Supreme Court of Canada Rules on Losses Stemming from Derivative Contract
This appeal dealt with what are known as derivative contracts and whether gains and losses from those contracts are to be characterized as on income account or on capital account. The Tax Court of Canada (“TCC”) found that relevant cash settlement payments were on account of income and were deductible as such. The Federal Court of Appeal (“FCA”) reversed that decision on the basis that Mr. MacDonald was hedging, and thus the settlement payments were capital payments. The Supreme Court of Canada (“SCC”) agreed with the FCA and dismissed Mr. MacDonald’s appeal.
Since the SCC has heard very few tax cases recently, any new decisions are read with great interest. The MacDonald decision is certainly no different.
Mr. MacDonald was experienced in the area of capital markets and corporate finance, with over 40 years of experience. His brokerage firm was acquired by the Bank of Nova Scotia (“BNS”) in 1988. As a result of this acquisition, Mr. MacDonald became the owner of 183,333 common shares of BNS. He continued working for BNS until March 1997. At this time, and in the context of a new business, the TD Bank offered a credit facility to Mr. MacDonald of $10.5 million. Mr. MacDonald pledged as security the shares he held of BNS. The credit offer also required Mr. MacDonald to enter into a “forward contract” as part of the pledge.
Simply put, a forward contract is an agreement for the purchase/sale of an asset at an agreed future date. Technically speaking, “…a forward contract is a type of derivative contract that creates an obligation for one party to sell, and another party to buy, an underlying asset (“Reference Asset”) at a pre-determined future date (“Forward Date”) and at a pre-determined price.” Forward contracts can be settled by physical delivery of the underlying asset, or “cash settled” by one party paying the other based on whether the forward price is higher or lower than the market price on the forward date. The purpose in either scenario is to reduce the risk of uncertainty relating to future price changes.
Mr. MacDonald entered into the forward contract with TD Securities Inc. on June 26, 1997. The Reference Assets underlying the forward contract were 165,000 BNS shares. The forward contract was to be cash settled and was structured so that Mr. MacDonald would make money if the BNS stock price decreased. Specifically, if the BNS shares decreased in value, TD Securities would pay Mr. MacDonald the full amount of the decrease and if the BNS shares increased in value, Mr. MacDonald would pay TD Securities the full amount of the increase. The payments made pursuant to the forward contract were known as “Cash Settlement Payments”.
As a practical matter, the price of the BNS shares increased and Mr. MacDonald made cash settlement payments totaling approximately $10 million.
Mr. MacDonald deducted the settlement payments as income losses (as opposed to capital losses) for his 2004, 2005 and 2006 taxation years on the basis that he used the forward contract for speculation, not hedging. The Minister of National Revenue (“Minister”) reassessed Mr. MacDonald and characterized the settlement payments as capital losses on the basis that the forward contract was a hedge of the BNS shares, which he held on account of capital.
The TCC allowed Mr. MacDonald’s appeal on the basis that his intention in entering into the forward contract was to speculate, not hedge and that there was no linkage between the forward contract and his BNS shares. The FCA found that the TCC erred, and that intention is not a condition precedent to hedging. A derivative contract will be a hedging instrument if the party entering into the contract owns assets exposed to risk from market fluctuation, the contract neutralizes or mitigates this risk, and the party entering into the contract understands the contract’s nature. These requirements were met in this case since Mr. MacDonald owned Bank of Nova Scotia shares exposed to risk from market fluctuation, the forward contract had the effect of neutralizing that risk, and Mr. MacDonald understood that it had this effect. Mr. MacDonald’s testimony regarding his intentions could not overwhelm these facts.
Decision & Analysis
The SCC examined the relevant jurisprudence and restated the following relevant principles. First, financial derivatives are contracts whose value is usually based on the value of an underlying asset. Depending on the nature of that underlying asset, gains and losses arising from derivative contracts may be taxable either as income or capital.
Second, there are two basic types of derivative contracts, namely, forward contracts and options. Though both forwards and options are about the future purchase/sale of assets, the fundamental difference is that forward contracts create a mutual obligation to buy or sell, while options provide one party the right, but not the obligation, to purchase/sell the asset. Third, derivative contracts are used to either speculate on the movement of the underlying asset or to hedge exposure to a particular financial risk such as the risk posed by volatility in the prices of commodities. If the contract is a hedge, the gain or loss assumes the character of the underlying asset. Speculative derivatives, on the other hand, are characterized on their own terms, independent of an underlying asset or transaction.
There was no dispute that the BNS shares were a capital asset and that if the forward contract was a hedge, the settlement payments would be capital losses. The question became, how does one go about characterizing a contract as a hedge? Relying on prior case law, the SCC opined that the characterization of a derivative contract as a hedge turns on the contract’s purpose, and that the purpose is determined on an objective basis.
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. Furthermore, the more closely the derivative contract is linked to the item it is said to hedge, the more likely it is that the purpose of the derivative contract was to hedge. In Mr. MacDonald’s case, “…the substantial linkage between the forward contract and Mr. MacDonald’s Bank of Nova Scotia shares fully supports Noël C.J.’s conclusion that the forward contract was a hedge.”
The settlement payments arising from the forward contract were found to derive their income tax treatment from the underlying BNS shares, and there was no dispute between the parties that those shares were held by Mr. MacDonald on account of capital. The Court found that the purpose of the forward contract was to hedge against market price fluctuations the BNS shares were exposed to. The SCC dismissed Mr. MacDonald’s appeal.
First, there are very interesting dissenting reasons, and they place much more emphasis on the subjective intentions of Mr. MacDonald. The dissent is a thought-provoking review of the trial judge’s reasons in allowing the appeal.
Second, the SCC found in obiter that even without the loan agreement, the contract was likely still a hedge.
Third, the Court stated that Mr. MacDonald’s ex-post facto testimony regarding his intentions could not overcome the existence of a different purpose objectively ascertainable from the record. This is a critical finding and is a repeated conflict in many income versus capital cases.
by Amit Ummat
Ummat Tax Law
 Para. 4.
 Para. 14.
 The SCC hints that subjective intentions can be relevant but usually not determinative.
 Para. 33.