Hedging or Not: What Is Sufficient Linkage?
In MacDonald v. The Queen (2017 TCC 157;
under appeal), losses on a forward contract against the price of
capital assets held were determined to be on account of income because
the taxpayer intended to speculate and the transactions were not
sufficiently linked to an underlying capital asset to constitute a hedge
for tax purposes. This decision comes as a surprise, since past
jurisprudence had loosened the linkage principle and broadened the
circumstances in which a hedge may be found for tax purposes (George Weston Limited v. The Queen, 2015 TCC 42).
According to taxinterpretations.com, a CRA spokesperson said at an APFF
round table on October 6, 2017 that the approach to the linkage
principle in MacDonald is irreconcilable with George Weston
and previous jurisprudence; furthermore, the CRA is considering whether
to change its approach while awaiting the FCA's decision on the MacDonald appeal.
In MacDonald, the taxpayer held Bank of Nova Scotia (BNS)
shares for over 30 years and intended to hold on to them indefinitely.
In 1998, the taxpayer expected BNS's share price to be hurt by the
recession and saw an opportunity to profit from the short-term decline
in share prices. The taxpayer therefore entered into a forward contract
relating to 165,000 BNS shares, under which the taxpayer would pay
TD Bank if the forward share price exceeded $68.46 and TD Bank would pay
him if it did not. The taxpayer terminated the contract, but not before
the former event had occurred, resulting in losses for the taxpayer.
The taxpayer's view was that because the forward contract was entered
into with a purely speculative intention, the resulting losses should be
treated as being on account of business.
The minister took the position that the forward contract was entered
into in order to hedge the taxpayer's long-term investment in his BNS
shares; accordingly, losses on the settlement of the hedge against
capital assets were on account of capital. Because the reference shares
for the forward contract were also BNS shares, no other linkage was
required to conclude that a hedge existed. The purpose of the forward
contract was to lock in an economic gain on the underlying BNS shares
and to reduce the risk of loss in case of a price drop.
The TCC ruled in favour of the taxpayer. The forward contract was
entered into not to hedge for BNS shares but to speculate. The taxpayer
was not exposed to any risk of loss prior to entering into the contract
because he intended to hold on to the BNS shares indefinitely. Instead
of offsetting financial risks, which a hedge would do (Placer Dome Canada Ltd. v. Ontario (Minister of Finance), 2006 SCC 20),
the forward contract only increased the taxpayer's risk exposure; the
probability of gain or loss was uncertain at the time the contract was
entered into. Furthermore, the taxpayer sold only a small number of BNS
shares to balance his investment portfolio, and this sale occurred long
after the cash settlement. The timing and quantum did not suggest any
linkage between the BNS shareholdings and the forward contract. The mere
fact that the taxpayer also held shares of the same company at the time
the contract was entered into was insufficient to establish a hedging
This case sets a much stricter standard for a transaction to be
considered a hedge for tax purposes: although an activity may be a
hedging transaction for economic purposes, it will not be a hedge for
tax purposes unless there is (1) an intention to eliminate risk and
(2) an extremely close link between the underlying asset and the
derivative in both timing and quantum. Forward contracts with cash
settlements are likely to be viewed as speculative and on account of
income because the underlying assets are not the delivery asset. In
short, settlement options for a financial derivative (such as cash
settlements versus physical delivery of underlying assets) will affect
how the gain or loss will be taxed.
Grant Thornton LLP, Toronto
Grant Thornton LLP, Toronto