| March 27, 1990 | |
| Ms Christine Savage | Financial Industries |
| A/Director | Division |
| Provincial and International | Clayton Robb |
| Relations Division | 957-2744 |
| Attention: David R. Senécal | |
| File No. 7-4600 |
Subject: OECD Working Party #6
Enclosed is a copy of a detailed note on the subject of new financial instruments. The note has been prepared along the lines of the 24(1)
The 24(1) survey does not appear to be incorrect with respect to its comments on Canada.
Part II of the OECD questionnaire remains outstanding at this time.
for DirectorFinancial Industries DivisionRulings Directorate
Enclosure
Restricted
NEW FINANCIAL INSTRUMENTS
(Note by the Delegate for Canada)
This paper reports on exchange traded options and financial futures and provides a general overview of their tax treatment in Canada.
1. Introduction
The domestic options markets are well organized in Canada. Approximately 75% of the activity in this area takes place in Toronto, followed by Montreal with about 18% of the market and Vancouver with the remainder. Financial futures are some what more segregated by market. Montreal offers bond futures contracts and Toronto offers a stock index option. Canadians also participate actively in the United States options and futures markets.
2. Exchange Traded Options
A call option ("call") allows the holder to purchase securities at a specified price for a specified time in return for a premium. A put option ("put") allows the holder to sell securities at a specified price for a specified time in return for a premium. An option expires worthless if it is not exercised prior to the time of expiry. Options may be written "covered" (i.e., the writer owns the underlying security) or "naked" (i.e., the writer does not own the underlying security).
A trader or dealer in options recognizes all transactions on income account regardless of whether the option is exercised, closed out or allowed to expire. The primary issue facing a trader or dealer is in respect of timing. The following table summarizes the tax treatment by type of option.
Table 1: Options on Income Account
CALL OPTIONS
| Holder | Writer |
| EXERCISED - added to cost of shares | - brought into income in year |
| exercised | |
| EXPIRES - deducted in year of expiry | - premium included in year of expiry |
| CLOSE OUT - netted against premium received | - netted with the cost of acquiring |
| in taxation year of close out | offsetting position |
PUT OPTIONS
| EXERCISED - deducted from proceeds of shares | - premium received is deducted from |
| cost of shares required to be | |
| purchased | |
| EXPIRES - deducted in year of expiry | - premium included in year of expiry |
| CLOSE OUT - netted against premium received | - netted with the cost of acquiring the |
| in taxation year of close out | offsetting position |
Note the following:
(a) When the holder exercises a call option the cost of the option forms part of the cost of the shares. The tax effects of the option are therefore deferred until the underlying security is sold.
(b) If the options constitute inventory to the taxpayer a deduction is available if the market value of the option is less than cost at year end. Alternatively, the option may be carried at market.
(c) The writer of the option cannot cake a deduction for anticipated losses.
The tax treatment accorded to others depends on the facts of the particular case. Revenue Canada generally presumes that
(a) the gain or loss realized by a holder of options is on the same account as the holder's transactions in shares,
(b) the gain or loss realized by the writer of covered options is on the same account as the underlying shares; and
(c) the gain or loss realized by a writer of naked options is normally on income account.
Where the facts indicate that income treatment is appropriate, the tax treatment described in Table I above will be applicable. Table 2, below, summarizes the tax treatment where the option transactions are to be reported on capital account and is based on specific legislation contained in the Income Tax Act (Canada) (the "Act").
CALL OPTIONS
| Holder | Writer |
| EXERCISED - added to cost of shares | - capital gain at time of writing; may |
| be reversed and added to proceeds of | |
| shares | |
| EXPIRES - capital loss in year of expiry | - no tax consequences |
| CLOSE OUT - net gain or loss recognized in | - capital loss in year of close out in year of close out |
PUT OPTIONS
| EXERCISED - cost of acquiring option deducted | - capital gain at time of writing; may |
| from proceeds of sale of shares | be reversed and deducted from cost |
| of acquiring shares | |
| EXPIRES - capital loss in year of expiry | - no tax consequences |
| CLOSE OUT - net gain or loss recognized | - capital loss in year of close out |
| in year of close out |
Note the following:
(a) Wherever possible the option is tied to the transaction in the underlying shares.
(b) Capital losses may only be offset against capital gains. Therefore, the taxpayer may have losses to carry back or forward.
(c) No accrued losses are deductible by the holder.
Financial Futures
Financial futures are futures contracts to make or take delivery of the underlying financial instrument at a specified time In the future. The nature of the obligations created are fundamentally different from options. At the end of the specified time an option expires worthless without further obligations on the writer. Financial futures, on the other hand, if not closed out, require the holder to take or make delivery of the instrument by following complex procedures. In general, futures contracts tend to be closed out prior to expiry.
The income tax treatment of futures contracts is primarily a function of the type of market participant rather than being dependent on the type of property. Those whose business involves trading in the underlying instruments and those who trade futures contracts generally report their transactions on income account. Speculators are allowed to choose between income and capital account. Once a choice is made the speculator must be consistent. In certain instances it may be appropriate to characterize the gain or loss on a futures contract in conjunction with the gain or loss on an underlying transaction. This will most typically be the case where the taxpayer is hedging a specific foreign currency exposure.
New Financial Instruments
The evolution of new financial instruments particularly swaps, stock index options, and interest rate and bond futures in response to the demand for products that allow the purchaser to speculate on general economic trends or to reduce various types of risk provides significant challenges to Canada's income tax system.
21(1)(b)