Court rules on exchange rates

Federal Court decision will affect foreign-denominated convertible debt

The Federal Court of Appeal’s recent decision in R. v. Agnico-Eagles Mines Limited regarding the tax treatment of exchange rates will be of interest to many businesses and lawyers who are involved in cross-border transactions.

A unanimous panel ruled that foreign exchange gains arising on the conversion of convertible debentures denominated in US dollars should be assessed by comparing the Canadian dollar equivalent of the debentures when they were issued to fair market value of the shares in Canadian dollars on the date of conversion.

“Issuers of foreign-denominated convertible debt should consider the tax and corporate consequences of issuing these securities in light of this case,” write James Morand and Christopher Norton of Toronto in a Cassels, Brock & Blackwell LLP client bulletin.

The case originated in 2002 when Agnico issued US$144 million of convertible debentures. The equivalent value in Canadian dollars at the time was approximately $230 million.

Debentures holders also had a conversion right, exercisable at any time before redemption or maturity. In December, 2005 Agnico gave notice of its intention to redeem the debentures by issuing some 63,000 common shares per debenture. Because the conversion provisions provided for the issue of 71,000 shares, most holders exercised their conversion right.

When the conversions occurred, the Canadian dollar had strengthened considerably. The CRA took the position, therefore, that Agnico had made foreign exchange gains of approximately C$62 million, represented by the difference in Canadian dollars between the principle amount of the debentures when they were issued and the value of the shares on conversion.

As William Innes of Rueters LLP in Toronto sees it, the CRA’s position defied common sense. “Agnico had to repay indebtedness of $1,588.10 by means of the issuance of shares having a market value of $1,998.48 resulting, on the face of it, in a [non-deductible] economic loss of $410.48,” he says. “The Crown’s position was simply tinkering with exchange rate differentials irrespective of the underlying economic substance.”

Agnico, represented by Brian Carr of KPMG Law LLP in Toronto, argued that no foreign exchange gain had been realized because there had been no disposition of property to satisfy the debentures; rather, the common shares were merely issued for the consideration originally paid by the subscribers for the debentures.

The Tax Court of Canada agreed with Agnico, concluding that there was no foreign exchange gain. The court reasoned that the value of the Canadian dollar on the date of conversion was not relevant because value had to be determined when the debentures were first issued.

The Federal Court, however, noted that the terms of the debentures made it clear that common shares issued on conversion were meant to satisfy Agnico’s obligation to repay the principal amount owing under the debentures and extinguish any remaining rights of the debenture holders. Here, there was a foreign exchange gain because the fair market value of the common shares issued on conversion, calculated in Canadian dollars at the time of conversion, exceeded the principal amount of the debentures computed in Canadian dollars at the time of issue. In other words, Agnico had to pay less to convert the debt into shares than the principal amount it had received when it issued the debt.

In the result, the FCA allowed the appeal and awarded costs to the Crown.

Ironically, the Federal Court of Appeal’s reasoning led to substantially the same economic result produced in the TCC. As the FCA saw it, the CRA had erred in failing to take into account Agnico’s cost of issuing the common shares. When this was taken into account, it reduced the foreign exchange gain substantially.

“The ruling essentially wipes out most of the tax liability,” Carr says.

According to Innes, the difference in their reasoning doesn’t change the fact that both the TCC and the FCA decisions lead to “much more realistic results” than the CRA’s analysis, because they correspond with economic reality.

But Innes call the costs award an “aberration” in light of the economic result. For his part, Carr wonders whether the Federal Court of Appeal fully appreciated the financial impact of its decision. “Certainly in terms of the results in dollars, we were equally successful in both courts,” he said. “In any event, the costs are so small they’re not worth fighting about.”

The Crown has advised that it will not seek leave to appeal from the Supreme Court of Canada.