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 the hedge used to offset the effects of foreign exchange movements in the value of the shares of the foreign subsidiaries on account of income or capital?
Position: Income account
Reasons: No underlying transaction (as supported by case law
March 12, 2010
Toronto Centre TSO Headquarters
Large File Case Manager Income Tax Rulings
453-3-1 Directorate
Attention : Carme Lau C. Tremblay, CMA
(819)281-6906
2009-035206
XXXXXXXXXX ("Canco")
Foreign Exchange Gains/Losses on Hedging Transactions
This is in reply to your memorandum of November 30, 2009, wherein you asked us our opinion as to whether Canco should be treating its foreign exchange gains/losses that were labelled CTA Hedges in the XXXXXXXXXX taxation years on income or capital account. Canco entered into the CTA Hedges for the purpose of offsetting the effects of foreign exchange movements in the carrying value (mainly US dollar denominated) of the company's investments in self-sustaining operations conducted through foreign subsidiaries for consolidated financial reporting purposes. The shares of the foreign subsidiaries of Canco were long-term investments. For income tax purposes, Canco reported the gains and losses on the CTA Hedges on capital account which was accepted by CRA in past audits. In your view, however, income treatment should be applied.
Note that XXXXXXXXXX ("SubCanco"), a corporation that was once a subsidiary of Canco, then amalgamated with it and was subsequently purchased by XXXXXXXXXX , had entered into the same type of hedging transactions with the same intention and purpose. SubCanco reported the gains and losses on income account however the CRA auditor in that file is seeking capital treatment. It is the view of that auditor 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. We agree with that view.
Facts:
Canco used short-term forward foreign exchange contracts (referred to as CTA Hedges) to hedge its exposure to foreign exchange risk in its investments in foreign subsidiaries. During the period under review, Canco entered into multiple groupings of CTA Hedges with various financial institutions with a term to maturity ranging from XXXXXXXXXX months to XXXXXXXXXX months. Each group of contracts could have a single maturity date. As the CTA contracts matured, new contracts were entered into to achieve a fully hedged position in respect of foreign exchange rate exposure in its net investments in foreign subsidiaries (net of offsetting exposure). Net investments in the above foreign subsidiaries were computed as the foreign currency denominated carrying value (book value) of the net foreign assets of the foreign subsidiaries, i.e., the amount by which the foreign currency denominated assets exceeded the foreign currency denominated liabilities of the foreign subsidiaries.
Pre XXXXXXXXXX :
Canco's accounting policies on functional currency and translation of foreign currencies for the period prior to XXXXXXXXXX are described in Note 1 to its XXXXXXXXXX Consolidated Financial Statements as follows:
"XXXXXXXXXX ."
The following summarizes Canco's accounting policies on functional currency and translation of foreign currencies for the period prior to XXXXXXXXXX as described in its XXXXXXXXXX legal entity financial statements:
Canadian dollar was the unit of measure (functional currency) of Canadian operations.
Canadian dollar was the reporting currency of the statements.
Temporal method under Canadian GAAP applied:
Foreign denominated monetary assets and liabilities (non-Canadian) were translated at prevailing year-end exchange rates.
Revenues and expenses (other than depreciation) were translated at average rates of exchange during the year.
Exchange gains and losses arising on translation were included in earning statements.
Non-monetary assets and liabilities were translated at historical rates of exchange.
Canco uses forward foreign exchange contracts and foreign denominated obligations to protect the value of its investments in its foreign subsidiaries.
Effective XXXXXXXXXX , the United States dollar ("US dollar") was adopted as the unit of measure of Canco's Canadian operations which reflects significant operational exposure to the US dollar and predominantly the US dollar-based asset and investment base of the Corporation. Concurrent with this change in functional currency, Canco adopted the US dollar as its reporting currency.
Issues:
The issue is whether the gains and losses realized on the CTA contracts originated before XXXXXXXXXX and used to hedge Canco's exposure to foreign exchange rate changes in respect of the carrying value (book value) of its net investments in foreign subsidiaries should be characterized on income account or capital account.
For income tax purposes, Canco adopted capital treatment in reporting the gains and losses on the CTA Hedges.
TSO Views and Analysis:
Firstly, we would like to note that we found your analysis and views to be very well researched and prepared, and we are reiterating many of your comments below.
In your view, the short term forward foreign exchange contracts (CTA Hedges) designated to hedge Canco's net investments in self-sustaining foreign operations, conducted through foreign subsidiaries, were properties that, by their very nature, are held on income account. The rights and obligations created under the foreign currency contracts did not produce income. Rather, they produced gains or losses by virtue of the fluctuating value of the contracts upon maturity. Therefore, unless otherwise proven, these foreign currency contracts were properties held on income account.
Hedge accounting principles under Canadian GAAP:
Under AcG13 of the CICA Handbook, hedge accounting could be applied, provided that the hedging instrument is designated as a hedge of the item to which it relates and there was reasonable assurance that it was and would continue to be effective as a hedge. For a hedging relationship to be effective there should be a high degree of correlation between changes in the hedging instrument and changes in the hedged item.
- Effective April 2005, AcG13 was replaced by Section 3865 of the CICA Handbook. Section 3865-Hedges, specifies the conditions that must be satisfied for a hedging relationship to qualify for hedge accounting. Under Section 3865 of the CICA Handbook, hedge effectiveness is the extent to which changes in the fair value of a hedged item or changes in the cash flows of a hedged item, that is attributable to a particular risk being hedged and arising during the term of a hedged relationship, are offset by changes in the fair value or cash flows of the hedging item (a derivative financial instrument).
- A hedged item is all, or a portion of a recognized asset, a recognized liability, an anticipated transaction or a net investment in a self-sustaining foreign operation, or a group of similar recognized assets, recognized liabilities or anticipated transactions, having an identified risk exposure that an entity has taken steps to modify.
- A hedging item is all or a specified percentage of a derivative, or all or a specified percentage of a group of derivatives, offsetting a risk exposure identified in the hedged item.
- Hedge accounting for foreign currency transactions and balances, is specifically addressed in Section 1650-Foreign Currency Transactions of the CICA Handbook. Under Section 1650 of the CICA Handbook, if a foreign exchange contract, asset, liability or future revenue stream is to be regarded as a hedge of a specific foreign currency exposure, it should be identified as a hedge of the item(s) to which it relates; and there should be reasonable assurance that it is and will continue to be effective as a hedge.
Hedge effectiveness for tax purposes
Criteria for hedge
The Income Tax Act does not define the term "hedge". Whether a financial instrument constitutes a hedge is relevant to the computation of profit. The Supreme Court of Canada stated in Canderel Ltd v The Queen 98 DTC 6100, that 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 GAAP, are not rules of law but interpretative aids. One would have to rely on case law principles to determine if financial instruments are hedges for income tax purposes. In the following cases, the courts have confirmed that whether an activity constitutes hedging depends on sufficient inter-connection or integration with the underlying transaction:
Salada Foods Ltd. v Her Majesty the Queen, 74 DTC 6171(FCTD)
Minister of Finance (Ontario) v Placer Dome Canada Limited, 2006 DTC 6532 (SCC)
Echo Bay Mines Ltd. v Her Majesty the Queen, 92 DTC 6437 (FCTD)
Degree of linkage between a derivative financial instrument and an underlying transaction
Consistent with this general principle, the courts have held that for financial instruments to constitute a hedge there must be sufficient linkage with the underlying transaction. Where there was sufficient linkage between the financial instrument that is used as a hedge and the particular asset or liability underlying a transaction, the character of the financial instrument (hedging item) would follow the character of the hedged asset or liability (hedged item).
In Salada, the Federal Court concluded that the forward currency contracts were part of a speculative venture because Salada acted in the same manner as, a dealer or speculator in currencies would act. The Federal Court found little or no hedge relationship between the gain received by Salada on its forward currency sale contract and its actual investment loss occurring as a result of the devaluation of the pound. The court noted the following: there was no underlying capital transaction. Salada did not realize an investment loss because it had not sold the shares of the U.K. subsidiaries. A portion of the taxpayer's investment in the subsidiaries represented undistributed profits that Salada might never receive. These undistributed profits did not form part of Salada's investment in its U.K. subsidiaries.
In Shell Canada Limited v The Queen, 99 DTC 5669 (SCC), there was sufficient linkage between the forward contract and the underlying capital transaction, namely the repayment of the capital loan. The court held that the gain from the forward currency contract was on account of capital.
In the Placer Dome and Echo Bay cases, the courts held that the specific underlying transactions that were being hedged were "anticipated sales" that the company intended to make through future production. Accordingly, the courts held that the gain and loss on the forward sales contracts was an integral part of the taxpayers' production revenue.
The following discusses why, in your opinion, the short-term foreign currency contracts (CTA Hedges) did not constitute a hedge of a capital transaction for income tax purposes:
Insufficient linkage - No underlying capital transaction exposed to foreign currency rate fluctuations. There was no actual or anticipated sale of investments or capital assets.
a) There was no actual disposition or anticipated disposition of Canco's direct and indirect investments in the foreign subsidiaries. Thus, the gains and losses on the CTA Hedges did not offset any actual gains and losses in the investments in the shares of the foreign subsidiaries. The disposition of XXXXXXXXXX . to XXXXXXXXXX , a wholly-owned Canadian subsidiary of Canco, on XXXXXXXXXX was effected through a subsection 85(1) tax free rollover. More specifically, Canco did not and could not realize an investment gain or loss from the actual or anticipated disposition of the lower tiered foreign operating subsidiaries since their shares were held through foreign holding companies.
The maturity dates of the CTA Hedges did not correspond to the date of the underlying transaction, on which the risk was anticipated to materialize. In Salada, the court noted that the absence of an intention to dispose of the U.K. investments was a persuasive reason to conclude that the necessary linkage was missing and that the forward currency contract did not constitute a hedge. In Shell, the Supreme Court considered the perfect matching of the maturity date of the forward currency contracts to the date of repayment of the borrowings and found sufficient linkage between the forward currency contracts and the underlying capital transaction, namely the repayment of the capital loan. The CTA Hedges were short-term foreign currency contracts maturing in XXXXXXXXXX to XXXXXXXXXX months while Canco's direct and indirect investments in the foreign subsidiaries were long-term investments. There was no actual disposition or expressed intention to dispose of these direct or indirect investments. Thus, there was no linkage between the maturity dates of the foreign currency contracts and any actual or intended date of disposition of the direct or indirect investments. Accordingly, the foreign currency contracts did not constitute a hedge of an underlying capital transaction for income tax purposes.
b) The CTA Hedges were put in place independently of any expectation of realizing a gain or loss on, an actual underlying transaction. There was little correlation between the notional amount of the foreign currency contracts and the value of the long-term investments that the contracts intended to protect as alleged by Canco. This is evident from the fact that the amount of the CTA Hedges was solely based on the book value of the net foreign assets (assets minus liabilities denominated in foreign currency) of the foreign subsidiaries and not on the actual sales price or anticipated fair market value of Canco's investments in the shares of the foreign subsidiaries. Canco carried the investments in the foreign subsidiaries at historical cost. The only way that their actual value could have been determined at the time of the completion of the CTA Hedges would have been a sale of the shares of the foreign subsidiaries or by way of an independent valuation. That value would have been substantially different than the historical cost of the investments and the book value of the net assets of the foreign subsidiaries. As evident from the T2057 filed in respect of the subsection 85(1) rollover of XXXXXXXXXX . to XXXXXXXXXX on XXXXXXXXXX , the fair market value of XXXXXXXXXX . was $XXXXXXXXXX which significantly exceeded Canco's adjusted cost base of $XXXXXXXXXX
c) The linkage principle established in the jurisprudence cited above refers to the linkage of the hedge to an underlying transaction, not assets and liabilities. The CTA Hedges were used to hedge the foreign currency assets and liabilities (net foreign assets) of Canco's foreign subsidiaries. To the extent that the hedges were related to the consolidation of the operations of the self-sustaining foreign operations, many of the assets and liabilities in question were owned and owed by the foreign subsidiaries, not by Canco. Canco could not realize a capital gain or capital loss from the actual or anticipated disposition of the assets of the foreign subsidiaries.
Further, you disagree with Canco's proposition that the day-to-day fluctuation in the book value of the foreign subsidiaries, in foreign currency relative to the Canadian dollar, was an underlying capital transaction that met the hedge criteria. The Income Tax Act does not define the term "transaction". Black's Law Dictionary defines the term "transaction" to mean: "1. The act or an instance of conducting business or other dealings; esp. the formation, performance, or discharge of a contract. 2. Something performed or carried out; a business agreement or exchange. 3. Any activity involving two or more persons."
In your view, and we share that view, the day-to-day movement in the book value of the foreign subsidiaries arising from foreign exchange rate fluctuations is an unrealized foreign exchange translation adjustment rather than an activity, involving Canco and another person, performed in the course of conducting Canco's business. The foreign exchange translation adjustment is not a transaction that would trigger the realization of a gain or loss; this would only occur upon the actual or planned disposition of the investments in the shares of the foreign subsidiaries. Applying the Federal Court's analysis in Salada, you found little or no hedge relationship or linkage between the gains and losses realized by Canco on the CTA Hedges and an underlying capital transaction whether actual or anticipated, that was exposed to foreign exchange risk. As such, in your view, the foreign currency contracts did not constitute a hedge of an underlying capital transaction for income tax purposes.
Canco's objective was not to protect or preserve the value of any particular investment but to hedge its exposure to foreign exchange rate changes in respect of the book value of its net investments in foreign subsidiaries, i.e., to achieve a fully hedged consolidated balance sheet. This is evident by the fact that the notional amount of the CTA Hedges was based on the aggregate book value of the net foreign assets of the foreign subsidiaries (net of offsetting exposures), which were subject to the foreign currency translation rules on consolidation. As you discussed above, the net book value of the foreign subsidiaries could be significantly different than the fair market value of the shares of the foreign subsidiaries. Accordingly, we agree that it is difficult to see how the CTA Hedges could protect or preserve the value of the shares of the foreign subsidiaries.
Further, in your view, the accounting treatment of the CTA Hedges as a net investment hedge, to reflect the economic position of Canco's consolidated corporate group, did not necessarily mean that the CTA Hedges were hedges for income tax purposes. Hedge accounting for consolidated financial reporting is not determinative of the tax treatment of the CTA Hedges for separate legal entity tax reporting. The courts have repeatedly expressed the view that accounting practices, by themselves do not establish rules of law. In Shell Canada Limited v The Queen et al, 99 DTC 5669 (SCC), the Supreme Court stated:
"....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. The Court has frequently held that accounting practices, by themselves, do not establish rules of income tax law. At any rate, non-tax financial accounting is designed to reflect the economic position of the entire corporation. It therefore, should not be surprising that the same transaction may properly be assessed differently for different purposes..."
We agree and further submit that accounting principles may not always apply, as in the case of Saskferco Products ULC v The Queen (2008 DTC 6698), in which hedge accounting based on generally accepted accounting principles was rejected by the Federal Court of Appeal. This case supports the view that legal principles take precedence over accounting principles.
You disagree with Canco's view that linkage is established by the stated intent applicable only at the time when the derivative contracts are entered into, since the original stated intent may subsequently be changed before the contract matures. Accordingly, it is your 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.
When Canco changed its functional currency and reporting currency from Canadian dollar to the US dollar on XXXXXXXXXX , the linkage was lost and the pre-existing CTA Hedges lost their effectiveness as a hedge (at least for accounting purposes) of the foreign exchange rate exposure in respect of the book value of Canco's net investments in the foreign subsidiaries.
Hedging to Minimize Volatility in Consolidated Financial Statements
As discussed above, Canco's objective was not to protect or preserve the value of any particular long-term investment but to hedge its exposure to foreign exchange rate changes in respect of the book value of its net investments in foreign subsidiaries, i.e., to achieve a fully hedged consolidated balance sheet. The notional amount of the CTA Hedges was based on the aggregate book value of the net foreign assets of the foreign subsidiaries (net of offsetting exposures), which were subject to the foreign currency translation rules on consolidation. As a public company, an integral part of Canco's business was the preparation of consolidated financial statements, in accordance with GAAP, to meet the requirements of its shareholders, investors, bankers, stock exchanges and other interested members of the investing public. The CTA Hedges could be viewed as an integral part of Canco's efficient management of this ordinary business earning process and, therefore, were on income account.
Manner in which the Forward Foreign Exchange Contracts were Transacted
As evident in Canco's Corporate Treasury Policies, the corporation has a well-defined set of foreign exchange rate risk management strategy and policies. During XXXXXXXXXX , Canco had full-time employees in its treasury department who consistently managed the company's exposure to foreign exchange rate risk from month-to-month. These employees carefully designated, monitored and controlled the forward foreign exchange contracts for the purpose of hedging identified exposures in investments in foreign subsidiaries, foreign currency denominated assets and liabilities, and foreign currency revenues derived from the sale of metals. These employees had the sophisticated knowledge of dealing in forward foreign exchange contracts and acted in a manner similar to that of a dealer or speculator in currencies would act. Accordingly, it is your view, that it can be argued that Canco was in the business of trading foreign currencies and the CTA Hedges were on account of income. As was stated in the conclusion in the Salada case, "Having found that the income was from an adventure in the nature of trade ..., it is immaterial what the motive was that brought the profit into existence and how it was applied thereafter."
Taxpayer's Position
Canco has disagreed with your proposal and takes the position that the gains and losses from the CTA Hedges were on account of capital. Relying on the court's analysis in the Echo Bay case, Canco is of the view that the key factors necessary to obtain hedge treatment for tax purposes are 1) to establish an intent to use the derivative contracts as a hedge at the time the contract is entered into, and 2) to make some reasonable effort to correlate the notional amount of the contract with the amount or value of the item being hedged. Also relying on the Echo Bay case, Canco takes the view that it is not necessary to have a perfect match to have a hedge for tax purposes.
Intent and Purpose
Canco emphasized that it was not in the business of speculating on foreign currency but its intent was to protect the value of its long-term investment in the shares of its foreign subsidiaries. Canco takes the position that the CTA Hedges satisfied both the intent and purpose tests, that is, to hedge its exposure to foreign exchange rate risk in respect its net investments in foreign subsidiaries. Since the long-term investments were on account of capital, it is Canco's view that the gains and losses on the CTA Hedges were also on capital account.
Canco submitted that the intent and purpose of the CTA Hedges is clearly stated in its Treasury Policy and corroborated by the fact that the company recorded the deferred gains and losses on the CTA Hedges entered into by XXXXXXXXXX in the Investments and Advances section of the company's legal entity balance sheet.
Canco dismissed the case law cited by the CRA as irrelevant: Canco claimed that the derivative transactions cited by the CRA in the Shell, Placer Dome and Echo Bay cases only dealt with transactional hedges and did not consider how derivative contracts could be linked to long-term capital investments. Canco submitted the facts in the Salada case can be distinguished from Canco's situation in the following respects:
- The transaction in Salada appears to have been isolated, non-recurring and managed in the same manner as a dealer or speculator in securities. In contrast, Canco followed a sophisticated risk management policy using the forward contracts throughout the period to hedge its exposure to foreign exchange fluctuations related to specific long term capital assets; and,
- Salada reported the gain on the derivative transaction on capital account but treated the loss on a similar derivative transaction in a prior year on income account. In contrast, Canco has been consistent in giving capital treatment to the CTA Hedges for the entire period under review.
Canco submitted that an underlying transaction is not essential to achieve a hedge. In support of its argument, Canco claimed that in Echo Bay even though the forward sales contracts exceeded actual sales in the relevant period, the court held that all the forward sales contracts were hedges.
Canco claimed that notwithstanding it used the cost method of accounting for its direct investments in the foreign subsidiaries in the legal entity financial statements (non-consolidated) it would still have to bear the related foreign exchange exposure. According to Canco, this is the case as long as those foreign subsidiaries were directly owned by Canco.
Canco distinguished the facts in the XXXXXXXXXX of the "XXXXXXXXXX Hedge" contracts in the XXXXXXXXXX taxation years from this situation. According to Canco, the "XXXXXXXXXX Hedge" contracts taken out by Canco in XXXXXXXXXX sought to hedge Canco's indirect exposure to foreign exchange that was directly borne by another Canadian taxpayer, namely its subsidiary. Canco argued that the linkage that existed in the CTA Hedges was not present in the "XXXXXXXXXX Hedge" contracts.
Canco indicated that it may be prepared to acknowledge that all forward contracts entered after XXXXXXXXXX may be on income account as the hedge between the U.S. dollar forward contracts and the U.S. dollar denominated capital assets may no longer be evident after XXXXXXXXXX .
Based on jurisprudence, it is CRA's 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. The CRA's long-standing position as stated in the 36th Tax Conference, 1984, at Question 63 is 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 an underlying transaction. It would also seem that we need an underlying 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 or loss.
- 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 speculation 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).
Generally, we have taken the position that 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. In this regard, the Federal Court in Echo Bay accepted the following criteria:
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 Placer Dome. CRA stated in document 9218915 that for the appropriate degree of linkage to exist, an intention to dispose of the capital asset might be necessary. In Shell, 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. The court stated:
"[70] The gain on the Debenture Agreements was characterized as being earned on capital account and so therefore should the gain on the Forward Exchange Contract. Both gains were earned on capital account and three-quarters of them are taxable when realized."
The first court case on the linkage principle was in Salada, 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".
The Supreme Court of Canada in the Placer Dome could be cited in support of a strict approach to the linkage principle as follows:
"...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 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. The CRA 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 purported 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.
As the response to Question 14 of the 2007 Canadian Tax Conference dealing with a question regarding the criteria for determining a hedge 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. 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."
The case of Salada 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 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. Translation hedging could be distinguished from a hedge that might be entered into if a subsidiary was being sold, in which case an anticipatory hedge of the foreign exchange risk attributable to the expected proceeds between the time of the firm commitment to sell and the sale date may be appropriate. In such a case, it may be possible to establish the required degree of linkage to obtain capital treatment on the hedge.
From Canco's XXXXXXXXXX Legal Entity, Financial Statements Note 9 on Financial Instruments:
"XXXXXXXXXX ." As a result of the functional currency change after XXXXXXXXXX , the program was changed to hedge Canadian dollars. In our view, income treatment is more appropriate.
Summary:
In your submission, you noted that "in order to determine if the gains and losses on the CTA contracts should be given capital treatment, it is necessary to determine if the CTA contracts constituted a hedge for income tax purposes. This in turn requires a determination of whether there was sufficient linkage between the CTA contracts and the underlying hedged items which must be capital [in] nature. In considering whether a strong linkage existed, consideration should be given to the following factors:", and we have provided our general comments below to your specific queries which followed:
1) Does there have to be an underlying capital transaction in order for there to be sufficient linkage?
We are of the view that there must be a transaction and that transaction must be sufficiently linked to be considered a capital transaction, i.e., repayment of a loan for there to be considered sufficient linkage.
a) Does the taxpayer have to hedge an actual or anticipated disposition of a capital investment?
In our view, there must be an actual or anticipated disposition of a capital investment in order to be given capital treatment.
b) How closely do the timing and maturity of the derivative contract have to match the underlying capital transaction?
The timing and maturity dates of the derivative should reflect the underlying capital transaction but it does not have to be a perfect match. A corporation could choose to only hedge part of a transaction, for example.
c) How closely does the value of the derivative contract have to match the value of the capital asset, i.e., fair market value v. book value?
We do not have a firm position on this yet.
d) Does the day-to-day fluctuation in the book value of foreign subsidiaries in foreign currency relative to the Canadian dollar constitute an underlying capital transaction?
From our review of various dictionaries, a transaction is defined as an agreement between a buyer and a seller to exchange an asset for payment. In accounting, it has been described as 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.
e) Does the legal entity which entered into the derivative contract have to directly own the underlying hedged item, i.e., have a direct exposure to the foreign exchange risk?
In order to match the underlying transaction, in our view, the legal entity should have a direct exposure to the foreign exchange risk.
2) Is it possible to have sufficient linkage when the foreign exchange exposure exists only on the consolidated financial statements and the purpose and intent is to use the derivative contract to offset such foreign exchange exposure and eliminate the volatility on the consolidated financial statements?
We do not think so.
3) Is the linkage established by the stated intent applicable only at the time the derivative contract is entered into?
a) Does the original stated intent govern the capital nature of the hedge for the entire term of the
derivative contract even though the hedging relationship ceases to exist before the contract is settled?
b) Should capital treatment be given to new derivative contracts entered into solely for the purpose of early closing out of open derivative contracts that were originally intended to hedge a capital item, after the hedging relationship ceases to exist?
In our view, if a loan that is hedged with a derivative product is repaid but the derivative product remains, the derivative product becomes speculative and is on account of income.
4) Where a corporation uses a hedging program to minimize its financial statements volatility due to currency translation, and where the particular hedging contracts are not designed to manage the foreign exchange rate risk of a particular asset or liability or a particular transaction, would the hedging activities be considered as part of its ordinary business activities?
In our view, if there is no link to an underlying transaction, then the hedging activities are considered part of its ordinary business activities.
5) Where a corporation has a sophisticated foreign exchange risk management policy and has employees that are familiar in dealing in forward foreign exchange contracts that are consistently used from month-to-month and from year-to-year to hedge identified foreign exchange rate exposures in respect of foreign currency denominated balance sheet items and foreign currency revenues, would the hedging activities be considered as part of its ordinary business activities?
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.
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 U.S. 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 U.S. 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 with similar timing and maturity. In our view, the 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 a debt. Accordingly, we support your view that the gains and losses on the CTA contracts 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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