In Print George Weston and the Characterization of Gains on Derivatives Synopsis

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In Print
George Weston and the Characterization
of Gains on Derivatives
As originally published by the Canadian Tax Foundation.
Synopsis
Jonathan Bright (PwC Law
LLP)
2015
The authors of this article argue that the Tax Court of Canada’s decision in
George Weston Limited v. The Queen is a natural and expected result of 75 years
of UK and Canadian jurisprudence on the treatment of foreign exchange gains
and losses and gains and losses arising from hedging activity such as currency
swaps and commodity futures trading. Further, the authors argue that the
published administrative positions of the Canada Revenue Agency (CRA) at the
time of the court’s decision—specifically those referring to a requirement that any
hedging activity be directly connected temporally and financially to an underlying
transaction in order for the hedge to be treated on capital account—were not
consistent with the jurisprudence on this point. The authors suggest that the
decision in George Weston may make it significantly more difficult in future
cases for the CRA to argue that certain new, innovative, and dynamic hedging
arrangements are not related to an underlying capital asset, and therefore that
gains and losses must be on income account. The courts may instead take a
broader approach in assessing the linkages between creative hedging techniques
and the relevant underlying asset.
Contact:
Jonathan Bright
[email protected]
First published in Canadian Tax Journal (2015) 63:3, 779 - 801. Reproduced with
permission. Copyright remains with the author.
PwC refers to PricewaterhouseCoopers LLP, an Ontario limited liability partnership.
canadian tax journal / revue fiscale canadienne (2015) 63:3, 779 - 801
International Tax Planning
Co-Editors: Ken J. Buttenham and Michael Maikawa*
George Weston and the Characterization
of Gains on Derivatives
Jonathan Bright and Steven Baum**
The authors of this article argue that the Tax Court of Canada’s decision in George Weston
Limited v. The Queen is a natural and expected result of 75 years of uk and Canadian
jurisprudence on the treatment of foreign exchange gains and losses and gains and
losses arising from hedging activity such as currency swaps and commodity futures
trading. Further, the authors argue that the published administrative positions of the
Canada Revenue Agency (cra) at the time of the court’s decision—specifically those
referring to a requirement that any hedging activity be directly connected temporally and
financially to an underlying transaction in order for the hedge to be treated on capital
account—were not consistent with the jurisprudence on this point. The authors suggest
that the decision in George Weston may make it significantly more difficult in future cases
for the cra to argue that certain new, innovative, and dynamic hedging arrangements are
not related to an underlying capital asset, and therefore that gains and losses must be
on income account. The courts may instead take a broader approach in assessing the
linkages between creative hedging techniques and the relevant underlying asset.
Keywords: Derivatives n hedging n Canada Revenue Agency n jurisprudence n
transactions n capital
Contents
Introduction
The Facts and Issues in George Weston
The Prior Jurisprudence
Imperial Tobacco
The Facts
The Arguments
The Court of Appeal Decision
780
782
784
784
784
784
785
* Of PricewaterhouseCoopers LLP, Toronto.
** Of PwC Law LLP, Toronto (affiliated with PricewaterhouseCoopers LLP). We would like to
thank Patrick Lindsay of PwC Law LLP, Calgary, for his assistance in the preparation of this
article.
 779
780  n  canadian tax journal / revue fiscale canadienne
(2015) 63:3
Atlantic Sugar
The Facts
The Arguments
The Supreme Court Decision
Tip Top Tailors
The Facts
The Arguments
The Supreme Court Decision
Salada Foods
The Facts
The Arguments
The Federal Court Decision
Echo Bay
The Facts
The Arguments
The Federal Court Decision
Shell Canada
The Facts
The Arguments
The Supreme Court Decision
Recent Judicial Decisions
The CRA’s Administrative Positions
Findings and Holding in George Weston
Concluding Comments
How Does George Weston Compare with the Jurisprudence?
The Impact of George Weston
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785
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788
789
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Introduction
In the recent decision in George Weston Limited v. The Queen,1 the Tax Court of
Canada appears to have dispensed with years of established jurisprudence on the
characterization of income arising from derivatives—and the related question of
the characterization of foreign exchange gains and losses—in making a broad determination that any gain derived from a derivative used to hedge a capital investment
will be on account of capital.
There is no definition of a hedge in the Income Tax Act,2 but, put simply, hedging activity has as its purpose the mitigation or elimination of risk. In the currency
market, for example, the typical risk for a Canadian taxpayer lies in fluctuations,
relative to the Canadian dollar, in the value of foreign currency that the taxpayer
directly or indirectly holds, is expected to receive, or owes, or in which the taxpayer’s
investments and holdings are denominated. In that context, parties may enter into
1 2015 TCC 42.
2 RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as “the Act”). Unless otherwise
stated, statutory references in this article are to the Act.
international tax planning  n  781
what is termed a “currency forward agreement,”3 a “currency hedged borrowing,”4 a
“currency forward contract,” or a “currency swap,” under the terms of which parties
typically agree to lock in a rate in anticipation of a future exchange of an amount of
one currency for another. This allows a party vulnerable to foreign-currency risk to
offset any potential losses in respect of either its underlying holdings or investments, or of the agreement itself, by way of a correlative future gain arising from
the other currency. There are, of course, many varieties of hedges, including “commodity futures,”5 “share swaps,” “interest rate hedges,” and, quite simply, any
agreement intended to offset losses with a view to mitigating risk.6 In today’s sophisticated financial markets, hedging arrangements are very dynamic in their variety,
type, scope, and extent, and they are almost unlimited in their ability to allow taxpayers to parse and eliminate various risks, or part thereof, in respect of a particular
capital asset.7 The Canada Revenue Agency (CRA) has published a number of administrative documents that set out its position on the characterization of gains or
losses from such agreements, which are discussed in some detail below.8
3 The rules surrounding “derivative forward agreements,” as defined in subsection 248(1), were
the subject of a number of reforms announced in the 2013 federal budget. In this analysis, we
do not address those changes, or the underlying rules, but for a thorough discussion of both,
see Edward Miller and Matias Milet, “Derivative Forward Agreements and Synthetic
Disposition Arrangements,” in Report of Proceedings of the Sixty-Fifth Tax Conference, 2013
Conference Report (Toronto: Canadian Tax Foundation, 2014), 10:1-50.
4 For a discussion of foreign-currency hedged borrowings, in which borrowers hedge both
interest and principal payments, see Stephen S. Ruby, “Recent Financing Techniques,” in
Report of Proceedings of the Forty-First Tax Conference, 1989 Conference Report (Toronto:
Canadian Tax Foundation, 1990), 27:1-46. See also the discussion of the Shell Canada case
below (infra note 59 and the related text), which involved a similar arrangement.
5 Our analysis does not discuss the timing aspects of hedging activity (which are particularly
important for certain commodity-based hedges). For an in-depth discussion on this topic, see
Robert A. Kopstein and Janette Y. Pantry, “Foreign Exchange Issues,” in Report of Proceedings of
the Fifty-Fifth Tax Conference, 2003 Conference Report (Toronto: Canadian Tax Foundation,
2004), 27:1-59.
