2015 TCC 119
MAJESTY THE QUEEN,
REASONS FOR JUDGMENT
The main issue in this appeal
is whether, in computing income for the year, Kruger can mark to market foreign
exchange option contracts at the end of its fiscal year. The Crown’s position
is that foreign exchange contracts are to be valued only when realized. Expert
evidence agree that for financial reporting purposes, mark to market is the
appropriate method of valuing such options. The Income Tax Act ("ITA"
or "Act") requires financial institutions, as defined, to mark
to market what it defines as "mark to market property". Foreign
exchange option contracts are not included in the definition of such property
(section 142.2 of the ITA).
Nevertheless, for ease of
administration of the ITA, the Canada Revenue Agency ("CRA")
has taken upon itself to permit financial institutions to mark to market such
option contracts. It also permits some regulated businesses that are not
defined as "financial institutions" to mark to market property.
Kruger is not a financial
institution and does not carry on a regulated business. However, it is one of
the larger participants in the Canadian market. It values its foreign exchange
option contracts on a mark to market basis for both tax and financial
reporting. The mark to market values used by Kruger were the values it adopted
from its co-contractors, various banks, the values of which may vary from bank
to bank. The CRA did not allow the appellant to mark to market value its
foreign exchange option contracts as at the end of its 1998 taxation year.
A taxpayer is to value its
property on a consistent basis. Mark to market valuation may create income in
one year and a loss in another year. A taxpayer is to include an amount in
income for the year or deduct an amount in computing income for the year only
if required or permitted by the ITA. Mark to market valuation should be
applied only in the limited circumstances where it is sanctioned by the ITA,
by section 142.2 and section 1801 of the Income Tax Regulations ("ITR").
Kruger’s alternative argument
was that it was in the business of both writing and purchasing foreign exchange
option contracts and that the contracts were inventory. Kruger did carry on
such a business. However, the foreign exchange option contracts it wrote were
liabilities and not inventory. The contracts it purchased were inventory and
may be valued accordingly.
The principal subject matter of this appeal from
the income tax assessment for 1998 of Kruger Incorporated ("Kruger") is
whether, in computing income for the year, foreign exchange option contracts
should be valued mark to market at the end of the appellant's taxation year, as
claimed by Kruger, or when finally realized, as assessed. Appellant's
alternative submission is that in 1998 it carried on a business in which the
contracts are property that is inventory and in computing its income from its
business for 1998 the contracts are to be valued as such in accordance with
subsections 10(1) and 248(1) of the Act and section 1801 of
the ITR. In effect, mark to marketing the contracts and valuing them as
inventory in accordance with section 1801 of the ITR would have the
These reasons refer to several foreign exchange
option contract terms
which are summarized in the following paragraphs:
A "Derivative" is a contract
between two or more parties whose price is dependent upon or derived from, one
or more "underlying assets" or factors. Its value is
determined by fluctuations in the price of the underlying asset or factor.
A "European option" is an
option that may be exercised only on its expiry date. Kruger entered into
European Options which constituted the bulk of the foreign currency market.
The "Holder" or "Purchaser"
of a "call" option wants the price of the foreign currency to
increase above the strike price; the holder or purchaser of a "put"
option wants to price the currency to decrease to be less than the strike
The "Intrinsic Value" of a
derivative contract is the difference between the current price of the
derivative and the strike price, i.e. the gain that would be made if the option
expired based on current conditions, also known as the amount by which the
option is "in the money". Only "in the money" options have
an intrinsic value. If the strike price of a call option is above the current
price of the underlying asset, the call option is "out of the money".
An option is "in the money" when the strike price is below the
underlying asset's price because the holder could exercise the call option by
paying the strike price and profiting on the balance. Put options are the exact
opposite; it is "out of the money" when the strike price is
below the current market price of the underlying asset and "in the
money" when the strike price is above the current price.
"Mark to market" method of
accounting is an accrual method of accounting by which both parties to the
option, the option holder/purchaser and the option writer/issuer, recognize and
value the option at its market value as at the date of the balance sheet, in
this appeal, December 31, 1998, and recognize any changes in market value
from the beginning to the end of the period as a gain or loss in the income
statement. It is relevant for tax purposes when an option entered into in one
taxation year expires in a subsequent taxation year. When a liquid security is
traded in an open market, the mark to market value is easy to determine by
reference to its most recently traded price. When there is no open market or
exchange, the mark to market value is calculated in accordance with various
A "Market Maker" is a person,
usually a bank, who participates in transactions to facilitate the desire of
clients to purchase or write options.
An "Option contract" is a
derivative contract by which one party, the writer or issuer, sells (or issues)
the contract to another party (the option holder or purchaser) for the payment
of a premium. Under the contract the purchaser may have the right, but not the
obligation to buy or sell the underlying asset, in the examples at bar, foreign
currency, at a fixed price (the "strike" or "exercise
price") on a specific date or during a specified period of time
("expiration" or "exercise" date).
"Over the counter" or
"OTC" market refers to privately negotiated option contracts between
the principals to the contracts, in the appeal at bar, between Kruger and its
individual counterparty banks.
The "Premium" is the
consideration or price paid for the option. The holder (or purchaser) of an
option cannot lose more than the premium the holder paid for the contract, no
matter what happens with the value of the foreign currency. The potential
profit to the holder is unlimited in theory; the value of the foreign currency
can increase based on the market. If the value of the foreign currency is less
than the strike price, the holder would let the option expire. On the other
hand the writer (or issuer) of an option cannot gain or profit more than the
premium already received in value, the writer must absorb the increase.
A premium has two components, "intrinsic value" and "time
"Realization" for accounting purposes
is similar to cash basis accounting, as opposed to mark to market accounting
which is an accrual method of accounting. In the realization method of
accounting, a transaction is recognized as complete when an entity has a claim
to be paid in cash or an obligation to pay cash. The realized value is certain
and not subject to any estimate of value.
The "Strike Price" or "Exercise
Price" is a fixed exchange rate in the contract at which the option
may be exercised; i.e., that the purchaser of the option must pay the writer
(or issuer) to exercise the "call" option to acquire the underlying
asset, the foreign currency in this appeal, or the amount that the holder (or
purchaser) will receive from the writer (or issuer) on the exercise of a
"put" option to sell the foreign currency. The "Pay off"
represents the value that flows from the writer to the owner of an option if
and when exercised. European style options can only be exercised at the
maturity date of the option at which date the "Pay off", if
positive, is realized.
An option's "Time Value" is the
difference between its market value and its intrinsic value.
The "Underlying Asset" in the
options referred to in these reasons is foreign currency, primarily, if not
wholly, United States dollars.
"Volatility" is the variation
in price of an underlying asset during a specified period, the fluctuation in
value of the underlying asset during the term of the option. It is a variable
in option pricing formulas showing the extent to which the price of the
underlying asset may fluctuate between the date the option is valued and its
After all is said and done, the principal issue
in this appeal is whether Kruger, for purposes of computing its income or loss
for the year under the Act, may value its foreign currency option
contracts at the end of its financial year on a mark to market accounting
All of the options in issue were entered into Kruger's 1998 taxation year and
were to be exercised in its 1999 taxation year. In the event it cannot value
its derivative properties on the mark to market basis, then the appellant
argues that the derivative properties were inventory, thus permitting Kruger to
value the contracts, in accordance with section 10 of the Act in
computing income for 1998 at the lower of their costs or fair market values,
whichever is lower, or in accordance with section 1801 of the ITR,
their fair market value.
In filing its income tax return for its taxation
year ending on December 31, 1998, Kruger claimed losses aggregating
$91,104,379 from a business of trading in derivatives, applying
subsection 9(2) of the Act.
The position of the Minister of National Revenue ("Minister") is that
the amount of $91,104,959 was not deductible in computing Kruger's income for
1998, but the amount of $18,696,881 which Kruger had included in computing its
income as the amortized portion of the net of premium income and premium
expenses regarding the foreign exchange option contracts are to be excluded in
computing its income for 1998, with the result that the appellant's income for
1998 was thereby increased by the net amount of $72,407,498, the difference
between $91,104,379 and $18,696,881.
The Minister also included the amount of $91,104,379 in Kruger's taxable capital
for purposes of the large corporations tax: subsection 181.2(3) in
Part 1.3 of the Act. The appellant opposes such inclusion in its
The Minister also says that Kruger was not
carrying on a business of trading in derivatives and the derivatives were not
inventory of the appellant.
The Minister considered the losses to be "merely a reserve or contingent
amount", the deduction of which is prohibited by section 9 and
paragraph 18(1)(e) of the Act. For income tax purposes Kruger
is required to calculate its gains or losses from the derivative contracts on
the realization method. Apparently, the purported fair market values of the
contracts were less than their costs at year end. Therefore, if the contracts
are inventory, they would be valued at fair market value, potentially producing
the same result to income as valuing the contracts mark to market.
The parties agree that Kruger entered into
foreign exchange option contract transactions as a speculator to profit from
the sale or purchase of such options, anticipating, rightly or wrongly, on how
foreign exchange rates would move in the future. The parties also agree that
Kruger reported its income and losses from trading in foreign option contracts
on income account.
In her pleadings, at paragraph 20(4) of her
Further Fresh Reply to the Notice of Appeal, the respondent referred to the
appellant amortizing a portion of the net of premium income and premium
expenses, $18,696,881, regarding the option contracts and as a result, the
appellant’s income was thereby increased by $72,407,498, the aggregate being
The respondent submitted that the mark to market
values recorded by Kruger were not in accordance with mark to market valuations
since it amortized the premium paid. Respondent’s counsel referred to this as a
“hybrid” method which created inaccuracies in computing income. Appellant’s
counsel submitted that the respondent’s allegation that Kruger did not properly
apply mark to market accounting was not pleaded and ought to be rejected.
The respondent led evidence that the mark to
market method requires that any premium on options should not be amortized over
the life of the option but, rather, should be entered in the computation of
income when paid and received. The appellant states that the respondent did not
question the appellant's method of amortization in its pleadings and is
therefore not permitted to raise the issue at trial.
The respondent did question the
appropriateness of amortizing a premium in mark to market accounting. The
purpose of pleadings is to inform the other party of one’s position, not to
take the other party by surprise. I do not believe the allegation in
subparagraph 20(4) is sufficient to inform the appellant that the very
foundation of its method of valuing its option contracts was being challenged.
Accordingly, I did not consider this submission.
Mr. George Bunze, Vice-chair and
Director of Kruger as well as Chair of its Audit Committee, testified on the
appellant's behalf. Kruger is a private corporation although one of its
subsidiaries offers shares to the public. Its core business is the
manufacturing of newsprint and coated paper products and tissue paper which, during
the period 1997 to 2004, Kruger sold as to 80 per cent to the United States and the balance to the United Kingdom and South America. Canada is not one of its significant
markets. Kruger is the third largest newsprint company in North America. Kruger
also operates a lumber business selling to the U.S. market.
Consolidated sales by Kruger and its
subsidiaries, Mr. Bunze testified, were "around $2,500,000,000"
during the period 1997 to 2004. The sales by the appellant itself were
"about a billion dollars". Accounts receivable of Kruger and its
subsidiaries are "around the $175,000,000 to $200,000,000 at any point in
time". Mr. Bunze estimated that 75 per cent of the receivables
are in U.S. dollars.
In the 1980s, recognizing its exposure to foreign
currencies, Kruger started to purchase and sell foreign currency option
contracts, principally United States dollars, on its own behalf and on behalf
of a wholly‑owned subsidiary, Corner Brook Pulp and Paper Limited. At
times when newsprint prices were rapidly declining, Kruger participated in
hedging commodities but this was not done on a regular basis, according to
Kruger started trading in foreign currency
contracts by hiring a trader to help make "more sophisticated" trades
and maximize profits. Later Kruger was employing a group of four experienced
and knowledgeable full‑time traders to trade derivatives on its behalf. Kruger's
volume in dollars of purchases of derivate products, Mr. Bunze stated,
placed Kruger in the top three or four non banking enterprises in Québec, after
the Caisse de Dépôt and Hydro Québec. For the purpose of managing credit
risk, Mr. Bunze said, Kruger in 1998 dealt with both
Schedule "A" Canadian banks, led by the Bank of Montreal, Royal
Bank, TD Bank and Banque Nationale, as well as Schedule "B"
banks, foreign based banks, such as Citibank, Société Générale,
Deutsch Bank, NatWest Bank and J.P. Morgan Bank.
In 1992 or 1993, Kruger hired
Richard Bradley, a former chief trader for the Toronto Dominion Bank in
London, a person Mr. Bunze described as "a very sophisticated and
knowledgeable individual involved in all aspects of foreign currency … and we
built on that …".
Mr. Bradley's mandate, Mr. Bunze
explained, originated from meetings with Mr. Bunze and Mr. Lloyd Johns,
who in 1998 was Assistant Treasurer of Kruger and at time of trial was
Director, Taxation and Insurance for Kruger. Mr. Johns was also a witness
in this appeal The meetings would review "whatever intelligence
[Mr. Bradley] would bring to the table … through his own network" and
determine the position Kruger would wish to take on currency exposure at the
time. Mr. Bradley did not have a "blank cheque" to trade as he
wanted, but he acted within parameters and recommendations that were discussed.
Mr. Bunze described the trader's livelihood depending on his or her access
to other traders and Mr. Bradley had such access. Mr. Bradley,
Mr. Bunze declared, "knew how to make sure that we maximize our
credit strength and also our contracts".
As years went by Kruger increased what
Mr. Bunze called its "trading treasury group" by hiring
"some bond traders, some commodity hedge type traders for products like
newsprint and lumber". Kruger also established a "backroom" to
handle the trading style of Mr. Bradley. The "backroom" also
supported Kruger's pension fund investments. In short, Mr. Bunze described
it as "a many investment institutional trading floor".
Mr. Bunze described the object of the
trading team was "to mirror a sophisticated trading flow on a miniature scale
…" with the "same sort of structure" as the trading flow of the
Toronto Dominion Bank, "an open office concept where the traders were all
exchanging information flow and so forth". The objective, he said, was
"to generate and produce profits on an individual profit centre
basis" for Kruger and with this purpose Kruger both bought and sold
foreign option currency contracts.
The person ultimately responsible at Kruger for
the administration and control of the trading group during the period 1997 to
2004 was Mr. Bunze. The "ultimate decision maker" was the CEO
and Chairman of Kruger, Mr. Kruger.
Kruger's relationship with the banks was
important, Mr. Bunze stated. He recollected that about 30 financial
institutions were supporting Kruger directly through actual credit facilities,
loan facilities or project financing. Mr. Johns testified that one of the
reasons Kruger dealt with a multitude of banks was to expand Kruger's credit
risk and get competitive prices.
Kruger had contracts and credit agreements with
individual banks as well as with bank syndicates. These contracts,
Mr. Brunze explained, had specific covenants and restrictions as to what
Kruger could do with the proceeds. A typical credit arrangement would include
an actual term loan or a credit facility or a "revolver" that
permitted Kruger to "borrow up and down" but with a limit to the
maximum it could borrow not only with that bank but with others, as well.
The bank syndicates dealing with Kruger required
Kruger to report to the lead lender — Mr. Bunze believed this was the
Bank of Montréal at the time — all of the foreign exchange contracts it
entered into and outstanding "on a quarterly basis derived on the basis of
mark to market and based on the individual institutions confirming in writing
that the mark to market values were calculated by them", that is, each
bank would have to confirm the actual mark to market value of the contracts it
had with Kruger.
Mr. Bunze recalled that the accounting
profession had prepared drafts on how to treat financial investments in the
financial statements and "somewhere in '97 we were notified by Price
Waterhouse … we will have to start reporting in '98 and onwards the financial
trading that we were doing as it's not hedging on a mark to market basis …
" Mr. Bunze agreed with respondent's counsel that the purpose of this
requirement was for the consortium of banks to follow the credit risk of
Kruger's financial statements for 1998 and
subsequent years state and reflect that derivative financial instruments were
held for trading purposes. Kruger's trades, Mr. Bunze stated on cross‑examination,
allowed the trader to "actually speculate and take … any side of the
transaction they deemed fit", both writing options and purchasing options,
always dealing with banks.
Mr. Johns corroborated much of
Mr. Bunze's evidence. When he joined Kruger in 1982, Kruger
"already" had a currency trader. By 1998 Kruger had four traders
including Mr. Bradley as well as three bond and security traders. Only Mr. Bradley
traded in currency.
Mr. Johns managed and supervised Kruger's
treasury back office approving and authorizing daily transfers and monthly
treasury reports which would summarize the various transactions. The "back
office" included a person responsible for day to day banking, including
preparation of daily bank reports, a person working in the money market and a
third person dealing in the foreign currency market. Mr. Johns prepared
the quarterly officer certificate for loan agreements and ensured that all the
debt repayments and debt rollovers were performed. He was also responsible for
Canadian corporate tax for Kruger and its major subsidiaries.
The following is Mr. Johns' description of
how the "back office" functioned:
… a trader would produce a trade ticket and
that trade ticket would go to the Back Office and the Back Office would then
verbally confirm all the trade details with the counterparty. Should they
agree, then the Back Office would input it into the Treasury System, and the
Treasury System would then produce a trade ticket number that couldn't be
altered or deleted and it's a – it was a unique number and the Back Office
would put that on the trade ticket and that's how we accounted for all the
The Back Office would then prepare a monthly summary
that would go to myself and Accounting of all the opened transactions, closed
transactions and outstanding transactions for the month.
Kruger's financial results from its derivative
trading activities were kept separate from the financial results of its manufacturing
activities, according to Mr. Johns. The results of these two activities
were kept in separate ledger books, each having its own separate General
Appellant's counsel directed Mr. Johns to a
statement by Mr. Richard Poirier, an expert witness, that the
currency option contracts could be closed prior to maturity. Mr. Johns
recalled that "very few" would have closed prior to maturity in 1998
because of the "drastic changes" in the Canadian dollar. Management
had decided "to roll these over".
Kruger both issued and acquired option contracts
with the banks but not at the same level, according to Mr. Johns. "We
would have sold more then we would have bought … in 1998, I think it was close
to four to one" and that at all relevant times Kruger's books would have
about three times more written or sold contracts than bought options. The
reason for the sales was that management believed the Canadian dollar was
grossly undervalued and that the value would be coming back and that it would
be a good time to sell options within the year, the "bad ones, we would
roll them over."
In 1999, Mr. Johns explained, the options
would have been rolled over because they were at a loss, or "under
water". In 1998 the Canadian dollar (to the U.S. dollar) fell from 1.40 to
1.5750, a historical loss, said Mr. Johns. In 1999, the Canadian currency
strengthened to 1.44.
Mr. Johns stated that Kruger's sold options
had "an intrinsic value, worth nothing". But because the options had
staggering maturity dates over the year‑end past the year, the options
had time value, not just an intrinsic value, he stated. He estimated the time
value to be "anywhere from 16 to 20 million" even if the intrinsic
value was nil. And, therefore, management decided to roll these options over
but hoping the dollar would strengthen in the shorter term.
