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Foreign currency considerations in tax law and policy.

I INTRODUCTION

II NORMATIVE LENS OF ECONOMIC EFFICIENCY

III ANALYTICAL FRAMEWORK & THE ECONOMICS OF FOREIGN
CURRENCY EXCHANGE
 Two-Step Analytical Framework
 The Economics of Future Currency Exchange Rates
 Discount Bonds: An Analogy
 Summary of the Economics of Foreign Exchange Gains and Losses

IV THE CURRENT STATE OF CANADIAN TAX LAW
 Purchase of Inventory in Foreign Currency
 Disposition of Capital Valued in Foreign Currency
 Foreign Currency Debt Redemption
 Treatment of Futures Contracts and Hedging
 Subsection 39(2): The Residual Treatment of Foreign Currency Gains
 or Losses

V ECONOMIC ANALYSIS OF INCENTIVES CREATED BY THE CURRENT
LEGAL REGIME
 Purchase of Inventory in Foreign Currency
 Disposition of Capital Valued in Foreign Currency
 Foreign Currency Debt Redemption
 Treatment of Futures Contracts and Hedging

VI PROPOSED POLICY FRAMEWORK


Abstract

This article examines the Canadian tax jurisprudence and statutory regime relating to foreign currency transactions and critically analyzes the systematic incentives created by the law through the normative framework of economic neutrality. Canadian tax law has approached the treatment of foreign currency transactions on an inconsistent and piecemeal basis. Historically, the courts have applied general rules such as the surrogatum principle or the test in Gaynor v. Minister of National Revenue without a principled justification for their use. The legislature has responded to discrete issues as they arise, failing to adopt a general statutory framework dealing with the issue as a whole.

By focusing on the economic substance of foreign currency movements as explained by the interest rate parity relationship, this article attempts to articulate a tax policy framework that is internally coherent, consistent with the general scheme of the Income Tax Act, and minimally distortionary. First, the author argues that a currency-related gain or loss must be analyzed separate and apart from its underlying transaction. Second, foreign currency gains or losses must be analyzed in terms of two distinct types of gains or losses. The first relates to an expected gain or loss that can be described by the current interest rate environment and the interest rate parity. The second is an unexpected gain or loss that is explained by changes which occur subsequent to the entering into of a transaction. Finally, the author argues that expected gains or losses should be fully taxable as income or deductible as losses and that unexpected gains or losses should be treated on capital account.

Resume

Cet article examine la jurisprudence fiscale canadienne et le regime statutaire lie aux operations en monnaies etrangeres et fait une analyse critique de l'incitative systematique creee par la loi en utilisant le cadre normatif de la neutralite economique. Le droit fiscal canadien a aborde la question du traitement d'operations en monnaies etrangeres d'une maniere fragmentaire et incoherente. Au niveau historique, les tribunaux ont applique des regles generales, comme le principe <<surrogatum >> ou le test propose dans Gaynor v. le Ministre du Revenu national sans justifier leur raisonnement. La legislature a repondu aux questions concretes lorsque qu'elles se sont presentees, mais n'a pas adopte une reponse legislative generale pour completement resoudre le probleme.

En se concentrant sur la realite economique des mouvements en monnaies etrangeres, expliquee par le partenariat de parite des taux d'interet, cet article essaye d'articuler une politique fiscale qui est coherente, uniforme au plan general de la Loi de l'impot sur le revenu, et qui cause le moins de distorsions possible. Premierement, l'auteur avance qu'une perte ou un profit lie a l'unite monetaire doit etre analyse separement de sa transaction sous-jacente. Deuxiemement, les pertes ou les gains lies a l'unite monetaire doivent etre analyses avec deux types de pertes ou de gains distincts. Le premier est lie a une perte ou a un gain prevu qui peut etre decrit selon l'environnement actuel des taux d'interet et la parite des taux d'interet. Le deuxieme est une perte ou un gain imprevu qui s'explique par les changements surgissant a meme la transaction. Finalement, l'auteur avance que les pertes et les gains prevus devraient etre completement declares comme revenu ou deduits comme perte, et que les pertes et les gains imprevus devraient etre traites comme un compte capital.

I INTRODUCTION

As the Canadian corporate taxpayer competes in a global marketplace, all facets of corporate strategy and planning must take account of international considerations. International trade and finance provide significant opportunities to Canadian business while at the same time introducing risk associated with the fluctuating value of foreign currencies relative to the Canadian dollar. This exposure to foreign currency risk has significant tax implications that may bias corporate decision-making and lead to market inefficiencies and significant deadweight losses. The premise of this article is that a gain or loss that is realized as a result of a foreign currency exchange transaction can be analyzed in terms of two separate and distinct types of gain or loss. The first is an expected gain or loss representing the accrual of interest that is implicit in the relative value of a currency and is explained by the interest rate parity theorem. The second is an unexpected gain or loss relating to changes that occur after entering into the transaction and which qualitatively affect the value of the currency purchased or sold. The objective of this article is to articulate a policy framework for the treatment of foreign currency transactions that is internally coherent, consistent with the general scheme of the Income Tax Act, (1) and minimally distortionary--that is, neutral--from an economic efficiency standpoint. Largue that the ITA should be amended so that expected gains or losses from foreign currency transactions are fully taxable on an income basis while unexpected gains or losses should be treated on account of capital.

This article is organized into rive parts. It begins with an outline of the normative economic lens through which the current law is critically examined. The most important economic criterion around which the analysis will be organized is neutrality. The current Canadian foreign currency tax law regime is assessed on the basis of how it affects the business and economic factors that otherwise motivate corporate decision-making. A failure to ensure tax neutrality in this context encourages tax-motivated planning that may be economically inefficient and affect a taxpayer's decision to enter foreign capital markets.

The second part of the article establishes the analytical framework with which different types of foreign currency problems are examined. I argue that each transaction should be subject to a bifurcated analysis separating the foreign currency component from the underlying transaction. A two-step analysis makes explicit the treatment of the foreign currency aspect of a transaction and avoids misapplication of one mode of analysis to different types of factual circumstances. I also briefly summarize the economics of foreign currency valuation with a particular emphasis on the interest rate parity theorem. This is followed by an analogy drawn between foreign currencies and discount bonds to assist in clarifying the distinction between the expected interest income and unexpected capital components of a single foreign currency transaction.

The third part of the article is a summary of the current state of Canadian tax law with respect to the treatment of foreign currency transactions. By reviewing the characterization of foreign currencies in Canadian tax jurisprudence, I consider whether there are any general principles that may serve to guide the analysis. First, I consider the treatment of international contracts for purchase and sale, as they relate to both inventory and capital property. Second, I summarize the approach of Canadian courts with respect to the redemption of foreign currency debt obligations. This particular area of tax law has recently resulted in significantly divided opinions among the members of the Supreme Court of Canada, as shown in Imperial Oil Ltd. v. Canada. (2) Finally, I will consider the treatment of derivative-based transactions used by taxpayers to hedge foreign currency exposure and exploit asymmetries between the economic substance and the tax treatment of cross-border transactions. (3)

The fourth part of the article explores the incentives created by the current Canadian regime for taxpayers to engage in tax-motivated foreign currency planning. The objective is to systematically uncover the structures that drive a wedge between the economic substance of a transaction and its tax treatment. The main concern is the possibility of tax-deferral through the structuring of transactions with a view to manipulating timing and the characterization of gains (with a preference for gains on account of capital) and losses (with a preference for losses on income account). (4)

The final part of the article is an attempt to articulate an economically efficient policy framework for the Canadian tax treatment of foreign currency transactions. The two key areas that will be analyzed are the treatment of the foreign currency aspect of a transaction as separate and apart from its underlying subject, and the characterization of foreign currency and hedging gains or losses as being on account of capital or income. Keeping in mind the goal of economic neutrality, the policy framework emphasizes the need for a principled approach to the analysis of foreign currency transactions.

II NORMATIVE LENS OF ECONOMIC EFFICIENCY

Tax law can be examined within a wide range of analytical frameworks. At a high level of generalization, the analysis of tax law can be either normative or descriptive. A normative study of tax law may centre around the frequently invoked policy objectives of equity, simplicity, economic stabilization, international competitiveness, or specific social objectives such as the promotion of retirement saving and home ownership. (5) Normative analyses rest on the idea that tax laws should be structured in certain ways and not in others. This article focuses on the economic normative criterion of neutrality. Therefore, the analysis proceeds on the basic economic assumption that individuals are rational actors that weigh the costs and benefits of any given activity, and that, because an individual is the best judge of his or her own subjective interests, the allocation of resources between individuals in a society ought to be left to the workings of free market forces and ought not be affected by tax laws.

In the context of international trade transactions, this means that the taxation of foreign currency gains or losses must minimally distort a taxpayer's normal business decision-making process, when he or she considers whether or not to purchase inventory or sell goods in currencies other than the Canadian dollar. With respect to international finance, tax law should not distort the capital structuring decisions of corporations when deciding whether or not to issue debt securities in foreign capital markets. It is important to note that Canadian tax law currently provides incentives for businesses to use debt financing in the form of interest deductibility. (6) Therefore, the capital structure mix of debt and equity is already affected by some tax considerations. (7) Nevertheless, I proceed on the basis that, ceteris paribus, the taxation of foreign-currency-denominated debt should not provide further incentives or disincentives that may otherwise affect the capital structure decisions of taxpayers as they now stand. The taxation of foreign-currency-denominated debt instruments also raises two other subsidiary issues concerning macroeconomic policy. First, the tax treatment of foreign debt influences the efficacy of Canada's domestic capital markets. Favourable treatment of currency

fluctuations as they relate to foreign-denominated debt may drive Canadian business to seek financing in other markets, thus leaving Canadian capital markets thinner and less liquid than they otherwise would be. Second, the participation of taxpayers in foreign currency markets, if motivated by tax incentives, may create abnormal volatility in the valuation of other countries' currencies, resulting in undue uncertainty in international financial markets and perhaps creating political tensions. By focusing on the normative goal of neutrality, I assume that the decision of taxpayers to participate in foreign markets is motivated by non-tax considerations such as liquidity, size and depth of the market, and the cost of market entry. In addition, concerns over the erosion of Canadian capital markets and foreign currency market volatility should be subject to a separate and discrete policy analysis that may be layered on top of foreign currency transaction taxation. Finally, I also consider whether the current tax treatment of derivative contracts affects the financial planning of taxpayers as it relates to risk management through hedging arrangements. A tax-neutral policy, with respect to futures and other derivative contracts, avoids providing incentives for taxpayers either to mitigate risk to a greater extent than they otherwise would, or to defer taxation of income through the use of hedging strategies that result in current realization of losses and deferral of gains.

