In MacDonald v. Canada (MacDonald)1, the majority of the Supreme Court of Canada (SCC) held that a derivative contract entered into by the taxpayer constituted a “hedge” of the taxpayer's capital property since it had the effect of neutralizing risk associated with owning this property. As a result, cash settlement payments made by the taxpayer under the contract were “capital” in nature, and thus not fully deductible for tax purposes.
What you need to know
- Issue. The issue in
MacDonald was whether cash settlement payments made by the
taxpayer under a derivative contract were on “income”
account, and thus fully deductible for tax purposes, or on
“capital” account, with more restricted deductibility.
- The character of cash payments made under a derivative contract generally turns on whether the derivative is speculative in nature or a “hedge” of an asset, liability or transaction. Based on principles developed in earlier cases, it is generally accepted that speculative contracts are regarded as being on income account and hedging contracts are regarded as being on capital account when the underlying item being hedged is on capital account.
- The “linkage principle” has been developed by the courts to determine whether a derivative contract constitutes a “hedge” and examines the link between the contract and the underlying asset, liability or transaction that is purportedly being hedged, with one factor in establishing a link being the purpose of the contract.
- SCC decision. The
majority of the SCC held that the taxpayer's derivative
contract was a hedge of capital property. The key principles
stemming from the majority's decision are as follows:
- The proper approach to determine the character of cash payments made under a derivative contract is to ascertain whether the derivative contract is a hedge under the linkage principle.
- Under the linkage principle, whether a derivative contract constitutes a hedge turns on its purpose. The primary source to determine a derivative contract's purpose is the extent of the linkage between the contract and an underlying asset, liability or transaction. The closer the link, the more likely the purpose of the contract is to hedge.
- In applying the linkage principle, the first step is to identify an underlying asset, liability or transaction which exposes the taxpayer to a financial risk. The second step is to then determine how effective the contract is at mitigating or neutralizing the identified risk. The sufficiency of the linkage depends on the effectiveness of the derivative contract at neutralizing the risk and the degree of connectedness to the asset, liability or transaction purportedly hedged. In this regard, the majority held that a perfect linkage is not required and that absence of a corresponding transaction (i.e., the sale of an asset or settlement of a liability) does not equate to the absence of financial risk.
The taxpayer, Mr. James MacDonald, had over 40 years of capital markets and corporate finance experience. In 1988, Mr. MacDonald was a senior executive at a brokerage firm which was acquired by a Canadian financial institution (FI). As a result of the acquisition, he acquired 183,333 common shares of FI (FI shares). According to Mr. MacDonald, he intended to hold the FI shares indefinitely. These shares were capital property to him for tax purposes.
In June 1997, shortly after leaving his employment at FI, Mr. MacDonald entered into a cash-settled forward contract with a third-party counterparty (CP). The forward referenced 165,000 FI shares, had an initial term of five years (which was subsequently extended) and could be settled in part or in full prior to maturity.
Under the terms of the forward, the parties were required to make cash payments at the time of any settlement. Mr. MacDonald was obligated to pay to CP the amount, if any, by which the market value of the number of FI shares (subject to the settlement) at that time exceeded the forward price in respect of such number of shares (which, in general, per FI share, reflected the market value of an FI share at the start of the forward contract). CP was obligated to pay to Mr. MacDonald the amount, if any, by which the forward price of the number of FI shares (subject to the settlement) exceeded the market price of such number of FI shares at that time.
Shortly after entering into the forward contract, Mr. MacDonald entered into a credit facility for $10.5 million with a third-party lender associated with CP (lender). The terms of the credit facility required Mr. MacDonald to pledge as security 165,000 FI shares and his rights to receive cash settlement payments under the forward. Mr. MacDonald borrowed $4.9 million under the credit facility and these amounts were fully repaid in 2004.
Mr. MacDonald opted to partially settle the forward contract in 2004 and 2005, and finally settled it in 2006. As part of these settlements, Mr. MacDonald made cash settlement payments to CP of nearly $10 million.
For tax purposes, Mr. MacDonald took the position that he had entered into the forward for speculation, and, as such, the cash settlement payments made by him were fully deductible in computing his income. Disagreeing with this position, the Canada Revenue Agency (CRA) reassessed Mr. MacDonald on the basis that the forward was a hedge of the FI shares, a capital property of Mr. MacDonald, and, as such, the cash settlement payments constituted capital losses.
Lower court decisions
In considering the deductibility of the cash settlement payments made by Mr. MacDonald, the Tax Court of Canada (TCC) and the Federal Court of Appeal (FCA) took different approaches in applying the linkage principle to determine if the forward contract entered into by Mr. MacDonald was a hedge, and in particular, the manner in which the “purpose” of the contract is to be established.
