Supreme Court defines test for characterizing derivatives transactions

On March 13, 2020, the Supreme Court of Canada released its decision in MacDonald v Canada[1] which provides important guidance in determining whether a financial derivative is on income or capital account for the purposes of the Income Tax Act (Canada).

The issue was whether the taxpayer could deduct, as income losses, the cash settlement payments he made under a forward contract. This turned on whether the purpose of the forward contract was to hedge a financial risk or to speculate. If the forward contract were a hedge, gains or losses from the forward contract would derive their character from the underlying asset hedged. Conversely, if the forward contract were a speculation, the gains or losses would be on income account.

Despite the taxpayer’s testimony in the Tax Court of Canada that he intended the forward contract to be a speculative venture, a majority of the Supreme Court held that the taxpayer’s settlement payments were on capital account because the forward contract hedged the ownership risk of a capital property of the taxpayer.


The taxpayer was a broker whose firm was acquired by the Bank of Nova Scotia (“BNS”) in 1988. As a result, the taxpayer acquired 183,333 shares of BNS (the “BNS Shares”). There was no dispute that the BNS Shares were capital property of the taxpayer.

In June 1997, the taxpayer entered into a forward sale contract with TD Securities Inc. (“TDSI”) with respect to 165,000 BNS Shares. The contract was to be cash-settled with no option for physical settlement. Under a forward sale agreement, the forward sale price is determined with reference to certain factors including the current spot price of the reference asset, dividends expected to be received and the risk-free interest rate. At maturity, if the forward sale price exceeded the market price of the BNS Shares, TDSI would pay the taxpayer the difference. If the market price of the BNS Shares exceeded the forward price, the taxpayer would pay TDSI the difference.

Before entering into the forward contract, The Toronto-Dominion Bank (“TD Bank”) offered a credit facility to the taxpayer on condition that he maintain the forward contract and pledge 165,000 BNS Shares and any payments made under the contract. The amount that could be drawn was limited to approximately $10.5 million (not exceeding 95% of the spot price of the pledged BNS Shares). The taxpayer drew only $4,899,000 of the amount available and it was fully repaid by the end of 2004.

The taxpayer’s evidence at trial was that his intention was to achieve a profit on an anticipated decline in the value of the BNS Shares based on “storm clouds” he saw on the investment horizon. The taxpayer stated that his intention was not to hedge.

The taxpayer did not terminate the forward contract in or around 1998 when the market was down and he would have realized a substantial gain, which the taxpayer characterized as a major error with the benefit of hindsight.

The forward contract contemplated partial terminations. The taxpayer made a number of partial terminations as a result of which he was required to make “cash settlement payments” to TDSI since BNS Shares had increased in value. These payments were approximately $10 million in aggregate, which the taxpayer treated as deductible payments on income account. The Minister of National Revenue disagreed and reassessed on the basis that the forward contract was a hedge of a capital property, the BNS Shares, such that the payments were on capital account.

Judicial History:

In the Tax Court of Canada, the trial judge considered that it was necessary first to consider whether the forward contract was, in and of itself, an adventure or concern in the nature of trade. If so, it was necessary to determine whether it was sufficiently linked with an underlying capital asset to convert payments made by the taxpayer from income account to capital account. Given that a forward sale agreement does not produce income prior to maturity, it is surprising that the trial judge found it necessary to consider the first question. Regardless, having found that the forward contract was an adventure in the nature of trade, the trial judge concluded that it was not a hedge of the BNS Shares. The trial judge considered that a hedge requires both a clear intention to hedge as well as a close linkage between the purported hedging instrument and the underlying asset or transaction. Having accepted the taxpayer’s evidence that his intention was to speculate rather than hedge, the trial judge held that the cash settlement payments were on income account.

In the Federal Court of Appeal, Noël CJ held that the appeal did not turn on whether the Tax Court judge chose the proper analytical approach because, regardless of the approach taken, the matter must ultimately be resolved by determining whether the forward contract was a hedging instrument. The forward contract would be a hedging instrument if it neutralized or mitigated risk to which the underlying asset was exposed. While the person concerned must understand the nature of the contract being entered into, Noël C.J. held that an intention to hedge has never been made a prerequisite for hedging. The Court expressly refused the taxpayer’s invitation to alter the law to make intention a prerequisite for hedging despite the taxpayer’s argument that failing to do so would lead to “accidental hedgers”. The example given was a person who enters into a contract to sell forward 100 BNS Shares while holding none, but who inherits 100 BNS Shares before the forward date thereby becoming an “accidental hedger”. However, Noël C.J considered that the so-called “accidental hedger” would not be caught by the existing test, as the person concerned could not possibly have understood that the contract entered into would have the effect of mitigating risk. Moreover, the taxpayer was not in that position as he owned assets covered by the forward contract at the time when it was entered into and was fully aware that the contract would mitigate risk on those assets.  It did not matter if it was TD Bank, as lender, that wanted the BNS Shares to be protected from market risk, as the taxpayer was fully aware that risk had to be neutralized.

Supreme Court-Analysis of the Majority:

Abella J, writing on behalf of the majority (eight of the nine justices), set out a framework for describing and taxing financial derivatives. That framework can be summarized as follows:

  1. Financial derivatives are contracts whose value is based on the value of an underlying asset, reference rate, or index. The two basic types of derivative contracts are forward contracts, which create mutual buy/sell obligations, and options, which give one party the right (but not the obligation) to buy or sell an asset.
  2. Derivative contracts are used for two purposes – to hedge exposure to a financial risk, or to speculate on the movement of an underlying asset, reference rate or index.
  3. If a derivative contract is a hedge, gains and losses from the contract will take their character from the underlying asset, liability or transaction being hedged. If a derivative contract is speculative, the character of the contract is determined independently of an underlying asset or transaction.
  4. In order to determine whether a financial derivative is a hedge or speculative, the contract’s purpose must be determined. In determining the contract’s purpose, the taxpayer’s stated intention to speculate or to hedge may “sometimes be relevant”, but is not determinative. Instead, the contract’s purpose is to be ascertained objectively.
  5. The “primary source” for objectively determining whether a financial derivative is a hedge or speculative is the linkage between the contract and the underlying asset, liability or transaction. The stronger the linkage, the stronger the inference that the purpose of a derivative contract is to hedge.
  6. The linkage analysis involves two steps: identifying the underlying asset, liability or transaction which exposes the taxpayer to a particular financial risk, and then considering the extent to which the derivative contract mitigates or neutralizes the risk. Perfect linkage is not required.

Abella J found that in this case, there was substantial linkage between the forward contract and the taxpayer’s BNS Shares, and therefore the forward contract was a hedge. The forward contract had the effect of “nearly perfectly neutralizing fluctuations in the price” of the taxpayer’s BNS Shares.

Abella J agreed with Noël CJ that the trial judge erred in law by apparently concluding that the taxpayer was not exposed to any risk because he intended to hold the BNS Shares indefinitely. Instead, she followed George Weston[2] and other cases which held, in Abella J’s words, that

“[t]he absence of a synchronous transaction [i.e., a sale of BNS Shares] used to offset gains or losses arising from a derivative contract is not equivalent to the absence of risk and is not, by itself, determinative of the characterization of a derivative contract.”

Abella J also held that the trial judge erred by allowing the taxpayer’s ex post facto stated intention to speculate and the fact that the forward contract was settled by cash to “overwhelm her analysis.” Furthermore, the hedging purpose was “most apparent” when considered alongside the loan and pledge agreements. On this point, she acknowledged the rule in Shell Canada[3] that the economic realities of a situation cannot be used to recharacterize a taxpayer’s bona fide legal relationships, but did not agree that she was recharacterizing the forward contract by considering the loan and pledge agreements. In her view, the loan and pledge agreements were contextual evidence of the purpose of the forward contract. Further, she noted that a good argument can be made that even without the loan and pledge agreements, the forward contract was a hedge as, considered independently, it perfectly sheltered the bulk of the BNS Shares from market price fluctuation.

Abella J endorsed Noël J’s observation that “the combined effect” of the forward contract, the loan and the pledge was to create “credit backed by collateral that was free from market fluctuation risk.” The pledged shares matched the shares contemplated in the forward contract, and as the number of shares under the forward decreased each time the taxpayer made cash settlements, the same number of shares were released from collateral. The purpose of the forward contract was to hedge.

Accordingly, the majority of the Supreme Court held that the cash settlement payments made under the forward contract were on account of capital as they derived their income tax treatment from the underlying BNS Shares, which were themselves held on capital account.

Supreme Court- Analysis of the Dissent:

Côté J, the sole dissenting judge, framed the issue more broadly. In her formulation, the issue was whether the forward contract was an adventure in the nature of trade, such that the gains or losses would be on account of income, or a hedge, such that they would be on account of capital. For a hedge to exist, there must be an intention to hedge that is supported by objective manifestations of that intention, being either sufficient linkage between the derivative and the underlying asset, or integration of the derivative transaction into the taxpayer’s profit-making activities.

Côté J’s dissent was lengthy, but there was one key point on which she agreed with the majority. Côté J stated that she did agree with Abella J that, in any event, the taxpayer’s exposure to fluctuations in the price of his BNS Shares was a risk that would exist without the existence of a synchronous transaction used to offset gains or losses arising from a derivative contract.


Given the few cases reviewed by the Supreme Court, the tax community was initially surprised that leave was granted in this case. Moreover, there were concerns that, in dealing with the appeal, the Supreme Court could impose very restrictive conditions in order to find that a derivative was a hedge such that positions, which a taxpayer currently views as hedges of a capital asset, are instead found to be on income account. On the other hand, the decision in the Federal Court of Appeal itself could have had anomalous results for certain taxpayers. For example, if a taxpayer has a foreign subsidiary, should unrelated transactions in the relevant foreign currency nonetheless be regarded as hedging the investment in the foreign subsidiary such that they are on capital account?

The strong majority position is therefore a welcome clarification of the test for characterizing derivative transactions and is an affirmation of the approach of the lower courts in other cases as to the meaning of a hedge in the context of derivatives and the extent of the linkage between the derivative contract and an underlying asset, liability or transaction. The concession that, in determining the contract’s purpose, the taxpayer’s stated intention to speculate or to hedge may “sometimes be relevant” should be helpful in resolving some issues such as characterizing foreign currency transactions where the taxpayer has a foreign subsidiary.

If the taxpayer had entered into the transactions today, the provisions of the Income Tax Act (Canada) relating to “synthetic disposition arrangements” would have applied. The taxpayer would have been treated as disposing of the 165,000 BNS shares on entering into the forward sale agreement for proceeds equal to fair market value, thereby recognizing the accrued gain on the shares.


[1]       2020 SCC 6.

[2] George Weston Ltd v R, 2015 TCC 42 at para 97.

[3] Shell Canada Ltd. v. Canada, [1999] 3 SCR 622.



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