Case Commentary – MacDonald v The Queen, 2017 TCC 157

Income tax issues raised by derivative contracts are central for parties and their advisers.  Although the definition of derivative contracts is elusive, they can be generally conceptualized as contracts that derive their value from something else, be it an underlying property, a reference rate or an index.[1]  Determining the tax treatment of payments made and received is crucial because the pricing spreads do not have buffers for unexpected tax costs.[2]

One of the central issues in assessing the tax treatment of derivative contracts is whether the gains or losses under the contract will be on account of income or capital.  Under the Income Tax Act (Canada)[3] (the "Act"), account receipts and payments are fully included or deducted in the computation of income, while capital gains are half included in income, and capital losses are only half deductible against capital gains.[4] 

There are a number of forms of derivative activity: speculation, hedging, asset liability management and arbitrage.[5]  Canadian tax law has focused on whether an activity was undertaken for speculative or hedging purposes.  The central question in determining the characterization of a hedging transaction has been whether the transaction is sufficiently connected to some underlying transaction to justify a characterization by reference to it.

In MacDonald v The Queen,[6] the Tax Court of Canada found that cash losses realized on closing out an isolated forward contract were fully deductible under subsection 9(1) of the Act.  The forward contract represented an adventure in the nature of trade, and did not hedge a capital asset of the taxpayer.

The decision introduces a clear framework for the analysis of derivative transactions and confirms the close linkage requirement for hedging arrangements established in prior case law.  Moreover, together with the Tax Court of Canada's 2015 decision in George Weston Limited v R,[7] it establishes the limits to the spectrum of hedging arrangements.

Jurisprudence on Hedging and the Linkage Requirement

Courts have held that, in order to support a hedge for the purposes of the Act, there must be an extremely close link between the purported hedge and the underlying item.  Most of the cases have been decided in the context of foreign exchange gains or losses, nevertheless, the general principles are applicable to all types of derivatives.  The central indicia of a hedge are the intention to eliminate risk and that the hedging instrument is directly linked to the underlying item in both terms of quantum and timing.[8]  The jurisprudence prior to MacDonald clarifies the application of these criteria.

In Salada Foods,[9] the Court found that there was insufficient linkage between a forward currency contract and the taxpayer's investments in its UK subsidiaries. By consequence, the forward contract was not a hedge of a capital asset.  The Canadian corporate taxpayer owned a number of subsidiaries in the UK.  Anticipating a decline in the pound sterling against the Canadian dollar, the taxpayer sold pounds forward for delivery at its option the following year.  The pound declined in value against the Canadian dollar and the taxpayer closed out its short position realizing a substantial profit. 

The profit was assessed as income and the taxpayer argued that it was capital gain on the basis and the transaction was a hedge to protect its investment in its UK subsidiaries against a decline in the value of the pound.  The taxpayer had argued that the undistributed profits of its UK subsidiaries were part of its investment in the UK companies, but the Court rejected that submission because the taxpayer's investments had never been appraised, the quantum of the forward did not match the alleged investments and the subsidiaries were separate, legal, foreign entities.  Additionally, it was found that the taxpayer had "acted in exactly the same fashion as a dealer in securities would act."

Later, in Echo Bay Mines Ltd. v Canada,[10] a case concerning forward sale contracts for silver hedging the silver production of a mine, the Federal Court built upon Salada Foods by addressing the intention to hedge.  While exact matching of timing and quantum was not necessary to establish a hedge, the Court held that the existence of a clear business purpose underlying the taxpayer's hedging activity and the integration of that purpose with the taxpayer's production and sales were sufficient to determine that the gain arising from the taxpayer's hedging activity was income from that business.

Courts further clarified the type of linkage required to establish a hedging arrangement, in Shell Canada Ltd. v Canada[11] and Saskferco Products ULC v Canada.[12]  In Shell Canada, the Supreme Court found that the taxpayer's intention to mitigate currency fluctuation risks related to borrowing was relevant in finding that the taxpayer had hedged on account of capital.  More importantly, the Supreme Court did not state that an underlying transaction is a prerequisite of hedging, but the analysis focused on the existence of an underlying risk.  Later, in Saksferco, concerning a natural hedge, the Federal Court of Appeal decided that merely having the intention to hedge is not sufficient to establish such an arrangement.

Finally, in George Weston, the capstone of the prior jurisprudence on derivatives, the Tax Court of Canada grappled for the first time with the issue of hedging to protect a group's consolidated balance sheet.  The taxpayer realized a gain on the termination of cross-currency swap contracts and reported the gain on account of capital.  In 2001, the taxpayer had acquired new US subsidiaries and entered into a number of term swaps at approximately the same time as the acquisition of the business and having a notional amount approximately equal to the subsidiaries' total net value.  The taxpayer had entered into the swaps to protect its consolidated balance sheet from foreign exchange fluctuations.  The taxpayer's debt-to-equity had increased well above its internal guidelines of 1:1, and resulted in a credit watch warning from Standard & Poor's.  By 2003, the taxpayer had repaid its debt to a point where the risk of foreign exchange was at an acceptable level and the taxpayer terminated the swaps without an associated disposition of the underlying the US operations.  The Court found that the swaps had hedged the acquisition of US subsidiaries and that the taxpayer was entitled to report the swap gains on account of capital.

The Tax Court of Canada considered that in order to characterize the proceeds from a derivative transaction, one needs to identify the underlying item that created the risk to which the derivative relates and determine whether that underlying item is capital or income in nature.[13]  The taxpayer's intention was to hedge its US investment, which was on capital account, and protect against currency risk that impacted its capital structure.  Absent the investment, the taxpayer would not have entered into the swaps since it did not, as a matter of policy, generally participate in derivatives.

Some commentators considered that George Weston dispensed with years of established jurisprudence on the characterization of income arising from derivatives in making a broad application of the linkage principle.[14]  However, the Court's decision in MacDonald clarifies that George Weston is a continuation of pre-existing law and that the central elements of a hedging transaction are (i) the intention to hedge, and (ii) the existence of a close linkage between the quantum and timing of the hedging instrument and the underlying item.

CRA Positions on Derivatives and Hedging

Prior to George Weston, the Canada Revenue Agency (the "CRA") commented in respect of derivatives, in general, that its position is that unless a derivative contract is a hedge for tax purposes of a capital transaction, the closing out of a derivative contract is on account of income.  Moreover, whether a specific derivative contract is such a hedge "would depend on whether there was sufficient linkage between that specific derivative contract and an underlying capital transaction of the taxpayer such as the acquisition or disposition of a capital asset by the taxpayer or the repayment of a debt of the taxpayer which itself was on account of capital."[15] 

The CRA appeared to assume that a derivative that is not entered into for hedging purposes is speculative.  However, as some commentators noted, that will not always be the case, for example a derivative contract can be a way of obtaining dividend-like payments although the taxpayer is precluded from holding the underlying asset.  By consequence, practitioners suggested that the character of gains or losses on equity derivatives that are not entered into for hedging purposes should be determined on the basis of the principles enunciated in the cases on whether property is held on income or capital account.[16]

The Court's decision in MacDonald adopts a clear legal framework for analyzing derivative transactions.  Through its analysis, the Court alleviates the concern that gains or losses from derivative contracts that are not hedges would automatically be deemed to be on account of income.[17]

After George Weston, when asked, the CRA stated that it would accept the Tax Court of Canada's decision, but emphasised the linkage aspect to the detriment of the intention to hedge.  The CRA clarified that in order for a foreign currency derivative to be considered a hedge of a taxpayer's net investments in foreign operations there must be evidence that the derivative is sufficiently linked to the underlying capital assets.  Such a determination could only be made after considering all the surrounding circumstances.  Among the criteria for determining linkage, the CRA mentioned that the decisive factors in George Weston were that the notional value of the swaps closely approximated the investments in the US operations and that the taxpayer's formal derivative policy and its credit facilities prohibited it from speculating in derivatives.[18]

However, the CRA clarified that it would not extend the George Weston decision to other types of derivatives, such as interest rate derivatives.[19]  The CRA considered that George Weston did not impact its administrative position of treating interest rate derivatives as independent from other transactions and therefore on income account.

In MacDonald, the CRA tested the outer limits of hedging, as formulated in George Weston.  It tried to argue that a taxpayer could not speculate in derivatives while holding a long position in the underlying assets because the linkage requirement between the derivative and the security would be automatically met as a consequence of owning and using, for financing purposes, the underlying securities.

Facts and Issues in MacDonald

James Macdonald ("MacDonald") held a significant investment in the common shares of the Bank of Nova Scotia ("BNS") since 1988.  In the late 1990s, MacDonald anticipated, on the basis of his view of certain world financial events, that the BNS shares he held could decline in value in the short term, despite his optimism about their long-term potential value.  By consequence, in 1997, MacDonald entered into a contract with TD Securities Inc. for the forward sale of a reference number of BNS shares (the "Forward Contract").  The Forward Contract could only be cash settled.  The forward sale date was initially June 26, 2002, but was subsequently extended.  MacDonald made cash settlement payments under the Forward Contract in 2004, 2005, and 2006 on income account and claimed business losses of $9,936,149.  The contract was terminated on March 29, 2006.

Around the same time as entering into the Forward Contract, MacDonald entered into a loan agreement (the "Loan") with the Toronto-Dominion Bank ("TD Bank").  MacDonald also entered into a securities pledge agreement with TD Bank pursuant to which he pledged 165,000 BNS shares and all amounts which may become payable to him under the Forward Contract as collateral security for the Loan (the "Pledge").  The terms of the Loan provided that MacDonald could borrow up to $10,477,480 from TD Bank, subject to a maximum of 95% of the spot price of the BNS shares.

In 1997, MacDonald borrowed $4,899,000 under the Loan.  The proceeds were used for the purposes of investing in MacDonald's business and other various securities.  Substantially all of the borrowed funds had been repaid before the commencement of the taxation years under dispute. 

The Court found that MacDonald treated the Loan and the Forward Contract as two separate instruments and that MacDonald did not consider the Loan to be part of the Forward Contract.[20]  Additionally, both MacDonald's and the Crown's experts agreed that the existence of the Loan was irrelevant to the determination whether the Forward Contract was a hedge.

Findings and Holdings In MacDonald

The parties disputed three main issues: (i) the legal framework for analyzing the Forward Contract, (ii) whether the Forward Contract was in itself an adventure in the concern and nature of trade and (iii) whether the Forward Contract was the hedge of a capital asset.

Legal Framework

MacDonald and the Crown proposed two competing legal frameworks for analyzing the Forward Contract.  MacDonald submitted that the Court should first determine whether the Forward Contract was, in and of itself, an adventure or concern in the nature of trade as a speculative investment.  Second, under MacDonald's analysis, the Court had to determine whether the Forward Contract was sufficiently linked, both in terms of timing and quantum, with an underlying capital asset so as to convert the payments on income account made by MacDonald under the Forward Contract to payments on capital account, resulting in capital losses.

The Crown, submitted that the Court's analysis should start from whether the Forward Contract was a hedge of BNS shares.  If the Court concluded that the Forward Contract was a hedge, it would have to determine the character of the BNS shares. 

The Court adopted MacDonald's reasoning because it considered, in accordance with the principles for ascertaining profit under subsection 9(1) of the Act, developed by the Supreme Court of Canada in Canderel Ltd. v R,[21] that "[i]n seeking to ascertain profit, the goal is to obtain an accurate picture of MacDonald's profit for the given year."[22] 

The Court recognized that according to the Supreme Court in Friesen v R,[23] section 3 of the Act recognizes two basic categories of income, "ordinary income" under paragraph 3(a), which includes income from business, and income from a capital source, or capital gains which are covered under paragraph 3(b).[24]  Therefore, the losses from the settlement of the Forward Contract would be considered on income account provided that they were from a source that is business, including an adventure of concern in the nature of trade.

The Forward Contract: An Adventure or Concern in the Nature of Trade or Capital Property

Lafleur J. found that the Forward Contract was an adventure in the nature of trade because there was a scheme of profit-making.  In finding that there was a scheme of profit-making, the Court relied on four indicia related exclusively to the Forward Contract itself. 

First, the Forward Contract afforded MacDonald an opportunity to speculate on the outcome that the price of BNS shares would drop in the short term and that he could profit from that anticipated drop.[25]  Second, the Forward Contract did not involve an exchange, sale or delivery of any BNS shares as it was only cash settled.[26]  Additionally, the Court mentioned that although there is economic equivalence between a cash and a physically settled forward, such equivalence is irrelevant for the purposes of determining the tax treatment of the Forward Contract and that the Court's duty is to obtain an accurate picture MacDonald's income.[27]

Third, the Forward Contract involved great potential for risk and reward, it was isolated and non-recurring, and was not used to lock-in any gain in the BNS shares.[28]  Finally, although MacDonald was not exposed to risk by holding the BNS shares since he did not want to sell them in the long-run, he speculated because he increased his exposure by entering in the Forward Contract without knowing whether he would receive or have to make a payment under the Forward Contract.[29]

The Court rejected the Crown's proposal to consider factors external to the Forward Contract in determining whether the contract was an adventure or concern in the nature of trade. 

