Receiving a refund of overpaid taxes from the Canada Revenue Agency (CRA) is great. But what if the refund of the overpayment results in a foreign exchange (FX) gain? This gain can occur when the taxpayer reports in a foreign currency, converts its liability to Canadian dollars (CAD) to pay the tax in CAD, receives a CAD refund and then coverts that refund back to its reporting currency. How should the gain on conversion of the refund be reflected in the taxpayer’s income?
The CRA addressed these issues in a recent technical interpretation, 2016-0649631I7. In particular, the CRA considered whether such a FX gain would be on account of income or capital.
Primer on income tax reporting and functional currency rules
Section 261 of the Income Tax Act (ITA) generally requires that Canadian taxpayers use CAD to determine Canadian tax results. However, an exception allows a Canadian resident corporation to elect to determine its Canadian tax results using a ‘qualifying functional currency’. A qualifying functional currency includes currencies of the United States, United Kingdom, European Monetary Union (Euro), Australia and a prescribed currency.
Further, notwithstanding the qualifying functional currency exception, a taxpayer’s tax instalment obligations must be computed (and paid) in CAD. Thus, if a Canadian resident corporation elects to determine its Canadian tax results using a qualifying functional currency, it would still be required to compute and pay its income tax instalment obligations in CAD.
Section 261 also provides a mechanism to convert foreign denominated amounts to CAD or vice versa. Essentially, these conversions must be made using the ‘relevant spot rate’ for the day on which the particular amount arose.
CRA view 2016-0649631l7
A Canadian corporation (Canco) elected to report its Canadian tax results in its functional currency other than CAD. Although, the CRA view is silent on the functional currency used by Canco, for illustrative purposes we assume that Canco reports its Canadian tax results in United States dollars (USD).
In the current year, Canco realizes that it overstated its income for the previous taxation year, and had thus overpaid income tax to the CRA. For example, Canco reported a net income of USD 80 for its previous taxation year, which it realizes should actually have been USD 60. Assuming a corporate tax rate of 30 per cent, Canco originally computed its income tax liability as USD 24, which should have been USD 18.
Given Canco is required to remit its income taxes in CAD, it converted the originally-computed USD 24 to CAD using a FX rate of 1 CAD = 0.8 USD (relevant spot rate as on the day of payment) and remitted CAD 30 to the CRA. On realizing that it had overstated its income for that year, Canco converted its revised income tax liability of USD 18 to CAD 22.5, using the same FX rate of 1 CAD = 0.8 USD.
Canco requested a refund of the excess income tax paid (CAD 7.5), which was approved and processed in CAD. As Canco reports its Canadian tax results in USD, it converted the amount of refund to USD using the FX rate of 1 CAD = 1 USD (spot rate as on the day of receipt of refund). Therefore, Canco reported a refund of USD 7.5 in its Canadian tax results, rather than the USD 6 (difference between USD 24 originally computed and the USD 18 under the revised computation). Canco therefore realized a gain of USD 1.5 on conversion of the refund.
Because Canco's income taxes are payable and refunded in CAD, while its income is computed in USD for accounting and Canadian tax purposes, the resulting FX gain (of USD 1.5 in this example) reflected for financial accounting purposes in respect of its refund is relevant to the determination of its income for Canadian tax purposes.
FX gain on refund of overpaid tax to be on account of capital
The CRA observed that this situation is similar to that of a Canadian-resident taxpayer that pays income tax in a currency other than CAD to a foreign jurisdiction. The CRA therefore relied on its long-standing position in that regard and stated that FX gain or loss incurred in these situations are to be treated the same way as the FX gain or loss on the payment of any other debt denominated in a foreign currency under subsection 39(2), in other words as a capital transaction.
Functional currency filers should consider FX rates when requesting refund of overpaid taxes
Functional currency filers may realize FX capital gains or losses on refunds of overpaid Canadian taxes (in CAD). To optimize a functional currency filer’s tax position, this CRA view may incentivize diligent review of prior year income tax returns and monitoring of FX fluctuations to evaluate the expected FX capital gain or loss in submitting an application for a refund.