Foreign Exchange

The taxpayer was found to have realized foreign accrual property income from the investing activities of its Barbados subsidiary (GBL). These activities included using funds received from the taxpayer to invest in U.S.-dollar short-term debt obligations and to enter into cross-currency swaps and interest rate swaps with U.S. banks to convert the resulting interest income into fixed-rate Canadian dollar interest revenue. In finding that its resulting foreign exchange gains and losses were realized under s. 95(2)(f) on income account, C Miller J stated (para. 276):

The acquisition of the short term securities, taking their yield and funding a derivatives program to produce a greater yield is … using these short term securities in a manner akin to inventory in an income producing scheme.

As a result of its financing of the acquisition in 2001 of a U.S. bakery business ("Bestfoods") by indirect subsidiaries through a large issuance by it of (mostly) Canadian-dollar debt, the consolidated debt-to-equity ratio of the taxpayer ("GWL"), which was a Canadian public company, increased well above its internal guidelines of 1:1, and resulted in a credit watch warning from S&P. In order to hedge against the effect that a relative depreciation in the U.S. dollar could have on its creditworthiness and share price, GWL entered into long-term (10 to 15 year) cross currency swaps "fairly close" (para. 71) to the acquisition time (likely within one month given a reference to Atlantic Sugar, [1949] S.C.R. 706, at 711-712), whose amount "closely approximated" (para. 16) the total net value of its indirect U.S. investments at that time (i.e., including pre-2001 acquisitions), and were intended as hedges of those net investments (paras. 72, 3). Divestitures by some indirect U.S. subsidiaries in 2002 resulted in it being over-hedged, so that it terminated a portion of its swaps at that point. In 2003, GWL's debt/equity ratio had declined to approaching 1:1 (para. 90), and the U.S. dollar had depreciated to the point where further substantial declines were less likely. Accordingly, GWL terminated all its swaps, resulting in a gain of Cdn.$317 million.

This was a capital gain. Lamarre ACJ noted (at para. 81, see also 98) the principle that "in order to characterize the proceeds from a derivative transaction, one needs to identify the underlying item that created the risk … to which the derivative relates (which item does not necessarily need to be a transaction)" and that if, as was the case here, "it is found that the derivative was used to hedge a capital investment, any gain derived from the derivative will be on capital account." Furthermore, it was relevant that GWL was also "hedging" as this term was "understood under well-established business principles, including GAAP" (para. 92). The Crown position "which denies capital treatment … if there is no sale or proposed sale of the underlying item being hedged … has no legal basis" (para. 97), and "the settlement of derivative contracts in advance of their maturity date does not preclude those transactions from constituting a hedge (Echo Bay…)" (para. 88).

Unlike for Salada ("which was regularly speculating in currency" (para. 79)), the taxapyer had not entered into many other FX derivatives (paras. 24, 89) and the derivative here was a hedge and not speculative (paras. 70, 96, 97, 100). In particular, swaps, unlike futures and options, were unsuited to speculation due to their high initial transaction costs and lower liquidity (para. 106).

In rejecting a submission of the taxpayer that foreign exchange losses on U.S. borrowings of the taxpayer were on income account because those U.S. dollar borrowings were hedged by a stream of U.S.-dollar revenues of the taxpayer, Woods J. stated (at para. 74):

The principle that a foreign exchange gain or loss on indebtedness takes its character from the character of the indebtedness has been followed in a long line of jurisprudence in this country and in the United Kingdom.

In the Court of Appeal, Evans JA stated (at para. 34):

The attribution of foreign exchange gains or losses on income account for tax purposes when income transactions are hedged by derivative contracts is an inadequate basis for extending them to commercially independent transactions and thereby departing from the well-accepted principle that foreign exchange losses on the repayment of a loan take their character from that of the loan itself.

The taxpayer was found to have incurred foreign exchange losses on U.S.-dollar borrowing that were used by it to purchase railcars and aircraft for leasing purposes on capital account. Although the taxpayer carried on a financing business and although in Avco Financial Services Ltd. v. Federal Commissioner of Taxation (1982), 13 ATR 63 (Aust. (AC) hire purchase agreements were treated as being in the same category as money lending activities, in that case no borrowings were for the purpose of specific lending transactions whereas here, at the time the taxpayer borrowed the money, the borrowed money was earmarked to buy specific railcars or aircraft.

Before finding that the taxpayers were not entitled to recognize deductions under s. 20(1)(f)(ii) at the time they repaid U.S.-dollar denominated debentures following an appreciation in the U.S. dollar, LeBel discussed Tip Top, Eli Lilly, Alberta Gas and Imperial Tobacco, and stated (at para. 45):

[T]he above cases stand for the proposition that foreign exchange gains and losses incurred in relation to foreign trade cannot be separated from the underlying transaction such that the foreign exchange gain or loss would be on capital account while the underlying transaction would be on income account. … The above cases are not of assistance in the cases at bar, where it is common ground that but for an express statutory provision, the foreign exchange loss would be on capital account because the borrowing was on capital account.

In order to refinance U.S.-dollar loans that it had received to finance the development of its mine, the Australian taxpayer negotiated a new Euronote facility pursuant to which it issued 90-day non-interest bearing promissory notes which were sold at a discount to members of a banking consortium who were successful in U.S. dollar tendering for the purchase of the notes to be issued, with the same procedure being repeated upon maturity of the notes. In finding that foreign exchange gains or losses were realized by the taxpayer on capital account, Hill J. stated (p. 4954):

"... [T]he funds borrowed were not used in or as an integral part of the profit-making activities of the taxpayer but in the financing of those activities. So seen, the exchange gains or losses were on capital account. The fact that the manner of borrowing, namely, through discounting of Euronotes, occurred with regularity so that, on the Commissioner's submissions, the exchange gains or losses occurred with the same frequency is not, of itself, sufficient, in my view, to characterise those gains or losses as being on revenue account. Ultimately, it is the purpose of the financing which will determine the character of the exchange gains or losses."

The taxpayer, who in addition to being a consulting engineer, also engaged in speculation in commodities and investment in revenue-producing apartments, borrowed Swiss francs pursuant to a demand loan that was secured through a fresh mortgage on a previously acquired Canadian rental property, and converted the Swiss francs into Canadian dollars for use in his commodity trading activities, which he treated as a business. In finding that the foreign exchange loss sustained by the taxpayer when he repaid the borrowing was a capital loss, Brule J indicated that the character of the loss as arising in connection with the taxpayer's trading business was not affected by the capital nature of the rental property.

In each of 1971 and 1972 the taxpayer borrowed 50m Swiss francs repayable in 5 years time (or earlier at the option of the taxpayer subject to a premium for early repayment), converted the Swiss francs to sterling and incurred a foreign exchange loss on repayment of the loans. The Special Commissioners found that the loss was deductible in light of the purpose of the borrowing, which was to deal with temporary cash flow difficulties in the taxpayer's retail trade.

The loss was incurred on capital account. "The temporary and fluctuating borrowings incurred in transacting business are revenue transactions." Here, however, there was a borrowing of a definite sum for a fixed term of 5 years; a borrowing which did not form part of the day to day activities of the taxpayer in earning income.

The taxpayer ("OCFL") was incorporated as a subsidiary of a shipping company ("OCL") and interposed between OCL and German lenders in order to transmute foreign exchange losses on capital account into losses on income account. Since, having regard to the overall fiscal purpose of the group of the companies, the loan transaction entered into by OCFL had no commercial justification, the transaction was not a trading transaction, and the foreign exchange loss was realized by OCFL on capital account.

The taxpayer was a US-controlled Canadian finance company which borrowed funds in US dollars on the Eurodollar market from arm’s length lenders and on-lent the funds in US dollars to Canadian affiliates (so that, as an economic matter, it was fully hedged from FX risk). Although it realized an FX gain when one Canadian affiliate repaid a loan (with the repayment proceeds then re-lent to another Canadian affiliate), it did not treat itself as realizing any net FX gain for ITA purposes because it was recognizing FX gains or losses both on its US-dollar obligations and US-dollar receivables as they accrued.

