Derivative Forward Agreement

Administrative Policy

2 December 2014 CTF Roundtable, Q. 1

exchangeable shares and units generally not DFAs

Embedded right. Does the first fact pattern in the Explanatory Notes under the heading "Example – Exchangeable Shares", involving a share of a Canco that is exchangeable by its terms for shares of a Forco, not constitute a "derivative forward agreement" because the exchange right embedded in the share is not an agreement? CRA responded:

The DFA rules are… intended to address certain structures that have the effect of transforming income into capital gains. … The CRA cannot confirm that an exchange right embedded in a share is not an "agreement" for purposes of the DFA definition. The reason why the first fact pattern in the explanatory note example is not a DFA and the second pattern is a DFA relates to subparagraph (c)(ii) of the DFA definition, as discussed further below. An analysis of the other portions of the DFA definition needed to be undertaken regardless of whether the exchange right is an agreement because the call right is an agreement.

Q.1 (b) Ancillary put right. Where the terms of an exchangeable share permit the taxpayer to exchange its shares with the issuer for shares of another company, would ancillary rights enabling such taxpayer to put its shares to another person for the shares of the other company in the event the issuer is unable to effect the exchange be considered to be an agreement for purposes of the DFA definition? CRA responded:

No… We would require further information regarding the nature and form of these rights to make a determination.

Q1. (c) Embedded partnership unit

Is the answer to Q1(a) or Q1(b) affected by whether the property is a partnership interest (which is contractual in nature) or a share? CRA responded:

The answers to [(a)] and [(b)] apply equally to a partnership interest. …As discussed…below…many exchangeable partnership interests would not be DFAs as a result of subparagraph (c)(ii) of the DFA definition.

Q1. (d) Parent with other assets

How does (c)(ii) of the DFA definition apply to the right to exchange shares for securities (the "second securities") of another entity that only holds interests (directly or indirectly) in the entity that issued the exchangeable shares, or that also holds other property the fair market value of which exceeds the fair market value of direct and indirect interests in the entity? CRA responded:

The CRA will compare the opportunity for profit and risk of loss of the exchangeable shares to the opportunity for profit and risk of loss of the second securities. Consistent with the explanatory notes, many standard exchangeable share transactions will not be DFAs as a result of the application of (c)(ii) of the DFA definition because the risk of loss and opportunity for profit associated with the exchangeable shares will generally be very similar to the risk of loss and opportunity for profit associated with the second securities.

Articles

Joint Committee, "Technical Amendments Package of September 16, 2016", Submission letter of 15 November 2016

The draft DFA amendment erroneously refers to an obligation that is “capital property” rather than an “obligation.”

Raj Juneja, "Taxation of equity derivatives", 2015 CTF Annual Conference paper

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.

Edward Miller, Matias Milet, "Derivative Forward Agreements and Synthetic Disposition Arrangements", 2013 Conference Report, (Canadian Tax Foundation), pp 10:1-50

Targeted mutual fund forward sale agreements (p. 10:2)

Many mutual funds (both mutual fund trusts and mutual fund corporations…) used forward agreements (both forward sale transactions and forward purchase [or pre-paid forward] transactions) to provide investors with an economic return based on the performance of a reference portfolio that would generate ordinary income while having that return taxed as a capital gain….In the case of a forward sale agreement, the mutual fund would enter into an agreement with a counterparty (often a financial institution) to sell the Canadian securities portfolio for a purchase price based on the performance of the bond portfolio to which the mutual fund was seeking to gain exposure. Each time the mutual fund would settle the forward agreement physically (that is, sell Canadian securities to the counterparty under the forward agreement), the mutual fund would realize gains and losses on capital account, and, by virtue of the forward agreement, such capital gains and losses would reflect a return based on the performance of the bond portfolio.

Targeted mutual fund forward purchase agreements (p. 10:2-3)

An alternative structure would be where a mutual fund would enter into an agreement to acquire a portfolio of Canadian securities. The mutual fund would prepay its obligation to purchase the portfolio of Canadian securities upon entering into the agreement. The value of the Canadian securities to be delivered on settlement of the agreement would be determined by reference to the performance of, for example, a bond portfolio (as in the forward sale example described above). Each time the mutual fund physically settles the forward agreement, the counterparty to the forward purchase agreement would deliver Canadian securities with a value based on that of the bond portfolio and the mutual fund would then immediately sell the Canadian securities for cash. The Canadian securities would generally be listed, non-dividend paying shares of Canadian public corporations that would be sufficiently liquid to allow for an immediate sale by the mutual fund.

Application of s. 248(10) to "series" (p.10:5)

The DFA definition applies to a single agreement with a term that exceeds 180 days, as well as a series of agreements where the term of the series exceeds 180 days. It is arguable that the concept of "series of agreements" concept is covered by subsection 248(10), which provides that "the series shall be deemed to include any related transactions or events completed in contemplation of the series". [fn 9: See Michael Kandev, Brian Bloom, and Olivier Fournier, "The Meaning of ‘Series of Transactions’ as Disclosed by a Unified Textual, Contextual, and Purposive Analysis" (2010) 58:2 Canadian Tax Journal 277-330, at note 6, where the authors state that "[w]e are of the view that the application of subsection 248(10) is not limited only to those instances where the exact expression 'series of transactions or events' appears in the Act. Significantly, this expression is the broadest of the 'series' references in the Act and should be seen to include the narrower references in other provisions. In this regard, see the decision of the Federal Court of Appeal in OSFC...where Rothstein J stated, at paragraph 37, 'I read subsection 248(10) to apply whether a series is a series of transactions, a series of events, or a series of transactions and events.' Also consider that subsection 248(10)...is intended to clarify the meaning of the word "series" and not the meaning of the words 'transaction' and 'event.' Therefore, subsection 248(10) should apply to all 'series' references in the Act"] If subsection 248(10) applies to modify the concept of series of agreements, a taxpayer's intention regarding the term of an agreement on entering into an initial agreement with a term of 180 days or less is unlikely to be relevant if a subsequent agreement or subsequent agreements, when combined with the term of the initial agreement, results in a series of agreements with a term in excess of 180 days….

Distinction between ACB and cost/proceeds and sale price (p. 10:12)

[P]aragraph 49(3)(b) provides that the cost to the purchaser of the property under an option includes the adjusted cost base to the purchaser of the option itself….

[P]aragraph 49(3)(a) provides that the proceeds of disposition to the person disposing of property on the exercise of an option include the consideration received by that person for the option (i.e., the option premium)….

Example of distinction between ACB and cost (p. 10:13)

[A] taxpayer has an option to purchase a share that would be held as capital property in 200 days. The taxpayer paid an option premium of $3, the strike price of the option is $105, the fair market value of the share at the time of acquiring the option is $100, and the fair market value of the share at the time of exercising the option is $107.

The fair market value of the property delivered on settlement of the agreement is $107. If the amount paid for the property is the strike price of $105, the difference of $2 appears to be wholly attributable to the change in the fair market value of the property over the term of the agreement (an increase of $7). Accordingly the exception in subparagraph (b)(i) of the DFA definition in subsection 248(1) should apply, and the exercise of the option to purchase would not be a DFA.

However, if the amount paid for the property includes the option premium, the difference between the fair market value of the property delivered on settlement of the agreement and the amount paid for the property becomes -$1. On the basis of this interpretation, the difference between $108 (the amount paid for the property) and $107 (the fair market value of the property delivered on settlement of the agreement) should not be considered to be wholly attributable to the $7 increase in the fair market value of the property over the term of the agreement. Accordingly, the option would be considered to be a DFA in this case….

Exclusion for purchase options (p. 10:13)

In the case of a call option...the exception in subparagraph (b)(i)...should apply, provided that the difference between the fair market value of the property delivered on settlement and the amount paid for the property is wholly attributable to changes in the fair market value of the property over the term of the agreement. This reasoning applies where the change in the fair market value of teh property over the term of the agreemetn is equal to or greater than the difference beween the fair market vlaue of the proeprty delivered on settlement and the amount paid for the properyy.. .

Exchangeable securities – exclusion for embedded exchange rights? (pp. 10:15-16)

When dealing with exchangeable shares…the Department of Finance's view in the technical notes is that the taxpayer would retain sufficient economic exposure to the shares of the Canadian corporation such that the agreement to sell those shares would not be a DFA….

The reason for [this conclusion]…is not immediately evident. It is possible that the reason that exchangeable shares with an exchange right embedded in the share terms would not be a DFA is because the price for the shares of the Canadian corporation corresponds to the inherent value of those shares by virtue of the share terms. It is also possible, however, that the presence of the exchange right in the share terms does not constitute an agreement to sell capital property….

[B]ased on the Department of Finance's conclusions with respect to exchangeable shares and the policy regarding retention of economic exposure stated above, it is worth considering whether a right embedded in any security, regardless of that to which the right relates, would exclude the security from the DFA Rules in all cases….

Currency forwards as potential DFAs (pp. 10:h18-19)

[T]he calculation of the forward price under a currency forward agreement takes account of: (i) the spot exchange rate at the time the forward agreement is entered into, (ii) the interest rate in the base currency, (iii) the interest rate in the secondary currency and (iv) the term of the agreement. …

[A] taxpayer may choose to sell forward USD$100 in a year to hedge its exposure to the US dollar. Assume for these purposes that the one year forward rate results in the taxpayer receiving CAD$110 in one year in exchange for USD$100 to be paid on the one year maturity date and that, based on the current spot rate, USD$100 has a fair market value of CAD$105 at the time that the forward agreement is entered into. In this case, the sale price of the property is fixed at CAD$110 and the fair market value of the property at that time is CAD$105, resulting in a difference of CAD$5 for purposes of subparagraph (c)(i) of the definition of DFA…

[S]ince the sale price of CAD$110 is based on the forward rate (which is based in part on the interest rate differential described above), the difference between the sale price of the property and the fair market value of the property at the time the agreement is entered into (i.e., CAD$5) is attributable in part to a rate (i.e., an interest rate). This difference has been fixed at the time of entering into the agreement with the result that the exception in clause (c)(i)(A) is not available in this example. The exception in clause (c)(i)(B) is also not available in this example as the sale price of US dollars is denominated in Canadian dollars….

[A]n analysis should be completed of the transaction as a purchase agreement of that same taxpayer as well….Since the purchase price for the Canadian currency in this case is denominated in US dollars, it is possible that the exception in subparagraph (b)(ii) could apply. In any event, if the currency forward transaction would be a DFA under the analysis in paragraph (c), it is arguable that an exclusion under paragraph (b) would not be sufficient to conclude that the currency forward transaction would not be a DFA. …

[G]iven that the common law principles as to whether currency transactions should be on capital account are well-established, and the fact that the intent of a currency forward transaction does not fit within the description of the type of transaction being targeted by the DFA Rules, presumably the underlying intent of the DFA Rules is not for all currency forward agreements to be DFAs….

Ian Caines, Chris Van Loan, "Character Conversion Transactions and Synthetic Disposition Arrangements Updated", Corporate Finance, Volume XIX, No. 1, 2013, p. 219.

Economic exposure requirement (p. 2198)

…before a sale agreement will be considered to be a DFA [derivative forward agreement], the agreement must be part of an "arrangement" that has the effect of eliminating a majority of the taxpayer's risk of loss and opportunity for gain or profit with respect to the property (which we will refer to as "economic exposure")….

Economic exposure where one-sided exposure (p. 2199)

…The inclusion of this version of the economic exposure test in the DFA rules also highlights questions about how the test should be interpreted generally, and whether it involves a one-pronged or a two-pronged inquiry, which is discussed below in the context of the SDA rules. In the technical notes, Finance has indicated that this new condition should exempt from the DFA rules sales of securities pursuant to the exercise of both typical "covered calls" and the call rights commonly used in "exchangeable share" structures, in each case because the taxpayer would retain significant exposure to the value of the underlying property. [fn 3: It is interesting to note that in its discussion of "exchangeable share" structures, the technical notes indicate that an agreement to sell a share for an amount based on the value of another security does not eliminate the taxpayer's economic exposure to the share (and therefore does not give rise to a DFA) if the share itself contains an "embedded exchange right" for the other security and therefore naturally tracks its value. If the "embedded exchange right" was not present, however, the technical notes indicate that a DFA would arise. Under the DFA rules, therefore, a special significance is attached to exchange rights that are "baked in" to the terms of shares or other securities.]

Embedded interest in forward as an underlying interest (p. 2199)

… The technical notes reiterate that the concept of an "underlying interest" is intended to be interpreted broadly, and list several examples. In addition to unsurprising items (such as the value of a reference fund or a multiple of the return on the TSX), this list also includes "an express or implied fixed interest rate." This suggests that the implicit interest rate used in setting a fixed forward price in a typical forward sale contract would be an "underlying interest" and that the difference between the fair market value of the property at the time that the forward sale contract was entered into and the fair market value at the time of sale should therefore be on income account.

Full tainting of gain (p. 2199)

… the revised DFA rules continue to treat the full amount of the inclusion under paragraph 12(l)(z.7) or deduction under paragraph 20(1)(xx) on income account, even if that gain is only partially attributable to a "bad interest", and even if that "bad interest" would not itself have been on income account if realized directly. Also, the revised rules still do not appear to apply if a DFA is cash settled.

Jack Bernstein, "Exchangeable Shares and UPREITs Are at Risk in Canada", Tax Notes International, 20 May 2013, 783

The recent Canadian federal budget of March 13, 2013, contains a provision to prevent the conversion, through the use of derivative contracts, of returns that would have the character of ordinary income to capital gains, only 50 percent of which are included in income. Exchangeable shares and exchangeable partnership interest (UPREIT) structures permit the deferral of capital gains rather than the conversion of capital gains and should not be caught by the proposed anti-avoidance rule that applies to a derivative forward agreement. Unfortunately, the proposed definition of a derivative forward agreement is broad enough to potentially encompass such transactions. The Department of Finance has acknowledged that exchangeable shares and UPREIT structures were not the target of the budget proposal, but Finance will consider whether any such transactions should be covered. Finance, which only found out about these concerns in the last few weeks, is concerned that a wholesale exception for exchangeables would not be appropriate, since some give rise to a character conversion. For example, this may occur when income distributions under the economic equivalence provisions were instead added to the redemption amount regarding the exchangeable interest rather than being paid. Draft legislation that may clarify the ambit of the new legislation is expected in June.

Finance

Sec. Bull. Issue 37/07 13 February 2014 OSC Staff Notice 81-723 - 2013 Summary Report for Investment Fund Issuers

2.5 Character Conversion Transactions

On March 21, 2013, the Minister of Finance presented the federal government's 2013 budget. The budget contained amendments to the Tax Act (the Budget Amendments), which impacted investment funds that used specified derivatives (generally forward agreements) to provide investors with an economic return based on the performance of a reference fund.

Through the use of forward agreements, these funds were able to characterize the economic return of a reference fund, which would otherwise be treated as ordinary income in the hands of its securityholders, as capital gains. Investment funds that employed this structure generally have investment objectives of providing "tax advantaged" returns to securityholders. The Budget Amendments effectively prohibited the character conversion described above, meaning that from the effective date of the Budget Amendments, the economic returns provided to investors would be taxable as ordinary income.

Subsequent to the budget announcement, we issued OSC Staff Notice 81-719 Effect of Proposed Income Tax Act Amendments on Investment Funds -- Character Conversion Transactions (the Conversion Notice). The Conversion Notice stated that investment fund managers should consider the effects of the Budget Amendments on their investment funds, particularly if income conversion was an essential aspect of the fund, as evidenced by the fund's investment objective, name or the manner in which the fund was marketed. The Conversion Notice further advised investment fund managers that they should consider whether affected investment funds should be capped to new and additional investments.

Investment Funds staff took part in several discussions with senior staff from the Ministry of Finance (Canada) and Canada Revenue Agency concerning the Budget Amendments. In these discussions, we provided background information on the use of character conversion transactions by investment funds and the impact of the Budget Amendments.

As a result of the Budget Amendments, we reviewed a number of prospectus amendments for investment funds, as well as applications that were filed in connection with fundamental changes being made by investment funds to alter their investment structures.

Paragraph (b)

Subparagraph (b)(iii)

Articles

Nigel P.J. Johnston, Roger E. Taylor, "Taxation of Hedges and Derivatives: Recent Developments", 2016 Conference Report (Canadian Tax Foundation), 13:1-36

Potential application of pre-amendment DFA definition to currency forwards (pp. 13:15-16)

A currency forward locks in the exchange rate for the purchase or sale of a currency on a future date. The mechanism for determining a currency forward rate depends on the interest rate differentials for the currency pair if both currencies are freely traded. Assume that the current spot rate for the Canadian dollar is US$1 = Cdn$1.25 and the taxpayer enters into an agreement to sell US$1 million a year from now at the forward rate of US$1 = Cdn$ 1.2685. If in a year's time the spot rate is US$1 = Cdn$1.20 (that is, the Canadian dollar has appreciated against the US dollar), the taxpayer realizes a gain of Cdn $68,500 (by selling US$1 million for Cdn$l,268,500 rather than at the spot rate of Cdn$1.20 or Cdn$1.2 million). If one assumes that the gain would otherwise be a capital gain, the currency forward may fall within the definition of a DFA because

1) the agreement is a sale agreement (selling US dollars);

2) the sale price (Cdn$l,268,500) of the property (US$1 million) is different from the fair market value of the property at the time the agreement was entered into (Cdn$1.25 million);

3) the difference is attributable, in whole or in part, to an underlying interest because the US and Canadian interest rates are "rates" as used in the definition;

4) the difference is not attributable to "changes in the fair market value of the property over the term of the agreement, or any similar criteria in respect of the property" because the price is fixed at outset;

5) since the sale price is denominated in Canadian dollars, the exception applicable to changes in the value of Canadian currency does not apply;

6) the agreement is part of an arrangement that eliminates a majority of the taxpayer's risk of loss and opportunity for gain or profit in respect of the US dollars sold forward for more than 180 days.

…[I]t could be argued that references to "property" in the definition of a DFA should not include money and that money is not a capital property—in other words, that a gain or loss would be on capital account even though there is no capital property…

Addition of (b)(iii) and (c)(i)(C) to DFA definition (pp. 13:16-17)

The September 16, 2016 proposed amendments would add an additional exception…

[T]he reference to reducing the risk of fluctuations in the value of the currency in which a purchase or sale by the taxpayer of a capital property is denominated presumably refers to hedging the sale or purchase price of a property that is denominated in another currency. The reference to reducing the risk of fluctuations in the value of the currency from which a capital property of the taxpayer derives its value should include shares of foreign subsidiaries, for example. However, the reference to reducing the risk of fluctuations in the value of the currency in which an obligation that is a capital property of the taxpayer is denominated is not clear. An obligation issued by the taxpayer is not property of the taxpayer. It seems likely that the intention was to include "an obligation issued the taxpayer that is on capital account."…

The comments above regarding the drafting of the exception in the context of a sale agreement are equally applicable in the context of a purchase agreement.

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