Canada: ThumbTax: New Tax Rules Adversely Affect Monetization, Derivative And Similar Transactions

The Federal budget, released on March 21, 2013 (the "Budget"), proposes to introduce new rules that may have significant tax implications to any person entering into agreements or other arrangements that effectively lock in the gain on property held by the person or certain other non-arm's length persons but do not give rise to a taxable disposition of the property. The categories of transactions that may be affected are extremely broad and may include certain hedging transactions, forward sales, exchangeable debt and put-call arrangements (see the table below for examples of transactions that may be subject to the proposed rules).

Currently, such arrangements are not taxable in many circumstances because they are structured to defer an "actual sale" of the property until sometime in the future, even though the arrangements may effectively crystallize the taxable gain and often allow the person to monetize their position upon entering into the arrangements.

The Budget proposes to drastically change the tax consequences associated with such "synthetic disposition arrangements" by deeming a taxable disposition to have occurred at the time the arrangements are entered into.

The proposed rules will generally apply to any agreements or arrangements entered into (or extended) on or after March 21, 2013, that:

  1. have the effect of eliminating all or substantially all of a person's risk of loss and opportunity for gain or profit in respect of property held by the person; and
  2. do not otherwise result in a taxable disposition of the property within one year of entering into the agreements or arrangements.

There is no requirement that the person receive money, replacement property or other funding of any kind whatsoever at the time the person enters into the arrangement. Moreover, the intention or motivation of the person at the time of entering into the agreements or arrangements is generally irrelevant (aside from special rules dealing with transactions entered into by persons not dealing at arm's length with the owner of the property). Accordingly, the proposed rules have an extremely broad reach and are not limited to classic "monetization" transactions.

The proposed rules contain very limited exceptions for the leasing of tangible personal property, certain "ordinary" hedging transactions (i.e., transactions that only minimize risk of loss as opposed to opportunity for gain) and short-term transactions.

Taxpayers and their advisors must carefully consider the potential application of these proposed rules generally with respect to any transaction that may have the effect of mitigating risk or monetizing the value of property held by the taxpayer or a person not dealing at arm's length with the taxpayer.

Examples of Potential "Synthetic Disposition Arrangements"1

Forward sale of a property

A contract to sell property in the future at a fixed price. May be combined with a loan secured against the property that is the subject of the forward sale.

A put-call collar in respect of an underlying property

Owner of property sells a call option that allows the holder to purchase the property in the future at a given price. Owner then uses the proceeds from the sale of the call option to purchase a put option that allows the holder to require another party to purchase the property in the future at a given price.

Exchangeable debentures/Lending transactions combined with a put-call

Debentures that are exchangeable/redeemable for property held by the issuer.

Total return swap

In a total return swap, the party receiving the total return will receive any income generated by the asset as well as benefit if the price of the asset appreciates over the life of the swap. In return, the total return receiver must pay the owner of the asset the set rate over the life of the swap. If the price of the assets falls over the swap's life, the total return receiver will be required to pay the asset owner the amount by which the asset has fallen in price.

Commodity straddle

An arrangement whereby an investor enters into long and short futures contracts of a commodity for delivery in different months but the investor does not actually own or take delivery of the commodity.

Transactions that Should not be "Synthetic Disposition Arrangements"2

Tax-deferred share-for-share or debt-for-share transactions, including:

  • estate freezes
  • exchangeable share transactions

Among other reasons, such transactions generally result in a dispositions for tax purposes under the existing rules and therefore are not subject to the proposed rules.

Ordinary convertible debt or convertible share transactions, which do not give rise to a disposition for tax purposes, are specifically excluded from the application of the proposed rules. A contract to sell property in the future at a fixed price. May be combined with a loan secured against the property that is the subject of the forward sale.

Secured loans

Loans secured by property should not be subject to the new rules provided the borrower can repay the loan with cash (i.e., the lender cannot demand repayment of the loan via delivery of the property). In such cases, the borrower should retain the opportunity to profit in respect of future increases in the property's value.

Short-term agreements/arrangements (taxable disposition of underlying property occurs within one year of entering into the arrangements)

Specifically excluded from the application of the proposed rules.

Leases of tangible property

Specifically excluded from the application of the proposed rules.

"Ordinary" hedging transactions that only mitigate risk of loss but leave the person with the opportunity of gain/profit

Should not be subject to the new rules according to the Budget materials.

"Ordinary-course" securities lending arrangements

Should not be subject to the new rules according to the Budget materials.

Footnotes

1 The following describes at a high level certain transactions that may be particularly problematic with respect to the proposed rules. This list is by no means exhaustive of all potentially problematic transactions.

2 The following describes at a high level certain transactions that should not be subject to the proposed rules. However, every transaction is unique and you should always consult with a tax lawyer to assess any potential risk or exposure prior to implementing.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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