Income Tax Implications of the Non-Dispositive Transfer of Equity Securities
Timothy R. Hughes
ABSTRACT
Whether securities are given income or capital treatment under the Income Tax Act (the Act), a taxpayer who holds securities that have risen dramatically in value can be exposed to a significant tax burden if a sale, or other disposition, at fair market value takes place. This article evaluates a number of strategies that can reduce tax exposure in situations where a taxpayer's economic requirements could result in a s. 54 disposition or s. 12(1)(b) sale of equity securities. Such strategies, which effect what the article terms a 'non-dispositive transfer' of equity securities, allow for the reduction or postponement of tax while retaining the desired economic result for the non-dispositive transferor.
This article draws conclusions through a review of first principles and the administrative positions of Revenue Canada because there is a relative dearth of specific legislation and jurisprudence dealing with the non-dispositive transfer of equity securities. The first section of the article discusses the tax meaning of "disposition" as defined by s. 54 of the Act and an "amount receivable by the taxpayer in respect of property sold" as described in s. 12(1)(b). Section II raises issues involving the potential recharacterization of a non-dispositive transfer of equity securities through the application of s. 245(2), or through an economic substance analysis. Recent pronouncements made by the Supreme Court of Canada regarding the dominance of the legal form of a transaction over its economic substance are of benefit to a non-dispositive transferor, but it remains unclear how this issue will be approached under s. 245(2). Section III examines the "securities lending arrangement" rules in the Act that deal specifically with certain transactions involving the non-dispositive transfer of securities, including short sales and repurchase arrangements.
A non-dispositive transfer of equity securities that has gained notoriety in the United States is the so-called short sale against the box, which is described in section IV of the article and evaluated from a Canadian income tax perspective. It is concluded that this strategy can be of some use to a Canadian taxpayer, although there are fewer tax benefits than were previously available to US taxpayers. Even if such a transaction falls outside the Act's provisions for securities lending arrangements, the timing rules applicable to short sales can likely be used to effect such a non-dispositive transfer. Whether the rules governing the disposition of identical properties apply to a short sale against the box remains unclear. It is evident, however, that a Canadian taxpayer will not be able to eliminate exposure to tax altogether if the short position remains open at the time of the taxpayer's death.
The fifth section of the article analyzes income tax implications of the non-dispositive transfer of equity securities effected through the use of equity derivatives, including exchangeable debentures, DECS Trust units, and total return swaps. With regard to equity exchangeable debentures, Revenue Canada's aversion to the bifurcation of such instruments suggests that the issuer will not be taxed on a deemed gain arising from the disposition of a call option on the underlying securities under s. 49. The roll-over applicable to ordinary convertible debt under s. 51(1) and the withholding tax exception under s. 212(1)(b)(vii)(E) will, however, be lost to an investor in exchangeable debentures. In addition, it must be kept in mind that ss. 80 and 20(1)(f) operate together to form what the article defines as a 'tax collar' on exchangeable debentures.
The DECS Trust structure uses exchangeable trust units to achieve a non-dispositive transfer of equity securities. As such, the income tax aspects of this type of instrument are somewhat different than those present in the issuance of equity exchangeable debentures. For example, because debt is not issued, the tax collar applicable to exchangeable debentures has no application. The cost of maintaining a trust over a potentially significant period of time may reduce the attractiveness of the structure. It is concluded that the term of a DECS Trust should be kept to the minimum period of time in which the owner of the underlying shares is likely to be able to satisfy exchange requirements in cash, so that a disposition of the underlying equity securities can be avoided.
A total return equity swap may be used by the total return payer as a method of non-dispositive transfer to hedge the risk inherent in a portfolio of equity securities. The equivalent economic result to the total return receiver is that of a fully leveraged purchase of equity securities. It is argued that Revenue Canada's position with regard to interest rate swaps is equally applicable to equity swaps. However, this administrative position should be contrasted with the rules pertaining to interest deductibility under s. 20(1)(c), especially in light of the Bronfman Trust case and the test for interest deductibility found in the Federal Court of Appeal decision in Sherway. Care should be taken to structure total return swaps to comply with the legislation or to ensure that adequate compensation is made to the total return receiver in the event that Revenue Canada has a change of heart.
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Citation: (1999) 57(1) U.T. Fac. L. Rev. 43.
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