Neutrality requires that tax law not distort people's behaviour. The underlying assumption of this norm is that free market allocation of goods and services will yield the most efficient outcome. Therefore, the remainder of this article will attempt to clarify the economic substance of foreign currency transactions. When the effect of tax law on particular transactions, whether deliberate or unintended, is inconsistent with the underlying economic effect of those transactions, the law ceases to be neutral. It is only once the economic substance of the foreign currency element of a transaction is analyzed and understood that an appropriate tax policy may be formulated to provide harmony between legal and economic consequences.

III ANALYTICAL FRAMEWORK &THE ECONOMICS OF FOREIGN CURRENCY EXCHANGE

Two-Step Analytical Framework,

The first question that must be addressed when examining the economic substance of foreign currency transactions is whether the foreign exchange component should be analyzed separately from the transaction to which it relates. Earlier decisions, such as Minister of National Revenue v. Tip Top Tailors Ltd., (8) show the tendency of courts to conflate the two and treat them as a single transaction. The courts make this move as part of applying the surrogatum principle in their reasoning. (9) However, as LeBel J.'s discussion of the issue in Imperial Oil indicates, this has only proved to cloud the underlying assumptions and basis of the analysis, making the precedents difficult to apply to different fact situations. It is this reasoning which led to the mistaken interpretation of Gaynor v. Minister of National Revenue (10) as standing for the proposition that each element in all equations outlined in the ITA must be converted to Canadian dollars at the exchange rate prevailing at the relevant time of the transaction.

It may be argued, in the final analysis, that the appropriate approach is to follow the surrogatum principle and that the foreign currency element of a transaction should take on the characterization of its underlying transaction. On the other hand, it may be argued that the variables that drive foreign currency valuation demand currency conversions be treated as separate and distinct from their connected transactions. In either case, it is preferable to proceed with a two-step analysis by first considering the gain on both elements separately and then assessing the appropriateness of either approach. In this way we can recognize the distinct components of the transaction and make the analytical steps clear and unambiguous in order to avoid the confusion that arises with the reasoning in cases such as Gaynor. I next consider the nature of foreign currencies and the economic variables that explain their valuation relative to other currencies.

The Economics of Future Currency Exchange Rates

Currencies can generally be divided into two broad categories: fixed and floating. The value of a fixed exchange rate currency is pegged to another reference value by its government. (11) These reference values may be another country's currency, a basket of foreign currencies, or other standards such as precious metals. Floating exchange rate currencies are freely tradable in foreign exchange markets and are subject to market forces like any other tradable property right. In the current business environment, a Canadian taxpayer will almost exclusively deal in floating rate currencies as the vast majority of countries have floating currencies. This may not have been the case several years ago when China's renminbi was pegged to the US dollar; recent Chinese government economic policies, however, have seen the Chinese currency transform from a fixed rate currency to a floating one. (12) It is these floating rate market fluctuations in exchange rates that result in exchange rate gains and losses for Canadian taxpayers. In order to determine how to treat these market rate fluctuations, it is necessary to explain what accounts for such rate movements.

There are three important features of foreign currency markets that drive currency exchange movements. First, it must be noted that the value of a foreign currency does not fluctuate in absolute terms; that is, it does not make sense to speak of the pound sterling as appreciating or depreciating unless it is in reference to another currency. Foreign currencies are therefore relational--they change in value relative to other currencies. Second, the relative values of currencies are determined by a variety of factors. Arguably, the most important factors are the market forces of supply and demand that are largely driven by international trade requirements. Therefore, exchange rates reflect the trade balance of imports and exports as between different countries. When there is a trade surplus (positive net exports), there will be a greater demand for domestic currency and therefore an appreciation in the relative value of the domestic currency; the opposite is true of trade deficits (negative net exports). The relative inflationary pressures of different countries may also help explain differences in exchange rates. Geo-political risk as well as market speculation may also contribute to exchange rate volatility. Several other factors may contribute to exchange rate volatility; this is not an exhaustive account. Third, all of the factors that affect the change in relative value of a foreign currency to a domestic one can be represented by interest rates. This is because foreign currencies can, like bonds, be priced on yields. Holding a currency provides a minimum expected return based on the risk-free interest rate of that particular currency. In other words, "la] foreign currency can be regarded as an investment asset paying a known dividend yield. The 'dividend yield' is the risk-free rate of interest in the foreign currency." (13) The future changes in the relative value between two currencies can therefore be explained by the differences between their respective interest rates. This is reflected by the "interest rate parity relationship from international finance" (14)

[F.sub.0] = [S.sub.0][e.sup.(r-rf)T]

where "[F.sub.0]" represents the future price of the foreign currency in dollars, "[S.sub.0]" represents the current spot price of the foreign currency in dollars, "r" represents the domestic risk free interest rate, "[r.sub.f]" represents the foreign risk free interest rate, "e" is the logarithmic exponential function representing continuous compounding of interest rates, and "T" represents the time period in years.

The interest parity relationship shows the relationship between currency exchange rates and interest rates. As an example, if we assume that the current Canadian dollar (C$) price for one pound sterling ([pounds sterling]) is C$2.20/[pounds sterling], the Canadian one-year risk-free interest rate is 4.25%, and the United Kingdom one-year risk-free interest rate is 5.25%, then the one-year future price for the pound sterling will be C$2.18/[pounds sterling]. If we assume that the Canadian risk-free rate is equal to the UK risk-free rate, the future exchange rate would equal the current spot rate. Keeping all other variables constant, an increase in the foreign interest rate results in a corresponding drop in the futures price for that foreign currency. The increased cost of borrowing that currency (because of the higher interest rate) is offset by a currency exchange gain upon conversion for repayment in the future (as a result of the lower future price for the foreign currency). Therefore, any expected changes in the future exchange rate are explained by interest rate spreads between the two currencies. When the foreign interest rate exceeds the domestic rate, the interest rate spread manifests in a lower price for the foreign currency in the future and represents a gain on conversion to domestic currency. That is, the incremental foreign interest rate gain is realized in a lower cost for the future currency. Conversely, when the domestic rate of interest is greater than the foreign rate, the foreign currency becomes more expensive to purchase in the future. The interest rate parity in international finance therefore provides insight as to the true character of expected foreign currency gains. The expected changes between spot (current) and future exchange rates are explained by interest rate spreads between the two currencies. However, although interest rate parity is a generally accepted theory, empirical research of exchange rate movements has shown that uncovered interest rate parity is not necessarily a perfect explanation of exchange rate movements. Historical evidence has shown that a strategy of converting a low-interest rate currency into a high interest rate currency and holding the latter may result in larger gains than would be expected under the interest rate parity principle. The additional gain realized by holding the higher interest rate currency has been attributed to a "risk premium" associated with high interest rate currencies, which may be explained by political risk, developing economies and central bank policies among other things. (15) Therefore, although expected future exchange rate changes can be attributed to interest rate differentials, additional unexpected returns may also arise which may be attributable to other factors such as the risk premium or, as is explained below, subsequent changes in the interest rate environment.

It is fundamental to the analysis to recognize that the future exchange rate can be forecasted based on current information. In this way, Canadian taxpayers may plan for future foreign currency transactions by referring to futures market quotes. When a Canadian taxpayer purchases pounds sterling today, implicit in the purchase of that currency is the interest rate return or, to use Hull's analogy, the "dividend yield", which is reflected in future exchange rates and realized on future conversion. Using the figures from the example above, when a Canadian taxpayer sells pounds sterling today at C$2.2000/[pounds sterling], the taxpayer expects, based on all of the available information reflected in the futures market, that one year from now they can repurchase them for C$2.1781/[pounds sterling]. Therefore, the interest rate environment at the time the transaction is entered into explains the expected future gains or losses on currency conversions. However, unexpected changes to the future exchange rate that are not attributable to the current interest rate environment may result in a different type of gain or loss on the future foreign currency conversion. These unexpected gains or losses may be explained by the interest rate fluctuations or by other factors such as the so-called risk premium.

To continue with the numerical example above, if the UK risk-free rate increases to 10%, the future price of pounds sterling will be C$2.08/[pounds sterling]. The gain on the future currency conversion can therefore be separated into two discrete transactions. First, when a taxpayer enters into a foreign currency transaction, there is an expected gain realized in the future conversion that is explained by the spread between the domestic and foreign risk-free interest rates as they are at the time the transaction is entered into. The second gain occurs when there are subsequent changes to factors affecting the valuation of the foreign currency, such as changes to the interest rate environment or to perceived risks that are reflected in the risk premium. As these factors change, after the transaction has been entered into, there are corresponding changes in the exchange rate that result in further gains or losses. The character of these two types of gains or losses, however, is fundamentally different. To better illustrate how these two changes in foreign exchange rates differ, an analogy can be drawn to an investment in domestic discount bonds.

Discount Bonds: An Analogy

Assume that a Canadian taxpayer purchases a one-year treasury bill with a face value of $1,000 that pays 10% interest at a discount. (16) Therefore, the taxpayer purchases the bond for $909 and in a year's time the bond matures to $1,000. The taxpayer purchased the bond with an understanding of the current rate of interest that it pays. Canadian tax law treats the $91 gain on the redemption of the bond as fully taxable interest income. In the foreign currency context we can compare this to a purchase of foreign currency by a Canadian taxpayer.

A Canadian taxpayer can purchase one pound sterling today at a price of C$2.20/[pounds sterling]. By purchasing the sterling, the taxpayer can expect to sell it one year from now at a price of C$2.18/[pounds sterling] because the Canadian dollar and pound sterling interest rates are 4.25% and 5.25% respectively. The taxpayer can expect to surfer a loss on the resale of the pound in one year's time because he or she is also receiving a higher interest rate, relative to the Canadian dollar, while holding the sterling. The higher sterling interest rate results in a loss on future conversion in order to maintain parity with the value of the Canadian dollar. In simple mathematical terms: foreign interest income + foreign currency exchange gain or loss = domestic interest income. The international finance interest rate parity provides an answer to the question of how to characterize the expected loss on a foreign currency conversion: it must be fully deductible from income to maintain interest rate symmetry between the relative values of currencies.

