Federal Court of Appeal allows use of mark-to-market tax accounting

Taxpayers are entitled to use the mark-to-market method to compute income for federal tax purposes if it provides a more accurate picture of a taxpayer’s income, ruled the Federal Court of Appeal.

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, [1998] 1 S.C.R. 147 and in Ikea Ltd. v. Canada, [1998] 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., [1962] 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.

New accounting rules making lawyer’s job tougher

When a slew of Canadian organizations made the transition at the beginning of the year to an international financial reporting standard, lawyers faced almost overnight new ground rules that could prove to be burdensome, endanger solicitor-client privilege, and potentially prejudice defense in litigation cases.

Misgivings arise from the way that unresolved legal claims, or “contingencies” in accounting speak, must be reported under International Financial Reporting Standards (IFRS). IFRS, quite simply, imposes a higher threshold for identifying claims, takes a different approach to estimating the expected value of a claim, and has more extensive disclosure requirements.

“I don’t see lawyer’s lives getting any easier with IFRS,” remarked Stephen Kerr, a partner with Fasken Martineau Dumoulin LLP, who practices general corporate and commercial law. “Suddenly we’re going to be asked to do a lot more, with a lot more precision and a lot faster.”

On January 1, 2011, publicly accountable for-profit corporations, government business enterprises and other enterprises that chose to do so began using IFRS as the basis for preparing their financial statements. Under IFRS, unresolved legal claims are subjected to International Accounting Standard 37, Provisions, Contingent Liabilities and Contingent Assets (IAS37). In place for over a decade, IAS 37 differs significantly from the way that unresolved claims are interpreted by Canadian Generally Accounting Principles (GAAP).

The Canadian Bar Association (CBA) and the Auditing and Assurance Standards Board (AASB), the Canadian authority that sets generally accepted auditing standards (GAAS) for financial statement audits, have issued interim guidelines to assist lawyers with audit-related inquiries about unresolved legal claims but some questions will likely remain unanswered until either the courts themselves provide guidance or lawyers come to an understanding of how the rules should be interpreted, contend legal observers.

“There is going to be an evolution over the next little while as lawyers work together with their clients and as clients work with their auditors to find the best way to give auditors what they need to have while at the same time preserving the client’s position as best as possible,” said Mark Selick, a partner with Blakes who helped draft the interim guidance. “Most situations probably won’t be tough but there will be some, and I think there is going to have to be some dialogue to figure out the right way to deal with it.”

In both IFRS and GAAP, financial statements should recognize an obligation arising out of a past event when it is probable that a payment will have to be made to settle the legal obligation. The difference between both standards lies in the interpretation of when such legal claims must be reported. Under GAAP’s Section 39 rule, corporations would report legal claims when it is “likely” a payment must be made, something that has over time been interpreted as meaning there is a greater than 70 per chance that a payment may have to be made. IAS 37 uses a wider net and a lower threshold thanks to a “more likely than not” approach. Though there is no official interpretation, corporations would be expected to report legal claims when there is a greater than 50 per cent likelihood of being settled against the corporation.

As important, organizations no longer have the leeway GAAP provided them to report claims. Unlike GAAP’s section 3290, which allows corporations to avoid reporting legal claims when there is insufficient or conflicting evidence, IAS 37 does not grant such latitude.

“Lawyers are going to have to revisit decisions they made in the past about claims, and going forward they’re going to have to ask themselves questions about future claims, taking into account that it’s a different test, with a wider net,” said Kerr. “It’s going to be fascinating to see how lawyers and accountants interpret these rules.”

It’s going to be just as intriguing to see how the legal profession will tackle IAS 37’s requirement that clients be able to give a reliable estimate of the amount that might be owing due to the legal claim. Under IAS 37, corporations are required to provide a “best estimate,” a higher test than GAAP’s “reasonable estimate” approach. Organizations will likely have to perform complex measurement calculations in order to come to a “best estimate” and consult with their counsel to confirm their analysis, but it remains that outside counsel will shoulder much of the burden. Aside from likely approving the “best estimate,” a conundrum by itself, lawyers will have to ensure that the “best estimate” does not harm the interests of their client.

“It’s another conundrum lawyers face because it’s asking us to quantify something that we didn’t have to quantify with as much specificity in the past,” said Kerr. “Business people and auditors, who are closer to the numbers than lawyers are, are now going to be pressed into a situation to try to quantify what the potential impact is going to be if there’s an adverse judgment – and that just makes the lawyer’s job that much more difficult to try and figure out what these things are worth.”

Disclosure of the “best estimate” also can play into the hands of plaintiffs who have claims against entities reporting under IFRS, said Trevor Scott, a leading corporate commercial lawyer in British Columbia. Besides the inherent difficulties of trying to come up with a “best estimate” when so many different factors must be taken into account in a case involving litigation, such disclosure could potentially prejudice the defense of the defendants.

“There is a risk in describing a claim in your financial statement, describing the likelihood of that claim and its possible outcome that the plaintiff could look at that information and use it to their advantage,” noted Scott, a partner with Farris, Vaugh, Wills & Murphy LLP.

Coming up with a “best estimate” could also put in jeopardy solicitor-client privilege, particularly if the client and the auditor do not see eye-to-eye. The interim guidance provided by the CBA and the Canadian auditing authorities states that to protect privilege clients should communicate directly with the law firm without disclosing the communication to the auditor. Lawyers responding to audit inquiry letters should only confirm or deny the reasonableness of the client’s descriptions and estimates, adds the interim guidance. But it may not be that simple, observed Selick.

“In replying to audit inquiry letters, we always have to have in the back of our minds the risk that it might not be privileged,” said Selick. “Once you start talking to someone outside that tent, there is the potential of losing that privilege. So the goal is to keep the reply which would go to the auditor as short and succinct as possible, and not get into anything more than the bare essentials.”

In-house counsel too face new dilemmas, especially since the interim guidance appears to have been drafted with outside counsel in mind, said Fred Headon, who heads Air Canada’s in-house labour and employment law team. The interim guidance does not spell out the what in-house counsel should do when faced with an audit inquiry letter, a situation all the more vexing given that the entity is their client.

“We need to be thinking about it,” said Headon, who was part of the CBA committee that drafted the interim guidance. “When you read the guidance, it seems to presume that the lawyer will always be an external lawyer. We have not tackled the question of what may need to change in the underlying context for an in-house counsel. That’s still to come.”

In the meantime, entities reporting under IFRS risk facing a higher legal tab, says Kerr. “As the detail and disclosure becomes more extensive, as the job become more difficult in trying to estimate liability, I can’t believe it’s not going to add costs and complexity to our clients,” said Kerr.

“I don’t see lawyer’s lives getting any easier with IFRS,” remarked Stephen Kerr, a partner with Fasken Martineau Dumoulin LLP, who practices general corporate and commercial law. “Suddenly we’re going to be asked to do a lot more, with a lot more precision and a lot faster.”

On January 1, 2011, publicly accountable for-profit corporations, government business enterprises and other enterprises that chose to do so began using IFRS as the basis for preparing their financial statements. Under IFRS, unresolved legal claims are subjected to International Accounting Standard 37, Provisions, Contingent Liabilities and Contingent Assets (IAS37). In place for over a decade, IAS 37 differs significantly from the way that unresolved claims are interpreted by Canadian Generally Accounting Principles (GAAP).

The Canadian Bar Association (CBA) and the Auditing and Assurance Standards Board (AASB), the Canadian authority that sets generally accepted auditing standards (GAAS) for financial statement audits, have issued interim guidelines to assist lawyers with audit-related inquiries about unresolved legal claims but some questions will likely remain unanswered until either the courts themselves provide guidance or lawyers come to an understanding of how the rules should be interpreted, contend legal observers.

“There is going to be an evolution over the next little while as lawyers work together with their clients and as clients work with their auditors to find the best way to give auditors what they need to have while at the same time preserving the client’s position as best as possible,” said Mark Selick, a partner with Blakes who helped draft the interim guidance. “Most situations probably won’t be tough but there will be some, and I think there is going to have to be some dialogue to figure out the right way to deal with it.”

In both IFRS and GAAP, financial statements should recognize an obligation arising out of a past event when it is probable that a payment will have to be made to settle the legal obligation. The difference between both standards lies in the interpretation of when such legal claims must be reported. Under GAAP’s Section 39 rule, corporations would report legal claims when it is “likely” a payment must be made, something that has over time been interpreted as meaning there is a greater than 70 per chance that a payment may have to be made. IAS 37 uses a wider net and a lower threshold thanks to a “more likely than not” approach. Though there is no official interpretation, corporations would be expected to report legal claims when there is a greater than 50 per cent likelihood of being settled against the corporation.

As important, organizations no longer have the leeway GAAP provided them to report claims. Unlike GAAP’s section 3290, which allows corporations to avoid reporting legal claims when there is insufficient or conflicting evidence, IAS 37 does not grant such latitude.

“Lawyers are going to have to revisit decisions they made in the past about claims, and going forward they’re going to have to ask themselves questions about future claims, taking into account that it’s a different test, with a wider net,” said Kerr. “It’s going to be fascinating to see how lawyers and accountants interpret these rules.”

It’s going to be just as intriguing to see how the legal profession will tackle IAS 37’s requirement that clients be able to give a reliable estimate of the amount that might be owing due to the legal claim. Under IAS 37, corporations are required to provide a “best estimate,” a higher test than GAAP’s “reasonable estimate” approach. Organizations will likely have to perform complex measurement calculations in order to come to a “best estimate” and consult with their counsel to confirm their analysis, but it remains that outside counsel will shoulder much of the burden. Aside from likely approving the “best estimate,” a conundrum by itself, lawyers will have to ensure that the “best estimate” does not harm the interests of their client.

“It’s another conundrum lawyers face because it’s asking us to quantify something that we didn’t have to quantify with as much specificity in the past,” said Kerr. “Business people and auditors, who are closer to the numbers than lawyers are, are now going to be pressed into a situation to try to quantify what the potential impact is going to be if there’s an adverse judgment – and that just makes the lawyer’s job that much more difficult to try and figure out what these things are worth.”

Disclosure of the “best estimate” also can play into the hands of plaintiffs who have claims against entities reporting under IFRS, said Trevor Scott, a leading corporate commercial lawyer in British Columbia. Besides the inherent difficulties of trying to come up with a “best estimate” when so many different factors must be taken into account in a case involving litigation, such disclosure could potentially prejudice the defense of the defendants.

“There is a risk in describing a claim in your financial statement, describing the likelihood of that claim and its possible outcome that the plaintiff could look at that information and use it to their advantage,” noted Scott, a partner with Farris, Vaugh, Wills & Murphy LLP.

Coming up with a “best estimate” could also put in jeopardy solicitor-client privilege, particularly if the client and the auditor do not see eye-to-eye. The interim guidance provided by the CBA and the Canadian auditing authorities states that to protect privilege clients should communicate directly with the law firm without disclosing the communication to the auditor. Lawyers responding to audit inquiry letters should only confirm or deny the reasonableness of the client’s descriptions and estimates, adds the interim guidance. But it may not be that simple, observed Selick.

“In replying to audit inquiry letters, we always have to have in the back of our minds the risk that it might not be privileged,” said Selick. “Once you start talking to someone outside that tent, there is the potential of losing that privilege. So the goal is to keep the reply which would go to the auditor as short and succinct as possible, and not get into anything more than the bare essentials.”

In-house counsel too face new dilemmas, especially since the interim guidance appears to have been drafted with outside counsel in mind, said Fred Headon, who heads Air Canada’s in-house labour and employment law team. The interim guidance does not spell out the what in-house counsel should do when faced with an audit inquiry letter, a situation all the more vexing given that the entity is their client.

“We need to be thinking about it,” said Headon, who was part of the CBA committee that drafted the interim guidance. “When you read the guidance, it seems to presume that the lawyer will always be an external lawyer. We have not tackled the question of what may need to change in the underlying context for an in-house counsel. That’s still to come.”

In the meantime, entities reporting under IFRS risk facing a higher legal tab, says Kerr. “As the detail and disclosure becomes more extensive, as the job become more difficult in trying to estimate liability, I can’t believe it’s not going to add costs and complexity to our clients,” said Kerr.

Do jail sentences deter future white-collar crimes?

The courts appear to have heard calls from victims of white-collar crime demanding stiffer sentences against those found guilty of swindling investors.

In October 2009, Vincent Lacroix, a high-profile Quebec white-collar criminal found guilty of masterminding a $130-million fraud with 9,200 victims, was sentenced to 13 years in jail. A little over a year later, in February 2010, former Montreal financial adviser Earl Jones was sentenced to 11 years in prison, after pleading guilty to two fraud charges related to a $50-million Ponzi scheme he orchestrated.

But an accounting professor who published a study on occupational fraud is far from convinced that stiff jail sentences on white-collar criminals will prove to be an effective deterrent.

“Jail sentences do not deter future white-collar crimes,” said Dominic Peltier-Rivest, Chair and associate professor at the department of accountancy at the John Molson School of Business at Concordia University. There is no evidence or studies that suggest that extended incarceration yields additional deterrence, he maintains. “What discourages future white-collar criminals is the fear of getting caught, not the length of sentence.”

Peltier-Rivest asserts in his study, “Detecting Occupational Fraud in Canada: A Study of its Victims and Perpetrators,” that measures such as a fraud hotline or an anonymous reporting program, fraud awareness training programs as well as surprise and external audits can be effective tools to limit the losses incurred by occupational fraud.

Occupational fraud is costly. Peltier-Rivest, a certified fraud examiner (CFE) who earned his PhD studying financial statement fraud, estimates that public and private-sector Canadian organizations lose five per cent of sales to fraud every year, with small business (defined as having less than 100 employees) being particularly vulnerable. Smaller organizations, notes the study, tend to have fewer internal controls largely due to fewer or more limited resources.