6 Several commentators have provided excellent overviews of the tax rules relating to hedging
activity, including the following: Jonathan Tennant, “The Taxation of Derivatives: The Basic
Rules,” in Report of Proceedings of the Fifty-Seventh Tax Conference, 2005 Conference Report
(Toronto: Canadian Tax Foundation, 2006), 41:1-17; David G. Broadhurst, “Income Tax
Treatment of Foreign Exchange Forward Contracts, Swaps, and Other Hedging Transactions,”
in Report of Proceedings of the Forty-First Tax Conference, 1989 Conference Report (Toronto:
Canadian Tax Foundation, 1990), 26:1-32; and Norman C. Loveland, “Taxation of Currency
and Interest Rate Risk Management Strategies and Products,” in Income Tax and Goods and
Services Tax Considerations in Corporate Financing, 1992 Corporate Management Tax Conference
(Toronto: Canadian Tax Foundation, 1993), 11:1-38.
7 For a more detailed discussion of the economic theory underpinning certain hedging activity,
such as dynamic hedging, see Tom Clearwater, “The Judicial Role in Derivative Taxation: The
Queen v. Shell Canada Limited and Financial Contract Economics” (1998) 46:6 Canadian Tax
Journal 1212-44.
8 The documents reviewed for the purposes of this article include Interpretation Bulletin IT-95R,
“Foreign Exchange Gains and Losses,” December 16, 1980, and CRA document nos. 9427166,
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(2015) 63:3
In George Weston, the court took note of the cra’s statements of its administrative
position and, despite their apparent grounding in and reliance on well-established
jurisprudence, questioned their basis in law. In this article, we will argue that, on the
basis of the jurisprudence, the decision in George Weston does not—as a review of
the cra’s longstanding administrative position may indicate—signal a sea change
in the judicial treatment of foreign-currency hedges; rather, the logic and analysis
underlying the Tax Court’s decision flow naturally and directly from that jurisprudence.9 We will also argue that the holding in George Weston provides support for
the view that the cra’s administrative position in this area has always construed the
judicial authority too narrowly, particularly in requiring an underlying transaction
that is directly connected both temporally and financially to the hedging activity.
The Facts and Issues in George Weston 10
George Weston Ltd. (“gwl”) operated a business that included investing capital in
subsidiaries, which in turn invested in various businesses in the United States (referred to as “us dollar operations”). The fact that gwl’s assets, capital structure,
and consolidated financial statements were expressed in Canadian dollars, combined
with the natural fluctuation in the value of the us dollar relative to the Canadian
dollar, exposed gwl’s capital to significant currency risk.
In 2001, gwl borrowed funds to invest in subsidiaries that then acquired a major
us-based business for us $1.765 billion (“the acquisition”). After the acquisition, the
total amount that gwl had invested in us dollar operations that was exposed to
the above-noted currency risk was approximately us $2 billion. On February 20,
2001, Standard & Poor’s Global Credit Portal issued a report entitled “George
September 18, 1995; 2000-0027485, September 15, 2000; 2003-0036081I7, February 13, 2004;
2005-0117751I7, May 6, 2005; 2009-0352061I7, March 12, 2010; 2009-0345921I7, April 15,
2010; 2009-0348961I7, April 15, 2010; 2010-0355871I7, April 21, 2010; 2009-0352061I7,
March 21, 2012; and 2013-0481691E5, June 26, 2013.
9 A number of commentators have questioned the basis for the CRA’s administrative position; for
example, see Laura White, “Recent Income Tax Developments Relevant to the Mutual Fund
Industry,” in Report of Proceedings of the Sixty-Third Tax Conference, 2011 Conference Report
(Toronto: Canadian Tax Foundation, 2012), 39:1-36, for a detailed discussion of the judicial
treatment of these very issues, and support for the conclusion that the decision in George Weston
was not only natural, given the jurisprudence, but expected. Also see Mathew Desilets,
“Currency Swaps: CRA’s Linkage Principle Overturned” (2015) 5:2 Canadian Tax Focus 2-3;
and Katy Pitch and Marianne Kennedy Beaulne, “Tax Court Rejects Longstanding CRA
Position on Hedges,” OBA Taxation Law Section Newsletter, April 9, 2015. Also on this point see
Jerald M. Wortsman, Christopher S. Purkis, and Leonard Nesbitt, “Complex Financial
Instruments: An Industry and Practitioner Perspective on Equity Derivatives,” in Report of
Proceedings of the Sixty-First Tax Conference, 2009 Conference Report (Toronto: Canadian Tax
Foundation, 2010), 8:1-41, at 8:14.
10 The following summary is based on information provided in the published decision, supra note 1,
at paragraphs 1-30, as well as a review of each party’s written submissions to the Tax Court of
Canada.
international tax planning  n  783
Weston Ltd. ‘A’ Ratings Placed on Credit Watch Negative,” which noted that the
acquisition would be bank financed and stated, in support of the negative credit
report, that “[t]he net effect [of the acquisition] will be detrimental to Weston’s
[gwl’s] capital structure in light of . . . much higher overall leverage.”11
In the decade prior to the acquisition, gwl’s debt-to-equity ratio had always
remained higher than 1:1;12 after the transaction, however, it dropped significantly
below 1:1. This was concerning in itself, but it also raised the additional concern
that any devaluation of the us dollar relative to the Canadian dollar would further
reduce the value of gwl’s equity, with profoundly negative knock-on effects on the
company’s capital structure.13
Accordingly, gwl decided to hedge its us dollar currency risk by entering into
17 new currency swaps, most of which were entered into for terms of 10 to 15
years.14 However, in March 2002, the us-based business purchased in the acquisition
was sold for proceeds of approximately us $610 million, which was approximately
us $200 million more than anticipated. Since gwl’s credit facilities and corporate
policy precluded the retention of swaps superfluous to the company’s currency
hedging needs, gwl terminated the amount of swaps that corresponded to the unanticipated gain.
Further, gwl determined in 2003 that its exposure to risk associated with the
investment in us dollar operations had decreased, and gwl’s debt-to-equity ratio
was expected to be better than 1:1 by the end of 2003. Accordingly, gwl terminated
the remaining swaps in September and October 2003. The relative strength of the
us dollar led to gwl’s realizing a gain of Cdn $316,932,896 upon termination.
As discussed at greater length below, the decision of the Tax Court in George
Weston to characterize this gain as a capital gain flows naturally and directly from
almost three-quarters of a century of jurisprudence on the treatment of foreign
exchange gains and losses and derivative gains and losses,15 beginning with the uk
Court of Appeal’s 1943 decision in Imperial Tobacco Co. (of Great Britain and Ireland)
Ltd. v. Kelly (hm Inspector of Taxes).16
11 “Summary: George Weston Ltd.,” published by Standard & Poor’s on August 7, 2001.
Exchange rate changes just prior to the release of the report affected GWL’s equity, and
consequently its debt-to-equity ratio, credit rating, and cost of capital.
12 As required by internal GWL guidelines.
13 Paragraph 22 of written submissions of the appellant in George Weston, supra note 1.
14 The swaps were intended to balance any potential losses caused by further devaluation of the
US dollar.
15 In the Canadian jurisprudence, the cases prior to 1971 were decided in a context in which
capital gains were not subject to tax; following the tax reforms implemented between 1969 and
1971, capital gains were, indeed, subject to tax, but were taxed at a significantly reduced rate, as
is the case now. Accordingly, the characterization of profit was—and remains—a topic of great
concern to taxpayers.
16 (1943), 25 TC 292 (CA); aff ’g. [1943] 1 All ER 431 (KB).
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The Prior Jurisprudence 17
Imperial Tobacco
The Facts
Imperial Tobacco Co. (of Great Britain and Ireland) Ltd. (“Imperial Tobacco”) was
a manufacturer of tobacco products made primarily from tobacco leaf purchased in
the United States, and shipped to the United Kingdom, by an affiliated entity. To
finance these purchases, Imperial Tobacco bought us dollars in the United Kingdom and remitted the funds to the affiliate prior to the growing season, with a view
to building up an annual us dollar reserve. In the decision of the Court of Appeal
in the case, Lord Greene noted that all of Imperial Tobacco’s us dollar purchases
were made “in contemplation of ” the purchase of an input (raw tobacco) for its primary business.18
Upon Britain’s entry into the Second World War in September 1939, the uk
Treasury issued orders to Imperial Tobacco to cease its purchasing of tobacco and
currency, and sell its now significantly appreciated accumulation of us dollars to
the Treasury.19 Imperial Tobacco realized a significant profit upon this sale; the
question before the court was whether or not that profit was derived from Imperial
Tobacco’s manufacturing business.
The Arguments
Counsel for Imperial Tobacco argued that the correct question for the court to
answer was not “whether the profit arose . . . in the course of carrying on a trade,
but whether it was in fact a profit arising from the carrying on of a trade.”20 In other
words, according to counsel, the profit was merely incidental to Imperial Tobacco’s
business. Counsel also argued that the rules surrounding the deductibility of trading
losses should apply inversely in this case, in the sense that only losses that were
“truly incurred in the carrying on of the trade” were deductible.21
17 Although not every judicial decision highlighted in this analysis dealt directly with the kind of
currency forward arrangement central to the George Weston case, each played an essential role
in our mapping of the logical and analytical path that led to the decision in that case.
18 Imperial Tobacco, supra note 16 (CA), at 299.
19 The Treasury orders were issued pursuant to the Defence (Finance) Regulations, 1939 (made
under the Emergency Powers (Defence) Acts, 1939 and 1940: printed as amended up to June 3,
1941) together with a classified list of orders made under the Defence (Finance) Regulations,
1939, in force on June 3, 1941. Lord Greene was unclear as to whether the Treasury
communications were more in the nature of a prohibition or a “firm request.” In any event,
Imperial Tobacco was precluded from purchasing tobacco from the United States.
20 See Imperial Tobacco, supra note 16 (CA), headnote. Counsel for Imperial Tobacco was
J. Millard Tucker, KC, the future chair of the Committee on the Taxation of Trading Profits,
which played a significant role in UK tax reform in the 1950s.
21 Imperial Tobacco, supra note 16 (CA), headnote.
international tax planning  n  785
The Court of Appeal Decision
Lord Greene first noted that the court’s primary role in this case was to determine
the purpose for which Imperial Tobacco purchased the us dollars, holding that,
because those purchases were “a first step in the carrying out of a commercial transaction, which would be completed by the purchase and delivery of the leaf and
payment of the dollar purchase price for it,” they were “an essential part of a contemplated commercial operation.”22 Putting the point concisely, Lord Greene
stated that this transaction was
precisely on all fours with the case of any trader who, having acquired commodities for
the purpose of carrying out a contract, which falls under the head of revenue for the
purpose of assessment . . . then finds that he has bought more than he ultimately needs
and proceeds to sell the surplus. In that case it could not be suggested that the profit so made
was anything but income. It had an income character impressed upon it from the very first.23
Giving some colour to his decision, Lord Greene suggested that if Imperial
Tobacco had at some point formed the intention to use the us dollars as a speculation, he might have ruled differently.24 However, noting the invariable nature of
Imperial Tobacco’s intentions, he determined that the purchase of us dollars itself
and the resulting profit were on account of revenue. This determination laid the
foundation for the Canadian jurisprudence on the question of gains arising from
commodity hedges, which began in 1949 with the Supreme Court of Canada’s decision in Atlantic Sugar Refineries v. Minister of National Revenue.25
Atl antic Sugar
The Facts
Atlantic Sugar is often cited for propositions relating to the question of when a business is being carried on by a company, but the Supreme Court of Canada also dealt
in this case with the question of whether profit arising from a transaction on a commodity futures market should be characterized for tax purposes as being on account
of income or on account of capital.
22 Ibid., at 300.
23 Ibid., (emphasis added).
24 Ibid., at 301-2. For example, in McKinlay v. HT Jenkins and Son, Limited (1926), 10 TC 372
(KB), a contractor purchased Italian lire in advance of undertaking work that required Italian
granite. Following an increase in the value of the lira, the contractor sold his holdings at a
profit, and later repurchased Italian lire, for the purposes of buying the Italian granite, after the
value of the currency had again fallen. In holding that the contractor’s gain was not on account
of income, the court found that the contractor’s intention in selling his holdings of Italian lire
was not related to the purchase of an input to his business, that the sale of Italian lire was not
“connected with the contract to construct,” and that the gain was simply an appreciation in a
temporary investment.
25 [1949] SCR 706.
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The taxpayer (“Atlantic Sugar”) operated a sugar refinery business. Although in
the ordinary course of its business Atlantic Sugar did not sell raw sugar, in 1937 and
1939 it did so, as a result of events related to the outbreak of war. In 1939, the Canadian government requested that the major sugar refineries supply out of their own
stocks the Canadian military’s increased and unforeseen demand for refined sugar,
and implemented controls on the price of refined sugar. Anticipating potential
losses caused by the scarcity of inputs and a reduced price for its outputs, Atlantic
Sugar decided to short-sell on the New York Coffee and Sugar Exchange as a means
of protecting against such losses. Those transactions gave rise to a gain in 1939 of
Cdn $71,183.09. The question for the Supreme Court was whether that gain was to
be treated as a capital gain or as income.
The Arguments
The president and manager of Atlantic Sugar asserted, on the record, that the short
sales were “not in the nature of hedges but speculative transactions entered into in
the hope of recouping part at least of an anticipated loss in the purchases [of raw
sugar] made at such high figures.”26 Essentially, Atlantic Sugar’s position was that its
futures trading was unconnected with its ordinary business.
The Supreme Court Decision
Despite the above assertions, while noting the necessity of hedging in businesses
like Atlantic Sugar’s, the Supreme Court found that the taxpayer was not “investing
idle capital funds nor was it disposing of a capital asset.”27 Citing Imperial Tobacco,
Kerwin j (writing for himself and Taschereau j, with Rinfret cj concurring) held
that the taxpayer’s intention in entering into the futures transactions was an important
consideration for the court, and that the intention in this case was “to do something
as part of [Atlantic Sugar’s] business and to secure a profit.”28 The court dismissed
the taxpayer’s appeal, holding that the gain from the raw sugar futures transactions
was properly included in its income for 1939.
Although the decision in Atlantic Sugar dealt with a slightly more complex question than that addressed in Imperial Tobacco, the Supreme Court returned to the
latter question almost a decade later, in its 1957 decision in Tip Top Tailors Ltd. v.
The Minister of National Revenue.29
26 Ibid., at 710.
27 Ibid., at 709.
28 Ibid., at 707.
29 [1957] SCR 703; aff ’g. [1955] CTC 113 (Ex. Ct.); rev’g. (1954), 9 Tax ABC 377. See also Eli
Lilly & Co. Ltd. v. Minister of National Revenue, [1955] SCR 745, where the Supreme Court had
dealt with a similar question involving a pharmaceutical manufacturer. In 1945, the taxpayer
(Eli Lilly & Co. Ltd.) owed a debt to its US-based parent company for purchases of raw
materials. Following the lifting of foreign exchange controls that had been in effect since the
international tax planning  n  787
Tip Top Tailors
The Facts
Similarly to the taxpayer in Imperial Tobacco, Tip Top Tailors Ltd. (“Tip Top”) carried on a business that required the purchase of a significant quantity of cloth from
the United Kingdom. In the normal course of its business, Tip Top would typically
pay for each lot of cloth promptly by remitting funds to the vendor in the United
Kingdom. However, toward the end of December 1947, Tip Top noted the potential for a devaluation of the pound sterling, established a uk line of credit up to the
amount of £250,000, and altered its approach to paying uk suppliers:
The new procedure adopted by the appellant was that, upon receipt of the goods purchased in Great Britain and the invoices therefor, it instructed its bankers in London,
England, to issue cheques to the vendors in payment for their goods and to charge
these cheques against the taxpayer’s line of credit in the British bank. Thus, in so far as
the vendors were concerned, they were in the same position as they were under the old
procedure, in that they received prompt payment for the goods sold and delivered.30
When the pound was ultimately devalued in September 1949, the amount owing by
Tip Top under the line of credit totalled approximately Cdn $588,000. Tip Top’s net
profit on the settlement of the line of credit was approximately Cdn $160,000, and
it was that amount of profit that the Supreme Court was asked to characterize as
income or capital.
The Arguments
The argument advanced by counsel for Tip Top proceeded in four steps:
1. The profit was earned on a collateral borrowing of capital.
2. The borrowing was a single and discrete transaction.
3. The transaction was not in the course of Tip Top’s business.
4. Accordingly, the transaction was a temporary investment in foreign currency,
and not taxable as income.
outbreak of the Second World War, the Canadian dollar rose to parity with the US dollar. On
October 22, 1946, the taxpayer realized a significant foreign exchange gain on the repayment
of that debt, which the minister added to the taxpayer’s income for 1946. In determining that a
foreign exchange gain realized on the reduction or elimination of an amount of debt can be
treated as income, even though no amount is directly received, the Supreme Court held, in the
context of a debt incurred to purchase business inputs, that “whether there be a loss or a gain in
respect to the item of foreign exchange it should be taken into account as a trading loss or
profit in the computation of income tax”: ibid., at 751.
30 Tip Top Tailors, supra note 29 (TAB), at 378.
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Tip Top relied on the uk Tax Court decision in McKinlay 31 and the South African Tax Court decision in Income Tax Case No. 308 32 (inter alia). In No. 308, the
court dealt with a situation very similar to that in Tip Top Tailors; the South African
taxpayer had financed a number of its operations by way of an overdraft account in
London, which the court found “impossible to dissect”33 in order to determine
whether the various amounts were on account of income or capital.
The Crown, not unexpectedly, rejected Tip Top’s arguments, positing that the
taxpayer’s chosen method of financing its uk purchases was “an inseparable part of
and merged in the business in which the company was engaged.”34 In the alternative, the Crown argued that Tip Top’s actions fell within the definition of “business”
in paragraph 127(1)(e) of the 1948 Income Tax Act.35
The Supreme Court Decision
The court dismissed the appeal in a decision that included three separate judgments.36 Rand j (with Fauteux j concurring) began by accepting the proposition that
the risk of a change in the value of capital investments is a risk on account of capital
and that, accordingly, the “capital machinery within and by means of which the
business . . . is carried on is distinct from that business itself.”37 He then referred to
McKinlay, inter alia,38 in distinguishing the facts in Tip Top Tailors from those in the
cases that stand for that proposition. Specifically, Rand j clarified the definition of a
“temporary investment” in the sense of McKinlay:
Surely it involves the putting at risk of an asset or interest of value by the investor from
which an increment of additional return of value is ordinarily hoped for. Here there
was simply an accumulation of debt as the transactions of the business proceeded.39
31 See supra note 24 for a summary of the McKinlay case. In particular, Tip Top relied on the
concept of “temporary investment” as articulated in McKinlay, supra note 24, at paragraph 19.
32 (1934), 8 SATC 99.
33 Ibid., at 100.
34 Tip Top Tailors, supra note 29 (SCC), at 709.
35 Income Tax Act, SC 1948, c. 52. Paragraph 127(1)(e) read as follows:
127(1) In this Act . . .
(e) “business” includes a profession, calling, trade, manufacture or
undertaking of any kind whatsoever and includes an adventure or concern in the
nature of trade but does not include an office or employment.
36 See Tip Top Tailors, supra note 29 (SCC), headnote. For the purposes of this review, our analysis
considers only the judgment written by Rand J.
37 Ibid., at 710.
38 In addition to McKinlay, supra note 24, Rand J considered Montreal Coke and Manufacturing
Company v. MNR, [1944] CTC 94 (PC); Bennett & White v. MNR, [1949] CTC 1 (SCC); and
Davies (HM Inspector of Taxes) v. Shell Company of China, Ltd. (1951), 32 TC 133 (CA): Tip Top
Tailors, supra note 29 (SCC), at 710-11.
39 Tip Top Tailors, supra note 29 (SCC), at 711.
international tax planning  n  789
In addition to finding that the facts in Tip Top Tailors did not bring the case
within the scope of the holding in McKinlay, Rand j noted that, in No. 308, the court
was unable to determine the nature of each item in the taxpayer’s overdraft account,
whereas in Tip Top Tailors it was perfectly clear that the debt in question was used
exclusively to cover payments made in the course of Tip Top’s trade. Rand j looked
instead to Imperial Tobacco for guidance, ultimately holding that in both that case
and Tip Top Tailors “the foreign currency was used in the purchase of a commodity
for the company’s trade, [and] in [Tip Top Tailors], the pound sterling representing
the debt had no existence apart from that use.”40
In 1974, almost 20 years after the Supreme Court’s decision in Tip Top Tailors,41
and 25 years after the decision in Atlantic Sugar, the Federal Court Trial Division
addressed a question that engaged the issues confronting the higher court in each
of those cases, in its now seminal decision in Salada Foods Ltd. v. The Queen.42
Sal ada Foods
The Facts
Salada Foods Ltd. (“Salada”) carried on a food manufacturing and distribution business both directly and through subsidiaries, including subsidiaries in the United
Kingdom. Fearing the consequences of a devaluation of the pound sterling, Salada
entered into a forward sale contract with the Canadian Imperial Bank of Commerce
(“cibc”) on August 29, 1967, which resulted in a gain in 1968 to Salada of
Cdn $185,312 arising from a significant drop in the value of the pound sterling.43
The minister included this amount in Salada’s taxable income for 1968, and it was
this inclusion that was the subject of the litigation.
The Arguments
Counsel for Salada contended that the 1968 currency forward contract
was entered into for the sole purpose of protecting its investments in the uk subsidiaries and if Salada realized a gain . . . [it] was on capital account and did not result from
40 Ibid., at 713-14.
41 In the interim, several other decisions had followed the ruling in Tip Top Tailors that the
treatment of a foreign exchange gain as income or capital is based on the characterization of
the underlying transaction; two important examples are Alberta Gas Trunk Line Co. Ltd. v.
