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: Information requested with respect to option investing in a registered account
Position: General comments provided
Reasons: Application of the provisions of the Act
February 8, 2011
Dear XXXXXXXXXX ,
Re: Option Investing in a Registered Account
This is in response to your email dated April 23, 2010, wherein you requested information regarding option investing in a registered account.
Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an Advance Income Tax Ruling request. Where the particular transactions are completed, the inquiry should be addressed to the relevant Tax Services Office. We are, however, prepared to provide the following general comments on option transactions. Although these comments are provided in the context of tax-free savings accounts (TFSAs), similar rules apply to registered retirement savings plans, registered retirement income funds and registered education savings plans.
In general, a trust governed by a TFSA is permitted to invest in publicly-listed put and call options. Paragraph (d) the definition "qualified investment" in section 204 of the Income Tax Act (the "Act"), which is incorporated by reference into the TFSA qualified investment definition in subsection 207.01(1) of the Act, provides that any security (other than futures contracts or other derivative instruments in respect of which the holder's risk of loss may exceed the holder's cost) that is listed on a designated stock exchange is a qualified investment.
Certain unlisted options are also eligible for investment. Pursuant to paragraph 4900(1)(e) of the Income Tax Regulations, an option is a qualified investment if it gives the holder the right to acquire, either immediately or in the future, property that is a qualified investment. In general, the underlying property must be a share, unit, debt or warrant of the issuer of the option and the issuer cannot be a connected person in relation to the TFSA trust.
With respect to the writing of put and call options, no property is actually acquired by the option writer at the time the option is sold (other than the option premium). The option writer merely accepts the obligation to sell or buy the underlying property at the agreed upon price should the option holder exercise their right. Therefore, option writing, in and of itself, is generally not subject to or constrained by the TFSA qualified investment rules. It should be noted, however, that several income tax rules may restrict the ability of a TFSA trust to engage in option writing strategies.
Subsection 146.2(6) of the Act provides that a TFSA trust is taxable on any business income earned by the trust. A TFSA trust that engages in option writing strategies that are speculative in nature may be considered to be carrying on a business and thus taxable on any premiums or other income earned in connection such activities. The determination of whether a particular taxpayer carries on a business is a question of fact that can only be determined following an assessment of all of the facts relating to the taxpayer's particular circumstances.
It is our view that the writing of a covered call option, whereby a TFSA trust sells a call option in respect of an underlying property which it already owns, does not result in the TSFA trust being considered to be carrying on a business. In contrast, the writing of an uncovered call option, or the writing of a put option, whether alone or in combination with other positions, may result in the TFSA trust being considered to be carrying on a business. As noted above, such a determination is a question of fact.
Paragraph 146.2(2)(f) of the Act prohibits a TFSA trust from borrowing money or other property for the purposes of the arrangement. Depending on the circumstances, the writing of an option may result in the writer having to borrow funds to cover their obligation under the option agreement. If a TFSA trust were to borrow money, it would cease to be a TFSA and automatically lose its tax-exempt status.
It is common practice for brokerage firms to impose margin requirements in connection with various options strategies. For example, an option writer may be required to deposit cash with their brokerage firm to cover their obligation under the option agreement. If a TFSA trust were to deposit cash with a brokerage firm for any length of time (i.e., longer than a few days), it is our view that the deposit would generally not be a qualified investment for the TFSA trust. Where a TFSA trust acquires a non-qualified investment, section 207.04 of the Act imposes a special tax on the holder of the TFSA equal to 50% of the fair market value of the property. In addition, any income earned on a non-qualified investment is taxable in the hands of the TFSA trust pursuant to subsection 146.2(6) of the Act.
The qualified investment rules may also have application where the option premium is paid in non-cash form or in the case of a non-cash settled option. Any property that is acquired by a TFSA trust must be a qualified investment in order to avoid the adverse tax consequences described above.
In addition, the TFSA advantage rules in section 207.05 of the Act could have application if a TFSA trust were to engage in certain option strategies. This would be the case, for example, where the counterparty to the option contract does not deal at arm's length with the TFSA holder or where the contract does not reflect commercial terms the result of which is to artificially shift value into the TFSA. If a transaction were found to be an advantage under these rules, any increase in the fair market value of the TFSA property that is reasonably attributable to the advantage would be subject to a special 100% tax.
We trust that these comments will be of assistance.
Mary Pat Baldwin, CA
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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