CRA rejects the recognition of a loss on a s. 261 conversion to the U.S. dollar

Canco had all along been preparing its financial statements is U.S. dollars and then validly elected to adopt the USD as its functional currency effective the beginning of its 2015 taxation year. It proposed to recognize a loss for ITA purposes equal to the difference between (i) its USD retained earnings (“R/E”) balance in its 2014 USD balance sheet (used for financial statement purposes) and (ii) its “R/E for Canadian income tax purposes” resulting from converting its December 31, 2014 R/E into USD under s. 261(7)(h) using the December 31, 2014 relevant spot rate. (There, that was easy to say!)

CRA identified a fundamental flaw: s. 261 does not recognize gains or losses on the conversion, and the conversion only affects the computation of subsequently realized (or otherwise recognized) amounts. In any event, Canco’s year-end retained earnings are not an amount “that is relevant in determining the Canadian tax results” and, therefore, are not to be converted under s. 261(7)(h). For instance, the retained earnings that is referenced for thin cap purposes is the retained earnings in the opening balance sheet contained in the financial statements used for accounting purposes.

Neal Armstrong. Summary of 2 March 2017 External T.I. 2016-0633981E5 under s. 261(7)(h).