26 June 2013 External T.I. 2013-0481691E5 - Hedging - ITA 39(2)

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: What is the appropriate income tax treatment for losses on forward contracts which were settled and re-entered into on a monthly basis where the amount hedged related to a long-term debt outstanding.

Position: The losses on the forward contracts are not linked to the gains on the long-term-debt. The losses would be on account of income.

Reasons: Linked transactions must match in terms of timing and amount. The transactions in this case do not match in terms of timing.

XXXXXXXXXX
2013-048169
Andrea Boyle, CGA

June 26, 2013

Dear XXXXXXXXXX:

Re: Hedging Transaction

We are writing in reply to your letter dated March 13, 2013 regarding the income tax treatment of forward contract gains and losses. You have outlined the following fact situation:

1. Over a four-year period, a taxpayer had a foreign currency debt owing to related parties. In the last year the debt was settled (refinanced).

2. Over the course of this four-year period, the taxpayer entered into foreign currency forward contracts which were settled and re-entered into on a monthly basis.

3. For the first few years, the amounts of the forward contracts were equal to the principal portion of the loan outstanding; subsequently, the amounts of the forward contracts were equal to the outstanding principal plus interest.

4. The purpose of the forward contracts was to hedge the debt for accounting purposes. For financial statement reporting purposes, the taxpayer netted the amounts (i.e. unrealized gains or losses on the debt were offset with realized gains or losses on the forward contracts).

5. For income tax purposes the taxpayer deducted the unrealized gains on the debt on the Schedule 1. No adjustment was made on the Schedule 1 for the losses on the forward contracts resulting in a 100% deduction of the forward contract losses for income tax purposes. In the final year, the taxpayer recognized a capital gain on the settlement of the debt for income tax purposes.

In summary: forward contract losses treated as being on account of income were claimed each year, and a gain on account of capital on the debt settlement was reported in the last year.

YOUR QUESTION

You have asked whether the fact that the forward contracts were settled on a monthly basis and the loan was settled a few years later impacts the linkage of the transactions for income tax purposes. More specifically, you have questioned whether the renewal of the contract on a monthly basis, from inception to settlement, really differs in principle from a single hedge over the term of the loan.

OUR COMMENTS

The Income Tax Act (the "Act") does not contain rules to determine whether foreign exchange gains and losses are income or capital in nature; rather, general principles of characterization have been developed by the courts.

Similarly the Act does not define the term "hedge" and there are no specific rules in the Act which address situations where foreign exchange items are hedged. Case law principles apply to determine if a derivative financial instrument constitutes a hedge for income tax purposes.

Based on jurisprudence, the relevant tax principle to consider in evaluating hedging situations is "linkage". The courts (Echo Bay Mines Ltd v. The Queen, 92 DTC 6437, Salada Foods Ltd v. The Queen, 74 DTC 6171, Ontario (Minister of Finance) v. Placer Dome Canada Limited, 2006 SCC 20) have confirmed that whether an activity constitutes hedging depends on sufficient inter-connection or integration with the underlying transaction.

For a derivative financial instrument to constitute a hedge there must therefore be sufficient linkage (in terms of both timing and amount) between the derivative and the underlying transaction. In our view, the timing and maturity date of the derivative should reflect the underlying capital transaction although it does not necessarily have to be a perfect match. Where a hedge is not sufficiently linked to a capital transaction, the gain or loss is on income account.

In Shell Canada Limited v The Queen, 99 DTC 5669 (SCC), the Supreme Court of Canada accepted the linkage principle in the context of forward contracts that hedged against currency fluctuations under the repayment of a foreign currency denominated debt obligation. The Supreme Court considered the perfect matching of the maturity date of the forward currency contracts to the date of repayment of the borrowings and found sufficient linkage between the forward currency contracts and the underlying capital transaction, namely the repayment of the capital loan.

In the situation which you have described, the maturity dates of the forward contracts do not in any way correspond to the date of the underlying transaction on which the risk was anticipated to materialize. It appears that the hedges were put in place independently of any expectation of realizing a gain or loss on the settlement of the debt. Thus, there is no linkage between the maturity dates of the foreign currency contracts and any actual or intended date of settlement of the debt. Accordingly, in our view, the foreign currency contracts did not constitute a hedge of an underlying capital transaction for income tax purposes. Any gain or loss on the forward contracts described would therefore be on account of income.

We trust that these comments will be of assistance.

Yours truly,

Doug Watson
for Director
Corporate Financing Section
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch