21 November 1997 Roundtable, 9729790 - FOREIGN AFFILIATES - CURRENCY HEDGING GAINS

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: characterization of group lending foreign affiliate’s foreign currency hedging gains and losses.

Position: If lending affiliate carries on investment business and gains and losses on income account, they would be included in computing FAPI

Reasons: Paragraph 95(2)(a) does not apply

Draft

1997 Tax Executives Institute Conference

Question XVIII

Foreign Affiliates - Cross-Currency Swaps

A group of related foreign affiliates ("Opcos") resident and carrying on active businesses in various countries receive financing from another foreign affiliate ("Finco") resident in country A. The lending activities of Finco represent an "investment business" as that term is defined in subsection 95(1). Finco makes loans to each of the Opcos in the currency of the country in which the particular Opco is resident. Finco, in respect of each loan made by it, immediately then enters into a cross-currency swap (the "Hedge") to swap the loans into country A currency. Assume that in respect of a particular loan (the "Loan"), any exchange gain or loss on the Hedge exactly offsets a corresponding gain or loss realized on the maturity and repayment of the Loan receivable. The Loan generates interest income that is characterized as active business income to Finco by subparagraph 95(2)(a)(ii).

Since Finco bears no economic gain or loss on the currency exchange from the hedged Loan, there should be symmetrical treatment for tax purposes. We invite the Department’s comments.

Department’s Position

The determination of how the foreign affiliate provisions apply to the money lending activities of a financing affiliate is a complex subject, requiring an in-depth understanding of the arrangements under consideration. We will however, make the following general observations in reference to the above simplified example.

It is not clear from the facts whether in the above circumstances the Loan would be a capital property of Finco. Assuming however, that the Loan was capital property, it is the Department’s view that it would be "excluded property" of Finco as defined in subsection 95(1). Therefore the capital gain or loss arising on the maturity and repayment of the Loan would be computed in the currency of country A in accordance with the provisions of paragraph 95(2)(f)(ii) and would be excluded from the computation of foreign accrual income ("FAPI") under B and E of the definition in subsection 95(1).

The gain or loss computed in reference to the settlement of the Hedge is characterized for tax purposes depending upon the transaction being hedged. Therefore since we have assumed in this case, that the Loan was on capital account, the gain or loss realized on the settlement of the Hedge would be on capital account. However, since the Hedge itself is in our view not "excluded property" of Finco, the taxable capital gain or allowable capital loss arising from the settlement thereof would be included in the computation of FAPI. Where the Loan represents permanent capital, it may be difficult to arrange agreements which will protect Finco from fluctuations in the value of currency which can be considered a hedge as described above. In such case, the arrangements may be viewed as speculation the profit or loss from which would be treated as income from the investment business of Finco.

In the event that the Loan is not capital property of Finco, it is our view that the profit or loss determined on the maturity and repayment of the Loan would be determined in Canadian dollars and be included in the computation of the income from the investment business of Finco. Moreover, it is our view that such profit or loss would not be included in the income from an active business of Finco pursuant to subparagraph 95(2)(a)(i) on the basis that such profit or loss would not satisfy the test in clause (B) thereof. However, the profit or loss on the settlement of the Hedge in these circumstances would also be included in computing the income from the investment business. Therefore the profit or loss on the settlement of the Hedge would effectively be netted with the profit or loss arising on the maturity and repayment of the Loan in computing the FAPI of Finco.

Prepared by: Olli Laurikainen

November 21, 1997

File 972979