Exhibit
1.3














2007


Management’s
Discussion and


Analysis
of Results of Operations


and
Financial Condition










February
7, 2008









Table of
      Contents





1.
            Preface
            12.
            Caution
      Regarding Forward-Looking Information
            23.
            Industry
      Interests
            34.
            Business
      Strategy
            45.
            Significant
      Events
            56.
            Accounting
      Policies
            87.
            Results
      of Operations – Quarter 4 2007
            137.1.
            Air
      Canada
            167.2.
            Corporate
      Items and Eliminations (“CIE”)
            178.
            Results
      of Operations – 2007
            188.1.
            Air
      Canada
            218.2.
            Aeroplan
            228.3.
            Jazz
            228.4.
            ACTS
            238.5.
            Corporate
      Items and Eliminations (“CIE”)
            239.
            Financial
      and Capital Management
            249.1.
            Analysis
      of Financial Position
            249.2.
            Consolidated
      Cash flows
            269.3.
            Contractual
      Obligations
            279.4.
            Air
      Canada Pension Funding Obligations
            289.5.
            Air
      Canada Capital Expenditures and Related Financing
    Arrangements
            299.6.
            Air
      Canada Fleet
            319.7.
            ACE
      Share Information
            3310.
            Related
      Party Transactions
            3411.
            Off-Balance
      Sheet Arrangements
            4112.
            Derivatives
      and Financial Instruments
            4313.
            Critical
      Accounting Estimates
            4614.
            Risk
      Factors
            5015.
            Sensitivity
      of Results
            6216.
            Quarterly
      Financial Information
            6317.
            Selected
      Annual Information
            6418.
            Controls
      and Procedures
            6519.
            Subsequent
      Events
            6620.
            Non-GAAP
      Financial Measures
            6721.
            Glossary
      of Terms
            70










2007
      Management’s
      Discussion and Analysis
  1.         Preface


ACE
Aviation Holdings Inc. (“ACE”), which was incorporated on June 29, 2004, is an
investment holding company of various aviation interests.  During
2007, ACE had the following reportable segments: Air Canada, Aeroplan Limited
Partnership (“Aeroplan”) up to March 14, 2007, Jazz Air LP (“Jazz”) up to May
24, 2007, ACTS LP (“ACTS”) up to October 16, 2007, and Corporate Items and
Eliminations (“CIE”). As at December 31, 2007, ACE had two reportable
segments:  Air Canada and CIE.





Following
the completion of the ACTS monetization transaction on October 16, 2007, ACE
holds a 23% interest in Aero Technical Support & Services Holdings (“ACTS
Aero”), a company which purchased the assets of ACTS and which conducts the
business previously operated by ACTS.





ACE is
listed on the Toronto Stock Exchange (“TSX”) where its Class A variable voting
shares and Class B voting shares are traded under the symbols ACE.A and ACE.B,
respectively.





This
Management’s Discussion and Analysis of Results of Operations and Financial
Condition (“MD&A”) for 2007 should be read in conjunction with ACE’s audited
consolidated financial statements and notes for 2007.  Reference to
“Corporation” in this MD&A refers to, as the context may require, ACE and
its aviation interests collectively, ACE and one or more of its aviation
interests, one or more of ACE’s aviation interests, or ACE
itself.  Except where the context otherwise requires, all monetary
amounts are stated in Canadian dollars.  For an explanation of certain
terms used in this MD&A, refer to section 21 “Glossary of
Terms”.  Except as otherwise noted, this MD&A is current as of
February 7, 2008.





Certain
comparative figures have been reclassified to conform to the financial statement
presentation adopted in the current period.  In particular, Air Canada
has reclassified the presentation of certain aircraft sublease revenues from
Jazz.  The revised presentation relates to aircraft that are accounted
for as owned aircraft by Air Canada but are accounted for as operating leases in
Jazz.  This revised presentation does not impact the consolidated
results for any period presented, however it does result in an increase in Air
Canada’s inter-segment revenue and aircraft rent of $5 million for the three
months ended December 31, 2007 and $22 million for the twelve months ended
December 31, 2007 ($8 million for the three months ended December 31, 2006 and
$27 million for the twelve months ended December 31, 2006).





Forward-looking
statements are included in this MD&A.  See "Caution Regarding
Forward-Looking Information" in section 2 of this MD&A for a discussion of
risks, uncertainties and assumptions relating to these
statements.  For a detailed description of the risks relating to ACE
and its subsidiaries, see section 14 "Risk Factors" of this
MD&A.





The
ACE Audit, Finance & Risk Committee reviewed this MD&A and the 2007
audited consolidated financial statements and notes and ACE’s Board of Directors
approved these documents prior to their release.  For further
information on ACE’s public disclosure file, including ACE’s Annual Information
Form, please consult SEDAR at www.sedar.com, EDGAR at www.sec.gov/edgar.shtml or
ACE’s website at www.aceaviation.com.




















1




2007
      Management’s
      Discussion and Analysis


2.         Caution
      Regarding Forward-Looking Information


ACE’s
communications often contain written or oral forward-looking statements which
are included in the MD&A and may be included in filings with securities
regulators in Canada and the United States.  These forward-looking
statements are identified by the use of terms and phrases such as “anticipate”,
“believe”, “could”, “estimate”, “expect”, “intend”, “may”, “plan”, “predict”,
“project”, “will”, “would”, and similar terms and phrases, including references
to assumptions.  Such statements may involve but are not limited to
comments with respect to strategies, expectations, planned operations or future
actions.





Forward-looking
statements, by their nature, are based on assumptions and are subject to
important risks and uncertainties.  Any forecasts or forward-looking
predictions or statements cannot be relied upon due to, amongst other things,
changing external events and general uncertainties of the
business.  Results indicated in forward-looking statements may differ
materially from actual results for a number of factors, including without
limitation, energy prices, general industry, market and economic conditions,
war, terrorist attacks, changes in demand due to the seasonal nature of the
business, the ability to reduce operating costs and employee counts, employee
relations, labour negotiations or disputes, pension issues, currency exchange
and interest rates, changes in laws, adverse regulatory developments or
proceedings, pending litigation and actions by third parties as well as the
factors identified throughout this MD&A and, in particular, those discussed
in section 14 “Risk Factors” of this MD&A.  The forward-looking
statements contained in this discussion represent ACE’s expectations as of
February 7, 2008, and are subject to change after such date.  However,
ACE disclaims any intention or obligation to update or revise any
forward-looking statements whether as a result of new information, future events
or otherwise, except as required under applicable securities
regulations.




















2





2007
      Management’s
      Discussion and Analysis


3.         Industry
      Interests


The
following is a listing of ACE’s aviation interests as at February 7,
2008.





Aviation
      Interests
            OwnershipAir
      Canada
              (TSX:
      AC.A, AC.B)
            Air
      Canada is Canada's largest domestic and international airline and the
      largest provider of scheduled passenger services in the Canadian market,
      the Canada - US transborder market and in the international market to and
      from Canada.  Wholly-owned subsidiaries of Air Canada
      include:
              
              ·AC Cargo Limited Partnership ("Air Canada Cargo") which, together
      with Air Canada, are Canada's largest provider of air cargo
      services.
              
              ·ACGHS Limited Partnership ("Air Canada Ground Handling") which is a
      passenger and ground handling service provider.
              
              ·Touram Limited Partnership ("Air Canada Vacations") which is a
      major Canadian tour operator offering leisure vacation
      packages.
            75.0
      %Aeroplan
              (TSX:
      AER.UN)
            Aeroplan
      is Canada's premier loyalty marketing program.  Aeroplan
      provides its commercial partners with loyalty marketing services designed
      to stimulate demand for such partners' products and
      services.  ACE’s ownership interest in Aeroplan is held
      indirectly through its holdings of Aeroplan Income Fund
      units.  On December 20, 2007, Aeroplan acquired privately-held
      LMG, a leading loyalty marketing and customer-driven insight and analysis
      company that owns and operates the Nectar loyalty program in the United
      Kingdom.  See “Significant Events”.
            20.1%Jazz
              (TSX:
      JAZ.UN)
            Jazz
      is the largest regional airline and second largest airline in Canada,
      after Air Canada, based on fleet size and number of routes
      operated.  Jazz operates both domestic and US transborder
      services for Air Canada under a capacity purchase agreement.  As
      at December 31, 2007, ACE had a 20.1% indirect ownership interest in Jazz
      through its holdings of Jazz Air Income Fund units.  On January
      24, 2008, ACE reduced its indirect ownership in Jazz to
      9.5%.  See “Significant Events”.
            9.5%ACTS
      Aero
            ACTS
      Aero is a full-service aircraft maintenance, repair and overhaul
      organization that competes on a global basis.  See “Significant
      Events”.
            23.0%











3





2007
      Management’s
      Discussion and Analysis


4.         Business
      Strategy


For
the past several years, ACE has been executing its strategy to surface
shareholder value.





In
2007, ACE distributed units of Aeroplan Income Fund and Jazz Air Income Fund to
shareholders by way of return of capital in the amount of $2.0 billion; acquired
80% of Aeromantenimiento, S.A. (“Aeroman”); disposed of its remaining stake in
US Airways; completed the sale of a majority stake in ACTS for total net
proceeds of $763 million after release of funds held in escrow; completed
secondary offerings of Aeroplan Income Fund and Jazz Air Income Fund for net
proceeds of $463 million and $263 million, respectively; and launched a $1.5
billion share buyback which was completed in January 2008.  In
January, ACE sold units of Jazz Air Income Fund for proceeds of approximately
$97 million which further reduced its indirect ownership in Jazz to
9.5%.





The
transactions completed between January 1, 2007 and January 24, 2008 are outlined
in section 5 “Significant Events” of this MD&A.





As at
February 7, 2008, ACE’s assets, including its retained interests in Air Canada,
Aeroplan, Jazz and ACTS Aero have a value exceeding $2 billion.  In
2008, ACE will continue, market conditions permitting, to execute its business
strategy to maximize shareholder value.


























4





2007
      Management’s
      Discussion and Analysis


5.         Significant
      Events


A
number of significant events occurred during the period January 1, 2007 to
February 7, 2008.  These events are summarized below.





Aeroplan


On
January 10, 2007, ACE shareholders received a special distribution of 50,000,000
units of Aeroplan Income Fund representing 0.442 units per Class A variable
voting share, Class B voting share and preferred share (on an as converted
basis) of ACE.  For the purpose of the special distribution, ACE
exchanged 50,000,000 Aeroplan LP units into 50,000,000 Aeroplan Income Fund
units which were distributed to ACE’s shareholders on the record
date.  Based on a closing price of $17.97 per unit of Aeroplan Income
Fund on the TSX on January 10, 2007, the distribution was valued at
approximately $899 million or $7.95 per ACE share.





On
January 10, 2007, ACE exchanged 60,000,000 Aeroplan LP units for
60,000,000 Aeroplan Income Fund units.  The exchange was made for
internal reorganization purposes.





On
March 14, 2007, ACE distributed to its shareholders 20,272,917 units of Aeroplan
Income Fund representing 0.177 units per variable voting share, voting
share and preferred share (on an as converted basis) of ACE.  On March
14, 2007, ACE exchanged its remaining 40,545,835 units of Aeroplan LP into
40,545,835 units of Aeroplan Income Fund.  Based on a closing
price of $19.40 per unit of Aeroplan Income Fund on the TSX on March 14, 2007,
the distribution was valued at approximately $393 million or $3.45 per ACE
share.





On May
24, 2007, ACE distributed to its shareholders 18,000,000 units of Aeroplan
Income Fund representing 0.157 units per variable voting share, voting share and
preferred share (on an as converted basis) of ACE.  Based on a closing
price of $21.50 per unit of Aeroplan Income Fund on the TSX on May 24, 2007, the
distribution was valued at approximately $387 million or approximately $3.39 per
ACE share.





On
October 22, 2007, ACE completed the secondary offering of 22,000,000 units of
Aeroplan Income Fund at a price of $21.90 per unit for gross proceeds of $482
million ($463 million, net of fees).  ACE retained 40,292,088 units of
Aeroplan Income Fund.  Refer to section 6 of this MD&A for
information relating to a change in ACE’s accounting for its investment in
Aeroplan.





On
December 20, 2007, Aeroplan acquired privately-held LMG for a purchase price of
£350 million (Cdn$717.5 million) plus working capital adjustments of £18 million
(Cdn$36.9 million) for total consideration of £368 million (Cdn$754.4
million).  LMG is a leading loyalty marketing and customer-driven
insight and analysis company that owns and operates the Nectar loyalty program
in the United Kingdom.





Jazz


On
March 14, 2007, ACE distributed to its shareholders 25,000,000 units of
Jazz Air Income Fund representing 0.219 units per variable voting share,
voting share and preferred share of ACE (on an as converted
basis).  Based on a closing price of $8.60 per unit of Jazz Air Income
Fund on the TSX on March 14, 2007, the distribution was valued at approximately
$215 million or $1.88 per ACE share.  On March 14, 2007, ACE
exchanged 25,000,000 units of Jazz into 25,000,000 units of Jazz Air
Income Fund.





On
March 30, 2007, ACE exchanged its remaining 47,226,920 units of Jazz into
47,226,920 units of Jazz Air Income Fund.  The exchange was made for
internal reorganization purposes.





On May
24, 2007, ACE distributed to its shareholders 12,000,000 units of Jazz Air
Income Fund representing 0.105 units per variable voting share, voting share and
preferred share (on an as converted basis) of ACE.  Based on a closing
price of $8.26 per unit of Jazz Air Income Fund on the TSX on May 24, 2007, the
distribution was valued at approximately $99 million or approximately $0.87 per
ACE share.









5




2007
      Management’s
      Discussion and Analysis




On
October 22, 2007, ACE completed the secondary offering of 35,500,000 units of
Jazz Air Income Fund at a price of $7.75 per unit for gross proceeds of $275
million ($263 million, net of fees).  ACE retained 24,726,920 units of
Jazz Air Income Fund.  Refer to section 6 of this MD&A for
information relating to a change in ACE’s accounting for its investment in
Jazz.





On
January 24, 2008, ACE sold 13,000,000 units of Jazz Air Income Fund on an exempt
trade basis to certain funds and accounts managed by West Face Capital Inc. and
to Sunrise Partners Limited Partnership at a price of $7.45 per unit
representing total net proceeds to ACE of approximately $96.85
million.





ACTS


On
February 13, 2007, ACTS, through a wholly-owned subsidiary, acquired 80% of
Aeromantenimiento, S.A. ("Aeroman"), the aircraft maintenance division of Grupo
TACA Holdings Limited ("Grupo TACA") of El Salvador. Total consideration for
this acquisition included cash as well as a right to acquire an equity stake in
ACTS.





The
cash component of US$45 million consisted of cash of $50 million (US$43 million)
on closing and milestone payments of up to $2 million (US$2 million) in the
aggregate, funded by ACTS through ACE's available cash resources.





A
Class A non-voting redeemable share in a wholly-owned subsidiary of ACTS
(“exchangeable share”) was issued to Grupo TACA.  The rights attached
to the exchangeable share provide for, upon the closing of the monetization
transaction pertaining to ACTS, the exchangeable share held by Grupo TACA to be
exchanged for a variable number of shares or equity interest in
ACTS.  Subsequent to the issue of the exchangeable share, ACE agreed
to a transfer of Grupo TACA’s rights to a Grupo TACA related party.The estimated
fair value of this redemption obligation was presented as a liability. As part
of the monetization process, on October 16, 2007, the exchangeable share was
exchanged for a 5% equity stake in ACTS Aero and cash of $31
million.  The Grupo TACA related party can put its equity in ACTS Aero
to ACE at $18 million (US$18 million) over 12 months commencing from the date of
monetization.





On
October 16, 2007, ACE sold substantially all the assets and liabilities of ACTS
to ACTS Aero.  As a result of the monetization of ACTS, the $200
million intercompany note payable by ACTS to ACE was settled through the issue
of additional partnership units of ACTS to ACE.  After settlement of
certain obligations, ACE received cash proceeds of $723 million. Subsequent to
December 31, 2007, ACE received an additional $40 million in cash proceeds from
funds held in escrow that was conditional upon the completion of certain
supplier contracts within specified terms. In addition, on closing, Air Canada
received cash proceeds of $65 million, comprised of $28 million for the sale of
a building, $20 million pursuant to the transfer of repair schemes and $17
million as repayment of a note.  ACE realized a gain of $565 million
on the monetization, which includes the funds held in escrow received subsequent
to closing.  ACE continues to own 100% of ACTS, which is now a
non-operating company, and ACTS Aero conducts the business previously operated
by ACTS.  Following the redemption of the exchangeable share issued to
a party related to Grupo TACA as discussed above and the establishment of an
initial ACTS Long Term Incentive Plan (“LTIP”), ACE holds a 23% equity interest
in ACTS Aero.




US
Airways Investment


In
2005, ACE made an investment of US$75 million in US Airways Group, Inc. (“US
Airways”) for 5 million shares.  In 2006, ACE disposed of 4,500,000
shares of its holdings in US Airways for net proceeds of $232 million and
recorded pre-tax gains totalling $152 million.  In 2007, ACE disposed
of the remaining 500,000 shares of its holding in US Airways for total net
proceeds of $16 million and recorded a pre-tax gain totaling $8
million.





Air
Canada Vacations


In
2007, ACE sold its 49% interest in Air Canada Vacations to Air Canada, for
proceeds of $10 million.  Air Canada Vacations is now 100% owned by
Air Canada.  ACE’s indirect ownership in Air Canada Vacations was
reduced from 87.25% to 75%.






6




2007
      Management’s
      Discussion and Analysis


Substantial
Issuer Bid for ACE Class A Variable Voting Shares and Class B Voting
Shares


On
January 10, 2008, ACE accepted for purchase and cancellation a total of
40,023,427 Class A variable voting shares and 9,894,166 Class B voting shares at
$30.00 per share for an aggregate purchase price of approximately $1.498 billion
in accordance with the terms of a substantial issuer bid
completed.  No convertible preferred shares of ACE were deposited on
an as converted basis under the offer. Refer to section 19 of this MD&A
“Subsequent Events” for additional information.





Gains
on Disposal of Aviation Interests


Gains
on disposal realized in 2007 and 2006 as a result of transactions involving the
disposition, by way of sale, of various aviation interests were as
follows:





2007
            2006Air
      Canada initial public offering
            $           -
            $        25Aeroplan
      secondary offering
            539
            -Jazz
      initial public offering
            -
            220Jazz
      secondary offering
            233
            -ACTS
      monetization
            565
            -US
      Airways
            8
            152Gains
      on disposal of aviation interests
            $   1,345
            $     397





ACE
realized a gain of $190 million as a result of the initial public offering of
Aeroplan in 2005.














7




2007
      Management’s
      Discussion and Analysis


6.         Accounting
      Policies





ACE
prepares its consolidated financial statements in accordance with Canadian
Generally Accepted Accounting Principles (“GAAP”).





Significant
accounting policies and methods used in preparation of ACE’s audited
consolidated financial statements are described in Note 2 to ACE’s 2007 audited
consolidated financial statements.





ACE’s
2007 results reflect the consolidation of Aeroplan’s operations only up to March
14, 2007, the consolidation of Jazz’s operations only up to May 24, 2007 and the
consolidation of ACTS’ operations only up to October 16, 2007.  After
those dates, ACE’s investments in Aeroplan, Jazz and ACTS Aero are accounted for
using the equity method.  ACE’s 2006 results reflect the consolidation
of Aeroplan’s, Jazz’s and ACTS’ operations.  Consequently, ACE’s
results of operations for 2007 are not directly comparable to its operating
results for 2006.





The
preparation of ACE’s consolidated financial statements in conformity with
Canadian GAAP requires management to make estimates and assumptions that affect
the reported amounts of assets and liabilities, disclosures of contingent
liabilities and reported amounts of revenues and expenses for the period of the
consolidated financial statements.  ACE and its operating companies
evaluate these estimates and assumptions on a regular basis, based on historical
experience and other relevant factors.  Actual amounts could differ
materially from those estimates and assumptions.  Refer to section 13
of this MD&A for a discussion of ACE’s Critical Accounting
Estimates.





Accounting
for Aeroplan


As a
result of ACE's special distribution of Aeroplan Income Fund units and the
conversion of its remaining units of Aeroplan into units of Aeroplan Income Fund
on March 14, 2007, ACE no longer consolidates the results of operations, assets
and liabilities and cash flows of Aeroplan after that date and accounts for its
investment using the equity method of accounting.





ACE’s
consolidated financial statements as at December 31, 2007 do not include the
financial position of Aeroplan.  The comparative December 31, 2006
consolidated statement of financial position included the following items
related to Aeroplan:





·
            Cash
      and cash equivalents of $167 million, short-term investments of $453
      million and other current assets of $72
million;


·
            Long-lived
      assets of $373 million;


·
            Current
      liabilities of $670 million;


·
            Long-term
      debt of $300 million; and


·
            Aeroplan
      long-term deferred revenues of $801
million.





Immediately
prior to the distribution on March 14, 2007, ACE’s investment in Aeroplan was
negative $710 million, which was negative due to accumulated distributions to
ACE in excess of income and capital invested, and net of fair value adjustments
recorded upon the application of fresh start reporting.  Subsequent to
the distribution on March 14, 2007, ACE's 40.1% proportionate interest in the
accumulated deficit of Aeroplan was $284 million.  ACE has retained
this negative investment of $284 million and reflected the amount in other
long-term liabilities.  As a result, the difference between the net
investment prior to and after the distribution was recorded as a credit to
contributed surplus in the amount of $426 million.  The May 24, 2007
distribution of Aeroplan units further reduced the negative investment in
Aeroplan by $63 million with a credit to contributed surplus in the amount of
$57 million and a reduction to interest expense of $6 million for a total credit
to contributed surplus of $483 million for the year ended December 31,
2007.




The
cash flow impact of ACE’s deconsolidation of Aeroplan was $231
million.  This reflects the Aeroplan cash that was removed from ACE’s
consolidated statement of financial position as a result of the deconsolidation
of Aeroplan and was classified as a cash outflow from investing activities on
ACE’s consolidated statement of cash flows.







8




2007
      Management’s
      Discussion and Analysis




ACE’s
secondary offering of 22,000,000 units of Aeroplan Income Fund on October 22,
2007 resulted in a reduction of $76 million to ACE’s negative investment in
Aeroplan.





Refer
to section 10 of this MD&A for a summary of the related party transactions
between Aeroplan and Air Canada.





Aeroplan Miles
Obligation




In
2001, Air Canada established Aeroplan as a limited partnership wholly-owned by
Air Canada.  The Aeroplan loyalty program was previously a division of
Air Canada.





Under
the Commercial Participation and Services Agreement (“CPSA”) between Air Canada
and Aeroplan, Air Canada retained responsibility for the 103 billion Miles to be
redeemed from accumulations up to December 31, 2001.  Aeroplan assumed
responsibility for all Miles issued beginning January 1, 2002.  On
December 31, 2001, there were 171 billion Miles outstanding of which, after
considering breakage, management estimated that 103 billion Miles would be
redeemed.





In
2006, management of Air Canada and Aeroplan re-estimated the number of Miles
expected to be redeemed from accumulations up to December 31,
2001.  As a result, management of Air Canada and Aeroplan expected
that 112 billion Miles would be redeemed compared to the original estimate of
103 billion.  Pursuant to the terms of the CPSA dated June 9, 2004, as
amended, management of Air Canada and Aeroplan agreed to further amend the terms
of the CPSA.  Effective October 13, 2006, by amendment, Air Canada
assumed responsibility for the redemption of up to 112 billion Miles and, as a
result, recorded a special charge of $102 million for the incremental 9 billion
Miles against operating revenues in the year ended December 31, 2006 and
increased the Aeroplan miles obligation.  This amendment to the CPSA
represented full and final settlement with Aeroplan of Air Canada’s obligations
for the redemption of pre-2002 Miles.  Aeroplan is responsible for any
redemption of Miles in excess of the re-estimated 112 billion
Miles.  The amount of the additional liability was determined by
valuing the incremental Miles at fair value.





Accounting
for Jazz


As a
result of the special distribution of Jazz Air Income Fund units on May 24,
2007, ACE no longer consolidates the results of operations, assets and
liabilities and cash flows of Jazz after that date and accounts for its
investment using the equity method of accounting.





ACE’s
consolidated financial statements as at December 31, 2007 do not include the
financial position of Jazz.  The comparative December 31, 2006
consolidated statement of financial position included the following items
related to Jazz:





·
            Cash
      and cash equivalents of $135 million and other current assets of $109
      million;


·
            Long-lived
      assets of $239 million;


·
            Current
      liabilities of $213 million;


·
            Long-term
      debt of $115
million;  and


·
            Other
      long-term liabilities of $71
million.





As at
May 24, 2007, ACE’s net investment in Jazz was $48 million.





The
cash flow impact of ACE’s deconsolidation of Jazz was $138
million.  This reflects the Jazz cash that was removed from ACE’s
consolidated statement of financial position as a result of the deconsolidation
of Jazz and is classified as a cash outflow from investing activities on ACE’s
consolidated statement of cash flows.





Refer
to section 10 of this MD&A for a summary of the related party transactions
between Jazz and Air Canada.




9




2007
      Management’s
      Discussion and Analysis




Accounting
for ACTS


As a
result of the monetization of ACTS on October 16, 2007, ACE no longer
consolidates the results of operations, assets and liabilities and cash flows of
ACTS from that date and accounts for its investment using the equity method of
accounting.





ACE’s
consolidated financial statements as at December 31, 2007 do not include the
financial position of ACTS Aero, as ACTS Aero is equity accounted for subsequent
to the monetizatiion.  The comparative December 31, 2006 consolidated
statement of financial position included the following items related to
ACTS:





·
            Cash
      and cash equivalents of nil and other current assets of $837
      million;


·
            Long-lived
      assets of $141 million; and


·
            Current
      liabilities of $653 million.





As at
October 16, 2007, ACE’s net investment in ACTS Aero was $76 million, subsequent
to the sale.





The
cash flow impact of ACE’s deconsolidation of ACTS was $7
million.  This reflects the ACTS cash that was removed from ACE’s
consolidated statement of financial position as a result of the deconsolidation
of ACTS and is classified as a cash outflow from investing activities on ACE’s
consolidated statement of cash flows.





Refer
to section 10 of this MD&A for a summary of the related party transactions
between ACTS and Air Canada.





Financial
Instruments


On
January 1, 2007, Air Canada adopted CICA accounting handbook section 3855, Financial Instruments – Recognition
and Measurement, section 3861, Financial Instruments and
Presentation, section 3865, Hedges, section 1530, Comprehensive Incomeand
section 3251,
Equity.





Section
3861 establishes standards for presentation of financial instruments and
non-financial derivatives, and identifies the information that should be
disclosed about them.  The purpose of the section is to enhance
financial statement users’ understanding of the significance of financial
instruments to an entity’s financial position, performance and cash
flows.





Section
3855 establishes standards for recognizing and measuring financial assets,
financial liabilities and non-financial derivatives.  Under this
standard, all financial instruments are required to be measured at fair value on
initial recognition except for certain related party
transactions.  Measurement in subsequent periods is dependent upon the
classification of the financial instrument as held-for-trading,
available-for-sale, held-to-maturity, loans and receivables, or other financial
liabilities.





The
Corporation has implemented the following classifications:





·
            Cash
      and cash equivalents are classified as held-for-trading and any period
      change in fair value is recorded through net
  income.


·
            Aircraft-related
      deposits are classified as held-to-maturity investments and are measured
      at amortized cost using the effective interest rate
      method.  Interest income is recorded in net income, as
      applicable.


·
            Accounts
      receivable are classified as loans and receivables and are measured at
      amortized cost using the effective interest rate method. Interest income
      is recorded in net income, as
applicable.


·
            Accounts
      payable, credit facilities, bank loans and the financial liability
      component of convertible notes and convertible preferred shares are
      classified as other financial liabilities and are measured at amortized
      cost using the effective interest rate method.  Interest income
      is recorded in net income, as
applicable.





Derivative
instruments are recorded on the consolidated statement of financial position at
fair value, including those derivatives that are embedded in financial or
non-financial contracts. Changes in the fair values of derivative instruments
are recognized in non-operating income (expense) with the exception of foreign
exchange risk management contracts and derivatives designated as effective cash
flow hedges.





10


2007
      Management’s
      Discussion and Analysis




Changes
in the fair value of foreign currency forward contracts, option agreements and
currency swap agreements used for foreign exchange risk are recorded in foreign
exchange gain (loss). These contracts are included in prepaid expenses and other
current assets, deposits and other assets, accounts payable and accrued
liabilities, or other long-term liabilities as appropriate.





The
standards 3865 also provide guidance on accounting for derivatives in hedging
relationships.  In addition to requiring all derivatives to be fair
valued on the consolidated statement of financial position, the standards
require the effectiveness of the hedging relationships for the reporting period
to be quantified.  The effective portion of the change in the fair
value of the hedging derivative is recognized in other comprehensive income
(“OCI”) while the ineffective portion is recognized in non-operating income
(expense).  Upon maturity of fuel derivatives, the effective gains and
losses previously recognized in Accumulated OCI (“AOCI”) are recorded in fuel
expense. These derivatives are recorded in prepaid expenses and other current
assets, deposits and other assets, accounts payable and accrued liabilities, or
other long-term liabilities as appropriate.





OCI
represents changes in shareholders’ equity during a period arising from
transactions and other events with non-owner sources that are recognized in
comprehensive income, but excluded from net income.





Impact upon
Adoption


In
accordance with the transitional provisions of the standards, prior periods have
not been restated for the adoption of these new accounting
standards.





The
transition adjustments attributable to the re-measurement of financial assets
and financial liabilities at fair value, other than financial assets classified
as available-for-sale and hedging instruments designated as cash flow hedges,
were recognized in the opening deficit of the Corporation as at January 1, 2007.
The cumulative effective portion of any gain or loss on the hedging instruments
classified as cash flow hedges was recognized in AOCI, while the cumulative
ineffective portion was included in the opening deficit of the Corporation as at
January 1, 2007.





Upon
adoption, the Corporation recorded the following adjustments to the consolidated
statement of financial position:





($
      millions)
            Increase/(decrease)Deposits
      and other assets
            $   23Future
      income taxes ($6 million, net of a valuation allowance of $6
      million)
            -Deferred
      charges
            (29)Intangible
      assets
            (3)Accounts
      payable and accrued liabilities
            19Long-term
      debt and capital leases
            (30)Non-controlling
      interest
            4Retained
      earnings, net nil of tax
            5Accumulated
      other comprehensive income (loss) , net of tax of $4
    million
            (7)





Convertible
and Other Debt Instruments with Embedded Derivatives


EIC-164
provides guidance on whether an issuer of certain types of convertible debt
instruments should classify the instruments as liabilities or equity, whether
the instruments contain any embedded derivatives, and how the instruments should
be accounted for and presented. The guidance also addresses earnings per share
implications.  The Corporation adopted this guidance in Quarter 1 2007
to financial instruments accounted for in accordance with section
3855.  There is no financial statement impact as a result of the
adoption.






11


2007
      Management’s
      Discussion and Analysis




Future
Accounting Changes


The
Corporation will adopt the following new accounting standards on January 1,
2008:





Capital Disclosures and
Financial Instruments – Presentation and Disclosure


The
CICA issued three new accounting standards: section 1535, Capital Disclosures,
section 3862, Financial Instruments – Disclosures, and section 3863, Financial
Instruments – Presentation. These new standards will be effective for fiscal
years beginning on or after October 1, 2007 and the Corporation will adopt them
on January 1, 2008. The Corporation is in the process of evaluating the
disclosure and presentation requirements of the new standards.




Section
1535 establishes disclosure requirements about an entity’s capital and how it is
managed. The purpose will be to enable users of the financial statements to
evaluate the entity’s objectives, policies and processes for managing
capital.




Sections
3862 and 3863 will replace section 3861, Financial Instruments – Disclosure and
Presentation, revising and enhancing its disclosure requirements, and carrying
forward unchanged its presentation requirements. These new sections will place
increased emphasis on disclosures about the nature and extent of risks arising
from financial instruments and how the entity manages those risks.




Inventories


The
CICA issued section 3031, Inventories, will replace section 3030, Inventories.
This new standard is effective for fiscal years beginning on or after July 1,
2007, and the Corporation will adopt this section on January 1,
2008.  Section 3031 provides more extensive guidance on measurement,
and expands disclosure requirements to increase transparency.  The
Corporation’s accounting policy for inventories is consistent with measurement
requirements in the new standard and therefore it is not anticipated that the
results of the Corporation will be impacted, however, additional disclosures
will be required in relation to inventories carried at net realizable value, the
amount of inventories recognized as an expense, and the amount of any
write-downs of inventories.




















12




2007
      Management’s
      Discussion and Analysis


7.         Results
      of Operations – Quarter 4 2007


The
following table reflects the results of the Corporation, the results of its
reportable segments and certain non-GAAP measures for Quarter 4
2007.  Segment information has been prepared consistent with how
financial information is produced internally for the purposes of making business
decisions.  Segments negotiate transactions between each other as if
they were unrelated parties.  Refer to Note 18 “Segment Information”
in ACE’s 2007 audited consolidated financial statements for additional
information.





Unaudited
            Quarter
      4 2007($
      millions)
            Air
      Canada
            ACTS(1)
            CIE
            ACE
      TotalOperating
      revenuePassenger
      revenue
            $   2,196
            $        -
            $        -
            $   2,196Cargo
      revenue
            141
            -
            -
            141Other
      revenue
            170
            9
            4
            183External
      revenue
            2,507
            9
            4
            2,520Inter-segment
      revenue
            6
            33
            (39)
            -2,513
            42
            (35)
            2,520Operating
      expensesWages,
      salary and benefits
            468
            13
            20
            501Aircraft
      fuel
            615
            -
            -
            615Aircraft
      rent
            62
            -
            -
            62Airport
      user fees
            238
            -
            -
            238Aircraft
      maintenance, materials, and supplies
            173
            11
            (17)
            167Communications
      and information technology
            67
            1
            (3)
            65Food,
      beverages and supplies
            67
            -
            (1)
            66Depreciation,
      amortization, and obsolescence
            140
            1
            (1)
            140Commissions
            37
            -
            -
            37Capacity
      purchase with Jazz
            227
            -
            -
            227Other
      operating expenses
            347
            13
            (4)
            3562,441
            39
            (6)
            2,474Operating
      income (loss)
            72
            3
            (29)
            46Non-operating
      income (expense)Interest
      income
            22
            -
            18
            40Interest
      expense
            (89)
            -
            (16)
            (105)Interest
      capitalized
            20
            -
            -
            20Equity
      investment income(1)(2)
            -
            -
            17
            17Gain
      on disposal of assets
            -
            -
            1,339
            1,339Loss
      on financial instruments
            (1)
            -
            -
            (1)Other
      non-operating expense
            (4)
            -
            1
            (3)(52)
            -
            1,359
            1,307Income
      before the following items
            20
            3
            1,330
            1,353-
            -Non-controlling
      interest
            (3)
            -
            (6)
            (9)Foreign
      exchange gain (loss)
            20
            (3)
            1
            18Provision
      for income taxes
            (2)
            -
            (232)
            (234)Income
      for the period
            $     35
            $       -
            $   1,093
            $   1,128EBITDAR/EBITDA(3)
            $   274
            $      4
            $     (30)
            $      248





1.
            Reflects
      ACTS results from October 1 to October 15, 2007.  Commencing
      October 16, 2007, ACE is accounting for its investment in ACTS Aero under
      the equity method and has recorded equity income from the ACTS Aero
      investment in non-operating income under “Equity investment income” within
      the CIE segment.


2.
            ACE
      is accounting for its investments in Aeroplan, Jazz and ACTS Aero
      (commencing October 16, 2007) under the equity method and, for Quarter 4
      2007, has recorded equity income from these investments in non-operating
      income under “Equity investment income” within the CIE
      segment.


3.
            Refer
      to section 20 "Non-GAAP Financial Measures" in this MD&A for a
      reconciliation of EBITDAR/EBITDA to operating income
    (loss).






13




2007
      Management’s
      Discussion and Analysis




The
following table reflects the results of the Corporation, the results of its
reportable segments and certain non-GAAP measures for Quarter 4
2006.





Unaudited
            Quarter
      4 2006($
      millions)
            Air
      Canada
            Aeroplan
            Jazz
            ACTS
            CIE
            ACE
      TotalOperating
      revenuePassenger
      revenue
            $   2,071
            $      -
            $      -
            $      -
            $     25
            $   2,096Cargo
      revenue
            165
            -
            -
            -
            -
            165Other
      revenue
            138
            205
            2
            64
            (126)
            283External
      revenue
            2,374
            205
            2
            64
            (101)
            2,544Inter-segment
      revenue
            49
            3
            350
            164
            (566)
            -2,423
            208
            352
            228
            (667)
            2,544Operating
      expensesWages,
      salary and benefits
            443
            21
            82
            85
            3
            634Aircraft
      fuel
            583
            -
            69
            -
            (68)
            584Aircraft
      rent
            83
            -
            34
            -
            (10)
            107Airport
      user fees
            232
            -
            46
            -
            (45)
            233Aircraft
      maintenance, materials, and supplies
            205
            -
            27
            56
            (164)
            124Communications
      and information technology
            68
            7
            2
            4
            (9)
            72Food,
      beverages and supplies
            76
            -
            4
            -
            -
            80Depreciation,
      amortization, and obsolescence
            135
            3
            5
            8
            6
            157Commissions
            49
            -
            -
            -
            (1)
            48Capacity
      purchase with Jazz
            224
            -
            -
            -
            (224)
            -Special
      charge for labour restructuring
            (8)
            -
            -
            -
            -
            (8)Other
      operating expenses
            338
            140
            50
            63
            (151)
            4402,428
            171
            319
            216
            (663)
            2,471Operating
      income (loss)
            (5)
            37
            33
            12
            (4)
            73Non-operating
      income (expense)Interest
      income
            24
            6
            2
            1
            3
            36Interest
      expense
            (88)
            (4)
            (2)
            (6)
            (5)
            (105)Interest
      capitalized
            22
            -
            -
            -
            -
            22Gain
      (loss) on disposal of assets
            (10)
            -
            -
            -
            31
            21Gain
      on financial instruments
            1
            -
            -
            -
            -
            1Other
      non-operating expense
            (1)
            -
            (1)
            -
            -
            (2)(52)
            2
            (1)
            (5)
            29
            (27)Income
      (loss) before the following items
            (57)
            39
            32
            7
            25
            46Non-controlling
      interest
            (3)
            -
            -
            -
            (16)
            (19)Foreign
      exchange gain (loss)
            (107)
            -
            -
            1
            1
            (105)Recovery
      of income taxes
            23
            -
            -
            -
            6
            29Income
      (loss) for the period
            $   (144)
            $     39
            $     32
            $     8
            $     16
            $     (49)EBITDAR/EBITDA(1)
            $      213
            $     40
            $     72
            $   20
            $    (8)
            $     337EBITDAR/EBITDA(1)
      excluding special charge
            $      205
            $     40
            $     72
            $   20
            $    (8)
            $     329





1.
            Refer
      to section 20 "Non-GAAP Financial Measures" in this MD&A for a
      reconciliation of EBITDAR/EBITDA to operating income (loss) and
      EBITDAR/EBITDA excluding special charges to operating income
      (loss).






14


2007
      Management’s
      Discussion and Analysis




As
previously discussed, ACE’s investments in Aeroplan, Jazz and ACTS Aero are
accounted for using the equity method effective March 14, 2007, May 24, 2007 and
October 16, 2007, respectively.  Consequently, ACE’s results of
operations and EBITDAR for Quarter 4 2007 are not directly comparable to its
operating results and EBITDAR for Quarter 4 2006.





ACE
recorded operating income of $46 million in Quarter 4 2007 compared to operating
income of $73 million in Quarter 4 2006.  ACE’s consolidated results
for Quarter 4 2006 included operating income from Aeroplan, Jazz and ACTS of $37
million, $33 million and $12 million, respectively.





EBITDAR
of $248 million was recorded in Quarter 4 2007 compared to EBITDAR of $337
million in the same period in 2006.  In Quarter 4 2006, Aeroplan, Jazz
and ACTS recorded EBITDAR of $40 million, $72 million and $20 million,
respectively.  In Quarter 1 2006, Air Canada recorded a special charge
for labour restructuring of $28 million related to a non-unionized workforce
reduction program.  In Quarter 4 2006, the estimated cost of this
program was revised which allowed Air Canada to record a favourable adjustment
of $8 million to the special charge for labour
restructuring.  Excluding the favourable adjustment to the special
charge for labour restructuring of $8 million in Quarter 4 2006, operating
income and EBITDAR in Quarter 4 2006 were $65 million and $329 million,
respectively.





ACE
recorded operating revenues of $2,520 million and operating expenses of $2,474
million in Quarter 4 2007.  In the same period in 2006, ACE recorded
operating revenues of $2,544 million and operating expenses of $2,471
million.  As a result of the deconsolidation of Aeroplan, Jazz and
ACTS, ACE’s Quarter 4 2007 operating revenues and expenses are not directly
comparable to Quarter 4 2006.





Non-operating
income amounted to $1,307 million in Quarter 4 2007 compared to non-operating
expense of $27 million in Quarter 4 2006.  Included in non-operating
income were gains on disposal of assets of $1,339 million, which included a gain
on disposal of $565 million related to the monetization of ACTS completed on
October 16, 2007, a gain on disposal of $539 million related to the Aeroplan
secondary offering completed on October 22, 2007, and a gain on disposal of $233
million related to the Jazz secondary offering completed on October 22,
2007.  In Quarter 4 2007, net interest expense of $45 million
decreased $2 million from the same period in 2006 due to an increase in interest
income.  ACE’s consolidated statement of operations for Quarter 4 2007
included $17 million of equity income from its investments in Aeroplan and Jazz
and for its investment in ACTS commencing October 16, 2007.





Net
gains on foreign currency monetary items amounted to $18 million in Quarter 4
2007 compared to losses of $105 million in Quarter 4 2006.





Non-controlling
interest amounted to $9 million in Quarter 4 2007 compared to $19 million in
Quarter 4, 2006, a decrease of $10 million.  This change is mainly
attributed to the change to the equity method of accounting for ACE’s
investments in Aeroplan and Jazz.





Net
income in Quarter 4 2007 amounted to $1,128 million or $8.88 per diluted
share.  Net loss in Quarter 4 2006 amounted to $49 million or $(0.48)
per diluted share.





15




2007
      Management’s
      Discussion and Analysis


7.1. Air
Canada




Air
Canada reported operating income of $72 million in Quarter 4 2007 compared to an
operating loss of $5 million in Quarter 4 2006, an improvement of $77
million.  EBITDAR of $274 million in Quarter 4 2007 reflected an
increase of $61 million over Quarter 4 2006.  In Quarter 1 2006, Air
Canada recorded a special charge for labour restructuring of $28 million related
to a non-unionized workforce reduction program.  In Quarter 4 2006,
the estimated cost of this program was revised which allowed Air Canada to
record a favourable adjustment of $8 million to the special charge for labour
restructuring.  Excluding the favourable adjustment to the special
charge for labour restructuring of $8 million in Quarter 4 2006, operating
income and EBITDAR improved $85 million and $69 million,
respectively.





Operating
revenues increased $90 million or 4% to $2,513 million mainly reflecting a
passenger revenue increase of $125 million or 6.0% compared to Quarter 4
2007.  System RASM improved 3.3% over Quarter 4 2006 reflecting system
yield growth of 3.3% coming from domestic and US transborder
markets.  In Quarter 4 2007, traffic grew 2.6% on a capacity increase
of 2.6% over Quarter 4 2006, resulting in an unchanged passenger load factor
from the same period in 2006.





Operating
expenses were $2,441 million in Quarter 4 2007, an increase of $13 million over
Quarter 4 2006.  System CASM, as measured by operating expense per
ASM, decreased 2.0% over Quarter 4 2006.  Excluding fuel expense and
the favourable adjustment to the special charge for labour restructuring of $8
million in 2006, CASM was down 3.9% over the same period in 2006.  The
stronger Canadian dollar was a factor in the overall unit cost decrease over
Quarter 4 2006, particularly in aircraft fuel.





Non-operating
expense amounted to $52 million in Quarter 4 2007, unchanged from Quarter 4
2006.  In Quarter 4 2007, net interest expense of $47 million
increased $5 million from Quarter 4 2006.  In Quarter 4 2006, Air
Canada recorded an impairment provision of $7 million related to a real estate
property and recorded other losses on disposal of assets amounting to $3
million.  No gains or losses on disposal of assets were recorded in
Quarter 4 2007.





Net
gains on foreign currency monetary items amounted to $20 million in Quarter 4
2007.  This compared to losses of $107 million in Quarter 4
2006.





The
income tax provision was $2 million in Quarter 4 2007.  In Quarter 4
2006, the recovery of income tax was $23 million.  The tax provision
for Quarter 4 2007 was favourably impacted by a credit related to changes in
federal corporate income tax rates during the period amounting to $12 million,
after consideration of the valuation allowance.





Segment
income of $35 million was recorded in Quarter 4 2007 compared to a segment loss
of $144 million in Quarter 4 2006.




16




2007
      Management’s
      Discussion and Analysis


7.2. Corporate
Items and Eliminations (“CIE”)




CIE
includes the corporate, financing and investing activities of ACE.  As
previously discussed, ACE’s investment in ACTS Aero was changed during 2007 from
consolidation to the equity method of accounting reported under the CIE
segment.  Up until the time of deconsolidating ACTS Aero, the CIE
segment for Quarter 4 2007 also included certain consolidation adjustments
related to revenue recognition differences for maintenance services provided by
ACTS (completed contract basis of accounting for engine and component
maintenance services versus the expense recognition basis in Air Canada and
Jazz, which is as the work is completed).  In addition, consolidation
adjustments were made related to timing of revenue and expense recognition
pertaining to power-by-the-hour contracts. Subsequent to the change in the
accounting for ACE’s investment in ACTS, these consolidation adjustments are no
longer required.





The
consolidated statement of operations for Quarter 4 2007 reflects $17 million of
equity income from ACE’s investment in Aeroplan, Jazz and ACTS
Aero.  CIE recorded an operating loss of $29 million in Quarter 4 2007
compared to an operating loss of $4 million in Quarter 4
2006.  Negative EBITDAR of $30 million was recorded in Quarter 4 2007
compared to negative EBIDTAR of $8 million in Quarter 4 2006.





In
Quarter 4 2007, ACE recorded gains on disposal of assets of $1,339 million,
within the CIE segment, mainly comprised of the following
transactions:





·
            A
      gain on disposal of $565 million related to the monetization of ACTS
      completed on October 16, 2007;


·
            A
      gain on disposal of $539 million related to the secondary offering of
      22,000,000 trust units of Aeroplan Income Fund completed on October 22,
      2007; and


·
            A
      gain on disposal of $233 million related to the secondary offering of
      35,500,000 trust units of Jazz Air Income Fund completed on October 22,
      2007.





In
Quarter 4 2006, ACE recorded a gain on disposal of assets of $25 million as a
result of ACE’s initial public offering of Air Canada.











17


2007
      Management’s
      Discussion and Analysis


8.         Results
      of Operations – 2007


The
following table reflects the results of the Corporation, the results of its
reportable segments and certain non-GAAP measures for the year ended December
31, 2007.





Year
      ended December 31, 2007($
      millions)
            Air
      Canada
            Aeroplan(1)
            Jazz(2)
            ACTS(3)
            CIE
            ACE
      TotalOperating
      revenuePassenger
      revenue
            $   9,329
            $       -
            $       -
            $       -
            $      15
            $   9,344Cargo
      revenue
            548
            -
            -
            -
            -
            548Other
      revenue
            649
            198
            3
            193
            (109)
            934External
      revenue
            10,526
            198
            3
            193
            (94)
            10,826Inter-segment
      revenue
            120
            3
            610
            604
            (1,337)
            -10,646
            201
            613
            797
            (1,431)
            10,826Operating
      expensesWages,
      salary and benefits
            1,920
            17
            139
            272
            35
            2,383Aircraft
      fuel
            2,552
            -
            125
            -
            (124)
            2,553Aircraft
      rent
            282
            -
            57
            -
            (16)
            323Airport
      user fees
            1,022
            -
            80
            -
            (81)
            1,021Aircraft
      maintenance, materials, and supplies
            757
            -
            50
            235
            (527)
            515Communications
      and information technology
            275
            7
            2
            13
            (16)
            281Food,
      beverages and supplies
            313
            -
            6
            -
            (1)
            318Depreciation,
      amortization, and obsolescence
            548
            3
            9
            31
            (9)
            582Commissions
            201
            -
            -
            -
            -
            201Capacity
      purchase with Jazz
            923
            -
            -
            -
            (386)
            537Special
      charge for labour restructuring
            -
            -
            -
            15
            -
            15Other
      operating expenses
            1,420
            134
            83
            211
            (204)
            1,64410,213
            161
            551
            777
            (1,329)
            10,373Operating
      income (loss)
            433
            40
            62
            20
            (102)
            453Non-operating
      income (expense)Interest
      income
            92
            3
            2
            -
            29
            126Interest
      expense
            (348)
            (3)
            (3)
            (14)
            (52)
            (420)Interest
      capitalized
            108
            -
            -
            -
            -
            108Equity
      investment income(1)(2)(3)
            -
            -
            -
            -
            71
            71Gain
      on disposal of assets
            19
            -
            -
            -
            1,347
            1,366Gain
      on financial instruments
            26
            -
            -
            -
            -
            26Other
      non-operating income (expense)
            (19)
            (1)
            1
            (2)
            9
            (12)(122)
            (1)
            -
            (16)
            1,404
            1,265Income
      before the following items
            311
            39
            62
            4
            1,302
            1,718Non-controlling
      interest
            (9)
            -
            -
            -
            (148)
            (157)Foreign
      exchange gain (loss)
            317
            -
            -
            (4)
            -
            313Provision
      for income taxes
            (190)
            -
            -
            -
            (286)
            (476)Income
      for the period
            $     429
            $     39
            $      62
            $      -
            $     868
            $   1,398EBITDAR/EBITDA(4)
            $  1,263
            $     43
            $   128
            $   51
            $  (127)
            $   1,358EBITDAR/EBITDA(4)
      excluding special charge
            $  1,263
            $     43
            $   128
            $   66
            $  (127)
            $   1,373





1.
            Reflects
      Aeroplan results from January 1 to March 13, 2007.  Since March
      14, 2007, ACE is accounting for its investment in Aeroplan under the
      equity method and, for the period March 14 to December 31, 2007, has
      recorded equity income from the Aeroplan investment in non-operating
      income under “Equity investment income” within the CIE
      segment.


2.
            Reflects
      Jazz results from January 1 to May 23, 2007.  Since May 24,
      2007, ACE is accounting for its investment in Jazz under the equity method
      and, for the period May 24 to December 31, 2007, has recorded equity
      income from the Jazz investment in non-operating income under “Equity
      investment income” within the CIE
segment.


3.
            Reflects
      ACTS results from January 1 to October 15, 2007.  Commencing
      October 16, 2007, ACE is accounting for its investment in ACTS under the
      equity method and has recorded equity income from the ACTS investment in
      non-operating income under “Equity investment income” within the CIE
      segment.


4.
            Refer
      to section 20 "Non-GAAP Financial Measures" in this MD&A for a
      reconciliation of EBITDAR/EBITDA to operating income (loss) and
      EBITDAR/EBITDA excluding special charges to operating income
      (loss).






18


2007
      Management’s
      Discussion and Analysis


The
following table reflects the results of the Corporation, the results of its
reportable segments and certain non-GAAP measures for the year ended December
31, 2006.





