1 November 2010 External T.I. 2010-0364991E5 - Transaction in securities

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: 1) What is the tax treatment of a gain or loss on a short sale transaction? 2) What is the tax treatment of the compensatory payments on short sale transactions?

Position: 1) Usually considered as income taxable pursuant to subsection 9(1) of the Act. 2) Where the transaction is considered a SLA pursuant to subsection 260(1) of the Act, the tax consequence is governed by the provisions of subsections 260(5) and (6) of the Act.

Reasons: Consistent with CRA's published position set out in paragraph 18 of IT-479R.

XXXXXXXXXX
									2010-036499
									V. Srikanth
November 1, 2010

Dear XXXXXXXXXX :

Re: Short Sale Transaction

This is in response to your e-mail dated April 23, 2010, wherein you requested our comments on the tax implications of a short sale transaction. Specifically, you wanted our views on the tax treatment of:

• a gain or loss on a short sale of securities, and
• dividends paid in a short sale transaction.

Our Comments

Written confirmation of the tax implications inherent in actual proposed transactions is given by this Directorate only where the transactions are the subject of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, entitled Advance Income Tax Rulings. This Information Circular and other Canada Revenue Agency ("CRA") publications can be accessed on our website at http://www.cra-arc.gc.ca. If, however, the particular transactions are completed or partially completed, the enquiry should be addressed to the relevant Tax Services Office. Your request was not submitted as an advance income tax ruling request, however, as stated in paragraph 22 of IC 70-6R5, we do provide written opinions on general enquiries which are not binding and we are prepared to provide you with the following comments.

Selling Short

In the discussion of a convertible hedge strategy in the Federal Court of Appeal decision, Rezek et al v the Queen (2005 DTC 5373), the following comments were made with respect to short sale transactions:

"A short sale of shares is a sale of shares that the seller does not own. The shares are said to be "borrowed", and that means that the sale is facilitated by entering into an agreement with a broker who will permit the sale of shares belonging to another person (who may be the broker or a customer of the broker). The proceeds of the sale, net of broker's fees, are credited to the account of the short seller... When shares are sold short, [the short seller pays a] fee called a "rental fee" to the broker. In addition, [the short seller pays] an amount equal to the dividends paid on the shares ("compensatory dividends") between the time they are borrowed and the time they are returned.

[Generally,] a profit or loss on a short sale is determined when the short sale is "closed out". That occurs when the short seller replaces the borrowed shares. This is done by having the broker purchase an equivalent number of identical shares for the person who lent them to the short seller. The cost of the purchase, including broker's fees, is debited to the account of the short seller.

If the cost of acquiring the replacement shares is less than the proceeds of the short sale (because the value of the shares has declined), the short seller realizes a profit on the short sale. [However,] if the cost of acquiring the replacement shares is more than the proceeds of the short sale (because the value of the shares has increased), the short seller will realize a loss on the short sale. Any broker's fees, rental fees and compensatory dividends paid by the short seller between the short sale and the close out will reduce the profit or increase the loss.

A short sale of shares is different from a normal sale of shares in two ways. First, the seller receives the proceeds of sale before incurring the cost of acquiring the shares. Secondly, a short sale results in a profit only if the value of the shares declines, while a normal sale results in a profit if the value of the shares increases."

The tax consequences of a short sale transaction depends on whether it is considered a securities lending arrangement (a "SLA") as defined in subsection 260(1) of the Act. When such a transaction satisfies the definition of a SLA, the provisions of section 260 will govern the tax treatment. Basically, in a SLA, qualified securities are lent or transferred from one party (the 'lender') to another (the 'borrower'), with whom the lender deals at arm's length. The arrangements are in place such that the borrower can reasonably be expected to return the lent security to the borrower at a later date. Further, the arrangement must be such that the lender's risk of loss or opportunity for profit in respect of the loaned security is not changed in any material respect, and in situations where the qualified security is a share of a corporation, the borrower must be obligated to pay the lender amounts equal to and as compensation for dividends that would have been received by the lender on the loaned or transferred security if it had not been loaned or transferred.(Short seller and borrower may be used interchangeably throughout this letter.)

We provide below our comments on the tax consequences when a transaction is not considered a SLA and when it is.

Gain or Loss on a Short Sale

I) Transaction is not a SLA- section 260 does not apply

It is CRA's position that the transfer of the securities by a lender to a 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 honour 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.

II) Transaction is a SLA - provisions of section 260 apply

In the case of a short sale arrangement to which section 260 of the Act applies, the lender is deemed not to have disposed of the shares for purposes of the Act pursuant to subsection 260(2). The borrower, however, is considered to have acquired the shares and the consideration paid to the lender is the obligation of the borrower to deliver identical shares to the lender at some time in the future. While a question of fact, it is arguable that the value of this consideration is equal to the fair market value at the time the shares are acquired.

Consequently, the borrower is considered to have acquired the shares from the lender and to have then sold them and, if these transactions form a constituent part of the business activity of the particular taxpayer, any resulting income would be included in the income of the borrower for tax purposes pursuant to section 9 of the Act. In a situation in which these two transactions occur contemporaneously, the short sale proceeds may well equal the cost of the shares acquired by the borrower from the lender with the result that there would be no net amount included in the income of the borrower at the time of the short sale.

As regards the determination of the gain or loss, as the case may be, to the borrower upon the termination of the short sale, generally, the tax consequence is the same to the borrower irrespective of whether the short sale transaction was considered a SLA. (That is, the borrower will purchase from a third party the number of securities it originally borrowed 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.)

This above paragraph reflects the general position and as such it might not apply to the terms and circumstances of a particular lending arrangement. As stated in paragraph 18 of the Interpretation Bulletin IT-479R, entitled Transactions in Securities, the gain or loss on the "short sale" of shares is generally considered to be on income account; however, this depends on the facts of the case. If short sale transactions form a constituent part of the business activity of the particular taxpayer, any resulting income would be included in the income of the short seller for tax purposes pursuant to section 9 of the Act. Whether the income is business or property income depends on the facts of the case.

However, where a short sale is entered into in order to hedge a taxpayer's position with respect to shares held on capital account, the short sale is considered to be on capital account. It may also be noted that where a taxpayer is eligible to make an election under subsection 39(4) of the Act, and does so, the gain or loss on a short sale of Canadian securities, would be on account of capital. Again, this is a question of fact.

Further, based on the realization principle, the gain or loss is realized only when the short sale transaction is closed. A short sale transaction is considered completed only when the short seller already owns or purchases identical shares and returns the same to the lender, thereby, settling the obligation. Where the short seller satisfies the obligation by borrowing an identical security from a different broker, it does not close the short position of the initial borrowing, i.e., the constant borrowing of shares to repay the previous lender does not close out the short position.

Compensation payment

As noted above, in a short sale transaction, the seller of the shares does not own the shares to be sold and, in order to effect the sale, borrows shares from the actual owner and then sells those borrowed shares to a third party. Hence, the short seller may be expected to compensate (make 'compensatory payments') to the lender of the securities for any income lost on those securities during the holding period. Again, when such a transaction satisfies the definition of a SLA in subsection 260(1) of the Act, the provisions of section 260 will govern the tax treatment of the compensation payment.

I) Transaction is not a SLA - section 260 does not apply

In the case of a dividend compensation payment, it is a question of fact as to whether such payment, under the terms of a lending arrangement to which section 260 does not apply, may be deductible by the borrower. In our view, such payments may be deductible to a payor as an outlay or expense incurred for the purpose of gaining or producing income from a business. Where it is determined that the short sale is on income account, a compensation payment may be deductible to a borrower who is in the business of trading in securities, under subsection 9(1) of the Act, in the year that the short sale transaction is completed, i.e., in the year of purchase to replace the shares borrowed. However, where the transaction is on account of capital, 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.

II) Transaction is a SLA - provisions of section 260 apply

a) Dividend payment

In a SLA, any dividend compensation payment received by the security lender is governed by subsection 260(5) of the Act, while the treatment for the payor, i.e., the security borrower of the amount, is governed by subsections 260(6) and (6.1) of the Act.

With respect to the security lender, an amount received as compensation for a dividend on the security will be deemed to have been received by that person as a taxable dividend on the share to the extent that the various conditions prescribed in subsection 260(5) are met. With respect to non-dividend compensation, the characterization of the income will depend on the source of the income. (The proposed new subsection 260(5.1), as discussed below, addresses the taxation of non-dividend compensation in the hands of the lender.)

With respect to the payor of the compensation payment, pursuant to subsection 260(6) of the Act, where a taxpayer is not a registered securities dealer, no deduction is allowed where such amounts if paid would be deemed by subsection 260(5) to have been received by another person as a taxable dividend. Where the taxpayer is a registered securities dealer, the amount of the deduction is restricted to 2/3 of the amount paid as compensation.

b) Other compensatory payments

Other compensation payments which are not deemed to be received as dividends by virtue of subsection 260(5) of the Act are treated the same as compensation payments where the transaction is not a SLA and the comments above apply here as well.

c) Proposed amendments to section 260

It should be noted that amendments have been proposed to subsection 260(5), which make reference to new subsection 260(5.1), and subsection 260(6). The proposed amendments, (pursuant to subsection 155(7) of the Income Tax Amendment Act, 2010, Legislative Proposals of July 16, 2010, previously Bill C-10 (2007)), are applicable to arrangements made after 2001. The Department of Finance's Technical Notes, with respect to those proposals, state that:

"New subsection 260(5.1) of the Act treats a given compensation payment as one of three things: a dividend, an amount paid by a trust and having the same characteristics, source and purpose as the "underlying payment" amount paid by the trust directly, or interest. The overall effect of the provision is, in addition to replicating the former dividend deeming rule, to deem compensation payments in respect of payments from a trust to have the same characteristics, source and purpose as if the amounts were paid by the trust."

The Technical Notes give the following explanation to the proposed amendment to subsection 260(6):

"Amended subsection 260(6) retains this 2/3 dividend compensation payment deduction for registered securities dealers. It also allows any taxpayer - including but not limited to registered securities dealers - a deduction in respect of compensation payments, either SLA compensation payments or dealer compensation payments (both are new terms defined under the proposed amendments to subsection 260(1) of the Act), that are not dividend compensation payments. The amount of this new deduction is computed differently depending on the actions of the taxpayer in question (the one who made the payment and seeks to deduct it). If the taxpayer has disposed of the borrowed security and has included any resulting gain or loss in computing business income, the compensation payment is fully deductible. In any other case, new subsection 260(6) allows a deduction to the extent of the lesser of (i) the compensation payment and (ii) the amount, to which the compensation payment relates, included in the taxable income of the taxpayer or persons related to it."

We trust our comments will be of assistance to you.

Yours truly,

R.A. Albert, CA
For Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch