6 May 2005 Internal T.I. 2005-0117751I7 - Foreign Currency Hedging Losses - Resource Profits

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.

Principal Issues: Whether losses on certain foreign exchange forward contracts would reduce either "gross resource profits" or "resource profits".

Position: Yes.

Reasons: The facts of this situation and historic jurisprudence support the view that the foreign exchange forward contracts should be considered as integral to the taxpayer's mineral production business. As such, it is appropriate that the losses realized in respect of those contracts be taken into account in the determination of the taxpayer's "gross resource profits". Even if it could be found that any amount of such losses should not be taken into account in that determination, such amount would reduce the taxpayer's "resource profits" as the facts indicate it would relate to a "resource activity" of the taxpayer rather than a business, or other source, not including any resource activity of the taxpayer.

									May 6, 2005
	Compliance Programs Branch 				Resources Industry Section
	Industry Specialist Services					A.A. Cameron
	Christine Savage						(613) 347-1361
	Co-ordinator, Resource Industries
	Attention:  Peter Lee
	2005-011775

XXXXXXXXXX (the "Company")
Foreign Currency Hedging Losses and Resource Profits

We are writing further to your memorandum of February 18, 2005 wherein you have requested our opinion regarding whether certain foreign currency hedging losses incurred by the Company in its XXXXXXXXXX taxation year would be excluded from the determinations of "gross resource profits" and "resource profits" under subsections 1204(1) and 1204(1.1) of the Income Tax Regulations (the "Regulations"), respectively. We also acknowledge receipt of a copy of a submission dated November 3, 2004, from an accounting firm representing the Company, regarding this matter (the "Submission").

Our understanding of the facts relevant to this situation is as follows:

XXXXXXXXXX

7. In your view, having reference to the facts of this situation and historic jurisprudence, the Hedging Losses should be included in the calculation of "gross resource profits". Alternatively, you are of the view that the Hedging Losses would have to be deducted in the calculation of "resource profits" pursuant to paragraph 1204(1.1)(a) of the Regulations. Furthermore, you believe these views are consistent with the positions taken in a memorandum dated June 11, 2002 issued by this Directorate (our file number 2002-013620, the "Opinion").

Our Comments

Gross Resource Profits

We agree that the facts of this situation, along with historic jurisprudence, support the view that the Hedging Losses should be taken into account in the determination of the Company's "gross resource profits" for its XXXXXXXXXX taxation year. As you have noted, such view is consistent with the view expressed in the Opinion.

Pursuant to subsection 1204(1) of the Regulations, gross resource profits of a taxpayer for a taxation year includes the amount by which the taxpayer's income for the year from "the production and processing of ore...from mineral resources in Canada operated by him to any stage that is not beyond the prime metal stage or its equivalent" exceeds the aggregate of the taxpayer's loss for the year from that source and certain specified deductions including "any other deductions for the year that can reasonably be regarded as applicable to" that source of income (other than deductions under certain provisions of the Act and Regulations that are not relevant to the matter at hand).

It is our understanding that it is not in question that the Company was producing and selling XXXXXXXXXX from the mines referred to in paragraph 1 above which was not beyond the prime metal stage or its equivalent. In addition, as you have noted, the wording of the test in subsection 1204(1) of the Regulations relating to income from "production" was considered in the decision of the Federal Court - Trial Division in the Echo Bay Mines Ltd. case (92 DTC 6437) wherein MacKay, J. made the following comments at page 6447 thereof:

...income from "production" may be generated by various activities provided those are found to be included in production activities. Production activities yield no income without sales. Activities reasonably interconnected with marketing the product, undertaken to assure its sale at a satisfactory price, to yield income, and hopefully a profit, are, in my view, activities that form an integral part of production which is to yield income, and resource profits, within Regulation 1204(1).

...

... There was a clear business purpose in its sales and settlement of silver futures contracts, a purpose integrated with its sales of product to yield income; the plaintiff was trying to obtain an assured price for the sale of the silver it produced. That activity was similar to the attempt of the taxpayer in Tip Top Tailors, supra, to obtain raw materials necessary to its business at an assured price.

									(Emphasis added.)

In the decision of the Supreme Court of Canada in the Tip Top Tailors Limited case (57 DTC 1232) to which you have also referred, it was found that a foreign exchange profit (on a line of credit in pounds sterling arranged to make payments to British suppliers) was made as part of the company's trading operations. In particular, Locke J. commented at pages 1236 - 1237 of the decision that:

I agree with the learned trial judge that it was a scheme for profit-making in one necessary part of the appellant's trading operations, namely, the purchase of sterling funds and part of an integrated commercial operation being the purchase of the supplies and the payment for them in that currency. ...

