27 January 1983 Income Tax Severed Letter

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.

JAN 27 1983

HEAD OFFICE Corporate Rulings Division F.B. Fontaine 995-1723

RE: Inventory Valuation in the Commodity Industry

This will reply to your memorandum dated August 17, 1982 concerning the above captioned subject.

You have outlined two hypothetical situations which you state could be widespread in the commodity industry. The first situation envisages futures contracts entered into either to hedge inventory against a market decline or for speculative purposes. The second situation contemplates both futures contracts and bookings (open forward sales contracts).

XXXX

Your first situation illustrates the case of fully hedged inventories in a falling market. A taxpayer may purchase, on June 15, 1981, 300 tons of sugar at $500 per ton and on the same day contract to sell short the same quantity on the futures market at $500 per ton, for delivery 3 months later. At the fiscal year end, June 30, 1981, the market value of sugar was $400 per ton. In respect of this particular transaction, there will be two adjusting journal entries booked as at June 30, 1981:

(1) The reduction of inventories to the lower of cost or market
(300 x $100)
DR (P & L) Cost of goods sold                 $30,000
CR (Bal. Sheet) Inventories                    30,000

(2) The composite part of the "sugar position" journal entry, relating to this particular transaction:

DR (Bal. Sheet) "Prepaid expenses              30,000
CR (P. & L.) Terminal liquidations outstanding 30,000

In this situation it is your opinion that the term "market" as used in the phrase "lower of cost or market" should mean the price at which the inventory is being hedged. That is, for the purposes of valuing the inventory at year-end, the market price should be $500 rather than $400 per ton. However, you feel that the Department could adopt the entries in (1) above to reduce cost to "market" in arriving at the "lower of cost or market".

The second situation concerns unhedged inventories, at a time when prices are rising, and describes the situation in which the taxpayer enters into the following transactions:

June 15, 1981: Inventories on hand (opening)         2500 tons

Bookings Actual commitments for future sales (off the futures market) (1800 tons)

Futures Transactions (terminal)
Long positions - 500 tons
Short positions - (900 " )         (400 tons)        (2200 tons)

June 30, 1981: Inventory (closing)                     300 tons

Cost of inventory is $500 per ton. Market value at year-end is $600 per ton.

Our understanding of this second situation is that for accounting purposes inventory would be valued at market to account for accrued gains and losses, arising from speculative positions, on the accrual basis in accordance with generally accepted accounting practice applicable in the commodity industry. You state that the accrual basis is the only acceptable method in the industry.

In both situations it is your concern that it could be argued that the taxpayer is effectively being taxed on unrealized gains relating to sales that have not been consummated.

The Department's position with regard to futures trading as described at TOM 1473(6.1), (also see IT-346R ) is that all open trades should be brought to market and applied against related inventories. This will apply in the case where inventories are being hedged (primarily on the futures market) against possible future losses. However, where a taxpayer enters into open trade contracts which are not being used to protect inventory from losses, he will be viewed as having participated in a form of gambling. Such open trade contracts constitute inventory which should be valued at market for the purpose of bringing into income the gain or loss thereon.

The effect of the two journal entries in (1) and (2) of the first situation above, in fact, is:

DR: Prepaid Expenses CR: Inventories;

since the other two entries, (i.e. the debit and credit to P & L) offset each other. Based on the treatment mentioned in the immediate two paragraphs above it would appear, that for tax purposes, both journal entries (1) and (2) above, would be necessary to reflect the transactions.

In your second situation, in addition to futures contracts, you discuss "bookings" which can be described as open forward sales contracts. It is our opinion that such contracts are not inventory because the taxpayer does not deal in these contracts. Unlike futures contracts, they are not entered into with the intention of trading them. They are nothing more than commitments between a specific buyer and specific seller to purchase and sell the commodity at a fixed price on a fixed future date. Neither do we think that the underlying commodity can properly be inventory until title has passed to the purchaser. Notwithstanding these views, it is our opinion, for the reasons below, that the Department would continue to treat the open forward contracts in the same manner as open futures contracts as set out in TOM 1473.6(1) and as described above if the taxpayer accepts that treatment. However, if the taxpayer rejects that treatment, it is our opinion that the open forward contracts should be considered as future commitments with the result that both the unrealized losses and gains are excluded from taxable income.

The above recommended treatment of futures contracts is considered by both the commodity industry and the Canadian Institute of Chartered Accountants to be the treatment that most accurately reflects the financial position in such dealings. That is, the overall treatment relating to open trades including open forward contracts must, therefore, be construed to be in accordance with generally accepted accounting practice in that industry.

Our general view is that the Act would appear to be silent on the question of unrealized gains and losses on futures trading and in this regard, the industry practice would normally be adopted for tax purposes.

We realize that the situations outlined in your memo are hypothetical in nature at this time. However, it should not be overlooked that the final disposition of any factual situation would ultimately depend on the particular relevant circumstances.

Chief Merchandising, Manufacturing & Construction Section Corporate Rulings Division Legislation Branch