16 January 1998 External T.I. 9617905 - foreign affiliates - active business income

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:

A foreign affiliate is in the business of lending money to related non-resident companies in circumstances where the interest on the loans subject to 95(2)(a)(ii) of the Act. The loans are on income account. Would the foreign affiliate's foreign exchange gains and losses on repayment of those loans and gains and losses from hedging such loans be included in its active business income pursuant to 95(2)(a)(i)?

Position:

No

Reasons:

The test in clause 95(2)(a)(i)(B) is not satisfied in respect of either gain of loss. Therefore the gains and losses realized on the repayment of loans and settlement of hedges would be included in the computation of FAPI (income from investment business).

961790
XXXXXXXXXX O. Laurikainen
(613)957-2116
Attention: XXXXXXXXXX

January 22, 1998

Dear Sirs:

Re: Subparagraph 95(2)(a)(i) of the Income Tax Act

This is in reply to your letter wherein you request our view whether the above provision of the Income Tax Act (the"Act") applies to foreign exchange and currency hedging gains of a foreign affiliate in the following hypothetical example.

1) FA is a controlled foreign affiliate of a corporation ("Canco") resident in Canada.

2) FA is resident in country X.

3) FA lends money to various operating controlled foreign affiliates ("Opcos") of Canco in various different foreign countries. The loans made by FA are not capital property of FA but rather are on income account.

4) Subject to the application of paragraph 95(2)(a) of the Act, all of the income of FA is income from an "investment business" as that term is defined in subsection 95(1) of the Act. The circumstances are such that the interest on all of the loans made by FA is included in FA's income from an active business by virtue of subparagraph 95(2)(a)(ii) of the Act.

5) FA makes loans to each of the Opcos in the currency of the country in which the particular Opco is resident. In respect of each loan made by it, FA immediately then enters into a cross-currency swap (a "hedge") to swap the loan into country X currency.

You request our view whether in the above circumstances the gain or loss on the settlement of a hedge would satisfy the tests in subparagraph 95(2)(a)(i) of the Act and be included in the income of FA from an active business.

Our Comments

In the above circumstances a gain or loss of FA arising on the settlement of a hedge would be on income account because a gain or loss on the settlement of the hedge derives its character from the loan which is being hedged. The foreign currency gain or loss on the repayment of each loan and the gain or loss from the settlement of the related hedge would be calculated in Canadian dollars and be included in computing the income of FA from an investment business.

In our view subparagraph 95(2)(a)(i) would not apply for the reason that the test in clause (B) thereof would not be satisfied. In our view, the test in clause 95(2)(a)(i)(B) of the Act requires that one assess whether the gains or losses would be income from active business in the hands of an Opco if the Opco had loaned money in a foreign currency other than the calculating currency and hedged such loans. We note that each gain or loss realized by FA on the repayment of a loan and the gain or loss on the settlement of the related hedge results from money lending activities of FA. Moreover, each hedging transaction entered into by FA is to protect FA not a particular Opco from fluctuation in the value of the currency in which the related loan is denominated. Therefore assuming a particular Opco to whom a loan was made, is not in the business of lending money, the gains and/or losses of FA, if realized by such Opco, would not qualify as active business income and the test in clause 95(2)(a)(i)(B) would generally not be satisfied.

Our position that subparagraph 95(2)(a)(i) of the Act is not broad enough to apply in this case is supported by the existence of subparagraphs 95(2)(a)(iii) and (iv). Those provisions were deemed necessary in spite of the fact that they arguably deal with amounts of income which are shifts of a portion of the active business income of a related non-resident corporation to the particular foreign affiliate. In the case at hand there is no such shift of income and in the absence of FA the Opcos would not have earned the income in question.

Furthermore, if clause 95(2)(a)(ii)(A) of the Act is relied upon so that income derived from interest payments on the loans is deemed to be income from an active business, it would not be logical that subparagraph 95(2)(a)(i) of the Act apply to the foreign exchange gains an losses on the repayment of those loans and even less logical that it apply to gains and losses on the settlement of hedges related to those loans.

We trust this is the information you require.

The foregoing comments are given in accordance with the practice referred to in paragraph 22 of Information Circular 70-6R3 and are not binding on Revenue Canada.

Yours truly,

for Director
Reorganizations and International Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch
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