This is article is part of a series dealing with draft legislation released for comment by the Department of Finance on July 29th. Read the complete series:

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 as inventory.

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.