2014-0546641I7 Foreign exchange on a debt arising on reduction of capital

Principal Issues: Whether 95(2)(i) applies to a debt arising as a result of the reduction of capital.

Position: There were conditions in clauses (A) and (B) that were not satisfied.

Reasons: Legislation.

Author: Belova, Julia
Section: 39(2); 95(2)(i); 95(2)(f); 95(2)(f.12)-(f.15); Reg. 5907; 20(1)(c)

                                                                  April 27, 2015

      Rosemary Shuttleworth                      Headquarters
      International Auditor                           Income Tax Rulings
      Montreal TSO                                     Directorate
                                                                 Julia Belova
                                                                 (416) 954 8531

                                                                 2014-054664

      Capital Decrease under Hungarian Law

We are writing in response to your initial request dated September 18, 2014 supported by the additional representations received on March 09, 2015, in which you asked for our views regarding the application of paragraph 95(2)(i) to the settlement of a U.S. dollar denominated debt owed to a Canadian taxpayer (“Canco” or “Taxpayer”) by its wholly-owned subsidiary (“FA”) resident in Hungary. The debt arose as a result of a reduction in the capital (“the Capital Decrease”) of the shares of the capital stock of the FA that was affected under Hungarian corporate law.

Unless otherwise stated, all references to a statute are to the Income Tax Act (Canada), R.S.C.  1985, c.1 (5th Supp.), as amended to the date of this letter (the “Act”) and every reference herein to a section, subsection, paragraph, subparagraph or clause is a reference to the relevant provisions of the Act.

Our understanding of the facts relevant to the situation you are considering is as follows:

1.    The Taxpayer obtained a Hungarian legal opinion that concluded that the Capital Decrease created an absolute and enforceable right for Canco, as the sole shareholder of the FA, to receive from the FA an amount equal to the Capital Decrease denominated in U.S. dollars as of the effective date of such decrease. Since no payment was made on the effective date, a U.S. dollar denominated liability (the “Liability”) was created in favour of Canco at the effective time of the Capital Decrease. While it was outstanding, the Liability receivable by Canco from the FA was transferrable to another party by Canco, irrespective of any transfer of the shares of the FA.

2.    The Liability was settled by several cash payments made within a few months after the effective date of the Capital Decrease. As a result of the fluctuation in the value of the U.S. dollar relative to the Canadian dollar (Canco’s reporting currency) between the effective date and the payment date of the Liability, Canco sustained a foreign exchange loss, which it claimed as a capital loss.

3.    The Taxpayer took the position that paragraph 95(2)(i) applied in respect of the Liability such that in combination with paragraph 95(2)(f.15) the FA could use the U.S. dollar, its calculating currency, to determine the capital gain on the settlement of the Liability. As a result, no foreign exchange gain was sustained by the FA on the payment of the Liability and no FAPI arose.

4.    The Taxpayer’s position is that, analogous to paragraph 20(1)(c), the indirect use test and the “filling the hole” principle should apply in the context of paragraph 95(2)(i). The Liability replaced the capital originally invested by Canco in the FA which had been used by the FA to make U.S. dollar denominated loans (the “US Loans”) to other foreign affiliates.   The interest income from the US Loans is re-characterized into active business income pursuant to paragraph 95(2)(a). Therefore, the Taxpayer’s view is that clause 95(2)(i)(i)(B) applies in respect of the settlement of the Liability.

5.    The US Loans constituted substantially (90% or more) all the assets of the FA.

Our Comments

We understand that you have not yet completed the audit procedures to confirm the validity of the Hungarian legal opinion and consequently the existence of the Liability and the corresponding foreign exchange loss of Canco. However, on the assumption that the opinion is valid we are prepared to provide the following comments.

If the Liability is in fact separate and distinct from the shares of the FA as was concluded in the opinion, the subsequent payment of the Liability would not be considered a transaction “in respect of shares of the capital stock” of the FA for purposes of subsection 39(2). As such, subject to the application of paragraph 95(2)(i), the FA could realize a foreign exchange gain on the settlement of the Liability and such gain would be deemed to be a capital gain from the disposition of currency other than Canadian currency.

If the Liability is a debt referred to in subparagraphs 95(2)(i)(i) or (ii), the amount of the capital gain of the FA in respect of the Liability is determined pursuant to paragraph 95(2)(f.15) by substituting the references in subsection 39(2) to “Canadian currency” with references to the FA’s “calculating currency”. The combined result of these provisions is that the FA would not have a foreign exchange gain on the settlement of the Liability which is denominated in US dollars, since it would use its calculating currency, the U.S. dollar, to determine the amount of the gain.

However, for the reasons described below, we are of the view that paragraph 95(2)(i) would not apply in respect of the settlement of the Liability. Pursuant to paragraph 95(2)(f.14) the FA would be required to determine a capital gain on the settlement of the Liability using Canadian currency and include it in the computation of the foreign accrual property income (“FAPI”) of the FA under element B of the formula in the definition of FAPI in subsection 95(1). The amount of the FAPI of the FA arising on the settlement of the Liability should correspond to the amount of the allowable capital loss sustained by Canco in respect of that same transaction. 

It is our view that the requirement in the preamble of 95(2)(i)(i) that there be “proceeds” from the Liability is not satisfied  because the FA did not receive anything (money or other property) on the Capital Decrease which gave rise to the Liability.   In addition, the requirement in clause 95(2)(i)(i)(A) is not satisfied because there was no property acquired by the FA as a consequence of the Capital Decrease. Finally, the condition in clause 95(2)(i)(i)(B) that the proceeds of the debt be used to earn income from an active business “carried on by the debtor” is not satisfied.  While the interest income earned by the FA is income that is deemed to be income from an active business of the FA by the provisions of paragraph 95(2)(a), those provisions do not deem the FA to carry on an active business. 

In sum, none of the provisions in paragraph 95(2)(i) apply to the settlement of the Liability.   Accordingly, the taxable capital gain on the settlement of the Liability must be computed in accordance with paragraph 95(2)(f.14) in Canadian currency and included in the computation of the FAPI of the FA.

Olli Laurikainen, CPA, CA
Section Manager
For Division Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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