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 gain arising on the disposition of a forward contract on account of income or capital?
Position: The gain is on account of capital in the hands of the subsidiary.
Reasons: See 1980 Revenue Canada Round Table - Section 85 Rolls.
March 5, 2014
XXXXXXXXXX Tax Services Office Headquarters
Large Business Audit Income Tax Rulings
Attention : XXXXXXXXXX
This is in reply to a memorandum of August 13, 2013, by XXXXXXXXXX that included representations from the taxpayer. This is also further to a meeting on September 17, 2013, where the XXXXXXXXXX TSO representatives, namely XXXXXXXXXX requested that we provide our views as to whether the gains on the foreign exchange forward contracts are on account of income or capital.
Parent is a public corporation and is the holding company of a corporate group of companies. In XXXXXXXXXX and XXXXXXXXXX, Parent borrowed funds by issuing senior notes for US$XXXXXXXXXX that would mature on XXXXXXXXXX. In XXXXXXXXXX, Parent then entered into a series of foreign currency forward contracts ("forward contracts") with XXXXXXXXXX (the "Counterparty") for an amount of US$XXXXXXXXXX in order to hedge the repayment of the borrowed funds. On XXXXXXXXXX, Parent assigned the rights and obligations under the forward contracts to a wholly-owned subsidiary ("Subco"). On the assignment, the two taxpayers elected, pursuant to subsection 85(1), at an agreed amount of $XXXXXXXXXX. At that time, the termination value of the contract was approximately $XXXXXXXXXX. Subco subsequently terminated the forward contracts and received $XXXXXXXXXX from the counterparty. (This is an assumed fact. The taxpayer uses the term "sold" but does not identify a purchaser. Normally, such contracts are terminated with the counterparty in accordance with the standard pricing terms for these types of contracts.) Subco had $XXXXXXXXXX in capital losses to carry forward to future years at the time. Subco reported a capital gain for tax purposes when it terminated the forward contract.
1) Should Parent have a gain on account of capital or income when Parent assigns the forward contracts to Subco, and if so, at what amount?
2) Is the gain realized by Subco on account of capital or income when Subco terminates the forward contracts?
The TSO's Views
In the opinion of the XXXXXXXXXX TSO, the forward contracts were sufficiently linked to the capital borrowing such that any gain or loss on the forward contracts would have been on account of capital to Parent.
The Subco gain is on account of income since the loan that was being hedged remained with Parent while the forward contract was assigned to Subco. The forward contract was not held as a hedge of any Subco transaction. Subco acquired the forward contract with the purpose of terminating it and realizing the income.
In our September 17, 2013 meeting, the TSO representatives put forward the view that the Subco gain could be split into a capital and an income component: an argument advanced by the taxpayer. That is, for the period of time prior to the acquisition of the forward contracts by Subco, the increase in value could be treated as a capital gain in Subco and the remainder of the gain would be on account of income.
The Taxpayer's Views
The taxpayer has argued that the intention to use the forward contracts as a hedge did not change to speculation when Parent transferred them to Subco. The taxpayer indicates that the law does not preclude hedging on a consolidated basis such that the forward contracts continued to be linked to the Parent's capital transaction. Consequently, the Subco gain is on account of capital.
From a policy perspective, the taxpayer stated that the purpose of the transfer was to offset capital gains on the forward contracts with the capital loss carry-forwards in Subco, and apply a form of loss consolidation between related corporations. As such, it is the taxpayer's view that the outcome is not offensive.
It was further argued that, at the time of the transfer, the contracts had a "latent" capital gain that accrued while Parent held the contracts. To ignore that gain is to retroactively dismiss the linkage principle. In accordance with this principle, the taxpayer would accept that a portion of the Subco gain is on account of capital and the remainder on account of income.
We agree with both the taxpayer and the TSO that the forward contracts were linked to the repayment of the debt issued by Parent. While the hedge was put in place a few years after the issuance of the debt, the aggregate amount of the forward contracts was similar in amount to the debt and the maturity date of the contracts matched the maturity date of the debt. As a result, we agree that the forward contracts are linked to a capital transaction such that, if the forward contracts had been terminated by Parent, the resulting gain would have been on capital account.
With regard to the transfer of the forward contracts pursuant to subsection 85(1), it must first be established that the contracts are eligible property, as defined in subsection 85(1.1). As indicated in Rulings document XXXXXXXXXX, we have previously confirmed that an "in-the-money" forward contract is an eligible property within the meaning of subsection 85(1) provided that it was linked to a capital transaction.
In a 1983 Round Table Question, the Canada Revenue Agency was asked for its position on section 85 character rollovers:
"We have been asked to clarify the position given in our response to question 8 of the 1980 Round Table in which we were asked whether we would rule favourably on a proposed transaction where a taxpayer holding appreciated capital property transfers such property under subsection 85(1) and the acquiring corporation immediately thereafter sells the property at a profit. The issue was, of course, whether the profit would still be considered to be a capital gain in the light of the short holding period of the recipient corporation.
Our response was intended to indicate that we are prepared to accept the 85(1) roll and would also accept that the profit would still be a capital gain, despite the short holding period, where the roll was between two sister corporations or a parent and its controlled subsidiary and the ultimate sale was to an arm's length third party. We confirm this position and are now prepared to rule in those specific circumstances."
It is our view that the gain in this situation falls within the parameters described in the 1983 Round Table. Therefore, we are of the opinion that the entire gain realized by the subsidiary on the disposition of the forward contract is on account of capital.
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 by contacting Ms. Céline Charbonneau at (613) 952-1361. A copy will be sent to you for delivery to the client.
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, 2014
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, 2014