Tax Alert Canada. TCC rejects mark-to-market accounting for option contracts. The decision

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1 2015 Issue No June 2015 Tax Alert Canada TCC rejects mark-to-market accounting for option contracts EY Tax Alerts cover significant tax news, developments and changes in legislation that affect Canadian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. Recently, the Tax Court of Canada (TCC) issued its judgement in the tax appeal of Kruger Inc. v. The Queen, 2015 TCC 119. The primary issue in the case was the computation of income under s. 9 of the Income Tax Act (the Act) and specifically whether mark-to-market accounting is an acceptable method of computing profit for tax purposes trading foreign currency option contracts. The alternative issue was whether, if the mark-to-market method of computing income was not acceptable, foreign exchange option contracts purchased and written by the taxpayer were inventory for purposes of the Act and, therefore, could be valued at fair market value at year end by virtue of s. 10(1) and s of the Regulations, thus effectively achieving the same result as the mark-to-market method. The decision Former Chief Justice Gerald Rip held that, notwithstanding that mark-to-market accounting is a well-accepted business principle, it is contrary to the basic tax principle that income or loss is not taxed until realized. The mark-to-market method of computing profit is acceptable for tax purposes only in the limited circumstances where s requires financial institutions to compute income from mark-tomarket property (as defined) or as permitted under the Act, e.g. as permitted by s. 10(1) and s of the Regulations in valuing inventory at fair market value (FMV). According to Justice Rip:

2 The realization principle is basic to Canadian tax law. It provides certainty of a gain or loss. Without some support from the statutory language or a compelling interpretation tool it ought not to be cast aside. This is found in sections to 142.5; these provisions, like subsection 1801 of the ITR, are exceptions to the realization principle and a departure from the general principle that assets are valued at their historical cost. Justice Rip, dealing with the taxpayer s alternative argument, determined that option contracts purchased by the taxpayer were property that was inventory to the taxpayer and could therefore be valued at fair market value at year end. However, option contracts written by the taxpayer were not property to the taxpayer rather, they were obligations to the taxpayer and therefore were not inventory; accordingly, they could not be valued at fair market value at year end. The facts The taxpayer was in the business of manufacturing newsprint and paper products. Approximately 80% of its sales were in the US. In the 1980 s, recognizing its exposure to foreign currencies, it began the enterprise of writing and selling foreign currency option contracts. The taxpayer became a very large participant in the Canadian options market, both writing and purchasing. It hired experienced personnel including the former chief trader for the Toronto Dominion Bank in London. It staffed its own treasury back office. The financial results from its foreign exchange business were kept separate from its other business. In 1998, the taxpayer began to account for its foreign exchange operations using mark-tomarket accounting. (Mark-to-market accounting is an accrual method of accounting where the option is valued at market value as at the balance sheet date and any change in the market value from the beginning to the end of the period is recognized as a gain or loss in the income statement for the period.) In 1998, the taxpayer used the mark-to-market method as well in computing income for its foreign exchange operations for tax purposes, as a result of which it reported a loss from its foreign exchange trading business of approximately $91m under subsection 9(2). In 1998, it had sold about four times as many options as it had bought. The Canada Revenue Agency (CRA) reassessed the taxpayer s 1998 tax return and denied the loss and added the amount to taxable capital for purposes of Part 1.3. The Minister asserted that: 1. The taxpayer was not carrying on a business of trading in derivatives; 2. The taxpayer was required to calculate profit or loss from the options on a realization basis; 3. The losses were merely a contingent reserve prohibited by paragraph 18(1)(e); and 4. The option contracts were not inventory. The TCC analysis 1. Taxpayer was carrying on a business of trading in derivatives Based upon the facts (discussed above), Justice Rip decided that the taxpayer was in the business of trading in derivatives (in addition to its paper manufacturing business). TCC rejects mark-to-market accounting for option contracts 2

3 2. Realization vs Mark-to-market Justice Rip framed the question as one of whether the mark-to-market valuations provided an accurate picture of the taxpayer s income for the year consistent with the provisions of the Act, case law and well accepted business principles. Relying on comments of the Supreme Court of Canada (SCC) in Friedberg, (SCC) 93 DTC 5507, Friesen, (SCC) 95 DTC 5551, and Canderel, (SCC) 98 DTC 6100, Justice Rip determined that the mark-to-market method of income computation was not available to any taxpayer unless such method was specifically required or permitted under the Act. Expert witnesses, for the Crown and for the taxpayer, testified that the preferred basis under both US and Canadian GAAP in 1998 (and under International Accounting Standards) for computing income from trading in option contracts was the mark-to-market method. Justice Rip accepted that the mark-to-market income computation methodology was consistent with well-accepted business principles. However, he concluded on the basis of his analysis of comments made by the SCC in Consolidated Glass, SCC 57 DTC 1041, Friedberg and Friesen that the mark-to-market to method was not consistent with the fundamental tax law principle of realization, a principle which was not to be departed from except with the support of a provision of the Act or a compelling interpretive tool. Justice Rip cited s as one such exception to the realization principle. It requires that financial institutions compute their income by marking to market certain shares and debt obligations (which fell within the definition of mark-to-market property ) and any other property the value of which is determined by those shares or debt obligations. As the taxpayer was not a financial institution (as defined), subsection did not apply to it. Subsection 10(1) was cited as another exception to the realization principle. Subsection 10(1), by reference to s of the Regulations, permits a taxpayer to value inventory at fair market value at the end of the year. Judge rip determined that if the foreign exchange options were inventory to the taxpayer, it could value them at fair market value, thus achieving the same result as mark-tomarket accounting (discussed below). The taxpayer had called at trial, among other witnesses, a Canada Revenue Agency (CRA) Financial Products Specialist to testify that the CRA accepts that banks (which are financial institutions, as defined) can compute income from options both written and purchased on a mark-to-market basis, notwithstanding those options, whether bought or sold, are not markto-market property as defined in the Act. Further, the taxpayer adduced at trial evidence that banks engaged in proprietary trading of foreign currency options in addition to being market makers. On this basis, the taxpayer argued that it must be the case that the Minister regarded as appropriate the mark-to-market method of income computation from options trading either because it provided the truer picture of income from that business for the year (relative to the realization method), or because options contracts were inventory and accordingly could be written to fair market value at the end of the year. Justice Rip considered the Minister s assessing position to be not more than an administrative concession to financial institutions and other regulated entities rather than a reflection of the Minister s view of the correct application of income computation principles for income tax purposes to the trading of options. In this regard Justice Rip allowed that he was not surprised that the taxpayer, in particular in view of its extensive dealings in derivatives, felt odd man out. 3. Losses prohibited by s. 18(1)(e) Given his conclusions regarding the nonavailability of the mark-to-market method to the taxpayer and the non-inventory status of written options (below), Justice Rip did not deal with the question of whether Kruger s losses were prohibited as deductions under s. 18(1)(e). 4. Foreign exchange options as inventory Justice Rip determined that the purchased options constituted inventory of the taxpayer and could therefore be written up or down to FMV under s. 10(1) of the Act and s of the Regulations. However, the same did not hold TCC rejects mark-to-market accounting for option contracts 3

4 true for written options. The Court accepted the Crown argument that written options did not constitute property but rather only obligations, and therefore could not be inventory under the Act. (Inventory is defined in the Act as a description of property the cost or value of which is relevant to the computation of a taxpayer s income from a business for a taxation year.) The Court did not accept the taxpayer s argument that options, both written and purchased, were contracts which contained rights as well as obligations, such that both kinds of options qualified as property and therefore as inventory. Implications of the decision The reasons of Justice Rip are clear that the mark-to-market method of computing income from financial instruments is not available to any taxpayer, including financial institution taxpayers, unless the financial instruments qualify as mark-to market property (as defined in s.142.2), in which case marking such property to market is mandatory, or unless the financial instruments qualify as inventory and are thus capable of being written to fair market value under s. 10(1) and Regulation Since foreign exchange option contracts do not qualify as mark-to-market property (this is not controversial), they can be marked to market only as inventory under s. 10(1) of the Act and s of the Regulations. However, an asymmetry results from the decision because only purchased option contracts are property that can be inventory whereas written option contracts cannot be inventory. While the case dealt with whether written options were property that was inventory, the same principles could perhaps be applied to determine whether an option is mark to market property. Under s an option is a mark-to-market property if it is a tracking property. A tracking property is defined as property of the taxpayer the FMV of which is determined primarily by reference to one or more criteria in respect of property that, if owned by the taxpayer, would be mark-to-market property of the taxpayer. In other words, applying the decision, an option held by a financial institution on a share would be a mark-to-market property only if it was purchased by the taxpayer. If it is an option written by the financial institution it would not qualify as mark-to-market property. Should CRA assess based upon this decision, any options written by a financial institution would not be considered mark-to-market property or inventory. If the taxpayer is long a share that is mark-to-market property and has also written an option on the share, the financial institution would be required to mark-to-market the share but not the option. Arguably such would not present an accurate picture of the taxpayer s profit for the year. This asymmetry may be problematic for financial institutions. Writing only purchased foreign exchange options to fair market value at year end while computing income from written foreign exchange options on a realization basis may not result in an accurate picture of the income from that business for a taxation year, in which case financial institutions may be obligated henceforth to report income from options trading on a realization basis only. TCC rejects mark-to-market accounting for option contracts 4

5 EY Assurance Tax Transactions Advisory Learn more For more information, please contact your EY or Couzin Taylor advisor or one of the following professionals: Reya Ali-Dabydeen Angelo Nikolakakis David Robertson Daniel Sandler Louis Tassé About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization and may refer to one or more of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. About EY s Tax Services EY s tax professionals across Canada provide you with deep technical knowledge, both global and local, combined with practical, commercial and industry experience. We offer a range of tax-saving services backed by in-depth industry knowledge. Our talented people, consistent methodologies and unwavering commitment to quality service help you build the strong compliance and reporting foundations and sustainable tax strategies that help your business achieve its potential. It s how we make a difference. For more information, visit ey.com/ca/tax. About Couzin Taylor Couzin Taylor LLP is a national firm of Canadian tax lawyers, allied with EY, specializing in tax litigation and tax counsel services. For more information, visit couzintaylor.com Ernst & Young LLP. All Rights Reserved. A member firm of Ernst & Young Global Limited. Roger Taylor roger.taylor@ca.ey.com And for up-to-date information on the federal, provincial and territorial budgets, visit ey.com/ca/budget. This publication contains information in summary form, current as of the date of publication, and is intended for general guidance only. It should not be regarded as comprehensive or a substitute for professional advice. Before taking any particular course of action, contact EY or another professional advisor to discuss these matters in the context of your particular circumstances. We accept no responsibility for any loss or damage occasioned by your reliance on information contained in this publication. TCC rejects mark-to-market accounting for option contracts 5