Exemption of foreign exchanges from requirement to be recognized (pp. 17:9-10)
[T]he explanatory notes to the July 31, 2015 legislative proposals indicate that an exchange will be a recognized derivatives exchange if a provincial securities commission has published a statement or notice to this effect and that both Canadian and foreign exchanges potentially meet the requirements of the definition. However, it is understood that securities commission notices usually exempt foreign exchanges from the requirement to be recognized or registered
Ambiguity of purpose test (p.17:11)
It is unclear what the "main reason" anti-avoidance test in point 1(b) above is targeting. It appears to apply where one of main reasons for entering into the agreement is to obtain the benefit of a deduction in respect of a dividend equivalent payment or a reduction of an income inclusion on account of an adjustment for dividends on the underlying shares.
No allowance for profit on qualifying offset (p.17:11)
Subparagraph (b)(ii) of the "synthetic equity arrangement" definition excludes an agreement that would otherwise be a synthetic equity arrangement where it was entered into for the purpose of offsetting all amounts included or deducted in computing the taxpayer's income with respect to another agreement of the taxpayer under which the taxpayer receives substantially all of the economics in respect of the share (an agreement under which the taxpayer has the long position). This provision is intended to apply to exempt an equity derivative from being a synthetic equity arrangement when the taxpayer entered into the derivative to hedge the taxpayer's long position under another derivative. An issue with the wording of this exception is that the purpose test requires that the derivative have been entered into to offset all amounts under the long position, which is unlikely to be the case because it does not allow for any profit to be earned between the two transactions.
Exclusion for acquisition of control (p. 17:11-12)
Subparagraph (b)(iii)…was introduced in the legislative proposals released on July 31, 2015 in response to a submission by the Joint Committee on Taxation…[which] noted that the version of the rules in the 2015 federal budget could apply in many typical commercial share-purchase transactions whereby pre-sale dividends (including safe income dividends) are paid.
Ordering rule limiting access to 365-day stop-loss exception (p.17:14)
[A] specific ordering rule will be included in subsection 112(10), which provides that if a synthetic equity arrangement is in respect of fewer shares than owned by the taxpayer, that arrangement is deemed to be in respect of the shares in the order in which the taxpayer acquired them for the purpose of the stop-loss rules. This ordering rule prevents a taxpayer from matching synthetic equity arrangements to more recently acquired shares, while allowing previously acquired shares to meet the 365-day ownership requirement and benefit from the exclusion from the stop-loss rules on a subsequent disposition.
Deemed non-ownership under SDA for stop-loss purposes (p. 17:14)
An additional rule in subsections 112(8) and (9) also applies where the derivative is a "synthetic disposition arrangement" (as defined in subsection 248(1)). As noted below, the typical types of equity derivatives discussed herein are synthetic disposition arrangements. In such cases, where the derivative is for 30 days or more, the taxpayer is deemed not to own the shares for the purpose of the stop-loss rules for the duration of the derivative unless the taxpayer held the shares for the 365-day period that preceded the date of the derivative.
Previous forward agreements engaging the rule (pp. 17:14-15)
...Prior to the introduction of the rules, many mutual funds were entering into forwards in respect of shares of Canadian corporations to effectively convert ordinary income into capital gains….
The first version was a forward agreement whereby the mutual fund would purchase a portfolio of shares of Canadian corporations on the day that the forward was entered into. The mutual fund would sell those shares to the counterparty under the forward on the settlement dates in return for cash in an amount based on a return on other property (property that would produce income if held by the mutual fund). The mutual fund would have made an election under subsection 39(4) so that there is no question that the disposition of the shares would be on capital account, given that mutual fund trusts and mutual fund corporations are excluded from the exceptions in subsection 39(5) to making the subsection 39(4) election. Therefore, any gains by the mutual funds on dispositions of the shares were capital gains.
