A decision published the week of February 21 calls for a fresh look at the taxation of derivative transactions. To protect their portfolio, some investors implement hedging strategies (puts, calls, etc.). How will the profits and losses resulting from the sale and purchase of derivatives be taxed? How do hedging transactions and the holding of shares interact?
Interpretation of the tax authorities
Until now, the Canada Revenue Agency ("CRA") was of the opinion that profits or losses resulting from such transactions were speculative, unless it could be shown that a hedging transaction was involved. It is important to note that the profits realized from a speculative transaction are fully taxable: 100% of the profit must be added to the taxpayer's income, unlike capital gains, of which only 50% are taxable.
The tax laws do not define what constitutes a hedging transaction. The courts have developed the concept over the years. In light of many court decisions, the CRA first recognized that holding a derivative would be regarded as part of a hedging transaction if there was a sufficient match between the derivative and the underlying transaction. The CRA specified, however, that for there to be a sufficient match, the amount and the expiration of the derivative must generally match the amount and the expiration of the underlying transaction (without it necessarily being a perfect match).
The CRA's position raises several problems. First, the CRA states that there cannot be a hedging transaction without an underlying "transaction," in this case the sale of shares. However, many hedging strategies are used to cover the risks of holding assets rather than the risks of realizing a transaction. For many investors, it is then impossible to receive advantageous tax treatment for hedging transactions because, in many circumstances, the shares were not sold.
The George Weston Ltd. decision
What is of note in the George Weston Limited decision rendered by the Tax Court of Canada is the judge's analysis of the taxation of hedging transactions and of the new circumstances in which this concept should apply. The facts in the George Weston case have nothing to do with the way investors manage their assets for retirement. However, this decision enables us to identify analysis principles which, according to our understanding, apply to all taxpayers.
Contrary to the position of the CRA and according to the reasons in the George Weston case, it is not necessary to close out a position in order to benefit from a hedging transaction. Consequently, taxpayers can keep their stocks while making successive hedging transactions. That is great news, because the sale of shares is no longer necessary, and investors can adapt their hedging strategies to the economic situation and to the risk they are incurring.
To receive advantageous treatment of hedging transactions, taxpayers must, however, show that the stocks they hold represent capital and that the hedging transactions were made in order to preserve this capital and to protect against certain market risks they had identified. This is a question of fact, and taxpayers who wish to receive tax treatment for hedging transactions must provide adequate proof.
Finally, to receive this tax treatment, taxpayers must not be speculating on stocks and, once again, they must prove this. In this regard, to verify if speculative transactions are involved, Interpretation Bulletin IT-479 can be consulted by clicking on the following link: http://www.cra-arc.gc.ca/E/pub/tp/it479r/it479r-e.html. In our opinion, some stock speculators can still receive tax treatment for hedging transactions for the part of their portfolio that represents capital, if separate intentions can be clearly shown with respect to the holding of stocks.
In the taxation field, good news is rare, especially in these times of austerity. Investors can therefore be pleased about this positive decision, because it can certainly reduce their tax bill.
1 To read this decision: http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/108150/index.do.
Since the levels and bases of taxation can change, any reference in this publication to the impact of taxation should not be construed as offering tax advice; as with any transaction having potential tax implications, clients should consult with their own tax advisors.