The federal appeal court decision bolsters the possibility for taxpayers to use methods to compute income that are not forbidden by the Income Tax Act (Act), affirms Canada Revenue Agency’s administrative position that allows regulated financial institutions to tax derivatives on a mark-to-market basis, and may open the door to allow financial accounting to become more influential in determining what constitutes an acceptable method of computing income from business, according to tax experts.
“The case confirms that taxpayers are to determine profit for tax purposes on the basis that reflects an accurate picture of the taxpayer’s income,” said James Morand, a Toronto tax lawyer with Cassels Brock & Blackwell LLP. “If mark-to-market presents a truer picture of a taxpayer’s income than realization or some other method of computation, it is preferable.”
Kruger Inc., a Montreal newsprint and paper products manufacturing company that generated approximately 80 per cent of its sales in the U.S., started a business during the 1980s that purchased and sold foreign currency option contracts in order to reduce its exposure to foreign currencies. That line of business became so successful that it eventually became an industry leader in the Quebec options market, ranking among the top three or four non-banking enterprises in Quebec, behind the Caisse de dépôt et placement du Québec and Hydro-Québec. Beginning in 1997, Kruger began to account for its foreign exchange operations using mark-to-market accounting for financial reporting purposes. In 1998, Kruger’s foreign exchange operations claimed a loss of approximately $91 million, which the CRA denied.
Former Chief Justice of the Tax Court of Canada Gerald Rip denied the mark-to-market losses on option contracts written by Kruger. Although he found that the mark-to-market method was consistent with well-accepted business principles and generally accepted accounting principles (GAAP), former Justice Rip held that “a general principle of taxation is that neither profits nor losses are recognized under the Act until realized except if the Act provides an exception to the realization principle.”
Mark-to-market accounting is an accrual method of accounting where the option is valued at market value as at the balance sheet date, and any change in the market value from the beginning to the end of the period is recognized as a gain or loss in the income statement for the period. In contrast, under the realization method of accounting, a transaction is recognized as complete when an entity has a claim to be paid in cash or an obligation to pay cash. The realized value is certain, and not subject to any estimate of value.
But the federal appeal court, in overturning the lower court decision, rejected the notion that the realization principle is an “overarching” principle that applies in the absence of a provision authorizing or requiring the application of a different method. Such an approach flies in the face of established case law and runs counter to decisions by the Supreme Court of Canada, said Chief Justice Marc Nöel in a unanimous 34-page ruling in Kruger Incorporated v. Canada, 2016 FCA 186.
The SCC held, in Canderel Ltd. v. Canada,  1 S.C.R. 147 and in Ikea Ltd. v. Canada,  1 S.C.R. 196, that the realization principle can give way to other methods of computing income (pursuant to section 9 of the Act) “where these can be shown to provide a more accurate picture” of the taxpayer’s income for the year. In another decision issued some fifty years ago, the SCC held in Canadian General Electric Co. v. M.N.R.,  S.C.R. 3 that gains and losses on income account resulting from foreign currency fluctuation may be recorded on an accrual basis for tax purposes.
“The decision reinforces the possibility for a taxpayer to use any method that is not forbidden by the Act or rules of law,” noted Louis Tassé, a tax lawyer with EY Law LLP, who successfully plead the case. “Our position from the beginning was that Kruger was allowed to use mark-to-market as it gave a clearer picture of its income and was not otherwise forbidden by the Act or by case law. The decision is a simple application of the principles outlined by SCC in Canderel. It might serve as a healthy reminder of such principles.”
The appeal court also noted that there is “broad recognition” of mark-to-market accounting for the purpose of computing income from dealing in foreign exchange options. Uncontested evidence revealed that banks, financial institutions and mutual funds that deal with foreign exchange options have been given the green light by CRA to report their income using the mark-to-market method, pointed out the appeal court. It is also a method that is “consistent” with well-accepted business principles, GAAP and international accounting, added the appeal court.
“This is an important case because it significantly extends the SCC decision in the Canadian General Electric case,” said Neal Armstrong, a Toronto tax lawyer with Davies Ward Phillips & Vineberg LLP. “Until the Kruger case people thought that Canadian General Electric was restricted to the foreign exchange situation. Kruger extends mark-to-market accounting to a broader range of matters where the instruments are held in income account.”
In fact the appeal court decision seems to suggest that a taxpayer which has derivatives, other property or obligations acquired or incurred on income has the option to report its gains or losses on those holdings on a mark-to-market rather realization basis for tax purposes if, under GAAP, the taxpayer prepares financial statements on a mark-to-market basis, added Armstrong.
But taxpayers cannot switch between mark-to-market and realization tax accounting methods depending on whether they have accrued losses, said Paul Ryan, a Montreal tax lawyer with Ravinsky Ryan Lemoine LLP. The courts and CRA require that taxpayers use a consistent method of computation from year to year, added Ryan. “There has to be consistency as the federal appeal court decision points out,” said Ryan. “A taxpayer cannot choose one method when he has suffered losses, and another method when he’s making gains. That is very important.”
Some have suggested that the appeal court decision may have wider implications. In a bulletin PwC said that it is possible that the Kruger decision “will start a trend” in which financial accounting becomes more influential in determining what constitutes an acceptable method of computing income from a business.
Tassé says only time will tell. Morand believes the courts will continue to rely on the guidance set out by the SCC in Canderel and Ikea – that is, determining profit for tax purposes on a basis which reflects the most accurate picture. “This may be consistent with financial accounting but the fact that it is will not be determinative of whether it should be used for tax profit computation,” said Morand. In a similar vein, Armstrong said that while accounting principles do have some relevance, they are certainly not binding. “And the Kruger case hasn’t changed that,” added Armstrong.