18 September 1995 Internal T.I. 9427166 - FOREIGN EXCHANGE GAINS AND LOSSES

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

1.Funds borrowed in a foreign currency - whether forex gains are on account of income or capital.

2.Foreign currency swap entered into several years after the loans were entered into to i) lock in forex gains on foreign currency loans and ii) effectively convert floating interest rate on loans to fixed interest rate.

Position TAKEN:

1.If funds are borrowed for general corporate purposes, gains are probably on account of income unless it can be demonstrated that the company was "grossly" undercapitalized in which case the gains will be on account of capital.

2.To the extent that the swap can be considered a hedge of the forex and/or interest rate exposure, gains/losses will be tied to the nature of any gains/losses on the underlying borrowings.

Reasons FOR POSITION TAKEN:

Various jurisprudence

			September 18, 1995

	Audit Technical Support Division						Rulings Directorate
E. H. Gauthier								J.P. Dunn
	Director									(613)957-2747
	Attention:  Blair Chisholm
	              Industry Specialist Services

			942716

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Cross Currency/Interest Rate Exchange Agreements

We are writing in response to your correspondence regarding the above referenced taxpayer and certain cross currency/interest rate exchange agreements (the "swap agreements") entered into by it.

We apologize for the delay in responding. As you are likely aware we had started a project to review the taxation of financial instruments the scope of which would have included the subject matter of your request. Unfortunately our study had to be temporarily suspended due to a lack of resources and workload and quite unintentionally our response to you was delayed as a consequence. In the future we will endeavour to provide our comments in respect of your referrals on a more timely basis.

Our understanding of the facts is as follows:

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Comments

We understand that the basis for the reassessing action by the District Office was that the borrowed funds were used for general corporate purposes and, as such, did not constitute fixed capital of the taxpayer. Consequently, the gains were considered to have been realized on account of income. We are unable to comment on the merits of this decision as we are not in possession of sufficient facts to warrant a considered opinion. We would, however, offer the following comments.

To the extent that the borrowed funds were used for general corporate purposes, we would agree that any gains derived from currency revaluations would be on account of income, but only, as discussed more fully below, in the event that the borrowed funds cannot be considered to constitute fixed capital of the taxpayer. Furthermore, we would consider that such gains, or losses, as the particular situation may be, to the extent they are found to be on account of income, should be accrued and reported by the taxpayer on an annual basis. On the other hand, to the extent that borrowed funds constituted fixed capital of the taxpayer, any gains or losses incurred due to currency fluctuation would be realized for income tax purposes only at the time that the debt is repaid notwithstanding that the taxpayer may have eliminated the effects of any future fluctuations by entering into the swap agreements.

As noted by Cullen. J. in Ethicon Sutures Ltd. v. The Queen 85 DTC 5290 (F.C.- T.D.), there are several principles which have evolved from the jurisprudence in distinguishing whether a foreign exchange gain or loss is on account of income or capital. Briefly, those principles are:

1.To determine whether a foreign exchange gain is to be treated as income or capital, it is necessary to look at the underlying transaction which gave rise to the gain.

2.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.

3.Where the transaction is 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.

4.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 the case at hand, it would appear that the criteria noted in points 3 and 4 above would not be applicable as the loans would not appear to have been taken out for the purpose of speculation in foreign currency nor would the loans constitute an investment of idle funds or a temporary investment. Although, the foreign currency did not arise as a result of the taxpayer's trading operations, such funds may be found to have been acquired in order to enable the taxpayer to carry on its trading operations on which basis the funds would be found to be held on account of income.

These points are further elaborated in Aluminium Union Ltd. v. M.N.R. 60 D.T.C. 1138 (E.C.C.) where it is noted at p. 1140 that,

The tests to be applied in determining if a gain resulting from the variations in foreign exchange rates is taxable income are the same as those applicable to other profits. If the exchange profit is derived from funds forming part of capital assets, it is not taxable; but if it results in respect of funds received on revenue account, the profit is income.

With respect to borrowed funds, the Court noted at p. 1142 that,

There is no doubt in my mind that the monies borrowed by the appellant from the bank were for the purpose of carrying on its business operations. The debt due to the bank was incurred for the purpose of gaining or producing income from its business. The profit realized from the use of the funds obtained for the purpose of carrying on a business and of producing income from the business seems to me to meet the requirements of s. 4 of the Act.

and further;

At the time of the settlement of the yen borrowings, the appellant was indebted to the bank in the amount of 713,104.05 yen. The amount had been borrowed not for capital purpose, but, as stated in evidence, to pay for current expenses of carrying on the business. The borrowings were not made for investment purposes but to meet the expenditures incurred in the operation of its business activities. In other words, it was circulating capital used in its trade.

On deciding that the foreign currency gains were on account of income, the Court stated at p. 1143 that,

Though the buying and selling or the exchanging of dollars for yen was not the primary business of the appellant, that operation was necessary for the purpose of its transactions on revenue account and the settlement of its debt with the bank in Japan was a part of its trading operations.

In our view, it is important to note that the Court, in reaching its decision, refers repeatedly to the purpose for which the borrowed funds were acquired and, after analysing the actual use of the borrowed funds, finds the use of the funds as confirmation of the purpose. The Court commented at p. 1143

The profit made on the exchange of dollars for yen, when it settled its account with the bank in Japan, was made on funds which had been borrowed and used to pay expenses of its trading operations.

In other words, the taxpayer borrowed funds to pay expenses of its trading operations and the evidence disclosed that the funds were, in fact, used to that end. The gains were, accordingly, found to be on account of income.

In Ethicon Sutures, supra, the Court also reiterated the comments of Urie, J. in Salada Foods Ltd. v. The Queen 74 DTC 6171 (F.C.-T.D.) wherein it was noted that "when a foreign exchange gain has been realized, the mode of its application (eg. whether it is used to pay dividends or trade payables) has no bearing whatever upon whether the gain was of a capital or income nature". The Court did additionally note, however, that the "mode of application" of any gain or loss may "buttress the decision made at the outset whether the fund is of a capital or income nature". Accordingly, while the use of any funds acquired in the realization of a gain may not, in and of itself, be relevant in the determination, that use may be of assistance in confirming the original intention of the taxpayer in acquiring the foreign currency.

In this respect, the Court in Ethicon Sutures also commented that "the principle of primary and secondary intention also applies" and found that, while the taxpayer had maintained that its primary intention in acquiring the foreign currency was for a capital purpose (ie. the payment of dividends), the taxpayer also had a secondary intention that the funds be used for income purposes (ie. the payment of trade payables) and, consequently, found the foreign exchange gains to be on account of income because of this secondary intention.

The intention of a taxpayer in acquiring foreign currency is a major factor used by the Courts to determine if that currency was held by the taxpayer on account of income or capital and the Courts will examine the conduct of the taxpayer in his use of the currency to either substantiate or refute his alleged intention. Although we have noted that the Courts will look to the taxpayer's intention in acquiring foreign currency, the objective determination of this intention will normally require an examination of the actual use of that currency. Accordingly, from an audit perspective, an analysis of the use of borrowed funds may be the best, or only, practical method of determining the reasons for acquiring the currency.

In the case of Tip Top Tailors Ltd. 57 DTC 1232 (S.C.C.), the taxpayer testified that it was their intention to use the foreign currency to pay for cloth supplies from the United Kingdom to be used in the carrying on of its trading operations. The Court examined the actual transactions involving the currency and, having found that the taxpayer did, in fact, use the currency as intended, found that the gains realized were on account of income as the funds were acquired, as was noted in Ethicon Sutures, "for the purpose of carrying on trading operations". We also note that the Court found that the taxpayer was, as a determination of fact, trading in foreign currency.

As noted previously, in Ethicon Sutures, the taxpayer maintained that its intention in accumulating the foreign currency was for a capital purpose which was the payment of scheduled dividends, however, upon examination by the Court, it was found that the funds were actually used for a variety of purposes, some capital and some income, and, accordingly, the Court rejected the taxpayer's contention that the funds had been acquired solely for capital transactions.

This notion of intention is further evidenced in the case of Imperial Tobacco Co. of Great Britain and Ireland Ltd. v. C.I.R (1943) 2 ALL E.R.119 as, in that case, the foreign currency was never itself used prior to being expropriated by the government of the United Kingdom. The Courts looked to the intention of the taxpayer in acquiring the foreign currency which, it was admitted by the taxpayer, was for the purpose of paying for inventory supplies. In light of the taxpayer's stated intention, the Court examined the actual use of similar funds and found that those funds had, in fact, been used to purchase tobacco inventory thereby substantiating the taxpayer's stated intent in acquiring the foreign currency which was the subject of that action. In this case, the Court found the evidence consistent with the taxpayer's stated intent and determined the gains, notwithstanding the actual manner in which the funds were disposed of, to be on account of income. The Court noted that, once the currency had been acquired with a specific purpose in mind, any transactions with respect to that currency, barring any subsequent specific reallocation of those funds towards another purpose, would be treated in a like manner as if they had been used as first intended. In essence, the Court found that, as the funds were acquired for the purpose of carrying on the taxpayer's business any gains realized upon the disposition of that currency would similarly be treated as being on account of income.

In the present case, you have advised that the minutes of the meetings of the Board of Directors of XXXXXXXXXX indicate that the proposed use of the proceeds of the two loans was for general corporate purposes. You have further advised that the borrowed funds were, in fact, used for these general corporate purposes. As the use of the funds does not conflict with the taxpayer's stated intent of the taxpayer in borrowing the foreign currency, it is our view that the treatment of any foreign exchange gains relative to these borrowings as being on account of income would not conflict with the above referenced jurisprudence.

The Courts have found, however, that in circumstances in which the taxpayer is undercapitalized and, consequently, unable to carry on its business without the borrowed funds, any exchange gain or loss realized in respect of those funds will be on account of capital regardless of the intended or actual use of the funds. Unfortunately, the Courts have not provided substantial guidance in the determination of the undercapitalization of a corporation in the cases reported on this topic.

In Columbia Records of Canada v. MNR 71 DTC 5486 (F.C.-T.D.) the Court found as a question of fact that the corporation was undercapitalized and that, notwithstanding that the funds borrowed from its parent were used for a variety of purposes including ongoing business expenses, the losses incurred upon repayment of these loans was on account of capital.

Similarly, in Canadian SKF Company Limited 66 DTC 140 (T.A.B.) the taxpayer maintained that exchange losses were on account of income, however, the Board found, as a fact, that the taxpayer was insufficiently capitalized in order to carry on its day-to-day activities and, consequently, notwithstanding that the borrowed funds had been applied to both income and capital uses, all losses were found to be on account of capital. The finding of fact in this case is based primarily on the terms of the foreign currency loans. Loans taken out in 1952, 1953 and 1954 which were originally repayable on three months notice were, in 1961, extended to 1968. The Board states with reference to these loans at p. 152 that,

they had thus all become long-term borrowings in the year in question.

and further,

These facts appear to establish conclusively that these loans had become, in point of fact, capital financing of a long-term duration. The appellant company had been greatly underfinanced.

The concept of borrowings constituting permanent capital of an enterprise was judicially considered in Bennett and White Construction Co. Limited v. MNR 49 DTC 5134 (S.C.C). In that case, the taxpayer required substantial bank loans in order to carry on and expand its business of construction. In order to obtain these loans, guarantees were provided by the shareholders and the guarantee fees paid in respect thereof were sought to be deducted from its income from business. Upon analysing the capital structure of the company, the Court found that "its paid up capital and surplus were such that in relation to the volume of business available it required additional funds" and, accordingly, decided that the borrowings and the guarantees in support thereof were on account of capital and not deductible for income tax purposes. In support of this judgment, Estey, J. stated at p. 517,

This was not a borrowing of money on a temporary or short-term basis such as is necessary and incidental to the ordinary and usual transactions in the course of the appellant's business. In effect this line of credit made available to the appellant for an indefinite period the ability to borrow funds for the purpose of accepting contracts beyond the volume its paid-up capital and surplus would permit. The provision for the cancellation of the guarantee, having regard to the relation of the guarantors to the company, and the practice since 1934, does not detract from the conclusion that this line of credit provided a long-term basis upon which the company might obtain the funds it required.

Rand J. concurred with the dismissal of the taxpayer's appeal and made the following statements regarding the distinction between permanent and circulating capital:

The case for the company is that the payments were "wholly, exclusively and necessarily" paid out to earn the income. In a remote sense that is so; but the same can be said for almost every outlay in the organization of the company. The conception of the statute however is an earning of income through the use of capital funds which in one form or another constitute the means and instruments by which the business is prosecuted; but that providing or organizing them must be clearly differentiated from the activities of the business itself has been lately reaffirmed by the Judicial Committee in Montreal Coke and Manufacturing Company v. The Minister of National Revenue, (1944) A.C. 126.

The acquisition of capital may be by various methods including stock subscriptions, permanent borrowings through issues of securities, or term loans; and ordinarily it should make no difference in taxation whether a company carried on financially by one means or another. In the absence of statute, it seems to be settled that to bring interest paid on temporary financing within deductible expenses requires that the financing be an integral part of the business carried on. That is exemplified where the transactions are those of daily buying and selling of securities: Farmer v. Scottish North American Trust, (1912) A.C. 118: or conversely lending money as part of a brewery business: Reid's Brewery v. Mail, (1891) 2 Q.B. 1.

We would note that the Courts have not provided any discrete demarcations in distinguishing between permanent and circulating capital and, in those cases in which borrowed funds are found to constitute permanent capital, that decision has been based upon a finding of fact that the enterprise is undercapitalized absent the borrowed funds.

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We trust that this assists in your assessment of the pertinent issues in this case and, again, apologize for the delay in our response.

Section Chief
Financial Institutions Section
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch