Timing of employer loss recognition on hedge of phantom unit obligations (pp. 13:9-10)
Corporate employers may create phantom stock plans and similar arrangements… .
…Often, the employer will enter into a total return swap or forward contract with a counterparty under which the counterparty will pay the employer any increase in value of the shares and the employer will pay the counterparty the amount of any decrease in value of the shares plus financing cost. …
The decision is Kruger…should not require the employer to mark the swap to market for purposes of computing income for tax, since entering into the swap is not part of a business carried on separately from the employer's core business.
Applicability of Kruger to adventures in the nature of trade (p. 13:28)
[I]t is possible that because Kruger was decided in the context of a taxpayer carrying on a business of speculating in derivatives, rather than the context of a hedge of an item on income account (which may be regarded as something more akin to an adventure in the nature of trade), the decision may not be applicable. However, given the reasons for which the various accounting bodies require the use of the MTM [mark-to-market] method for computing income from derivative contracts—that the derivatives are fully liquid and their values capable of accurate measurement—and given the accepted relevance of that reasoning in Kruger to the measurement of income for income tax purposes, it is difficult to see why the reasoning would not also to the results of derivative contracts that hedge items on income account. [fn 103: Even if the profit or loss on the hedging derivative were regarded as an adventure in the nature of trade for income tax purposes, the recognition of an unrealized profit or loss would not run afoul of subsection 10(1.01) since Kruger decided that these foreign-currency options did not constitute inventory.]
Relevance of GAAP to tax hedge accounting (pp. 13:28-30)
[A]ssume that, on December 1 of year 1, X Co expects with a high degree of probability to sell product for US$100,000 early in year 2. To hedge the risk of currency movement between December 1 and the expected sale, X Co hedges the value of the expected sale proceeds by entering into a forward contract to sell US $100,000 at the December 1 spot rate on January 2 of year 2.
Under GAAP, without hedge accounting X Co would be required to carry the unrealized gain or loss on the hedging derivative to the statement of profit and loss at the end of year 1. The loss or gain on the sale proceeds as a result of currency fluctuation would not be reflected on the statement of profit and loss until they were received in year 2….
Applying hedge accounting to the example above, X Co would not be required to carry any unrealized gain or loss on the hedging derivative to the statement of profit and loss in year 1. Rather, such gain or loss would be carried in other comprehensive income (OCI) [fn 106: Under IFRS] on the equity side of the balance sheet until the proceeds of the expected sale were received in year 2. At that point, any gain or loss on the US-dollar proceeds as a result of currency fluctuation would be offset by the loss or gain on the hedging derivative carried in OCI, which would be indicated on the statement of profit and loss. [fn 107: ASPE would permit the same result, except that the unrealized gain or loss on the hedging derivative would not appear on the balance sheet (ASPE does not have the concept of OCI) but the gain or loss would offset the loss or gain on the US dollar proceeds when the proceeds were received such that no gain or loss on the US dollar proceeds would be recorded in the statement of profit and loss.]
X Co, having chosen hedge accounting, could argue on the basis of Kruger that hedge accounting provided a more accurate picture of income; it matched the results of the hedged item with the results of the hedging item, thus producing a better match of profit and related loss than the realization principle. ...
[P]rofits and losses are not exactly the same concepts as revenues and expenses, but it is difficult to see why the matching principle should not apply equally to linked profits and losses in order to produce an accurate picture of income.
Potential treatment of a dynamic hedge as on capital account (pp. 13:11-12)
A static hedge is one that does not have to be rebalanced as the price or other characteristics of the underlying asset it hedges changes. …
In contrast, a dynamic hedge involves adjusting the hedge as the underlying security changes in value throughout the life of the contract. Assume that a party sells a call option on 100 shares of X Co, and that party's obligations under the call option are determined by X Co's share price when the option contract matures. If the party wants to hedge its contingent obligations under its short-option position, it can purchase a certain number of X Co shares at inception of the option contract. The number of shares is determined by considering a variety of factors, including the probability of X Co shares trading above the option strike price at maturity. As the stock price changes during the term of the option, the party will typically adjust its hedge position by buying or selling X Co shares in the market….
The Canadian fund manager mentioned above may similarly decide to engage in a dynamic currency-hedging strategy.
[T]he CRA's interpretation [2013-0481691E5] suggests that transactions resulting from a dynamic currency-hedging strategy adopted by a Canadian fund manager will generally be on income account.
However, based on George Weston, we believe that a compelling argument can be made that gains and losses resulting from a dynamic hedging strategy to hedge a capital asset should also be on capital account despite the fact that there may be numerous transactions. In our view, the relevant issue is the character of the risk that is being hedged (depreciation in value of a foreign-currency-denominated capital asset), not the number of transactions.
Potential application of pre-amendment DFA definition to currency forwards (pp. 13:15-16)
A currency forward locks in the exchange rate for the purchase or sale of a currency on a future date. The mechanism for determining a currency forward rate depends on the interest rate differentials for the currency pair if both currencies are freely traded. Assume that the current spot rate for the Canadian dollar is US$1 = Cdn$1.25 and the taxpayer enters into an agreement to sell US$1 million a year from now at the forward rate of US$1 = Cdn$ 1.2685. If in a year's time the spot rate is US$1 = Cdn$1.20 (that is, the Canadian dollar has appreciated against the US dollar), the taxpayer realizes a gain of Cdn $68,500 (by selling US$1 million for Cdn$l,268,500 rather than at the spot rate of Cdn$1.20 or Cdn$1.2 million). If one assumes that the gain would otherwise be a capital gain, the currency forward may fall within the definition of a DFA because
1) the agreement is a sale agreement (selling US dollars);
2) the sale price (Cdn$l,268,500) of the property (US$1 million) is different from the fair market value of the property at the time the agreement was entered into (Cdn$1.25 million);
3) the difference is attributable, in whole or in part, to an underlying interest because the US and Canadian interest rates are "rates" as used in the definition;
4) the difference is not attributable to "changes in the fair market value of the property over the term of the agreement, or any similar criteria in respect of the property" because the price is fixed at outset;
5) since the sale price is denominated in Canadian dollars, the exception applicable to changes in the value of Canadian currency does not apply;
6) the agreement is part of an arrangement that eliminates a majority of the taxpayer's risk of loss and opportunity for gain or profit in respect of the US dollars sold forward for more than 180 days.
…[I]t could be argued that references to "property" in the definition of a DFA should not include money and that money is not a capital property—in other words, that a gain or loss would be on capital account even though there is no capital property…
Addition of (b)(iii) and (c)(i)(C) to DFA definition (pp. 13:16-17)
The September 16, 2016 proposed amendments would add an additional exception…
[T]he reference to reducing the risk of fluctuations in the value of the currency in which a purchase or sale by the taxpayer of a capital property is denominated presumably refers to hedging the sale or purchase price of a property that is denominated in another currency. The reference to reducing the risk of fluctuations in the value of the currency from which a capital property of the taxpayer derives its value should include shares of foreign subsidiaries, for example. However, the reference to reducing the risk of fluctuations in the value of the currency in which an obligation that is a capital property of the taxpayer is denominated is not clear. An obligation issued by the taxpayer is not property of the taxpayer. It seems likely that the intention was to include "an obligation issued the taxpayer that is on capital account."…
The comments above regarding the drafting of the exception in the context of a sale agreement are equally applicable in the context of a purchase agreement.
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