12 October 2010 Internal T.I. 2010-0367611I7 - Cross Currency swap - Income or Capital

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: Is the loss on the swap on account of capital or income?

Position: On account of capital

Reasons: Underlying transaction is a loan used for a capital purpose

October 12, 2010

	XXXXXXXXXX TSO						Headquarters
	Tax Avoidance Section					C. Tremblay, CMA
									(819) 281-6906
	Attention : XXXXXXXXXX 

									2010-036761

		XXXXXXXXXX  ("Canco") 

Swap Transactions - Income or Capital Account

This is in reply to your enquiry of May 10, 2010 and is further to information sent by you on September 3, 2010. In your enquiry, you highlight a swap arrangement between Canco and Canadian banks. The swap arrangements were entered into to serve as a hedge against a loan denominated in a foreign currency, namely the XXXXXXXXXX , that Canco had transacted with a sister corporation. You ask whether the gain or loss on the foreign currency swap hedge is on account of income or capital.

The facts as we now understand them:

1. Canco is a Canadian corporation and wholly-owned subsidiary of XXXXXXXXXX ("Parent"), which is a US Corporation and a public corporation.

2. XXXXXXXXXX ("Sisterco") is a corporation resident in XXXXXXXXXX and is a wholly-owned subsidiary of Parent.

3. In XXXXXXXXXX , Canco wished to pay a dividend to Parent and needed to borrow the funds.

4. On XXXXXXXXXX , Canco borrowed the funds from Sisterco. Sisterco apparently had excess funds. Although resident of XXXXXXXXXX , the functional currency of Sisterco is the XXXXXXXXXX . Canco thus borrowed XXXXXXXXXX at XXXXXXXXXX % interest. The equivalent sum in Canadian dollars at the time was $XXXXXXXXXX CDN.

5. Canco then entered into swap agreements with Canadian banks to hedge the currency risk associated with the loan. Canco transfered the XXXXXXXXXX and charged a fixed rate of XXXXXXXXXX % on the funds and received $XXXXXXXXXX CDN from a bank and was charged a fixed rate of XXXXXXXXXX %.

6. Canco paid the $XXXXXXXXXX CDN dividend to Parent (we would have expected US funds).

7. Over the years (XXXXXXXXXX -XXXXXXXXXX ), Canco was profitable and returned the $XXXXXXXXXX CDN funds to the bank.

8. In XXXXXXXXXX , the Bank returned the XXXXXXXXXX to Canco.

9. Canco repaid Sisterco the XXXXXXXXXX it received from the bank.

10. Canco paid interest to Sisterco on the XXXXXXXXXX loan: in XXXXXXXXXX , $XXXXXXXXXX ; and in XXXXXXXXXX , $XXXXXXXXXX .

11. Canco paid swap payments on CDN funds to the banks. In XXXXXXXXXX , the amount was $XXXXXXXXXX , and in XXXXXXXXXX , it was $XXXXXXXXXX .

12. Canco earned income on XXXXXXXXXX funds from the bank. In XXXXXXXXXX , Canco earned $XXXXXXXXXX , and in XXXXXXXXXX , it earned $XXXXXXXXXX .

Taxpayer's Position:

Swap payments are deductible under section 9 of the Act, based on documents 92041145, and 2000-0036045. Income (see 12 above) earned from the swap was also included in income. The purpose of the swap was to hedge currency risks.

TSO Views:

Canco and the banks do not have a borrower-lender relationship and Canco entered into the swap agreements with the banks to hedge the currency risks associated with the loan that was between Canco and Sisterco. The cross-currency swap hedge arrangement should be on capital account.

Our Comments:

We agree that the gain realized or the loss incurred on the swap transaction should be on capital account. The loan with Sisterco was for the purpose of paying a dividend to Parent, a capital purpose. Generally, our position is that the gain or the loss realized on a hedge is either on capital or income account depending on the nature of the underlying transaction.

We have examined the two documents referred to by the taxpayer, and, in our view, the documents do not support them. Document 2000-0036045 states that the gain realized or the loss incurred on the termination of the swap agreement would be considered to be on the same account as that realized on the settlement of the debt, i.e., on account of either income or capital. In the case at hand, the debt is a capital item and since the swap normally follows the underlying transaction, it is also on account of capital.

In document 9204145, we stated that the current position of the Department on the tax treatment of swap transactions remains unchanged from the prior published positions. In particular, payments and receipts in respect of an interest rate swap will be considered to be on income account. In circumstances where a foreign currency borrowing is hedged with a foreign currency swap, the offsetting gain and loss on the receipt of the principal swap and repayment of the foreign currency loan will be treated on a consistent basis; and that is either both capital or both income. Notwithstanding the foregoing comments, in the event that the swap and the foreign currency loan are, or become, "unmatched", the tax consequences will be re-examined. In the case at hand, the loan and the foreign currency swap are of the same amount, can be matched, and relate to the payment of a dividend. Accordingly, in our view, the loss from the swap transaction should be on capital account.

The principles that have evolved under case law with respect to distinguishing whether a foreign exchange gain or loss is on income or capital account were summarized in Ethicon Sutures Ltd. v. The Queen, 85 DTC 5290, as follows:

• To determine whether a foreign exchange gain is to be treated as income or capital, it is necessary to look at the underlying transaction that gave rise to the gain or loss.
• If 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 on income account.
• If the transaction is speculation made in the hope of profit, it will be treated as an adventure in the nature of trade and the gain will be taxed as income.
• If the gain arises out of the investment of idle funds or the appreciation of a temporary investment, the gain will be treated as a capital gain.
• To be considered capital in nature, the funds must be surplus and must be exclusively for dividend or capital expenditures (i.e., "earmarked primarily" is not enough).

If funds are borrowed for capital purposes, or to provide fixed working capital and are not borrowed in the ordinary course of trading operations, the courts have held that the foreign exchange gain or loss is on capital account.

Foreign exchange gains and losses of a dealer that relate to transactions entered into in the ordinary course of its business, including gains or losses resulting from futures transactions in foreign currency, are generally on income account. In ISE Canadian Finance Ltd. v. MNR, 86 DTC 1344, the Tax Court held that foreign exchange gains and losses of a corporation whose business was the lending of funds to affiliates were on income account. In this decision, the court cited an earlier case, Dominion Steel & Coal Corporation Limited v. MNR, 57 DTC 147, which stated:

"The line that divides capital from income in exchange profits is the same as that which divides capital and income in any other sense. If the exchange profit is made on funds which are fixed capital as opposed to circulating capital, it is not taxable. If, however, it arises out of the use of circulating capital or monies in the income-earning process, it is just as taxable as the profit produced by the sale of the goods which those funds are used to acquire."

However, in this current case, the underlying transaction is a loan taken out from Sisterco in order to pay a dividend to Parent, i.e., the use of the funds for the loan is to pay a dividend to the Parent, a capital purpose. Further, although it may need to be established, the taxpayer has agreed that the purpose of the swaps entered into by Canco and the Canadian banks were to hedge the currency risk on the loan with Sisterco. As a hedge, an interest and currency rate swap would normally fix a taxpayer's overall exposure to changes in interest rates and currency rates when both sides of the hedge are considered.

As we stated in 2007-0255431C6, "Hedge" is not a defined term in the Act. The effectiveness of a hedge for tax purposes, i.e., whether a financial instrument constitutes a hedge, is relevant to the computation of profit. As the Supreme Court of Canada stated in Canderel Ltd v. The Queen, 98 DTC 6100, the determination of profit is a question of law. The courts (Echo Bay Mines Ltd v The Queen 92 DTC 6437, Salada Foods Ltd v. The Queen, 74 DTC 6171, and Ontario (Minister of Finance) v. PlacerDome Canada Limited, 2006 SCC 20) have confirmed that whether an activity constitutes hedging depends on sufficient inter-connection or integration with the underlying transaction.

So, in order for an instrument to be considered a hedge, there needs to be a link between the underlying transaction that was used as a hedge in reference to that transaction (see "The Taxation of Derivatives: The Basic Rule" by Jonathan Tennant, 2005, CTF's 57th Tax Conference). In this regard, the Federal Court in Echo Bay accepted the GAAP criteria which were:

1. The item to be hedged exposes the enterprise to price (or interest rate) risk.

2. The futures contract reduces that exposure and is designated as a hedge.

3. The significant characteristics and expected terms of the anticipated transactions are identified.

4. It is probable that the anticipated transaction will occur.

In Shell v. The Queen, 99 DTC 5669, the Court clearly accepted the linkage principle in the context of forward contracts that hedged against currency fluctuations under a foreign currency denominated debt obligation. The court stated:

"[70] The gain on the Debenture Agreements was characterized as being earned on capital account and so therefore should the gain on the Forward Exchange Contract. Both gains were earned on capital account and three-quarters of them are taxable when realized", i.e., there was a sufficient link to a transaction that was the repayment of the debt.

In summary, the gain or loss computed in reference to the settlement of a hedge is characterized for tax purposes depending upon the transaction being hedged. Therefore, in this case, since we have a loan to Sisterco as the underlying transaction, the loan would be considered on capital account since it was for the purpose of paying a dividend. In our view, the gain or loss realized on the settlement of the hedge would also be on capital account.

For your information, unless exempted, 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 the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this latter version should be made by you to Ms. Celine Charbonneau at (613) 957-2137. In such cases, a copy will be sent to you for delivery to the taxpayer.

R. Albert, CA
for Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch