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: 1) What is the proper tax treatment for foreign exchange gains or losses incurred by XXXXXXXXXX as a result of the Hedging Agreement?
2) When should the gains or losses be reported by XXXXXXXXXX?
Position: 1) On account of income. 2) Reported on an annual basis.
Reasons: See response.
December 21, 2012
XXXXXXXXXX TSO HEADQUARTERS
Income Tax Rulings Directorate
John Parker CMA
(613) 957-8284
2012-046556
Attention: XXXXXXXXXX
Hedging Agreement XXXXXXXXXX
We are writing in response to your query of October 11, 2012 wherein you asked our opinion as to the proper tax treatment and timing of any foreign exchange gains or losses incurred by XXXXXXXXXX as a result of an agreement ("the Hedging Agreement") between XXXXXXXXXX and its parent XXXXXXXXXX. Our understandings of the facts described in your referral are as follows:
Facts
XXXXXXXXXX is a Canadian corporation, 100% owned by XXXXXXXXXX, a XXXXXXXXXX company, which itself is ultimately controlled by the XXXXXXXXXX.
XXXXXXXXXX has been in financial difficulties since the acquisition of control by the XXXXXXXXXX in XXXXXXXXXX. The company has been short of funds to meet its interest payments. The parent company has been injecting funds into XXXXXXXXXX through different forms such as inter-company loans and the purchase of share capital.
In XXXXXXXXXX, XXXXXXXXXX borrowed US$XXXXXXXXXX (the "Loan") pursuant to a Credit Agreement dated XXXXXXXXXX between XXXXXXXXXX and XXXXXXXXXX (a XXXXXXXXXX Company), as borrowers, and XXXXXXXXXX, a XXXXXXXXXX exempted limited partnership as lender, in order to fund a subscription for common shares of XXXXXXXXXX.
The Loan was in US dollars, but the Euro is the unit of measure in XXXXXXXXXX's operations. Therefore, XXXXXXXXXX would bear any risk resulting from foreign currency fluctuations between the two currencies.
On XXXXXXXXXX, XXXXXXXXXX and XXXXXXXXXX signed a Hedging Agreement pursuant to which XXXXXXXXXX would be protected or compensated by XXXXXXXXXX against any foreign exchange loss resulting from foreign exchange fluctuations with respect to XXXXXXXXXX's obligations to XXXXXXXXXX under the Credit Agreement. In exchange, XXXXXXXXXX would receive the benefit of any foreign exchange gain resulting from such fluctuations.
On XXXXXXXXXX payment of US$XXXXXXXXXX was made by XXXXXXXXXX to XXXXXXXXXX in return for XXXXXXXXXX common shares of XXXXXXXXXX.
Taxpayer's Position
During the taxation year ended XXXXXXXXXX, for accounting purposes, XXXXXXXXXX recorded a foreign exchange gain of approximately $XXXXXXXXXX by crediting foreign exchange gain and debiting inter-company receivables.
However, for income tax purposes, XXXXXXXXXX deducted the $XXXXXXXXXX from its taxable income on schedule 1 of its XXXXXXXXXX T2 return as "Unrealized Foreign Exchange Gain". On XXXXXXXXXX's tax working paper concerning the foreign exchange gain, there is a note which states "XXXXXXXXXX".
The taxpayer's original position was that XXXXXXXXXX was only obligated to make a payment or was entitled to receive a payment under the Hedge Agreement when XXXXXXXXXX makes a payment to XXXXXXXXXX and at that time would realize a gain or loss under the Hedging Agreement.
On XXXXXXXXXX, the XXXXXXXXXX representative, made the following new representations to CRA's queries:
1) Neither party intended that any cash settlements would arise under the agreement until XXXXXXXXXX made a principal payment on the loan, thus realizing a gain or loss.
2) While the Hedge Agreement was a "hedge" from XXXXXXXXXX's point of view it was not a hedge from XXXXXXXXXX's point of view.
3) While XXXXXXXXXX subscribed for common shares of XXXXXXXXXX with the loan proceeds, this transaction was not related to the Hedge Agreement.
4) The taxpayer conceded that the Hedge Agreement as written did not reflect their understanding of XXXXXXXXXX's rights and responsibilities. Given the wording of the Hedge Agreement, they could understand CRA's position that foreign exchange gains or losses should be included in the computation of taxable income annually.
5) The transaction was not on account of income since XXXXXXXXXX is not in the business of writing Hedges. XXXXXXXXXX has put forward a settlement proposal. Under this proposal, they would be prepared to include XXXXXXXXXX% of the amount realized, in the XXXXXXXXXX taxation year, as a taxable capital gain provided that CRA would agree to treat any future losses accruing on foreign exchange transactions as capital losses in the year they accrue.
Your Position
The legal wording of the derivative contract (the Hedging Agreement), outlining the legal obligations and rights between the two related parties, should trigger a realization of income annually in spite of the fact that no cash payments have been made between the parties.
The Hedging Agreement is a derivative. However, there is no linkage to any transactions, capital assets or liabilities owned by XXXXXXXXXX. Therefore any gains or losses would be on account of income.
The primary purpose of the Hedging Agreement was to allow the foreign exchange risk related to the Loan to be transferred from XXXXXXXXXX to XXXXXXXXXX.
The Income Tax Act (the "Act") does not define the term "hedge", as such; case law principles apply to determine if a derivative financial instrument constitutes a hedge for income tax purposes. Where a hedge is not linked to a capital transaction the gain or loss is on income account.
Jurisprudence
Salada Foods v. The Queen (FCTD), 74 DTC 6171 was the first court case on the linkage principle, wherein the taxpayer did not convince the court that the hedge transaction was sufficiently integrated with the underlying capital risk it purported to hedge. The taxpayer anticipated a decline in the value of the pound sterling, which it anticipated would result in a decline in value of its UK subsidiaries. Purported with a view to protecting itself against such a decline in value, the taxpayer entered into a forward sale of sterling.
In the decision, Ethicon Sutures Ltd. v. The Queen (FCTD), 85 DTC 5290 it states: "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 which gives rise 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. Likewise, where the transaction is a 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. However, 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."
In Shell Canada Ltd. v. The Queen (SCC), 99 DTC 5669 at paragraph 68, it states: "
The characterization of a foreign exchange gain or loss generally follows the characterization of the underlying transaction
"
In the current case, the Hedging Agreement, between XXXXXXXXXX and XXXXXXXXXX can be considered to be a derivative. The Hedging Agreement derives its value from foreign exchange fluctuations relating to the Loan from XXXXXXXXXX to XXXXXXXXXX. Whether or not the Hedging Agreement is a "Hedge" from the perspective of XXXXXXXXXX can only be determined by identifying another transaction that creates opposite risk.
On page XXXXXXXXXX of the Hedging Agreement it states:
"XXXXXXXXXX"
From our review of the above paragraphs, XXXXXXXXXX has hedged its potential risk from foreign exchange fluctuations by entering into the Hedging Agreement while XXXXXXXXXX has not mitigated its potential losses. Therefore the agreement cannot be considered to be a hedge from XXXXXXXXXX's perspective.
In our opinion, there is insufficient linkage which would tie the foreign exchange gain, in XXXXXXXXXX, to any underlying capital transaction in XXXXXXXXXX. An underlying transaction would be present where there is a purchase, a sale, or a repayment of debt. In this case, the Loan was not XXXXXXXXXX's debt but that of XXXXXXXXXX. Accordingly, the foreign exchange transaction was a speculation made in the hope of profit, which would be treated as an adventure in the nature of trade, and any gains should be taxed as business income. Conversely, foreign exchange losses would be deductible as business losses. Therefore, the foreign exchange gain of approximately $XXXXXXXXXX made by XXXXXXXXXX in the XXXXXXXXXX taxation year would be on account of income.
Timing of the Gain
After reviewing paragraphs XXXXXXXXXX of the Hedging Agreement, it is our opinion that foreign exchange gains or losses, on the Loan, should be realized and taxed on an annual basis. The Hedging Agreement is not a hedge from XXXXXXXXXX's perspective. It is a legal contract between XXXXXXXXXX and XXXXXXXXXX that requires that all foreign exchange gains or losses regarding the Loan be paid or credited in respect of each financial year. In addition, it also states that the foreign exchange gains or losses shall be payable when owing, and reflected as a liability or receivable in the companies accounts.
The taxpayer stated that the Hedge Agreement as written did not reflect their intention that any cash settlements would not arise under the agreement until XXXXXXXXXX made a principal payment on the loan. However, the Hedging Agreement itself is a legal contract between the two parties and therefore pursuant to this agreement, the gains or losses would have to be recognized on an annual basis.
We trust our comments will be of assistance.
Yours truly;
Doug Watson
for Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5
© Her Majesty the Queen in Right of Canada, 2012
Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistributer de l'information, sous quelque forme ou par quelque moyen que ce soit, de facon électronique, méchanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.
© Sa Majesté la Reine du Chef du Canada, 2012
Email this Content