Derivative Forward Agreement

Targeted mutual fund forward sale agreements (p. 1)

Many mutual funds (both mutual fund trusts and mutual fund corporations…) used forward agreements (both forward sale transactions and forward purchase (or pre-paid forward) transactions) to provide investors with an economic return based on the performance of a reference portfolio that would generate ordinary income while having that return taxed as a capital gain….In the case of a forward sale agreement, the mutual fund would enter into an agreement with a counterparty (often a financial institution) to sell the Canadian securities portfolio for a purchase price based on the performance of the bond portfolio to which the mutual fund was seeking to gain exposure. Each time the mutual fund would settle the forward agreement physically (i.e., sell Canadian securities to the counterparty under the forward agreement), the mutual fund would realize gains and losses on capital account and, by virtue of the forward agreement, such capital gains and losses would reflect a return based on the performance of the bond portfolio.

Targeted mutual fund forward purchase agreements (p. 1)

An alternative structure would be where a mutual fund would enter into an agreement to acquire a portfolio of Canadian securities. The mutual fund would prepay its obligation to purchase the portfolio of Canadian securities upon entering into the agreement. The value of the Canadian securities to be delivered on settlement of the agreement would be determined by reference to the performance of, for example, a bond portfolio (as in the forward sale example described above). Each time the mutual fund physically settles the forward agreement, the counterparty to the forward purchase agreement would deliver Canadian securities with a value based on that of the bond portfolio and the mutual fund would then immediately sell the Canadian securities for cash. The Canadian securities would generally be listed, non-dividend paying shares of Canadian public corporations that would be sufficiently liquid to allow for an immediate sale by the mutual fund.

Application of s. 248(10) to "series" (p.3)

The DFA definition applies to a single agreement with a term that exceeds 180 days as well as a series of agreements where the term of the series exceeds 180 days. It is arguable that the concept of "series of agreements" is covered by subsection 248(10), which provides that "...the series shall be deemed to include any related transactions or events completed in contemplation of the series". [fn 10: See footnote 6 in Michael Kandev, Brian Bloom, and Olivier Fournier, "The Meaning of "Series of Transactions" as Disclosed by a Unified Textual, Contextual, and Purposive Analysis," (2010), vol. 58, no. 1 Canadian Tax Journal, 277-330, where the authors state that "[w]e are of the view that the application of subsection 248(10) is not limited only to those instances where the exact expression 'series of transactions or events' appears in the [ITA]. Significantly, this expression is the broadest of the 'series' references in the [ITA] and should be seen to include the narrower references in other provisions. In this regard, see the decision of the Federal Court of Appeal in OSFC...where Rothstein J. stated, at paragraph 37, 'I read subsection 248(10) to apply whether a series is a series of transactions, a series of events, or a series of transactions and events.' Also consider that subsection 248(10)...is intended to clarify the meaning of the word "series" and not the meaning of the words 'transaction' and 'event.' Therefore, subsection 248(10) should apply to all 'series' references in the ITA."] If subsection 248(10) applies to modify the concept of "series of agreements," a taxpayer's intention regarding the term of an agreement on entering into an initial agreement with a term of 180 days or less is unlikely to be relevant if a subsequent agreement or subsequent agreements, when combined with the term of the initial agreement, results in a series of agreements with a term in excess of 180 days….

Distinction between ACB and cost/proceeds and sale price (p. 9)

[P]aragraph 49(3)(b) provides that the cost to the purchaser of the property under an option includes the adjusted cost base to the purchaser of the option itself….

[P]aragraph 49(3)(a) provides that the proceeds of disposition to the person disposing of the property on the exercise of an option include the consideration received by that person for the option (i.e., the option premium)….

Example of distinction between ACB and cost (p. 10)

A taxpayer has an option to purchase a share that would be held as capital property in 200 days. The taxpayer paid an option premium of $3, the strike price of the option is $105, the fair market value of the share at the time of acquiring the option is $100 and the fair market value of the share at the time of exercising the option is $107.

The fair market value of the property delivered on settlement of the agreement is $107 in this case. If the amount paid for the property is the strike price of $105, the difference of $2 would appear to be wholly attributable to the change in the fair market value of the property over the term of the agreement (i.e., an increase of $7 in this example). Accordingly, the exception in subparagraph (b)(i) should apply and the exercise of the option to purchase would not be a DFA.

However, if "the amount paid for the property" includes the option premium, the difference between the fair market value of the property delivered on settlement of the agreement and the amount paid for the property becomes -$1. Based on this interpretation, the difference between $108 (the amount paid for the property) and $107 (the fair market value of the property delivered on settlement of the agreement) should not be considered to be wholly attributable to the $7 increase in the fair market value of the property over the term of the agreement. Accordingly, the option would be considered to be a DFA in this case….

Exchangeable securities – exclusion for embedded exchange rights? (pp. 11-212)

When dealing with exchangeable shares…the Department of Finance's view in the Technical Notes is that the taxpayer would retain sufficient economic exposure to the shares of the Canadian corporation such that the agreement to sell those shares would not be a DFA….

The reason for [this conclusion]…is not immediately evident. It is possible that the reason that exchangeable shares with an exchange right embedded in the share terms would not be a DFA is because the price for the shares of the Canadian corporation corresponds to the inherent value of those shares by virtue of the share terms. It is also possible, however, that the presence of the exchange right in the share terms does not constitute an agreement to sell capital property….