First, the Court confirmed that MacDonald acted as a dealer or trader in respect of the Forward Contract, although he might have been "passive" compared to a dealer or trader as he did not terminate the Forward Contract when he could have made a substantial profit.  The mere fact that MacDonald made a mistake in not taking the profit between July 2, 1997 and November 28, 1997, the only timeframe when the forward price was higher than the reference price, was not sufficient to persuade the Court that MacDonald was not involved in an adventure in the nature of trade.[30]  Additionally, the fact that MacDonald entered into a single Forward Contract for nine years, while a dealer or trader would have entered in multiple contracts, was not indicative of whether the contract was an adventure or concern in the nature of trade.[31]

Second, the Loan arrangement and Pledge arrangement were held to be irrelevant for the determination whether MacDonald was engaged in an adventure or concern in the nature of trade because MacDonald had considered them to be separate arrangements and the contractual obligations to maintain the Forward Contract during the operation of the Loan could have been extinguished by paying off the Loan.[32]

Third, the Court criticized the Crown for examining the BNS shares as it considered that the question was not whether MacDonald had speculated with the BNS shares, but whether he had speculated when he entered into the Forward Contract.  Thereby the Court considered that it was irrelevant how he dealt with publicly listed securities or whether he reported all transactions in securities on income account.[33]

Fourth, the Crown inferred a secondary intention to obtain a tax benefit from the Forward Contract and submitted that, according to Loewen v MNR,[34] such a motivation could not support an adventure or concern in the nature of trade.  The Court found that MacDonald did not intend to reduce his taxes by entering into the Forward Contract and, by consequence, the secondary intention argument was moot.[35]

Hedging

The second step of the Court's analysis was to determine whether MacDonald had hedged a capital asset when he entered into the Forward Contract, and thus converted the payments made under the contract into payments made on account of capital instead of income account.

The Court found that an essential component of a hedge is that the strategy used to hedge must result in an offset of investment risk.[36]  After a review of the cases on hedging, Lafleur J. found that the central indicia of a hedge are (i) an intention to eliminate risk (i.e., to hedge) and (ii) a close linkage between the purported hedging instrument and the underlying asset or transaction.  The judge considered that the link in quantum and timing is very important because it locks-in either a gain or a price.[37]  Later on, the judge stated that unless a taxpayer settles a forward contract in cash and disposes of the underlying shares at the same time on the market, he does not lock-in a gain upon the settlement of the forward contract.[38]

The Court did not re-analyze MacDonald's intention in entering in the Forward Contract.  It reiterated its earlier finding that MacDonald speculated at the time he concluded that agreement, and concluded that there was no intention to hedge.[39]

Regarding linkage, both parties referred to George Weston[40] to support their respective positions.  MacDonald argued that the George Weston decision confirmed the requirement of close linkage between the hedge and the underlying transaction, while the Crown submitted that, after George Weston, the hedged risk was MacDonald's ownership of BNS shares and the potential for price fluctuations.  The Court decided that there was no close linkage between the settlement of the Forward Contract and the BNS shares.  In particular, it found that the settlements were not based on any anticipated sale of the BNS shares and the sale of these shares did not occur in close proximity to the settlements.[41]

Moreover, the Court rejected the Crown's argument that links between the Forward Contract and the Loan or Pledge arrangement supported the finding that the contract was a hedge on account of capital.  The judge considered that it was irrelevant that (i) the amount of the Loan would have been reduced if the original forward price was reduced; (ii) if the number of reference shares under the Forward Contract were reduced, the credit facility available to MacDonald under the Loan would also be reduced; (iii) the terms of the Loan also required MacDonald to maintain the Forward Contract; and (iv) MacDonald also pledged as collateral the payments under the Forward Contract as well as 165,000 BNS shares.[42]

The Court rejected the aforementioned links because MacDonald had provided credible testimony regarding the absence of connection between the amounts he borrowed under the Loan and the value of the BNS shares as reference shares in the Forward Contract.

Concluding Comments

Comprehensive Approach to Derivative Contracts

MacDonald adopts a clear framework for analysing derivative transactions.  While prior case law first asked whether the derivative contract was a hedge of an underlying transaction, the Court chose to first determine whether the derivative contract itself was an adventure or concern in the nature of trade or a capital transaction.  This approach suggests that the CRA must rethink its position concerning derivatives and must first determine whether, at the time he entered into the derivative contract, the taxpayer dealt in derivatives or held the derivative itself on account of capital.  As a second step of the analysis, the Minister must determine whether the derivative contract is sufficiently linked to the underlying transaction to be a hedge. 

While the framework appears to be different from the one used in George Weston, the test for hedging remains the same after MacDonald.  In George Weston, the Court first inquired whether the swaps were hedges on account of capital and, in the alternative, whether the proceeds should be treated on the account of income.  Nevertheless, the taxpayer's intention to hedge was central to the Court's decision in both cases.

Under the Court's reasoning in MacDonald, the taxpayer's intention is reviewed twice: first, whether he intended to profit from the derivative itself, and second, whether he intended to mitigate an underlying risk.  It appears that if the Court decides that the taxpayer’s intention was to engage in an adventure in the nature of trade, the same intention will inform the hedging analysis. 

The Court has set out that both the intention to hedge and linkage are required for a transaction to constitute a hedge.  However this does not mean that once the Court determines that the taxpayer was engaged in an adventure or concern in the nature of trade it no longer needs to move forward to the hedging aspect because the intention aspect would be settled.  On the contrary, the Court continued to analyze the linkage requirement as a principal and not alternative argument.

This framework suggests that, in cases such as MacDonald, where it is clear that the taxpayer intended to make a profit pursuant to the derivative contract and not to mitigate risk, it could still be found that the taxpayer engaged in a hedge if the derivative transaction is offset by another transaction with the same underlying asset, closely linked in terms of quantum and timing with the derivative.  By engaging in this two-step analysis, the Court finds the right balance between assessing the subjective intention of the taxpayer and the objective manifestations of the purpose.[43]

Confirmation that Intention is Central for Hedging

The decision in MacDonald confirms the pre-existing case law on hedging.  While George Weston shows how broad the linkage can be while the transaction is still considered a hedge, MacDonald is at the other end of the spectrum.  The different outcomes are due to the fact that while the taxpayer intended to hedge in George Weston, the taxpayer explicitly intended to speculate in MacDonald.

In George Weston, the Court based its decision that the swaps were hedges of the taxpayer's acquisition of US subsidiaries on four main factors: (i) the taxpayer had the intention to hedge because the acquisition of the US subsidiaries triggered the decision to enter in the swaps;[44] (ii) the quantum of swaps closely matched the underlying value of the US assets;[45] (iii) the swaps were entered into a period that was fairly close to the date of acquisition of the US operations;[46] and (iv) there was a real risk in the taxpayer's business after the acquisition of the US subsidiaries.[47]  Additionally, the Court decided that a sale or proposed sale of the underlying item being hedged was not required to grant the taxpayer capital gains treatment.[48]

In MacDonald, the Court refused to find the required linkage for hedging because unlike in George Weston, the taxpayer did not intend to hedge.  MacDonald had testified that he wanted to keep the BNS shares for the very long term.  He had sold only a small number of BNS shares over the years to rebalance his portfolio.  He had owned the shares for the past 30 years.  Finally,  he had entered the cash settled Forward Contract with the intention not to sell the shares.  Based on these facts, the Court decided, that unlike in George Weston, MacDonald was not exposed to a real risk related to the ownership of the BNS shares.  Therefore, the Court held that in the absence of a link to a clear risk, "other links both in terms of quantum and timing, have to be present in order to find that the Forward Contract had hedged the BNS shares and that the existence of an offsetting transaction is a prerequisite to find a hedge in this particular case."[49]

George Weston and MacDonald clarify the boundaries of hedging.  After these Tax Court of Canada decisions, the crux of the hedging analysis is the taxpayer's intention to hedge or speculate.  Additionally, in the absence of the intention to hedge the clear risk of an underlying item, the Court would require a close linkage between the timing and quantum of the underlying item and the purported hedge, and an offsetting transaction.