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FEDERAL INCOME TAX - Capital gains and losses - Allowable capital losses

Friday, March 13, 2020 @ 1:49 PM  


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Appeal by MacDonald from a decision of the Federal Court of Appeal holding that Cash Settlement Payments made by MacDonald under a forward contract were capital losses and not income losses, and therefore not deductible on his tax return against income from other sources. MacDonald was the owner of 183,333 common shares of the Bank of Nova Scotia. In 1997, MacDonald obtained a credit facility from the Toronto‑Dominion Bank (“TD Securities”) for up to $10.5 million. The terms of the credit facility required MacDonald to pledge Bank of Nova Scotia shares as partial security, and also required the parties to execute a “forward contract”, a type of derivative contract creating an obligation for one party to sell, and another party to buy, an underlying asset (“Reference Asset”) at a predetermined future date (“Forward Date”) and at a predetermined price. The Reference Assets underlying the forward contract were 165,000 Bank of Nova Scotia shares. The forward contract was cash settled: if the shares decreased in value, TD Securities would pay MacDonald the full amount of the decrease; if the shares increased in value, MacDonald would pay TD Securities the full amount of the increase (“Cash Settlement Payments”). During the life of the forward contract, the price of the shares increased and MacDonald made Cash Settlement Payments totalling approximately $10 million. In computing his income for his 2004, 2005 and 2006 taxation years, MacDonald took the position that he used the forward contract for speculation, not hedging and, on this basis, characterized the Cash Settlement Payments as income losses deductible against income from other sources. The Minister of National Revenue (“MNR”) reassessed MacDonald and characterized the Cash Settlement Payments as capital losses, which could only be deducted against capital gains, on the basis that the forward contract was a hedge. MacDonald filed notices of objection and appealed the reassessments to the Tax Court of Canada. The trial judge accepted that MacDonald’s sole intention in entering into the forward contract was to speculate, not hedge, and consequently there was no linkage between the forward contract and his Bank of Nova Scotia shares. She concluded that the forward contract was a speculative instrument and the Cash Settlement Payments were properly characterized as losses on account of income. The Court of Appeal allowed the MNR’s appeal, holding that intention was not a condition precedent to hedging. Rather, a derivative contract would be a hedging instrument if the party entering into the contract owned assets exposed to risk from market fluctuation, the contract neutralized or mitigated this risk, and the party entering into the contract understood the contract’s nature. The Court of Appeal held that those requirements were met in this case, and therefore, the Cash Settlement Payments were capital losses.

HELD: Appeal dismissed. The income tax treatment of gains and losses arising from derivative contracts depended on whether the derivative contract was characterized as a hedge or speculation. Gains and losses arising from hedging derivative contracts took on the character of the underlying asset, liability or transaction being hedged. In contrast, speculative derivative contracts were characterized on their own terms, independent of an underlying asset or transaction. Jurisprudence supported the conclusion that the characterization of a derivative contract as a hedge turned on the contract’s purpose. Purpose was ascertained objectively. The primary source of ascertaining a derivative contract’s purpose was the linkage between the derivative contract and any underlying asset, liability or transaction purportedly hedged. The more closely the derivative contract was linked to the item it was said to hedge, the stronger the inference that the purpose of the derivative contract was hedging. The linkage analysis began with the identification of an underlying asset, liability or transaction which exposed the taxpayer to a particular financial risk, and then required consideration of the extent to which the derivative contract mitigated or neutralized the identified risk. The more effective the derivative contract was at mitigating or neutralizing the identified risk and the more closely connected the derivative contract was to the item purportedly hedged, the stronger the inference that the purpose of the derivative contract was to hedge. However, perfect linkage was not required to conclude that the purpose of a derivative contract was to hedge. The trial judge erred in concluding that MacDonald faced no risk from holding his Bank of Nova Scotia shares. This led her to conclude that he entered into the forward contract with the intention of speculating. She also allowed MacDonald’s ex post facto testimony and the fact that the forward contract was settled by cash, not physical delivery of the Bank of Nova Scotia shares, to overwhelm her analysis. The forward contract had the effect of nearly perfectly neutralizing fluctuations in the price of Bank of Nova Scotia shares held by MacDonald, pointing to a close linkage. The combined effect of the forward contract, the loan agreement and the pledge agreement allowed for credit backed by collateral that was free from market fluctuation risk. This arrangement revealed the necessary linkage between MacDonald’s Bank of Nova Scotia shares and the forward contract to indicate a hedging purpose. MacDonald’s ex-post facto testimony regarding his intentions could not overwhelm the manifestations of a different purpose objectively ascertainable from the record.

MacDonald v. Canada, [2020] S.C.J. No. 6, Supreme Court of Canada, J R. Wagner C.J. and R.S. Abella, M.J. Moldaver, A. Karakatsanis, S. Côté, R. Brown, M. Rowe, S.L. Martin and N. Kasirer JJ., March 13, 2020. Digest No. TLD-March92020013-SCC