Dockets: A-296-15
A-195-16
Citation:
2016 FCA 186
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CORAM:
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NOËL C.J.
SCOTT J.A.
DE MONTIGNY J.A.
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BETWEEN:
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KRUGER
INCORPORATED
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Appellant
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and
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HER MAJESTY THE
QUEEN
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Respondent
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REASONS
FOR JUDGMENT
NOËL C.J.
[1]
These are consolidated appeals brought by Kruger
Incorporated (the appellant). The appeal in file A-296-15 is from a decision by
former Chief Justice Rip of the Tax Court of Canada (2015 TCC 119), sitting as
a supernumerary judge (the Tax Court judge), allowing in part the appellant’s
earlier appeal against a reassessment issued by the Minister of National
Revenue (the Minister) with respect to its 1998 taxation year. By this
reassessment, the Minister denied business losses aggregating $91,104,379 which
the appellant claimed in its tax return for that year. The losses in question
arise from dealing in foreign exchange options.
[2]
The appeal in file A-195-16 is directed at the
cost award made by the Tax Court judge in favour of Her Majesty the Queen (the
Crown or respondent) in the course of a separate judgment rendered some six
months after the decision on the merits (2016 TCC 14). The appellant in lodging
this appeal merely seeks to insure that the Court is in a position to address
this award in the event that its appeal on the merits is successful.
[3]
The primary issue turns on the method according
to which the appellant can compute income from dealing in foreign exchange
options pursuant to section 9 of the Income Tax Act, R.S.C. 1985, c. 1
(5th Supp.) (the Act). The Tax Court judge agreed with the
Minister’s contention that in computing income from that source, the profit or
losses could only be recognized when realized, thereby rejecting the
appellant’s use of mark to market accounting as an acceptable
method for computing income under the Act. However, he accepted, in part, the
appellant’s alternative argument that its foreign exchange option contracts
were inventory, and could on that account give rise to a loss based on their
value at year end.
[4]
The appellant takes issue with the conclusion
reached by the Tax Court judge on the primary issue and both parties challenge
the conclusion which he reached on the alternative issue.
[5]
For the reasons which follow, I would allow the
appeal on the basis that the Tax Court judge did not adhere to established case
law and did not follow the framework of analysis set out in Canderel Ltd. v.
Canada, [1998] 1 S.C.R. 147 [Canderel] in rejecting mark to market
accounting. I would also find in the alternative that, having regard to the
meaning of the word “inventory” as defined in
subsection 248(1) of the Act and the findings of fact made by the Tax Court
judge, it was not open to him to hold that any of the foreign exchange option
contracts to which the appellant was a party, on December 31, 1998, were
inventory.
[6]
In the reasons which follow, the contracts to
which the appellant was a party during the relevant period are at times referred
to as foreign exchange option contracts or foreign exchange options; nothing
turns on this difference. The provisions of the Act which are relevant to the
analysis are reproduced in Annex I.
BACKGROUND AND
FACTS
[7]
The relevant facts are set out in detail in the
decision under appeal and need not be repeated. It is sufficient for
present purposes to provide a brief summary.
[8]
The appellant is a long established manufacturer
of newsprint and other paper products (Reasons, para. 11). The better
portion of its receivables (approximately 80%) has traditionally been in US
dollars (idem, para. 12).
[9]
In order to reduce its exposure to foreign
currencies, principally the US dollar, the appellant began during the 1980’s to
purchase and sell foreign currency option contracts (Reasons, para. 13). Over
time, it developed considerable expertise in dealing with these options to the
point that it began “to generate and produce profits
[from this activity] on an individual profit center basis” (idem,
para. 18).
[10]
The appellant eventually became an industry
leader in terms of volume of dollar purchases of derivative products ranking
amongst the top three or four non-banking enterprises in Quebec, after the Caisse de Dépôt and
Hydro-Québec (Reasons, paras. 14 and 38).
[11]
The appellant both bought and sold (i.e.: wrote)
foreign exchange options (Reasons, paras. 18, 24 and 35). The writer’s upside
is limited to the premium it charges for issuing the option but the
potential downside is unlimited as it hinges on the evolving strength or weakness
of the respective currencies at play. In contrast, the purchaser can lose no
more than the premium which it pays to acquire the option but benefits from a
conversely unlimited upside.
[12]
Starting in 1997, the appellant began to account
for its foreign exchange operations using mark to market accounting for
financial reporting purposes. The Tax Court judge suggests that 1998 was the
initial year (Reasons, para. 24), but the evidence indicates that mark to
market began to be used in 1997 (Appeal Book, Vol. 15, p. 3005).
[13]
All the foreign exchange option contracts to
which the appellant was a party at the close of its 1998 taxation year were
entered into during that year and were to be exercised during the following
year (Reasons, para. 3). Amongst these, the contracts written by the appellant
exceeded the contracts that it purchased by a margin of four to one (idem,
para. 30). The appellant attributes the magnitude of the loss which it recorded
at the close of its 1998 taxation year to the high number of contracts which it
held at that time and the historical dip which the Canadian dollar took in
relation to the US dollar in the course of that year (ibidem, paras. 29
to 33).
[14]
Mark to market accounting is an accrual method
of accounting whereby both the writer and the purchaser value the option at market
as at balance sheet date – in this case December 31, 1998 – and recognize any
change in the market value as a gain or loss for the period (Reasons, para. 2e;
Expert Report of Patricia L. O’Malley, Appeal Book, Vol. 12, p. 2410, paras.
26, 32 and 33). For that purpose, the premium reflects the value of the option
at inception, positive in the case of the purchaser and negative for the writer
(Appeal Book, Vol. 17, pp. 3393 to 3397).
[15]
All or almost all of the foreign exchange option
contracts in issue were “European options” i.e.:
options which are traded privately − “over the counter” in trade terms − and which may only be exercised on their expiry date (Reasons,
para. 2b and h). These options could be transferred before that date with the
consent of the non-transferring counterparty (idem, para. 45). The parties
could also choose to lock in the profit or limit the loss inherent in these options
(i.e.: close the position) by entering into an offsetting option contract (idem,
para. 43; Appeal Book, Vol. 2, p. 227; Vol. 13, pp. 2700 to
2711). In this regard, the foreign currency option market was and continues to
be fully liquid (Appeal Book, Vol. 2, pp. 207, 208 and 227; Vol. 13,
pp. 2681, 2716 to 2718; Vol. 17, p. 3364). The appellant decided to close “very few” positions prior to maturity in 1998
(Reasons, para. 29) and to “roll over” its
options to 1999 in the expectation that the Canadian dollar would firm up in
the short term, which it did (idem, paras. 31 to 33).
[16]
For the purpose of computing income from its
foreign exchange option operations for the year in issue, the appellant marked
to market the value of each contract to which it was a party at year end
and deducted as a loss the difference between their value at inception based on
the above computation (idem, para. 14) and their value at year end, as provided
by the financial institutions or banks which were the counterparties to these
contracts. In addition, the appellant “deferred and
amortized” the premiums paid and received over the term to maturity of
the related option (although the notes to the financial statements indicate
that only the premium income received on written options was treated this way (Appeal
Book, Vol. 2, p. 244), the working papers show that for tax purposes this
treatment was applied to all premiums, both received and paid (Appeal Book,
Vol. 10, pp. 2032 to 2057)). As a result, the net amount of premiums to
December 31, 1998 was included in income for that year, i.e. $18,696,881, and
the balance, i.e. $32,883,453, was deferred to 1999 (Reasons, para. 4,
footnote 4).
[17]
By notice of reassessment issued July 15, 2002,
the Minister denied the claimed loss, taking the view that the appellant could
not use the mark to market method of accounting, but had to record
income in conformity with the principle of realization. Consistent with this
principle – according to which the premium is taken into account only when the
option expires or is transferred – the Minister removed from income the premiums
which the appellant had included. The net effect of the reassessment was to add
to the declared income of the appellant the amount of $72,407,498 i.e.: the
difference between the loss claimed – $91,104,379 – and the amortized portion
of the premiums – $18,696,881. The large corporations tax under Part I.3 of the
Act was reassessed accordingly.
[18]
Because all the options held by the appellant at
the close of its 1998 taxation year were to expire during the following year,
and because the loss or profit generated over the life of any given contract is
the same regardless of the method used, the underlying issue is one of timing
only (Reasons, para. 68).
DECISION OF THE TAX COURT JUDGE
[19]
The Tax Court judge first addressed the
contention advanced by the Crown that the appellant did not implement the mark
to market method of accounting given that it amortized the net amount of
premiums for the year in issue (Reasons, para. 8). The Tax Court judge was
invited to dismiss the appeal on the basis that even if the appellant was
entitled to use mark to market accounting, it had not in fact implemented this
method.
[20]
This submission was advanced on the heel of uncontested
expert evidence adduced by the Crown which showed that the amortization of the premiums
did not conform with mark to market accounting (Expert Report of Patricia L.
O’Malley and related PowerPoint slide “Comparison
Between MTM and Kruger’s Method”, Appeal Book, Vol. 12, p. 2410, paras.
26, 32 and 33, and p. 2463J; Vol. 17, p. 3345).
[21]
The Tax Court judge refused to consider the
respondent’s submission on this point because the argument was not announced in
the Crown’s pleadings. He noted that although the appropriateness of amortizing
the premiums in mark to market accounting had been raised, it was not alleged
that the “very foundation of [the appellant’s] method
of valuing its option contracts was [thereby] being challenged”
(Reasons, para. 10).
[22]
Although the Crown maintains that the argument
was properly advanced (Memorandum of the Crown, para. 52), no cross-appeal was brought
nor does the Crown seek the reversal of the judgment issued by the Tax Court
judge on this ground (Memorandum of the Crown, Part IV,
“Order Sought”).
[23]
The Tax Court judge therefore conducted his
analysis on the basis that mark to market accounting was implemented and went
on to consider whether the use of this method was permitted (Reasons, paras. 85
and following). After reviewing the case law, including in particular the
decisions of the Supreme Court in Canadian General Electric Co. v. M.N.R.,
[1962] S.C.R. 3 [Canadian General Electric]; Friedberg v. Canada,
[1993] 4 S.C.R. 285 [Friedberg]; Canderel; and Friesen v.
Canada, [1995] 3 S.C.R. 103 [Friesen], the Tax Court judge expressed
the view 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” (Reasons,
para. 104).
[24]
Although he found that the method employed by
the appellant was consistent with well accepted business principles and generally
accepted accounting principles (GAAP), the Tax Court judge observed that, with
the exception of sections 142.2 to 142.5 of the Act and section 1801 of
the Income Tax Regulations, C.R.C., c. 945 (the ITR), no legislative
provision authorizes the use of mark to market valuation. Because foreign
exchange option contracts do not come within the ambit of sections 142.2 to
142.5 of the Act, the Tax Court judge held that Canada Revenue Agency’s (CRA)
administrative policy allowing banks and financial institutions to use mark to
market accounting with respect to these contracts, was of no assistance to the
appellant (Reasons, para. 115).
[25]
The Tax Court judge went on to hold that absent
a statutory provision authorizing the appellant to depart from the realization
principle, the foreign exchange option contracts had to be valued at their
historical costs, so that no loss of profit could be recognized from dealing in
these contracts until they were actually disposed of or expired (Reasons, para.
114).
[26]
Before closing on this issue, the Tax Court
judge indicated that even if he had found that the appellant was entitled to
use mark to market accounting, he “would not find that
the inconsistent bank values used by [the appellant] was [sic] properly applied
in calculating its losses” (Reasons, para. 116). While the values
ascribed by bank models were reliable, he was concerned by the fact that the
appellant obtained its values from different banks which used different models.
His confidence was “shaken” by evidence showing
that two reputable banks – the Bank of Nova Scotia and J.P. Morgan – had
ascribed substantially different values to two identical foreign exchange
option contracts (ibidem).
[27]
The Tax Court judge went on to address the
appellant’s alternative contention that its foreign exchange option contracts were
inventory and that it was therefore entitled to value these contracts at year end
at the lower of cost or fair market value pursuant to subsection 10(1) of the
Act or on a strict fair market value basis pursuant to section 1801 of the ITR.
He began by noting that inventory requires the existence of property, “the cost or value of [which] must be relevant in computing
a taxpayer’s income from a business” (Reasons, para. 124).
[28]
According to the Tax Court judge, the appellant
was carrying on the business of speculating on foreign exchange option
contracts, which sometimes involved “selling and
purchasing” those contracts (Reasons, paras. 38 and 125). He quoted the
definition of “inventory” in subsection 248(1)
and noted that there is no requirement that qualifying property be held for
sale (idem, paras. 123 and 124).
[29]
The Tax Court judge went on to find that the
foreign exchange option contracts purchased by the appellant, because they
conveyed rights, qualified as inventory as they constituted “property” within the meaning of the definition found
in subsection 248(1) of the Act. He reached the opposite conclusion with
respect to the contracts written by the appellant, as they only embodied liabilities
(Reasons, paras. 121, 122, 130 to 132).
[30]
The Tax Court judge therefore held that the
purchased foreign exchange contracts were inventory, but that the written
contracts were not. Giving effect to this conclusion, the judgment which he
issued allows the appeal and permits the appellant to value its purchased
contracts on a mark to market basis. Because of the concerns which he expressed
about the reliability of the values used by the appellant, the judgment
specifies that “[t]his assumes the values are not in
dispute” (Judgment, Appeal Book, Vol. 1, p. 6), thereby leaving it
to the Minister to accept or refuse the appellant’s values.
[31]
As it turned out, the appellant’s values were accepted.
In the debate which ensued as to costs, the Crown took the position that the
appellant could not claim to have been successful at trial because although the
appeal was allowed, the judgment given did not have the effect of reducing the
amount of taxes payable by the appellant for the year. For the purpose of making
this demonstration, the Crown asked the Minister to execute the judgment. In
giving effect to the judgment, the Minister’s official used the appellant’s
values based on the advice that “according to the
evidence tendered at trial, the best estimate of the fair market value of the
inventory of foreign currency option contracts owned by [the appellant] as of
December 31, 1998 is the marked to market value determined by the
financial institutions which were the counterparties to the contracts”
(Affidavit of Denis Dionne, sworn September 15, 2015, para. 6b, filed during
the hearing of the appeal). The Tax Court judge accepted this demonstration and
relied on this evidence to hold that the Crown was entitled to a measure of costs
notwithstanding that the appeal was allowed (Reasons in support of the cost
award in file A-195-16, paras. 4 and 20).
POSITION OF THE PARTIES
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The Appellant
[32]
The appellant submits that mark to market
accounting is an appropriate way of computing income derived from its foreign
exchange option contracts pursuant to section 9 of the Act, and advances a
number of arguments in support of that proposition.
[33]
First, the appellant contends that the basic
objectives of GAAP overlap significantly with profit computation for tax
purposes, as they both strive for “an accurate picture
of income for the year, one that depicts the reality of the financial situation
of the taxpayer for the year” (Memorandum of the appellant, para. 51).
[34]
Second, the appellant argues that the Tax Court
judge erred in applying the principle of realization as an overarching
principle which must be followed, absent a statutory provision providing
otherwise. In the appellant’s view, the decisions of the Supreme Court in Canderel
and Ikea Ltd. v. Canada, [1998] 1 S.C.R. 196 [Ikea] exemplify the
flaw in the Tax Court judge’s decision, for in both decisions there would not
have been any dispute had the principle of realization been given the sweeping
effect propounded by the Tax Court judge (Memorandum of the appellant, paras.
55 to 57).
[35]
Thus, the Tax Court judge failed to follow the
framework set out in Canderel which requires first a determination as to
whether valuating the foreign exchange option contracts in accordance with the
mark to market method as the appellant did is appropriate in the sense that it
provides an accurate picture of profit for the 1998 taxation year. Had he done
so, the Tax Court judge would have found that the mark to market method was
appropriate. This conclusion is reinforced by the decision of the Supreme Court
in Canadian General Electric where it was held that gains and losses on
income account resulting from foreign currency fluctuation may be recorded on
an accrual basis for tax purposes. This is clear authority, argues the
appellant, that mark to market accounting should take precedence over the
realization principle with respect to its foreign exchange option contracts (Memorandum
of the appellant, paras. 58 to 60).
[36]
The appellant adds that the decision of the
Supreme Court in Friedberg does not bar the use of an alternative
method, as the only issue before the Court in that case was whether the Crown
had demonstrated that the taxpayer’s adoption of the realization method was
inappropriate. Friedberg does not foreclose the use of profit
computation methods other than realization in appropriate circumstances (Memorandum
of the appellant, para. 62).
[37]
Third, the appellant submits that the
introduction of mandatory mark to market valuations for financial institutions
through sections 142.2 to 142.6 of the Act was intended to ensure that income
is measured appropriately. The CRA’s administrative policies
extending that treatment to foreign exchange option contracts held by financial
institutions, notwithstanding that such contracts fall outside the scope of
these provisions, reinforces this conclusion (Memorandum of the appellant,
paras. 63 to 67).
[38]
Fourth, the appellant argues that while
realization produces certainty of result, this is not the test mandated by
section 9 of the Act. It is rather the mark to market method which produces the
best measure of the results of its business of dealing in foreign exchange
option contracts. Indeed, although its losses at the end of the 1998 taxation
year were not “realized”, they nevertheless “could have been crystallized at any time, given the very
liquid … option market, by purchasing offsetting contracts from their bank
counterparties or other banks” (Memorandum of the appellant, para. 71).
[39]
Finally, the appellant asserts that the
inconsistency found by the Tax Court judge in respect of the values it used in
computing its income pursuant to the mark to market method is attributable to
clerical errors which it made in preparing its expert report. The appellant
maintains that once the proper calculations are made, the differences between
the values provided by the different bank counterparties are inconsequential (Memorandum
of the appellant, paras. 39 to 42).
[40]
Turning to the inventory issue, the appellant
asserts that for purposes of the Act, “[a]ll property
that is not capital property is inventory” citing inter alia Friesen,
paras. 28, 32, 66 and C.A.E. Inc. v. The Queen, 2013 FCA 92, para. 77 (C.A.E.)
(Memorandum of the appellant, para. 85). Because the foreign exchange
option contracts were not capital property, it necessarily follows that they
are inventory (ibidem).
[41]
Beyond this, the appellant argues that there is
no basis for the Tax Court judge’s conclusion that the written contracts were
not property and could not, on that account, be inventory. Specifically, the
appellant submits that the written options embody more than just a liability
and therefore come within the definition of “property”
in subsection 248(1) of the Act (Memorandum of the appellant, para. 95):
The [writer] of the contract thus has two
rights that subsist throughout the contract until maturity … : (i) the right to
retain the premium, pending the outcome of the contract at maturity, and (ii)
the right to receive from the purchaser the contract price … contingent upon
the purchaser exercising the option …
[42]
Finally, the appellant notes that the Tax Court
judge’s decision leads to an asymmetrical treatment because the income from its
purchased contracts is required to be computed on the basis of marking these
contracts to market at year end whereas the income from its written contracts
is only recognized upon realization. This imposition of different methods of
profit computation to a single business, the appellant argues, cannot yield an
accurate picture of the profit from that business (Memorandum of the appellant,
paras. 104 and 105).
[43]
The appellant accordingly asks that the appeal
be allowed with costs throughout.
-
The Crown
[44]
From the Crown’s perspective, the issues to be
decided are whether the Tax Court judge erred in law in concluding that:
- The mark to
market method did not provide an accurate picture of the appellant’s
income and that the realization method should apply;
•
The options written by the appellant do not
constitute inventory whereas the purchased options do (Memorandum of the Crown,
para. 26).
[45]
In addressing the first issue, the Crown stands
by the reasons advanced by the Tax Court judge and submits that he correctly
held that section 9 of the Act does not allow the appellant to value its
foreign exchange option contracts on a mark to market basis. Indeed, absent a
provision to the contrary, profit for tax purposes is only recognized when
realized. While mark to market accounting is consistent with GAAP, the Crown
maintains that GAAP are mere interpretative aids and do not amount to rules of
law. The Tax Court judge therefore properly concluded that income generated by
the appellant’s foreign exchange option contracts had to be recognized on a
realization basis, especially as his decision conforms with Friedberg,
where it was similarly determined that the mark to market method was not
appropriate notwithstanding that it may have better described the taxpayer’s
profit for some other non-tax purposes (Memorandum of the Crown, paras. 34 to
38).
[46]
The Crown’s further argument before the Tax
Court judge that the claimed loss should be denied based on paragraph 18(1)(e)
of the Act (Reasons, para. 5) was not pursued on appeal.
[47]
With respect to the second issue, the Crown
argues that neither the written or purchased options qualify as inventory. The
Crown asserts that the appellant “did not carry on the
business of selling and purchasing option contracts”, as its business
was rather “to enter into option contracts with a view
to exercise the rights under those it [purchased], and with the hope that its
counterparty would not exercise the right it had under the option it wrote”
(Memorandum of the Crown, para. 48). As such, the appellant’s business was “only based on the execution of the option contracts per se”
(ibidem).
[48]
With specific reference to the written options, the
Crown submits that the Tax Court judge correctly found that these options did
not qualify as property in the appellant’s hands and could not on that account
be inventory. The ownership of these options rather rested in the hands of the
financial institutions that acquired them (Memorandum of the Crown, para. 49).
[49]
However, the Crown argues that the Tax Court
judge erred in concluding that the purchased options are inventory as they were
not held for sale, a condition which must be met before property can qualify as
inventory (Memorandum of the Crown, para. 50).
[50]
In this respect, the Crown takes issue with the
appellant’s contention that Friesen stands for the proposition that
property that is not capital property is necessarily inventory. According to
the Crown, “[r]eading the … decision in this manner
would lead to an absurd result where cash on hand or accounts receivable
appearing on the balance sheet would qualify as inventory” (Memorandum
of the Crown, para. 47).
[51]
The Crown therefore asks that the appeal on the
merits be dismissed with costs, and that the cost award made by the Tax Court
be affirmed.
ANALYSIS
-
Mark to market vs realization
[52]
The determination of a taxpayer’s income from a
business pursuant to subsections 9(1) and (2) of the Act gives rise to a question
of law (Friesen, para. 41; Associated Investor v. M.N.R.,
[1967] 2 Ex. C.R. 96, p. 101; Canderel, paras. 32 and 53 at point 1). As
such, the Tax Court judge’s conclusion that this determination must be made in
accordance with the principle of realization is to be assessed on the standard
of correctness.
[53]
The precise issue which arises, independently of
considerations relating to the treatment of inventory, is whether the foreign
exchange option contracts to which the appellant was a party at the close of
its 1998 taxation year can give rise to a loss or profit in the absence of an
actual transfer or disposition. This in turn depends on whether the appellant
was authorized under the Act to use mark to market accounting in ascertaining
the profit or loss generated by its dealings in foreign exchange derivatives or
whether it was bound to apply the principle of realization, as the Tax Court
judge held.
[54]
Before turning to this question it is essential
to understand the exact nature of the appellant’s business. In this regard, the
Tax Court judge found that the appellant “carried on a
business of speculating on foreign exchange currency options” (Reasons,
para. 38). For that purpose, the options held by the appellant in 1998 could be
closed by purchasing an offsetting option contract (idem, para. 43),
rolled over to the next year (idem, paras. 31 to 33) or transferred
subject to obtaining the consent of the counterparty (idem, para. 45).
He further found that this business was conducted separate and apart from the
appellant’s core business and on a large scale, in a manner similar to
sophisticated traders in foreign exchange options (idem, para. 38).
The Tax Court judge also accepted that by writing more options than it
purchased, the appellant heightened the speculative risk inherent in its
foreign exchange dealings but also increased the potential for large profits (ibidem).
[55]
The Tax Court judge had before him extensive
evidence as to how income generated by this type of activity is to be portrayed
for accounting and financial reporting purposes. The record is clear that
speculative activity of this type is best reflected by valuing option positions
at market as of the balance sheet day and by recognizing any change in value
from the beginning to the end of the period as a gain or loss in the income
statement (Reasons, paras. 2e, 60 and 62). This is the position advocated by
GAAP both in Canada and the U.S. as well as by the U.S. Financial
Accounting Standards Board (FASB) (idem, para. 58). No evidence going
the other way was introduced on this point.
[56]
Despite this evidence and the fact that the
Minister accepts that banks and other financial institutions report their
income from such activity according to the mark to market method of accounting
(Reasons, para. 73), the Tax Court judge held that the appellant could not
avail itself of this method. Rather, it had to abide by the principle of
realization. The reasons which led the Tax Court judge to this conclusion are
encapsulated in the following passage (Reasons, para. 114):
The realization principle is basic to
Canadian tax law. It provides certainty of a gain or a 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.
[57]
The Tax Court judge noted that sections 142.2 to
142.5 did not authorize the use of the mark to market method with respect to
foreign exchange option contracts as these do not come within the defined
meaning “mark to market property” (Reasons,
para. 111). He further noted that even though the CRA allows banks and
financial institutions to use mark to market accounting, this does not assist
the appellant as his task is to apply the law rather than CRA’s administrative
policies (idem, para. 115). The suggestion is that mark to market
accounting is not an acceptable method of reporting income derived from dealing
in foreign exchange options regardless of who uses this method.
[58]
Because he was unable to identify any provision
in the Act or the ITR which “requires or authorizes”
a departure from the realization principle, the Tax Court judge held that this
principle was binding on the appellant. He came to this conclusion despite
finding that the mark to market method is consistent with well accepted
business principles, is GAAP’s preferred basis of accounting for foreign exchange
option contracts and that the FASB and international accounting recognize that
income generated by such dealings is best depicted in accordance with this
method (Reasons, para. 105).
[59]
I agree with the appellant that in so holding
the Tax Court judge treated the realization principle as an overarching
principle, an approach which runs counter to the decisions of the Supreme Court
in Canderel and Ikea. It is clear from both these decisions that
the realization principle can give way to other methods of computing income
pursuant to section 9 of the Act where these can be shown to provide a more
accurate picture of the taxpayer’s income for the year (see in particular Ikea,
paras. 40 and 41).
[60]
The Supreme Court in Canadian General
Electric, a decision rendered some fifty years earlier, reached a similar
conclusion in a context more closely connected to the present one. The issue in
that case was whether foreign exchange profits inherent in Canadian General
Electric’s (CGE) US dollars liabilities, as evidenced by outstanding promissory
notes, could be brought into income on an accrued basis according to the
relative value of the Canadian dollar at year end (CGE’s position), or whether
they could only be recognized in the year in which the notes were actually retired
(the Minister’s position). The Supreme Court, in a split decision, upheld CGE’s
position and rejected the Minister’s position that realization was mandatory.
[61]
The Tax Court judge appeared to distinguish this
decision on the basis that the foreign currency income in issue in that case
was generated in the context of CGE’s core business (i.e.: the selling of
electrical products acquired from US suppliers) and not in the pursuit of a
separate business (Reasons, para. 96). While this was no doubt a factor given
that CGE reported its income on an accrual basis, it is clear from the reasons
of the judges forming the majority (Martland J., Cartwright J., Ritchie J.)
that they would not have accepted CGE’s method of reporting its foreign
exchange profits unless they were satisfied that it provided a fair reflection
of the income derived from the outstanding notes (Canadian General Electric,
paras. 35 and 41). The proposition which flows from this decision is that both
methods had their virtues and that CGE was entitled to adopt the one of its
choice, subject to applying it consistently (idem, paras. 41 and 42).
In my respectful view, Canadian General Electric is in direct
contradiction with the Tax Court judge’s holding that realization is an
overarching principle which applies in the absence of a provision authorizing or
requiring the application of a different method.
[62]
The Tax Court judge also relied on the decision
of the Supreme Court in Friedberg, a case involving the tax treatment of
gold futures, specifically whether trading losses could be recognized in the
year of realization (Mr. Friedberg’s position), or whether income from that
source had to be accrued over the years during which the gold futures were held
by Mr. Friedberg (Crown’s position). In a judgment delivered from the
bench, the Supreme Court dismissed the Crown’s appeal, and confirmed Mr.
Friedberg’s entitlement to report his losses in the year of disposition.
[63]
Iacobucci J., writing for the Court, noted that
even though the method proposed by the Crown may better describe Mr.
Friedberg’s income position “for some purposes”,
the method used by Mr. Friedberg was the one to be applied for tax purposes (Friedberg,
para. 4). The Tax Court judge read Friedberg as supporting his
conclusion that mark to market accounting, although appropriate for financial
statement purposes, must give way to the principle of realization when comes
time to determine a taxpayer’s income under the Act (Reasons, paras. 108
to 110 and 114).
[64]
Again, this reading would be in direct contradiction
with Canadian General Electric. Recognizing that the matter is
not free from doubt, the better view is that in holding that the Crown “ha[d] not demonstrated that there [was] any error in
adopting [the realization method]” (Friedberg, para. 4), the
Court was leaving open the possibility that the loss could also be accrued in
line with what had been said in the two prior Federal Court decisions which were
confirmed (Federal Court, Appeal Division, 92 DTC 6031, p. 6036; Federal Court,
Trial Division, 89 DTC 5115, p. 5122). Given that no reference was made to
Canadian General Electric, it would be inappropriate to read Friedberg
as overturning the long standing rule established in that case.
[65]
In further support for his conclusion, the Tax
Court judge read the decision of the Supreme Court in Friesen as
standing for the proposition that realization is “a
general principle of taxation” which applies unless “the Act provides [for] an exception” (Reasons, para.
104). I respectfully disagree.
[66]
Friesen dealt
with the narrow question whether a taxpayer who was engaged in a “business” only by reason of the extended definition
of that term – i.e.: “business” includes an
adventure in the nature of trade (subsection 248(1)) – could consider the land,
which he had bought for resale, as inventory so as to benefit from the write-down
in value which subsection 10(1) authorizes. In a split decision, the Court
– Major J. writing for the majority – held that a taxpayer engaged in an
adventure in the nature of trade was in the same position as a regular land
trader and that Mr. Friesen could therefore avail himself of the
write-down. Although the reasons acknowledge that generally neither profits nor
losses are recognized until realized (Friesen, paras. 56 and 57), and that
realization plays a fundamental role under the Act (idem, paras. 105 to
109), nothing in the reasons of the majority or the minority indicates that
this principle cannot be departed from where appropriate, in order to provide
an accurate picture of income. On this point, it is useful to recall that Iacobucci
J., who authored the dissenting reasons in Friesen, wrote the unanimous reasons
in Canderel and Ikea which reject realization as an overarching
principle.
[67]
There is therefore no authority for the Tax Court
judge’s proposition that the principle of realization applies to the exclusion
of mark to market accounting unless the Act provides otherwise.
[68]
Because mark to market accounting cannot be
excluded as a competing method the question to be answered, when regard is had
to the framework of analysis set out at paragraph 53 of Canderel, is
whether the appellant has discharged the onus of showing that mark to market
accounting provides an accurate picture of its income for the year.
[69]
The Tax Court judge made no findings in this
regard. Although he asserts on a number of occasions that the goal in
determining profit and loss for financial/accounting purposes and for income
tax purposes are not necessarily the same (Reasons, paras. 65 and 108 to 110),
he does not indicate what differences were at play, if any, nor the impact which
they would have had on the accuracy of the income computed by the appellant for
tax purposes.
[70]
Absent some such indication, there is no basis
on which to hold that mark to market accounting does not procure an accurate
picture of the appellant’s income under the Act. As was stated in Canderel, “the goal of the legal test of ‘profit’ should be to
determine which method of accounting best depicts the reality of the financial
situation of the … taxpayer” (Canderel, para. 44). This
coincides with the goal which mark to market accounting seeks to achieve on the
facts of this case i.e.: recognizing income or losses based on the amount which
can be realized by dealers in derivatives at the balance sheet by inter alia
entering into an offsetting contract (Appeal Book, Vol. 12, pp. 2419, 2420,
2448 and 2449; Vol. 17, pp. 3376 and 3377). As it is otherwise undisputed that
this method is consistent with well accepted business principles, GAAP and
international accounting, I am satisfied that the appellant has made a prima
facie demonstration that mark to market accounting provides an accurate
reflection of its income.
[71]
The remaining question is whether the Crown has discharged
the onus of showing that realization procures a better picture of the
appellant’s income under the Act (Canderel, para. 53 at point 6). Because
the Crown’s position throughout has been that mark to market accounting is not
an authorized method, no attempt was made to make this demonstration. Indeed,
the Crown’s accounting expert expressed the opposite view (Expert Report of
Patricia L. O’Malley, Appeal Book, Vol. 12, p. 2,410, para. 94). Given the
findings made by the Tax Court judge as to the broad recognition of mark to
market accounting for purposes of computing income from dealing in foreign
exchange options, and the uncontested evidence that banks, financial
institutions and mutual funds which engage in this activity report their income
on this basis with the CRA’s approval, it seems clear that mark to market
provides a picture of the appellant’s income which is as accurate – and as
acceptable from the perspective of the tax collector – as that which the
principle of realization would provide.
[72]
Adhering to the framework of analysis set out in
Canderel, I conclude that there was no basis on which the Tax Court
judge could reject the appellant’s use of mark to market accounting in
computing income from its dealings in foreign exchange options.
-
Reliability of the appellant’s values
[73]
The Tax Court judge went on to explain that even
if mark to market accounting was authorized, he was not convinced that the
values used by the appellant were reliable (Reasons, para. 116). He drew no definite
conclusion on this point as evidenced by the judgment that he gave (see para. 30,
above). It is nevertheless useful to comment on this point given the information
that has since been brought to our attention by the appellant.
[74]
The Tax Court judge was concerned that the bank
counterparties to the contracts held by the appellant at the close of its 1998
taxation year would not “necessarily” have used
a model of valuation which relies on the same inputs (Reasons, para. 116). He
was taken aback by evidence tendered by the respondent’s expert (Professor
Klein) showing that two options written by the appellant with identical
terms were ascribed by distinct bank counterparties values which were
more than 20 percent apart (idem, paras. 48 and 116).
[75]
The appellant recognizes that such a difference would
shake one’s confidence. However, it submits that this discrepancy is due to a
clerical error made in preparing its own expert report. The following
extracts quoted from the memorandum of the appellant (references omitted)
provide the explanation:
40. Mr. Klein testified, with reference to his report, that
identical contracts dated May 13, 1998 for a call option sold by Kruger of $10
million USD at a strike price of $1.46 to mature in one year were valued by the
Bank of Nova Scotia (“BNS”) at $797,736 and by JP Morgan (“JPM”) at $612,200.
Reproduced in his report was the JPM communication to Kruger of the value of
that contract at 486,900 USD which, at the prevailing rate of exchange on
December 31, 1998 of 1.530[5] CAD, yielded a Canadian dollar value of $745,200,
not $612,200. The difference, therefore, between the JPM option contract
relative to the BNS option contract is, therefore, not $185,536 but rather
$52,536, and therefore not a difference of 26.3% but rather 6.8% …
41. Mr. Klein further testified, with reference to his report,
that identical contracts again dated May 13, 1998 for a put option sold by
Kruger of $10 million USD to mature May 13, 1999, at a strike price of
$1.40, again with both JPM and BNS as purchasers, were valued by the BNS at
$8,173 and by JPM at ($113,257). The JP Morgan communication of value to Kruger
sets the value of that contract at 7,900 USD which, translated to CAD at the
prevailing rate at December 31, 1998, yields the amount of $12,090, and not
($113,257). …
42. The remaining differences in values given to four other
option contracts with identical terms by two different banks set out in Mr.
Klein’s report at page 2386 are: -0.3%, 1.2%, -4.2% and 5.1% …
[76]
The Crown does not challenge the above
demonstration otherwise than by asserting that it is not supported by the
evidence (Memorandum of the respondent, para. 6). However, all the figures referred
to in the above quoted passage can be found in the record and when the
prevailing rate of exchange is applied (1.5305 CAD; Appeal Book, Vol. 12, p. 2,387),
it can readily be seen that the wrong rate was applied and that the variations
are within the narrow range described.
[77]
I do not believe that the Tax Court judge would
have been troubled by the values submitted by the bank counterparties if he had
been appraised of the actual figures. I should add that this no longer seems controversial
as the Minister has since recognized that the appellant’s values were reliable (see
para. 31, above).
- Inventory
treatment
[78]
The appellant contends in the alternative that
its foreign exchange options qualify as inventory and that the recorded loss
must, on that account, be recognized pursuant to subsection 10(1) of the
Act and section 1801 of the ITR. This is a different means of obtaining the
result which the appellant is entitled to pursuant to section 9. However, because
inventory treatment is mandatory, the reasons which I have given for allowing
the loss cannot stand if the appellant correctly asserts that its options are
inventory. I therefore feel compelled to address the issue.
[79]
Subsection 10(1) of the Act, by the use of the
word “shall”, requires a taxpayer who carries on
a business to value inventory on hand at the end of a taxation year at the lower of cost or fair market value. The result
is that when the fair market value of inventory has fallen below cost at the
end of a given taxation year, the fall in value is recognized in that year.
Section 1801 of the ITR when applied to the circumstances of the appellant provides
for the same treatment. The Tax Court judge addressed the inventory issue on
the basis, since confirmed, that the values provided by the bank counterparties
reflect the fair market value of the outstanding options at year end.
[80]
The question whether some or all of the
appellant’s options qualify turns on the defined meaning of the word “inventory” in subsection 248(1), as informed by the
case law. Based on this definition “inventory”
means “a description of property the cost or value of
which is relevant in computing … income from a business …”. Before
applying this definition, the Tax Court judge had to identify its correct
meaning.
[81]
The Tax Court judge held that the options
purchased by the appellant form part of inventory but that those written by the
appellant do not. He reached this conclusion on the basis that the purchased options
confer a right, and therefore constitute “property”
capable of forming part of the appellant’s “inventory”
(see subsection 248(1) as to both definitions), but that the written options
give rise to a liability, with the result that they cannot constitute “property” nor for that reason, “inventory”.
[82]
The result which flows from this reasoning is
that the income derived from the options purchased by the appellant must be
computed by marking them to market at year end, whereas the income derived from
the options which it wrote must be recognized in the following year upon these
options being transferred or expiring.
[83]
Both parties take issue with this approach
arguing that it cannot provide an accurate picture of the appellant’s income. They
contend that in order to provide an accurate picture of the appellant’s income,
all the options must be treated the same way, the appellant arguing that both
its written and purchased options are inventory and the Crown asserting that neither
qualifies. In my view, the position advocated by the Crown is the correct one.
[84]
As was found by the Tax Court judge, there is no
doubt that the Act departs from GAAP in allowing intangible property to be
treated as inventory (M.N.R. v. Curlett, [1967] S.C.R. 280; Dobieco
v. M.N.R., [1966] S.C.R. 95; CDSL Canada Limited et al. v. The Queen,
2008 FCA 400, paras. 24 and 27 to 30; see also subsection 10(5) of the Act
which explicitly recognizes that the work in progress of a professional is “for greater certainty” inventory). There is equally
no doubt that the Tax Court judge properly held that because the written options
only embody a liability, they are not “property”
and therefore cannot form part of “inventory” (Reasons,
paras. 130 and 131; see also the comment made by Rand J. in Tip Top Tailors
Limited v. M.N.R., [1957] S.C.R. 703, p. 714).
[85]
The broader issue which the Crown invites the
Court to address is whether “inventory”, as
defined in subsection 248(1), extends to property that is not held for sale.
The Tax Court judge held that this is not a required qualification (Reasons,
para. 124):
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
qualifies.
[86]
The evidence is clear that none of the options
to which the appellant was a party at the close of its 1998 taxation year were
held for sale. The Tax Court judge found that the appellant was in the business
of “speculating on foreign currency options”
(Reasons, para. 38), which would bring it to hold these options to maturity in
some cases, with or without closing the position, and sell them in others,
depending on the anticipated direction of the underlying currencies. While the
appellant was in the business of making money with options, it was not in the
business of purchasing options for resale nor was it holding its options for
sale. The precise evidence on point is that all the options on hand at the
close of the 1998 taxation year were rolled over to 1999 in the expectation
that the Canadian dollar would firm up (idem, paras. 29 to 33).
[87]
Although the definition of “inventory” in subsection 248(1) does not spell out
the requirement that qualifying property be “held for
sale”, this condition must be read into the definition when regard is
had to Friesen, the last pronouncement of the Supreme Court on the
subject.
[88]
As noted, Friesen turned on whether the
lower of cost or market rule embodied in subsection 10(1) of the Act extended
to the owner of vacant land who was in business only by reason of being engaged
in an adventure in the nature of trade. The write-down was claimed in taxation
years preceding the year of the sale, at a time when the land produced no
income. The argument against the extension of this rule to Mr. Friesen’s land
was that even if the land in question was inventory in the year of disposition,
it did not qualify in the year in which the write-down was taken because its
cost or value was not relevant in computing Mr. Friesen’s business income for
that year (Friesen, para. 23).
[89]
The majority disposed of this argument as
follows (Friesen, para. 24):
In my opinion, the interpretation urged by
the respondent runs contrary to the natural meaning of the words used in the
definition of inventory in s. 248(1) and to common sense. The plain meaning of
the definition in s. 248(1) is that an item of property need only be relevant
to business income in a single year to qualify as inventory: “relevant in
computing a taxpayer’s income from a business for a taxation year” [emphasis
in original]. In this respect the definition of “inventory” in the [Act] is
consistent with the ordinary meaning of the word. In the normal sense,
inventory is property which a business holds for sale and this term applies to
that property both in the year of sale and in years where the property remains
as yet unsold by a business. [My emphasis]
[90]
This passage reflects the ratio decidendi
of the decision. The rule stated is that in order for Mr. Friesen’s property to
come within the definition, it had to meet two qualifications: first its cost
or value had to be relevant in computing business income for a year –
not necessarily the year of the write-down – and second, the land had to be
held for sale. Had this last condition not been present during the year of the
write-down, Mr. Friesen’s land would not have qualified. The reasons cannot be
read otherwise and this is how they have been applied (C.A.E., paras.
108 to 110).
[91]
It follows that although the requirement that
qualifying property be “held for sale” is not
spelled out in express terms, it nevertheless forms part of the defined meaning
of “inventory” as this definition must be read
in a manner that is “consistent with the ordinary
meaning of the word” (Friesen, paras. 24 and 33).
[92]
Notably, the minority expressed no disagreement
with the majority’s conclusion that Mr. Friesen’s land had to be held for
sale in order to qualify. If anything, the minority would have read in the further
requirement that qualifying property be “stock in trade”
(Friesen, paras. 110, 122 and 133 at point 2).
[93]
Although the Act was amended shortly after Friesen
was rendered to prevent the application of the inventory write-down rule to
inventory held by a business that is an adventure in the nature of trade (see
subsections 10(1) and (1.01)), Parliament left the defined meaning of the word “inventory”, as construed in that case, untouched. As
a result, qualifying property must both impact on the computation of income and
be held for sale.
[94]
Giving effect to this meaning, the foreign
exchange options purchased by the appellant during its 1998 taxation year and
rolled over to 1999 do not qualify as inventory as they were not held for sale.
-
More than two classes of property under the Act?
[95]
It necessarily follows that the purchased options
are a type of property that is neither capital property nor inventory.
[96]
This creates a bit of a difficulty because after
having explained why Mr. Friesen’s land was inventory and setting out the above
interpretation (Friesen, paras. 20 to 24), the majority went on to address “other considerations” which supported its reading of
the definition (idem, para. 25). Amongst those, was the fact that the meaning
which it adopted had the advantage of fitting Mr. Friesen’s land into inventory,
one of the two known categories of property under the Act. In the words of the majority, “[t]he Act … creates a simple system which recognizes only
two broad categories of property” (idem, para. 28).
[97]
The appellant seizes on this passage to argue
that because its foreign exchange option contracts are not capital property,
they must be inventory.
[98]
As the reasons show, this cannot be the case as
it would entail giving the word “inventory” a
meaning which Friesen itself excludes.
[99]
In context, it appears that the majority was
simply asserting that because the Act only regulates two classes of property,
fitting Mr. Friesen’s land into one of these classes was preferable to fitting
it within an unknown class as the respondent would have it (Friesen,
para. 32). In C.A.E., this Court said much the same thing when
it held that courts should not resort to new categories of property where the
existing framework allows for a proper application of the Act (C.A.E.,
paras. 84 and 102).
[100] The present case is different because the purchased options cannot be
fitted within either of the two categories of property on which the Act is
premised. At the same time, they cannot be ignored because they have an impact
on the computation of the appellant’s income under the Act. The reluctance of
the courts to recognize categories of property beyond inventory and capital
property must give way where, as here, it becomes necessary to do so in order
to apply the Act.
[101] As noted earlier, the purchased options are property under the Act
but they are neither capital property nor inventory. In contrast, the written
options escape all three labels since they only embody the obligation to
deliver funds in the future. Yet, the evolving value of both instruments is
relevant in determining the appellant’s income under the Act. In short, although
the Act is premised on the existence of two broad classes of property, it
imposes no limit on the types of property or indeed liabilities that can impact
on the computation of income and which must be recognized for that purpose since
the goal pursuant to section 9 of the Act is to provide an accurate picture of
that income (Canderel, para. 53).
DISPOSITION
[102]
For the above reasons, I would allow the appeals,
and giving the judgment which ought to have been given, I would refer the reassessment
back to the Minister for reconsideration and reassessment on the basis that the
appellant is entitled to compute the income derived from its foreign exchange
option contracts in accordance with the mark to market method of accounting,
that is in conformity with its tax return position but without deferring or amortizing
any portion of the premiums paid or received during the 1998 taxation year. Given
this result, I would award costs in favour of the appellant both before this
Court and the Tax Court of Canada.
“Marc Noël”
“I agree.
A.F. Scott
J.A.”
“I agree.
Yves de
Montigny J.A.”
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