Year
      ended December 31, 2006($
      millions)
            Air
      Canada
            Aeroplan
            Jazz
            ACTS
            CIE
            ACE
      TotalOperating
      revenuePassenger
      revenue
            $   8,887
            $       -
            $       -
            $       -
            $       82
            $     8,969Cargo
      revenue
            625
            -
            -
            -
            -
            625Other
      revenue
            558
            759
            7
            228
            (489)
            1,063External
      revenue
            10,070
            759
            7
            228
            (407)
            10,657Inter-segment
      revenue
            196
            10
            1,374
            627
            (2,207)
            -10,266
            769
            1,381
            855
            (2,614)
            10,657Special
      charge for Aeroplan miles
            (102)
            -
            -
            -
            -
            (102)10,164
            769
            1,381
            855
            (2,614)
            10,555Operating
      expensesWages,
      salary and benefits
            1,816
            79
            311
            331
            16
            2,553Aircraft
      fuel
            2,544
            -
            285
            1
            (284)
            2,546Aircraft
      rent
            341
            -
            134
            -
            (34)
            441Airport
      user fees
            982
            -
            178
            -
            (177)
            983Aircraft
      maintenance, materials, and supplies
            768
            -
            98
            234
            (629)
            471Communications
      and information technology
            273
            24
            8
            14
            (30)
            289Food,
      beverages and supplies
            322
            -
            15
            -
            (2)
            335Depreciation,
      amortization, and obsolescence
            493
            14
            21
            31
            17
            576Commissions
            237
            -
            -
            -
            (1)
            236Capacity
      purchase with Jazz
            871
            -
            -
            -
            (871)
            -Special
      charge for labour restructuring
            20
            -
            -
            5
            -
            25Other
      operating expenses
            1,383
            512
            187
            241
            (618)
            1,70510,050
            629
            1,237
            857
            (2,613)
            10,160Operating
      income (loss)
            114
            140
            144
            (2)
            (1)
            395Non-operating
      income (expense)Interest
      income
            82
            20
            6
            1
            11
            120Interest
      expense
            (313)
            (15)
            (8)
            (18)
            (24)
            (378)Interest
      capitalized
            62
            -
            (1)
            -
            -
            61Gain
      (loss) on disposal of assets
            (6)
            -
            -
            -
            399
            393Loss
      on financial instruments
            (18)
            -
            -
            -
            -
            (18)Other
      non-operating income (expense)
            2
            (1)
            (1)
            1
            3
            4(191)
            4
            (4)
            (16)
            389
            182Income
      (loss) before the following items
            (77)
            144
            140
            (18)
            388
            577Non-controlling
      interest
            (12)
            -
            -
            -
            (60)
            (72)Foreign
      exchange gain
            12
            -
            -
            -
            -
            12Recovery
      of (provision for) income taxes
            3
            -
            -
            -
            (112)
            (109)Income
      (loss) for the period
            $    (74)
            $     144
            $    140
            $  (18)
            $     216
            $      408EBITDAR/EBITDA(1)
            $     948
            $     154
            $    299
            $     29
            $    (18)
            $   1,412EBITDAR/EBITDA(1)
      excluding special charges
            $  1,070
            $     154
            $    299
            $     34
            $    (18)
            $   1,539





1.
            Refer
      to section 20 "Non-GAAP Financial Measures" in this MD&A for a
      reconciliation of EBITDAR/EBITDA to operating income (loss) and
      EBITDAR/EBITDA excluding special charges to operating income
      (loss).






19


2007
      Management’s
      Discussion and Analysis
   As
previously discussed, ACE’s 2007 results reflect the consolidation of Aeroplan’s
operations only up to March 14, 2007, the consolidation of Jazz’s operations
only up to May 24, 2007 and the consolidation of ACTS’ operations only up to
October 16, 2007.  From those dates, ACE’s investments in Aeroplan,
Jazz and ACTS Aero are accounted for using the equity method.  ACE’s
2006 results reflect the consolidation of Aeroplan’s, Jazz’s and ACTS’
operations.  Consequently, ACE’s results of operations and EBITDAR for
2007 are not directly comparable to its operating results and EBITDAR for
2006.





ACE
recorded operating income of $453 million in 2007 compared to operating income
of $395 million in 2006.  EBITDAR of $1,358 million was recorded in
2007 compared to EBITDAR of $1,412 million in 2006.





In
2007, a special charge for labour restructuring of $15 million was recorded at
ACTS related to a workforce reduction resulting from the termination of a third
party heavy maintenance contract.  In 2006, a special charge of $102
million was recorded at Air Canada in connection with its obligations for the
redemption of pre-2002 Aeroplan miles, and a special charge of $25 million was
recorded ($20 million at Air Canada and $5 million at ACTS) relating to a
non-unionized workforce reduction plan.





Excluding
these special charges in both 2006 and 2007, operating income and EBITDAR for
2007 decreased by $54 million and $166 million, respectively, over
2006.  ACE’s consolidated results in 2006 included operating income
from Aeroplan and Jazz of $140 million and $144 million, respectively, and an
operating loss from ACTS of $2 million.  In 2006, Aeroplan, Jazz and
ACTS recorded EBITDAR of $154 million, $299 million and $29 million,
respectively.





In
2007, ACE recorded operating revenues of $10,826 million and operating expenses
of $10,373 million.  In 2006, ACE recorded operating revenues of
$10,555 million, including the special charge for Aeroplan miles, and operating
expenses of $10,160 million.  As a result of the deconsolidation of
Aeroplan, Jazz and ACTS, ACE’s operating revenues and expenses for 2007 are not
directly comparable to its operating revenues and expenses for
2006.





Non-operating
income amounted to $1,265 million in 2007 compared to non-operating income of
$182 million in 2006.  In 2007, ACE recorded gains on disposal of
assets totalling $1,366 million, mainly comprised of a gain of $565 million
related to the monetization of ACTS, a gain of $539 million related to the
secondary offering of 22,000,000 trust units of Aeroplan Income Fund, a gain of
$233 million related to the secondary offering of 35,500,000 trust units of Jazz
Air Income Fund and a gain of $8 million related to the sale of 500,000 shares
in US Airways.  In addition, Air Canada recorded gains of $14 million
related to a damaged aircraft and gains of $5 million mainly pertaining to the
sale of one real estate property.  In 2006, ACE recorded a gain of
$220 million related to the initial public offering of Jazz, a gain of $152
million relating to the sale of 4,500,000 shares of its holdings in US Airways
and a gain of $25 million as a result of ACE’s initial public offering of Air
Canada.  In 2007, net interest expense of $186 million decreased $11
million from 2006.  The interest expense increase of $42 million,
largely driven by the financing of additional aircraft, was more than offset by
higher interest income and interest capitalized relating to the acquisition of
new aircraft.  Net interest expense was favourably impacted by a
stronger Canadian dollar versus the US dollar in 2007.  In 2007, ACE
recorded equity investment income of $71 million from its investments in
Aeroplan, Jazz and ACTS.  Included in non-operating income was a gain
of $26 million in 2007 and a loss of $18 million in 2006 relating to fair value
adjustments on certain derivative financial instruments entered into by Air
Canada.





Net
gains from foreign currency monetary items amounted to $313 million in 2007,
attributable to a stronger Canadian dollar at December 31, 2007 compared to
December 31, 2006.  This compared to gains of $12 million in
2006.





Non-controlling
interest amounted to $157 million in 2007 compared to $72 million in 2006, an
increase of $85 million.  This change was mainly attributed to the
increased income from Air Canada in 2007, partially offset by the change to the
equity method of accounting for ACE’s investments in Aeroplan and
Jazz.





Provisions
for income taxes of $476 million were recorded in 2007 and included $190 million
related to Air Canada, $219 million related to the sale of aviation interests
and $37 million related to the special distributions of Aeroplan and Jazz
units.




20


2007
      Management’s
      Discussion and Analysis


Net
income for 2007 amounted to $1,398 million or $11.44 per diluted
share.  Net income for 2006 amounted to $408 million or $3.80 per
diluted share.




8.1.        Air
Canada




Air
Canada reported operating income of $433 million in 2007 compared to operating
income of $114 million in 2006, an increase of $319 million.  EBITDAR
of $1,263 million in 2007 reflected an improvement of $315 million over
2006.  In 2006, Air Canada recorded a special charge of $102 million
in operating revenues in connection with Air Canada’s obligations for the
redemption of pre-2002 Aeroplan miles.  Also in 2006, Air Canada
recorded a special charge for labour restructuring of $20 million related to a
non-unionized workforce reduction program.  Excluding the special
charge for Aeroplan miles and the special charge for labour restructuring in
2006, operating income and EBITDAR for 2007 increased by $197 million and $193
million, respectively, over 2006.





Operating
revenues of $10,646 increased $482 million or 5%, reflecting a passenger revenue
increase of $442 or 5% over 2006.  In 2007, traffic grew 3.3% on a
capacity increase of 2.8% over 2006, resulting in a passenger load factor
increase of 0.4 percentage points.  System yield increased 1.6%
reflecting improvements in all markets with the exception of the Atlantic
market.  RASM rose 2.1% due to both the growth in yield and the
improvement in system passenger load factor.





Operating
expenses were $10,213 million in 2007, an increase of $163 million or 2% over
2006.  CASM decreased 1.2% while CASM, excluding fuel expense and
special charges, was reduced by 0.4%.





Non-operating
expense amounted to $122 million in 2007 compared to non-operating expense of
$191 million in 2006.  In 2007, net interest expense of $148 million
decreased $21 million from 2006.  A $35 million increase in interest
expense, largely driven by the financing of additional aircraft, was more than
offset by growth in interest income and by a higher amount of capitalized
interest relating to the acquisition of new aircraft and growth in interest
income.  In 2007, Air Canada recorded gains of $14 million related to
a damaged aircraft and gains of $5 million pertaining to the sale of one real
estate property.  In 2006, Air Canada recorded an impairment provision
of $7 million relating to one real estate property, other losses on disposal
amounting to $4 million and a gain on sale of $5 million pertaining to one of
its commercial real estate properties.  Gains relating to fair value
adjustment on certain derivatives instruments amounted to $26 million in 2007
versus losses of $18 million in 2006.





Net
gains on foreign currency monetary items amounted to $317 million in 2007,
attributable to a stronger Canadian dollar at December 31, 2007 compared to
December 31, 2006.  This compared to gains of $12 million in
2006.  The net gains recorded in 2007 were comprised of gains of $541
million relating to the mark-to-market of US denominated long-term monetary
items partially offset by losses of $224 million relating to the mark-to-market
of foreign currency forward contracts.





The
income tax provision was $190 million in 2007 and represented an effective tax
rate of 31%.  In 2006, the income tax recovery was $3 million. The
effective income tax rate for 2007 was favourably impacted by the capital
portion of certain foreign exchange gains reported in the year, which are
tax-affected at 50% of the income tax rate.  In addition, the
favorable impact of a reduction in the federal corporate income tax rate was
recognized in 2007.  In addition to the federal changes, Air Canada
also recorded a current tax expense of $10 million related to the harmonization
of Ontario and federal income taxes.  This change in tax law results
in a tax liability of $10 million payable over a period of five years, beginning
in the 2009 taxation year.





Segment
income of $429 million was recorded in 2007 compared to a segment loss of $74
million in 2006.







21


2007
      Management’s
      Discussion and Analysis


8.2.        Aeroplan




ACE's
results from operations include the consolidation of Aeroplan's operations up to
March 14, 2007 within the Aeroplan segment.  After that date, Aeroplan
is accounted for using the equity method reported under the CIE
segment.  The following discussion is based on Aeroplan’s Quarter 1
2007 published results.  Refer to section 6 "Accounting Policies" of
this MD&A.





Aeroplan
recorded operating income of $48 million in Quarter 1 2007, an increase of $9
million over Quarter 1 2006.  EBITDA improved $8 million over Quarter
1 2006.  The improvement in operating income and EBITDA was mainly
driven by a 19% growth in miles redeemed as a result of higher redemption
activity.





Operating
revenues in Quarter 1 2007 were up $45 million or 23%, primarily attributable to
higher redemption activity and to higher cumulative average revenue recognized
per Aeroplan mile, and an increase of $3 million in breakage
revenues.





Total
operating expenses rose by $36 million or 22% in Quarter 1 2007, largely due to
an increase of $30 million in the cost of rewards, resulting from increased
redemptions.





Net
income of $50 million was recorded by Aeroplan in Quarter 1 2007, an improvement
of $39 million over Quarter 1 2006.





8.3.        Jazz




ACE's
results from operations include the consolidation of Jazz's operations up to May
24, 2007 within the Jazz segment.  After that date, Jazz is accounted
for using the equity method reported under the CIE segment.  The
following discussion is based on Jazz’s June 30, 2007 published
results.  Refer to section 6 "Accounting Policies" of this
MD&A.





In the
first half of 2007, Jazz reported operating income of $76 million, an
improvement of $4 million from the operating income of $72 million recorded in
the same period in 2006.  EBITDAR of $155 million was recorded in the
six months ended June 30, 2007 compared to EBITDAR of $148 million for the same
period in 2006.  The improvements in operating income and EBITDAR were
mainly due to a 14% increase in ASM capacity.





In the
first six months of 2007, operating revenues increased $79 million or 12% over
the corresponding period in 2006, reflecting a 13% increase in the block hours
flown, as well as a 16% increase in pass-through costs charged to Air Canada
under the Jazz CPA.





In the
first six months of 2007, operating expenses rose $75 million or 13% over the
corresponding period in 2006.  Increased pass-through costs under the
Jazz CPA represented $38 million of the total increase in operating
expenses.  Controllable costs reflected the remainder of the
increase.





Net
income of $76 million was recorded in the first six months of 2007, an
improvement of $7 million over the corresponding period in 2006.






22


2007
      Management’s
      Discussion and Analysis


8.4.        ACTS




ACE's
results from operations include the consolidation of ACTS' operations up to
October 16, 2007 within the ACTS segment.  After that date, ACTS is
accounted for using the equity method reported under the CIE
segment.  The following discussion is based on ACE’s September 30,
2007 published results for ACTS.  Refer to section 6 "Accounting
Policies" of this MD&A.





In the
first nine months of 2007, ACTS recorded operating income of $32 million,
excluding special charges, an improvement of $41 million from the same period in
2006.  Refer to section 20 “Non-GAAP financial measures” in this
MD&A.  The special charges related to workforce restructuring
programs and amounted to $15 million in 2007 and $5 million in
2006.





In the
first nine months of 2007, operating revenues of $755 million increased $128
million over the same period in 2006, the result of growth in the engine
maintenance business and Aeroman revenues of $37 million since its acquisition
in February 2007.





Operating
expenses of $738 million in the first nine months of 2007, including the special
charges discussed above, were up $97 million from the corresponding period in
2006, largely attributable to the increase in revenue and included expenses
related to Aeroman of $29 million in the first nine months of 2007.





A
segment result of break-even in the first nine months of 2007 reflected a $26
million improvement from the same period in 2006.


8.5.        Corporate
Items and Eliminations (“CIE”)




CIE
includes the corporate, financing and investing activities of ACE.  As
previously discussed, ACE’s investments in Aeroplan, Jazz and ACTS Aero were
changed during 2007 from consolidation to the equity method of accounting
reported under the CIE segment. CIE also included certain consolidation
adjustments related to revenue recognition differences amongst the operating
segments.  These consolidation adjustments were related to the timing
of recognition and the presentation of revenue related to Aeroplan redemptions
and the timing of revenue recognition related to maintenance services provided
by ACTS (completed contract basis of accounting for engine and component
maintenance services versus the expense recognition basis in Air Canada and
Jazz, which is as the work is completed).  In addition, consolidation
adjustments were made related to timing of revenue and expense recognition
pertaining to power-by-the-hour contracts.  Subsequent to the change
in the accounting for ACE’s investments in Aeroplan and ACTS, these
consolidation adjustments are no longer required.





The
consolidated statement of operations for 2007 reflects $71 million in equity
income from ACE’s investments in Aeroplan, Jazz and ACTS Aero.  CIE
recorded an operating loss of $102 million in 2007 compared to an operating loss
of $1 million in 2006.  Negative EBITDAR of $127 million was recorded
in 2007 compared to negative EBIDTAR of $18 million in 2006.





In
2007, ACE recorded gains on disposal of assets amounting to $1,347 million,
within the CIE segment, mainly comprised of the following
transactions:





·
            A
      gain on disposal of $565 million related to the monetization of ACTS
      completed on October 16, 2007;


·
            A
      gain on disposal of $539 million related to the secondary offering of
      22,000,000 units of Aeroplan Income Fund completed on October 22,
      2007;


·
            A
      gain on disposal of $233 million related to the secondary offering of
      35,500,000 units of Jazz Air Income Fund completed on October 22,
      2007;


·
            A
      gain on disposal of $8 million related to the sale of 500,000 shares in US
      Airways.





In
2006, ACE recorded gains on disposal of assets of $399 million, within the CIE
segment, mainly comprised of the following transactions:





·
            A
      gain on disposal of $220 million related to the initial public offering of
      Jazz;


·
            A
      gain on disposal of $152 million related to the sale of 4,500,000 shares
      in US Airways; and


·
            A
      gain on disposal of $25 million as a result of ACE’s initial public
      offering of Air Canada.


23
 2007
      Management’s
      Discussion and Analysis
 9.         Financial
      and Capital Management


The
following table summarizes the consolidated statement of financial position of
ACE as at December 31, 2007 and December 31, 2006.





Condensed
      Consolidated Statement of Financial Position($
      millions)
            December
      31, 2007
            December
      31, 2006AssetsCash,
      cash equivalents and short-term investments
            $        3,139
            $        3,178Other
      current assets
            1,482
            1,856Current
      assets
            4,621
            5,034Property
      and equipment
            7,925
            5,989Intangible
      assets
            647
            1,643Other
      assets
            578
            775$    13,771
            $    13,441LiabilitiesCurrent
      liabilities
            3,252
            3,948Long-term
      debt and capital leases obligations
            4,006
            3,759Pension
      and other benefits liabilities
            1,824
            1,876Aeroplan
      deferred revenues
            -
            801Other
      long-term liabilities
            715
            7859,797
            11,169Non-controlling
      interest
            757
            695Shareholders'
      equity
            3,217
            1,577$   13,771
            $   13,441




9.1.        Analysis
of Financial Position


Cash,
cash equivalents and short-term investments


The
Corporation maintains considerable liquidity in cash and short-term investments
along with access to additional funds under a credit facility.  Air
Canada has a secured syndicated revolving credit facility of $400
million.  As of the date hereof, no amounts have been drawn on this
credit facility.





At
December 31, 2007, cash, cash equivalents and short-term investments amounted to
$3,139 million, a decrease of $39 million from December 31, 2006.  ACE
recorded net proceeds amounting to $1,620 million in 2007 comprised
of:





·
            $723
      million related to the monetization of ACTS on October 16,
      2007;


·
            $65
      million received by Air Canada with respect to the monetization of ACTS on
      October 16, 2007, comprised of $28 million for the sale of a building, $20
      million in consideration of a transfer of repair schemes and $17 million
      for the repayment of a note;


·
            $463
      million related to the secondary offering of Aeroplan Income Fund on
      October 22, 2007;


·
            $263
      million related to the secondary offering of Jazz Air Income Fund on
      October 22, 2007;


·
            $16
      million related to the sale of its remaining shares of US Airways ($8
      million in Quarter 2 2007 and $8 million in Quarter 3 2007);
      and


·
            $90
      million related to the disposal of other
assets.





The
cash inflows from the above proceeds were offset by the exclusion of Aeroplan’s
and Jazz’s cash, cash equivalents and short-term investments amounting to $755
million (balance at December 31, 2006), as a result of deconsolidation, and a
decrease in Air Canada’s cash, cash equivalents and short-term investments of
$871 million, mainly due to investing activities related to aircraft
acquisitions.







24


2007
      Management’s
      Discussion and Analysis


At
December 31, 2007, ACE’s consolidated cash, cash equivalents and short-term
investments amounted to $3,139 million comprised of ACE’s unconsolidated cash,
cash equivalents and short-term investments of $1,900 million and Air Canada’s
cash, cash equivalents and short-term investments of $1,239
million.





The
following summarizes significant transactions which impacted ACE’s cash balances
subsequent to December 31, 2007:




·
            On
      January 10, 2008, ACE accepted for purchase and cancellation a total of
      40,023,427 Class A variable voting shares and 9,894,166 Class B voting
      shares at $30.00 per share for an aggregate purchase price of
      approximately $1.498 billion in accordance with the terms of the
      substantial issuer bid.




·
            On
      January 14, 2008, cash proceeds of $40 million representing the full
      balance of funds held in escrow on closing of the monetization of ACTS
      were received by ACE.




·
            On
      January 24, 2008, ACE completed the sale of a total of 13,000,000 units of
      Jazz Air Income Fund on an exempt trade basis to certain funds and
      accounts managed by West Face Capital Inc. and to Sunrise Partners Limited
      Partnership at a price of $7.45 per unit representing total net proceeds
      to ACE of approximately $96.85
million.




Following
the completion of these transactions, ACE’s unconsolidated cash, cash
equivalents and short-term investments (excluding Air Canada) amounted to $538
million on January 31, 2008.





Long-term
Debt


The
increase in long-term debt in 2007 was largely related to new borrowings by Air
Canada to finance the acquisition of seven Boeing 777 and 24 Embraer aircraft in
2007.  The increase in long-term debt resulting from these additional
borrowings approximated $1.0 billion.  In addition, on October 30,
2007, Air Canada entered into an agreement with a syndicate of banks for the
financing of pre-delivery payments (“PDP”) in the amount of US$540 million for
the Boeing 777 aircraft contemplated in Air Canada’s purchase agreement with
Boeing which is further described in section 9.5 of this MD&A.  At
December 31, 2007, the amount drawn was US$528 million (Cdn$521
million).  These increases were partly offset by scheduled debt
repayments amounting to $504 million and the appreciation of the Canadian dollar
against US dollar on US denominated debt.





Other
assets and liabilities


At
December 31, 2007, other assets and liabilities were largely impacted by the
change in accounting for ACE’s investments in Aeroplan, Jazz and
ACTS.  Refer to section 6 of this MD&A for additional
information.




25


2007
      Management’s
      Discussion and Analysis


9.2.        Consolidated
Cash flows




As
previously discussed, ACE’s 2007 results reflect the consolidation of Aeroplan’s
operations only up to March 14, 2007, the consolidation of Jazz’s operations
only up to May 24, 2007 and the consolidation of ACTS’ operations only up to
October 16, 2007.





The
following table summarizes ACE’s consolidated statement of cash flow for the
indicated periods.





Quarter
      4
            Year($
      millions)
            2007
            2006
            2007
            2006Cash
      from operating activities
            $         32
            $           6
            $        529
            $        732Cash
      from financing activities
            657
            179
            1,403
            591Cash
      from (used for) investing activities
            633
            (78)
            (1,486)
            (1,034)Net
      change in cash and cash equivalents during the period
            1,322
            107
            446
            289Cash
      and cash equivalents - Beginning of period
            978
            1,747
            1,854
            1,565Cash
      and cash equivalents - End of period
            $   2,300
            $   1,854
            $   2,300
            $   1,854





Cash
flows from operations increased $26 million in Quarter 4 2007 primarily as a
result of a decrease in pension funding versus Quarter 4 2006.  This
improvement was partly offset by the reduction in ACE’s interest in Aeroplan and
Jazz.  For the year 2007, cash from operations decreased $203 million
mainly due to the reduction in ACE’s interest in Aeroplan, Jazz and ACTS, partly
offset by an increase in cash from operations at Air Canada.





Aircraft
and facility related borrowings of $821 million in Quarter 4 2007 were mainly
related to the Air Canada PDP financing agreement in the amount of US$540
million discussed in section 9.1 of this MD&A and to the financing of one
Boeing 777 aircraft and eight Embraer aircraft.  Aircraft and facility
related borrowings of $1,914 million for the full year 2007 were mainly related
to the financing of seven Boeing 777 aircraft, the financing of 24 Embraer
aircraft and the PDP financing.





Scheduled
and other debt and capital lease payments in Quarter 4 2007 and in the full year
2007 amounted to $199 million and $504 million, respectively.





The
Aeroplan, Jazz and ACTS cash of $376 million which was removed from ACE’s
consolidated statement of financial position has been classified as cash
outflows from investing activities.





Cash
flows from investing activities in 2007 included the net disposal proceeds of
$1,555 million discussed in section 9.1 of this MD&A.  Cash flows
used for investing in 2007 included cash payments of $53 million in connection
with the acquisition of Aeroman.





Additions
to capital assets, which mainly related to Air Canada, totaled $923 million in
Quarter 4 2007 and mainly related to the PDP financing and the addition of eight
Embraer 190 aircraft.  In the year 2007, additions to capital assets
totaled $2,622 million, mainly related to the addition of seven Boeing 777
aircraft, 24 Embraer 190 aircraft and the PDP financing.




26


2007
      Management’s
      Discussion and Analysis




9.3.        Contractual
Obligations


The
following table provides Air Canada’s contractual obligations at December 31,
2007, with the exception of the Convertible Senior Notes which are ACE’s
obligation, for each of the next five years and after 2012.  The table
also includes the letters of intent for the sale and lease back transactions
concluded by Air Canada in January 2008 which are further described section 9.5
of this MD&A.





Contractual
      Obligations($
      millions)
            Total
            2008
            2009
            2010
            2011
            2012
            ThereafterLong-term
      debt obligations
            $    2,551
            $    160
            $   152
            $     141
            $     153
            $      166
            $     1,779Convertible
      Senior Notes
            273
            273
            -
            -
            -
            -
            -Debt
      consolidated under AcG-15
            896
            105
            51
            100
            288
            73
            279Capital
      lease obligations
            1,394
            223
            147
            142
            136
            177
            569Operating
      lease obligations(1)
            2,108
            339
            313
            291
            230
            212
            723Committed
      capital expenditures(2)
            4,739
            555
            102
            760
            891
            692
            1,739Total
      contractual obligations(3)
            $
      11,961
            $  1,655
            $  765
            $  1,434
            $  1,698
            $  1,320
            $   5,089Pension
      funding obligations (4)
            $    1,715
            $      343
            $   328
            $      338
            $      348
            $      358
            N/A





(1)
            Mainly
      relate to US dollar aircraft operating
leases.


(2)
            Mainly
      relate to US dollar aircraft-related expenditures.  Also include
      purchases relating to system development costs, facilities and leasehold
      improvements.  See section 9.5 of this MD&A for additional
      information on Air Canada’s planned and committed capital expenditures as
      well as the related financing
arrangements.


(3)
            Table
      above excludes commitments for goods and services required in the ordinary
      course of business.  Also excluded are future income taxes and
      other long-term liabilities mainly due to reasons of uncertainty of timing
      of cash flows and items which are non-cash in
  nature.


(4)
            See
      section 9.4 for additional information on Air Canada’s pension funding
      obligations.





Air
Canada leases and subleases certain aircraft to Jazz on a flow-through basis,
which are reported net on Air Canada’s statement of operations.  These
leases and subleases relate to 33 Bombardier CRJ-200 aircraft and 15 Bombardier
CRJ-705 aircraft.  The subleases with Jazz have the same terms and maturity
as Air Canada’s corresponding lease commitments to lessors.