MNR, [1972] SCR 498, at 505, and Columbia Records of Canada Ltd. v. MNR, [1971] CTC 839
(FCTD), at 845. The latter is notable for its holding, in the context of expenditures resulting in
foreign exchange losses, that borrowings of funds for the purpose of obtaining working capital
are distinct from income-earning activities and therefore are not transactions in the ordinary
course of the trading operations of a taxpayer.
42 74 DTC 6171 (FCTD).
43 Salada had previously incurred losses of Cdn $3,000 and Cdn $11,560 on similar contracts in 1966
and 1967, respectively, which were deducted in calculating Salada’s income. Ibid., at 6173.
790  n  canadian tax journal / revue fiscale canadienne
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either a transaction entered into by Salada in the course of or for the purpose of its
trading operations or an adventure in the nature of trade.44
In other words, despite its having made previous deductions on account of income,45 Salada’s position was that the court was required to look at the entirety of
the transaction in question, to see that the gain in this case was in respect of Salada’s
capital holdings in its uk subsidiaries.
Counsel for the Crown actually conceded that the transaction was not entered
into in the ordinary course of Salada’s business; however, the Crown contended that
the transaction was an adventure in the nature of trade.
The Federal Court Decision
Following a canvass of the case law relied upon by the Crown,46 the court noted that
the value of the forward sale contract did not reflect the value of Salada’s uk subsidiaries, and that the only way to determine the actual value of the subsidiaries was
to sell them or have them appraised, neither of which had occurred.
The court accordingly found that there was “little or no relationship between
the gain received by [Salada] on its forward sale contract and its actual investment
loss.”47 The court then turned to the question of whether the contract was an adventure in the nature of trade. It held that, because Salada “acted in exactly the same
fashion as a dealer or speculator in currencies would act,” the contract was an adventure in the nature of trade, and Salada’s intention in entering into the contract
was immaterial.48
Several years after the decision in Salada Foods, the Federal Court Trial Division
returned to the question of the appropriate treatment of a gain arising from a hedging transaction, in Echo Bay Mines Ltd. v. Canada.49 In its decision, the court clarified
the extent to which a gain would need to be linked to the underlying transaction
such that the characterization of that transaction would also apply to the gain.
44 Ibid., at 6173.
45 See supra note 43.
46 Mainly, MNR v. Taylor, 56 DTC 1125 (Ex. Ct.), in which the Exchequer Court dealt with the
meaning of the phrase “adventure or concern in the nature of trade,” and set out general
propositions as to when such an adventure or concern may exist. These are listed in the
decision in Salada Foods, supra note 42, at 6174.
47 Salada Foods, supra note 42, at 6175.
48 Ibid. The court’s discussion of intention related to similar discussions in Imperial Tobacco and
Atlantic Sugar. It should also be noted that the court stated that the transactions were
“acknowledged by the plaintiff to be wholly speculative”: Salada Foods, supra note 42, at 6175.
49 [1992] 2 CTC 182 (FCTD).
international tax planning  n  791
Echo Bay
The Facts
Between 1976 and 1982, Echo Bay Mines Ltd. (“Echo Bay”) operated a silver mine;
it sold the silver it produced at a price based on the market value of silver two
months from receipt. From 1978 through 1980, ostensibly to lock in a current price
and hedge its risk in the silver market, Echo Bay entered into forward sales contracts for silver under which no silver was actually delivered.50
In 1980, Echo Bay realized a gain of Cdn $29,359,967 on the settlement of these
forward sales contracts, which both Echo Bay and the Crown agreed was properly
included in Echo Bay’s income. The issue before the Federal Court Trial Division
was whether the amount could be considered to fall within the definition of “resource
profits” in regulation 1204(1)(b)(ii)(b) as it read in 1980. Without elaborating on the
concept of “resource profits” and its relevance in the case,51 for the purposes of this
analysis it should suffice to state that one of the definitions of “resource profits” at
the time included “income from the production of minerals in Canada.”52 In this
light, the broad question in Echo Bay, mirroring the central question in Atlantic
Sugar, was whether the forward sales contracts—or hedges—actually constituted
hedging activity (in that they were sufficiently connected to Echo Bay’s underlying
silver production business) or whether instead they were simply speculative.
The Arguments
Counsel for Echo Bay tendered two witnesses to speak to Echo Bay’s accounting
practices, and those of the industry in general;53 those witnesses provided support
for the following two general propositions:
50 Rather, the contracts were closed out when due or rolled into further forward sales contracts.
51 For a recent CRA position on hedging and “resource profits,” see CRA document no.
2000-0027485, September 15, 2000. For an in-depth discussion, see R.D. Brown, “The Fight
over Resource Profits” (1974) 22:4 Canadian Tax Journal 315-337; see also George R. Fraser,
“Recent Developments and Royalty Measures in the Mining Industry,” in Report of Proceedings
of the Twenty-Seventh Tax Conference, 1975 Conference Report (Toronto: Canadian Tax
Foundation, 1976), 419-37.
52 The phrase “resource profits” shares many similarities with the expression “profit arising from
the carrying on of a trade” as used in Imperial Tobacco, and for good reason. As the Federal
Court noted in its decision in Echo Bay, supra note 49, at 185, “[t]he importance of the
‘resource profits’ calculation was, and remains, its use as a base in calculating the deduction
available to taxpayers under paragraph 20(1)(v.1) . . . which permits a deduction in respect of
‘oil or gas wells in Canada or mineral resources in Canada.’ ”
53 This was itself a source of contention between the parties, since the Crown disputed the
evidentiary relevance of generally accepted accounting principles. The court admitted the
evidence, however, on the basis that accounting principles, while not conclusive, can be
instructive. See Echo Bay, supra note 49, at 186-89.
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1. that a “hedge transaction is considered to be an integral part of the sales
transaction”;54 and
2. that “the difference between hedging and speculating is that in the former
the company engaged in hedging sells forward or commits a product it has
the capability of producing and that it intends to produce.”55
In response, the Crown argued that, irrespective of whether the forward sales were
hedges, the contracts were insufficiently connected to Echo Bay’s production to
constitute a single business activity, precluding the application of the “resource
profits” rules. As the court noted in its decision, the Crown’s position (as the court
understood it) was that “income from any activity not directly involved with extraction of the metal or mineral to the prime metal stage is not to be included within
income from production.”56
The Federal Court Decision
The court ultimately concluded that the forward sales contracts did constitute
hedging activity, rejecting the Crown’s argument that such activity must, in all cases,
be directly involved with the taxpayer’s underlying business activity. Relying on the
Supreme Court’s decision in Atlantic Sugar, the court held that, in Echo Bay, “[e]xact
matching was not feasible from a practical point of view, nor is it required in order
to constitute hedging.”57 In addition, citing similarities between the case at bar and
Tip Top Tailors, the court held that the existence of a clear business purpose underlying Echo Bay’s hedging activity and the integration of that purpose with Echo
Bay’s production and sales were sufficient to determine that the gain arising from
Echo Bay’s hedging activity was not speculative.
The court’s decision in Echo Bay clarifies and updates Salada Foods by answering
a question that the earlier decision left unresolved: How closely integrated must a
taxpayer’s hedges be with the taxpayer’s underlying business activities for any gains
arising from those hedges to be characterized as gains on account of income? The
answer, according to the court in Echo Bay, is that a reasonably integrated and clear
business purpose should suffice.
