Principal Issues: Whether the CRA intend to change its administrative position on hedging following the T.C.C. decision George Weston Limited?
Position: No specific comments on question. CRA already stated that it accepted the decision George Weston Limited (Q.1 at 2015 IFA Conference CRA Round Table). However, reference to recent T.C.C. decision James S.A. MacDonald, 2017 CCI 157.
Reasons: Case law.
Financial Strategies and Financial Instruments Roundtable, 6 October 2017
2017 APFF Conference
Question 16
Derivatives used as equity hedges and the George Weston Limited case
The Income Tax Act does not contain a definition and does not determine the tax treatment of derivatives. It has been for the courts to determine the tax treatment of these products and, more specifically, to develop the criteria to be used to characterize the gain or loss on these products as on income or capital account.
Given their speculative nature, gains on derivatives may be more readily classified as on income account, but when used as part of a hedge against financial risk exposure, the courts have generally attributed to the hedge the same character, as to income or capital, as a gain realized on the sale of the hedged asset.
The CRA also formulated an administrative position to establish whether there is a sufficient connection to support the influence of the tax treatment of the hedged item on that of the hedging transaction.
Specifically, the CRA concluded that in order to qualify for capital tax treatment, among other factors, the hedge:
- must relate to a transaction of an underlying capital nature and not generally to the holding of an asset or a liability,
- must be related to the timing of transactions and their amounts, and
- must be undertaken in respect of an item that is owned directly by the taxpayer and not by another entity in its group.
If a derivative is not sufficiently linked to a capital transaction, the CRA would treat the hedge transaction as being instead a speculative transaction for which the gain or loss is on income account.
Very few derivatives used as hedges come within this interpretation, and the CRA's policy does not reflect the flexibility of the large number of customized hedging transactions available, nor the various ways in which they are utilized.
In the recent George Weston Limited v. The Queen case (footnote 1), the Tax Court of Canada decided in favour of the taxpayer challenging the restrictive position of the CRA. The taxpayer George Weston Limited had entered into several currency swap agreements to protect the value of its US investment, but no transaction in the property itself occurred. In addition, the investment was made by a subsidiary. The court stated that there was no legal basis for the CRA's administrative position that the hedge should be anchored to an underlying transaction. The court stated that the derivative must relate to a risk and that the characterization as to income or capital of the hedged item determines the nature of the gain on the derivative. The fact that the swaps were entered into by a holding company to hedge the investment of its subsidiaries should not affect their characterization as a hedge, because currency fluctuations constituted a credit rating risk for the taxpayer on a consolidated basis.
Question to the CRA
Does the CRA intend to loosen its administrative position to align it with the position taken by the court in George Weston Limited?
CRA response
George Weston Limited
The CRA has already stated that it accepts the decision of the Tax Court of Canada (TCC) in George Weston Limited.
However, on August 8, 2017, the TCC issued its decision in James S. MacDonald v. The Queen. The issue in this case was essentially whether the payments made by Mr. MacDonald as partial and final settlements of a futures contract were capital expenditures because the futures contract was used in a hedging transaction relating to shares of a public corporation (i.e., capital property) held by Mr. MacDonald, or were expenses of a current nature because the futures contract was used by Mr. MacDonald in an adventure in the nature of trade (a contract used for speculative purposes in order to make a profit).
In the James S. A. MacDonald case, the TCC concluded that there was not a hedging transaction and that the expenditures were of a current nature. The approach taken by the TCC in this case respecting, inter alia, the linkage principle appears to be irreconcilable with previous jurisprudence, including George Weston Limited.
The decision of the TCC in James S.A. MacDonald has been appealed to the Federal Court of Appeal.
Nevertheless, the CRA is currently considering whether to change its approach pending the Federal Court of Appeal decision in James S. A. MacDonald. Therefore, it is not possible to answer your question definitively at this time.
Provisions of the Income Tax Act on Derivatives
It should be noted that the concept of derivative product is very broad, and includes, for example, options. The Income Tax Act now includes several provisions that determine the tax treatment of transactions in certain derivatives. Certain provisions of the Income Tax Act (see, for example, subsection 13(5.3) and the provisions of the Income Tax Act on character-conversion transactions including the definition of "derivative forward agreement” under subsection 248(1) and paragraphs 12(1)(z), 20(1)(xx), 53(1)(s), 53(2)(w) and (x)) may have the effect of changing the nature of the gain or loss attributable to certain derivatives.
In addition, the March 22, 2017 Budget included proposed measures on derivatives. The 2017 budget proposed the provision of a mark-to-market election for eligible derivatives held on income account (section 10.1 as proposed in the March 22, 2017 Notice of Ways and Means Motions). A definition of "eligible derivative" is provided in proposed subsection 10.1(4) of the March 22, 2017 Notice of Ways and Means Motions. The 2017 Budget also proposed measures on straddle transactions that may be carried out with derivatives (proposed subsections 18(17) to 18(23) of the Notice of Ways and Means Motion of March 22, 2017).
Robert Gagnon
(613) 670-9018
October 6, 2017
2017-070518
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1. 2015 TCC 42
2. 2017 TCC 157