MacDonald v. Canada

MacDonald v. Canada
Collection
Supreme Court Judgments
Date
2020-03-13
Neutral citation
2020 SCC 6
Report
[2020] 1 SCR 319
Case number
38320
Judges
Wagner, Richard; Abella, Rosalie Silberman; Moldaver, Michael J.; Karakatsanis, Andromache; Côté, Suzanne; Brown, Russell; Rowe, Malcolm; Martin, Sheilah; Kasirer, Nicholas
On appeal from
Federal Court of Appeal
Subjects
Taxation
Notes
Case in Brief
SCC Case Information
Decision Content
SUPREME COURT OF CANADA
Citation: MacDonald v. Canada, 2020 SCC 6, [2020] 1 S.C.R. 319
Appeal Heard: October 17, 2019 Judgment Rendered: March 13, 2020 Docket: 38320
Between:
James S. A. MacDonald
Appellant
and
Her Majesty The Queen
Respondent
Coram: Wagner C.J. and Abella, Moldaver, Karakatsanis, Côté, Brown, Rowe, Martin and Kasirer JJ.
Reasons for Judgment: (paras. 1 to 45)
Dissenting Reasons: (paras. 46 to 88)
Abella J. (Wagner C.J. and Moldaver, Karakatsanis, Brown, Rowe, Martin and Kasirer JJ. concurring)
Côté J.
James S. A. MacDonald Appellant
v.
Her Majesty The Queen Respondent
Indexed as: MacDonald v. Canada
2020 SCC 6
File No.: 38320.
2019: October 17; 2020: March 13.
Present: Wagner C.J. and Abella, Moldaver, Karakatsanis, Côté, Brown, Rowe, Martin and Kasirer JJ.
on appeal from the federal court of appeal
Taxation — Derivative contracts — Hedging — Subjective and objective intention — Linkage — Taxpayer entering into derivative contract — Taxpayer pledging cash settlement payments and underlying asset from derivative contract as collateral for loan — Whether derivative contract should be characterized as hedge or speculation — Whether gains or losses arising from derivative contract are taxable on income or capital account.
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.
Held (Côté J. dissenting): The appeal should be dismissed.
Per Wagner C.J. and Abella, Moldaver, Karakatsanis, Brown, Rowe, Martin and Kasirer JJ.: Whether gains and losses from derivative contracts are to be characterized as on income account or on capital account depends on whether the contract is considered a hedge or speculation. A hedge is generally a transaction which mitigates risk, while speculation is the taking on of risk with a view to earning a profit. Gains and losses arising from hedging derivative contracts take on the character of the underlying asset, liability or transaction being hedged.
The characterization of a derivative contract turns on the contract’s purpose. While subjective manifestations of purpose may sometimes be relevant, the taxpayer’s stated intention is not determinative. The primary source of ascertaining a derivative contract’s purpose is the linkage between the derivative contract and any underlying asset, liability or transaction purportedly hedged.
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. Perfect linkage is not required to conclude that the purpose of a derivative contract was to hedge and the method by which a derivative contract is settled is not determinative of linkage or, ultimately, purpose. The relationship between the derivative contract and transactions or assets outside of the derivative contract will very often be relevant.
While M did not immediately sell his Bank of Nova Scotia shares to offset his losses under the forward contract, the absence of a synchronous transaction used to offset gains or losses arising from a derivative contract is not equivalent to the absence of risk and is not, by itself, determinative of the characterization of a derivative contract. In this case, the substantial linkage between the forward contract and the Bank of Nova Scotia shares fully supports the conclusion that the forward contract was a hedge. The forward contract had the effect of nearly perfectly neutralizing fluctuations in the price of Bank of Nova Scotia shares, pointing to the necessary linkage.
The purpose of the forward contract as a hedging instrument is most apparent when one considers the forward contract alongside the loan and pledge agreements. The loan and pledge agreements are part of the context relevant to ascertaining the purpose of the forward contract. They gave M 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 M could not exceed 95 percent of the value of his pledged Bank of Nova Scotia shares, and the shares pledged as collateral matched the shares contemplated by the forward contract. This arrangement allowed M access to a large credit facility on attractive terms. It also allowed Toronto‑Dominion Bank to provide the credit facility with the guarantee of collateral that was free from market fluctuation risk, since if the price of Bank of Nova Scotia shares increased, the value of M’s pledged shares would increase proportionally, but if the price decreased, M would be entitled to an offsetting cash settlement payment which would automatically be pledged as collateral. This arrangement reveals the necessary linkage between M’s Bank of Nova Scotia shares and the forward contract to indicate a hedging purpose.
The cash settlement payments arising from the forward contract derive their income tax treatment from the underlying Bank of Nova Scotia shares, which the parties agree were held by M on account of capital. When considered in its full and proper context, it is clear that the purpose of the forward contract was to hedge against market price fluctuations that M’s Bank of Nova Scotia shares were exposed to.
Per Côté J. (dissenting): The appeal should be allowed and the trial judge’s order restored. There is disagreement with the majority regarding the meaning of intent, the majority’s interference with the trial judge’s findings of fact and the relationship between the forward contract and M’s arrangements with other entities. There is no basis for intervening in the trial judge’s finding that M intended to speculate and not to hedge.
The tax characterization of the forward contract turns on the taxpayer’s intent, which is determined by reviewing the taxpayer’s subjective statements of intent and objective manifestations of intent. Neither the objective nor the subjective element is determinative on its own. A hedge may exist for tax purposes despite the absence of a synchronous transaction used to offset gains or losses arising from a derivative contract due to ownership risk. Ownership risk is a concept which recognizes that the owner of an asset is exposed to risks arising from fluctuations in the value of the asset, notwithstanding that the owner does not intend to sell the asset (and thereby incur a transactional risk).
The majority adopts a test which purports to be similarly anchored on a taxpayer’s subjective statements and objective manifestations of intent. However, its analysis looks only to the economic effects of the derivative instrument in order to ascertain its tax character. The majority’s test will introduce a significant degree of uncertainty into the tax treatment of derivative instruments, because a test which is in effect based solely on risk mitigation will have extensive repercussions for the taxation of financial derivatives.
There is disagreement with the majority on its treatment of the forward contract between M and TD Securities Inc. as an indistinguishable component of the credit facility and the securities pledge agreement between M and Toronto‑Dominion Bank. It is not a court’s role to prevent taxpayers from relying on the sophisticated structure of their transactions by imposing tax according to the transactions true economic and commercial effects. The tax character of the losses from the forward contract is not affected by M’s arrangements with other entities. The forward contract must be considered separately from the credit facility and the securities pledge agreement. Further, in tax characterization cases, it is the intention of the taxpayer which the court is concerned with, not the intention of other entities on the other side of the taxpayer’s transaction. Therefore, Toronto‑Dominion Bank’s interest in mitigating the risk of the Bank of Nova Scotia shares is not relevant. In order for the forward contract to constitute a hedge, it and M’s ownership risk in the Bank of Nova Scotia shares must stand on their own.
There is further disagreement with the majority’s three purported legal errors which they impute to the trial judge. Regarding the first error, the majority’s critique amounts to a difference of opinion as to the weight to be ascribed to the forward contract’s mode of settlement and to M’s evidence. The trial judge correctly identified and applied the relevant legal principles. She did not treat the mode of settlement as determinative. She did not treat M’s statements of intent as determinative. There is no basis for the Court to intervene. The second of the purported errors is based on a flawed reading of the trial judge’s reasons. The trial judge did not deny that the law recognizes the concept of ownership risk. Rather, she found as a matter of fact that a short‑term ownership risk was not a material concern to M and did not therefore inform his conduct or his intentions. With respect to the final purported error, the trial judge’s reasons must be considered as a whole. She did not focus solely on the absence of ownership risk. Rather, she considered a number of objective factors and made findings of credibility and reliability which are owed deference on appeal. Absent an extricable legal error, her factual findings that M had intended to speculate and that he had objectively manifested that intent are findings of fact that can be reviewed only for a palpable and overriding error.
Turning to the question of linkage, while the timing connection and quantum connections are imperfect, during its existence the forward contract achieved a theoretical partial economic hedge of M’s ownership risk in the Bank of Nova Scotia shares. However, economic realities are not the end of the analysis. M’s conduct was more consistent with that of a speculator than of a hedger, because the forward contract was cash‑settled and the forward contract was an isolated transaction. On balance, the trial judge’s findings of fact should not be overturned on the application of a deferential standard of review, because, while some of the objective economic indicators are consistent with an intent to hedge, there are also objective circumstances that suggest an intent to speculate.
In the final analysis, the Court should not disregard a unanimous precedent, applicable standards of review, findings of fact and a trial judge’s assessment of credibility in order to square a theoretical economic hedge into the round hole of an intention‑based test.
Cases Cited
By Abella J.
Considered: Placer Dome Canada Ltd. v. Ontario (Minister of Finance), 2006 SCC 20, [2006] 1 S.C.R. 715; Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622; A.‑G. of Man. v. A.‑G. of Can., [1925] 2 D.L.R. 691; Atlantic Sugar Refineries Ltd. v. Minister of National Revenue, [1949] S.C.R. 706; Salada Foods Ltd. v. The Queen, [1974] C.T.C. 201; Echo Bay Mines Ltd. v. Canada, [1992] 3 F.C. 707; George Weston Ltd. v. R., 2015 TCC 42, [2015] 4 C.T.C. 2010; referred to: Friesen v. Canada, [1995] 3 S.C.R. 103; Ludco Enterprises Ltd. v. Canada, 2001 SCC 62, [2001] 2 S.C.R. 1082.
By Côté J. (dissenting)
Underwood v. Ocean City Realty Ltd. (1987), 12 B.C.L.R. (2d) 199; Housen v. Nikolaisen, 2002 SCC 33, [2002] 2 S.C.R. 235; Symes v. Canada, [1993] 4 S.C.R. 695; Ludco Enterprises Ltd. v. Canada, 2001 SCC 62, [2001] 2 S.C.R. 1082; George Weston Ltd. v. R., 2015 TCC 42, [2015] 4 C.T.C. 2010; Barrick Gold Corp. v. R., 2017 TCC 18, [2017] 3 C.T.C. 2103; Echo Bay Mines Ltd. v. Canada, [1992] 3 F.C. 707; Atlantic Sugar Refineries Ltd. v. Minister of National Revenue, [1949] S.C.R. 706; Salada Foods Ltd. v. The Queen, [1974] C.T.C. 201; Canada Safeway Ltd. v. R., 2008 FCA 24, [2008] 2 C.T.C. 149; Friesen v. Canada, [1995] 3 S.C.R. 103; Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622; Canada v. Shell Canada Ltd., [1998] 3 F.C. 64; R. v. Javanmardi, 2019 SCC 54, [2019] 4 S.C.R. 3; Placer Dome Canada Ltd. v. Ontario (Minister of Finance), 2006 SCC 20, [2006] 1 S.C.R. 715.
Statutes and Regulations Cited
Income Tax Act , R.S.C. 1985, c. 1 (5th Supp .), s. 3.
Authors Cited
Balmer, Alexandra G. Regulating Financial Derivatives: Clearing and Central Counterparties. Northampton, Mass.: Edward Elgar Publishing, 2018.
Beitel, Jeremie. “Hedging Transactions — MacDonald Reversed” (2018), 66 Can. Tax J. 919.
Grottenthaler, Margaret E., and Philip J. Henderson. The Law of Financial Derivatives in Canada. Toronto: Thomson Reuters, 2019 (loose‑leaf updated 2019, release 2).
Hogg, Peter W., Joanne E. Magee, and Jinyan Li. Principles of Canadian Income Tax Law, 7th ed. Toronto: Carswell, 2010.
Krishna, Vern. Income Tax Law, 2nd ed. Toronto: Irwin Law, 2012.
Li, Jinyan, Joanne Magee, and J. Scott Wilkie. Principles of Canadian Income Tax Law, 9th ed. Toronto: Thomson Reuters, 2017.
APPEAL from a judgment of the Federal Court of Appeal (Noёl C.J. and Pelletier and de Montigny JJ.A.), 2018 FCA 128, [2019] 2 F.C.R. 302, 2018 D.T.C. 5077, [2019] 3 C.T.C. 79, [2018] F.C.J. No. 680 (QL), 2018 CarswellNat 3400 (WL Can.), setting aside a decision of Lafleur J., 2017 TCC 157, [2018] 1 C.T.C. 2239, 2017 D.T.C. 1104, [2017] T.C.J. No. 121 (QL), 2017 CarswellNat 3934 (WL Can.). Appeal dismissed, Côté J. dissenting.
Matthew Milne‑Smith, Elie S. Roth, Stephen S. Ruby and Chenyang Li, for the appellant.
Daniel Bourgeois and Eric Noble, for the respondent.
The judgment of Wagner C.J. and Abella, Moldaver, Karakatsanis, Brown, Rowe, Martin and Kasirer JJ. was delivered by
[1] Abella J. — This appeal deals with what are known as derivative contracts. Whether gains and losses from these contracts are to be characterized as on income account or on capital account depends on whether the contract is considered a hedge or speculation. A hedge is generally a transaction which mitigates risk, while speculation is the taking on of risk with a view to earning a profit.
[2] James S. A. MacDonald has over 40 years of capital markets and corporate finance experience. He was the head of mergers and acquisitions at McLeod Young Weir, a brokerage firm engaged in various aspects of corporate finance, when the firm was acquired by the Bank of Nova Scotia in 1988. As a result of this acquisition, Mr. MacDonald became the owner of 183,333 common shares of the Bank of Nova Scotia. He continued his career as an executive at the Bank until March 1997 when he left to start another company.
[3] Shortly after he left the Bank of Nova Scotia, the Toronto-Dominion Bank offered Mr. MacDonald a credit facility for up to $10.5 million. Under the terms of the offer, Mr. MacDonald was required to pledge Bank of Nova Scotia shares as partial security for the credit facility and the credit available to him would not exceed 95 percent of the value of these pledged shares. The credit offer also contemplated and required the existence of a “forward contract” as part of the pledge.
[4] A forward contract is an agreement for the purchase/sale of an asset at an agreed future date. More technically, 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 (“Reference Asset”) at a pre-determined future date (“Forward Date”) and at a pre-determined price (“Forward Price”) (Placer Dome Canada Ltd. v. Ontario (Minister of Finance), [2006] 1 S.C.R. 715, at para. 30; Margaret E. Grottenthaler and Philip J. Henderson, The Law of Financial Derivatives in Canada (loose-leaf), at p. 1‑5).
[5] Forward contracts can be settled by physical delivery of the underlying asset, or “cash settled” by one party paying the other based on whether the Forward Price is higher or lower than the market price on the Forward Date (Placer Dome, at para. 31; Grottenthaler and Henderson, at p. 11-18). In either case, forward contracts essentially function to “remove uncertainties relating to future price changes” of the Reference Asset (Alexandra G. Balmer, Regulating Financial Derivatives: Clearing and Central Counterparties (2018), at p. 24).
[6] Mr. MacDonald entered into the forward contract with TD Securities Inc. on June 26, 1997. The Reference Assets underlying the forward contract were 165,000 Bank of Nova Scotia shares. The forward contract was to be cash settled and was structured so that Mr. MacDonald would make money if the Bank of Nova Scotia stock price decreased. Specifically,
(a) if the 165,000 Bank of Nova Scotia shares decreased in value, TD Securities would pay Mr. MacDonald the full amount of the decrease (i.e., the amount by which the Forward Price exceeded the actual market price on the Forward Date multiplied by the number of Bank of Nova Scotia shares (165,000));
and
(b) if the 165,000 Bank of Nova Scotia shares increased in value, Mr. MacDonald would pay TD Securities the full amount of the increase (i.e., the amount by which the Forward Price fell below the actual market price on the Forward Date, multiplied by the number of Bank of Nova Scotia shares (165,000)).
[7] Payments made pursuant to the forward contract were known as “Cash Settlement Payments”. Mr. MacDonald had the option of terminating the contract early by making appropriate Cash Settlement Payments. He did so on several occasions with respect to a number of shares, which had the effect of correspondingly reducing the number of shares included under the forward contract.
[8] On July 2, 1997, Mr. MacDonald signed a pledge agreement, whereby he pledged 165,000 of his Bank of Nova Scotia shares and any Cash Settlement Payments he was entitled to receive from the forward contract as security for the credit facility. He formally accepted the credit offer shortly after on July 7, 1997.
[9] The parties originally set a Forward Date of June 26, 2002, but the contract was extended and amended several times before it was terminated on March 29, 2006.
[10] During the life of the forward contract, the price of Bank of Nova Scotia shares increased and Mr. MacDonald made Cash Settlement Payments totaling approximately $10 million.
[11] In computing his income for his 2004, 2005 and 2006 taxation years, Mr. MacDonald took the position that he used the forward contract for speculation, not hedging and, on this basis, characterized the Cash Settlement Payments as income losses deductible against income from other sources. The Minister of National Revenue reassessed Mr. MacDonald and characterized the Cash Settlement Payments as capital losses — which could only be deducted against capital gains — on the basis that the forward contract was a hedge of the Bank of Nova Scotia shares Mr. MacDonald held on account of capital.
[12] Mr. MacDonald filed notices of objection and appealed the reassessments to the Tax Court of Canada ([2018] 1 C.T.C. 2239).
[13] 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.
[14] Writing for a unanimous court, Noël C.J. allowed the Crown’s appeal ([2019] 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.
[15] For the following reasons, I would dismiss the appeal.
Analysis
[16] The basis for determining the income of a taxpayer is found in s. 3 of the Income Tax Act , R.S.C. 1985, c. 1 (5th Supp .):
3. The income of a taxpayer for a taxation year for the purposes of this Part is the taxpayer’s income for the year determined by the following rules:
(a) determine the total of all amounts each of which is the taxpayer’s income for the year (other than a taxable capital gain from the disposition of a property) from a source inside or outside Canada, including, without restricting the generality of the foregoing, the taxpayer’s income for the year from each office, employment, business and property,
(b) determine the amount, if any, by which
(i) the total of
(A) all of the taxpayer’s taxable capital gains for the year from dispositions of property other than listed personal property, and
(B) the taxpayer’s taxable net gain for the year from dispositions of listed personal property,
exceeds
(ii) the amount, if any, by which the taxpayer’s allowable capital losses for the year from dispositions of property other than listed personal property exceed the taxpayer’s allowable business investment losses for the year,
. . .
(d) determine the amount, if any, by which the amount determined under paragraph (c) exceeds the total of all amounts each of which is the taxpayer’s loss for the year from an office, employment, business or property or the taxpayer’s allowable business investment loss for the year[.]
[17] In Friesen v. Canada, [1995] 3 S.C.R. 103, Major J. explained that s. 3 of the Income Tax Act
recognizes two basic categories of income: “ordinary income” from office, employment, business and property, all of which are included in s. 3(a), and income from a capital source, or capital gains which are covered by s. 3(b). The whole structure of the Income Tax Act reflects the basic distinction recognized in the Canadian tax system between income and capital gain. [p. 111]
[18] Financial derivatives are “contracts whose value is based on the value of an underlying asset, reference rate, or index” (Placer Dome, at para. 29). Depending on the circumstances, gains and losses arising from derivative contracts may be taxable either as income or capital. There are two basic types of derivative contracts which form the building blocks for more complex structures: forward contracts and options. Though both forward contracts and options are about the future purchase/sale of assets, forward contracts create a mutual obligation to buy/sell, while options provide one party the right, but not the obligation, to purchase/sell the asset (Placer Dome, at para. 30; Grottenthaler and Henderson, at p. 1-4).
[19] Regardless of the type, derivative contracts are used for two purposes:
• “to speculate on the movement of the underlying asset, reference rate or index”;
or
• “to hedge exposure to a particular financial risk such as the risk posed by volatility in the prices of commodities” (Placer Dome, at para. 29).
[20] The income tax treatment of gains and losses arising from derivative contracts depends on whether the derivative contract is characterized as a hedge or speculation. Gains and losses arising from hedging derivative contracts take on the character of the underlying asset, liability or transaction being hedged (Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622, at paras. 68-70). In contrast, speculative derivative contracts are characterized on their own terms, independent of an underlying asset or transaction.
[21] In this case, there is no dispute that Mr. MacDonald’s Bank of Nova Scotia shares are a capital asset and that if the forward contract was a hedge of those shares, the Cash Settlement Payments will be characterized as capital losses. There is also no dispute that if the forward contract was not a hedge of Mr. MacDonald’s Bank of Nova Scotia shares, the Cash Settlement Payments will be characterized as income losses.
