Global Tax Alert (News from Americas Tax Center) | 4 October 2013
Canada releases draft legislative proposals regarding character conversion transactions and synthetic dispositions
On 13 September 2013, Canada’s Department of Finance released draft legislative proposals for a number of the measures that were first introduced as part of the 2013 federal budget on 21 March 2013.
The proposals include a measure aimed at ensuring that derivative transactions cannot be used to convert ordinary income into capital gains through so-called “character conversion transactions” (CCTs). To a large extent, these changes impact many public investment funds and their investors who had invested in mutual funds offering investment products based on this type of underlying derivative arrangement. Given the significant impact of these proposals on investors, further transitional relief with respect to their application was provided on 11 July 2013. The current legislative proposals appear to reflect the spirit of the 11 July 2013 release.
The proposals also include a measure to ensure that the tax consequences of disposing of property cannot be avoided by entering into an arrangement that is economically equivalent to a disposition of the property — a synthetic disposition arrangement (SDA). These rules are intended to apply where all or substantially all of a taxpayer’s risk of loss and opportunity for gain or profit with respect to a property owned by a taxpayer are eliminated through an SDA.
Interested parties are invited to provide comments on any of the draft legislative proposals by 15 October 2013.
Character conversion transactions
The CCT rules target arrangements that convert what would otherwise be fully taxed income into capital gains. To a large extent, CCTs have been undertaken by investment funds through the use of forward purchase or sale agreements of capital property ensuring a fixed rate of return through the subsequent purchase or sale of the property. These new rules are designed to eliminate the use of “derivative forward agreements” (DFAs) for such purposes and tax the resulting economic gains as ordinary income.
The definition of a DFA is to be included in subsection 248(1) of the Income Tax Act (the Act). In general, a DFA is an agreement with a term exceeding 180 days combining a derivative instrument and the sale or purchase of an unrelated capital asset. The aggregate term of a series of agreements must be taken into account for this purpose, thus prohibiting the use of a legally separate, but economically related, series of agreements of shorter duration to circumvent the 180- day test. Subparagraph (c)(ii) of the definition provides that an agreement will not be a DFA where the taxpayer retains a majority of the economic exposure to loss and opportunity for gain or profit on the property being sold for a period of more than 180 days (a deeming rule applies where such agreements are entered into by non-arm’s-length persons). This ensures that the CCT rules will not apply where the taxpayer’s economic exposure is still based primarily on the property being sold, even if there is a derivative component to the sale agreement.
Coming into force
Unless the transitional rules apply, the CCT rules are deemed to have come into force on 21 March 2013 and will apply to acquisitions and dispositions of property under a DFA entered into after 20 March 2013. In addition, to the extent the more favorable transitional rules outlined below do not apply to new DFAs entered into after 20 March 2013 but before 11 July 2013, such contracts may be grandfathered for a period not exceeding 180 days before proposed subsection 12(1)(z.7) would apply.
For the purpose of permitting an orderly unwind of character conversion type investment products that have been widely offered through the investment fund industry, transitional relief is provided under two measures:
- • Where a DFA is entered into after 20 March 2013 and it is part of a series of agreements where a predecessor agreement was entered into before 21 March 2013, transitional relief is provided until the end of 2014.
- • Where a predecessor agreement was entered into before 21 March 2013 but does not have a settlement period prior to 31 December 2014, such transitional relief will be extended to the later of the final settlement period after 31 December 2014 and 21 March 2018.
These transitional measures are provided as long as the taxpayer complies with certain conditions relating to the size of the DFA. However, in no case will transitional relief be extended to acquisitions and dispositions of property that occur after 21 March 2018.
Size conditions for short-term DFAs
Provided the notional amount of the DFA is at all times less than or equal to the amount determined by a specified formula, transitional relief should generally be available until 31 December 2014. In general, the formula permits the following:
- • Changes in the notional amount of the agreement that is attributable to the underlying interest
- • Investment of the cash on hand that was committed, before 21 March 2013, to be invested under the agreement
- • Increases in the notional amount as a result of a reinvestment from the final settlement of another DFA. The subsequent DFA must be substantially similar to the DFA in place prior to 21 March 2013.
- • Increases equal to the lesser of two amounts where:
- − The first amount is either (i) 5% of the notional amount of the agreement immediately before 21 March 2013 that exceeds the total of all amounts each of which is an increase in the notional amount of the agreement after 20 March 2013 and before 11 July 2013 that is not otherwise described in the formula, or (ii) the amount by which the prior agreement immediately before it was finally settled exceeds all amounts each of which is an increase in the notional amount of the agreement before 11 July 2013 that is not otherwise described above, and
- − The second amount, in all other cases, is the increase in the notional amount of the agreement before 11 July 2013 that is not otherwise described above
- • Less decreases in the notional amount attributable to the underlying interest
- • Less decreases for partial settlements in the DFA which are not reinvested in the agreement
Size conditions for long-term DFAs
The transitional rules for the respective “longer”-term DFAs that were in place prior to 21 March 2013 and which expire after 31 December 2014 are substantially the same as the above formula, other than they allow for the exercise of an over-allotment option issued prior to 21 March 2013 and in all cases limit such transitional relief up to and including 21 March 2018.
