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RECENT DEVELOPMENTS IN THE TAXATION OF DERIVATIVES AND
FINANCIAL PRODUCTS
Chris Van Loan
Partner
Blake, Cassels & Graydon LLP
September 27, 2013
10TH Taxation of Financial Products & Derivatives Course
Federated Press
Introduction
• Focus of presentation will be on recent legislative developments
affecting the Canadian income taxation of derivatives and financial
products
• 2013 Federal budget included two significant proposed changes:
– Character conversion transaction proposals
– Synthetic disposition arrangement proposals
• On July 11, 2013, the Department of Finance released a
backgrounder extending the grandfathering relating to the character
conversion proposals
• Legislative proposals released on September 13, 2013 include draft
provisions implementing the grandfathering discussed in the July 11,
2013 Backgrounder
2
Character Conversion
Transactions
• The proposed character conversion rule would treat
the gain (or loss) realized on a purchase or sale of
capital property under a “derivative forward
agreement” as ordinary income (or loss) rather than
capital gain (or loss)
• The new rules will significantly affect many
investment funds that have used forward contracts
or derivative contracts to convert ordinary income
into capital gains
3
Character Conversion
Transactions (cont’d)
• A derivative forward agreement is defined to include any agreement to purchase or
sell capital property where
(a) the term of the agreement or a series of agreements exceeds 180 days, and
(b) in the case of a purchase agreement, the difference between the fair market
value of property to be delivered on settlement, including partial settlement, of
the agreement and the amount paid is determined, in whole or in part, to an
underlying interest (including a value, price, rate, variable, index, event,
probability or thing) other than
(i) revenue, income or cash flow in respect of the property over the term of
the agreement, changes in the fair market value of the property over the
term of the agreement, or any similar criteria in respect of the property, or
(ii) where the purchase price is denominated in the currency of a country
other than Canada, changes in the value of the Canadian currency
relative to that other currency,
4
Character Conversion
Transactions (cont’d)
(c) in the case of a sale agreement,
(i) the difference between the sale price of the property and the fair market value of the property at
the time the agreement is entered into by the taxpayer is attributable, in whole or in part, to an
underlying interest (including a value, price, rate, variable, index, event, probability or thing)
other than
(A) revenue, income or cash flow in respect of the property over the term of the agreement,
changes in the fair market value of the property over the term of the agreement, or any
similar criteria in respect of the property, or
(B) where the sale price is denominated in the currency of a country other than Canada,
changes in the value of the Canadian currency relative to that other currency,
and
(ii) the agreement is part of an arrangement that has the effect — or would have the effect if the
agreements that are part of the arrangement and that were entered into by persons or
partnerships not dealing at arm’s length with the taxpayer were entered into by the taxpayer
instead of non-arm’s length persons or partnerships — of eliminating a majority of the taxpayer’s
risk of loss and opportunity for gain or profit in respect of the property for a period of more than
180 days;
5
Character Conversion
Transactions (cont’d)
• Proposed paragraph 12(1)(z.7) includes amounts in income
– For a sale, the amount by which the sale price of the property exceeds the fair
market value of the property at the time that the agreement is entered into
– For a purchase, include the amount by which the fair market value of the
property exceeds the cost to the taxpayer of the property
• Proposed paragraph 20(1)(xx) provides for a deduction equal to (subject to certain
restrictions)
– For a sale, the amount by which the fair market value of the property at the time
the agreement is entered into exceeds the sale price of the property
– For a purchase, the amount by which the cost of the property exceeds its fair
market value at the time it is acquired by the taxpayer
• Corresponding adjustments to adjusted cost base to prevent double tax
6
Example: Mutual Fund That Sells
Canadian Securities Forward
• The forward price is based on a reference basket of securities
• In this example, the mutual fund holds Canadian securities and agrees to sell them forward. The
fund has made an election under subsection 39(4) of the Income Tax Act (Canada) to obtain
guaranteed capital gains/capital losses treatment
• Prior to the derivative forward agreement proposal, the mutual fund was able to obtain a return
that is economically linked to the reference basket of securities in the form of capital gains or
capital losses
7
Mutual Fund
Trust
Financial
Product
Provider
Reference Bond
Portfolio Canadian Securities
Forward Sale
Example: Application of the Character
Conversion Transaction Proposal
• This transaction would fit within the definition of a “derivative forward agreement”, as the sale price of the
Canadian securities is determined by reference to a basket of securities that is not related to the value of the
Canadian securities sold forward
• The proposed character conversion rule would thus treat the gain or loss as ordinary income rather than as a
capital gain or capital loss
• I
8
Mutual Fund
Trust
Financial
Product
Provider
Reference Bond
Portfolio Canadian Securities
Forward Sale
Character Conversion
Transactions • The new rules will apply to agreements entered into on or after
March 21, 2013 and to existing agreements that are extended on or
after March 21, 2013
• On July 11, 2013, the Department of Finance released a backgrounder
setting out changes to the character conversion proposals and
extending grandfathering of derivative forward agreements entered into
before March 21, 2013
• The September 13, 2013 legislative proposals contain two sets of
transitional rules
– for series of short-term agreements, grandfathering may be available until the
end of 2014
– for a longer-term agreement, grandfathering may be available until the earlier of
its termination date or March 21, 2018
9
Transitional Rules for Grandfathered Series of
Short-Term Agreements Contained in
September 13, 2013 Legislative Proposals
• Qualifying derivative forward agreements with term
of 180 days or less if part of a series that includes a
derivative forward agreement entered into after
March 20, 2013 and before July 11, 2013 will be
entitled to grandfathering provided that the
agreements are not extended or renewed beyond
the end of 2014 and certain growth limits are
respected
10
Transitional Rules for Grandfathered Series of
Short-Term Agreements Contained in
September 13, 2013 Legislative Proposals (cont’d)
• Pursuant to these growth limits, the notional amount of a
derivative forward agreement eligible for grandfathering
cannot exceed the total of the following: 1. its notional amount when the agreement is entered into;
2. the total increase in the notional amount that is attributable to the underlying interest;
3. the amount of cash that was held by the taxpayer immediately prior to March 21, 2013 that was
committed to be invested under the derivative forward agreement;
4. the total increase in the notional amount of the derivative forward agreement that is attributable to the final
settlement of a qualifying terminated derivative forward agreement;
5. certain other permitted increases in the notional amount;
less
6. any total decrease in the notional amount attributable to the underlying interest; and
7. the total of partial settlements to the extent that they are not reinvested
11
Transitional Rules for Grandfathered
Long-Term Agreement Contained in
September 13, 2013 Legislative Proposals
• A qualifying derivative forward agreement entered into
before March 21, 2013 will be entitled to grandfathering
until the earlier of the termination date of the agreement
and before March 22, 2018 provided that the agreement
is not extended or renewed beyond the end of 2014 and
certain growth limits are respected
• Grandfathering will be permitted if an agreement is
extended to a date before 2015
12
Transitional Rules for Grandfathered
Long-Term Agreement Contained in
September 13, 2013 Legislative Proposals (cont’d)
• Pursuant to these growth limits, the notional amount of a
derivative forward agreement eligible for grandfathering
cannot exceed the total of the following: 1. its notional amount prior to March 21, 2013;
2. the total increase in the notional amount that is attributable to the underlying interest;
3. the amount of cash that was held by the taxpayer immediately prior to March 21, 2013 that was
committed to be invested under the derivative forward agreement;
4. the total increase in the notional amount of the derivative forward agreement as a consequence of the
exercise of an over-allotment option granted to March 21, 2013;
5. the total increase in the notional amount of a derivative forward agreement that is attributable to the final
settlement of a qualifying terminated derivative forward agreement;
6. certain other increases in the notional amount up to the lesser of 5% and total increases in the notional
amount after March 20, 2013 and before July 11, 2013;
less
6. any total decrease in the notional amount after March 20, 2013 attributable to the underlying interest; and
7. partial settlements after March 20, 2013 to the extent that they are not reinvested
13
Transitional Rules in September 13, 2013
Legislative Proposals
• One of the provisions included in the transitional rules is
intended to provide relief where a derivative forward
agreement is terminated, but another increased in notional
amount by no more than that of the terminated agreement
• This will allow grandfathering to continue to be available
where there is a merger of investment funds
• The term of the surviving derivative forward agreement cannot
exceed the term of the terminated derivative forward
agreement
14
Practical Implications
• Explanatory Notes accompanying the
September 13, 2013 Legislative Proposals
include a number of examples – a sale of property pursuant to a covered call option should
not, in and of itself, be a derivative forward agreement
– a sale of property pursuant to a put/call strategy could be a
derivative forward agreement
– exchangeable shares with an embedded exchange right
should not be caught
15
Practical Implications
• What are the implications for fixed forward
price contracts?
• What are the implications for currency
forward purchase and sale transactions?
16
Synthetic Disposition
Arrangement Proposal • The synthetic disposition arrangement proposal is aimed
at transactions that allow a taxpayer to defer the tax from
disposing of property by entering into transactions that
would put the taxpayer in the same economic position as
if it had sold a property with an accrued gain while
retaining ownership for tax purposes until a later date
• The new measures will deem a taxpayer to have
disposed of the property at fair market value at the time it
enters into a “synthetic disposition arrangement”
17
Synthetic Disposition
Arrangement Proposal (cont’d)
• A “synthetic disposition arrangement” is defined as one or more
agreements or other arrangements that (a) have the effect of
eliminating “all or substantially all” of the taxpayer’s risk of loss and
opportunity for gain or profit in respect of the property for more than
one year; and (b) do not otherwise result in a disposition of the
property within one year
• The explanatory notes that accompanied the budget proposal stated
that the rule is intended to apply to a wide range of monetization
structures, including forward sales, put-call collars, exchangeable
debt transactions, total return swaps, and securities borrowing
transactions used to facilitate a short sale of property that is
economically similar to the property of the taxpayer
18
Synthetic Disposition
Arrangement Proposal (cont’d)
A taxpayer will not be deemed to have disposed of property
under the synthetic disposition arrangement if
a) the disposition that would be deemed under this rule would not
realize in a capital gain or income
b) the property is a mark-to-market property
c) the arrangement is a lease of tangible property or, for civil law,
corporeal property;
d) the arrangement is an exchange of property to which subsection
51(1) applies
e) Property is disposed of as part of the arrangement within one year
after the day on which the synthetic disposition period of the
arrangement begins 19
Synthetic Disposition
Arrangement Proposal (cont’d)
• The notes accompanying the September 13, 2013 legislative
proposals provide a number of examples of transactions that would
or would not be considered to be subject to the synthetic disposition
arrangement proposal
• The following are included as transactions that would be considered
to be subject to the synthetic disposition proposal:
– put-call arrangements where all or substantially all of the risk of loss and
opportunity for gain has been given up
– sale of a very deep in the money call option
– a secured loan where the loan was in an amount approximately equal to the
value of the property provided as security and both the lender and borrower had
a right to settle the loan with the property
– the entering of a total return swap where the taxpayer owns the reference share
20
Synthetic Disposition
Arrangement Proposal (cont’d)
• The following are included in the notes accompanying the
September 13, 2013 legislative proposals as examples of
transactions that would not be considered to be subject to the
synthetic disposition arrangement proposal
– a put-call arrangement where the strike price on the call option was significantly
higher than the current value of the property and the strike price on the put
option was significantly less than the value of the property
– a loan which is simply secured by property, even if the borrower has the right to
settle the loan with the property
– a sale of property for a fixed price, but subject to the purchaser obtaining
regulatory approval
– a swap whereby the owner of the property only pays an amount equal to
dividends on the reference share and not changes in price
21
Synthetic Disposition
Arrangement Proposal (cont’d)
• In the budget documents, it was stated that the rule is not
intended to apply to “ordinary hedging” which the Department
of Finance seems to view as dealing only with potential risk of
loss
• The provision also does not require that the taxpayer actually
received a loan or was otherwise put into funds
• The new rules will apply to transactions entered into on or
after March 21, 2013 and also to existing agreements that are
extended on or after March 21, 2013 as if the agreement was
entered into at the time that it was extended
22
Example: Monetization
23
• Inception of Transaction
• The financial product provider has agreed to purchase the reference shares from the client at a point in the future for the forward price
• The financial product provider also makes a loan to the client with the same term as the forward
• Shares are pledged to the financial product provider as security for the transactions
Securities
Lender
Financial
Product
Provider
Client
Borrowing
of Shares
Market
Sale of share and
investment of sales
proceeds
Loan
Forward purchase
contract
on reference share
Example: Monetization
24
• Conclusion of Transaction
• The financial product provider’s payment obligation under the forward contract is generally set off against the client’s obligation to repay the loan
• The share purchased by the financial product provider is used to close out the securities borrowing transaction
Securities
Lender
Financial
Product
Provider
Client
Return of
Shares
Payment of forward purchase price
(generally applied to repay the loan
owed by the client)
Sale of share pursuant to forward
Repayment of Loan
Practical Implications
• An inherent level of uncertainty will be involved in
determining whether the taxpayer has eliminated “all or
substantially all” of the risk of loss and opportunity for gain
or profit
• CRA generally interprets “all or substantially all” as
meaning 90% or more
• Case law, however, has taken an approach which requires
that the particular facts and circumstances be considered
and has contemplated a lower threshold (see Wood v.
MNR, 87 DTC 312 and McDonald v. The Queen, 98 DTC
2151)
25
Synthetic Disposition Arrangement –
Application to “Dividend Stop-Loss Rules”
• Generally, the Income Tax Act (Canada) includes rules
that deny a corporation the ability to claim losses on the
disposition of a share of a Canadian corporation to the
extent that such corporation has received dividends on
the share that qualified for the inter-corporate dividend
deduction
• An exception to the rule is available if the share has
been owned for at least 365 days (and no more than 5%
of the class of shares were owned by the taxpayer and
non-arm’s length persons)
26
Synthetic Disposition Arrangement –
Application to “Dividend Stop-Loss Rules” (cont’d)
• The synthetic disposition arrangement definition (with the one year
threshold replaced by a 30-day threshold) will apply for purposes of
the dividend stop-loss rule
• Where this rule applies, for purposes of the 365-day ownership
requirement threshold, the taxpayer will be deemed not to own the
share during the “synthetic disposition period”
• This rule will not apply where the taxpayer owned the relevant
property throughout the 365-day period preceding the synthetic
disposition period
• Not clear which shares are affected where the taxpayer owns more
than what are subject to the synthetic disposition arrangement
27
Synthetic Disposition Arrangement –
Application to “Dividend Stop-Loss Rules” (cont’d)
• A corresponding rule will apply in the context of claiming
foreign tax credits for non-Canadian taxes on foreign
securities held for less than a year
• These proposals will have wide-ranging implications
• For example, the rule would apply to an equity derivative
transaction where a taxpayer hedges its obligations by
purchasing the underlying shares or securities
• Would the rule apply where the “hedge” is entered into
prior to the relevant shares having been acquired?
28
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