Operating
      lease commitments($
      millions)
            Total
            2008
            2009
            2010
            2011
            2012
            ThereafterAircraft
      subleased to Jazz
            $    1,067
            $    84
            $    84
            $    76
            $    75
            $    75
            $    673







As at
December 31, 2007, the future minimum non-cancelable commitments for the next 12
months under the capacity purchase agreements with Jazz is approximately $650
million and with unaffiliated regional carriers is $20 million.  The
initial term of the Jazz CPA expires December 31, 2015 with two automatic
renewal periods of five years each, subject to either party’s right not to renew
by notice at least one year prior to the expiration of the then applicable
term.  As the rates under the Jazz CPA are subject to adjustments beginning
in 2009, it is not possible to determine the minimum non-cancelable commitments
beyond 2008, however, they are not expected to change significantly from the
2008 amount.




Under
the terms of their respective land leases, each Fuel Facility Corporation
(described in section 11 of this MD&A “Off-Balance Sheet Arrangements”) has
an obligation to restore the land to vacant condition at the end of the lease
and to rectify any environmental damage for which it is responsible. If it were
found that the Fuel Facility Corporations had to contribute to any remediation
costs, each contracting airline would share pro-rata, based on system usage, in
the costs. For all Fuel Facility Corporations in Canada in which Air Canada
participates, Air Canada has recorded an obligation of $7 million ($44 million
undiscounted) representing the present value of the estimated decommissioning
and remediation obligations at the end of the lease using an 8% discount rate,
with lease term expiry dates ranging from 2032 to 2039. This estimate is based
on numerous




27


2007
      Management’s
      Discussion and Analysis




assumptions
including the overall cost of decommissioning and remediation and the selection
of alternative decommissioning and remediation approaches.  The
estimated fair value of the obligation is nil.




During
2005, ACE issued $330 million of Convertible Senior Notes due 2035 (“Convertible
Notes”) for net proceeds of $319 million.   The Convertible Notes
bear interest at 4.25% per annum payable semi-annually in arrears on June 1 and
December 1 in the year commencing December 1, 2005.  Holders may
convert their Convertible Notes into Class B voting shares (if the holder is
Canadian) or into Class A variable voting shares (if the holder is not
a  Canadian) prior to maturity based on a conversion rate per $1,000
principal amount of Convertible Notes.  Refer to section 9.7 for
additional information.




9.4.        Air
Canada Pension Funding Obligations




The
table below provides projections for Air Canada’s pension funding obligations
for the years 2008 through to 2012, assuming no change in economic conditions.
Changes in the economic conditions, mainly the return on fund assets and changes
in interest rates will impact projected required contributions.  These
funding obligations are updated annually.  The required contributions
disclosed below assume no future gains and losses on plan assets and liabilities
over the projection period and do not reflect the economic experience of
2007.





Based
on preliminary estimates, the solvency deficit on the registered pension plans
at January 1, 2008 is expected to increase compared to January 1, 2007 and, as a
result, employer contributions determined in accordance with regulations are
expected to increase by $90 million in 2008 and $120 million each year
thereafter.  These preliminary estimates have not been reflected in
the table below.





Air
      Canada
              ($
      millions)
            
            
            2008
            2009
            2010
            2011
            2012Past
      service domestic registered plans
            
            
            $   91
            $   92
            $   93
            $   93
            $   93Current
      service domestic registered plans
            
            
            166
            171
            176
            181
            186Other
      pension arrangements(1)
            
            
            86
            65
            69
            74
            79Projected
      pension funding obligations
            
            
            $   343
            $   328
            $   338
            $   348
            $   358





(1)
            Includes
      retirement compensation arrangements, supplemental plans and international
      plans.





The
above pension funding requirements are in respect of Air Canada’s pension
arrangements. For domestic registered pension plans, the funding requirements
are based on the minimum past service contributions disclosed in the January 1,
2007 actuarial valuation plus a projection of the current service
contributions.  Air Canada entered into the Pension and Benefits
Agreement with ACTS and ACTS Aero.  Refer to section 10 of this
MD&A for additional information.





The
net deficit, on an accounting basis, at December 31, 2007 for pension benefits
was $403 million compared to $1,377 million at December 31, 2006.  The
decrease in the accounting deficit was mainly the result of an increase in the
discount rate and the funding of past service contributions of $134 million
offset by a negligible return on plan assets.








28


2007
      Management’s
      Discussion and Analysis




9.5.        Air
Canada Capital Expenditures and Related Financing
Arrangements




In
2004, Air Canada signed definitive purchase agreements with Empresa Brasileira
de Aeronautica S.A. (“Embraer”) for the acquisition of regional jet aircraft. In
November 2005, Air Canada also concluded agreements with The Boeing Company
("Boeing") for the acquisition of Boeing 777 and Boeing 787
aircraft.




Boeing




In
November 2005, Air Canada concluded agreements with Boeing for the acquisition
of up to 36 Boeing 777 aircraft and up to 60 Boeing 787 Dreamliners. The initial
order for the 36 Boeing 777 aircraft was comprised of firm orders for 18
aircraft plus purchase rights for 18 more.  The initial order for the
Boeing 787 aircraft was comprised of firm orders for 14 aircraft plus purchase
rights, options and rolling options (collectively “purchase rights”) for 46
aircraft.  In conjunction with the initial agreements, Air Canada
received financing commitments from Boeing and the engine manufacturer for all
firm aircraft orders covering up to 90% of the capital
expenditure.  This available financing is based on a floating or fixed
rate equivalent and was at 8.70% at December 31, 2007.  The term to
maturity is 15 years with principal payments made on a mortgage style basis
resulting in equal instalment payments of principal and interest over the term
to maturity.





During
2007, Air Canada amended agreements with Boeing to cancel orders for two Boeing
777 aircraft scheduled for delivery in 2009. In addition, Air Canada increased
its order for Boeing 787 aircraft by 23, bringing its total firm orders to 37
Boeing 787 aircraft. The first delivery of the Boeing 787 firm aircraft is
scheduled for 2010 and deliveries of all 37 firm aircraft are scheduled to be
completed by 2014.  As at December 31, 2007, 18 purchase rights for
Boeing 777 aircraft and 23 options for Boeing 787 aircraft remained
exercisable.  In January, 2008, Boeing announced a delay in the
production of its first Boeing 787 aircraft from the end of Quarter 1 2008 to
the end of Quarter 2 2008 due to production delays.  Air Canada has
not been notified that its Boeing 787 deliveries have been affected, however,
Air Canada expects to receive an update towards the end of Quarter 1
2008.





In
conjunction with the amended agreements, Air Canada received additional
financing commitments from Boeing for seven of the additional Boeing 787
aircraft (21 Boeing 787 aircraft in total) on the same terms and conditions as
described above. Should Air Canada not utilize any of the financing commitments
on the Boeing 777 aircraft, the financing commitments for the Boeing 787
aircraft will be increased to 31 aircraft of which the terms for 28 aircraft
would be revised to cover 80% of the aircraft delivery price and the term to
maturity would be reduced to 12 years with straight-line principal repayments
over the term to maturity.





As at
December 31, 2007, seven of the Boeing 777 firm aircraft under the purchase
agreement with Boeing have been delivered with the remaining nine firm
deliveries expected to be delivered by end of year 2008.  The first
seven aircraft were financed under loan guarantee support from the Export-Import
Bank of the United States (“EXIM”).  All of the nine Boeing 777 firm
aircraft deliveries expected in 2008 have commitments for loan guarantee support
to be provided by EXIM which was signed in January 2008.  The loan
guarantee, subject to certain conditions, covers a 12-year loan term for 85% of
the capital expenditure at an interest rate based on a floating rate. This loan
guarantee from EXIM is expected to be used instead of the financing commitments
provided by Boeing and the engine manufacturer described above. As a result, it
is not expected that any of Boeing’s and the engine manufacturer’s financing
commitments for the Boeing 777 aircraft will be utilized.  The firm
commitment financing on capital purchase commitments disclosed below reflects
this EXIM guarantee support for only five aircraft in 2008 given Air Canada
expects to sell and lease back the other four aircraft (see below).





On
October 30, 2007, Air Canada entered into an agreement with a syndicate of banks
for the financing of pre-delivery payments (“PDP”) for 10 of the 16 Boeing 777
aircraft contemplated in Air Canada’s Purchase Agreement with
Boeing.  The PDP financing is a series of loans that are aircraft
specific with a maximum aggregate commitment of up to $568 million (US$575
million).  The PDP loans have a term of five years, but may be prepaid
upon the delivery of the aircraft without penalty.  Air Canada has
already prepaid the PDP loans on the first two aircraft delivered in November
2007 and January 2008.  In addition, Air Canada has served notice to
the PDP syndicate that it will be prepaying the PDP loans on delivery of
aircraft three to eight.  Air Canada’s intent is to prepay all PDP
loans upon delivery of the relevant aircraft, using the committed long-term
aircraft financing and leases for the aircraft to be delivered.  The
tenth and last aircraft in this PDP financing is




29


2007
      Management’s
      Discussion and Analysis


currently
scheduled for delivery in November 2008, at which time Air Canada expects to
have fully repaid the PDP loans.  At year-end 2007, the amount drawn
on the PDP loans was $521 million (US$528 million).  Air Canada is
using the PDP financing to settle most of the outstanding pre-delivery payments.
This results in a significant shift in capital expenditures from 2008 to 2007
from that which was previously disclosed due to the pre-delivery deposit being
recorded as a capital expenditure when paid.





This
PDP financing replaces a significant portion of the pre-delivery financing
arrangements that Air Canada had in place with Boeing.  This PDP
financing was entered into as it offered more attractive terms than the
arrangements with Boeing.





In
January 2008, Air Canada signed letters of intent for the sale and lease back of
four of the nine Boeing 777 scheduled for delivery in 2008.  The lease
terms for two of the Boeing 777 aircraft is 12 years.  The other two
Boeing 777 aircraft each have 10.5 year lease terms and Air Canada has options
to extend each for an additional 18 months.  All four leases are at
market rates.  This replaces an equivalent number of aircraft loan
guarantee support commitments provided by EXIM. As a result, the capital
expenditure forecast in the table below does not include expenditures relating
to these aircraft. These four aircraft deliveries are included in the operating
lease commitments table disclosed in section 9.3 of this MD&A. The impact of
these leases results in a significant reduction in capital expenditures from
what was previously projected.  Operating lease commitments have
increased as a result of this change.





Embraer




The
agreement with Embraer covers firm orders for 45 Embraer 190 series aircraft.
The purchase agreement also contains rights to exercise options for up to 60
additional Embraer 190 series aircraft as well as providing for conversion
rights to other Embraer models. As of December 31, 2007, 31 options remain
exercisable.




The
Embraer 190 series deliveries commenced in December 2005. As at December 31,
2007, 42 of the Embraer 190 series firm aircraft orders have been completed and
an additional aircraft was delivered in January 2008. The final two Embraer 190
series firm aircraft are scheduled for delivery in Quarter 1 2008.





Air
Canada has received loan commitments from third parties for the remaining three
firm aircraft covering approximately 80% of the capital expenditure to be repaid
in quarterly instalments for a 12-year term. Two of these aircraft will be based
on floating rates at the 90-day US LIBOR plus 1.90% and one will be based at the
fixed rate equivalent of the 90-day US LIBOR plus 1.70%.





Aircraft
Interior Refurbishment Program




In
addition to acquiring new aircraft, Air Canada commenced a major refurbishment
of the interior of its existing aircraft in April 2006.  Air Canada
has completed the refurbishment of 26 Airbus A319 aircraft, 30 Airbus A320
aircraft, 10 Airbus A321 aircraft and 15 Boeing 767-300 aircraft to date, for a
total of 81 aircraft. The Embraer and Boeing 777 aircraft are being delivered
with the new seats and entertainment systems already installed. The capital
expenditures associated with this program, which are committed, are amortized
over a five-year period.  A significant portion of the remaining
capital expenditures relating to this program are included in the capital
commitments table below.





Capital
Commitments




The
estimated aggregate cost of the future firm deliveries as well as other capital
purchase commitments as at December 31, 2007, including the impact of the sale
and lease back transaction described above and the loan guarantee support signed
in January 2008, approximates $4,739 million (of which $2,698 million is subject
to committed financing, subject to the fulfillment of certain terms and
conditions). US dollar amounts are converted using the December 31, 2007 noon
day rate of Cdn$0.9881. The estimated aggregate cost of aircraft is based on
delivery prices that include estimated escalation and, where applicable,
deferred price delivery payment interest calculated based on the US 90-day LIBOR
rate at December 31, 2007.




30


2007
      Management’s
      Discussion and Analysis


Projected
Planned and Committed Capital Expenditures




The
table below provides projections for aircraft expenditures for firm aircraft
orders, net of aircraft financing, combined with planned and committed
expenditures for aircraft engines, inventory, property and equipment, net of
related financing, if applicable, for the years 2008 through to 2012 and
thereafter.





In
addition to the firm aircraft orders, Air Canada's purchase agreements include
options and purchase rights, none of which are included in these
projections.





The
following table provides Air Canada’s current and planned committed capital
expenditures and the related financing arrangements as at December 31,
2007.  The table also reflects the letters of intent for the sale and
leaseback of four of the Boeing 777 aircraft scheduled for delivery in 2008 as
well as the EXIM loan guarantee support, all of which were signed in January
2008.





Projected
      planned and committedCapital
      expenditures ($ millions) (1)(2)
            2008
            2009
            2010
            2011
            2012
            ThereafterProjected
      committed expenditures
            $    555
            $    102
            $    760
            $    891
            $    692
            $    1,739Projected
      planned but uncommitted expenditures
            260
            205
            169
            104
            70Total
      projected expenditures
            
            815
            307
            929
            995
            762Projected
      financing on committed expenditures
            (591)
            -
            (684)
            (804)
            (619)Total
      projected expenditures,
              net
      of financing
            $    224
            $    307
            $    245
            $    191
            $    143





(1)
            US
      dollar amounts are converted using the December 31, 2007 noon day rate of
      1US$ = Cdn$0.9881. Final aircraft delivery prices include estimated
      escalation and interest on deferred delivery payments, which is calculated
      based on the 90-day USD LIBOR rate at December 31,
  2007.


(2)
            The
      dollar amounts reflected above do not include obligations pertaining to
      day-to-day operations.







9.6.        Air
Canada Fleet


Air
Canada’s operating fleet at December 31, 2007 (excluding aircraft operated by
Jazz under the Jazz CPA) was as follows:





Total
      seats
            Number
      of operating aircraft (1)
            Average
      age
            Owned(2)
            Capital
      Lease(2)
            Consolidated
      under
              AcG-15(2)
            Operating
      LeaseAir
      CanadaWidebody
      AircraftBoeing
      777-300
            349
            5
            0.6
            4
            -
            -
            1Boeing
      777-200
            270
            3
            0.3
            3
            -
            -
            -Boeing
      767-300
            203-222
            31
            14.4
            1
            6
            6
            18Boeing
      767-200
            207
            10
            20.7
            10
            -
            -
            -Airbus
      A340-300
            285-286
            5
            9.8
            -
            5
            -
            -Airbus
      A330-300
            274
            8
            7.2
            -
            8
            -
            -Narrowbody
      Aircraft
            
            
            -
            -
            -
            -Airbus
      A321
            166-174
            10
            5.8
            -
            -
            5
            5Airbus
      A320
            140
            41
            14.7
            -
            -
            -
            41Airbus
      A319
            120
            37
            9.7
            -
            17
            15
            5Embraer
      190
            93
            42
            0.9
            42
            -
            -
            -Embraer
      175
            73
            15
            2.3
            15
            -
            -
            -Total
            
            207
            9.0
            75
            36
            26
            70







(1)
            Excludes
      aircraft which have been removed from
service.


(2)
            Owned
      aircraft as well as capital leases and leases consolidated under AcG-15
      are carried on Air Canada’s statement of financial
      position.  Owned aircraft include aircraft financed under
      conditional sales agreements.







31


2007
      Management’s
      Discussion and Analysis


In
order to support the expansion of its international operations, Air Canada is
progressively introducing Boeing 777 aircraft into its fleet with nine Boeing
777 aircraft delivered to date.





The
following table provides the existing and planned fleet changes to Air Canada’s
fleet (excluding aircraft operated by Jazz):





Actual
            Planned
            Planned
      2009 fleet changesFleet
      Plan
            Year
      End 2006
            New
      Deliveries
            Sublease
      to Third Party
            Lease
      returns
            Sales
            Parked
            Year
      End 2007
            New
      Deliveries
            Sublease/lease
      to Third
              Party
      / Sale by Air Canada
            Lease
      returns
            Sales
            Parked
            Year
      End 2008
            Year
      End 2009B777-300
            -
            5
            -
            -
            -
            -
            5
            6
            -
            -
            -
            -
            11
            1
            12B777-200
            -
            3
            -
            -
            -
            -
            3
            3
            -
            -
            -
            -
            6
            -
            6B767-300
            33
            -
            -
            (2)
            -
            -
            31
            -
            -
            (2)
            -
            -
            29
            (1)
            28B767-200
            11
            -
            -
            -
            -
            (1)
            10
            -
            -
            -
            (4)
            (2)
            4
            -
            4A340-500
            2
            -
            (2)
            -
            -
            -
            -
            -
            -
            -
            -
            -
            -
            -
            -A340-300(1)
            10
            -
            (3)
            (2)
            -
            -
            5
            -
            (5)
            -
            -
            -
            -
            -
            -A330-300
            8
            -
            -
            -
            -
            -
            8
            -
            -
            -
            -
            -
            8
            -
            8A321
            10
            -
            -
            -
            -
            -
            10
            -
            -
            -
            -
            -
            10
            -
            10A320
            47
            -
            -
            (6)
            -
            -
            41
            -
            -
            -
            -
            -
            41
            -
            41A319(2)
            45
            -
            (6)
            -
            (2)
            -
            37
            -
            -
            (2)
            -
            -
            35
            -
            35EMB
      190
            18
            24
            -
            -
            -
            -
            42
            3
            -
            -
            -
            -
            45
            -
            45EMB
      175
            15
            -
            -
            -
            -
            -
            15
            -
            -
            -
            -
            -
            15
            -
            15Total
            199
            32
            (11)
            (10)
            (2)
            (1)
            207
            12
            (5)
            (4)
            (4)
            (2)
            204
            -
            204Average
      age
              (years)
            9.6
            
            
            
            
            
            9.0
            
            
            
            
            
            9.0
            
            9.9





(1)
            Two
      Airbus A340-300 aircraft were retired from service prior to December 31,
      2007. One of the aircraft is pending its return to the lessor and the
      second aircraft is pending its sublease to a third
  party.


(2)
            One
      Airbus A319 aircraft was retired from service prior to December 31, 2007
      pending its sale.








Pursuant
to the Jazz CPA, Jazz operates 133 aircraft with an average age of 12.5 years
comprised of the following aircraft:





·
            24
      Bombardier CRJ-100 aircraft;


·
            33
      Bombardier CRJ-200 aircraft;


·
            16
      Bombardier CRJ-705 aircraft;


·
            26
      Dash 8-300 aircraft; and


·
            34
      Dash 8-100 aircraft.







32


2007
      Management’s
      Discussion and Analysis




9.7.        ACE
Share Information




At
January 31, 2008, the issued and outstanding common shares of ACE, along with
common shares potentially issuable, pursuant to convertible preferred shares,
convertible notes and stock options were as follows:





Number
      of shares (000)
            At
      January 31, 2008Issued
      and outstanding common sharesClass
      A variable voting shares
            40,643Class
      B voting shares
            15,393Total
      issued and outstanding common shares
            56,036Common
      shares potentially issuableConvertible
      preferred shares
            11,338Convertible
      notes
            12,600Stock
      options
            1,678Total
      common shares potentially issuable
            25,616Total
      outstanding and potentially issuable common shares
            81,652





On
January 10, 2008, ACE accepted for purchase and cancellation a total of
40,023,427 Class A variable voting shares and 9,894,166 Class B voting shares at
$30.00 per share for an aggregate purchase price of approximately $1.498 billion
under the terms of a substantial issuer bid.  No convertible preferred
shares of ACE were deposited on an as converted basis under the
offer.





In
connection with the distributions of units of Aeroplan Income Fund and Jazz Air
Income Fund to the shareholders of ACE, the conversion rate of the 4.25%
Convertible Senior Notes, due 2035 (“Convertible Notes”) to Class A variable
voting shares (if the holder is not a Canadian) or Class B voting shares (if the
holder is Canadian) per $1,000 principal amount of Convertible Notes, was
adjusted to 37.6879 as at December 31, 2007.  Effective January 11,
2008, the conversion rate was further adjusted to 39.0341.




In
accordance with the terms of the ACE stock option plan, each distribution
triggered an adjustment to the weighted average exercise price and the number of
options outstanding.  Effective on the applicable dates of the
distributions, the adjustments were applied to all unexercised ACE stock
options, whether vested or not, in a consistent manner with the adjustment to
the conversion rate for the Convertible Notes.  In relation to the
January 10, 2007 distribution, the weighted average option exercise price and
number of options outstanding was amended from $26.04 and 3,570,390 options to
$20.95 and 4,436,644 options.  In relation to the March 14, 2007
distributions, the weighted average option exercise price and number of options
outstanding was amended from $22.02 and 3,397,496 options to $18.76 and
3,989,011 options.  In relation to the May 24, 2007 distributions, the
weighted average option exercise price and number of options outstanding was
amended from $18.53 and 3,854,370 options to $15.98 and 4,466,744
options.





The
Board of ACE resolved to vest all of the remaining unvested ACE stock options
under the rules of the ACE stock option plan and as accepted by the TSX,
effective November 12, 2007.  In 2007, 3,665,774 stock options were
exercised.











33


2007
      Management’s
      Discussion and Analysis


10.         Related
      Party Transactions


At
December 31, 2007, ACE had a 75% ownership interest in Air
Canada.  Air Canada has various related party transactions with ACE
and other ACE-related entities, including Aeroplan, Jazz and ACTS
Aero.   ACTS Aero conducts the business operated by ACTS prior to
the ACTS monetization completed on October 16, 2007.





The
Relationship between Air Canada and Aeroplan




At
December 31, 2007, ACE had a 20.1% ownership interest in Aeroplan Income
Fund.  Aeroplan operates a loyalty program which provides loyalty
marketing services to its customers.  The transactions between Air
Canada and Aeroplan described below are recorded at the exchange amount and are
settled by netting amounts payable against amounts receivable in accordance with
the intercompany agreements with any outstanding balance paid in the subsequent
period.  Accordingly, at December 31, 2007 and December 31, 2006, the
amounts have been presented on a net basis as the parties intend to settle on a
net basis.





Aeroplan Commercial
Participation and Services Agreement (Aeroplan CPSA)




Air
Canada and Aeroplan are parties to the Aeroplan CPSA dated June 9,
2004.  Pursuant to the Aeroplan CPSA, Air Canada allocates 8% of the
seat capacity to Aeroplan on the flights operated by Air Canada and Jazz and
certain other air carriers under the Air Canada code (collectively, the "AC
Flights") at a fixed redemption cost. In 2007, the rates charged for such seat
capacity were renegotiated in accordance with the Aeroplan CPSA for the period
January 1, 2008 through to December 31, 2010.Aeroplan may also
purchase an unlimited number of available seats based on published fares with a
variable discount depending on the fare product. Any adjustment to this variable
discount is based on an identified set of parameters. The Aeroplan CPSA also
provides that Aeroplan will be charged the lowest fares charged to any other
loyalty program taking into account Aeroplan’s volume purchase of Air Canada’s
seat inventory.   The Aeroplan CPSA expires June 29, 2020 with
four automatic renewals of five year each, unless either party provides notice
of its intention not to renew at least twelve months prior to the expiry of the
applicable term.





Air
Canada is one of Aeroplan’s leading partners and it pays a fee to participate in
the Aeroplan program, which fee is based on the Aeroplan miles awarded to
Aeroplan members who are Air Canada customers traveling on AC Flights. Aeroplan
is required to purchase a minimum number of reward travel seats on AC Flights
annually, 2007 - $171 million (2006 - $170 million), which number is a function
of Aeroplan’s consumption of seats in the three preceding calendar years.
Moreover, Air Canada is required to purchase a minimum number of Aeroplan miles
annually.





The
Aeroplan CPSA also provides that Aeroplan shall, in return for a service fee,
manage Air Canada’s frequent flyer tier membership program for Air Canada Super
EliteTM, EliteTM and PrestigeTM customers, as well as perform certain marketing and
promotion services for Air Canada, including call centre services for the
frequent flyer tier membership program.





Aeroplan Master Services
Agreement (Aeroplan MSA)




Air
Canada and Aeroplan are parties to the Aeroplan MSA effective January 1, 2005
pursuant to which Air Canada provides certain services to Aeroplan in return for
a fee based on Air Canada's fully-allocated cost of providing such services to
Aeroplan plus a mark-up to reflect overhead and administrative costs. Pursuant
to the Aeroplan MSA, Air Canada provides Aeroplan with infrastructure support
which is mostly administrative in nature, including information technology,
human resources, finance and accounting, and legal services.




Aeroplan General Services
Agreement (GSA)




Air
Canada and Aeroplan are parties to the Aeroplan GSA effective January 1, 2005
pursuant to which Air Canada provides Aeroplan with the services of a group of
call centre employees of Air Canada. Aeroplan must reimburse Air Canada for all
costs, including salary and benefits, related to the call centre employees on a
fully-allocated basis. With regard to the shortfall in the pension plan
maintained by Air Canada which covers, among others, these call centre
employees, Aeroplan has agreed to pay an amount not to exceed $11 million over a
six year period to compensate Air Canada for call centre employees' share of the
unfunded Air Canada pension liability.




34


2007
      Management’s
      Discussion and Analysis


Either
party may, subject to collective agreements of the employees assigned to
Aeroplan, terminate the GSA upon six months notice




Trademark License
Agreement




Pursuant
to a Trademark License Agreement effective May 13, 2005, Air Canada and Aeroplan
have granted each other reciprocal royalty-free, non-exclusive,
non-sublicensable, non-assignable rights to use certain of each other’s
trademarks around the world which incorporate their names or logos, solely in
association with the Aeroplan Program.




The
Relationship between Air Canada and Jazz




At
December 31, 2007, ACE had a 20.1% indirect ownership interest in Jazz Air
Income Fund.  On January 24, 2008, ACE reduced its ownership interest
in Jazz Air Income Fund to 9.5%.  Air Canada has no ownership interest
in Jazz. Jazz is consolidated in Air Canada’s consolidated financial statements
under AcG-15 up to May 24, 2007.  Jazz is still considered to be a
variable interest entity to Air Canada however Air Canada is no longer the
primary beneficiary under AcG-15.  Air Canada and Jazz negotiate
transactions between each other as unrelated parties and on an arm’s length
basis.  The deconsolidation of Jazz does not impact any of the
contractual arrangements between Air Canada and Jazz.





