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Taxation of Foreign Exchange Options – Sas Ansari

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Taxation of Foreign Exchange Options

Kruger Incorporated v The Queen, 2016 FCA 186

At issue in this appeal was whether foreign exchange options are subject to market-to-market accounting for recognition of profits and losses and whether they are inventory that can give rise to losses at the year-end based on their value.

The TCC held (2015 TCC 119) that the options were not subject to market-to-market accounting. However, Chief Justice Rip (as he then was) held that the options were inventory.

The FCA held:

  • The realization principle is not overarching in that an exception needs to be provided by the ITA – Section 9 only requires that the method chosen be one that accurately reflects income for the year;
  • Inventory must be property that is held for sale; and
  • The ITA contains more than two types of property – capital and inventory – with purchased options being an example of the third type.


The taxpayer manufactured paper products. About 80% of the taxpayer’s receivables were in USD. In order to reduce exposure to foreign currency fluctuations it purchased and sold foreign currency option contracts and began to produce profits from this activity on an “individual profit center basis”, growing to be an industry leader in terms of volume in dealing with derivative products.

For the purchaser, the upside is unlimited while the downside is limited by the premium paid. For the issuer, the downside is unlimited while the upside is limited to the premium charged.  In 1997 it began to use market-to-market accounting for financial reporting purposes in relation to the options activities.   Market-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 [..] and recognize any change in the market value as a gain or loss for the period [..]. 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

All or almost all of the taxpayer’s options were “European” and “over the counter” – may only be exercised on their expiry and traded privately – could be transferred before expiry with the consent of the counter party, and could be closed off by entering into offsetting positions.  At the end of the year, it claimed losses on the basis of the difference between the value of the option at the beginning of the year compared to the end, and it also deferred the premium paid until the maturity date of the option.

The Minister took the position that market-to-market accounting was not an option for the taxpayer and losses and income, including premiums, are only reportable on close of the option – realization basis.

The Tax Court held that the ITA, other than sections 142.2 to 142.5, and Regulations 1801, do not allow for market-to-market accounting and that the taxpayer was not helped by the administrative policy of the CRA allowing financial institutions to use this method for options.  Absent a legislative provision permitting the taxpayer to deviate from the realization principle, foreign exchange options had to be valued at historical cost such that gains/losses cannot be recognized until the option was disposed of or expired.

The Tax Court, however, held that the taxpayer was in the business of buying and selling contracts and,  on the basis of the definition of “inventory” in 248(1) not requiring the property to be held for sale, found the options to be inventory. This was only for options purchased as they conferred a “right” which falls within the definition of “property” in 248(1) but not the options written as they give rise to a liability.


Market to market accounting

The FCA stated the analysis by stating that the question of law – the calculation of income and loss from a business pursuant to ITA 9(1) and (2) – is reviewed on a standard of corrected.   This requires the court to understand the exact nature of the taxpayer’s business.  Despite realisation being at the core of Canada’s income tax system, where it can be shown that another method provides a more accurate picture of the taxpayer’s income for the year, that other method can be used by the taxpayer to determine its income or loss under ITA s 9(1) and (2) (para 59) – Canadian General Electric Co. v. M.N.R., [1962] S.C.R. 3.  There is no need for the ITA to provide an exception to realization for a different method to be available to the taxpayer (para 65).  The realization principle can be departed from where it provides a better picture of the taxpayer’s income for the year (para 66).  Realization is not an overarching principle (para 66).

The FCA concluded, at paragraph 70:

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 [sic] 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 […]. 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 [sic] to market accounting provides an accurate reflection of its income.

Unless the crown can show that its preferred method shows a better picture of income for the taxpayer than the taxpayer’s preferred method, the taxpayer can use its accounting method (para 71).

Contracts as inventory

Are contracts inventory of the taxpayer, losses on which can be recognized pursuant to ITA s 10(1) and 1801 of the Regulations? The inventory adjustment is mandatory.

Subsection 10(1) requires that a taxpayer who carries on business must value inventory on hand at the end of the taxation year at the lower of cost or fair market value. If the FMV is less than cost, the loss is recognized that year.

Inventory is defined in subsection 248(1) of the ITA as meaning “a description of property the cost or value of which is relevant in computing … income from a business..”.     The ITA deviates from GAPP and allows intangible property to be treated as inventory – M.N.R. v. Curlett, [1967] S.C.R. 280Dobieco v. M.N.R., [1966] S.C.R. 95CDSL Canada Limited et al. v. The Queen, 2008 FCA 400.  The ITA also recognizes explicitly at the work in progress of a professional is “for greater certainty” inventory – ITA s 10(5).   Also , only rights can be property such that liabilities cannot be property – Tip Top Tailors Limited v. M.N.R., [1957] S.C.R. 703.

The FCA also held that in order for property to be inventory, it must be held for sale (para 87).  The SCC in Friesen v. Canada, [1995] 3 S.C.R. 103, at para 23, said:

 “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.

Purchased options are neither inventory nor capital property, but rather are a different type of property (para 100).  Written options are not property. The FCA stated, by reference to Canderel Ltd. v. Canada, [1998] 1 S.C.R. 147:

  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.

Sas Ansari, BSc BEd PC JD LLM PhD (exp) CPA In-Depth Tax 1, 2 &3

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Professional Advice Capital v Income – Sas Ansari

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Professional Advice –  Capital v Income 

Rio Tinto Alcan Inc v Canada, 2016 TCC 172

At issue was whether legal fees, investment banking fees, fees in respect of government representations, and other matters incurred at a time where take-overs and spin-offs were being conducted were  on account of capital (and added to the ACB of the shares) or income.


Although ITA subsection 9(1) allows for the deduction of expenses from revenue in determining profit, paragraphs 18(1)(a) and (b) limit deductions that may be claimed.  The outlay or expense must have been incurred for the purpose of gaining or producing income from a business (s 18(1)(a)), and cannot be an outlay or expense that is of a capital nature (s 18(1)(b)).

The respondent argued that the expenses were current expenses as they relate to the cost of professional advice relied on by the board of directors in deciding whether or not to approve the transactions – “oversight expenses” rather than “execution costs”.

What is meant by “on account of capital” as used in 18(1)(b) is not defined in the ITA.  No rigid or single test applies and the courts must draw the distinction on the facts of a particular case – Johns‑Manville Canada Inc. v. The Queen,[16]:

  • The matter turns on how the expenditure is calculated to effect from a practical and business point of view rather than based on juristic classification of the legal rights secured, employed or exhausted in the process (para 73);
  • The distinction draws a line between: (i) the acquisition of the means of production and the use of such means; (ii) establishing or extending a business organization and carrying on business; (iii) implements employed in work and the regular performance of work; (iv) the enterprise itself and the sustained effort of those engaged in the enterprise;
  • Other considerations include: (i) the character of the advantage sought and its lasting qualities; (ii) the recurrence of the expense; (iii) the manner in which the advantage is to be used or enjoyed; (iv) the means adopted to obtain the advantage;
  • The expense is on income account where the purpose of the expense which would fall into the class of thing that in aggregate are in constant demand;

The Court identified the three tests developed by the courts in distinguishing between capital and income:

  1. The recurring expense test – though just because an expense is made once and for all does not mean it is of capital nature (para 75);
  2. Enduring benefit or asset test – looks to whether the expenditure creates a lasting benefit for the business (para 76);
  3. Underlying Purpose or Rationale Test – if an expense is incurred to a matter related to the income earning process, it is likely current, while an expense incurred as part of the implementation of a transaction resulting in the creation or acquisition of a capital asset, or expansion of business, is likely on capital account (para 77) analyzed in the context of the taxpayer’s business with a view to the commercial purpose of the payment-  Ikea Ltd. v. Canada,  [1998] 1 S.C.R. 196; Morguard Corp. v. The Queen, 2012 FCA 306.

The tests above must be applied on a case-by-case basis and none alone provides a definitive answer in all circumstances (para 79).

Just because an expenditure was made as part of the decision-making process or oversight process of determining whether or not to bring about a capital asset does not make the expense one of capital nature.  These expenses may still result from the current operations of the business and part of the concern of directors and officers for conducting the daily operations in a business-like manner (para 80) – Bowater Power Co. Ltd. v. M.N.R., 71 DTC 5469; Wacky Wheatley’s TV & Stereo Ltd. v. M.N.R., 87 DTC 576; see also IT‑475 “Expenditures on Research and for Business Expansion.

The court noted that the current business environment demands greater oversight over activities of the corporation, with the board challenging and testing proposals by managers by, in part, seeking independent professional advice to guide their decision-making process (para 87).  The court held at paragraph 88:

Simply put, Oversight Expenses are current expenses because they relate to the management of a corporation’s income‑earning process. Proper management includes the judicious allocation or reallocation of capital for the purpose of maximizing the income earned by the corporation. Ineffective oversight over the capital allocation process is a formula for disaster that often leads to a decline in earnings and cash flow and, as a result, the destruction of shareholder value. In this context, Oversight Expenses serve an income‑earning purpose. Oversight Expenses per se do not create enduring benefits for taxpayers. Rather, it is the actual implementation of an approved capital transaction that creates the enduring benefit. In this context, the Court must carefully scrutinize the evidence, with proper regard to the applicable evidentiary burden, in order to ensure that the expenses that are treated by a taxpayer as current expenses actually pertain to advice given to the board of directors to assist it in the decision‑making process undertaken as part of the exercise of the board’s oversight function. This is to be contrasted with expenses incurred as part of the implementation of a transaction leading to the acquisition of capital property. In that context, the Court must look at the primary purpose of the work performed. Was the work commissioned primarily to assist in the oversight or management process, or was it primarily linked to the implementation of a transaction carried out on capital account?

Sas Ansari, BSc BEd PC JD LLM PhD (exp) CPA In-Depth Tax 1, 2 &3

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