21 August 2002 Internal T.I. 2002-0138617 - LIFE INSURANCE FOREIGN CURRENCY SWAPS

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:

Whether swap losses are deductible in determining taxable income of a resident multinational life insurance company if the underlying investments (foreign currency bonds) are non-designated investment property.

Position:

Will depend upon the particular facts and whether the swap or forward contracts are used or held in carrying on the insurance business in Canada.

Reasons:

A derivative agreement such as a swap or forward contract is a contractual arrangement separate from any associated asset or liability for which it may be designed to hedge. In this instance, the foreign currency bonds and related swap or forward contracts are two distinct groups of assets each with their own different characteristics and related tax consequences. It is a question of fact whether the swap and forward contracts will be considered to the used or held in the course of carrying on an insurance business in Canada and that the fact that the contracts have been used to hedge against potential losses arising from non-designated property is an important fact which in our view supports the view that the related swap losses are not deductible. This does not mean that the contracts are not being treated as transactions separate from the underlying bonds, merely that the nature of the underlying asset is an important factor in the determination of whether the contracts were used or held in the insurance business in Canada.

August 21, 2002

Income Tax Appeals Division					Income Tax Rulings
John Crowley							  Directorate
Manager							K. Cooper, LL. B.
									957-8984
Attention: John Kingston
									2002-013861

Losses on Foreign Currency Swaps related to Non-Designated Assets

We are writing in response to your memorandum of May 2, 2002 requesting our comments with respect to a referral you received regarding a claim by XXXXXXXXXX for a deduction in respect of losses on foreign currency swaps related to non-designated foreign currency bonds in taxation years prior to 1998. In this regard you enclosed the referral you had received from the TSO that contained a description of the facts and positions of the parties with respect to the issues discussed as well as various other documents. We will not repeat this material herein except as required.

Issue

The issue raised in the referral is whether swap losses are deductible in determining taxable income of a resident multinational life insurance company if the underlying investments (foreign currency bonds) are non-designated investment property.

Comments

We maintain the view expressed in our document dated September 13, 2000 (#2000-0042885) that a derivative agreement such as a swap or forward contract is a contractual arrangement separate from any associated asset or liability for which it may be designed to hedge. In this instance, the foreign currency bonds and related swap or forward contracts are two distinct groups of assets each with their own different characteristics and related tax consequences. The principal question when dealing with a resident multinational life insurer will be whether such assets are used or held in carrying on the insurance business in Canada within the meaning of subsections 138(2) and 138(9) of the Income Tax Act (the "Act") since the insurance company will only be taxed with respect to its business carried on in Canada and with regard to investment assets that constitute designated property. The basis upon which these determinations are made will depend upon the facts of each particular situation.

With respect to the underlying foreign currency bonds, we have been advised that for the most part these bonds were not property used or held by the insurer in the course of carrying on an insurance business in Canada, i.e. non-designated investment property, and, as such, any interest income related thereto have not been included in the taxable income of the insurer on the basis of subsection 138(9) of the Act.

Regarding the swap or forward contracts, the inclusion of any resulting gains or losses should be based on the principles in subsections 138(2) and (9) of the Act. Since the swap or forward contracts are not investment property within the meaning of subsection 2405(3) of the Income Tax Regulations (the "Regulations") as it read during the relevant taxation years, for the insurer to be able to deduct the swap losses on the basis of subsection 138(9) of the Act, the contracts would have to be deemed to be designated by virtue of paragraph 2400(1)(e) of the Regulations, which provided as follows during the relevant taxation years:

(e) such non-segregated property or portion thereof (other than investment property) owned by the insurer at any time in the year and used by it in the year in, or held by it in the year in the course of (determined without reference to this subsection), carrying on an insurance business in Canada shall be deemed to have been designated by the insurer for the year; and

Therefore, the insurer must demonstrate that the contracts were "used by it in the year in, or held by it in the year in the course of ... carrying on an insurance business in Canada." The taxpayer states as fact that the contracts are other insurance property within the meaning of paragraph 2400(1)(e) of the Regulations and supports the assertion with the single statement that the contracts were entered into by it in the course of carrying on its insurance business in Canada and cites as evidence the fact that gains and losses arising from the contracts are reported in the "In Canada Only" Annual Statement to OSFI. We could find no further evidence or submissions in the material provided to support the taxpayer's position in this regard.

It would seem from the material provided that Audit, particularly with respect to the 1994 and 1995 taxation years, has disallowed most of the losses arising from the hedges on the basis that the contracts were related to foreign currency bonds that were not designated property for the purposes of subsection 138(9) of the Act and that the losses were not related to the insurance business in Canada within the meaning of subsection 138(2) of the Act. The basis for this position seems to be that since the purpose of the hedges are to protect against risks associated with the underlying foreign currency bonds, which are non-designated property, the related swap and forward contracts cannot be said to be used or held by the insurer in the course of carrying on an insurance business in Canada and, therefore, do not meet the test in paragraph 2400(1)(e) of the Regulations. For the same reason, Audit concluded that the losses were not related to the insurance business in Canada for the purposes of subsection 138(2) of the Act.

As noted above, it is a question of fact whether the swap and forward contracts will be considered to be used or held in the course of carrying on an insurance business in Canada and the fact that the contracts have been used to hedge against potential losses arising from non-designated property is a fact which in our view supports Audit's position. This does not mean that the contracts are not being treated as transactions separate from the underlying bonds, merely that the nature of the underlying asset is an important factor in the determination of whether the contracts were used or held in the insurance business in Canada. We believe that support for this position may be found in the Supreme Court of Canada's decision in Shell v. H.M.Q., 99 DTC 5669, in which, notwithstanding the Court's admonition to treat the two transactions separately, the Court held that the characterization of "hedging" gains and losses in respect of foreign currency borrowings is to be derived from the characterization of the underlying transaction. In the absence of further facts related to the actual contracts themselves, eg. how were they entered into, where, who are the parties, and facts related to the actual use of the underlying assets, it is reasonable to assume that since the contracts are for the purposes of hedging against losses arising from non-designated property the contracts are not related to the insurance business in Canada and any losses arising therefrom should not be deductible by virtue of either subsection 138(2) or (9) of the Act.

An argument could have been made by the insurer that the swaps and forwards are in respect of a business that is other than an insurance business. If this argument could have been substantiated, which in our view would have required evidence demonstrating that the underlying foreign currency bonds are not held in support of an insurance business carried on outside of Canada, then the income or loss from such assets would also be included in the calculation of their Canadian income in accordance with the general provisions of Part I. However, given their argument that the swap and forward contracts are other insurance property within the meaning of paragraph 2400(1)(e) of the Regulations, as they read during the relevant taxation years, we do not believe that such an argument can be made.

Since the swaps and forwards are alleged to have been entered into in support of the life insurance business, the tax treatment of the transactions is governed by subsections 138(2) and (9) of the Act and we do not believe that paragraph 18(1)(c) of the Act is relevant to the issue.

We trust that these comments are helpful. If you have any questions, or wish to discuss these issues in further detail, please do not hesitate to contact Karen Cooper (613-957-8984) or myself directly.

For/F. Lee Workman
Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch