SCC tax decision: Derivative contract that neutralizes risk is a hedge

In MacDonald v. Canada (MacDonald)¹, the majority of the Supreme Court of Canada (SCC) held that a derivative contract entered into by the taxpayer constituted a “hedge” of the taxpayer’s capital property since it had the effect of neutralizing risk associated with owning this property. As a result, cash settlement payments made by the taxpayer under the contract were “capital” in nature, and thus not fully deductible for tax purposes.

What you need to know

• Issue. The issue in MacDonald was whether cash settlement payments made by the taxpayer under a derivative contract were on “income” account, and thus fully deductible for tax purposes, or on “capital” account, with more restricted deductibility.
  • The character of cash payments made under a derivative contract generally turns on whether the derivative is speculative in nature or a “hedge” of an asset, liability or transaction. Based on principles developed in earlier cases, it is generally accepted that speculative contracts are regarded as being on income account and hedging contracts are regarded as being on capital account when the underlying item being hedged is on capital account.
  • The “linkage principle” has been developed by the courts to determine whether a derivative contract constitutes a “hedge” and examines the link between the contract and the underlying asset, liability or transaction that is purportedly being hedged, with one factor in establishing a link being the purpose of the contract.

• SCC decision. The majority of the SCC held that the taxpayer’s derivative contract was a hedge of capital property. The key principles stemming from the majority’s decision are as follows:
  • The proper approach to determine the character of cash payments made under a derivative contract is to ascertain whether the derivative contract is a hedge under the linkage principle.
  • Under the linkage principle, whether a derivative contract constitutes a hedge turns on its purpose. The primary source to determine a derivative contract’s purpose is the extent of the linkage between the contract and an underlying asset, liability or transaction. The closer the link, the more likely the purpose of the contract is to hedge.
  • In applying the linkage principle, the first step is to identify an underlying asset, liability or transaction which exposes the taxpayer to a financial risk. The second step is to then determine how effective the contract is at mitigating or neutralizing the identified risk. The sufficiency of the linkage depends on the effectiveness of the derivative contract at neutralizing the risk and the degree of connectedness to the asset, liability or transaction purportedly hedged. In this regard, the majority held that a perfect linkage is not required and that absence of a corresponding transaction (i.e., the sale of an asset or settlement of a liability) does not equate to the absence of financial risk.

Factual overview

The taxpayer, Mr. James MacDonald, had over 40 years of capital markets and corporate finance experience. In 1988, Mr. MacDonald was a senior executive at a brokerage firm which was acquired by a Canadian financial institution (FI). As a result of the acquisition, he acquired 183,333 common shares of FI (FI shares). According to Mr. MacDonald, he intended to hold the FI shares indefinitely. These shares were capital property to him for tax purposes.

In June 1997, shortly after leaving his employment at FI, Mr. MacDonald entered into a cash-settled forward contract with a third-party counterparty (CP). The forward referenced 165,000 FI shares, had an initial term of five years (which was subsequently extended) and could be settled in part or in full prior to maturity.

Under the terms of the forward, the parties were required to make cash payments at the time of any settlement. Mr. MacDonald was obligated to pay to CP the amount, if any, by which the market value of the number of FI shares (subject to the settlement) at that time exceeded the forward price in respect of such number of shares (which, in general, per FI share, reflected the market value of an FI share at the start of the forward contract). CP was obligated to pay to Mr. MacDonald the amount, if any, by which the forward price of the number of FI shares (subject to the settlement) exceeded the market price of such number of FI shares at that time.

Shortly after entering into the forward contract, Mr. MacDonald entered into a credit facility for $10.5 million with a third-party lender associated with CP (lender). The terms of the credit facility required Mr. MacDonald to pledge as security 165,000 FI shares and his rights to receive cash settlement payments under the forward. Mr. MacDonald borrowed $4.9 million under the credit facility and these amounts were fully repaid in 2004.

Mr. MacDonald opted to partially settle the forward contract in 2004 and 2005, and finally settled it in 2006. As part of these settlements, Mr. MacDonald made cash settlement payments to CP of nearly $10 million.

