Supreme Court Confirms Linkage Principle for Hedging Transactions
In the MacDonald case, the Supreme Court of Canada upheld what has been known as the “linkage principle” applicable to certain derivative contracts. Basically, the principle holds that if there is sufficient linkage between a derivative contract and the value or amount of a property, liability, or transaction, so that the derivative is effectively a “hedge”, then the gains or losses on the derivative for income tax purposes take on the character of the property, liability or transaction being hedged.
MacDonald owned shares in the Bank of Nova Scotia. He arranged a substantial line of credit with TD Bank, pledging the shares as collateral for the line of credit. In addition, MacDonald entered into a “forward contract” with TD Securities, which is part of the same TD Bank group. Under the forward contract, MacDonald was required to pay amounts to TD Securities if the value of the shares increased over the forward price, whereas TD Securities was required to pay him if shares’ value decreased below the forward price. Over the course of three years, the value of the shares increased, and MacDonald paid about $10 million to TD Securities under the forward contract.
MacDonald took the position that the forward contract was speculative in nature so that the $10 million constituted a business loss. If it was a business loss, it was fully deductible against his other sources of income. The Canada Revenue Agency (CRA) disagreed, arguing that the contract acted as a hedge of the value of the shares. Since the shares were capital property to MacDonald, the CRA assessed the $10 million as a capital loss. Only half of the capital loss was deductible, and only against MacDonald’s taxable capital gains.
The Tax Court of Canada agreed with MacDonald’s position. However, on appeal, the Federal Court of Appeal upheld the CRA assessment. The Court of Appeal held that there was sufficient linkage between the forward contract and the shares.
In a rare move, the Supreme Court of Canada granted leave to MacDonald to appeal further (the first technical income tax case the Supreme Court has agreed to hear in many years). However, in the end, the Supreme Court upheld the Court of Appeal decision. The Supreme Court concluded: “When considered in its full and proper context, it is clear that the purpose of the forward contract was to hedge against market price fluctuations that Mr. MacDonald’s Bank of Nova Scotia shares were exposed to.” Since the shares were capital property, the forward contract loss was a capital loss, not a deductible business loss.