During my third year of law school, I was involved in the Bowman Tax Moot competition, which is a mock appeal. As part of the competition, students drafted a factum and argued their ‘client’s’ case in front of actual lawyers and judges. It was quite the experience, particularly because it exposed me to the fascinating field of statutory interpretation.
As part of the competition, the competition’s organizers distributed a problem to all the competitors, one based the case of Kruger Incorporated. This decision was complicated; the Federal Court of Appeal and the Tax Court of Canada reached opposite conclusions on essentially the same facts, though on appeal to the Federal Court of Appeal (“FCA”) there was a factual correction of a clerical error. One aspect of the decision touched on derivatives taxation and the mark-to-market method of accounting. Another touched on the law of statutory interpretation.
This comment discusses these two aspects of the decision in turn. In particular, it highlights how both aspects are prime examples of the importance of marshaling facts on appeal and properly characterizing an issue, and how the latter interpretive aspect is an example of the complexity of the law of statutory interpretation. The fundamental nature of statutory interpretation law, and the scant authority, judicial or otherwise, for mark-to-market accounting in tax reporting, make a re-examination of this decision worthwhile, despite amendments and proposals to amend the ITA following the decision.
Kruger Incorporated v Canada
In Kruger, the taxpayer was a pulp and paper company that strayed into the world of foreign exchange trading. In the 1980s, the company decided to hedge its exposure to the US Dollar arising from its US operations, so it started a trading operation designed to mitigate currency fluctuations in the CAD/USD pair. Eventually, Kruger’s trading operation became a speculative trading operation instead of a hedging operation. The particular market in which Kruger Incorporated had operated was the foreign currency options market.
During the relevant taxation years, Kruger suffered a trading loss that it sought to claim as a tax deduction under s.9, or alternatively, s.10 of the Income Tax Act. The issues before the court were whether mark-to-market accounting was a permissible method of measuring one’s taxable income under the Income Tax Act (“ITA”), thus allowing Kruger to claim the loss under s.9. The other issue was whether derivatives are inventory under s.10 of the ITA, thus allowing Kruger to claim the fair market value decline in the derivatives it held as part of trading operation.
At the Tax Court of Canada, Justice Rip held that the plain language of s.10 of the ITA refers to “any property the cost or value of which is relevant to the computation of business income”, which is very broad language. Nothing in the language prevents taxpayers from including derivatives in their inventory for tax purposes and subsequently claiming deductions for fair market value declines in the value of their derivatives inventory. That is, Justice Rip held that derivatives were inventory. Justice Rip also held that realization accounting provides certainty, and is more accurate than mark-to-market accounting on the facts. Thus, Kruger was not allowed to mark-to-market its derivatives.
At the Federal Court of Appeal, after receiving submissions as to a clerical error that occurred in the valuation of Kruger’s derivatives contracts, Justice Noël held that the mark-to-market method was at least as accurate as the realization method and that the Minister had not discharged its burden of proving that realization was more accurate. Thus, Justice Rip’s decision was reversed, and Kruger was allowed to mark-to-market its derivatives losses. In addition, Justice Noël held that the ordinary meaning of the word inventory is property held for sale, which qualifies the statutory definition of “inventory” under s.248. Noël J followed the Supreme Court of Canada’s decision in Friesen v Canada, holding that the derivatives were not inventory because they were held for speculative purposes instead of for sale.
Options Pricing: Marking to What?
One of the primary issues in this decision is that the particular valuation methods used by Kruger were not properly characterized, which in my view affected the result under s.9. Characterization is a crucial aspect of legal analysis.
In this regard, two problems emerge. One is that mark-to-market accounting is not exactly the same as fair value accounting, though the terms are used synonymously because of the breadth of the fair value concept. In addition to mark-to-market accounting, fair value also encompasses valuation methods that are more appropriately associated with mark-to-model accounting, which is fundamentally different. Thus, fair value is broader than mark-to-market per se.
In Kruger, there was no market, as the derivatives were traded over-the-counter, which is a term used to describe private transactions between two trading partners. Kruger did not value its derivatives by reference to an open market price; in fact, Kruger’s counterparties themselves gave Kruger the values it used to price its options. According to Kruger’s submissions, its counterparties used a particular model to value Kruger’s options. The model was the Black-Scholes model. This model provides a theoretical price estimate for the options, but it does not establish a market price in the sense of a standardized, open price quote.
At trial, Justice Rip summarized a part of the evidence provided by Professor Klein, who was one of the expert witnesses that testified:
 In Professor Klein’s view, Kruger’s mark to market valuations at the end of 1998 were not based on a market or a traded price, “they represented theoretical estimates determined by sophisticated pricing models where market values of other securities were used to determine some of the input variables.” The bank’s pricing models are “very mathematical and rely on highly idealized assumptions” with respect to how securities markets operate. Mark to market values are unreliable.
Professor Klein was the only witness to give evidence regarding the reliability of the models used to value Kruger Incorporated’s currency options. In Klein’s view, Kruger’s counterparties used inaccurate models to price Kruger’s options. An actual market price did not exist.
That Kruger used models instead of markets to price its derivatives for tax purposes leads to the second problem with mischaracterizing its valuation method as mark-to-market instead of mark-to-model. The significance of using modeling for valuing a property, instead of gleaning a market price, is evident when one considers the technical point that the Black-Scholes model relies on the assumption that asset returns are normally distributed. In my respectful view, this is not true. The falsity of this assumption is crucial because a model is only as strong as its assumptions. For great certainty, a normal distribution is one that results if we plot each period’s returns the graph will represent a bell-curve. Asset returns are not normally distributed. Thus, “highly idealized assumption” is perhaps an inadequate characterization of the underpinnings of the model used by Kruger’s counterparties to value the relevant derivative contracts.
For practical purposes, mark-to-market and fair value are most often interchangeable. But it is important to be clear that they are not the same concepts because a model provides a hypothetical price the truth of which depends on its underlying assumptions, whereas a market price represents the price a taxpayer would actually realize upon the disposition of property. A model price might differ substantially from the actual market price i.e. the realizable value of the property.
In my view, treating fair value and mark-to-market as identical terms obfuscated the legal ramifications of using these terms. It would have been more accurate to focus on Kruger’s accounting method as mark-to-model. This obfuscation leads to the other point I make above, namely that asset prices are not normally distributed. The model has questionable accuracy over the long run because one of its assumptions is false. Taken together, these points suggest that realization, which garners an actual market price, is more accurate than Kruger’s “mark-to-market” model.
An Error at the Federal Court of Appeal: Inconsistent Values or Models?
The Federal Court of Appeal’s decision highlights in two ways the importance of properly characterizing an issue. The first has to do with Justice Noël’s analysis of Justice Rip’s finding that realization is more accurate than mark-to-market. Justice Noël reasoned:
 The Tax Court judge went on to explain that even if mark to market accounting was authorized, he was not convinced that the values used by the appellant were reliable (Reasons, para. 116). He drew no definite conclusion on this point as evidenced by the judgment that he gave (see para. 30, above). It is nevertheless useful to comment on this point given the information that has since been brought to our attention by the appellant.
 The Tax Court judge was concerned that the bank counterparties to the contracts held by the appellant at the close of its 1998 taxation year would not “necessarily” have used a model of valuation which relies on the same inputs (Reasons, para. 116). He was taken aback by evidence tendered by the respondent’s expert (Professor Klein) showing that two options written by the appellant with identical terms were ascribed by distinct bank counterparties values which were more than 20 percent apart (idem, paras. 48 and 116).