The financial statements for 1999 show a
decrease in the notional and adjusted fair value of the written options, the
latter amounts decreasing substantially due to the improvement in the exchange
rate, according to Mr. Johns. He stated that Kruger continued to believe
that if the Canadian dollar was "way under valued … that eventually would
get back" to normal. Currency rates in 1998 were "unheard of"
and the dollar fluctuation was very volatile. Management was of the view that
the loss contracts be rolled over until currency rates "would come back
down, which, in fact, did happen".
Mr. Johns confirmed that the market values
applied by Kruger were the mark to market values from its counterparty banks. He
stated that Kruger did not have the ability or capability at that time to value
mark to market and by Kruger adopting individual bank values, the individual banks
could not dispute the values.
During the years subsequent to 1998 Kruger
continued entering into both written and purchased option contracts until 2004
when there was a significant decrease in the number of both option contracts.
According to Mr. Johns, the Canadian dollar in 2004 was trading at $1.35
and continuing to decrease. A "lot of the so‑called options expired
worthless and in August of 2004 we basically closed out a lot of our
positions" before maturity.
Kruger received mark to market values from the
banks on a quarterly basis and used them for officers' certificates for the
banks and for the audited financial statements until it leased a system that
was "basically" used by the Laurentian Bank, called "Super
Derivatives". (The date when Kruger started using Super Derivatives is not
in evidence.) Super Derivatives, said Mr. Johns, essentially monitors
every transaction on the market in real time. It permitted Kruger itself to
value mark to market. However, for year‑end purposes, Kruger used the
counterparties' mark to market values "to be consistent and to make sure
that there was a third party mark to market … to alleviate any requirement by
anybody that we were falsifying our mark to market …"
Mr. Johns declared that there was no
attempt on Kruger's part to match the option contracts with its receivables.
Kruger carried on
I find that Kruger carried on a business of
speculating on foreign exchange currency options that was separate from its
manufacturing business. It was a leading trader in such options in Québec. It entered
into a large number of contracts and the amounts of the contracts were
substantial. Kruger created a facility and hired experienced personnel to
operate the business in a manner similar to that undertaken by sophisticated
traders in foreign exchange options. Decisions to write or purchase was carried
out in a businesslike manner. The parties agreed that Kruger was a speculator
when acquiring or writing options and was not hedging its receivables or
payables from its principal business. Kruger reported its income and loss from
the option contracts on revenue account. Kruger's speculation in foreign
exchange options, by writing more options than it would purchase, Prof. Klein,
an expert witness for the respondent, opined, carried significant risk but also
chances for large profits. This was all part of a business entreprise
undertaken by Kruger to earn income separate and apart from its manufacturing
Mark to Market v. Realization
In addition to Messrs. Bunze and Johns,
there was an additional lay witness for the appellant,
Mr. Douglas Watson, a CRA official. There were also four witnesses
who were qualified to testify as experts in their field of endeavour,
Mr. Richard Poirier and Mlle Chantal Leclerc, CPA.CA for
the appellant and Professor Peter Klein and
Ms. Patricia O'Malley, CPA.CA for the respondent.
At time of trial Mr. Poirier, who was qualified
as an expert on the operation of foreign currency option markets, carried on
his own business but in previous years was director general of several foreign
currency funds operated by the Banque Nationale du Canada and was also a trader in foreign currency markets. He described
himself as a "mainteneur de marché", a market
maker. Kruger was a client of Mr. Poirier when it dealt with the Banque
Nationale du Canada.
Professor Peter Klein, a Professor of
Finance at the Beedie School of Business at Simon Fraser University in Burnaby, B.C., testified as an expert on derivative instruments, in particular foreign
currency contracts, from a financial perspective. Professor Klein has a
Ph.D. (Finance) degree from the University of Toronto and LL.B. and M.B.A.
(Joint Program) degrees from the University of Western Ontario. He is a
Certified Financial Analyst, amongst other designations. During the period 1984
to 1992 he worked at C.I.B.C./Wood Gundy Inc. at several positions, including
Chief Trader, Capital Markets in London, which included derivative trading. He
has written extensively and has delivered academic papers and speeches on
option valuation and the effect of credit risks on options. He has been the
recipient of research grants and teaching awards in financial matters.
Both Mr. Poirier and Professor Klein described and explained
the nature of, and market for, foreign currency option contracts, how they are
purchased and sold, how they are exercised, how a gain or loss
is calculated, etc. Several strategies in trading option contracts were also
described. The options Kruger entered into were European style options.
Kruger's option transactions were "over the counter" puts and calls
on U.S. and Canadian foreign exchange rates. Since Kruger wrote many more
options than it purchased, it was exposed it to the risk of being forced to
make large pay offs, according to Professor Klein.
Mr. Poirier described the foreign currency
option market as a large market and the most liquid of all option markets, that
it is possible to close a position at any moment during the term of an option. Professor Klein
agreed that the size of the primary market for OTC currency options is
considerable when transactions by all market participants are considered. But
he cautioned that "overall market size should not be confused with
liquidity available to any single market participant". A European option,
Prof. Klein explained, can be settled
in several ways: by cash or physical delivery of a forward contract of equal
value or by "rolling the option" into a new option.
Professor Klein stated that markets for settling prior to expiry or for rolling
the option are illiquid because they consist of a single participant who is the
party on the other side of the original contract and the party wishing to
settle before the expiry date has little negotiating power. Ms. O'Malley
agreed that because it may not be possible to dispose of a contract in the OTC
market, it is possible to close a contract before expiry through negotiation
with the other party, in particular when the subject matter of the contract is
"deep liquid and active like the market for major currencies".
Instead of closing the original contract, “the contract can be rolled over.”
Professor Klein testified that prior to a
party agreeing with a bank to enter into a relationship to trade foreign
exchange option contracts, the party and the bank would put into place a ISDA
to regulate their relationship. Kruger was a party to an ISDA Master Agreement
with each of its counterparty banks. A ISDA Master Agreement, Prof. Klein
explained, allows the parties to trade options in an efficient way by agreeing
orally to each option contract and then following up with a written
confirmation of the trade. An ISDA Master Agreement governs most OTC options,
including the OTC options by Kruger and its counterparties.
An ISDA Master Agreement, Prof. Klein
stated, does allow European options to be transferred before Expiry Date provided
the non transferring party consents to the transfer. He added that the
requirement for such consent is "well known" by writers and buyers of
According to Prof. Klein, Kruger entered
into options that generally represented "unique property" because of
their specific terms and because of Kruger's credit risk as a writer.
Mr. Bunze described the various banks who
were Kruger's counterparties. Mr. Poirier explained that the banks always
consider the credit of a customer to be a risk and is a factor in the bid/offer
spread with the client. Professor Klein stated that the credit of the
customer is an input into the bank's pricing model. Banks, Mr. Poirier
stated, used the same pricing models to determine the value of options during
the term of a contract. Professor Klein does not agree. He testified banks
disagree on mark to market value because their respective pricing models may
differ. Evidence also established that these models were not identical. In
valuing a derivative or counterpart on a mark to market basis, Kruger adopted
the model used by the bank that was its counterparty for the particular
derivative. The values of contracts with different banks for the same amount
and on identical terms may vary depending on the input variables in the particular
bank's model. Several examples were discussed at trial.
An example used by Prof. Klein were identical
options owned by Morgan Guaranty Bank and the Bank of Nova Scotia. Both were
written by Kruger. Each contract was written on May 13, 1998 for
US$ 10,000,000 with an exercise price of 1.46 exercisable on May 13,
1999. The Bank of Nova Scotia valued its option at $797,736 while Morgan
Guaranty valued its option at $612,200, both as at December 31, 1998, a difference
of over 20 per cent. Professor Klein stated that on May 13,
1998, when the Canadian‑US exchange rate was 1.443, the market value of
the option was CAD$ 125,500, approximately. On December 31, 1998 the
exchange rate increased to 1.5305, roughly 6 per cent, yet Kruger
recorded the mark to market value on that date at CAD$ 612,000, four times
larger than the value of the option when it was written. Then, during the final
half of 1999, the U.S. dollar weakened approximately 5 per cent to
1.405, a change sufficient to reduce the actual Pay Off on May 13
1999 to CAD$ 5,000, a 99 per cent decline in the five months
between December 31, 1998 and May 13, 1999. The mark to market values
are, Prof. Klein concluded, very sensitive to changes in the input
variables in estimating value.
Professor Klein compared several other
pairs of options by different banks having similar trade dates, amounts, rates
and expiry dates and found that there were differences in December 31,
1998 values based on the particular banks' valuation models, ranging from
29 per cent to − .03 per cent.
In Professor Klein's view, Kruger's mark to
market valuations at the end of 1998 were not based on a market or a traded
price, "they represented theoretical estimates determined by sophisticated
pricing models where market values of other securities were used to determine
some of the input variables." The bank's pricing models are "very
mathematical and rely on highly idealized assumptions" with respect to how
securities markets operate. Mark to market values are unreliable.
Professor Klein stated that there are a number
of models banks may choose to price a foreign currency option and the result
will depend on which model is chosen and, as stated above, leads to bank
disagreements on mark to market value. The weakness in the mark to market
method, Professor Klein declared, is that the list of input variables to
the models themselves as well the "estimation" methods for the input
variables can differ, causing further uncertainty as to the best estimate of
risk to market value. Different banks can value as at different times of the
day for example. The mark to market value is very sensitive to small changes in
the input variables and are poor estimates of the value of the option that is
ultimately realized. Banks caution that they do not represent the value at
which options could be terminated. The difference between a mark to market
value for an OTC option on its realized value and expiry date of the option,
Professor Klein stated, is very large. The only clear value for Kruger options,
in Professor Klein's opinion, was realized value that was determined by payment
on the expiry date of the option.
Professor Klein did not agree that Kruger's
activities were similar to those of banks notwithstanding Ms. Leclerc's
evidence that banks also speculate in foreign options. He stated that a bank
facilitates trades for its clients, to facilitate demand and supply of options
from these clients. Kruger is one such client and Kruger's position
"consisted primarily of well‑known speculative trades". However,
there was evidence that banks do speculate at times.
Ms. Leclerc is Senior Manager and Partner,
Assurance and Advisory Services at Deloitte & Touche. She is also leader of
the firm's Montréal complex accounting group and a Financial Instruments
National Subject Matter Expert at Deloitte dealing with hedging and derivative
matters. She has worked at Deloitte's San Francisco's office as a member
of the firm's U.S. Financial Investment Specialist Group. At time of trial,
Ms. Leclerc was the Deloitte representative in the Office of the
Superintendent of Financial Institutions, Auditor Deposit Taking Institutions
Committee and during 2003 to 2007 was on the Canadian Institute of Chartered
Accountants Financial Investments Implementation Committee.
Ms. Leclerc was engaged by the appellant's
counsel to report on the application of Canadian generally accepted accounting
principles ("Canadian GAAP") to the transactions in issue for the
period January 1, 1998 to December 31, 1999 inclusive.
Ms. O'Malley was a partner with the
national office of KPMG in 1999 when she left the partnership to become the
first full‑time Chair of the Canadian Accounting Standards Board
("CASB") which was authorized by the Canadian
Institute of Chartered Accountants ("CICA")
to set accounting standards that are applied as GAAP for chartered accountants.
The CICA Handbook, she testified, is the product of the work of the CASB.
Ms. O'Malley also served as Vice‑chair
of the CASB and as a member of the emerging issues Committee of the CICA which
dealt with the interpretation of standards. Gradually, she said, she developed
a specialty in accounting standards for financial instruments. In the late
1990s she represented the CASB as part of the Canadian delegation to the Joint
Working Group on Financial Instruments, later becoming the International
Accounting Standards Board, an "international consortium working to
develop an accounting standard with respect to financial instruments",
Both Ms. Leclerc and Ms. O'Malley
reviewed literature and guidance on the application of Canadian GAAP. They
agreed that Canadian GAPP's preferred basis of accounting for foreign exchange
option contracts in 1998 was the mark to market method, that the option
contracts be measured on the balance sheet at their fair market value and,
Ms. O'Malley wrote, recognize changes in the fair value of income in the
period of the change.
Ms. Leclerc and Ms. O'Malley also
reviewed principles of US GAAP as they applied to derivative financial
instruments, including options. These included specific to derivative financial
instruments, including options, found in standards published by the United
States Financial Accounting Standards Board ("FASB") for the relevant
time. Ms. Leclerc wrote that the FASB was "one of the most dominant
standard setters in the world" at the time and its approved financial
statements concepts were highly aligned with those of the CICA. Upon review of
several FASB statements (FAS 133, FAS 80, 52) and other studies she concluded that the U.S. standards
"indicate that the most relevant and decision‑useful accounting
policy for non‑hedging option contracts was fair value (or market value)
where changes in fair values, whether hedged or unrealized, were recorded
In her report Ms. Leclerc writes that not
only financial institutions but non‑financial institutions as well who
traded in foreign currency option contracts in 1998 applied mark to market
valuation for accounting purposes. Attached to her report was an appendix
confirming Mr. Poirier's claim that Canadian chartered banks speculated on
foreign currency option contracts.
Ms. Leclerc referred to a text by
Ross M. Skinner
for the view that "it is hard to avoid a conclusion that speculative
activity is best portrayed by valuing speculative option positions at market,
regardless of the manner in which other assets and liabilities are
reported" and it makes no difference whether the options are puts or sales
(p. 284). Ms. Leclerc stated Mr. Skinner had identified three
possible measurement basis for purchased options held for speculative purpose:
cost basis, the lower of cost and market basis for purchased option (or highter
of cost or market for written options) and market value basis.
Ms. O'Malley agreed that the FAS 133
required that "all derivative financial instruments (including forwards
and options) to be recognized in the financial statements at fair value when
the contract is entered into and at each financial reporting date thereafter,
with any change in value recognized in income in the period of the
change". A rationale for the FASB's requirement is that "fair value
is the most relevant measure for financial instruments and the only relevant
measure for derivative instruments".
Among the reasons Ms. O'Malley lists for
the conclusion that fair value is the appropriate measurement for derivatives
(a) Fair values of
financial instruments show the market's assessment of the present value of the
net future cash flows directly or indirectly embodied in them, discounted to
reflect both current interest rates and the market's assessment of the risk
that the cash flows will not occur. Information about fair market value better
enables investors, creditors, and other users to assess an entity's performance.
(c) Fair value measurement is practical for most
financial assets and liabilities. Fair value measurements can be observed in
markets or estimated by reference to markets for similar instruments. If market
information is not available, fair value can be estimated using other
measurement techniques, such as discounted cash flow analysis and option
Ms. O'Malley also referred to an
International Accounting Standard 39, issued in March 1999 (effective for fiscal years
commencing on or after January 1, 2001) to the effect that all derivatives
were to be measured at fair value at each financial reporting date with the
change in value recognized in income in the period. Ms. O'Malley explained
that when the derivative is not actively traded but its value is derived from a
commonly used technique and the inputs to that technique are all derived from
active markets, that value is also appropriately referred to as a market value.
As far as Kruger's foreign currency options are
concerned, Ms. O'Malley wrote that the option pricing models:
… are well established as valuation
techniques and all the major inputs needed for those models can be observed in
active markets. In addition, Kruger had the ability to check on the reliability
of the quotes it was given as the cost to close its contracts by obtaining
quotes from more than one of its counterparties. Thus, Kruger's implementation
of a fair value accounting policy for its option contracts is also equivalent
to the mark to market method.
This does not appear
to coincide with Professor Klein’s view.
Ms. O'Malley also referred to
Mr. Skinner to explain that the goal of financial accounting is not
necessarily the same as for tax accounting.
He noted that the objective of financial statements is to provide information
to the users of the statements that will be useful to them in making decisions.
Primary users of financial statements are investors, including potential
investors, and creditors who do not have internal access to an entity's
information. Creditors and investors are interested in the entity's ability to
earn income and to generate cash flows in the future. Creditors want to make
sure that they will not lose money if things are going badly; investors will do
well if the entity does well and lose if the entity is doing poorly. The
investor wants to know what his or her portfolio is worth at a given time so as
to decide to buy, sell or hold onto the investment or if one is a potential
creditor, to consider possible terms of a loan. The financial information of
the entity provided as financial statements as at a particular date gives a
picture of the entity's health at that date so as to make a decision.
The difference in mark to market and realization
methods of value is simply one of timing. Ms. O'Malley described four
different methods of valuing options that could be applied in calculating
income on option contracts for accounting purposes: realization and three
methods of accrual accounting that are premium amortization, loss accrual
method and the mark to market method.
The premium amortization method would reflect
changes in the time value of the premium paid and received; the premium could
be amortized into income "in some systematic way" over the term. The
loss accrued method requires the writer/owner to recognize, fully or partially,
the potential loss on a contract that was in the money. This method would
normally be combined with the premium amortization method since it would not be
realistic to recognize a loss without also recognizing at least a portion of
the premium received to assume the risk.
The choice of method affected only the timing of
the recognition of the income and losses. In the realization method, for
example, Kruger would have no loss or income in 1998, the income would be
realized in 1999. The premium amortization method would reflect income in 1998
and a loss in 1999. The loss accrued and mark to market methods both reflect
losses in 1998 and income in 1999. But in all cases, Ms. O’Malley
concluded, the income was the same amount over entire period from inception of
the first contract to final expiry of the contract. The loss or gain in any one
year depends on the choice of accounting method.
The appellant called upon
Mr. Douglas Watson, a CRA officer, to testify how the CRA
administered sections 142.2 to 142.5 of the Act. Mr. Watson
has worked for the CRA for 30 years. During the period 2000 to 2012 he was
a Financial Product Specialist, advising CRA auditors "how to audit and
analyze situations involving financial products, primarily derivative
transactions and the applicable tax principles that would apply". At time
of trial, he was manager of the Corporate Financing Section in the Rulings
Division. Mr. Watson was not comfortable testifying.
Mr. Watson recalled that in the early
1990's the term "mark to market" was "a very broad term …
someone was trying to estimate the value of something, maybe the value of what
it could be sold for or discharged at". However, in 1997 fair value
accounting was introduced in Canada and the term mark to market became more
specific, a term meaning one method of estimating fair value.
Mr. Watson agreed with appellant's counsel
that the valuation of a derivative financial instrument is based on existing
market prices, among other things. However, he said, this is not the situation
where there are no public market prices, in over the counter transactions, for
example. Where banks are concerned, a bank will use its own pricing model. Like
Prof. Klein, Mr. Watson did not agree with the appellant that all
banks use the same pricing model.
Mr. Watson declared that he is "aware
of the fact that [CRA] bank auditors have challenged the banks on the output of
certain … of their pricing models." Discussions took place with the
parties and were "resolved without ever having to go to court". He
insisted "our auditors do not accept the output of the pricing models at
face value, they do some audit work to satisfy themselves that there are
reasonable values for purposes of the Income Tax Act".
With respect to taxpayers that are not financial
institutions or investment dealers, Mr. Watson stated that pricing is done
on a realization value. In principle, the CRA has
allowed the mark to market method relied on by the banks as an acceptable
method of computing income for tax purposes.
In discussing a cancelled CRA Income Tax
Technical News publication, Mr. Watson shared CRA's concern that taxpayers other than
financial institutions use the mark to market method of accounting. An email of
October 9, 2001 from Mr. Watson to colleagues at CRA discussed the
difficulty CRA had in verifying the mark to market values and the concession
the CRA granted to mutual fund trusts, permitting them to apply mark to market
The opinion given in IT Technical News No. 14 applies only to
mutual funds as defined in section 138 of the Act. The concern with the
mark to market method is the difficulty with the verification of the value of
derivatives. Mutual Fund Trusts are regulated and must provide daily market valuations
for the benefit of unit holders. Therefore, they are subject to the scrutiny of
these parties. In addition, the majority of their investments are in publicly
traded derivatives, the value of which can be verified. For these reasons, CCRA
granted the concession expressed in the publication.
Other taxpayers cannot use this position. Valuations prepared for
shareholders may be skewed by the accounting principle of conservatism such
that profitable positions are understated. Similarly, valuations prepared for
tax purposes may lack consistency between profitable and unprofitable
positions. At this point in time, we lack the tools to verify the valuation of
derivatives. The realization method is supportable in law and, although it may
present timing opportunities for taxpayers, as it is based on transactions,
taxpayers can easily comply and CCRA can easily audit.
The CRA permitted the Investment Funds Institute
to compute income from derivative transactions by either realization method or
mark to market accounting because it was satisfied that "their accounting
systems were true and their methods were accurate" as well as being
subject to regulations.
Thus, CRA’s concern with non financial
institutions using mark to market accounting was, a) except for regulated
institutions, mark to market values could not be relied on as accurate, and
b) CRA lacked the audit capacity to verify the accuracy of mark to market
Mr. Watson agreed with appellant's counsel's
suggestion that derivative financial instruments such as foreign currency
option contracts are not mark to market property as defined by
subsection 142.2(1). Banks "include these products in that section
(i.e. s. 142.2) and the manner in which they file their tax returns, and (CRA)
auditors do not generally dispute that."
Mr. Watson acknowledged that when the
Minister makes a concession to a taxpayer, it must be in accordance with the
law although "we do not always necessarily apply the law as it applies to
timing differences". There are circumstances he said, where the CRA will
reduce the compliance burden for both parties for administrative ease.
Apparently, Mr. Watson's and his employer's view is that only financial
institutions and those taxpayers whose activities are "regulated" may
have access to mark to market accounting in computing income for tax purposes.
I am not surprised that Kruger, in particular in view of its extensive dealings
in derivatives, felt odd man out.
The appellant's alternative position is that the
foreign exchange option contracts are inventory and that in computing income
from its business of speculating in such contracts it is therefore permitted to
value the contracts pursuant to subsection 10(1) of the Act or
section 1801 of the ITR. The Minister states that Kruger does not
carry on such a business and if it does, then, in any event, the option
contracts are not inventory of Kruger. I have found that Kruger does carry on a
business of speculating in option contracts. The issue then is whether the
contracts are inventory.
Ms. Leclerc's report is silent with respect
to whether foreign currency option contracts may be considered inventory in
accordance with Canadian GAAP but in a question put to her, she agreed that as
an accountant she would not consider a derivative property inventory.
Ms. O'Malley's view is that in accordance with GAAP, inventory consists of
tangible assets held for sale in the ordinary course of business. She states
that foreign currency options purchased are intangible assets and that foreign
currency options issued (written) are liabilities and not assets.
Ms. O'Malley acknowledges that
section 3030 of the CICA Handbook does not define the term
"inventories" but does not contemplate inventories as being anything
other than goods. CICA's Terminology for Accountants, 4th ed.,
1992, defines inventory
… as items of tangible property that are held for resale in the
ordinary course of business or are being produced for sale, or are to be
consumed directly or indirectly in the production of goods or services to be
available for sale.
Ms. O'Malley testified that U.S. GAAP also
recognizes "inventories" to be tangible assets, "a stock of
goods" held for resale in the course of business or in the process of
production for such sale or are to be consumed in the production of goods for
sale. The International Standards (IAS2) is similar to the U.S. definition of inventories and specifically excludes financial instruments from the score of
For Canadian GAAP, Ms. O'Malley stated,
foreign currency options are either financial assets or financial liabilities,
not inventory. The portions of the CICA Handbook definitions pertaining to
options states a financial asset is a contractual right to exchange financial
instruments with another party under conditions that are potentially
favourable. A contractual obligation to exchange financial instruments with
another party under conditions that are potentially unfavourable is a financial
liability. The overall definition of financial assets includes cash.
Appellant says that it is irrelevant that
derivative financial instruments were not inventories in accordance with GAAP
because they were not tangible properties and because they were either
financial assets or financial liabilities. All this is meaningless for tax purposes.
Whether Canadian GAAP categorizes contracts as financial assets or financial
liabilities does not disqualify them as inventory. The IAS definition of
inventory excluded financial instruments from inventory and the reason,
according to Ms. O'Malley, was that financial instruments were to be
valued at fair value at the end of the year, not the lower of market and cost
as required for inventory.
to market vs. realization
The appellant submits that in calculating its
loss of $91,104,379 for its 1998 taxation year from trading in foreign exchange
contracts it applied the provisions of the Act as required by
subsection 9(2) of the Act. The appellant states that in accordance
with section 9 it is entitled to value its foreign exchange option
contracts on the mark to market method in reporting its income or loss for the
year from a business.
Both expert accounting witnesses testified that
GAAP recognizes mark to market as the preferred method to value derivative
property at the end of a taxation year. However, I must determine if mark to
market valuations employed by Kruger for its foreign exchange option contracts
are consistent and appropriate for purposes of the Act and thus provide
an accurate picture of Kruger’s income for the year consistent with the
provisions of the Act, case law and well accepted business principles.
For the 1998 taxation year subsections 9(1)
and (2) of the Act read as follows:
to this Part, a taxpayer's income for a taxation year from a business or property
is the taxpayer's profit from that business or property for the year.
réserve des autres dispositions de la présente partie, le revenu qu'un
contribuable tire d'une entreprise ou d'un bien pour une année d'imposition
est le bénéfice qu'il en tire pour cette année.
to section 31, a taxpayer's loss for a taxation year from a business or
property is the amount of the taxpayer's loss, if any, for the taxation year
from that source computed by applying the provisions of this Act respecting
computation of income from that source with such modifications as the
réserve de l'article 31, la perte subie par un contribuable au cours
d'une année d'imposition relativement à une entreprise ou à un bien est le montant
de sa perte subie au cours de l'année relativement à cette entreprise ou à ce
bien, calculée par l'application, avec les adaptations nécessaires, des
dispositions de la présente loi afférentes au calcul du revenu tiré de cette
entreprise ou de ce bien.
None of the words "income", "profit" and
"loss" found in section 9 is defined in the Act, except
that subsection 9(1) assimilates income and profit. To determine a
taxpayer’s loss from a business or property, subsection 9(2) requires that
the loss be computed applying the provisions of the Act respecting the
computing of income from a business or property but with modifications based on
The losses claimed by Kruger are not the result
of deductions incurred by Kruger for the purpose of earning income; the
purported losses result from a change in values of certain option contracts. In
M.N.R. v. Consolidated Glass Ltd.,
Rand J., at p. 174, asked
… [h]ow can profits and gains be considered to have been made in any
proper sense of the words otherwise than by actual realization? This is no
inventory valuation feature in relation to capital assets. That the words do
not include mere appreciation in capital values is, in my opinion, beyond
controversy. It is difficult if not impossible to say that where only value is
being considered in which a variable inheres you can have any other than a
fluctuating estimate. The word "loss" in the context means absolute
and irrevocable, finality. That state of things is realized upon a sale; …
In Mountain Park Coals Ltd. v. M.N.R., Thorson P.
opined that “… loss is the inverse of profit…”
In Symes v. Canada,
Iaccobucci J., writing for the majority of the Supreme Court approved the
comments of Thorson P.
in Royal Trust Co. v. M.N.R.,
where the latter wrote that the first approach to determine whether an expense
is deductible in computing income for income tax purposes is to ascertain
whether the deduction is "consistent with ordinary principles of
commercial trading or well accepted principles of business and accounting
Earlier, in Canadian General Electric Co. Ltd v. M.N.R.,
Martland J., at p. 11, referred to Dominion
Taxicab Association v. M.N.R.,
for the principle enunciated by Cartwright J. that "whether or not a
sum in question constitutes profit must be determined on ordinary commercial
principles unless the provisions of the Income Tax Act require a
departure from such principles."
There are several reported cases where taxpayers
revalued properties at its year end for tax purposes. In Canadian General
the taxpayer (“CGE”) borrowed U.S. dollars from its American parent in 1950 to
acquire goods and services from U.S. suppliers. At the time the U.S. dollar was
at a substantial premium over the Canadian dollar and CGE’s U.S. parent made
U.S. funds available to it so as to acquire its supplies. At the time each note
was given, CGE set up in its books not only the liability for the fair value of
the notes but also the amount of the premium necessary to pay back the notes in
U.S. funds. Between 1950 and early 1952 CGE issued numerous promissory notes to
its parent as evidence of its indebtedness. Soon after the U.S. dollar declined
in value and CGE paid off some notes in 1951 and the balance in 1952, saving
$512,847. There was no issue that the $512,847 was income to CGE. However, CGE,
who reported income on an accrual basis, claimed that in order to give a true
picture of its financial position it was necessary to revalue the amount of
Canadian dollars necessary at the end of each year to pay off the notes. Thus,
CGE apportioned the $512,847 profit as to $64,675 to 1950 and $259,820 to 1951
and $188,352 to 1952. CGE argued it always used this method in dealing with its
current obligations in U.S. currency. The fisc was of the view that the
$512,847 profit arose only upon actual payment of the notes and argued that
$81,774, the amount paid in 1951, was taxable in 1951 and $431,073, the amount
paid in 1952, was taxable in 1952.
The Minister’s position was that a taxable
profit is not realized and does not arise by the mere revaluation in a trader’s
accrual of the cost of Canadian dollars, at any given time, of paying off an
indebtedness payable as a foreign currency. Such a profit would be an
unrealized profit. Profit, insisted the Crown, can only be realized on actual
payment of the notes in 1951 and 1952.
The Supreme Court held that it was proper for
CGE to compute its profits, in relation to the notes, in the manner in which it
did. There would be no "profit" at all in respect of the notes in
1952 save for the fact that their value had to be estimated under the accrual
method of accounting in 1950 in order to determine CGE's profit for that year.
Being a matter of estimate, Martland J., Cartwright and Ritchie J.J.
concurring, wrote that the valuation of the liability should continue to be
revised in each year thereafter until the year of actual payment. The Supreme Court allowed CGE’s
appeal. The profit for 1952 in relation to the notes should be the amount by
which, in terms of Canadian dollars, the cost of payment was reduced in that
year, the difference between the estimate of the cost of payment at the
beginning of 1952 and the actual cost of payment in 1952.
CGE’s liability on the promissory notes was the
result of it securing product from its parent for sale in its regular Canadian
business operations and not part of a separate business carried on by CGE.
Abbott J. dissented; he favoured the
realization method. In 1952, he wrote, CGE was able to acquire for
CDN$ 9,032,383, US$ 9,225,327 to discharge a liability of
CND$ 9,461,455 which it had claimed and was allowed as a deduction from
gross income in arriving at its profits in 1950 and 1951. It thus realized a
gain of CDN$ 431,073 which on the principles laid down in several cases must be taken into the
computation of profit and loss for tax purposes and this exchange gain must be
taken into account in 1952, the year in which it became a reality.
On p. 20, Abbott J. stated:
Particularly in the absence of a fixed exchange rate, a liability
incurred by a Canadian debtor in terms of a foreign currency must always
contain a contingent element and what the appellant did, in reality, in
revaluing its U.S. dollar liability at the end of each fiscal period, was
merely (1) to state from time to time in its balance sheet, a revised estimate
of the Canadian dollar equivalent of what it owed to its parent company in U.S.
dollars and (2) to write down the amount of that indebtedness as originally
entered in its books and treat the resulting "gain" as a capital
profit apportioned over three years. The fact that appellant used the accrual
system of accounting in calculating its trading profits for each year had no
relevance to this purely bookkeeping operation. No doubt the entries made by
appellant in its books were proper from an accounting standpoint in order to
present from time to time, as accurate a balance sheet as possible, but in my
opinion they had no bearing upon the appellant's liability for income tax.
The Supreme Court considered mark to market
accounting in Friedberg v. Canada.
In Friedberg, the taxpayer relied on the lower of cost or market method
in computing his income from trading in gold futures. He reported unrealized
losses when they actually occurred but reported gains only when they were
actually realized. The Crown assessed on the basis he ought to have valued the
gold future contracts on the mark to market method, recognizing all unrealized
losses and gains. The Court rejected the mark to market accounting method
stating that although that method may have described better the taxpayer's
income position for some other purpose, which I assume the Court meant
financial purposes, the Court was not satisfied that it can describe income for
income tax purposes. The Supreme Court held that the procedure used by
Mr. Friedberg in reporting his income was proper.
Expert evidence in Friedberg agreed that
the lower of cost or market method was acceptable under Canadian GAAP and the
Federal Court of Appeal agreed that the method used by Mr. Friedberg was
"appropriate to the business" and told "the truth about the
I agree with appellant's counsel that the
Supreme Court held that on the facts, the Crown did not demonstrate that there
was any error in Mr. Friedberg's approach in computing income from his
business. Counsel submitted that the Supreme Court did not close the
possibility of applying mark to market accounting for income tax purposes.
The principles applied to determine a taxpayer’s
income or profit also determine a taxpayer’s loss. A comprehensive and critical
analysis of profit computation for tax purposes is found in Justice Iaccobucci's
reasons in Canderel v. The Queen.
In Canderel the issue was whether a tenant inducement payment is to be
deducted from income entirely in the year in which it was made or is it to be
amortized over the term of the lease to which it relates. The Supreme Court
held that the taxpayer's income calculation, amortizing the payments, provided
an accurate picture of income for the year in question and was not inconsistent
with any principle of the Act.
 Iaccobucci J. wrote:
30 What, then, is the true nature of “profit” for tax
purposes? While the concept has been variously expressed, perhaps the clearest
and most concise articulation of the term is to be found in the oft-quoted
decision of this Court in M.N.R. v. Irwin,  S.C.R. 662, at p. 664,
where profit in a year was taken to consist of “the difference between the
receipts from the trade or business during such year ... and the expenditure
laid out to earn those receipts” (emphasis in original). This definition was
echoed by Jackett P. in Associated Investors of Canada Ltd. v. M.N.R.,
 2 Ex. C.R. 96, where he stated at p. 102:
Ordinary commercial principles
dictate, according to the decisions, that the annual profit from a business
must be ascertained by setting against the revenues from the business for the
year, the expenses incurred in earning such revenues.
31 Accepting this fundamental definition, in Symes,
supra, at pp. 722-23, the majority made the following observations about the
computation of profit:
. . . the “profit” concept in s. 9(1)
is inherently a net concept which presupposes business expense deductions. It
is now generally accepted that it is s. 9(1) which authorizes the deduction of
business expenses; the provisions of s. 18(1) are limiting provisions only. . .
Under s. 9(1), deductibility is
ordinarily considered as it was by Thorson P. in Royal Trust, [Royal
Trust Co. v. Minister of National Revenue, 57 D.T.C. 1055 (Ex. Ct.)] (at p.
... the first approach to the
question whether a particular disbursement or expense was deductible for income
tax purpose was to ascertain whether its deduction was consistent with ordinary
principles of commercial trading or well accepted principles of business
... practice ... (Emphasis added.)
Thus, in a deductibility analysis,
one’s first recourse is to s. 9(1), a section which embodies, as the trial
judge suggested, a form of “business test” for taxable profit.
… it is more appropriate in considering the s. 9(1) business test to
speak of “well accepted principles of business (or accounting) practice” or
“well accepted principles of commercial trading”.
32 The great difficulty which seems to have plagued the
courts in the assessment of profit for income tax purposes bespeaks the need
for as much clarity as possible in formulating a legal test therefor. The
starting proposition, of course, must be that the determination of profit under
s. 9(1) is a question of law, not of fact. Its legal determinants are two in
number: first, any express provision of the Income Tax Act which
dictates some specific treatment to be given to particular types of
expenditures or receipts, including the general limitation expressed in s.
18(1)(a), and second, established rules of law resulting from judicial
interpretation over the years of these various provisions.
33 Beyond these parameters, any further tools of analysis
which may provide assistance in reaching a determination of profit are just
that: interpretive aids, and no more. Into this category fall the
“well-accepted principles of business (or accounting) practice” which were
mentioned in Symes, also referred to as “ordinary commercial principles”
or “well-accepted principles of commercial trading”, among other terms. A
formal codification of these principles is to be found in the “generally
accepted accounting principles” (“GAAP”) developed by the accounting profession
for use in the preparation of financial statements. … What must be remembered,
however, is that these are non-legal tools and as such are external to the
legal determination of profit, whereas the provisions of the Act and other
established rules of law form its very foundation.
34 That is not to minimize the key role played by such
well-accepted business principles (as I shall hereafter refer to them) in the
profit-computation process. In Friesen v. Canada,  3 S.C.R. 103,
Major J. made the following observation at para. 41:
The Act does not define
“profit” nor does it provide any specific rules for the computation of profit.
Tax jurisprudence has established that the determination of profit under s.
9(1) is a question of law to be determined according to the business test of
“well-accepted principles of business (or accounting) practice” or
“well-accepted principles of commercial trading” except where these are
inconsistent with the specific provisions of the Income Tax Act. . . .
35 I think this statement aptly describes the proper relationship
between tax law and business principles. In the absence of a statutory
definition of profit, it would be unwise for the law to eschew the valuable
guidance offered by well-established business principles. Indeed, these
principles will, more often than not, constitute the very basis of the
determination of profit. However, well-accepted business principles are not
rules of law and thus a given principle may not be applicable to every case.
More importantly, these principles must necessarily take a subordinate position
relative to the legal rules which govern.
36 The reason for this is simple: generally speaking,
well-accepted business principles will have their roots in the methodology of
financial accounting, which, as was expressed in Symes, is motivated by
factors fundamentally different from taxation. Moreover, financial accounting
is usually concerned with providing a comparative picture of profit from year
to year, and therefore strives for methodological consistency for the benefit
of the audience for whom the financial statements are prepared: shareholders,
investors, lenders, regulators, etc. Tax computation, on the other hand, is
solely concerned with achieving an accurate picture of income for each
individual taxation year for the benefit of the taxpayer and the tax collector.
Depending on the taxpayer’s commercial activity during a particular year, the
methodology used to calculate profit for tax purposes may be substantially
different from that employed in the previous year, which in turn may be
different from that which was employed the year before. Therefore, while
financial accounting may, as a matter of fact, constitute an accurate
determinant of profit for some purposes, its application to the legal question
of profit is inherently limited. Caution must be exercised when applying
accounting principles to legal questions.