Jazz Capacity Purchase
Agreement (Jazz CPA)




Air
Canada and Jazz are parties to the Jazz CPA, effective January 1, 2006 pursuant
to which Air Canada purchases substantially all of Jazz’s fleet capacity based
on predetermined rates, in addition to reimbursing Jazz, without mark-up, for
certain pass-through costs as defined in the Jazz CPA which include fuel,
airport and navigation fees.  The fees include both a variable
component that is dependent on Jazz aircraft utilization and a fixed
component.    The initial term of the Jazz CPA expires
December 31, 2015.  There are two automatic renewal periods of five
years each, subject to either party’s right not to renew by notice at least one
year prior to the expiration of the then applicable term.  The rates
under the Jazz CPA are subject to periodic adjustment with the next adjustment
scheduled for the start of 2009.





Jazz Master Services
Agreement (Jazz MSA)




Air
Canada and Jazz are parties to the Jazz MSA pursuant to which Air Canada
provides certain services to Jazz in return for a fee based on the fair market
value of the services provided by Air Canada to Jazz.  Pursuant to the
Jazz MSA, Air Canada provides Jazz with infrastructure support consisting
principally of administrative services in relation with information technology,
corporate real estate, environmental affairs and legal services.  Jazz
benefits from certain information technology services available to Air Canada
from third parties and from Air Canada’s internal information technology
resources.





Either
Air Canada or Jazz may elect to terminate any services under the Jazz MSA
(without terminating the whole Jazz MSA) or the entire Jazz MSA upon one year’s
prior written notice.  The Jazz MSA terminates upon the termination of
the Jazz CPA.




Jazz Trademark License
Agreements




Air
Canada and Jazz are parties to the Jazz Trademark License Agreement pursuant to
which Air Canada has granted Jazz a royalty-free, non-exclusive,
non-sublicensable, non-assignable right to use certain trademarks owned or
registered by Air Canada around the world including “Jazz” and certain
trademarks which incorporate the Air Canada name, and/or Air Canada’s roundel
design, solely in association with the Jazz business.  The Jazz
Trademark License Agreement can be terminated in the event that the Jazz CPA is
terminated.  However, Air Canada and Jazz have also entered into a
Jazz Special Trademark Agreement which would grant all of Air Canada’s rights to
the Jazz trademark to Jazz (and preclude Air Canada from using the Jazz
trademark or licensing the Jazz trademark to third parties) upon the occurrence
of certain events involving (i) the expiration or termination of the Jazz CPA
if, at such time, Jazz is no longer an affiliate of Air Canada; (ii) the
occurrence of a change of control pursuant to which Jazz ceases to be an
affiliate of Air Canada if, at or prior to such time, the Jazz CPA has expired
or has been terminated; or (iii) the sale or transfer of all or substantially
all of the assets or business of Jazz to a third party that is not an affiliate
of Air Canada if, at or prior to such time, the Jazz CPA has expired or has been
terminated.




35


2007
      Management’s
      Discussion and Analysis


Air
Canada and Jazz are also parties to a number of lease agreements pursuant to
which Jazz leases or subleases, from Air Canada, certain premises at airports
across Canada.




The
Relationship between Air Canada and ACTS




ACTS
was a wholly-owned subsidiary of ACE providing full-service maintenance, repair
and overhaul services. On October 16, 2007, ACE sold substantially all of the
assets and liabilities of ACTS to ACTS Aero.  ACTS Aero conducts the
business previously operated by ACTS.  As at December 31, 2007, ACE
has a 23% interest in ACTS Aero.




The
ACTS Maintenance Agreements, the ACTS Master Services Agreement, the ACTS
Trademark License Agreement, the Repair Schemes and Non-Compete Agreement and
the ACTS General Services Agreements, all between Air Canada and ACTS and
described below were assigned from ACTS to ACTS Aero upon closing of the
monetization of ACTS.  On closing of the ACTS monetization, Air Canada
recorded proceeds of $28 million for the sale of a building to ACTS Aero, $17
million for the settlement of a intercompany note with ACTS, $20 million
pursuant to the transfer of repair schemes and as described below and the
funding of a letter of credit in the amount of $101 million related to a
“Pension and Benefits Agreement” as described below.  ACTS Aero is a
related party to the Corporation due to ACE’s investment in both
entities.




ACTS Maintenance
Agreements




ACTS
Aero and Air Canada are parties to a general terms and related services
agreements effective October 1, 2006, pursuant to which ACTS Aero provides
technical services to Air Canada including engine and auxiliary power unit
maintenance services, aircraft heavy maintenance services (excluding line and
cabin maintenance services which are provided by Air Canada), component
maintenance services, paint services, training services and ancillary services.
ACTS Aero serves as Air Canada's exclusive repair agency in respect of aircraft
heavy maintenance, engine maintenance, auxiliary power unit maintenance services
as well as for maintenance services relating to certain components. ACTS Aero
serves as Air Canada's non-exclusive repair agency in respect of other services
provided. Except for the services agreement relating to aircraft heavy
maintenance services which expires in October 2011 and the services agreement
relating to paint services which expires in October 2009, each of the agreements
referred to above expires in October 2013.




ACTS
Aero and Jazz are parties to a component maintenance agreement (the “ACTS-Jazz
Agreement”) dated August 1, 2005, pursuant to which ACTS Aero provides selected
maintenance, repair, overhaul and related services with respect to Jazz’s CRJ
regional jets. Pursuant to the ACTS-Jazz Agreement, ACTS Aero serves as Jazz’s
exclusive repair agency to provide component repair and overhaul work on parts
which can be removed from the aircraft in respect of CRJ-100/200 and common
CRJ-705 parts not performed internally by Jazz employees.  The initial
term of the ACTS-Jazz Agreement expires in August 2015 and it is renewable for
three successive two-year periods.  Jazz amounts with ACTS are not
reported for the period after Jazz’s deconsolidation on May 24,
2007.




ACTS Master Services
Agreement (ACTS MSA)




ACTS
Aero and Air Canada are parties to an amended and restated master services
agreement (the “ACTS MSA”), effective January 1, 2007, pursuant to which Air
Canada provides ACTS Aero with services including infrastructure support and
services which are mostly administrative in nature, including information
technology, human resources, finance and accounting, and claims services in
return for fees paid by ACTS Aero to Air Canada.  ACTS Aero may elect
to terminate any services under the ACTS MSA or the entire ACTS MSA upon six
months' prior written notice, with the exception of services relating to
information technology which ACTS Aero cannot terminate prior to the expiry of
the ACTS MSA. Air Canada may elect to terminate any services under the ACTS MSA
or the entire ACTS MSA upon 18 months' prior written notice.




36


2007
      Management’s
      Discussion and Analysis


ACTS Trademark License
Agreement




ACTS
Aero and Air Canada are parties to a trademark license agreement (the “ACTS
Trademark License Agreement”), effective September 30, 2004, pursuant to which
Air Canada has granted ACTS Aero a royalty-free, non-exclusive, non-assignable
right to use certain Air Canada trademarks which incorporate the Air Canada
name, and Air Canada's roundel design, solely in association with the provision
of heavy maintenance, component maintenance and supply chain business services
in Canada and the United States.  The ACTS Trademark License Agreement
was amended on closing of monetization of ACTS to provide for the termination of
the agreement on October 16, 2008.




ACTS General Services
Agreements




ACTS
Aero and Air Canada are parties to an amended and restated general services
agreement (the “ACTS GSA”), effective as of June 22, 2007 pursuant to which Air
Canada provides ACTS Aero with the services of a group of unionized employees
for which Air Canada is reimbursed by ACTS Aero for all costs, including salary
and benefits, on a fully allocated basis. Non-unionized employees, previously
assigned to ACTS under another general services agreement, were transferred to
ACTS on October 16, 2007.  The ACTS GSA may be terminated by either
party at any time upon 30 days' prior written notice.





Real Estate
Agreements




As
part of the closing of the monetization of ACTS, Air Canada sold a building to
ACTS Aero for proceeds of $28 million effective as of October 16,
2007.  In connection with the sale, Air Canada and ACTS Aero entered
into a land sublease for certain land contiguous with the building and a service
contract whereby Air Canada provides ACTS Aero certain services related to the
operation of the building.




ACTS
Aero and Air Canada are parties to a master lease agreement, effective as of
October 1, 2006, pursuant to which ACTS Aero leases space from Air Canada at the
Vancouver, Winnipeg, Toronto and Montreal airports.





Pension and Benefits
Agreement




Air
Canada, ACTS LP and ACTS Aero entered into a Pension and Benefits Agreement
effective as of October 16, 2007 (“Pension and Benefits Agreement”), relating to
pension and benefits arrangements pertaining to non-unionized and unionized
employees of Air Canada who were previously assigned to ACTS LP pursuant to
general services agreements between Air Canada and ACTS LP. On October 16, 2007,
non-unionized employees of Air Canada who were previously assigned to the ACTS
LP operation became employees of ACTS Aero.  New defined benefit and
defined contribution pension plans as well as other employee and retiree benefit
arrangements (including health, life and disability) are to be established by
ACTS Aero (the “ACTS Benefit Arrangements”).  Upon receipt of
regulatory approval where required and based upon valuations of the relevant
pension and benefit arrangements of Air Canada (the “Air Canada Benefit
Arrangements”) as at October 16, 2007, the assets and obligations under the Air
Canada Benefit Arrangements pertaining to the transferring non-unionized
employees will be transferred to ACTS Aero or the ACTS Benefit Arrangements, as
applicable.  Any solvency deficiency in the defined benefit pension
plans as at October 16, 2007 related to transferring non-unionized employees
will be funded by Air Canada through quarterly payments to ACTS Aero until
2014.  The accounting liability as at October 16, 2007 in respect of
retiree and disability benefits related to transferring non-unionized employees
will be funded by Air Canada through quarterly payments to ACTS Aero until
2012.  Until such future time as the assets and obligations under the
Air Canada Benefit Arrangements pertaining to non-unionized employees may be
transferred to ACTS Aero, the current service pension cost and the current
service and interest costs for other employee benefits will be expensed by Air
Canada with a full offset recorded as an amount charged to affiliates (ACTS
Aero).





In
addition, the Pension and Benefits Agreement contemplates similar asset and
liability transfer and compensation arrangements in respect of unionized
employees, which arrangements would take effect at such future time as those
unionized employees may be transferred from Air Canada to ACTS
Aero.  However, the solvency deficiencies in respect of transferring
unionized employees for which the future quarterly compensation payments would
be made are determined as at October 16, 2007, subject to certain adjustments,
and the discount rate used to compute the accounting liability for the unionized
employees’ retiree and disability benefits is fixed as at October 16,
2007.  The compensation payments in respect of these




37


2007
      Management’s
      Discussion and Analysis


solvency
deficiencies and accounting liabilities would be made quarterly during the five
years beginning after the unionized employees are transferred to ACTS Aero, but
only if such a transfer occurs.  Until such future time as the assets
and obligations under the Air Canada Benefit Arrangements pertaining to
unionized employees may be transferred to ACTS Aero, the current service pension
cost and the current service and interest costs for other employee benefits in
respect of Air Canada employees providing services to ACTS Aero are charged to
ACTS Aero.





The
Pension and Benefits Agreement also required that Air Canada provide letters of
credit to ACTS Aero on October 16, 2007, to secure the above-described payment
obligations in respect of the solvency deficiencies of the defined benefit
pension plans and accounting liabilities for other retiree and disability
benefit arrangements. The letters of credit total $101 million, subject to
adjustment once the exact amounts of the relevant solvency deficiencies and
accounting liabilities as at October 16, 2007 are determined by actuarial
valuations.  The face amount of the letter of credit in respect of the
unionized solvency deficiency is also adjusted annually to recognize past
service costs paid by Air Canada to the plan in respect of unionized employees
assigned to ACTS Aero.  The face amounts of the letters of credit
decrease as the related quarterly funding payments described above are
made.  ACTS Aero may call the letters of credit in whole or in part,
in the event of a default as defined in the Pension and Benefits
Agreement.  Collateral equal to the amount of the letters of credit
was paid in cash with the asset recorded in deposits and other
assets.





Non-Compete and Repair
Schemes Transfer Agreement




ACTS
Aero and Air Canada are parties to a non-compete and repair schemes transfer
agreement, effective as of October 16, 2007 (the “Repair Schemes and Non-Compete
Agreement”).  Generally described, repair schemes are processes and
methods which may be used in the maintenance and repair of aircraft and related
equipment.  The Repair Schemes and Non-Compete Agreement confirmed an
arrangement and provides for the sale from Air Canada to ACTS Aero (as successor
to ACTS) of an undivided joint ownership interest in repair schemes owned by Air
Canada or approved under Air Canada’s airworthiness engineering organization as
well as the sale from ACTS Aero to Air Canada of an undivided joint ownership
interest in the repair schemes owned or developed by ACTS Aero and applicable to
airframe heavy maintenance services provided by ACTS Aero to Air Canada under
the parties’ airframe heavy maintenance services agreement. However, in
September 2004, as part of the implementation of the Corporation’s plan of
arrangement under the Companies’ Creditors Arrangement Act, the Corporation had
already granted ACTS full and exclusive right to these schemes on a royalty-free
basis.





The
Repair Schemes and Non-Compete Agreement also restricts Air Canada’s ability to
own any equity interest in an entity (other than entities in which Air Canada
previously held interests), or to carry on a business activity, related to the
following commercial maintenance, repair and overhaul services in the airline
industry, namely, airframe heavy maintenance and paint services, engine and
auxiliary power unit (“APU”) overhaul maintenance services, and component
maintenance services. The applicable non-compete periods are as
follows:







·
            With
      respect to airframe heavy maintenance services and paint services, the
      non-compete period ends one year after the current heavy maintenance
      services agreement is terminated or expires (the current term of the heavy
      maintenance services agreement expires October 1,
  2011);




·
            With
      respect to engine and APU overhaul maintenance services, the non-compete
      period ends on October 1, 2015; and




·
            With
      respect to component maintenance services, the non-compete period ends on
      October 1, 2016.




The
Repair Schemes and Non-Compete Agreement does not restrict Air Canada from
holding interests in any entities in which it held interests at the time of
concluding the agreement nor does it limit Air Canada’s line maintenance
activities which it continues to operate.




In
consideration for the transfer of repair schemes, Air Canada received $20
million in 2007.




38


2007
      Management’s
      Discussion and Analysis


Loan and Prepayment
Agreements between ACTS and Air Canada




Pursuant
to a Prepayment Agreement dated October 26, 2006, Air Canada prepaid an amount
of approximately $595 million to ACTS Limited Partnership (the predecessor to
ACTS LP and ACTS Aero) under the ACTS Maintenance Agreements for the estimated
equivalent of 12 months of service to be rendered to Air Canada under the ACTS
Maintenance Agreements starting on November 1, 2006. The amount of such
prepayment was immediately loaned back by ACTS to Air Canada pursuant to a loan
agreement dated October 26, 2006. Such loan was non-interest bearing and
repayable in instalments starting on November 1, 2006. The amount of the
instalments was equal to the amount that would otherwise have been payable
by Air Canada under the ACTS Maintenance Agreements and became due and payable
on the day on which the amount became payable under the ACTS Maintenance
Agreements. Repayment of the entire amount of the loan was completed in
2007.





The
Relationship between Air Canada and ACE





Air Canada
Vacations




In
2007, ACE sold its 49% interest in Air Canada Vacations to Air
Canada.  Air Canada Vacations is now 100% owned by Air
Canada.  Air Canada Vacations remains consolidated within the results
of the Corporation.





Share purchase rights sold
by Air Canada to ACE




During
2007, Air Canada entered into an aircraft transaction with an unrelated third
party whereby partial consideration was paid to Air Canada in the form of a
right to acquire shares of the unrelated third party.  The transaction
related to the sale by Air Canada of two Airbus A319 aircraft and the sublease
by Air Canada of an additional two Airbus A319 aircraft, all of which was
completed in 2007 with the exception of one of the owned A319 aircraft, which
was completed in January 2008.  Air Canada sold the right to acquire
shares received from the unrelated third party to ACE, at fair value, for
proceeds of $1 million.





Warrants purchased from
ACE




During
2007, Air Canada purchased certain share warrants held by ACE for consideration
of $4 million.  These warrants are for the purchase of shares of an
unrelated third party from which Air Canada purchases services.





ACE Master Services
Agreement (ACE MSA)




Air
Canada provides certain administrative services to ACE in return for a fee. Such
services relate to finance and accounting, information technology, human
resources and other administrative services.




39




2007
      Management’s
      Discussion and Analysis


The
related party balances resulting from the application of the commercial
agreements were as follows:




($
      millions)
            
            2007Accounts
      receivableAeroplan
      (Air Canada)
            
            $      20Aeroplan
      - distribution receivable (ACE)
            
            3Jazz
      (Air Canada)
            
            85Jazz
      - distribution receivable (ACE)
            
            2ACTS
      Aero (Air Canada)
            
            99$   209Accounts
      payable and accrued liabilitiesJazz
      (Air Canada)
            
            $     71ACTS
      Aero (Air Canada)
            
            88$   159





The
related party revenues and expenses with Aeroplan (period from March 14, 2007 to
December 31, 2007), Jazz (period from May 24, 2007 to December 31, 2007) and
ACTS Aero (period from October 16 to December 31, 2007) are summarized as
follows:





($
      millions)
            
            2007RevenuesRevenues
      from Aeroplan related to Aeroplan rewards net of purchase of Aeroplan
      miles
            $    137Property
      rental revenues from related parties
            
            11Revenues
      from corporate services and other
            
            24Aircraft
      sublease revenues from Jazz
            
            14Air
      Canada Ground Handling revenues from Jazz
            
            33Maintenance
      revenue from Jazz (ACTS)
            
            21$   240ExpensesMaintenance
      expense for services from ACTS/ACTS Aero
            
            $    107Expense
      from Capacity Purchase Agreement with Jazz
            
            537Pass
      through fuel expense from Jazz
            
            197Pass
      through airport expense from Jazz
            
            120Pass
      through other expense from Jazz
            
            17Other
      expenses
            
            9Recovery
      of wages, salary and benefit expense for employees assigned to related
      parties
            (43)$   944





In
addition to the above revenues and expenses with Jazz, Air Canada transfers fuel
inventory and subleases certain aircraft to Jazz on a flow through basis, which
are reported net on Air Canada’s statement of operations.










40


2007
      Management’s
      Discussion and Analysis


11.         Off-Balance
      Sheet Arrangements


The
following is a summary of the Corporation’s more significant off-balance sheet
arrangements.





Guarantees




Performance Obligations
Relating to Aircraft Leasing Agreements




With
respect to 45 Air Canada aircraft leases, the difference between the amended
rents as a result of the implementation of the Plan of Reorganization,
Compromise and Arrangement (the “Plan”) under the Companies’ Creditors
Arrangement Act (“CCAA”) on September 30, 2004 and amounts due under the
original lease contracts will be forgiven at the expiry date of the leases if no
material defaults have occurred. If a material default occurs, this difference
plus interest will become due and payable and all future rent will be based on
the original contracted rates. Rent expense is being recorded on the
renegotiated lease agreements and any liability would be recorded only at the
time management believes the amount is likely to occur.




Guarantees in Fuel
Facilities Arrangements




Air
Canada participates in fuel facility arrangements operated through fuel facility
corporations ("Fuel Facility Corporations"), along with other airlines that
contract for fuel services at various major airports in Canada. The Fuel
Facility Corporations operate on a cost recovery basis. The purpose of the Fuel
Facility Corporations is to own and finance the system that distributes the fuel
to the contracting airlines, including leasing the land rights under the land
lease. The aggregate debt of the five Fuel Facility Corporations in Canada that
have not been consolidated by Air Canada under AcG-15 was approximately $119
million as at December 31, 2007 ($108 million as at December 31, 2006), which is
Air Canada’s maximum exposure to loss without taking into consideration any cost
sharing that would occur amongst the other contracting airlines. Air Canada’s
views this loss potential as remote. Each contracting airline participating in a
Fuel Facility Corporation shares pro-rata, based on system usage, in the
guarantee of this debt.




Indemnification
Agreements




Air
Canada enters into real estate leases or operating agreements, which grant a
license to Air Canada to use certain premises, in substantially all cities that
it serves. It is common in such commercial lease transactions for Air Canada, as
the lessee, to agree to indemnify the lessor and other related third parties for
tort liabilities that arise out of or relate to the Corporation's use or
occupancy of the leased or licensed premises. Exceptionally, this indemnity
extends to related liabilities arising from the negligence of the indemnified
parties, but usually excludes any liabilities caused by their gross negligence
or willful misconduct. Additionally, Air Canada typically indemnifies such
parties for any environmental liability that arises out of or relates to its use
or occupancy of the leased or licensed premises.




In
aircraft financing or leasing agreements, Air Canada typically indemnifies the
financing parties, trustees acting on their behalf and other related parties
and/or lessors against liabilities that arise from the manufacture, design,
ownership, financing, use, operation and maintenance of the aircraft and for
tort liability, whether or not these liabilities arise out of or relate to the
negligence of these indemnified parties, except for their gross negligence or
willful misconduct. In addition, in aircraft financing or leasing transactions,
including those structured as leveraged leases, Air Canada typically provides
indemnities in respect of various tax consequences including in relation to the
leased or financed aircraft, the use, possession, operation, maintenance,
leasing, subleasing, repair, insurance, delivery, import, export of such
aircraft, the lease or finance arrangements entered in connection therewith,
changes of law and certain income, commodity and withholding tax
consequences.




When
Air Canada, as a customer, enters into technical service agreements with service
providers, primarily service providers who operate an airline as their main
business, Air Canada has from time to time agreed to indemnify the service
provider against liabilities that arise from third party claims, whether or not
these liabilities arise out of or relate to the negligence of the service
provider, but excluding liabilities that arise from the service provider's gross
negligence or willful misconduct.




41


2007
      Management’s
      Discussion and Analysis




Under
its general by-laws, Air Canada has indemnification obligations to its directors
and officers. Pursuant to such obligations, the Corporation indemnifies these
individuals, to the extent permitted by law, against any and all claims or
losses (including amounts paid in settlement of claims) incurred as a result of
their service to Air Canada.




The
maximum amount payable under the foregoing indemnities cannot be reasonably
estimated. Air Canada expects that it would be covered by insurance for most
tort liabilities and certain related contractual indemnities described
above.













42


2007
      Management’s
      Discussion and Analysis


12.         Derivatives
      and Financial
Instruments
 Air
Canada manages its currency risk, interest rate risk and market risk through the
use of various foreign exchange, interest rate and fuel derivative financial
instruments.





Fuel
Price Risk Management


To
manage its exposure to jet fuel prices and minimize volatility in operating cash
flows, Air Canada enters into derivative contracts with financial
intermediaries.  As at December 31, 2007, Air Canada had mainly collar
options and swap structures in place to hedge a portion of its anticipated jet
fuel requirement over the 2008, 2009 and 2010 periods.  Air Canada
uses derivative contracts on jet fuel and also on other crude oil-based
commodities, such as heating oil and crude oil, due to the relative limited
liquidity of jet fuel derivative instruments on a medium to long term horizon,
since jet fuel is not traded on an organized futures exchange.  Air
Canada does not purchase or hold any derivative financial instruments for
trading purposes.





As at
December 31 2007, Air Canada had hedged 20% of its projected fuel requirement
for 2008, 3% of its projected fuel requirement for 2009 and 2% of its fuel
requirement for 2010.  Since December 31, 2007, Air Canada has entered
into new hedging positions, using swap and costless collar option structures,
which have added 8% coverage to 2008, 3% coverage to 2009 and 1% coverage to
2010.  2008 is hedged at prices that can fluctuate between an average
of US$101 to US$103 per barrel for jet-fuel based contracts, an average of US$94
to US$98 per barrel for heating oil-based contracts and an average of US$61 to
US$68 per barrel for West Texas Intermediate (WTI) crude-oil based
contracts.





Air
Canada designates certain of its fuel derivatives as cash flow hedges and
applies hedge accounting as prescribed under CICA section 3865,
Hedges.  Air Canada also holds certain fuel derivatives instruments
that do not qualify for hedge accounting.  Management believes that
these derivatives constitute good economic hedges in managing Air Canada’s
exposure to jet fuel prices.  These contracts, classified as economic
hedges, are recorded at fair value at each balance sheet date and the change in
fair value is recognized in non-operating income (expense) when it
occurs.





Fuel
derivative instruments designated under hedge accounting result in all period
changes in the fair value of the hedging items that are considered effective
being recorded in Accumulated Other Comprehensive Income (“AOCI”) until the
underlying jet fuel is consumed.  Upon maturity of the hedging item,
the effective gains and losses are recorded in fuel expense.  The
ineffective component of the change in fair value is recorded in non-operating
income (expense).  Air Canada is exposed to the risk that periodic
changes in fair value will not be perfectly effective.  As defined by
Air Canada’s fuel hedging policy, ineffectiveness results when the change in the
derivative’s fair value does not perfectly offset the change in the intrinsic
value of the anticipated jet fuel purchase.  The ineffective portion
relating to the change in a derivative’s intrinsic value is calculated by
comparing it to the change in intrinsic value of a proxy perfect hedge based on
Air Canada’s jet fuel weighted average price.  As Air Canada’s current
policy does not take into account variables affecting fair value such as
volatility and time value of money, a significant component of the change in
fair value of outstanding fuel derivatives may be recorded as ineffective under
the current policy.





Ineffectiveness
is inherent in hedging diversified jet fuel purchases with derivative positions
in crude oil and related commodities and in the differences between intrinsic
values and fair values of the derivative instruments, especially given the
magnitude of volatility observed in oil market prices.  Air Canada is
unable to predict the amount of ineffectiveness that could be recorded for each
period.  This may result, and has resulted, in increased volatility in
the accounting results of Air Canada but has no impact on the underlying cash
flows.





The
following information summarizes the financial statement impact of derivatives
designated under fuel hedge accounting before the impact of tax:





·
            The
      fair value of outstanding fuel derivatives under hedge accounting at
      December 31, 2007 was $67 million in favour of Air
  Canada.





·
            The
      2007 benefit to fuel expense for the year ended December 31, 2007 was $31
      million.








43


2007
      Management’s
      Discussion and Analysis


·
            The
      non-operating income (expense) for the year ended December 31, 2007 was
      $12 million.  The amount in non-operating income (expense)
      represents the ineffective portion of the fair value change in items under
      hedge accounting.





·
            The
      effective change in the fair value of derivatives recorded in OCI for the
      period was $110 million before tax expense of $28 million.  OCI
      amounts for the year ended December 31, 2007 are presented net of this tax
      expense in Air Canada’s consolidated statement of comprehensive
      income.





·
            The
      estimated net amount of existing gains and losses reported in AOCI that is
      expected to be reclassified to net income during 2008 is $68
      million.





The
following provides the changes in fair value of derivatives not designated under
hedge accounting, but held as economic hedges before the impact of tax during
the year ended December 31, 2007:





·
            The
      fair value of outstanding fuel derivatives not under hedge accounting at
      December 31, 2007 was $10 million in favour of Air
  Canada.





·
            The
      non-operating income for the year ended December 31, 2007 was $26
      million.  The amount in non-operating income (expense)
      represents the change in fair value of these contracts (realized and
      unrealized) since December 31 2006.





Foreign
Exchange Risk Management


Air
Canada enters into certain foreign exchange forward contracts or currency swaps
to manage the risks associated with foreign currency exchange
rates.  As at December 31, 2007, Air Canada had entered into foreign
currency forward contracts and option agreements on US$2.158 billion and EUR$18
million of future purchases in 2008 and 2009.  The fair value of these
foreign currency contracts as at December 31, 2007 was $124 million in favour of
the counterparties (December 31, 2006 - $25 million in favour of Air Canada on
US$503 million of future purchases in 2007).  These derivative
instruments have not been designated as hedges for accounting
purposes.  The unrealized loss has been recorded in foreign exchange
gain (loss).





Air
Canada has entered into currency swap agreements for 16 CRJ operating leases
until lease terminations between 2007 and 2011.  During 2007, five
currency swaps were settled with a fair value of $10 million (which was equal to
carrying value) (December 31, 2006 - $10 million in favour of the
counterparties).  Air Canada has 11 currency swap agreements
remaining. These currency swaps with third parties have a nominal fair value in
favour of Air Canada as at December 31, 2007 (December 31, 2006 — $3 million
favour of Air Canada). The notional amount under these swaps is US$79 million as
at December 31, 2007 (December 31, 2006 – US$88 million).  These have
not been designated as hedges for hedge accounting purposes.





Interest
Rate Risk Management


Air
Canada enters into forward interest rate agreements to manage the risks
associated with interest rate movement on US dollar and Canadian dollar floating
rate debt. During 2006, Air Canada entered into 19 interest rate swaps with a
notional value of US$414 million to receive floating rates and pay a weighted
average fixed rate of 5.81% for the debt to be arranged in relation to the
financing of Embraer 190 aircraft between June 2006 and February 2008. The swaps
have 15-year terms from the expected delivery date of the aircraft and their
maturities range from June 2021 to December 2022. Air Canada has been settling
the interest rate swaps upon delivery of the related aircraft. Air Canada did
not apply hedge accounting to these derivative instruments. As at December 31,
2007, one contract remains outstanding with a fair value of $2 million in favour
of the counterparty.  (December 31, 2006 - $13 million in favour of
the counterparty for 12 contracts outstanding).  During 2007, 11
contracts were settled at a net loss of $10 million.





Air
Canada has entered into two interest rate swap agreements with a term to January
2024 which convert lease payments related to two Boeing 767 aircraft leases
consolidated under AcG-15 from fixed to floating rates.  These have
not been designated as hedges for accounting purposes.  As at December
31, 2007, these two swaps have a fair value of $7 million in favour of Air
Canada ($4 million in favour of Air Canada as at December 31,
2006).  The notional amount under these two swaps is US$104 million as
at December 31, 2007 (December 31, 2006 – US$112 million).


44


2007
      Management’s
      Discussion and Analysis




Statement
of Consolidated Financial Position - Fair Values of Financial
Instruments


The
carrying amounts reported in the Corporation’s consolidated statement of
financial position for cash and short-term investments, accounts receivable and
accounts payable approximate fair values due to the immediate or short-term
maturities of these financial instruments.





The
carrying amounts of foreign currency and interest rate swaps and fuel
derivatives is equal to the fair value, which is based on the amount at which
they could be settled based on estimated current market rates.




The
following is a comparison of fair value versus carrying value of the
Corporation’s long-term debt and capital lease obligations, as at December 31,
2007, which was estimated using valuation techniques based on current market
rates of interest for similar financial liabilities:




($
      millions)
            Carrying
      Value
            Estimated
      Fair ValueDirect
      Corporation debt
            $    2,551
            $    2,611Convertible
      Senior Notes
            273
            273Debt
      consolidated under AcG-15
            896
            933Capital
      lease obligations
            972
            1,127$   4,692
            $   4,944








Concentration
of Credit Risk


The
Corporation does not believe it is subject to any significant concentration of
credit risk. Cash and short-term investments are in place with major financial
institutions, Canadian governments and major corporations. Accounts receivable
are generally the result of sales of tickets to individuals, often through the
use of major credit cards, through geographically dispersed travel agents,
corporate outlets, or other airlines, often through the use of major credit
cards.





Asset-Backed
Commercial Paper (ABCP)


Air
Canada holds $37 million ($29 million net of a fair value adjustment) in a
non-bank sponsored ABCP which has been recorded in deposits and other assets on
the statement of financial position.  These investments, which were
scheduled to mature during Quarter 3 2007, were previously recorded in cash and
cash equivalents and the transfer to deposits and other assets was reflected as
an investing activity on Air Canada’s consolidated statement of cash
flows.  An agreement in principle to restructure the ABCP investments
was approved by the Pan-Canadian Committee for Third Party Structured ABCP
(“Committee”) on December 23, 2007.  The approval of the
restructuring, subject to a vote by all investors, is anticipated to occur by
March 2008.  Under the terms of the restructuring, all of the ABCP
would be exchanged for longer term notes that will match the maturity of the
underlying assets in the proposed structure.  Air Canada is not
accruing interest on these investments.




During
2007, Air Canada recorded a charge of $8 million ($5 million after tax) in
non-operating income (expense).  The charge is based on a number of
assumptions as to the fair value of the investments including factors such as
estimated cash flow scenarios and risk adjusted discount rates.  The
assumptions used in estimating the fair value of the investments are subject to
change, which may result in further adjustments to non-operating results in the
future.












45


2007
      Management’s
      Discussion and Analysis


13.         Critical
      Accounting Estimates
 Critical
accounting estimates are those that are most important to the portrayal of the
Corporation’s financial condition and results of operations. They require
management's most difficult, subjective or complex judgments, often as a result
of the need to make estimates about the effect of matters that are inherently
uncertain. Actual results could differ from those estimates under different
assumptions or conditions.





The
Corporation has identified the following areas that contain critical accounting
estimates utilized in the preparation of its consolidated financial
statements:





Passenger
and Cargo Revenues


Air
Canada passenger and cargo advance sales are deferred and included in current
liabilities. Advance sales also include the proceeds from the sale of flight
tickets to Aeroplan which provides loyalty program services to the Corporation
and purchases seats from Air Canada under the Aeroplan
CPSA.  Passenger and cargo revenues are recognized when the
transportation is provided, except for revenue on unlimited flight passes which
is recognized on a straight-line basis over the period during which the travel
pass is valid. Air Canada has formed alliances with other airlines encompassing
loyalty program participation, code sharing and coordination of services
including reservations, baggage handling and flight schedules. Revenues are
allocated based upon formulas specified in the agreements and are recognized as
transportation is provided.





Air
Canada performs regular evaluations on the deferred revenue liability which may
result in adjustments being recognized as revenue. Due to the complex pricing
structures, the complex nature of interline, and other commercial agreements
used throughout the industry, historical experience over a period of many years,
and other factors including refunds, exchanges and unused tickets, certain
relatively small amounts are recognized as revenue based on estimates. Events
and circumstances may result in actual results that are different from
estimates, however, these differences have historically not been
material.





Employee
Future Benefits


Air
Canada maintains several defined benefit and defined contribution plans
providing pension, other retirement and post-employment benefits to its
employees, including those employees of Air Canada who are contractually
assigned to ACTS Aero and Aeroplan.  These employees are members of
Air Canada’s sponsored defined benefit pension plans and also participate in Air
Canada’s sponsored health, life and disability future benefit
plans.  Air Canada’s audited consolidated financial statements for
2007 include all of the assets and liabilities of all sponsored plans of Air
Canada. Employee benefits expense reflects a cost recovery which is charged to
the related parties for those employees currently performing work for their
benefit.  The cost recovery includes current service costs for
pensions along with their portion of post-employment and post-retirement
benefits based on the actuarial calculation for their specific employee
group.  The cost recovery amounted to $40 million for the year ended
December 31, 2007.






46


2007
      Management’s
      Discussion and Analysis




Management
makes a number of assumptions in the calculation of both the accrued benefit
obligation as well as the pension costs:





December
      31, 2007
            December
      31, 2006Weighted
      average assumptions used todetermine
      accrued benefit obligationDiscount
      rate as at period-end
            
            5.75%
            5.00%Rate
      of compensation increase(1)
            
            2.50%
            2.50%Weighted
      average assumptions used todetermine
      pension costsDiscount
      rate as at period-end
            
            5.00%
            5.00%Expected
      long-term rate of return on plan assets
            
            7.15%
            7.50%Rate
      of compensation increase (2)
            
            2.50%
            4.00%





(1)
            As
      a result of the pay awards during 2006, a rate of compensation increase of
      1.75% was used for the years 2007 and 2008 in determining the net benefit
      obligation for the pension plan and 2.5% for the remaining
      years.


(2)
            A
      rate of compensation increase of 2% in 2006 and 2% in 2007 was used in
      determining the net benefit pension
expense.





Discount
Rate


The
discount rate used to determine the pension obligation was determined by
reference to market interest rates on corporate bonds rated "AA" or better with
cash flows that approximately match the timing and amount of expected benefit
payments.





Expected Return on Assets
Assumption


Air
Canada’s expected long-term rate of return on assets assumption is selected
based on the facts and circumstances that exist as of the measurement date and
the specific portfolio mix of plan assets. Air Canada’s management, in
conjunction with its actuaries, reviews anticipated future long-term performance
of individual asset categories and considers the asset allocation strategy
adopted by Air Canada, including the longer duration in its bond portfolio in
comparison to other pension plans. These factors are used to determine the
average rate of expected return on the funds invested to provide for the pension
plan benefits. While the review considers recent fund performance and historical
returns, the assumption is primarily a long-term, prospective rate.





Asset
Allocation


The
composition of the domestic registered plan assets and the target allocation
consists of the following:





November
      30, 2007
            November
      30, 2006
            Target
      allocationEquity
            58.9%
            59.1%
            59.0%Bonds
      and Mortgages
            36.1%
            34.7%
            41.0%Short-term
      and Other
            5.0%
            6.2%
            0.0%Total
            100.0%
            100.0%
            100.0%





Domestic Registered
Plans


For
the domestic registered plans, the investments conform to the Statement of
Investment Policy and Objectives of the Air Canada Pension Master Trust Fund
(Fund). The investment return objective of the Fund is to achieve a total
annualized rate of return that exceeds inflation by at least 3.75% over the long
term.





In
addition to the broad asset allocation, as summarized in the asset allocation
section above, the following policies apply to individual asset
classes:





·
            Equity
      investments can include convertible securities and are required to be
      diversified among industries and economic sectors. Foreign equities can
      comprise 37% to 43% of the total market value of the trust. Limitations
      are placed on the overall allocation to any individual security at both
      cost and market value. Derivatives are permitted to the extent they are
      not used for speculative purposes or to create
  leverage.






47


2007
      Management’s
      Discussion and Analysis


·
            Bond
      and mortgage investments are oriented toward risk averse, long-term,
      investment grade securities rated "A" or higher. With the exception of
      Government of Canada securities, or a province thereof, in which the plan
      may invest the entire fixed income allocation, fixed income investments
      are required to be diversified among individual securities and sectors.
      The target return is comprised of 40% of the total return of the Scotia
      Capital Universe Bond Index and 60% of the total return of the Scotia
      Capital Long Term Bond Index.





Similar
investment policies are established for the other pension plans sponsored by Air
Canada.





Best Estimate of Employer
Contributions


Based
upon an agreement between Air Canada and representatives of the unionized and
non-unionized employees and retirees with respect to the funding of the domestic
registered plans, which agreement is subject to approval of the Office of the
Superintendent of Financial Institutions (Canada) ("OSFI"), the actual 2006 and
2007 contributions were as follows:





($
      millions)
            
            2007
      Contributions
            2006
      ContributionsPast
      service cost for registered pension plans
            
            $     134
            $     224Current
      service cost for registered pension plans
            
            160
            140Other
      pension arrangements (1)
            
            84
            83Air
      Canada (2)
            
            $     378
            $     447Jazz
            
            4
            8Consolidated
            
            $    382
            $    455





(1)
            Includes
      retirement compensation arrangements, supplemental plans and international
      plans.


(2)
            Includes
      obligations relating to employees who have been assigned to related
      parties.





Jazz’s
employer contributions amounted to $8 million in 2006 and $4 million for the
period up to May 24, 2007.





As
previously discussed, Air Canada recovers costs relating to some employees who
have been contractually assigned to ACTS Aero and Aeroplan. The cost recovery
relating to Air Canada’s sponsored defined pension plans amounted to $23 million
for 2007 and $33 million for 2006. The cost recovery relating to Air Canada’s
sponsored future benefit plans amounted to $17 million for 2007 and $23 million
for 2006.





Sensitivity
Analysis


Sensitivity
analysis on the 2007 pension expense based on different actuarial assumptions
with respect to discount rate and expected return on plan assets is as
follows:





0.25
      percentage pointImpact
      on 2007 pension expense in $ millions
            Decrease
            IncreaseDiscount
      rate on obligation assumption
            $    12
            $    (12)Long-term
      rate of return on plan assets assumption
            $    27
            $    (27)





Assumed
health care cost trend rates have a significant effect on the amounts reported
for the health care plans. A 9.25% annual rate of increase in the per capita
cost of covered health care benefits was assumed for 2007 (9.75% was assumed for
2006). The rate is assumed to decrease gradually to 5% by 2013. A one percentage
point increase in assumed health care trend rates would have increased the
service and interest costs by $1 million and the obligation by $16 million. A
one percentage point decrease in assumed health care trend rates would have
decreased the service and interest costs by $1 million and the obligation by $16
million.





Income
Taxes


The
Corporation utilizes the liability method of accounting for income taxes under
which future income tax assets and liabilities are recognized for the estimated
future income tax consequences attributable to differences between the financial
statement carrying value amount and the tax basis of assets and
liabilities.  Management uses judgment and estimates in determining
the appropriate rates and amounts in recording future taxes, giving
consideration to timing and probability.  Actual taxes could
significantly vary from these estimates as a result of future events, including
changes in income tax law or the outcome of reviews by tax authorities and
related appeals.  The resolution of these uncertainties and the
associated final taxes may result in adjustment to the Corporation’s tax assets
and tax liabilities.




48


2007
      Management’s
      Discussion and Analysis


Future
income tax assets are recognized to the extent that realization is considered
more likely than not.  The Corporation considers past results, current
trends and outlooks for future years in assessing realization of income tax
assets.




Cash
Tax Projections


As at December 31, 2007, the
Corporationhas substantial tax attributes largely in the form of
undepreciated capital cost and other tax attributes to shelter future taxable
income.  These tax attributes are expected to continue to increase
over the next several years due to capital expenditures related to aircraft
acquisitions. The Corporation does not forecast having any significant current
taxes payable within the foreseeable future.





Impairment
of Long-Lived Assets


Long-lived
assets are tested for impairment whenever circumstances indicate that the
carrying value may not be recoverable.  When events or circumstances
indicate that the carrying value of long-lived assets, other than indefinite
life intangibles, are not recoverable, the long-lived assets are tested for
impairment by comparing the estimate of future expected cash flows to the
carrying amount of the assets or groups of assets. If the carrying value of
long-lived assets is not recoverable from future expected cash flows, any loss
is measured as the amount by which the asset's carrying value exceeds fair value
and recorded in the period. Recoverability is assessed relative to undiscounted
cash flows from the direct use and disposition of the asset or group of
assets.  Assessing the fair value of intangible assets requires
significant management estimates on future cash flows to be generated by the
assets, including the estimated useful life of the assets.





Property
and Equipment


Property
and equipment is originally recorded at cost. Property under capital leases and
the related obligation for future lease payments are initially recorded at an
amount equal to the lesser of fair value of the property or equipment and the
present value of those lease payments.





Property
and equipment are depreciated to estimated residual values based on the
straight-line method over their estimated service lives. Property and equipment
under capital leases and variable interest entities are depreciated to estimated
residual values over the life of the lease. Air Canada’s aircraft and flight
equipment, including spare engines and related parts (“rotables”), are
depreciated over 20 to 25 years, with 10 to 20% estimated residual values.
Aircraft reconfiguration costs are amortized over three to five years.
Betterments to owned aircraft are capitalized and amortized over the remaining
service life of the aircraft. Betterments to aircraft on operating leases are
amortized over the term of the lease.





Buildings
are depreciated over their useful lives not exceeding 40 to 50 years on a
straight-line basis. An exception to this is where the useful life of the
building is greater than the term of the land lease. In these circumstances, the
building is depreciated over the life of the lease. Leasehold improvements are
amortized over the lesser of the lease term or five years. Ground and other
equipment is depreciated over three to 25 years.





Aircraft
depreciable life is determined through economic analysis, a review of existing
fleet plans and comparisons to other airlines operating similar fleet types.
Residual values are estimated based on Air Canada’s historical experience with
regard to the sale of aircraft and spare parts, as well as forward-looking
valuations prepared by independent third parties.





Intangible
Assets


The
identifiable intangible assets of the Corporation were recorded at their
estimated fair values at September 30, 2004. Indefinite-life intangible assets
are subject to impairment tests under Canadian GAAP on an annual basis or when
events or circumstances indicate a potential impairment.  If the
carrying value of such assets exceeds the fair values, the assets are written
down to fair value.





Fair
value under Canadian GAAP is defined as "the amount of the consideration that
would be agreed upon in an arm's length transaction between knowledgeable,
willing parties who are under no compulsion to act". Assessing the fair value of
intangible assets requires significant management estimates on future cash flows
to be generated by the assets, including the estimated useful life of the
assets.




49


2007
      Management’s
      Discussion and Analysis
 14.         Risk
      Factors


The
risks described herein may not be the only risks faced by the Corporation. Other
risks which the Corporation is not aware of or which the Corporation currently
deems to be immaterial may surface and have a material adverse impact on the
Corporation’s business, results from operations and financial
condition.




Risks
Related to ACE




Reliance on Key
Personnel




The
success of ACE depends on the abilities, experience, industry knowledge and
personal efforts of senior management of ACE. The loss of the services of such
key personnel could have a material adverse effect on the business, financial
condition or future prospects of ACE. In addition, ACE may not be able to
attract and retain additional qualified management as needed in the
future.






Changes to the Canadian
Federal Income Tax Treatment of Income Trusts




On
October 31, 2006, the Minister of Finance (Canada) announced a “Tax Fairness
Plan” which, in part, proposed changes to the manner in which certain
flow-through entities and the distributions from such entities are taxed (the
“SIFT Rules”). Bill C-52, Budget Implementation Act, 2007, which received Royal
Assent on June 22, 2007, contained the SIFT Rules, which are designed to
implement these proposals. Under the SIFT Rules, Aeroplan Income Fund and Jazz
Air Income Fund, as publicly traded income trusts, are considered SIFTs and will
be subject to trust level taxation as of January 1, 2011, at a rate comparable
to the combined federal and provincial corporate tax rate on certain types of
income. This trust level taxation will reduce the amount of cash available for
future distributions.  Loss of the deferred application of the SIFT
Rules until 2011 could have a material adverse effect on the value of ACE’s
interest in Aeroplan Income Fund and Jazz Air Income Fund.




Restrictions on Unitholders
of Aeroplan Income Fund and Jazz Air Income Fund




The
declaration of trust of each of Aeroplan Income Fund and Jazz Air Income Fund
impose various restrictions on unitholders. Non-resident unitholders are
prohibited from beneficially owning more than 49.9% of the units of each of
Aeroplan Income Fund and Jazz Air Income Fund. These restrictions may limit (or
inhibit the exercise of) the rights of certain unitholders, including
non-residents of Canada and US persons, to acquire units, to exercise their
rights as unitholders and to initiate and complete take-over bids in respect of
the units. As a result, these restrictions may limit the demand for units of
Aeroplan Income Fund or Jazz Air Income Fund, as the case may be, from certain
unitholders and thereby adversely affect the liquidity and market value of the
units of Aeroplan Income Fund or Jazz Air Income Fund, as the case may be, which
could have a material adverse effect on the value of ACE’s interest in Aeroplan
Income Fund and Jazz Air Income Fund.




Dependence upon Principal
Investments




ACE is
a holding company of various aviation interests and most of ACE’s assets are its
ownership interest in Air Canada, Aeroplan, Jazz and ACTS Aero. ACE’s cash flows
and ability to distribute earnings to its shareholders are dependent upon the
ability of ACE to realize these investments and on the ability of these entities
to pay dividends or distributions to ACE.




The
ability of these entities to pay dividends or distributions will be dependent
upon their operating performance and profitability, and will be subject to
applicable laws and regulations and contractual restrictions that may be
contained in the instruments governing any indebtedness of those
entities.  Each of these separate legal entities has no legal
obligation to pay dividends or distributions to ACE.









50


2007
      Management’s
      Discussion and Analysis




Risks
Related to Air Canada




Operating
Results




In the
past, Air Canada has sustained significant operating losses and may sustain
significant losses in the future. On September 30, 2004, Air Canada and certain
of its subsidiaries emerged from protection under the CCAA and implemented the
Plan.  For the three years ended December 31, 2003, Air Canada
incurred operating losses before reorganization and restructuring items and
non-recurring labour expenses of over $1.6 billion. For the nine-month period
ended September 30, 2004, Air Canada realized operating income before
reorganization and restructuring items of $120 million and, for the three-month
period ended December 31, 2004, the Corporation incurred an operating loss of
$59 million.  For the years ended December 31, 2007, 2006 and 2005,
the Corporation realized operating income of $495 million, $259 million and $318
million, respectively.  Despite Air Canada's emergence from creditor
protection under the CCAA, the resulting and ongoing business initiatives and
efforts at cost reductions and its recent results, the Corporation may not be
able to successfully achieve planned business initiatives and cost reductions,
including those which seek to offset significant fuel and other expense
increases or restore positive net profitability and may sustain significant
losses in the future.




Leverage and
Liquidity




Air
Canada has, and is expected to continue to have, a significant amount of
indebtedness, including substantial fixed obligations under aircraft leases and
financings. Air Canada may incur additional debt, including secured debt, in the
future. The amount of indebtedness that Air Canada currently has and which it
may incur in the future could have a material adverse effect on Air Canada, for
example, by (i) limiting Air Canada's ability to obtain additional financing ,
(ii) requiring Air Canada to dedicate a substantial portion of its cash flow
from operations to payments on its indebtedness and fixed cost obligations,
thereby reducing the funds available for other purposes, (iii) making Air Canada
more vulnerable to economic downturns, and (iv) limiting Air Canada's
flexibility in planning for, or reacting to, competitive pressures or changes in
its business environment.





The
ability of Air Canada to make scheduled payments under its indebtedness will
depend on, among other things, its future operating performance and its ability
to refinance its indebtedness, if necessary. Each of these factors is to a large
extent subject to economic, financial, competitive, regulatory, operational and
other factors, many of which are beyond Air Canada's control. In addition, as
Air Canada incurs indebtedness which bears interest at fluctuating interest
rates, to the extent these interest rates increase, its interest expense will
increase. There can be no assurance that Air Canada will be able to generate
sufficient cash from its operations to pay its debts and lease
obligations.




Need for Additional
Capital




Air
Canada faces a number of challenges in its current business operations,
including high fuel prices and increased competition from international,
transborder and low-cost domestic carriers. In order to meet such challenges and
to support Air Canada's business strategy, significant operating and capital
expenditures are, and may in the future be, required. There can be no assurance
that Air Canada will continue to be able to obtain on a timely basis sufficient
funds on terms acceptable to Air Canada to provide adequate liquidity and to
finance the operating and capital expenditures necessary to support its business
strategy if cash flows from operations and cash on hand are
insufficient.





Failure
to generate additional funds, whether from operations or additional debt or
equity financings, may require Air Canada to delay or abandon some or all of its
anticipated expenditures or to modify its business strategy, which could have a
material adverse effect on Air Canada's business, results from operations and
financial condition. Furthermore, the ability of competitors to raise money more
easily and on less onerous terms could create a competitive disadvantage for Air
Canada.





In
addition, Air Canada's credit ratings influence its ability to access capital
markets. There can be no assurance that Air Canada's credit ratings will not be
downgraded, which would add to Air Canada's borrowing and insurance costs,
hamper its ability to attract capital and limit its ability to operate its
business, all of which could have a material adverse effect on Air Canada's
business, results from operations and financial condition.




51


2007
      Management’s
      Discussion and Analysis


Fuel
Costs




Fuel
costs constituted the largest percentage of the total operating costs of Air
Canada in 2007.Fuel prices fluctuate
widely depending on many factors including international market conditions,
geopolitical events and the Canada/US dollar exchange rate.  Air
Canada cannot accurately predict fuel prices. During 2005, 2006 and 2007, fuel
prices increased and fluctuated near or at historically high levels. Should fuel
prices continue at, or continue to increase above, such high levels, fuel costs
could have a material adverse effect on Air Canada's business, results from
operations and financial condition. Due to the competitive nature of the airline
industry, Air Canada may not be able to pass on increases in fuel prices to its
customers by increasing its fares. Based on 2007 volumes, Management estimates
that a US$1 per barrel movement in the average price of West Texas Intermediate
crude oil would have resulted in an approximate Cdn$26million change in 2007
fuel expense for Air Canada (excluding any impact of fuel surcharges, foreign
exchange rates and fuel hedging), assuming flying capacity remained unchanged
and that refining spreads between West Texas Intermediate crude oil and jet fuel
as well as foreign exchange rates remained constant.




Labour Costs and Labour
Relations




Labour
costs constitute one of Air Canada's largest operating cost items. There can be
no assurance that Air Canada will be able to maintain such costs at levels which
do not negatively affect its business, results from operations and financial
condition. There can be no assurance that future agreements with employees'
unions or the outcome of arbitrations will be on terms consistent with Air
Canada’s expectations or comparable to agreements entered into by Air Canada’s
competitors. Any future agreements or outcome of negotiations, mediations or
arbitrations including in relation to wages or other labour costs or work rules
may result in increased labour costs or other charges which could have a
material adverse effect on Air Canada's business, results from operations and
financial condition.





Most
of Air Canada's employees are unionized and long-term collective agreements were
concluded in 2003 and 2004. No strikes or lock-outs may lawfully occur during
the term of the collective agreements expiring in 2009. However, there can be no
assurance that there will not be a labour conflict that could lead to an
interruption or stoppage in Air Canada's service or otherwise adversely affect
the ability of Air Canada to conduct its operations, all of which could have a
material adverse effect on its business, results from operations and financial
condition.





If
there is a labour disruption or work stoppage by any of the unionized work
groups of Jazz, there could also likely be a material adverse effect on Air
Canada’s business, results from operations and financial condition. In addition,
labour conflicts at Air Canada's Star Alliance® partners could result in lower
demand for connecting traffic with Air Canada and, ultimately, could have a
material adverse effect on Air Canada's business, results from operations and
financial condition.




Airport User Fees and Air
Navigation Fees




With
the privatization of airports and air navigation authorities over the last
decade in Canada, new airport and air navigation authorities have imposed
significant increases in their fees. If authorities in Canada or elsewhere
continue to increase their fees at the rate at which they have increased them in
the recent past, Air Canada's business, results from operations and financial
condition could be materially adversely affected.




Competition




Air
Canada operates within a highly competitive industry. Over the past few years,
several carriers have entered or announced their intention to enter into the
domestic, the US transborder and international markets in which Air Canada
operates.





Canadian
low-cost and other carriers have entered and/or expanded or announced their
intention to compete in many of Air Canada's key domestic markets and, along
with some US carriers have also entered and/or expanded their operations in the
US transborder market. Some US carriers, having recently completed substantial
reorganizations, have reduced levels of indebtedness and lower operating costs
and may be in a position to more effectively compete with Air Canada. Air Canada
is also facing increasing competition in international markets as carriers
increase their international capacity, both by expansion and by shifting
existing domestic capacity to international operations to avoid low-cost
domestic competition.




52


2007
      Management’s
      Discussion and Analysis


If
Canadian low-cost and other carriers are successful in entering or expanding
into Air Canada’s domestic and the US transborder markets, if additional US
carriers are successful in entering Air Canada's transborder market or if
carriers are successful in their expansion in international markets of Air
Canada, Air Canada's business results from operations and financial condition
could be materially adversely affected.





Air
Canada also encounters substantial price competition. The expansion of low-cost
carriers in recent years, along with the advent of Internet travel websites and
other travel products distribution channels, has resulted in a substantial
increase in discounted and promotional fares initiated by Air Canada’s
competitors. The decision to match competitors' fares, to maintain passenger
traffic, results in reduced yields which, in turn, could have a material adverse
effect on Air Canada's business, results from operations and financial
condition. Furthermore, Air Canada's ability to reduce its fares in order to
effectively compete with other carriers is dependent on Air Canada’s ability to
achieve acceptable operating margins and may also be limited by government
policies to encourage competition.





In
addition, consolidation in the airline industry could result in increased
competition as some airlines emerging from such consolidations may be able to
compete more effectively against Air Canada which could have a material adverse
effect on Air Canada's business, results from operations and financial
condition.




Limitations Due to
Restrictive Covenants




Some
of the financing and other major agreements of Air Canada contain restrictive
covenants which affect and, in some cases, significantly limit or prohibit,
among other things, the manner in which Air Canada may structure or operate its
business, including by limiting Air Canada's ability to incur indebtedness,
create liens, sell assets, make capital expenditures and engage in acquisitions,
mergers or restructurings.  In addition, certain financing
arrangements require Air Canada to maintain financial ratios. Any future
borrowings may also be subject to similar covenants which limit Air Canada's
operating and financial flexibility, which could materially and adversely affect
Air Canada's profitability.





A
failure by Air Canada to comply with its contractual obligations (including
restrictive covenants), or to pay its indebtedness and fixed costs could result
in a variety of material adverse consequences, including the acceleration of its
indebtedness, the withholding of credit card proceeds by the credit card service
providers and the exercise of remedies by its creditors and lessors, and such
defaults could trigger additional defaults under other indebtedness or
agreements. In such a situation, it is unlikely that Air Canada would be able to
repay the accelerated indebtedness or fulfill its obligations under certain
contracts, make required aircraft lease payments or otherwise cover its fixed
costs. Also, the lenders under the financing arrangements could foreclose upon
all or substantially all of the assets of Air Canada which secure Air Canada's
obligations.




Strategic, Business,
Technology and Other Important Initiatives




In
order to operate its business, achieve its goals and remain competitive, Air
Canada continuously seeks to identify and devise, invest in and implement
strategic, business, technology and other important initiatives, such as those
relating to the aircraft fleet restructuring program, the aircraft refurbishment
program, the new revenue model, the reservation and airport customer service
initiative (which will also support the revenue model), the  business
process initiatives as well as other initiatives.  These initiatives,
including activities relating to their development and implementation, may be
adversely impacted by a wide range of factors, many of which are beyond Air
Canada’s control. Such factors include the performance of third parties,
including suppliers, the implementation and integration of such initiatives into
Air Canada’s other activities and processes as well as the adoption and
acceptance of initiatives by Air Canada’s customers, suppliers and
personnel.  A delay or failure to sufficiently and successfully
identify and devise, invest in or implement these initiatives could adversely
affect Air Canada’s ability to operate its business, achieve its goals and
remain competitive and could have a material adverse effect on Air Canada's
business, results from operations and financial condition.




53


2007
      Management’s
      Discussion and Analysis


For
instance, a key component of Air Canada's business plan is the restructuring of
its aircraft fleet, including the elimination and replacement of older, less
efficient aircraft, the introduction of new regional jet aircraft, and the
modernization of its international wide-body fleet through the acquisition of
new and more efficient aircraft. A delay or failure in the completion of Air
Canada's fleet restructuring, including a delay by the manufacturers in the
delivery of wide-body aircraft, or an inability to remove, as planned, certain
aircraft from the fleet in coordination with the planned entry into service of
new aircraft, could adversely affect the implementation of Air Canada's business
plan which may, in turn, have a material adverse effect on Air Canada's
business, results from operations and financial condition.





Another
important component of the Corporation’s business plan is the replacement of its
legacy systems for passenger reservation and airport customer service with a
newly developed web-enabled system in order to support the rapid and efficient
implementation of the Corporation's revenue model.  A delay or failure
in the implementation of the Corporation's new system could adversely affect the
implementation of the Corporation's business plan which may, in turn, have a
material adverse effect on the Corporation's business, results from operations
and financial condition.




Dependence on
Technology




Air
Canada relies on technology, including computer and telecommunications equipment
and software and Internet-based systems, to operate its business, increase its
revenues and reduce its costs. These systems include those relating to Air
Canada’s telecommunications, websites, computerized airline reservations and
airport customer services and flight operations.





These
technology systems may be vulnerable to a variety of sources of failure,
interruption or misuse, including by reason of third party suppliers’ acts or
omissions, natural disasters, terrorist attacks, telecommunications failures,
power failures, computer viruses, unauthorized or fraudulent users, and other
operational and security issues. While Air Canada continues to invest in
initiatives, including security initiatives and disaster recovery plans, these
measures may not be adequate or implemented properly. Any such technology
systems failure could materially and adversely affect Air Canada's operations
and could have a material adverse effect on Air Canada's business, results from
operations and financial condition.




Key Supplies and
Suppliers




Air
Canada is dependent upon its ability to source, on favourable terms and costs,
sufficient quantities of goods and services in a timely manner, including those
required for Air Canada’s operations such as fuel, aircraft and related parts
and aircraft and engine maintenance services (including maintenance services
obtained from ACTS Aero). In certain cases, such goods and services may only be
available from a limited number of suppliers. Such failure, refusal or inability
may arise as a result of a wide range of causes, many of which are beyond Air
Canada's control. Any failure or inability of Air Canada to successfully source
goods and services, including by reason of a failure, refusal or inability of a
supplier, or to source goods and services on terms and pricing and within the
timeframes acceptable to Air Canada, could have a material adverse effect on Air
Canada's business, results from operations and financial condition.




Aeroplan




Through
its relationship with Aeroplan, Air Canada is able to offer its customers who
are Aeroplan members the opportunity to earn Aeroplan miles. Based on customer
surveys, Management believes that rewarding customers with Aeroplan miles is a
significant factor in customers' decision to travel with Air Canada and Jazz and
contributes to building customer loyalty. The failure by Aeroplan to adequately
fulfill its obligations towards Air Canada under the Aeroplan CPSA and in
connection with the Aeroplan program, or other unexpected interruptions of
Aeroplan services which are beyond Air Canada's control could have a material
adverse effect on Air Canada's business, results from operations and financial
condition.





54


2007
      Management’s
      Discussion and Analysis


Jazz




Under
the Jazz CPA, Jazz provides Air Canada's customers service in lower density
markets and higher density markets at off-peak times throughout Canada and to
and from certain destinations in the United States and also provides valuable
traffic feed to Air Canada's mainline routes. Air Canada reimburses Jazz,
without mark-up, for certain pass-through costs incurred directly by Jazz, such
as fuel, navigation, landing and terminal fees and certain other costs.
Significant increases in such pass-through costs, the failure by Jazz to
adequately fulfill its obligations towards Air Canada under the Jazz CPA, or
other unexpected interruptions of Jazz's services which are beyond Air Canada's
control could have a material adverse effect on Air Canada's business, results
from operations and financial condition. In addition, the Jazz CPA requires that
Jazz maintain a minimum fleet size and contains a minimum average daily
utilization guarantee which requires that Air Canada make certain minimum
payments to Jazz regardless of the revenue generated by Jazz.




Pension
Plans




Canadian
federal pension legislation requires that the funded status of registered
pension plans be determined periodically, on both a going concern basis
(essentially assuming indefinite plan continuation) and a solvency basis
(essentially assuming immediate plan termination).





The
solvency liability is influenced primarily by long-term interest rates and by
the investment return on plan assets. The interest rate used to calculate
benefit obligations for solvency purposes is a prescribed rate derived from the
interest rates on long-term Government of Canada bonds. In the current low
interest rate environment, the calculation results in a higher present value of
the pension obligations, leading to a larger unfunded solvency
position.





In May
2004, Air Canada and the Office of the Superintendent of Financial Institutions
agreed on a protocol pursuant to which the solvency funding requirements for Air
Canada's registered pension plans provided for in the then existing regulations
were amended retroactive to January 1, 2004. Air Canada is required to make
substantial annual cash contributions, and the level of those contributions will
increase in the event of poor pension fund investment performance and/or further
declines in long-term Government of Canada bond rates. See "Management's
Discussion and Analysis — Critical Accounting Estimates — Employee Future
Benefits — Sensitivity Analysis". Underfunded pension plans or a failure or
inability by Air Canada to make required cash contributions to its registered
pension plans could have a material adverse effect on Air Canada's business,
results from operations and financial condition. Refer to section 9.4 of this
MD&A for information on Air Canada’s projected pension funding
obligations.




Star
Alliance®




The
strategic and commercial arrangements with Star Alliance® members provide Air
Canada with important benefits, including code sharing, efficient connections
and transfers, reciprocal participation in frequent flyer programs and use of
airport lounges from the other members. Should a key member leave Star Alliance®
or otherwise fail to meet its obligations thereunder, Air Canada's business,
results from operations and financial condition could be materially adversely
affected.




Interruptions or Disruptions
in Service




Air
Canada's business is significantly dependent upon its ability to operate without
interruption at a number of hub airports, including Toronto Pearson Airport.
Delays or disruptions in service, including those due to security or other
incidents, weather conditions, labour conflicts with airport workers, baggage
handlers, air traffic controllers and other workers not employed by Air Canada
or other causes beyond the control of Air Canada could have a material adverse
impact on Air Canada's business, results from operations and financial
condition.





55


2007
      Management’s
      Discussion and Analysis


Foreign
Exchange




Air
Canada's financial results are sensitive to the changing value of the Canadian
dollar. In particular, Air Canada has a significant annual net outflow of US
dollars and is affected by fluctuations in the Canada/US dollar exchange rate.
Management estimates that during 2007, a $0.01 increase in the Canada/US dollar
exchange rate (i.e., $0.99 to $0.98 per US dollar) would have had an estimated
$25 million favourable impact on operating income and an estimated $72 million
favourable impact on pre-tax income. Conversely, an opposite change in the
exchange rate would have had the opposite effect. Air Canada incurs significant
expenses in US dollars for such items as fuel, aircraft rental charges, interest
payments, debt servicing and computerized reservations system fees, while a
substantial portion of its revenues are generated in Canadian dollars. A
significant deterioration of the Canadian dollar relative to the US dollar would
increase the costs of Air Canada relative to its US competitors and could have a
material adverse effect on Air Canada's business, results from operations and
financial condition. In addition, Air Canada may be unable to appropriately
hedge the risks associated with fluctuations in exchange rates.




Current Legal
Proceedings




The
European Commission, the United States Department of Justice and the Competition
Bureau in Canada, among other competition authorities, are investigating alleged
anti-competitive cargo pricing activities, including the levying of certain fuel
surcharges, of a number of airlines and cargo operators, including Air Canada, a
number of whom, including Air Canada, have received a statement of objections
from the European Commission that sets out the European Commission's preliminary
assessment in relation to such matter. Competition authorities have sought or
requested information from Air Canada as part of their
investigations.  Air Canada is cooperating with these investigations,
which are likely to lead to proceedings against Air Canada and a number of
airlines and other cargo operators in certain jurisdictions.  Air
Canada is also named as a defendant in a number of class action lawsuits that
have been filed before the United States District Court and in Canada in
connection with these allegations.  Management has determined that it
is not possible at this time to predict with any degree of certainty the outcome
of these proceedings, but these proceedings may result in a material liability
to Air Canada.





In
February 2006, Jazz commenced proceedings before the Ontario Superior Court of
Justice against Porter Airlines Inc. (“Porter”) and other defendants
(collectively the “Porter Defendants”) after Jazz became aware that it would be
excluded from operating flights from Toronto City Centre (Island) Airport (the
“TCCA”). On October 26, 2007, the Porter Defendants counter-claimed against Jazz
and Air Canada alleging various violations of competition law, including that
Jazz and Air Canada’s commercial relationship contravenes Canadian competition
laws, and claiming $850 million in damages. Concurrently with the Ontario
Superior Court of Justice proceedings, Jazz commenced judicial review
proceedings against the Toronto Port Authority (”TPA”) before the Federal Court
of Canada relating to Jazz’s access to the TCCA. The Porter Defendants were
granted intervener and party status in these proceedings. In January of 2008,
Porter filed a defence and counterclaim against Jazz and Air Canada making
allegations and seeking conclusions similar to those in the Ontario Superior
Court counterclaim. Management views Porter’s counterclaims in both
jurisdictions as being without merit.





In
October 2006, ACPA commenced proceedings before the Ontario Superior Court of
Justice against Air Canada, ACE and certain members of the board of directors of
Air Canada alleging that certain past and future actions are oppressive to it. A
variety of remedies were sought against the parties including an injunction to
impose, among other things, limits on corporate distributions including those
contemplated under the ACE plan of arrangement which became effective on October
10, 2006.  Following a hearing in December, 2006, Mr. Justice Cumming
of the Ontario Superior Court of Justice dismissed ACPA's application for an
injunction and granted Respondents’ Cross-motion to dismiss ACPA's
claim.  ACPA has not appealed the dismissal of the injunction
application but has appealed the order dismissing its claim and the appeal is scheduled to be heard
by the Ontario Court of Appeal in March 2008.  Management is of
the view that the ACPA claim is without merit.





The
Canadian Union of Public Employees (“CUPE”), which represents Air Canada’s
flight attendants, has a complaint before the Canadian Human Rights Commission
where it alleges gender-based wage discrimination.  CUPE claims the
predominantly female flight attendant group should be paid the same as the
predominantly male pilot and mechanics groups because their work is of equal
value.  The complaint dates from 1991 but has




56


2007
      Management’s
      Discussion and Analysis


not
been investigated on the merits because of a legal dispute over whether the
three groups work in the same “establishment” within the meaning of the Canadian
Human Rights Act.  On January 26, 2006, the Supreme Court of Canada
ruled that they do work in the same “establishment” and sent the case back to
the Canadian Human Rights Commission, which may now proceed to assess the merits
of CUPE’s complaint.  On March 16, 2007, the Canadian Human Rights
Commission referred the complaint against Air Canada for
investigation.  Air Canada considers that any investigation will show
that it is complying with the equal pay provisions of the Canadian Human Rights
Act; however, management has determined that it is not possible at this time to
predict with any degree of certainty the final outcome of the Commission’s
investigation.





On
January 10, 2008, a decision was rendered by the Canadian Transportation Agency
(Decision No. 6-AT-A-2008) following an application pursuant to
subsection 172(1) of the Canada Transportation Act, S.C., 1996, c. 10,
as amended, against Air Canada and other air carriers and parties concerning the
fares and charges to be paid by persons with disabilities who require additional
seating to accommodate their disabilities to travel by air on domestic air
services. Management has determined that it is not possible at this time to
predict with any degree of certainty the outcome of any proceedings which may be
taken on appeal of the CTA decision or the final effects thereof.




Key
Personnel




Air
Canada is dependent on the experience and industry knowledge of its executive
officers and other key employees to execute its business plan. If Air Canada
were to experience a substantial turnover in its leadership or other key
employees, Air Canada's business, results from operations and financial
condition could be materially adversely affected. Additionally, Air Canada may
be unable to attract and retain additional qualified key personnel as needed in
the future.





Risks
Relating to the Airline Industry






Economic and Geopolitical
Conditions




Airline
operating results are sensitive to economic and geopolitical conditions which
can have a significant impact on the demand for air transportation. Airline
fares and passenger demand have fluctuated significantly in the past and may
fluctuate significantly in the future. Air Canada is not able to predict with
certainty market conditions and the fares that Air Canada may be able to charge.
Customer expectations can change rapidly and the demand for lower fares may
limit revenue opportunities. Travel, especially leisure travel, is a
discretionary consumer expense. A downturn in economic growth in North America,
as well as geopolitical instability in various areas of the world, increased
concerns about the environmental impacts of air travel and tendencies towards
“green” travel initiatives where consumers reduce their travel activities, could
have the effect of reducing demand for air travel in Canada and abroad and,
together with the other factors discussed herein, could materially adversely
impact Air Canada's profitability. Especially in light of Air Canada's
substantial fixed cost structure, any prolonged or significant weakness of the
Canadian, US or world economies could reduce the demand for air transportation
which in turn could have a material adverse effect on Air Canada’s business,
results from operations and financial condition.




Airline Industry
Characterized by Low Gross Profit Margins and High Fixed
Costs




The
airline industry is characterized by low gross profit margins and high fixed
costs. The costs of operating any particular flight do not vary significantly
with the number of passengers carried and, therefore, a relatively small change
in the number of passengers or in fare pricing or traffic mix could have a
significant effect on Air Canada's operating and financial results. This
condition has been exacerbated by aggressive pricing by low-cost carriers, which
has had the effect of driving down fares in general. Accordingly, a shortfall
from expected revenue levels could have a material adverse effect on Air
Canada's business, results from operations and financial condition. Air Canada
incurs substantial fixed costs which do not meaningfully fluctuate with overall
capacity. As a result, should Air Canada be required to reduce its overall
capacity or the number of flights operated, it may not be able to successfully
reduce certain fixed costs in the short term and may be required to incur
important termination or other restructuring costs, which could have a material
adverse effect on Air Canada's business, results from operations and financial
condition.




57


2007
      Management’s
      Discussion and Analysis


Terrorist Attacks and
Security Measures




The
September 11, 2001 terrorist attacks and subsequent terrorist activity, notably
in the Middle East, Southeast Asia and Europe, caused uncertainty in the minds
of the traveling public. The occurrence of a major terrorist attack (whether
domestic or international and whether involving Air Canada or another carrier or
no carrier at all) and increasingly restrictive security measures, such as the
current restrictions on the content of carry-on baggage and current or proposed
passenger identification document requirements, could have a material adverse
effect on passenger demand for air travel and on the number of passengers
traveling on Air Canada's flights. It could also lead to a substantial increase
in insurance, airport security and other costs. Any resulting reduction in
passenger revenues and/or increases in insurance, security or other costs could
have a material adverse effect on Air Canada's business, results from operations
and financial condition.




Epidemic Diseases (Severe
Acute Respiratory Syndrome (SARS), Influenza or Other Epidemic
Diseases)




As a
result of the international outbreaks of Severe Acute Respiratory Syndrome
(SARS) in 2003, the World Health Organization (the "WHO") issued on April 23,
2003 a travel advisory, which was subsequently lifted on April 30, 2003, against
non-essential travel to Toronto, Canada. The seven day WHO travel advisory
relating to Toronto, the location of Air Canada's primary hub, and the
international SARS outbreak had a significant adverse effect on passenger demand
for air travel in Air Canada’s markets and resulted in a major negative impact
on traffic on the entire network. The WHO warns that there is a substantial risk
of an influenza pandemic within the next few years. An outbreak of SARS or of
another epidemic disease such as influenza (whether domestic or international)
or a further WHO travel advisory (whether relating to Canadian cities or regions
or other cities, regions or countries) could have a material adverse effect on
passenger demand for air travel. Any resulting reduction in traffic in the
markets served by Air Canada could have a material adverse effect on Air
Canada's business, results from operations and financial condition.




Casualty
Losses




Due to
the nature of its core operating business, Air Canada may be subject to
liability claims arising out of accidents or disasters involving aircraft on
which Air Canada's customers are traveling or involving aircraft of other
carriers maintained or repaired by Air Canada, including claims for serious
personal injury or death. There can be no assurance that Air Canada's insurance
coverage will be sufficient to cover one or more large claims and any shortfall
may be material. Additionally, any accident or disaster involving one of Air
Canada's aircraft or an aircraft of another carrier receiving line maintenance
services from Air Canada may significantly harm Air Canada's reputation for
safety, which would have a material adverse effect on Air Canada's business,
results from operations and financial condition.




Seasonal Nature of the
Business, Other Factors and Prior Performance




Air
Canada has historically experienced considerably greater demand for its services
in the second and third quarters of the calendar year and significantly lower
demand in the first and fourth quarters of the calendar year. This demand
pattern is principally a result of the preference of a high number of leisure
travelers to travel during the spring and summer months. Air Canada has
substantial fixed costs that do not meaningfully fluctuate with passenger demand
in the short term.





As
described elsewhere, demand for air travel is also affected by factors such as
economic conditions, war or the threat of war or terrorist attacks, fare levels
and weather conditions. Due to these and other factors, operating results for an
interim period are not necessarily indicative of operating results for an entire
year, and operating results for a historical period are not necessarily
indicative of operating results for a future period.




58


2007
      Management’s
      Discussion and Analysis


Regulatory
Matters




The
airline industry is subject to extensive Canadian and foreign government
regulations relating to, among other things, security, safety, licensing,
competition, noise levels and the environment and, in some measure, pricing.
Additional laws and regulations may be proposed, and decisions rendered, from
time to time which could impose additional requirements or restrictions on
airline operations. The implementation of additional regulations or decisions by
Transport Canada, the Competition Bureau and/or the Competition Tribunal, the
Canadian Transportation Agency or other domestic or foreign governmental
entities may have a material adverse effect on Air Canada's business, results
from operations and financial condition. Air Canada cannot give any assurances
that new regulations or revisions to the existing legislation, or decisions,
will not be adopted or rendered. The adoption of such new laws and regulations
or revisions, or the rendering of such decisions, could have a material adverse
effect on Air Canada's business, results from operations and financial
condition.





The
availability of international routes to Canadian air carriers is regulated by
agreements between Canada and foreign governments. Changes in Canadian or
foreign government aviation policy could result in the alteration or termination
of these agreements and could adversely affect Air Canada's international
operations.





In
July 2000, the Government of Canada amended the CTA, the Competition Act and the
Air Canada Public Participation Act to address the competitive airline
environment in Canada and ensure protection for consumers. This legislation
included airline-specific provisions concerning "abuse of dominance" under the
Competition Act, later supplemented by creating "administrative monetary
penalties" for a breach of the abuse of dominance provisions by a dominant
domestic air carrier.





In
July 2003, the Competition Tribunal released its reasons and findings in a
proceeding between the Commissioner of Canada and Air Canada which had
considered the approach to be taken in determining whether Air Canada was
operating below "avoidable costs" in violation of one of the new
airline-specific abuse of dominance provisions. The Competition Tribunal applied
a very broadly crafted cost test in its decision. In September 2004, the
Commissioner of Competition published a letter describing the enforcement
approach that would be taken in future cases involving the airline-specific
abuse of dominance provisions, which included a statement that the Tribunal's
approach to avoidable costs remains relevant.





On
November 2, 2004, the Minister of Industry tabled amendments to the Competition
Act in Bill C-19 which, if enacted, would have removed the airline-specific
"abuse of dominance" provisions from the Competition Act. However, on November
29, 2005, the 38th Parliament of Canada was dissolved. As a result, the
legislative process relating to the adoption of Bill C-19 was terminated. On
October 16, 2007, private Bill C-454 containing provisions to remove the
airline-specific “abuse of dominance” provisions from the Competition Act, was
tabled for first reading in the House of Commons.  Management cannot
predict if or when such proposed legislation will come into force.





If the
Commissioner of Competition commences inquiries or brings similar applications
with respect to significant competitive domestic routes and such applications
are successful, it could have a material adverse effect on Air Canada's
business, results from operations and financial condition.





Air
Canada is subject to domestic and foreign laws regarding privacy of passenger
and employee data, including advance passenger information and access to airline
reservation systems, which are not consistent in all countries in which Air
Canada operates. Compliance with these regulatory regimes is expected to result
in additional operating costs and could have a material adverse effect on Air
Canada's business, results from operations and financial condition.




Increased Insurance
Costs




Since
September 11, 2001 the aviation insurance industry has been continually
reevaluating the terrorism risks that it covers and this activity may adversely
affect some of Air Canada's existing insurance carriers or Air Canada's ability
to obtain future insurance coverage. To the extent that Air Canada's existing
insurance carriers are unable or unwilling to provide it with insurance
coverage, and in the absence of measures by the Government of Canada to provide
the required coverage, Air Canada's insurance costs may increase further and may
result in Air Canada being in breach of regulatory requirements or contractual
arrangements requiring that




59


2007
      Management’s
      Discussion and Analysis


specific
insurance be maintained, which may have a material adverse effect on Air
Canada's business, results from operations and financial condition.




Third Party War Risk
Insurance




There
is a risk that the Government of Canada may not continue to provide an indemnity
for third party war risk liability coverage, which it currently provides to Air
Canada and certain other carriers in Canada. In the event that the Government of
Canada does not continue to provide such indemnity or amends such indemnity, Air
Canada and other industry participants would have to turn to the commercial
insurance market to seek such coverage. Air Canada estimates that such coverage
would cost Air Canada approximately $15 million per year. Alternative solutions,
such as those envisioned by the International Civil Aviation Organization
("ICAO") and the International Air Transport Association ("IATA"), have not
developed as planned, due to actions taken by other countries and the recent
availability of supplemental insurance products. ICAO and IATA are continuing
their efforts in this area, however, the achievement of a global solution is not
likely in the immediate or near future. The US federal government has set up its
own facility to provide war risk coverage to US carriers, thus removing itself
as a key component of any global plan.





Furthermore,
the London aviation insurance market has introduced a new standard war and
terrorism exclusion clause which is applicable to aircraft hull and spares war
risk insurance, and intends to introduce similar exclusions to airline passenger
and third party liability policies. Such clause excludes claims caused by the
hostile use of a dirty bomb, electromagnetic pulse device, or biochemical
materials. The Government of Canada indemnity program is designed to address
these types of issues as they arise, but the Government of Canada has not yet
decided to extend the existing indemnity to cover this exclusion. Unless and
until the Government of Canada does so, the loss of coverage exposes Air Canada
to this new uninsured risk and may result in Air Canada being in breach of
certain regulatory requirements or contractual arrangements, which may have a
material adverse effect on Air Canada's business, results from operations and
financial condition.







Risks
Related to Aeroplan and Jazz




Risks Related to
Aeroplan




The
following is a list of the key risk factors related to Aeroplan based on
Aeroplan's most recent public disclosure filings:





·
            Dependency on top three
      partners




·
            Reduction in activity usage
      and accumulation of Aeroplan
Miles




·
            Greater than expected
      redemptions for rewards




·
            Labour
      relations




·
            Technological disruptions and
      inability to use third party
software




·
            Leverage and restrictive
      covenants in current and future
  indebtedness




·
            Economic
      downturn




·
            Cash distributions are not
      guaranteed and will fluctuate with the business
      performance




·
            Restrictions on certain
      unitholders and liquidity of
units







60


2007
      Management’s
      Discussion and Analysis


Risks Related to
Jazz




The
following is a list of the key risk factors related to Jazz based on Jazz's most
recent public disclosure filings:





·
            Dependence on Air
      Canada




·
            Termination of the Jazz
      CPA




·
            Labour costs and labour
      relations




·
            Impact of competition on Air
      Canada's need to utilize Jazz's
services




·
            Impact of increased
      competition in the regional airline industry on Jazz's growth
      opportunities




·
            Cash distributions are not
      guaranteed and will fluctuate with the business
      performance




·
            Restrictions on certain
      unitholders and liquidity of
units
















61


2007
      Management’s
      Discussion and Analysis


15.         Sensitivity
      of Results


The
Corporation’s financial results are subject to many different internal and
external factors which can have a significant impact on operating
results.  In order to provide a general guideline, the following table
describes, on an indicative basis, the financial impact that changes in
operating metrics would generally have had on Air Canada’s operating
results.  These guidelines were derived from Air Canada’s 2007 levels
of activity.  The impacts are not additive and do not reflect the
interdependent relationship of the elements and may vary significantly from
actual results due to factors beyond the control of Air
Canada.  Conversely, an opposite change in the sensitivity factor
would have had the opposite effect on operating income.





($
      millions)
            
            
            
            
            Favourable
      / (Unfavourable)Key
      Variable
            
            2007
      Measure
            
            Sensitivity
      factor
            Estimated
      Operating
              Income
      ImpactRevenue
      MeasuresPassenger
      yield (cents)
            System
            18.4
            
            1%
      increase in yield
            $
            89Canada
            24.3
            
            
            
            $
            38Traffic
      (RPMs) (millions)
            System
            50,629
            
            1%
      increase in traffic
            $
            81Canada
            16,284
            
            
            
            $
            34Passenger
      load factor
            System
            80.6
            
            1
      percentage point increase
            $
            101RASM
      (cents)
            System
            14.8
            
            1%
      increase in RASM
            $
            85Cost
      MeasuresLabour
      and benefits expenses ($ millions)
            1,920
            
            1%
      increase
            $
            (19)Fuel
      – WTI price (US$/barrel)(1)
            
            69.9
            
            US$1/barrel
      increase to WTI
            $
            (26)Fuel
      – jet fuel price (Cdn cents/litre) (1)
            66.3
            
            1%
      increase
            $
            (26)Cost
      per ASM (cents)
            
            16.3
            
            1%
      increase in CASM
            $
            (102)





(1)
            Excludes
      the impact of fuel surcharges and fuel
hedging.








($
      millions)
            
            
            Favourable
      / (Unfavourable)Key
      Variable
            2007
      Measure
            Sensitivity
      Factor
            Estimated
      Operating
              Income
      Impact
            Estimated
      Pre-Tax
              Income
      Impact(1)Currency
      ExchangeCdn$
      to US$
            1US$
      = Cdn$ 0.99
            1
      cent increase
            $    25
            $    72(e.g.
      $0.99 to $0.98)





(1)
            Excludes
      the impact of foreign exchange forward contracts and currency
      swaps.











62


2007
      Management’s
      Discussion and Analysis


16.         Quarterly
      Financial Information


The
table below describes the Corporation’s quarterly financial results for the
eight most recent quarters.  ACE’s results reflect the consolidation
of Aeroplan’s operations only up to March 14, 2007, the consolidation of Jazz’s
operations only up to May 24, 2007 and ACTS’ operations only up to October 16,
2007.  After those dates, ACE’s investments in Aeroplan, Jazz and ACTS
Aero are accounted for using the equity method.  The equity income
from ACE’s investment in Aeroplan, Jazz and ACTS Aero is recorded in
non-operating income (expense) on ACE’s consolidated statement of
operations.





($
      millions, except per
            Q1
            Q2
            Q3
            Q4
            Q1
            Q2
            Q3
            Q4share
      amounts)
            2006
            2006
            2006
            2006
            2007(2)
            2007(3)
            2007
            2007(4)Operating
      revenues
            $    2,484
            $    2,682
            $    2,947
            $    2,544
            $    2,625
            $    2,659
            $    3,022
            $    2,520Special
      charge for Aeroplan miles(1)
            -
            -
            (102)
            -
            -
            -
            -
            -Operating
      revenues
            2,484
            2,682
            2,845
            2,544
            2,625
            2,659
            3,022
            2,520Operating
      expenses
            (2,546)
            (2,501)
            (2,642)
            (2,471)
            (2,654)
            (2,563)
            (2,682)
            (2,474)Operating
      income (loss)(5)
            (62)
            181
            203
            73
            (29)
            96
            340
            46Total
      non-operating income (expense), non-controlling interest, foreign exchange
      gain (loss) and income tax (6)
            180
            55
            (100)
            (122)
            (43)
            22
            (116)
            1,082Net
      income (loss)
            $    118
            $    236
            $     103
            $     (49)
            $     (72)
            $    118
            $    224
            $   1,128Earnings
      (loss)Per
      share – basic
            $    1.15
            $    2.32
            $    1.01
            $  (0.48)
            $  (0.70)
            $    1.14
            $    2.17
            $  10.81Per
      share – diluted
            $    1.12
            $    2.05
            $    0.95
            $  (0.48)
            $  (0.70)
            $    0.98
            $    1.84
            $    8.88





1.
            Quarter
      3 2006 includes a special charge of $102 million in connection with Air
      Canada’s obligations for the redemption of pre-2002 Aeroplan
      miles.


2.
            ACE
      ceased consolidating Aeroplan’s results effective March 14,
      2007.


3.
            ACE
      ceased consolidating Jazz’s results effective May 24,
  2007.


4.
            ACE
      ceased consolidating ACTS’ results effective October 16,
    2007.


5.
            Quarter
      1 2006 includes a special charge for labour restructuring of $33 million.
      Quarter 4 2006 includes a $8 million reduction to the special charge for
      labour due to the favourable impact of attrition and other factors which
      reduced the cost of achieving the target to $25
      million.  Quarter 1 2007 and Quarter 2 2007 include special
      charges for labour restructuring of $9 million and $6 million,
      respectively.


6.
            Quarter
      1 2006 includes a dilution gain of $220 million and a tax provision of $10
      million as a result of the initial public offering of Jazz Air Income
      Fund.  Quarter 2 2006 includes a gain of $100 million and a tax
      provision of $17 million relating to the sale of 3.25 million shares of
      its holdings in US Airways.  Quarter 3 2006 includes a gain of
      $52 million and a tax provision of $9 million relating to the sale of 1.25
      million shares of its holdings in US Airways.  Quarter 4 2006
      includes a dilution gain of $25 million and a tax expense of $4 million
      related to the Air Canada initial public offering.  Quarter 2
      2007 includes a gain of $4 million and a tax provision of $1 million
      relating to the sale of 0.249 million shares of its holdings in US
      Airways.  Quarter 3 2007 includes a gain of $4 million and a tax
      provision of $1 million relating to the sale of 0.251 million shares of
      its holdings in US Airways. Quarter 4 2007 includes an aggregate gain on
      disposal of $1,339 million and a tax provision of $214 million mainly
      comprised of a gain on disposal of $565 million and a tax provision of $82
      million related to the monetization of ACTS which was completed on October
      16, 2007, a gain on disposal of $539 million and a tax provision of $91
      million related to the secondary offering of 22,000,000 trust units of
      Aeroplan Income Fund and a gain on disposal of $233 million and a tax
      provision of $41 million related to the secondary offering of 35,500,000
      trust units of Jazz Air Income
Fund.





Seasonality


The
demand for services experienced within the segments of the Corporation varies
over the calendar year. Air Canada and Jazz have historically experienced
greater demand in the second and third quarters as a result of the high number
of leisure travelers with the preference to travel during the spring and summer
months. Both Air Canada and Jazz have substantial fixed costs in their
structures that do not fluctuate with passenger demand and load
factors.  ACTS (up to October 16, 2007) has experienced lower activity
in the third quarter as the high demand for travel during the summer months
results in airlines scheduling their maintenance service outside of that peak
travel period.




63


2007
      Management’s
      Discussion and Analysis


17.         Selected
      Annual Information


The
following table provides selected annual information for ACE for the years 2007,
2006 and 2005. ACE’s 2007 results reflect the consolidation of Aeroplan’s
operations only up to March 14, 2007, the consolidation of Jazz’s operations
only up to May 24, 2007 and the consolidation of ACTS’ operations only up to
October 16, 2007.  After those dates, ACE’s investments in Aeroplan,
Jazz and ACTS Aero are accounted for using the equity method.  The
equity income from ACE’s investment in Aeroplan, Jazz and ACTS is recorded in
non-operating income (expense) on ACE’s consolidated statement of
operations.





($
      millions, except per share figures)
            2007(1)
            2006
            2005Operating
      revenues
            $      10,826
            $      10,657
            $      9,830Special
      charge for Aeroplan miles (2)
            -
            (102)
            -Operating
      revenues
            $    10,826
            $    10,555
            $    9,830Operating
      expenses (3)
            (10,373)
            (10,160)
            (9,375)Operating
      income
            $         453
            $         395
            $       455Total
      non-operating income (expense), non-controlling interest,foreign
      exchange gain (loss) and income tax
            945
            13
            (194)Net
      income (loss)
            $     1,398
            $        408
            $       261EBITDAR
      (4)
            $     1,358
            $     1,412
            $    1,354EBITDAR
      excluding special charges (4)
            $     1,373
            $     1,539
            $    1,354Earning
      (loss) per share-
      Basic
            $     13.51
            $       4.01
            $      2.66-
      Diluted
            $     11.44
            $       3.80
            $      2.48Cash,
      cash equivalents and short-term investments
            $     3,139
            $    3,178
            $    2,181Total
      assets
            $   13,771
            $  13,441
            $  11,847Total
      long-term liabilities (5)
            $     5,357
            $    4,775
            $    4,402





(1)
            The
      results and financial position of Aeroplan, Jazz and ACTS are not
      consolidated with ACE effective March 14, 2007, May 24, 2007 and October
      16, 2007, respectively.  Since those dates, ACE is accounting
      for its investments in Aeroplan, Jazz and ACTS under the equity
      method.


(2)
            2006
      includes a special charge of $102 million in connection with Air Canada's
      obligation for the redemption of pre-2002 Aeroplan
  miles.


(3)
            2006
      includes a special charge for labour restructuring of $25
      million.  2007 includes special charges for labour restructuring
      of $15 million.


(4)
            Refer
      to section 20 "Non-GAAP Financial Measures" in this MD&A for a
      reconciliation of EBITDAR to operating income (loss) and EBITDAR excluding
      special charges to operating income
(loss).


(5)
            Total
      long-term liabilities include long-term debt (including current portion)
      and capital leases, convertible preferred shares and other long-term
      liabilities.








64


2007
      Management’s
      Discussion and Analysis


18.         Controls
      and Procedures


Disclosure
Controls and Procedures


Management
of the Corporation, with the participation of the Corporation's Chief Executive
Officer and Chief Financial Officer, has evaluated the effectiveness of the
Corporation's disclosure controls and procedures (as defined in Rules 13a-15(e)
and 15d-15(e) under the U.S. Securities Exchange Act of 1934, as amended (the
"U.S. Exchange Act"), and the rules of the Canadian Securities Administrators
("CSA")).  Based on that evaluation, the Corporation's Chief Executive
Officer and Chief Financial Officer have concluded that, as of December 31,
2007, the Corporation's disclosure controls and procedures were effective to
provide reasonable assurance that the information required to be disclosed by
the Corporation in reports that it files or submits under the U.S. Exchange Act
and Canadian securities laws is (i) recorded, processed, summarized and
reported, within the time periods specified in the rules and forms of the
Securities and Exchange Commission and CSA, and (ii) accumulated and
communicated to management, including its Chief Executive Officer and Chief
Financial Officer, as appropriate to allow timely decisions regarding required
disclosure.





Management’s
Report on Internal Control over Financial Reporting


Management
of the Corporation is responsible for establishing and maintaining adequate
internal control over financial reporting (as defined in Rule 13a – 15(f) under
the U.S. Exchange Act). Internal control over financial reporting includes those
policies and procedures that (i) pertain to the maintenance of records that in
reasonable detail accurately and fairly reflect the transactions and
dispositions of the assets of the Corporation; (ii) provide reasonable assurance
that transactions are recorded as necessary to permit preparation of financial
statements, and that receipts and expenditures of the Corporation are being made
only in accordance with authorizations of Management and the Board of Directors;
and (iii) provide reasonable assurance regarding prevention or timely detection
of unauthorized acquisition, use or disposition of the Corporation's assets that
could have a material affect on the financial statements.





All
internal control systems, no matter how well designed, have inherent
limitations. Therefore, even those systems determined to be effective can
provide only reasonable assurance with respect to financial statement
preparation and presentation. Because of its inherent limitations, internal
control over financial reporting may not prevent or detect
misstatements.  Also, projections of any evaluation of effectiveness
to future periods are subject to the risk that controls may become inadequate
because of changes in conditions, or that the degree of compliance with the
policies or procedures may deteriorate.





Management
assessed the effectiveness of the Corporation’s internal control over financial
reporting as at December 31, 2007.  In making this assessment,
management used the criteria set forth by the Committee of Sponsoring
Organizations of the Treadway Commission (“COSO”) in Internal Control Integrated
Framework and has concluded that ACE’s internal control over financial reporting
is effective.  Management has not identified any material
weaknesses.





The
effectiveness of the Corporation's internal control over financial reporting as
of December 31, 2007 has been audited by PricewaterhouseCoopers LLP, the
independent auditors, as stated in their report.





Changes
in Internal Control over Financial Reporting


There
were no changes to the Corporation's internal control over financial reporting
during the year ended December 31, 2007 that have materially affected, or are
reasonably likely to materially affect, its internal control over financial
reporting, except for remediation of the material weakness in the Corporations’
internal control over financial reporting as at December 31, 2006 with
respect to accounting for income taxes.








65


2007
      Management’s
      Discussion and Analysis
  19.         Subsequent
      Events


Substantial
Issuer Bid


On
January 10, 2008, ACE accepted for purchase and cancellation a total of
40,023,427 Class A variable voting shares and 9,894,166 Class B voting shares at
$30.00 per share for an aggregate purchase price of approximately $1.498 billion
in accordance with the terms of ACE’s Substantial Issuer Bid dated December 6,
2007.  No convertible preferred shares of ACE were deposited on an as
converted basis under the bid.





In
connection with the share purchase and cancellation by ACE, the conversion rate
of ACE's Convertible Notes was adjusted from 37.6879 to 39.0341 Class A variable
voting shares or Class B voting shares per $1,000 principal amount of
convertible notes. The adjustment is effective January 11, 2008 and has been
determined in accordance with the terms of the indenture governing the
Convertible Notes.





ACTS


On
January 14, 2008, ACE received the full balance of $40 million in cash proceeds
from funds held in escrow on closing of the monetization of ACTS in October
2007.





Disposal
of Jazz Air Income Fund Units


On
January 24, 2008, ACE sold a total of 13,000,000 units of Jazz Air Income Fund
to certain funds and accounts managed by West Face Capital Inc. and to Sunrise
Partners Limited Partnership at a price of $7.45 per unit representing total net
proceeds to ACE of approximately $96.85 million.  ACE now holds
approximately 9.5% of the issued and outstanding units of Jazz Air Income
Fund.





Cash
Position


Following
the completion of these transactions, ACE’s unconsolidated cash, cash
equivalents and short-term investments (excluding Air Canada) amounted to $538
million on January 31, 2008.











66


2007
      Management’s
      Discussion and Analysis


20.         Non-GAAP
      Financial Measures


EBITDAR/EBITDA


EBITDAR
(earnings before interest, taxes, depreciation, amortization, obsolescence and
aircraft rent) is a non-GAAP financial measure commonly used in the airline
industry to view operating results before aircraft rent, depreciation,
obsolescence and amortization, as these costs can vary significantly among
airlines due to differences in the way airlines finance their aircraft and other
assets.  For businesses without aircraft rent, such as Aeroplan and
ACTS, EBITDA (earnings before interest, taxes, depreciation, amortization and
obsolescence) is used to view operating results before depreciation,
amortization and obsolescence, as these costs can vary significantly among
companies due to differences in the way companies finance their
assets.  EBITDAR and EBITDA are not recognized measures for financial
statement presentation under GAAP and do not have a standardized meaning and are
therefore not likely to be comparable to similar measures presented by other
public companies.  EBITDAR and EBITDA are reconciled to operating
income (loss) as follows:





Quarter
      4
            
            Year($
      millions)
            2007
            2006
            $
      Change
            2007
            2006
            $
      ChangeAir
      CanadaGAAP
      operating income (loss)
            $     72
            $     (5)
            $       77
            $     433
            $      114
            $       319Add
      back:Aircraft
      rent
            62
            83
            (21)
            282
            341
            (59)Depreciation,
      amortization and obsolescence
            140
            135
            5
            548
            493
            55EBITDAR
            $   274
            $   213
            $      61
            $
      1,263
            $     948
            $      315Add
      back:Special
      charge for Aeroplan miles
            -
            -
            -
            -
            102
            (102)Special
      charge for labour restructuring
            -
            (8)
            8
            -
            20
            (20)EBITDAR
      excluding special charges
            $   274
            $   205
            $      69
            $
      1,263
            $  1,070
            $      193Aeroplan(1)GAAP
      operating income
            $        -
            $      37
            $    (37)
            $       40
            $     140
            $    (100)Add
      back:Depreciation,
      amortization and obsolescence
            -
            3
            (3)
            3
            14
            (11)EBITDA
            $        -
            $     40
            $   (40)
            $      43
            $    154
            $  (111)Jazz(1)GAAP
      operating income
            $        -
            $     33
            $    (33)
            $      62
            $     144
            $     (82)Add
      back:Aircraft
      rent
            -
            34
            (34)
            57
            134
            (77)Depreciation,
      amortization and obsolescence
            -
            5
            (5)
            9
            21
            (12)EBITDAR
            $        -
            $     72
            $   (72)
            $   128
            $    299
            $   (171)





(1)
            The
      information above reflects Aeroplan’s results from January 1 to March 13,
      2007 and Jazz’s results from January 1 to May 23, 2007.  ACE
      ceased consolidating Aeroplan’s and Jazz’s results effective March 14,
      2007 and May 24, 2007.











67


2007
      Management’s
      Discussion and Analysis





Quarter
      4
            
            Year($
      millions)
            2007
            2006
            $
      Change
            2007
            2006
            $
      ChangeACTS(1)GAAP
      operating income (loss)
            $     3
            $     12
            $      (9)
            $       20
            $       (2)
            $      22Add
      back:Depreciation,
      amortization and obsolescence
            1
            8
            (7)
            31
            31
            -EBITDA
            $     4
            $     20
            $   (16)
            $      51
            $       29
            $     22Add
      back:Special
      charge for labour restructuring
            -
            -
            -
            15
            5
            10EBITDA
      excluding special charges
            $     4
            $     20
            $   (16)
            $       66
            $       34
            $      32ACE
      Consolidated(2)GAAP
      operating income
            $    46
            $      73
            $    (27)
            $      453
            $      395
            $      58Add
      back:Aircraft
      rent
            62
            107
            (45)
            323
            441
            (118)Depreciation,
      amortization and obsolescence
            140
            157
            (17)
            582
            576
            6EBITDAR
            $  248
            $   337
            $   (89)
            $  1,358
            $  1,412
            $   (54)Add
      back:Special
      charge for Aeroplan miles
            -
            -
            -
            -
            102
            (102)Special
      charge for labour restructuring
            -
            (8)
            8
            15
            25
            (10)EBITDAR
      excluding special charges
            $  248
            $   329
            $   (81)
            $   1,373
            $   1,539
            $  (166)





(1)
            The
      information above reflects ACTS’ results from January 1 to October 15,
      2007.  ACE ceased consolidating ACTS’ results effective October
      16, 2007.


(2)
            The
      information above reflects Aeroplan’s results from January 1 to March 13,
      2007, Jazz’s results from January 1 to May 23, 2007 and ACTS’ results from
      January 1 to October 15, 2007.  ACE ceased consolidating
      Aeroplan’s, Jazz’s and ACTS’ results effective March 14, 2007, May 24,
      2007 and October 16, 2007,
respectively.









68


2007
      Management’s
      Discussion and Analysis




Operating
Income (Loss) excluding Special Charges


ACE
uses operating income (loss) excluding the special charges for Aeroplan miles
and labour restructuring to assess the operating performance of its ongoing
business without the effects of these special charges. These items are excluded
from ACE financial results and from Air Canada and ACTS results as they could
potentially distort the analysis of trends in business
performance.  The special charge for Aeroplan miles was for the full
and final settlement between the parties in connection with Air Canada’s
obligation for the redemption of pre-2002 Aeroplan miles.  The special
charge for labour restructuring in 2006 was for the total cost of the 20%
non-unionized workforce reduction plan announced in February
2006.  The special charge for labour restructuring in 2007 was for the
cost of the workforce reduction resulting from the termination of a third party
heavy maintenance contract.





The
following measure is not a recognized measure for financial statement
presentation under Canadian GAAP and does not have a standardized meaning and is
therefore not likely to be comparable to similar measures presented by other
public companies.





Operating
income (loss) excluding special charges for labour restructuring is reconciled
to operating income as follows:





Quarter
      4
            
            Year($
      millions)
            2007
            2006
            $
      Change
            2007
            2006
            $
      ChangeAir
      CanadaGAAP
      operating income (loss)
            $    72
            $     (5)
            $     77
            $   433
            $    114
            $      319Add
      back:Special
      charge for Aeroplan miles
            -
            -
            -
            -
            102
            (102)Special
      charge for labour restructuring
            -
            (8)
            8
            -
            20
            (20)Operating
      income (los), excluding special charges
            $   72
            $   (13)
            $     85
            $   433
            $   236
            $     197ACTS(1)GAAP
      operating income (loss)
            $      3
            $      12
            $     (9)
            $     20
            $     (2)
            $        22Add
      back:Special
      charge for labour restructuring
            -
            -
            -
            15
            5
            10Operating
      income (loss), excluding special charges
            $      3
            $      12
            $    (9)
            $     35
            $       3
            $       32ACE(2)GAAP
      operating income
            $     46
            $      73
            $   (27)
            $    453
            $    395
            $       58Add
      back:Special
      charge for Aeroplan miles
            -
            -
            -
            -
            102
            (102)Special
      charge for labour restructuring
            -
            (8)
            8
            15
            25
            (10)Operating
      income, excluding special charges
            $    46
            $      65
            $  (19)
            $   468
            $   522
            $   (54)





(1)
            The
      information above reflects ACTS’ results from January 1 to October 15,
      2007.  ACE ceased consolidating ACTS’ results effective October
      16, 2007.


(2)
            The
      information above reflects Aeroplan’s results from January 1 to March 13,
      2007, Jazz’s results from January 1 to May 23, 2007 and ACTS’ results from
      January 1 2007 to October 15, 2007.  ACE ceased consolidating
      Aeroplan’s, Jazz’s and ACTS’ results effective March 14, 2007, May 24,
      2007 and October 16, 2007,
respectively.











69


2007
      Management’s
      Discussion and Analysis


21.         Glossary
      of Terms


Available Seat Miles or ASMs —
A measure of passenger capacity calculated by multiplying the total number of
seats available for passengers by the miles flown;





CASM —Operating expense per
ASM;





EBITDA — EBITDA is earnings
before interest, taxes, depreciation, amortization and obsolescence and is a
non-GAAP financial measure;





EBITDAR — EBITDAR is earnings
before interest, taxes, depreciation, amortization, obsolescence and aircraft
rent and is a non-GAAP financial measure;





Passenger Load Factor — A
measure of passenger capacity utilization derived by expressing Revenue
Passenger Miles as a percentage of Available Seat Miles;





Passenger Revenue per Available Seat
Mile or RASM— Average passenger revenue per ASM;





Revenue Passenger Miles or
RPMs — A measure of passenger traffic calculated by multiplying the total
number of revenue passengers carried by the miles they are carried;





Yield — Average passenger
revenue per RPM.











70