26 February 2002 Internal T.I. 2002-0117147 - WEAK CURRENCY LOANS

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: weak currency loans

Position: general comments provided on section 20.3

Reasons: N/A

									February 26, 2002

TORONTO CENTRE TSO					HEADQUARTERS
Verification and Compliance Division 			Corporate Financing Section
G. Moore
Attention:  Thomas Haddrath					(613) 957-8953

								2002-011714

Weak Currency Debt - Subsection 20.3(1) of the Income Tax Act

We are writing in response to your correspondence of December 24, 2001, regarding subsection 20.3(1) of the Income Tax Act (the "Act").

You have asked for our comments regarding the tax treatment of weak currency debt incurred or assumed after February 27, 2000, and in particular, for clarification regarding the meaning of the term "reference rate" in paragraph 20.3(1)(c) of the Act. You have also asked for our comments and suggestions regarding the application of section 20.3(1) of the Act to the following example:

"X Co. needs a loan of $10 million Canadian dollars for three years. X Co. decides to borrow from a financial institution in the Country Zen. At the time the loan is taken, C$1 = $ 1.2 Zen dollars. Therefore, to obtain $10 million Canadian dollars, X Co. must borrow $12 million Zen dollars. Because the Zen dollar's value is expected to fall, the future spot rate when the loan must be repaid in three years is C$1 = $1.5 Zen dollars. Assume that the reference rate is 2 points higher than an equivalent 3-year loan in Canadian dollars. (The reference rate is neither the prime rate nor the prescribed rate. Basically, to prove the loan is two points higher, you have to find another existing loan and compare the rules to each other. This is how the relevant rate is defined)

All excess interest is disallowed in the current year. The excess is calculated each year and accumulated. In the year the foreign gain is realized, the accumulated excess can be deducted against the foreign gain. Note that the remaining foreign gain is treated as income not capital gains under the new rules.

For. Loan Interest	Can. Loan Interest	Denied Interest
					    Deduction
Year 1		    C$500			C$400		   C$100
Year 2		    C$450			C$375		   C$ 75
Year 3		    C$278			C$222		   C$56    

Excess Interest Disallowed			 		   C$231

Year 3: the foreign gain is $400. Therefore, $400 - $231 = $169 Treated As Income Only (Not Capital Gain)."

Our Comments

As you know, section 20.3 limits the deductibility of interest expense and adjusts foreign exchange gains and losses in respect of weak currency debts and associated hedging transactions. Section 20.3 sets out specific rules concerning the taxation of weak currency debts to the debtor. When it is expected that a currency will decline in value relative to a reference currency, the interest rate on a loan in the weak currency will generally be higher than on a loan on similar terms in the reference currency. The higher rate reflects the market's expectation that the amount of the loan expressed in the weak currency will be worth less in terms of the reference currency when the loan is repaid. Lenders generally demand a higher interest rate to compensate for this expected depreciation. If, as expected, the weak currency depreciates, the borrower will realize a foreign exchange gain when the principal of the loan is repaid in the depreciated foreign currency. In economic terms, this gain compensates for the higher interest payments made during the term of the loan. Hedging transactions may be used to fix the reference currency cost of the interest and principal payments that are required to be made in the weak currency.

In general, section 20.3 applies when a taxpayer incurs foreign currency indebtedness that meets the following conditions:

- the proceeds from the indebtedness are not used directly in the currency of the debt, but rather are converted into another currency and used in that form by the taxpayer;

- the interest rate on the debt is more than two percentage points above the rate on an equivalent borrowing in the currency used to earn income; and

- the principal amount of the debt exceeds $500,000.

When these conditions are met, generally, the following rules will apply:

- deductible interest on the indebtedness will be limited to the interest that would have been payable if the taxpayer had incurred an equivalent debt directly in the currency of use;

- the total interest expense disallowed over the term of the indebtedness will be subtracted from the foreign exchange gain or loss realized when the debt is repaid; and

- any foreign exchange gain or loss realized on repayment of the debt, and the gain or loss on any associated hedge, will be on income account.

With respect to the example you provided, we agree with the result outlining the application of section 20.3. It is our view that the "reference rate", as referred to in paragraph 20.3(1)(c) of the Act, is the interest rate on a loan for an equivalent amount denominated in the final currency (Canadian dollars in your example) for the same terms as the foreign loan taken in the weak currency. You may wish to add a comment to the example stating that the application of the rule in section 20.3 does not fully eliminate the exchange gain because the calculation in that provision takes the simplifying approach of allowing the interest deduction over the term of the loan at a fixed percentage of the original Canadian dollar value of the principal. In theory, the foreign exchange gain should be fully offset by the aggregate of the non-deductible interest (Can $) over the term of the loan. Also, for purposes of your example, you indicate that the reference rate, as referred to in paragraph 20.3(1)(c) of the Act, is 2 points higher than an equivalent 3-year loan in Canadian dollars. Instead of referring to the reference rate, it may be more helpful to indicate that X Co. could have borrowed $10 million in Canada for a three-year loan at, say 4%, but instead borrowed the Canadian dollar equivalent of $12 million Zen dollars at, say 7%, on the same terms. Then, you could explain in the example that, since X Co. could have borrowed the Canadian dollar equivalent of $12 million Zen dollars ($10 million Canadian dollars) on the same terms for 4%, X Co.'s annual interest deduction is limited to 4% of C$10 million (i.e., C$400,000). If you choose to include specific interest rates in your example, the figures for interest paid on the foreign loan and annual deductible interest should be revised accordingly. In addition, the use of fluctuating interest rates in your example makes it more difficult to follow. We would suggest that you utilize the same interest rate over the term of the loan.

We trust our comments will be of assistance. If you wish to discuss this further, please contact Gwen Moore at 957-2747.

Paul Lynch
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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