Canada: New And Improved Functional Currency Proposals - Tax Topics

On November 10, 2008, the Department of Finance released draft legislation to amend the recently enacted functional currency rules in section 261 of the Income Tax Act (Canada) (the ''Act''). The proposed amendments follow from the Finance press release of June 27, 2008, which first announced the most significant of the intended changes. Among other things, that press release extended the first deadline for electing into the functional currency regime to October 31, 2008 for taxation years of Canadian corporations beginning after December 13, 2007. In an October 29, 2008 press release, that deadline was further extended to December 15, 2008. The new draft legislation incorporates this initial extended election deadline, adopts the changes first announced on June 27, 2008, and implements numerous other modifications to the functional currency regime in the course of completely rewriting section 261.

This article reviews the key changes to the functional currency regime proposed in the draft legislation, and describes in high-level terms the operation of the new overhauled rules. The draft legislation proposes a comprehensive replacement of section 261, and the accompanying Finance explanatory notes (the ''Explanatory Notes'') provide quite a helpful description of the many changes. This article therefore highlights only the more significant changes to build on the commentary in the Explanatory Notes. New aspects of the proposed functional currency rules that deal with their application to partnerships and to ''reversionary years'' of taxpayers that exit from the functional currency regime are noted, but not discussed.

Overview Of The Revised Functional Currency Rules

All taxpayers are subject to subsection 261(2), which requires that Canadian currency be used to determine the Canadian tax results of a taxpayer, unless the taxpayer is a Canadian resident corporation that has elected instead to determine its Canadian tax results using a qualifying functional currency. The Canadian tax results that are to be determined in either Canadian currency or a functional currency are the computations of a taxpayer's income, taxable income, taxable income earned in Canada, tax or other amounts payable by or refundable to the taxpayer, and any amounts relevant in determining such amounts — in other words, every computation that matters for tax purposes.

The general rule in subsection 261(2) clarifies that, for most purposes of the Act, where a taxpayer has not elected to use a foreign functional currency, and therefore uses Canadian currency to determine its Canadian tax results any relevant amounts expressed in a non-Canadian currency are to be converted into Canadian currency using the relevant spot rate for the day on which the particular amount first arose. The relevant spot rate for converting to or from Canadian currency is defined as the rate quoted by the Bank of Canada for noon on the particular day (or the closest preceding day for which a rate is quoted), although it may also include another rate of exchange that is acceptable to the Minister, providing some degree of potential flexibility in cases where the noon Bank of Canada rate may not be appropriate.

However, the main thrust of the functional currency rules is contained in new subsection 261(5), which applies where a Canadian resident corporate taxpayer has elected to determine its Canadian tax results in a qualifying functional currency. In this case, the Canadian tax results are to be determined using the ''elected functional currency''; namely, the functional currency for the taxpayer's first functional currency year. For most purposes, the Act is to be effectively reread for such taxpayers so that references to amounts expressed in Canadian dollars are instead to be read as references to amounts expressed in the taxpayer's elected functional currency, using the relevant spot rate for the first day of the particular taxation year. Nonetheless, proposed subsection 261(11) confirms that, while taxes payable under the Act are computed in the elected functional currency, taxes must be paid in Canadian dollars (converted using the relevant spot rate for the taxpayer's balance-due day).

For electing taxpayers, and for most purposes of the Act, where particular amounts relevant in determining a taxpayer's Canadian tax results are expressed in a currency other than the taxpayer's elected functional currency, the amounts are to be converted into the elected functional currency using the relevant spot rate for the day on which the amount first arose. For such conversions between two non-Canadian currencies, the definition of ''relevant spot rate'' requires an indirect conversion by reference to the Bank of Canada rate for exchanging each of those foreign currencies into Canadian dollars at noon on the particular day (or the closest preceding day for which both such exchange rates are quoted), although provision is made for using another rate of exchange that is acceptable to the Minister. This potential flexibility is even more likely to be required where, for example, exchange rates between two foreign currencies are directly quoted from other reputable sources in other time zones contemporaneous with the actual transaction, in cases where an indirect conversion using noon Bank of Canada rates would be more cumbersome and less precise.

One aspect of the functional currency rules of particular relevance for Canadian corporations with foreign affiliate groups is the rule in proposed paragraph 261(5)(h), which requires the references to ''Canadian currency'' in section 95, and the regulations made for purposes of sections 95 and 113, to be read as ''the taxpayer's functional currency''. Thus, for instance, calculations of a foreign affiliate's foreign accrual property income (''FAPI'') must be made in the functional currency, and not in Canadian dollars, pursuant to the proposed calculating currency rules in paragraph 95(2)(f.14). Canadian corporations that adopt an elected functional currency that is the same as the calculating currency of their foreign affiliates will have a substantially easier time managing foreign exchange risk in circumstances where the relieving rules in paragraph 95(2)(g) or (i ) do not apply. For instance, until now, it has generally been advisable to denominate loans between foreign affiliates and their parent Canadian corporation in Canadian dollars to eliminate the ''mismatch'' foreign exchange risk (for example, the risk that a foreign exchange capital loss in the parent would not be available to shelter the FAPI income inclusion from the equivalent foreign exchange capital gain in the foreign affiliate). Under the functional currency rules, foreign affiliate loans to or from the Canadian parent corporation may now be made in the taxpayer's elected functional currency without risk of inadvertently triggering foreign exchange gains or losses that could potentially give rise to unsheltered FAPI.

One common issue for all taxpayers under both the Canadian currency regime and the functional currency regime is the requirement to convert amounts into the tax reporting currency based on the relevant spot rate for the day on which the amount ''first arose''. The application this requirement is not as clear as it could be for accruing amounts such as, for example, salary expenses or interest costs, which might be said to arise continuously during the period they accrue. Or take the case of a repayment of amount of principal of borrowed money — can it be said that the amount ''first arose'' when the principal was advanced, or when it was repaid? Practically, it is expected that the relevant day for converting such foreign currency amounts in most cases will be the day of payment in the foreign currency, but additional guidance to resolve these ambiguities would be helpful. In addition, it is noted that the historic administrative position of the Canada Revenue Agency, as expressed for example in IT-95R, is to accept consistently applied alternative methods of converting foreign currency amounts, including the use of an average rate of exchange during the year. It remains to be seen whether these administrative policies will be continued or modified under the statutory authority that the relevant spot rate is based on the Bank of Canada noon rate for the day the amount first arose, ''or another rate of exchange that is acceptable to the Minister''.

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