[22] A long line of jurisprudence supports the conclusion that the characterization of a derivative contract as a hedge turns on the contract’s purpose. Purpose is ascertained objectively (Ludco Enterprises Ltd. v. Canada, [2001] 2 S.C.R. 1082, at para. 54). While subjective manifestations of purpose may sometimes be relevant, the taxpayer’s stated intention, as Noël C.J. noted, is not determinative. The taxpayer’s conduct is generally more revealing than “ex post facto declarations” of the taxpayer (Vern Krishna, Income Tax Law (2nd ed. 2012), at p. 161; see also Jinyan Li, Joanne Magee and J. Scott Wilkie, Principles of Canadian Income Tax Law (9th ed. 2017), at p. 296). As the cases demonstrate, the primary source of ascertaining a derivative contract’s purpose is the linkage between the derivative contract and any underlying asset, liability or transaction purportedly hedged. The more closely the derivative contract is linked to the item it is said to hedge, the stronger the inference that the purpose of the derivative contract was hedging.
[23] A.-G. of Man. v. A.-G. of Can., [1925] 2 D.L.R. 691 (P.C.), provides an early description of hedging and of the importance “purpose” and “linkage” play in defining a derivative contract as a hedge. In that case, the Judicial Committee of the Privy Council reviewed the Manitoba legislature’s authority to enact the Grain Futures Taxation Act, S.M. 1923, c. 17, which imposed a tax on gains arising from grain futures (a type of derivative instrument similar to a forward contract). In finding the statute ultra vires, Viscount Haldane described the use of grain futures as “hedges”, noting that grain sellers use grain futures to “guard against” and “avoid possible loss from a drop in market-price” while waiting to sell their grain on the market (p. 694). He observed that the grain seller does this by buying and selling grain futures equivalent to the quantity of grain actually held with an “aim . . . to eliminate the risk which he runs from fluctuations in the general market-price while waiting to sell what he actually possesses” (p. 694 (emphasis added)). As Viscount Haldane’s description implies, the linkage between the underlying asset (the grain possessed) and the derivative contract (the grain futures) is central in defining the contract’s purpose.
[24] A similar understanding of hedging was applied in Atlantic Sugar Refineries Ltd. v. Minister of National Revenue, [1949] S.C.R. 706, where this Court explored the bounds of linkage. The issue was how to characterize a sugar refinery’s earnings arising from entering into sugar futures under the Income War Tax Act, R.S.C. 1927, c. 97. In concluding that the futures were a hedge, Kerwin J. observed that the subject of the derivative contract was the same as the taxpayer’s business (raw sugar) and found that the purpose of the sugar futures was “to offset losses either actual or feared” from the taxpayer’s purchase of higher-than-normal quantities of raw sugar during wartime conditions (p. 707). He concluded that the profits from these futures were sufficiently connected to the taxpayer’s business operations such that they should be treated the same way as its other business earnings. It was added by Locke J., in concurring reasons, that although the futures were not entered into at the exact time the raw sugar was purchased, this lack of synchronized timing did not change the essential nature of the futures as a hedge. Locke J. concluded that the futures were a hedge despite testimony of the president of the taxpayer company that the sales “were not in the nature of hedges but speculative transactions” (p. 710).
[25] Salada Foods Ltd. v. The Queen, [1974] C.T.C. 201 (F.C.T.D.), provides an example of how an insufficient connection will lead to the conclusion that the derivative contract was entered into for speculation, not hedging purposes. In that case, Salada Foods entered into a forward sale contract for £500,000 with the Canadian Imperial Bank of Commerce, from which it realized a substantial profit. Salada Foods argued that the contract was entered into with the sole purpose of protecting the value of its investment in its U.K. subsidiaries (which it considered capital assets). It submitted, therefore, that gains arising from this contract should be taxed as capital gains. Urie J. rejected the argument, noting that the value of the forward sale contract did not align with the value of Salada Food’s investments into its subsidiaries, and that there was “little or no relationship between the gain received by [Salada Foods] on its forward sale contract and its actual investment loss occurring as a result of the devaluation of the pound” (p. 206). As a result, notwithstanding Salada Food’s stated intentions, Urie J. found that the purpose of the forward sale contract was speculative, and concluded that gains arising from it were taxable on account of income.
[26] The definition of hedging and the required sufficiency of linkage were further discussed in Echo Bay Mines Ltd. v. Canada, [1992] 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:
... under 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]
[27] MacKay J. concluded that despite imperfect symmetry between the quantum of the forward contracts and the actual production from the mine, and between the timing of production sales and the settlement of the forward contracts, “[e]xact matching was not feasible from a practical point of view, nor is it required in order to constitute hedging” (p. 731). He held that the linkage between the forward contracts and the mine’s production was sufficient to support the conclusion that the purpose of the forward contracts was to hedge against price fluctuations in silver. On this basis, he concluded that earnings and losses from the forward contracts were to be treated as part of the price received for the silver produced by the mine and included as “resource profits” (p. 732).
