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Kruger: FX Derivatives Gains/Losses Taxed Only When Realized

In Kruger Incorporated v. The Queen (2015 TCC 119), the Tax Court held that the taxpayer could not value its foreign exchange options contracts on a mark-to-market basis, with the result that certain losses were not deductible by the taxpayer in a year. The Kruger case is another recent judgment of the Tax Court in the developing law on the Canadian tax treatment of financial derivative products (see George Weston Limited v. The Queen (2015 TCC 42)).

Facts

Kruger’s core business was manufacturing newsprint, paper-coated products and tissue paper. In the 1980s, Kruger started trading in foreign currency contracts, and over time these activities grew to involve more than 10 employees trading in currency, bonds and securities.

In 1997, Kruger was advised that it was required to start reporting its financial trading activities on a mark-to-market basis, which required the recognition of any change in market value in a year as an income gain or loss.

In 1998, certain of Kruger’s U.S. currency options contracts were “under water” due to fluctuations in the Canada-U.S. exchange rate. Accordingly, for its 1998 tax year, Kruger claimed losses totaling $91,104,379 from a business of trading in derivatives. The CRA reassessed to deny the deduction of $91,104,379, but excluded from income the amount of $18,696,881, which Kruger had included as the amortized portion of the net of premium income and expenses for the foreign exchange options contracts. The CRA also included the amount of $91,104,379 in Kruger’s taxable capital for the purposes of the large corporations tax (which has now been generally repealed).

Kruger appealed the reassessment on the basis that, in accordance with section 9 of the Act, it was entitled to value its foreign exchange options contracts using the mark-to-market method, and argued in the alternative that its foreign exchange options contracts were inventory and were to be valued at the lower of cost and fair market value under subsection 10(1) of the Act.

Analysis

The Court reviewed the key Canadian judicial authorities regarding the test for determining income under the Act, including Friedberg v. The Queen ([1993] 4 S.C.R. 285), Canderel Limited v. The Queen ([1998] 1 S.C.R. 147), Friesen v. The Queen ([1995] 3 S.C.R. 103). The Court referred to the oft-cited principles from Canderel that the determination of profit is a question of law, and a taxpayer is free to adopt any method for determining profit that is not inconsistent with the provisions of the Act, case law, and well-accepted business principles. Once the taxpayer has shown that it has provided an accurate picture of income, the onus shifts to the CRA to establish that the amount is not an accurate picture of profit or that another method would provide a more accurate picture.

The Court noted there were no provisions in the Act that required or authorized the valuation of property on a mark-to-market basis. Further, there is an important difference between financial and tax accounting:

[109] Financial accounting … is concerned with constructing a picture of profit from year to year in a consistent manner for the benefit of the audience for whom financial statements are prepared: shareholders, investors, lenders, etc. … FASB views mark to market valuation for the same reasons: to better enable investors, creditors and others to assess the entity’s performance. …

[110] Tax accounting normally is not overly concerned with the past; it wants a picture of income for a particular year and … the methodology used to calculate income in one year may be different from that used in an earlier year. … statements for tax purposes are solely concerned with the computation of income in achieving an accurate picture of income for the particular taxation year.

The Court noted that sections 142.2 to 142.5 of the Act require financial institutions and investment dealers to use mark-to-market, but these rules did not apply to Kruger. The Court stated,

[114] Mark to market accounting … would compel a taxpayer to include any loss or gain in value of the property at year-end in income for the year. This may be appropriate for financial statements for reasons discussed earlier. But, for income tax purposes, the taxpayer may be compelled to include an amount in income where there is no clear statutory language requiring him or her to do so. The realization principle is basic to Canadian tax law. It provides certainty of a gain or loss. Without some support of the statutory language or a compelling interpretation tool it ought not to be cast aside.

The Court also noted a difficulty in respect of the market prices for the foreign exchange options contracts, namely that such prices were formulated by the counter-parties to the contracts (i.e., Kruger’s banks). The Court held there was a “probably inconsistency in values” depending on the pricing method used by the counter-party.

