Foreign Exchange Gains on a T2: Income, Capital or Unrealized

Are foreign exchange (currency) gains taxable for a Canadian corporation?

Generally yes. A realized gain is taxable: as income when it comes from business sales, purchases or operating loans, and as a capital gain, of which 50% is taxable, when it comes from a capital asset or capital loan. A year-end paper gain on an open income-account item can also be in income, depending on the accounting method; on a capital-account item it is not taxed until realized. The Income Tax Act has no provision saying which applies; the transaction that produced the gain decides (CRA bulletin IT-95R). The CRA no longer updates that bulletin, so read it as the CRA's long-standing view, beside the T2 guide and audit manual. The income-or-capital rules apply to any foreign currency, such as euros or pounds, not only US dollars. This page covers the federal return. For other provinces and territories the CRA assesses tax on the taxable income the T2 allocates to each; Quebec and Alberta corporations also file their own provincial returns, whose rules need a separate check.

Realized means settled or converted; unrealized, or a paper gain, means still open: the invoice unpaid, the loan outstanding, the cash not yet converted. Income account means business profit; capital account means a capital gain or loss.

Character sets the tax. Income-account exchange is taxed in full with the rest of business profit. A capital gain is taxable at the inclusion rate, and a capital loss only offsets capital gains. For a Canadian-controlled private corporation, a net taxable capital gain is also investment income. Unless it comes from selling an active business asset, it counts toward adjusted aggregate investment income, and once that total, with associated corporations, passes $50,000 in a year, the next year's small business limit shrinks (subsection 125(5.1); subsection 129(4); investment income and the small business deduction).

A case stops being simple when:

• The books show an exchange line you cannot trace to an invoice, bill, loan or asset.
• A US-dollar loan or a large US-dollar balance sits on the balance sheet at year end.
• The books revalue open items at year end, so book profit holds paper amounts the return may have to remove or keep.
• One account receives sales proceeds, loan proceeds and money set aside as a holding.
• Earlier T2s ignored foreign exchange.
• The corporation reports, or may report, in US dollars.
• Control of the corporation may change while a US-dollar loan or a capital loss is open.

Gather the foreign exchange ledger by item (invoice, bill, loan, held cash, investment), each loan agreement showing its purpose and repayment terms, the rate source for every date, the year-end revaluation entries, and last year's Schedule 1.

Is my foreign exchange gain on income account or capital account?

The item the gain came from decides. Exchange on goods and services bought or sold in the business is income; exchange on capital assets and capital debt is capital (IT-95R; audit manual, section 27.7.2).

• Borrowed US dollars. A gain on repaying a loan used in ordinary operations is income. It is capital where the borrowed money forms part of the corporation's permanent capital. Being short of capital is not enough on its own; then the use made of the money decides. The audit manual says exchange on foreign-currency loans that finance investments is generally on account of capital.
• Paying for a capital item, such as equipment, with US dollars earned from sales. The exchange difference on the earned dollars goes to income when the payment is made, as if they had been converted first. A capital gain or loss may follow when the capital debt is discharged (IT-95R).
• Subsection 39(2). It treats a currency gain as capital only where the gain would not otherwise be income, so the income-or-capital test comes first (section 39).

The $200 yearly exemption in subsection 39(1.1) is for an individual other than a trust. A corporation does not get it.

Are unrealized gains at year end taxable?

A paper gain on a capital-account item is not taxed until realized. For an open income-account item the answer depends on the accounting method.

For an open income-account item the CRA accepts the settlement method (bring the gain in when the account is settled) or the current-rate method (adjust open accounts to the year-end rate and include the result in income; the usual practice), provided the method follows accepted accounting practice and is the same in the financial statements and the return (IT-95R, paragraphs 7 and 8; audit manual, section 27.7.2). IT-95R allows a change of method only if shown to be more appropriate.

Accounting standards call for an exchange gain or loss on unsettled amounts at each period end, while the audit manual says the CRA does not require income recognition of a mere paper gain. The sources do not say whether the settlement method stays open to a corporation whose statements revalue at year end, so a corporation with open US-dollar receivables or payables usually settles its method with its accountant.

Books that keep unrealized and realized exchange in separate accounts make the Schedule 1 adjustment easier to trace. A paper gain removed on Schedule 1 this year is part of the gain taxed when the item is realized, so carry the adjustment into the next year. The book entries are in foreign exchange on a US-dollar account.

Where does a foreign exchange gain or loss go on the T2?

Realized income-account exchange sits in net income on the income statement and needs no Schedule 1 change. Capital exchange is reported on Schedule 6 (dispositions of capital property), and Schedule 1 swaps the booked amount for the taxable one. Schedule 1 reconciles net income on the financial statements to net income for tax (T2 guide).

The T2 guide says exchange on buying or selling capital properties is capital, and Schedule 6, Part 4 lists amounts from foreign currency transactions. A capital exchange loss reduces only taxable capital gains: it can be applied to the three previous years and carried forward indefinitely. To carry it back, ask on Schedule 4, Part 2 by the loss year's T2 filing deadline, six months after the loss-year tax year-end; the CRA must then reassess the earlier year (subsection 152(6)). A later request is only for the CRA to consider (taxpayer requested adjustments, paragraphs 40 to 42). If control of the corporation is acquired, earlier capital losses cannot be deducted afterward, and exchange accrued on an open US-dollar capital loan can be deemed realized then (subsections 111(4) and 111(12)). An income exchange loss reduces other income.

How is a gain on a US-dollar loan different from a gain on a US-dollar receivable?

A receivable is a business asset and a loan is a debt, so they move in opposite directions, and a loan can be taxed differently. A receivable gains when the US dollar rises; a loan gains when it falls.

The loan columns turn on the facts in IT-95R: what the borrowed funds were used for and whether they form part of the corporation's permanent capital. A loan that funds both operations and equipment needs that call made item by item.

These columns assume an arm's-length lender. If the lender is a shareholder, a relative or a related company, the CRA's comments on accepted methods may not apply (IT-95R, paragraph 10), and a deemed gain can arise if a non-arm's-length holder takes over the debt to avoid subsection 39(2) (subsections 39(2.01) and 39(2.02)). A loan from the corporation's own foreign affiliate can reduce the gain or loss (subsection 39(2.1)). For the books, see the shareholder loan account.

What does a US-dollar functional currency election change on the T2?

It changes the currency the whole return is worked out in. A corporation resident in Canada throughout the year can elect to determine its Canadian tax results in a functional currency, and the US dollar qualifies (section 261; CRA: functional currency). The US dollar must be the primary currency of the books throughout the year, and investment, mortgage investment and mutual fund corporations cannot elect.

An authorized officer signs Form T1296, and the corporation files it by the deadline: 60 days after the first day of the tax year (the CRA words this as the first 61 days of the tax year). A debt issued before the first elected year has its own transition rules (subsections 261(7) to 261(10)), so that year needs care. A corporation can make the election once. It cannot revoke in its first elected year; later, a revocation applies only to years that begin at least six months after the notice (subsection 261(4)), and the CRA lists a prior election or revocation as a bar to electing again. Treat the election as permanent. The books side is in US-dollar sales and marketplace payouts.

What records support the rate and the gain?

Use the Bank of Canada rate for the day the amount arose, or the closest earlier day with a quoted rate, and keep the rate behind each line. That is the CRA's general rule for converting a foreign amount (folio S5-F4-C1; Bank of Canada rates). Other rate sources and average rates have conditions; see which rate to use.

Keep for each exchange line:

• The US-dollar invoice or bill, with its date and the Canadian amount booked.
• The payment or bank confirmation showing the US dollars and Canadian dollars moved.
• A dated copy of the rate used.
• For a loan, the agreement, the amounts advanced, what they were used for and each repayment.
• The year-end revaluation entry and the Schedule 1 adjustment that went with it.
• The T1296, if the corporation elected.

What if earlier T2s left foreign exchange out?

The corporation can ask the CRA to change an assessed T2, in either direction, within the reassessment period. The CRA can usually reassess a Canadian-controlled private corporation within three years of the original notice of assessment, and other corporations within four years. The Act adds three years for listed foreign matters, such as a required T1135 not filed while income from the foreign property went unreported (subsection 152(4)). The period can be extended in other ways too, and there is no time limit where a misrepresentation was made through neglect, carelessness, wilful default or fraud (CRA: when we reassess).

A missed gain adds tax and interest. A missed loss could be claimed by the same request, but a carryback of it is no longer a right once the loss year's filing deadline has passed (CRA: requesting a reassessment). Carried-forward amounts, such as the cost of held currency and unused capital losses, roll into later years, so one wrong year can change several. See how far back the CRA can reassess, correcting a T2 after filing and reviews, audits and voluntary disclosure.

Example

These examples are illustrative. Figures are in Canadian dollars unless marked US$.

A US-dollar invoice is paid

A corporation invoices a US customer US$100,000 when the rate is 1.35, so it books C$135,000. The customer pays when the rate is 1.38, which is C$138,000. The C$3,000 gain arose on a business receivable, so it is on income account. It is already in net income, and Schedule 1 needs no change for it.

Had the invoice still been open at year end, with the rate at 1.40 (C$140,000), the current-rate method brings a C$5,000 gain into that year and a C$2,000 loss into the next, while the settlement method brings the C$3,000 gain into the year of payment. The total is the same; the year differs.

US dollars held as an investment

A corporation buys US$50,000 at 1.30, a cost of C$65,000, and holds it as an investment, not as working funds. At year end the rate is 1.40, so the balance is worth C$70,000 and the books show a C$5,000 unrealized gain. If the funds are on capital account, the CRA does not require the paper gain in income, so the accountant removes the C$5,000 on Schedule 1.

The next year the corporation converts all of it at 1.45 and receives C$72,500, a gain of C$7,500 against cost. The example assumes capital reporting. For currency dealings outside its business, the CRA's long-standing view treats the corporation like a commodity speculator: it may report them as capital or as income, the same way every year, and cannot change back once it uses income treatment. With special inside information about exchange rates, the gain is income (IT-95R, paragraph 6; IT-346R, paragraphs 7 and 8). Reported as capital, the books show only C$2,500 that year (C$72,500 less the C$70,000 year-end value), but Schedule 6 reports the full C$7,500, so the C$5,000 removed earlier is not lost. At a 50% inclusion rate the taxable part is C$3,750, which Schedule 1 adds in place of the C$2,500 booked. Reported as income, all C$7,500 would be taxable when the dollars are converted.

A US-dollar loan for equipment is repaid

A corporation borrows US$100,000 at 1.40 (C$140,000) to buy equipment and later repays it at 1.30 (C$130,000). The C$10,000 gain arose on a debt taken on to buy a capital asset. If the loan forms part of the corporation's permanent capital, the CRA treats the gain as capital. It is then reported on Schedule 6. At a 50% inclusion rate the taxable part is C$5,000, which Schedule 1 adds in place of the C$10,000 booked.

Different for you?

• The books show exchange lines you cannot classify, revalue open US-dollar items at year end, or carry a US-dollar loan (especially from a shareholder or related company) or a large US-dollar balance, or control of the corporation may change: each item's character, the Schedule 1 adjustment and any change-of-control effect need professional judgment. Get corporate tax help and bring the exchange ledger, loan agreements, the revaluation entries and last year's Schedule 1.
• Earlier T2s may have left out foreign exchange: the answer depends on which years are still open and why the exchange was missed. See how far back the CRA can reassess and correcting a T2 after filing, and get corporate tax help. If whole years were never filed, see catching up on unfiled corporate returns.
• You are thinking about reporting in US dollars: the election is due 60 days after the first day of the tax year and is hard to undo, so settle whether it suits the corporation with corporate tax help well inside that deadline.
• The exchange was never booked, or the US-dollar account does not tie to the books: fix the books before the return. See catching up on overdue books and bookkeeping help.
• You need the journal entries, the rate on US-dollar sales or the cost of US-dollar inventory: see foreign exchange on a US-dollar account, US-dollar sales and marketplace payouts and US-dollar inventory cost.
• The account holds US-dollar investments: see adjusted cost base in Canadian dollars.
• The account is at a US bank, or US tax was paid: see US bank account for a Canadian corporation, foreign property and affiliate reporting and claiming US tax on your corporate return.
• You need the statements or the T2 itself: see year-end financial statements for a corporation, book profit versus taxable income and filing your corporate return.