This is article is part of a series dealing with draft legislation released for comment by the Department of Finance on July 29th. Read the complete series:
- The evolving taxation of derivatives
- Sales of linked notes
- Taxation of switch fund shares
- Changes coming to country-by-country transfer pricing documentation requirements
- Proposed replacement of eligible capital property rules by new depreciable property class
- Alternative arguments in support of tax assessments
- Foreign exchange gains on debt-parking
- Cross-border surplus stripping
New rules have been proposed that would require accrued foreign exchange gains on a foreign currency debt to be realized when the debt becomes a parked obligation. These rules address a perceived gap in the existing debt parking rules which the Department of Finance appears to believe some taxpayers have been exploiting.
Under the ITA, income must generally be computed in Canadian dollars. This necessitates the conversion of amounts denominated in a foreign currency to Canadian dollars. As a result, a foreign exchange gain or loss may be realized on the repayment of a debt denominated in a foreign currency if the foreign currency has fluctuated relative to the Canadian dollar.
Some taxpayers have entered into transactions referred to as debt-parking transactions in order to avoid realizing a foreign exchange gain on the repayment of a foreign currency debt. For example, a debtor might enter into an arrangement where a non-arm’s length party acquires the debt from the original creditor for a price equal to its principal amount. The original creditor would be repaid, but the new creditor would allow the debt to remain outstanding to avoid the debtor realizing a foreign exchange gain.
The existing debt-parking rules in the ITA help ensure that the debt forgiveness rules are not avoided in transactions similar to this. However, the debt-parking rules do not address foreign exchange gains. Under the existing debt-parking rules, the debt is deemed to be repaid for an amount equal to the cost of the debt to the new creditor. Although these rules deem the foreign currency debt to have been settled at the time of the acquisition by the new creditor, any foreign exchange gain realized on the debt is not taken into account.
Budget 2016 stated that such transactions could be subject to challenge under the general anti-avoidance rule in the ITA if a taxpayer were to avoid realizing a foreign exchange gain, but in any event, the government proposed new rules that would require an accrued foreign exchange gain on a foreign currency debt to be realized when the debt becomes a parked obligation.
Although no detailed provisions to implement this proposal were included in Budget 2016, they are now included in the July 2016 Legislative Proposals. However, the detailed provisions released in July differ in some important respects from the original proposal in Budget 2016. In particular, the 2016 Legislative Proposals also include parallel debt parking rules to be included in section 261 of the ITA for taxpayers that report in a foreign functional currency. In addition, the July 2016 proposals omit specific relief that was contemplated in Budget 2016 for financially distressed debtors. Budget 2016 had proposed relief, as follows:
Related rules will provide relief to financially distressed debtors. This relief will be similar to the deductions currently available to debtors with respect to amounts included in income because of the application of the debt forgiveness rules. For instance, where a debtor is a corporation resident in Canada, a rule will ensure that the combined federal/provincial taxes payable on a deemed foreign exchange capital gain will not result in the corporation’s liabilities exceeding the fair market value of its assets.
The principal changes are to section 39 of the ITA. Where a foreign currency debt has become a parked obligation at a particular time, proposed subsection 39(2.01) will, for the purposes of the foreign currency capital gains and losses provision in existing subsection 39(2), deem a taxpayer to have realized the gain that the taxpayer otherwise would have made if it had paid an amount in satisfaction of the debt equal to:
- Where the debt becomes a parked obligation as a result of its acquisition by the current holder, the amount for which the debt was acquired; and
- In other cases, the FMV of the debt.
For the purpose of proposed subsection 39(2.01), proposed subsection 39(2.02) will provide that a foreign currency debt will become a parked obligation at any time where:
- At that time, the current holder of the debt does not deal at arm’s length with the debtor or, where the debtor is a corporation, has a significant interest in the corporation;
- At any previous time, a person who held the debt dealt at arm’s length with the debtor and, where the debtor is a corporation, did not have a significant interest in the corporation, typically being shares having 25 per cent or more of the votes or value; and
- It is reasonable to consider that one of the main reasons for the transaction or event or series of transactions or events resulting in the acquisition of the debt by the current holder was to avoid the application of proposed subsection 39(2.01).
This last condition is designed to ensure that foreign currency debt does not become a parked obligation as a result of a bona fide commercial transaction where one of the main purposes was not to avoid a foreign exchange gain. Although as noted above, it does not appear to cover the situation of financially distressed debtors as was contemplated by Budget 2016 – it should be noted that, likewise, the technical notes accompanying the 2016 Legislative Proposals also do not comment on a situation where there is a financially distressed debtor.
For the purposes of subsections 39(2.01) and 39(2.02), proposed subsection 39(2.03) incorporates certain interpretative provisions from the debt forgiveness and parking regime relating to the determination of whether parties are related, whether a person controls another person or whether a person has a significant interest in another person.
Finally, proposed subsections 261(10.1) and (14.1) will provide substantially similar debt parking rules in respect of taxpayers that report their Canadian tax in a foreign functional currency. These new subsections will apply for purposes of calculating a taxpayer’s gain or loss pursuant to subsections 261(10) and 261(14), respectively.
The 2016 Legislative Proposals will apply to a foreign currency debt that meets the conditions to become a parked obligation on or after March 22, 2016. However, subsections 39(2.01), 261(10.1) and 261(14.1) will not apply to a debt that, because of a written agreement entered into before March 22, 2016, becomes a parked obligation before 2017.