910743
Dear Sirs:
Re: Short Sale of Stocks
We are writing in response to your correspondence of March 12, 1991 regarding the treatment for income tax purposes of a short sale of stocks by a brokerage firm. We apologize for the considerable delay in rendering our response.
It is our understanding that a short sale is a transaction in which a person (the "short seller") sells securities, which he has acquired from a second person (the "short lender"), to a third person (the "short purchaser"). The short seller is obligated to return securities which are identical to those sold short to the short lender at some time in the future. Generally, a brokerage firm will act as the intermediary between the short lender and the short seller, however, for the purpose of this discussion, the brokerage firm, as the short seller, is considered to be acting as principal and is acquiring the securities directly from the short lender on its own behalf.
In an informal discussion with this division it was suggested that the revenue received upon the short sale would be included in income for tax purposes pursuant to paragraph 12(1)(a) of the Income Tax Act (the "Act") and that a deduction pursuant to paragraph 20(1)(m) would be permitted with respect to any outstanding obligation to purchase and deliver the shares sold short after the end of the year.
Upon further consideration we are not able to confirm this opinion, but would offer the following alternative comments.
It is the view of the Department that, when the shares to be sold short are borrowed by the short seller, these shares are acquired from the lender of those shares. To the extent that the shares constitute a "qualified security" as defined in subsection 260(1) of the Act, the lender is deemed not to have disposed of the shares for purposes of the Act pursuant to subsection 260(2). The borrower, however, is considered to have acquired the shares and the consideration paid to the lender is the obligation of the borrower to deliver identical shares to the lender at some time in the future. While a question of fact, it is arguable that the value of this consideration is equal to the fair market value at that time of the shares acquired.
Consequently, the short seller is considered to have acquired the shares from the lender and to have then sold them and, if these transactions form a constituent part of the business activity of the particular taxpayer, any resulting income would be included in the income of the short seller for tax purposes pursuant to section 9 of the Act. In a situation in which these two transactions occur contemporaneously, the short sale proceeds may well equal the cost of the shares acquired by the short seller from the lender with the result that there would be no net amount included in the income of the short seller at the time of the short sale.
Subsequent to the short sale, the short seller remains obligated to deliver shares, identical to those sold short, to the lender. In the event that the taxation year of the short seller ends prior to the fulfilment of this obligation, it is the view of the Department that any revaluation of this obligation to reflect the fair market value of the shares to be delivered after that time would constitute a contingent liability of the taxpayer, the deduction of which for income tax purposes is expressly prohibited by paragraph 18(1)(e) of the Act. Also, as noted by yourself, the liability at year end representing the commitment to purchase and deliver the shares previously sold short cannot be considered to an item of inventory of the short seller and, consequently, any provisions of the Act or Income Tax Regulations regarding the valuation of inventory would not be applicable in such circumstances. We would concur with this observation.
Although we trust that our comments are of assistance to you, we would note that they do not constitute an advance income tax ruling and are, therefore, not binding upon the Department with respect to any particular situation.
Yours truly,
for DirectorFinancial Industries DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch