25 April 1990 Income Tax Severed Letter RCT-0155

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.

N.B.: THE FOLLOWING IS A TRANSLATION OF THE MEMORANDUM #7-3958
DATED JANUARY 15, 1990 WRITTEN IN FRENCH.

This is in reply to your memorandum dated May 17, 1989 in which you requested our opinion concerning the treatment to be given to transactions involving the short selling of securities.

The facts submitted by you, as we understand them, are as follows:

FACTS:

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YOUR QUESTIONS

In your memorandum you requested our opinion on the following two questions:

(A) Must the "expense" dividends that the Corporation has to Pay to those purchasing the shares it sells to them (without having them in their possession) be considered as "expenses" for dividends that would be deductible from its other income or must they be added to the cost of the shares concerned when the Corporation purchases them?

(B) When and how must the gain (or loss) resulting from a short selling transaction be calculated?

YOUR SUBMISSIONS

In your opinion, the "expense" dividends should be treated as costs relating to the purchase of the security when the gain (or loss) on the sale of the security in question is calculated.

You did not express an opinion concerning the time when the gain (or loss) on a short sale should be reported and how it should be calculated.

OUR COMMENTS

First, we should point out that our comments do not take into account the Draft Legislation Concerning Security Lending and Dividend Rental Arrangement Release, issued by the Department of Finance on April 27, 1989.

(A) concept of short selling

The concept of short selling is not easy to understand. Consequently, before we can determine the tax treatment of such a transaction, we must necessarily define it.

Roughly, short selling is a transaction in which a person (hereinafter the "short seller") sells to another person (hereinafter the "short purchaser") securities that he acquired from a third person (hereinafter the "short lender") . A stock broker acts as the intermediary between the short seller and the short lender so that the former can obtain a security that can be sold short later. It will often happen that the stock broker is also the short lender.

The aim of the short seller is to sell a security for a price greater than the price of the security that he will eventually have to give back to the short lender. Short selling is thus a speculative transaction. This is why the Department of Revenue regards income obtained from short selling as business income (Interpretation Bulletin IT-479R, paragraph 18).

At page P-60 of the course entitled Cours sur le commerce des valeurs mobilieres au Canada (Canadian Securities Course) (1986 edition) the Canadian Securities Institute ("L'Institut canadien des valeurs mobilieres") states the following concerning short selling:

• Lorsque des titres sont vendues a decouvert, leur livraison est assuree par le courtier du vendeur qui s'arrange pour les emprunter a meme le compte d'un autre actionnaire, habituellement un epargnant avec un compte sur marge.
• Le vendeur a decouvert doit verser a son courtier une couverture determinee en garantie de la vente. La couverture deposee dans le compte du vendeur a decouvert doit toujours exceder d'un certain pourcentage la valeur au cours du marche des titres vendus a decouvert.
• Lorsuqe le vendeur achete finalement les titres (qu'il avait vendus a decouvert), il les rend au preteur. Tout solde en especes qui reste apres l'achat appartient au vendeur a decouvert. Si les titres sont rachetes a un cours plus eleve que celui auquel ils avaient ete vendus a decouverts (c.-a-d. si le cours a monte apres la vnete a decouvert), le vendeur a decouvert doit alors payer le montant integral de l'insuffisance.
• (Free translation) Where securities are sold short, they are delivered by the stockbroker, who makes arrangements to borrow them from the account of another shareholder, usually a saver with a margin account.
• The short seller must provide his broker with sufficient guarantee to cover the sale. The amount deposited in the short seller's account must always exceed the current stock market value of the securities sold short by a certain percentage.
• Where the seller finally purchases the securities (which he had sold short), he returns them to the lender. Any cash balance remaining in the account after the purchase belongs to the short seller. If the securities are purchased by the short seller at a higher price than that at which they were sold short (i.e., if the price rose following the short sale) the short seller must then make up the short-fall in full.

So, when a person sells short he is really selling a security. However, this security was "borrowed" from another person on condition that a similar security will ultimately be returned to him and he will be compensated for any dividend that may be declared on the shares that he does not receive because he is no longer the registered shareholder. The "expense" dividends paid by the short seller are thus paid to the short lender and not to the short purchaser, as your first question suggests.

