Synthetic Dispositions: Get Cash Now, Pay Tax Later
The 2013 budget addresses concerns about transactions that use financial engineering to disentangle economic substance from legal form, effectively making the timing of a disposition of property for tax purposes an election. Normally, the purpose of such a transaction is to obtain the cash for property while deferring the tax on a gain--for example, in an equity monetization (EM). However, nothing in the proposals limits their application to equity holdings or even to capital property, and the budget notes that the transaction's purpose could be to more fully recognize a loss by avoiding stop-loss rules rather than to defer tax on a gain.
An EM in its plain vanilla form may be as simple as a loan secured by a pledge of shares, without further recourse against the borrower. The taxpayer retains the title to the shares, the voting rights, and the right to any dividends declared and paid. Upon maturity (typically, five years or longer), the taxpayer may forfeit the pledged shares (likely, if they are worth less than the outstanding loan balance) or settle the loan in cash and secure the return of the pledged shares (likely, if they are worth more than the outstanding loan balance). Further refinements of this simple arrangement using options and other financial derivatives can also eliminate the upside potential of holding the shares in return for increased cash.
The government's problem is that there are a wide variety of potential deal structures, some of which leave the equity owner with more risk or return than others. When the government legislated against a previous tax-avoidance strategy involving derivatives known as weak currency loans, it chose a specific quantitative threshold ("exceeds by more than two percentage points": subsection 20.3(1)). This time, the government has chosen a more conceptual approach: the budget proposes to create a deemed disposition at the time the taxpayer enters into a synthetic disposition arrangement, which is defined to be all types of transactions that "have the effect of . . . eliminating all or substantially all of the taxpayer's risk of loss and opportunity for gain or profit in respect of the property for a period of more than one year" (subject to certain exclusions). Thus, the loan-based EM discussed above would not be caught unless the refinement eliminating the upside potential was also added.
In the United States, similar issues have been addressed for many years in the interplay between EMs and both the "constructive sale" provisions and the meaning of the "sale or exchange" of property. Accordingly, the US market response may provide some guidance on how to structure transactions to stay outside the proposed Canadian legislation as well as the general legal definition of "disposition." The following amendments to EM deals may be instructive:
the taxpayer retains the benefit of price appreciation of up to 10 percent, and accepts the risk of price decreases of up to 10 percent over the length of the contract (perhaps five years);
the pledged shares are not to be lent to the party on the other side of the transaction (typically a bank) or, for 60 days, to any other party;
the taxpayer retains voting and dividend rights; and
at the maturity of the contract, the taxpayer has the option of making a cash settlement rather than delivering the shares, and of delivering other shares rather than the specific shares originally pledged.