Denial of Capital Losses from Foreign Currency Fluctuations
New subsection 39(2), as proposed in Bill C-48 (first reading November 21, 2012), resolves a longstanding uncertainty about whether certain foreign exchange gains or losses are recognized for tax purposes under subsection 39(1) or under subsection 39(2). The new rules may trigger the application of stop-loss rules, which, in some foreign affiliate situations, may cause a real economic loss not to be recognized for Canadian tax purposes.
Current subsection 39(2) applies when a taxpayer makes a gain or sustains a loss from foreign exchange fluctuations, whereas subsection 39(1) applies when a taxpayer disposes of property. These two provisions seem to overlap when there is a capital gain or loss from a disposition of property and all or part of that capital gain or loss is derived from foreign currency fluctuations relative to Canadian currency. Is the capital gain or loss determined under subsection 39(1) or under subsection 39(2)?
This question is of little consequence if there is a gain. If there is a loss, however, a taxpayer may gain an advantage from the application of subsection 39(2): one could argue that the stop-loss rules in section 40 do not apply because the loss would be deemed to be a capital loss "from the disposition of currency of a country other than Canada" rather than from the disposition of the property itself. The CRA has said that subsection 39(2) applies if the capital loss arises solely from foreign currency fluctuations (CRA document no. 2009-0327061C6, October 9, 2009), but many commentators have suggested that subsection 39(2) applies more broadly.
Bill C-48 resolves this issue. New subsection 39(2) does not apply to any capital gain or capital loss to which subsection 39(1) applies: foreign exchange gains or losses in respect of asset dispositions--including dispositions of foreign currency--will be determined exclusively under subsection 39(1) (subject to the $200 de minimis amount for individuals other than trusts, which is continued with some changes in new subsection 39(1.1)). Therefore, subsection 39(2) will apply to debtors upon the repayment of debt and similar obligations that are denominated in foreign currency. Creditors will compute their foreign exchange gains or losses derived from the disposition of those debts and similar obligations under subsection 39(1).
This clarification of the application of subsection 39(1) may give rise to odd results in the case of transactions with foreign affiliates. For example, suppose that a Canadian corporation (the creditor) sustains a foreign exchange loss on the disposition to one of its foreign affiliates (FA 1) of an obligation denominated in foreign currency and owed by another foreign affiliate (FA 2). The creditor holds the obligation on account of capital, and the transfer occurs at fair market value. In this case, there is no capital loss: paragraph 40(2)(e.1) applies to deem the loss to be nil (because the loss is sustained on the disposition of an obligation between related parties and the obligation is still payable after the transfer by the debtor to the new creditor). Paragraph 53(1)(f.11) adds the amount of the foreign exchange capital loss to the adjusted cost base (ACB)of the obligation to FA 1. Because FA 1 is not liable to income tax in Canada, this increase in the ACB is irrelevant (except for the purposes of determining the FAPI and surplus of FA 1). Thus, even though the loss is real, it is still eliminated from the standpoint of the Canadian tax base. Note that this problem would not arise if the transaction had occurred between two related Canadian corporations, because the increase in the ACB would still be within the Canadian tax system.
Another consequence of the amendments to subsection 39(2) is that they close off the tax-planning opportunities introduced by McMillan-Bloedel (99 DTC 5454 (FCA)) relating to the redemption of preferred shares denominated in foreign currency. (See Bretsen and Kerr, "Tax Planning for Foreign Currency," in the 2009 Conference Report, 35:1-47.)
PricewaterhouseCoopers LLP, Quebec City