29 September 1989 Ministerial Letter 73788 F - Discount on Obligations and Foreign Exchange Losses on Repayment

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.

Subject: Applicability of paragraph 20(1)(f) and subsection 39(2) of the income Tax Act (the "Act") - Discount on  obligations and foreign exchange Losses on repayment of the said obligations.

24(1)

This is in reply to your memorandum dated April 28, 1989, wherein you request our opinion on the above mentioned subject.

FACTS

24(1)

TAXPAYER'S POSITION

5.     Although paragraph 20(1)(f) of the Act is commonly said to apply to discount on obligations, its actual application may be much broader.

6.     24(1)

7.     24(1)

AUDITOR'S POSITION

8.     The auditor agrees with the taxpayer that paragraph 20(1)(f) of the Act has a much broader application than original issue so called "discounts".  However, he does not think that paragraph 20(1)(f) applies to the foreign exchange loss realized on the repayment of the notes on 24(1)

9.     These foreign exchange losses or gains, which ever is applicable, on the fluctuation after 1971 of a foreign currency in relation to Canadian currency are taxable or deductible, depending on their nature.  If the gain or loss results from transactions of an income nature, the full amount becomes relevant in computing the taxpayer's income.  On the other hand, if the gain or loss is of a capital nature, subsection 39(2) of the Act applies and the gain or loss is deemed to be a capital gain or loss.

10.     24(1)

11.     The intent of paragraph 20(1)(f) of the Act, as explained in paragraph 19 of IT-114, is to permit a deduction for a true so called "discount" paid in the year and not in respect of the foreign exchange losses.

12.     24(1)

     To support this position, the preamble under subsection 20(1) of the Act reads that:  "There may be deducted such part of the following amounts as may reasonably be regarded as applicable thereto"; therefore, even though the taxpayer did pay 24(1) the part of this amount as may reasonably be applicable determining the deduction under paragraph 20(1)(f) of the Act should be 24(1)(The underlining is the auditor's).

13.     If the taxpayer's interpretation of paragraph 20(1)(f) of the Act is followed, it could have implications even when the obligation is issued without a discount or if the transactions is of an income nature.  (the underlining is the auditor's).

QUESTIONS

14.     Assuming the auditor's position is adopted with respect to the applicability of paragraph 20(1)(f) of the Act, what would be the tax consequence if the foreign exchange rate had dropped from 1.2345 to 1.15 on 24(1).  Would a deduction under paragraph 20(1)(f) of the Act 24(1) be allowed together with a capital gain under subsection 39(2) the Act?

15.     If the taxpayer's position was accepted with respect to the applicability of paragraph 20(1)(f) of the Act, in a situation where the borrowed funds were not capital debt obligations and the taxpayer reported the foreign exchange loss as an income loss on the repayment, paragraph 18(1)(f) of the Act would effectively prohibit the deduction described in paragraph 20(1)(f) of the Act except as expressly permitted by that paragraph.  The computation under paragraph 20(1)(f) of the Act would reduce the deduction to 507. thereof.  (The underlining is the auditor's).

16.     Are the auditor's position and comments regarding the applicability and anomalies of paragraphs 20(1)(f) and 18(1)(f) and subsection 39(2) well founded?

DISCUSSION AND OPINION

17.     Our comments are limited to the questions submitted.

18.     Firstly, it should be stated that in order to give rise to a capital gain or loss in respect of a foreign currency transaction under subsection 39(2) of the Act, there are two essential elements:  first, the transaction must be expressed in a currency other than the Canadian dollar; secondly, the transaction must be settled at a time subsequent to the transaction date as it is for the case under review.

A.   MEASUREMENT OF EXPENDITURES

19.     Income or losses and, capital transactions must be measured in Canadian dollar for Canadian tax purposes (see for example Alberta Gas Trunk Line Co. Ltd. v., MNR 71 DTC 5403 at page 5403, concerning income measurement).  This principle is also in accordance with accounting principles (see paragraph 1650.13 of the CICA Handbook).

B.   SEPARATE TRANSACTIONS

20.     24(1)

21.     24(1) Although the Act is silent on this matter, the Canadian Jurisprudence has tended to follow the "separate transactions" theory (see for example Cockshutt Farm Equipment of Canada Ltd. v. M.N.R. 66 DTC 544, at page 551).

22.     Therefore there are two transactions for tax purposes:  a discount and a foreign exchange gain or loss.  Again, this principle is in accordance with the accounting principles (see paragraph 1650.12 of the CICA Handbook).

23.     Moreover, we are of the opinion that the use of the terms "an amount paid" in paragraph 20(1)(f) of the Act is a reference to the timing of the deductions and the terms "principal amount" defined at subsection 248(1) and used in paragraph 20(1)(f) of the Act refer to the maximum amount payable in Canadian dollars under the terms of the obligation as computed and ascertained at the time of the issue of the said obligation, and payable on account of the obligation (and not to any gain or loss on foreign exchange.  Therefore, the "principal Amount" in this case is 24(1).

C.   TAX TREATMENT OF A DISCOUNT

24.     The department's position concerning the treatment for tax purposes of a discount on the redemption of a debt obligation is stated in the interpretation bulletin IT-114.  The term "discount" refers to a discount from the principal amount of an obligation on the issue thereof as stated in paragraph 2 of IT-114.

25.     Therefore, we agree with the computation of the discount deductible made by the auditor, pursuant to subparagraph 20(1)(f)(i) of the Act.

D.   TAX TREATMENT OF FOREIGN CURRENCY TRANSACTIONS

26.     The Department `s position concerning the treatment for tax purposes of foreign currency transactions is stated in the Interpretation Bulletin IT-95R.

27.     The general principles stated in this bulletin and established by the courts for foreign currency transactions are the following:

a)     where the gain or loss arises in connection with the purchase or the sale of property or services, the nature of the gain and loss will be determined by the nature of the transaction.  If the gain or loss results from a sale of inventory of the taxpayer, it would be one on account of income, taxable or deductible under subsection 9(1) of the Act.  if the gain or loss results from the sale of a capital property, it would be on account of capital subject to the applicability of subsection 39(2).  (See paragraph 2 of IT-95R.)

b)     where the gain or loss arises from borrowings from a third party, such as in the present case, "it is prima facie" evidence that the gain or loss is on account of capital but the use-of-funds factor plays a deciding role in the final determination of the tax treatment as stated in paragraph 3 of IT-95R.  If the borrowed funds are used in the ordinary course of a taxpayer's business operations, any foreign exchange gain or loss incurred or repayment of the loan would be on account of income. 

     However if the borrowed funds form part of the permanent or `fixed capital of the company regardless of the use of the funds, then the foreign exchange gain or loss incurred would be on account of capital (see paragraph 3 of IT-95R).

28.     In the present case, it seems that there is no doubt as to the nature of the transaction, that is, on account of capital (see paragraph 11 above).  Therefore, subsection 39(2) of the Act applies to the loss incurred on the foreign currency transaction.

29.     The timing of recognition of a foreign exchange gain or loss differs, depending upon whether the gain or loss is on income or on capital account.  For income items, the taxpayer may choose the cash or accrual basis as long as the method is followed consistently.  For capital items, it is clear from the reading of subsection 39(2) of the Act, that only the cash basis may be used.  However, this matter is not the main issue here.

E.   CONCLUSION

30.     In conclusion, we agree with the tax treatment proposed by the auditor.

31.     More specifically the answer to the first question of the auditor is yes, pursuant to the "separate transactions" theory.  In the hypothetical situation submitted and from an accounting point of view, it is useful to note that upon the settlement of the obligation, a capital gain would be realized both on the principal amount and on the discount as they form the whole of the obligation.  This hypothetical situation stresses also the fact that the "quantum" of the discount is established at the time of the issue of the obligation because of the wording in either paragraph 20(1) (f) and subsection 248(1) (in the definition of "principal amount"), but the timing of recognition of the discount is upon payment of the obligation.  Any fluctuation of the foreign currency until the settlement of the obligation gives rise to a foreign currency gain or loss.

We hope that you will find these comments useful.  If you have any question on this matter, please contact us.

for the DirectorBilingual Services and ResourceIndustries DivisionRulings Directorate