Wednesday, October 25, 2006

Imperial Oil Ltd v. Canada -- Thumbs Down

Nothing quite stiffens up the sinews and summons up the blood like a decision on when foreign exchange losses are fully deductible from income for tax purposes.

The Alpha and Omega of the Pithlord's approach to tax policy is Kenneth Carter's* line that "a buck is a buck is a buck." In other words, I am a believer in the Haig-Symons doctrine that income just is increase in wealth plus consumption. Any attempt to distinguish between increases or decreases in the value of assets (capital gains/losses) from other forms of income is doomed to be arbitrary and ad hoc.

But whatever its merits, the distinction is with us. And so, every taxpayer wants to portray good news as a capital gain, but bad news as an income loss. The Man feels exactly the opposite, of course. Since the distinction is actually bogus, this gives a lot of opportunities to tax lawyers to feed their families. If I were a better person (or a tax lawyer), I wouldn't resent this, but I'm not, so I do.

One issue that comes up from time-to-time is whether the foreign exchange gains/losses of transactions conducted in non-Canadian currencies are capital or income losses/gains. The governing principle, I am lead to understand, is that the same characterization that applies to the non-currency part of the transaction, applies to the whole of it. If I buy stock in a Malaysian company, then the whole of my loss--whether attributable to undisclosed financial irregularities by senior management or a tanking Canadian dollar -- is a capital loss. If I buy and sell widgets in Kazakhstani dinars (or whatever), then it's a business loss/gain and is taxable (or deductible) as ordinary income.

Along with this principle (and necessary to make sense of it) is the principle that the only currency for the purposes of Canadian law is the Canadian dollar -- every element of a statutory formula must be translated into loonies.

The Imperial Oil case turned on a type of transaction that is a capital one, but is specifically designated as deductible from income by the Income Tax Act -- the redemption of debt obligations. There's a long and boring story about why that is, but that need not concern us here. Imperial lost some US money buying back some debentures, but because the Canadian dollar fell between issuance and redemption, it lost even more Canadian money. The Rev allowed the non-currency related loss as deductible from ordinary income, but said the exchange loss was a capital loss. In other words, it said the first principle didn't apply.

If those were the rules, the Pithlord would be unconcerned. We could maybe say that the foreign exchange aspects of all transactions are always capital gain/losses. But we don't and never have, so the Rev was wrong, as the Federal Court of Appeal found.

Bad as the Rev's argument was, though, it wasn't as bad as the one that the majority of the Supremes came up with. Instead of abandoning the principle that the characterization of the foreign exchange aspects of a transaction follows the nature of the transaction, they abandoned the principle that Canadian law always uses Canadian dollars. So now the amount of the loss is calculated in US dollars, even though it is defined in terms of two different magnitudes (roughly, the amount the debentures were issued for and the amount they were redeemed for).

The majority quotes one charmingly innumerate House of Lords decision to abandon a rather basic principle and thereby cause reams of confusion. The Court remarks that the principle that all magnitudes must be measured in Canadian dollars isn't in the Income Tax Act, but it is in section 14 of the Currency Act, as both parties apparently pointed out. The majority mentions this, without reasoned response. The principle that "all magnitudes must be translated into Canadian dollars" has been abandoned for "most magnitudes must be translated into Canadian dollars" without any guidance on the appropriate exceptions and without any reason for muddying everything up. In addition to patriotism, as your Grade 7 Science teacher ought to have told you, it is just darn important when measuring things to use the same measure all the time.

Case Comment of Imperial Oil Ltd. v. Canada; Inco Ltd. v. Canada, 2006 SCC 46

*Someone really should put the Carter Commission report online.

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