The Dominion Steel and Coal Corporation Limited case (57 DTC 147) referred to in the Opinion involved a situation where the taxpayer received substantial orders for steel and coal from customers in Great Britain, with payment to be made in pounds sterling, and sold sterling futures to protect itself against a drop in value of sterling between the time of acceptance of the order and delivery under same. As described by the Tax Appeal Board, at page 150 of the decision, the circumstances under consideration were those:

... where the appellant is carrying on business through sales in foreign countries, receiving payment therefore in foreign currencies while engaging in a trade where transactions in futures in that foreign currency are a common, and indeed a necessary, practice in the ordinary course of carrying on the business of the company.

The Tax Appeal Board looked to the decision of the SCC in the Atlantic Sugar Refineries, Limited case (49 DTC 602, where certain dealings in raw sugar futures were found to be part of the taxpayer's business resulting in a profit from that business) and concluded at page 150 of the decision that:

In the present instance, I am of the opinion that the sale of sterling futures by the appellant cannot be said to have produced profits from an investment and, in my opinion, it was not an employment of fixed capital of the appellant. I have reached the conclusion that the profit here realized was one which was made in the course of the appellant's normal business operations while carrying out its profit-making undertakings through the sale of its goods in Great Britain. It was merely one of what have become recognized as ordinary incidents in the doing of business, and accordingly I am of the opinion that the appellant has been properly assessed on the profit realized by it in the circumstances.

								(Emphasis added.)

XXXXXXXXXX

In our view, the above information clearly indicates that the Company's primary business operation was the production of XXXXXXXXXX and that such operation was carried on in a global marketplace where XXXXXXXXXX sales were priced in U.S. dollars. Furthermore, given the extent to which the Company's revenues were denominated in U.S. dollars (with the expenditures incurred to earn such revenues being denominated in Canadian dollars) foreign exchange rates could have a very significant impact on the profit or loss realized from the Company's operations. As such, in our view, entering into the foreign exchange forward contracts that gave rise to the Hedging Losses was an activity integral to the Company's business operation, being the production of XXXXXXXXXX (consistent with the findings in the Tip Top Tailor and Dominion Steel and Coal cases referred to above). In addition, it is our opinion that the existence of the Hedging Policy described in paragraph 2 above provides support for this connection and that the terms of the Policy do not suggest that the Company was involved in a speculative activity separate from its business of producing XXXXXXXXXX.

It would also appear that the Company entered into the foreign exchange forward contracts that gave rise to the Hedging Losses to help ensure that its U.S. dollar revenues, to be realized from the production and sale of the XXXXXXXXXX, would yield a certain amount of Canadian dollars. Therefore, in our view and consistent with the findings in the Echo Bay case referred to above, such activities may be seen as "reasonably interconnected with marketing the [XXXXXXXXXX], undertaken to assure its sale at a satisfactory price, to yield income, and hopefully a profit" such that they may be considered "activities that form an integral part of production which is to yield income" for purposes of subsection 1204(1) of the Regulations.

We would note in passing the reference to the Echo Bay case in the decision of the Court of Appeal for Ontario in the Placer Dome Canada Limited case ([2004] 5016 ETC dated August 31, 2004). The issue in that case was whether certain financial transactions constituted "hedging" as defined in the Mining Tax Act (Ontario) such that net gains from the transactions would be taxable under that legislation. In concluding that they were not, the Court of Appeal looked to the express wording of the definition of "hedging" contained in that legislation and stated at paragraph [25] of its decision, that:

The Echo Bay case involved the interpretation of the meaning of "resource profits" in the regulations under the Income Tax Act. Neither the Income Tax Act nor the regulations contained a definition of "hedging". Instead, the court relied upon the expert accounting evidence to assist in its determination of that concept. In my view, the broader concept of hedging, as described in Echo Bay, simply does not fit the more limited definition prescribed by the [Mining Tax] Act which restricts hedging to "the fixing of a price for the output of a mine". Furthermore, the evidence in relation to [Generally Accepted Accounting Principles] was not before the court in this case. The trial judge noted that the parties chose not to call such evidence. I do not believe it was open to the trial judge to fill what he perceived to be a deficiency in the record by relying on the evidence in Echo Bay. ...

       (Emphasis added.)

In our view, the situation in the Placer Dome case can be distinguished from the situation at hand as that case concerned different legislation containing an express definition of "hedging", that the court found to be more limiting than the "broader concept" relevant to Echo Bay situation. In addition, evidence with respect to Generally Accepted Accounting Principles was not before the court in the Placer Dome case.

At paragraph [26] of the decision in the Placer Dome case the view was expressed that "in Echo Bay the court was involved in a search for the 'economic realities' of the transactions under consideration" and it was further stated that:

Echo Bay is a 1992 case that was decided several years before McLachlin J.'s caution, in Shell Canada, to avoid a searching inquiry for the "economic realities" of a particular transaction in the face of a clear and unambiguous provision of a statute.

In our view, it should be kept in mind that the above comment was made in the context of a situation where the view had already been expressed, at paragraph [19] of the decision, that the definition under consideration was "clear, unambiguous and precise." Clearly, this is not the case for the definition of "gross resource profits" as evidenced by the jurisprudence on this subject. Furthermore, we would note that leave was recently granted to appeal the decision in the Placer Dome case to the Supreme Court of Canada.

Resource Profits

We also agree that, even if it were to be determined that the Hedging Losses did not reduce the Company's "gross resource profits", the facts of this situation support the view that the Hedging Losses should be deducted in the determination of the Company's "resource profits" for its XXXXXXXXXX taxation year. This view, as you have noted, is also consistent with the view expressed in the Opinion.

Subsection 1204(1.1) of the Regulations reads, in part, as follows:

..."resource profits" of a taxpayer for a taxation year means the amount, if any, by which the taxpayer's gross resource profits for the year exceeds the total of
(a) all amounts deducted in computing the taxpayer's income for the year other than

(i) an amount deducted in computing the taxpayer's gross resource profits for the year,

...

(iv) an amount deducted in computing the taxpayer's income for the year from a business, or other source, that does not include any resource activity of the taxpayer, and

(v) an amount deducted in computing the taxpayer's income for the year, to the extent that the amount

(A) relates to an activity

(I) that is not a resource activity of the taxpayer, and

(II) that is

(1) the production, processing, manufacturing, distribution, marketing, transportation or sale of any property,(2) carried out for the purpose of earning income from property, or
(3) the rendering of a service by the taxpayer to another person for the purpose of earning income of the taxpayer, and

(B) does not relate to a resource activity of the taxpayer, ...

It is clear that the wording of the above provision expressly provides that "all amounts deducted in computing the taxpayer's income for the year" are to be deducted in the determination of the taxpayer's "resource profits", subject to the exceptions provided in subparagraphs 1204(1.1)(a)(i) through (v) of the Regulations. On the assumption that the Hedging Losses do not reduce the Company's "gross resource profits" as discussed above, the provisions that are relevant to the Company's situation are subparagraphs 1204(1.1)(a)(iv) or (v) of the Regulations.

In order for the exceptions in subparagraph 1204(1.1)(a)(iv) or (v) of the Regulations to preclude a reduction in the determination of "resource profits" for a deduction in respect of the Hedging Losses, the Hedging Losses would have to be either a deduction

? in computing the Company's income "from a business, or other source, that does not include any resource activity of" the Company; or.

? that "does not relate to a resource activity of" the Company.

As noted above, based upon the facts of this situation, it is our view that the Company incurred the Hedging Losses in the course of gaining or producing income from its business of producing XXXXXXXXXX and that such losses did not relate to any other source of income. In addition, the production of XXXXXXXXXX is an activity encompassed by paragraph (b) to the definition of the term "resource activity" in subsection 1206(1) of the Regulations. Furthermore, as you have noted, paragraphs (g) and (i) of the "resource activity" definition expressly include "activities performed by the taxpayer that are ancillary to, or in support of" a qualifying "production" activity and "activities that the taxpayer undertakes as a consequence of" such a production activity (notwithstanding that the production activity may have ceased). In our view, these factors provide additional support for the view that the Hedging Losses would be deducted in computing the Company's income from a business that includes a resource activity of the Company, or that it would be appropriate to consider the Hedging Losses as being related to the Company's "resource activity" of the production of XXXXXXXXXX. Therefore, it is our view that neither of the exceptions in subparagraphs 1204(1.1)(a)(iv) or (v) of the Regulations would exclude a deduction for the Hedging Losses in the determination of the Company's "resource profits".

This memorandum will be severed using the Access to Information Act criteria and placed in the Canada 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 severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

If we can be of further assistance with regard to this matter, please contact the writer.

for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Planning Branch