The study discloses that 90 per cent of all occupational fraud cases involve asset misappropriation, with a median loss of $200,000. And it reveals that 42 per cent of occupational frauds were committed by employees, 38.6 per cent by managers and nearly 20 per cent by owners and executives.

But while owners and executives perpetrate less frauds, they commit larger frauds, with median losses estimated at $1-million compared to $165,000 for managers and $75,000 for employees. Executives typically have more opportunity to commit larger frauds “due to their high level of authority, which enables them to override controls more easily than lower-level employees,” according to the report. Executives also frequently have greater access to organizational assets than their subordinates, adds the study.

That’s why it is important for organizations to tailor anti-fraud measures, said Peltier-Rivest.  External audits are the most frequently tool to detect frauds, with nearly 80 per cent of organizations examined by Peltier-Rivest resorting to them. But they are from being the most effective anti-fraud measure. External audits detected only 6.7 per cent of frauds. In contrast 13 per cent of occupational frauds were detected by internal audits, 19 per cent by an organization’s internal controls, and a surprising 42 per cent through tips from employees, vendors, customers or anonymous sources.

In fact, organizations that use hotlines detect fraud far quicker and experience much lower median fraud losses than those that did not ($90,000 compared to $197,500). “This result brings some support to new audit committee regulations adopted by most Canadian provinces in the last few years, which require audit committees of publicly traded companies to establish reporting mechanisms to receive and address complaints regarding internal controls and financial matters of the company,” said Peltier-Rivest.

Peltier-Rivest believes that such reporting mechanisms should also apply to investment funds and private or close-end investment firms as a means to minimize and detect fraud such as was committed by Lacroix. At present, investment funds are not compelled to follow Regulation 52-110 respecting Audit Committees, which requires all reporting issuers to have an audit committee. Nor do investment funds and close-end investment firms have to abide by Regulation 52-109 respecting certification of disclosure in issuers’ annual and interim filings, which calls for every issuer to have disclosure controls and procedures and internal control over financial reporting.

“We should work on prevention and earlier detection as opposed to relying on giving somebody 12 years in jail and hoping that it will curb future crimes,” said Peltier-Rivest.

Michel Magnan, editor of the world-renowned quarterly journal Contemporary Accounting Research, also believes that stringent internal controls, rather than heavy prison sentences, are key to preventing occupational fraud. Magnan, like Peltier-Rivest, notes that there is a paucity of evidence emanating from studies over the efficacy of stiff prison sentences to deter occupational fraud.

“It is wiser to invest in prevention, that is, before the monies disappear,” said Magnan. “A stiff sentence will not deter occupational fraud. It will succeed in making these people more careful in the way that they will commit the fraud. Internal controls really are the key.”

Four more found guilty in Mount Real investment scandal

The other financial scandal that struck Quebec, the one that did not receive nearly the same attention that the defunct mutual fund company headed by Vincent Norbourg did, is winding its way through the courts.

Three more individuals linked with the bankrupt Montreal financial group Mount Real Corp. were recently condemned to pay fines ranging $13,000 to $425,000 while a fourth pled guilty to 40 counts, making it 18 individuals who have so far pled guilty to 478 counts, with fines totalling $2.2 million. Continue reading “Four more found guilty in Mount Real investment scandal”

Scrambling to convert to IFRS

When the Canadian Securities Administrators issued a staff notice during the summer that all registrants regulated directly by Canadian securities regulatory authorities would be required to prepare financial statements using International Financial Accounting Standards beginning on January 1, 2011, it literally set off a scramble.

Registrants such as investment counsel and portfolio managers, limited market dealers, exchange-contracts dealers, restricted dealers (and in Quebec, mutual fund dealers), who are not members of a self-regulatory organization (SRO) like the Investment Industry Regulatory Organization of Canada and the Mutual Fund Dealers Association of Canada, suddenly were faced with a significant undertaking that could materially affect their reported financial position and results of operations.

“For smaller portfolio managers who may not have been thinking about IFRS, this was a crucially important notice,” remarked Scott McEvoy, a lawyer with Borden Ladner Gervais LLP in Vancouver who specializes in the investment management industry. “Now they have to be thinking about it darn quick.”

Continue reading “Scrambling to convert to IFRS”

Canada’s longest trial again in the news

Nearly 15 months after the Quebec Court of Appeal griped about the legal war of attrition that has lasted more than a decade in the case against a former accounting giant and its partners over the infamous collapse of Montreal real-estate firm Castor Holdings Inc., the highest court of the province recently dismissed yet another appeal.

The defendants sought to appeal an interlocutory judgment that dismissed their motion to obtain an additional $17-million in payment bonds from the respondents, and declare them to be jointly and severally liable of costs. Judge Lise Côté of the Quebec Court of Appeal upheld the lower court ruling.

Continue reading “Canada’s longest trial again in the news”