For tax purposes, Mr. MacDonald took the position that he had entered into the forward for speculation, and, as such, the cash settlement payments made by him were fully deductible in computing his income. Disagreeing with this position, the Canada Revenue Agency (CRA) reassessed Mr. MacDonald on the basis that the forward was a hedge of the FI shares, a capital property of Mr. MacDonald, and, as such, the cash settlement payments constituted capital losses.

Lower court decisions

In considering the deductibility of the cash settlement payments made by Mr. MacDonald, the Tax Court of Canada (TCC) and the Federal Court of Appeal (FCA) took different approaches in applying the linkage principle to determine if the forward contract entered into by Mr. MacDonald was a hedge, and in particular, the manner in which the “purpose” of the contract is to be established.

The TCC assessed purpose largely by reference to Mr. MacDonald’s subjective intention, which it accepted was speculative in nature, such that the payments were on income account. In contrast, the FCA downplayed Mr. MacDonald’s subjective intention and assessed purpose by reference to the effect of the forward contract: since the forward had the effect of mitigating risk associated with FI shares held by Mr. MacDonald, which the parties accepted as being capital property to him for tax purposes, the forward was a hedge of capital property and the payments were on capital account.

SCC analysis

Majority opinion

The majority of the SCC upheld the FCA’s order, agreeing with the FCA that the forward contract was a hedge of the FI shares.

The SCC found that derivatives are used for two purposes: to speculate on the movement of an underlying asset, reference rate, or index, or to hedge exposure to a particular financial risk.

The income tax treatment of a derivative contract depends on whether it is characterized as a hedge, or speculation. A derivative contract that is a hedge takes on the character of the underlying asset for tax purposes. If the underlying asset is a capital asset, then the derivative will be on capital account. A derivative contract that is speculative is characterized on its own terms.

The SCC described and relied on a long line of jurisprudence for the conclusion that the characterization of a derivative contract as a hedge turns on its purpose. The more closely the derivative contract is linked to the item it is said to hedge, the more likely it is that the purpose of the derivative contract is hedging.

Broadly, the SCC described two steps for the linkage analysis. The first step is to identify an underlying asset, liability or transaction that exposes the taxpayer to a financial risk. The second step is to consider the extent to which the derivative contract mitigates or neutralizes that risk. The more effective the derivative contract is at mitigating or neutralizing the risk, the stronger the inference that the contract is a hedge. Perfect linkage is not required.

The SCC found that there was substantial linkage between the forward contract and Mr. MacDonald’s FI shares. The forward contract had the effect of nearly perfectly neutralizing the fluctuations in price of the FI shares held by Mr. MacDonald. In arriving at this conclusion, the SCC considered that the combined effect of the pledge agreement and loan with lender, and the forward contract with CP, was to allow for credit backed by collateral (the FI shares) that was free from market risk. This context was significant for the SCC in assessing the close linkage between the forward contract and the FI shares.

The FCA had faulted the trial judge for failing to follow the TCC’s decision in George Weston², which found, contrary to the longstanding historic position of the CRA, that ownership risk can be hedged for tax purposes. In particular, the trial judge’s finding that there was no risk as long as Mr. MacDonald did not intend to sell his shares was incorrect—ownership risk can only exist if the underlying property is not sold. The SCC echoed the FCA’s criticism and relied on George Weston in concluding that risk arises even in the absence of a transaction (i.e., ownership risk).

The SCC also agreed with the FCA that the stated intent of the taxpayer—to hedge or speculate—is not determinative of the contract’s purpose. In this regard, the SCC criticized the TCC judge for allowing Mr. MacDonald’s testimony to “overwhelm her analysis”.

The dissent

Justice Côté, in dissent, would have restored the order of the TCC. Based on the findings of fact by the TCC with regard to Mr. MacDonald’s intent, Justice Côté concluded that the forward contract was an adventure in the nature of trade, and not a hedge of Mr. MacDonald’s FI shares.

Justice Côté stated that the determination of whether a derivative contract is a hedge turns on the taxpayer’s intent. This is determined by reviewing the taxpayer’s subjective statements and objective manifestations of intent. According to Justice Côté, since the taxpayer’s intent is important in determining whether a transaction is on account of capital or income, it should also be important in determining whether a transaction is a hedge.

