Certain derivatives held on income account have been treated as
inventory for tax purposes, thereby allowing the deduction of
unrealized losses on such derivatives. This treatment was supported
by the 2015 decision of the Tax Court of Canada in Kruger Inc.
v. The Queen (2015 TCC 119), holding that certain foreign
exchange related derivative contracts owned by the taxpayer at its
year-end were inventory, and that the taxpayer was permitted
(likely required) to value such derivatives at the lower of cost or
FMV pursuant to section 10 of the ITA. The result is an asymmetry:
taxpayers deduct unrealized losses on such derivatives under
section 10 of the Income Tax Act (Canada)
("ITA") while having no corresponding requirement to
include unrealized gains in computing income.
In response, Budget 2016 proposed new rules that would prevent
taxpayers from treating certain derivatives held on income account
The legislative proposals released for comment by the Department
of Finance on July 29, 2016 ("2016 Legislative
Proposals") are quite surgical and do not differ materially
from the version set out in the Notice of Ways Motion released with
Budget 2016. In particular, the 2016 Legislative Proposals would
add new subsection 10(15) to the ITA which will provide that
"a swap agreement, a forward purchase or sale agreement, a
forward rate agreement, a futures agreement, an option agreement or
any similar agreement" will not be considered inventory for
the purposes of section 10. In addition, proposed paragraph
18(1)(x) will provide that where a taxpayer uses the lower of cost
or FMV to value such derivative contracts for accounting purposes,
and therefore, for the purposes of section 9 of the ITA, no
deduction can be made except where there has been a disposition of
the derivative contract during the year. Both these changes will
apply to agreements entered into on or after March 21, 2016.
In the meantime, however, the Kruger case was appealed
and the Federal Court of Appeal released its decision in June (2016
FCA 186), just months after Budget 2016. The Court reversed the
decision of the Tax Court in respect of the finding that the
particular derivative contracts at issue were inventory for the
purposes of the ITA. The Court instead held that the derivatives
were on income account, but were neither inventory nor capital
property. Further, for the purpose of calculating its business
profits under section 9 of the ITA, the taxpayer was permitted to
use 'mark-to-market' accounting for the derivatives. As a
result, the decision requires both unrealized gains and losses to
be recognized by taxpayers under section 9 of the ITA, preventing
the asymmetry that likely prompted the original legislative
response. In other words, if the Department of Finance had waited
for the judicial process to be completed, the proposed changes to
the ITA may not have been necessary.
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guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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