The Supreme Court of Canada (SCC) has dismissed an appeal in the case of a taxpayer who argued that payments of approximately $10 million he made as part of a derivatives contract were losses on account of income, rather than capital.
In an 8-1 decision released on March 13, the SCC in James S.A. MacDonald v The Queen upheld the decision made by the Federal Court of Appeal (FCA) that the derivatives contract in question constituted a hedge, and not a speculative transaction as argued by the taxpayer. The FCA ruling overturned a Tax Court of Canada (TCC) decision that found in favour of MacDonald.
MacDonald, the former head of mergers and acquisitions at McLeod Young Weir, became the owner of 183,333 shares of the Bank of Nova Scotia (BNS) when the bank acquired the brokerage in 1988. MacDonald served as an executive at the bank until March 1997, at which time he left the company.
Shortly thereafter, Toronto-Dominion Bank offered MacDonald a credit facility for up to $10.5 million with the BNS shares pledged as partial security. Later, MacDonald entered into a forward contract with a TD subsidiary with 165,000 BNS shares as reference assets. The forward contract was cash settled and structured so that MacDonald would make money if the BNS shares decreased in price.
During the life of the contract, which terminated in March 2006, the price of BNS shares increased and MacDonald made cash settlement payments totalling about $10 million in respect of the derivatives contract.
On his 2004, 2005 and 2006 tax returns, MacDonald characterized the cash settlement payments as income losses deductible against income from other sources, taking the position that the forward contract represented speculation, and not a hedge. The CRA reassessed MacDonald and characterized the payment as capital losses on the basis that the forward contract was a hedge of the BNS shares MacDonald held on account of capital. Capital losses can only be deducted against capital gains.
MacDonald filed notices of objection and appealed the reassessments to the TCC, which found in favour of the taxpayer, holding that MacDonald’s intention in entering into the contract was speculation, and that there was no link between the contract and the shares.
The FCA allowed the Crown’s appeal, finding that intention is not a “condition precedent” to hedging: a contract is a hedge if the party who agrees to the contract owns assets exposed to market fluctuations, the contract mitigates the risk and the party understands the contract’s nature.
Justice Rosalie Abella, writing for the majority in the SCC decision, found that “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.” She went on to add that “Mr. MacDonald’s ex-post facto testimony regarding his intentions cannot overwhelm the manifestations of a different purpose objectively ascertainable from the record.”
A PricewaterhouseCoopers CanadaTax Insights analysis of the decision says that determining whether a derivative contract is a hedge has been a “longstanding taxpayer concern,” because case law sometimes conflicts with CRA guidance. The SCC ruling provided clarity on the issue.
“In MacDonald, the SCC confirmed many of the guiding principles developed through previous jurisprudence and that were relied on by the FCA to determine what constitutes a hedge for tax purposes,” the PwC report says.
However, the reports goes on to say that the decision presents “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.”