Adjustment to cost base
Where an amount has been included in income under paragraph 12(1)(z.7) or where a loss has been deducted under paragraph 20(1)(xx) of the Act, paragraphs 53(1)(s), 53(1)(t) and 53(2)(w) provide for an adjustment to the respective adjusted cost base of the capital property.
Proposed new subsection 80.6(1) of the Act deems a taxpayer to have disposed of a property owned by the taxpayer for proceeds equal to its fair market value and to have immediately reacquired the property at that fair market value where the taxpayer has entered into an SDA for a period of more than one year. The synthetic disposition rules apply to arrangements entered into after 20 March 2013. There is no transitional relief for the extension of any existing arrangement that was entered into prior to 21 March 2013 where the extension occurs after 20 March 2013. Any such extensions will be treated as new arrangements and subject to these rules.
The deemed disposition of the property is at the time immediately before the SDA is entered into. The rules will not apply where a disposition of the property would not result in the realization of a gain or income at the time of entering into the SDA, where the property is mark-to-market property, to leases of tangible and corporeal property, arrangements to which subsection 51(1) apply or where the property is actually disposed of within one year of the commencement of the SDA.
What is an SDA?
The proposed definition of an SDA is to be included in subsection 248(1) of the Act. An SDA will be deemed to arise where a taxpayer has effectively transferred all or substantially all of the taxpayer’s risk of loss and opportunity for gain or profit in the underlying property for a definitive or indefinite time period. It should be noted that an SDA in respect of a property of the taxpayer could include a cash-settled derivative that offsets the taxpayer’s interest in the property whether or not the taxpayer is required to own the underlying property.
In the Explanatory Notes accompanying the legislative proposals, the Department of Finance when an SDA arises:
- • Short selling where a single taxpayer acquires the same security (note that if there is no gain on the security, subsection 80.6(1) will not apply even though this is an SDA)
- • Put and call options on a particular property where the floor and ceiling under the options would eliminate all or substantially all of the respective upside and downside to taxpayer
- • Future sales where a taxpayer sells a property for a set price at a specified date in the future
- • Secured loans with an embedded option for the borrower and the lender to settle the loan with the secured property at a set price
- • Total return swaps which swap out the respective income and change in fair market value of the taxpayer’s property whether or not the property is disposed of
The Explanatory Notes also include a number of examples to illustrate when an SDA would not arise:
- • Short selling of a security by a taxpayer, whereby an identical security is also held long by another non-arm’s-length taxpayer and the purpose of the arrangement is not to eliminate the risk of loss or opportunity for gain or profit
- • Put and call options on a particular property where the floor and ceiling under the options do not substantially eliminate all or substantially all of the risk and opportunity for gain or profit
- • Future sales where a taxpayer sells a property for its fair market value at a point in the future where the sale is dependent on a bona fide condition precedent
- • Secured loans which do not have an embedded option for the borrower or lender to settle the debt with the property at a predetermined price
- • Swap arrangements where the taxpayer swaps a non-significant portion of the risk and opportunity for gain inherent in a particular property
Based on the above examples, it is clear that the application of the SDA rules will indeed be highly factual.
Other SDA-related limitations
The Act contains various stop-loss rules applicable to corporations to reduce what otherwise would be a loss on the disposition of shares by the amount of tax-free dividends received on those shares. These stop-loss rules are subject to exceptions that apply depending on whether the corporate shareholder holds the share as a capital property, as income property or as a mark-to-market property. Certain exceptions to these stop-loss rules apply, including where the shares have been held for a continuous 365-day period prior to when the SDA was first entered into.
New subsection 112(8) is added to ensure that the 365-day test cannot be met by entering into an SDA where the shares have not already been held for at least 365 days prior to when the arrangement was entered into by the corporate taxpayer. Generally, where an SDA is for 30 days or more, the share that is the subject of the agreement is considered not to be owned during that period.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (Canada), Toronto
- • Alycia Calvert
+1 416 943 4441
- • Greg Boehmer
+1 416 943 3463
- • Jill Nicolson
+1 416 943 4474
- • Joseph N. Micallef
+1 416 943 3494
- • Reya Ali-Dabydeen
+1 416 943 2220
Ernst & Young LLP (Canada), Quebec and Atlantic Canada
- • Alain Leonard
+1 514 874 4363
- • Benoît Millette
+1 514 879 3562
- • Christian Desjardins
+1 514 879 3551
Ernst & Young LLP (Canada), Prairies
- • Warren Pashkowich
+1 403 206 5168
- • Doron Barkai
+1 403 206 5209
Ernst & Young LLP (Canada), Vancouver
- • Billie Raptis
+1 604 891 8215
- • Elise Rees
+1 604 643 5420
Couzin Taylor LLP, Canada
- • Daniel Sandler
+1 416 943 4434
- • David Robertson
+1 403 206 5474
- • Louis Tassé
+1 514 879 8070
- • Roger Taylor
+1 613 598 4313
EYG no. CM3852