10 December 1996 CICA Roundtable Q. 16, 9638910 - HEDGED DEBT & PART I.3

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

We are advised that new CICA Handbook section 3860 requires recognition of the increase or decrease in the value of a hedge instrument on foreign denominated debt. Recognition means that a foreign exchange gain or loss on the debt, calculated using exchange rates in effect at the balance sheet date, is offset by a corresponding loss or gain on the hedging instrument (an off-balance sheet transaction). The balancing entry (to the increase or decrease in the debt) is the creation of a hedge asset or hedge liability which are reflected on the balance sheet. The Issue is the treatment of the hedge asset or liability for Part I.3 purposes.

Position TAKEN:

Subsection 181(1) requires the use of amounts reflected in a GAAP-prepared balance sheet. Hedge asset and hedge liability do not fit squarely within the specific capital provisions of subsection 181.2(3) although it is arguable that a hedge liability may fall within the meaning of a "reserve" and be included in capital under paragraph 181.2(3)(b). It appears that a technical amendment may be necessary to correct this anomaly in the same manner as proposed 181.2(3)(b.1) and (k) affect deferred unrealized foreign exchange gains and losses.

Reasons FOR POSITION TAKEN:

Legislation.

Revenue Canada Round Table
Tax Executive Institute Conference
December 10, 1996

Question 16

LARGE CORPORATION TAX - HEDGED DEBT

Section 3860 of the Canadian Institute of Chartered Accountants (CICA) Handbook summarizes the financial statement presentation and disclosure for financial instruments, including corporate debt denominated in a foreign currency (the "debt") that is hedged or otherwise combined with a foreign currency swap or forward contract. The net result of the guidance in the Handbook (subsection 3860.34, paragraph 3860.41(a), subsection 3860.09 and paragraphs 3860.05(a), (b) and (c)) is that, where there is no legal right of offset, the debt must, for fiscal years beginning on or after January 1, 1996 (the "application date"), be translated at the foreign exchange rate in effect as at the date of the balance sheet. In addition, the "net principal value" of the currency swap or forward contract must be reflected as an asset or liability (referred to below as a "hedge asset" or "hedge liability") at the presentation date. Prior to 1996, the net principal value of the foreign currency swap or forward contract was netted against (or combined with) the debt.

The following example illustrates the financial statement presentation under the new rules:

On January 1, 1996, Canco issues a US$100M denominated debt when the exchange rate is US$1 = CAN$1.30. The debt matures on January 1, 1999. On the same date, Canco enters a currency swap transaction ("the hedge") under which it agrees to exchange its US$100M liability for a CAN$130M liability to be re-exchanged on the maturity date.

1.On December 31, 1996, the exchange rate is US$1 = CAN$1.40. The financial statement presentation at that date is:

Asset				Liability

		Hedge Asset	$10M		Hedge Debt	$140M

2.On December 31, 1997, the exchange rate is US$1 = CAN$1.20. The financial statement presentation at that date is:
Asset				Liability
							Debt      	$120M
							Hedge liab.	  10M

3.On December 31, 1998, the exchange rate is US$1 = CAN$1.30. The financial statement presentation at that date is:
Asset				Liability
							Debt			$130M

Under the rules in effect until 1995, the financial statements would have reflected a net debt of $130M every year. What is Revenue Canada's position on the treatment of amounts presented as a hedge asset and a hedge liability in the above example for the purposes of computing taxable capital under section 181.2 of the Act?

Department's Position

It is our understanding that, prior to the application date of CICA Handbook section 3860, generally accepted accounting principles ("GAAP") required that the carrying value of the debt reflect unrealized foreign exchange gains and losses on such debt and that such gains and losses be deferred and amortized into income over the life of the debt. The debt and deferred exchange gains and losses were reflected on the balance sheet at the exchange rates in effect at the balance sheet date.

We note that the CICA has recently issued a re-exposure draft on the accounting implications of foreign currency translation (CICA Handbook section 1650). We have been advised, in informal discussions with the CICA, that proposals advanced in that draft could have repercussions on the accounting for hedging of foreign denominated debt. Such proposals have not been taken into consideration in this response.

For purposes of Part I.3 of the Act proposed paragraphs 181.2(3)(b.1) and (k), applicable to the 1995 and subsequent taxation years, specifically provide that unrealized foreign exchange gains be included in capital and that unrealized foreign exchange losses be deducted from capital. The net effect for Part I.3 is that the debt is included in capital at the exchange rate in effect on the date the debt was issued.

It has been the Department's position, prior to these proposed amendments, to consider that deferred unrealized foreign exchange gains were included in the capital of a corporation either as "other surpluses" pursuant to paragraphs 181.2(3)(a) of the Act or as "reserves" in accordance with paragraph 181.2(3)(b) of the Act but that there was no provision in the Act permitting an adjustment to take into account deferred unrealized deferred foreign exchange losses. The proposed amendments correct this anomaly.

Where the debt is fully hedged you advise that, prior to the application date of CICA section 3860, the carrying value of the debt, in accordance with GAAP, was not adjusted to reflect unrealized exchange gains and losses. The debt would be reflected on the balance sheet, for each of the years throughout which it is outstanding, at an amount that employs the exchange rate in effect on the date on which the debt was issued. In the example above the debt would be reflected on the balance sheet at a carrying value of $130M for each of the years to maturity. This value would be included in capital for Part I.3 purposes pursuant to subsection 181.2(3).

You advise that the net result of the guidance in CICA Handbook is that a value be attributed both to the hedge instrument and the debt. In your example the hedging transaction is composed of two components. In the first, the debt is increased by $10M to $140M to reflect the exchange rate in effect at December 31, 1996 and a foreign exchange loss is recognized. In the second, a value of $10M is attributed to the hedge instrument (recognized as an asset (the "Hedge asset")) and a corresponding gain of $10M is recognized. It appears that, for financial statement purposes, that the gain on the hedge instrument and the loss on the debt are offset. For Part I.3 purposes the debt would be included in capital under subsection 181.2(3) at its carrying value of $140M however there is no specific provision within Part I.3 that would provide for a reduction with respect to the Hedge asset, therefore a net $140M would be included in capital with respect to the debt. Similarly there is no provision to recognize the December 31, 1997 Hedge liability although it may be arguable that this amount may be included in capital within another provision of subsection 181.2(3) (i.e. a reserve pursuant to paragraph 181.2(3)(b)).

It appears that a technical amendment to Part I.3 similar to that of proposed paragraphs 181.2(3)(b.1) and (k) would be required to address this matter.

Author: G. Donell
File: 963891
Date: November 27, 1996