37 I do not wish to be taken, however, as minimizing the role
of GAAP in the determination of profit for income tax purposes. … GAAP will
generally form the very foundation of the “well-accepted business principles”
applicable in computing profit. It is important, however, for the courts to
avoid delegating the criteria for the legal test of profit to the accounting
profession, and therefore a distinction must be maintained. That is, while GAAP
may more often than not parallel the well-accepted business principles
recognized by the law, there may be occasions on which they will differ, and on
such occasions the latter must prevail: see, for example, Friedberg v.
38 … GAAP will surely not be
determinative as to the method by which an accurate picture of profit may be
obtained for taxation purposes, though it may still be useful as a guide to the
various acceptable methods of computation, one of which may yield the
appropriate result for taxation.
39 A good example of the relationship among the provisions of
the Act, the principles developed in the case law, and GAAP or
well-accepted business principles can be found in s. 18(9) of the Act,
which requires the amortization of certain prepaid expenses over the periods of
time to which they relate.
40 I pause here for a moment to distinguish the role of the
courts in this regard from that of Parliament. Generally speaking, the courts
are free, in the absence of contrary legislation or established rules of law,
to assess the taxpayer’s computation of income in accordance with well-accepted
business principles. Obviously, this will require an assessment in each case of
which of these principles apply to the particular circumstances which present
themselves. However, it is not for the court to decide that one principle is
paramount, or applicable to the exclusion or subordination of all others by
saying that it has been elevated to the status of a rule of law which is to be
applied in all situations. That is exclusively within the province of
Parliament, and the willingness of Parliament to exercise this power is
exemplified by s. 18(9) and by countless other codifications in the Act
of what would otherwise likely be considered well-accepted business principles:
see Symes, supra, at pp. 723-25.
42 Of course, this is distinct from the interpretation of
such rules, such as, for example, the elucidation of the otherwise undefined
concept of “profit”, which is well within the jurisdiction of the courts. Such
interpretive jurisprudence will fall within the category of “rules of law”
which, as a matter of course, will predominate over well-accepted business
principles. However, when no specific legal rule has been developed, either in
the case law or under the Act, the taxpayer will be free to calculate his or
her income in accordance with well-accepted business principles, and to adopt
whichever of these is appropriate in the particular circumstances, is not
inconsistent with the law, and, as I shall elaborate upon below, yields an
accurate picture of his profit for the year. The simple application by a court
of one or another well-accepted business principle to a particular case or
cases, moreover, will not ordinarily amount to the elevation of that principle
to the status of a “rule of law”. In general, the Minister will not be entitled
to insist that one method supported by business practice and commercial
principles be employed over another, equally supported method, unless, as I
will develop below, the method chosen by the taxpayer fails to yield an
accurate picture of his or her income for the taxation year.
Interpretive Goal: An Accurate Picture of Income
43 Having established an appropriate framework for analysis,
I should now like to discuss what exactly is the question that must be answered
when attempting to assess a taxpayer’s profit for tax purposes. A good place to
begin is with the decision of the Federal Court of Appeal in West Kootenay,
supra, where MacGuigan J.A. stated at p. 745:
The approved principle is that
whichever method presents the “truer picture” of a taxpayer’s revenue, which
more fairly and accurately portrays income, and which “matches” revenue and
expenditure, if one method does, is the one that must be followed.
44 … that 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 particular taxpayer. If this is accomplished by applying the
matching principle, then so be it. On the other hand, if some other method is
appropriate, is permissible under well-accepted business principles, and is not
prohibited either by the Act or by some specific rule of law, then there
is no principled basis by which the Minister should be entitled to insist that
the matching principle -- or any other method, for that matter -- be
employed. MacGuigan J.A. in West Kootenay seemed to advert to this
notion at pp. 745‑46, in the passage immediately following the
The result often will not be
different from what it would be using a consistency principle, but the “truer
picture” or “matching approach” is not absolute in its effect, and requires a
close look at the facts of a taxpayer’s situation. [Emphasis added.]
47 … To the extent that they may be applicable to particular
circumstances, well-accepted business principles are to be assessed and applied
only on a case-by-case basis, and only for the purpose of achieving an accurate
picture of profit for the year in question for income tax purposes. …
50 It follows from all of this that in calculating his or her
income for a taxation year, the taxpayer must adopt a method of computation
which is not inconsistent with the Act or established rules of law, which
is consistent with well‑accepted business principles, and which will
yield an accurate picture of his or her income for that year. In the simplest
cases, it will not even be necessary to resort formally to the various well‑accepted
business principles, as the simple formula by which revenues are set against
the expenditures incurred in earning them is always the basic determinant.
53 The outlined framework for
analysis is, of course, only as useful as its application to actual cases.
Turning to the facts of this case will illustrate how this principled approach
to the computation of income is intended to operate. Before I do this, however,
it may be both convenient and useful to summarize the principles which I have
set out above:
(1) The determination of
profit is a question of law.
(2) The profit of a business for a taxation year is to be
determined by setting against the revenues from the business for that year the
expenses incurred in earning said income: M.N.R. v. Irwin, supra,
Associated Investors, supra.
(3) In seeking to ascertain profit, the goal is to obtain an
accurate picture of the taxpayer’s profit for the given year.
(4) In ascertaining profit, the taxpayer is free to adopt any
method which is not inconsistent with
provisions of the Income Tax Act;
case law principles or “rules of law”; and
(5) Well-accepted business principles, which include but are
not limited to the formal codification found in GAAP, are not rules of law but
interpretive aids. To the extent that they may influence the calculation of
income, they will do so only on a case-by-case basis, depending on the facts of
the taxpayer’s financial situation.
(6) On reassessment, once the taxpayer has shown that he has
provided an accurate picture of income for the year, which is consistent with
the Act, the case law, and well-accepted business principles, the onus
shifts to the Minister to show either that the figure provided does not
represent an accurate picture, or that another method of computation would
provide a more accurate picture.
In Friesen v. Canada, the
Supreme Court of Canada considered whether a taxpayer’s venture in the nature
of trade was a true business allowing the taxpayer to value vacant land as
inventory under subsection 10(1) of the Act. Both
Major J., at para. 45 and 46 and Iaccobucci J., at para. 105 to 108, notwithstanding they were on opposite
sides, agreed that a general principle of taxation is that neither profits nor
losses are recognized under the Act until realized except if the Act
provides an exception to the realization principle. Iaccobucci J., in
dissent, emphasized, at para. 160, that:
… whenever the Income Tax Act permits deemed dispositions at
fair market value without actual realizations, it does so narrowly and in a
highly circumscribed manner: for example, when a taxpayer ceases to be a
Canadian resident (s. 48 (now repealed)), or upon death (s. 70), or
upon change of control (s. 111). Exceptions from the realization principle
are thus clearly stipulated and explicitly codified, unlike the exception upon
which the appellant seeks to rely. For the most part, the Act does not
recognize “unrealized” or “paper” gains or losses: Krishna, supra, at
Mark to market valuation is consistent with well
accepted business principles and practice. GAAP’s preferred basis of accounting
for foreign exchange option contracts in 1998 was mark to market. International
accounting also recognizes that these options be valued mark to market. However,
except for sections 142.2 to 142.5 of the Act (and
section 1801 of the ITR), there is no express statutory provision
requiring or authorizing valuation of property on a mark to market basis.
The provisions of section 142.2 to
section 142.5 require financial institutions and investment dealers to use
mark to market; there is no option. These provisions did not speak to the
entitlement or lack of entitlement of any other class of taxpayer to use mark
to market accounting for trading in financial instruments. Kruger submits that
its entitlement to use mark to market accounting in respect of its profits and
losses from foreign currency option contracts is in no way affected by the fact
that it is not a financial institution.
GAAP is a non‑legal tool, external to the
legal determination of profit. To determine whether mark to market is a proper
method available to taxpayers for income tax purposes, one is bound by the
provisions of the Act and rules of law. Any given accepted business
principle may not be applicable to every case.
Iaccobucci J. warns that caution must be
exercised when applying accounting principles to legal questions. The goals in determining
profit and loss for financial purpose and tax purposes are not the same.
Financial accounting, Iaccobucci J. states,
is concerned with constructing a picture of profit from year to year in a
consistent manner for the benefit of the audience for whom financial statements
are prepared: shareholders, investors, lenders, etc. Ms. O’Malley
described a statement for financial purpose as "a snapshot" of the
entity at a precise moment. FASB views mark to market valuation for the same
reasons: to better enable investors, creditors and others to assess the
entity’s performance. Mark to market value is the market’s assessment of the
present value of net future cash flows directly or indirectly embodied in them,
discounted to reflect both current interest rates and the market’s assessment
of the risk of the cash flows that will not occur, as well as reflecting the current
cash equivalent of the financial instrument rather than its historic cost. Any
loss in a mark to market valuation is temporary; the loss is not absolute,
irrevocable or final.
Tax accounting normally is not overly concerned
with the past; it wants a picture of income for a particular year and, as
Iaccobucci J. writes, the methodology used to calculate income in one year
may be different from that used in an earlier year. Ms. O’Malley’s view is
similar: statements for tax purposes are solely concerned with the computation
of income in achieving an accurate picture of income for the particular
The parties agree that a foreign exchange
currency option contract does not qualify as a "mark to market
property" for purposes of section 142.5 of the Act. I agree.
Notwithstanding that a foreign currency option contract is not a "mark to
market property" for purposes of the section 142.2, Mr. Watson acknowledged that the CRA permits financial
institutions to use mark to market foreign currency option contracts.
The reasons of Major J. in Friesen
are relevant to the mark to market issue, in particular his remarks on
pages 129 to 130 and page 135. Subsection 10(1) of the Act
requires a business to value its inventory at the lower of cost or market value.
This principle, states Major J., is an exception to the general principle
that neither profits nor losses are recognized until realized. That the
business shall value its inventory at the lower of cost or market value means
that the business will not include any value in excess of cost in calculating
its income for the year. Subsection 10(1) imposes a cost value ceiling on
inventory. As Major J. states on page 130:
… the well-accepted principle of
conservatism which underlies the valuation method in s. 10(1) represents
not only an exception to the realization principle (in cases of loss) but also
an exception to the principle of symmetry since gains are not recognized until
they are realized. Thus the taxpayer who is entitled to rely on
s. 10(1) is allowed to claim a business loss where the value of inventory
falls but is not required to declare a business profit until the inventory is
sold even if the value of the inventory rises.
Earlier, Professor Brian J. Arnold
explained the effect upon profit for tax purposes of the three methods of
inventory valuation allowed by subsection 10(1) of the Act and
section 1801 of the ITR, the latter being similar to mark to market. He wrote:
… If all property in inventory is valued at cost, profit or loss
will arise in respect of that inventory only if the property is sold for more
or less than its original cost; fluctuations in the value of the property will
not result in any profit or loss. On the other hand, if all property in
inventory is valued at its fair market value, profit or loss will result if the
fair market value of the property at the end of the taxation year is different
from that value at the commencement of the taxation year or at the time of
acquisition of the property (where the property is acquired during the year).
If the property has appreciated in value at the end of the taxation year, the
amount of the appreciation reduces the cost of goods sold and thereby increases
income for tax purposes. Conversely, if the property has declined in value at the
end of the year, the amount of the reduction is reflected in a larger cost of
goods sold and smaller amount of income. Under the lower of cost and fair
market value rule, if the value of property declines below its cost, the amount
of the decrease in value increases the cost of goods sold and reduces the
amount of income for the year. Appreciation in the value of the property does
not, however, have the converse effect.
Mark to market accounting, therefore, as I
understand it, would compel a taxpayer to include any loss or gain in value of the
property at year‑end in income for the year. This may be appropriate for
financial statements for reasons discussed earlier. But, for income tax
purposes, the taxpayer may be compelled to include an amount in income where
there is no clear statutory language requiring him or her to do so. The
realization principle is basic to Canadian tax law. It provides certainty of a
gain or loss. Without some support of the statutory language or a compelling
interpretation tool it ought not be cast aside. This is found in
sections 142.2 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.
The appellant can find no solace in the fact
that the CRA has recognized that mark to market is an appropriate method of
computing income for tax purposes in derivative financial instruments,
including foreign exchange option contracts. All agree that derivative
financial instruments are not "mark to market" property as defined by
section 142.2. Yet the CRA has accommodated banks and others to value such
contracts mark to market. The CRA has also published Technical Interpretation
approving "mark to market valuation".
At the end of the day, however, it falls to Parliament to enact the law, the
courts to interpret the law and the CRA to enforce the law, notwithstanding
CRA's administration policies.
There is also a difficulty with Kruger’s option
contract themselves. As I view the evidence, and as Professor Klein
suggests, the market prices of OTC foreign exchange option contracts are
estimates, if not artificial. Kruger’s contracts are European contracts and
cannot be traded during the time the contract is made until it matures, except
with consent of the other contracting party. Each bank formulates its own
market value based on its own model applying inputs that are not necessarily
used by another bank. There is no consistency or objective, it appears to me,
by the banks in fixing a common fair market value for a given day (or time of
day). Professor Klein described two identical contracts as to amounts and
expiry dates, among other things, having a significant difference in values on
December 31, 1998. This shakes my confidence as to the other market values
used by Kruger, not because Kruger was trying to do something nefarious, which
it was not, but because of a probable inconsistency in values depending on the different
models used by Kruger’s counterparties. I may have had more comfort in agreeing
with Kruger’s valuations if all the contracts were valued using the same
models, not a variety of models used by different banks. Thus even if I found
that it was appropriate for Kruger to mark to market its derivatives for income
tax purposes, I would not find that the inconsistent bank values used by Kruger
was properly applied in calculating its losses on derivative trading in 1998.
The appellant’s alternative submission is that both
written and purchased foreign exchange option contracts are inventory and are
to be valued as required by subsection 10(1) of the Act. The Crown
denies their status as inventory.
The appellant finds comfort in Friesen where
the Supreme Court held that the Act defines two types of property,
capital property, which creates a capital gain or loss on disposition, and
inventory, property the cost or value of which is relevant to the computation
of business income. "There are separate rules", Major J. stated,
for each of capital property and inventory, "and the taxpayer should be
entitled to take the benefit as well as bear the burden applicable to the
category into each property falls". The parties acknowledge that the
foreign exchange option contracts are not capital property. Therefore, they
must be inventory, says the appellant.
The respondent argues that the written foreign
exchange option contracts are not inventory for two reasons: one, that they are
rights and not tangible property and two, that they do not represent a right on
the part of the writer but a liability and, therefore, are not property of the
Both Ms. Leclerc and Ms. O’Malley
testified that for GAAP, inventory must be a tangible asset. A foreign exchange
option contract is not inventory for accounting purposes. The respondent’s
expert, Ms. O’Malley, described a written foreign exchange option contract
as a "financial liability" and the purchased option contract is a "financial
asset", as far as accounting practice is concerned. As far as I am aware
the terms "financial asset" and "financial liability" have
not been considered in earlier cases.
Notwithstanding GAAP, any property, taxable or
intangible, may be inventory for purposes of the Act. The word
"property" in subsection 10(1) is defined in subsection 248(1)
of the Act (1998) and means property of any kind whatever whether real
or personal or corporeal or incorporeal and includes:
a) a right
of any kind whatever, a share of a chose in action,
droits de quelque nature qu’ils soient, les actions ou parts;
 The courts have assumed that intangibles may
be inventory. In M.N.R. v. Curlett, for example, there was no dispute that
second mortgages were inventory when the mortgages earlier had been sold in the
ordinary course of business. The issue was whether the profit realized on the
sale of second mortgages was profit from the sale of a business as a going
concern or simply a profit from the sale of the bulk of the existing inventory
of second mortgages.
 The respondent insists that inventory only
constitutes property held for sale. Subsection 248(1) of the Act
defines inventory to mean:
"a description of property the cost or
value of which is relevant in computing a taxpayer’s income from a business for
a taxation year"
 There is no requirement that property must
be held for sale to qualify as inventory. However, the cost or value of the
property must be relevant in computing a taxpayer’s income from a business. If
property that is a foreign exchange option contract is so relevant, then it so
 I have found that in 1998 Kruger carried on
a business of selling and purchasing foreign exchange option contracts. What I
now have to determine is whether both or one of the written contracts or
purchased contracts are properties and if either or both are property, whether
they are property that is inventory.
 The position of the appellant is that the written
option contracts have both rights and obligations and are property held by
Kruger, not simply the obligation contained in the contract. A written option
contract contains a property right which subsists during the life of the
contract and which fluctuates in value, from the amount of the premium paid
down to zero, during the life of the contract. Thus a written option represents
a property right to the writer as much as the purchaser’s right. The value of
both these rights fluctuates with the fluctuation of the values of the
currencies involved relative to each other, as well as the passage of time.
 The purported property right of the writer
is the premium, the writer’s right to retain the premium that is paid by the
purchaser for the contract. However, appellant’s counsel states, the premium,
when received, is not profit, and when paid, is not an expense; the profit or
loss is only computed at maturity or settlement of the contract.
 If the option contract terminates upon
maturity or settlement and the contract has no value, i.e., the price the
purchaser is entitled to buy foreign currency is higher than the spot price at
the time, the contract is worthless. It is not until maturity or settlement,
the appellant submits, that the premium belongs to the writer absolutely and,
under the realization method is considered income to the writer. Until
maturity, the writer has had the contracted right to retain the amount of the
premium but the amount does not constitute profit from the contract or revenue
from the contract.
 According to appellant’s counsel, examples of
journal entries used by both Ms. Leclerc and Ms. O’Malley, reflect
the fact that the writer has a contractual right to retain the premium which
subsists until the contract ends, at which time the writer’s right to keep the
amount of premium becomes absolute and is income or the purchaser will exercise
the option to buy in which case the writer will have to purchase foreign
currency at the higher spot price to fulfill its contractual obligation to sell
the currency at the lower price, at which point the writer will lose all or
part of the premium or have to pay an additional amount to satisfy the obligation.
 The eventual result, as I appreciate
appellant’s submission, rests until maturity or settlement. In other words, the
economic effects of the option contract must wait to maturity or settlement
date. The writer’s obligation does not become exigible until such time. In any
event, notwithstanding the accounting treatment of the premium, a premium is
what the writer receives as consideration for the contract. Until maturity or
settlement, the writer is liable to the purchaser; that is the essence of the
foreign exchange option contracts. The accounting profession is not wrong in
describing the writer’s obligation as a financial liability. The writer has no
proprietary interest in the contract.
 However, the purchased contracts are
property owned by the purchaser. The purchaser of an option contract has
acquired property to deal with as it wishes on maturity.
 The appeal will be allowed only to permit
the appellant to value its purchased foreign exchange option contracts in
accordance with subsection 10(1) of the Act, including section 1801
of ITR. This assumes the values are not in dispute. The appellant is not
permitted to otherwise value its foreign exchange option contracts on mark to
market. The amount of $91,104,379, subject to any adjustment as a result of
valuing purchased foreign option contracts as inventory, shall be included in
the appellant’s capital in accordance with Part I.3 of the Act.
The parties will
have 30 days, or such longer delay as approved by the Court, to make
submissions in writing as to costs.
 These amended reasons for judgment are issued in substitution to the
reasons for judgement issued on May 26, 2015.
Signed at Ottawa, Canada, this 10th day of June