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: Whether ss. 39(2.1) can apply on the repayment of a pre-transition debt owing by a taxpayer to a foreign affiliate that is deemed, under ss. 261(10), to result in a gain or loss of the taxpayer in the year of repayment.
Position: Yes, provided that the foreign affiliate and the taxpayer have the same year end.
Reasons: A deemed gain or loss on capital account under ss. 261(10) is considered to be a capital gain or loss for the purposes of ss. 39(2) and such gain or loss is eligible for ss. 39(2.1) relief where its other conditions are met.
Author: Grondin, Yves
2015 International Fiscal Association Conference
Question 8 – Subsection 39(2.1) and Functional Currency Tax Reporting
Subsection 39(2.1) of the Act applies to reduce a capital gain or capital loss, as determined under subsection 39(2), where a corporation resident in Canada (the “borrowing party”), has received a loan from its foreign affiliate prior to August 20, 2011, a partial or full repayment of the loan is made prior to August 20, 2016, and the borrowing party’s capital gain or loss matches the affiliate’s capital loss or gain, as the case may be.
Assume that: (i) the borrowing party and its foreign affiliate are calendar year taxpayers; (ii) the borrowing party makes a functional currency election starting in 2014; (iii) the U.S. dollar is both the elected functional currency and the currency of the loan; (iv) the loan is on account of capital; and (v) the loan is repaid in 2015. In these circumstances, subsection 261(10) applies to deem the borrowing party to make a gain or sustain a loss, as the case may be, in 2015 relating to the loan’s foreign currency fluctuations, vis-à-vis the Canadian dollar, that occurred in the time preceding the borrowing party’s transition to the functional currency tax reporting regime.
Given that the matching condition for the application of subsection 39(2.1) requires that the borrowing party’s capital gain or loss be determined under subsection 39(2), will subsection 39(2) apply to a gain that is “made” (by virtue of paragraph 261(10)(a)) or a loss that is “sustained” (by virtue of paragraph 261(10)(b)) in respect of the repayment of the loan?
Subsection 261(10) of the Act can apply if a taxpayer has made a payment, during a functional currency year of the taxpayer, on account of the principal amount of a debt incurred at a time before it was a functional currency taxpayer (referred to as a “pre-transition debt”) where the debt is denominated in a currency other than the Canadian dollar. If the debt is on account of capital, the taxpayer is deemed to “make” a gain or to “sustain” a loss, as the case may be, for that taxation year. The amount of the deemed gain or loss is determined by taking the amount of what the taxpayer’s gain or loss attributable to a fluctuation of a currency would have been had it settled (an equivalent proportional amount of) the pre-transition debt by paying it on the last day of its last Canadian currency year, and then converting that gain or loss into the taxpayer’s elected functional currency as of that last day.
If the debt is an upstream loan which was issued prior to August 20, 2011 and repaid prior to August 20, 2016, it could benefit from the transitional relief provided under subsection 39(2.1) of the Act, if certain conditions are met. One of these conditions is that the amount of the debtor’s capital gain or loss determined under subsection 39(2) must equal the amount of the foreign affiliate’s capital loss or gain, as the case may be.
It is our view that a gain that is deemed to be “made”, or a loss that is deemed to be “sustained”, under subsection 261(10) is a gain or loss that is contemplated by subsection 39(2) such that it would, in turn, be deemed to be a capital gain or a capital loss from the disposition of currency. We believe this position is consistent with the purpose and the policy underlying subsection 261(10), which is to ensure that any foreign exchange gains or losses on pre-transition debts which accrue up until the time of conversion to the functional currency regime are recognized and appropriately included in determining the functional currency reporter’s income. We also find textual support for this position in the choice by Parliament to use the terms “make a gain” and “sustain a loss” in subsection 261(10) which, in our view, suggests that the provision is meant to tie in with subsection 39(2).
Thus, in situations such as the one noted above, it should be possible for subsection 39(2.1) to apply, assuming its other conditions are met, given that the foreign affiliate’s gain or loss determined without reference to paragraph 95(2)(g.04) of the Act, by virtue of the interaction between subsections 261(6.1) and 261(10), should generally match the taxpayer’s loss or gain amounts, as the case may be. However, in situations where a taxpayer and its foreign affiliate do not have the same year end, and as a result do not convert to the functional currency regime on the same day, the matching requirement would not generally be expected to be met, and subsection 39(2.1) would not apply.
May 28, 2015
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