When a taxpayer purchases a discount bond he or she may also realize gains or losses resulting from subsequent changes to domestic interest rates; these gains, however, are unexpected, are capital in nature, and do not represent interest income. To continue with the example in which the taxpayer purchased a 10% discount treasury bill, if interest rates increase subsequent to that purchase, the bond will depreciate in value, and vice versa. That is, there is an inverse relationship between the value of bonds and the interest rates. Suppose that the taxpayer holds on to the 10% one-year bond for a period of six months, at which time Canadian interest rates fall to 8% and the taxpayer disposes of the bond. The bond would have increased in value to $962 and the taxpayer would therefore realize a profit of approximately $53 ($962 less $909). There are, however, two components to this profit. The first is the accumulation of interest on the bond at the rate of 10% at which it was issued, which amounts to $44. The second component of the gain is a capital appreciation of the value of the bond as it relates to the change in interest rates, which amounts to a capital gain of approximately $9. This is a capital gain because it does not represent the interest payable on the terms of the bond entered into at the time of purchase but rather an appreciation of the value of the bond relative to other bonds of the same maturity because of a change in interest rates. Thus, there is the potential for both an income and a capital gain element when investing in debt securities. This income and capital distinction can also be made with respect to an investment in foreign currencies.

When a Canadian taxpayer purchases a foreign currency, there is an expected future gain or loss from the currency conversion based on interest rates at the time the currency was purchased that should be treated as income. If subsequent to the purchase of the foreign currency there is a change in either domestic or foreign interest rates, there will be an additional gain or loss upon conversion. To continue with the example above, if a Canadian taxpayer purchases pounds sterling at prevailing interest rates he or she will pay C$2.20/[pounds sterling] and will expect to receive C$2.18/[pounds sterling] upon resale in one year's time. On the other hand, if UK interest rates increase to 8%, the Canadian taxpayer will only receive C$2.12/[pounds sterling] upon conversion. The difference between the expected exchange rate at the time of purchase (C$2.18/[pounds sterling]) and the actual exchange rate at the time of conversion (C$2.12/[pounds sterling]) represents a change in the relative value of the foreign currency purchased and the foreign currency sold; this difference, therefore, represents a depreciation that is capital in nature. (17)

Summary of the Economics of Foreign Exchange Gains and Losses

The next section of the article, which examines the relevant case law, will show that the indiscriminate application of the surrogatum principle to the currency exchange elements of international financial transactions has resulted in confusion in the extension of the principle to new factual circumstances. The preferred approach is to analyze the foreign exchange gains or losses separately from their underlying transactions. This requires an examination of the economic substance of foreign exchange rate fluctuations. The interest rate parity relationship in international finance states that expected future changes in currency exchange rates are explained by the relative differences in interest rates between the two currencies in question. At the time of purchase of a foreign currency, the Canadian taxpayer can ascertain the future exchange rate at which he or she may sell and any resulting gain or loss associated with that change. Therefore, the conversion of foreign currencies at rates ascertainable at the time of purchase should be treated in a manner consistent with interest income, as they represent an adjustment to compensate for interest rate differentials and create interest rate parity.

Changes in interest rates and, by extension, currency exchange rates that follow the purchase of a foreign currency, will also give rise to additional gains or losses. Likewise, additional gains or losses may arise that can be attributed to a risk premium that reflects risk associated with particular currencies. These gains or losses, however, should be treated on account of capital, as they represent a change in the value of the foreign currency purchased relative to the foreign currency that is ultimately sold. The analytical distinction between the two can be likened to the changes in the value of discount bonds that arise as a result of implied interest payable at the time of purchase, as opposed to changes to the interest rate environment or changes to default risk that affect the relative value of the debt instrument. The change in the value of a foreign currency can therefore be separated into two distinct components: (1) an expected return based on interest rate differentials at the time of entering a transaction, and (2) an unexpected return attributable to factors such as subsequent interest rate fluctuations and risk premiums. The former is based on accrual of interest income implicit in the value of a currency and the latter is based on relevant qualitative differences between currencies. I will now consider the current jurisprudential and statutory treatment of foreign currency transactions in Canadian tax law.

IV THE CURRENT STATE OF CANADIAN TAX LAW

Canadian income tax law only recognizes Canadian currency. (18) The assessment of a taxpayer's income and resultant tax liability thus must be determined in Canadian dollars. This raises complications when taxpayers transact in foreign denominations and currency conversions are required. Two fundamental factors must be addressed when considering foreign currency transactions. The first is timing: at what moment should foreign currency figures be converted into Canadian dollars for the purposes of applying Canadian income tax law? The second factor is the characterization of foreign currency gains and losses as capital or income. Most currencies are traded freely in markets, not unlike public securities, and are susceptible to significant value fluctuations relative to the Canadian dollar. Therefore, the gain (or loss) that results from those fluctuations must be characterized as being fully taxable income (or deductible loss), a capital gain (or allowable capital loss), or it should fall into some other category altogether. (19)

The following is a summary of the Canadian jurisprudence and statutory law that applies to foreign currency transactions. This article focuses on the treatment of foreign currency transactions from the perspective of a Canadian resident taxpayer. It is important to note that there are also foreign currency considerations in other contexts. For example, the translation of repatriated profits from a foreign branch of a Canadian corporate taxpayer also raises questions of timing and, to a lesser degree, characterization. Issues such as foreign direct investment, however, may involve an entirely different set of policy assumptions. At the very least they require consideration of bilaterally negotiated tax conventions between nations and rest on international tax law concepts such as the norm against double taxation, source taxation, residence taxation, and the definition of 'resident'. These are important issues but are beyond the scope of this article. The emphasis here is on the domestic treatment of contracts for purchase and sale, credit arrangements, capital gains treatment, debt redemption and futures hedging transactions denominated in foreign currencies. (20)

Purchase of Inventory in Foreign Currency

The most basic way in which foreign currency may affect the tax treatment of inventory occurs when a taxpayer purchases and immediately pays for goods in a foreign currency. The cost of goods must be converted into Canadian dollars at the prevailing spot rate at the time of purchase, because "Canadian currency... is the only monetary standard of value known to Canadian law". (21) The spot rate conversion of a purchase of foreign goods reflects the true economic reality of the transaction as the Canadian dollar cost of the inventory is assessed at the time of purchase, which is also the actual time of payment. The difficulty arises when there is an interval between the time the purchase is made and the time that the payment is due. In foreign currency terms, the purchase price and payment remain constant and equal; however, if the value of the foreign currency relative to the Canadian dollar fluctuates between those points in time, there is a resultant gain or loss on the conversion into domestic currency for tax purposes. Therefore, I will consider the Canadian tax law treatment of foreign currency fluctuations in three distinct transactions in which there is a delay between purchase and payment: (1) the purchase of foreign inventory; (2) the purchase and resale of foreign capital property; and (3) the redemption of foreign-denominated debt.

One of the leading Canadian cases dealing with the use of a foreign-currency-denominated credit facility to pay for inventory purchases is the Supreme Court of Canada decision in Tip Top, in which the taxpayer purchased cloth from the UK that it used in its retail clothing business. It normally paid for these cloth purchases and converted the cost from pounds sterling into Canadian dollars at the spot rate at the time of sale. In anticipation of devaluation of the pound sterling, the taxpayer decided to set up a credit facility with a bank in the UK, denominated in pounds sterling, which it used to pay for its cloth purchases. The subsequent drop in value of the pound sterling relative to the Canadian dollar resulted in a gain on repayment of the credit facility; the economic effect of the arrangement was to lower the cost of goods in Canadian dollars. The taxpayer argued that the foreign exchange gain arose as a result of the borrowing of capital and was effectively an investment in foreign currency. The Court rejected the taxpayer's arguments and held that the foreign exchange gain on repayment of the credit facility was fully taxable as income from its business. The majority accepted the proposition that the change in the value of capital securities due to exposure to factors including foreign currency risks may be on account of capital. Nevertheless, the majority distinguished "[b]onds and securities representing permanent or fixed features of the capital structure" of the taxpayer from short term indebtedness that was directly connected with the cost of goods of the business. (22) The Court held that the foreign currency credit arrangement was "merely a substitution of creditor for the actual transaction". (23) As the foreign currency credit payments were inextricably linked to the payment for inventory used in the business and because of the short term, impermanent nature of the financing arrangement, the gains or losses on foreign currency translations arising from the repayment of the credit balance were treated as income. The majority essentially applied the surrogatum principle to hold that the characterization of the underlying transactions--in this case the purchase of inventory--will be attributed to the foreign currency gains.

When there is a delay between the rime of sale and payment for inventory purchases denominated in a foreign currency, whether as a result of a short-term credit facility used to pay for those purchases or accounts receivable arrangements negotiated directly with the seller, the gain or loss arising from the fluctuation of foreign currency will be fully taxable as income or deductible as a loss. Implicit in the judgment of the Court in Tip Top is the question of whether the gain from the sale of the inventory and the gain on the foreign currency are kept analytically distinct. In the final analysis the foreign currency aspect of the transaction was subsumed by the transaction to which it related. The Court in Tip Top effectively analyzed the foreign currency and inventory purchase transactions as a single transaction.

One shortcoming of the reasoning in Tip Top is that it proceeds on the basis that the use of the foreign credit facility could not be an investment because an investment would require
 the putting at risk by the investor of an asset or interest of
 value from which an increment of additional return of value is
 ordinarily hoped for. Here there was simply an accumulation of debt
 as the transactions of the business proceeded. No asset was put at
 risk by the company. (24)


By contrast, if one views the borrowing of pounds sterling as a short sale, then there is an asset being put at risk: the foreign currency itself. (25) A short sale essentially bets on a devaluation of the property that is sold. Therefore, the taxpayer did run the risk of the sterling appreciating in value relative to the Canadian dollar. To recognize that a foreign currency could be purchased and sold--or even sold short--rests on the idea of foreign currency as a form of property in and of itself and is consistent, or at least not inconsistent, with the inclusion of "money" in the definition of "property" in s. 248(1) of the ITA. The definition does, however, qualify the inclusion of "money" to the extent that "a contrary intention is evident".