In respect of Kruger’s alternative argument that the options contracts were inventory, the Court determined that Kruger was carrying on a business of speculating on foreign exchange currency options that was separate from its manufacturing business. Further, the Court determined that the foreign exchange options contracts were financial liabilities when such contracts were written by Kruger, and property (i.e., inventory) when purchased by Kruger.

The Court allowed the appeal only to permit Kruger to value its purchased foreign exchange options contracts in accordance with subsection 10(1) of the Act (which would have an effect similar to mark-to-market accounting in that the contracts would be valued each year at the lower of cost and fair market value). Additionally, the amount of $91,104,379 was to be added to Kruger’s taxable capital for the purposes of the large corporations tax

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Kruger: FX Derivatives Gains/Losses Taxed Only When Realized

Ironside: TCC Orders Hearing of Question on Rule 58 Motion

In Ironside v. The Queen (2015 TCC 116), the Tax Court allowed the Crown’s Rule 58 motion for a determination of a question of law before the hearing, namely whether the taxpayer was estopped from litigating an issue that had been adjudicated in an earlier Tax Court decision.

In the prior case (Ironside v. The Queen (2013 TCC 339)), the taxpayer had incurred legal and professional fees to defend himself against allegations of committing improper disclosures after being charged in June 2001 by the Alberta Securities Commission. The taxpayer sought to deduct such fees in the 2003 and 2004 tax years.

The Tax Court concluded that the taxpayer’s legal and professional fees had not been incurred to gain or produce income from his chartered accounting business, rather such expenses were personal in nature and were incurred to protect his reputation in the oil and gas industry. The Tax Court dismissed the taxpayer’s appeal.

Subsequently, the taxpayer sought to make the same deductions in the 2007, 2008 and 2009 tax years. The CRA reassessed to deny the deductions, and the taxpayer again appealed to the Tax Court.

In its Reply, the Crown raised the issue of whether “the appeal or a portion of it is barred by application of the doctrine of issue estoppel or is otherwise an abuse of the process of the Court”. The Crown then brought a motion for an order pursuant to Rule 58 of the Tax Court of Canada Rules (General Procedure) for a determination of a question prior to the appeal:

Whether the Appellant is barred from litigating within proceeding 2014-1619(IT)G whether the legal and professional fees paid to defend himself in Alberta Securities Commission proceedings and the subsequent appeal are deductible as amounts incurred to gain or produce income from a business or property, on the basis that the characterization of such fees has been previously adjudicated upon and therefore the doctrines of issue estoppel and or abuse of process operate to bar re-litigation of the issue.

The Tax Court noted that Rule 58 contains a two-step process. At the first stage, the Tax Court must determine whether the question posed by the moving party is an appropriate one that should be heard in a subsequent hearing (the second stage).

At the first stage, three elements must exist:

  1. The question proposed must be a question of law, fact, or mixed fact and law;
  2. The question must be raised in the pleadings; and
  3. The determination of the question may dispose of all or part of the appeal, may substantially shorten the hearing, or may result in substantial cost saving.

If all of these elements are present, the Court may set a hearing of the proposed question before a motions judge prior to the hearing of the appeal.

In the present case, the Tax Court held that all three requirements were satisfied. The Court stated,

[12] Clearly, there is the potential that a determination of this question may, according to the materials I have before me and the submissions I heard, dispose of part of the appeal and I need only be satisfied that it “may” so dispose of some of the appeal. I do not have to be absolutely convinced that it will do so in order to refer the question to a Stage Two determination prior to the hearing. If part of the appeal is disposed of, it follows that the proceeding will be substantially shortened. This is precisely the type of question that Rule 58 is meant to target.

The Tax Court ordered that the Crown’s question be set down for a hearing for determination by a motions judge and that certain evidence be presented at the determination (i.e., the pleadings from both appeals, and the Tax Court’s decision in Ironside v. The Queen (2013 TCC 339)).

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Ironside: TCC Orders Hearing of Question on Rule 58 Motion

Crowdfunding: Update From the CRA

In a short technical interpretation (CRA Document 2015-0579031I7 “Crowdfunding” (April 1, 2015)), the CRA has restated its views on the tax treatment of amounts raised via crowdfunding arrangements (see our previous post here).

The CRA stated that amounts received by a taxpayer under a crowdfunding arrangement could represent a loan, capital contribution, gift, income or a combination thereof. The CRA will evaluate each situation on a case-by-case basis.

The CRA stated that, in its view, where funds are received by a taxpayer for the development of a new product and the taxpayer carries on a business or profession, the funds will be taxable income unless the taxpayer can establish that such funds are a loan, capital contribution or other form of equity. The CRA noted that any reasonable costs related to the crowdfunding arrangements would likely be deductible in computing that income.

The CRA noted that, in Canada, crowdfunding activities typically do not involve the issuance of securities, but that some securities regulators may be considering changes to existing regulatory rules. The CRA will evaluate the income tax consequences if such regulatory changes take place.

Finally, the CRA noted that the subject of crowdfunding is briefly addressed in Folio S3-F9-C1 “Lottery Winnings, Miscellaneous Receipts, and Income (and Losses) from Crime” (April 3, 2015) in respect of whether such amounts may be a gift by a donor. The CRA provided an example from the Folio:

Example 2

Assume a business uses crowdfunding as a method of raising funds for the development of a new product and the contributors do not receive any form of equity. The amounts received by the business would be included in its income pursuant to subsection 9(1). 

Taxpayers who seek and obtain crowdfunding (for business and non-business purposes) should be aware of the potential tax implications, particularly in light of fact-specific results and the CRA’s evolving views on the subject.

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Crowdfunding: Update From the CRA

CRA: Tax treatment of Ponzi scheme investments

We have previously written about court decisions on the tax results arising from taxpayers’ (failed) investments in Ponzi schemes (see our posts on Roszko v. The Queen (2014 TCC 59), Johnson v. The Queen (2011 TCC 54) and (2012 FCA 253), Hammill v. The Queen (2005 FCA 252) and Orman v. Marnat (2012 ONSC 549)).

These decisions raise questions as to how the CRA may assess all aspects of the income earned and losses suffered by the duped investors. For example, while the cases focused on whether the taxpayer was required to report some of the returned funds as income, the tax treatment of losses after the collapse of the fraudulent scheme has not been considered.

The CRA has now provided some guidance on how it will administer the Income Tax Act (Canada) in respect of the income and losses arising from Ponzi schemes. In CRA Document No. 2014-0531171M6 “Fraudulent Investment Schemes” (July 3, 2014), the CRA stated:

  • Income inclusion – Amounts paid to a taxpayer that are returns on their investment should be included in the taxpayer’s income. The fact that the funds were not invested on behalf of the taxpayer does not change the nature of the transaction for the taxpayer.
  • Bad debt – If the investment was a fraudulent scheme, the taxpayer may be able to claim a bad debt under paragraph 20(1)(p) of the Act in respect of the lost investment funds. The amount of the bad debt claim will be subject to certain adjustments. The bad debt should be claimed in the year the fraud is discovered (i.e., the year in which fraud charges are laid by the Crown against the perpetrator, or at such earlier time as the debt is established to have become bad).
  • Losses – The taxpayer may be able to claim a capital loss or business investment loss:
    • Capital loss – The taxpayer may be able to claim a capital loss under paragraph 39(1)(b) of the Act, which may be carried back three years or forward indefinitely. A net capital loss may only be applied against a taxable capital gain.
    • Business investment loss – Under paragraph 39(1)(c), a business investment loss is a capital loss from a disposition of a share of a small business corporation or a debt owing to the taxpayer by a Canadian-controlled private corporation that was a small business corporation. Under paragraph 38(c) of the Act, one-half of a business investment loss is an allowable business investment loss, which may be deducted against all sources of income.
  • Other deductions – The taxpayer may be able to claim interest expenses or other carrying charges not previously claimed by filing a T1 Adjustment Request form.
  • Recovered amounts – Where the taxpayer recovers funds from a scheme (i.e., through a legal settlement or otherwise), these recovered amounts may be taxable as recovery of a previously deducted bad debt, recovery of a previously deducted business loss, or recovery of a previously deducted capital loss.
  • Taxpayer relief – The CRA will consider requests for taxpayer relief on a case-by-case basis.

