25 June 1999 Internal T.I. 9905707 - RESOURCE ALLOWANCE

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues: commodity hedge, resource allowance

Position: Question of fact whether a hedge, and must examine capacity and intent to produce product at time when forward sale is entered.

Reasons: Echo Bay reasons for judgment

June 25, 1999

	XXXXXXXXXX Tax Services Office	Resource
	Industries Section
	Denise Dalphy
	Attention : XXXXXXXXXX	(613) 957-9231

990570

XXXXXXXXXX - Hedging or Speculative Transactions

This is in reply to your facsimile transmission of March 4, 1999 concerning the impact of the case of Echo Bay Mines Ltd. (92 DTC 6437) on certain transactions of XXXXXXXXXX.

Facts

1. XXXXXXXXXX

2. XXXXXXXXXX

Issues

1. Are the gains incurred on the early close outs of forward sales by XXXXXXXXX a hedge and, if so, are they included in determining its resource profits, or were they speculative transactions (which are not included in determining resource profits)?

2. When are gains and losses on gold loans of a resource company in the business of producing gold included in computing its income?

Discussion

Hedge or Speculative

Whether an effective hedge exists is a question of fact. This does not mean, however that Echo Bay is only relevant where there is an identical fact pattern. The ratio decidendi, or reason for the decision, is a precedent and the case therefore has broad application to forward sale contracts effected by resource companies of their production. In Echo Bay, Mr. Justice MacKay determined that, to the extent that the forward sale contracts matched production, they were a "hedge". Mr. Justice Mackay stated:

"It is my view that the transactions in respect of the forward sales contracts entered into on behalf of the plaintiff constitute "hedging" as that was defined bv the plaintiff's expert, Bowles, and accepted by the Court and by counsel." [emphasis added]

"Mr. Bowles testified that, under generally accepted accounting principles, a producer's gain or loss from its execution of forward sales contracts may be considered a "hedge" and therefore matched against the production of the goods produced, if four conditions are met. These were set out in his report, to which there is no dispute (save for the objection respecting relevancy), as follows:

1. The item to be hedged exposes the enterprise to price (or interest rate) risk.

2. The futures contract reduces the exposure and is designated as a hedge.

3. The significant characteristics and expected terms of the anticipated transactions are identified.

4. It is probable that the anticipated transaction will occur.

In his view, the difference between hedging and speculating is that the former the company engaged in hedging sells forward or commits a product it has the capability of producing and that it intends to produce: if it has neither the capacity nor the intention of meeting its commitments through production it is speculating in engaging in forward sales contracts." [emphasis addedi

MacKay, J. then concluded:

"Whether a transaction is a hedge depends upon assessment at the time forward sales contracts are concluded of capacity and intention to produce product committed under those contracts." [emphasis added]

The fact pattern in XXXXXXXXXX is somewhat different from that in Echo Bay, for, in XXXXXXXXXX, it seems that all of the forward sale contracts were closed out early, whereas in Echo Bay, many were closed out as they came due. Nonetheless, the ratio of Echo Bay must be followed in order to determine whether XXXXXXXXXX program was a hedge or speculative.

The purpose of a hedge is to fix the price in advance of a product. The fact that a company de-hedged and re-hedged its products, even if done frequently, would not in itself fail to satisfy the criteria set out in Echo Bay. The issue remains the same: did the company have the capacity and the intention to produce the products? An objective analysis of XXXXXXXXXX transactions at the time they entered into them would provide this information.

The fact that a company de-hedged and re-hedged forward sale contracts does not in itself mean that the company was not attempting to set a future price, since the marketplace may necessitate adjustments. In Echo Bay, Mr. Robert Parsons stated:

“ if the producer should choose to close out the forward sales contract earlier than it was required to do, by purchasing an equivalent amount of product, this action does not alter the characterization of the gain or loss on the forward sales contract as a hedging transaction. The effect would merely be that during the period from the date of closing out the contract to the date of receipt for production delivered, the producer would not be protected from the risk that prices would fall."

Mr. Parson's reasoning is consistent with the AtZantic Sugar Refineries case (49 DTC 602) and Echo Bay. In Echo Bay, Mr.

Justice MacKay stated:

"What is particularly interesting in the Atlantic Sugar Refineries decision, is that the taxpayer, seeking to have the gain characterized as investment income and not as a part of it business operations, attempted to provide evidence that its activities on the Exchange could not be characterized as hedging. Locke, J., Kellock, J. concurring, addressed the evidence in his reasons for judgment, as follows, at 711 S.C.R., 604 DTC, 202 C.T.C.:

According to the witness, in the ordinary case of a hedge, the selling for future delivery synchronizes with the purchase of the commodity while, in the present case, the short sales were made over the period of a month following the cash purchases. I think that this circumstance does not affect the matter to be determined. While not carried out contemporaneously with the purchases, the short sales were in effect a hedge by the company against a possible loss on the purchases made and it was only the imposition of control on October 2nd [by government under the War Measures Act] that rendered further hedging operations inadvisable. In trades where natural products are purchased in large quantities, hedging is a common, and in some cases, a necessary practice, and the cost of such operations in trades of this nature is properly allowable as an operating expense of the business. Where, as in the present case, the trader elects to close out his short sales and take a profit, this is, in my opinion, properly classified as profit from carrying on the trade. [emphasis added]"

Mr. Justice MacKay also concluded that early close-outs do not preclude transactions from being considered hedges. He stated:

I make this finding [that the transactions in Echo Bay were hedges] after full consideration of the submissions advanced on behalf of the defendant that the transactions should not be so considered based on the fact that the transactions were carried out by the plaintiff's parent company, with no evidence before me of close consultation with the plaintiff's officers or employees. Moreover, it is urged that there was insufficient matching, in respect of quantity of production and time of delivery of product and closing out of the forward sales contracts, between the two parallel sets of transactions, but I note that there is no evidence of correlation or lack of it. Rather, the only evidence is that of Mr. Jenner that the forward sales contracts were hedging, undertaken to assure returns by fixing the price for future production in a fluctuating market, that the sales contracts did not exceed anticipated production, and further the admission of counsel that a number of the forward sales contacts were settled in advance of their date for maturity. Mr. Jenner testified that the estimates upon which the forward sales transactions were based, in total, were close approximations of the actual production carried out. Estimates were being continually revised in order that quantities of silver to be sold forward did not exceed actual production. True, the futures market transactions were carried out by officials of the parent company, through instructions to American brokerage firms, but those transactions were carried out for the plaintiff and recorded only in its ledgers, and, in my view, must be considered to have been carried out by the plaintiff. Exact matching was not feasible from a practical point of view, nor is it required in order to constitute hedging. In respect of this final conclusion, I rely on the reasons of Locke, J. in Atlantic Sugar Refineries, quoted supra. [emphasis added]

Hedge Profits as Resource Profits

In Echo Bay, the Court was asked to distinguish the Supreme Court's decision in Atlantic Sugar on the basis that the issue in that case was broader (whether the gain was income from business or a capital gain) than in Echo Bay (where the issue was whether the profit on hedging was from a particular source, namely production", within business income). Mr. Justice Mackay stated:

"I turn to the issue whether, if the activities of the plaintiff constituted hedging, there is sufficient inter-connection or integration with the business of production of silv?r that a gain from hedging activities can be considered to be income from that business."

"If one turns to Regulation 1204(1), I note that a fuller excerpt of the words used in defining "resource profits" than that offered by the defendant more fully represents the provision. Thus, these profits are defined, in part in paragraph (b), as "the amount. . .of the aggregate of. incomes. . .from the production in Canada of. . metals or minerals" [to the primary metal stage]. The use of the words aggregate" and "incomes', and the implicit inclusion of income. . derived from transporting, transmitting or processing" [to the primary metal stage] in the case of metals or minerals under 1204(1)(b) which arises from 1204(3), both signify that income from "production" may be generated by various activities provided those are found to be included in production activities. Production activities yield no income without sales. Activities reasonably interconnected with marketing the product, undertaken to assure its sale at a satisfactory price, to yield income, and hopefully a pr.ofit, are, in my view, activities that form an integral part of production which is to yield income, and resource profits, within Regulation 1204(1)."

"Here the plaintiff took the only course open to it to assure the price for future deliveries, by selling and settling forward sales contracts on the commodities market. That activity was hedging, minimizing the risk of loss on future sales by assuring a return at prices prevailing when the forward sales contracts were negotiated. That return was realized from the proceeds of sales to the refiner purchaser together with the gain or loss on settlement of future sales contracts."

"There was a clear business purpose in its sales and settlement of silver futures contracts, a purpose integrated with its sales of product to yield income; the plaintiff was trying to obtain an assured price for the sale of the silver it produced. That activity was similar to the attempt of the taxpayer in Tip Top Tailors, supra, to obtain raw materials necessary to its business at an assured price."

"Here the forward sales transactions were in respect of the same commodity as the plaintiff's production; both were, in my view, integral aspects of the plaintiff's business of producing silver, and returns from these activities were income from production of metals within Regulation 1204(1)

"Finally, I find support for the conclusions expressed herein from the decision in Atlantic Sugar Refineries, a unanimous decision of the Supreme Court. The fact that in this case, the transactions were not isolated but a regular part of the plaintiff's practices, renders, in my view, the reasoning in Atlantic Sugar Refineries more, not less, persuasive in its application to the case before me."

"Furthermore, this result corresponds to business practice and accounting principles, which, while not determinative of the taxation treatment of the plaintiff's income from production for the purposes of Regulation 1204, nevertheless reflect the reality of the taxpayer's actions. Wherever possible, the courts should attempt to interpret the statutory provisions of the Income Tax Act and Regulations in a manner taking into account that reality: see Mcclurg V. M.N.R., supra. Preventing a taxpayer from taking advantage of various markets in the marketing of its goods, unless required by the words of the legislation, would be unduly formalistic."

Although it is not relevant for the years that you are currently auditing, we note that, for taxation years beginning after XXXXXXXXXX, these transactions would be accounted for in computing a taxpayer's "resource loss" as well as its "resource profits" for a year.

Timing of inclusion in gross resource Drofits - Regulation 1204

The positions described in #9226381 (October 2, 1992), in particular the discussion about resource profit recognition, have not changed. It first must be determined whether a loan or forward sale contract is a hedge. If a hedge in fact exists, the gain or loss on the hedge is included in resource profits when the related commodity is produced and sold. The Court in Echo Say stated:

"Where the transaction is a hedge, profits realized on settlement of the contracts are considered a component of the price realized. for the product when sold and under accounting practice are included in income from sales."

However, when a forward sale contract, for example, ceases to be a hedge (for example, the hedged commodity is produced and sold, but the forward sale contract is closed out in a subsequent year), the gains or losses for that subsequent year would not be included in resource profits.

For your information, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Department's mainframe computer. A severed copy will also be distributed to commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, he can be provided with the LAD version or he may request a copy severed using Privacy Act criteria which does not remove the client's identity. Requests for this latter version should be made by you to Jackie Page at (613) 994-2898. The severed copy will be sent to you for delivery to the client.

If we can be of any further assistance or if you wish to discuss this matter further, please contact the writer.

John Chan, Manager
Resource Industries Section
Resources, Partnerships and Trusts Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch