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.
Principal Issues: Is it appropriate for the CFA to claim the mark-to-market foreign losses in computing its FAPI and what exchange rate should the taxpayer use when it disposes of its cash?
Position: As the taxpayer is already using GAAP, the temporal method is a method that the CRA accepts. Thus, the taxpayer would have to translate the monetary items at the exchange rate in effect at the balance sheet date. In addition, offsetting FAPI with foreign exchanges losses stemming from year-end exchange rate fluctuations do not seem inappropriate since none of the income of the CFA is from an active business and all amounts seem relevant in the computation of FAPI.
Reasons: Previously stated -- position unchanged.
December 21, 2010
Marian Young Headquarters
Toronto Taxation Office Income Tax Ruling
1 Front Street W. Directorate
c/o: 452-1-6 (5th floor west)
3E-713-A Nancy Turgeon, CGA
ILB - Foreign Affiliates and FAPI
Toronto ON M5J 2X6 2010-035442
Foreign exchange loss on disposition of cash
We are writing in response to your email of February 18, 2010 in which you requested our opinion on the exchange rate that a controlled foreign affiliate should use when it disposes of cash. From the limited facts given to us, we understand the situation under review to be as follows for transactions that took place before 2005:
A controlled foreign affiliate (CFA) of a Canadian corporation carries on an insurance business in a foreign country. The CFA involved is a captive that only deals with the insurance and reinsurance of Canadian risks; its income (presumably from premium received) is thus considered to be income from a business other than an active business pursuant to paragraph 95(2)(a.2) of the Income Tax Act (ITA). Consequently, the business income of the CFA is foreign accrual property income (FAPI) as defined in subsection 95(1), and more specifically under letter A of the definition in subsection 95(1). In the computation of its business income, the CFA converts its income and expense items at the average rate of exchange for the year.
The CFA also has investments that are acquired for the purpose of building up a reserve for potential claims. The income from these investments is FAPI. At year-end, the monetary items of the CFA are valued at market in accordance with generally accepted accounting principles (GAAP) and converted into Canadian dollars using the applicable exchange rate at year-end. This valuation can give rise to gains or losses, typically, not because of a change in the inherent value of the investments, but because of changes in the applicable exchange rates. Later, the CFA converts the monetary assets into cash, for example, to pay a dividend.
You would like to know whether it is appropriate for the CFA to claim the mark-to-market foreign losses against the FAPI and what exchange rate the taxpayer should use when it disposes of its cash.
The Interpretation Bulletin IT-95R Foreign exchange gains and losses mentions in part at paragraph 7 in respect of "Income Transactions Method of Accounting":
7. The Department will accept any method used to determine foreign exchange gains or losses on income transactions provided that method is, under the circumstances, in accordance with generally accepted accounting principles. Further the method used should be the same for both financial statement and income tax purposes. In the Department's view a determination of foreign exchange gains and losses cannot be properly made under section 9 if the taxpayer is inconsistent in his approach from year to year and, once he has chosen one method, the taxpayer should, in subsequent years, use the same method. ...
And at paragraph 8:
8. Transactions on income account are normally recorded in a taxpayer's accounts in the Canadian dollar equivalent determined according to the rate of the exchange prevailing at the time of the transaction. If full or partial settlement (i.e. receipt or payment of Canadian dollars) of an account is made within the taxation year, any foreign exchange gain or loss is reflected in income in that taxation year and at the end of the year the normal practice is for a taxpayer to adjust to Canadian dollars all his current accounts to reflect the exchange rate prevailing at that time and to include any resulting foreign exchange gains or losses in income in the year (current rate or accrual method)...
We conclude from this position in the IT-95 that when a taxpayer is using GAAP, the temporal method is accepted by the CRA, adjusting the accounts based on the applicable exchange rate on the balance sheet date. Therefore, all incomes and expenses should be translated using the exchange rate when they occur or using the annual average rate. On the balance sheet, all monetary items should be translated using the exchange rate at the balance sheet date. The year-end conversion generally gives rise to foreign exchange gains and losses. These have to be reported in the taxpayer's income according to GAAP.
Given that the relevant taxation years are before 2005, the rule in paragraph 95(2)(f) is applicable to a taxpayer who is computing its FAPI. In addition, subsections 5907(5) and (6) of the Regulations are generally relevant. Subsection 5907(5) indicates that for the purpose of the calculation of taxable gains and allowable losses, the taxpayer should use the rate of exchange on the date of the disposition.
Offsetting FAPI with foreign exchanges losses stemming from year-end exchange rate fluctuations does not seem inappropriate since none of the income of the CFA is from an active business and all amounts are relevant in the computation of FAPI.
As for the appropriate exchange rate that a taxpayer should use when it disposes of its cash, it would seem to us that the comments at paragraph 13 of IT-95R would be relevant:
"Foreign currency funds on deposit are not considered to be disposed of until they are converted into another currency or are used to purchase a negotiable instrument or some other asset, i.e. foreign funds on deposit may be moved from one form of deposit to another as long as such funds can continue to be viewed as "on deposit". Term deposits, guaranteed investment certificates and other similar deposits which are in fact not negotiable, are considered funds on deposit. Transactions in which foreign currency funds are invested in negotiable instruments such as notes, bonds mortgages, debentures, U.S. government treasury bills and notes and U.S. commercial paper, will require a foreign exchange gain or loss calculation at the time the foreign currency funds are used to purchase these investments and as well, each time such investments mature or are otherwise disposed of, whether or not the funds are rolled over into like securities."
Accordingly, it would seem to us that when foreign currency funds or cash on deposit are disposed of, a foreign exchange gain or loss calculation will be required at the time the foreign currency funds are used. If the funds were valued at the balance sheet date using a certain exchange rate, a gain or loss will result on the disposition of the cash if the relevant exchange rate at the time of the disposition is different from the exchange rate on the balance sheet date.
We trust that our comments will be of assistance.
International and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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