The TCC assessed purpose largely by reference to Mr. MacDonald's subjective intention, which it accepted was speculative in nature, such that the payments were on income account. In contrast, the FCA downplayed Mr. MacDonald's subjective intention and assessed purpose by reference to the effect of the forward contract: since the forward had the effect of mitigating risk associated with FI shares held by Mr. MacDonald, which the parties accepted as being capital property to him for tax purposes, the forward was a hedge of capital property and the payments were on capital account.
The majority of the SCC upheld the FCA's order, agreeing with the FCA that the forward contract was a hedge of the FI shares.
The SCC found that derivatives are used for two purposes: to speculate on the movement of an underlying asset, reference rate, or index, or to hedge exposure to a particular financial risk.
The income tax treatment of a derivative contract depends on whether it is characterized as a hedge, or speculation. A derivative contract that is a hedge takes on the character of the underlying asset for tax purposes. If the underlying asset is a capital asset, then the derivative will be on capital account. A derivative contract that is speculative is characterized on its own terms.
The SCC described and relied on a long line of jurisprudence for the conclusion that the characterization of a derivative contract as a hedge turns on its purpose. The more closely the derivative contract is linked to the item it is said to hedge, the more likely it is that the purpose of the derivative contract is hedging.
Broadly, the SCC described two steps for the linkage analysis. The first step is to identify an underlying asset, liability or transaction that exposes the taxpayer to a financial risk. The second step is to consider the extent to which the derivative contract mitigates or neutralizes that risk. The more effective the derivative contract is at mitigating or neutralizing the risk, the stronger the inference that the contract is a hedge. Perfect linkage is not required.
The SCC found that there was substantial linkage between the forward contract and Mr. MacDonald's FI shares. The forward contract had the effect of nearly perfectly neutralizing the fluctuations in price of the FI shares held by Mr. MacDonald. In arriving at this conclusion, the SCC considered that the combined effect of the pledge agreement and loan with lender, and the forward contract with CP, was to allow for credit backed by collateral (the FI shares) that was free from market risk. This context was significant for the SCC in assessing the close linkage between the forward contract and the FI shares.
The FCA had faulted the trial judge for failing to follow the TCC's decision in George Weston2, which found, contrary to the longstanding historic position of the CRA, that ownership risk can be hedged for tax purposes. In particular, the trial judge's finding that there was no risk as long as Mr. MacDonald did not intend to sell his shares was incorrect—ownership risk can only exist if the underlying property is not sold. The SCC echoed the FCA's criticism and relied on George Weston in concluding that risk arises even in the absence of a transaction (i.e., ownership risk).
The SCC also agreed with the FCA that the stated intent of the taxpayer—to hedge or speculate—is not determinative of the contract's purpose. In this regard, the SCC criticized the TCC judge for allowing Mr. MacDonald's testimony to “overwhelm her analysis”.
Justice Côté, in dissent, would have restored the order of the TCC. Based on the findings of fact by the TCC with regard to Mr. MacDonald's intent, Justice Côté concluded that the forward contract was an adventure in the nature of trade, and not a hedge of Mr. MacDonald's FI shares.
Justice Côté stated that the determination of whether a derivative contract is a hedge turns on the taxpayer's intent. This is determined by reviewing the taxpayer's subjective statements and objective manifestations of intent. According to Justice Côté, since the taxpayer's intent is important in determining whether a transaction is on account of capital or income, it should also be important in determining whether a transaction is a hedge.
According to Justice Côté, the forward contract should be considered on its own terms, not alongside the credit facility and securities pledge. In this regard, Justice Côté emphasized that the forward contract was entered into with CP, whereas the credit facility and securities pledge were entered into with lender. Relying on the SCC's decision in Shell Canada3, Justice Côté stated that the tax character of the losses on the forward contract should not be affected by Mr. MacDonald's arrangements with lender. Justice Côté criticized the majority for relying “on Mr. MacDonald's arrangements with [lender] in order to recharacterize the tax treatment of his arrangements with [CP]”.
Justice Côté also suggested that lender may have had an intention to hedge the market fluctuation risk on the pledged FI shares. However, Justice Côté noted that lender's intention is irrelevant, since we are concerned with the intentions of Mr. MacDonald.
For Justice Côté, the TCC's factual findings on Mr. MacDonald's intent to speculate were unchallenged on appeal. According to Justice Côté, none of the legal errors identified on appeal stand up to scrutiny, and it is not appropriate for an appellate court to transform its opposition to a trial judge's factual findings into legal errors.
1. 2020 SCC 6, aff'g 2018 FCA 128, rev'g 2017 TCC 157.
2. George Weston Limited v. The Queen, 2015 TCC 42.
3. Shell Canada Limited v. Canada,  3 S.C.R. 622.
Originally published 29 April, 2020
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