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: Are foreign exchange gains or losses on account of income or capital?
Position: Depends on the purpose of the use of the funds
Reasons: Ethicon Sutures and various court decisions
March 19, 2009
Calgary TSO Headquarters
Large Files Claude Tremblay, CMA
(613) 957-8979
Attention: Patricia Ross (819) 281-2916
2008-030465
XXXXXXXXXX ("XXXXXXXXXX Co")
Foreign Exchange Gains on Commercial Paper
This is in reply to your memorandum of December 15, 2008 and further to our memorandum of October 30, 2008, regarding the above-noted subject.
During a recent audit, the treatment on US denominated LIBOR and Commercial Paper was reviewed. XXXXXXXXXX Co had initially reported the foreign exchange gains as XXXXXXXXXX % on account of income and XXXXXXXXXX % on account of capital. After further analysis, XXXXXXXXXX Co submitted a request to treat the entire foreign exchange gain as on account of capital.
In XXXXXXXXXX , XXXXXXXXXX Co's Board of Directors (the "Board") approved a resolution for the corporation to enter into a new credit facility with a syndicate of banks. The Board authorized XXXXXXXXXX Co to borrow up to $XXXXXXXXXX Canadian for general corporate purposes including repayment of certain existing facilities of XXXXXXXXXX Co and XXXXXXXXXX ("ACo"), financing of acquisitions, working capital requirements and liquidity support for XXXXXXXXXX Co's commercial paper program. The credit agreement states that XXXXXXXXXX Co agrees to use the borrowings only for general corporate purposes (domestic and international) including to support the issuance of commercial paper, acquisitions, working capital, and to repay the existing bank debt of ACo.
XXXXXXXXXX Co's Board authorized a $XXXXXXXXXX commercial paper program for the issuance and sale of unsecured short term notes. The commercial paper would be used to phase out an existing $XXXXXXXXXX program at the subsidiary (ACo) level and would be increased to $XXXXXXXXXX when bank facilities were restructured. The criteria influencing the issuance of commercial paper, Canadian medium-term notes and US long-term, fixed rate debt was the amount of short-term debt, future cash deficiency, acquisitions, market tone (flattening yield curve, rates rising, spreads widening), and the unique opportunity (reverse inquiries, new products).
XXXXXXXXXX Co included foreign exchange gains (both realized and unrealized) in its net income for accounting purposes. The current portion of long-term debt and mandatory debt payments for XXXXXXXXXX excluded Bankers' Acceptances ("BA") and commercial paper, which were fully supported by revolving credit and term loan facilities, and had no repayment requirements within the next year.
XXXXXXXXXX Co's policy is to include the following borrowings in long-term debt:
1. bank loans through BA's and/or LIBOR borrowings,
2. commercial paper,
3. unsecured notes,
4. unsecured debentures,
5. the increase in the fair market value of ACo acquired debt of $XXXXXXXXXX as of XXXXXXXXXX (this debt is being amortized over an average XXXXXXXXXX -year period), and
6. borrowings in Canadian or foreign currencies. If borrowing by a Canadian company is in foreign currencies, it is converted at month-end exchange rates to Canadian dollars and any gains or losses are charged to earnings immediately.
Borrowings using BA's and commercial paper are fully supported and management currently expects that they will continue to be supported by revolving credit and term loan facilities that have no repayment requirements within the next year and are therefore recorded as long-term debt.
XXXXXXXXXX Co reported foreign exchange gains (losses) on US denominated LIBOR loans and commercial paper as follows:
YEAR LIBOR LOANS COMM Paper FX Gain (Loss)
XXXXXXXXXX
X 50%
Taxable Capital Gain XXXXXXXXXX
Taxpayer's Position:
XXXXXXXXXX Co is claiming that all the above gains are on account of capital. In their explanations, they assert that the balances outstanding for US denominated debt instruments remained relatively constant throughout XXXXXXXXXX . The LIBOR and commercial paper debt obligations (both Canadian and US) are part of the fixed and permanent capital of the company. The treasury group receives cash requirements from all business units and these are rolled into a daily forecast. Some business units may be long and some units may be short, the net position is what the treasury group looks at. If there is a cash shortfall, the treasury group will issue more commercial paper and/or LIBOR loans. If there is excess cash, the treasury group will apply the funds to pay off some loans. The Board mandated a range of XXXXXXXXXX % to XXXXXXXXXX % for fixed interest vs. floating rate interest and the same range for US denominated debt. US commercial paper and LIBOR loans are grouped together as revolving debt for financial statement purposes and are treated as long-term debt. This position is in accordance with GAAP and debt classification for Balance Sheet purposes and is supported by XXXXXXXXXX Co's externally audited financial statements. XXXXXXXXXX Co provided documentation to support their position which included an analysis of debt levels, on a monthly basis for US commercial paper and LIBOR loans and for Canadian commercial paper and BA's, summary of cash forecasts, daily cash forecasts, explanation for XXXXXXXXXX capital treatment and ratios, and excerpts from XXXXXXXXXX presentation to the Board regarding debt metrics.
