Section 261

CRA considered that a Canadian corporation (“Issuer”) which has the U.S. dollar as its elected functional currency nonetheless is required to keep track of the paid-up capital of its shares, so that if it issued U.S.$100,000 of shares when the Canadian dollar was at par and redeemed those shares when their Canadian-dollar equivalent was $125,000, there would be a resulting deemed dividend to its shareholder (assuming the shareholder was not a functional currency tax reporter) However, there would be no Part VI.1 tax, as that would relate to the tax results of the corporation rather than its shareholder.

If the shareholder also was a Canadian corporation that also had the U.S. dollar as its effective functional currency (“EFC”) for the relevant period, the deemed dividend would be determined in U.S. dollars so that no deemed dividend would arise, e.g., for Part IV tax or dividend refund purposes. However, Issuer would still be required to produce its information returns in respect of the shareholder based on calculations using Canadian dollar amounts.

If the shareholder was a Canadian corporation with the euro EFC and Issuer had a U.S. dollar EFC, Issuer would maintain its PUC in US$ for the purposes of determining its Canadian tax results (“CTRs”), and in C$ for all other purposes of the Act. Shareholder would have to maintain that PUC balance in € for the purposes of determining its CTRs.

If, rather than redeeming, Issuer returned capital to Shareholder in the amount of US$100,000 thereby invoking subsection 84(4), the same analysis would apply in determining whether amount paid by it on the reduction of capital exceeded the PUC reduction in respect of the class of shares owned by Shareholder.

The maintenance of legal stated capital in a foreign currency does not change any of these answers as PUC is fundamentally a C$ tax concept, absent functional currency considerations.

A Canadian public company (Canco), which carries on business primarily in Canada, incorporates Subco to hold its shares of a U.S. controlled foreign affiliate and to assume control of the financing of the affiliate, which will occur in U.S. dollars. Subco maintains its records and books of account in US dollars. Is Subco precluded from reporting its Canadian tax results in US dollars because its financial results are consolidated with those of Canco, whose reporting currency is the Canadian dollar?

CRA indicated that satisfaction of these two conditions was required:

1) The US dollar is the business currency of Subco (that is, the primary currency in which its transactions occur). In this respect, we expect that Subco would raise its capital in US dollars and derive the majority of its revenues in US dollars.

2) Subco's balance sheet and income statement are prepared in US dollars for the purposes of presenting the financial condition of the corporation to its shareholder and, where applicable, its creditors.

Respecting the second condition, CRA stated that "financial reporting must be the primary reason that the books and records are maintained in a qualifying currency," so that maintaining them in a qualifying currency without this purpose is not sufficient.

Is a corporation required to rely on GAAP in interpreting the words "for financial reporting purposes" in the “functional currency”? CRA responded:

[T]he accounting standards (GAAP or International Financial Reporting Standards) adopted by a corporation cannot be used as authorities in determining "the primary currency in which the taxpayer maintains its records and books of account for financial reporting purposes” for the purposes of section 261.

CRA went on to indicate three requirements for determining a functional currency:

1) The currency must be a currency of a foreign country that is used throughout the year. Even if a taxpayer keeps its books and records for financial reporting purposes in accordance with accounting standards in a foreign currency, that foreign currency may not qualify as a functional currency for the purposes of section 261 if it is only used for part of the year.

2) The currency must be a qualifying currency, as that term is defined in subsection 261(1). Rules made for accounting purposes may provide for a currency other than a qualifying currency.

3) The currency must be the primary currency in which the taxpayer maintains its records and books of account for financial reporting purposes. That requirement implies that the primary currency be identified, whereas the applicable accounting standards may permit the maintenance of a taxpayer's books and records in various currencies for the purpose of financial reporting.

When and for what length of period is it acceptable to use an average exchange rate? CRA responded:

[F]or purposes of determining a taxpayer's income, the CRA will generally accept the use of an average exchange rate over a given period of time (e.g., annual, quarterly or monthly) to convert amounts arising from foreign currency transactions, if all of the following conditions are met:

• the amounts (as determined in foreign currency) are relatively stable and evenly distributed over the given period
• the amounts arising in the particular period are sufficiently frequent that they do not distort income
• the relevant exchange rate does not fluctuate significantly over the period; and
• the chosen approach is used consistently from year to year.

… [I]f there are very few transactions (e.g. annual, semi-annual or quarterly payments), the use of the applicable daily exchange rates will be required.

As a general rule, the CRA will not accept the conversion of a gain or loss on the disposition of a capital property using an average exchange rate. … Consequently, the daily exchange rate for the particular dates should be used to determine, in Canadian dollars, the adjusted cost base ("ACB") of such property and any proceeds of disposition from its disposition.

What will CRA accept as “another rate of exchange that is acceptable to the Minister” under the relevant spot rate definition? CRA responded:

• The Minister will generally accept a rate quoted by another source [rather than the daily rate quoted by the Bank of Canada] provided it is:
  
  • widely available;
  • verifiable;
  • published by an independent provider on an ongoing basis [e.g., Bloomberg L.P., Thomson Reuters Corporation and OANDA Corporation, whose rates are "generally acceptable"]; …
  • used in accordance with well-accepted business principles;
  • used for the preparation of the taxpayer’s financial statements; and
  • used consistently from year to year by the taxpayer. ...
• The Bank of Canada rate will still be required in respect of a taxpayer transitioning into or out of income tax reporting in its elected functional currency in accordance with subsections 261(7) or 261(12)... .

When asked to comment on the exchange rate to use for interest, dividends and capital gains, CRA stated, after referring to the reference in the definition to "another rate of exchange that is acceptable" (TaxInterpretations translation):

[A]n average rate of exchange could qualify in this regard. However, we do not accept using an average exchange rate respecting the calculation of capital gains and losses. Thus…all amounts expressed in a foreign currency before being taken into account in the calculation of such gains or losses (namely, the adjusted cost base, the proceeds of disposition and the expenses of the disposition) must be converted into Canadian dollars in accordance with the "relevant spot rate" for the day or days when they arose. This result accords with the principles elaborated…in Gaynor.

CRA considered that s. 261(21) did not apply to deny an FX loss sustained by a Canadian subsidiary (“Holdco”) of a non-resident parent (“Parent”) on hedging agreements it entered into with Parent to hedge its FX exposure on a U.S. dollar loan it had made to a Canadian subsidiary of Holdco which, unlike Holdco, had the U.S. dollar as its reporting currency, given that any of Parent's Canadian tax results would have been determined in Canadian dollars.

Where a taxpayer other than a financial institution holds a stripped coupon denominated in a foreign currency on which interest is deemed to accrue, what date should be used to apply the exchange rate?

After noting that a stripped coupon is described in Reg. 7000(1)(b), CRA indicated that interest under s. 12(3) was deemed to accrue on a daily basis during the taxation year in which the accrued interest arises, and similarly for s. 12(4) except that interest accruing beyond the anniversary date occurring in the year is not recognized in that year. CRA indicated that, accordingly, there was interest that accrued in the foreign currency on each such day during the above periods in each taxation year, and that the exchange rate applicable to the conversion of that currency into Canadian dollars for the portion accrued during each of those days (i.e., the relevant spot rate) must be used.

CRA indicated that for purposes of claiming the foreign tax credit under s. 126 in situations where the foreign tax is paid at a different time than the income arose, the foreign tax can be translated into Canadian dollars on the date of payment of the foreign tax or, alternatively, through use of the same relevant spot rate as was used for the conversion for the foreign income itself: either method is acceptable as long as it is used consistently from one year to another.

What foreign exchange rate is applied to the accrued interest on an FX-denominated debt to which s. 20(14) applies?

CRA indicated that in applying ss. 261(2)(b) and 20(14), it is the amount of foreign currency interest accrued at the time of transfer that is translated using the day of the transfer. Therefore, the accrued interest converted to Canadian dollars, using the relevant spot rate for the date of transfer, is what is used in determining both the transferor’s income inclusion under s. 20(14)(a), and the transferee’s deduction under s. 20(14)(b). That spot rate is appropriate from the transferor’s perspective as the day the accrued interest is computed and the rights thereto disposed of, and also from the transferee’s perspective as the day on which it acquired the right thereto.

A trader in U.S. securities used funds in a U.S.-dollar account to purchase the securities, with proceeds being deposited to that account. CRA indicated that FX gains were realized on the application of such funds to purchase the securities.

CRA indicated that where the parties to a s. 85 rollover transaction have different tax reporting currencies (as defined in s. 261(1)), it would require that two separate forms T2057 be filed. The amounts would be reported and denominated in the transferor’s tax reporting currency on the first form T2057, and in the transferee’s tax reporting currency on the second T2057.

A majority of the common shares of a Canadian public corporation (Pubco) were held by foreign holdcos (ultimately controlled by Foreign ‘Parent) directly or through “Canholdcos.” Most of Pubco’s assets were investments in foreign affiliates, and the paid-up capital of the various “cross-border classes” of shares (being the Pubco shares held directly by a foreign holdco and the shares held by the foreign holdcos in the Canholdcos) had been previously reduced under s. 212.3(7) as a result of Pubco investing in an offshore Finco which, in turn, financed a large development project of an indirect offshore subsidiary of Pubco (Opco).

Under the ruled-upon transactions, Opco borrowed U.S. dollars to repay some of the Finco loans (directly and by way of repaying loans from Forco 2). Finco, in turn, inter alia paid dividends on its common shares and “distributions” on its mandatorily redeemable preferred shares to Pubco (the “Finco Distributions”). CRA ruled that the Finco Distributions were receipts of property described in s. (B) of variable A of the s. 212.3(9)(b)(ii) formula, i.e., they restored the cross-border PUC held in Pubco and in the relevant Canholdcos on the basis that Pubco had received equivalent property as dividends on the shares of the subject corporation (Finco).

However, Pubco had previously elected under s. 261(3) for the U.S. dollar to be its elected functional currency. CRA indicated that the PUC of the cross-border classes for both Pubco and the Canholdcos should be computed at the same time in U.S. dollars (on the basis that the entries to the PUC accounts for the cross-border classes held in the Canholdcos were relevant to the Canadian tax results of Pubco) and also in Canadian dollars (see also 2016-0642111C6). CRA then ruled that the full restoration of the cross-border PUC was dependent on the total amount of the Finco Distributions being no less than the previous net grinds to the PUC of the cross-border classes of shares computed both in Canadian and U.S. dollars.

In response to a query as to the basis for CRA's conclusion that s. 261(11)(d ) (which applies only to taxes that are computed "for the particular taxation year") applies to a Part III tax assessment pursuant to s. 184(2) (which arises "at the time of the election" and does not relate to a particular taxation year), CRA stated:

...an amount of Part III tax payable by a taxpayer which arises as a consequence of an election in respect of a dividend payable in a taxation year is an amount of tax payable "for the particular year" for the purposes of paragraph 261(11)(d)....

In response to the question:

Since paragraph 261(11)(e) applies "for the particular taxation year", whereas, pursuant to subsection 83(4), the penalty for a late-filed form T2054 is calculated based on the number of months ending on the day on which the election is made, how does a functional currency reporter compute the penalty imposed by subsection 83(4) in Canadian dollars?

CRA stated:

Canco's liability for the late filed capital dividend election will be the lesser of the two Canadian dollar amounts (i.e. the amount in paragraph 83(4)(a) computed in Canco's functional currency and converted into Canadian dollars) and the amount in paragraph 83(4)(b) computed in Canadian dollars.

Where Canco (a Canadian resident corportion) has elected a functional currency (i.e. other than the Canadian dollar), it would be permitted to have its shareholders' resolutions denominated "in a currency other than its elected functional currency, without affecting the validity of its functional currency election in Canadian dollars." However

Canco must maintain its capital dividend account in its elected functional currency and must report all amounts on Form T2054 [the capital dividend election form] in its elected functional currency.

Where a Canadian corporation (“Canco”) with an “elected functional currency” is subject to “transfer pricing income adjustments” respecting a “functional currency year” (as defined in ss. 261(1), 247(1) and 261(1), respectively),what relevant spot rate would be used to convert the C$5,000,000 threshold stated in s. 247(3)(b)(ii) into the elected functional currency, having regard to the statement in s. 261(5)(b) that, unless the context otherwise requires, each collar amount reference in the Act “other than in respect of a penalty or fine” is to be expressed in the taxpayer’s elected functional currency using the relevant spot rate for the first day of the particular taxation year in issue.

