derivative taxation

1212 (1998), Vol. 46, No. 6 / no 6

The Judicial Role in Derivative Taxation:The Queen v. Shell Canada Limited andFinancial Contract Economics

Tom Clearwater*

PRCISLa dcision rcente de la Cour dappel fdrale dans laffaire The Queenv. Shell Canada Limited soulve la question de savoir si un tribunal est enmesure de rgler la question de limposition des instruments drivs.Laffaire Shell Canada porte sur limposition conteste dune couvertureen monnaie faible, qui constitue un instrument driv. Le tribunal saisi dulitige a eu recours aux moyens prvus en vertu de la common law, soitune notion dtaille du terme intrt , pour rgler les problmes posspar linstrument driv en cause. Cet article aborde la question de savoirsi la Cour a correctement rgl le litige qui lui a t soumis et, dans cebut, il prsente une explication dtaille des thories et des pratiques quipeuvent permettre de comprendre limposition des instruments drivsen gnral.

Il est difficile dtablir le traitement fiscal des instruments drivs, cardans certains contextes pratiques, certains lments du rgime fiscalactuel ne peuvent pas leur tre appliqus. Il est plus facile de comprendreces difficults la lumire des thories conomiques sous-tendantlobjectif des instruments drivs. Ces thories, dont trois sont examinesdans cet article, soulignent les quivalents conomiques entre certainescombinaisons dinstruments drivs et dautres instruments utiliss dansdes contextes prcis. Llment quivalent permet aux instrumentsdrivs de reproduire les incidences financires dinstruments comportantdes conditions juridiques diffrentes et entrane donc des problmes auchapitre du report du revenu et de la nature des instruments drivs.

Aprs avoir dcrit la nature et la source de ces problmes, lauteurexamine des solutions proposes limposition gnrale des instrumentsdrivs, ainsi que des solutions lgislatives et dautres solutions traitantspcifiquement des oprations de couverture en monnaie faible. Ladcision rendue dans laffaire Shell Canada est ensuite examine endtail. Lauteur conclut que la Cour dappel fdrale a outrepass son rleen rendant pareille dcision dans laffaire Shell Canada et quil vaut mieuxsen remettre au Parlement pour rgler la question complexe de

* Of McCarthy Ttrault, Vancouver.

THE JUDICIAL ROLE IN DERIVATIVE TAXATION 1213

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limposition des instruments drivs (y compris la couverture en monnaiefaible). Cependant, la Cour a rendu un service prcieux en rendant sadcision, car elle a permis que la rflexion sur limposition desinstruments drivs progresse suffisamment pour que la vritable portedes questions souleves soit enfin comprise.

ABSTRACTThe recent decision of the Federal Court of Appeal in The Queen v. ShellCanada Limited raises the question whether a court is properly equippedto address derivative taxation. Shell Canada involves the questionedtaxation of a weak currency hedge, a derivative instrument. The court inthe case used common law meansan elaborated notion of interesttoaddress problems generated by the derivative in question. This articleaddresses whether the court properly resolved the matter before it and,to this end, provides a broad theoretical and policy context forunderstanding derivative taxation generally.

Derivatives have proven difficult to tax because they render elementsof the present tax system unworkable in certain practical contexts. Thesedifficulties are best understood in light of economic theories underlyingderivative design. These theories, three of which are reviewed in thearticle, underscore economic equivalents between certain combinationsof derivative and other instruments employed in specified contexts. Thisequivalence element allows derivatives to replicate financial effects ofinstruments bearing different legal characters and thus gives rise toincome deferral and characterization problems.

After describing the nature and source of these problems, the authorreviews proposed solutions addressing derivative taxation generally, andlegislative and other proposed solutions addressing weak currency hedgetransactions in particular. Following this review, the Shell Canadadecision is discussed in detail. The author concludes that the FederalCourt of Appeal overstepped its role in deciding Shell Canada as it didand that the complicated matter of derivative (including weak currencyhedge) taxation is better left to Parliament. The court, however,performed a valuable service by deciding the case as it did throughraising the discussion of derivative taxation to a level at which issues findtheir proper bearing.

INTRODUCTIONThe recent Federal Court of Appeal decision in The Queen v. Shell CanadaLimited 1 has created quite a stir. At last count, nine commentaries on the

1 98 DTC 6177 (FCA), per Linden JA, Stone JA concurring; revg. Shell Canada Limitedv. The Queen, 97 DTC 395 (TCC). Shell Canada Ltd. (Shell) was granted leave to appealthe decision to the Supreme Court of Canada, [1998] SCCA no. 179, October 8, 1998. TheFederal Court of Appeal decision is herein referred to as Shell Canada.

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case have appeared.2 None particularly approves the Federal Courts rea-sons or outcome, and most decry the decisionespecially Linden JAsreasonsas a source for heightened future uncertainty. One commentarysuggests that the decision will cause wide-spread damage to businessesand financial markets alike.3

These predictions tend to the apocalyptic and divert attention from thedifficult problem the court in Shell Canada faced. This problem ulti-mately concerns the judicial role in the complicated, unresolved matter ofderivative taxation. Derivatives have proven particularly difficult to taxunder the present tax system because they render certain of its underlyingtenets unworkable in practice. Derivatives are designed by reference toeconomic models to create innovative financial flows. These financialflows, according to J. Scott Wilkie, are, and often are designed to be,beyond the prescriptive limits of a countrys tax system.4 The trans-action featured in Shell Canada, a weak currency hedge,5 illustrates thisprecisely. The hedge was designed by reference to the economic theory ofinterest- and exchange-rate parity and produced questionable tax effectswhen traditional taxing provisions of the Income Tax Act6 were applied toit. The court in Shell Canada addressed this problem headlong. Viewedfrom this perspective, Linden JAs decision in the case reveals itself asperhaps the first judicial forayat least in Canadainto resolving deriva-tive taxation by reference to the economic theory underlying the generationof the tax consequence in question. The case accordingly raises questionsbeyond the proper rules of statutory interpretation and is better under-stood as a judicial attempt to address, directly through common law means,the most difficult of the tax problems derivatives occasion.

2 John R. Owen, Shell Canada Limited: A New Test of Economic Substance overForm (September 1998), 30 The Canadian Business Law Journal 449-62; John R. Owenand Karen Sharlow, Legal Analysis of Tax Motivated Transactions (March-June 1998),77 Canadian Bar Review 265-75; Brian Arnold, Canadian Federal Court of Appeal StrikesDown Kiwi Loans (April 13, 1998), 16 Tax Notes International 1115-19; William Innes,A Critique of the Decision of the Federal Court of Appeal in The Queen v. Shell CanadaLimited (1998), vol. 6, no. 1 Tax Litigation 350-58; Richard B. Thomas, Shellshocked,Current Cases feature (1998), vol. 46, no. 2 Canadian Tax Journal 357-65; Douglas J.P.Forer, Recent Tax Cases and Legislative Proposals, in 1998 Prairie Provinces Tax Con-ference (Toronto: Canadian Tax Foundation, 1998), tab 15; Joseph Frankovic, SupremeCourt To Rule on Weak Currency Loans, Tax Topics, no. 1390 (North York, Ont.: CCHCanadian, October 29, 1998), 1-3; Wayne Tunney and Lori Dunn, Kiwi Doesnt Fly(May 19, 1998), 6 Canadian Tax Highlights 33; and Blake Murray and Yi-Wen Hsu, R. v.Shell : Horse v. Apple Cart (April 1998), 8 Canadian Current Tax 67-71.

3 Innes, supra footnote 2, at 358.4 J. Scott Wilkie, Looking Forward into the Past: Financial Innovation and the Basic

Limits of Income Taxation (1995), vol. 43, no. 5 Canadian Tax Journal 1144-66, at 1146.5 A weak currency hedge involves a loan taken in a weak currency coupled with a

hedge into a strong currency.6 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.


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This article elaborates a context for analyzing the Federal Court ofAppeals decision from this larger perspective. It builds on recent analy-ses of derivative taxation taken primarily from the US tax literature,drawing from these the various points required for establishing the broadtheoretical and regulatory context that the article intends.7 The discussionthat follows is divided into five main sections. The first section illustratesderivative design and function in light of three economic theories thatunderscore economic equivalences between particular financial instrumentsin specified contexts. The second section suggests that this equivalenceelement gives rise to two taxation difficulties: it opens avenues to incomedeferral through interactions it generates with the realization principle,and it troubles the consistent characterization of financial transactions. Thethird section reviews certain proposed general solutions for dealing withthese problems. The fourth section focuses the discussion of solutions byreviewing proposed and enacted legislative mechanisms for taxing weakcurrency hedges. Against this background, the fifth section presents adetailed analysis of the Shell Canada case, and particularly Linden JAs reasons.

DERIVATIVE ECONOMICSA derivative is a financial contract between two parties the subject matterof whichusually a form of payment transferderives its value by refer-ence to something external to it.8 That external thing can be the perform-ance of a stock or interest-rate index, the exchange rate of a comparablecurrency, or the price of a designated commodity. Derivative instrumentsare formed, as their name might imply, by combining traditional financialproductsbonds and shares, for examplewith an external value refer-ence or by writing notional principal products that operate entirely byreference to that external marker.9

As a value-derived instrument, a derivative replicates economic incidentsof owning a given type of property without creating a legal connection tothat property. Because derivatives peg contractual obligations to propertyvalue fluctuations through abstract means, they are inexpensive to imple-ment, are portable, and may be transposed, either singly or in combination,

7 The article relies primarily on Alvin C. Warren Jr., Financial Contract Innovationand Income Tax Policy (December 1993), 107 Harvard Law Review 460-92; and RobertH. Scarborough, Different Rules for Different Players and Products: The Patchwork Taxa-tion of Derivatives (December 1994), 72 Taxes: The Tax Magazine 1031-49. A helpfulCanadian paper examining certain issues addressed in this article is Tim Edgar, The TaxTreatment of Interest and Financing Charges in a World of Financial Innovation: WhereShould We Be Going? in Current Issues in Corporate Finance, 1997 Corporate Manage-ment Tax Conference (Toronto: Canadian Tax Foundation, 1998), 10:1-57. Other relevantarticles in the Canadian literature, some of which are referred to in this article, are listedin Edgars paper.

8 Any derivative is but a variation of this basic structure. Viewed in more practicalterms, a derivative is a cash flow contract that allocates risk. Notional principal contractscan be viewed solely as risk allocation contracts.

9 Warren, supra footnote 7, at 460.


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to a variety of financial circumstances to produce made-to-design finan-cial effects. They can be similarly employed to produce made-to-designtax effects, and here lies their rub: specifically, derivatives can be used torender certain otherwise non-elective elements of the tax systemincludingrealization timing and, in some cases, characterizationelective in effect.Viewed from this angle, derivatives represent a considerable challenge topresent methods of measuring and taxing income.

The particular problems posed by derivatives are nicely illustrated byviewing derivatives through the lens of economic theories informing theirdesign. These theoriesmathematical models of derivative behaviourunderscore functional economic equivalences between traditional-derivativeand derivative-derivative combinations for specified contexts. Spotlight-ing this equivalence element helpfully illuminates the discussion ofderivative taxation by situating the relevant issues in proper relief. Threetheories are described briefly below. The first two, the put-call paritytheory and the Black-Scholes differential equation, suggest the means bywhich ownership of property bearing a fixed return can be simulated by con-tracts referring to property bearing a contingent return. The third theory,the interest-rate parity theory, suggests the means by which offsettingfixed and deferred positions can be generated from what is economicallya single composed debt instrument.

Put-Call Parity TheoryIn its most basic terms, put-call parity theory is a mathematical equationspecifying circumstances in which two unlike financial instruments willbehave as economically equivalent investments. A simple form of thisequation can be illustrated by two investment positions, each combining atraditional financial instrument (here, a debt and an equity instrumentrespectively) with an option. The equation states that an investment com-prising a share (S) and a put option on that share (P) is economicallyequivalent to an investment comprising a zero coupon bond (B) and a callon the share (C ). Expressed formulaically:

S + P = B + C.As an economic model, this equation predicts real-world behaviour

only under certain specified assumptions. The minimum assumptions10required for present purposes are that

1) markets for all instruments S, P, B, and C are adequately competitive;and2) the exercise price and exercise date of the options are the same as theredemption price and redemption date of the bond.

10 These are the necessary assumptions to make the theory work. Other assumptionscan be introduced to account for real-world factors like credit risk and transaction andoption costs without changing the essential operation of the equation illustrated in the text.For purposes of simplicity, the present discussion is confined to the basic theory.


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On these assumptions, the equation above states a reasonably reliableeconomic equivalence. This equivalence is easily demonstrated:

Assume that a zero-coupon bond carries a face value of $100 redeemable atfuture date X. Also assume that the put and call options are exercisable ona share at that date for the same face amount (per assumption 2 above). Ifthe price of the share is $125 at date X, the shareholder will forgo the putoption, valued, accordingly, at $0, in favour of realizing the greater valueof the share. The value of S + P at the exercise date is therefore $125. Tothe same effect, the bond holder will exercise the call at date X for theprice of the bond and receive the share. The value of B + C at the exercisedate is therefore also $125.11Jogging the above equation slightly reveals the means by which a

share can be synthesized with a non-share instrument. Subtracting a putfrom both sides of the original equation renders that equation

S = B + C P.As simple mathematics suggests, adding a factor of one to each side

of a balanced equation does not alter the equations balance. The eco-nomic equivalence of the reordered equation remains and again is easilydemonstrated:

If the share is worth $125 on the option exercise date X, the bond holderwill exercise either the call or the negative put for the price of the bond toacquire the share. The investments represented by each side of the equationat date X are therefore each worth $125.Although the investments described by the original and reordered equa-

tions are economically equivalent, they are not tax equivalent becausedifferent rules specifying different income and loss timing apply to thevarious components of which these investments are constituted. The taxdiscontinuities arising on this timing mismatch are discussed below underthe heading Derivative Taxation.

Black-Scholes Differential EquationA second economic theory, an option pricing model propounded by FischerBlack and Myron Scholes in 1973,12 reveals a second set of circumstances

11 Where market competition is sufficiently robust, this equivalence will obtain at alltimes before the exercise date. As stated by Warren, supra footnote 7, at 466, If the stockplus a put must equal the [bond] plus a call on the exercise date, the two positions mustalso be equal in value before that date if there are competitive markets for each contract.Otherwise, arbitragers would sell the more expensive position to obtain a riskless windfallto the extent of the difference in value. Further to this, although put-call parity is illus-trated in the text by traditional instruments (share, bond, and options), the theory appliesto any assets for which markets are sufficiently competitive.

12 Fischer Black and Myron Scholes, The Pricing of Options and Corporate Liabilities(May-June 1973), 81 Journal of Political Economy 637-54. See also Charles T. Terry,Option Pricing Theory and the Economic Incentive Analysis of Nonrecourse AcquisitionLiabilities (Fall 1995), 12 The American Journal of Tax Policy 273-397, at 327 andfollowing, for an accessible explanation of the Black-Scholes option pricing theory.


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in which different investment positions will behave as economic equiva-lents. The theory, the Black-Scholes differential equation, posits anequivalence between purchasing a share with borrowed money and pur-chasing a call option on that share. In a simplified example, assume thatthe current trading price of a share is X and that this price is expected tobe either X + Z or X Y in one year. The value of a call on this share willbe Z if the share value increases to the upper posited value over the yearand will be nil if the share value decreases. Where the volatility of theshare price is reasonably known for a given term, an investor can pur-chase a fraction of that share with borrowed money and receive the samereturn (whether the value of the share increases or decreases) as if a callwere purchased on a whole share.13

The Black-Scholes model works only if the upper and lower possibleshare values can be reasonably determined.14 Moreover, for any givenshare fraction, only one appreciated and one depreciated value will pro-duce an economic equivalence between the two forms of investment.15The Black-Scholes theory, as Warren thus explains, is therefore a modelof dynamic hedging, for in actual practice, share quotients and loanquantums must be revised periodically to correct for changed market expec-tations. Within these constraints, the model works and has beensuccessfully employed in financial markets.

As in the case of the put-call parity theory, although the investmentsthat the Black-Scholes differential equation describes are economicallyequivalent, they are not tax equivalent because different rules specifyingdifferent income and loss timing apply to the individual components con-stituting these investments.

Interest-Rate Parity TheoryA third economic theory, the interest-rate parity theory, suggests an eco-nomic equivalence between interest-rate differences of comparable foreigncurrencies and relative differences in the values of those currencies

13 Warren, supra footnote 7, at 468-69, provides the following example. Assume that ashare sells for a current price of $120, that call and put options are available for anexercise price of $120 one year hence, and that the share price in one year will be either$100 or $200. If an investor purchases a call option on the share and the share increases invalue over the year, the value of the call at the exercise date will equal the amount bywhich the share price appreciated over the year and will be worth $80 accordingly; if thevalue of the share decreases over the year, the call option will be worthless. The sameeconomic result is obtained by borrowing $73 at 10 percent interest and purchasing 810 ofa share for $96. If the share rises in value over the year to $200, the value of the fractionalshare, $160, will be $80 net of repaying the borrowed money. If the share falls in value to$100, the value of the fractional share, $80, will just cover the repayment obligation.

14 Economists have developed several stochastic models to predict stock price trends.See John C. Hull, Options, Futures, and Other Derivatives, 3d ed. (Englewood Cliffs, NJ:Prentice-Hall, 1997), 209 and following.

15 Ibid., at 236.


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expressed in spot and future exchange rates.16 The theory states that theinterest-rate difference between two international currencies reflects mar-ket expectations of the relative worth of those currencies. This interest-ratedifferential, as an expression of expected relative worth, generates a for-ward currency-exchange pricing curve reflecting relative differences inthe purchasing powers of those currencies posited over a specified term.The higher relative interest rate on a weaker currency accordingly reflectsthe additional compensation required to compensate a weak currency lenderfor a greater decline in lender purchasing power over time owing to higherinherent inflation on the weaker currency.

In a UK study of the taxation of foreign exchange gains and lossesconducted by John Kay and John King, the authors observed that

differences in interest rates reflect market expectations of currency appre-ciation or depreciation. Of course, such market expectations will almostalways turn out, with hindsight, to be wrong. But we should not expectthem to be persistently and systematically wrong. If the market expects thedollar to fall, and it continues to rise, then sooner or later either the dollarwill fall or the market will change its mind. If this is true, then althoughforeign exchange markets display enormous short-run volatility, in the longrun there should be a broad equivalence between relative currency move-ments and interest rate differentials. The existence of such a relationshipwould have considerable significance for the taxation of currency gainsand losses.17

The interest-rate parity theory is aptly illustrated by a weak currencyhedge, the subject transaction of Shell Canada. On a weak currency hedge,a borrower initially borrows in a weak currency at a (necessarily) higherrate of interest than if the loan were denominated in the stronger refer-ence currency. The borrower then converts the weak currency principalinto that stronger currency and repays its weak currency obligations, boththe ongoing interest obligations and the final closeout of principal, byreconverting appropriate strong currency amounts into the weak currencyat designated times.18 The final closeout conversion triggers a gain because

16 See generally David G. Broadhurst, Income Tax Treatment of Foreign ExchangeForward Contracts, Swaps, and Other Hedging Transactions, in Report of Proceedings ofthe Forty-First Tax Conference, 1989 Conference Report (Toronto: Canadian Tax Founda-tion, 1990), 26:1-32; and Stephen S. Ruby, Recent Financing Techniques, ibid., 27:1-46.

17 John Kay and John King, Taxing Currency Fluctuations? The Tax Treatment of For-eign Exchange Gains and Losses (London: Institute for Fiscal Studies, 1985), 17-18. Notethat the evidence led at trial in Shell Canada Limited v. The Queen, supra footnote 1(TCC), was that actual and predicted spot rates for the transaction in question deviated nogreater than 5.01 percent. Average deviation was much less, a remarkable result.

18 This function is usually performed on a forward exchange contract, as it was in ShellCanada. Such a contract is not entirely necessary and merely provides a measure ofcertainty to the borrower by allocating the risk of a misguided guess concerning futuremarket movements to the lender-contractor. The hedge, in any event, operates of its owneconomic accord on market-determined changes in the relative values of the currencies inquestion.


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the weak currency will have declined in value over the life of the loan.This gain is anticipated from the outset and represents the economic equiva-lent of the total extra interest paid on the higher interest rate of theweaker currency. This economic equivalence between the total of theextra interest amounts and the closeout gain is the basis for the interest-rate parity theory.

Once again, although a simple strong currency loan and a weak cur-rency hedge loan are economic equivalents, they are not tax equivalentsbecause different rules specifying different timings for income inclusionand loss recognition apply to the various components of the simple strongcurrency and weak currency hedge varieties of the loan.

DERIVATIVE TAXATIONThe three theories described aboveput-call parity, the Black-Scholesdifferential equation, and interest-rate paritydisclose economic equiva-lences between investment positions comprising instruments bearingdifferent legal characters. The equivalences revealed on the first twotheories suggest the means by which financial instruments of one legalcharacter can be synthesized using instruments of another. The equiva-lence revealed on the third suggests the means by which offsetting positionscan be generated from a debt transaction keyed to market interest andexchange-rate expectations. The tax problems arising from these equiva-lences are explained below.

Income DeferralThe principal problem associated with financial equivalences is electiveincome deferral. An investor implementing certain combinations of deriva-tives can defer income via interactions that these combinations generatewith the realization principle underlying the timing of income and lossrecognition for contingent elements in these combinations.19 Incomedeferral reduces the effective rate of tax for that transaction, skews thetax burden, and contributes to an inefficient allocation of resources.20

The realization principle represents perhaps the chief compromise ofour income tax system, and the possibility for income deferral to which itgives rise represents one of the chief taxation concerns.21 An ideal incometax charges tax on net changes in economic worth22 on an accrual basis

19 The income deferral problem generated by derivatives is the primary focus ofScarboroughs very helpful article, supra footnote 7.

20 See Deborah H. Schenk, Taxation of Equity Derivatives: A Partial Integration Pro-posal (Summer 1995), 50 Tax Law Review 571-641, at 577.

21 See Christopher H. Hanna, The Virtual Reality of Eliminating Tax Deferral (Fall1995), 12 The American Journal of Tax Policy 449-512.

22 This is a standard version of the economists definition of income. Such definition,as accepted by the Carter commission, took the name economic power, which the com-mission measured as the sum of three components. The third of these suggests that the

(The footnote is continued on the next page.)


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measured over a specified period of time. For political, administrative,and liquidity reasons, our present tax system eschews accrual measure-ment as a general rule, favouring income measurement under the guise ofa judicially defined notion of realization.23 The realization principle oftaxation, broadly accepted in the Canadian jurisprudence, is described byBrian Arnold:

The requirement that income be realized is well established as a fundamen-tal principle of income taxation in the jurisprudence of the United Kingdom,the United States, and Canada. Potential, anticipated, or expected profitsare not subject to tax until they have been realized. In the English case ofOstime v. Duple Motor Bodies Ltd., Lord Reid stated that . . . [it] is acardinal principle that profit shall not be taxed until realized; if the marketvalue fell before the article was sold the profit might never be realized.Similarly, in the Canadian case of MNR v. Consolidated Glass Co. Ltd.,Rand, J. said,

. . . [H]ow can profits and gains be considered to have been made in anyproper sense of the words other than by actual realization? This is noinventory feature in relation to capital assets. That the words do notinclude mere appreciation in capital value is, in my opinion, beyondcontroversy.24

Under realization taxation, accrued but unrealized gains and losses areconsidered contingent. Being contingent, they are considered not properlytaxable and accordingly represent a form of allowed income deferral.Such income deferral, we can presume, is the intended consequence forcircumstances for which realization timing is considered appropriate.

Derivatives can be designed to skirt distinctions on which realizationtiming operates and can render realization, and the income deferral thatthis principle implies, elective in effect. Derivatives allow a taxpayer tosynthesize ownership of property bearing a fixed (currently taxable) returnby instruments pegged to assets bearing a contingent (future taxable)return,25 or vice versa, and can be employed in combinations to gener-ate income and loss timing discontinuities,26 absent corresponding net

change over the year in the market value of the total net assets held by the tax unit(current saving = change in net worth = change in wealth) must be included in the incomecalculation. This aspect of the definition suggests that economic income is defined as anychange in net worth. See Canada, Report of the Royal Commission on Taxation, vol. 3(Ottawa: Queens Printer, 1966), 23.

23 Statutory accrual and realization timings are prescribed for particular circumstancesand properties.

24 B.J. Arnold, Timing and Income Taxation: The Principles of Income Measurement forTax Purposes, Canadian Tax Paper no. 71 (Toronto: Canadian Tax Foundation, 1983), 127-28.

25 The distinction between fixed and contingent returns is taken from Warren, suprafootnote 7.

26 Mark P. Gergen, Apocalypse Not? (Summer 1995), 50 Tax Law Review 833-59, at848-49, describes the notion of tax discontinuity as follows: The concept of continuity

22 Continued . . .



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economic changes. These discontinuities can be marshalled to advantageto devise tax effects to meet perceived tax needs.27

To illustrate one possibility, recall the discussion of put-call parityabove. Put-call parity posits a formula by which a share can be synthe-sized using a zero-coupon bond and appropriate options. Although theformula describes economically equivalent investments, these investmentsdo not receive the same tax treatment. Sharesand perhaps put and calloptionsare subject to realization taxation, but the bond is taxable cur-rently on an accrual basis.28 Moreover, by specifying the means by whichbonds can be synthesized with shares and vice versa, put-call parity opensan avenue by which income and loss timing differences for the variouscomponents of an overall zero-sum economic transaction can be leveragedto generate a tax advantage. This result will obtain where an investoroffsets one derivative position with its synthesized negative. Warren illus-trates this possibility:

Recall that put-call parity indicates that we could theoretically construct asynthetic share of stock by purchasing a zero coupon bond and a call, whilewriting a put:

S = Zk + Ck PkBy now it should be obvious that we could create a negative synthetic

share of stock by negating the right-hand side of this relationship. That is,by promising to pay a fixed amount in the future without stated interest,writing a call, and buying a put, we would always have a cash flow thatnegated the results of owning the stock:

S = Zk Ck + PkAn investor who purchased a share of stock at the same time she created

the synthetic negative share on the right-hand side of this equality would

can be grasped by picturing financial contracts as located within a space based on theirfundamental economic characteristics. For the moment, put aside the question of whatthose characteristics might be, or, to put the point in spatial terms, what dimensions definethe space of financial contracts. Also, put aside the question of why one should care aboutcontinuity. Tax law is acceptably continuous when one can move through space, passingfrom one position (a position may consist of one or more contracts) to another positionwith slightly different characteristics without any abrupt changes in the tax they bear. Forexample, the current law on debt instruments may be acceptably continuous because whilethe tax varies depending on whether an instrument pays variable or contingent interest,these differences tend to be negligible for debt instruments that lie in the gray areasbetween these cubbyholes. Conversely, there is a grave discontinuity in the treatment ofdebt and equity because a small change in the economic characteristics of an instrumentcan have a large tax impact. Linden JAs statement in Shell Canada, supra footnote 1, at6188, that I need not be constrained by contract theory merely expresses his dissatisfac-tion that two like economic positionswhat Linden JA calls, ibid., the practical realitiesof the situationcan create tax discontinuity.

27 Scarborough, supra footnote 7.28 A zero-coupon bond is taxable as a discounted debt obligation to which regulation

7000 of the Income Tax Regulations applies. Regulation 7000 requires that a zero-couponbond holder include in income deemed interest amounts calculated on an accrual basis.

26 Continued . . .


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have no non-tax consequences, because her positions would always be off-setting. Her tax return would, however, show interest deductions from theborrowing that would not be offset by gains until the disposition of thestock and options.29

The upshot here, says Warren, is that put-call parity reveals the meansby which a taxpayer can defer taxation of unrelated investment income.30The same general observation holds for the other two theories describedabove.31

Uncertain CharacterizationDerivatives also render uncertain (and perhaps entirely confound) theproper characterization of financial transactions. The importance of con-sistent characterization for properly administering an income tax, and theparticular trouble generated by derivative instruments, is explained byWilkie. He says:

The [present tax] system depends on the ability to identify the nature of assetsand obligations according to norms grounded in the most basic of taxationprinciples. Outside these limits, the system can become disoriented. Indeed,the tools of tax analysis grounded in typical financial assets and liabilitieslose much of their force when confronted with arrangements seeminglyformulated outside traditional legal and financial bounds. Financial theory,however, is capable of devising limitless combinations of debt- and equity-like characteristics to produce instruments that are neither the one thingnor the other. To similar effect, the form of debt or equity may simply be adevice for reflecting a matrix of implicit transactions that may not be evidentand do not have separate lives for the taxpayer concerned. . . . Anythingthat undermines the reliability of the systems classification of financial incomeputs at risk the coherent and consistent application of the systems rules.32

Where taxation is made to depend on characterization, characterizationuncertainty will generate tax reduction opportunities. Such opportunities,for instance, can arise with respect to the classification of income andcapital properties, the classification of certain tax-excluded properties,and classifications relating to cost base and withholding tax calculations.Generally speaking, if the worst case result of losing a characterization

29 Warren, supra footnote 7, at 471-72.30 Ibid., at 472-73.31 Edgar, supra footnote 7, at 10:10-12, puts the matter as follows: Although oversim-

plified, it is probably correct to say that all cash flows, whatever their form, must bevalued for capital market purposes, and differences in attributes affect the valuation exer-cise only. Arbitrage pricing identifies functionally equivalent cash flows and ensures thatthey are valued or priced equivalently. However, under the recognized tax cubbyholes,slight changes in the form of financial instruments can produce significant differences intax treatment that contrast with financial theory and its recognition of certain basicequivalences. The differences in tax treatment permit the replication of cash flows associ-ated with conventional securities in unconventional forms that attract tax consequences,even though the financial positions are functionally equivalent.

32 Supra footnote 4, at 1152-53.


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bet requires that a taxpayer pay tax otherwise owing, the greater theuncertainty that can be generated, the more the revenue authorities standto lose.

The different taxation of income and capital receipts is perhaps themost fertile ground on which characterization-based tax advantages mightbe sought. Fixed returns, to use Warrens language, are normally classi-fied as income receipts, and contingent returns as capital receipts. Wherea taxpayer offsets a fixed-return with a contingent-return derivative, orsimulates a fixed-return investment with a hedged contingent-returnderivative, the resulting tax position will prove beneficialagain, absentany correlating economic changewhere typical fixed/contingent charac-terizations apply.

Wilkie, referring to a garden-variety equity derivativea swapillus-trates how intractable the characterization problem might be.33 Where aninvestor enters a swap to simulate purchasing an asset with borrowedmoney, the question arises how the swap should be characterized for taxpurposes. Wilkie highlights the uncertainty attending the characterization:

Does a swap have any intrinsic legal significance, or is it merely descrip-tive of the fact that parties have obligated themselves contractually to makepayments to each other that are unspecific in traditional legal terms? Arethe payments revenue itemsthat is, on income, rather than capital, ac-count? Do the amounts accrue, or should they be accounted for on a receivedor receivable basis allowing for the possibility of deferral? If the taxpay-ers counterparty is a non-resident, does withholding tax apply to the amountpaid that approximates funding interest? What is the cost of the contract,and are payments in respect of (as distinguished from payments arisingfrom) the contractual right, in conventional terms, on capital or revenueaccount? For tax rules concerned with asset characterization, such as theforeign property rules, what is the nature of this contract? An unspecificintangible? Contingent indebtedness? A marketable security? What is itscost? These determinations are fundamental to a constructive application ofthe existing law.34

Absent an objective or predetermined classification scheme, deriva-tives create possibly unmanageable characterization problems, for theyare hybrid entities lying somewhere on a continuum only the poles ofwhich can be defined as recognizable traditional instruments.

A recent case of the Supreme Court of Canada, Canadian DepositInsurance Corp. v. Canadian Commercial Bank (CDIC),35 illustrates thispoint clearly. The respondent bank received certain funds from the CanadaDeposit Insurance Corporation and other parties under a participationagreement intended to preserve the banks solvency. The funds were in-vested with an agreed return combining elements of equity and debt. The

33 Ibid., at 1154.34 Ibid., at 1154-55.35 (1992), 97 DLR (4th) 385 (SCC).


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bank failed to perform its obligations and became insolvent. As an inci-dent of the bankruptcy proceedings that followed, the investmentinstrument was required to be characterized as either debt or equity. Thecharacterization matter was litigated and eventually found its way to theSupreme Court of Canada. There, Iacobucci J treated the issue as a matterof contract interpretation and looked first to the intentions of the partiesmanifest in the agreement and surrounding circumstances. He stated:

As in any case involving contractual interpretation, the characterizationissue facing this court must be decided by determining the intentions of theparties to the support agreements. This task, perplexing as it sometimesproves to be, depends primarily on the meaning of the words chosen by theparties to reflect their intention. When the words alone are insufficient toreach a conclusion as to the true nature of the agreement, or when outsidesupport for a particular characterization is required, a consideration of ad-missible surrounding circumstances may be appropriate.36

With respect, party intention is a thin thread on which to hang theproper characterization of a derivative instrument. Intentions vary asbetween investor and investee, and may be multiple for either. As DavidHariton states:

With the proliferation of derivative transactions in the 1990s, . . . distin-guishing between equity and debt has become especially difficult. Inexchange for capital, corporations can offer investors any set of rights thatcan be described by words, subject to any conceivable set of qualifications,and in consideration of any conceivable set of offsetting obligations. Indoing so, corporations do not have a specific objective to attract share-holders, creditors or something in between. Nor do they have an intentionthat can be identified as such, such as to permit investors to embark uponthe corporate venture or to permit investors to avoid taking risk. A corpora-tions objectives in raising capital (apart from obtaining it at the lowestpossible price) vary, and may include obtaining a favorable rating agencytreatment, meeting a specified regulatory objective, getting a certainaccounting treatment, matching anticipated payments with anticipated cashflows, hedging a perceived exposure to price or interest rate risk, reducingexposure to the operation of certain high-risk businesses, hedging againstperceived cyclicality in business operations, responding to a wide varietyof U.S. tax rules, lowering foreign taxes, meeting foreign regulatory require-ments, manipulating control of the company, altering the perceptions ofmarket analysts and providing incentives to employees and management.Investors objectives vary as well, for investors are equally likely to haveregulatory objectives or constraints, tax and accounting considerations andviews as to the direction of the market.37

Returning to CDIC, the instrument in question in that case clearly wasneither pure debt nor pure equity, yet the characterization task requiredthat the court produce an either/or answer. There lay the problem. Iacobucci J

36 Ibid., at 405.37 David P. Hariton, Distinguishing Between Equity and Debt in the New Financial

Environment (Spring 1994), 49 Tax Law Review 499-524, at 500-1.


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recognized the hybrid nature of the instrument, then proceeded to searchfor the essence or substance of the instruments charactermuch, perhaps,as Linden JA did in Shell Canada. Iacobucci J stated:

I see nothing wrong in recognizing the arrangement for what it is, namely,one of a hybrid nature, combining elements of both debt and equity butwhich, in substance, reflects a debtor-creditor relationship. Financial andcapital markets have been most creative in the variety of investments andsecurities that have been fashioned to meet the needs and interests of thosewho participate in those markets. It is not because an agreement has certainequity features that a court must either ignore these features as if they didnot exist or characterize the transaction on the whole as an investment.There is an alternative. It is permissible, and often required, or desirable,for debt and equity to coexist in a given financial transaction without alteringthe substance of the agreement. Furthermore, it does not follow that eachand every aspect of such an agreement must be given the exact same weightwhen addressing a characterization issue. Again, it is not because there areequity features that it is necessarily an investment in capital. This is par-ticularly true when, as here, the equity features are nothing more thansupplementary to and not definitive to the essence of the transaction. Whena court is searching for the substance of a particular transaction, it shouldnot too easily be distracted by aspects which are, in reality, only incidentalor secondary in nature to the main thrust of the agreement.38

Characterization of derivatives, if one follows the above directive, resolvesinto a matter of weighing the individual (bifurcated)39 elements of aninvestment or transaction, and deciding which predominate. Apart fromnot solving the difficult timing problem, say, of according different weightsto an option before and after its exercise,40 the suggestion that one needonly ferret out determinative factors begs the original question: whatcriterion determines which elements are themselves determinative? Fur-thermore, why the equity features of the instrument in question werenothing more than supplementary to and not definitive of the essence ofthe transaction the court did not state. A reasonable guess as to thereason for the courts reticence on this point is that the determination,ultimately, was arbitrary by necessity.

Bankruptcy law might not find its way into the tax jurisprudence, butthe above case illustrates the difficulties attending the characterization ofderivatives using pigeon-hole classifications developed for traditional instru-ments. One might reasonably conclude from the case that traditionalclassification methods are simply inadequate to the task.

38 Supra footnote 35, at 406.39 The notion of bifurcation is discussed below.40 This issue split the Ontario Court of Appeal in a similar case, Central Capital Corp.

(Re) (1996), 27 OR (3d) 494 (CA). The question in this case was whether certain prefer-ence shares bearing a right of retraction were debt or equity instruments. Characterizationturned on the proper weight to be accorded this right, and on this weight the judgescould not agree.


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PROPOSED SOLUTIONSSeveral solutions have been proposed for the tax difficulties that deriva-tives occasion. These proposals are based on different practical andtheoretical assumptions, and none achieves an ideal result. The more im-portant are reviewed below.

Mark-to-Market ValuationIf derivatives facilitate income deferral by rendering realization elective,the simplest solution is to prescribe mandatory realization through mark-to-market valuation. Says Edward Kleinbard:

In the abstract, a mark-to-market system is a panacea for many of the illsdescribed above: it solves, at least theoretically, all timing discontinuities(by converting all unrealized gains and losses to realized amounts); ifcombined with a favorable statutory resolution of the capital/ordinary forliability hedges . . . a mark-to-market system also poses no characterwhipsaw problems.41

Posing the possibility of wholesale marking to market, however, begsthe question why realization taxation was adopted in the first place. Reali-zation timing addresses certain purely political and other liquidity andadministrative concerns and represents a compromise from the theoreticalideal. Certain of these compromises, however, represent the best achiev-able under real world conditions and will therefore form part of theadministration of any income tax, however conceived. Wholesale mark-ing to market is therefore excluded from the outset.42 As Warren states,unless we are to abandon the very realization basis of the income tax,which would create unworkable complications in important contexts, this[mark to market] response is necessarily limited in scope.43 Althoughwholesale mark-to-market valuation is not a viable general solution, themethod is favoured by the US Internal Revenue Code as a piecemealsolution for particular derivative transactions44 and has been used to limitedeffect in the Canadian Act.45

Formulaic TaxationFormulaic taxation mimics mark-to-market valuation by taxing the reali-zation of investment contingencies via prescribed formulas applied ex

41 Edward D. Kleinbard, Beyond Good and Evil Debt (and Debt Hedges): A Cost ofCapital Allowance System (December 1989), 67 Taxes: The Tax Magazine 943-61, at 956.

42 Mark-to-market valuation generates several problems, the most difficult of whichconcerns the basis on which investment positions might be valuated. See Kleinbard, ibid.,at 955 and following. See also Warren, supra footnote 7, at 474.

43 Warren, supra footnote 7, at 474.44 See Scarborough, supra footnote 7, at 1035 and following. The US legislative approach

to derivatives is discussed further under the heading Current and Proposed Taxation ofWeak Currency Hedges.

45 See, for example, the rules for mark-to-market properties in section 142.5.


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ante or ex post. These formulas are supplemented by prescribed adjust-mentsthe operation of which is triggered by traditional realizationeventsto adjust for accurate measure. Formulaic methods can be classi-fied under three general headings:

1) Prospective taxation. Under this method, financial products are taxedprospectively on the gain they are expected to produce. Because invest-ment gains cannot be accurately predicted for investments bearing otherthan a riskless rate of return, this proposal requires that the prospectivelyapplied tax be adjusted retrospectively upon the happening of a specifiedrealization event to adjust for otherwise inaccurate measurement outcomes.This latter requirement generates additional administrative burdens.46

2) Retrospective taxation. This method is the mirror image of the firstone. Under it, tax is levied on the happening of a normal realizationevent, although the tax charge is augmented to compensate the revenueauthorities for the income deferral accompanying the use of realizationincome and loss recognition. The method introduces inaccuracy to theextent that retrospective allocations inaccurately track actual accrued gains,as they necessarily will.47

3) A variation combining elements of either of the above.48Formulaic taxation is a halfway house between mark-to-market valua-

tion and realization taxation, and also represents a compromise from thetheoretical ideal. Where the line of compromise might be drawn for anyinstance of application depends on administrative, liquidity, and politicalfactors bearing on the particular circumstance or transaction in question.

Loss MatchingA third solution prescribes a form of loss matching for a small range oftransactions.49 This proposal remedies income deferral arising from trans-actions that create offsetting gain and loss positions subject to different

46 The primary proponent of prospective taxation is Reed Shuldiner, A General Approachto the Taxation of Financial Instruments (December 1992), 71 Texas Law Review 243-350,at 266 and following. Shuldiner names the approach expected value taxation. See alsoScarborough, supra footnote 7, at 1046 and following; and Warren, supra footnote 7, at 478and following.

47 Warren, supra footnote 7, at 477 and following. See also Mark P. Gergen, TheEffects of Price Volatility and Strategic Trading Under Realization, Expected Return andRetrospective Taxation (Winter 1994), 49 Tax Law Review 209-68, for an economic com-parison of prospective and retrospective methods of taxation.

48 One variant imputes a generalized standard rate of return and levies the tax chargeon a current or deferred basis. The method implies that investment losses will be posi-tively taxed, an inverse of allowing deductions for appreciating assets under Canadascurrent capital cost allowance system.

49 Scarborough, supra footnote 7; Schenk, supra footnote 20; David A. Weisbach, TaxResponses to Financial Contract Innovation (Summer 1995), 50 Tax Law Review 491-544;and Jeff Strnad, Commentary: Taxing New Financial Products in a Second-Best World:Bifurcation and Integration (Summer 1995), 50 Tax Law Review 545-69. Loss matchingalso goes by the name integration.


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income and loss timing. Such transactionsnormally of the hedgingvarietyare taxed as an integrated whole, the so-called integration simplymatching the timing of loss and gain recognition, thereby preventingincome deferral. Loss matching through integration infuses certain USlegislative provisions and features in certain Canadian and US cases inthe tax jurisprudence.50

Absent a wholesale regime specifying the taxation of all componentsof a composed transaction for each party concerned, integration will gen-erate tax asymmetry as a practical incident of its application. Circum-stances, of their own accord, rarely allow all parties to a so-calledintegrated transaction to be taxed symmetrically. Shell Canada illustratesthis precisely: if Shell is taxed, on the Federal Court of Appeals direc-tive, on an integrated basis, the parties with whom Shell transacted neces-sarily cannot be similarly taxed. The mere fact that Shell transacted withmore than one party on the other side of the composed transaction issufficient to lead to this conclusion.

Loss matching (integration) also generates administrative difficulties.Warren states:

Although consideration should be given to expanding integration of trans-actions when feasible, the potential generality of this approach is limitedby the burden it places on the Internal Revenue Service to identify offset-ting positions. In the examples above, exact equivalences were used forillustrative purposes, but actual transactions are more likely to involveequivalences that are not quite exact. A requirement that non-exact equiva-lences be integrated for tax purposes would create new and arbitrarydistinctions that would be extremely difficult to enforce. The arbitrarinessof such a requirement would derive in part from the widespread acceptanceof the standard recommendation of modern financial theory that investmentportfolios be diversified. Accordingly, the vast majority of investors can beexpected to hold positions that are intended to be offsetting under differenteconomic conditions.51

Integration poses a further problem: it cannot anchor the characteriza-tion of transactions or instruments to an objective reference. Many eco-nomic equivalents exist for a given transaction, and choosing a taxreference for characterization purposes is necessarily arbitrary to somedegree. On the choice between economic equivalents, [t]he law, saysWilkie, does not direct a conclusion.52 Moreover, contextwith its over-riding importance for tax characterization and its inherent variabilityspells further difficulty in this regard. And where a notion of taxpayer or

50 Minnesota Tea Co. v. Helvering, 302 US 609 (1938); and Shell Canada, supra foot-note 1. In Canada, see also Schultz et al. v. The Queen, 95 DTC 5657 (FCA). The latterillustrates a form of back-door integration, relying, as it did, on partnership law to achievean integrated tax result.

51 Warren, supra footnote 7, at 475-76.52 Supra footnote 4, at 1161.


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transaction purpose enters the characterization analysis, any characteriza-tion chosen will likely reflect the business perceptions of only one party,53as necessarily occurred, again, in Shell Canada.

BifurcationAn approach often viewed as an opposite to integration bears the unwieldyname bifurcation.54 This approach disaggregates a composed instrumentinto component parts, each of which is then taxed according to rulesapplicable to traditional financial instruments. The overall taxation of thecomposite whole is simply the summed taxation of its component parts.55

This approach does not solve the problem of income deferral, andalthough it qualifies as a characterization method, it does little to solvecharacterization uncertainties beyond placing them in better perspective.Like the integration method, the bifurcation of financial transactions can-not be pegged to an objective reference and therefore cannot consistentlyand reliably suggest the components into which a given financial contractshould be decomposed. Because any composed contractand any indi-vidual derivative component of a composed contractcan be said torepresent a variety of instruments combined just so, bifurcation will pro-duce arbitrary results absent a predesignated classification scheme. Thisarbitrariness becomes the more acute if one again considers the over-riding importance of context in characterizing tax events, and in anyevent it simply begs the original question driving the analysis.

Revenue Canada, for its part, seems to disfavour bifurcation. In Inter-pretation Bulletin IT-96R6, the department states:

In the case of a security with a conversion feature which is not severablefrom the security and cannot be separately traded, no part of the issue pricecan be allocated to the conversion feature.56

On the whole, bifurcation perhaps best serves as a tool for revealingtax discontinuities.57

53 Ibid.54 The approach is also referred to as decomposition, disaggregation, or tax

deconstructionism.55 See generally Frank V. Battle Jr., Bifurcation of Financial Instruments (December

1991), 69 Taxes: The Tax Magazine 821-33. See also Jeff Strnad, Taxing New FinancialProducts: A Conceptual Framework (February 1994), 46 Stanford Law Review 569-605.

56 Interpretation Bulletin IT-96R6, Options Granted by Corporations To Acquire Shares,Bonds or Debentures and by Trusts To Acquire Trust Units, October 23, 1996, paragraph 9.

57 Kleinbard, supra footnote 41, at 952, states, At its best, the vogue for taxdeconstructionism [bifurcation] points out the shortcomings of our current approach to thetaxation of such straightforward financial instruments as forwards and options. At itsworst, tax deconstructionism substitutes complex and artificial timing models for existingrules that more accurately reflect the commercial context in which notional principalamount contracts and other liability management tools are utilized. See also Gergen,supra footnote 26, at 848-50.


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Judicial ActivismThe above approaches represent theoretical approaches to taxing deriva-tives under one or another form of a modified realization scheme. Giventhe complications that these approaches entail, they are better left, as thecommentators suggest, to (detailed) legislative enactment. One alterna-tive to detailed legislation is to leave derivative taxation to the courts.This approach is favoured by Wilkie.58 If the tax system, he says, doesnot recognize a given financial arrangement, either that arrangement mustremain outside the system entirely, or the rules of the system must bestretched to accommodate it. Accommodating novel arrangements throughjudicial elaborations of relevant rules, says Wilkie, is . . . implicit in,and a fairer expectation of, the exercise of interpreting and applying thelaw.59 In light of the intractable difficulties posed by financial innova-tion, and especially considering the difficulty of designing, with appropriatespeed, forward-looking rules of properly delineated application,60 judicialelaboration might strike the better balance between the many factorsinvolved. Says Wilkie:

I suggest that precise revisions of statutory law cannot be counted on to filltechnical and perhaps substantial gaps in the Act revealed by financialinnovation. Legislation tends to be backward looking; commercial enter-prise in this area, in contrast, is driven by novelty. Moreover, legislativechange may require such a fundamental rethinking of basic tax law con-cepts and their consistent application in both simple and complex situationsthat the pace of change will be slower than is needed.61

Wilkie then suggests that a more activist stance is required of all con-cerned and posits a central role for an activist bench. He states:

[A] more activist interpretive attitude is required by all concerned withtaxation, notably tax administrators and the courts, but also advisers. Ineffect, it must be conceded that the interpretive bounds of the tax law arenot clear, but it must also be recognized that they may be made clearer,case by case, in groups of transactions with similar characteristics andperhaps even in principle, by an organic expansion, where necessary, ofexisting tax principles. The role of pragmatic or economic analysis is todefine and control this interpretive development. The point of both is to makethe law work in a constructive and positively directed fashion, tempered bya thoughtful awareness of its intrinsic limits.62

58 Supra footnote 4.59 Ibid., at 1162.60 The inability of technical rule making to keep pace with financial innovation is the

subject of David P. Haritons article, The Tax Treatment of Hedged Positions in Stock:What Hath Technical Analysis Wrought? (Summer 1995), 50 Tax Law Review 803-27.

61 Supra footnote 4, at 1164.62 Ibid., at 1166. Neil Brooks, who also favours judicial activism, might be taken as a

proponent for solving derivative tax problems through judicial means: see Neil Brooks,The Responsibility of Judges in Interpreting Tax Legislation, in Graeme S. Cooper, ed.,Tax Avoidance and the Rule of Law (Amsterdam: IBFD Publications, 1997), 93-129. Brooks



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Lawrence Lokken, an American academic, also condones a judicialapproach. In a 1991 article analyzing the then-new US regulations on thebifurcation of contingent debt instruments,63 Lokken states a preferencefor regulations adopting broad principles the application of which, on hisdesign, is left to the courts. He calls this the common law approach.64

Lokkens proposal might foster the measured application of law that,as Wilkie suggests, could represent the best means of dealing with deriva-tive taxation. Implementing Lokkens proposal would also relieve allparties concerned of the enormous task of deciphering legislative provi-sions otherwise promulgated for an already daunting array of derivativescurrently available in financial markets.

Lokkens proposal also reveals a limitation in Wilkies version of thejudicial approach. Courts can and should elaborate the law in circum-stances involving the novel application of settled principles. Courts,however, must respect their jurisdictional authority and should not decidematters that are properly the province of Parliament. Where a given statutereveals no direction down which judicial elaboration can sighta direc-tion such as would be provided by the broadly framed regulations thatLokken recommendsa courts hands are tied. Interpretive bounds(Wilkies phrase), far from being the proper outcome of judicial elabora-tion, are the essential first starting block for it and are therefore prerequisiteto a courts properly fulfilling its mandate as the institution bearing frontline responsibility for defining the application of statutory law.65 Thus,where Parliament has not settled its mind on a matter, as it admittedly has

suggests that economic equivalents should be similarly taxed without regard to form. Hestates, at 96, Parties often have a choice of legal forms to achieve the same economicconsequences; for example, they can choose to fashion the conveyance of an asset for itsuseful life either as a sale or a lease, or they can raise capital and provide a promised rateof return and a defined degree of security using an instrument written as either a debt or anequity instrument in company law. Since tax policy distinguishes between taxpayers on thebasis of their economic circumstances, courts should be free to assess them on the basis ofthe economic substance of their transactions.

63 Contingent debt combines a traditional debt instrument with interest pegged to acontingent index (a stock or commodities index, for example).

64 Lawrence Lokken, New Rules Bifurcating Contingent DebtA Good Start (April29, 1991), 51 Tax Notes 495-504. Lokken states, at 504, I favor the common law approach.Although I am generally skeptical of rough cuts, 200-page outpourings have their place. Ifthere are a finite number of cases to which a principle might apply (or even a finitenumber of important cases), Treasury has an obligation to say what the rules are for thesecases. If it takes 200 pages to do this and the affected taxpayers have the resources todecipher them, 200 pages is the proper length. In a more fluid situation, in contrast,comprehensiveness becomes a futile struggle for foresight. The best that can be done is amasterful job in providing for last years deals. How the rules might apply to next yearsdeals can be no more than a guess. Not even the greatest grand master announces his gameplan in advance if his opponent retains the ability to improvise.

65 Robert Thornton Smith, Interpreting the Internal Revenue Code: A Tax Jurispru-dence (September 1994), 72 Taxes: The Tax Magazine 527-58, at 550 and following.

62 Continued . . .


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not for most aspects of derivative (including weak currency hedge) taxa-tion, nothing exists for a court to applyneither express directive, norpolicy, nor implied principle, nor generalized unstated rule. Furthermore,if clarifying interpretive bounds . . . by an organic expansion involvesdrawing lines of practical compromiseor, worse, involves a fundamen-tal rethinking of basic tax law concepts and their consistent applicationas Wilkie suggests66judicial elaboration clearly overreaches.CURRENT AND PROPOSED TAXATION OFWEAK CURRENCY HEDGESOne further contextual matter should be addressed before the decision inShell Canada is analyzed. Several jurisdictions, and some writers in thefield, have proposed policy or legislative solutions to the specific taxproblems posed by weak currency hedges.67 Four of these solutions arereviewed below. Each is based on the adoption of an integration approach.

1) United States. The United States has long enacted detailed legisla-tion addressing derivative taxation. In the 1986 tax reform, it enactedcomprehensive legislation for foreign currency transactions. One of theprovisions enacted, section 988, deals specifically with foreign currency(including weak currency) hedges. Section 988(d) describes the generaltreatment accorded such hedges:

(d) TREATMENT OF 988 HEDGING TRANSACTION(1) IN GENERALTo the extent provided in regulations, if any section988 transaction is part of a 988 hedging transaction, all transactions whichare part of such 988 hedging transaction shall be integrated and treated asa single transaction or otherwise treated consistently for purposes of thissubtitle.68

The US legislation adopts an integration approach to taxing weak cur-rency hedges according to their economic substance.69 The relevantregulations fine tune the application of this approach, with provisionsdealing with both lenders and borrowers and with various circumstancesarising in the practical contexts in which hedge transactions are used.70Scarboroughs explanation of the operation of section 988(d) in light of

66 Supra footnote 4, at 1164.67 The US and OECD solutions are discussed by Broadhurst, supra footnote 16, at

26:24 and following. See also David G. Broadhurst, Tax Considerations for HedgingTransactions, in Taxation of Financial Transactions: Effective Strategies for CorporateFinancing (Mississauga, Ont.: Insight, 1991), article I.

68 Section 988(d) of the Internal Revenue Code of 1986, as amended (herein referred toas IRC). See also IRC reg. section 1.988-5.

69 United States, Staff of the Joint Committee on Taxation, General Explanation of theTax Reform Act of 1986, 100th Cong., 1st sess. (May 4, 1987), 1102.

70 For a detailed review of IRC section 988(d), see Laura A. Homan, The Section988(d) Hedging Rules: Room To Expand Integration Treatment (Summer 1993), 46 TheTax Lawyer 887-921.


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applicable regulations illustrates the workings of certain of these fine-tuning measures:

A third matching rule integrates foreign currency-denominated debt issuedor held by the taxpayer with derivatives that hedge the foreign currencyrisk on that debt. This rule applies to derivatives that take the form ofcurrency swaps, forwards, options or similar contracts. While the two posi-tions are in place, they are treated as a single dollar-denominated debtinstrument. If the taxpayer legs out by disposing of the derivative, thehedged debt will be marked to market on the date that the derivative isdisposed of, thereby generally matching gain or loss on the derivative withgain or loss on the debt. Similarly, if the taxpayer legs out by disposingof the hedged debt, the derivative will be marked to market and unrealizedgain or loss will be recognized at that time.71

2) OECD. A similar general treatment for weak currency hedges is im-plied in a discussion of foreign exchange issues by the OECD. In a reporton the taxation of foreign exchange gains and losses, the OECD states thefollowing general proposition:

It seems to the Committee that if problems arise in practice in this field,something useful could be done to mitigate the adverse taxation effects ofcurrency fluctuations on taxpayers and tax authorities alike if the relevantauthorities: . . .

2. sought as far as practicable to avoid imbalances between the taxationof foreign exchange gains and the allowance of foreign exchange losses,particularly where such gains and losses are counterbalancing aspects ofwhat is essentially a single underlying transactione.g. gains and lossesforming part of a hedging arrangement.72

3) Kay and King. In the UK study cited earlier, Kay and King proposethat foreign currency exchange gains and losses be taxed on incomeaccount without regard to the realization principle (that is, taxed on anaccrual or mark-to-market basis). They state:

[T]he distinction between realised and unrealised currency gains and lossesis exceptionally difficult to establish. There are liabilities with a set matu-rity date on which currency is purchased to make up the loss incurred. Butisolated transactions of this kind are exceptional. There is an infinite rangeof monetary assets and liabilities, with an active secondary market in mostof them. Transactions are rarely isolated; hedges and swaps are common,and most large corporations manage their currency exposure as part of anintegrated portfolio. In a world of electronic money transmission, the con-cept of realisation no longer means what it did in the days when bills andmortgages were the dominant instruments of commercial finance.73

Although Kay and King do not propose a specific rule for taxing for-eign exchange hedge transactions, their approach implies an integrated

71 Scarborough, supra footnote 7, at 1040.72 Organisation for Economic Co-operation and Development, Tax Consequences of

Foreign Exchange Gains and Losses (Paris: OECD, 1988), 45.73 Kay and King, supra footnote 17, at 56.


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(net income-account accrual) taxation similar to that adopted in the USlegislation. They suggest that the proper source of law is definitivelegislation.74

4) Broadhurst. In his review of derivative hedges, also cited earlier,Broadhurst proposes that weak currency hedges be taxed on an integratedbasis. He says:

For a fully hedged financing transaction, the tax consequences of the variouselements should be integrated and treated as a single financing transaction;the cost of borrowing should be amortized in a manner consistent with suchassumptions without regard to the realization principle. The model shouldbe based on the US codification of section 988 hedging transactions.75

Broadhurst also prefers a legislative solution.76 He suggests, moreover,that any change in policy should apply prospectively, and any codifica-tion of policy should include liberal grandfathering provisions.77

The above proposals, and the one instance of legislative enactment,adopt an integrated approach to taxing weak currency hedges. The pro-posals suggest that this approach is best implemented through legislativecode. The one instance of relevant legislation, IRC section 988(d), appliesthe integration approach with considerable modifications for circumstan-tial exigencies.

SHELL CANADAThe discussion turns now to Shell Canada. The facts of the case aresomewhat complicated and need not be recounted in their entirety. Forpresent purposes, a brief summary suffices. In 1988, Shell sought US $100million debt financing for its American operations. Rather than engage asimple US $ borrowing, it borrowed the equivalent of US $100 million inNew Zealand (NZ) dollars, a weaker currency, and immediately flippedthe NZ $ into US $. No longer having NZ $ for its NZ $ obligations, Shellcontracted with a second party78 to convert appropriate US $ amounts intoNZ $ at specified times. This contract, a master forward exchange agree-ment, obligated Shell to pay specified US $ amounts at designated timesin return for NZ $, with the obligations being gauged to the NZ $ amounts

74 Ibid., at 70.75 Broadhurst, supra footnote 16, at 26:31.76 Broadhurst states, ibid., It is absolutely vital to determine and codify a coherent

policy regarding foreign currency and interest-rate productssoon. He also states, at26:24, From the taxpayers side, the current non-legislative framework under which all ofthese transactions take place is undesirable. Businesspeople value certainty, above all;those who think that there is certainty in the current state of affairs do not appreciate thespeed with which a single adverse judgment in a federal court could overturn all of theassumptions under which the system now operates. One has only to remember the confu-sion caused during the spring of 1987 by the Bronfman decision to realize what couldhappen if the courts were called upon to wade into this ocean of uncertainty.

77 Ibid., at 26:32.78 The first party, the lender, was a consortium of parties.


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calculated on a forward exchange rate curve settled in the agreement, andthe conversion amounts being determined by reference to Shells interestand closeout obligations on the NZ $ loan.

The transaction was a weak currency hedge. To be clear, Shell did notrequire the transaction to hedge any NZ $ risk to which it was otherwiseexposed.79 Shell simply used the transaction to lower its overall cost ofborrowing US $ through tax benefits arising on the comparative tax treat-ment accorded the hedge version of the loan. These benefits combined theeffect of higher current interest deductions and a deferred (capital) gaininclusion. More specifically, the hedge loan generated higher interest pay-mentsand higher interest deductionsthan would have obtained on astraight US $ borrowing, since the NZ $, being a weaker currency, bore ahigher interest rate than the US $ (15.4 percent versus 9.1 percent) at therelevant time. Shell claimed the interest deductions on a current basis.The transaction also generated a foreign currency exchange gain on thecloseout conversion, which Shell claimed on expiry of the loan. The com-posed transaction thus generated a deferral of tax payable.80 This benefitwas augmented by Shells claiming the gain on capital account.

The minister disputed the tax consequences that Shell claimed, andShell appealed. The minister lost at trial, then appealed to the FederalCourt of Appeal, and won. Writing for the majority, Linden JA found that

the extra amounts paid by Shell on the higher NZ $ interest ratewere not interest but payments of capital and therefore were non-deductible;

the extra amounts paid by Shell were interest but were non-deductible because the NZ $ borrowing did not meet the purpose test; and

the extra amounts paid by Shell were interest but were non-deductible because they were unreasonable.81

Linden JAs decision reveals two bases for his ultimate conclusion thatthe extra amounts were non-deductible. The first involves a commonlaw elaboration of the notion of interest. Linden JA employed the interest-rate parity theory on an integration analysis to define the true interestin the circumstances. This basis is revealed in the first of the three find-ings above and is the primary basis for his decision.82 The second basis isalternative to the first and involves an interpretation of paragraph 20(1)(c).This basis is revealed in the second and third findings above. These two

79 Shell itself had created this risk in the same instrument with which it hedged it.80 Technically, the transaction deferred income on the gain and thus deferred overall

tax payable.81 Linden JA also found that the gain was capital. This aspect of his decision is not

addressed in this article, nor does the article deal extensively with Stone JAs concurringdecision, which is confined to section 245.

82 If it is not the primary basis for his decision, it is certainly the more interesting andcontroversial of the two. Note that Linden JAs integration analysis infuses his finding thatthe extra interest amounts were unreasonable under paragraph 20(1)(c).


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bases, to be clear, are true alternatives: either the extra amounts, so-called, were interest (to which paragraph 20(1)(c) would apply), or theywere not.83

On this reading, the more important question that Shell Canada raises,in my opinion, does not concern statutory interpretation. Rather, it con-cerns whether a court may employ economic theory, absent an appropriatestatutory grant directing or allowing it to do so, to determine the taxationof a financial product designed by reference to the theory so employed.Linden JA used the interest-rate parity theory to elaborate a common lawdefinition of interest for the transaction in question. Did he appropriatelyexercise judicial authority in doing so? An important concern driving thisquestion is whether a court should sideline itself to a taxpayers electivelydeferring income through a selective use of derivative instruments. What,in ultimate terms, is the courts role in derivative taxation?

83 This point passes largely unnoticed in the Shell Canada case comments referred to infootnote 2, supra, and deserves some elucidation. Linden JAs integration analysis consti-tutes a common law elucidation of the meaning of the term interest. Paragraph 20(1)(c)applies only to interest. Linden JAs conclusion drawn from an integration analysis istherefore a conclusion drawn anterior to applying paragraph 20(1)(c). Appropriate quota-tions from his judgment bear this out. Linden JA, supra footnote 1, at 6187, states:

[T]he amounts that were paid, in my view, were not entirely interest; a portion ofthose payments were really principal. Let me explain.

The 15.40% interest that Shell paid is not the true interest rate. If it were, Shellwould not have paid it. The true interest rate is the real rate paid when the transac-tions are looked at in their entirety.

Linden JA continues by explaining his notion of true interest. Again at 6187:[T]he assessment of what exactly is the interest must include the predeterminedgain realized at the retirement of the loan, brought about by the discounted forwardrate on the currency. The evidence heard at trial and accepted in the literature isthat, in reality, there is no discrepancy between interest rates for convertible curren-cies. This is so because the interest rate parity theory dictates that the differentialbetween the forward and spot exchange rates of two currencies equals the differen-tial between the interest rates of those two currencies. As a result, the rate ofinterest on the foreign currency, if hedged against the fluctuation of the currencies,is equal to the domestic rate of interest.

Finally, at 6187-88, Linden JA suggests, on rightly understood economic terms, that theinterest paid beyond the domestic rate was really a repayment of capital:

The portion of interest paid above 9.1% is not interest for the purposes of paragraph20(1)(c). It was not compensation for the use of borrowed money. Essentially, itwas the borrowed money. The higher interest rate coupled with the discountedforward rate created a blended payment of interest and principal.

Though this determination is cloaked in the guise of discussing the second condition ofparagraph 20(1)(c), the actual element of that condition to which Linden JA refers is thecommon law test for interest; see ibid., at 6183. Linden JAs conclusion regarding thetrue interest is therefore a common law conclusion determined anterior to applyingparagraph 20(1)(c). Consistent with this understanding, if one assumes that the interest-rateparity theory does not properly define interest in the circumstances in question, Linden JAsuse of paragraph 20(1)(c) then comes into play.


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Judicial Elaboration of InterestThis question is not easily answered. Wilkie, who (as noted earlier) approvesjudicial activism as an important part-solution to the tax problems gener-ated by financial innovation, might favour using the interest-rate paritytheory to expand the common law notion of interest. Wilkie supports thereasoned elaboration of tax concepts84 and might be taken to agree withLinden JAs expanded test for interestassuming, perhaps, that it is con-fined to the context that the case involved. Lokken, on the other hand,probably would not support such use of the theory because the Act doesnot grant requisite authority to the court to employ it.

Viewing matters from a policy perspective, the outcome in Shell Canadaseems unarguably correct, or at least so far as the taxation of Shells partof the deal is concerned. The sources for critical policy analysis of weakcurrency hedges discussed abovethe US legislative commentary, theOECD report, the Kay and King study, and Broadhursts articlessuggestthat weak currency hedges should be taxed on an integrated basis.85 Arnoldlikewise supports the result in Shell Canada, though he perhaps does notsupport the Federal Courts reasons. He states:

[I]t seems clear that a tax system cannot tolerate transactions such as Kiwiloans, whereby capital is magically transformed into deductible interest. Ifit had worked with New Zealand dollars, presumably it would have workedto even greater effect with weaker currencies.86

Given that a court bears responsibility for actively adjusting the law tochanging circumstances, and given the near consensus on the proper gen-eral approach to taxing weak currency hedges, did the Federal Court ofAppeal properly resolve the issue in Shell Canada by adjusting the lawthrough adopting an integration approach? My personal opinion is that itdid not. Although the courts elaborated definition of interest creates a(mostly) acceptable tax outcome for the transaction and the party in question,it also raises a host of questions not properly answerable within furtherjudicial means. These questions, elucidated below, require responses of atrue policy natureresponses that strike practical compromises betweenaffected taxpayer groups, between select tax outcomes for specified circum-stances, and/or between competing tax principles on an overall and nec-essarily compromised outcomeand are not properly the courts to decide.

84 Wilkie relies on Smith, supra footnote 65, for the further reaches of his proposal.Smith set out the primary proposition that he defends, ibid., at 528: The judicial functionin interpreting the Internal Revenue Code should include the (common law) power toelaborate (adjust, if you will) the provisions of the statute beyond any accepted meaningof its words, in order to better effectuate the principles and policies underlying the statuteas an organic whole and, where appropriate, elsewhere in the law; and in so doing, a courtshould (at times) view itself as acting on its own responsibility and not merely as seekingeither the meaning of the pertinent provision of the Code or the legislative intent inrespect of the matter.

85 An exception, perhaps, is Ruby, supra footnote 16.86 Arnold, supra footnote 2, at 1119.


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Perhaps the most difficult questions raised by the courts integrationtest concern the proper boundaries within which that test will be seen tooperate. Integration, as stated previously, is a form of loss matching appli-cable to hedges of general description. Is the integration test to be appliedonly to weak currency hedges? Will it apply to strong currency hedgessuch that lower interest payments are integrated with a closeout conver-sion loss? Will it apply to any hedge creating tax discontinuities? If chosenas a solution for the problems posed by derivative hedges generally, thetest will require that offsetting positions be identified on a consistent,predictable basis. By what means will a judge-made rule foster (conjure?)a workable identification scheme? The Shell Canada transactionfor itspart, a small player in the world of derivative hedge transactionsrepre-sents the tip of an iceberg of transactions that might function within anoverall offsetting position. For instance, holding multiple investments inportfolio format easily accomplishes an overall hedged position eventhough no single investment specifically offsets (or is intended to offset)another. The loose relation between individual investments so held allowsa portfolio holder to cherrypick losses by selectively realizing invest-ments with accrued losses.87 Should these (unrelated? semi-related?)positions be integrated? If less than closely related positions are inte-grated, at what point does integration halt? Should only substantiallyoffsetting positions be integrated? Should positions of different legal char-acters be integrated? Should positions possibly subject to other taxationrules be integrated? If yes to this latter, what determines which particularrule predominates? On a related note, what determines proper characteri-zation for integration purposes? Does the integration test for interest requirethat a taxpayer or transaction evince an income-deferring purpose? If itdoes, what of integrating strong currency hedgesshould the conversionloss be matched with lower interest payment deductions? If no,

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