According to Justice Côté, the forward contract should be considered on its own terms, not alongside the credit facility and securities pledge. In this regard, Justice Côté emphasized that the forward contract was entered into with CP, whereas the credit facility and securities pledge were entered into with lender. Relying on the SCC’s decision in Shell Canada³, Justice Côté stated that the tax character of the losses on the forward contract should not be affected by Mr. MacDonald’s arrangements with lender. Justice Côté criticized the majority for relying “on Mr. MacDonald’s arrangements with [lender] in order to recharacterize the tax treatment of his arrangements with [CP]”.

Justice Côté also suggested that lender may have had an intention to hedge the market fluctuation risk on the pledged FI shares. However, Justice Côté noted that lender’s intention is irrelevant, since we are concerned with the intentions of Mr. MacDonald.

For Justice Côté, the TCC’s factual findings on Mr. MacDonald’s intent to speculate were unchallenged on appeal. According to Justice Côté, none of the legal errors identified on appeal stand up to scrutiny, and it is not appropriate for an appellate court to transform its opposition to a trial judge’s factual findings into legal errors.

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¹ 2020 SCC 6, aff’g 2018 FCA 128, rev’g 2017 TCC 157.

² George Weston Limited v. The Queen, 2015 TCC 42.

³ Shell Canada Limited v. Canada, [1999] 3 S.C.R. 622.

Le mois dernier, le Canada a publié sa première Stratégie industrielle de défense (la Stratégie), qui souligne l’engagement du Canada à développer une base industrielle de défense solide et à stimuler la croissance économique. Ces efforts pourraient aussi comprendre le renforcement de l’état de préparation à la biodéfense et aux contre-mesures médicales, ce qui pourrait constituer des débouchés pour le secteur canadien des sciences de la vie en raison de l’importance accordée aux capacités nationales en ce sens et de la nécessité d’atténuer les risques d’urgences sanitaires.

Développement de contre-mesures médicales au Canada

Comme indiqué dans les bulletins précédents, le quatrième pilier de la Stratégie est axé sur la « sécurisation des chaînes d’approvisionnement pour les intrants et les biens clés » par le renforcement de la production nationale et le stockage de ressources. L’accent est mis tout particulièrement sur les contre-mesures médicales, en précisant que nos « alliés ont établi un lien explicite entre l’état de préparation à la biodéfense et aux contre-mesures médicales et leur sécurité économique et nationale, en élaborant de nouvelles stratégies et de nouveaux mécanismes pour faire progresser ces travaux ». Les contre-mesures médicales désignent divers produits réglementés pouvant être utilisés pour protéger la population lors d’une situation d’urgence de grande ampleur, comme l’éclosion d’une maladie ou une attaque impliquant des armes chimiques, biologiques ou nucléaires. Il peut s’agir de vaccins, de médicaments thérapeutiques et produits biologiques, de dispositifs de tests diagnostiques, des équipements de protection individuelle ou industrielle, et d’autres dispositifs médicaux. Les contre-mesures médicales sont essentielles à la réduction et à l’atténuation des dommages lors d’une urgence de santé publique.

Exploiter les voies réglementaires mises en place lors de la pandémie de COVID-19

Pendant et après la pandémie de COVID-19, le Canada a mis en place plusieurs nouvelles voies réglementaires comme mécanismes d’accélération des approbations de produits médicaux, ce qui pourrait offrir au gouvernement des options pour déployer des contre-mesures médicales afin de faire face aux risques pour la santé publique. Au début de la pandémie, Santé Canada a émis diverses ordonnances provisoires pour permettre l’importation et la vente de médicaments et de dispositifs médicaux qui n’avaient pas eu l’approbation des voies réglementaires traditionnelles. Or, Santé Canada a plutôt fait confiance aux voies d’approbation réglementaire et de l’exemption de certaines exigences en homologation de produits des pays impliqués dans la transaction. Beaucoup de ces règles provisoires ont depuis été officiellement intégrées à la réglementation en vertu de la Loi sur les aliments et drogues et ont été appliquées bien après la COVID-19. Conformément au Règlement sur les aliments et drogues, Santé Canada tient à jour la Liste des maladies qui menacent la santé publique et utilisera une procédure d’autorisation modifiée pour les médicaments d’urgence de santé publique pouvant traiter les affections figurant sur la liste. De même, le Règlement sur les instruments médicaux a établi une liste d’instruments médicaux répondant à un besoin urgent de santé publique, ce qui permet à Santé Canada d’autoriser la commercialisation de ces instruments de manière accélérée. Ces outils réglementaires sont utilisés automatiquement quand une situation médicale présente un grand risque pour la santé publique au Canada et nécessite une action immédiate pour contrer ce risque.

