15 April 2010 Internal T.I. 2009-0348961I7 - Foreign Exchange/Gains & Losses

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 forward contracts on foreign exchange designed to hedge foreign subsidiaries on account of income or capital?

Position: Income since there is no underlying transaction.

Reasons: Salada (74 DTC 6171)

									April 15, 2010
			Toronto Centre TSO																Headquarter
			Albert Leung 				C. Tremblay, CMA
			Large File Section			(819) 281-6906
			1213-453-2-9
									2009-034896

XXXXXXXXXX ("SubCanco")

Foreign Exchange Gains/Losses on Hedging Transactions

This is in reply to your memorandum of November 19, 2009, wherein you asked us our opinion as to whether SubCanco should be treating its foreign exchange gains/losses on US$ forward contracts hedging against the net balance sheet items of all self-sustaining US subsidiaries using income or capital account. SubCanco has been reporting the gains/losses on income account. In your view, capital treatment should be applied as the "item being hedged" is actually the long-term investment in shares of the US subsidiaries.

We note that XXXXXXXXXX ("Canco"), a corporation that once owned most of SubCanco then amalgamated with it and was subsequently purchased by XXXXXXXXXX , entered into the same type of hedging transactions with the same intention and purpose. Canco reported the gains and losses on capital account, however, the CRA auditor in that file is seeking income treatment. We are in agreement with your view that since Canco and SubCanco were in the same/similar business, the tax treatment of foreign exchange gains/losses on hedging transactions should be consistently applied for both corporations.

Specifically, you are concerned with SubCanco's XXXXXXXXXX Balance Sheet hedges undertaken to approximate the net translation exposure on the balance sheet for both US$ denominated working capital and long-term assets (net of long-term US$ debt). The purpose of XXXXXXXXXX is described under its XXXXXXXXXX and is stated as follows:

"XXXXXXXXXX "

SubCanco manages its exposure by entering into forward foreign exchange and option contracts to hedge the effect of exchange rate changes by creating an offsetting position. SubCanco's financial statements state that its risk management policy provides for the limited use of financial instruments for discretionary trading purposes. However, SubCanco does not acquire, hold or issue derivative financial instruments for trading purposes.

SubCanco states that translation of balance sheet items and net foreign investment in self-sustaining operations does not represent true economic risk to the company under normal circumstances. However, large changes in shareholder's equity can affect the company's financial ratios, and hence, credit quality. Therefore, this risk is hedged. Also, it is the company's policy to use offsetting assets and liabilities to reduce the overall exposure to translation. For example, US$ denominated debt is a natural hedge for US$ denominated assets. The remainder of the translation exposure from long term assets and liabilities will be hedged using financial instruments.

Based on your review, the balance sheet items under XXXXXXXXXX were: US$ long-term debt accounts, US$ net current assets (such as US$ valued inventory, US$ short-term investments, foreign currency petty cash and bank accounts, accounts receivables, accounts payables and inter-company trade accounts with foreign subsidiaries), US$ net investment in respect of self-sustaining foreign subsidiaries, and US$ dividends received from foreign subsidiaries. All US$ denominated assets and liabilities were marked-to-market monthly and the translation exposure was tracked monthly by SubCanco in a Statement of US$ Balance Sheet Exposure. Generally, if the financial risk management was effective, the fluctuations in value of the US$ forward contracts would offset the fluctuations in value of the above balance sheet items. However, XXXXXXXXXX was not perfectly effective due to the mismatch in duration of the US$ forward contracts (usually under XXXXXXXXXX days) and the hedged items (long-term debt and long-term investments in foreign subsidiaries).

Effective XXXXXXXXXX , SubCanco adopted the US$ as its functional and reporting currency for accounting purposes. As a result, the hedging of the US$ denominated net foreign investments balance sheet items is no longer required from XXXXXXXXXX onwards, and, in our view, if SubCanco continued with its hedging policy past that date, any gains/losses would be speculative and on account of income.

Our Comments:

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.

The Act does not contain a definition of a hedge but based on jurisprudence, it is also CRA's long-standing position that 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.

Further, in our view, we need to have a transaction. A transaction has been defined in dictionaries of financial products as the entry or liquidation of a trade; in other dictionaries, as an agreement between a buyer and a seller to exchange an asset for payment. In accounting, a transaction is any event or condition recorded in the book of accounts. Accordingly, in our view, day-to-day fluctuations in the book value of foreign subsidiaries in foreign currency relative to the Canadian dollar would not constitute an underlying capital transaction.

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).

Foreign exchange gains and losses of a dealer in commodities that relate to transactions entered into in the ordinary course of its business, including gains or losses resulting from futures transactions in foreign currency, are generally on income account.

In order for an instrument to be considered a hedge, there needs to be a link between the underlying transaction and the forward contract that was used as a hedge in reference to that transaction (see "The Taxation of Derivatives: The Basic Rule" by Jonathan Tennant, 2005, CTF's 57th Tax Conference). In this regard, the Federal Court in Echo Bay v. The Queen 92 DTC 6437 accepted the following:

1. The item to be hedged exposes the enterprise to price (or interest rate) risk.

2. The futures contract reduces that exposure and is designated as a hedge.

3. The significant characteristics and expected terms of the anticipated transactions are identified.

4. It is probable that the anticipated transaction will occur.

The above criteria were accepted by the Supreme Court of Canada in Ontario (Minister of Finance) v. Placer Dome Canada Ltd. 2006 SCC 20. CRA stated in document 9218915 that for the appropriate degree of linkage to exist, there is a strong argument that an intention to dispose of the capital asset is necessary. In Shell v. The Queen 99 DTC 5669, the Court clearly accepted the linkage principle in the context of forward contracts that hedged against currency fluctuations under a foreign currency denominated debt obligation.

In Salada Foods Ltd v the Queen (74 DTC 6171), the court recognized a linkage principle for hedging derivatives. The taxpayer entered into forward sales contracts in respect of the sale of British pound sterling, stating that its objective was to protect the value of its investment in its UK subsidiary (which largely represented undistributed profits). When the pound was devalued, the taxpayer recognized a large foreign exchange gain on the forward sales contracts, which it treated as a capital gain. The court found that the taxpayer acted in the same manner as a dealer or speculator in currencies, and because the realization of the loss on the investment was not anticipated, there was little or no relationship between the gain on the forward sale contract and the actual investment loss occurring as a result of the devaluation of the pound. As a result, the court held that the taxpayer had engaged in a speculative transaction with a view to earning a profit and the entire gain was on income account. It is not clear from the Salada case to what extent the court was influenced by the conduct of the taxpayer as a speculator or by the lack of linkage with the realization of the loss on the investment.

The Supreme Court of Canada in Placer Dome could be cited in support of a strict approach to the linkage principle:

"Although I am mindful that Echo Bay Mines concerned a different statute, one in which "hedging" is not a defined term, I conclude that the general principles articulated in that case have some relevance here. The central issue in Echo Bay Mines was whether gains and losses from hedging were sufficiently linked to the underlying transactions, namely the production and sale of silver, to constitute "resource profits" within the meaning of the Regulations under the Income Tax Act. "

It would appear from the above quote that the Supreme Court of Canada did reference the purported hedge to a transaction for purposes of establishing a hedge transaction. In that case and in Echo Bay, the relevant underlying transaction was to 'sales', including "intention of meeting its commitments through production" assessed at the time the forward sales contracts were concluded.

In our view, the linkage principle in a hedge context is that the hedge should be linked to the specific underlying or related transaction, not assets or liabilities. In the case of a capital transaction, the argument is the gains or losses derived from the hedge should be recognized when the underlying transaction was realized. We stated in document 9218915 that where a foreign currency liability was used to acquire a capital asset, the foreign exchange gains or losses in respect of the liability or the gains or losses of any related hedge cannot be deferred beyond the maturity of the liability or hedging instrument even though the asset may not have been disposed of. If the linkage principle needs a transaction, i.e., "realization" in the case of capital transactions, the hedge must be closely related to the expected realization date of the underlying transaction. For example, in Shell, the forward contracts matured when the borrowing was repaid. In summary, 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.

At the 2007 Canadian Tax Foundation Conference, in answer to Question 14 - Criteria for determining hedge effectiveness for tax purposes, 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.... 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, the Salada case raises a serious question about whether the hedging of net investments from an accounting perspective (that is, hedging translation exposure, as discussed above) can ever be sufficiently linked to the shares of a subsidiary that are capital property so as to obtain capital account treatment. Such translation hedging is geared toward the net investment of the parent in a subsidiary on a book basis (including undistributed earnings) and not toward a particular transaction exposure.

While there are only a few reported tax cases that deal with hedging transactions, there is an extensive body of case law dealing with the characterization of foreign exchange gains and losses. The general principle established by these cases is that it is necessary to look to the underlying transaction in which the foreign exchange gain or loss arises and characterize the gain or loss accordingly.

For example, where a foreign exchange gain arises on the repayment of the principal amount of a debt that was incurred to acquire a capital asset, the foreign exchange gain will normally be considered to be capital in nature. In a 1995 article entitled "Income Tax Consequences of Using Derivatives for Hedging Purposes in a Canadian Petroleum Tax Journal, the author, Edward A. Heakes, states: "...There are two more recent cases that deal with hedging arrangements. In the first, MacMillan Bloedel Limited v The Queen (99 DTC 5454), the taxpayer had made arrangements to borrow US dollars at a future date to be used for capital purposes. The taxpayer also entered into forward contracts, maturing on or about the date of the proposed borrowing, to, in effect, sell the US dollars for a fixed amount of Canadian dollars. The taxpayer incurred a loss on these contracts and sought a deduction. The court expressly refused to treat the forward sale as part of the borrowing but instead indicated that it was a separate and distinct transaction. The Court allowed the taxpayer to deduct its loss on the forward sale under paragraph 20(1)(e) of the Act. Paragraph 20(1)(e) provides a deduction for certain expenses incurred in the course of financing or refinancing that are "not otherwise deductible". Therefore, the conclusion that paragraph 20(1)(e) applied necessarily implied that the Court had characterized the forward contracts as being otherwise non-deductible, presumably because they were capital in nature given their connection to the borrowing. However, by allowing the deduction, the Court was also quite clearly treating the forward contract as being separate from (rather than being integrated with) the actual borrowing...".

One also wonders what the result would have been had there been a gain, as clearly paragraph 20(1)(e) of the Act would have no application. The CRA considers that the decision reached by the Federal Court in the MacMillan Bloedel case is limited to the particular facts of that situation. At the 1994 Round Table, we stated: "We are not prepared to adopt as a general position that foreign currency gains or losses that arise as the consequence of the sale of a currency pursuant to the exercise of a forward contract would be an expense incurred in the year in the course of borrowing money for purposes of paragraph 20(1)(e). In particular we have difficulty characterizing a gain as an expense incurred in the course of borrowing money."

Once a particular amount is characterized as being income or capital in nature, the timing of the recognition of that amount for tax purposes must also be considered. Capital receipts are generally recognized on a realization basis rather than on an accrual basis. Expenses that are on capital account are not deductible absent a specific permissive provision that will also generally address timing of the deduction. The Act has not addressed whether foreign exchange gains and losses reported on income account should be reported on an accrual or realized basis. As a result, it would appear that the method adopted should represent the better business method in accordance with the decision in Canderel. However, we note that in Canadian General Electric Co. Ltd. v. Minister of National Revenue, 61 DTC 1300 (S.C.C.) and D.W.S. Corporation v. Minister of National Revenue, 68 DTC 5045 (Ex. Ct.), it was held that it was proper to use the accrual method in recognizing foreign exchange losses or gains on debts of a non-capital nature.

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, in our view, must be present, and 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 repayment of debt. Accordingly, in our view, the XXXXXXXXXX Balance Sheet hedges of SubCanco should be reported 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