Tax Court rules favourably on capital protection hedge

Profits made under  currency swap transactions designed to hedge currency risk in a taxpayer’s investment in foreign subsidiaries have been found to be on capital account by the Tax Court of Canada.

The case is George Weston Limited v. The Queen2015 TCC 42. Justice Lucie Lamarre concluded that the Appellant, a parent company with U.S. subsidiaries, entered into swap agreements in order to protect the currency risk that was inherently involved in its investments in U.S. operations and the resulting possible effect on its corporate debt/equity ratio (because assets whose value derives from the US dollar may increase or decrease in value to a Canadian parent as the currency fluctuates). As such, she stated they were a hedge related to a capital asset of the taxpayer:

In sum, the present case involves a situation that has not previously been brought before the courts, at least that I am aware of. The appellant made a commercial and business decision, after careful consideration, to enter into the swaps in order to protect its consolidated group equity. It knew better than anyone else the consequences of having its net investment assets exposed to the risk of currency fluctuations. The swaps are commercial derivatives designed expressly to circumvent that kind of risk. As stated by Ms. Frost, the swaps were not speculative transactions. They were designed for hedging in the financial market. Now when the risk vanished, there was no need to keep the swaps. Here, GWL was satisfied that the swaps were no longer necessary when the risk exposure of the net investment assets was reduced significantly. They therefore decided to unwind the swaps. I have concluded that the swaps were entered into to protect a capital investment, and therefore they were linked to a capital asset. Absent unacceptable risk with regard to those capital assets, the swaps had to be terminated since the reason for their existence no longer applied, and the gain or loss from unwinding the swaps should, in my view, be treated as being on capital account.

It is useful to have a clear statement from the Tax Court that such hedges (which CRA sought to tax on income account since (a) the assets hedged were not proposed or likely to be sold by the taxpayer and (b) could only be linked to assets owned not by the taxpayer, but by subsidiaries) are nevertheless treated on capital account given the important business purpose to which they were put. “Linkage”, incidentally, is a quasi-technical concept important in the tax treatment of hedging gains and losses.

Hedging issues, and the correct tax treatment and characterization of hedge contracts (or any swaps and derivatives), are extremely complex and if you have questions regarding the characterization of gains or losses on a swap or derivative, consult your tax advisors or experienced tax counsel.

Written by Craig Burley

Craig is a tax lawyer in private practice in Hamilton, Ontario. Call Craig at (905) 870-0196 to discuss issues that you think may need independent tax advice. In addition to tax, Craig writes and works publicly on a number of other issues related to law, justice, and public affairs.