Canada: Mark-To-Market Recognition Of Foreign Exchange Gains/Losses For Tax Purposes

Last Updated: July 6 2016
Article by James G. Morand and Christopher Norton

In the recent Federal Court of Appeal case of Kruger Incorporated v. The Queen, 2016 FCA 186, the Court held that marking-to-market the value of foreign exchange option contracts provided a more accurate picture of Kruger's income for the year (compared to recognizing such income or loss only when realized, under the realization principle applied by the Tax Court). This decision overturned the Tax Court's earlier decision, which held that Kruger can only recognize such gains and losses for tax purposes when realized (through the sale or  closed-out of the contracts).

Kruger carried on a business of speculating on foreign exchange currency options. The options held by Kruger in 1998 could be closed by purchasing an offsetting option contract, rolled over to the next year or transferred (with counterparty consent). This business was conducted separate and apart from Kruger's core business of manufacturing newsprint and other paper products, and had its genesis in Kruger's desire to reduce its exposure to foreign currency fluctuations, since approximately 80% of its receivables from its paper business were traditionally in US dollars. Kruger carried on its option business on a large scale, in a manner similar to sophisticated traders in foreign exchange options.

The Court of Appeal agreed with Kruger that the treatment by the Tax Court of the realization principle (recognizing income or loss only when the related contracts were sold or closed-out) as an overarching principle runs counter to the decisions of the Supreme Court in Canderel1 and Ikea2. These decisions held that the realization principle can give way to other methods of computing income for tax purposes where these can be shown to provide a more accurate picture of the taxpayer's income for the year. This conclusion is reinforced by the decision of the Supreme Court in Canadian General Electric3 which held that gains and losses on income account resulting from foreign currency fluctuation may be recorded on an accrual basis for tax purposes.

The Court of Appeal held that there is no authority for the proposition that the principle of realization applies to the exclusion of mark-to-market accounting, unless the Tax Act provides otherwise. Since there was no basis to hold that mark-to-market accounting did not produce an accurate picture of Kruger's income, and was consistent with business principles, GAAP and international accounting, the Court of Appeal was satisfied that mark-to-market income recognition provided an accurate picture of Kruger's income. The Court also noted that mark-to-market was acceptable to the CRA in other circumstances

Kruger argued in the alternative that its foreign exchange options were inventory and that the recorded loss must be recognized, since inventory must be valued at the lower of cost or market under the Income Tax Act (Canada) (the "Tax Act") for tax purposes.

"Inventory" is defined in the Tax Act to mean " property the cost or value of which is relevant in computing ... income from a business." The Court imported into the definition of "inventory" the requirement that the foreign exchange options must be "held for sale," relying on the Supreme Court of Canada decision in Friesen.4

The Tax Court had concluded that the options "purchased" by Kruger were inventory but that those written by it were not, on the basis that the purchased options confer a right, and therefore constitute "property" capable of forming part of Kruger's "inventory," but that the "written" options created a liability, with the result that they cannot constitute "property," and consequently could not be "inventory."

The result which flows from the Tax Court reasoning was that the income derived from the options purchased by Kruger and treated as inventory must be computed by marking them to market at year end, whereas the income derived from the options which it wrote (and which the Tax Court held could not be inventory) must be recognized in the following year when these options were transferred or expired. This reasoning was rejected by the Court of Appeal.

In conclusion, determining profit for tax purposes on a basis which reflects the most accurate picture of the taxpayer's income continues to be a guiding principle of taxation. If the application of mark-to-market principles presents a truer picture of a taxpayer's income than realization or some other method of computation, it is preferable and should be accepted for tax purposes, subject to other methods which may be mandated by the Tax Act.

Taxpayers that utilize mark-to-market income computation for tax purposes in circumstances where other methods are not expressly mandated by the Tax Act should take comfort from this decision.


1 Canderel Ltd. v. Canada, [1998] 1 S.C.R. 147

2 Ikea Ltd. v. Canada, [1998] 1 S.C.R. 196

3 Canadian General Electric Co. v. M.N.R., [1962] S.C.R. 3

4 Friesen v. Canada, [1995] 3 S.C.R. 103

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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James G. Morand
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