SCC Tax Decision: Derivative Contract That Neutralizes Risk Is A Hedge

• Published date: 22 May 2020
• Author: Miss Gwen Watson, Leonard Nesbitt and Patrick Reynaud
• Subject Matter: Finance and Banking, Corporate/Commercial Law, Litigation, Mediation & Arbitration, Tax, Financial Services, Commodities/Derivatives/Stock Exchanges, Contracts and Commercial Law, Trials & Appeals & Compensation, Income Tax, Tax Authorities, Securities
• Law Firm: Torys LLP

In MacDonald v. Canada (MacDonald)¹, the majority of the Supreme Court of Canada (SCC) held that a derivative contract entered into by the taxpayer constituted a 'hedge' of the taxpayer's capital property since it had the effect of neutralizing risk associated with owning this property. As a result, cash settlement payments made by the taxpayer under the contract were 'capital' in nature, and thus not fully deductible for tax purposes.

What you need to know

• Issue. The issue in MacDonald was whether cash settlement payments made by the taxpayer under a derivative contract were on 'income' account, and thus fully deductible for tax purposes, or on 'capital' account, with more restricted deductibility
  • The character of cash payments made under a derivative contract generally turns on whether the derivative is speculative in nature or a 'hedge' of an asset, liability or transaction. Based on principles developed in earlier cases, it is generally accepted that speculative contracts are regarded as being on income account and hedging contracts are regarded as being on capital account when the underlying item being hedged is on capital account.
  • The 'linkage principle' has been developed by the courts to determine whether a derivative contract constitutes a 'hedge' and examines the link between the contract and the underlying asset, liability or transaction that is purportedly being hedged, with one factor in establishing a link being the purpose of the contract.

• SCC decision. The majority of the SCC held that the taxpayer's derivative contract was a hedge of capital property. The key principles stemming from the majority's decision are as follows
  • The proper approach to determine the character of cash payments made under a derivative contract is to ascertain whether the derivative contract is a hedge under the linkage principle.
  • Under the linkage principle, whether a derivative contract constitutes a hedge turns on its purpose. The primary source to determine a derivative contract's purpose is the extent of the linkage between the contract and an underlying asset, liability or transaction. The closer the link, the more likely the purpose of the contract is to hedge.
  • In applying the linkage principle the first step is to identify an underlying asset, liability or transaction which exposes the taxpayer to a financial risk. The second step is to then determine how effective the contract is at mitigating or neutralizing the identified risk. The sufficiency of the linkage depends on the...