9 March 2007 External T.I. 2006-0178661E5 - New Accounting Standards for Financial Instruments

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: How do the new accounting standards released by the Canadian Accounting Standards Board for financial instruments issued under the CICA Handbook sections 1530, 3251, 3855 and 3865, affect reporting for tax purposes?

Position: The new accounting standards constitute part of generally accepted accounting principles ("GAAP"), which is one element to consider in obtaining an accurate picture of profit.

Reasons: The new accounting standards are not law and as such, the standards and other equivalent regulations would not change how the CRA interprets and applies the Act with respect to financial instruments or a taxpayer's interests in financial instruments. However, the new accounting standards will be taken into consideration when the CRA interprets and applies the Act in a given situation.

XXXXXXXXXX 							2006-017866
S. Chua LLB(Hons), CA
March 9, 2007

Dear XXXXXXXXXX:

Re: Impact of New Accounting Standards for Financial Instruments

This is in reply to your letter dated March 24, 2006 concerning the impact of the new accounting standards for financial instruments released by the Canadian Accounting Standards Board in the CICA Handbook sections 1530, 3251, 3855 and 3865. Under the new standard, most financial instruments, including derivatives, are to be included and valued on financial statements at their fair value, i.e., similar to the mark-to-market method. Subject to specific provisions of the Income Tax Act (the "Act"), you ask how the new standards will affect reporting for tax purposes and whether some particular past interpretations and publications issued by the Canada Revenue Agency (the "CRA") and the Income Tax Rulings Directorate ("Rulings") would continue to apply in the light of the new accounting standards. We apologize for the delay in our response.

Our Comments

Written confirmation of the tax implications inherent in particular transactions are given by this Directorate only where the transactions are proposed and are the subject of an advance income tax ruling request submitted in a manner set out in Information Circular 70-6R5. As stated in paragraph 22 therein, written opinions are not advance tax rulings and, accordingly, are not binding on the Agency. The following comments are, therefore, of a general nature only.

As the Supreme Court of Canada stated in Canderel Ltd v The Queen 98 DTC 6100, the determination of profit is a question of law. Accounting standards are not law. In seeking to ascertain profit, the goal is to obtain an accurate picture of the taxpayer's profit, for purposes of section 3 of the Act for the given year. The Supreme Court stated that a taxpayer is free to adopt any method which is not inconsistent with: (a) the provisions of the Act; (b) established case law principles; and (c) well-accepted business principles. Well-accepted business principles, which include but are not limited to the formal codification found in generally accepted accounting principles ("GAAP"), are not rules of law but interpretive aids. They are non-legal tools, external to the legal determination of profit, unlike the provisions of the Act and other established rules of law. To the extent that well-accepted business principles 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, and only for the purpose of achieving an accurate picture of profit. Accordingly, we confirm that our interpretation of the Act is not altered by the new accounting standards except that we will take into consideration how the taxpayer reports under the new accounting standards, as part of our review of the taxpayer's determination of profit under GAAP. Again, as the Supreme Court stated, ultimately, it is the law that determines how the CRA interprets and applies the Act. We would be pleased to provide you with guidance on a specific fact situation, if you have any.

You have made specific reference to some CRA publications in your incoming letter that we would like to comment on. As you are aware, Interpretation Bulletin IT-95R and Income Tax Technical News No. 14 contain general statements about how the CRA interprets and applies the Act with respect to foreign exchange gains and losses and acceptable methods of reporting derivative income by mutual funds, respectively. As you may be aware, a general warning has been given that they may no longer reflect current law. For example, at the Tax Executives Institute Meeting of December 2006, the CRA was asked (see Question 22) when should a taxpayer report a foreign currency gain or loss in respect of funds denominated in a foreign currency on deposit for the purposes of the Act. Our response was as follows:

"The appropriate timing for the recognition of foreign currency gains or losses in respect of foreign currency on deposit for income tax purposes depends on whether the deposit is capital property. If the deposit is capital property, a foreign currency gain or loss would not be recognized for tax purposes until the foreign currency is converted to another currency or expended for some other purpose.

If however the deposit is on revenue account and a truer picture of a particular taxpayer's income for a taxation year would be reflected by recognizing an accrued foreign exchange gain or loss in respect of foreign currency on deposit at year end then such gain or loss would be included in income for that taxation year for the purposes of the Act. A truer picture of a taxpayer's income would normally be determined by following Generally Accepted Accounting Principles ("GAAP"). The GAAP require translation of monetary items at taxation year-end generally with the related foreign exchange gain or loss being included in the computation of income.

We recognize that IT-95R contains several administrative positions pertaining to the treatment of foreign currency gains and losses for the purposes of the Act. We intend to review those positions and may decide to archive IT-95R if we conclude that one or more positions are no longer supportable under the current law."

It should also be noted that the position in Income Tax Technical News No. 14 dealt with the reporting of derivative income by mutual funds governed by the securities legislation of a province or territory of Canada that allow investments in futures, forwards and options that are on income account. The CRA position in Income Tax Technical News No. 14 has not been extended beyond the scope indicated therein.

You also refer to 2002-0160807 which presented our advice to a CRA auditor on a specific fact situation of a particular taxpayer. The advice given was based on factual information that may not be present in other cases. For example, it was accepted in that fact situation that the derivatives that were used, i.e., the forward contracts, constituted hedges for income tax purposes. It was also assumed that the taxpayer did not carry on a business of earning income from financial instruments and derivative income. On a different fact pattern, our advice in 2002-0160807 could be different. Accordingly, we caution against extrapolating how the CRA would, in general terms, interpret and apply the Act based on advice given in specific fact scenarios.

Based on current jurisprudence, any method which is not inconsistent with the law or well-accepted business principles, and which represented a "truer picture" of the taxpayer's income, would be an acceptable method for purposes of the Act. This determination can only be made on a case-by-case basis. Accordingly, all CRA publications should have limited application to a specific fact situation that may contain more or less factual detail than the circumstances considered in the publication. This difference could significantly alter how the CRA would apply the Act to a given situation.

Other Comments

As you may be aware, the Backgrounder released by the Department of Finance on December 28, 2006 related, in part, to specific provisions that will be enacted in response to the new accounting standards. It has been proposed that all specified debt obligations held by financial institutions be treated as mark-to-market properties in the case where the specified debt obligations are required by GAAP to be carried on the financial statements of the financial institution at the fair market value. Additionally, it has been noted that policy reserves of insurance corporations will generally increase as a result of the new accounting standards, as the policy reserves are generally linked to the yield on assets that support them. This could result in significant increase in the policy reserves that are deductible under paragraph 20(7)(c) of the Act, or under paragraph 138(3)(a), depending on whether the taxpayer is a property and casualty insurance corporation or a life insurance corporation. The Backgrounder indicated that increases or decreases in policy reserves of insurance corporations attributable to changes in accounting standards will not be permitted in the year in which the accounting changes first take effect but would be spread evenly over a five-year period staring in the first year in which the accounting changes take effect.

We trust that the above comments will be of assistance to you. You may contact Suzanie Chua at (613) 957-2100 should you require further information.

Yours truly,

Roberta Albert, CA
For Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch