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: Should foreign currency denominated accounts receivable be translated at the year-end exchange rate where the receivables are hedged by forward currency contracts?
Position: Yes but the foreign exchange gain or loss on the accounts receivable will be offset by the foreign exchange loss or gain on the forward currency contracts. In effect, it is equivalent to using the forward exchange rate to translate the receivables.
Reasons: GAAP and "truer picture" as the foreign exchange gain or loss was locked in at the time the forward contracts were entered into.
April 16, 2003
Robert Collins Income Tax Rulings Directorate
Large Case File, Auditor International and Trusts Division
Audit Division S. Leung
Saint John Tax Services Office 952-4666
126 Prince Williams Street
St-John NB E2L 4H9
2002-016080
Foreign Exchange Gains or Losses on Translation of U.S. Currency Denominated
Accounts Receivable at Year End - XXXXXXXXXX
We are writing in reply to your memorandum of August 30, 2002, in which you requested our opinion as to whether, in the situation described below, the carrying value of the U.S. currency denominated accounts receivable at year end as determined by XXXXXXXXXX (the taxpayer) using the forward currency contract rate is appropriate for income tax purposes or should such receivable be converted at the prevailing year end foreign exchange rate.
The Situation
1. The taxpayer operates XXXXXXXXXX and sells XXXXXXXXXX products into the United States and other foreign markets. The taxpayer had accounts receivable denominated in U.S. dollars at XXXXXXXXXX.
2. In order to reduce potential impact of fluctuations on the Canadian dollar, the taxpayer has entered into forward (sell) contracts to hedge future sales1 (it is not clear whether to hedge future sales or to hedge accounts receivable, see comments below) denominated in U.S. dollars. At XXXXXXXXXX, the taxpayer had outstanding forward currency contracts to sell XXXXXXXXXX U.S. dollars. All forward contracts have a maturity of less than XXXXXXXXXX years.
3. It is the policy of the taxpayer that accounts receivable and accounts payable denominated in foreign currencies are translated at exchange rates prevailing at the balance sheet date or, for hedged amounts, at the relevant forward currency contract rate. Gains and losses arising on the translation of amounts to be settled within one year are included in the statement of operations or for amounts to be settled after one year deferred and amortized over the expected collection period.
4. The taxpayer determined its income for income tax purposes under section 9 of the Income Tax Act (the "Act") on this basis also. That is, no adjustment was made on Schedule 1 of its T2 income tax returns regarding the carrying value of accounts receivable denominated in U.S. dollars.
5. If the amounts of the accounts receivable which were hedged were to be translated at the prevailing year-end rates instead of the forward contract rates, there would be a decrease in taxable income in XXXXXXXXXX of $XXXXXXXXXX and an increase in taxable income in XXXXXXXXXX of $XXXXXXXXXX according to your calculations.
We have reviewed your analysis as well as the arguments of the taxpayer on the subject matter as provided in your memorandum. In the following comments, we assume that the foreign currency denominated accounts receivable (i.e., not future sales2 as noted in item 2 above) are hedged by the forward contracts.
1. IT-95R
First, it should be noted that IT-95R Foreign Exchanges Gains or Losses which was dated December 16, 1980 (i.e., over 20 years ago) is somewhat outdated as it does not reflect certain relevant courts' decisions (such as Gaynor (91 DTC 5288), Netupsky (92 DTC 2283), Koontenay (92 DTC 6023), Friedberg (93 DTC 5507), and Canderel (98 DTC 6100), the substantial amendments to section 1650 of the CICA Handbook in 1983 and the announcements of the Canada Customs and Revenue Agency (the "CCRA") at the 1984 Canadian Tax Foundation Annual Conference and in Income Tax Technical News No. 14 of December 9, 1998. More importantly, IT-95R does not deal with foreign exchange gains or losses involving hedging transactions. Therefore, while some of the general principles expressed in the bulletin are still applicable, certain positions expressed in the bulletin may not be relied upon as representing current law or the interpretative position of the CCRA in the area of the taxation of foreign exchange gains or losses. For example, the statement in paragraph 7 of that bulletin indicating that "the Department will accept any method used to determine foreign exchange gains or losses on income transactions provided that method is, under the circumstances, in accordance with generally accepted accounting principles" may not be applicable as a result of the decisions in Friedberg and Canderel. In those cases, the courts looked at whether the method used to determine income is consistent with the provisions of the Act (the legislation), the legal principles (the case law) and the well-accepted business practices. If more than one method is acceptable, then the method that represents the more accurate picture of profits should be used (see Canderel).
In summary, IT-95R is silent with respect to the treatment of the foreign exchange gain or loss of a foreign currency denominated monetary item (e.g., an account receivable) where such item is hedged by a forward currency contract and is somewhat outdated in certain aspects. It should not be relied upon in the situation at hand because it is not relevant.
2. Generally Accepted Accounting Principles
The generally accepted accounting principles ("GAAP") regarding foreign currency translation are governed by section 1650 of the CICA Handbook.3
Paragraph .14 of section 1650 of the CICA Handbook reads as follows:
"At the transaction date, each asset, liability, revenue or expenses arising from a foreign currency transaction of the reporting enterprise should be translated into Canadian dollars by the use of the exchange rate in effect at that date, except when the transaction is hedged, in which case the rate established by the terms of the hedge should be used."
Paragraph .16 reads:
"At each balance sheet date, monetary items denominated in a foreign currency should be adjusted to reflect the exchange rate in effect at the balance sheet date."
Paragraph .51, .52 and .54 read as follows:
".51 When there is reasonable assurance that an enterprise will undertake the purchase or sale of goods or services in a foreign currency in a future period, it may choose to hedge the transaction so that it establishes the Canadian dollar price of those goods or services at the time of entering into the hedge. Since a subsequent change in exchange rates will not affect the Canadian dollar price of the related goods or services, there will be no exchange gain or loss. Any cost associated with the hedge would be included in the Canadian price of the goods or services. If the hedge is terminated or ceases to be effective, any exchange gain or loss deferred thereon up to that date will continue to be deferred and included as part of the Canadian dollar price of the goods purchased or sold when the transaction takes place.
.52 When a purchase or sale of goods or services in a foreign currency is hedged before the transaction, the Canadian dollar price of such goods or services is established by the terms of the hedge.
.54 If a foreign currency denominated monetary item is covered by:
(a) a hedge that is itself a foreign currency denominated monetary item, any exchange gain or loss on the hedge should be offset against the corresponding exchange loss or gain on the hedged item;
(b) a hedge that is a non-monetary item, any exchange loss or gain on the foreign currency denominated monetary item should be deferred until the settlement date of that monetary item."
Section 1650 of the CICA Handbook indicates that after a sales transaction has been effected, the resulting monetary asset (accounts receivable in this case) may be hedged before its settlement. It also states that where a monetary liability is identified as a hedge of a monetary asset, the intent is to offset the exchange gains or losses arising on one monetary item against the corresponding exchange gains or losses arising on the other monetary item which has been identified as a hedge. The exchange gains or losses on both monetary items are calculated in accordance with the regular procedures for monetary items and are offset against each other before recognition in the financial statements.
Where a monetary asset is hedged with a forward exchange contract which expires within a year, one author opined that the foreign currency denominated asset should be translated at the prevailing year-end rate but the difference between the rate at the time of the transaction and the prevailing year end rate would be charged to a deferred exchange account which is to be settled at the expiration of the forward contract (i.e., offset at that time against the gain or loss of the forward contract). In other words, the difference in the two rates would not be recognized for computing current year income and will be offset when the forward contract is settled.4
In summary, it is our understanding that GAAP does not require that the exchange gain or loss on a foreign currency denominated monetary item be included in computing income where the item is covered by a hedge of another foreign currency denominated monetary item. Either the foreign exchange gain or loss on the hedged item is offset by the loss or gain on the item which is identified as the hedge or the gain or loss on the hedged item is charged to a deferred account which will be offset at the time the item that is identified as the hedge is settled.
You will have to verify whether GAAP described above is considered to be well-accepted business practices as, according to Canderel, they may not be the same. It should be noted that one of the criteria of determining which method is acceptable in computing income for income tax purposes is that it is to be consistent with the well-accepted business practices.
3. Court Cases
As noted above there are various court cases that deal with the method of computing income for income tax purposes. Those cases cited above are only some of the more familiar ones. We understand that you base your position on the issue at hand mainly on the Friedberg case while the taxpayer disagreed with your interpretation of that case and put more emphasis on the Canderel case. Both of these cases are decided by the Supreme Court of Canada, the highest court in the land, while Canderel was decided later than Friedberg. It is your position that in accordance with the decision in Friedberg, the so-called realization method of computing income in respect of a financial instrument should be used. The taxpayer in Friedberg who traded extensively in gold futures used the "lower of cost or market" accounting method in calculating income. Pursuant to this method, a gain in trading is recognized as income when it is closed out and sold, whereas an unrealised loss is immediately accounted for and debited from income. In each taxation year under appeal, the taxpayer closed out his losing legs on the spread positions but deferred closing out those that were showing a profit until after the end of the taxation year, thereby securing for himself substantial deferrals of income. The court found that no "unincurred losses" were deducted by the taxpayer on the facts of the case and, accordingly, there was no need for it to determine the income tax validity of the implication of the "lower of cost or market" method in that case. It is, therefore, your opinion that since the forward exchange contracts have not been closed out at the end of the taxation year, they could be ignored in computing income of the taxpayer for that year, and since GAAP requires that at year end monetary items denominated in foreign currency be translated at the prevailing year end rate (see paragraph .16 of section 1650 of the CICA Handbook described above), the U.S. dollar denominated accounts receivable should be translated at the prevailing year end rate in computing income of the taxpayer for income tax purposes.
However, while the CCRA recognizes the realization method of computing income in respect of a financial instrument for a trader in commodity future, it does not mean that the Supreme Court of Canada precluded the use of the "mark-to-market" method (or the margin account balance method) in computing income for income tax purposes.5 In fact, the Federal Court of Appeal in Friedberg recognized that both accounting experts who testified before the trial judge agreed that the "mark-to-market" method would be a more accurate reflection of the true financial position of the taxpayer, it was only that no legislation required that this method be used. The Supreme Court of Canada in Canderel stated that while the "mark-to-market" accounting method proposed by the Minister may better describe the taxpayer's income position for some purposes, it was not satisfied that it can describe income for income tax purposes. However, it did not say that the "mark-to-market" method is not an acceptable method. Therefore, if the taxpayer in this case did not want to use the realization method, it is perfectly legitimate if the method that the taxpayer wanted to use is also acceptable for income tax purposes in that it does not conflict with any provisions of the Act, the case law or the generally accepted business practices.
Furthermore, the case of Friedberg involves the method of reporting gains or losses of gold future contracts which is quite different from the situation at hand which deals with the method of translating foreign currency denominated monetary asset (accounts receivable) at year end where the monetary asset is hedged. In Friedberg no foreign currency denominated contract was involved. Therefore, there was no need to decide in that case whether a foreign currency denominated contract should be translated at the year-end rate.
Several court cases indicated that the method that accords the "truer picture" of the taxpayer's income should be adopted.6 We feel that, in the case at hand, it will give a "truer picture" of the taxpayer's income if any foreign exchange gain or loss on the foreign currency denominated accounts receivable is offset by the foreign exchange loss or gain of the forward currency contracts.
4. Our Previous Technical Opinions
In file #73789, dated May 10, 1989, (the position of which was also referred to in file #9507334, dated January 25, 1996) under the title "Treatment of Exchange Gains or Losses on Specific Hedges", we stated that a taxpayer will not have foreign exchange gains or losses on either a foreign currency debt or a forward contract if
(a) the foreign funds to be purchased under a forward contract are irrevocably committed to payment of a specific debt; and
(b) the forward contract can be considered to be an agreement relating to that specific debt.
It is a question of fact whether in this case the forward contracts were irrevocably committed to the receipt of the accounts receivable and are considered to be an agreement relating to a specific receivable. If they were, it is not our practice to require the taxpayer to report the foreign exchange gains or losses.
In file #9824405, dated November 23, 1999, we concluded that the realization method of reporting transactions in future contracts is acceptable. However, in certain fact situations the principles of Canderel may have application.
Conclusion
In summary, it is our view that the foreign currency denominated accounts receivable should be translated into Canadian currency at the prevailing year end exchange rate but so should the forward currency contracts such that any foreign exchange gain or loss on the receivables would be offset by the foreign exchange loss or gain of the forward currency contracts. Since there is no net foreign exchange gain or loss recognized after the dates the forward currency contracts were entered into because of the offset described above, the taxpayer's method of using the forward contract rates to report its U.S. dollar denominated accounts receivable is acceptable since the result is consistent with what is stated above and is not inconsistent with (i) the provisions of the Act, (ii) the established case-law principles, and (iii) well-accepted business practices.
Our above comments apply only to the facts of the situation described above. They may not be applicable to swaps, options or forward contracts that are used to hedge other monetary or non-monetary items.
We trust you will find the above to be of assistance. If you have any question regarding the above, please do not hesitate to contact us.
For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the CCRA's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Request for this latter version should be made by you to Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
Jim Wilson
Section Manager
for Division Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch
ENDNOTES
1 In your submission regarding the taxpayer's financial disclosure on foreign currency, under the caption Financial Instruments in the Notes to the Financial Statements, it is stated that "...the Company has entered into forward (sell) contracts to hedge future sales denominated in U.S. dollars..." (Underline added).
2 If a specific sales transaction is hedged by a forward contract, the sales should be recorded at the forward contract rate and there should not be any exchange gain or loss (see paragraph .51 of section 1650 of the CICA Handbook).
3 The accounting and auditing handbook published by Canadian Institute of Chartered Accountants.
4 See an example of a hedge of a foreign currency monetary liability with a forward exchange contract in "Foreign Currency Translation", by Christina S.R. Drummond, published by Butterworths, 1983.
5 See legal opinion referred to in file #97507334.
6 See, for examples, Silverman, Maritime Telegraph, West Kootenay, and Canderel.
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