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: Should the gains and losses arising on the close out of certain XXXXXXXXXX derivative contracts by this Canadian taxpayer be treated as on account of income or on account of capital for Canadian federal income tax purposes.
Position: On account of income.
Reasons: Generally, unless a derivative contract is a hedge for tax purposes of a capital transaction, the closing out of a derivative contract is on account of income. There is no evidence that the XXXXXXXXXX derivative contracts in this file were hedges for tax purposes of capital transactions.
July 10, 2012
XXXXXXXXXX, Manager HEADQUARTERS
XXXXXXXXXX TSO Income Tax Rulings
Large File Case Program Directorate
L. Carruthers, CA
Gains and Losses Incurred by a Canadian Parent of a Foreign Affiliate on the Closing out of XXXXXXXXXX Derivative Contracts Reported for Accounting Purposes as Hedges
We are writing in response to your Memorandum dated August 22, 2011, in which you asked for our view, based on the facts of this case, the submissions to date, and in light of more recently issued Income Tax Rulings Directorate letters, as to whether certain losses incurred by XXXXXXXXXX (“Canco”) over the XXXXXXXXXX period could be fully allowed as deductions on account of income for Canadian federal income tax purposes.
Our understanding of the facts described in your referral is as follows
Canco, a corporation resident in Canada, has a number of direct and indirect subsidiaries around the world and together with those subsidiaries is engaged in the XXXXXXXXXX. Canco did not, over the XXXXXXXXXX period, hold any XXXXXXXXXX reserves or production related assets, however, it had a long-standing business based at its XXXXXXXXXX head office involving, at times, over XXXXXXXXXX employees that, among other things, included treasury, financial and hedging operations.
XXXXXXXXXX ("FXXXXXXXXXXco"), a corporation resident in XXXXXXXXXX in the XXXXXXXXXX business, had been conducting its own hedging activities and its XXXXXXXXXX activities were conducted through a network of subsidiaries.
Canco acquired FXXXXXXXXXXco in XXXXXXXXXX.
In XXXXXXXXXX, FXXXXXXXXXXco and XXXXXXXXXX (another XXXXXXXXXX affiliate of Canco) paid an amount (“the Compensation Amount”) to Canco and XXXXXXXXXX Hedging Partnership ("Canco Partnership") to assume the legal obligations, flowing from a set of approximately XXXXXXXXXX derivative contracts contained in a hedge book (the "Hedge Book"). The Hedge Book included long and short positions in XXXXXXXXXX forwards, XXXXXXXXXX call and put options, XXXXXXXXXX knock-in and knock-out options, and other complex variations of these derivative contracts. The underlying obligations contained in the Hedge Book were legally assumed by Canco and Canco Partnership as a result of a novation. Canco and Canco Partnership assumed all of the obligations, risks and rewards relating to the derivative contracts contained in the Hedge Book after the novation. FXXXXXXXXXXco was fully released and had no further interest in the derivative contracts contained in the Hedge Book after the novation.
Prior to Canco’s XXXXXXXXXX assumption of the Hedge Book, Canco XXXXXXXXXX was reducing its hedge program and XXXXXXXXXX to simplify and reduce the hedge position that had increased as a result of its acquisition of FXXXXXXXXXXco.
Canco submits that its assumption of the Hedge Book was carried out so that it could manage the related derivative contracts at its head office in XXXXXXXXXX and that the purpose of the Compensation Amount was to compensate Canco and Canco Partnership for the amount those derivative contracts were "out of the money" at the date of the novation based on XXXXXXXXXX prices, interest rates and other applicable contract pricing factors, relevant at the date of the novation. The Compensation Amount was reported on account of income by Canco and Canco Partnership in the XXXXXXXXXX fiscal year.
Over time, Canco's obligations under the Hedge Book were settled by making cash payments to its counterparties, in some cases as the individual derivative contracts matured and in other cases before maturity. Canco reported these payments in the years incurred as expenditures on account of income.
Canco has confirmed that on a consolidated basis for the Canco group of companies, the derivative contracts contained in the Hedge Book had been treated as hedges in the economic sense and for financial statement purposes.
Canco reported both net aggregate hedging gains and losses over the fiscal years included in the XXXXXXXXXX period. The gains and losses for the XXXXXXXXXX period incorporated gains and losses as well as the Compensation Amount paid to Canco pertaining to the Hedge Book.
You asked for our view concerning whether the gains and losses arising on the close out of the XXXXXXXXXX derivative contracts contained in the Hedge Book by this Canadian taxpayer, should be treated on account of income for Canadian federal income tax purposes, given that the contracts related to the hedging for financing statement purposes of a foreign affiliate's mining production.
Although relevant to any proposed assessment, our response does not address any transfer pricing issues.
As you noted in your referral, there have been numerous Income Tax Rulings documents written in the recent past on the subject of capital vs. income treatment of derivative contracts. These documents can all be summarized, as standing for the position that:
- generally, unless a derivative contract is a hedge for tax purposes of a capital transaction, the closing out of a derivative contract is on account of income; and
- whether a specific derivative contract held by a taxpayer is a hedge for tax purposes of a capital transaction would depend on whether there was sufficient linkage between that specific derivative contract and an underlying capital transaction of the taxpayer such as the acquisition or disposition of a capital asset by the taxpayer or the repayment of a debt of the taxpayer which itself was on account of capital.
There is no evidence that the derivative contracts contained in the Hedge Book were held by Canco as hedges for tax purposes of capital transactions of Canco. In our view, the better view is that the Hedge Book was acquired by Canco as part of its ongoing treasury, financial and hedging operations and perhaps as an accounting and/or economic hedge for its investment in FXXXXXXXXXXco, however, neither of these uses of the Hedge Book constitutes a linkage to an underlying capital transaction of Canco. Therefore, the gains and losses arising on the close out of the derivate contracts contained in the Hedge Book by Canco should be treated as on account of income for Canadian federal income tax purposes.
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 Ms. Celine Charbonneau at (613) 952-1361. A copy would be sent to you for delivery to the client.
Olli Laurikainen, CA
International Section II
Income Tax Rulings Directorate
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