SCC Confirms Limited Role for Intent In Characterizing Tax Losses from Futures Contracts
The case involves a former employee of the Bank of Nova Scotia, who received a large number of Bank of Nova Scotia shares upon his departure. He borrowed money from TD Bank, pledged most of these shares as collateral for the loan, and entered into forward contracts with TD Bank for him to sell these same shares at their price when he entered into the contract. These futures contracts would benefit him if the price of the shares fell. The Appellant’s view, which the Tax Court of Canada agreed with, was that these were independent speculative investments. The CRA’s view was that these were either “hedge” instruments intend to insure him against reductions in value.
The value of the shares increased, and the Appellant lost money on the futures contracts. He attempted to characterize these losses as losses from an “adventure in the nature of trade”, which can be deducted against income from any source. The CRA disagreed, and recharacterized them as capital losses, which can only be deducted at a rate of 50%, and only against capital gains.
The distinction between capital gains and business income is not set out in detail under tax legislation. Rather, the Courts have developed a framework for distinguishing the two in the course of interpreting broadly worded provisions.
In most contexts, the analysis of whether a gain or loss from a transaction was of an income or a capital nature turns on the seller’s intended use of the property (with older decisions including Sutton Lumber & Trading Co. v. MNR, 53 DTC 1158 (SCC) and more recent decisions including Canada Safeway Ltd. v. R., 2008 FCA 24). Property purchased to be sold, particularly where the taxpayer plans to do something to increase the profitability of the sale, generates income when disposed of, while property purchased for the taxpayer’s personal or income-earning use usually results in capital gains.
As the reliance on intention to characterize gains is largely a judicial creation, courts can also change the emphasis in different contexts. This means that the relevant considerations can change according to context. An intent to sell is not always determinative—for example, in many cases gains from “true” speculative investments, where the taxpayer is betting on an appreciation in value over time without their active involvement, may not be sufficiently “active” to constitute a business.
In the context of futures transactions, the analysis does not centre the taxpayer’s intended use of the futures contract (futures are clearly purchased either to be exercised or sold to a third party). Where dealing with a futures contract, the question turns on whether the transaction was a “hedge”, which mitigates the risk of an underlying operation or asset, or a “speculative instrument”, which increases risk in pursuit of a profit.
Where the contract is a speculative in nature, losses can be characterized as losses from a business and deducted against income. Where the contract is a hedge, characterization of the gains or losses turns on the nature of the underlying asset: where hedging against the risk of a business (e.g., a farmer with commodity futures), gains or losses are business gains or losses. Hedging against appreciation or depreciation of a capital asset, gains or losses are capital gains or losses. Both parties in this case agreed that the underlying shares were of a capital nature, and so if the contract was a hedge, the losses were on account of capital.
As per the Court of Appeal in this case, an “intention to hedge” in the sense of that being the underlying motive for a transaction is not a prerequisite for a transaction to be a hedge. Rather, the purchaser of the contract must simply be aware that an underlying asset exposes them to risk, and aware that the futures contract would have “the effect of neutralizing or mitigating that risk.” The Federal Court of Appeal concluded that the Appellant in this case clearly had this level of understanding, and so reversed the judge of the Tax Court. The Supreme Court of Canada. The majority of the Supreme Court substantially agreed with this analysis, and concluded that this level of awareness was obvious on the facts.
The Appellant’s position, that the futures contracts were intended to be an independent speculative investment, was perhaps somewhat suspect given that they “had the effect of nearly perfectly neutralizing fluctuations in the price of Bank of Nova Scotia shares”. Given this, he must have faced an uphill battle at trial establishing even a subjective intention to speculate, as one imagines he was well represented and knew what he was doing. Even if the Appellant had not wanted to sell the shares, he had still used them as collateral for a loan, making the hedging effect of the transaction obvious.
The Supreme Court’s reasons largely disregarded the trial judge’s finding that the Appellant had not intended to sell the shares. The Appellant’s reasons for raising this were sensible—if he did not intend to sell the options in five years, then the futures contracts did not hedge against any risks that he cared about.
As the Court noted, a taxpayer’s testimony as to their subjective intentions does not matter a great deal in tax appeals where it is not supported by objective evidence. It is understandable that the courts would not want to apply a test that places a great deal of emphasis on the taxpayer’s intended holding period, as there may be few outward manifestations that could distinguish between an intended sale in five years and in twenty. If the Appellant could hedge against short-term losses and claim losses on account of income, consecutive contracts would plausibly allow him to hedge against longer-term risks and deduct losses currently.
This decision and the Federal Court of Appeal’s before it clarifies previous disputes in the caselaw about characterizing gains and losses from futures contracts and is a reminder to tax practitioners that characterizing gains and losses from the sale of assets can be context-dependent, with intentions not always being determinative.
– James Alvarez, Tax Counsel
© Kalfa Law 2020