With respect to the time when the short seller must "cover his short Position", the Canadian Securities Institute states at cage P-64 of the Course referred to earlier:

• 4. Aucun limite a la duree d'une position a decouvert
• Il n'y a pas de limite quant a la duree d'une position a decouvert tant que le courtier du vendeur peut emprunter une quantite equivalente de titres vendus a decouvert et que le vendeur maintient une couverture suffisante dans son compte a decouvert.

(...)

• 5. Couverture d'un vente a decouvert
• Si, a un moment donne, le courtier du vendeur a decouvert s'apercoit qu'il n'est pas possible d'emprunter d'autres titres pour maintenir la position a decouvert, le client doit alors acheter les titres necessaires sur le marche poru couvrir sa vente a decouvert. Cela doit etre fait, que le vendeur veuille ou non racheter les titres vendus a decouvert, et quel que soit le cours en vigueur des titres ainsi vendus.

(Free Translation)
4. No limit on duration of a short position

• There is no limit on the duration of a short position as long as the seller's broker can borrow an equivalent quantity of securities sold short and the seller maintains sufficient coverage in his short selling account.

(...)

• 5. Covering of a short sale
• If at any particular time the short seller's broker realizes that it is not possible to borrow other securities to maintain the short position, the client must purchase the necessary securities on the market to cover his short sale. This must be done, regardless of whether the seller wishes to purchase back the securities sold short and regardless of the current price of the securities sold.

(B) Legal definition of short selling under the Civil Code

In this section we shall examine the different possibilities in term of civil law (Civil Code of Lower Canada) with respect to the legal aspect of transactions concluded in a context of short sales.

• (a) Relationship between the short seller and the short lender

As we noted in the previous section, the first stage in short selling requires the short seller to obtain a security from another person, the short lender, so that he can sell it to the short purchaser. We must now consider the legal aspect of this first transaction.

• (i) Sale

Article 1472 of the Civil Code of Lower Canada (hereinafter the "Civil Code") defines "sale" as "a contract by which one party gives a thing to the other for a price in money which the latter obliges himself to pay for it".

Since in a short selling transaction the short seller undertakes to give an identical security to the short lender and not a price in money, the relationship between these two persons cannot be that of vendor and purchaser. Under the civil law, therefore, the transaction is not a sale.

• (ii) using

Leasing is defined in Article 1600 of the Civil Code as "a contract by which the lessor binds himself towards the lessee to grant him the enjoyment of a thing during a certain time, for a consideration, the rent". The lessee is required to return the thing leased on the termination of the lease (Article 1617, Civil Code). Since in a short selling transaction there does not seem to be a rent paid by the short seller to the short lender and since, moreover, the short seller does not have to return the "borrowed" security but only an identical security, the relationship between the short seller and the short lender cannot be that of lessor and lessee.

• (iii) Loan

Articles 1762 et seq of the Civil Code define the notion of "loan". According to the Civil Code, there are two sorts of loan in Quebec civil law"

• Art 1762. Loans are of two kinds: 1. The loan of things which may be used without being destroyed, called loan for use (commodatum); 2. The loan of things which are consumed by the use made of them, called loan for consumption (mutuum).

The following article defines the loan for use as follows:

• Art 1763. Loan for use is a contract by which one party, called the lender, gives to another, called the borrower, a thing to be used by the latter gratuitously for a time, and then to be returned by him to the former.

Since in a short sale the short seller does not undertake to return to the short lender the security in question but an identical one, it cannot be a loan for use either.

A loan for consumption is defined in article 1777 of the Civil Code:

• Art 1777. Loan for consumption is a contract by which the lender gives the borrower a certain quantity of things which are consumed by the use made of them, under the obligation by the latter to return a like quantity of things of the same kind and quality.

According to article 1778 of the Civil Code, the borrower in a loan for consumption becomes the owner of the thing loaned.

