Dear Sirs:
This is in reply to your correspondence dated December 13, 1990 wherein you requested our opinion as to the rationale behind Correction Sheet No. 11 dated October 19, 1984 which amended paragraph 3 of Interpretation Bulletin IT-95R "Foreign Exchange Gains and Losses" dated December 16, 1980.
Paragraph 3 of IT-95R read as follows prior to the issuance of the correction sheet:
"Generally, where borrowed funds are used in the ordinary course of a taxpayer's trading operations, any foreign exchange gain realized on the repayment of the loan is considered to be an income gain and any foreign exchange loss incurred on repayment of the loan is considered to be an income loss. However, where it is obvious that the capitalization of a company is insufficient, and funds are borrowed in a foreign currency to offset this deficiency, any gain or loss as a result of repayment of such funds will be on account of capital, regardless of the use of the funds".
The correction sheet amended the final sentence in paragraph 3 to read as follows:
"The fact that a company which borrowed in a foreign currency was not adequately capitalized does not automatically result in capital treatment of any foreign exchange gains or losses arising on repayment. Capital treatment will result where it can be shown that the borrowed funds form part of the permanent or fixed capital of the company, regardless of the use of the funds. In other cases of 2 inadequate capitalization, the use made of the borrowed funds will determine whether such gains or losses should be on income account or on capital account".
The reason for the correction sheet was to clarify the Department's position concerning the treatment of foreign exchange gains or losses in situations where a corporation is insufficiently capitalized and funds are borrowed in a foreign currency. Paragraph 3 of IT-95R may have been misleading in that it could have been interpreted as meaning that in all cases - where the capitalization of a company was insufficient and the company borrowed funds in a foreign currency, any gain or loss as a result of repayment of such borrowing would always be on account of capital regardless of the use of the funds.
The relevant jurisprudence does not support such a position. The "thin capitalization" concept as it applies to foreign exchange gains and losses is based on the decisions in Montreal Coke and Manufacturing Co. v. M.N.R. 1944 A.C. 126, Bennett and White Const. Co. Ltd. v. M.N.R. 1949 CTC 1, and Columbia Records of Canada Ltd v. M.N.R. 71 DTC 5486. The principal of the concept is that where borrowed funds represent part of the permanent or fixed capital structure of a taxpayer the borrowed funds are on capital account even if the funds have been used in the trading operations of the taxpayer's business.
However, in Aluminum Union v. M.N.R. 60 DTC 1138 and D.W.S. Corporation v. M.N.R. 68 DTC 5045 it was established that even if an obligation is outstanding for a long term this does not in and by itself mean that any foreign exchange gains and losses thereon are capital in nature. Situations could exist where a corporation is inadequately capitalized but borrowed funds (short term or otherwise) do not become a part of its permanent capital. In such cases, as stated in the revision to IT-95R paragraph 3, it will be the use of the borrowed funds which determines whether or not gains or losses are on income or capital account.
We trust the foregoing clarifies the Department's position on this issue.
Yours truly,
for DirectorReorganizations and Non-Resident DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch