MacDonald v. Canada: Clarity to the Taxation of Derivative Contracts
Taxpayers try to characterize their expenses, gains, and losses in a way that benefits them. Thus, the characterization of expenses, gains, or losses as on account income or capital has always been a major theme of tax law disputes. One such dispute was addressed in MacDonald v. Canada, 2020 SCC 6 [MacDonald], a decision by the Supreme Court of Canada (“SCC”) released on March 13, 2020. The case was concerned with whether a derivative contract was considered a speculation or a hedge. If a speculation, the Income Tax Act, RSC 1985, c. 1 (“ITA“) would have considered MacDonald’s losses resulting from the contract on account of income. In contrast, if a hedge, the ITA would have found the losses on account of capital.
Facts and Issue
James S. A. MacDonald was in possession of 183,333 common shares of the Bank of Nova Scotia (“BNS Shares”) (MacDonald, para 2). He had contracted with Toronto-Dominion (“TD”) Bank for a Credit Facility—a type of loan that allows the borrower to take out money over an extended period of time—for up to $10.5 million. Under the terms, MacDonald pledged his BNS Shares as security (para 3).
The terms of the Credit Facility required a Forward Contract, a type of derivative that hedged against price fluctuations faced by the BNS Shares (para 40). MacDonald entered into this contract with TD Securities. Under the terms, MacDonald would receive a cash payment from TD Securities if the price of the BNS Shares declined during the duration of the contract. In contrast, he would make a cash payment to TD securities if the price of the shares increased (para 6). Ultimately, the price of the BNS Shares increased and MacDonald made a Cash Settlement Payment to TD Securities of approximately $10 million (para 10).
When computing his income for tax purposes, MacDonald took the position that this $10 million loss resulting from the Forward Contract was due to speculation and not due to hedging against the price of his BNS Shares. A loss due to speculation meant a loss on account of income. MacDonald could then deduct this loss against income from other sources. In contrast, the Minister of National Revenue took the position that the $10 million was a capital loss. If the Forward Contract was characterized as a hedge against MacDonald’s BNS Shares, the loss would have been on account of capital, which is only deductible against capital gains.
Ultimately, the issue in this case was whether the Forward Contract between MacDonald and TD securities was for speculation or for hedging—i.e., offsetting the risk associated with holding onto 183,333 common shares of BNS.
At the Tax Court of Canada (“TCC”), the trial judge found that the Forward Contract was for speculation because MacDonald’s intention in entering into the contract was to speculate on the price of BNS Shares. Further, the finding that MacDonald had the intention to speculate was a result of his credible and reliable testimony. Therefore, the TCC did not find a linkage between the Forward Contract and the BNS Shares that MacDonald already owned. This meant that the Forward Contract was not a hedge against the risk associated with the BNS Shares (para 13).
At the Federal Court of Appeal (“FCA”), the Court allowed the Crown’s appeal. The FCA found that the intention of the taxpayer was not a condition precedent to whether the Forward Contract was one for hedging. Instead, the judge found that a derivative contract will be considered a hedging instrument if the contract neutralizes or mitigates risks associated with the contracting parties’ assets (para 14).
Supreme Court of Canada Decision — Majority Opinion
Justice Abella, with Chief Justice Wagner and Justices Moldaver, Karakatsanis, Brown, Rowe, Martin and Kasirer concurring, cited a long line of jurisprudence stating a derivative contract to be a hedge depending on the contract’s purpose. And thus, a taxpayer’s intentions would be relevant but not determinative in finding whether the contract was a speculation or hedge. This differed from the FCA opinion which found intent to be out of the equation. Justice Abella further submitted that the primary factor in determination was the “… extent of the linkage between the derivative contract and an underlying asset, liability, or transaction” (para 32). The majority opinion also stated its disagreement with the trial court decision.
The majority opinion articulated a linkage analysis to determine whether a derivative contract was closely related enough to an underlying asset, liability, or transaction to consider it a hedge. A court must first identify the underlying asset, liability, or transaction that exposes the taxpayer to a risk. Then, the more effective the derivative contract in question is at mitigating or neutralizing the risk, the stronger the link and the stronger the inference that the contract was a hedge. Additionally, the linkage does not have to be perfect to determine the contract as a hedge (para 32). Based on this analysis, the majority found that there was sufficient linkage to find that the Forward Contract was a hedge (para 33).
Multiple factors were used to determine that there was a sufficient linkage between the Forward Contract and the BNS Shares. First, Justice Abella agreed with the FCA’s determination that the derivative and the underlying asset, transaction, or liability do not have to be “synchronous” for linkage to be present. Thus, even if MacDonald did not intend to sell his BNS Shares in the foreseeable future, it did not mean that his risk was not mitigated (para 34).
Second, the majority noted that the Credit Facility extended by TD bank was “part of the context relevant to ascertaining the purpose of the Forward Contract” (Para 39). Observed by the FCA and reiterated by the majority, “the combined effect of the Forward Contract, the loan agreement and the pledge agreement allowed for credit backed by collateral [to be] free from market fluctuation risk” (para 40). Therefore, TD Bank’s collateral was protected from market fluctuation—an arrangement that would make TD Bank more open to providing the Credit Facility (para 41).
Disagreement with the Trial Court
The majority disagreed with the trial judge’s reasoning because she “… allowed Mr. 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”. (para 35) Justice Abella noted that “forward contracts settled by physical delivery are economically equivalent [to cash settled payments]” and treating them differently for tax purposes would create “an unjustified artificial distinction” (para 36).
Supreme Court of Canada Decision — Dissenting Opinion
Justice Côté penned the dissenting opinion alone. She submitted that there was no reason to overturn the trial judge’s findings and that the taxpayer’s intent should determine the tax characterization of the Forward Contract. Additionally, the FCA erred in their holding that the intent to hedge was not a requirement to determine that a derivative was to hedge against a risk. Justice Côté disagreed with the majority that linkage had been established and that the Credit Facility extended by TD Bank was relevant to the establishment of the linkage. She also disagreed with the majority’s analysis of the trial judge’s reasoning.
The dissenting opinion submitted that the linkage between the Forward Contract and the BNS Shares was weak. This was due to the poor timing connection, as MacDonald owned the BNS Shares 10 years before entering into the Forward Contract. Additionally, the number of BNS Shares owned by MacDonald and the number of BNS Shares contemplated by the Forward Contract did not match. MacDonald at the time owned 183,333 BNS Shares while the Forward Contract was made for 165,000 shares of BNS (para 83).
Justice Côté also noted some of the broader implications of the majority’s decision:
I would also point out that a test which is in effect based solely on risk mitigation will have extensive repercussions for the taxation of financial derivatives. For example, the fact that there is often a high correlation between the values of two investments of the same type, such as bank stocks, means that — because of the risk mitigation effect — my colleague’s test would lead to the conclusion that a derivative instrument that shorted shares in [TD Bank] was a hedge of the BNS Shares regardless of the taxpayer’s intentions. Therefore, this test will introduce a significant degree of uncertainty into the tax treatment of derivative instruments. (Para 60).
Further, Justice Côté firmly disagreed with the majority’s finding that TD Bank’s extension of credit to MacDonald was relevant to the linkage between the Forward Contract and the BNS Shares. She claimed that the Forward Contract was an independent transaction from the Credit Facility. The Forward Contract also remained in existence 16 months after the Credit Facility was repaid, which Justice Côté claimed weakened the relevance of the Credit Facility (para 83).
The Dissent’s Issues with the Majority’s Treatment of the Trial Decision
Justice Côté argued that the majority made three errors when analyzing the trial judge’s decision:
(1) that the trial judge placed undue significance on Mr. MacDonald’s evidence and on the Forward Contract’s mode of settlement; (2) that the trial judge failed to appreciate that the BNS Shares were exposed to risk despite the absence of a “synchronous transaction used to offset gains or losses”; and (3) that the second of these errors “necessarily” led the trial judge to conclude that Mr. MacDonald’s intention had been to speculate (para 70).
With respect to the first point, Justice Côté noted that the appellate court’s role is not to retry the case or reweigh the evidence. She also took issue with how the majority opinion emphasized that, in the context of the Forward Contract, a Cash Settlement Payment did not determine the contracts characteristic as a speculation or hedge. Justice Côté pointed out that “Nowhere in her reasons did the trial judge treat the mode of settlement as determinative” (para 75).
To the second and third point, Justice Côté submitted that the trial judge did appreciate the risk exposure of the BNS Shares but found them immaterial due to the evidence before her (para 80). She felt that the majority made their conclusion by not taking into consideration the trial judge’s full arguments, but by considering her arguments by way of “surgical analysis” (para 81).
MacDonald v. Canada provides clarity on how derivatives contracts are taxed—contrary to Justice Côté’s argument that the majority’s test makes the taxability of derivatives more uncertain. The majority opinion outlines new and reaffirms old factors that determine whether a derivative contract is a speculation or a hedge. This includes the fact that (1) a linkage analysis starts with identifying the underlying asset, liability, or transaction and then determines how effective the derivative contract is at mitigating or neutralizing the risk of it; (2) the timing of the derivative’s life and the ownership of the underlying asset, liability, or transaction do not need to match to find the derivative as a hedge; (3) the courts can consider related transactions, such as an extension of credit, outside of the derivative contract to determine the purpose of the derivative; (4) neither a cash settlement nor the physical delivery of shares determine whether the derivative is a speculation or hedge; and, (5) the intention of the taxpayer is relevant but not determinative in finding whether the derivative is a speculation or hedge.
It is also important that the majority decision did not completely agree with the FCA decision. The SSC majority found the taxpayer’s intention relevant but not determinative, while the FCA found the intention to hedge is not a condition precedent for hedging. By constituting intention as relevant but not determinative, the majority takes into account that investors and other similar individuals have contemplated whether a derivative is a hedge or speculation and how this contemplation plays a part into their overall investment strategy and portfolio.
However, these guidelines are not perfect. It is still uncertain how much mitigation or neutralization a derivative contract must supply for the courts to consider it a hedge. We also do not understand what types of third-party transactions can support a derivative contract’s linkage to an underlying asset, liability, or transaction. An ideal next step is for the Canadian Revenue Agency (“CRA”) to provide further clarifications on these questions. Although the SCC has provided principles, it is left to the CRA to fill in the details. The muddy water will likely become clearer as tax planners work with the CRA for clarifications on specific situations.