Although the first transaction in short selling has a number of similarities with a loan for consumption, we feel that it has more in common with a contract of exchange, as defined below. Furthermore, we doubt that the securities in question can be consumed by use. Notwithstanding the foregoing, the effects are the same, whether we have a loan for consumption or a contract of exchange; in both cases the right of ownership is transferred.

• (iv) Contract of exchange

A contract of exchange is defined in article 1596 of the Civil Code as follows:

• art 1506. Exchange is a contract by which the parties respectively give to each other one thing for another.

In volume 7 of his work, Le Droit Civil Canadien, P.B. Mignault analyses the legal aspect of the contract of exchange. we shall quote the main thrust of his observations:

• En droit romain, l'echange etait un contrat reel. La simple convention d'echanger n'etait qu'un pacte non productif d'obligations: le contrat se formait lorsque l'une des parties avait transfere la propriete d'une chose pour en acquerir une autre en echange. Il y avait alors, au profit de celle des parties qui avait ainsi aliene sa chose, une action praescriptis verbis pour se fair livrer la chose promise en retour.
• Il n'en est plus de meme aujourd'hui. L'echange, comme la vente, est purement consensuel: il existe, avec tous les effets qui lui sont propres, des que les parties sont d'accord, et independamment de toute tradition. Ainsi, lorsque nous osmmes convenus d'echanger votre pre contre ma maison, l'echange existe par le seul effet de notre consentement; chacun de nous devient immediatement, et sans qu'il y ait besoin d'aucune tradition, proprietaire de la chose qu'il a stipulee en echange de la chose qu'il a promise.

(Le premier alinea de l'article 1596 definit l'echange comme suit"

• 1596. "Lechange est un contrat par lequel les parties se donnent respectivement une chose pour une autre.")
• Cette definition n'est pas exacte. Prise a la lettre, elle nous conduirait a dire qu'il est de l'essence de l'echange d'operer, des sa formation et par sa seule energie, une double datio, c'est-a-dire une double mutation de propriete, et qu'ainsi il n'existe point, s'il n'est par lui-meme translatif de propriete ab utraque parte. Or, si cette double et immediate mutation a lieu le plus souvent dans l'echange, elle n'est point porutant de son essence: car, de meme que la vente peut n'etre pas translative de propriete (voy. supra, p. 13), de meme l'echange peut etre, comme elle, simplement generateur d'obligations. Ainsi, lorsque deux personnes se promettent reciproquement des choses qui ne sont pas determinees que quant a l'espece, lors, par exemple, que l'une promet tant de mesures de ble et l'autre tant de mesures de vin, cette convention est un echange, quoiqu'elle n'opere actuellement et par elle-meme aucune mutation de propriete. Que si l'une des parties a promis un corps certain a elle appartenant, en retour d'une chose qui n'est point determinee individuellement, par exemple, tel cheval en echange de tant de mesure de ble, cette convention est encore un echange, bien qu'elle n'ait transfere que la propriete de l'une des deux chose qu'elle a eues pour objet.
• En resume, les parties ont-elles l'une et l'autre promis un corps certain: l'echange est translatif de propriete ab utraque perte. Chacune des parties aliene sa chose et recoit en retour la propriete de la chose qui lui a ete promise.
• Ont-elles l'une et l'autre promis une chose qui n'est determinee que quant a l'espece: l'echange n'est translatif de propriete d'aucun cote; il est simplement generateur d'obligations. Chacun des coechangistes devient debiteur de la chose qu'il a promise et creancier de celle qu'il a stipulee.
• Ont-elles, enfin promis, l'une un corps certain, l'autre un genre: l'echange est translatif de propriete, d'un cote, et, de l'autre, simplement generateur d'une obligation. Ainsi, lorsque j'ai stipule de vous tant de mesures de ble en echange de mon cheval, je deviens creancier du ble que vous m'avez promis, tandis que vous devenez proprietaire du cheval que vous avez stipule.
• L'echange est donc un contrat par lequel les parties se donnent reciproquement, ou s'engagent a se donner, une chose pour une autre.

It is our opinion that the transaction between the short seller and the short lender is a contract of exchange since the first party acquires a security from the second subject to a commitment to deliver an identical security to him later.

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To the same effect we find a memorandum (file #7-3945) dated November 19, 1987 from the Financial Institutions Section in our Division, which states:

• As you are aware the tax treatment of securities lending has been under review for quite some time now. We believe that a loan' of marketable securities from one parson to another, pursuant to which the borrower is only obliged to repay the loan' by delivering any securities of the same quantity, nature and kind, constitutes a disposition for purposes of the act.
• (b) Relationship between short seller and short purchaser

Once the relationship between the short seller and the short lender has been determined, it is easier to determine the relationship between the short seller and the short purchaser.

As we noted in the preceding section, in a contract of exchange there is a transfer of ownership of the property that is involved in the exchange. Thus, in the case of a short sale, the short seller obtains full title to the property (that will later be sold short) from the short lender . The transfer of the security in question from the short seller to the short purchaser involves purely and simply a contract of purchase and sale, which entitles the short seller to the proceeds of the sale and gives full ownership of the security to the short purchaser.

• (c) Taxation of short selling transactions

It was stated earlier that in a short selling transaction the short seller obtains a security from the short lender on condition that he later return an identical security and compensate him for any dividend that might be declared on the security in the meantime. In our view, the cost of the security to the short seller is equal to the value of the debt assumed by him which is owed to the short lender. It's of course impossible to determine the exact cost of the security to the short seller as long as he has not given a similar security back to the short lender. However, we feel that the cost of this security to the short seller should, from a tax viewpoint, be equal to the value of the debt assumed on the date of the exchange. This argument seems to be supported by B.J. Arnold in his work, Timing and Income Taxation: The Principles of Income Measurements for Tax Purposes, at page 149-150 of which he states the following concerning the proceeds of disposition and the cost of acquisition of a property in an exchange transaction:

• The amount realized by a taxpayer on an exchange of property is the fair market value of the property received by the taxpayer. If the property received in a exchange is valued at more or less than its fair market value, an appropriate adjustment will be made in the taxation year in which the property is sold. The extend to which the subsequent adjustment will offset the tax effect of the inaccurate valuation depends on a number of factors, such as the applicable tax rates, the taxpayer's marginal rate, and the number of taxation years between the initial year and the year of adjustment. Where property is transferred to a corporation in exchange for shares with a par value, the transferor is considered to have realized proceeds equal to the fair market value of the shares and not their par value. Assuming an arm's length transaction, the cost to the transferor of the property received on the exchange is the fair market value of that property at the time of the exchange. This result is not, however, inevitable since the cost of acquisition is the value of what the taxpayer gave up in order to acquire the property. (Emphasis added.)

Thus, according to Mr Arnold, the cost of the security received by the short seller from the short lender will be equal to the fair market value of the security on the day of the exchange, therefore this means that in a short selling transaction the cost is equal to the debt assumed by the short seller on the date of the exchange.

In the memorandum referred to above (file #7-3945) the Financial Institutions section stated that the proceeds of disposition to the short seller of the securities were as follows:

• The proceeds from the disposition by the lender would be equal to the value of the consideration received i.e. the value of the right to require delivery of identical shares at a specified time for no further consideration.

If the proceeds of disposition to the short lender are equal to the value of the right to receive identical shares later, there is every reason to believe that the cost to the short seller of acquiring the shares is equal to the proceeds of disposition to the short lender.

Our position also finds support in the fact that the relationship" between the short seller and the short lender involves two reciprocal donations. Here we should recall the quotation from Mignault, where he indicates "L'echange est donc un contrat par lequel les parties se donnent reciproquement, ou s'engagent a se donner, une chose pour une autre.". (Free translation: "Exchange is thus a contract by which the parties give each other, or undertake to give each other one thing for another"). Thus, paragraph 69(1)(c) of the Act provides that where a taxpayer acquires property by way of gift he is deemed to have acquired it for a sum equal to its fair market value at the time he so acquired it.

