Effective January 1, 2008, the Income Tax Act (the Act) was amended to eliminate non-resident withholding tax on most arm’s-length interest payments, thereby facilitating cross-border loans to Canadian borrowers. Notwithstanding this relieving amendment, Canadian borrowers must still consider foreign currency issues. In this regard, the Act does not contain rules to determine whether foreign exchange gains and losses are income or capital in nature; rather, general principles of characterization have been developed by the courts. In Shell Canada Limited v. The Queen,1 the Supreme Court of Canada affirmed the following two principles: (1) the character of a foreign exchange gain or loss realized upon a repayment of debt generally follows the character of the underlying debt, and (2) the character of a foreign exchange gain or loss arising in connection with a hedging contract generally follows the character of the item to which the hedge relates.
In Saskferco Products ULC v. The Queen,2 the Federal Court of Appeal considered which of the foregoing principles applied for purposes of characterizing foreign exchange losses realized upon the repayment of US dollar denominated notes, where the currency of the notes was chosen in part for purposes of hedging foreign currency fluctuations on US dollar revenue.
The taxpayer, Saskferco Products ULC, was a Canadian corporation established in 1990 to construct a plant in Saskatchewan and thereafter produce and sell fertilizer. In order to partially finance the construction of the plant, in July 1990, the taxpayer issued a series of notes. The notes were denominated in US dollars, had an aggregate principal amount of US$231 million and had maturity dates that varied from five to seventeen years from their date of issue. The evidence disclosed that the taxpayer’s financial advisor had recommended that the notes be denominated in US dollars as this would hedge foreign currency exposure on US dollar revenue and US dollars could be borrowed at a lower interest rate.
The taxpayer completed the plant in 1993, full operations commenced immediately afterward and the taxpayer starting to make principal payments on the notes in 1995. For financial reporting purposes, the taxpayer adopted hedge accounting with respect to foreign exchange fluctuations on the principal of the notes and the portion of US dollar revenue used to fund the principal payments. According to the taxpayer’s auditors, hedge accounting could be used provided that the taxpayer had sufficient US dollar cash flows from revenue, and such cash flows were accumulated, to fund the principal payments on the notes. The taxpayer forecasted that approximately 50 percent of its sales would be in the US and that this revenue stream would be sufficient to fund principal payments on the notes.3
From 1990 to 1999, the Canadian dollar weakened significantly relative to the US dollar. Under the hedge accounting methodology, the taxpayer translated the principal payments on the notes, and the US dollar revenue used to fund such payments, from US dollars into Canadian dollars using the exchange rate in effect at the time the notes were issued in July 1990. As a result, the foreign exchange losses otherwise arising on the principal payments on the notes were eliminated, and the revenue arising in the same years as the debt repayments was reduced by an equivalent amount. The taxpayer adopted hedge accounting for purposes of computing its profit under Section 9 of the Act.
The Minister reassessed the taxpayer’s 1995, 1996, 1998 and 1999 taxation years to reverse the effects of hedge accounting by translating the principal payments, and US dollar revenue, into Canadian dollars using the exchange rates in effect when these payments were made and the revenue earned, respectively. The Minister also treated the foreign exchange gains on the taxpayer’s revenue on income account and the foreign exchange losses on the principal payments on capital account. These adjustments resulted in a net increase to the taxpayer’s income for each of the taxation years in question
Tax Court of Canada Decision
The two issues considered by the Tax Court of Canada were as follows: (1) whether the taxpayer was entitled to use hedge accounting for purposes of computing profits under Section 9 of the Act, and, in the alternative, (2) whether the foreign exchange losses realized on the principal payments on the notes were on income or capital account.
With respect to the first issue, the taxpayer argued that hedge accounting was appropriate for tax purposes since this approach was acceptable under generally accepted accounting principles and it accurately reflected revenue and income. In addition, the taxpayer submitted that when a hedge is put in place to eliminate foreign currency exposure on revenue, the revenue should be determined for tax purposes by taking the hedge into account. The Tax Court of Canada rejected the taxpayer’s position for three reasons. First, the Court was of the view that even though hedge accounting was permitted under generally accepted accounting principles, this method distorted revenue and was therefore not acceptable for tax purposes. Second, prior case law, including M.N.R. v. Tip Top Tailors Limited,4 did not support computing revenue or expenses denominated in a foreign currency using an exchange rate other than the rate in effect at the time when the revenue or expense was recognized for tax purposes. Lastly, the method of reporting revenue under hedge accounting effectively combined the results of two transactions into one, which was inconsistent with the principle that revenue and costs are to be determined only in accordance with the relevant sale or purchase contract.
With respect to the second issue, the Crown relied on Shell Canada and CCLI (1994) Inc. v. The Queen5 for the principle that a foreign exchange gain or loss realized on the repayment of debt generally takes its character from the character of the debt. In the case at hand, since the taxpayer had used the proceeds from the notes to finance the construction of a plant, a capital asset, it followed that the notes, and the foreign exchange losses realized by the taxpayer in connection with the principal payments on the notes, would be capital in nature. In contrast, the taxpayer relied on Shell Canada for the principle that the character of a foreign exchange gain or loss arising in connection with a hedging contract generally takes its character from the character of the item being hedged. The taxpayer argued that the currency of the notes was effectively a hedging instrument that was intended to protect the taxpayer against foreign currency losses on a portion of its US dollar revenue stream. Since revenue was on income account, the foreign exchange losses realized on the principal payments on the notes should likewise be on income account. The taxpayer acknowledged that the hedging principle had not been applied to foreign currency fluctuations on debt and referred the Court to Netupsky v. The Queen6 as additional support for characterizing the foreign exchange losses as being on income account. In Netupsky, the taxpayer, who speculated in commodities, borrowed money in Swiss francs, converted the loan proceeds into Canadian dollars and used those proceeds to refinance a loan on capital account. The Tax Court of Canada accepted that the foreign exchange losses realized in connection with the Swiss francs loan were on income account given that the currency of the loan was selected purely for speculation purposes.
To promote certainty, the Tax Court of Canada decided to apply the characterization principle advanced by the Crown, given that this principle had been followed in a long line of cases in Canada and the United Kingdom, the most recent being Gifford v. The Queen.7 The Court commented that Netupsky was difficult to reconcile with these decisions and concluded that it should not be followed. In obiter dicta, the Court noted that it was not satisfied that foreign currency risk was the only reason the taxpayer chose to issue the notes in US dollars, given that written recommendations from the taxpayer’s financial advisors also cited lower interest rates as an advantage of borrowing in that currency. This comment implies that the Court may have found in favour of the taxpayer if the notes had been denominated in US dollars solely to hedge currency fluctuations on US dollar revenue.
Federal Court of Appeal Decision
The taxpayer appealed to the Federal Court of Appeal regarding the issue of the character of the foreign exchange losses. The taxpayer recognized that the notes had both a financing purpose and a hedging purpose, and argued that the foreign currency losses on the principal payments on the notes were more closely linked to the loan’s hedging purpose because an important reason, albeit not the sole reason, for issuing the notes in US dollars was to hedge US dollar revenue. In response, the Crown relied on The Queen v. Canadian Pacific Limited8 for authority that the denomination of a debt in a foreign currency is not an independent transaction; since tax liability must be assessed by reference to transactions undertaken by a taxpayer, the character of the foreign exchange losses had to be assessed by reference to the notes themselves. Because the notes were on capital account, the foreign exchange losses on the principal payments on the notes were on capital account.
The Federal Court of Appeal dismissed the taxpayer’s appeal, refusing to apply the hedging principle relied on by the taxpayer to a situation where the hedging instrument had a separate and independent commercial purpose. In doing so, the Court did not depart from the long-standing principle that foreign exchange gains and losses on debt repayments take their character from the character of the debt. Here, the relevant transactions were the notes, as opposed to a derivative contract, and the fact that the notes were denominated in US dollars, in part for hedging purposes, did not alter the character of the notes as borrowed money used to finance a capital asset. The Court also held that Netupsky did not assist the taxpayer since that case did not involve a hedge, and by focusing on the denomination of the loan, the reasoning was inconsistent with Canadian Pacific.9
The Federal Court of Appeal decision in Saskferco is of general interest in that it represents confirmation by a senior court of the principle that the character of a foreign exchange gain or loss arising upon a repayment of debt as income or capital will generally follow the character of the debt. The Court clarified that this principle will apply even if the currency of the debt is chosen to hedge foreign exchange gains or losses on other items, given that a debt, by its very nature, has a separate and independent commercial purpose. Arguably, the decision in Saskferco does not impact the principle that the character of a foreign exchange gain or loss arising in connection with a hedging contract generally follows the character of the item to which the hedge relates, where the hedging contract in question is a derivative contract, such as a swap or forward contract.