Administrative Policy
20 February 2018 External T.I. 2017-0727811E5 F - Synthetic disposition
Ten months after the formation by him of a small business corporation, Mr. A agrees with an arm’s length employee of the corporation to sell 1/3 of his shares to him for their fair market value on that agreement date, but with the transfer of ownership postponed for 14 months, in order that the two-year holding requirement in the qualified small business corporation definition can satisfied.
CRA confirmed that if the sale price was fixed, this would likely qualify as a “synthetic disposition arrangement” (SDA), so that the shares would be deemed to be disposed of for their FMV at the time of making the agreement. CRA went on to state that, if the agreement instead provided that the aggregate share price would be increased by 20% of the profits made during the 14-month period, “it appeared” that there would no longer be an SDA (i.e., although there still was no downside risk - other than credit risk, which was not discussed - the opportunity for gain was no longer substantially eliminated), stating:
[A]lthough the agreement reached in these circumstances appears to have the effect of eliminating the possibility of sustaining losses, it appears that it would not have the effect of eliminating all or substantially all of the opportunity to realize gains or profits in respect of the shares of the corporation held by Mr. A. If this were the case, it is possible that the agreement does not qualify as a "synthetic disposition arrangement" within the meaning of paragraph 248(1), and subsection 80.6(1) would not apply.
Articles
Edward Miller, Matias Milet, "Derivative Forward Agreements and Synthetic Disposition Arrangements", 2013 Conference Report, (Canadian Tax Foundation), pp 10:1-50
Similar U.S. constructive sale proposal (p. 10:26)
Even if one were to decide that 90 percent is generally an appropriate threshold in statutory provisions using a substantially all standard, in the case of risk of loss and opportunity for gain or profit in the SDA Rules one is left with the question: 90 percent of what? This issue was considered in the United States in commentary concerning an early version of the U.S. constructive sale rules, which were close cousins to the SDA Rules: [fn 47: The proposed constructive sale rule that was the subject of the cited commentary (Section 9512 of the Revenue Reconciliation Bill of 1996, which was not enacted in the form proposed) bore considerable similarity to the deemed disposition provision of the SDA Rules (subsection 80.6(1), read in conjunction with the SDA definition). The proposed U.S. rule would have deemed a taxpayer to have sold at fair market value an appreciated stock, debt instrument, or partnership interest when the taxpayer substantially eliminated both risk of loss and opportunity for gain for some period with respect to such appreciated security.]
- To illustrate the difficulty of measuring risk of loss and opportunity for gain, consider a taxpayer who owns a share of common stock that is currently trading at a price of $100. The maximum amount that a taxpayer could "lose" over any time period with respect to this share of stock is $100. Accordingly, one might initially conclude that if a taxpayer purchased a put option with an exercise price of, say, $90, the taxpayer has retained only 10% of the total risk of loss with respect to the share of stock. On closer examination, however, the analysis is significantly more complex, because the likelihood that the stock will trade between $100 and $90 is considerably greater than the likelihood that the stock price will drop close to zero during the term of the option. Accordingly, some element of probability should be taken into account in quantifying the risk of loss with respect to the stock.
The U.S. multi-factorial approach (p. 10:27-28)
[T]he multi-factorial approach (taking into account for example volatility, yield, and interest rates in respect of the property in question over the term of the arrangement) suggested by the Senate report, as well as a somewhat objective methodology like option pricing or other approaches involving mathematical financial models, should be considered in seeking to apply the substantially all test in the SDA Rules. Another such approach that has been considered in the United States as potentially helpful in addressing the above-mentioned challenge in the constructive sale rules is a so-called delta approach, which involves measuring the rate at which an offsetting position changes in value relative to an underlying asset. A perfectly hedged position under which the changes in value of the hedge are equal to the change in value of the underlying property would have a delta of 1.00….
[T]hese financial measures have been derived from the context of liquid public markets, where measurements of volatility of a security are meaningful. The SDA Rules, however, also apply to properties which are not publicly traded, where such approaches are inapplicable or unavailable….
Retroactive effect of one-year rule (p. 10:35)
Tax compliance conundrums can arise as a result of the fact that a taxpayer may not know at the time of entering into an SDA that the synthetic disposition period will turn out to be one year or more. For example, an executory contract of sale where the transaction takes far longer to close than anticipated could result in the taxpayer having to amend the return for the year in which the SDA was entered into in order to report a deemed disposition not then known to have occurred….
Example of interaction of SDA and DFA rules (pp. 10:35-36)
The interaction of the SDA Rules and DFA Rules may be illustrated by means of an example. [fn 69: The example is found in the technical notes, supra note 11, at 60-61.] A taxpayer who holds as capital property ABC Co shares with an adjusted cost base of $1 million and a fair market value of $10 million receives a five-year loan for $10 million from a purchaser (with interest of $2 million payable in five years). Under the arrangement, the taxpayer obtains a right to settle the loan (including accrued interest) in five years by transferring the ABC Co shares to the purchaser, and the purchaser obtains a right to acquire the shares from the taxpayer in five years for $12 million….The taxpayer would therefore be considered to have entered into an SDA…[and] there would be a deemed disposition for $10 million at the inception of the SDA, resulting in a $9 million capital gain,…
The difference between the $12 million sale price and the $10 million value when the "sale agreement" was entered into is attributable to something other than dividends on the ABC Co shares or changes in the value of such shares. Moreover, as noted above, the sale agreement is 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. Such a sale agreement is therefore a DFA, and, as a result, the $2 million difference between the $12 million proceeds of disposition and the $10 million value at the time the agreement was entered into would be included as ordinary income under subparagraph 12(1)(z.7)(ii)….
Ian Caines, Chris Van Loan, "Character Conversion Transactions and Synthetic Disposition Arrangements Updated", Corporate Finance, Volume XIX, No. 1, 2013, p. 219.
One-sided v. two-sided test (p. 2200)
One interesting question that is not fully resolved (but that is highlighted by the inclusion of an elimination of risk and opportunity test in the DFA [derivative forward agreement] rules, as discussed above) is whether eliminating all or substantially all of (or, alternatively, a majority of) a taxpayer's "risk ... and opportunity" is a two-pronged or a one-pronged test. That is, does the test require the elimination of substantially all of the risk of loss as well as the elimination of substantially all of the opportunity for gain or profit, or is it sufficient to eliminate substantially all of the aggregate of the risks and opportunities. This distinction would be particularly relevant for properties presenting highly asymmetric profit and loss potential (such as short-term government bonds) or in the context of the DFA rules where the lower "majority of threshold is used. The language of the proposed rules standing on its own appears to be ambiguous on this point, but the technical notes at least suggest the former interpretation - though falling short of a definitive statement.