Date: 20081006
Docket: A-433-07
Citation: 2008 FCA 297
CORAM: NADON
J.A.
EVANS J.A.
PELLETIER
J.A.
BETWEEN:
SASKFERCO PRODUCTS ULC
Appellant
and
HER MAJESTY THE QUEEN
Respondent
REASONS FOR JUDGMENT
EVANS J.A.
A. INTRODUCTION
[1]
For income
tax purposes, foreign exchange losses or gains on the repayment of a loan
denominated in a foreign currency take their character as income or capital from
the nature of the loan. So, if a loan finances the construction of a capital
asset, foreign exchange losses on repayments are on the borrower’s capital
account and cannot be used to reduce its income tax liability. See, for example,
CCLI (1994) Inc. v. The Queen, 2007 FCA 185, 2007 D.T.C. 5372.
[2]
The question
to be decided in this appeal is whether the “debt principle” as the basis for
characterizing a foreign currency loss or gain is displaced when an important
reason for borrowing in a foreign currency is to “hedge”, or neutralise the
impact of currency fluctuations on, income earned by the borrower in that
currency from otherwise unrelated transactions.
[3]
This is an
appeal by Saskferco ULC from a decision of the Tax Court of Canada (2007 TCC
462) in which Justice Woods dismissed Saskferco’s appeal from its income tax
assessments for the taxation years 1995, 1996, 1998, and 1999. In preparing its
income tax returns, Saskferco had applied hedge accounting principles, whereby
it booked both US dollar sales revenues (to the extent of loan repayments) and repayments
of a loan denominated in US dollars at the rate of exchange prevailing when the
loan was made. This effectively eliminated the impact of changes in the rates
of exchange of US and Canadian dollars in the taxation years in question.
[4]
In the
notices of reassessment, the Minister reversed the effects of hedge accounting
on the calculation of Saskferco’s tax liability by booking revenue at the
exchange rates at the date of a sale and by booking loan repayments at the
exchange rate when they were made. The effect was to increase Saskferco’s US
dollar denominated sales revenue and to create foreign exchange losses when it
made loan repayments. This result was purely the function of the direction in
which the exchange rate had moved in the taxation years in question. Thus, if,
instead of declining in these years against the US dollar, the Canadian dollar
had appreciated, Saskferco would have shown less sales revenue, and gains on loan
repayments.
[5]
In
addition to changing the timing of the exchange transactions, the Minister
treated the gains and losses asymmetrically by attributing currency gains on
sales revenue to income account, and currency losses on loan repayments to
capital account.
[6]
Saskferco
appealed the Minister’s notices of reassessment to the Tax Court of Canada. In
dismissing its appeal, Justice Woods applied the principle that foreign
exchange losses on loan repayments take their character from the debt. She rejected
the claim that hedge accounting principles applied in this case so as to cancel
out, for tax purposes, Saskferco’s foreign currency losses and gains on its loan
repayments and revenue from US sales respectively. Since the
foreign exchange losses were on capital account they could not offset Saskferco’s
gains from its US sales in order to reduce its
income tax liability.
[7]
In its
appeal to this Court, Saskferco says that, under the hedging principle, foreign
exchange losses or gains take their character as income or capital from the
nature of the transaction being hedged. Counsel argues that the Judge erred in
law by ignoring the fact that an important reason for the loan of US$231 million
was to hedge Saskferco’s US dollar income and that its foreign currency losses on
the repayment of the loan were more closely linked to the loan’s hedging
purpose than to its financing purpose. The losses are therefore attributable to
income account and are available to reduce Saskferco’s “hedged” revenue from
its US sales.
[8]
In
response, the Minister says that income tax liability is based on transactions,
not overall economic reality. And, since the denomination of a loan in a
foreign currency is not a transaction, the only relevant transaction is Saskferco’s
borrowing to finance a capital project. Saskferco’s foreign exchange losses on
the loan repayments are therefore also on capital account for tax purposes.
[9]
In my
view, Justice Woods made no reversible error in reaching her conclusion.
Accordingly, I would dismiss the appeal.
B. FACTUAL BACKGROUND
[10]
While
planning to embark on the production of nitrogen-based fertilizer, Saskferco
estimated that approximately 50% of future sales would be in US markets, and
that the annual revenue from total sales would be US$100 million. The Province of Saskatchewan’s potential partner
in the joint venture was concerned about the exposure of the US sales revenue to currency fluctuations.
If the Canadian dollar appreciated against the US dollar, the value of the
Saskferco’s US sales revenue would be diminished when converted into Canadian
dollars, an especially important consideration since most of its operating and
construction costs would be payable in Canadian dollars.
[11]
On the
basis of a report by its financial adviser, Saskferco financed the construction
of its plant largely by issuing notes totalling US$231 million, repayable in
instalments. Denominating the loan in US dollars allowed Saskferco to take
advantage of lower interest rates in the United States and to protect itself
against uncertainties in its revenue from US sales as a result of currency
fluctuations in the relative values of the US and Canadian dollars. US dollar
revenues from Saskferco’s sales would be used to repay the notes. This matching
of foreign denominated revenues against debts or other expenses in a foreign
currency is known as a “natural hedge”.
[12]
Saskferco adopted
this means of minimising the effects of currency fluctuations on its sales
revenue because it had been unable to enter into contracts at a commercially
viable cost for the forward purchase of US dollars, or other kinds of
“derivative” contracts commonly used to provide a hedge against foreign
exchange exposure on a transaction in a foreign currency.
[13]
In the
four taxation years in question in this appeal, years when notes were repaid,
the Canadian dollar declined sharply against the US dollar. This resulted in
total foreign currency losses on Saskferco’s repayments of principal in these
years of more than Cdn$13 million.
[14]
Saskferco
was advised by its auditors that it could offset the foreign currency gains on
its US sales revenues and losses on
its loan repayments by using hedge accounting, if it preserved sufficient US
dollars from its sales revenue to make loan repayments. Because the value of
Saskferco’s sales exceeded its loan repayments, the loan did not hedge its
entire US revenue. The “unhedged”
portion of the revenue was converted into Canadian dollars at the rate of
exchange rate prevailing when it was earned.
[15]
In fact, Saskferco
converted the US dollar proceeds of its sales into Canadian dollars because it
could earn a higher rate of interest in Canada. In order to preserve the hedge, Saskferco
purchased derivative contracts at the time when the sales revenue was
converted, in order to eliminate any currency exposure between the times when
the sales revenues were received and the loan repayments were made.
C. DECISION OF THE TAX COURT
[16]
Justice
Woods addressed two issues. First, Saskferco argued that the hedge accounting
principles used for calculating Saskferco’s sales revenue in its financial
statements were equally applicable for income tax purposes. Thus, for the years
that loan repayments were made, Saskferco calculated the portion of its sales
revenues needed to cover the exchange losses on the loan repayments, as well as
the repayments of the loan itself, in Canadian dollars at the rate of exchange when
the notes were issued. Hedge accounting was said to be appropriate because it reflected
the reality of Saskferco’s financial position by cancelling currency losses on
the loan repayments and currency gains on the sales revenue.
[17]
Justice
Woods rejected this argument, which she described as the “primary argument of
the appellant”, and held that, even if this method of accounting conformed to
generally accepted accounting principles, it was not acceptable for calculating
profit for the purpose of subsection 9(1) of the Income Tax Act, R.S.C.
1985 (5th Supp.), c. 1.
|
9.(1)
Subject to this Part, a taxpayer’s income for a taxation year from a business
or property is the taxpayer’s profit from that business or property for the
year.
|
9.(1)
Sous réserve des autres dispositions de la présente partie, le revenu qu’un
contribuable tire d’une entreprise ou d’un bien pour une année d’imposition
est le bénéfice qu’il en tire pour cette année.
|
[18]
The Judge held that
it was contrary
to the principle, supported in the jurisprudence, that a taxpayer must use the
rate of exchange at the time of the transaction, which, on the present facts,
was when the contracts of sale and the loan repayments were made. Saskferco
does not challenge this conclusion in its appeal.
[19]
Second,
Justice Woods refused to apply to the facts of this case the principle that a
hedging contract takes its character as income or capital from the character of
the item hedged. She pointed out that, while hedge accounting principles look
at the reality of a business’s financial position, the Income Tax Act
makes a fundamental distinction between income and capital.
[20]
The Judge found
that, unlike other kinds of “derivative” transactions (such as contracts for
the future purchase of foreign currency and currency “swaps”) entered into to
hedge items on income account, Saskferco’s loan was denominated in US dollars
not only to hedge its foreign exchange exposure on the sales revenue, but also to
reduce the cost of financing the construction of its plant by obtaining a lower
rate of interest. She was not satisfied that the loan would have been
denominated in Canadian dollars even if currency fluctuations had not been a consideration.
[21]
In these
circumstances, Justice Woods concluded that the jurisprudence establishing that
foreign exchange losses on a debt take their character from that of the debt
applied in this case, even though protection against currency fluctuations was
“an important factor” (at para. 80) in Saskferco’s decision to denominate the
loan in US dollars. Accordingly, Saskferco was entitled to use losses on the
loan to reduce only capital gains, not income.
[22]
However,
Justice Woods was not unsympathetic to the position of Saskferco, describing
(at para. 87) as “harsh” the asymmetrical tax consequences of attributing foreign
exchange losses on the debt to capital account, and gains to income. She also
seemed to imply (at para. 80) that, if the loan had been denominated in US
dollars solely to offset foreign exchange losses (that is, interest rates were
not a consideration), the result would have been different. Because these
observations are not integral to her decision, I do not wish to express a firm
view on their correctness. I would, however, make two points.
[23]
First, when
the Canadian dollar appreciates against the US dollar, Saskferco’s foreign
currency gains on the loan repayments will be on capital account, thus making
it liable to tax at the lower rate imposed on capital gains. This, in my view, mitigates
the alleged “harshness” of the effect of the tax asymmetry in the present case,
whereby Saskferco must pay income tax on all foreign exchange gains on its
sales revenue.
[24]
Second, as
for the suggestion that it would (or should) have made a difference if
Saskferco had denominated the loan in US dollars solely for currency exchange
reasons, I would note that, unlike other arrangements for hedging currency
exposure, such as the forward purchase of foreign currency, Saskferco’s loan
had an independent commercial purpose (financing the construction of the plant)
that was unrelated to the contracts of sale. That Saskferco was unable to enter
into a derivative contract at a commercially viable cost does not warrant
treating foreign currency losses on the repayment of money borrowed to finance a
capital expenditure as on income account for tax purposes.
D. ISSUES AND ANALYSIS
[25]
Since the
determination of this appeal turns on a question of law, correctness is the applicable
standard of review. So much is common ground.
[26]
The legal
issue to be decided in this appeal is fairly narrow. Saskferco does not base
its argument on the interpretation of a provision of the Income Tax Act.
It is conceded that subsection 39(2), which deems foreign exchange losses to
be on capital account, only applies if the underlying transaction in connection
with which the losses were incurred is capital in nature: Imperial Oil Ltd.
v. The Queen, 2004 FCA 361, 2004 D.T.C. 6702 at para. 16. Nor is there any judicial
authority directly on point.
[27]
Counsel for
Saskferco says that the question at stake is one of principle: should the tax
treatment of exchange losses and gains on contracts for the forward purchase of
foreign currency to protect against foreign exchange exposure on other
transactions on revenue account apply to the facts of this case, where hedging
was an important, but not the only, reason for its US dollar denominated loan.
He submits that the answer is to be found in deciding which of two competing
principles is applicable here: foreign exchange gains or losses take their
character as income or capital from that of the underlying loan or, when
foreign exchange gains or losses arise on a hedging transaction, they take
their character from that of the hedged transaction.
[28]
Acknowledging
that liability under the Income Tax Act is based on transactions,
Saskferco says that the transaction in question here is its US dollar
denominated loan. It concedes that the denomination of a loan in a foreign
currency is not an independent transaction: Canadian Pacific Ltd. v. The
Queen, [2002] 3 F.C. 170, 2001 FCA 398 at para. 23 (Canadian Pacific).
Rather, Saskferco argues that the currency of its loan is an element of the loan
when viewed in its totality, and that the foreign exchange losses incurred in
repaying it are more closely connected to the loan’s hedging than to its financing
function.
[29]
Attractively
as counsel put his argument, I cannot accept it. First, I do not see how one
can avoid the conclusion that the relevant transaction is a loan taken to
finance the construction of a capital project, the proceeds of which were in
fact used for this purpose. The loan was unrelated to the US sales, except in the obvious, but
irrelevant, sense that, without the plant, Saskferco would have had no
fertilizer sales at all. Indeed, the foreign exchange gains on the sales
revenues arose at different times from the losses on the loan: that is, the
conclusion of the contracts of sale and the repayments of the loan. Sales
income was entered throughout the year as it arose, while loan repayments were
entered once a year.
[30]
The fact
that the loan was denominated in US dollars for financing and foreign exchange reasons
does not alter its essential character as borrowed money to finance a capital
project: Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622 at para, 32. Therefore,
foreign currency gains or losses on its repayment are also on capital account.
[31]
Second,
the case principally relied upon by Saskferco as supporting its position is Netupsky
v. The Queen, 92 D.T.C. 2282 (T.C.C.), where a taxpayer was able to claim
currency exchange losses on a loan denominated in Swiss francs, even though the
proceeds of the loan, when converted into Canadian dollars, were used to refinance
a rental property.
[32]
Netupsky is distinguishable from the
present case because it did not involve a hedge, and (although this is not
altogether clear) the taxpayer’s only purpose in borrowing in Swiss francs
seems to have been to make a profit from speculating in commodities. More
important, however, the basis of the Court’s decision was that the taxpayer had
entered into two separate transactions: the borrowing in Swiss francs, and
their conversion into Canadian dollars and use for the mortgage. However, this
reasoning is inconsistent with the subsequent decision of this Court in Canadian
Pacific, holding that the denomination of a loan in a foreign currency is
not a transaction separate from the borrowing. Netupsky thus does not
materially assist Saskferco. To the extent that MacMillan Bloedel Ltd. v. The
Queen, 90 D.T.C. 6219 (F.C.T.D.) was decided on the basis that a borrowing
and its currency denomination constitute two transactions, its authority is
also in doubt.
[33]
Third, the
law of taxation rests largely on a complex statutory scheme in which particularities
rather than general principles normally determine outcomes. Hence, courts should
approach with considerable scepticism arguments based solely on general
principle, even where, as here, the Income Tax Act does not deal
comprehensively with an issue. It is notoriously difficult for policy-makers,
let alone judges, to foresee the ramifications of general principles when
employed as the basis for the determination of liability to tax.
[34]
Whether courts
have accepted hedge accounting as a taxation principle at the level of generality urged upon us
by Saskferco seems to me highly questionable. The attribution of foreign
exchange gains or losses on income account for tax purposes when income
transactions are hedged by derivative contracts is an inadequate basis for
extending them to commercially independent transactions and thereby departing
from the well-accepted principle that foreign exchange losses on the repayment
of a loan take their character from that of the loan itself.
[35]
Counsel argued that it
would be bad public policy for the Court not to generalize hedge accounting principles
and apply them to the facts of this case for tax purposes. In particular, he
said, for the law of taxation to prefer some hedging transactions (derivative
contracts) over others with a hedging purpose (the loan in this case) would
have a distorting effect on the market, to the detriment of international trade
and commerce, because a “natural hedge” would not eliminate all the
uncertainties flowing from currency fluctuations. I am not in a position to
assess the merits of this argument; it is more appropriately raised as a policy
issue with the Department of Finance and, ultimately, with Parliament. It
cannot, in my view, warrant the Court’s extension of the law respecting the tax
treatment of losses and gains on hedging transactions in the manner urged by
Saskferco.
[36]
I would only note in
this context that, tax consequences aside, the foreign exchange risks were in
fact hedged as intended, albeit that, since the value of the Canadian dollar declined
during the taxation years in question, foreign exchange gains on Saskferco’s sales
revenues offset losses on its loan repayments, and not vice versa. Tax
considerations appear to have played no part in Saskferco’s decision to
denominate the loan in US dollars.
E. CONCLUSIONS
[37]
For these
reasons, I would dismiss the appeal with costs.
"John
M. Evans"
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