http://decisions.fca-caf.gc.ca/fca-caf/decisions/en/item/145505/index.do
Kruger Incorporated v. Canada (June 22, 2016 – 2016 FCA 186, Nöel C. J. (author), Scott, de Montigny JJ. A.).
Précis: This is an appeal from a Tax Court decision blogged earlier on this site. Because of its exposure to currency risk in multiple jurisdictions Kruger Incorporated (“Kruger”) started an aggressive risk management program using foreign exchange options. The program expanded to the point that they had a foreign exchange desk in house similar to that found in mainstream investment houses. Kruger started to mark its foreign exchange contracts to market, in the same manner as financial institutions. CRA denied Kruger’s mark to market positions and Kruger appealed to the Tax Court. The Tax Court held that notwithstanding industry and accounting opinions, the basic principle for the purposes of the Income Tax Act (the “Act”) was the “realization principle”, i.e., gains and losses were not recognized until they were in fact realized. In the case of foreign exchange options held as inventory however, section 10 of the Act permitted Kruger to value these at year end. This position extended to options acquired by Kruger, but not options issued by it since the latter were liabilities of Kruger and not “property” for the purposes of the Act. The Tax Court appeal was allowed to that extent.
The Court of Appeal allowed Kruger’s appeal from the Tax Court decision. It held that the Tax Court’s reliance upon the realization principle was misplaced and that, on the evidence, marking the options to market was the most accurate reflection of its income. Kruger was awarded costs both in the Tax Court and the Court of Appeal.
Decision: The Court of Appeal rejected the Tax Court’s reliance upon the “realization principle”:
[67] There is therefore no authority for the Tax Court judge’s proposition that the principle of realization applies to the exclusion of mark to market accounting unless the Act provides otherwise.
[68] Because mark to market accounting cannot be excluded as a competing method the question to be answered, when regard is had to the framework of analysis set out at paragraph 53 of Canderel, is whether the appellant has discharged the onus of showing that mark to market accounting provides an accurate picture of its income for the year.
The Court of Appeal was satisfied, on the evidence, that the mark to market method provided an accurate reflection of Kruger’s income:
[69] The Tax Court judge made no findings in this regard. Although he asserts on a number of occasions that the goal in determining profit and loss for financial/accounting purposes and for income tax purposes are not necessarily the same (Reasons, paras. 65 and 108 to 110), he does not indicate what differences were at play, if any, nor the impact which they would have had on the accuracy of the income computed by the appellant for tax purposes.
[70] Absent some such indication, there is no basis on which to hold that mark to market accounting does not procure an accurate picture of the appellant’s income under the Act. As was stated in Canderel, “the goal of the legal test of ‘profit’ should be to determine which method of accounting best depicts the reality of the financial situation of the … taxpayer” (Canderel, para. 44). This coincides with the goal which mark to market accounting seeks to achieve on the facts of this case i.e.: recognizing income or losses based on the amount which can be realized by dealers in derivatives at the balance sheet by inter alia entering into an offsetting contract (Appeal Book, Vol. 12, pp. 2419, 2420, 2448 and 2449; Vol. 17, pp. 3376 and 3377). As it is otherwise undisputed that this method is consistent with well accepted business principles, GAAP and international accounting, I am satisfied that the appellant has made a prima facie demonstration that mark to market accounting provides an accurate reflection of its income.
The Crown had not demonstrated, on the evidence before the Tax Court, that the realization approach offered a better picture of the taxpayer’s income:
[71] The remaining question is whether the Crown has discharged the onus of showing that realization procures a better picture of the appellant’s income under the Act (Canderel, para. 53 at point 6). Because the Crown’s position throughout has been that mark to market accounting is not an authorized method, no attempt was made to make this demonstration. Indeed, the Crown’s accounting expert expressed the opposite view (Expert Report of Patricia L. O’Malley, Appeal Book, Vol. 12, p. 2,410, para. 94). Given the findings made by the Tax Court judge as to the broad recognition of mark to market accounting for purposes of computing income from dealing in foreign exchange options, and the uncontested evidence that banks, financial institutions and mutual funds which engage in this activity report their income on this basis with the CRA’s approval, it seems clear that mark to market provides a picture of the appellant’s income which is as accurate – and as acceptable from the perspective of the tax collector – as that which the principle of realization would provide.
[72] Adhering to the framework of analysis set out in Canderel, I conclude that there was no basis on which the Tax Court judge could reject the appellant’s use of mark to market accounting in computing income from its dealings in foreign exchange options.
Although it was not strictly necessary given the conclusion on “mark to market”, the Court went on to reject the alternative argument advanced by Kruger that the options were “inventory”:
[93] Although the Act was amended shortly after Friesen was rendered to prevent the application of the inventory write-down rule to inventory held by a business that is an adventure in the nature of trade (see subsections 10(1) and (1.01)), Parliament left the defined meaning of the word “inventory”, as construed in that case, untouched. As a result, qualifying property must both impact on the computation of income and be held for sale.
[94] Giving effect to this meaning, the foreign exchange options purchased by the appellant during its 1998 taxation year and rolled over to 1999 do not qualify as inventory as they were not held for sale.
Finally the Court concluded that the options were neither capital property nor inventory:
[101] As noted earlier, the purchased options are property under the Act but they are neither capital property nor inventory. In contrast, the written options escape all three labels since they only embody the obligation to deliver funds in the future. Yet, the evolving value of both instruments is relevant in determining the appellant’s income under the Act. In short, although the Act is premised on the existence of two broad classes of property, it imposes no limit on the types of property or indeed liabilities that can impact on the computation of income and which must be recognized for that purpose since the goal pursuant to section 9 of the Act is to provide an accurate picture of that income (Canderel, para. 53).
As a result the appeal was allowed with costs both in the Tax Court and the Court of Appeal:
[102] For the above reasons, I would allow the appeals, and giving the judgment which ought to have been given, I would refer the reassessment back to the Minister for reconsideration and reassessment on the basis that the appellant is entitled to compute the income derived from its foreign exchange option contracts in accordance with the mark to market method of accounting, that is in conformity with its tax return position but without deferring or amortizing any portion of the premiums paid or received during the 1998 taxation year. Given this result, I would award costs in favour of the appellant both before this Court and the Tax Court of Canada.