Ottawa is proposing two measures in this year's federal budget affecting the tax treatment of derivatives, sophisticated financial instruments whose value is derived from the value of an underlying interest.
Specifically, the government is proposing an anti-avoidance stop-loss rule that would target so-called straddle transactions. It is also proposing an amendment to the Income Tax Act to allow mark-to-market elections when derivatives are held on an income account.
Generally, an eligible derivative will be any derivative held on income account that meets certain conditions, including that the derivative is valued in accordance with accounting principles at its fair value in a taxpayer's audited financial statements, or otherwise has a readily ascertainable fair market value.
In certain cases involving taxpayers who hold derivatives on an income account, a taxpayer may be able to realize gains and losses on these derivatives selectively through so-called straddle transactions.
A straddle is a transaction in which a taxpayer enters into two or more positions — usually derivative positions — at the same time that are expected to generate offsetting gains and losses. Shortly before the end of a taxation year, the taxpayer disposes of the position with the accrued loss; then, shortly after the beginning of the following taxation year, the taxpayer disposes of the offsetting position with the gain.
The taxpayer claims a deduction in respect of the realized loss against other income in the initial taxation year and defers the recognition of the offsetting gain until the following year. This way, the taxpayer claims the benefit of the deferral even though the two positions are offsetting. Furthermore, the taxpayer could attempt to defer the recognition of the gain indefinitely by entering into successive straddle transactions.
Such straddle transactions raise significant tax base and fairness concerns, the government says in the budget documents. Currently, these transactions are being challenged using certain judicial principles and existing provisions of the Income Tax Act. However, these challenges can be time-consuming and costly, the federal government says.
As part of Budget 2017, the government is proposing a stop-loss rule that would effectively defer the realization of any losses on the disposition of a position to the extent of any unrealized gain on an offsetting position. A gain in respect of an offsetting position would generally be unrealized where the offsetting position has not been disposed of and is not subject to mark-to-market taxation.
Read: Budget 2017
"The rule would prevent a taxpayer from realizing a loss in one year and deferring the gain into a subsequent year," says Debbie Pearl-Weinberg, executive director of tax and estate planning with Canadian Imperial Bank of Commerce's wealth-strategies group in Toronto.
For the purposes of the stop-loss rule, a position will generally be defined as including any interest in actively traded personal properties (e.g., commodities), as well as derivatives and certain debt obligations. An offsetting position with respect to a position held by a taxpayer will generally be a position that has the effect of eliminating all, or substantially all, the taxpayer's risk of loss and opportunity for gain or profit in respect of the position.
The stop-loss rule would be subject to several exceptions, including in cases where financial services institutions are holding the derivatives, and when they are being used in certain hedging strategies in the ordinary course of a taxpayer's business, among other exceptions.
This measure will apply to any loss realized on a position entered into on or after Budget Day.
Elective use of mark-to-market
Although there's a mark-to-market property regime applicable to financial services firms, there are otherwise no specific rules in the Income Tax Act that govern the timing of the recognition of gains and losses on derivatives held on income account.
In the past, it was uncertain as to whether taxpayers could mark-to-market their derivatives held on income account under the general principles of profit computation. That situation changed recently when a decision of the Federal Court of Appeal allowed a taxpayer that wasn't a financial services institution to use the mark-to-market method.
For a taxpayer, the mark-to-market method provides the advantage of a potential reduction of book-to-tax differences. For the government, the taxpayer's use of the mark-to-market method eliminates the possibility of the selective realization of gains and losses on such derivatives by removing the taxpayer's control over when these gains and losses are recognized for tax purposes.
To provide a clear framework for exercising the choice of using the mark-to-market method and to ensure that this choice does not lead to avoidance opportunities, this year's federal budget proposes to introduce an elective mark-to-market regime for derivatives held on income account.
Specifically, an election will allow taxpayers to mark-to-market all of their eligible derivatives. Once made, the election will remain effective for all subsequent years unless revoked with the consent of the Minister of National Revenue. The taxpayer will be required to annually include in computing its income the increase or decrease in value of its eligible derivatives.
Furthermore, the recognition of any accrued gain or loss on an eligible derivative that was previously subject to taxes on a realization basis at the beginning of the first election year will be deferred until the derivative is disposed of.
This election will be available for taxation years that begin on or after Budget Day.