Criteria for Determining Hedge Effectiveness for Tax Purposes
For accounting purposes, hedge effectiveness is the extent to which changes in the fair value or cash flows of a hedged item, relating to a risk being hedged and arising during the term of a hedged relationship, are offset by changes in the fair value or cash flows of the corresponding hedging item. Guidance on hedge accounting can be found in CICA Handbook Section 3865.
Question
Can the CRA provide guidance on the criteria to evaluate the effectiveness of a hedge for tax purpose?
Response
“Hedge” is not a defined term in the Act. The effectiveness of a hedge for tax purposes, i.e., whether a financial instrument constitutes a hedge, is relevant to the computation of profit. As the Supreme Court of Canada stated in Canderel Ltd v The Queen, 98 DTC 6100 (“Canderel”), the determination of profit is a question of law. Accounting standards are not law. Well-accepted business principles, which include but are not limited to the formal codification found in generally accepted accounting principles (“GAAP”), are not rules of law but interpretive aids. The CRA will take into consideration how the taxpayer reports under the new accounting standards as part of our review of the taxpayer’s determination of profit under GAAP. Accordingly, the new accounting standards, which include guidance on hedge accounting in CICA
Handbook Section 3865, would not cause the CRA to change how it interprets and applies the Act with respect to whether a financial instrument constitutes a hedge for tax purposes. The courts (Echo Bay Mines Ltd v. The Queen, 92 DTC 6437, Salada Foods Ltd v. The Queen, 74 DTC 6171, Ontario (Minister of Finance) v. Placer Dome Canada Limited, 2006 SCC 20) have confirmed that whether an activity constitutes hedging depends on sufficient inter-connection or integration with the underlying transaction. Again, as the Supreme Court stated in Canderel, ultimately, it is the law that determines how the CRA interprets and applies the Act.