Disposition of Capital Valued in Foreign Currency

The gain or loss from the disposition of a capital property, such as foreign securities in appropriate circumstances, gives rise to taxable capital gains or allowable capital losses. The gains and losses are calculated as the amount by which the proceeds from the disposition of the capital property exceed its adjusted cost base. The value of the gain or loss represents a fluctuation in the value of the asset over time. The addition of a foreign currency element introduces added complexity to the calculation because it layers on the fluctuation in the value of the foreign currency amount for which the property was acquired and disposed.

The leading Canadian case dealing with the calculation of capital gains or losses on the disposition of a foreign-currency-denominated capital property is Gaynor, (26) which involved a Canadian resident taxpayer who had disposed of shares listed on an American stock exchange that were purchased and sold in US dollars. The taxpayer argued that the gain was appropriately calculated by netting the US dollar values of the proceeds from disposition and adjusted cost base to determine the gain, and only then, once the US dollar value of the gain was calculated, converting it into Canadian dollars for tax purposes.

Rejecting this approach, the Federal Court of Appeal held that the appropriate approach is to convert the US dollar value of the shares into Canadian dollars at the spot exchange rate prevailing at the relevant times--that is, at acquisition and at disposition. Therefore, the cost of the securities to the appellant must be expressed in Canadian currency at the exchange rate prevailing at the time of their acquisition, while the valuation of the proceeds of disposition of the same securities must be made in Canadian currency at the rate of exchange prevailing at the time of the disposition. (27) The two Canadian dollar amounts would then be used to determine the total gain on the disposition of the American shares. The Court reached this conclusion by reasoning that the determination of a capital gain or loss is essentially the comparison between two amounts--adjusted cost base and proceeds. Since "Canadian currency ... is the only monetary standard of value known to Canadian law", each of those amounts must be expressed in Canadian dollar terms. (28)

The approach urged by the taxpayer, if accepted, would effectively ignore any appreciation or depreciation in the US dollar value component of the share price. The holding of the Court on the other hand integrates the two. The application of the rule in Gaynor blends both the foreign currency and share price appreciation and treats both as a capital gain. There are two ways that one may interpret this result. First, one may infer that the Court directly associates the value of the foreign currency to the property itself so that the two parts of the transaction are melded into one in which the foreign currency becomes part of and takes on the character of the property to which it attaches. In other words, the foreign currency value is not separate from the share, but rather becomes a part of it. The second possible interpretation is that the Court recognizes two distinct transactions, one involving the appreciation of foreign currency, and the other the appreciation of the share. The gain on the currency appreciation represents the gain from a kind of property wholly separate from the share but which is treated in the same way as the share price appreciation because of the surrogatum principle. Although both approaches lead to the same result on the facts of Gaynor, the analytical distinction can give rise to contrasting results in other contexts. Until recently, the accepted interpretation was the former: that the so-called Gaynor principle requires that all variables in a tax calculation must be converted into Canadian currency at the relevant points in rime. However, as discussed below, the Supreme Court of Canada decision in Imperial Oil has reined in this interpretation and restricted its application in the context of foreign currency debt redemption. (29)

Foreign Currency Debt Redemption

Canadian corporations often access foreign debt capital markets. The currency risk inherent in foreign-denominated debt arises because the terms of the debt instrument or bond are set at the time of issue, whereas payment of interest and redemption of the face value of the bond occur at a later time. The majority's decision in Tip Top alluded to the treatment of foreign currency translations as it relates to the capital machinery of a business, finding that when considering capital debt, the principal value of which fluctuates as a result of the repayment in a foreign currency, those "fluctuations in its value have no bearing on the losses or profits of the business" and as such are treated as on capital account. (30)

There have been several cases subsequent to Tip Top that have followed the rule that a foreign currency gain or loss on debt capital must, as a result of the nature of the property or obligation to which it attaches, be treated as a capital gain or loss. In Neonex International Ltd. v. R., the Federal Court of Appeal reasoned that "[t]he borrowing was from the beginning to end to finance a capital acquisition which in the event was abortive, and, therefore, the foreign exchange gain arose as an incident relating to the repayment of a loan made for a capital purpose". (31) In Columbia Records of Canada Ltd. v. Minister of National Revenue, (32) the Federal Court disallowed the deduction of losses from the repayment of foreign currency debt in part because the funds were borrowed for the purpose of "bringing into existence an advantage for the enduring benefit" of the taxpayer's business. (33) Therefore, the general rule is that when foreign "exchange profits or losses ... stem from dealings in capital assets, the result is not income but it is on capital account". (34) It follows that if the debt has the character of "permanence" or represents the general corporate financial structure of a business, any foreign exchange fluctuations associated to it will be treated as capital gains or losses. There are, however, two other cases that further address foreign exchange considerations with respect to specific debt redemption issues.

Shell Canada Ltd. v. R. is the leading precedent in cases that deal with so-called weak currency borrowing. (35) In Shell the taxpayer issued NZ$150 million of debt in New Zealand. Because of the declining value of the New Zealand dollar at the time, the forward value of the NZ$150 million that Shell was required to repay on redemption was expected to be less than the spot rate. Therefore, Shell converted the capital raised into US dollars and entered into forward contracts to repay the interest and debt at the lower exchange rate, thereby locking in a gain on the currency conversion upon redemption. Not only was Shell able to guarantee a profit upon redemption through the forward contracts but it also benefited from the higher interest rate that the New Zealand bond carried in the form of larger interest deductions from its income. The transaction allowed the taxpayer to deduct larger interest payments while realizing offsetting foreign exchange gains, taxable on capital account, which essentially lowered the effective interest rate payable on the debt. The Minister reassessed Shell on the basis that the two legs of the transaction, the loan and the forward hedge, ought to be treated as one. Given the "economic realities" of the transaction, the Minister argued, the "reasonable" interest that may be deducted must be calculated based on the prevailing interest rate on US dollar loans at the time. (36)

The Supreme Court unanimously rejected the Minister's arguments and held that the foreign exchange gains upon repayment of the debt obligation were on capital account, while the interest rate payable on the New Zealand bonds were fully deductible at the rate prescribed in the debenture agreement relating to the bonds. The Court began its analysis by holding that although "courts must be sensitive to the economic realities of a particular transaction.., it bas never been held that the economic realities of a situation can be used to recharacterize a taxpayer's bona ride legal relationships". (37) Therefore, the legal obligation to pay interest under the debenture agreement must be recognized as separate and apart from the legal rights and obligations under the forward contracts. As a result, there are two gains that arise: the first from the currency exchange for payments of interest and repayment of the debt, and the second from the spread between the forward exchange rate and the spot exchange rate at maturation of the hedging contracts. Justice McLachlin held that
 the characterization of a foreign exchange gain or loss generally
 follows the characterization of the underlying transaction ... if the
 underlying transaction was entered into for the purpose of
 acquiring funds to be used for capital purposes, any foreign
 exchange gain or loss in respect of that transaction will also be
 on capital account. (38)


Because the purpose of the bond issue was to raise long-term financing for Shell, it constituted a capital debt obligation and accordingly the corresponding gain from the currency translation was also on account of capital. Not only was the foreign currency gain from the repayment of the principal on account of capital but, perhaps less obviously, so too was the foreign currency gain relating to the interest payments. The Minister argued that, because the interest was fully deductible from income, any foreign currency gain associated with interest payment must also be fully included in income to maintain symmetry. The Court rejected this argument and held that "the mere fact that the gains are related to the interest expenses incurred under the Debenture Agreements, which s. 20(1) (c)(i) allows Shell to deduct from its income, does not mean that the net foreign exchange gain should also be considered on income account". (39) Instead, McLachlin J. reasoned that
 it is important to underline that interest expenses on money used
 to produce income from a business or property are only deemed by s.
 20(1)(c)(i) to be current expenses and, in the absence of that
 provision, would be considered to be capital expenditures ... the
 gains should be treated as being on capital account. (40)


With respect to the gain from the hedging transaction, McLachlin J. held that
 [w]hether a foreign exchange gain arising from a hedging contract
 should be characterized as being on income or capital account
 depends on the characterization of the debt obligation to which the
 hedge relates. (41)


Because Shell entered into the forward contract to protect against foreign exchange risks associated with the debentures, the gain from the hedging transaction was also on account of capital. The Court therefore accepted the taxpayer's arguments and held that the foreign exchange gains arising from the devaluation of the New Zealand dollar on both the repayment of principal and the interest payment were on account of capital.

In response to these financing structures, s. 20.3 was enacted to reverse the result of the Supreme Court's decision in Shell. Section 20.3 defines a "weak currency loan" as one in which the proceeds from the debt issue are denominated in a currency ("weak currency") other than the currency with which the proceeds are actually put to use ("final currency"). In addition, the amount of the debt must exceed $500,000, and the interest rate on the weak currency loan must exceed the comparable interest on a comparable loan in the final currency by 2%. When such a loan exists, s. 20.3(2) provides that: (a) the excess interest is not deductible, (b) the foreign exchange gain or loss on the repayment of the debt shall be fully taxable as income or deductible as a loss, and (c) the amount of interest which is not deductible as a result of (a) is deductible as a loss from the foreign exchange gains or losses in (b). Furthermore, s .20.3(3) provides that any foreign exchange gain or loss resulting from a hedge entered into for the repayment of the weak currency loan shall accordingly decrease or increase the amount payable on account of interest or repayment of principal of the loan.

The most recent Supreme Court case dealing with foreign currency gains or losses relating to debt financing is Imperial Oil. (42) The taxpayer in Imperial Oil issued debentures denominated in a foreign currency in order to finance its capital program. Upon repayment of the principal, the taxpayer suffered a foreign exchange loss as a result of the weakening of the Canadian dollar vis-a-vis the US dollar. It was accepted that, in general, because the borrowing was on capital account, "any foreign exchange loss on the debentures would be a payment on account of capital because the characterization of a foreign exchange gain or loss generally follows the characterization of the underlying transaction". (43) The case, however, turned on an interpretation of s. 20(1)(f) that allowed a deduction for the amount by which "the lesser of the principal amount of the obligation and all amounts paid in the year or in any preceding year in satisfaction of its principal amount exceeds the amount for which the obligation was issued". (44) The issue was whether discounts resulting from fluctuations in foreign currency values are captured by the provision. The taxpayer argued that s. 20(1)(f) refers to discounts that result as a repayment of "principal". Subsection 248(1) defines "principal" as the "maximum amount payable" upon redemption, which is only ascertainable at the time of payment. Therefore, under Gaynor, the principal must be converted into Canadian dollars at the exchange rate prevailing at the time of repayment. This argument was accepted by the minority of the Supreme Court in Binnie J.'s judgment; nevertheless, it was roundly rejected in the reasons of Lebel J. for the majority, which rested on a more purposive interpretation of the provision. In attempting to ascertain whether the legislature intended to include foreign currency within the parameters of s. 20(1)(f), the majority ultimately concluded that it did not, and that this conclusion was buttressed by the treatment of foreign currency gains or losses in s. 39(2). More interesting, however, is Lebel J.'s review of the common law relating to foreign currency conversions, and in particular his holding that
 Gaynor does not support the proposition that all elements of a
 statutory formula must be converted into their Canadian dollar
 value at the relevant time--it was premised on the prior conclusion
 that the foreign exchange gains in issue were capital gains.
 Converting the amounts in the statutory formula merely simplified
 the method of calculating the amount of the capital gain in that
 case, which did not purport to establish a new general principle.
 (45)


Justice Lebel went on to provide what is perhaps the most comprehensive statement regarding the treatment of foreign currency gains and losses in Canadian income tax law:
 [W]ithout a conversion of currency, the mere repayment of the
 principal--the very thing that was borrowed--cannot yield a profit
 or a loss. Any appreciation or depreciation of the principal amount
 does not result from the simple fact that it bas been borrowed and.
 repaid. If there is a profit or a loss, it must arise from something
 other than the borrower-lender relationship per se. In the capital
 gains context, the disposition of a capital asset bas been treated
 in the cases as an event triggering taxation of the appreciation or
 depreciation of that asset in addition to any foreign exchange gains
 or losses, whether actual or notional. In the income context,
 foreign exchange gains and losses have been treated as an ordinary
 expense in carrying out foreign trade such that, even when incurred
 in separate transactions, they must be accounted for in determining
 the price paid or received for traded goods. In such cases, an
 actual disposition of inventory occurs, and this disposition
 triggers a valuation in order to determine the actual price received
 for it (in domestic currency). (46)


Therefore, if the proceeds of a foreign currency debt are not converted into Canadian dollars, there is no gain or loss--there is simply repayment of what was borrowed. It is only when there is "an actual currency conversion" that the law must consider the treatment of those foreign currency gains and losses. Justice Lebel's reasoning rests on drawing a sharp analytical distinction between the foreign currency aspect of a transaction and the underlying transaction itself. He holds that the precedents do not subsume the former into the latter, but rather implicitly accepts the bifurcation of the transaction into its underlying and foreign exchange elements. Therefore, the rule in Gaynor, although it does not explicitly separate the foreign exchange gain from the share price appreciation, should be read as implicitly doing so. In Lebel J.'s view, this is correct because there has been an actual disposition of the share and foreign currency. Likewise, cases such as Tip Top can be reconciled
 by the fact that the borrower-lender relationship in those cases
 arose directly out of the purchaser-vendor relationship and that
 there was an actual currency conversion (and, as a result, an
 actual foreign exchange gain), such that the foreign exchange gain
 was an integral part of the purchase price of the goods. (47)


In the case of foreign debt then, if the proceeds are not converted into Canadian dollars--and therefore require another conversion--there is no actual disposition of foreign currency and no corresponding gain or loss.

Treatment of Futures Contracts and Hedging

The use of futures contracts can play an important role in structuring tax-motivated transactions involving foreign currencies. This section addresses the tax law treatment of two aspects of futures contracts. The first is whether a gain from a futures hedge is characterized as income or on account of capital. In Shell, the Supreme Court held that the characterization of a gain from a hedging contract depends on the underlying transactions that it is designed to hedge. If the future or forward contract is entered into to hedge against foreign fluctuations in respect of capital assets, any gains arising form that hedge will be treated on account of capital. The second issue is related to the timing of gains arising from futures hedges and whether they are accounted for on a realization or accrual (marked-to-market) basis for tax purposes. The leading case addressing this issue is Friedberg v. Canada (48) in which the taxpayer held off-setting (long and short) positions in futures contracts but only closed out and realized on the losing positions. The taxpayer deducted the losses as realized but did not report the gains on the correlative long position that he held on the same contract because it had not been closed out yet. The Minister argued that the futures contracts should be taxed on a marked-to-market basis and that both the long and short positions should be netted to reflect the true economic position of the taxpayer. The Supreme Court rejected this argument and held that the two positions represent distinct legal contracts with separate legal obligations and rights, and, therefore, they should not be treated as one. Furthermore, the Court held that the losses could be reported for tax purposes when they are realized and that
 while the 'marked to market' accounting method proposed by the
 appellant may better describe the taxpayer's income position for
 some purposes, we are not satisfied that it can describe income for
 income tax purposes, nor are we satisfied that a margin account
 balance is the appropriate measure of realized income for tax
 purposes. (49)


As a result, the taxpayer was permitted to defer the gains on the long positions until such time that they were closed and realized, and did not have to report unrealized marked-to-market gains.

In response to Friedberg, Parliament enacted s. 142.5, requiring that "financial institutions" use the marked-to-market method argued for by the Minister in Friedberg for the valuation of particular properties, including positions in derivative contracts. This set of rules does not seem to apply to non-financial institutions, so companies that are not engaged in the business of finance may still benefit from the holding in Friedberg when hedging particular aspects of their business operations or capital structure.

Subsection 39(2): The Residual Treatment of Foreign Currency Gains or Losses

Subsection 39(2) of the ITA provides that any gains or losses that result from a fluctuation of the value of a foreign currency relative to the Canadian dollar will be treated as capital gains or losses from the disposition of that foreign currency. (50) This subsection applies only to the extent that the foreign currency gains or losses are not otherwise included in evaluations of the taxpayer's income. Both the majority and dissent in Imperial Oil confirmed the residual nature of this provision. The majority held that although "s. 39 is a residual provision, this section is also a statement of Parliament's intent to treat foreign exchange losses as capital losses", (51) Justice Binnie held that "s. 39(2) is confined to a residual status and applies only to the extent that a foreign currency loss is not otherwise deductible in computing income". (52) Therefore, to the extent that a foreign currency gain or loss is not otherwise fully included in calculating a taxpayer's income, s. 39(2) provides that it is treated on account of capital.

V ECONOMIC ANALYSIS OF INCENTIVES CREATED BY THE CURRENT LEGAL REGIME

Purchase of Inventory in Foreign Currency

Tip Top stands for the proposition that a gain realized by a business that results from a foreign currency conversion relating to the purchase of inventory is fully taxable as income. This rule is economically efficient because the tax effect of the transaction does not distort the decision that a taxpayer would otherwise make. For example, assume that the taxpayer in Tip Top had a choice between purchasing cloth from Australia or from a Euro ([euro]) country. If the price to purchase the cloth from an Australian supplier at an exchange rate of C$0.95/AU$ amounts to C$1,045 and the price for the same cloth purchased from a European supplier costs a total of C$1,008 at an exchange rate of C$1.55/[euro] then all things being equal, it would be cheaper to buy from the European dealer and realize a savings of C$38. That savings would ultimately be fully taxable as it would lower the cost of goods and therefore correlatively increase profits. If, however, at the rime of purchase, the futures markets indicate that the Australian dollar will devalue to a rate of C$0.92/AU$, while the Euro will remain approximately constant, the taxpayer's decision may be affected by how the gain on the currency conversion will be taxed. Such a drop in the value of the Australian dollar would result in a currency exchange gain of C$38 at the time of payment. If this currency exchange gain were taxed as a capital gain, the Canadian taxpayer would only include an additional C$19 of taxable income to its tax liability. Therefore, if gains on currency conversions were treated on account of capital, the taxpayer would choose to purchase the goods on credit from the Australian supplier even though the economic gain is exactly the same had the purchase been immediately made from the European dealer. To maintain neutrality in the context of inventory purchases, any associated currency gain or loss must be treated as fully taxable, and the rule in Tip Top is thus economically efficient, because it does not create incentives for taxpayers to structure their inventory purchases so as to benefit from asymmetrical tax treatment. In other words, the rule in Tip Top ensures that the taxpayer would be indifferent, on a tax basis, as to whether to purchase from the Australian or the European supplier and the decision would be informed only by non-tax considerations.

This conclusion accords with the application of both the surrogatum principle and the principle that future currency exchange rates at the time of entering a transaction represent interest income. In respect of the former, inventory purchases and sales are treated as deductible expenses and fully taxable income, and the surrogatum principle would require that the related foreign currency gain or loss be treated in the same manner. The principle derived from the international interest rate parity relationship also supports the treatment of the gain as income. The future devaluation of the Australian dollar in the hypothetical posed above arises from interest rate differentials between the Canadian and Australian dollars and as such the gain should be treated as income. The current position of Canadian law is consistent with either line of reasoning and is economically neutral.

Disposition of Capital Valued in Foreign Currency

In order to critically analyze the law with respect to foreign currency gains or losses relating to the disposition of capital property, we can consider an example similar to the factual circumstances in Gaynor. Suppose a Canadian taxpayer purchased UK listed shares of XYZ for 1,000 [pounds sterling] at a rime when the exchange rate was C$2.00/[pounds sterling], and then sold these shares in one year's time for proceeds of 1,500 [pounds sterling] when the prevailing exchange rate was C$2.06/[pounds sterling]:

Gain on sale of XYZ shares: (1,500 [pounds sterling] - 1,000 [pounds sterling]) x C$2.00/[pounds sterling] = C$1,000

Gain on currency conversion: (C$2.06/[pounds sterling] - C$2.00/[pounds sterling]) x 1,500 [pounds sterling] = C$91

Total Gain: C$1,091

The key issue is the treatment of the C$91 gain. The Court's reasoning in Gaynor relies on the surrogatum principle to hold that the gain should be treated similar to the gain on the shares on account of capital. The financial analysis of forward currency exchange rates, however, suggests that the C$91 gain is explained by the interest rate differentials between the two currencies and as such should be treated as fully taxable interest income. While the treatment of such a foreign exchange gain on account of capital does have some intuitive appeal, the cogency of the argument based on the interest rate parity can be illustrated by using an example in which the shares of XYZ may be purchased on either the Toronto Stock Exchange or the London Stock Exchange; that is, if we assume that the shares of XYZ can be purchased and sold either in Canadian dollars or in pounds sterling.

A Canadian taxpayer may invest in XYZ in one of two ways. First, the taxpayer may purchase and sell the shares of XYZ listed on the UK stock exchange and realize a total gain of C$1,091 as detailed in the table above. Alternatively, the taxpayer can achieve the same result by (a) purchasing the Canadian dollar-denominated shares of XYZ and realizing a capital gain of $1,000 on their disposition; and (b) borrowing approximately 890 [pounds sterling], converting those pounds sterling into C$1,780 and investing the Canadian funds at the domestic risk-free rate of interest to earn C$91 interest income. The purchase of the Canadian dollar XYZ shares and investment in the Canadian dollar results in a total gain of C$1,091. Either strategy results in a total return of C$1,091 for the taxpayer. Under the rule in Gaynor, however, the taxable amount of the return of purchasing and disposing the UK-listed XYZ shares amounts to approximately C$546 (the total capital gain of C$1,091 at the 50% inclusion rate); whereas the taxable gain from the alternative strategy totals approximately C$591 (the sum of the $1,000 capital gain on the shares at a 50% inclusion rate and the fully taxable C$91 of interest income). The taxable income of the second strategy is greater than that in the first notwithstanding the fact that the total returns are identical. Therefore, under the rule in Gaynor, there are systematic incentives for Canadian taxpayers to invest in strong-currency-denominated capital properties. Correlatively, the capital treatment of foreign exchange losses creates disincentives for taxpayers to invest in capital properties in weak foreign currency markets. From the normative perspective of neutrality, the foreign exchange gain or loss relating to the disposition of capital property should therefore be treated as, respectively, fully taxable or deductible from income.

A potential argument against the income treatment of the foreign exchange component of capital property disposition is that taxpayers who purchase a property for investment typically do not know precisely when in the future they will sell it. Unlike a contract for the purchase of inventory or a debt agreement, the future payment or receipt of funds is unknown and, therefore, the taxpayer is not necessarily investing with the expectation of receiving a calculated return that is explained by the accrual of interest. At the time of purchase, the taxpayer does not know with certainty when in the future he will make a sale and therefore cannot determine with the same precision as a debtor what gain he may realize upon disposition of the capital property. It would follow that almost all of the fluctuations in currency exchange rates for the owner of a foreign-currency-denominated capital property can be characterized as the second kind of foreign currency fluctuation--a relative change in value due to market fluctuations subsequent to the purchase of the foreign currency--because of this uncertainty. This argument, however, confuses the subjective expectations of the investor at the time of purchase with the objective market expectations of foreign exchange rates at the time of purchase. To continue with the example above, when the taxpayer disposes of the XYZ shares there is an extensive history of futures prices available, from which one can determine the expected foreign exchange rates at the time of purchase. Therefore, if at the time of purchase, the one-year foreign exchange rate was C$2.06/[pounds sterling], a subsequent sale at that rate would be attributable to interest rates at the time of purchase. In contrast, if after selling the pounds sterling for C$2.06/[pounds sterling], the taxpayer can show that the expected foreign exchange rate in the futures markets at the time of purchase was C$2.01/[pounds sterling], then C$0.05/[pounds sterling] is explained by changes in interest rates subsequent to the purchase and can be treated on account of capital. The timing of subsequent sales may also be affected by unanticipated change in exchange rates. For example, if an asset is purchased in a previously strong currency that subsequently becomes a weak currency, the asset may be sold and reinvested elsewhere. This approach conforms to the norm of neutrality, even though it may be argued that it adds a layer of administrative complexity.

Foreign Currency Debt Redemption

The disbursement of interest on and redemption of debt present two points in time in which foreign exchange gains or losses may affect the borrower's tax liability. In Shell, the Supreme Court of Canada held that the "mere fact that the gains are related to the interest expenses incurred under the Debenture Agreements, which s. 20(1)(c)(i) allows Shell to deduct from its income, does not mean that the net foreign exchange gain should also be considered on income account". (53) The Court reasoned that the interest relates to capital debt and as such should be treated on account of capital, as should any related foreign currency gains or losses on the repayment of that interest. The financing structure in Shell, so-called "weak currency debt", paints the clearest picture of the contrast between the surrogatum principle and a principled analysis of the underlying transactions.

Shell was advised to issue debt in New Zealand because the futures markets and interest rate indicators showed that it was expected to depreciate relative to the Canadian dollar. The structure allowed Shell to borrow New Zealand dollars and subsequently deduct the higher foreign interest rate payable on the debt from income, while only including half of the foreign currency gain on the conversion of Canadian dollars to New Zealand dollars required to make those interest payments. This is the paradigmatic example of the interest rate parity relationship: New Zealand interest rate + Currency Exchange gain = Canadian interest rate. (54) In economic terms this simple mathematical relationship is held to be true; and if the individual variables in the equation are treated similarly for tax purposes--that is, all are treated as income--the tax effect will also reflect the economic substance. The decision in Shell, however, created an asymmetry, and in effect an arbitrage opportunity, by characterizing the currency exchange gain variable as being on account of capital. This treatment in tax law creates a strong incentive for Canadian taxpayers to borrow the foreign currency and benefit from both the higher interest rate and the inequitable tax treatment of the consequential currency exchange gain. To put it another way, the interest rate parity relationship stands for the proposition that a borrower would be indifferent to the choice of either (a) borrowing New Zealand dollars and realizing a currency exchange gain, or (b) simply borrowing Canadian dollars. In light of the holding in Shell, however, this decision is no longer neutral and creates strong tax incentives to pursue the former course.

The same economic principles also apply the treatment of currency exchange gains or losses on the repayment of the debt principal. To the extent that the future exchange rate, as derived by interest rates at the time of debt issuance, reflects an accrual of foreign interest, it too should be taxed on account of income and not on a capital basis. Therefore, even if Shell was decided differently and foreign exchange gains on the interest payments were fully taxable, there would still be an incentive for Canadian taxpayers to issue weak currency debt in order to take advantage of the currency exchange gain on repayment of principal, if that repayment is treated on account of capital. So long as the foreign exchange gain or loss on any component of the foreign-denominated debt--whether interest payments or the repayment of principal--is taxed on account of capital, there will be tax-incentives for taxpayers to structure their debt accordingly.

In response to the decision of the Court in Shell, Parliament enacted s. 20.3 to deal with "weak currency debt". Subject to certain de minimus requirements, (55) s. 20.3 provides the following: (1) it limits the interest deductible to the amount payable on domestic loans of the same terms; (2) any foreign exchange gain or loss related to the repayment of the debt is fully taxable or deductible on income account; and (3) the amount of interest disallowed is deducted from foreign currency gains associated with the settlement and extinguishment of the debt. The effect of this provision is to bring the tax effect of such transactions in line with the economic substance as explained by the interest rate parity relationship. It is equivalent to requiring that any and all foreign exchange elements related to the debt must be treated as fully taxable income or deductible losses accordingly. There is, nonetheless, an aspect of the provision that may prove problematic and ultimately create disincentives for taxpayers to access foreign capital markets. The wording of the provision captures both kinds of foreign exchange gains or losses that were distinguished above. That is, both the accrued income attributable to interest rates at the time of debt issuance and the capital gain resulting from subsequent changes in interest rates are fully taxable as income under s. 20.3. A Canadian taxpayer would therefore be less inclined to risk being taxed on such foreign exchange gains and would likely opt for an equivalent Canadian debt. As shown above, a subsequent change in Canadian interest rates would introduce a capital element of gain or loss upon redemption of the debt, and thus the Canadian dollar debt would be slightly tax-advantaged as compared to weak currency debts. Furthermore, s. 20.3 only addresses "weak currency debts" whose interest rates exceed domestic rates; it does not apply to what may be called "strong currency debts" It is, therefore possible that the Canadian taxpayer would avoid foreign financial structures that suffer from the treatment of foreign currency exchange losses on repayment of strong currency interest and principal on account of capital. This treatment of foreign currency exchange losses sustained on strong currency debts was the issue that the Supreme Court dealt with in Imperial Oil.

The taxpayer in Imperial Oil issued US dollar-denominated bonds. It suffered a loss upon repayment of the principal as a result of an appreciation of the US dollar against the Canadian dollar. (56) The effective Canadian dollar value of the principal upon repayment was therefore in excess of its dollar value at time of issue. For the same reasons offered in respect of weak currency debts, the decision in Imperial Oil distorts the norm of neutrality by providing disincentives for taxpayers to pursue foreign currency financing in strong currency markets. Just as any currency exchange gain on the repayment of weak currency debt ought to be fully taxable as income, so too any exchange loss on the repayment of strong currency debt should be fully deductible. Using the simplified mathematical relationship: US Dollar interest rate + Currency exchange loss = Canadian interest rate. By treating the currency exchange loss on the US dollar debt as on account of capital, the Court has created a strong incentive for Canadian taxpayers to issue comparable Canadian dollar debt. This creates tax-motivated incentives notwithstanding that the issuance of debt in the foreign currency may serve other business strategies such as establishing a presence in foreign capital markets.

Treatment of Futures Contracts and Hedging

The characterization, for tax purposes, of gains and losses arising from the settlement of futures or forward contracts used in hedging arrangements must also be considered. In Shell, McLachlin J. held that "[w]hether a foreign exchange gain arising from hedging contract should be characterized as being on income or capital account depends on the characterization of the debt obligation to which the hedge relates". (57) Based on this principle, McLachlin J. concluded that the gain from foreign currency futures contracts entered into to hedge interest payments were only taxable as capital gains notwithstanding that the interest payments they were designed to hedge were fully deductible. What is problematic with this reasoning is that the surrogatum principle is applied wholesale without consideration for the true underlying transaction that the derivative contract was designed to hedge. A position in a foreign currency futures contract in relation to foreign-currency-denominated capital debt does not hedge against the capital debt; rather, it is a hedge against the foreign currency component that relates to that debt. In other words, the hedge does not provide a means for making the interest payments, but instead provides a rate at which foreign currency can be bought to make those payments. Therefore, a correct application of the surrogatum principle would treat the gain on the hedge in the same way as the currency exchange gain or loss it is designed to offset. The value of a foreign currency futures contract is derived from the spread between spot or market prices and the futures price for currencies. If we accept the argument that changes in foreign currencies are explained by interest rate differentials and thus a bare foreign currency exchange gain or loss should be treated as a fully taxable gain or loss, then a hedge designed to offset those fluctuations must be treated in the same way.

As described above, there are two different kinds of gains that can be realized by investing in foreign currency. The first is taxable income that is realized by converting at the future exchange rate as determined by interest rates at the time of entering into the transaction. The second relates to gains or losses that arise out of interest rate changes subsequent to entering into the transaction. When "Canadian taxpayers enter into futures contract agreements, they are guaranteed a certain currency exchange rate at some time in the future. That rate is determined using the interest rate parity discussed above and is, therefore, the purest form of the first kind of income--fully taxable income or deductible loss. To use a numerical example, assume that a Canadian taxpayer purchases Euros today for a price of C$1.50/[euro], and simultaneously hedges that position by entering into a futures contract to sell those Euros one year from now at a price of C$1.55/[euro]. (58) In one year the taxpayer will realize a gain of C$0.05/[euro] (C$1.55/[euro] less C$1.50/[euro]) on the transaction. As explained earlier, this gain represents the interest rate differential between the two currencies and as such should be treated the same as interest income. In contrast, if the actual exchange rate in one year's time is C$1.58/[euro], (59) the taxpayer will surfer a loss of C$0.03/[euro] (C$1.55/[euro] less C$1.58/[euro]). Like the change in value of a discount bond, this loss should be treated as on account of capital. (60)

VI PROPOSED POLICY FRAMEWORK

The above analysis demonstrates the tax-motivated incentives that distort taxpayer behaviour when the legal form and characterization of transactions are at odds with their economic substance. The treatment by Canadian tax law of foreign currency transactions has largely proceeded without a clear and consistent view of the economic fundamentals that drive currency exchange gains and losses. The most effective approach to structuring neutral tax policy is to first have an understanding of the financial economics that explain foreign currency valuation. With this understanding of the economics of foreign currency exchange markets now in place, we are left with the question of how best to integrate it into a tax policy framework.

One possibility is to address currency exchange issues from time to time as they arise through the conventional mechanisms of tax administration--particularly, with judicial decisions. This is how Canadian tax law has frequently tackled these issues. The enactment of s. 20.3 in response to weak currency financing is an example of this reactive approach by Parliament. Such a piecemeal approach creates incongruities with respect to the treatment foreign currency throughout the ITA. Although s. 20.3 does succeed in establishing a tax-neutral policy with respect to weak currency borrowings, its narrow focus fails to create the same neutrality in respect of strong currency financing. Besides, the treatment of currency exchange gains in the context of weak currency borrowing is difficult to reconcile, on a principled basis, with the treatment of currency exchange gains or losses in the context of strong currency borrowing or capital gains. This approach also creates a degree of uncertainty for taxpayers. Without a general framework or principles on which to rely, a taxpayer may have difficulty planning particular transactions involving foreign currency if there has not yet been a ruling or specific provision dealing with the matter. This uncertainty in the law may result in taxpayers taking more overly conservative positions if they are risk-averse; on the other hand, if taxpayers are risk-neutral, they may engage in more aggressive tax-avoidance structures.

A preferable approach is to articulate a policy framework that relies on general principles that can be applied to existing and new situations as they arise, is consistent with the scheme of the ITA, and conforms to the economic norm of neutrality. The first principle that can be drawn from the foregoing analysis is that foreign exchange gains and losses must be analyzed separately and distinctly from the underlying transaction with which they are associated. This reflects the fact that foreign currency valuation can be explained by specific variables--namely foreign and domestic risk-free rates of return--that may have no bearing on the valuation of the underlying transaction. Foreign currency can be viewed as an investment in and of itself, akin to the purchase and sale of interest bearing securities. Therefore, the simple application of the surrogatum principle may lead to inefficient results to the extent that it does not reflect this distinct character of foreign currency valuation.

The second guiding principle recognizes that an "investment" in foreign currency may result in gains or losses that are on account of capital or fully taxable as, or deductible from, income. As detailed above, an expected gain or loss from a currency conversion at the rate ascertainable, based on the current relative interest rate environment at the time of investment, should be fully taxable as, or deductible from, income. However, an unexpected gain or loss resulting from an exchange conversion based on changes to interest rates subsequent to the time of investment or the realization of a currency risk premium should be treated on account of capital. Therefore, the general aim of Canadian tax policy should be to treat the expected foreign exchange element of all transactions as fully taxable income unless the exchange is attributable to subsequent unexpected currency value fluctuations.

With respect to any foreign-currency-denominated debt, any currency exchange gain or loss realized on the repayment of principal or on the payment of interest should be fully taxable as, or deductible from, income. This holds only insofar as the gain or loss reflects the exchange rate expectations at the time of issue. Otherwise, the gain or loss should be treated on account of capital. This also applies to any foreign currency debt, whether "strong" or "weak". The effect of such a policy is that a Canadian taxpayer's decision of whether to raise debt financing in foreign markets will be minimally distorted by tax-based incentives. The decision of whether to issue debt in one foreign market as opposed to another, or whether to pursue foreign markets as opposed to domestic markets, will be neutral from a tax perspective.

Any currency exchange gain or loss relating to the disposition of capital property should also be treated in a like manner. This ensures that Canadian-resident taxpayers do not make their international capital investment decisions based on tax-motivated considerations. International trade contracts for purchase and sale of inventory should receive similar treatment for the same reasons.

Finally, the gain on a foreign currency forward or futures derivative contract used for hedging may also be treated on account of income or capital. The reasoning underlying this policy is, however, based on the surrogatum principle. If the treatment of a gain or loss from a derivate is treated differently from the underlying element it is designed to hedge, there will be asymmetries in returns and therefore incentives for structuring tax-advantaged hedging transactions. Nevertheless, when applying t he surrogatum principle to a foreign currency hedge, the underlying exposure being hedged is the currency exchange gain component of the transaction. For example, a currency futures contract used to hedge the repayment of foreign-currency-denominated debt principal is not treated as capital because it relates to debt capital; instead, it is treated as income because it relates to the foreign currency element of the debt capital. Therefore, the gain on the spread between the futures price and the spot price at the time of purchase is treated as income while the spread between the futures price and the spot price at maturity is treated on account of capital. (61)

The features of the proposed policy framework in respect of foreign currency transactions may, in some instances, appear to be a significant departure from the current state of Canadian law and the scheme of the ITA as a whole. For example, the proposition that foreign exchange gains related to the disposition of capital property ought to be fully taxable as income is contrary to the current position of the law as enunciated in Gaynor. One may also argue that it is contrary to the scheme of the ITA to the extent that it treats the purchase and sale of an investment property in foreign currency as income rather than on account of capital. However, once it is accepted that the future difference in relative value between two currencies is generally explained by their respective interest rates, these policy proposals rapidly fall into line with the scheme of the ITA as a whole. The crux of this move is to recognize that interest rate differentials drive the future valuation of one currency relative to another. The ITA provides for both the deductibility of interest expenses (62) and the inclusion of interest income (63) in calculating the taxpayer's income for the period. The fluctuation of a foreign currency's value reflects an accrual of interest. Therefore, to treat currency exchange gains and losses on account of income is not inconsistent with the scheme of the ITA, but is rather in harmony with the way in which the ITA treats interest income and interest expenses.

* The author gratefully acknowledges the guidance and assistance of Professor Benjamin Alarie. The author would also like to thank the editors of the University of Toronto Faculty of Law Review for their helpful comments and suggested revisions.

(1) R.S.C. 1985 (5th Supp.), c.1 [ITA]. Any references to legislation refer to this Act.

(2) [2006] 2 S.C.R. 447, 2006 SCC 46 [Imperial Oil].

(3) A derivative is a financial instrument or contract, the value of which is derived from some underlying asset. For example, a "call option" on a stock is a derivative contract in which the holder has the discretion but not the obligation to purchase the underlying stock at an agreed-upon price (the "strike price"). In this way, the option derives its value from the underlying stock.

(4) Canadian tax law draws a distinction between income from a source and taxable capital gains. The latter is currently subject to 50% inclusion in a taxpayer's income, whereas the former is fully taxable. This distinction creates incentives for taxpayers to characterize their gains as being on account of capital (to reduce tax payable) and their losses as being fully taxable as income (to allow for full deductibility of the loss from income).

(5) Peter W. Hogg, Joanne E. Magee & Jinyan Li, Principles of Canadian Income Tax Law, 5th ed. (Toronto: Thomson Carswell, 2005) at 26.

(6) This relationship was articulated in the classic statements by Miller and Modigliani (M&M Propositions I and II). M&M Proposition Il proves that there is a positive linear relationship between the use of financial leverage and a firm's cost of equity capital because of increased financial risk related to debt. Nonetheless, once the effects of corporate taxation are introduced-specifically, the deductibility of interest on debt financing-Miller and Modigliani have shown that a company's cost of capital declines as the debt-to-equity ratio increases. Therefore, all other things being equal, the tax treatment of interest leads to the conclusion that 100% debt financing is the optimal capital structure. As cited in Stephen A. Ross et al., Fundamentals of Corporate Finance, 3d Can. ed. (Toronto: McGraw-Hill Ryerson) at 527.

(7) The Canadian income trust structure, which interposes a trust between the operating corporation and investors, substitutes a direct share investment with high-yield "subordinated 'junk' debt" to minimize tax leakage. The effectiveness of this structure relies on the deductibility of interest payments to the unit holder trust through "junk debt" as opposed to dividend payments that are not deductible by the operating corporation. See Tim Edgar, "The Trouble with Income Trusts" (2004) 52:3 Can. Tax J. 819.

(8) [1957] S.C.J. No. 49, [1957] C.T.C. 309, 57 D.T.C. 1232 (S.C.C.) [Tip Top].

(9) The "surrogatum principle" is the idea that for tax purposes, amounts received by a taxpayer incident to or in place of a particular source of income take on the income or capital character of the underlying source to which they relate. For a discussion of case law relating to the surrogatum principle see Tim Edgar & Daniel Sandler, eds., Materials on Canadian Income Tax, 13th ed. (Toronto: Thomson Carswell, 2005) at 87.

(10) [1991] 1 C.T.C. 470, 131 N.R. 65, 91 D.T.C. 5288 (F.C.A.) [Gaynor].

(11) Ultimately, the value of foreign currencies is driven by fundamental macroeconomic factors. Therefore even "fixed" currencies are subject to market pressures and revaluations in the international market are based on these fundamentals. In this sense, a fixed currency does fluctuate with less fluidity than floating exchange rates.

(12) Note that the renminbi is not purely a floating rate currency, but rather a 'managed-floating currency'. For the purposes of this article the finer distinctions and subcategories of floating exchange rates will be disregarded.

(13) John C. Hull, Options, Futures & Other Derivatives, 6th ed. (Upper Saddle River, N.J.: Prentice Hall, 2005) at 115 [Hull].

(14) Ibid. at 113.

(15) The observation of and explanations for the empirical failure of the interest rate parity are far from settled and a subject of considerable academic debate. Some academics argue that the rejection of interest rate parity is less decisive over longer periods while others argue that the parity holds over shorter windows of time. For a discussion on the empirical failures of the interest rate parity see Alain P. Chaboud & Jonathan H. Wright, "Uncovered Interest Parity: It Works, But Not For Long", International Finance Discussion Papers No. 752 (Washington, D.C.: Board of Governors of the Federal Reserve System, December 2002), online: Board of Governors of the Federal Reserve System <http://www.federalreserve.gov/pubs/ifdp/2003/ 7 52/ifdp752.pdf>.

(16) Discount bonds are a paradigmatic example of the fundamental principle of the time-value of money. This principle states that a dollar today is worth more than a dollar in the future due to the interest-earning potential of money.

(17) The bond analogy can also be extended to help explain the 'risk premium' posited to explain exchange rate returns that exceed those predicted by the interest rate parity theory. A bond is not only susceptible to interest rate risk but is also affected by default risk. Therefore, the value of a bond may change due to relative changes in interest rates or a change in the ability of the borrower to repay the bond in full. Likewise, foreign currencies are susceptible to changes in interest rates (a type of interest rate risk) but may also be affected by political risks reflected by an additional risk premium (a type of default risk). Currencies from countries that are more politically volatile or have not developed mature market economies may be perceived as inherently riskier than other currencies, just as bonds from particular borrowers are perceived as riskier than those from more reliable borrowers.

(18) Imperial Oil, supra note 2 at para. 76.

(19) It may be that foreign currency gains or losses ought to be treated as 'tax nothings'. Alternatively, they might be characterized as 'Allowable Business Investment Losses', which reflect mixed characteristics such as the full deductibility of otherwise capital investments.

(20) Investors enter into futures contracts to purchase or sell an underlying asset at a given price (the future price). Futures can be used as a hedge when, for example, the investor holds a particular asset and purchases a futures contract to sell that asset at a given future price. In this way the investor locks in the price which he or she will receive for that asset and hedges against any future price fluctuations in that asset. Investors use a wide variety of derivative contracts to hedge their position.

(21) Gaynor, supra note 10 at para. 4.

(22) Supra note 8 at para. 16.

(23) Ibid. at para. 12.

(24) Ibid.

(25) A short sale is a transaction in which an investor borrows an asset and sells it today with the obligation to repurchase the same asset in the future. A short sale (or short position generally) is taken when the investor expects the asset to depreciate in value and therefore expects to create profit by selling at a higher current price and purchasing at a lower future price.

(26) Supra note 10.

(27) Ibid. at para. 4.

(28) Ibid.

(29) Supra note 2 para. 52.

(30) Supra note 8 at para. 8.

(31) [1978] C.T.C. 485, 78 D.T.C. 6339, 22 N.R. 284 (F.C.A.) at para. 19 [Neonex International].

(32) [1971] C.T.C. 839, 71 D.T.C. 5486 (F.C.T.D.).

(33) Ibid. at para. 31.

(34) I.S.E. Canadian Finance Ltd. v. M.N.R., [1986] T.C.J. No. 301 at para. 19, [1986] 1 C.T.C. 2473, 86 D.T.C. 1344 (T.C.C.).

(35) [1999] S.C.R. 622, [1999] 4 C.T.C. 313, 99 D.T.C. 5669 [Shell].

(36) Ibid. at para. 36.

(37) Ibid. at para. 39.

(38) Ibid. at para. 68.

(39) Ibid. at para. 74.

(40) Ibid.

(41) Ibid. at para. 70.

(42) Supra note 2.

(43) Ibid. at para. 32.

(44) ITA, supra note 1, s. 20(1)(f)(i)(B).

(45) Supra note 2 at para. 52.

(46) Ibid. at para. 55.

(47) Ibid. at para. 54. This holds true even though cases such as Tip Top involve the repayment of debt.

(48) [1993] S.C.J. No. 123, [1993] 2 C.T.C. 306, 93 D.T.C. 5507 (S.C.C.) [Friedberg].

(49) Ibid. at para. 4.

(50) This is subject to a C$200 de minimis rule when applied to individuals.

(51) Supra note 2 at para. 68.

(52) Ibid. at para. 99.

(53) Supra note 35 at para. 74.

(54) This is a simplification of the mathematical relationship discussed above; it disregards the effects of compounding but still shows the basic relationship.

(55) The "weak currency debt" must be in excess of $500,000 and the foreign interest rate payable on that debt must exceed the interest payable on an equivalent loan denominated in the currency in which the funds are ultimately put to use.

(56) Supra note 2 at para. 2.

(57) Above note 35 at para 70.

(58) This future exchange rate is based on the interest rate parity relationship described above assuming a domestic interest rate of 5.00% and a foreign interest rate of 2.00% for a one-year period.

(59) A reduction in the foreign interest rate, for example, might have this effect.

(60) A second issue with respect to such futures and forward contracts is whether they should be assessed on a realization or mark-to-market (accrual) basis. In Friedberg, the Supreme Court of Canada unanimously held that futures contracts could be reported on a realization basis for tax purposes. This meant that taxpayers could hold offsetting futures positions (both long and short) and realize losses on one position by closing it out (realization) while accumulating and deferring returns (as well as the connected tax liability) by maintaining the opposite position. This decision resulted in economic inefficiency because it created incentives for taxpayers to structure their transactions such that they could indefinitely defer their tax liability while realizing the correlative loss. h must be noted that once the losing position is closed out, the taxpayer is left holding a naked position and as such is exposed to market risks. However, if we assume that the long-term trend can be reasonably forecasted based on futures prices, the market risk is lessened. This does not however negate the fact that there is a tax asymmetry created by the ability to deduct losses while deferring gains-notwithstanding that the economic (mark-to-market) position may be nil. The decision disconnects the economic reality of a transaction from its legal effect.

In response to this decision, Parliament enacted s. 142.5 that required tax reporting on a mark-to-market basis. Although this provision was a step in the right direction, it did not go far enough in remedying the distortionary effects on taxpayer decision-making. Section 142.5 only applies to "financial institutions"; this is an arbitrary distinction. Any taxpayer, whether in the financial services industry or otherwise, can participate in derivative markets and hedging strategies. For example, an oil and gas producer could potentially completely hedge its production by taking offsetting positions in crude oil futures and only close out losing positions while continuing to hold winning positions. This is the precisely the same situation as in Friedberg but simply in a different factual context. Therefore the requirement of mark-to-market tax reporting for offsetting derivative positions should apply equally to ail taxpayers. More importantly, however, is the fact that s. 142.5 only contemplates the netting, through a mark-to-market accounting, of offsetting futures positions. If a taxpayer simply entered into a long futures position, the gains or losses on that position would not attract the mark-to-market requirements of s. 142.5. This fails to recognize the fact that a business may simply "offset" a futures position with a natural hedge, that is, an operational hedge. As an example, assume that the taxpayer in Tip Top observes that the value of the pound sterling is expected to appreciate relative to the Canadian dollar. If the taxpayer requires monthly purchases of cloth priced in pounds sterling, it will surfer a currency exchange loss on each payment. At the same time, the taxpayer may negotiate a long-term forward contract with a financial institution, in which it takes a long-position in the pound sterling. The result would be that the taxpayer could realize and deduct its current losses on the payment of pounds sterling for each purchase of inventory while at the same time accruing an exact offsetting gain through the forward contract. On mark-to-market terms, this would result in a zero sum gain, as the positions perfectly offset each other. However, because Friedberg and s. 142.5 allow the taxpayer to report the losses on realization but treat the gains on an accrual basis, the taxpayer may effectively defer its tax liability on any gain on the hedge for however long the period of the forward agreement provides. This creates incentives for taxpayers to temporally allocate losses and to enter into transactions they may not otherwise enter into in order to benefit from the deferral of tax on the accrual of hedging gains.

It must be noted that an operational hedge is much more difficult to perfectly execute than a financial one. This is due to the fact that the business operations of a taxpayer and its resultant financial results are not "locked-in" in the same way as is the case in a taking a position in a derivative contract. There may be any number of interim business and market factors that affect the results of a business and therefore create an imbalance between the operational outcomes and the hedge results. Furthermore, there may be a number of policy purposes, such as encouraging the use of hedging to promote stable financial returns and facilitate long-term financial planning that would support the taxation of hedging contracts only on realization. These considerations are not affected by the proposition that, from a strict neutrality perspective, the returns on derivate hedges should be accounted for on a mark-to-market or accrual basis to avoid the possibility of tax deferral.

(61) A secondary issue that this article examined was the timing of foreign currency futures. Although somewhat less important than the issue of characterization, the timing of futures contracts can affect taxpayer behaviour through the possibility of tax deferral strategies. Even though s. 142.5 was a step in the right direction, it did not go far enough to eliminate incentives for all taxpayers to engage in tax-deferral through futures contracts. The mark-to-market method of accounting should be applied to all taxpayers to avoid the possibility of tax deferral through financial or operational hedges. This is not simply a preference for the financial accounting methodology over other possible treatments of derivative income; rather it is the recognition of the taxpayer's economic return from these instruments. The tierce competitiveness of financial markets provides an active field for financial alchemists to create exotic instruments of increasing complexity with a view to driving a wedge between legal form and economic substance. A general application of the mark-to-market accounting for tax liability would be a relatively simple tool to ensure the returns from derivative instruments are attributed to the taxpayer.

(62) Supra note 1, s. 20(1)(c). This section provides that interest on money borrowed by the taxpayer to earn income from a business or property is deductible.

(63) Ibid., s. 12(1)(c). This section provides that amounts received in satisfaction of interest shall be included in the income from a business or property for the year.

SINA AKBARI, B.Comm. (Calgary), J.D. (Toronto). The author is currently a Student-at-Law at Osier, Hoskin & Harcourt LLP in Toronto.
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