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: Are the hedges to be reported on account of income or capital?
Position: Income
Reasons: No underlying transaction
April 21, 2010
Toronto Centre TSO HEADQUARTERS
Large File Case Auditor Income Tax Rulings
453-2-1 Directorate
Attention: Nada Hrvojic C. Tremblay, CMA
(819) 281-6906
2010-035587
XXXXXXXXXX ("Canco"), formerly XXXXXXXXXX
Characterization of Gains and Losses Realized on Foreign Exchange Contracts Used to Hedge Net Investments
This is in response to your memorandum of January 21, 2010, wherein you asked our opinion as to how, for income tax purposes, the gains and losses realized by Canco on certain of its foreign currency transactions should be characterized. Canco has advised the CRA of its intention to amend its filing position for the XXXXXXXXXX and subsequent years in order to characterize its gains and losses realized on hedging transactions as being on account of income. Canco's representative XXXXXXXXXX has requested the change.
You advise that in the absence of clear statutory, judicial and administrative guidance there seems to be inconsistencies in the way CRA deals with derivative-based net balance sheet and net investment hedges. Given the significance and materiality of the issues raised, you would appreciate receiving a written opinion from us as to the proper characterization of the foreign exchange gains and losses arising from Canco's foreign exchange contracts used to hedge net investments.
We refer you to letters we recently sent to your office, namely document 2009-034592, 2009-034896, 2009-035206, for our position on similar types of derivative hedging contracts and why we are of the view that such gains/losses on these types of hedging contracts should be reported on income account.
General Issue:
Canco enters into certain hedging transactions relating to net investments in subsidiaries and foreign currency denominated assets and liabilities. These hedging transactions result in foreign exchange (FX) gains and/or losses that the taxpayer originally treated on account of capital. Canco now wishes to amend its filing position and treat these FX gains/losses on account of income. You request our views on whether income treatment is the correct treatment given the original intent of the hedges and the linkage back to the original item hedged.
Background
XXXXXXXXXX
Facts
Years XXXXXXXXXX and XXXXXXXXXX
For taxation years up to and including XXXXXXXXXX , Canco's functional currency was the Canadian dollar. In XXXXXXXXXX , the US dollar became the functional currency of Canco's consolidated operations. Prior to XXXXXXXXXX , Canco held interests in US and UK self-sustaining subsidiaries and was required to report the book value of its US and UK investments in Canadian dollars based on the exchange rate prevailing on the balance sheet date. Under GAAP, Canco recorded any adjustments attributable to FX gains/losses as follows:
Net Investments in Subsidiaries
FX gains/losses relating to net investments in subsidiaries are recorded in the cumulative translation account, or CTA, balance. Because Canco must treat the entire net asset position as if it were denominated in the subsidiary's functional currency, the foreign exchange contract entered into by Canco does not itself achieve a complete economic hedge of its invested capital in the subsidiary. Canco was concerned that fluctuations between the Canadian dollar and the US dollar and the UK pound sterling could cause distortions in financial ratios and other amounts so Canco implemented a net investment hedging strategy which for years XXXXXXXXXX and XXXXXXXXXX involved the forward sale of US dollars and UK pound sterling in exchange for Canadian dollars. The amount hedged was based on the estimated net book value of Canco's investments in its US and UK subsidiaries.
Foreign Currency-Denominated Assets and Liabilities
FX gains/losses relating to changes in the value of foreign currency denominated assets and liabilities (net monetary assets) due to foreign exchange fluctuations are recorded in the income statement. You note that XXXXXXXXXX did not hedge the value of any net monetary assets until after the US dollar became its functional currency in XXXXXXXXXX .
Below is an excerpt of Canco's XXXXXXXXXX Annual Report describing their foreign exchange policy:
XXXXXXXXXX
Below is an excerpt from Canco's XXXXXXXXXX Annual Report explaining the company's accounting policies:
XXXXXXXXXX
Tax Reporting As Filed:
For tax purposes, Canco has, for years XXXXXXXXXX , split its FX gains/losses realized through its net investment hedging strategy into two components: a "foreign exchange component" and an "interest differential component". They treated the gains/losses on the "foreign exchange component" as being on capital account and the gains/losses on the "interest differential component" as being on income account. Starting in the XXXXXXXXXX taxation year, Canco decided that it would no longer bifurcate the gains/losses realized through its net investment hedging strategy. As a result, for years XXXXXXXXXX , Canco reported all realized FX gains/losses as being on capital account.
The foreign exchange gain or loss is viewed as the amount that is equal, but opposite, to the foreign exchange gain or loss with respect to the underlying asset, liability or cash flow, that is being hedged. The "interest differential" is viewed as interest expense or income, relating to the hedge. Canco calculates the foreign exchange gain or loss by multiplying the foreign currency forward contract amount by the difference between the foreign exchange rates prevailing on the date the forward exchange contract is entered into, and the market rate prevailing on the maturity of the contract. The interest differential, revenue or expense is computed by multiplying the foreign currency forward contract amount, by the difference between the foreign exchange rate specified in the contract and the foreign exchange rate prevailing on the date the forward exchange contract is entered into. As noted above, in XXXXXXXXXX , Canco decided it would no longer distinguish between the two foreign exchange components, and reported all gains and losses realized in respect of its investment hedging strategy as being on capital account. For taxation years XXXXXXXXXX , CRA denied income treatment on the interest differential component and reclassified such amounts as being on account of capital. You advise us that the audits of XXXXXXXXXX are still outstanding.
Change in Tax Reporting As Requested:
Canco has advised CRA of its intention to amend its filing position for years XXXXXXXXXX in order to re-characterize its gains and losses realized on hedging transactions from being on capital account to being on account of income. The correspondence requesting the above has been received on November 30, 2009 from XXXXXXXXXX .
XXXXXXXXXX Annual Reports indicate that all hedging relationships, risk management objectives and hedging strategies are formally documented.
TSO Analysis and Position:
The Act does not differentiate between monetary and non-monetary items. Instead, the Act differentiates between income and capital items. Where the gain or loss relates to a trading activity it will be treated as income in nature. Where the gain or loss relates to non-trading activity it will be treated as capital in nature. Exchange gains and losses of a capital nature are included in taxable income only in the taxation year that they are actually realized. This is similar to the generally accepted accounting principles ("GAAP") treatment of non-monetary foreign exchange items carried at cost. In other words, after the item is recorded at the original foreign exchange amount, no subsequent changes in foreign exchange are accounted for at each balance sheet date. Only when subsequently sold are the realized foreign exchange amounts recognized for income tax purposes. There are no specific rules on situations where foreign exchange items are hedged. The Act does not contain rules to determine whether foreign exchange gains and losses are income or capital in nature; rather, general principles of characterization have been developed by the courts.
In Shell Canada Limited v. The Queen, (99 DTC 5669) the Supreme Court of Canada affirmed the following two principles: (1) the character of a foreign exchange gain or loss realized upon a repayment of debt generally follows the character of the underlying debt, and (2) the character of a foreign exchange gain or loss arising in connection with a hedging contract generally follows the character of the item to which the hedge relates. The court held that the manner in which Shell recorded the net foreign exchange gain for its non-tax financial accounting is not determinative of the proper tax treatment. Non-tax financial accounting is generally designed to reflect the overall economic position of the entire corporation. Subparagraph 20(1)(c)(i) of the Act, in contrast, applies to the tax treatment of specific transactions. It, therefore, should not be surprising that the same transaction may properly be assessed differently for different purposes: see generally Friedberg v Canada, [1993] 4 S.C.R. 285, at p. 286, per Iacobucci J. In support, you quote from paragraph 74 in the Shell decision, where in the Court's view,
"the mere fact that the gains are related to the interest expenses incurred under the Debenture Agreements, which subparagraph 20(l)(c)(i) allows Shell to deduct from its income, does not mean that the net foreign exchange gain should also be considered on income account......Furthermore, it is important to underline that interest expenses on money used to produce income from a business or property are only deemed by subparagraph 20(l)(c)(i) to be current expenses and, in the absence of that provision, would be considered to be capital expenditures: Canada Safeway, (1957 DTC 1239), per Judge Rand J., at p.727. This Court was not invited on this appeal to revisit this characterization of such interest expenses: they therefore remain capital expenses which [subparagraph] 20(1)(c)(i) deems to be deductible from Shell's gross income notwithstanding the general prohibition of such capital deductions in [subsection] 18(1)."
In Saskferco Products ULC v. The Queen, (2008 DTC 6698), the Federal Court of Appeal considered which of the foregoing principles applied for purposes of characterizing foreign exchange losses realized upon the repayment of US dollar denominated notes, where the currency of the notes was chosen in part for purposes of hedging foreign currency fluctuations on US dollar revenue. The two issues considered by the Tax Court of Canada were as follows: (1) whether the taxpayer was entitled to use hedge accounting for purposes of computing profits under section 9 of the Act, and, in the alternative, (2) whether the foreign exchange losses realized on the principal payments on the notes were on income or capital account. With respect to the first issue, the Tax Court of Canada was of the view that even though hedge accounting was permitted under GAAP, this method distorted revenue and was, therefore, not acceptable for tax purposes. With respect to the second issue, the Crown relied on Shell for the principle that a foreign exchange gain or loss realized on the repayment of debt generally takes its character from the character of the debt. Since the taxpayer had used the proceeds from the notes to finance the construction of a plant, a capital asset, it followed that the notes, and the foreign exchange losses realized by the taxpayer in connection with the principal payments on the notes, would be capital in nature. In contrast, the taxpayer relied on Shell for the principle that the character of a foreign exchange gain or loss arising in connection with a hedging contract generally takes its character from the character of the item being hedged. The taxpayer argued that the currency of the notes was effectively a hedging instrument that was intended to protect the taxpayer against foreign currency losses on a portion of its US dollar revenue stream. Since revenue was on income account, the foreign exchange losses realized on the principal payments on the notes should likewise be on income account.
The Federal Court of Appeal decision in Saskferco is of general interest in that it represents confirmation by a senior court of the principle that the character of a foreign exchange gain or loss arising upon a repayment of debt as income or capital will generally follow the character of the debt. The Court clarified that this principle will apply even if the currency of the debt is chosen to hedge foreign exchange gains or losses on other items, given that a debt, by its very nature, has a separate and independent commercial purpose. Arguably, the decision in Saskferco does not impact the principle that the character of a foreign exchange gain or loss arising in connection with a hedging contract generally follows the character of the item to which the hedge relates, where the hedging contract in question is a derivative contract, such as a swap or forward contract.
Conclusion:
You note that the absence of clear statutory, judicial and administrative guidance on the tax issues surrounding foreign exchange gain/loss hedges has contributed to inconsistencies in how the gains and losses from these hedge transactions are characterized for tax purposes, not only by the taxpayers but also by CRA auditors.
Taxpayer's Position:
Canco is requesting that the foreign exchange gains/losses from its hedging transactions should be accorded income treatment. Canco's position is founded in the "linkage principle"; namely, that the foreign exchange gains/losses in question are not linked to specific, identifiable capital transactions. The hedges were of a short-term nature and entered into to minimize the volatility that would otherwise arise because of the application of GAAP in the preparation of financial statements. In this respect, as the hedges were independent of any actual underlying transactions, income treatment should prevail.
It has been the CRA's long-standing position (36th Canadian Tax Foundation Conference, 1984, Question 63) that the characterization of gains or losses as on account of income or capital from a forward contract that was a hedging instrument depended on the underlying use of the funds that the forward was designed to hedge. The forward contract intended as a hedge would be considered separately from the underlying transaction that is being hedged, although its nature is characterized by the underlying transaction. Thus, it needs to be established that the forward contracts were used as hedges for purposes of the underlying transaction.
Salada Foods v The Queen (74 DTC 6171) was the first court case on the linkage principle, wherein the taxpayer did not convince the court that the hedge transaction was sufficiently integrated with the underlying capital risk it purported to hedge. The taxpayer anticipated a decline in value of the pound sterling, which it anticipated would result in a decline in value of its UK subsidiaries. Purportedly with a view to protecting itself against such a decline in value, the taxpayer entered into a forward sale of sterling.
The court noted:
"In arranging the forward sale contract, the Plaintiff acted in exactly the same fashion as a dealer or speculator in currencies would act. There was never any intention on the part of Salada that the transaction be in any way an investment in its normal sense and, in fact, it was acknowledged by the Plaintiff to be wholly speculative. It was not investing idle capital funds nor was it disposing of a capital asset. What was done was done because Salada was confronted with an abnormal situation from which it hoped to gain an advantage, no matter what the motivating factor was for desiring such an advantage".
In our view, in order for a forward contract to be a hedge for income tax purposes, the forward contract needs to be linked to a transaction (e.g., sale, repayment of debt), not an asset or liability. However, in our view, a projected disposition of an asset may involve sufficient linkage.