Le rôle de la Stratégie dans le renforcement du régime réglementaire de la santé au Canada

La stratégie prévoit que le Canada adoptera une approche proactive en matière de planification en amont des crises sanitaires. Le gouvernement entend s’assurer que les produits médicaux sont déjà disponibles au Canada afin qu’ils puissent être distribués rapidement en cas d’urgence. D’autres modifications récentes au Règlement sur les aliments et drogues permettent de prépositionner au Canada tous les médicaments d’urgence en santé publique, ce qui signifie qu’ils peuvent être importés dans des installations d’entreposage canadiennes avant que leur mise sur le marché n’ait été autorisée. La Stratégie s’appuie sur ces fondements, en faisant référence à l’organisme existant Préparation aux crises sanitaires Canada (PCSC), un organisme opérationnel spécial au sein d’Innovation, Sciences et Développement économique Canada (ISDE), et à un nouveau Fonds des sciences de la vie, lesquels « collaborent avec des partenaires internationaux et de soutenir l’élaboration et la production de contre-mesures médicales ». PCSC supervise la Stratégie en matière de biofabrication et de sciences de la vie du Canada, qui vise à développer un secteur national des sciences de la vie fort et compétitif doté de capacités de biofabrication de pointe, en mettant l’accent sur la capacité à se préparer et à faire face aux futures priorités et crises sanitaires. Dans cette optique, il y aura des occasions pour les fabricants de nouer des collaborations de recherche et des accords commerciaux ou d’approvisionnement liés aux contre-mesures médicales financées par des programmes fédéraux.

Étroitement lié aux capacités nationales, le pilier III de la stratégie implique « Investissement ciblé pour renforcer un secteur canadien de la défense novateur », avec la promesse que le gouvernement fédéral « soutiendr[a] la recherche et le développement, protéger[a] la propriété intellectuelle, soutiendr[a] les petites et moyennes entreprises, investir[a] dans les compétences et la formation, et encourager[a] les exportations afin de créer un secteur de la défense agile et concurrentiel à l’échelle mondiale ». La nécessité de favoriser le développement de la propriété intellectuelle (PI) et la conservation des droits du Canada est mentionnée à plusieurs reprises dans la Stratégie. Par exemple, la Stratégie prévoit l’établissement de partenariats officiels avec l’industrie canadienne qui « [assureront] la propriété et le contrôle nationaux de la propriété intellectuelle (PI) et des capacités essentielles. » La Stratégie reconnaît l’immense talent des établissements canadiens et la précieuse recherche qui y est menée actuellement et qui est déjà financée par des subventions de recherche d’organismes tels que le Conseil de recherches en sciences naturelles et en génie et les Instituts de recherche en santé du Canada, et fait aussi référence à l’engagement de 1,6 milliard de dollars pour de nouveaux fonds de recherche dans le budget de 2025. Cette prise de conscience de la nécessité de promouvoir et de soutenir l’innovation au Canada laisse présager des possibilités de financement, notamment dans les domaines où le Canada accuse un retard en matière de production nationale et où des engagements d’investissement et de fabrication au Canada peuvent être pris.

Prochaines étapes

Dans les prochains mois, nous prévoyons que le gouvernement du Canada publiera d’autres directives et des mesures de suivi. L’équipe de défense des conservateurs poursuivra sa couverture de perspectives sur la défense au Canada en publiant une analyse supplémentaire pour donner des précisions sur l’incidence de la Stratégie sur de multiples secteurs.