October 30, 1986
Toronto District Office Audit Review Section Business Enquiries Group
P. J. Robinson
Head Office Specialty Rulings Directorate Tel: (613) 957-2117
XXXX
This is in reply to your memorandum of October 30, 1985 in which you request an opinion on the application of subsection 85(4) of the Income Tax Act (the "Act") to a foreign exchange loss incurred by XXXX.
We apologize for the delay in replying to your memorandum but our position with respect to the interaction of the application of subsections 39(1) and 39(2) of the Act has been subject to an extensive review which included requests for legal opinions. That review was completed on October 13, 1986 and our position in general on the interaction of subsections 39(1) and 39(2) of Act can be summarized as follows:
(a) Section 40 of the Act determines whether or not a taxpayer has made a gain or sustained a loss as the result of the disposition of a property.
(b) Only after such a gain or loss has been determined under the provisions of section 40 of the Act can section 39 of the Act be used to compute the capital gain or capital loss as the result of the disposition of that property.
(c) If the gain or loss calculated pursuant to section 40 of the Act arises solely by virtue of any fluctuation in the value of a currency then subsection 39(2) of the Act should be used to compute the capital gain or capital loss. If the gain or loss is not solely attributable to the fluctuation in the value of currency then subsection 39(1) of the Act should be used to compute the capital gain or capital loss.
(d) Generally on an exchange of one property for another to which the rollover provisions of the Act apply, the application of the rules in Section 40 of the Act do not produce a gain or loss either because the exchange has been deemed not to be a disposition of property or the proceeds of disposition are equal to the adjusted cost base of the property disposed of. Therefore, as the result of such an exchange of property there is no gain or loss to which either subsection 39(1) or (2) of the Act can apply.
(e) Where the entire gain that could be realized on the disposition of a property is solely attributable to a fluctuation in currency but only partially deferred as the result of the application of a rollover provision of the Act (e.g. subsections 85(1), and 86(1) of the Act), the provisions of subsection 39(2) of the Act apply to compute the portion of the capital gain which is not deferred. In any other case the portion of the capital gain which is not deferred is computed under the provisions of subsection 39(1) of the Act.
(f) Where a loss otherwise determined from the disposition of property is nil pursuant to the provisions of section 40 of the Act, no loss has been sustained for the purposes of subsection 39(2) of the Act even where the loss otherwise determined is solely attributable to a fluctuation in the value of currency.
(g) Where the provisions of paragraph 40(2)(e) or (g) of the Act apply as the result of the disposition of a capital property and the loss otherwise determined as the result of the disposition of the capital property is solely attributable to a fluctuation in the value of currency, for the purposes of subsection 85(4) such a transaction is considered in isolation from other transactions of the taxpayer that might have produced a foreign exchange gain or loss in the same year. The capital loss, thus isolated, is from the disposition of capital property and subsection 85(4) of the Act applies.
The situation you are concerned about is as follows:
XXXX
4. XXXX reported the above losses as capital losses on its 1981, 1982 and 1983 T2 returns. The corporation's position in this regard is based on the commentary at page 39-111 in the Canada Tax Service published by Richard De Boo which states in part:
"Where a taxpayer repays a debt on capital account and that debt is expressed in a foreign currency, the taxpayer at that time may make a gain or sustain a loss to which subsection 39(2) would apply. Where the taxpayer has transferred immovable property and a part of the consideration is the assumption of a mortgage debt relating to that property, the same result will follow. Where the taxpayer and the transferee are not at arm's length, it would appear that the rules which would otherwise deny a capital loss to the taxpayer, contained in paragraphs 40(2)(e) and (g) and subsection 85(4), cannot have application, since the taxpayer is deemed by subsection 39(2) to have sustained a loss from the disposition of foreign currency and it cannot be said that for the purposes of the Act, this presumed disposition was made to any particular person."
Our Position as it Relates to XXXX
The Department has taken the long standing position that the "accrual" method of accounting for foreign exchange gains and losses is not acceptable for the purposes of reporting foreign exchange gains and losses on account of capital. In order to account for such gains or losses for tax purposes there must be a disposition of property. In the case of XXXX it is our view that repayment of the debenture in whole or in part constitutes a disposition by XXXX of capital property (being the portion of the debentures repaid) to XXXX Therefore XXXX has the losses set out in item 3 above as the result of the disposition of capital property.
In accordance with item (a) and (b) above, it is our position that the provisions of section 40 of the Act apply to determine whether or not there are losses to which subsection 39(2) of the Act applies in the computation of capital losses. Based on the information provided it appears that either paragraph 40(2)(e) or 40(2)(g) of Act apply to deem the losses as otherwise determined to be nil and as there are no losses to which subsection 39(2) of the Act can apply XXXX would not be allowed the capital losses which it claimed as described in item 4 above.
Should the losses be denied pursuant to the application of paragraph 40(2)(e) or paragraph 40(2)(g) of the Act it is our position that the provisions of subsection 85(4) of the Act apply to add the denied losses to the ACB of the shares of XXXX.
In conclusion we agree with your view that while the provisions of subsection 39(2) of the Act apply to the debtor as set out above in the quotation from the Canada Tax device, the provisions of section 40 of the Act apply to the creditor and where either paragraph 40(2)(e) or (g) of the Act apply to deem the creditor's loss to nil, the provisions of subsection 85(4) of the Act apply to the denied loss.
Chief Foreign and Small Business Section Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch
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