This guidance is helpful, but there are many technical requirements for the operation of these provisions, and further it is not clear how the CRA’s administrative views accord with the case law. For example, at least two cases (Roszko, Orman) have held that amounts paid out a fraudulent scheme are not income to the duped investor. A third case (Hammill) held that a fraudulent scheme cannot give rise to a source of income. In future cases, we expect the courts will continue to clarify the tax treatment of income and losses arising from failed Ponzi schemes.

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CRA: Tax treatment of Ponzi scheme investments

Tax Court Rules Amounts Paid Out of Ponzi Scheme Not Taxable

The tax treatment of amounts paid out of failed Ponzi schemes is once again in the news. In Roszko v. The Queen (2014 TCC 59), the Tax Court of Canada allowed the taxpayer’s appeal and held that amounts paid out of a fraudulent scheme were not taxable as interest income.

Roszko follows two recent decision on this issue. In Johnson v. The Queen (2012 FCA 253), the Federal Court of Appeal held that amounts paid out of a Ponzi scheme in excess of the duped taxpayer’s original investment were taxable as income. And in Orman v. Marnat (2012 ONSC 549), the Ontario Superior Court of Justice held that amounts received out of a Ponzi scheme were not investment income (see also this article on the court’s consideration of whether it could rectify certain corporate documents of two companies that had invested in the fraud).

In Roszko, the taxpayer was induced to invest in TransCap Corporation, which was allegedly trading commodities, on the basis that the investment would return 18% to 22% annually. In 2006, the taxpayer made an initial investment of $100,000, which was structured as a loan.  In 2006 and 2007, the taxpayer loaned a total of $800,000 to TransCap. From 2006 to 2009, TransCap paid to the taxpayer a total of $408,000 as follows: $22,500 in 2006, $81,000 in 2007, $156,000 in 2008, and $148,500 in 2009.

In December 2009, the taxpayer became suspicious of the activities of TransCap, which lead to an investigation by the Alberta Securities Commission, which eventually determined that TransCap had perpetrated a fraud on investors.

The issue before the Tax Court was whether the $156,000 received by the taxpayer in 2008 was interest income under paragraph 12(1)(c) of the Income Tax Act.

The Tax Court cited the Federal Court of Appeal’s decision in Johnson for the proposition that there can indeed be a source of income in a Ponzi scheme. However, the Tax Court held that the facts in the Johnson case – wherein the Federal Court of Appeal held that the $1.3 million received by the taxpayer out of the Ponzi scheme was taxable – were different from the facts of the present case. Specifically, in Roszko, the taxpayer’s agreement with TransCap stipulated how the funds were to be invested, the taxpayer was lead to believe the funds would be so invested, the funds were not invested in that manner (i.e., the taxpayer’s contractual rights were not respected), it was agreed that TransCap perpetrated a fraud, and the fraud was described in a decision of the Alberta Securities Commission.

The Tax Court held that the facts of Roszko were more like those in the case of Hammill v. The Queen, in which the Federal Court of Appeal held that a fraudulent scheme from beginning to end cannot give rise to a source of income from the victim’s point of view and hence cannot be considered as a business under any definition.

The Tax Court noted that, in Roszko, the Crown had argued that the income was property income in the form of interest. However, the Tax Court held the amount received by the taxpayer was not income from property, but rather a return of capital to the extent of the original amounts invested. The Tax Court noted that excess returns might be considered income. The Tax Court allowed the appeal .

This is a victory for the taxpayer for the 2008 tax year, but the unanswered question that looms in the background is how the taxpayer’s overall loss ($392,000) on the Ponzi scheme investment will be treated for tax purposes.

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Tax Court Rules Amounts Paid Out of Ponzi Scheme Not Taxable

CRA Considers Tax Treatment of Crowdfunding

Hot on the heels of the CRA’s recent publication of a “fact sheet” on its views on the tax treatment of Bitcoin currency (which has been in the news recently – see articles here and here), the CRA has published two technical interpretations on the tax treatment of “crowdfunding“.

In CRA Document No. 2013-0508971E5 (October 25, 2013) and CRA Document No. 2013-0509101E5 “Crowdfunding” (October 29, 2013) the CRA was asked about the tax treatment of amounts received by taxpayers through a crowdfunding arrangement.

The CRA stated that it understood crowdfunding to be a way of raising funds for a broad range of purposes, using the internet, where conventional forms of fundraising funds might not be possible (and which may or may not involve the issuance of securities).

The CRA stated that, depending on the specific circumstances, crowdfunding amounts received by the taxpayer could represent a loan, capital contribution, gift, income or a combination thereof. The CRA noted its position described in Interpretation Bulletin IT-334R2 “Miscellaneous Receipts” (February 21, 1992) that voluntary payments received by virtue of a taxpayer’s profession or carrying on of a business are considered taxable receipts. The CRA also noted that, on the other hand, a non-taxable windfall may exist where the taxpayer made no organized effort to receive the payment and neither sought nor solicited the payment. The CRA’s view is that a business has commenced where the taxpayer has started some significant activity that is a regular part of the business or that is necessary to get the business going (see Interpretation Bulletin IT-364 “Commencement of Business Operations” (March 14, 1977)). Conversely, a gift may exist where the donor transfers property with no right, privilege, material benefit or advantage conferred in return.

These two recent technical interpretations follow an earlier publication (CRA Document No. 2013-0484941E5 “Crowdfunding” (August 13, 2013)), in which the CRA stated that amounts received by a taxpayer from crowdfunding activities would generally be included in the taxpayer’s income pursuant to subsection 9(1) of the Income Tax Act as income from carrying on a business (and that certain expenses may be deductible).

These views from the CRA are helpful guidance for those who have undertaken or are considering crowdfunding. We agree that a taxpayer’s specific circumstances will be determinative of the tax treatment of the crowdfunded amounts (i.e., on a case-by-case basis). However, because of the various activities for which crowdfunding may be sought, and the ease with which crowdfunding may be accessed, it is less clear when a taxpayer’s activities (including seeking crowdfunding and any other associated activities) will result in the conclusion that a taxpayer has commenced carrying on business.

Accordingly, taxpayers who seek and obtain crowdfunding (for business and non-business purposes) should be aware of the potential tax implications, particularly in light of fact-specific results and the CRA’s evolving views on the subject.

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CRA Considers Tax Treatment of Crowdfunding

The Tax Court of Canada and the World of Opera

Moliere once said, “Of all the noises known to man, opera is the most expensive.”

In Knapik-Sztramko v. The Queen (2013-799(IT)I, October 17, 2013), the Tax Court of Canada managed to reduce some of that cost, at least for one opera performer.

The taxpayer was an opera singer. In 1997, she entered a vocal competition organized by the Gerda Lissner Foundation. The taxpayer won the competition and from 1997 to 2006 she received monies for the payment of singing coaches, stage training, accommodation and travel expenses. The CRA reassessed the taxpayer to include in her income the amounts received from the Foundation.

Under paragraph 56(1)(n), a taxpayer must include in his/her income any amount received as or on account of a prize other than a “prescribed prize”. Section 7700 of the Income Tax Regulations states,

7700. For the purposes of subparagraph 56(1)(n)(i) of the Act, a prescribed prize is any prize that is recognized by the public and that is awarded for meritorious achievement in the arts, the sciences or service to the public but does not include any amount that can reasonably be regarded as having been received as compensation for services rendered or to be rendered.

In this case, the Crown conceded that the prize was recognized by the public and was for meritorious achievement in the arts. However, the Crown argued, the prize was paid as compensation for services. In the Crown’s view, the taxpayer had undertaken certain activities (coaching, training, career development, etc.) for, and provided services to, the Foundation in exchange for the money.

The Tax Court found that the taxpayer had provided no services to the Foundation, and that the activities undertaken by the taxpayer were consistently comprised of training, support and education to enhance her performance abilities:

The identification of the appellant as someone worthy of specialized study and training was the basis for awarding the prize from the Foundation’s perspective. This prize was not a relationship of, or in substitution for, employment, but a prize awarded on merit with reasonable conditions attached in order to ensure that the burgeoning talent identified was further refined by the benefactor.

The Tax Court allowed the taxpayer’s appeal.

The tax treatment of prizes is a nuanced area, dovetailing as it does with the taxation of scholarships, bursaries, fellowships and employment income. The issue seems to garner public attention every four years when the CRA responds to queries as to whether Olympic medal-winning athletes are subject to tax in Canada on their prizes (answer: Canadian athletes, yes (see CRA Document No. 2004-0098691E5 “Prizes paid to amateur athletes” (January 21, 2005), CRA Document No. 2008-0300071M4 “Olympic medals” (June 26, 2009) and CRA Document No. 2012-0458181M4 “Olympic performance awards” (September 18, 2012)); non-resident athletes, no (see subsection 115(2.3) of the Income Tax Act)).

The Tax Court’s decision in Knapik-Sztramko is a helpful case in a limited body of jurisprudence on what qualifies as a non-taxable prize under paragraph 56(1)(n) and Regulation 7700.

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The Tax Court of Canada and the World of Opera

Daishowa-Marubeni: A Tree Fell in the Forest and the SCC Caught it!

In Daishowa-Marubeni International Ltd. v. The Queen, 2013 SCC 29, Justice Rothstein marries tax philosophy and tax practice by asking and answering the question:

If a tree falls in the forest and you are not around to replant it, how does it affect your taxes?

The Court analyzes the difference for tax purposes between liabilities and embedded obligations, considers the law of contingent liabilities, the role of tax symmetry in the Income Tax Act (Canada) (the “Act”), the role of the agreement between the parties and the role of accounting treatment in reaching the conclusion that embedded obligations are not liabilities that form part of proceeds of disposition.

For a full analysis of the decision, click here.

Daishowa-Marubeni: A Tree Fell in the Forest and the SCC Caught it!

Provincial Income Allocation: Salaries and Wages to Include All Taxable Benefits

In the Provincial Income Allocation Newsletter No. 4 (March 2013), the Canada Revenue Agency notes that the Allocation Review Committee (“ARC”) has changed its position on amounts previously excluded in calculating “salary and wages paid in the year” for provincial income allocation purposes:

Effective for the 2013 tax year, the amount of salaries and wages paid in the year for the purpose of provincial income allocation calculations will include all taxable benefits that are to be included in the employees’ income in the year. This includes deemed amounts such as stock option benefits under section 7 of the Income Tax Act (Canada), regardless of whether these benefits are deductible in calculating the employer’s income.

Corporations having a permanent establishment in more than one province will need to consider the ARC’s change in position when preparing their next income tax return.  Applying the previous year’s method of calculation salaries and wages may fail to include all of the amounts now required to be included in the calculation.

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Provincial Income Allocation: Salaries and Wages to Include All Taxable Benefits

Supreme Court dismisses leave application in Johnson v. The Queen

On March 21, 2013, the Supreme Court of Canada dismissed (with costs) the application for leave to appeal in the case of Donna M. Johnson v. Her Majesty The Queen.

The issue in Johnson was the tax treatment of receipts from a Ponzi scheme. The Tax Court (2011 TCC 540) allowed the taxpayer’s appeal and held that the receipts were not income from a source for the purpose of paragraph 3(a) of the Income Tax Act. The Federal Court of Appeal (2012 FCA 253) reversed the lower court’s decision, allowing the Crown’s appeal.

I commented on the decisions of the Tax Court and the Federal Court of Appeal in the March 2013 Ontario Bar Association Tax Section newsletter.

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Supreme Court dismisses leave application in Johnson v. The Queen