Functional Currency Election Issues

A recent CRA technical interpretation (2017-0691211C6, April 26, 2017) regarding subsections 261(20) and (21) raises issues that taxpayers may want to consider before they make a functional currency election.

Suppose that a Canadian company (Canco 1) has elected pursuant to subsection 261(3) to have the US dollar as its tax-reporting currency. Canco 1 has a wholly owned foreign affiliate (Forco). Canco 1's sister company in Canada (Canco 2) has not made a functional currency election, and therefore its tax-reporting currency is the Canadian dollar; however, it has received a US-dollar-denominated loan from Forco. Assume that the loan is capital property in respect of Canco 2 and Forco. If Forco were to realize any foreign exchange gain or loss on the repayment of the loan, the gain or loss would be relevant in computing Forco's FAPI because the loan is not excluded property.

Suppose that Canco 2 realizes a foreign exchange loss on the repayment of the loan. The question is whether subsection 261(21) might apply to deem this loss not to have occurred. Many practitioners had thought that this rule could not apply, especially if Forco did not have a taxable presence in Canada (and thus would normally not be considered to have "Canadian tax results" and therefore a Canadian "tax reporting currency," as those terms are defined in subsection 261(1)). However, subsection 261(6.1) deems that Forco has elected to compute its Canadian tax results in the same elected functional currency as Canco 1 (the US dollar), and that its Canadian tax results include its FAPI in respect of Canco 1. As the TI notes, Forco and Canco 2 will have different tax-reporting currencies (the US dollar for Forco and the Canadian dollar for Canco 2) during the period in which the foreign exchange gain or loss was accrued. The effect is that the transaction between Canco 2 and Forco will satisfy the conditions in subsection 261(20). Therefore, subsection 261(21) will deny the deductibility of the foreign exchange loss to Canco 2.

A second issue is that the CRA notes that if the loan was denominated in a currency other than Canco 1's elected functional currency (the US dollar), foreign exchange losses realized by Forco could be denied in computing its FAPI.

Finally, it should be noted that in the situation analyzed in the TI, the loss offsets (in pre-tax terms) a foreign exchange gain realized on a third-party hedge. However, this fact was not mentioned in the CRA's analysis of the tax consequences of the transactions. Thus, in the example above, the loss to Canco 2 would be denied even if it had offset a gain on such a hedge. This outcome is problematic on policy grounds; an intercompany transaction generating a foreign exchange loss, in conjunction with a third-party hedge or a borrowing from a third party generating an offsetting gain, is a legitimate business transaction that should not be subject to a tax disincentive. After all, the purpose of the anti-avoidance rule in subsections 261(20) and (21) is to protect against abuses of the functional currency reporting regime, and the rule should not interfere with legitimate business transactions. This issue was also raised in the January 19, 2012 submission to the Department of Finance from the Joint Committee on Taxation of the Canadian Bar Association and CPA Canada.

Silvia Wang and Joe Zahary
BDO Canada LLP, Mississauga

Canadian Tax Focus
Volume 7, Number 3, August 2017
©2017, Canadian Tax Foundation