Words and Phrases - "hedge"
MacDonald v. Canada, 2020 SCC 6, [2020] 1 S.C.R. 319
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.
| 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 | 335 |
| 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
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."
| 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 | 297 |
MacDonald v. The Queen, 2017 TCC 157, rev'd 2018 FCA 128, which was aff'd in turn by 2020 SCC 6
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.
| 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 | 199 |
Echo Bay Mines Ltd. v. The Queen, 92 DTC 6437, [1992] 2 CTC 182 (FCTD)
MacKay J. found that the taxpayer (which operated a silver mine in the Northwest Territories) entered into forward sales contracts as hedging transactions and noted that "exact matching was not feasible from a practical point of view, nor is it required in order to constitute hedging" (p. 6447). In going on to find that gains realized by the taxpayer from closing out the forward sales contracts were included in its income from the production of metals for purposes of Regulation 1204(1), he stated (p. 6447):
"Activities reasonably interconnected with marketing the product, undertaken to assure its sale at a satisfactory price, to yield income, and hopefully a profit, are, in my view, activities that form an integral part of production which is to yield income ...".