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The Supreme Court of Canada (SCC) recently released an important taxation decision dealing with how to characterize capital and income losses under a derivative contract. In MacDonald v. Canada, a taxpayer sought to deduct payments he had made to his bank as part of a loan arrangement. His position was that the payments were income losses. The Canada Revenue Agency (CRA) considered them to be capital losses. The difference in positions created a huge financial risk for the taxpayer. The answer to that question would have significant precedent value in future assessments of tax liability.

What is a Derivative, or Forward, Contract?

The taxpayer was experienced in the financial world and had acquired a great number of shares in a major Canadian bank. He started a new business and obtained a loan from his bank, pledging his shares as collateral for the loan. If he did not repay the loan, the bank could sell his shares to recoup its investment. 

As part of the loan agreements, the parties entered into a “forward-contract” covering potential fluctuations in the value of the shares over the course of the loan term. This was an agreement to buy and/or sell based on the underlying value of the shares from time to time. This is a common form of agreement in the financial world. They are also referred to as derivative contracts as the outcome or performance is dependant on the value of some other asset.

Speculation vs. Hedging

Investors in forward-contracts are motivated by two very different goals.  On the one side is the goal of hedging, which, like insurance, seeks to soften the blow of any losses in another investment. The flip side is the goal of speculation, where the goal is a high return for increasing their risk (making the investment). Here, if the share(s) cumulative value increased, the taxpayer was required to pay to the creditor bank the difference in their fair market value and the price specified in the forward-contract. On the other hand, if the shares decreased in value the bank would pay the difference to the taxpayer which it would hold as further security.

The shares rose in value, and the taxpayer was obligated to pay the bank over ten million dollars. This was the amount he deducted from his income. 

The Income Tax Act seeks to tax both ordinary income and capital gains. Ordinary income is derived from employment or business. Capital gains are derived from selling something you own for a profit, such as real property or shares. The increase in the value of the asset represents the capital gain. Equally, there can be capital losses. 

The taxpayer said he was speculating and therefore could deduct the payment as an income loss. CRA said he was using it to hedge and therefore could only deduct them from capital gains. The Tax Court sided with the taxpayer and characterized the forward contract as speculation, The Federal Court of Appeal (FCA), on the other hand, found it to be hedging. Rolling the dice once more, the taxpayer appealed to the SCC.

Determination Dependent on Intent of Contract

The majority found that the intent behind, and purpose of a derivative contract determines its characterization as one of speculation or one of hedging. To discover the purpose of such contracts one needs to examine how closely it is related to the underlying asset, in this case, the shares. The closer the relationship, the more likely to be considered a hedge, especially where it is lowering the risk of exposure to losses. Speculation is the purpose at the other end of the spectrum.

Here, the majority found the purpose to be hedging so the taxpayer could claim his payment only as a capital loss. Why? The contract provided protection for the taxpayer. The shares could rise or fall in value yet his loan would not be impacted as the payment would provide the bank additional security. There was very little risk for the bank either. He gave the same shares as security as were tied up in the forward or derivative contract. There was therefore a significant connection between the contract and the shares to show a hedging purpose.

If you find yourself in a contractual dispute and require legal representation, contact the highly skilled  Toronto litigators at Milosevic Fiske LLP.  Our team of exceptional Toronto business law lawyers provide both proactive contract review and drafting services, as well as skillful representation of clients involved in all types of contractual disputes. We have helped businesses of all sizes across various sectors manage potential pitfalls and address them through litigation where necessary. We are the lawyers other lawyers turn to for complex commercial litigation. Call us at 416-916-1387 or contact us online for a consultation.