YIN In-Depth: F/X Essentials Panel

Transcription

1 YIN In-Depth: F/X Essentials Panel Moderator Ryan Rabinovitch, McCarthy Tétrault LLP, Montreal Panelists Chris Anderson, Davies Ward Phillips & Vineberg LLP, Toronto Erin Foote, Deloitte LLP, Toronto Ilia Korkh, EY Law LLP, Vancouver Phil Ward, Bennett Jones LLP, Toronto Tuesday April 25 & Wednesday April 26 Metro Toronto Convention Centre

2 F/X Essentials - Overview Introduction Foreign currency-denominated debt Functional currency regime Foreign affiliates Foreign exchange hedging 2

3 Introduction Canadian currency requirement Subject to certain exceptions, taxpayers are required to use Canadian currency to determine their "Canadian tax results" s.261(2)(a) If an amount relevant to computing such results is expressed in a foreign currency, it must be converted to an amount in Canadian currency using the "relevant spot rate" for the day on which the particular amount arose s.261(2)(b) 3

4 Introduction income or capital account Income or capital characterization of F/X gain or loss generally follows characterization of underlying transaction F/X gains and losses on income account governed by s.9 o Generally recognized in accordance with GAAP o May be recognized on accrual or realization basis F/X gains and losses on capital account governed by s.39 o Generally recognized on realization basis 4

5 5 Foreign Currency Debt

6 Foreign Currency Debt - Overview Subsection 39(2) o Overview o When it applies o Miscellaneous issues Debt forgiveness o Implications under s.39(2) o Implications under s.80 o Debt parking Other technical issues o Loss restriction event o Thin capitalization o Pertinent loan or indebtedness ( PLOI ) 6

7 Subsections 39(1) & (2) F/X Essentials S.39(1) - normal rule for determining capital gains or losses "from the disposition of property" o Generally applies in the case of a lender S.39(2) generally applies to recognize F/X gains and losses where s.39(1) does not apply o E.g., on settlement of debt, there is no disposition of property by the debtor 7

8 Subsection 39(2) - overview If, because of any fluctuation in the value of a foreign currency relative to Canadian currency, a taxpayer has made a gain or sustained a loss in a taxation year, the amount of the gain or loss is deemed to be a capital gain or loss for the year from the disposition of currency other than Canadian currency See C6 for example of the application of s.39(2) on a partial repayment of debt 8

9 Subsection 39(2) when it applies When does taxpayer "make a gain" or "sustain a loss"? CRA - there must be a transaction resulting in a gain or loss to the taxpayer losses sustained "on paper" do not qualify: IT-95R Application of s.39(2) common examples: o Repayment of all or part of a debt o Conversion of foreign currency Non-application of s.39(2) common examples o Recognition on an accrual basis not permitted o Movement of funds on deposit from one type of deposit to another (e.g., from cash to term deposits or GICs and back) S.39(2) does not apply to a gain or loss in respect of a transaction or event in respect of shares of the taxpayer 9

10 Subsection 39(2) miscellaneous issues Conversion of foreign currency convertible debenture o Agnico-Eagle, 2016 FCA 130: Indebtedness is repaid by the issuance of common shares Compare the amount given up by the taxpayer on conversion/repayment (FMV of the shares issued converted to CAD on conversion date) against the amount received by the taxpayer on debt issuance (principal amount converted to CAD on debenture issuance date) o CRA accepted the methodology set out in Agnico-Eagle for determining gain but does not consider that any loss could be claimed under s.39(2): C6 Any loss cannot be said to have been sustained due to foreign currency fluctuations Possible application of s.143.3(3) in similar circumstances 10

11 Subsection 39(2) miscellaneous issues Stop-loss rules: s.40(3.3), (3.4), 40(2)(g)(i) o Stop-loss rules regarding transfers to affiliated persons do not apply on the settlement of a debt obligation: E5 o CRA position that stop-loss rules regarding transfers to affiliated persons do not apply to the disposition of foreign currency cash: I7 F/X gains to debtor under s.39(2) on settlement of debt cannot constitute gains from the disposition of taxable Canadian property: I7 11

12 Debt forgiveness and foreign exchange s.39(2) A debtor only makes an F/X gain or sustains an F/X loss for purposes of s.39(2) to the extent it repays the debt: E5 o Where debt is forgiven without any repayment, CRA has stated that there is no transaction to which s.39(2) would apply o However, in CRA s view a deemed repayment under the ITA could give rise to a capital gain or loss under s.39(2) 12

13 Debt forgiveness and foreign exchange s.80(2)(k) ITA s.80(2)(k) - where an obligation is denominated in a foreign currency, the forgiven amount shall be determined with reference to the relative value of that currency and Canadian currency at the time the obligation was issued Rule intended to prevent debtors from having to recognise debt forgiveness because of foreign currency fluctuations See example in Technical Notes Application is less straightforward when debt is repaid in Canadian currency, or in kind o See CRA document and article by Thomas Bauer, Restructuring Debt Obligations 13

14 Debt parking and F/X gains anti-avoidance Until recently, could arguably avoid F/X gains under s.39(2) by parking debt (subject to GAAR) ITA s.39(2.01)-(2.03) were enacted following 2016 Budget to address this issue Where a foreign currency debt has become a parked obligation at a particular time, the debtor is deemed for the purposes of s.39(2) to have made any gain that it would have made if it had settled the debt Definition of parked obligation for these purposes contains a principal purpose test o Only a parked obligation if it can reasonably be considered that one of the main purposes is to avoid the application of s.39(2) 14

15 Loss restriction event and accrued F/X gains/losses Under s.111(4), when a taxpayer is subject to a loss restriction event ( LRE ): o Accrued capital losses on property must be recognized o Capital losses cannot be used following the LRE o Taxpayer can elect to trigger accrued capital gains on its property to use up the expiring capital losses S.111(12) extends the rules under s.111(4) to accrued F/X gains and losses on debts owed by the taxpayer o Taxpayer is essentially deemed to own notional property with accrued gain or loss equal to that which would be recognized under s.39(2) if the debt were to be repaid S.40(10) and (11) adjust the F/X gain/loss realized by the taxpayer on subsequent repayment of the debt See example in Technical Notes to s.40(11) 15

16 Thin capitalization rules and foreign currency debt Former CRA position o Convert foreign currency debt into CAD on an ongoing basis o Unhelpful F/X fluctuations could cause taxpayers to fall offside permitted thin cap debt:equity ratio Current CRA position: C6 o Foreign currency debt should be converted to CAD on the date the debt arose o Helpful F/X fluctuations should not affect the application of the thin cap rules 16

17 PLOI imputed interest and F/X fluctuations S.17.1 imputes interest to a corporation resident in Canada ( CRIC ) in respect of a PLOI o CRIC is required to include in its income interest at least equal to interest calculated using the prescribed interest rate in Reg. 4301(b.1) CRA - the prescribed interest rate should be applied to the principal amount of the debt converted to CAD at the date the debt was issued: E5 o The minimum rate of imputed interest would not be affected by subsequent F/X fluctuations 17

18 18 Functional Currency Regime

19 FC Regime: Background F/X Essentials Functional Currency Regime (the Regime ) enacted in 2007 and subsequently revised in Response by Finance to help taxpayers fix the gap between tax and GAAP and to improve international competitiveness of Canadian companies. Main goals: reduce compliance costs and promote more representative financial reporting. Similar regimes in other countries. Comprehensive regime in s.261. Elective but subject to restrictions. Number of technical issues remain outstanding. See 2012 Joint Committee submissions. 19

20 FC Regime: Application Canadian tax results in a particular year are determined using tax reporting currency. Although it is CAD by default, it may be elected functional currency ( EFC ). To elect: meet criteria in s.261(3) whereby taxpayer must: o be a corporation resident in Canada; o file an election (FormT1296) within 60 days after the start of the taxation year; o have a functional currency ( FC ); o have not previously filed an election for the Regime; and o have not filed a revocation election. No need to have an active business: Holdcos may elect if they meet the criteria. 20

21 FC Regime: What is Functional Currency? S.261(1): functional currency defined as: o qualifying currency; and the primary currency in which the taxpayer maintains its records and books of account for financial reporting purposes. Qualifying currency limited to USD, GBP, AUD, EUR Taxpayer must have a FC for financial reporting purposes to be entitled to elect. So generally need to meet the test under GAAP. Question of fact whether (a) taxpayer maintains records and books in a currency other than CAD and (b) which currency is primary currency for financial reporting purposes. Primary currency is usually easy to determine. Complex situations involve two GLs, or multiple businesses. 21

22 FC Regime: Transition to Regime Transition rules in s.261(7)-(10) apply to convert CAD tax attributes to EFC using the relevant spot rate ( RSR ) on the last day of the last Canadian currency year. Different approaches to pools/attributes/assets and debts. o S.261(7): Convert cost of property, resource pools, loss carryforwards, reserves, PUC, etc. to EFC using RSR. Adjusting the cost of property crystallises the FX gain and defers its realisation to the future disposition. o S.261(8)-(10): Apply to pre-transition debts. Combined operation of the provisions results in debtor computing pregnant pre-transition FX gains/losses on non-cad debts. The gain/losses are crystallised, converted into EFC, and pro-rata realised on future repayments. Posttransition FX gains/losses are realised separately. 22

23 FC Regime: Pre-Transition Debts Borrowing Time CAD Functional Last Day before Transition USD as EFC Repayment Time CAD Debt No FX on CAD/CAD USD Debt No FX on USD/USD GBP Debt 23

24 FC Regime: Ongoing application of the Regime S.261(5): Main operative rule: for each FC Year ( FCY ): o Use EFC to determine Canadian tax result of the taxpayer for the taxation year; So where amounts such as PUC are also used to determine the Canadian tax result of other taxpayers, may need to keep dual accounts. Similarly, where taxpayer with EFC is shareholder in another taxpayer, must re-compute certain Canadian tax results in EFC. Notably, Part XIII tax is Canadian tax result of the nonresident, so has to be determined in CAD. See C6 re deemed dividends. o Convert amounts in other relevant currencies to EFC using RSR where necessary. 24

25 FC Regime: Ongoing application of the Regime S.261(6) and (6.1): Partnership and Foreign Affiliate rules: o Functional currency election is made by the partner, not the partnership; o Reading rules may result in a timing mismatch; o Issue where partners have different EFC: may require double book-keeping by the partnership; o FA rules only relevant for FAPI computation purposes: FAPI amounts are computed with reference to EFC. S.261(11): Determination of amounts payable under the Act. But remittances are still made in CAD using RSR. 25

26 FC Regime: Revocation / Transition Out of Regime Taxpayers may revoke the election and revert to CAD tax reporting. Revocation election can be filed in any year after the first FCY and generally applies the years following the year of revocation election. Any such years are then the reversionary years. Specific transition rules in s.261(12)-(14) convert the EFC amounts back into CAD, mirroring the rules in s.261(7)- (10) applicable on transitioning into the Regime. 26

27 FC Regime: FX Planning Retroactive application of Regime on amalgamation or wind-up where EFC following the deemed tax year end is different than that of the predecessors year deemed to have ended (s.261(16)-(17)). May be used for retroactive planning subject to broad anti-avoidance rules below. S.261(18) gives discretion to the Minister to use a different currency where property is transferred in a FCY, and one of the main purposes is to compute the tax result in respect of the property using different currency. S.261(20)-(21) contain loss denial rules where specified transaction among related parties with different tax reporting currencies result in a smaller FX income/gain or a greater FX loss. No purpose test. 27

28 28 Foreign Affiliates

29 Foreign Affiliates Computing FX Gain / Loss S.95(2)(f): F/X Essentials A foreign affiliate ( FA ) is deemed to be resident in Canada for purposes of determining the FA s: (i) Capital gain, capital loss, taxable capital gain or allowable capital loss from the disposition of property (ii) Income or loss from a property, from a business other than an active business or from a non-qualifying business Income or loss from an active business generally computed under income tax law of country in which FA is resident (Reg.5907(1) earnings ) 29

30 Foreign Affiliates Computing FX Gain / Loss S.95(2)(f.12) to (f.15): F/X Essentials Use FA s calculating currency to determine: (i) capital gain, capital loss, taxable capital gain or allowable capital loss from the disposition of excluded property (ii) income or loss from an active / deemed active business Use CAD / elected functional currency to determine: (i) FAPI capital gain on disposition of excluded property (ii) all other amounts Calculating currency of a FA (a) (b) the currency of the country in which the FA is resident any currency taxpayer demonstrates to be reasonable in the circumstances 30

31 Foreign Affiliates Settlement of Debt S.95(2)(i): F/X Essentials Income, gain or loss of FA deemed to be income, gain or loss from disposition of excluded property if derived from: (i) Settlement of debt where proceeds of debt used (A) to acquire property that was at all times excluded property (B) at all times to earn income from an active business (ii) (iii) Settlement of debt where proceeds used to settle a debt referred to in (i) Currency hedge agreement with respect to a debt referred to in (i) or (ii) 31

32 Foreign Affiliates Settlement of Debt S.95(2)(i): F/X Essentials Canco FA Holdco (U.S.) USD Loan EP Shares FA Opco (U.S.) 32

33 Foreign Affiliates Settlement of Debt F/X Essentials Where s.95(2)(i) does not apply, FA Holdco s FX gain/loss on settlement computed in CAD, resulting in a FAPI capital gain/capital loss. Canco will also realize a FX gain/loss on settlement. If Canco realizes a FX gain and FA Holdco realizes a FX loss, FA Holdco s FACL cannot be used to offset Canco s taxable capital gain. If Canco realizes a FX loss and FA Holdco realizes a FX gain, Canco s allowable capital loss will not shelter the FAPI inclusion. Canco FA Holdco (U.S.) FA Opco (U.S.) FX gain/loss USD Loan FX gain/loss (FAPI/FACL) 33

34 Foreign Affiliates Foreign Exchange Debt & Shares S.95(2)(g): FX gain or loss in reference to: (i) a debt obligation owing to or from a qualified FA ; (ii) the redemption, acquisition or cancellation of, or a qualifying return of capital in respect of, a share of a qualified FA ; or (iii) the disposition to a qualified FA of a share of another qualified FA Deemed to be nil if: (iv) taxpayer has a qualifying interest in the FA or the FA is a CFA; and (v) gain or loss due to a fluctuation in value of the currency of a country other than Canada relative to Canadian currency S.95(2)(g.03) application of s.95(2)(g) to partnerships 34

35 Foreign Affiliates F/X Essentials Foreign Exchange Debt & Shares S.95(2)(g): Canco USD functional currency USD functional currency FA Finco FA Opco GBP functional currency GBP Loan Impact where loan excluded property? Non-excluded property? 35

36 Foreign Affiliates Other Considerations F/X Essentials Carve out rule s.95(2)(f.1) Currency hedging s.95(2)(g.01), s.95(2)(a)(iv) Hedge agreements as excluded property s.95(1)(c.1) Hedging exception to loss limitation rules in s.93(2) to (2.31) Application of functional currency rules to FAs s.261(6.1) - potential FAPI implications where staggered year-ends - potential FAPI implications on amalgamation of Cancos s.261(17.1) ACB and surplus computations - converting amounts included in surplus to FA s calculating currency - converting surplus balances to CAD - how to compute ACB of property that oscillates between EP and non- EP? 36

37 37 F/X Hedging

38 Hedging: Background F/X Essentials There is no definition of a hedge or hedging transaction for purposes of the Act. (S.20.3) Indicia of a hedge found in jurisprudence: (i) an intention to eliminate risk; and (ii) carried out through an instrument that is linked (or symmetrical) to an underlying asset in both quantum and timing. (Reference re Grain Futures Taxation Act (Manitoba). Natural Hedge Foreign denominated debt can reduce FX risk from assets denominated in same currency. Derivatives value is determined by an underlying price, value, rate, variable, index or event, probability or thing. 38

39 Hedging: Overview of Primary Tax Considerations The treatment of hedging gains and losses on income or capital account. The timing of income inclusion: realization or accrual. o Canadian General Electric Co. v MNR, [1962] SCR 3 o Friedberg v Canada, [1993] 4 SCR 285 o Kruger Incorporated v The Queen, 2016 FCA 186 o Proposed s.10.1 Foreign affiliate considerations o Excluded property status under paragraph (c.1) o S.95(2)(a)(vi) deemed active business income o S.95(2)(g.01) hedging of certain FAPI FX gains/losses o S.95(2)(i) deemed excluded property status 39

40 Hedging: Income v Capital For a hedge to be effective from a tax perspective, the hedge must have the same character as the underlying transaction that is being hedged. What is the character of the underlying item? How is the character of a hedging transaction determined? Will the Court consider other factors to establish a speculative intent? Did George Weston (2015 TCC 42) change the law as it applied to hedging or was it an evolution of the existing law? 40