Several years after this clarification,58 the Supreme Court of Canada had the opportunity to again consider the issues that arose in Salada Foods, when it heard the
54 Ibid., at 187.
55 Ibid.
56 Ibid., at 191.
57 Ibid., at 195.
58 In the interim, in Ethicon Sutures Ltd. v. The Queen, 85 DTC 5290 (FCTD), the Federal Court
had also considered the question of whether foreign exchange gains on term deposits were to
be characterized as gains on account of capital or on account of income. In that decision, the
international tax planning  n  793
appeal in Shell Canada Ltd. v. Canada.59 That case involved a taxpayer that had borrowed funds pursuant to debenture agreements with three foreign lenders, and had
also entered into a currency forward contract with a foreign bank.
Shell C anada 6 0
The Facts
Shell Canada Ltd. (“Shell”) entered into debenture purchase agreements (“the debentures”) with three foreign lenders, pursuant to which it borrowed approximately
nz $150 million at an interest rate of 15.4 percent.61 Shortly thereafter, Shell entered into a forward exchange contract (“the forward contract”) with Sumitomo
Bank Ltd. in respect of us $100 million, purchased for the amount of the debentures. The forward contract allowed Shell to exchange an amount of us dollars for
nz dollars on each day that interest under the debentures was due, as well as upon
maturity of the debentures.
The Supreme Court highlighted what may have been the most important facts
in the case as follows:
Because of the declining value of the nz $ at the time, the forward value (in us $) of the
nz $150 million Shell was required to repay the foreign lenders in 1993 was expected
to be less than the current (or “spot”) value (in us $) of the same nz $150 million when
Shell borrowed it in 1988. Shell accordingly expected to realize a foreign exchange
gain when it closed out the Forward Exchange Contract and repaid the principal to
the foreign lenders using the devalued nz $.62
In respect of Shell’s 1993 taxation year, during which the company was able to realize
its expected gains, Shell reported a capital gain of approximately us $21.5 million.
The minister included that amount in Shell’s income for tax purposes, refusing to
treat it as a capital gain.
court cited McKinlay, Atlantic Sugar, Tip Top Tailors, and Salada Foods in holding that foreign
exchange gains realized by a Canadian subsidiary of a US corporation on term deposits in
which the subsidiary accumulated money intended to pay mandatory dividends to its parent
and to purchase inventory were on account of income. The court held, ibid., at 5294, that “[t]o
be considered capital in nature, the funds must be surplus [and] must be exclusively for
dividend or capital expenditures.”
59 [1999] 3 SCR 622; rev’g. 98 DTC 6177 (FCA); aff ’g. 97 DTC 395 (TCC).
60 See Clearwater, supra note 7, for an economics-based discussion of the judiciary’s ability to
determine the types of questions before the Supreme Court in Shell Canada.
61 The terms of the debentures required Shell to pay NZ $11.55 million twice each year until
1993 and to return the principal on May 10, 1993.
62 Shell Canada, supra note 59 (SCC), at paragraph 4.
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The Arguments
Apart from arguments presented by both sides as to whether the gain arose from
two separate transactions or one 63 (a question that the court held to be immaterial
to the determination of whether the gain should be treated as income or capital),64
the parties disagreed as to whether Shell entered into the debentures and the forward contract in order to acquire funds for capital purposes or whether instead the
transactions amounted to an adventure in the nature of trade. The Crown specifically posited that Shell “was acting like a trader” in borrowing nz dollars through the
debentures and exchanging them for us dollars through the forward contract.65
The Supreme Court Decision
First, the court cited Tip Top Tailors, Alberta Gas,66 and Columbia Records 67 in noting
that “[t]he characterization of a foreign exchange gain or loss generally follows the
characterization of the underlying transaction.”68 Second, the court concluded—on
the basis of the holding in Columbia Records that borrowings of funds for the purpose
of obtaining working capital are not transactions in the ordinary course of the trading operations of a taxpayer—that any gain arising from the sale of the debentures
was on account of capital.
The court then commented on the relevance of whether Shell’s gain arose fortuitously—or, in the sense of Imperial Tobacco, Atlantic Sugar, and Tip Top Tailors,
whether the gain arose from a temporary investment or speculation—to the determination of the treatment of such gain, holding that
the proper tax treatment of a foreign exchange gain on both the initial borrowing and
any related hedge transaction is to be assessed in light of the characterization of the
underlying debt obligation. Transactions giving rise to debt obligations obviously do
not have to be speculative to be capital in nature.69
63 Counsel for Shell argued that the US $21.5 million actually arose from two separate gains: first,
a gain of US $19.5 million that arose on the debentures, which required only US $81.5 million
to repay; and second, a gain of approximately US $2 million on the forward contract, which Shell
was able to settle for only US $79.5 million based on a discounted rate previously contracted
for. The Crown disagreed, contending that the amount of the gain arose solely from the sale of
the debentures.
64 The court also held that “absent a specific provision of the Act to the contrary or a finding that
they are a sham, the taxpayer’s legal relationships must be respected in tax cases”: Shell Canada,
supra note 59 (SCC), at paragraph 39. See Tennant, supra note 6, at 41:6-7, for more on this
point and for a discussion of Rezek v. Canada, 2005 FCA 227; rev’g. in part 2003 TCC 93, in
which the Federal Court of Appeal, in addition to providing an excellent summary description of
the relevant strategies involved in hedging, followed the decision in Shell Canada in this respect.
65 Shell Canada, supra note 59 (SCC), at paragraph 71.
66 Supra note 41.
67 Ibid.
68 Shell Canada, supra note 59 (SCC), at paragraph 68.
69 Ibid., at paragraph 76.
international tax planning  n  795
The Supreme Court’s decision in Shell illustrates the fairly straight path taken by
the jurisprudence, in that it highlights the courts’ consistency 70 on three specific
themes:
1. Perhaps most important, the treatment of a foreign exchange gain as income
or capital is based on the characterization of the underlying transaction.
2. The intention of the taxpayer in entering into a forward contract—or, more
generally, a hedge—is informative in the determination of the correct treatment of gains arising from that hedge.
3. Exact matching is not required in order to determine that there is a relationship between the gain on a putative hedge and the investment loss ostensibly
being hedged.
Recent Judicial Decisions
Recent judicial decisions have further considered the appropriate treatment of gains
from hedging arrangements, but none has strayed materially from the above three
themes. For example, in Imperial Oil Ltd. v. Canada,71 the taxpayer argued (as many
taxpayers before it had also argued) that a particular foreign exchange gain was realized on a “temporary investment” in foreign currency. Citing Imperial Tobacco, Tip
70 In Canadian Pacific Limited v. The Queen, 99 DTC 5132, the Federal Court of Appeal relied on
the Supreme Court’s decision in Shell Canada in rejecting the CRA’s reassessment of a taxpayer
involved in a similar plan. Canadian Pacific additionally involved a reassessment under the
general anti-avoidance rule in section 245. The history of the case is somewhat convoluted:
98 DTC 2021 (TCC) (July 3, 1998): allowed the taxpayer’s appeal from the minister’s
reassessment;
n 99 DTC 5132 (FCA) (February 9, 1999): affirmed the Tax Court of Canada decision;
n [1999] SCCA no. 97 (SCC) (November 10, 1999): referred the Federal Court of Appeal
decision back to that court for reconsideration in light of the Supreme Court’s decision
in Shell Canada;
n 2000 DTC 6174 (FCA) (February 17, 2000): reconsidered in light of Shell Canada and
remitted to the Tax Court of Canada in respect of section 245;
n 2000 DTC 2428 (TCC) (October 13, 2000): allowed the taxpayer’s appeal in respect of
section 245;
n 2002 DTC 6742 (FCA) (December 21, 2001): affirmed the Tax Court of Canada
decision; and
n [2002] 2 CTC 150 (FCA) (March 12, 2002): refused to reconsider.
n
In response to this series of decisions, the Department of Finance introduced the weakcurrency debt rules in section 20.3, which, notably, do not recharacterize any gain realized on
an arrangement such as that employed in Shell Canada and Canadian Pacific, but instead simply
reduce the interest deduction available to the taxpayer. See Tim Edgar, “Some Lessons from
the Saga of Weak-Currency Borrowings” (2000) 48:1 Canadian Tax Journal 1-34.
71 [2006] 2 SCR 447. For further discussion of this decision, and the court’s decisions in related
cases heard concurrently, see Hugh G. Chasmar, “Foreign Exchange Gains and Losses: Recent
Developments,” in Report of Proceedings of the Fifty-Eighth Tax Conference, 2006 Conference
Report (Toronto: Canadian Tax Foundation, 2007), 12:1-23.
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(2015) 63:3
Top Tailors, Alberta Gas, and Eli Lilly,72 the Supreme Court of Canada held that these
four cases
stand for the proposition that foreign exchange gains and losses incurred in relation to
foreign trade cannot be separated from the underlying transaction such that the foreign
exchange gain or loss would be on capital account while the underlying transaction
would be on income account.73
Similarly, in its decision in Placer Dome Canada Ltd. v. Ontario (Minister of Finance),74
the Supreme Court dealt with the question that was before the Federal Court Trial
Division in Echo Bay, upholding the decision of the trial court (which had relied in
part on Echo Bay and Atlantic Sugar) that “some link is required between an operator’s hedging transactions and output.”75
Further to these decisions, in 2008, the Federal Court of Appeal dealt with the
question of whether costs could be netted against profits by way of hedge accounting
rules in order to treat foreign exchange gains arising on a borrowing incurred to
finance a capital project as gains on account of income. In Saskferco Products ulc v.
Canada,76 the Tax Court of Canada and the Federal Court of Appeal were asked to
apply one of two distinct principles to a situation in which the taxpayer, being unable to enter into currency forward contracts at a commercially viable cost, chose to
issue us dollar denominated debt as what the Federal Court of Appeal called a “natural hedge,”77 matched by us dollar denominated revenues. The taxpayer wanted
the courts to apply the “hedging principle,”78 that the character of a gain or loss
arising from a hedge is based on the character of the item being hedged. The
Crown, in contrast, argued for the “debt principle,”79 that the correct characterization of foreign exchange losses realized on the repayment of debt is based on the
character of the underlying debt. Citing the Supreme Court’s decision in Shell Canada, the Federal Court of Appeal rejected the taxpayer’s argument, holding that “[t]he
fact that the loan was denominated in us Dollars for financing and foreign exchange
reasons does not alter its essential character as borrowed money to finance a capital
project.”80 In other words, echoing the decision in Salada Foods, the court in Saskferco
72 See supra note 29 for a summary of the Supreme Court’s decision in the Eli Lilly case.
73 Imperial Oil, supra note 71, at paragraph 45.
74 2006 SCC 20; rev’g. (2004), 190 OAC 157 (CA); aff ’g. (2002), 61 OR (3d) 628 (SC).
75 Placer Dome, ibid. (ONSC), at paragraph 16.
76 2008 FCA 297; aff ’g. 2007 TCC 462. For a more detailed discussion of Saskferco, see White,
supra note 9, at 39:13-14; and Kurt G. Wintermute, “Review of Current Cases,” in 2009
Prairie Provinces Tax Conference (Toronto: Canadian Tax Foundation, 2009), 1:1-24, at 1:20-21.
77 Saskferco, supra note 76 (FCA), at paragraph 11.
78 Ibid., at paragraph 7.
79 Ibid., at paragraphs 2 and 27-28.
80 Ibid., at paragraph 30.
international tax planning  n  797
determined that the taxpayer’s overall economic reality was not relevant for the purposes of determining its tax liability; indeed, the only relevant transaction in this
case was the loan used to finance a capital project, losses arising from which were on
account of capital.
The logical and analytical path taken by the foregoing jurisprudence is clear and
relatively unwavering; however, the administrative positions taken by the cra in
respect of the questions raised in these cases appear, at best, to overstate various
findings of fact and law and, in certain instances, even to misstate such findings.
The CRA’s Administr ative Positions
The cra first set out its administrative position on the treatment of gains on hedging transactions at the 36th annual conference of the Canadian Tax Foundation in
1984, stating that the character of a gain arising from a hedge flows from the character of the item being hedged.81 Some 30 years later, in a document issued in 2013,
the cra confirmed that “[b]ased on jurisprudence, the relevant tax principle to
consider in evaluating hedging situations is ‘linkage.’ ”82 More specifically, citing
Salada Foods, Echo Bay, and Placer Dome, the cra stated that courts “have confirmed
that whether an activity constitutes hedging depends on sufficient inter-connection
or integration with the underlying transaction.”83
To put it even more clearly, the cra has stated elsewhere that
[w]here there was sufficient linkage between the financial instrument that is used as a
hedge and the particular asset or liability underlying a transaction, the character of the
financial instrument (hedging item) would follow the character of the hedged asset or
liability (hedged item).84
This does not seem to contradict the principles derived from the jurisprudence, nor
does the CRA’s decades-old position that “[t]he intention of a taxpayer in acquiring
foreign currency is a major factor used by the Courts to determine if that currency
was held by the taxpayer on account of income or capital.”85
However, in the same letter in which the cra set out the clear statement about
the linkage principle, reproduced above, it made the following claim:
Based on jurisprudence, it is cra’s position that in order for a forward contract to be a
hedge for income tax purposes, the forward contract needs to be linked to a transaction (e.g., sale, repayment of debt), not an asset or liability. . . . The forward contract
81 “Revenue Canada Round Table,” in Report of Proceedings of the Thirty-Sixth Tax Conference,
1984 Conference Report (Toronto: Canadian Tax Foundation, 1985), 783-847, question 63, at
828-29.
82 CRA document no. 2013-0481691E5, June 26, 2013.
83 Ibid.
84 CRA document no. 2009-0352061I7, March 12, 2010.
85 CRA document no. 9427166, September 18, 1995.
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(2015) 63:3
intended as a hedge would be considered separately from the underlying transaction
that is being hedged, although its nature is characterized by the underlying transaction. Thus, it needs to be established that the forward contracts were used as hedges
for purposes of an underlying transaction. It would also seem that we need an underlying transaction.86
In support of this position, the cra cited the decisions in Salada Foods, Echo Bay,
Shell Canada, and Placer Dome. However, it is important to note that these four decisions simply happened to deal with hedging activity correlative to transactional
activity; at no point did the court in any decision state that such a transaction was a
necessary component of the analysis.
In a comprehensive discussion of these issues, before the decision in George
Weston,87 Laura White reviewed four cra administrative documents that had been
released in 2010 and that relied heavily on the decisions in Salada Foods, Shell Canada, and Saskferco.88 She concluded that
the focus of the cra’s analysis and comments was on the existence or expectation of an
underlying transaction rather than on the type and degree of interconnection or integration necessary to establish the requisite link between the forward contracts and their
subject matter.89
It appears that, in the intervening years, the cra has not reviewed its position on
these questions, such that it continues to rely on the above-noted jurisprudence to
take the position—in addition to its significantly more supportable position that the
character of any gain arising from a hedge flows from the character of the item being
hedged—that an underlying transaction is an essential component of the analysis,
without which hedging activity could not be linked to an underlying hedged item.
It may be that George Weston was the first case in many years in which the cra
decided to stand firm on its position on these issues in instructing Crown counsel;
or it may simply be that George Weston is the first case on these issues in many years
to have reached litigation. In any event, the court, in its decision in George Weston,
made it clear that the cra will need to undertake a long-overdue reconsideration of
its stated administrative position.
86 CRA document no. 2009-0352061I7, March 12, 2010.
87 White, supra note 9, at 39:3-5.
88 CRA document nos. 2009-0352061I7, March 12, 2010; 2009-0345921I7, April 15, 2010;
2009-0348961I7, April 15, 2010; and 2010-0355871I7, April 21, 2010. We also reviewed these
documents (among others) for the purposes of this article (see supra note 8).
89 White, supra note 9, at 39:4 (emphasis in original).
international tax planning  n  799
Findings and Holding in George Weston
As noted above, the court in George Weston characterized gwl’s gain as a gain on
account of capital. Resting heavily on the analysis in the cra’s administrative positions noted above, the Crown argued, first, that
[a]bsent a linkage to a capital transaction or a debt obligation denominated in a foreign
currency that exposed the appellant to foreign currency risk, the foreign exchange gain
is considered to be part of business income90
and, second, that
[i]t is not sufficient to hedge the net investment in foreign subsidiaries . . . without
having an intention to sell that investment, as there is no offsetting position against
which any of the gains or losses arising from the contract could be matched.91
Lamarre j indicated in her reasons what appears to have been fairly significant
disagreement with and disapproval of the Crown’s arguments. First, she reviewed
the jurisprudence relied on by the Crown,92 noting in each case why that decision
does not support the Crown’s “restrictive approach to the linkage principle”:93
[T]his view has no legal basis and is a wrong interpretation of the case law. In Salada
Foods, there was no evidence linking the proceeds from the derivative to the capital
investment in the subsidiaries, and the derivative was clearly speculative. In Shell, it
was determined that hedge proceeds will be on capital account if the item being
hedged is a capital item. The Court did not lay down a rule that would support the
respondent’s restrictive approach. In Atlantic Sugar and Tip Top Tailors, the derivatives
were used to hedge what were clearly income transactions. With regard to Placer Dome
and Echo Bay, neither of these cases involved a capital versus income characterization.
In Ethicon, a secondary intention was established and a portion of the funds was clearly
used for income transactions.94
Second, Lamarre j addressed the Crown’s alternative argument, that the hedges
amounted to an adventure in the nature of trade, in the sense of Salada Foods or Shell
Canada. She found that gwl’s intention with respect to its hedging activity remained constant throughout the relevant time frame, and that
90 George Weston, supra note 1, at paragraph 76.
91 Ibid.
92 The Crown in George Weston, relied on Atlantic Sugar, supra note 25; Tip Top Tailors, supra
note 29; Salada Foods, supra note 42; Ethicon Sutures, supra note 58; Shell Canada, supra note 59;
Saskferco, supra note 76; Echo Bay, supra note 49; and Placer Dome, supra note 74.
93 George Weston, supra note 1, at paragraph 85.
94 Ibid., at paragraph 97.
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gwl did not transform into a speculator in the derivatives market, thereby violating
its internal policies and credit agreements, simply because the swaps were “in the
money” when terminated.95
In essence, the decision in George Weston is a repudiation of the cra’s administrative position on the existence of an underlying transaction requirement. While
much of the above-noted administrative guidance appears to be congruent with the
jurisprudence, it now seems clear that the cra’s position with respect to the existence
of a transaction is not correct and does not reflect the significant judicial authority.
Concluding Comments
How Does George Weston Compare
with the Jurisprudence?
Although the decision in George Weston appears to differ in material respects from
the cra’s administrative guidance, it nevertheless follows the principles set out in
the above-noted jurisprudence. Specifically, the decision
1. properly applies the linkage principles articulated in Atlantic Sugar, Tip Top
Tailors, and later decisions;
2. highlights the importance of the taxpayer’s intention with respect to its hedging activity; and
3. practically applies the notion, as stated in Echo Bay, that exact matching of
a hedge to a transaction (or of the amount of the hedge to the amount of a
transaction) is not required to find a linkage.
Despite being distinguished, on the facts, from almost every decision set out
above, George Weston is a perfect capstone for this analysis for the very reason that
it is, to borrow a phrase from Lord Greene, “precisely on all fours” with the logical
and analytical path carved out by the jurisprudence that came before it.96
The Impact of George Weston
Although few commentators have yet to weigh in on the decision in George Weston,
it appears that the majority are waiting with great anticipation to see what impact
the decision will have on the cra’s administrative stance on this point. We also believe that reconsideration by the cra is not a question of “whether” but “when”:
although this was a lower court decision, the absence of an appeal and the clarity
of Lamarre j’s remarks would make it very difficult for the cra to maintain its
position.
95 Ibid., at paragraph 105.
96 See Lord Greene’s comments in Imperial Tobacco, supra note 23 and the related text.
international tax planning  n  801
It strikes us that it would be perfectly reasonable for the cra to return to its
earlier administrative position that appeared to be in line with the jurisprudence;
perhaps in an upcoming income tax folio the cra could clarify its position in light
of the decision in George Weston. In any case, it appears clear that the cra cannot
continue to take the position that derivative transactions are on income account
where taxpayers have an intention of hedging an asset or liability on capital account
but fail to meet the purported underlying transaction requirement, or where the
extent and timing of the derivative hedge are partial.
An interesting question remains as to how far the new principle extends, and
whether the cra or the courts will struggle with forms and uses of derivatives for
hedging that are more dynamic, temporary, or innovative. For example, recent
scholarship from the United States suggests that us courts may have difficulty in
determining the appropriate tax treatment of “delta-neutral” hedging arrangements, through which a neutral hedging position is accomplished by way of daily,
or even hourly, adjustments to a portfolio designed to hold assets with equal and
opposite sensitivity to risk.97 Though this is typically a speculative type of holding,
as evidenced by the frequent and regular rebalancing, the decision in George Weston
may stand for the proposition that a taxpayer hedging risk in a capital asset by way
of a delta-neutral arrangement may be able to claim capital treatment for any gain
arising from that arrangement, despite the lack of a transaction and of a direct temporal connection between the arrangement and the asset. This is but one example
of the potential for innovation in the context of derivative instruments, but it speaks
volumes to the reality that the design and use of such instruments are limited only
by the taxpayer’s imagination.
97 For a discussion of recent US judicial treatment of derivatives, and specifically of delta-based
derivatives, see Thomas J. Brennan, “Law and Finance: The Case of Constructive Sales”
(2013) 5 Annual Review of Financial Economics 259-76, reviewed in the Current Tax Reading
feature (2013) 61:4 Canadian Tax Journal 1244-45.