In finding that, in light of the quoted exclusion, the threshold amount was to be converted using the relevant spot rate for the first day of Canco’s particular taxation year in respect of which “transfer pricing income adjustments” are made, CRA stated:

The C$5,000,000 threshold amount in subparagraph 247(3)(b)(ii) is one of the two components that delineate the threshold above which a penalty might be assessed. It is only if the amount determined under paragraph 247(3)(a) exceeds the amount determined under paragraph 247(3)(b) that the taxpayer is subject to pay a penalty. The amount of the penalty itself is equal to 10% of the amount determined under paragraph 247(3)(a) and does not take into account paragraph 247(3)(b).

… [P]redictability should prevail in applying subsection 247(3), and the application of paragraph 261(5)(b) to identify the “relevant spot rate” as the relevant spot rate for the first day of the particular taxation year when converting the C$ 5,000,000 threshold under subparagraph 247(3)(b)(ii) is consistent with that goal.

Canco, which had elected a qualifying currency as its functional currency, claimed a refund (made in Canadian dollars as required by s. 261(11)) by filing an amended return (apparently as a result of carrying back a loss to that year). As a result of the subsequent appreciation of the Canadian dollar as compared to the "exchange rate applicable to determine its taxes payable for [that] year," it realized an FX gain (relative to the qualifying currency) when it received the refund in Canadian dollars. Was this gain to be included in Canco’s income as ordinary income or a taxable capital gain?

After noting that “where a loss from a subsequent taxation year is carried back to a particular taxation year, the revised income taxes payable and any resulting refund are computed using the exchange rates applicable to that particular year, regardless of the exchange rate in the subsequent year,” the Directorate stated that “a functional currency reporter being required to compute and pay their income tax in a currency other than their tax reporting currency is similar to that of a Canadian-resident taxpayer that pays income tax in a currency other than CAD … to a foreign jurisdiction.” After referencing the positions in Folio S5-F2-C1, paras. 1.4301.44, that “the rules in subsection 39(2) will apply to gains or losses arising from the currency conversion of the amounts of … foreign taxes” based on the difference between their amount at the FX rate used for foreign tax credit purposes and that at the rate at the time of settlement of the tax liability or receipt of the refund, the Directorate stated:

These same principles are applicable to a functional currency reporter in respect of the reporter’s income taxes payable under the Act and gains or losses of a functional currency reporter on exchange in respect of [whether] its income taxes payable under the Act are gains or losses to which the rules in subsections 39(1) to (2.1) apply.

Consequently, the foreign exchange gain realized by Canco for financial accounting purposes in respect of the refund it received … will result in the realization of a capital gain … .

Canco’s 2014 financial statements were reported in U.S. dollars (USD) in the consolidated financial statements of its U.S. parent.. Canco made a valid election under s. 261(3)(b) to report its income in USD effective the start of its 2015 taxation year, and purportedly converted its retained earnings (“R/E”) at the December 31, 2014 relevant spot rate. The resulting “R/E for Canadian income tax purposes [were] less than its R/E for financial statement purposes… .” On this basis, Canco intends to report a one-time foreign currency loss in 2015 of this difference. Is this approach correct?

In rejecting this approach, CRA first indicated:

[W]hile an electing corporation may have been calculating its financial statements in its elected functional currency, section 261 does not refer or rely on these amounts in converting CAD Year Amounts or amounts related to CAD Year Debts to the corporation’s elected functional currency.

As well, there is nothing in section 261 to provide for any adjustment to amounts to reconcile them with what the amounts would have been had the corporation always reported its income under the Act in its elected functional currency. Instead, conversions are made as of the time the conversion takes place using the relevant spot rate at that time. As such, no immediate income consequences result.

and later stated “that not recognizing any gain or loss on the making of a functional currency election is consistent with our understanding of the tax policy.”

Turning specifically to the R/E, it first noted that s. 261(7)(h) referred to the conversion of an amount “that is relevant in determining the Canadian tax results,” and stated:

[F]or determining a taxpayer’s [thin cap] limitation…the R/E used would be the opening R/E taken from the corporation’s USD financial statements used for financial reporting. As such it is our view that R/E in Canco’s last Canadian currency year is not relevant in determining the Canadian tax results for its first elected functional currency taxation year and, consequently, is not to be translated pursuant to paragraph 261(7)(h)… .

How should the capital dividend account of a Canadian corporation ("Canco") be converted from Canadian currency into US dollars, where Canco has a June 30th year end and has validly filed for its 12-month year commencing July 1, 2012 to use the US dollar as its functional currency? CRA stated:

Pursuant to paragraph 261(7)(h) of the Act, in applying the Act to a taxpayer for a particular functional currency year, any Canadian dollar amount that arises in a taxation year prior to the taxpayer's first functional currency reporting taxation year that is relevant in determining the taxpayer's "Canadian tax results" for the particular functional currency reporting year is to be converted from Canadian dollars into the taxpayer's elected functional currency using the "relevant spot rate" for the last day of the taxpayer's last Canadian currency year.

Pursuant to paragraph 261(5)(b) of the Act, any Part III tax due by Canco (pursuant to subsection 184(2) of the Act) in the event it makes a capital dividend election in excess of its CDA balance, is relevant in determining Canco's "Canadian tax results". Since the CDA balance is relevant in determining whether Canco will incur a Part III tax liability, Canco must maintain its CDA in its elected functional currency.

As Canco's last Canadian currency year ended on June 30, 2012, it must convert the balance in the CDA on June 30, 2012 using the "relevant spot rate" on that date as defined in s. 261(1).

Where a taxpayer with an elected functional currency (e.g., the USD) has an accrued FX loss on a debt obligation owing in another foreign currency (e.g., the euro), an s. 111(4)(e) election made following an acquisition of control of the taxpayer will not affect the FX gain which would be realized under s. 261(10) re a pre-transition debt, so that it is only changes in the euro/USD exchange rate occurring from the beginning of the taxpayer’s first "functional currency year" up to the acquisition of control that would be subject to ss. 111(4) and (12).

Canco, whose elected functional currency ("EFC") has been the U.S. dollar, deducted non-capital losses from subsequent years in computing its taxable income for Years 1 and 2. Where an amount is deducted under s. 111(1)(a) for a particular taxation year in respect of a subsequent year's non-capital loss for a subsequent taxation year, (a) which instalment method should be used, and (b) should previously applied non-capital losses from subsequent years be considered, in recalculating a functional currency reporter's taxes payable (or refund) for the particular taxation year?

Q. a

CRA noted that ss. 261(11)(a) and (b) incorporate the initial computation of the taxes payable as determined in the reporter's EFC ("EFC Taxes Payable") in order to determine the reporter's ultimate taxes payable in CAD ("CAD Taxes Payable"), and that they contemplate the use of any of the instalment methods described in s. 157(1)(a)(i) ("Estimated Method"), 157(1)(a)(ii) ("First Instalment Base Method"), or 157(1)(a)(iii) ("Second Instalment Base Method"). Furthermore, in computing the reporter's remainder of taxes payable, each of its required CAD instalment payment obligations are converted to its EFC at the applicable spot rates for the instalment due dates, with the total of the required instalments, as expressed in the EFC, then deducted from its EFC Taxes Payable for the year and with the difference, if any, converted to Canadian dollars at the spot rate on the balance-due day. After noting (following I.G. Rockies Corp, 2005 DTC 289) that "a corporation may opt for whichever instalment method under paragraph 157(1)(a) that it wishes, regardless of the instalment method that is deemed by subsection 161(4.1) to have been used for purposes of computing the corporation's interest in respect of unpaid or late instalments," CRA stated that "a corporation's functional currency election…does not hinder its ability to choose…[an] instalment method under paragraph 157(1)(a)," stated that it "will not consider the use of either the First Instalment Base Method or the Second Instalment Base Method where a reporter's Total EFC Instalments [the total required instalments, as converted to the EFC] using the respective instalment method exceed the reporter's EFC Taxes Payable for the year," and that it was appropriate "that each assessment of the CAD Taxes Payable of a functional currency reporter…[use] the instalment method that gives rise to the least amount of CAD Taxes Payable" – so that when re-determining the CAD Taxes Payable for a particular taxation year as a result of a s. 111(1)(a) deduction of a subsequent year's loss, the same instalment method that was originally used for the particular year is not required to be used to recalculate the CAD Taxes Payable.

Q. b

CRA noted that although s. 161(7) ensures interest and penalties are computed without regard to reductions in taxes payable resulting from application of subsequent years' losses, "no similar provision exists that would exclude such a deduction from the determination or redetermination of a taxpayer's actual instalment obligations, nor from the determination of the remainder of taxes payable in respect of a taxation year under paragraphs 157(1)(a) and (b)," and concluded:

[T]here is no provision…that would, in re-determining a functional currency reporter's CAD Taxes Payable for a taxation year as the result of a loss carried back to that year, prevent consideration of each prior amount of a loss that was previously applied in that year.

CRA ruled on transactions for the transfer of losses by Lossco to Profitco, which entailed transactions to transfer Lossco losses to its new subsidiary, Newco 1, with Newco 2 then being sold to Profitco so that Profitco could access the Newco 2 losses through winding-it up pursuant to s. 88(1.1).

Profitco had made a functional currency election. The rulings included a ruling as to the application of s. 261(16)(a) to the wind-up of Newco into Profitco, including regarding Newco 2 being deemed to have elected Profitco’s tax reporting currency for its second short taxation year (of less than one day ending with its dissolution) and regarding the non-application of the avoidance rule in s. 261(18) and the stop-loss rule in s. 262(21).

S. 261(6.1) deems a foreign affiliate, for purposes of computing foreign accrual property income (FAPI), to have an elected functional currency that is the same as that of the Canadian taxpayer of which it is an FA. Suppose that FA is a U.S. subsidiary of Cansub, that Cansub has elected to have the U.S. dollar as its functional currency, that FA makes a U.S.-dollar loan to Parent (which has the Canadian dollar as its functional currency and is the parent of Cansub), and that Parent hedges this U.S. dollar exposure by entering into a Canadian-U.S. dollar cross-currency swap with a bank.

In 2017-0691211C6, CRA indicated that if Parent realizes an FX loss on the maturity of the loan to it, this loss will be denied under s. 261(21), mainly because the loan is on FAPI account, and therefore within the scope of s. 261(6.1) so that FA would have a tax-reporting currency of the U.S. dollar.

Suppose instead that the “specified transaction” is a loan from Parent to FA (the Parent-FA Loan) and that the gain or loss from the settlement of this loan is deemed, under s. 95(2)(i), to be a gain or loss from the disposition of an excluded property of FA (not giving rise to FAPI). Would s. 261(21) apply to the Parent-FA Loan?

After noting that the central question was whether Parent and FA had different tax reporting currencies, CRA noted that Parent’s tax reporting currency was the Canadian dollar and that no amount would be included in FA’s FAPI in respect of Cansub on the settlement of the Parent-FA loan, on the basis of the Parent-FA loan being excluded property. As FA would not have Canadian tax results, it also would not have a tax reporting currency, so that such condition for s. 261(20) to apply would not be met: s. 261(21) would not cancel the loss in Parent.

In order to hedge a U.S.-dollar Loan made by it to its Canadian subsidiary (Opco, whose tax reporting currency was the U.S. dollar), Opco (whose reporting currency was the Canadian dollar) entered into a Hedging Agreements with its non-resident Parent. When the Loan to Opco was settled at a gain, Holdco realized foreign exchange losses on settlement of the Hedging Agreements.

In finding that Holdco and Parent did not have different tax reporting currencies, sot that this condition in s. 261(20) was not met, CRA stated:

If Parent had Canadian tax results for the taxation years in that period, subsection 261(2) would require that Parent’s Canadian tax results be determined in Canadian currency, as Parent is not eligible as a non-resident to make a functional currency election. As a result, Parent’s tax reporting currency for those taxation years would be Canadian currency, the same tax reporting currency as Holdco. Alternatively, if Parent did not have any Canadian tax results for the taxation years in which the Hedging Agreements were outstanding, it would not have had a tax reporting currency for those years.

In going on to find that s. 261(2) could not be applied on the basis that the Hedging Agreements were part of the same specified transaction as the Loan, CRA stated:

[T]he gain or loss in respect of the settlement of the hedging arrangement and the gain or loss in respect of the settlement of the liability are nevertheless still taxed as separate transactions. In our view, the same principles apply for purposes of subsection 261(21)… .