In concluding that this accrual approach was authorized by the CGE case, Brulé J found that the taxpayer was engaged in a money-lending business whose circulating capital included the US-dollar payables, given the large volume of loan transactions in which it engaged. It accordingly was unnecessary to consider the detailed submissions made regarding the appropriate treatment of the FX gains and losses had its assets and obligations been on capital account.

A company which borrows foreign-currency funds and lends the same foreign currency funds to its customers will not realize a profit or loss [or, for that matter, a capital gain or capital loss] as a result of fluctuations in the relative value of the foreign currency if there has been no conversion of the foreign-currency funds into home-currency funds by the company. Unless such conversion occurs, the company is not at risk.

Moneys borrowed in a foreign currency by a consumer finance company in the ordinary course of its business, i.e., for the purpose of lending the borrowed money by way of personal loans, hire-purchase-transactions and consumer mortgages, gave rise to foreign exchange gains and losses that were on revenue account.

The Australian taxpayer imported nickel products from England for purchase prices payable in sterling and generally paid for the goods after they were resold. The taxpayer realized an exchange gain on income account when the pound sterling was devalued in 1967, (even after taking into account a reduction in terms of Australian dollars of its receipts from its customers).

"Where income is assessed on an accruals basis, a purchase of stock in trade is taken into the books at the time when the purchase is made ... . However if in a subsequent income year, when the time for payment arrives, the taxpayer is compelled, because of a change in the rate of exchange, to expend a larger amount in Australian dollars in discharging his liability for the price than had already been allowed as a deduction, the additional amount which he is required to expend - the exchange loss - is an allowable deduction in that subsequent year." The same principles applied to foreign exchange gains.

An Australian finance company realized a foreign exchange gain on capital account on the early repayment of U.S.-dollar borrowings from the Bank of America, notwithstanding that 65% of the borrowed funds were required under the terms of the loan to be kept in cash and money market instruments (which yielded a lower interest rate than the interest rate payable under the loan). "[T]he principal purpose of the borrowing was not to arm the taxpayer with more funds to lend or apply in the ordinary course of its finance business - thirty-five percent only of the loan could be so applied - but rather to provide a base of additional assets which would generally strengthen the taxpayer's financial standing ... . In these circumstances the principal purpose of the borrowing was to strengthen the business entity, structure, or organization set up or established for the earning of profit".

The taxpayer, which was in the business of importing petroleum products and selling them in Australia, incurred a large U.S. dollar debt with an American affiliate (the "Old Supplier") for the purchase of such products over a period of years. When a new American affiliate was formed in 1936 (the "New Supplier") to be the sole supplier of the taxpayer, the New Supplier loaned dollars to the taxpayer which used the borrowed sums to pay off its indebtedness to the Old Supplier.

Dixon, C.J. found that "nothing has happened but the novation of a dollar indebtedness, or something equivalent or akin to a novation" and that, therefore, there was "nothing amounting to a realization or definite accrual or establishing of the loss."

Before agreeing to distribute its petroleum products through an agent in China, the taxpayer would require the deposit with it by the agent of a sum in Chinese dollars, which was repayable when the agency came to an end, and until then was available for making good any default of the agent under the agreement. When conditions in China began deteriorating in 1937, the taxpayer converted the deposits into sterling, and realized a foreign exchange gain when most of its 600 agency arrangements ultimately were terminated.

Jenkins L.J. characterized the deposits as being in essence loans by the agents to the taxpayer which formed a part of the taxpayer's fixed capital and noted (at p. 156) that:

"The mere fact that it was the Company's regular practice to appoint agents does not in my view invest the deposits taken from the agents with the character of trading receipts any more than the fact that it is the practice of a multiple trader to buy shops up and down the country whenever he sees fit to open a new branch invests his expenditure on such shops with the character of trade outgoings."

The gain was realized on capital account.