Principal Issues: Whether an average exchange rate may be used for the calculation of deemed accrued interest on coupons.
Position: The use of an average rate should generally be allowed, provided that it is reasonable to conclude that the use of the average rate would still result in a reliable approximation of what a taxpayer's income would have been using daily exchange rates.
Reasons: Provided that the foreign exchange rates are sufficiently stable and the taxpayer uses the average rate consistently, the use of an average rate for the conversion of deemed accrued interest on stripped coupons is likely to be tax-neutral and is unlikely to provide any tax advantage.
FINANCIAL STRATEGIES AND FINANCIAL INSTRUMENTS ROUNDTABLE, 10 OCTOBER 2024
2024 APFF CONFERENCE
Q.2 Clarification regarding the exchange rate and deemed accrued interest
In the APFF 2023 Financial Strategies and Financial Instruments Roundtable,(footnote 1) the CRA indicated that where a stripped coupon is denominated in a foreign currency, the exchange rate that must be used is the exchange rate applicable to the conversion of such currency into Canadian dollars for the portion accrued during each of the days during which such deemed accrued interest must be calculated pursuant to subsections 12(3), 12(4) and 12(9).
Question
Could the CRA accept, for practical reasons, the use of an average exchange rate for the conversion of this deemed accrued interest into Canadian dollars?
CRA Response
Paragraph 261(2)(b) requires that any foreign currency amount taken into account in computing Canadian tax results be converted into its Canadian dollar equivalent using the relevant spot rate for the day on which the particular amount arose.
Subsection 261(1) defines the term “relevant spot rate”. Paragraphs 261(1)(a) and 261(1)(b) give the Minister discretion to accept an exchange rate other than the rate defined in paragraph 261(2)(b) that is acceptable to the Minister.
In paragraph 1.6.1 of Income Tax Folio S5-F4-C1, (footnote 2) the CRA states that, for practical reasons, the use of an average of exchange rates over a period of time in order to convert certain income items is accepted. However, if exchange rates fluctuate significantly, the use of the average exchange rate for a period will not generally be accepted.
As stated in the response to Question 3 of the APFF 2022 Financial Strategies and Financial Instruments Roundtable, (footnote 3) the CRA's acceptance of an average rate is based on the condition that it is reasonable to conclude that the use of an average rate will provide a faithful approximation of the taxpayer's income as if the taxpayer had used daily exchange rates.
That response sets out the four conditions that must be met for the CRA to accept the use of an average exchange rate, namely that:
- the amounts to be converted (as determined in foreign currency) are relatively stable and evenly distributed over the given period (for example, annual, quarterly or monthly);
- the amounts arising in the particular period are sufficiently frequent and spread out to not distort income;
- the relevant exchange rate does not fluctuate significantly over the period; and
- the average rate is the rate used by the taxpayer each time these conditions are met.
Deemed accrued interest calculated as provided for in the Income Tax Act in respect of stripped coupons satisfies the first two conditions above.
As for the first condition, the amounts of deemed accrued interest on stripped coupons are effectively stable and evenly distributed over the given period. The interest rate is determined pursuant to subsection 7000(2) of the Income Tax Regulations (footnote 4) in foreign currency on the assumption that the coupon will be held to maturity, and the computation applies throughout the holding period of the coupon. Consequently, this computation distributes the deemed interest evenly on a daily basis until the coupon maturity date.
As for the second condition, the interest amounts arise during each of the days on which the deemed accrued interest must be computed pursuant to subsections 12(3), 12(4) and 12(9). The daily computation of the deemed interest amounts is frequent enough that the use of an average exchange rate does not distort income.
The third condition depends on the unfolding of the foreign exchange market. If the exchange rate in question fluctuates significantly over the period, this condition will not be satisfied. What constitutes a significant difference can be determined in light of the exchange rate difference and the impact of that difference on the amount to be converted.
The fourth condition requires that the taxpayer use the same approach from period to period. The taxpayer using the average rate undertakes to use the chosen approach consistently from one year to the next. The existence of a difference in exchange rates having a significant impact on the converted amount, such that the third condition above is not satisfied during a given period and preventing the use of the average rate during that period, would not affect the use of the average rate to the extent that the average rate is used during all prior and subsequent periods during which the third condition is satisfied.
Those conditions are intended to ensure that the use of the average exchange rate cannot be made with a view to obtaining a tax advantage.
John Fowler
October 10, 2024
Response prepared in collaboration with:
James Atkinson and Marc Bourbeau, Coordinator and Specialist, Industry Specialist Services - Financial Industries Section
Domestic Tax Division
International and Large Business Directorate
Compliance Programs Branch
FOOTNOTES
Due to the requirements of our systems, the footnotes contained in the original document are reproduced below:
1 CANADA REVENUE AGENCY, Technical Interpretation 2023-0978651C6, November 3, 2023.
2 CANADA REVENUE AGENCY, Income Tax Folio S5-F4-C1, “Income Reporting Currency”, June 27, 2024.
3 CANADA REVENUE AGENCY, Technical Interpretation 2022-0943261C6, October 7, 2022.
4 C.R.C., c. 945 (the “Reg”).