Tax Insights: FCA’s decision in MacDonald – The objective approach to hedging

Issue 2018-25

In brief

On June 29, 2018, the Federal Court of Appeal (FCA) released its decision in Her Majesty the Queen v. James S. A. MacDonald.¹ The FCA reversed the Tax Court of Canada’s (TCC’s) decision that derivative transactions undertaken by the taxpayer did not represent hedges for tax purposes. 

The FCA’s key findings are that:

• an intention to hedge is not a condition precedent for hedging
• a derivative contract will constitute a hedge if:
  • the assets owned by a taxpayer are exposed to market fluctuation risk, and 
  • the derivative contract has the objective effect of neutralizing or mitigating that risk

This is an important development for taxpayers who engage in derivative transactions because the decision provides more clarity on what constitutes a hedge for tax purposes. 

In detail

Facts

In 1988, the taxpayer acquired Bank of Nova Scotia (BNS) common shares. In 1997, the taxpayer anticipated that the price of the BNS shares would decline due to certain international events, and to profit from this expectation, he entered into a cash-settled forward contract with a counterparty. The taxpayer made settlement payments under the forward contract of approximately $10 million between 2004 and 2006 and claimed the payments as business losses. 

The Minister reassessed the taxpayer on the basis that the forward contract was entered to hedge his BNS shares (considered to be capital property of the taxpayer), so the taxpayer should have claimed the payments as capital losses. 

Issue

The primary issue is whether the gains or losses realized by the taxpayer on the forward contract should be treated on capital or income account. To resolve the issue, it was necessary for the courts to establish whether the forward contract constituted a hedge of the taxpayer’s BNS common shares. The parties both agreed that the BNS common shares were long-term capital property of the taxpayer.

TCC’s decision

The TCC held that the forward contract was not a hedging instrument because it was linked neither to the taxpayer’s ownership of his BNS shares nor to any disposition of these shares. 

The TCC determined that the forward contract was entered into by the taxpayer as an adventure or concern in the nature of trade and that the payments under the contract should be on income account.

The TCC indicated that the most important factor when determining if a transaction is on income or capital account, is the taxpayer’s intention at the time of entering into the forward contract. In the TCC’s view, the facts showed that the taxpayer legitimately intended to profit from the forward contract with no intention to mitigate the expected drop in value of his BNS shares, because he had no intention of selling his shares. Further, the fact that the forward contract could only be settled in cash supported the taxpayer’s speculative position.

The Crown’s appeal

The Crown appealed the TCC's decision, arguing that the TCC:

• erred in law by failing to apply the proper legal test when determining if the forward contract was a hedging instrument 
• placed too much weight on the taxpayer’s subjective statement of intention, and
• failed to adhere to the TCC’s decision in George Weston Limited v. The Queen²

FCA’s decision 

The FCA addressed the TCC’s decision, focusing on intention and linkage. 

Intention

The FCA determined that intention was not a condition precedent to a hedge. Rather, a hedge exists when a derivative contract neutralizes or mitigates some sort of risk to which assets held by the taxpayer are exposed. 

Based on jurisprudence, the character of the asset or liability being hedged determines the treatment of any gain or loss derived from the hedging itself.³

In MacDonald, the BNS shares held by the taxpayer during the period when the forward contract was in place were capital property, so that if the forward contract had the effect of hedging risk linked to these shares, the losses incurred from making the cash settlement payments should be treated as capital losses.

In the FCA’s view, whether the forward contract was entered into many years after the assets were acquired is immaterial. The hedge's term does not have to match the period of ownership of the underlying asset or liability. What matters is that the taxpayer’s BNS shares were exposed to market fluctuation risk and that this risk was neutralized by the forward contract.

Linkage

The FCA also determined that an actual transaction (e.g. a sale or acquisition of BNS shares) is not required for a hedge to exist. This conclusion is consistent with Weston, in which currency swaps were considered a hedge on a subsidiary’s US dollar operations even though the swaps were settled and the shares of the subsidiary were still held.

The takeaway

Determining what constitutes a hedge for tax purposes has been a longstanding taxpayer concern because jurisprudence sometimes conflicts with Canada Revenue Agency (CRA) guidance. 

In MacDonald, the FCA reinforces the guiding principles on the meaning and tax treatment of a “hedge”:

• the character of the asset or liability being hedged determines the tax treatment of any gain or loss derived from a derivative contract⁴
• an intention to hedge is not a condition precedent for hedging
• a hedge exists as long as the derivative has the effect of neutralizing or mitigating some sort of risk to which the assets owned are subject⁵
• a transaction to sell or settle the underlying asset or liability is not required for a hedge to exist and the form in which a derivative contract is settled (i.e. cash or physical delivery) does not impact whether the derivative contract constitutes a hedge for tax purposes⁶

Although these guiding principles are helpful, the FCA comment that “an intention to hedge is not a condition precedent for hedging” may perpetuate situations in which intended business or investment strategies yield mismatched tax implications.

Nevertheless, the FCA’s decision provides clarity of what constitutes a hedge for tax purposes. It also creates an opportunity to start discussions with the CRA to:

• re-establish some clear guiding principles on how to determine the character of gains and losses from derivative transactions, and
• eliminate the uncertainty that currently exists for taxpayers trying to align jurisprudence and CRA commentary

These arrangements could occur on a very broad basis or at the individual level. 

PwC welcomes the opportunity to assist in these discussions and conversations.

<sup>1.  2018 FCA 128 
2.  George Weston Limited v. The Queen, 2015 TCC 42
3.  Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622, [Shell] paras. 68 and 70, citing Tip Top Tailors Ltd. v. Minister of National Revenue, 1957 CanLII 71 (SCC), [1957] S.C.R. 703, [Tip Top Tailors], at p. 707; Alberta Gas Trunk Line Co. v. M.N.R., 1971 CanLII 179 (SCC), [1972] S.C.R. 498; Columbia Records of Canada Ltd. v. M.N.R., [1971] C.T.C. 839 (F.C.T.D.)
4.  Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622
5. Placer Dome Canada Ltd. v. Ontario (Minister of Finance), 2006 SCC 20
6. Ibid</sup>