13 May 1992 External T.I. 9134537 F - Securities Lending Arrangements

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.

Subject: Securities Lending Arrangements - Section 260 of the Income Tax Act (hereafter "the Act")

This is in response to your memorandum of December 11, 1991, requesting our interpretation of section 260 of the Act in the context of an hypothetical situation which is similar to an actual taxpayer's case.  We apologize for the delay in responding.

You asked that we confirm the tax consequences of certain payments made and received in transactions involving short selling of shares.  In a telephone conversation with A. St-Amour you made some modifications to the facts of the hypothetical situation.  The facts are now as follows:

1)     On May 1, Broker #1 sold short X Ltd.'s shares, acting on behalf of his client, Mr. Shorter.  These shares were purchased, on the same day, by  Mr. Smith, an investor.

2)     Broker #1, on behalf of Mr. Shorter, entered into a security lending arrangement (hereafter "SLA") with another broker (hereafter "Broker #2"), for X Ltd.'s shares to be delivered to Mr. Smith.

3)     X Ltd. paid a dividend on May 10. 

4)     The following payments occurred on May 10:

     a)     X Ltd. paid a dividend to Mr. Smith.  This dividend was received by Broker #1 and deposited to the account of Mr.Smith. 

     b)     Mr. Shorter paid a compensating payment, equivalent to the dividend, to Broker #2.  This payment was received by Broker #1 for delivery to Broker #2.

5)     Broker #1 and Broker #2 are corporations resident in Canada who deal at arm's length and are registered or licensed under the laws of a province to trade in securities.

6)     The compensating payment for the taxable dividend, was paid on a share of the capital stock of a public corporation and the share is a "qualified security" as defined in subsection 260(1) of the Act.

7)     The SLA meets the definition of subsection 260(1) of the Act.

Our Comments:

1)     Treatment of the compensating payments for taxable dividends to the recipients

Subsection 260(5) of the Act provides that a compensation payment received in lieu of a taxable dividend will be treated as a taxable dividend to the recipient if the following criteria are met:

a)     The compensating payment must be in respect of a share of the capital stock of a public corporation and the share must be a "qualified security" as defined in paragraph 260(1) of the Act.   By virtue of the definition of public corporation in paragraph 89(1)(g) of the Act, the corporation paying the dividend will be required to be a corporation resident in Canada.

b)     The payer of the compensating payment must be one of the following persons:

i)     a person resident in Canada who made the payment as part of an SLA;

ii)     a non-resident person who made the payment in the course of carrying on business through a Canadian permanent establishment (as defined by draft regulations 8201, for example a Canadian Branch) and as part of an SLA; or

iii)     a provincially registered or licensed trader or dealer in securities who is resident in Canada, where the amount is paid by such person in the ordinary course of the business of trading or dealing in securities carried on by that person.

c)     Paragraph 260(5)(b) of the Act provides that where the payer is not one of the three classes of persons described in item (b) above, the compensating payment will still be treated as a taxable dividend if the recipient is a person described in item (b)(iii).  It also should be noted that no SLA agreement is necessary where the payer or recipient is a person described in item (b)(iii) above.

The dividend is included in Mr. Smith's income under clause 82(1)(a)(ii)(A) of the Act.  In this case, the payer is a corporation resident in Canada and the payment was received as a taxable dividend.  

The compensating payment, paid as part of a security lending arrangement, is included in the income of Broker #2 in accordance with clause 82(1)(a)(ii)(A) of the Act.  The payment is deemed by subsection 260(5) of the Act to be received as a taxable dividend. 

The various payments received by Broker #1 have no tax impact on him given that he was acting as an agent for his clients, Mr. Shorter and Mr. Smith.

2)Treatment of the compensating payments to the payers

Subsection 260(6) of the Act provides that compensating payments are not deductible by the taxpayer in computing income from a business or property in respect of an amount deemed to be received by another person as a taxable dividend.  However, subsection 260(6) of the Act is subject to transitional provisions in the case of provincially registered or licensed trader or dealer in securities.  It provides that two-thirds of the amount of compensating dividend payments can be deductible until 1993.  Where the borrower is an individual, however, compensating payments may be deducted from and to the extent of taxable dividend received.  Except for these relieving provisions, the compensating payments made in respect of subsection 260(5) of the Act are non-deductible to the borrower and may not be added to the cost of securities sold short.

The payment made by Mr. Shorter was made pursuant to an SLA, entered by Broker #1 on his behalf.  This compensating payment is deemed, by subsection 260(5) of the Act, to have been received by Broker #2 as a taxable dividend and cannot be claimed as a deduction by Mr. Shorter under subsection 260(6) of the Act. 

However, since Mr. Shorter is an individual, the compensating payment will be deductible against other dividends received in accordance with clause 82(1)(a)(ii)(B) of the Act.  Any excess compensating payment will be non-deductible by Mr. Shorter and may not be added to the adjusted cost base of the security.       

The payment made by Broker #1 to Broker #2 has no tax impact on Broker #1 given that he made these payments as an agent.            

3)     Intention of the legislation

You also asked the reason for limiting the deduction of a compensating payment under clause 82(1)(a)(ii)(B) of the Act to the amount of dividends received during the year.  You indicated that Mr. Shorter finds this treatment unfair.  He claims that individuals are not treated equally because only those persons receiving dividends, at least equal to the compensating payment, are allowed a deduction. 

One of the government's concerns about an SLA was that it resulted in a loss of tax revenue.  This loss of revenue was perceived to arise from the fact that payers were receiving full deductions for compensating payments while payees were obtaining favourable tax treatment on the receipt of taxable dividend.

In order to deal with this perceived loss of revenue, subsection 260(6) of the Act was enacted to deny the deductibility of all compensating payments which are treated as taxable dividends to the recipient.  As noted above, this provision is subject to a transitional provision which was introduced to give the securities industry until 1993 to make representations concerning the impact of the new legislation on capital markets. 

Clause 82(1)(a)(ii)(B) of the Act was introduced to put individuals on the same basis as corporations.  It is intended to produce the same after tax results for individuals investing in shares and for individuals investing in debts or obligations.

We trust this is satisfactory.  If you have any further questions, do not hesitate to contact us.

for the DirectorFinancial Industries DivisionRulings Directorate