2016-0649631I7 Functional currency - fx gain on refund

Principal Issues: Can fluctuations in exchange rate between Canadian dollars and a functional currency reporter's elected functional currency in respect of income taxes payable result in foreign exchange gains or losses?

Position: Yes.

Reasons: Canadian currency fluctuations relative to the reporter’s elected functional currency result in capital gains or losses in these situations.

Author: Johns, Jeffrey
Section: 39(1) and (2), 261(3), 261(11)

                                                                                                 July 31, 2018

Attention: Bonnie Jarrett                                                           HEADQUARTERS
Canada Revenue Agency                                                         Income Tax Rulings
International and Large Business Directorate                           Directorate
50 Queen Street N.                                                                   Jeffrey Johns
Kitchener ON  N2G 4N1                                                            (416) 954 4020

                                                                                                    2016-064963

Treatment of foreign exchange fluctuations in respect of taxes payable

You have asked for our views regarding the income tax treatment of foreign exchange fluctuations between Canadian currency and a taxpayer’s elected functional currency in respect of amounts of income tax that are paid by and later refunded back to the taxpayer.

The facts can be summarized as follows:

1.    Canco is a corporation resident in Canada for purposes of the Income Tax Act (the “Act”).  For its XXXXXXXXXX and subsequent taxation years, Canco elected under subsection 261(3) of the Act to report its Canadian tax results in its functional currency of XXXXXXXXXX.

2.    In XXXXXXXXXX, Canco filed an amended XXXXXXXXXX income tax return, resulting in a reduction to its taxable income, as determined in XXXXXXXXXX, for that year.

3.    As a result of the filing of the amended return, Canco’s Part I income tax payable for its XXXXXXXXXX taxation year was recomputed.  In accordance with subsection 261(11), Canco’s income tax payable in XXXXXXXXXX was converted to Canadian dollars (“CAD”) to determine Canco’s income taxes payable for the year. As a result of the re-computation, Canco’s taxes payable in XXXXXXXXXX as determined for XXXXXXXXXX was reduced by XXXXXXXXXX$XXXXXXXXXX which, using the exchange rate applicable to determine its taxes payable for its XXXXXXXXXX taxation year, resulted in a reduction of its taxes payable for that year of CAD$XXXXXXXXXX.

4.    On XXXXXXXXXX, Canco received the refund of its overpayment of income tax for its XXXXXXXXXX taxation year of CAD$XXXXXXXXXX.

On XXXXXXXXXX, the CAD/XXXXXXXXXX exchange rate was higher than in XXXXXXXXXX and on the date of the refund, CAD$XXXXXXXXXX was equal to XXXXXXXXXX$XXXXXXXXXX.  As a result of the difference, as expressed in XXXXXXXXXX, of the XXXXXXXXXX$XXXXXXXXXX reduction of its income taxes payable in XXXXXXXXXX and the amount, as expressed in XXXXXXXXXX, of the refund received, converted using the relevant spot rate for the day the refund was received, Canco booked a foreign exchange gain in its general ledger of XXXXXXXXXX$XXXXXXXXXX.

You have requested our views as to whether the shift in the CAD/XXXXXXXXXX exchange rate between the rate used to determine Canco’s XXXXXXXXXX income taxes payable and the rate existing at the time Canco’s refund was paid gives rise to a gain that will be relevant to the computation of Canco’s income under section 3 of the Act and, if so, whether the gain would be on income or capital account.

Existence of a gain

Paragraph 261(5)(a) provides that Canco is to compute its Canadian tax results in its elected functional currency.  Paragraph 261(5)(c) requires amounts denominated in a currency other than the taxpayer’s elected functional currency to be converted to that currency as of the day it arises.  Further, paragraph 261(5)(e) acts as a “read as” rule that changes the references to “Canadian currency” in subsection 39(2) to “the taxpayer’s functional currency”.  As a result of the application of these provisions, Canco determines foreign exchange gains and losses under the Act in relation to its elected functional currency.  This means that Canco may have a foreign exchange gain or loss in determining its Canadian tax results (as defined in subsection 261(1)) in respect of amounts that are denominated in CAD.

Subsection 261(11) requires that, “notwithstanding” the provisions of subsection 261(5), the income taxes of Canco must still be computed in CAD.  It provides the mechanism through which the Canco’s functional currency denominated income taxes payable for a given taxation year are converted to CAD.  In respect of income taxes payable under Part I of the Act for a particular taxation year, subsection 261(11) accomplishes this conversion by reference to Canco’s instalment dates as determined under subsection 157(1) and its “balance-due day” for the particular year.  As a result, as outlined in Document 2014-0540631I7, where a loss from a subsequent taxation year is carried back to a particular taxation year, the revised income taxes payable and any resulting refund are computed using the exchange rates applicable to that particular year, regardless of the exchange rate in the subsequent year.

Since Canco’s income taxes are payable and refunded in CAD, while its income is computed in XXXXXXXXXX for accounting and Canadian tax purposes, the resulting foreign exchange gain reflected for financial accounting purposes in respect of its XXXXXXXXXX refund is relevant to the determination of its income for Canadian tax purposes.

Inclusion of the gain under the Act

In our view, a functional currency reporter being required to compute and pay their income tax in a currency other than their tax reporting currency is similar to that of a Canadian-resident taxpayer that pays income tax in a currency other than CAD (or, where the taxpayer is a functional currency reporter, the taxpayer’s elected functional currency) to a foreign jurisdiction.  In this respect, CRA’s long-standing position is outlined in paragraphs 1.43 and 1.44 of Folio S5‑F2-C1 - Foreign Tax Credit:

“1.43 The rules in subsection 39(2) will apply to gains or losses arising from the currency conversion of the amounts of foreign income and the foreign taxes (just as in the case of a foreign exchange gain or loss on the payment of any other debt denominated in a foreign currency) due to a fluctuation in the exchange rates causing a difference between:

• the Canadian dollar equivalent of the amount of the foreign tax liability used for purposes of the foreign tax credit, as determined in accordance with ¶1.42 above; and

• the Canadian dollar equivalent of the amount (or amounts) paid in settlement of the foreign tax liability determined as of the date (or dates) of payment.

1.44 If the taxpayer has overpaid the tax, the overpayment is not allowable as a foreign tax credit (see ¶1.32–1.35). The overpayment should be converted to Canadian dollars under the rules discussed in ¶1.42, and any difference between this figure and the Canadian dollar value of a refund of the overpayment, computed as of the day of its receipt, will be a gain or loss on exchange to which the rules in subsections 39(1) to (2.1) will apply.”

These same principles are applicable to a functional currency reporter in respect of the reporter’s income taxes payable under the Act and gains or losses of a functional currency reporter on exchange in respect of its income taxes payable under the Act are gains or losses to which the rules in subsections 39(1) to (2.1) apply.

Consequently, the foreign exchange gain realized by Canco for financial accounting purposes in respect of the refund it received in XXXXXXXXXX will result in the realization of a capital gain under the Act for its XXXXXXXXXX taxation year.

We trust our comments will be of assistance.

Yours truly,

Yves Moreno
Manager
for Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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