New rules related to the taxation of derivatives are being extended to all taxpayers.
Now, all taxpayers, not just financial institutions, can elect under a new mark-to-market regime to recognize unrealized gains and losses on eligible derivatives each year, rather than only as they are realized. As a result of these new rules, all taxpayers can choose to record unrealized gains and losses in respect of eligible derivatives in income each year, without having to establish that this mark-to-market method provides a better picture of income for purposes of section 9 of the Act. These rules apply for taxation years beginning after March 21, 2017.
While financial institutions are required to mark-to-market their assets that are defined to be "mark-to market-property", many derivatives are not described in that definition. For an electing financial institutions, the new regime effectively broadens the mark-to-market rules so that they will also apply to the financial institution's eligible derivatives. As a result, financial institutions will no longer have to rely on CRA administrative positions as to whether certain derivatives constitute mark-to-market property.
Taxpayers, including financial institutions, that wish to elect into the mark-to-market regime for eligible derivatives must file an election on or before their tax-filing due date for the particular year. Once a taxpayer makes an election, it is valid for that particular year and all subsequent taxation years, unless the CRA grants them permission to revoke the election under subsection 10.1(2). Where an election has been revoked, the taxpayer can subsequently re-elect into the mark-to-market regime, but only on a prospective basis.
The CRA has not yet released a prescribed form for taxpayers to make the mark-to-market election.
In addition, the regime contains a transitional rule that generally requires taxpayers to defer the recognition of a gain or loss that accrued on eligible derivatives held at the beginning of an election year until a later time when the derivative is ultimately disposed of.
Background and legislative history
Previously, the Act did not contain specific rules to govern the timing and recognition of gains and losses on derivatives held on income account. This created uncertainty as to whether a taxpayer could mark-to-market their derivatives held on income account. Finance introduced the new elective mark-to-market regime for derivatives held on income account following the Federal Court of Appeal's (FCA) decision in Kruger Incorporated v. The Queen (2016 FCA 186).
In this case, the FCA held that the taxpayer (Canco), which was not a financial institution but carried on a business of dealing in options, was entitled to use the mark-to-market accounting method to determine its income for tax purposes. The FCA stated that the realization principle is not an "overarching principle" and concluded that Canco had established that the mark-to-market treatment provided the most accurate picture of Canco's income for the purpose of section 9 of the Act.
Financial institutions are subject to current tax on their accrued gains and losses on "mark-to-market property" under subsection 142.5(2). Mark-to-market property is broadly defined for tax purposes to include certain shares of a corporation, certain "specified debt obligations" and "tracking properties". Although the definition of mark-to-market property in subsection 142.2(1) does not specifically include FX options and certain derivatives, the CRA has historically allowed financial institutions to recognize unrealized gains and losses in respect of FX options and certain derivatives in income on a current basis each taxation year as though they were mark-to-market property.
Finance's 2017 federal budget introduced these new mark-to-market measures and they were enacted on December 14, 2017.
Summary of new legislation for taxpayers (other than financial institutions)
Where a taxpayer that is not a financial institution elects into the new mark-to-market regime under subsection 10.1(1), each eligible derivative will be deemed to be disposed of (and reacquired) for proceeds equal to its fair market value at the end of each taxation year, under subsection 10.1(6). Consequently, any unrealized gains or losses in respect of these properties will be deemed to be realized for the current year and included in the taxpayer's income. However, where a taxpayer did not previously calculate its profit or loss in respect of derivatives using a method similar to the mark-to-market method, a transitional rule in subsection 10.1(7) requires the taxpayer to defer the recognition of the gain or loss that accrued on eligible derivatives held at the beginning of the election year until the derivative is ultimately disposed of.
To be eligible, a derivative must generally be a swap agreement, forward purchase or sale agreement, forward rate agreement, futures agreement, option agreement, or "similar agreement". Additionally, the derivative must not be a capital property, a Canadian resource property, a foreign resource property, or an obligation on account of capital.
In addition, the taxpayer must either produce audited financial statements that value the derivative, or have an approach to determining a verifiable fair market value for the derivative. Finance suggests some acceptable methods for making this determination in the explanatory notes to subsection 10.1(5), including where:
According to subsection 10.1(8), taxpayers that are not financial institutions and that do not elect into the mark-to-market regime are not allowed to compute their income in a way that "produces a substantially similar effect" to electing taxpayers. In other words, the realization method of profit computation will apply to these taxpayers so that gains or losses on derivatives that are held on income account will not be recognized on a current basis until the derivative is disposed of.
Summary of new legislation for financial institutions
For electing financial institutions, the new regime broadens the pre-existing mark-to-market rules by deeming each eligible derivative held by a financial institution at any time of the year to be a mark-to-market property for the purpose of subsection 142.5(2). In essence, financial institutions will now be able to elect to recognize unrealized gains and losses on eligible derivatives in income on a current basis, rather than simply relying on CRA administrative policy.
The definition of eligible derivative that applies to all taxpayers that are not financial institutions also generally applies to financial institutions. However, under paragraph 10.1(5)(c) the new rules specifically exclude derivatives that would otherwise already be considered mark-to-market property.
For more information, contact your KPMG adviser.