 The appellant recognizes that such a difference would shake one’s confidence. However, it submits that this discrepancy is due to a clerical error made in preparing its own expert report. The following extracts quoted from the memorandum of the appellant (references omitted) provide the explanation:
- Mr. Klein testified, with reference to his report, that identical contracts dated May 13, 1998 for a call option sold by Kruger of $10 million USD at a strike price of $1.46 to mature in one year were valued by the Bank of Nova Scotia (“BNS”) at $797,736 and by JP Morgan (“JPM”) at $612,200. Reproduced in his report was the JPM communication to Kruger of the value of that contract at 486,900 USD which, at the prevailing rate of exchange on December 31, 1998 of 1.530 CAD, yielded a Canadian dollar value of $745,200, not $612,200. The difference, therefore, between the JPM option contract relative to the BNS option contract is, therefore, not $185,536 but rather $52,536, and therefore not a difference of 26.3% but rather 6.8% …
- Mr. Klein further testified, with reference to his report, that identical contracts again dated May 13, 1998 for a put option sold by Kruger of $10 million USD to mature May 13, 1999, at a strike price of $1.40, again with both JPM and BNS as purchasers, were valued by the BNS at $8,173 and by JPM at ($113,257). The JP Morgan communication of value to Kruger sets the value of that contract at 7,900 USD which, translated to CAD at the prevailing rate at December 31, 1998, yields the amount of $12,090, and not ($113,257). …
- The remaining differences in values given to four other option contracts with identical terms by two different banks set out in Mr. Klein’s report at page 2386 are: -0.3%, 1.2%, -4.2% and 5.1% …
 The Crown does not challenge the above demonstration otherwise than by asserting that it is not supported by the evidence (Memorandum of the respondent, para. 6). However, all the figures referred to in the above quoted passage can be found in the record and when the prevailing rate of exchange is applied (1.5305 CAD; Appeal Book, Vol. 12, p. 2,387), it can readily be seen that the wrong rate was applied and that the variations are within the narrow range described.
 I do not believe that the Tax Court judge would have been troubled by the values submitted by the bank counterparties if he had been appraised of the actual figures. I should add that this no longer seems controversial as the Minister has since recognized that the appellant’s values were reliable (see para. 31, above).
The above extract references paragraph 116 of the Tax Court decision:
 There is also a difficulty with Kruger’s option contract themselves. As I view the evidence, and as Professor Klein suggests, the market prices of OTC foreign exchange option contracts are estimates, if not artificial. Kruger’s contracts are European contracts and cannot be traded during the time the contract is made until it matures, except with consent of the other contracting party. Each bank formulates its own market value based on its own model applying inputs that are not necessarily used by another bank. There is no consistency or objective, it appears to me, by the banks in fixing a common fair market value for a given day (or time of day). Professor Klein described two identical contracts as to amounts and expiry dates, among other things, having a significant difference in values on December 31, 1998. This shakes my confidence as to the other market values used by Kruger, not because Kruger was trying to do something nefarious, which it was not, but because of a probable inconsistency in values depending on the different models used by Kruger’s counterparties. I may have had more comfort in agreeing with Kruger’s valuations if all the contracts were valued using the same models, not a variety of models used by different banks. Thus even if I found that it was appropriate for Kruger to mark to market its derivatives for income tax purposes, I would not find that the inconsistent bank values used by Kruger was properly applied in calculating its losses on derivative trading in 1998.
Justice Noël’s reasoning that more consistent values would have been more palatable to Justice Rip is one possible interpretation of the Tax Court decision. Justice Rip wrote, “even if I found that it was appropriate for Kruger to mark to market its derivatives for income tax purposes, I would not find that the inconsistent bank values used by Kruger was properly applied in calculating its losses on derivative trading in 1998.”
However, Justice Rip stated, prior to the above sentence, “This shakes my confidence as to the other market values used by Kruger … because of a probable inconsistency in values depending on the different models used by Kruger’s counterparties. I may have had more comfort in agreeing with Kruger’s valuations if all the contracts were valued using the same models, not a variety of models used by different banks.”
That latter part enables one to interpret paragraph 116 of the Tax Court decision in one of two ways. First, the inconsistent values themselves troubled Justice Rip. Second, and alternatively, the inconsistent modeling troubled Justice Rip. These are not the same. The values are the outputs of the models, while the actual models themselves are equations that use inputs to produce outputs.
If one accounts for the proposition above that the Black-Scholes model, of which some variation was used by all of Kruger’s counterparties, is fundamentally flawed because of its assumption that asset returns are normally distributed, it is more reasonable to suppose that Justice Rip had been troubled by the models themselves, rather than their outputs. But this is not clear on the evidence, nor the judicial findings.
Regardless, Justice Rip’s reliance on the realization principle, and his view of the evidence of Professor Klein, suggest that the inconsistency in model troubled him more than the inconsistency in value, particularly when we look to the word “may” in the sentence, “I may have had more comfort in agreeing with Kruger’s valuations if all the contracts were valued using the same models”. The word “may” suggests that Justice Rip would not have agreed that Kruger’s method was more accurate than the Minister’s was even if identical contracts had identical values. It suggests that Justice Rip’s primary concern was the use of a different model by each one of Kruger’s counterparties.
This alternative interpretation of paragraph 116 suggests that the FCA might have erred in substituting its view of the facts on the issue of whether mark-to-market accounting was as accurate as realization accounting. If Justice Rip’s problem was the inconsistent values assigned to identical contracts, then this substitution is likely appropriate because it prevented a re-examination of the facts at trial, which is a very practical resolution that conserves scarce judicial resources. But if the problem was inconsistent modeling, then the substitution should not have occurred, because nothing disclosed at the FCA undermined Justice Rip’s findings in this respect. Justice Rip heard the evidence as to how the options were priced, and made a finding of fact as to the accuracy of this method and the permutations thereof, holding that realization provided the more accurate picture. Nothing at appeal affected the evidence that supported this particular finding.
The Inventory Question: Whether Inventory is Property Held for Sale
The second issue in Kruger was the interpretive issue under s.10 of the Income Tax Act (“ITA”), whether options were “inventory”. Respectfully, Justice Noël’s reasoning on this issue also highlights the importance of properly characterizing an issue.
This issue invokes the fundamental statement of the law of statutory interpretation, the modern principle. In Canada Trustco Mortgage , the Supreme Court of Canada held:
10 It has been long established as a matter of statutory interpretation that “the words of an Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act, the object of the Act, and the intention of Parliament”: see 65302 British Columbia Ltd. v. Canada, 1999 CanLII 639 (SCC),  3 S.C.R. 804, at para. 50. The interpretation of a statutory provision must be made according to a textual, contextual and purposive analysis to find a meaning that is harmonious with the Act as a whole. When the words of a provision are precise and unequivocal, the ordinary meaning of the words play a dominant role in the interpretive process. On the other hand, where the words can support more than one reasonable meaning, the ordinary meaning of the words plays a lesser role. The relative effects of ordinary meaning, context and purpose on the interpretive process may vary, but in all cases the court must seek to read the provisions of an Act as a harmonious whole.
Courts have interpreted this legal principle in at least two ways. At times, the statement has been interpreted as referring to the precise, plain text of the statute. At other times, courts distinguish “plain meaning” from “ordinary meaning”, noting that the former references a textual approach, while the latter references a contextual approach. Indeed, in regards to the subtle distinction between these two concepts, the Supreme Court’s itself in Canada Trustco Mortgage might conflate these two concepts, as the Court’s statement appears to equate “plain meaning” and “ordinary meaning” in the sentence, “When the words of a provision are precise and unequivocal, the ordinary meaning of the words play a dominant role in the interpretive process.” This statement suggests the ordinary meaning of a word is precise and capable of only one interpretation, which is precisely what the plain meaning is.