Audit's Position:
In your view, the nature of the underlying instruments determines whether the related foreign exchange gain or loss is on account of capital or income. You also include the position found in paragraphs 1 to 3 in IT-95R and the reason the correction to paragraph 3 was amended. As you noted, paragraph 1 to 3 now reads as follows:
1. There are no provisions in the Act which specify whether a foreign exchange gain or loss is on account of income or capital. In determining whether such a gain or loss is on account of income, the basic principles of determining income from a business or property for purposes of subsection 9(1) of the Act must be applied. Thus the major problem in determining the income tax status of foreign exchange gains or losses is the identification of the transactions from which they resulted, or, in the case of funds borrowed in a foreign currency, the use of the funds. A related problem is the determination of the method of accounting to be followed in reporting foreign exchange gains or losses for tax purposes.
2. Where it can be determined that a gain or loss on foreign exchange arose as a direct consequence of the purchase or sale of goods abroad, or the rendering of services abroad, and such goods or services are used in the business operations of the taxpayer, such gain or loss is brought into income account. If, on the other hand, it can be determined that a gain or loss on foreign exchange arose as a direct consequence of the purchase or sale of capital assets, this gain or loss is either a capital gain or capital loss, as the case may be. Generally, the nature of a foreign exchange gain or loss is not affected by the length of time between the date the property is acquired (or disposed of) and the date upon which payment (or receipt) is effected.
3. Generally, where borrowed funds are used in the ordinary course of a taxpayer's business operations, any foreign exchange gain realized on the repayment of the loan is considered to be an income gain and any foreign exchange loss incurred on repayment of the loan is considered to be an income loss. The fact that a company which borrowed in a foreign currency was not adequately capitalized does not automatically result in capital treatment of any foreign exchange gains or losses arising on repayment. Capital treatment will result where it can be shown that the borrowed funds form part of the permanent or fixed capital of the company, regardless of the use of the funds. In other cases of inadequate capitalization, the use made of the borrowed funds will determine where such gains or losses should be on income account or on capital account.
You request our opinion on the following:
1. If the bank can terminate the commercial paper at any time, and the LIBOR loans must be used, in part, as support for the commercial paper program, is the commercial paper and LIBOR loans part of the permanent or fixed capital of XXXXXXXXXX Co?
2. Where a corporation is adequately capitalized, does the use of funds determine whether a foreign exchange gain is on account of income or capital, regardless of whether the corporation considers the funds to be part of its permanent or fixed capital?
3. Does the balance sheet classification as Long-Term Debt preclude CRA from analyzing the use of funds to determine whether the foreign exchange gain is on account of income or capital?
Generally, it is the purpose of the use of the funds that determine whether the gain or loss is on account of income or capital. The Courts have repeatedly referred to the purpose for which the borrowed funds were acquired and after analyzing the actual use of the borrowed funds, finds the use of the funds the confirmation of the purpose.
Briefly, to answer your questions:
1. In our view, the fact that the bank can terminate the commercial paper at any time, and the LIBOR loans must be used, in part, as support for the commercial paper program, that fact alone does not render the commercial paper and LIBOR loans part of the permanent or fixed capital of XXXXXXXXXX Co.
2. In our view, where a corporation is adequately capitalized, the use of the funds will determine whether a foreign exchange gain is on account of income or capital, regardless of whether the corporation considers the funds to be part of its permanent or fixed capital.
3. In our view, the balance sheet classification as long-term debt does not preclude the CRA from analyzing the use of funds to determine whether the foreign exchange gain is on account of income or capital.
As stated by the courts in Ethicon Sutures Ltd. 85 DTC 5293, "to determine whether a foreign exchange gain is to be treated as income or capital, it is necessary to look at the nature of the underlying transaction that led to the gain. Where the foreign currency was acquired as a result of the taxpayer's trading operations or for the purpose of carrying on trading operations, any gains will be treated as occurring in the course of the taxpayer's trade and will be treated as income."
Generally, if funds are borrowed for general corporate purposes, gains are probably on account of income unless it can be demonstrated that the company was "grossly" undercapitalized in which case the gains will be on account of capital. XXXXXXXXXX Co has confirmed that they are not "grossly" undercapitalized; accordingly, we look at the nature of the underlying transaction that led to the gain. Montreal Coke was cited with approval in Tip Top Tailors Limited vs. the Minister of National Revenue 57 D.T.C. 1232, a case where the Supreme Court of Canada dealt with the taxation of foreign exchange profits and concluded that the foreign exchange profits in that case were on income account.
As foreign exchange losses or gains on the repayment of a loan denominated in a foreign currency take their character as income or capital from the nature of the loan, we would need to examine the nature of the loan and its use. So, if a loan finances the construction of a capital asset, foreign exchange gains or losses on repayments are on capital account. Otherwise, if the funds are borrowed for inventory or for general corporate purposes, the gains or losses are generally on account of income.
For your information a copy of 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. You should make requests for this latter version to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
R. Albert, CA
For Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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