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After analysing the decision of the Supreme Court of Canada in Canadian General Electric Co Ltd v. M.N.R., [[1961] C.T.C. 512] 61 D.T.C 1300, the author of the opinion stated the following at page 24:

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Thus, in a short sale, if the short seller sells a security for a price equal to its fair market value, for example $100, the cost of the security sold to the short seller will also be $100. Usually there will not be a gain or loss in short selling. However, if the quoted value of the security sold falls between the date on which it is sold and the date on which the security is given back to the short lender (short covering transaction), the gain attributable to this fall in value will be viewed by the Department of Revenue as business income of the short seller for the taxation year in which the short covering transaction takes place. Since this business income must be included under section 9 of the Act, paragraphs 80(1)(a) and (b) of the Act (settlement of debts) will not apply because of paragraph 80(1)(f) of the Act.

• (d) "Expense" dividends

In short selling transactions the short lender agrees to relinquish his security to the extent that the short seller later returns an identical security and compensates him for the value of any dividend that may be declared on the security in the meantime.

Should the short seller be forced to pay the short lender a sum in compensation for dividends declared on the security involved in the short selling, we feel that this sum must be treated either as an integral part of the cost of the security (that has to be given back to the short lender) to the short seller or as an expenditure for the purpose of earning business income. whichever position is adopted, the result will be the same, given the Department's position that an expenditure must generally be claimed in the year in which the income to which it relates is taxed. This position is stated in paragraphs 2 and 3 of Interpretation Bulletin IT-417R, dated July 5, 1982:

• 2. As a general rule, taxpayers are required to use the accrual method of accounting to calculate the income from a business or property as contemplated by section 9. In calculating income for tax purposes, the Department requires that the accounting for prepaid expenses and deferred charges be in accordance with the matching principle as required in generally accepted accepted principles, subject always to any contrary provision of the Act.
• 3. To remove any uncertainty, subsection 18(9) of the Act was enacted into law on February 26, 1981 effective from December 11, 1979 and requires a taxpayer to match certain specified expenditures to the taxation year to which they can reasonably be considered to relate. The Department takes the view that subsection 18(9) was enacted for greater certainty and notwithstanding that it does not cover deferred charges or all types of expenses that can be prepaid, it is considered that the Income Tax Act (even as it read prior to the introduction of subsection 18(9)) always required and continues to require that all costs that could clearly be related to future periods be expensed in those periods, if they are material and if failure to defer the expense would distort the net profit not only of the year during which the expense was incurred but also of the subsequent year or years to which the benefit relates. The Department recognizes that the determination of such materiality is a matter of judgement and has not therefore established any de minimis rules. The Department will, in any case, continue its present practice of ignoring adjustments for insignificant amounts. (Emphasis added.)

The principle is therefore that the expense dividends paid by the short seller cannot be deducted by him until the taxation year of the income to which it relates. The exception is that the Department is prepared to allow the deduction of "expense" dividends in the year of payment if the value of such expenses is insignificant.

CONCLUSION

In our view, short selling a security does not in itself give rise to income and it is only the economic gain realized as a result of a fall in the quoted value of the security that will produce a taxable gain for the short seller. The income will be taxable in the taxation year in which the short covering transaction occurs and will be equal to the amount by which the cost of acquisition to the short seller of the security sold short exceeds the cost to this person of the stock given back to the lender. This income is taxed as business income. Note that if the quoted value of the security increases rather than drops, all the transactions may result in a business loss to the short seller if we are dealing with a business within the meaning of subsection 248(1) of the Act.

"Expense" dividends must normally be deducted from the income to which they relate and only in the year in which such income is taxed. However, the Department is prepared to allow these expenses to be deducted in the year in which they were incurred, despite the fact that the corresponding income is not included until a subsequent year, as long as the amount of these expenses is immaterial.

Finally, we wish to draw your attention once again to the fact that the opinions stated in this memorandum do not take into account the Draft Legislation Concerning Security Lending and Dividend Rental Arrangement Release issued by the Department of Finance on April 27, 1989. This Draft Legislation contains a number of presumptions that will make our statements on short selling transactions concluded after April 26, 1989, to which the new rules will apply, irrelevant.