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 relationship.

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.

Killy He
Grant Thornton LLP, Toronto

Jennifer He
Grant Thornton LLP, Toronto

Canadian Tax Focus
Volume 7, Number 4, November 2017
©2017, Canadian Tax Foundation