27 June 2003 Internal T.I. 2003-0019667 - Conversion rate for US dollar receivable

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: Would foreign exchange gains or losses arising as a result of the translation of foreign currency denominated accounts receivable at the year end exchange rate be offset by the foreign exchange gains or losses on the forward currency contracts which are entered into to hedge the projected cash flows from the accounts receivable?

Position: Yes if the forward contracts are not for speculation purposes in that they never exceed the projected foreign currency denominated cash flows from the accounts receivable.

Reasons: This is in accordance with GAAP and it gives a "truer picture".

June 27, 2003

Mr. 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
	New Brunswick

		2003-001966

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 May 16, 2003, in which you requested our opinion as to whether the conclusion set out in our previous memorandum to you (document 2002-016080) ("Previous Memo") applies to the situation described therein in view of the additional information you provided in your memorandum. You provided us several one-page forward currency contracts and Notes 1 to 3 of "Notes to Financial Statements" of XXXXXXXXXX (the taxpayer) as at XXXXXXXXXX.

Note 1 of "Notes to Financial Statements" indicates that it is the accounting 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.

Note 3 of "Notes to Financial Statements" deals with foreign currency of financial instruments and states that the taxpayer's activities result in exposure to fluctuations in foreign currency exchange and interest rates. In order to reduce the potential impact of fluctuations in the Canadian dollars, the taxpayer has entered into forward (sell) contracts to hedge future sales denominated in US dollars. At XXXXXXXXXX, the taxpayer had outstanding forward currency contracts to sell US$XXXXXXXXXX. All forward contracts have a maturity of less than XXXXXXXXXX years. The taxpayer does not engage in any foreign currency activities which have not been specifically identified as hedges.

The one-page forward contracts between the XXXXXXXXXX and the taxpayer that you provided us are substantially similar in that each of them contains the deal date, the option start date, the option end date, the purchase amount in US dollars, the sale amount in Canadian dollars, the exchange rate, the means by which the deal was arranged (e.g., by phone), and the signature of a representative of the taxpayer. It appears that under these contracts the XXXXXXXXXX were committed to purchase from the taxpayer a specified amount of US dollars within the period from the option start date to the option end date at a specified exchange rate for an amount of Canadian dollars specified in the contract. Nowhere in the contracts are there indications that the contract was linked to a specific US dollar denominated account receivable or was entered into for the purpose of hedging such receivable. The US dollar amount specified as the purchase amount in the contracts are in round numbers of $10,000 or its multiples (e.g., $3 million, $1,050,000, or $700,000). This would indicate that each contract is not tied to a specific account receivable from a specific customer of the taxpayer.

Our Comments

You have asked us to give further clarification to the comments we provided in the Previous Memo on the assumption that "the hedge was set-up for future sales". However, based on a subsequent telephone conversation on June 24, 2003 (Wilson/Collins), you indicated that the client has advised you that the forward contracts are generally linked to expected future cash flows arising from accounts receivable. Therefore, the purpose of the forward contracts appears to be to hedge the client's exposure to foreign currency fluctuations with respect to its accounts receivable. You also indicated that as far as you are aware, the amount of the forward contracts are determined generally as an estimate of future cash flows from US denominated accounts receivable. However, as far as you are aware, forward contracts never exceeded the future cash flows expected from the US denominated accounts receivable. Therefore, the forward contracts will not provide 100% protection to the client for his exposure to foreign currency fluctuations on US denominated accounts receivable. In our opinion, the fact that the forward contracts never exceed the projected US denominated cash flow from accounts receivable gives support that these forward contracts are not for speculation purposes and are intended to serve, as indicated by Note 3 of the "Notes to Financial Statements", as a hedge of a significant portion of the foreign currency fluctuation inherent in the US denominated accounts receivable.

In the Previous Memo, we assumed that the foreign currency denominated accounts receivable are hedged by specific forward contracts (i.e., we assumed that the forward contracts are directly linked to the accounts receivable). Based on that assumption, we concluded 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 contracts such that any foreign exchange gain or loss on the receivables would be offset by the foreign exchange loss or gain on the forward contracts. Based on the information provided, we remain of the view that any foreign exchange gain or loss reported at year end on the US denominated accounts receivable should be offset (this would not be a full offset since the entire amount of the US denominated accounts receivable is not hedged by forward contracts). In this regard, without evidence to the contrary, it does not seem commercially unreasonable for the taxpayer to hedge US denominated accounts receivable in the manner described above.

Section 1650 of the CICA Handbook states that exchange gains or losses on foreign currency denominated monetary items that are covered by a hedge that is itself a foreign currency denominated monetary item should be offset with the exchange gains or losses on the hedge instrument. We would suggest that in the situation at hand the forward contracts, regardless that each contract is not specifically identified to a particular account receivable, is likely intended to fall within these rules (for GAAP purposes). That is, we do not believe the expression "covered by a hedge" in paragraph .54 of section 1650 of the CICA Handbook requires that each individual receivable be linked to a separate hedging instrument (such as a forward contract). Also, as indicated in the Previous Memo, jurisprudence supports that method of reporting income which accords the "truer picture" of the taxpayer's income. We are of the view that the "truer picture" would require a matching of exchange gains or losses on the receivables and forward contracts. It does not make sense to us on the facts available that an accrual/mark-to-market approach should be used for reporting exchange gains or losses on the US denominated accounts receivable and a settlement/realization approach on the exchange gains or losses on the forward contracts.

As indicated above, we have not been provided any information that would cause us to question the taxpayer's stated motive of entering into forward currency contracts to serve as hedges on its foreign currency denominated monetary items. For example, Note 3 of the "Notes to Financial Statements" states that "The Company does not engage in any foreign currency activities which have not been specifically identified as hedges". However, if you are concerned that our understanding of the facts is incomplete, you may want to find more information or request a detailed explanation from the taxpayer as to the method of determining the amounts of the forward contracts. You may consider examining, for example, the Director's resolutions or any other corporate documents or operational procedure manuals that may shed some light on the taxpayer's foreign currency hedging policies (i.e., there is a lot of money involved here for there not to be documented procedures in place).

In business operations such as those of the taxpayer, it may be difficult or too troublesome to enter into a forward contract to hedge a specific account receivable from a specific customer simply because of the sheer volume of sale transactions (which result in a large volume of foreign currency denominated accounts receivable) that are carried out daily to different customers at different time. You may also want to verify with your Head Office industry specialists (e.g., Doug Watson - Compliance Programs Branch) if the taxpayer's foreign currency procedures are within normal commercial practice.

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 Canada Customs and Revenue Agency'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

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