The appellant taxpayer entered into debenture agreements to borrow New Zealand dollars at a high interest rate, and simultaneously entered into a forward exchange contract to convert the funds to US dollars for use in its business, while hedging the exchange rate risk.
The taxpayer deducted the high interest payments under s. 20(1)(c)(i) of the Income Tax Act and reported the resulting foreign exchange gain on capital account.
The Minister reassessed the taxpayer, arguing the interest deduction should be limited to the lower rate applicable to US dollars based on the economic realities of the transaction.
The Supreme Court of Canada held that the taxpayer's legal relationships must be respected and that the borrowed New Zealand dollars were directly used to earn income.
The Court allowed the appeal, permitting the full interest deduction, and dismissed the Minister's cross-appeal, holding the foreign exchange gain was on capital account.
