Tax: Derivative Contracts
MacDonald v. Canada, 2020 SCC 6 (38320)
“In 1988, M became the owner of 183,333 common shares of the Bank of Nova Scotia. In 1997, the Toronto‑Dominion Bank offered M a loan for up to $10.5 million. The loan also contemplated and required the existence of a forward contract as part of the pledge. A forward contract is a type of derivative contract that creates an obligation for one party to sell, and another party to buy, an underlying asset at a pre‑determined future date and at a pre‑determined price.
Shortly before signing the loan and pledge agreements to gain access to the loan, M entered into the forward contract with TD Securities Inc. The assets underlying the forward contract were 165,000 Bank of Nova Scotia shares, the same number of shares M eventually pledged as collateral for the loan. The forward contract was to be cash settled and was structured so that M would make money if the Bank of Nova Scotia stock price decreased. M was required to pledge Bank of Nova Scotia shares and any cash settlement payments he was entitled to receive from the forward contract as security for the loan. M entered into the forward contract with TD Securities Inc. on June 26, 1997.
During the life of the forward contract, the price of Bank of Nova Scotia shares increased and M made cash settlement payments totaling approximately $10 million. In computing his income for the 2004, 2005 and 2006 taxation years, M characterized the cash settlement payments as income losses deductible against income from other sources. The Minister of National Revenue reassessed M and characterized the cash settlement payments as capital losses on the basis that the forward contract was a hedge of the Bank of Nova Scotia shares. M filed notices of objection based on the position that he used the forward contract for speculation, not hedging. The Tax Court concluded that the forward contract was a speculative instrument such that the cash settlement payments were properly characterized as losses on account of income. The Federal Court of Appeal unanimously allowed the Crown’s appeal, holding that the forward contract was a hedge of M’s Bank of Nova Scotia shares and, therefore, the cash settlement payments were capital losses.”
The S.C.C. (8:1) dismissed the appeal.
Justice Abella wrote as follows (at paras. 13-15, 26, 32-33, 39-42):
“The trial judge held that Mr. MacDonald’s sole intention in entering into the forward contract was to speculate, not hedge and that there was no linkage between the forward contract and Mr. MacDonald’s Bank of Nova Scotia shares. On this basis, she concluded that the forward contract was a speculative instrument and the Cash Settlement Payments were properly characterized as losses on account of income.
Writing for a unanimous court, Noël C.J. allowed the Crown’s appeal ( 2 F.C.R. 302). In his view, intention is not a condition precedent to hedging: a derivative contract will be a hedging instrument if the party entering into the contract owns assets exposed to risk from market fluctuation, the contract neutralizes or mitigates this risk, and the party entering into the contract understands the contract’s nature. These requirements were met in this case since Mr. MacDonald owned Bank of Nova Scotia shares exposed to risk from market fluctuation, the forward contract had the effect of neutralizing that risk, and Mr. MacDonald understood that it had this effect. Mr. MacDonald’s testimony regarding his intentions could not overwhelm these facts. For these reasons, Noël C.J. concluded that the forward contract was a hedge of Mr. MacDonald’s Bank of Nova Scotia shares and, therefore, the Cash Settlement Payments were capital losses.
For the following reasons, I would dismiss the appeal.
The definition of hedging and the required sufficiency of linkage were further discussed in Echo Bay Mines Ltd. v. Canada (T.D.),  3 F.C. 707. The issue was whether income from the settlement of forward sales contracts for the delivery of silver counted as “resource profits” within the meaning s. 1204(1) of the Income Tax Regulations, C.R.C., c. 945. MacKay J. found that the resolution of the case required a determination as to whether the forward sales contracts were a hedge of the mine’s silver production. This in turn required consideration of the following:
- [U]nder generally accepted accounting principles [GAAP], a producer’s gain or loss from its execution of forward sales contracts may be considered a “hedge” and therefore matched against the production of the goods produced, if four conditions are met . . . .
- 1. The item to be hedged exposes the enterprise to price (or interest rate) risk.
- 2. The futures contract reduces that exposure and is designated as a hedge.
- 3. The significant characteristics and expected terms of the anticipated transactions are identified.
- 4. It is probable that the anticipated transaction will occur. [pp. 715-16]
As these cases demonstrate, the characterization of a derivative contract as a hedge turns on its purpose. The primary source for ascertaining a derivative contract’s purpose is the extent of the linkage between the derivative contract and an underlying asset, liability, or transaction. The linkage analysis begins with the identification of an underlying asset, liability or transaction which exposes the taxpayer to a particular financial risk, and then requires consideration of the extent to which the derivative contract mitigates or neutralizes the identified risk. The more effective the derivative contract is at mitigating or neutralizing the identified risk and the more closely connected the derivative contract is to the item purportedly hedged, the stronger the inference that the purpose of the derivative contract was to hedge. However, as noted, perfect linkage is not required to conclude that the purpose of a derivative contract was to hedge (see e.g. Atlantic Sugar, at p. 711; Echo Bay Mines, at pp. 22-23; Placer Dome, at para. 49; George Weston, at paras. 96-98).
In this case, the substantial linkage between the forward contract and Mr. MacDonald’s Bank of Nova Scotia shares fully supports Noël C.J.’s conclusion that the forward contract was a hedge.
When assessing whether a derivative contract is a hedge or speculation, the relationship between the derivative contract and transactions or assets outside of the derivative contract will very often be relevant. By definition, a hedging derivative contract is aimed at reducing the risk associated with some asset, liability or transaction. In this case, the loan and pledge agreements are part of the context relevant to ascertaining the purpose of the forward contract. Considering these agreements will in no way recharacterize Mr. MacDonald’s bona fide legal relationships.
As Noël C.J. observed, the combined effect of the forward contract, the loan agreement and the pledge agreement allowed for credit backed by collateral that was free from market fluctuation risk. The loan and pledge agreements gave Mr. MacDonald access to a large credit facility but required him to maintain the forward contract and to pledge, as collateral, Bank of Nova Scotia shares and all Cash Settlement Payments owed to him pursuant to the forward contract. The credit available to him could not exceed 95% of the value of his pledged Bank of Nova Scotia shares. The shares pledged as collateral matched the shares contemplated by the forward contract. As the number of shares covered by the forward contract decreased due to settlement, the same number of shares were released from being collateral under the loan and pledge agreements.
From the perspective of TD Bank, this meant that the value of the collateral was perfectly protected from market fluctuations: if the price of Bank of Nova Scotia shares increased, the value of Mr. MacDonald’s pledged shares would increase proportionally; if the price decreased, Mr. MacDonald would be entitled to an offsetting Cash Settlement Payment which would automatically be pledged as collateral. This arrangement allowed Mr. MacDonald to gain access to a large credit facility on attractive terms and allowed TD Bank to provide the credit facility with the guarantee of protected collateral.
In my view, this arrangement reveals the necessary linkage between Mr. MacDonald’s Bank of Nova Scotia shares and the forward contract to indicate a hedging purpose. The fact that Mr. MacDonald did not sell his Bank of Nova Scotia shares immediately to offset his losses under the forward contract does not sever this connection. Although the loan and pledge agreements form part of the context in this case and shed light on the purpose of the forward contract as a hedge, the forward contract, considered independently, perfectly sheltered the large bulk of Mr. MacDonald’s Bank of Nova Scotia shares from market price fluctuations. A good argument can be made, therefore, that even without the loan agreement, the contract was still a hedge.”