There are two main treatments for the conversion: an adjustment to the value of an asset or liability, or an adjustment to income or expenses.

Since day-to-day transactions are usually converted invoice by invoice, the gains or losses on purchases and sales caused by fluctuations in the exchange rate are absorbed as incurred. Transactions that affect the balance sheet, however, are a more complex matter.

Capital Assets

The cost of operating equipment purchased in a foreign currency must be converted to the Canadian-dollar equivalent at the time of purchase. For example, equipment purchased for $100,000 (USD) when the exchange rate is $0.83 (CAD) gives a conversion rate of $1.20 (CAD) for every US dollar. The cost of the equipment now translates into $120,000 (CAD), the amount on which the company can claim the capital cost allowance (tax depreciation). Appropriate allocation of the exchange ensures the company maximizes the capital cost allowance used to reduce the net income for tax purposes. Should the exchange be allocated instead as an expense, expenses would be overstated and net income reduced improperly for tax purposes. Given a corporate tax rate of 20%, the improper allocation would understate income tax payable by $4,000 (CAD). If, however, the Canadian dollar were trading at a premium to the US dollar, improper allocation would overstate income thus increasing the tax liability!

Cash in Foreign Banks

Businesses or individuals who maintain cash or negotiable instruments on deposit in a foreign currency are generally not subjected to income tax as long as the amounts are on deposit. This implies that cash in a foreign bank account, term deposits or other forms of short-term investments not negotiable outside the financial institution are not subject to the vagaries of the exchange rate as long as they remain within the definition of funds on deposit.

Extreme changes in foreign exchange rates should prompt businesses to review their portfolio to determine whether converting to Canadian dollars or holding foreign currency is more advantageous. If $50,000 (USD) in term deposits were purchased at a conversion rate of $1.20 (CAD), the asset value is $60,000 (CAD). If the exchange rate returns to par, the term deposit is worth only $50,000 (CAD). A $10,000 (CAD) loss has occurred but only on paper. Until the funds on deposit are actually converted to the Canadian dollar equivalent, the loss is not considered a loss for tax purposes.

An inadvertent conversion to the Canadian-dollar equivalent may create unexpected exchange gains or losses that may impact the business and income taxes.

To ensure you do not unintentionally trigger exchange gains or losses when dealing with “on deposit” amounts, consider the following situations that will, according to CRA, create gains or losses:

• Converting the foreign on-deposit amount to the Canadian-dollar equivalent
• Converting the foreign on-deposit amount to a currency other than Canadian
• Paying a debt with the foreign deposit even if the debt is with the same financial institution or in the same country
• Using the foreign currency deposit to purchase other investments or capital items

Investment in Foreign Share Capital

The exchange rate at the time of any foreign indirect investment should be recorded. If a $150,000 (CAD) investment is made when the exchange rate is $0.83 (CAD) (conversion rate $1.20 (CAD)), the Canadian dollar equivalent will be $180,000 (CAD). Should the exchange rate change to $0.80 (CAD) (conversion rate $1.25 (CAD)), the investment would be worth $187,500 (CAD). This would represent a gain of $7,500 (CAD). This gain however is, in effect, only a paper gain and does not create tax consequences as long as the investment is held.

Realization of funds on deposit or the sale of foreign equity investments triggers two types of gains or losses at the time of the transaction. The first is an actual gain or loss regarding the value of the security. The second is the gain or loss that results when converting from the foreign currency to the Canadian dollar equivalent. Provided that a business or individual does not regularly buy and sell funds on deposit and foreign equity, i.e., becomes a trader, it is likely that both types of gain or loss will be considered a capital loss or gain.

You must determine whether the business has accumulated capital gains or losses for income tax purposes. Existing accumulated losses may suggest a strategy of selling foreign stocks whose value has increased solely through foreign exchange gains. This strategy would permit capital losses to be reported with few or even no tax consequences. If accumulated gains exist, perhaps stocks that are down because of exchange losses could be sold and the proceeds applied to reduce the overall loss created by the exchange and facilitate reinvestment.

Investors taking losses must be sure not to invoke the superficial loss rules by purchasing identical stocks within 30 days of the original sale. It is always prudent to discuss your capital expenditure and investment strategies with your chartered accountant to ensure that the appropriate treatment of foreign asset purchases and sales does not expose your business to unnecessary investment risk or unnecessary income taxes.