Income Taxation Of Derivatives

• Author: Lara Friedlander/Andrew Auerbach
• Profession: Associate, Osler, Hoskin & Harcourt LLP/Tax Policy Officer, Tax Legislation Division, Department of Finance (Canada)
• Pages: 656-705

Chapter Twenty-Four

Income Taxation of Derivatives*

Lara Friedlander and Andrew Auerbach

A. INTRODUCTION

Derivatives have been the subject of scrutiny by the Canadian tax authori-

ties for many decades; some of the leading cases on futures and forward

agreements date back to the 1940s. Even the swap, a type of derivative that

has appeared somewhat more recently, received attention from the Canadi-

an tax authorities in the early 1980s. Notwithstanding this relatively long

history of derivatives experience, the Canadian tax system generally does

not address derivatives as such, relying instead on general taxation princi-

ples and on a handful of specific and narrowly applicable provisions. This

chapter will provide an overview of the rules governing the taxation of

derivatives in Canada, and will then compare the Canadian system with

other approaches to the taxation of derivatives from a tax policy perspective.

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* The authors would like to thank Andrew McGuffin and Daniel MacIntosh, of Osler,

Hoskin & Harcourt LLP, for their contributions to this chapter. Much of the substance

of this chapter is based on a paper entitled “Fiscalité des produits dérivés” written by

Lara Friedlander for a conference entitled “Financement nord-américain dans la tur-

bulence — Partie 1” held by the Association de planification fiscale et financière in

2001, as well as “Taxation of Derivatives: Canada” in S.D. Conlon and V.H. Aquilino,

Principles of Financial Derivatives and International Taxation(Valhalla, New York: War-

ren, Gorham & Lamont, 1999), also by Lara Friedlander. The views expressed in this

chapter are those of the authors and do not represent the opinions, views, or positions

of the Department of Finance (Canada).

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B. GENERAL CONSIDERATIONS RELEVANT TO THE FEDERAL

INCOME TAXATION OF DERIVATIVES

Derivative instruments, as a category, are not explicitly addressed by the

Income Tax Act (Canada) (the “Act”).1Certain provisions of the Act address

specific types of derivatives, such as s. 49 of the Act, which governs the treat-

ment of options on capital account. Other provisions of the Act focus on spe-

cific aspects of the taxation of derivatives, such as s. 20.3 of the Act, which

addresses the deduction of interest on hedged weak currency loans; the post-

amble to subparagraph 212(1)(b)(vii), which addresses non-resident with-

holding tax on certain types of participating interest payments; and proposed

s. 94.2(9) of the Act, which is the key component of a special taxation regime

in respect of “tracked interests” designed to prevent the usage of offshore

investments to defer current taxation in Canada. However, in most cases, an

analysis of the taxation of derivative instruments relies on the application of

more general income tax principles to the particular transaction in question.

1) Nature of a Derivative

For Canadian federal income tax purposes, the nature of a derivative instru-

ment is not necessarily determined by the nature of the reference asset, lia-

bility or transaction. For example, the payment by one person to another

person under an interest rate swap will not necessarily be considered

“interest” under the Act; rather, that payment will be considered interest

only if it meets the requirements set out in the case law governing the char-

acterization of a payment as interest.2

There are some situations, however, in which the nature of a derivative

may be assimilated to the nature of the underlying transaction, asset or lia-

bility. For example, in Echo Bay Mines Ltd. v. Canada,3profits on cash-set-

tled forward sales contracts for silver4entered into by a taxpayer who

Income Taxation of Derivatives 657

1 R.S.C. 1985, 5th supp. c.1 as amended.

2 An amount is “interest” if (i) it constitutes compensation for the use of borrowed

money; (ii) it is calculated with reference to a principal amount and (iii) it accrues

daily. See Reference as to the Validity of Section 6 of the Farm Security Act, 1944

(Saskatchewan), [1947] S.C.R. 394, aff’d [1949] A.C. 110 (P.C.); Re Balaji Apartments

and Manufacturer’s Life Insurance Co. (1979), 100 D.L.R. (3rd) 695 (Ont. H.C.J.); Attor-

ney-General (Ontario) v. Barfried Enterprises Ltd., [1963] S.C.R. 570. See also Sherway

Centre Ltd. v. The Queen, [1998] 2 C.T.C. 343 (F.C.A.). Generally, no funds are consid-

ered to be borrowed under a swap. See discussion at Section 4, below.

3 [1992] 2 C.T.C. 182 (F.C.T.D.) [Echo Bay].

4 The contracts could have been physically settled but were settled in cash as they

became due or were rolled over for new forward contracts.

operated a silver mine were considered to constitute part of the taxpayer’s

“income for the year from . . . the production in Canada of . . . metals or

minerals . . . from mineral resources in Canada operated by him . . . ” and

therefore the taxpayer’s “resource profits” under s. 1204(1) of the regula-

tions to the Act. The Federal Court, Trial Division held that “[a]ctivities rea-

sonably interconnected with marketing the product, undertaken to assure

its sale at a satisfactory price, to yield income, and hopefully a profit, are, in

my view, activities that form an integral part of production which is to yield

income, and resource profits, within Regulation 1204(1).”5Cases like Echo

Bay, however, reflect a statutory expansion of a concept or a creation of a

particular type of category of transaction, expense or receipt.6

Nevertheless the instances where the nature of a derivative is assimi-

lated to the underlying transaction, asset or liability are relatively rare.

Instead, in most instances, the nature of a derivative instrument and the

nature of the underlying asset, liability or transaction diverge, giving rise to

opportunities and problems for taxpayers.

One of the most common examples of a situation in which derivatives

are used to replicate economics without replicating the nature of the under-

lying transaction, asset or liability for taxation purposes is the “clone fund.”

Pension funds and certain other tax-exempt entities are subject to a special

penalty tax under Part XI of the Act if such an entity owns “foreign proper-

ty” in excess of a given threshold, currently 30% of all property owned by

ADVOCACY AND TAXATION IN CANADA658

5Ibid. at 196. “Resource profits” are a component of the calculation of the “resource

allowance,” for which taxpayers are entitled to a deduction under paragraph 20(1)(v.1)

of the Act.

6 Recently the Canada Revenue Agency (the “CRA”) issued a statement that could be

viewed as an expansion of circumstances when the nature of a derivative may be

influenced by the nature of the hedged transaction. In CRA Document No. 2002-

0138617 (August 21, 2002), the CRA considered whether an insurer, who is subject to

a very specific and detailed income tax regime for insurance companies, could deduct

losses on foreign currency swaps on the basis that the swaps were “used . . . or held

by it in the year in the course of . . . carrying on an insurance business in Canada.”

The swaps hedged foreign currency bonds that were not used or held by the insurer

in the course of carrying on an insurance business in Canada. The CRA took the posi-

tion that, in the absence of additional facts such as the identity of the parties, the cir-

cumstances under which the swaps were entered into and the use of the bonds, the

swaps should not be considered to be property used or held in the course of carrying

on an insurance business in Canada. The CRA referred to the Shell decision

(described and reviewed below) in support of this position. The CRA stated that “the

nature of the underlying asset is an important factor in the determination of whether

the contracts were used or held in the insurance business in Canada,” but also said

that their position was not that “the contracts are not being treated as transactions

separate from the underlying bonds.”