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Hedging for Tax Purposes - Does the Common Law Require an Underlying Transaction?
The Canada Revenue Agency ("CRA") recently released 4 internal technical interpretations ("TIs") on the characterisation of foreign exchange ("FX") gains or losses from forward contracts used to hedge foreign investments. One of the issues addressed in the TIs pertained to the definition of a hedge. On this issue, for tax purposes, the CRA unequivocally stated that the hedged item must be a transaction, not an asset or liability. Thus, gains or losses from a forward contract used to hedge foreign investments or subsidiaries should be reported on account of income since "day-to-day fluctuation in the book value of foreign subsidiaries [....] does not constitute an underlying capital transaction." In contrast, the International Financial Reporting Standards ("IFRS") are more flexible and recognise hedging of assets (including foreign investments) or liabilities. In support of its decision, CRA cited a set of court cases. Taxand Canada examines these cases, and considers and comments on whether CRA's reliance on them is justified.
Unlike the IFRS, the CRA has taken the position that the hedged item must be a transaction for a hedge to exist for tax purposes. It is irrelevant if the underlying exposure is capital in nature, and all other conditions for recognising a hedge for tax purposes are met. The CRA primarily relies on the common law to support its administrative position. However, contrary to the assertions of the CRA, the common law cases that it relies on do not rule out the possibility that a forward contract can be linked to something other than a transaction and still be considered a hedge for tax purposes.
While the CRA is correct in stating that the IFRS and commercial principles do not have the force of law, they are not without value. Courts have often relied on accounting and commercial principles as tools of interpretation whenever statutory definitions are absent or incomplete. Indeed, the other factors used to determine if a hedge exists for tax purposes closely mirror those used in IFRS to determine if hedge accounting is appropriate. Exposure to balance sheet volatility from FX fluctuations is a risk faced by many corporate taxpayers, and the hedge of this exposure is recognised by the IFRS. Thus, in the absence of a clear statutory prohibition in the ITA and common law, it is not clear that the CRA should adopt such a restrictive definition of "hedging" and not take into consideration the IFRS or commercial principles.
Nevertheless, based on the TIs, it seems clear that the CRA is not prepared to revisit their long-standing position.
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