Canco, which had elected a qualifying currency as its functional currency, claimed a refund (made in Canadian dollars as required by s. 261(11)) by filing an amended return (apparently as a result of carrying back a loss to that year). As a result of the subsequent appreciation of the Canadian dollar as compared to the "exchange rate applicable to determine its taxes payable for [that] year," it realized an FX gain (relative to the qualifying currency) when it received the refund in Canadian dollars. Was this gain to be included in Canco’s income as ordinary income or a taxable capital gain?
After noting that “where a loss from a subsequent taxation year is carried back to a particular taxation year, the revised income taxes payable and any resulting refund are computed using the exchange rates applicable to that particular year, regardless of the exchange rate in the subsequent year,” the Directorate stated that “a functional currency reporter being required to compute and pay their income tax in a currency other than their tax reporting currency is similar to that of a Canadian-resident taxpayer that pays income tax in a currency other than CAD … to a foreign jurisdiction.” After referencing the positions in Folio S5-F2-C1, paras. 1.4301.44, that “the rules in subsection 39(2) will apply to gains or losses arising from the currency conversion of the amounts of … foreign taxes” based on the difference between their amount at the FX rate used for foreign tax credit purposes and that at the rate at the time of settlement of the tax liability or receipt of the refund, the Directorate stated:
These same principles are applicable to a functional currency reporter in respect of the reporter’s income taxes payable under the Act and gains or losses of a functional currency reporter on exchange in respect of [whether] its income taxes payable under the Act are gains or losses to which the rules in subsections 39(1) to (2.1) apply.
Consequently, the foreign exchange gain realized by Canco for financial accounting purposes in respect of the refund it received … will result in the realization of a capital gain … .