The first article in this two-part series discussed taxation of investment gains in general. Part 2 will examine some of the common issues of taxation of derivative gains and losses.

1. Tax treatment of trading gains and losses from derivatives

There are no rules in the Income Tax Act determining if trading gains and losses from derivatives should be taxed as business income or as capital gains. In fact, this isn’t an unusual state of affairs; there are simply no clear rules for all types of gains and losses, derivatives or otherwise. Ultimately, it’s the facts of each situation that determine the appropriate tax treatment.

Due to the lack of rules around gains and losses, the courts have developed a framework to determine the appropriate treatment. This framework uses the concepts of primary and secondary intentions, which are inferred based on factors—such as the frequency of transactions, the nature of transactions, the knowledge of the taxpayer, the length of period of ownership, and the relationship to the taxpayer’s business—to determine the appropriate tax treatment. For example, if an exporter frequently uses foreign currency futures to hedge its currency exposure, then the trading gains and losses will most likely be taxed as business income and losses. Similarly, the trading gains and losses of an individual day trader will most likely be taxed as business income and losses, especially if the trader is knowledgeable and experienced in trading derivatives.

Another issue associated with trading-related gains and losses is the disguise of periodic income as trading gains. If the trading gains and losses are being taxed on capital account, then it becomes attractive for a taxpayer to try to structure periodic payments as trading gains. Why? Because periodic payments are fully taxable while capital gains are only 50 percent taxable. The nature of derivatives can allow the flexibility for such manoeuvres.

2. An ineffective post-tax hedge

The tax treatment of derivatives can cause a perfectly hedged position to be ineffective post-tax. There are several possible scenarios that can cause this to happen. Here are two.

Scenario 1: If the hedged instrument is tax-exempt while the hedging derivative is fully taxable, then the design of the hedge must take the impact of different tax treatments into consideration so the hedge is effective post-tax.

Scenario 2: If the hedged instrument is taxed on capital account because of the tax treatment elected by the taxpayer while the hedging derivative is fully taxable.

Note, in some situations, it’s possible for a taxpayer to elect to have all gains and losses from Canadian securities to be taxed as capital gains and losses. This will provide the taxpayer with certainty regarding the tax treatment of trading gains and losses from all Canadian security trading.

3. Accounting and tax deviation

The International Financial Reporting Standards (IFRS) generally requires all derivatives to be marked to market, even derivatives in a hedging relationship. Therefore, gains and losses are realized in the income statement or other comprehensive income periodically with or without actual dispositions. However, losses can’t be tax-deductible unless there have been actual dispositions. There have been court cases on this topic where taxpayers deducted losses mandated by the IFRS but which are generally not allowed by tax law. So far, the general rule that only losses resulting from actual dispositions can be deducted has been upheld, except in the case of inventory. The Canada Revenue Agency has allowed taxpayer deductions when the derivatives were considered inventory of a taxpayer because taxpayers can choose to report inventory at cost or market value for income tax purposes.