The other version of these transactions was a prepaid forward agreement whereby the mutual fund would pay a fixed sum of money at the outset of the agreement as a prepayment for the purchase of shares of Canadian corporations that would be received by the mutual fund at the time of the settlements under the agreement. The value of the shares of the Canadian corporations delivered to the mutual fund on the settlement dates would be based on a return on other property (property that would produce income returns if held by the mutual fund). The mutual fund would take the position that there was no gain under the forward because of section 49.1, which provides in general terms that there is no disposition of a right to acquire property under a contract when the property is acquired under such contract. In addition, the mutual fund would sell the shares acquired under the forward on the market, and it would report any gain as a capital gain (the mutual fund would have made the subsection 39(4) election as described above).
The derivative forward agreement rules are intended to prohibit these character conversion transactions by including the full amount of any return arising as a result of a derivative forward agreement as income under paragraph 12(l)(z.7) (or allowing, any loss to be deducted under paragraph 20(1)(xx))….
Equity forward not a DFA based on implicit interest factor (pp. 17:16)
The concern that has been raised in respect of equity forwards is that the forward price is typically determined, in part, by applying an interest factor for the expected term of the agreement. However, in any agreement for a purchase at a future date, one would expect that the purchase price would need to take into account the time value of money. Given the purpose of the rules and the fact that equity forwards would not typically provide how the forward price is determined, it seems unlikely that a court would conclude that a typical equity forward as described under the heading "Overview of Derivatives" is a derivative forward agreement. Such a conclusion is even less likely where the taxpayer is the purchaser, because the time of settlement is the relevant time for determining whether the difference between the amount paid and the fair market value of the property is in part attributable to interest, and at that time such a difference may not be attributable to interest at all.
Potential capital treatment of equity derivatives (p.17:18-19)
[E]quity derivatives in many cases are not entered into to hedge exposure to other property. Rather, other transactions may be entered into to hedge a party's obligation under the equity derivative (the party with a short position will typically purchase the reference shares to hedge its position under the equity derivative). ...
The CRA appears to assume [e.g., in 2011-0418541I7] that a derivative that is not entered into for hedging purposes is speculative. However, this will not always be the case. For example, what if a person acquires a long position under a TRS in respect of shares because it was restricted from purchasing the underlying shares, and the reason for entering into the TRS was to receive dividend equivalent payments (and not a gain on settlement) but the person happens to realize a gain on settlement? In these circumstances, the gain on settlement should be on capital account.
Implicit interest element where mismatched equity swap payments (p. 17:19-20)
[I]f the periodic payments under a TRS are not made by both parties contemporaneously, the CRA has stated that it will consider the payments made later to contain an interest element that could be subject to withholding tax [f.n. 23...2000-0051017....]. Although these comments were made in the context of interest rate swaps, the principles may potentially be extended to equity derivatives where there is a mismatch in the timing of payments. Any such interest will be subject to withholding tax under paragraph 212(1)(b) only if it is paid to a person with whom the payer does not deal at arm's length or if the interest constitutes "participating debt interest"… .
Non-application to equity swaps (p. 17:20)
The CRA has taken the position that where a Canadian resident borrower of a security pays a lending or borrowing fee to a non-resident as part of a securities lending agreement that is not governed by section 260, the fee would generally be considered to be for the use of or the right to use property in Canada and fall within 212(l)(d) [f.n.26...9530420...]. The CRA has been less clear in determining whether compensation payments for dividends or interest paid as part of such agreements would fit within paragraph 212(l)(d) and has generally indicated that this would be a question of fact.
However, paragraph 212(l)(d) should have no application to payments under a typical equity derivative. The relevant provisions in paragraph 212(l)(d) apply where the payments are for the use or the right to use property in Canada or are dependent on the use or production from property in Canada; but the payments (or adjustments) under a typical equity derivative are only in respect of notional or reference property and are not payments for the use of any property or based on any actual receipts by the party with the short position. Whether the party with the short position chooses to hold actual shares to hedge its position under the equity derivative should not affect this conclusion.
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