Foreign currency considerations in tax law and policy.

• Author: Akbari, Sina

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 > 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...