Citation: 2007TCC462
Date: 20070810
Docket: 2004-3592(IT)G
BETWEEN:
SASKFERCO PRODUCTS INC.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Woods J.
[1] Unlike some other countries, Canada
does not have income tax legislation that deals on a comprehensive basis with
foreign currency gains and losses. Instead, Canada
relies on judge-made law to develop the general legal principles that apply in
this area.
[2] This appeal confronts the question of whether the
general principles that have evolved are in fact “principled.” The answer, I
suggest, is that the applicable tests may not be entirely justifiable on a
principled basis, but they have been developed over a long period of time and
they should be respected in the interests of promoting certainty.
Overview
[3] The appellant, Saskferco Products Inc. (“Saskferco”),
appeals income tax assessments for the 1995, 1996, 1998 and 1999 taxation
years.
[4] The issue concerns gains and losses that were offset
on Saskferco’s financial statements using hedge accounting principles. The
appellant seeks to apply the same principles for the purpose of computing
profit under s. 9(1) of the Income Tax Act.
[5] Saskferco described the offsetting transactions as a
“natural hedge,” which is a term used to describe foreign currency receipts and
expenses that, considered together, eliminate exposure to foreign currency
fluctuations. In this case, the appellant offset foreign exchange losses on U.S. denominated indebtedness against revenues denominated
in the same currency.
[6] The accounting principles that were applied appear to
be based on the theory that foreign exchange fluctuations need not be
recognized to the extent that the foreign currency risk has been eliminated.
[7] Applying these principles for financial statement
purposes, Saskferco translated the principal amount of its U.S. denominated project debt at the rates of exchange in
effect when the debt was incurred. This had the effect of removing foreign
exchange losses on the principal of the debt. Saskferco also translated a
portion of its U.S. dollar revenues at the same exchange rate in years in which
the project debt was repaid. According to the accounting theory, this had the
effect of reducing foreign exchange gains that were embedded in the revenues.
[8] The same approach was used by the appellant in
preparing its income tax returns for taxation years in which principal
repayments were made on the project debt.
[9] The assessments that are under appeal reversed the
effects of this hedge accounting. Conceptually all sales revenue and debt
repayments were translated at current exchange rates for purposes of the
assessments, although the actual calculations were a bit more complicated for
reasons described below.
[10] The effect of the assessments was twofold: they
increased sales revenue and they also recognized an equivalent amount of
foreign exchange losses on principal repayments of the debt. The losses were
allowed as capital losses.
[11] Saskferco challenges the assessments on two
alternative grounds. First, it submits that it is entitled to use hedge
accounting for tax purposes so that a portion of its U.S. dollar sales revenue
can be translated at the rate of exchange in effect when the debt was issued.
Alternatively, it submits that the foreign exchange losses realized on the
project debt are deductible on current account on the basis that the debt was
denominated in U.S. currency in order to reduce currency risk on
revenues.
[12] Both parties raised alternative arguments in the
pleadings which were abandoned at the commencement of the hearing. Although
they are not relevant to this decision, I will mention them briefly for the
interest of readers.
[13] Saskferco had also argued that a portion of the
foreign exchange losses on the debt were deductible under s. 20(1)(f) of the Act.
After the pleadings were filed, this issue was conclusively decided in the
Crown’s favour by the Supreme Court of Canada (The Queen v. Imperial Oil
Limited and Inco Limited, 2006 D.T.C. 6639).
[14] The Crown also raised an argument that Saskferco did
not realize any foreign exchange losses on repayment of the project debt.
Although the Crown maintained the correctness of this position, it decided not
to pursue it.
Factual
background
[15] Saskferco was formed in or about 1990 as a sole
purpose corporation to produce and sell fertilizer. It has two principal
shareholders, Cargill Limited (“Cargill”) and a corporation owned by the Province of Saskatchewan (the “Province”).
[16] The fertilizer business was the brainchild of the
Province, who sought out Cargill as a joint venture partner to build a plant in
Saskatchewan to produce nitrogen-based fertilizer.
[17] Cargill was well-suited for the project because its
U.S.-based parent corporation, Cargill Inc., had extensive experience in the
production and marketing of fertilizer as well as other agricultural products.
[18] Cargill was interested in the Province’s proposal and
the terms of a joint venture were eventually settled on. It appears that the
venture has been quite successful, with revenues exceeding initial forecasts,
at least during the relevant period.
[19] Construction of the plant, which began in 1990, was
completed in 1993 and full operations commenced immediately afterward.
[20] Financing to sustain Saskferco during construction and
for the next couple of years was obtained partly through debt and partly by
equity injections from the shareholders. The equity component was about 30
percent, leaving 70 percent to be financed by debt.
[21] Merrill Lynch was the financial adviser to Saskferco and
it appears that they were instrumental in advising on the structure of the
project debt which is central to this appeal.
[22] In July 1990, project debt was issued which took the
form of a series of notes (“Notes”) that were issued to a number of United States institutions by way of private placement. The Notes,
which were denominated in United
States currency, had a principal
amount of US$231,000,000, were guaranteed by the Province, and had at an
average interest rate of 9.59 percent.
[23] The Notes were described in a Merrill Lynch report as
medium term notes, but this seems a bit misleading as the maturity of the Notes
varied from 5 to 17 years. The first Notes became due in 1995, which was two
years after the plant became operational.
[24] This appeal relates to several taxation years in which
Notes were repaid. The relevant years, and the amount of the respective principal
repayments, are outlined in the chart below.
|
Taxation year
|
Principal
repayment (US$)
|
|
1995
|
$ 6,400,000
|
|
1996
|
$14,600,000
|
|
1998
|
$13,000,000
|
|
1999
|
$15,000,000
|
[25] From the inception of the borrowing in July 1990 and throughout
the relevant period, the Canadian dollar weakened significantly relative to the
United States dollar. Accordingly, large foreign
exchange losses were realized on each principal repayment of the Notes.
[26] Shortly after the Notes were issued, Saskferco’s joint
auditors, Ernst & Young and KPMG Peat Marwick Thorne, advised it on the
proper accounting treatment for the indebtedness.
[27] Based on their advice, the decision was made to adopt
hedge accounting with respect to foreign exchange fluctuations on the principal
of the Notes and a portion of U.S. revenues. The basis for the decision was
that it was thought that Saskferco was assured of having a sufficient flow of
funds in U.S. dollars from its revenue stream to make principal repayments on
the debt. Based on forecasts, it was estimated that about 50 percent of
Saskferco’s sales would be in the United States. As
long as sufficient revenues were accumulated in U.S. dollars to repay the debt,
an effective hedge would be in place, it was reasoned (Ex. R-10).
[28] In Saskferco’s financial statements for the year ended
May 31, 1991, which is the first year in which the Notes were outstanding, a
note described the hedge accounting in the following manner.
The Company’s long-term U.S. dollar debt is
hedged by future revenue streams in U.S. dollars and any unrealized
gains/losses are deferred until repayment of the debt.
[29] The deferral that is referred to in this note appears
to be a reference to the accounting standard at the time which required, absent
hedge accounting, that accrued foreign exchange gains and losses be recognized
on an amortized basis, rather than when debt repayments are made.
[30] It was not clear from the evidence whether this
accounting treatment of the debt was a motivating factor in the decision to use
hedge accounting. Although some of the testimony suggested that the adoption of
hedge accounting by Saskferco was mandatory, Mr. Meghji, counsel for the
appellant, conceded in argument that this method of accounting was optional.
[31] The first year in which Notes were repaid was 1995,
and at this time Ernst & Young were the sole auditors for Saskferco.
[32] In the financial statements for that year, a note
described that the principal payments on the Notes, and the U.S. dollar
revenues from which the repayments are made, were both translated at the
exchange rate in effect when the Notes were issued, which was in July 1990. The
note read:
In July 1990, Saskferco borrowed $231
million U.S. in medium term notes to finance
construction of its nitrogen fertilizer plant. The repayment of this unhedged U.S. dollar liability is being made from U.S. dollar
revenue streams generated from fertilizer sales. The sales provide an effective
hedge against fluctuations in the U.S./Canadian exchange rate. […]
The principal payments on the notes and the
U.S. dollar revenue streams from which they are paid are both translated at the
historical exchange rate [i.e., the rate on July 1990] as prescribed by
generally accepted accounting principles.
[33] For clarity, I would
note that Saskferco did not adopt hedge accounting with respect to interest
payments on the Notes and these were translated at exchange rates in effect
when the interest was paid. This is perhaps not surprising because hedge
accounting would have had no net effect on the financial statements.
[34] Saskferco’s auditors advised that, in order for hedge
accounting to apply to the principal of the debt, it was necessary to preserve
in U.S. currency sufficient amounts from its
revenue stream in order to make principal repayments on the debt. From a
business perspective, this was not desirable because the revenue receipts could
be invested at higher interest rates in Canadian dollars.
[35] Accordingly, the decision was taken in 1995 to convert
the U.S. dollar revenue receipts into Canadian dollars. In order to preserve
the hedge, Saskferco purchased derivative contracts (i.e., swaps and forward
contracts) at the time of the conversion so that there would be no currency
exposure between the time the revenues were received and the debt repayments
were made. Derivative contracts were acquired for all exposed amounts except
for one debt repayment that was made in 1995 that was not completely hedged.
[36] As mentioned earlier, hedge accounting was also adopted
for income tax purposes. By translating the principal amount of the Notes and a
portion of U.S. dollar revenues at the July 1990 exchange rate as opposed to
the exchange rates in effect at the time of the respective transactions,
foreign exchange losses incurred on the repayment of the debt were eliminated,
and revenues arising in the same years as the debt repayments were reduced by
an equivalent amount.
[37] By notices of reassessment dated May 14, 2004,
Saskferco was reassessed to reverse the effects of the hedge accounting.
Accordingly, Saskferco’s revenues were increased by translating all U.S. dollar
revenues at exchange rates in effect when the revenues were earned. In
addition, capital losses were permitted with respect to the foreign exchange losses
incurred on principal repayments of the Notes.
[38] The actual adjustments that were made for purposes of
the reassessments were a bit more complicated because of the derivative
contracts that Saskferco entered into to preserve the hedge. I will not discuss
the nuances of these adjustments as it is not relevant to the issues to be
decided.
[39] The following is a summary of the adjustments that
were made in the reassessments, that is, amounts that were added to revenues
and equal amounts that were allowed as capital losses.
|
Taxation year
|
Revenue
increase/Loss on debt (Cdn$)
|
|
1995
|
$1,296,076
|
|
1996
|
$3,376,672
|
|
1998
|
$3,661,996
|
|
1999
|
$5,084,980
|
Discussion
[40] The appellant makes two similar, but distinct,
arguments in support of its position. The primary argument will be considered
first.
Translation of
revenues
[41] For financial statement purposes, the appellant
translated a portion of its U.S. dollar revenues at the rate of exchange in
effect when the Notes were issued. This method of translation was used in years
in which debt repayments were made and the portion of revenues affected were
such that the foreign exchange losses on the debt were completely offset.
[42] The primary argument of the appellant is that it is
appropriate to adopt the same method of translation for tax purposes. As argued
by Mr. Meghji, this issue does not require a characterization of the foreign
exchange losses on the Notes. The characterization question is engaged,
according to the appellant, only if it is determined that revenues must be
translated at current exchange rates.
[43] The focus, then, is on sales revenue. It is suggested
that when a taxpayer has put in place a hedge which effectively eliminates
foreign currency exposure on sales revenue, the sales proceeds are
appropriately determined by taking the hedge into account.
[44] The appellant argues that this approach is accepted
under generally accepted accounting principles, that it accurately reflects
revenue and income, and that it has been accepted in prior judicial decisions.
[45] I do not agree with this submission. Even if the
appellant’s method of translating revenues was in accordance with generally
accepted accounting principles, in my view the approach taken severely distorts
the sales revenue that the appellant earned. This is common sense but, in
addition, the jurisprudence does not support using translation rates other than
rates in effect at the time that the transactions are recognized for tax
purposes.
[46] The principle is a fundamental one: in computing
revenue or expenses denominated in a foreign currency, a taxpayer must use the
foreign exchange rate in effect at the time of the transaction.
[47] In Tip Top Tailors Ltd. v. M.N.R., 57 D.T.C.
1232 (S.C.C.), Rand J. suggests that the principle is uncontroversial (at p.
1233):
[…] Admittedly in such a mode of dealing
the rate of exchange at the time of payment and not at any other time controls:
the actual outlay by the purchaser to the seller for the goods received, in
terms of the domestic currency, is the amount which must be taken into the
account.
[48] In Saskferco’s case, the method of translating
revenues used by it is actually a method of reflecting the combined results of
two transactions. This approach may be acceptable for accounting purposes,
where notes to the financial statements can be used to inform the reader, but
it is not an acceptable method for tax purposes.
[49] In reference to the acceptability for tax purposes of accounting
methods which consolidate different transactions into one, I refer to two lines
of authority, one that deals with revenues, and the other, costs.
[50] In each case, the courts have held that either
revenues or costs are to be determined only in accordance with the relevant
sales or purchase contracts. Although there may be related transactions that
affect the overall economic result to the taxpayer, these are not to be taken
into account in determining revenues or costs.
[51] The first line of authority deals with the revenue
side. In Alberta Natural Gas Company v. M.N.R., 71 D.T.C. 5400 (S.C.C.) and Alberta Gas
Trunk Line Co. Ltd. v. The Queen, 71 D.T.C. 5403 (S.C.C.), the taxpayers
operated pipelines that transported natural gas. In order to protect against
currency fluctuations on U.S. dollar debt that was incurred to finance the
pipelines, the taxpayers negotiated a portion of their revenues to be payable
in U.S. dollars.
[52] The taxpayers attempted to determine their U.S. dollar
revenues by excluding foreign exchange gains on the basis that this was in
accordance with generally accepted accounting principles.
[53] The Supreme Court of Canada, in brief reasons,
rejected this position. A review of these reasons suggests that the Court was
persuaded by the fact that the foreign currency gains were inescapably part of
what customers were paying for the transportation service provided by the
taxpayers.
[54] At page 5406 of Alberta Gas Trunk:
As I said, in my reasons in the other case,
it is clear that the purpose of s. 12.2 [in the shipping contract] was to
provide the appellant with U.S. dollars with which to meet its obligation under
the U.S. pay securities. But, in my opinion, it is
equally clear, under the wording of s. 12.2, that the U.S. dollars which the
shippers were obligated to pay, and the appellant was obligated to accept, were
in payment of the monthly cost of service charge which the shippers were
required, by s. 2.3 of the agreement, to pay for the transportation of their
gas. […] it is my view, that the American dollars received by the appellant
represented income from its business operations, and their full value had to be
taken into account in determining its income from its business for tax
purposes.
[55] The same approach has been taken by the courts in
determining the cost of property. The cost of property is simply the price
paid, and it is not reduced by related agreements that may affect the cost in
an economic sense.
[56] In The Queen v. Canadian Pacific Limited, 77
D.T.C. 5383 (F.C.A.), one of the leading cases, the court had to consider how
to determine the cost of capital expenditures which were incurred at the
request of, and were reimbursed by, its customers. In concluding that the cost
should be determined exclusive of the reimbursements, Pratte J. referred to the
following passage from Birmingham Corp. v. Barnes, [1935] A.C. 292
(H.L.):
What a man pays for construction or for the
purchase of a work seems to me to be the cost to him: and that whether someone
has given him the money to construct or purchase for himself; or, before the
event, has promised to give him the money after he has paid for the work; or,
after the event, has promised or given the money which recoups him what he has
spent.
[57] Applying these principles to the facts in this case,
it is clear that the full value of the amounts receivable from purchasers of
fertilizer must be included in determining Saskferco’s profit under s. 9(1) of
the Act.
[58] I conclude, then, that the appellant’s revenues should
be determined using the exchange rates in effect at the time that the revenues
were earned.
[59] Mr. Meghji referred me to various judicial authorities
in support of the appellant’s position but in my view none of these decisions
affect the above principle.
[60] In particular, the appellant places considerable
emphasis on Ontario (Minister of Finance) v. Placer Dome Canada Ltd,
2006 D.T.C. 6532 (S.C.C.), which considered the meaning of “proceeds” from a
mine for purposes of the Ontario Mining Tax Act. In that case, the Supreme Court of Canada concluded
that a derivative contract, which was intended as a hedge of gold prices,
“fixed” the price of the gold and was included in the proceeds.
[61] The problem that the appellant has in relying on Placer
Dome is that the word “proceeds” was defined in the legislation and this
definition encompassed hedging arrangements. The decision may be useful in
considering when a hedging arrangement fixes a price in an economic sense, but
it does not assist in determining sales revenue in the absence of a statutory
definition.
[62] The appellant faces a similar problem in its reliance
on Echo Bay Mines Ltd. v. The Queen, 92 D.T.C. 6437 (F.C.T.D.). The
issue in that case was whether derivative contracts that fixed the price of
silver should be taken into account in determining income from the production
of silver for purposes of the resource allowance in the Income Tax Act.
[63] The question in Echo Bay Mines was whether
there was a sufficient inter-connection between the derivative contracts and
the taxpayer’s business of producing silver such that the gains under the
contracts could be considered part of the income from that business. This case is
relevant in determining income of business but in my view it has no relevance
in determining revenue.
[64] That disposes of this issue and in light of my
conclusion, it is not necessary that I consider whether the appellant’s method
of translating revenues conformed to generally accepted accounting principles
and gave an accurate picture of income.
[65] Both parties led extensive expert evidence on the
relevant accounting principles. The Handbook of the Canadian Institute of
Chartered Accountants, as it read at the relevant time, appears to recognize
hedge accounting for a revenue stream. The experts agreed that this has been a
very controversial provision in the Handbook but they differed as to whether it
was an appropriate method of accounting in Saskferco’s circumstances. The
appellant’s experts may be correct that Saskferco’s method of accounting was
accepted under the accounting standards at the time but I fail to see how this
is relevant to the question of how foreign currency revenues should be
translated for income tax purposes. In this regard, I agree with Mr. Chambers,
counsel for the Crown.
Foreign exchange losses
[66] Saskferco’s alternative argument focuses on the
character of the foreign exchange losses that were realized as the principal of
the Notes was repaid.
[67] The Crown’s position is that these losses are capital
losses, which allows them to offset any capital gains that Saskferco might
realize, but otherwise the losses are not deductible.
[68] Saskferco challenges this characterization on the
basis that the currency of the Notes is in effect a hedging instrument, which is
intended to protect against foreign currency losses on a portion of its U.S.
dollar revenue stream.
[69] Each party relies on a different legal principle in
support of its position.
[70] The Crown relies on the long-established principle
that a foreign exchange gain or loss on debt takes it character as income or
capital from the character of the debt: Shell Canada Limited v. The
Queen, 99 D.T.C. 5669, at para. 68; CCLI (1994) Inc. v. The Queen,
2007 D.T.C. 5372 (F.C.A.), at para. 19.
[71] The appellant relies on the principle, also accepted,
that a hedging contract takes it character from the item being hedged: Shell,
at para. 70.
[72] Mr. Meghji does not dispute that the hedging principle
has not to date been applied to foreign currency fluctuations on indebtedness.
However, he suggests that there is no principled basis for it not to apply in a
case such as this where the currency of the debt was selected purely for
hedging reasons.
[73] Whether or not Mr. Meghji is correct that there is no
principled basis not to apply the hedging principle to indebtedness, it would
be inconsistent with judicial precedent to do so.
[74] The principle that a foreign exchange gain or loss on
indebtedness takes its character from the character of the indebtedness has
been followed in a long line of jurisprudence in this country and in the United Kingdom. The same approach was also recently taken by the
Supreme Court of Canada in considering whether interest payable on indebtedness
is on current or capital account: Gifford v. The Queen, 2004 D.T.C.
6120.
[75] In my view, the long-standing approach to the
characterization of foreign exchange on indebtedness as stated in Shell
and CCLI should be followed in this case. One may question the theory
behind the basic principle, but it is important in the interests of providing
certainty that the test be respected.
[76] I would comment briefly on an earlier decision of this
Court that Mr. Meghji brought to my attention, Netupsky v. The Queen, 92
D.T.C. 2282 (T.C.C.). In that case, the taxpayer was allowed a deduction as a
current expense for foreign exchange losses realized on capital indebtedness.
The rationale for not following the traditional test in that case was that the
currency of the debt was selected purely for speculation reasons, which is
similar to the approach being suggested by the appellant in this case. The
decision is helpful to the appellant, but I have great difficulty in
reconciling it with the other judicial decisions and I do not think that it
should be followed by courts today.
[77] This is sufficient to deal with the appellant’s
alternative argument but I would also comment that I have difficulty with some
of the appellant’s factual assertions in support of its position.
[78] It was submitted that the foreign currency exposure on
revenues was the only factor that was taken into account in selecting the
currency of the project debt and that the debt would have been denominated in
Canadian dollars if it had not been for this exposure.
[79] I have not been persuaded of this by the evidence that
was before me.
[80] I accept that currency exposure was an important
factor that Saskferco’s officers and directors took into account in determining
the denomination of the debt, but the evidence is not sufficient to establish
that this was the only consideration, or that the debt would have otherwise
been in Canadian currency.
[81] Julian Hatherell, who was Cargill’s Vice President of
Finance at the relevant time, provided oral testimony to the effect that the
currency risk on revenues was the only factor that was considered by Saskferco
in determining the denomination of the project debt.
[82] This is not consistent, however, with memoranda that
were prepared during the decision-making process.
[83] In a report prepared for Saskferco by Merrill Lynch,
it was recommended that the project debt be denominated in U.S. currency in order to match the currency of the
revenue stream with financing costs. But the report also suggested that lower
interest rates was a second advantage (Ex. A1, Tab 3, p. 4). Merrill Lynch
also made reference to the depth of the market, presumably meaning the United States market, and they indicated that this has an effect on
yields. (Ex. A-1, Tab 2, p. 22).
[84] Mr. Hatherell testified that Merrill Lynch’s advice
regarding lower interest rates was not accepted by Saskferco but there was no documentary
support for this testimony.
[85] Another memorandum, which was presented to Cargill’s
management committee on December 12, 1989, also made reference to other
considerations. The memorandum, which was in the form of a power point
presentation, indicated that the currency of the debt was to be U.S. dollars
“to reduce cost and foreign exchange risk” (Ex. A-1, Tab 2, at p. 29 of attachment).
This presentation was made around the same time that Saskferco’s board of
directors were to receive final recommendations on the structure of the debt.
There is no evidence as to what the recommendations to the Saskferco directors
were, but it seems likely that the Cargill presentation would be consistent
with what was presented to them.
[86] For these reasons, I am not convinced that the
currency risk was the only consideration that was taken into account in
selecting the currency of the debt. I am also not satisfied that the debt would
otherwise have been denominated in Canadian dollars.
Conclusion
[87] For the reasons above, the appeal will be dismissed. I
would comment, though, that I have come to this conclusion with considerable
regret because the tax consequences to Saskferco of characterizing its foreign
exchange losses as on account of capital are harsh. Nevertheless, I view this
as a policy matter that is for Parliament to address and not the courts.
[88] The appeal is dismissed, with costs to the
respondent.
Signed at Ottawa, Canada, this 10th day of August 2007.
Woods
J.
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