2016-0633981E5 Retained Earnings and Functional Currency Election

Principal Issues: (1) Should the retained earnings balance of the taxpayer’s last Canadian currency year be translated to the taxpayer’s functional currency in the taxpayer’s first functional currency year? (2) Is there a loss or gain on the translation of any of the taxpayer's amounts on a functional currency election?

Position: (1) No. (2) No.

Reasons: (1) Subsection 261(7) does not apply to Canco’s retained earnings balance because it is not relevant in computing the taxpayer’s income. (2) There is no loss or gain on the conversion because the conversion is made using the relevant spot rate on the day of the conversion.

Author: Helmer, Shelley
Section: Subsections 261(1), 261(5), 261(7), section 9(1), paragraph 18(1)(a)

XXXXXXXXXX                                                                                                                   2016-063398
                                                                                                                                           Shelley Helmer LL.B.
March 2, 2017

Dear XXXXXXXXXX

Re: Conversion of Retained Earnings into Functional Currency

We are writing in response to your letter of February 26, 2016, wherein you inquired about whether a corporation realizes any immediate income tax consequences upon the corporation electing under section 261 of the Income Tax Act (the “Act”) to report its income tax in its functional currency.  Specifically, you have asked whether any income inclusion or deduction can result from a difference between the corporation’s historical functional currency-denominated retained earnings as computed in its financial statements and the corporation’s retained earnings as converted to the corporation’s functional currency in accordance with section 261. We also acknowledge our subsequent discussions (Helmer / XXXXXXXXXX, Young / XXXXXXXXXX and the additional submissions you provided on June 3, 2016. We apologize for the delay in responding.

You have provided us with the following information. Canco is a corporation resident in Canada that is owned by a non-resident corporation. Canco principally operates a XXXXXXXXXX business in the province of XXXXXXXXXX; however, its primary market is in the United States (“US”). Since inception, Canco has conducted its business in US dollars (“USD”) with the exception of its direct Canadian expenses that consist primarily of salaries, wages and rent. Canco’s 2014 financial statements were reported in USD for its parent company’s consolidated financial statements.  Within 61 days of the start of its 2015 taxation year, Canco made a qualifying functional currency election. Canco elected to report its income in USD pursuant to paragraph 261(3)(b) of the Act.

Pursuant to subsection 261(7), Canco converted its retained earnings (“R/E”) and other amounts using the rate quoted by the Bank of Canada for noon on December 31, 2014, (the “relevant spot rate” as defined in subsection 261(1)) to report its opening balances for Canadian income tax purposes. The resulting R/E balance (in USD) differed from Canco's R/E balance in its USD financial statements. You have stated that, for tax and financial statement purposes, Canco intends to report that it incurred a one-time foreign currency loss in 2015 of approximately USD XXXXXXXXXX.

Issues

Specifically, you have asked us the following questions:

*     Where a corporation that computes its financial statements in a certain currency elects to report its income for Canadian income tax purposes in that currency, does section 261 provide for an adjustment to income (i.e., an inclusion in or deduction from income) to align the translated amounts with the amounts recorded in its historical financial statements denominated in its elected functional currency? In particular, if its R/E for Canadian income tax purposes are less than its R/E for financial statement purposes, can the taxpayer deduct the difference to recognize the “loss”?

*     Does subsection 261(7) of the Act apply to require the translation of R/E of a corporation to its elected functional currency using the relevant spot rate?

Your Views

You submit that Canco is entitled to a deduction in computing income for Part I purposes as the result of translating its year-end R/E from Canadian dollars (“CAD”) to USD. You refer to the International Financial Reporting Standards (“IFRS”) and note the requirement to record any currency gain or loss on Canco’s financial statements. You submit that such gains or losses should also be reported for tax purposes and suggest subsection 9(1) and section 261 of the Act should be the provisions that determine the taxpayer’s profit from its business with respect to functional currency adjustments. Further, you submit that the “legislation includes provisions to deal with a taxpayer’s eligibility for the election and multiple anti-avoidance provisions to ensure it was not abused by taxpayers for such items as asset transfers intended to change functional currency or loss denial rules for transactions between related corporations with different tax currency reporting obligations”.

Our Comments

This technical interpretation provides general comments about the provisions of the Act, where referenced. It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R7, Advance Income Tax Rulings and Technical Interpretations.

At the outset, and as discussed below under the heading “Converting the R/E Balance”, we note that it is our view that R/E is not to be translated under the functional currency rules in computing a taxpayer’s Canadian tax results.

Income Tax Reporting Currency

Subsection 261(2) of the Act provides that, subject to a corporation making a functional currency election under subsection 261(3), each taxpayer is required to determine their “Canadian tax results” using CAD.  Canadian tax results are defined in subsection 261(1) as, generally speaking, the taxpayer’s income or income tax, as well as any amount related to those determinations.  Subsection 261(2) further provides that amounts relevant to a taxpayer’s Canadian tax results that are denominated in a currency other than CAD are to be converted to CAD using the relevant spot rate on the day the amount arose.

As a result, all amounts relevant to a CAD reporting taxpayer’s income and income tax under the Act must be determined and maintained in CAD.  As you state, the financial statements for financial reporting purposes of some corporations with CAD reporting currency may be computed in another currency.  For practical purposes, these statements would be considered by the corporation in order to determine the CAD amounts necessary to compute its income and income tax under the Act.  However, the non-CAD amounts in the corporation’s financial statements do not themselves constitute the corporation’s Canadian tax results. As well, reconciliations or translations to CAD of non-CAD financial statement amounts do not in and of themselves create a foreign exchange gain or loss under the Act.

Conversion to Reporting in Corporation’s Elected Functional Currency

The functional currency rules in section 261 allow a corporation to begin income tax reporting in its elected functional currency as of the first day of its first functional currency year.  Up until the date of conversion, all income, income tax and foreign exchange gains or losses are based on CAD.

Subsection 261(7) of the Act provides the mechanism by which amounts determined in an electing corporation’s previous CAD-reporting taxation years amounts (other than in respect of debts issued) (“CAD Year Amounts”) are translated into the corporation’s elected functional currency for its functional currency reporting years.  Subsection 261(7) provides that CAD Year Amounts are translated using the relevant spot rate on the corporation’s last day of its last CAD tax reporting year – i.e., the item’s value in the elected functional currency on the day before the corporation actually transitions.  Debts issued in CAD-reporting taxation years (“CAD Year Debts”) are dealt with in subsections 261(8) to (10).  These rules provide that, for foreign exchange gain or loss purposes, the debt is deemed to be issued on the first day of the corporation’s first functional currency year. As can be seen, while an electing corporation may have been calculating its financial statements in its elected functional currency, section 261 does not refer or rely on these amounts in converting CAD Year Amounts or amounts related to CAD Year Debts to the corporation’s elected functional currency.

As well, there is nothing in section 261 to provide for any adjustment to amounts to reconcile them with what the amounts would have been had the corporation always reported its income under the Act in its elected functional currency. Instead, conversions are made as of the time the conversion takes place using the relevant spot rate at that time.  As such, no immediate income consequences result. For example, if the conversion rate is CAD 1 = USD 0.80, then a balance of CAD 1,000 would be converted to USD 800. The amounts are equal; therefore, there is no gain or loss.

It is important for corporations in this situation to understand that the mechanism used by section 261 to convert amounts will in most cases result in ongoing differences between an electing corporation’s historical functional currency financial statement amounts and its historical functional currency amounts relevant for computing its income under the Act, notwithstanding that both are computed in the same currency. The existence of such a difference does not mean that the taxpayer has incurred a loss or realized a gain.

Converting the R/E Balance

As noted above, pursuant to subsection 261(7) of the Act, in applying the Act to a taxpayer for a particular functional currency year, the taxpayer is required to convert certain amounts from CAD into the taxpayer’s elected functional currency using the “relevant spot rate” for the last day of the taxpayer’s last Canadian currency year. In our view, paragraphs 261(7)(a) to 261(7)(g) are clearly not applicable to R/E. However, paragraph 261(7)(h) states: 

“any amount (other than an amount referred to in any of paragraphs (a) – (g) or any of subsections (6), (6.1) and (8)) determined under the provisions of the Act in or in respect of a Canadian currency year of the taxpayer that is relevant in determining the Canadian tax results of the taxpayer for the particular functional currency year.” 

As noted above, it is our view that R/E is not required to be translated under the functional currency rules in computing a taxpayer’s Canadian tax results. This is because R/E is an accounting concept and when provisions in the Act require the use of R/E, it is the R/E taken from the taxpayer’s financial statements or accounting records, as appropriate, at the particular point in time. For example, for determining a taxpayer’s limitation on the deduction of interest for thin capitalization purposes, in the definition of “equity amount” in subsection 18(5), the R/E “of the corporation at the beginning of the year” shall be used.  As a functional currency reporter, Canco’s R/E will be calculated in its functional currency. Therefore, the R/E used would be the opening R/E taken from the corporation’s USD financial statements used for financial reporting. As such it is our view that R/E in Canco’s last Canadian currency year is not relevant in determining the Canadian tax results for its first elected functional currency taxation year and, consequently, is not to be translated pursuant to paragraph 261(7)(h) nor any other provision of subsection 261(7).

Conclusion

In conclusion, in our view, the translation of CAD amounts to the taxpayer’s elected functional currency as of the end of the last Canadian currency year does not change the recorded value of the taxpayer’s property or any of its balances at that time. The election merely ensures that when the balances are utilized in computing income in the first or subsequent functional currency years, they will be in the elected functional currency. In other words, the election effectively eliminates from the effective date of the election going forward any uncertainty that would be caused by determining its Canadian tax results in CAD when the taxpayer has an elected functional currency.

As a final note, we are of the view that not recognizing any gain or loss on the making of a functional currency election is consistent with our understanding of the tax policy underlying section 261. In particular, it is our understanding that the functional currency election was only intended to apply prospectively from the effective date of the election.

We trust these comments are of assistance.

Yours truly,

Terry Young, CPA, CA
Manager, International Section I
For Director
International Division
Income Tax Rulings Directorate

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