Futures/Forwards/Hedges

Commentary

Where the business of a corporation entails the purchase or sale of a particular commodity (e.g., the sugar purchases of a sugar refiner), gains or losses on commodities futures contracts in that commodity in which the corporation engages in connection with that commodity will be realized on income account (Atlantic Sugar).

An individual who engages in frequent trading of commodities futures likely will also realize gains or losses on income account (Friesen), although in some circumstances CRA will permit speculators including frequent traders to treat their transactions in commodities futures as being on income account provided that this treatment is consistently followed by the taxpayer (IT-346R).

See further commentary under "Commodities."

Cases

MacDonald v. Canada, 2020 SCC 6

cash-settled forward sales were a hedge of a shareholding notwithstanding their settlement without a corresponding share sale and a stated intention to speculate

The taxpayer had held a significant investment in the common shares of a listed bank (“BNS”) since 1988. In 1997, due to “storm clouds,” he entered into a forward contract with TD Securities Inc. for the forward sale by him of a reference number of BNS shares, except that the Forward Contract could only be cash settled. The forward sale date initially was June 26, 2002, but the contract was subsequently extended. He made cash settlement payments under the contract in 2004, 2005 and 2006 totalling approximately $10 million (which he fully deducted as being on income account), and the contract was terminated on March 29, 2006. At all times, the reference number of shares under the forward contract did not exceed the number of BNS shares owned by him.

In 1997, he also monetized a portion of his BNS shareholding by receiving a loan from an affiliate of TD Securities (TD Bank) equalling approximately half of his shares’ value and pledging most of his BNS shares and the forward contract as security. He repaid the entire balance of the loan in 2004.

The Tax Court had accepted the taxpayer’s testimony that he had intended to profit from the anticipated decline in the value of the BNS shares under the forward contract but nevertheless retained ownership of the shares based on his belief that they would perform well in the long term. The Court affirmed the Federal Court of Appeal’s reversal of this decision in finding that the taxpayer had realized his losses under the forward contract on capital account.

In framing the issue as being whether there was sufficient linkage between the forward sales (viewed, at para. 18 as being, along with options, one of the “two basic types of derivatives”) and the BNS shareholding, Abella J stated (at paras. 20, 22):

The income tax treatment of gains and losses arising from derivative contracts depends on whether the derivative contract is characterized as a hedge or speculation. Gains and losses arising from hedging derivative contracts take on the character of the underlying asset, liability or transaction being hedged … . In contrast, speculative derivative contracts are characterized on their own terms, independent of an underlying asset or transaction. ...

Purpose is ascertained objectively (Ludco …). … As the cases demonstrate, the primary source of ascertaining a derivative contract’s purpose is the linkage between the derivative contract and any underlying asset, liability or transaction purportedly hedged. The more closely the derivative contract is linked to the item it is said to hedge, the stronger the inference that the purpose of the derivative contract was hedging.

In finding that there could be linkage notwithstanding that the forwards could only be cash settled and were settled without a sale of the BNS shareholding, she stated (at para. 34, see also para. 42) that “The absence of a synchronous transaction used to offset gains or losses arising from a derivative contract is not equivalent to the absence of risk and is not, by itself, determinative of the characterization of a derivative contract” and (at para. 36) adopted a principle endorsed in Placer Dome that “cash settled forward contracts and forward contracts settled by physical delivery are economically equivalent and treating them differently for tax purposes would create ‘an unjustified artificial distinction’.”

In finding that linkage was established here, she stated (at para. 37):

The forward contract had the effect of nearly perfectly neutralizing fluctuations in the price of Bank of Nova Scotia shares held by Mr. MacDonald, pointing to a close linkage. The purpose of the forward contract as a hedging instrument is most apparent when one considers the forward contract alongside the loan and pledge agreements between Mr. MacDonald and TD Bank. Seen in this light, there was considerable linkage between the forward contract and Mr. MacDonald’s Bank of Nova Scotia shares.

