Canadian Lawyer

May 2020

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32 www.canadianlawyermag.com LEGAL REPORT TAX MacDonald made cash settlement payments to TD Bank of more than $10 million under the forward contract. He later claimed the cash settlement payments as income losses that would be deductible from his income from other sources on his tax returns for 2004, 2005 and 2006. The Minister of National Revenue, however, found that the forward contract was a hedge of the appellant's Bank of Nova Scotia shares and, therefore, characterized the cash payments to TD Securities as capital losses and not as income losses that could be deducted 100 per cent from taxes owing. MacDonald filed an objection. The Income Tax Act recognizes two catego- ries of income: ordinary income, such as from employment and business; and income from a capital source or capital gain. In Canada, income is taxed at 100 per cent, while capital gains are taxed at just 50 per cent. The tax treatment of gains and losses that derives from derivative contracts — or contracts that have an underlying asset, such as shares or real estate — depends on whether the derivative contract is character- ized as a hedge or as speculation. Gains and losses arising from hedge derivative contracts take on the character of the underlying asset; in this case, bank shares. Speculative deriva- tive contracts are characterized on their own terms, independent of an underlying asset. On appeal from the Canada Revenue Agency's decision, the Tax Court agreed with the appellant that his intention was to spec- ulate and that there was no linkage between the forward contract and MacDonald's shares. Cash settlement payments were, therefore, properly characterized as income losses, the Tax Court found. The Federal Court of Appeal allowed the Crown's appeal. It found that MacDonald owned shares that were subject to market risk, and the forward contract had the effect of neutralizing that risk. The forward contract was, therefore, a hedge and the losses were capital losses. If the Bank of Nova Scotia shares that had been pledged by MacDonald had gone down rather than up in value, TD Securities would have paid MacDonald the full amount of the decrease in value, says Krishna. "So now he's covered. If the shares go up in value, he sells, he makes his money, pays off his loan, he's happy. If the value of the shares goes down, TD Securities pays him. He's hedged his bets." In the majority ruling, written by Justice Rosalie Abella, the court found that: i) it is the purpose of the derivatives contract that matters; ii) to look at purpose, one needs to look at the linkage between the purpose and the underlying asset; and iii) the full context is relevant, including the existence of other agreements working together. In this case, there was the forward contract between McDonald and TD Securities and INCOME LOSS MORE BENEFICIAL FOR TAX PURPOSES Appellant James MacDonald has two restrictions on declaring capital gains/losses: » He can deduct only 50% of any capital losses from his taxes; » He can deduct only against capital gains. However, MacDonald could have deducted 100% of income losses against taxes owing. "It's a much richer deduction," says Vern Krishna. "The court clarified that the existing case law continues to be relevant and rejected the application of a test based entirely on foresight of risk." Elie Roth, Davies Ward Phillips & Vineberg LLP 50% 100%

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