Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: Are CTA Hedges and Net Asset Balance Sheet Hedges to be reported on account of income or capital?
Position: Income
Reasons: No underlying transaction
April 15, 2010
Toronto Centre TSO Headquarters
Phil Keirstead C. Tremblay, CMA
Large File Case Auditor (819) 281-6906
453-3-2
2009-034592
XXXXXXXXXX ("Canco"), formerly XXXXXXXXXX
Characterization of gains and losses on certain foreign currency transactions:
1) Hedging foreign currency denominated assets and liabilities
("Net Asset Balance Sheet Hedges")
2) Hedging foreign currency denominated net investments in subsidiaries ("CTA Hedges")
This is in response to your memorandum of October 21, 2009, wherein you asked our opinion as to how, for income tax purposes, the gains and losses realized by Canco on certain of its XXXXXXXXXX foreign currency transactions should be characterized. We have attempted to answer your questions which you have identified as the Issues.
You advise that there is little in the way of jurisprudence and guidance from CRA dealing with derivative-based net balance sheet and net investment hedges. Given the significance and materiality of the issues raised in this referral, you request a written opinion as to the proper characterization of the foreign exchange gains and losses arising from Canco's Net Asset Balance Sheet Hedges and CTA Hedges.
Facts:
1. From XXXXXXXXXX , Canco made extensive use of derivatives to hedge foreign exchange exposures related to its Net Asset Balance Sheet Hedges. Canco reported the hedging gains and losses on capital account. Moreover, in the first quarter of XXXXXXXXXX , Canco changed its functional and reporting currency from the Canadian to the US dollar, requiring it to hedge its net investment in two self-sustaining Canadian subsidiaries, for which the Canadian dollar remained the functional currency. Canco is now seeking across-the-board income treatment for all the foreign exchange gains and losses arising from its Net Asset Balance Sheet Hedges and CTA Hedges. Canco's representative, XXXXXXXXXX, has made a submission outlining Canco's rationale for requesting income treatment.
2. From XXXXXXXXXX , the majority of Canco's assets and operations were located in Canada. As a result, Canco's functional currency was the Canadian dollar.
3. As part of its business activities, Canco held assets and entered into transactions that were not denominated in Canadian dollars. This resulted in Canco being exposed to foreign exchange risks in respect of the following items:
a) Net Investment in Subsidiaries
Canco was concerned that fluctuations between the subsidiaries' functional currencies and Canco's functional currency could cause distortions in financial ratios, capitalization metrics and other information that Canco was required to report to shareholders, creditors, analysts and investment partners.
b) Foreign currency-denominated assets and liabilities
These are Canco's direct and indirect (i.e, held by subsidiaries other than self-sustaining subsidiaries) assets and liabilities that are denominated in a currency different from Canco's functional currency.
4. Canco primarily entered into short-term forward currency contracts in order to reduce or eliminate the foreign currency exposures described above with respect to both the CTA Hedges and foreign currency-denominated Net Asset Balance Sheet Hedges. Generally, the foreign currency contracts were of a short-term nature and settlement dates varied. Upon closing of the contracts, Canco would settle any gain/loss with cash and would enter into new forward currency contracts for the upcoming reporting period.
5. Canco's policy throughout the XXXXXXXXXX taxation years was to maintain a relatively hedged consolidated balance sheet from a currency perspective, based on net book value, with the ability to carry unhedged or speculative positions from time to time that were pre-authorized and monitored on an ongoing basis. Currency positions were reviewed quarterly and adjusted as necessary. You have noted that Canco's XXXXXXXXXX annual reports reveal that Canco held US dollar foreign exchange contracts in the following notional amounts:
XXXXXXXXXX
Taxpayer's Position:
Canco is requesting that the foreign exchange gains/losses from its Net Asset Balance Sheet Hedges and CTA Hedges be accorded income treatment. Canco's position is based on the "linkage principle" and, specifically, that there is insufficient linkage for capital treatment as the foreign exchange gains/losses in question are not linked to specific, identifiable capital transactions. The hedges were of a short-term nature and entered into to minimize the volatility that would otherwise arise because of the application of generally accepted accounting principles ("GAAP") in the preparation of financial statements. In this respect, the hedges were independent of any actual underlying transactions and should be accorded income treatment.
TSO Position:
In your view, whether Canco's Net Asset Balance Sheet Hedges and CTA Hedges gains/losses should be reported on income or capital account turns on whether the foreign exchange contracts entered into by Canco to offset its foreign currency balance sheet constitute a hedge for tax purposes. You note that until such time as the courts deal with a situation involving a Canco-like hedging program, questions will arise as to the scope and applicability of the linkage principle in highly complex hedging scenarios and the proper characterization of the foreign exchange gains/losses arising from these situations. Your review of the cases and comments from various authors suggest that there is no clear authority on the subject. You note that Canco's exposures were inherently capital in nature and were of an on-going nature. In your view, Canco's situation is more conducive to capital treatment; as opposed to income treatment as accorded in the Salada Foods Ltd. v The Queen ( 74 DTC 6171) decision.
In your view, Canco has mitigated its balance sheet volatility with careful monitoring of both the timing value of its hedges and currency exposures and evidence of this matching is, in itself, evidence of linkage. In your conclusion, you note that the courts have not yet entertained cases involving hedging arrangements of the level and complexity that you have described herein. The cases that have been decided to date involved a limited number of short-lived hedging scenarios.
It has been the CRA's long-standing position (36th Canadian Tax Foundation Conference, 1984, Question 63) that the characterization of gains or losses as on account of income or capital from a forward contract that was a hedging instrument depended on the underlying use of the funds that the forward was designed to hedge. The forward contract intended as a hedge would be considered separately from the underlying transaction that is being hedged, although its nature is characterized by the underlying transaction. Thus, it needs to be established that the forward contracts were used as hedges for purposes of the underlying transaction.
Salada was the first court case on the linkage principle, 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 further 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".
In the following comments, we provide our responses to specific issues you raised in your incoming request.
1.a) In order to determine sufficient linkage does there have to be a transaction? For example, if you are hedging an asset including a net investment in a subsidiary, can you hedge a projected disposition of this asset in order to have sufficient linkage?
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. However, in our view, depending on the facts, a projected disposition of an asset may involve sufficient linkage.
b) How closely do the timing and maturity of the hedging contracts have to match the underlying hedged item to establish sufficient linkage? If the hedging contracts are short term (for example, 3-month foreign exchange forward contracts) but the corporation continually closes out and enters into new short term contracts and the hedged item has a longer term (i.e., a net investment in a subsidiary with no expected disposition or a long-term liability) would CRA consider there still to be sufficient linkage to allow capital treatment?
In our view, if there is no expected disposition of a subsidiary that is being hedged with a hedging contract, capital treatment is not available. The principles that have evolved under case law with respect to distinguishing whether a foreign exchange gain or loss is on income or capital account were summarized in Ethicon Sutures Ltd. v. The Queen (85 DTC 5290) as follows:
- To determine whether a foreign exchange gain is to be treated as income or capital, it is necessary to look at the underlying transaction that gave rise to the gain.
- If the foreign currency was acquired as a result of the taxpayer's trading operations or for the purpose of carrying on trading operations, any gains will be treated as occurring in the course of the taxpayer's trade and will be on income account.
- If the transaction is speculative made in the hope of profit, it will be treated as an adventure in the nature of trade and the gain will be taxed as income.
- If the gain arises out of the investment of idle funds or the appreciation of a temporary investment, the gain will be treated as a capital gain.
- To be considered capital in nature, the funds must be surplus and must be exclusively for dividend or capital expenditures (i.e., "earmarked primarily" is not enough).
c) Does the legal entity which enters into the hedging contract have to directly own the underlying hedged item? If hedges are entered into a consolidated basis, with the parent owning the hedging instrument and the subsidiary owning directly an underlying hedged item, can the characterization of the hedging contract be linked to the underlying hedged item?
In our view, the legal entity should have a direct ownership of the underlying hedged item. From a separate legal entity perspective, the legal entity should have an underlying transaction exposed to foreign exchange rate fluctuations, otherwise, there is no offsetting position against which any of the gains and losses arising from the hedges could be matched. In our view, if there is no linkage between the foreign currency contracts entered into by the legal entity and an actual or intended sale of foreign currency denominated capital assets, the foreign currency contracts do not constitute a hedge of a capital item for income tax purposes.
d) Is the purpose of entering into the hedging contract (i.e., the stated hedging policy is to hedge a net investment in subsidiaries) sufficient to establish linkage? (The assumption is that the corporation actually followed their policy).
In our view, we need an underlying transaction to establish linkage, so it may not be possible for a corporation even if it followed its policy of hedging its net investments in its subsidiaries to be accorded capital treatment. Since the Income Tax Act does not define the term "hedge", case law principles apply to determine if a derivative financial instrument constitutes a hedge for income tax purposes. The courts have held that for derivative financial instruments to constitute a hedge there must be sufficient linkage between the derivatives and the underlying transaction. Where a hedge is not linked to a capital transaction the gain or loss is on income account.
e) Can you hedge less than the value of the asset, or do the amounts have to be comparable in order to establish sufficient linkage? For example, if the taxpayer is hedging the net book value of an asset which is less than the fair market value will CRA still consider there to be sufficient linkage to establish capital treatment?
In our view, a hedge for less than the loan amount, for example, may still be an acceptable hedge and may establish sufficient linkage to establish capital treatment. 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. It is our 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.
2. Confirmation that if CRA determines that there is insufficient linkage between the hedging instrument and the underlying transaction and the underlying hedged capital item then the residual position is that the gain/loss on the "hedging" transactions will always be on account of income.
It is our view that where there is insufficient linkage with the underlying asset, the gain/loss on the "hedging" transaction will be on account of income. 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, as noted above. Further, 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.
3. Determination if it is possible to have sufficient linkage when the foreign exchange exposure exists only on the consolidated financial statements. Specifically, if consolidated financial statements are prepared using US dollar functional currency and the hedges are entered into by the Canadian parent to hedge net investments in Canadian subsidiaries, will capital treatment ever be appropriate? The legal entity financial statements of the Canadian parent for tax purposes are prepared using Canadian dollars, so for legal entity financial statement purposes there is no underlying hedged asset which has a foreign exchange risk.
In our view, where there is no underlying transaction involving a hedged asset which has a foreign exchange risk, the corporation cannot report the gain/loss on account of capital. Further, the accounting treatment of the hedges as a net investment hedge, to reflect the economic position of a Canadian parent's consolidated corporate group, does not necessarily mean that the hedge was a hedge for income tax purposes. Hedge accounting for consolidated financial reporting is not determinative of the tax treatment of a hedge 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 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 GAAP was rejected by the Federal Court of Appeal. This case supports the view that legal principles take precedence over accounting principles.
At the 2007 Canadian Tax Foundation Conference dealing with a question regarding the criteria for a hedge, 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."
Conclusion:
In our view, there must be an underlying capital transaction in order to offer sufficient linkage to be considered on account of capital. The transaction with respect to foreign investment must contemplate an actual or future sale of the shares. An underlying transaction, in our view, must be present and day-to-day fluctuation in the book value of foreign subsidiaries in 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, in our view, the "Net Balance Sheet Hedges" and "CTA Hedges" of Canco 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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