However, as Professors Siebrasse and Sullivan note, the ordinary meaning is not a literal, a-contextual approach that presumes text can have only one meaning, unlike the plain meaning, which is literal, purely textual approach. Instead, the ordinary meaning acknowledges the possibility of multiple meanings, and it looks to the meaning that jumps out at the particular reader of the text. This is a contextual approach because it presumes text can have multiple meanings. In other words, the textual approach in Canada is a contextual approach.
In Kruger, the trial and appeal decisions engaged with this subtle distinction.
Justice Rip at trial interpreted the words of s.10 and s.248 literally, finding that there was no qualifying language in the definition of inventory. Any property the cost or value of which is relevant to the computation of business income is inventory. The interpretive form of this argument is persuasive given the language of the ITA.
One issue with this interpretation emerges only if we look to the textual argument’s corollary: What is not capital property is necessarily inventory. From this perspective, the literal interpretation does not hold water in my view because there are several classes of property that are not inventory and not capital property, such as windfalls, depreciable property, Canadian resource property, and even mark-to-market property held by financial institutions.
On the other hand, Justice Noël interpreted the definition of inventory according to its ordinary meaning i.e. that inventory is property held for sale. This approach followed the Supreme Court’s analysis in Friesen. Note, the words “held for sale” are found nowhere in the s.248 definition of “inventory”. (Interestingly, they are found in only two places in the ITA: s.10(4) and s.10(5).)
Justice Noël’s analysis was succinct, relying heavily on the Friesen decision. One could view the interpretation that inventory is property held for sale as reading words into the statute, a sort of judicial legislating. Indeed, Justice Noël characterized the remedy as such. But one could also view it reading down the statute, giving meaning to the very word “inventory”. In this respect, Noël J may have erred in characterizing the remedy on appeal as reading words into the statute, which is another example of the importance of characterization that emerges from Kruger.
Reading down a provision of a statute is entirely within a court’s jurisdiction, whereas reading in words is not unless the court is interpreting the constitution. Both remedies require adding words to the statute, but reading down is a form of justifiable paraphrase that restates the text of the statute in a more comprehensible manner. More precisely, reading down qualifies or restricts the language of the statute, and reading in expands the language.
As Professor Sullivan puts it,
§7.13 At first glance, reading down and reading in may seem to be symmetrical techniques and remedies, two sides of the same coin. However, the courts are right to distinguish them and to be much more cautious in using the reading in technique or remedy. As an interpretation technique, reading down merely makes explicit what the court finds to be implicit in the legislative text. It is impossible for drafters to spell out every qualification or limitation that might appropriately apply in a given set of circumstances. Otherwise, provisions would go on for pages. Modern legislation is drafted in general terms, effectively delegating to official interpreters the work of adapting the language to particular facts and reading down its scope when there is a good reason to do so.
§7.14 Reading in is different. It does not purport to operate within the scope of the legislative text, but rather to expand that scope to matters that are neither explicit nor implicit in the legislation. It expands legislation to matters that cannot come within any plausible understanding of the wording adopted by the legislature.
The effect and legitimacy of reading down a provision is evident from the analysis in Manrell v Canada, which the courts cited in Kruger. In that case, the Federal Court of Appeal interpreted the definition of “property” in s.248, and held that the words “a right of any kind whatever” are so broad that they might be interpreted as having an infinite meaning according to the plain text (Para. 50). The court interpreted the words according to their ordinary meaning, to qualify the breadth of the ITA’s s.248 definition of “property”.
In much the same way, the words “any property the cost or value of which is relevant to the computation of business income” are words with of a very broad scope. Indeed, cash held on hand is property the cost or value of which is relevant to the computation, and so the fair market value decline in the cash balance that is attributable to inflation ought to be a deductible expense under s.10. But it is not. Something restricts the language of s.248 and s.10; namely, the ordinary meaning of the word “inventory”, which excludes cash balances even though cash is property the cost or value of which is relevant to the computation of business income. In this way, Justice Noël read down the definition of inventory to exclude property held for speculative purposes, such as Kruger’s derivatives.
A complicating factor for this view is that the ITA’s definition of “inventory” under s.248 suggests that the ITA’s definition is the sole, exclusive meaning of the word as it applies in the statute. This interpretation of the law of statutory interpretation is consistent with Parliament’s subsequent amendments, which left intact the definition of inventory under s.248, and simply introduced s.10(15), which excludes derivative forward agreements from the operation of s.10 of the ITA. On this view, one should interpret the definition of “inventory” literally. Yet, this view disregards the Supreme Court’s explicit statement that the words of a statute are always to be read in their ordinary and grammatical sense i.e. according to their ordinary meaning, because it interprets the words of the ITA literally.
Ultimately, the case is decided and Parliament has acted, so it is difficult to tell how “inventory” will be interpreted going forward. It is also difficult to tell how much precedential value Justice Noël’s reasoning has. What is clear, however, is that the reasoning is consistent with the Canadian approach to statutory interpretation and textual analysis.
The point to be made here is that it is important to distinguish between ordinary meaning and plain meaning, and reading in and reading down. Whether one should read the words according to their ordinary or plain meaning is a difficult question, as highlighted by the Supreme Court’s statements above and the different way in which courts have approached textual analysis over time. In the trial decision, Justice Rip read the words plainly, essentially disregarding the ordinary meaning of the text. As for reading in and reading down, the two are subtly distinct. At appeal, Justice Noël characterized the remedy as reading words into the statute, effectively mischaracterizing his decision as an unjustifiable judicial amendment, rather than a justifiable judicial paraphrase. Simply changing the word “in” to “down” would have made his decision more palatable.
Hopefully, this note highlights for readers the important effect of the characterization of an issue, as well as the effect of disregarding subtle differences in the meaning of different words or terms.
Below is a brief introduction to Parliament’s amendments and proposals following Kruger.
Parliament’s Response to Kruger
Parliament acted swiftly following the Kruger decision. In addition to enacting s.10(15), Parliament introduced other provisions and made several proposals to amend the ITA.
Subsection 10(15) excludes derivative forward agreements from the operation of s.10, by deeming such agreements to not be inventory. Parliament also restricted losses claimed on derivatives agreements, by amending s.18 of the ITA. Paragraph 18(1)(x) precludes any deduction caused by a reduction in value of a derivative property if (a) the method used to value the property is the lower of cost or fair market value, (b) the property is described in s.10(15), and (c) the property is not disposed of.
The 2017 Budget proposed an elective regime for “eligible derivatives” held on income account, which will require taxpayers to elect whether they will use the mark-to-market or realization methods to report their taxable income. Once an election is made, a taxpayer can change their method only with the consent of the Minister. A derivative agreement is eligible if the taxpayer has produced audited financial statements that are prepared according to Generally Accepted Accounting Principles or the derivative agreement has readily ascertainable fair market value, and the agreement is not capital property.
Several other proposals were made as well, including a proposal to exclude eligibile derivatives from the definition of eligible property under s.85 and s.97. The proposals are complicated and more analysis is needed to understand all the effects.
Disclaimer: This article provides an opinion about the Kruger decision and an overview of legislative amendments and proposals. It is not advice. Before acting, one should consult a professional about their specific situation.
 See Benoit Mandelbrot, The Misbehaviour of Financial Markets: A Fractal View of Financial Turbulence. See also JPM Asset Management, Non-Normality of Financial Returns: A Framework for Asset-Allocation Decision Making.
 See Ruth Sullivan, Sullivan on the Construction of Statutes. See especially Norman Siebrasse, “The Essential Elements Doctrine in Patent Infringement: Free World and Whirlpool in Light of Kirin-Amgen” at p. 9.
 Ruth Sullivan, Sullivan on the Construction of Statutes at §7.10ff.