Weak currency debt rules:
the right answer?
By: Elinore J. Richardson
The story which began, in 1987, with a call from Goldman Sachs New York office to the
author, came full circle on February 28, 2000. Within months of one another, in late 1987 and early
1988, several of Canada's corporate elite undertook the first few of what came to be known over the
next 13 years as the "Kiwi" deals. Almost immediately, the transactions gave rise to controversy, as
tax advisers predicted the chances of success or failure by taxpayers to secure the benefits offered.
Over the next few years, the transactions were featured in various articles and papers, presented in
such forum as the International Fiscal Association's Canadian Chapter meetings and conferences
sponsored by the Canadian Tax Foundation. It was not surprising, therefore, that the Canadian
revenue authorities should, sooner or later, given their profile, decide to review the transactions, and
having done so, to challenge them.
Thus, it was that Shell Canada Limited ("Shell"), faced with disallowance by the Minister of a
portion of its interest expense and recharacterization as income of its gains on repayment of
debentures it had issued in 1988, decided to take the matter before the Canadian courts. The results
of the various judgments in the Tax Court of Canada, the Federal Court of Appeal and finally, the
Supreme Court of Canada are well known to all. At each level, the court's "take" on the transaction
has been hotly debated. I do not intend to rehash either the judgments, or to take issue with those
who have, so definitively and with such perseverance, put their positions, at considerable cost to our
Canadian forests, to the Canadian government, to Canadian taxpayers and their advisers, and to
anyone else willing, or duly bound, to listen.
Suffice it to say that right or not, on October 15, 1999, the Supreme Court of Canada affirmed
Shell's right to deduct the full amount of its interest expense payable on its debentures and the capital
nature of its 1993 gain on the close out of its forward contract and repayment of the debentures.
Federal Budget Proposals
The government's response was swift. The February 28, 2000 federal budget included a series
of resolutions specifically addressing "weak currency debt". The Supplementary Information
accompanying the budget referred to these transactions as taking "advantage of the fact that, where a
currency is expected to decline in value relative to some reference currency, the interest rate on a
loan in the weak currency will be higher than on a loan on similar terms in the reference currency.
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The higher rate reflects the market's expectation that the borrowed amount will be less in terms of
the referenced currency when the loan is repaid." After noting the judgment of the Supreme Court
of Canada and the fact that the government is pursuing the challenge of post-GAAR transactions
before the Courts, the Supplementary Information continued:
"under the current law, prudent risk management supports the introduction, for
greater certainty, of specific legislative rules defining particular weak currency
arrangements and setting out their appropriate tax treatment."
The government's proposals can be summarized simply:



weak currency debt is indebtedness incurred, after February 27, 2000, either as a
borrowing of money or on an acquisition of property in a currency other than Canadian
dollars (the "weak currency") where:

the funds or property are converted to or settle an obligation in another currency (the
"final currency") and are used in that form by the taxpayer in its business;

the indebtedness exceeds $500,000 (Canadian); and

the rate of interest on the indebtedness exceeds by 2 percentage points (200 basis
points) the rate of interest which would have been charged on the same borrowing in
the final currency.
where a taxpayer (other than certain specified financial institutions) contracts a weak
currency debt:

a deduction for interest will be limited to the rate applicable on the hypothetical final
currency debt;

any disallowed interest will reduce the foreign exchange gain realized on close out of
a hedge contract and repayment of the debt; and

any foreign exchange gain or loss so computed will be on income account.
for this purpose, a hedge in respect of an indebtedness is specifically defined (in future,
notices of hedges are to be filed with the Minister).
The legislation will have application from July 1, 2000 to interest accrued after that date.
While not unexpected, the government's initiatives offer little to commend them. As early as
the late 1970's, concerns relating to the treatment of adjustments to the costs of financing stemmed
from a number of areas, i.e. the fact that of most borrowings by Canadian corporates were regarded
as capital, the limited deductions for interest afforded by the Canadian taxing legislation and the
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absence of definitive provisions dealing with foreign exchange gains and losses incurred on
borrowings or related hedging transactions. These concerns led to recommendations by the Joint
Committee of the Canadian Bar Association and the Institute of Chartered Accountants that a full
review of the legislation affecting participants in financial transactions be undertaken with the
objective of putting in place a consistent and comprehensive regime. The provisions of the
Canadian taxing legislation, it was argued, were outdated, discount and simple and compound
interest were cited as examples. As well, jurisprudence providing support for the capital nature of
borrowings was described as a concern in that it was not reflective of modern business realities
which suggested that treasury groups in many Canadian corporations were themselves profit centers
contributing to bottom line business profits. It was expected that there would be some pluses and
some minuses for Canadian taxpayers in the process, but the resulting certainty as to treatment of
such items as discounts and premiums, interest, foreign exchange and other related financing costs
would, it was felt, be well worth the price.
No study was undertaken. Since that time, the government has not made any attempt at
comprehensive revision. Instead, changes of very specific application to cure perceived abuses, have
been tacked on to the existing regime. Thus, for example, rules were introduced in 1980 to deal with
prescribed debt obligations and, in 1994, to address prepaid interest on debt obligations, as well as
bonuses and rate-reduction payments1. The new weak currency debt proposals follow this pattern.
They are designed to address what government perceives to be a very specific abuse and to legislate
the government's cure within very confined parameters. Seemingly, little consideration has been
given to assuring consistency across the board to taxpayer of the principles on which the rules are
based. Nor has much thought been given to the broader impact on issuers of and investors in
financial instruments, of continuing to legislate in this manner.
Prior to the late 1980's, when the first NZ dollar transactions were undertaken, Canadian
corporate issuers had borrowed in strong currencies (for example, Swiss Francs). The corporate
borrowers had no need for the strong currencies in their business. Proceeds of the borrowings were
converted into a currency of use and deployed in the business. The rate of interest was low
reflecting the strength of the currency borrowed. On repayment, the corporate borrower suffered a
loss which the tax man insisted was on capital account. As first swaps and then more sophisticated
derivatives made their way into Canada in the 80's, corporate borrowers hedged their strong currency
borrowings in order to fix these losses. No one suggested that the existence of these hedgers had
any effect on the nature of the loss incurred.
Canadian corporate borrowers still borrow in strong currencies. If one accepts that the
position reflected in the government's initiatives on weak currency debt produces the appropriate
1
For example, no attempt was made to conform discount treatments to that prescribed for prepaid interest
in 1994 or thereafter
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result, it is difficult to comprehend the tax policy basis for concluding that the same principles
should not be applied to increase deductions currency of taxpayers borrowing in a strong currency.
Even should we ignore, for a moment, issues relating to certainty, consistency and the need
for a comprehensive set of rules in this area, the proposals on weak currency debt still leave many
concerns unanswered. The government's description of the economics of weak currency debt is
accurate so far as it goes. However, the economic analysis, in that it assumes that differences in
interest rates derive only from relative strengths of currencies, is too simplistic. It ignores the fact
that a corporation may seek to borrow and may be prepared, quite reasonably, to incur extra costs to
obtain borrowings in a currency other than a currency of use. For example, if a corporation has
exhausted sources of funds at what it believes to be reasonable rates in its home market, or even if it
has decided not to concentrate all of its borrowings among a narrow basket of lenders, it may opt to
go to another market to access new sources of capital. Eventually, as its "name" increases in value in
that market, its cost of funds may reduce. Initially, however, it may have to pay a premium to break
into the market; it may also have to resort, initially, to less cost effective private placement or high
yield investors. The analysis, also, ignores the fact that only in a perfect global market will the
interest rate exactly mirror the relative strength or weakness of a currency. Real market distortions
generally occur as a result of things such as risk perception, market investor profile, etc. Such
distortions also affect interest rates.
One of the criteria of weak currency debt is the conversion, at any time, of proceeds in one
currency into another currency for use. Does this mean that all loan proceeds in foreign currency
will have to be traced to ensure that they are not at any point converted or reconverted? If this is the
case, at what point does the spread requisite discussed below kick in?
The other requisite (given that the $500,000 exemption will be of little relevance in most cases)
relates to the 200 basis point spread. Debt carrying an interest rate within 2 percentage points of that
of the hypothetical currency of use borrowing is "good"; that carrying a rate in excess of this band is
"bad". While the two percentage point spread could be justified as a safe harbour, it has not been so
proposed. As an absolute, the band raises many concerns. First, it is too narrow. Depending on the
circumstances of a particular borrower, a two percent spread over home market rates might not be at
all unreasonable in a foreign market. Moreover, the court in the Shell case based its findings, in part,
on the fact that Shell could have borrowed US dollars (the "currency of use") at a rate of 9.1%. It
was, indeed, fortunate, both that the information was so readily available and that the parties were
prepared to agree the rate for purposes of the litigation. Given that most bankers quote in ranges
until a transaction is priced, that rates for prior borrowings cannot be considered determinative due
to market and risk adjustments, and that all financial transactions are hypothetical until completed,
particularly as the consequences of a determination will now be significant to borrowers, it can be
expected that rates will become a major area of contention. What for example, is the rate to be
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assigned to the currency of use, if the borrower can establish that it was not able at all or only at an
uneconomic rate, at the time of its borrowing to obtain funds in that currency?
Conclusion
One final question remains. What will be the impact of the proposals on Canadian corporate
borrowers? It is already the case that Canadian issuers do not have the same flexibility as their
foreign competitors in the types of debt instruments they can viably issue to non-Canadian investors.
This lack of flexibility can be attributed to a number of factors – to cite just two, uncertainty as to
deductibility of original issue discounts and withholding taxes on indexed and short term debt. If
Canadian corporates borrow in other than their currency of use, they will now, in addition, have to
establish a clearly defensible benchmark cost of funds in the currency of use and stay within the 200
basis point range proposed by the legislation or face disallowance of a portion of their interest cost.
They will also have to consider tax if a change in currency of use is dictated by changes in their
business. These considerations will also affect credit reviews of Canadian borrowers by foreign
lenders. The result can only be to add a further complicating element to any business decision by a
Canadian corporate to seek financing abroad and to increase the cost to Canadian issuers of
borrowing in foreign markets!