Question
Canco and its wholly-owned subsidiary, Cansub, are taxable Canadian corporations that have a Canadian-dollar tax functional currency. Cansub issues to Canco a note denominated in US dollars that is convertible into common shares of Cansub at the option of the holder. On conversion, Cansub will issue shares to Canco with an FMV equal to the outstanding principal amount of the note, and will add an amount to the stated capital of Cansub equal to the Canadian-dollar equivalent of such amount computed using the Bank of Canada noon exchange rate on the date of the conversion. Cansub uses the proceeds of the note to acquire US-dollar assets.
Will Cansub realize a foreign exchange gain (or sustain a loss) under subsection 39(2) upon conversion of the note if the amount added to the stated capital of Cansub upon conversion is less than (or greater than) the Canadian-dollar equivalent of the principal amount of the Note on the date it was issued? (CRA document no. 2004‑0085081E5, September 8, 2005 suggests that the answer would be yes, although that interpretation did not address any potential loss.)
Response
Yes, the subsidiary will realize a gain or loss pursuant to subsection 39(2). The transaction appears to be somewhat artificial, and if anomalous tax results would otherwise arise, the anti-avoidance provisions of the Act may apply.