[28] In Shell Canada, a case where the derivative contract in question was agreed to be a hedge, this Court considered the tax treatment of a complex corporate finance arrangement involving several debenture purchase agreements and a forward exchange contract. Under this arrangement, Shell was effectively given access to a US$100 million loan at a lower-than-normal financing cost by obtaining the loan indirectly through the purchase and sale of New Zealand currency. One of the issues before the Court was the proper income tax treatment of Shell’s gains on the forward exchange contract entered into as part of the loan arrangement. In answering this question, McLachlin J. concluded:
Whether a foreign exchange gain arising from a hedging contract should be characterized as being on income or capital account depends on the characterization of the debt obligation to which the hedge relates. As noted, Shell entered into the Forward Exchange Contract in order to hedge with US$ the market risk on the Debenture Agreements, which were denominated in NZ$. Indeed, Shell would not have entered into the Debenture Agreements in the absence of the Forward Exchange Contract. The gain on the Debenture Agreements was characterized as being earned on capital account and so therefore should the gain on the Forward Exchange Contract. [para. 70]
[29] The most recent decision from this Court addressing hedging in the context of derivative contracts is Placer Dome. At issue was whether cash settled derivative contracts qualified as “hedging” transactions under Ontario’s Mining Tax Act, R.S.O. 1990, c. M.15. The Minister had previously excluded these contracts from the definition of “hedging” on the basis that cash settled derivative contracts were speculative and did not result in the physical delivery of output from a mine. LeBel J. noted that “[a] transaction is a hedge where the party to it genuinely has assets or liabilities exposed to market fluctuations, while speculation is ‘the degree to which a hedger engages in derivatives transactions with a notional value in excess of its actual risk exposure”’ (para. 29, citing Brent W. Kraus, “The Use and Regulation of Derivative Financial Products in Canada” (1999), 9 W.R.L.S.I. 31, at p. 38). He concluded that the derivative contracts at issue were “part of a comprehensive program designed to manage the risk associated with fluctuations in the [market] price of gold” and that, under Generally Accepted Accounting Principles (GAAP), “the way in which a derivative contract functions as a ‘hedge’ is unaffected by the method by which the contract is settled” (paras. 5 and 31). He endorsed the test used by the trial judge that, for a derivative contract not settled by physical delivery of a mine’s output to fit within the definition of “hedging” under the Mining Tax Act, there must be “some link” or “nexus” between the derivative contract and the output of the mine (para. 14). LeBel J. concluded that the definition of “hedging” under the Mining Tax Act included cash settled forward contracts.
[30] Placer Dome was considered by the Tax Court in George Weston Ltd. v. R., [2015] 4 C.T.C. 2010, where Lamarre A.C.J. further refined the bounds of sufficient linkage. In George Weston, the issue was the proper income tax characterization of gains from currency-exchange-based swap contracts, a type of derivative contract. The taxpayer, George Weston Ltd., argued that the swaps were entered into to hedge against foreign exchange rate fluctuation associated with its U.S. subsidiaries. The Crown argued that to constitute a hedge, the derivative contract must be associated with an underlying transaction and there was no underlying transaction because George Weston did not sell its U.S. subsidiaries.
[31] Lamarre A.C.J. rejected this argument, holding that it is possible for a derivative contract to be used for hedging even if “there is no sale or proposed sale of the underlying item being hedged” (para. 97). She observed that the swaps, though “not linked to the purchase or sale of commodities”, allowed George Weston “to stabilize the value of the USD assets exposed to currency risk on the balance sheet” (para. 77). On the facts of the case, Lamarre A.C.J. concluded that George Weston’s internal policies and the timing and quantum links between the swaps and George Weston’s net investment in its U.S. subsidiaries supported the finding that the swaps were used to hedge, not speculate.
[32] 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. 722-23; Placer Dome, at para. 49; George Weston, at paras. 96-98).
[33] 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.
[34] Based on his testimony, the trial judge found that Mr. MacDonald intended to hold his Bank of Nova Scotia shares indefinitely. On this basis, she concluded that “Mr. MacDonald was exposed to no risk by holding the [Bank of Nova Scotia