Words and Phrases
hedge speculation
Locations of other summaries Wordcount
Tax Topics - General Concepts - Purpose/Intention intention re forward contract determined on basis of objective linkage to hedged asset rather than testimony as to subjective purpose 319
Tax Topics - Income Tax Act - Section 18 - Subsection 18(1) - Paragraph 18(1)(b) - Capital Loss v. Loss - Hedges cash-settled forward “objectively” was a capital share hedge notwithstanding no matching share sale 542

The Queen v. Macdonald, 2018 FCA 128, aff'd 2020 SCC 6

cash-settled forward hedged bloc of shares irrespective of speculative intention

The taxpayer had held a significant investment in the common shares of Bank of Nova Scotia (“BNS”) since 1988. In 1997, due to “storm clouds,” he entered into a forward contract with TD Securities Inc. for the forward sale by him of a reference number of BNS shares, except that the Forward Contract could only be cash settled. The forward sale date initially was June 26, 2002, but the contract was subsequently extended. He made cash settlement payments under the contract in 2004, 2005 and 2006 totaling $9,956,837 (which he fully deducted as being on income account), and the contract was terminated on March 29, 2006. At all times, the reference number of shares under the forward contract did not exceed the number of BNS shares owned by him. The Tax Court had accepted the taxpayer’s testimony that he had intended to profit from the anticipated decline in the value of the BNS shares under the forward contract but nevertheless retained ownership of the shares based on his belief that they would perform well in the long term.

In reversing the finding below and holding that the taxpayer had realized his losses under the forward contract on capital account, Noël CJ stated (at para. 51) that:

[T]he BNS shares held by the respondent during the period when the Forward Contract was in place were capital property in his hands so that if the Forward Contract had the effect of hedging risk linked to these shares, the losses incurred by the respondent as a result of having been required to make cash settlement payments will be treated as capital losses.

After indicating (at para. 57, see also para. 90) that whether a derivative contract is settled by physical delivery of the underlying asset or by cash settlement does not affect whether it functions as a “hedge,” and that under Placer Dome, a hedge "neutralizes or mitigates risk [including market fluctuation risk] to which the underlying asset is exposed" (para. 61, see also para. 69), he concluded (at paras. 92-93):

[A]n intention to hedge is not a condition precedent for hedging. It suffices that the person concerned owns assets exposed to market fluctuation risk when the derivative contract is entered into and that the contract has the effect of neutralizing or mitigating that risk.

Mr. MacDonald was not an “accidental hedger”. He was aware of the hedging effect which the Forward Contract would have on the BNS shares that he pledged to the TD Bank and that it would continue to have on the corresponding number of shares that he held thereafter while the Forward Contract was in force.

After noting that George Weston dealt with a hedge of asset ownership rather than of transactional risk (and before agreeing with the Crown at para. 83 that George Weston was “dispositive” of the case before him), he stated (at para. 82) that:

A risk arising from ownership is equally capable of being hedged and there is no reason why the established rule that hedging gains or losses are treated the same way as the assets being hedged for tax purposes, should not apply…

and (at para. 88) that "ownership risk" (i.e., an impact on net worth - see para. 86) was a hedgeable risk irrespective whether the assets "have long been held or were recently acquired."

Words and Phrases
hedge
Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 18 - Subsection 18(1) - Paragraph 18(1)(b) - Capital Loss v. Loss - Hedges cash-settled forward was hedge of share bloc irrespective of speculative intention 269

Tamas v. The Queen, 81 DTC 5150, [1981] CTC 220 (FCTD)

individual's losses on silver futures trading on income account

Losses sustained by the taxpayer radiologist from the purchase and sale of silver futures were fully deductible. Dubé J stated (at p. 5152):

[B]earing in mind tht silver brings no interest and no dividend, it becomes obvious that his governing motive was to speculate. An intention to resell at the earliest and most opportune time in a fluctuating market in order to recoup his heavy losses had to be the motivating factor behind the purchase.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 18 - Subsection 18(1) - Paragraph 18(1)(b) - Capital Loss v. Loss silver futures trading on income account 114

Atlantic Sugar Refineries v. Minister of National Revenue, 49 DTC 602, [1949] S.C.R. 706

short sale of sugar futures for business hedging on income account

The taxpayer was in the business of purchasing, refining and selling sugar. It did not normally engage in hedging transactions. However, on the outbreak of the Second World War, it faced price controls on the sale of its product but was required to purchase large quantities of sugar at a rapidly escalating spot price. In order to try to offset its anticipated losses from this situation, it made short sales of sugar future contracts on the applicable New York exchange, and realized gains when it closed out the contracts.

Locke J rejected a submission that "this was simply a speculation in raw sugar resulting in a capital profit such as might have resulted from a speculation in shares" and stated (at p. 604):

In trades where natural products are purchased in large quantities, hedging is a common, and in some cases, a necessary practice, and the cost of such operations in trades of this nature is properly allowable as an operating expense of the business. Where, as in the present case, the trader elects to close out his short sales and take a profit, this is, in my opinion, properly classified as profit from carrying on the trade.

See Also

MacDonald v. The Queen, 2017 TCC 157, rev'd 2018 FCA 128

“the law still requires a close linkage between the purported hedging instrument and the underlying asset”

The taxpayer had held a significant investment in the common shares of Bank of Nova Scotia (“BNS”) since 1988. In 1997, due to “storm clouds,” he entered into a forward contract with TD Securities Inc. for the forward sale by him of a reference number of BNS shares, except that the Forward Contract could only be cash settled. The forward sale date initially was June 26, 2002, but the contract was subsequently extended. He made cash settlement payments under the contract in 2004, 2005 and 2006 totaling $9,956,837 (which he fully deducted as being on income account), and the contract was terminated on March 29, 2006.

Lafleur J found that these payments would have been on income account before considering whether the Forward Contract was a hedge of his capital investment in the BNS shares, given inter alia that:

  • it afforded him “an opportunity to speculate on the outcome that the price of the BNS Shares would drop in the short term” (para. 60)
  • it “could only be cash settled” (para. 61)
  • “it involved great potential for risk and reward…and was not used to lock-in any gain in the BNS shares” (para. 61)
  • “Mr. MacDonald was exposed to no risk by holding the BNS shares since he did not want to sell them for the very long term. Accordingly, by entering into the Forward Contract… he increased his risk… .” (para. 68)

Turning to whether the Forward Contract instead was held on capital account on the basis of being a hedge of a capital asset (the BNS shares), she stated (at paras. 85-86, 95):

[A]n essential component of a hedge is that the strategy used to hedge must result in an offset of investment risk… . [A] hedging instrument [must be] directly linked (or symmetrical) to the underlying asset that is the subject of the hedge in terms of both quantum and timing… . [T]he law still requires a close linkage between the purported hedging instrument and the underlying asset.

In finding that these hedging criteria were not satisfied, so that his settlement payments under the Forward Contract were fully deductible, she stated (at paras 107 and 112):

… [T]he settlements were not based on any anticipated sale of the BNS shares and the sale of BNS shares by Mr. MacDonald did not occur in close proximity to the settlements.

Mr. MacDonald owned the BNS [and predecessor] shares for approximately 30 years prior to entering into the Forward Contract. … Mr. MacDonald only had an unrealized gain on the BNS shares but an actual loss on the settlement of the Forward Contract. I am of the view that without Mr. MacDonald having sold BNS shares in very close proximity with the settlement of the Forward Contract, one cannot conclude that Mr. MacDonald had mitigated or reduced a risk. …

The fact that the taxpayer also received a TD loan (which was much less than the maximum he could have borrowed and was largely repaid by 2004) was of limited relevance.

Words and Phrases
hedge
Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 18 - Subsection 18(1) - Paragraph 18(1)(b) - Capital Loss v. Loss cash-settled forward sale of shares not sufficiently linked to underlying shareholding to be a hedge 193

Placer Dome Canada Ltd. v. Ontario (Minister of Finance), 2006 DTC 6532, 2006 SCC 20, [2006] 1 S.C.R. 715

“hedging “ includes cash settled derivatives including options

The taxpayer sold its gold production to bullion dealers at the spot price but also, in order to manage the risk associated with fluctuations in the spot price of gold, entered into cash-settled derivatives such as forward contracts, spot deferred contracts, fixed interest floating lease rate contracts, put options and call options. “Proceeds” for purposes of computing its mining profits under the Mining Tax Act (Ontario) referenced: (a) consideration received from the output of a mine; (b) consideration from hedging; and (c) consideration from future sales or forward sales of the output of the mine That Act in relevant part defined “hedging” as including “the fixing of a price for output of a mine before delivery by means of a forward sale or a futures contract on a recognized commodity exchange.”

In finding that the mining profits of the taxpayer included its profits from settling such derivatives, and in rejecting the taxpayer’s arguments that hedging referred only to contracts which entailed the physical delivery of mine output, LeBel J first noted (at para. 31) that

at least for the purposes of GAAP, the way in which a derivative contract functions as a “hedge” is unaffected by the method by which the contract is settled

and then went on to find (at para. 46) that the interpretation advanced by the taxpayer had the effect of making the “hedging” component of determining “proceeds” redundant. As to the meaning of “hedging,” he quoted (at para. 33) the statement in Echo Mines that

under generally accepted accounting principles, a producer’s gain or loss from its execution of forward sales contracts may be considered a “hedge” and therefore matched against the production of the goods produced, if four conditions are met. . . .

1. The item to be hedged exposes the enterprise to price (or interest rate) risk.

2. The futures contract reduces that exposure and is designated as a hedge.

3. The significant characteristics and expected terms of the anticipated transactions are identified.

4. It is probable that the anticipated transaction will occur.

and stated (at para. 35) that such general principles “have some relevance here.”

He also stated (at para. 51):

[A]lthough forward sales and options are distinguished from one another in terms of the particular way in which each is used to hedge price risk, both are used in much the same way to “fix the price” for output. PDC’s argument about the serious distortion implicit in treating options as a subset of forward sales is belied by the PDC’s own Annual Reports … .

Words and Phrases
hedging
Locations of other summaries Wordcount
Tax Topics - Statutory Interpretation - Interpretation Bulletins, etc. shifting CRA position could not be relied upon except to evidence ambiguity 73
Tax Topics - Statutory Interpretation - Redundancy/reading in words presumption against tautology 114
Tax Topics - Statutory Interpretation - Resolving Ambiguity residual presumption in favour of the taxpayer 125
Tax Topics - Income Tax Regulations - Regulation 1204 - Subsection 1204(1) - Paragraph 1204(1)(b) cash-settled derivatives had the effect of fixing mine production] 399
Tax Topics - Statutory Interpretation - Regulations/Statutory Delegation addition of regulation did not significantly expand scope of tax 223

Friesen v. The Queen, 95 DTC 492 (TCC)

The taxpayer, who did not have any business enterprises relating to the commodities in question, traded 66 times in commodities contracts (both long and short) from 1987 to 1989. In light of the number of trade transactions and the nature of the subject matter of the transactions, losses realized by him in 1988 and 1989 were fully deductible, notwithstanding that he included a small amount of profit as a capital in his 1987 income tax return (a year that was not an issue). Bell TCJ. stated (at p. 493) that "it is clear that the manner in which a taxpayer reports a profit does not determine the nature of that profit".

Administrative Policy

6 October 2017 APFF Financial Strategies and Financial Instruments Roundtable Q. 16, 2017-0705181C6 F - Hedging & George Weston Limited

CRA is considering changing its policy re what is capital hedge

After noting that “the CRA has already stated that it accepts the decision … in George Weston,” CRA noted, however, that:

The approach taken by the TCC in [MacDonald] respecting, inter alia, the linkage principle appears to be irreconcilable with previous jurisprudence, including George Weston Limited. ...

Nevertheless, the CRA is currently considering whether to change its approach pending the Federal Court of Appeal decision in James S. A. MacDonald.

21 October 2015 Internal T.I. 2015-0592781I7 - treatment of bond locks

hedges re dividend or interest obligations of parent on income account

Canco, which was wholly-owned by its Canadian Parent, entered into “Dividend Bond Locks” and “Interest Bond Locks” (collectively, the “Bond Locks”) with third-party counterparties. The Dividend Bond Locks were said by Canco to hedge against an increase in the dividend rate on preferred shares issued by Parent which provided for periodic resetting of the dividend rates thereon. Canco had to make a payment on the termination of the Dividend Bond Locks. The terms of the Interest Bond Locks were similar, except that they related to Debentures of Parent. Their settlement also was at a loss.

How should amounts paid under the Bond Locks be treated? CRA responded:

[T]he CRA’s administrative position on interest rate derivatives has been to treat them as being independent from other transactions and therefore on income account. Weston addresses the linkage principle in the context of foreign exchange derivatives that hedge investments in foreign operations. …

Given that it is our view that Weston should not have any effect on Rulings’ policy regarding interest rate derivatives, Rulings’ policy regarding interest rate derivatives would continue to apply and therefore the Bond Locks should be considered to be on income account. …

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 9 - Timing losses on interest or dividend rate hedges could be amortized/any gains immediately includible 213

5 March 2014 Internal T.I. 2013-0500891I7 - Hedging

s. 85(1) roll of FX forward to sub

Parent hedged a U.S.-dollar borrowing by entering into foreign currency forward contracts. In order to utilize capital loss carryforwards of a wholly-owned subsidiary ("Subco"), it assigned its rights and obligations under the forward contracts to Subco, and they elected under s. 85 for rollover treament. Subco then received a cash payment on settlement of the forward contracts. CRA first found that the forward contracts were capital property to Parent:

While the hedge was put in place a few years after the issuance of the debt, the aggregate amount of the forward contracts was similar in amount to the debt and the maturity date of the contracts matched the maturity date of the debt.

CRA then applied the following statement at the 1983 Roundtable to confirm that Subco's gain was on capital account:

We…are prepared to accept the 85(1) roll and would also accept that the profit would still be a capital gain, despite the short holding period, where the roll was between two sister corporations or a parent and its controlled subsidiary and the ultimate sale was to an arm's length third party.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 85 - Subsection 85(1.1) s. 85(1) roll of FX forward to sub 104
Tax Topics - Income Tax Act - Section 9 - Capital Gain vs. Profit - Foreign Exchange s. 85(1) roll of FX forward to sub 183

8 October 2010 CTF Roundtable, 2013-0507191C6 - Monetization of Securities - 2010 CTF Conference

equity forward gain on income account

Respecting arrangments for the monetization of shares of public corportions, CRA stated:

Ruling F in document 2007-0246461R3 provides that the amounts that will be received or paid by the corporations in settlement of the rights or obligations flowing from the forward contract will be on account of capital.

We are now of the opinion that the return that was included in the forward contract (through an increase of the forward price) would constitute income rather than capital. It should be noted that the agreement that was designated as a forward contract in document 2007-0246461R3, now appears to us to be more in the nature of an equity swap.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 39 - Subsection 39(1) - Paragraph 39(1)(b) payment under an equity swap not a capital loss because no disposition (and on income account) 177

2007 Ruling 2007-0246461R3 F - Monétisation d'actions d'une société publique

cash settlement of monetization contract on capital account
Proposed transactions

Holdco A and Holdco X (which are holding companies of the CEO and executive vice-president, respectively, of ACO, which is a Canadian public company) will enter into the Term Contract (having a maximum term of X years) with a Canadian financial institution (“FI”) under which they each will have an obligation to make a payment to FI if the closing price of referenced Class A (subordinated voting common) Shares of ACO is higher than the benchmark price on the settlement date, and with a correlative obligation of FI to make a payment on the settlement date if such closing price is lower. Concurrently with signing the Term Contract, Holdco A and Holdco X will secure their obligations thereunder by granting a hypothec to FI on their Class B (multiple voting common) Shares of ACO (but with the continued right to vote those shares and receive dividends thereon). They also will receive an interest-bearing loan from IF (to be used by them to make investments yielding interest or dividends higher than the loan interest) and will grant a second-ranking hypothec to FI on their Class B Shares and a first-ranking hypothec on their interest in the Term Contract to secure these loans. On the settlement of the Term Contract, Holdco A and Holdco X have the option of settling their obligations by delivering the subject Class A Shares (through converting their Class B Shares into Class A Shares) or by settling in cash.

Rulings

Include that the amounts which are paid or received by Holdco A and Holdco X on the settlement of the Term Contract will be on capital account.

12 January 2005 Miscellaneous 2004-0101161E5 - Trading in stock index futures

daily stock futures trading on income account

Would trading by an individual, who makes trades every day and where they constitute the major source of income, in stock index futures which are listed and traded in countries other than Canada be taxable on income or capital account? CRA responded:

Trading in stock option futures would normally be taxed on income account, unless, for example, it relates to the acquisition of capital. Generally, an individual who makes trades in stock index futures every day, particularly where those trades constitute the major source of income to that individual, will be taxed on the profit therefore on income account.

4 August 1994 External T.I. 9414045 - FINANCIAL FUTURES - CAPITAL OR INCOME ACCOUNT

mutual fund not a “speculator” re futures trading

Would trading in futures by a mutual fund give rise to capital gains, rather than ordinary income? CRA responded:

Although Interpretation Bulletin IT-346R allows speculators to report their transactions on capital account, a “speculator”, as defined in the Bulletin, is, essentially, anyone other than an active and knowledgeable investor. Generally, those whose business involves trading in the underlying instruments and those who trade futures contracts are not considered to be speculators and report their transactions on income account. In our view, a mutual fund trust or corporation would not be considered to be a “speculator” within the meaning ascribed to that term in the Bulletin.

25 May 1994 External T.I. 5-940421 -

A seat owner-member of a Futures Exchange whose business activity consisted of trading in futures would be required to report his transactions on income account.

31 March 1994 T.I. 933701 (C.T.O. "Mutual Fund Trust Investing in Futures - Income Account")

A mutual fund that invests primarily in derivatives, futures and like investments will realize resulting gains and losses on income account. Although transactions with respect to commodity futures contracts by a mutual fund trust are considered to be investing for purposes of s. 132(6), it does not follow that the resulting gains or losses would be on account of capital.

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 treatment of a dynamic hedge as on capital account (pp. 13:11-12)

A static hedge is one that does not have to be rebalanced as the price or other characteristics of the underlying asset it hedges changes. …

In contrast, a dynamic hedge involves adjusting the hedge as the underlying security changes in value throughout the life of the contract. Assume that a party sells a call option on 100 shares of X Co, and that party's obligations under the call option are determined by X Co's share price when the option contract matures. If the party wants to hedge its contingent obligations under its short-option position, it can purchase a certain number of X Co shares at inception of the option contract. The number of shares is determined by considering a variety of factors, including the probability of X Co shares trading above the option strike price at maturity. As the stock price changes during the term of the option, the party will typically adjust its hedge position by buying or selling X Co shares in the market….

The Canadian fund manager mentioned above may similarly decide to engage in a dynamic currency-hedging strategy.

[T]he CRA's interpretation [2013-0481691E5] suggests that transactions resulting from a dynamic currency-hedging strategy adopted by a Canadian fund manager will generally be on income account.

However, based on George Weston, we believe that a compelling argument can be made that gains and losses resulting from a dynamic hedging strategy to hedge a capital asset should also be on capital account despite the fact that there may be numerous transactions. In our view, the relevant issue is the character of the risk that is being hedged (depreciation in value of a foreign-currency-denominated capital asset), not the number of transactions.

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

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.