2018-0750261C6 IFA 2018 - Question 7

Principal Issues: Whether a debtor has “sustained a loss” for the purposes of subsection 39(2) upon the undertaking by a related corporation.

Position: No.

Reasons: A foreign exchange gain or loss might be made or sustained by a debtor for purposes of subsection 39(2) where the assumption of its debt by the related corporation results in the discharge, rescission or extinguishment of all or any part of the debt, resulting in a corresponding foreign exchange gain or loss being realized or incurred by the creditor.

Author: Chang, Jack Yu-Fan
Section: 39(2)

IFA 2018 International Tax Conference
Canada Revenue Agency Roundtable

Question 7 – Undertaking to Repay and subsection 39(2)

Consider the following hypothetical facts:

*     Canco owns 100% of the common shares of Canco 1 which owns 100% of the common shares of Canco 2.

*     Canco, Canco 1 and Canco 2 do not deal at arm’s length and are related and affiliated corporations for purposes of the Income Tax Act (the “Act”).

*     In year 1, Canco 1 realized a capital gain.

*     In the same year, Canco advanced an amount to Canco 1 as a US dollar denominated loan (the “Loan”).

*     In year 2, as a result of the fluctuation in the value of the Canadian dollar relative to the US dollar, Canco has an unrealized foreign exchange gain in respect of the Loan and Canco 1 has a corresponding unrealized foreign exchange loss.

The following transactions will be undertaken in year 2:

*     Canco 2 will agree to repay the Loan on behalf of Canco 1 at maturity and as consideration for that undertaking, Canco 1 will issue a Canadian dollar denominated note (the “Canco 1 Note”) payable to Canco 2. The principal amount of the Canco 1 Note will equal the Canadian dollar equivalent of the US dollar principal amount of the Loan based on the exchange rate at the time of issuance of the Canco 1 Note. The fair market value of the Canco 1 Note at the time of issuance will be equal to its principal amount.

*     Canco 1 will retain its obligations under the Loan and there will be no change to the principal amount, interest rate or maturity date of the Loan.

*     Under the relevant provincial law, Canco 2’s undertaking to repay the Loan on behalf of Canco 1 will not result in:

o     a novation in respect of any portion of the Loan;
o     a substitution of all or any portion of the Loan by a new debt; or
o     a discharge, rescission or extinguishment of all or any portion of the Loan.

Will the undertaking by Canco 2 in year 2 to repay the Loan on behalf of Canco 1 result in Canco 1 sustaining a loss that subsection 39(2) of the Act will deem to be a capital loss from the disposition of currency other than Canadian currency that Canco 1 can carry-back to offset the capital gain that it realized in year 1? 

CRA Response

In MNR v. Consolidated Glass Co Ltd, (1956) 2 D.L.R. (2d) 529, the Supreme Court of Canada concluded that the meaning of “losses sustained” and “profits and gains made” must be interpreted in a manner that is consistent with the realization principle. In particular, the Supreme Court of Canada stated that, in this context, the word “loss” has the meaning of “absolute and irrevocable, finality.”

It is well established that foreign exchange gains or losses are recognized in respect of a debtor under subsection 39(2) on the repayment of debt and generally where there is a legal novation of a debt.

As a result, it is our view that a foreign exchange gain or loss in respect of a debt obligation would be considered to have been made or sustained by the debtor upon the settlement or extinguishment of the debt, which can occur on the repayment, legal novation or rescission and substitution of the debt and would result in the creditor realizing or incurring a corresponding foreign exchange gain or loss, as the case may be.

In the circumstances described in this question, the legal obligations of Canco 1 under the Loan will continue to remain outstanding such that the undertaking by Canco 2 to repay the Loan on behalf of Canco 1 will not result in a legal novation, a substitution of all or any portion of the Loan by a new debt, or a discharge, rescission or extinguishment of all or any portion of the Loan.  As a result, it is our view that the undertaking by Canco 2 to repay the Loan on behalf of Canco 1 will not result in Canco 1 sustaining a loss for purposes of subsection 39(2).

Jack Chang / Yves Moreno
2018-075026
May 16, 2018

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