At the 2007 Canadian Tax Conference dealing with a question regarding the criteria for a hedge we stated: "Hedge" is not a defined term in the Act. The effectiveness of a hedge for tax purposes, i.e., whether a financial instrument constitutes a hedge, is relevant to the computation of profit. As the Supreme Court of Canada stated in Canderel Ltd v The Queen, 98 DTC 6100, the determination of profit is a question of law. Accounting standards are not law. Well-accepted business principles, which include but are not limited to the formal codification found in generally accepted accounting principles ("GAAP"), are not rules of law but interpretive aids. The CRA will take into consideration how the taxpayer reports under the new accounting standards as part of our review of the taxpayer's determination of profit under GAAP. Accordingly, the new accounting standards, which include guidance on hedge accounting in CICA Handbook Section 3865, would not cause the CRA to change how it interprets and applies the Act with respect to whether a financial instrument constitutes a hedge for tax purposes. The courts (Echo Bay Mines Ltd v. The Queen, 92 DTC 6437, Salada Foods Ltd v. The Queen, 74 DTC 6171, Ontario (Minister of Finance) v. Placer Dome Canada Limited, 2006 SCC 20) have confirmed that whether an activity constitutes hedging depends on sufficient inter-connection or integration with the underlying transaction. Again, as the Supreme Court stated in Canderel, ultimately, it is the law that determines how the CRA interprets and applies the Act."
In our view, if there is no expected disposition of a subsidiary that is being hedged with a hedging contract, capital treatment is not available. The principles that have evolved under case law with respect to distinguishing whether a foreign exchange gain or loss is on income or capital account were summarized in Ethicon Sutures Ltd. v. The Queen (85 DTC 5290) as follows:
- To determine whether a foreign exchange gain is to be treated as income or capital, it is necessary to look at the underlying transaction that gave rise to the gain.
- If 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 on income account.
- If the transaction is speculative 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.
- 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.
- To be considered capital in nature, the funds must be surplus and must be exclusively for dividend or capital expenditures (i.e., "earmarked primarily" is not enough).
In our view, the legal entity should have a direct ownership of the underlying hedged item. From a separate legal entity perspective, the legal entity should have an underlying transaction exposed to foreign exchange rate fluctuations, otherwise, there is no offsetting position against which any of the gains and losses arising from the hedges could be matched. In our view, if there is no linkage between the foreign currency contracts entered into by the legal entity and an actual or intended sale of foreign currency denominated capital assets, the foreign currency contracts do not constitute a hedge of a capital item for income tax purposes.
In our view, we need an underlying transaction to establish linkage, so it may not be possible for a corporation even if it followed its policy of hedging its net investments in its subsidiaries to be accorded capital treatment. Since the Act does not define the term "hedge", case law principles apply to determine if a derivative financial instrument constitutes a hedge for income tax purposes. The courts have held that for derivative financial instruments to constitute a hedge there must be sufficient linkage between the derivatives and the underlying transaction. Where a hedge is not linked to a capital transaction the gain or loss is on income account.
In our view, a hedge for less than the amount of a loan could still be an acceptable hedge and could establish sufficient linkage to establish capital treatment. The timing and maturity dates of the derivative should reflect the underlying capital transaction but it does not have to be a perfect match as a corporation could choose to only hedge part of a transaction. It is our opinion that the original stated intent does not govern the nature of a hedge for the entire term of the contract, particularly when the hedging relationship has ceased to exist before the contract matures.
In our view, the accounting treatment of the hedges as a net investment hedge, to reflect the economic position of Canadian parent's consolidated corporate group, does not necessarily mean that the hedge was a hedge for income tax purposes. Hedge accounting for consolidated financial reporting is not determinative of the tax treatment of a hedge for separate legal entity tax reporting. The courts have repeatedly expressed the view that accounting practices, by themselves do not establish rules of law; as you noted, see for example Shell. Accounting principles may not always apply, as in the case of Saskferco, in which hedge accounting based on GAAP was rejected by the Federal Court of Appeal. This case supports the view that legal principles take precedence over accounting principles.
Conclusion:
In our view, there must be an underlying capital transaction in order to offer sufficient linkage to be considered on account of capital. The transaction with respect to foreign investment must contemplate an actual or future sale of the shares. An underlying transaction must be present and, in our view, day-to-day fluctuation in the book value of foreign subsidiaries in a foreign currency relative to Canadian currency does not constitute an underlying capital transaction. An underlying transaction would only be present where there is a purchase, a sale, or a repayment of a debt. Accordingly, in our view, the hedges of Canco should be reported for income tax purposes on income account.
For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
R. Albert, CA
For Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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