[B]ased on the Department of Finance's conclusions with respect to exchangeable shares and the policy regarding retention of economic exposure stated above, it is worth considering whether a right embedded in any security, regardless of that to which the right relates, would exclude the security from the DFA Rules in all cases….

Currency forwards as potential DFAs (pp. 13-14)

[T]he calculation of the forward price under a currency forward agreement takes account of: (i) the spot exchange rate at the time the forward agreement is entered into, (ii) the interest rate in the base currency, (iii) the interest rate in the secondary currency and (iv) the term of the agreement. …

[A] taxpayer may choose to sell forward USD$100 in a year to hedge its exposure to the US dollar. Assume for these purposes that the one year forward rate results in the taxpayer receiving CAD$110 in one year in exchange for USD$100 to be paid on the one year maturity date and that, based on the current spot rate, USD$100 has a fair market value of CAD$105 at the time that the forward agreement is entered into. In this case, the sale price of the property is fixed at CAD$110 and the fair market value of the property at that time is CAD$105, resulting in a difference of CAD$5 for purposes of subparagraph (c)(i) of the definition of DFA.

[S]ince the sale price of CAD$110 is based on the forward rate (which is based in part on the interest rate differential described above), the difference between the sale price of the property and the fair market value of the property at the time the agreement is entered into (i.e., CAD$5) is attributable in part to a rate (i.e., an interest rate). This difference has been fixed at the time of entering into the agreement with the result that the exception in clause (c)(i)(A) is not available in this example. The exception in clause (c)(i)(B) is also not available in this example as the sale price of US dollars is denominated in Canadian dollars….

[A]n analysis should be completed of the transaction as a purchase agreement of that same taxpayer as well….Since the purchase price for the Canadian currency in this case is denominated in US dollars, it is possible that the exception in subparagraph (b)(ii) could apply. In any event, if the currency forward transaction would be a DFA under the analysis in paragraph (c), it is arguable that an exclusion under paragraph (b) would not be sufficient to conclude that the currency forward transaction would not be a DFA. …

[G]iven that the common law principles as to whether currency transactions should be on capital account are well-established, and the fact that the intent of a currency forward transaction does not fit within the description of the type of transaction being targeted by the DFA Rules, presumably the underlying intent of the DFA Rules is not for all currency forward agreements to be DFAs….

Economic exposure requirement (p. 2198)

…before a sale agreement will be considered to be a DFA [derivative forward agreement], the agreement must be part of an "arrangement" that has the effect of eliminating a majority of the taxpayer's risk of loss and opportunity for gain or profit with respect to the property (which we will refer to as "economic exposure")….

Economic exposure where one-sided exposure (p. 2199)

…The inclusion of this version of the economic exposure test in the DFA rules also highlights questions about how the test should be interpreted generally, and whether it involves a one-pronged or a two-pronged inquiry, which is discussed below in the context of the SDA rules. In the technical notes, Finance has indicated that this new condition should exempt from the DFA rules sales of securities pursuant to the exercise of both typical "covered calls" and the call rights commonly used in "exchangeable share" structures, in each case because the taxpayer would retain significant exposure to the value of the underlying property. [fn 3: It is interesting to note that in its discussion of "exchangeable share" structures, the technical notes indicate that an agreement to sell a share for an amount based on the value of another security does not eliminate the taxpayer's economic exposure to the share (and therefore does not give rise to a DFA) if the share itself contains an "embedded exchange right" for the other security and therefore naturally tracks its value. If the "embedded exchange right" was not present, however, the technical notes indicate that a DFA would arise. Under the DFA rules, therefore, a special significance is attached to exchange rights that are "baked in" to the terms of shares or other securities.]

Embedded interest in forward as an underlying interest (p. 2199)

… The technical notes reiterate that the concept of an "underlying interest" is intended to be interpreted broadly, and list several examples. In addition to unsurprising items (such as the value of a reference fund or a multiple of the return on the TSX), this list also includes "an express or implied fixed interest rate." This suggests that the implicit interest rate used in setting a fixed forward price in a typical forward sale contract would be an "underlying interest" and that the difference between the fair market value of the property at the time that the forward sale contract was entered into and the fair market value at the time of sale should therefore be on income account.

Full tainting of gain (p. 2199)

… the revised DFA rules continue to treat the full amount of the inclusion under paragraph 12(l)(z.7) or deduction under paragraph 20(1)(xx) on income account, even if that gain is only partially attributable to a "bad interest", and even if that "bad interest" would not itself have been on income account if realized directly. Also, the revised rules still do not appear to apply if a DFA is cash settled.

The recent Canadian federal budget of March 13, 2013, contains a provision to prevent the conversion, through the use of derivative contracts, of returns that would have the character of ordinary income to capital gains, only 50 percent of which are included in income. Exchangeable shares and exchangeable partnership interest (UPREIT) structures permit the deferral of capital gains rather than the conversion of capital gains and should not be caught by the proposed anti-avoidance rule that applies to a derivative forward agreement. Unfortunately, the proposed definition of a derivative forward agreement is broad enough to potentially encompass such transactions. The Department of Finance has acknowledged that exchangeable shares and UPREIT structures were not the target of the budget proposal, but Finance will consider whether any such transactions should be covered. Finance, which only found out about these concerns in the last few weeks, is concerned that a wholesale exception for exchangeables would not be appropriate, since some give rise to a character conversion. For example, this may occur when income distributions under the economic equivalence provisions were instead added to the redemption amount regarding the exchangeable interest rather than being paid. Draft legislation that may clarify the ambit of the new legislation is expected in June.