41 Pre-George Weston Salada Foods (74 DTC 6171 (FCTD)) o Taxpayer owned a number of UK subsidiaries o Taxpayer entered into forward contracts anticipating decline in, which occurred. o Taxpayer argued the gain on the forward contracts was on capital account to protect its investment in its UK subsidiaries. o Court held gain was on income account. The amount of the contract did not bear a close relationship to the value of the UK subsidiaries. "In arranging the forward sale contract the Plaintiff acted in exactly the same fashion as a dealer or speculator in securities would act." 41

42 Pre-George Weston F/X Essentials Echo Bay Mines (92 DTC 6437 (FCTD)) o Taxpayer operated silver mine o Entered forward contracts to deliver silver at future date. o No silver was delivered. Forward settled in cash or rolled. o Was forward profit "resource profits" for purpose of resource allowance? o Court held that transaction was a hedge. Clear intention to hedge production Evidence that forward contracts were intended to match estimated production Precise matching was not feasible, but was not required. See also: Placer Dome Canada Ltd. (2006 DTC 6531) 42

43 Pre-George Weston Shell Canada Ltd. [1999] 3 SCR 622 o Borrowed NZ$150M at a favourable rate, which was converted into US$100M o Entered into forward contract to sell US$ for NZ$ during the term of the loan. o Realized gain on settlement of forward contract. o Underlying borrowing was on capital account. o GAAP treatment not determinative. "Whether a foreign exchange gain arising from a hedging contract should be characterized as being on income or capital account depends on the characterization of the debt obligation to which the hedge relates." 43

44 Pre- George Weston F/X Essentials Saskferco Products ULC (2007 DTC 1183, 2007 TCC 462, aff'd 2008 FCA 297) o The Taxpayer was unable to hedge US FX exposure on US business income through derivative contract and borrowed US$ as a natural hedge. o Realized FX losses on borrowing and FX gains on US sales. Losses held to be on capital account based on nature of the borrowing. "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." 44

45 George Weston F/X Essentials The taxpayer realized a gain on the termination of cross-currency basis swap contracts. Reported as a capital gain. Entered the swaps to protect its consolidated balance sheet equity from FX fluctuations. The taxpayer's debt-to-equity had increased well above its internal guidelines of 1:1, and resulted in a credit watch warning from S&P. Taxpayer acquired a new US subsidiary and entered into term swaps at approximately the same time as the acquisition of the business and having a notional amount approximately equal to the subsidiaries total net value. 45

46 George Weston F/X Essentials The swaps were identified as hedges under GAAP. In 2002, certain of the swaps were closed following US divestitures to reduce the notional value closer to the net investment in the US subsidiaries. The remaining swaps were closed in 2003 when the taxpayer's debt to equity ratio stabilized. Minister argued that there was insufficient linkage to a transaction to be a hedge. There was no intention on the part of the taxpayer to sell the subsidiaries. Or that the swap was an adventure in the nature of trade. 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 46

47 Following George Weston CRA accepts the George Weston decision (CRA Document No C6.) While the decision affirmed that there are circumstances in which a foreign currency derivative can be considered a hedge of a taxpayer's net investments in foreign operations there must, however, be evidence that demonstrates that the derivative is sufficiently linked to the underlying capital assets. [T]he notional value of the swaps closely approximated the investments in the US Operations, the taxpayer's formal derivative policy and its credit facilities prohibited it from speculating in derivatives. CRA does not extend the George Weston decision to other types of derivatives, such as interest rate derivatives (CRA Document No I7) 47

48 Conclusion on Income v. Capital George Weston a continuation of the pre-existing law What is the underlying item that is being hedged? Linkage principle is relevant. o Timing considerations on entering and exiting the hedge. Amount of hedge? o Accounting treatment is relevant but not determinative. The intention in entering into the hedge. o Consider public disclosure on hedging practice. o Has the taxpayer entered any agreements that permit or prohibit speculation through derivatives? "Natural hedges" are subject to different considerations. 48

49 Proposed Section 10.1 F/X Essentials In Kruger Inc., the FCA held that the taxpayer was entitled to report gains and losses on derivative portfolio on a mark-to-market basis. [71] [M]ark to market provides a picture of the appellant's income which is as accurate and as acceptable from the perspective of the tax collector as that which the principle of realization would provide. Budget 2017 permits taxpayers to make an election to report gains and losses from "eligible derivatives" on a mark-to-market. The election is irrevocable subject to CRA approval. The rule can apply to deem "eligible derivative" to be a property of the taxpayer for tax purposes, even if it is legally an obligation. 49