3 July 2002 External T.I. 2002-0131355 - SHORT SALE

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 CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues:

Whether a a short sale transaction will be recharacterized such that the securities borrower will be considered to have disposed of other shares (original shares) which he or she acquired less than 2 years earlier through a stock option plan and held as investments and that are otherwise identical to the borrowed shares and which are ultimately used to settle the short position and as a consequence the original shares may not be eligible for the stock option deduction under paragraph 110(1)(d.1).

Position TAKEN:

The substance or economic realities of the series of transactions will not be used to recharacterize the short sale transaction.

Reasons FOR POSITION TAKEN:

The SCC's reasons in Shell held that the economic realities of a situation cannot be used to recharacterize a taxpayer's bona fide legal relationships. A contract relating to the short sale of securities acquired under the terms of a securities lending arrangement and the legal relationships created therein cannot, absent a specific provision of the Act to the contrary or a finding that there is a sham, be recharacterized. As such, a short sale transaction to hedge an individual's position with respect to identical shares held on capital account will not be considered a disposition, for purposes of the Act, of other shares held by the borrower that are otherwise identical to the borrowed shares and which are ultimately used to settle the short position.

XXXXXXXXXX 2002-013135
P. Diguer
July 3, 2002

Dear XXXXXXXXXX:

Re: Paragraph 110(1)(d.1) of the Income Tax Act (Canada) (the "Act")

This is in reply to your letter dated March 19, 2002, in which you request our views on the application of paragraph 110(1)(d.1) of the Act as it relates to a series of transactions that includes an acquisition of shares through a stock option plan, a securities lending arrangement and a short sale.

In particular you describe a situation where a Canadian resident individual (the "Individual") acquires shares (the "Shares") of a Canadian-controlled private corporation through his or her employer's stock option plan at an option exercise price that is less than the fair market value of the Shares at the time of granting. The Individual's acquisition of the Shares is subject to the rules in subsection 7(1.1) of the Act such that the benefit, if any, may be included in income only in the year the Shares are sold. The Shares are held by the Individual on capital account.

The Shares are currently trading at a higher price than the option exercise price at which the Shares were acquired. However, the market value of the Shares is steadily declining and the Individual wishes to dispose of the Shares before a further decline in their value. Nevertheless, the Individual does not wish to dispose of the shares within 2 years after the date on which the Shares were acquired in order that the deemed benefit, if any, pursuant to subsection 7(1)(a) on the sale of the Shares may be eligible for the stock option deduction under paragraph 110(1)(d.1).

As such, the Individual enters into a short sale of shares that are identical to the Shares in order to hedge his or her position with respect to the Shares. Sometime after the 2nd anniversary of the acquisition of the Shares, the Individual settles his or her short position by using the Shares to repay the borrowed securities which were received from the securities lender. The Individual will then have full use of any gain realized as a consequence of the series of transactions described above.

You ask that we confirm the following:

(a) the short sale transaction will not result in a disposition of the optioned securities for purposes of the Act;

(b) the settlement of the short position using the Shares will result in a capital gain or loss on the disposition of the Shares;

(c) the gain or loss on the short position will also be considered a capital gain or loss.

(d) if the Shares were acquired through stock options exercised after February 28, 2000, that the adjusted cost base ("ACB") of the Shares be tracked separately from the ACB of the borrowed shares.

Our comments

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. However, advance income tax rulings are not given where the major issue is whether a transaction should be viewed as being of an income or capital nature. Where the particular transaction is completed, the inquiry should be addressed to the relevant Tax Services Office. Although we are unable to provide an opinion in respect of the specific transactions described in your letter, we offer the following general comments in connection with your request which we hope are of assistance to you.

Short sales

The Supreme Court has held, in Shell Canada v. The Queen 99 DTC 5669 (SCC) and other decisions, that the economic realities of a situation cannot be used to recharacterize a taxpayer's bona fide legal relationships. It has held that, absent a specific provision of the Act to the contrary or a finding that there is a sham, the taxpayer's legal relationships must be respected in tax cases.

Thus, it is our view that generally a contract relating to the short sale of securities acquired under the terms of a securities lending arrangement and the legal relationships created therein cannot, absent a specific provision of the Act to the contrary, the general anti-avoidance rule or a finding that there is a sham, be recharacterized. As such, a short sale transaction to hedge an individual's position with respect to identical shares held on capital account will not be considered a disposition, for purposes of the Act, of other shares held by the borrower that are otherwise identical to the borrowed shares and which are ultimately used to settle the short position.

It is a question of fact whether a gain or loss on the disposition of a share is on income account or capital account. However, the CCRA generally considers the gain or loss realized by a taxpayer on the disposition of a share held for investment purposes to be on 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. In this regard we would consider a short sale entered into in order to hedge a taxpayer's position with respect to identical shares held on capital account to be a short sale that is on capital account.

Identical properties

Subsection 47(3) of the Act exempts certain securities acquired after February 27, 2000 from the provisions of subsection 47(1) (the averaging rule for identical properties) of the Act. The securities which may be exempted from the identical properties rule include a share acquired in circumstances to which subsection 7(1.1) of the Act applies.

Subsection 47(3) of the Act exempts the securities from the averaging rule in subsection 47(1) of the Act by deeming such securities not to be identical to others acquired by the taxpayer for purposes of section 47 of the Act. Each security to which subsection 47(3) of the Act applies has its own unique ACB, with the result that the capital gain and loss on its disposition is determined without regard to the ACB of other securities owned by the taxpayer.

We trust our comments will be of assistance to you.

Yours truly,

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