The Court of Appeal held that a debtor’s foreign currency loss arising on the redemption of debentures was deductible from business profits under a specific Canadian tax rule, but the Court’s reasons may have broader consequences. In some situations, taking immediate action may result in significant tax savings.

Historically, a debtor’s foreign currency losses arising on repayments of capital debts have been treated in Canada as outlays of, or on account of, capital. However, in Imperial Oil Limited v. The Queen (released in the last week of October 2004), the Federal Court of Appeal held that a foreign currency loss realized by Imperial Oil on the redemption of U.S. dollar long-term debentures was deductible from its business income under a specific provision of the Canadian Income Tax Act.

The Facts and Principal Issue in Imperial Oil

In October 1989, Imperial Oil issued 30-year redeemable debentures for an issue price reflecting an "original issue discount" of 1.199 %. The issuance of the debentures was a capital transaction. Ten years later, Imperial Oil redeemed some of the debentures.

The redeemed debentures had a total face amount of US$87.1 million and had been issued for US$86.1 million, reflecting an "original issue discount" of US$1.0 million. Expressed in Canadian dollars at the time of issue, the issue price was C$101.3 million and the "original issue discount" was C$1.2 million. However, because the Canadian dollar had depreciated relative to the U.S. dollar, the redemption payment of US$87.1 million was C$129.1 million, expressed in Canadian dollars at the time of redemption.

Consequently, in Canadian dollars, the redemption payment exceeded the issue price of the debentures by C$27.8 million. The parties did not agree on how much of the C$27.8 million excess was deductible from Imperial Oil’s business income under a specific provision of the Act.

The Parties’ Positions

Imperial was entitled to a deduction under the Act equal to three-quarters of the excess of (i) the principal amount of the debentures over (ii) the amount for which the debentures were issued if that excess was not a "shallow" discount; otherwise Imperial was entitled to a deduction for the full amount of the excess. Both Imperial Oil and the Crown agreed that, expressed in Canadian dollars, the amount for which the redeemed debentures were issued was C$101.3 million. However, the parties did not agree on how to express the principal amount of the redeemed debentures in Canadian dollars.

The Crown argued that the principal amount of the debentures was C$102.5 million expressed in Canadian dollars because the foreign exchange rate at the time of issue must be used; otherwise, there would be an increase in the principal amount of the debentures by virtue of currency fluctuations, which would be contrary to the Act’s definition of "principal amount" (generally, the maximum amount payable by the issuer on account of the obligation, other than interest or an early redemption premium). Therefore, in the Crown’s view, the amount deductible from Imperial Oil’s business income was C$1.2 million (the "original issue discount" expressed in Canadian dollars at the time of issue) because that was a "shallow" discount, and the balance of C$26.6 million was a capital loss sustained by Imperial Oil because of currency fluctuations that was not deductible from Imperial Oil’s business income.

Imperial Oil argued that the principal amount of the debentures was C$129.1 million expressed in Canadian dollars because the foreign exchange rate at the time of redemption must be used, and the excess amount was C$27.8 million. Therefore, Imperial Oil’s position was that the discount was not a "shallow" discount and the amount deductible from its business income was three-quarters of C$27.8 million.

The Federal Court of Appeal’s Decision

Since the 1991 decision of the Federal Court of Appeal in Gaynor, it has been accepted that, in computing capital gains and losses for Canadian tax purposes, the cost of a property acquired and the proceeds of the sale of the property must each be expressed in Canadian dollars using the foreign exchange rate at the time of the relevant transaction (that is, at the time of the acquisition and disposition of the property, respectively). The Tax Court’s decision in Imperial Oil restricted the application of the Gaynor principle to the computation of capital gains and losses and held that it did not apply to the computation of the amount deductible from Imperial Oil’s business income.

Both Imperial Oil and the Crown disagreed with this aspect of the Tax Court’s decision. On appeal, the Federal Court of Appeal agreed that the application of the Gaynor principle was not restricted to the computation of capital gains and losses but applied to any statutory formula in the Act. Therefore, the Court held that each element of the statutory formula that determines the amount deductible from Imperial Oil’s business income on the redemption of the debentures must be converted into Canadian dollars using the foreign exchange rate at the time of the relevant transaction.

The parties agreed that, applying the Gaynor principle, the debentures had been issued in 1989 for C$101.3 million, using the foreign exchange rate at the time they were issued. But two questions remained with respect to the determination of the principal amount of the debentures.

1. Fluctuating Principal Amount

Imperial Oil argued that, under the Gaynor principle, the Canadian dollar equivalent of the principal amount had to be determined using the foreign exchange rate at the time of the redemption. The Crown did not agree; it argued that the use of the foreign exchange rate at the time the debentures were redeemed resulted in an increase in the principal amount of the debentures, which was contrary to the Act’s definition of "principal amount."

The Court rejected the Crown’s argument and held that any fluctuation in the "principal amount," as defined for tax purposes, was mandated by the terms of a debt denominated in a foreign currency. Consequently, in Imperial Oil’s case, the Court found that the principal amount, expressed in Canadian dollars, of the redeemed debentures did increase from the time of their issue to the time of their redemption.

2. Time of Determination

In applying the Gaynor principle, Imperial Oil took the position that the principal amount of the debentures had to be expressed in Canadian dollars using the foreign exchange rate at the time of their redemption. The Crown disagreed. It argued that the correct time for such determination was the time the debentures were issued because a deduction in computing business income was intended to be available only for the "original issue discount."

The Court rejected the Crown’s argument and agreed with Imperial Oil’s position. The Act did not, either expressly or by necessary implication, limit the deduction available under the specific provision to original issue discounts. And the Crown’s position (like the Tax Court’s decision) produced an anomalous result because it would allow a deduction for a payment made at the time of redemption but the amount of the deduction would be determined using the foreign exchange rate at the time of issue. The Crown had also admitted that a deduction was available for commodity-based loans whether or not there was an original issue discount.

Implications of Imperial

The Federal Court of Appeal’s decision in Imperial Oil has many implications for issuers of debts denominated in a foreign currency (whether or not issued at a discount). It is still too early to say whether an appeal of the decision to the Supreme Court of Canada will be sought by the Crown or be allowed by the Supreme Court.

Nevertheless, Canadian taxpayers who have issued capital debts denominated in a foreign currency should take note of the following matters, some of which may require immediate action:

  • To the extent possible, taxpayers should consider filing amended tax returns for prior years to claim any losses arising on repayment of debt denominated in a foreign currency that remain unclaimed, or that may already have been claimed or allowed as capital losses.
  • Where possible, taxpayers should take into account foreign exchange rates and the conditions for a full deduction of any loss in determining when a debt denominated in a foreign currency should be repaid. A change in the timing of any repayment may produce substantial tax savings.

Taxpayers should also consider the implications of the Gaynor principle in other circumstances involving the application of a statutory formula under the Act with foreign currency elements. Depending upon their particular circumstances, taxpayers may wish to seek the appropriate confirmations from the Canada Revenue Agency or the Department of Finance.

Hemant Tilak and Sabrina Wong are partners in Osler's national Taxation Department, where Matt Peters is an associate.

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