-0087365) which sets out our views on lending arrangements under a short sale agreement to which section 260 of the Act does not apply ("non-qualifying lending arrangements"). In particular, technical interpretation letter # 2001-0087365, dated September 11, 2001 (the "Technical Interpretation") states the following:

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.

In particular you ask that we confirm your understanding of our Technical Interpretation.

(d) Whether compensation payments made by a financial institution to a securities lender under a securities lending arrangement to which section 260 of the Act does not apply, where the financial institution has the borrowed securities on income account, are deductible when paid pursuant to section 9 of the Act. In this regard you state as follows:

In our view where a financial institution has borrowed securities on income account pursuant to a securities loan that is not a securities lending arrangement and the institution consequently has received securities distributions (or compensation payments in respect of such distributions) that are included in computing its income, compensation payments made by the institution to the lender of the securities should be deductible when made as ordinary period costs in accordance with general principles and section 9 of the Act.

Our comments

The situations that are described in your letter appear to relate to either a series of proposed or completed transactions involving specific taxpayers. Written confirmation of the tax implications inherent in particular transactions are given by this Directorate only where the transactions are proposed and are the subject matter of an advance ruling request submitted in the manner set out in Information Circular IC-70-6R5 dated May 17, 2002. Where the particular transaction is completed, the inquiry should be addressed to the relevant Tax Services Office. Although we are unable to provide any opinion in respect of the specific transactions described in your letter, we have set out some general comments which we hope are of assistance to you. However, written opinions are not advance tax rulings and, accordingly not binding on the Canada Revenue Agency.

Our response below does not take into consideration the consequences, if any, of draft legislation including legislative proposals dated February 27, 2004, issued by the Department of Finance.

Your request does not include all of the information necessary to making a determination on the application of section 260. For example, you have not indicated whether Finco is a "registered securities dealer" as defined in subsection 248(1) of the Act. Additionally, you have not indicated whether the lenders of foreign securities to Finco and the borrowers of foreign securities from Finco are residents of Canada. Moreover, you have not indicated whether the lenders are registered securities dealers. There are a several possible combinations. For example, the lender may be a Canadian lender or a non-resident lender and the borrower may be a Canadian borrower or a non-resident borrower. Different combinations may result in different determinations in respect to the application of section 260.

In your letter you have grouped your queries under four broad headings. Our comments below are grouped in a similar fashion. Issues (a) and (b) below relate to interpretative matters concerning the Definition and in particular paragraph 260(1)(c) thereof and correspond to the first and second headings in your letter. Issue (c) below is in respect of the taxation implications of securities lending transactions and corresponds to the third heading in your letter. Issue (d) below is in regards to the deductibility of compensation amounts and corresponds to the fourth heading in your letter.

Issue (a)

In our view, the requirements in paragraph 260(1)(c) of the Definition, inter alia:

• Recognize and codify the terms of a conventional commercial securities lending arrangement wherein the lender's rights to and opportunities for income remains unchanged ("Conventional Lending Arrangement"); and
• Establish the legislators' intent to target the Conventional Lending Arrangement for purposes of section 260.

Interpreting this paragraph in a manner that would require that the borrower of a security "dispose" of the borrowed security in order for the lending arrangement to qualify as a securities lending arrangement to which section 260 of the Act would apply ("SLA"), such that subsection 260(2) would not apply to the securities lender would not, in our view, accord with the object and spirit of section 260.

Accordingly, it is our general view that a securities borrower is not required to have disposed of the borrowed security in order that the security lender meet the dividend compensation criteria in paragraph 260(1)(c) of the Definition.

Issue (b)

The determination of whether, under the terms of a lending arrangement, the "borrower is obligated to pay the lender amounts equal to and as compensation for all dividends, if any, paid on the security ..." is a question of fact and can only be made following a review of the specific facts and supporting documentation of a share lending arrangement.

Such a determination may be made in the context of an audit or an advance income tax ruling request.

With respect to your query, in our view, paragraph 260(1)(c) of the Definition restricts the scope of application of subsection 260(1) to a share lending arrangement where, inter alia, the lender's opportunity for income in respect of the share is not changed as a consequence of the arrangement.

To illustrate the operation of this interpretation, consider the following situation. A dividend paid directly to a Canadian securities lender on a qualified security to be loaned is subject to withholding such that the Canadian lender receives a net amount (the "Lender Net Amount"). Under the terms of the lending arrangement the amount to be paid by the Canadian borrower as compensation is equal (i.e. net of withholding) to the Lender Net Amount. The result is that under the terms of this lending arrangement the Canadian lender receives an amount equal to the amount that it would have received directly (i.e. if the share had not been lent). Generally, in these circumstances it would, in our view, be appropriate to consider such an arrangement to have met the compensation payment requirement in paragraph 260(1)(c) of the Definition.

Issue (c)

Our general position with respect to the transfer of securities under a short sale arrangement to which section 260 does not apply, as set out in the above-mentioned Technical Interpretation, remains unchanged. In this regard, a determination, in respect of a securities borrower, that a short sale arrangement to which section 260 does not apply, would not be considered to be a single transaction that includes the borrowing of the securities, the short sale of the borrowed securities and the subsequent redelivery of the borrowed securities, is based on the legal relationships created by the terms of the agreements (i.e. the lending arrangement and the securities sale agreement) rather than the underlying economic substance.

As such, in a short sale arrangement, it is our view that a borrowing of securities under the terms of a lending arrangement and the immediate disposition of the borrowed securities by the borrower to a third party are generally, independent transactions. Additionally, the subsequent transfer of securities by the borrower to the lender under the terms of the lending arrangement would generally be viewed as independent of the earlier sale of the borrowed security.

Determining the tax consequences to the borrower upon the settlement of the right to acquire securities given by the borrower to the lender in the circumstances described in your letter is a question of fact and can only be made following a review of the specific facts and supporting documentation of the share lending arrangement. Such a determination may be made in the context of an audit or an advance income tax ruling request.

Issue (d)

It is question of fact as to whether a dividend compensation payment, under the terms of a lending arrangement to which section 260 does not apply, may be deductible by the borrower.

Short sale

For example, where the lending arrangement is part of a "short sale" it must first be determined whether the "short sale" of shares is on income account or capital account.

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. Where it is determined that a short sale is on capital account, the gain or loss to the borrower on the disposition of the new securities would be a capital gain or loss.

Where it is determined that the short sale is on income account, a compensation payment (other than on a dividend payment on an SLA to which subsection 260(5) applies) may be deductible to a borrower who is in the business of security lending under subsection 9(1) of the Act. However, where the transaction is on capital account, there is no basis for allowing a deduction for a compensation payment in computing income of a taxpayer under the Act. Moreover, where the transaction is on capital account, the compensatory payments made by the borrower to the lender may not be added to the cost basis of the new securities acquired by the borrower from a third party nor can they be deducted in computing income from a source under the Act.

The opinions expressed herein are subject to the relevant income tax treaty provisions that may apply in a particular fact situation.

The foregoing comments represent our general views with respect to the subject matter. As indicated in paragraph 22 of Information Circular 70-6R5, the above comments do not constitute an income tax ruling and accordingly are not binding on the Canada Customs and Revenue Agency.

Yours truly,

Steve Tevlin
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch