2019-0798811C6 2019 IFA CRA Roundtable Q#5 - Functional currency

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 to which the rules in section 39 of the Act would apply?

Position: Yes.

Reasons: Canadian currency fluctuations relative to the reporter’s elected functional currency result in capital gains or losses to which the rules in section 39 of the Act would apply in these situations.

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

2019 International Fiscal Association Conference
CRA Roundtable

Question 5 - Foreign Exchange and Tax Refunds

Consider the following hypothetical facts:

1. Canco is a corporation resident in Canada for purposes of the Income Tax Act (the “Act”).  For its 2010 and subsequent taxation years, Canco elects under subsection 261(3) of the Act to report its Canadian tax results in its functional currency of US dollars (“USD”).

2.    In 2015, Canco files an amended income tax return in respect of its 2012 taxation year, resulting in a reduction to its taxable income determined in USD for that year.

3.    Consequently, the amount of Canco’s Part I income tax payable for its 2012 taxation year is reduced.  In accordance with subsection 261(11) of the Act, Canco’s income tax payable, as initially determined in USD, must be converted to Canadian dollars (“CAD”) to determine Canco’s income taxes payable for its 2012 taxation year.  As the amount of income tax payable by Canco under the amended return is lower than the amount of income tax actually paid by Canco, the amended return results in an overpayment of income taxes for Canco’s 2012 taxation year.

4.    On October 1, 2015, the amount of income tax overpaid is refunded to Canco.  The amount of the overpayment, if it were converted to USD using the exchange rate as of the date of the refund, is greater than the USD amount that would be determined by converting the overpayment to USD using the exchange rate(s) that were initially used in determining Canco’s income tax payable for its 2012 taxation year.

Does the fluctuation between the exchange rates initially used to determine Canco’s 2012 income taxes payable and the exchange rate at the time of Canco’s refund give rise to a gain that will be included in Canco’s income under the Act?

CRA Response

In general terms, subsection 261(2) of the Act requires that, subject to a taxpayer making a functional currency election, all taxpayers must use Canadian currency to determine their “Canadian tax results” under the Act.  The term “Canadian tax results” is defined in subsection 261(1) of the Act and includes a taxpayer’s income, taxable income, taxes payable and refundable, as well as any amount relevant to the determination of any of those amounts.  Subsection 261(2) of the Act also requires taxpayers to convert any amount determined in a foreign currency that is relevant to their Canadian tax results to Canadian currency as using the relevant spot rate for the day the amount arose.  Accordingly, where a taxpayer undertakes a transaction in a currency other than CAD, the gain or loss resulting from the fluctuation of the value of that currency relative to CAD will generally be relevant to the determination of the taxpayer’s income under the Act in respect of the transaction.

Conversely, paragraph 261(5)(a) of the Act requires that a functional currency reporter determine its Canadian tax results in its elected functional currency.  Making an election under subsection 261(3) of the Act allows a functional currency reporter to align its base currency for income tax purposes with its functional currency for financial reporting purposes.  The result of the election is that a functional currency reporter will no longer have foreign exchange gains or losses in respect of amounts relevant to the reporter’s Canadian tax results that are denominated in its elected functional currency.  However, another effect of the election is that, as of the beginning of the taxation year in which the election takes effect, the reporter will generally have foreign exchange gains or losses in respect of amounts relevant to the reporter’s Canadian tax results that are denominated in CAD.

Although subsection 261(5) of the Act provides that a functional currency reporter’s Canadian tax results are determined in the reporter’s elected functional currency, subsection 261(11) of the Act provides an exception to this rule by requiring that the reporter’s income taxes payable for each year be determined in CAD.  Subsection 261(11) of the Act provides the rules through which a reporter’s income taxes, which are generally first determined in its elected functional currency as a percentage of the reporter’s functional-currency-denominated taxable income, are converted to CAD.  However, notwithstanding that a functional currency reporter’s income taxes payable are computed in CAD, if a functional currency reporter’s income taxes payable inform the determination of any other aspect of the reporter’s Canadian tax results (in particular its income or taxable income), the amount of income taxes payable has to be converted back to the reporter’s elected functional currency for such determination.

Where a Canadian-resident taxpayer that is not a functional currency reporter pays income tax to a foreign jurisdiction and makes an overpayment of income tax to the foreign jurisdiction, the amount of the overpayment as converted to CAD using the exchange rate at the time of the refund will typically be different than the amount of the overpayment converted to CAD using the exchange rate for the year the taxes were originally payable.  The income tax treatment applicable to such a situation is discussed in paragraph 1.44 of Folio S5‑F2-C1 - Foreign Tax Credit, which states, in part:

“If the taxpayer has overpaid the tax, the overpayment is not allowable as a foreign tax credit …. The overpayment should be converted to Canadian dollars under the rules discussed in ¶1.42 (i.e. the conversion rate used to convert the amount of taxes originally paid), 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.”

In our view, a functional currency reporter’s foreign exchange risk in respect of an overpayment of its Canadian income taxes is comparable to a Canadian resident’s foreign exchange risk in respect of an overpayment of income taxes paid to a foreign jurisdiction.  As with a taxpayer paying foreign income tax, the fluctuation in the value of CAD relative to the reporter’s elected functional currency in respect of the CAD-denominated refund of income taxes that were overpaid is relevant to the determination of the functional currency reporter’s income.  Accordingly, the difference between the amount of an overpayment by a functional currency reporter of Canadian income taxes as converted to CAD using the rules in subsection 261(11) of the Act for the relevant taxation year, and the amount of that overpayment as converted to CAD at the time of refund, will be a gain or loss on exchange to which the rules in section 39 of the Act will apply.

In the hypothetical example, Canco has elected to report its income in USD.  Therefore, subsection 261(5) of the Act requires amounts relevant to Canco’s Canadian tax results, including amounts determined in CAD, to be converted to USD.  For the reasons described above, in this example Canco’s CAD-determined Part I income taxes are relevant to the determination of its income and so must be converted to USD.  More specifically, the difference between the amount of Canco’s overpayment refund, as converted to USD on the date of the refund, and the amount of the overpayment refund, as converted to USD using the exchange rates initially used in determining Canco’s 2012 income taxes payable, would result in Canco realizing a capital gain under section 39 of the Act for its 2015 taxation year.

Jeffrey Johns
2019-079881
May 15, 2019

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