Gains on foreign stocks vs currency appreciation

[cacortes]

How do I figure currency gains when investing in foreign stocks? Imagine I convert 2000 USD to CAD and buy 1000 USD worth of a Canadian company. Ten years later the CAD doubles against the USD and the company doubles in CAD. So my stock investment multiplies by 4 and my cash sitting in CAD doubles. When I convert back to USD I end up with 6000 USD.

How do I figure out the tax gain? You're supposed to convert your stock trade prices into USD, right? But what about the currency gain outside of the stock trade? If I do a direct capital gain calculation on my currency trades I end up adding an excess $1000 to my gains and adding $2000 to my net sales that have no cost basis. But if it's okay to ignore the currency appreciation, it's a currency trader's loop-hole. The third option is to add up the currency portion of stock appreciations and subtract that from the currency gains which could become unbelievably convoluted.

 

[tranquility]

Currency appreciation is included in the capital gain. Just as inflation or deflation is included. What did you pay? What did you realise on the sale? In $.

 

[cacortes]

Thanks for your reply! In actuality I'm buying CAD on an ongoing basis and buying lots of different companies over a long period of time and will do all my calculations programaticaly. But, going back to my example with a little more detail, lets use starting prices of 1 CAD/USD and 1 CAD/share and ending prices of 2 CAD/USD and 2 CAD/share. Then my stock gain would have been 3000 USD (started with 1000 USD ending with 4000 USD). That much is more or less straight forward reporting-wise with my schedule D. However, when I liquidate the CAD, I have a sale of 3000 CAD worth 6000 USD of which only 2000 CAD has a cost basis. That 'looks' like a gain of 2000 USD on the currency 'trade'. Add that to my stock gain and you get 5000 USD in capital gains where there is really only 4000 USD.

The problem is that by including currency appreciation in the stock gains, some of the currency gain is included. But not all of the currency gain is included, so I'd think you need to account for that. The funny thing is that with my broker a currency 'exchange' looks and costs the same as currency trade using currency contracts except for the leverage allowed. So if the rules say I can ignore the currency gains/losses, there is a loophole for currency traders. They could just buy a small amount foreign stock amid their currency trades as exchanges and ignore the bulk of their gains.

I need to get this right from the start. Thanks.

 

[tranquility]

I do numbers and taxes all day and I can hardly follow your logic or example. You are thinking too much.

Let's simplify:

1 CAD/USD and 1 CAD/share and ending prices of 2 CAD/USD and 2 CAD/share.

You bought 1 share of stock for $1 dollar. Then you sold that 1 share for a $1. No gain or loss other than transaction costs. (If 2CAD/USD means each USD is worth 2CAD and the stock sold for 2CAD.)

Then my stock gain would have been 3000 USD (started with 1000 USD ending with 4000 USD).

OK, I would have written the premise differently. Use equals in the future. But, I agree with the calculation.

However, when I liquidate the CAD, I have a sale of 3000 CAD worth 6000 USD of which only 2000 CAD has a cost basis. That 'looks' like a gain of 2000 USD on the currency 'trade'. Add that to my stock gain and you get 5000 USD in capital gains where there is really only 4000 USD.

You liquidated the stock as expressed in dollars. It doesn't "look" like anything. Unless you are in the business in speculating in foreign currency, this is the too much thinking part. *All* of the sale is dealt with as though it was done in USD. Just because you didn't sell the CAD yet is irrelevant.

If I do a direct capital gain calculation on my currency trades I end up adding an excess $1000 to my gains and adding $2000 to my net sales that have no cost basis.

You don't calculate everything from the value of the dollar as of the date of purchase.

But if it's okay to ignore the currency appreciation, it's a currency trader's loop-hole. The third option is to add up the currency portion of stock appreciations and subtract that from the currency gains which could become unbelievably convoluted.

Yes, if you want everything to be calculated from a single reference point it can become hard. That's why I used the example of inflation or deflation. This changes things from a reference point too. But, if we just calculate from a single perspective at the time of the action is taken, complexity disappears. No loophole. No problem.

 

[cacortes]

I really appreciate the attention you're giving to my problem, but I promise there's a subtlety here, and I don't think I've heard the answer yet.

First I think my 2 CAD/USD was meant to be the other way around. The point of my example is to assume a gain on currency changes and on stock appreciation in CAD. Forget about currency speculation as it is irrelevant. My example assumes a set of events involving profits that I need to report. The question is how to report. The example assumes the exchange rate is the same for both purchases of CAD and the canadian stock. This is a simplifying assumption which need not be the case, but I'm trying to keep things simple.

Here's the core point. At the end of the ten years I have downloaded the following trades and need to report them to the IRS:

buy 2000 CAD @ 1 USD/CAD for a net of -2000 USD
sell 3000 CAD @ 2 USD/CAD net 6000 USD

buy 1000 shares @ 1 CAD/share (@ 1 USD/share) net -1000 USD
sell 1000 shares @ 2 CAD/share (@ 4 USD/share) net 4000 USD

So I report the 3000 USD stock gain in my schedule D using exchange rate conversions. We agree on that. But at the end of the process I actually made 4000 USD not 3000 and there's a pair of currency transactions that you can't make equal to 1000 USD profit without factoring in the currency gain on the stock transaction (which is prohibitive with a more complex example). There's also the fact that in the end 1000 CAD (worth 2000 USD) has no obvious cost basis.

So ignoring all the complications of how to declare currency transaction (as section 988 or as 1256 contracts) which I've mostly figured out, how does one treat those currency transactions so that they are only worth 1000 USD gain? I'm starting to wonder if it's in the meat of section 988.

Thanks again.

 

[tranquility]

If your trade or business is as a speculator in such things that is one thing, but that is not what you seem to be saying.

There is not subtle thing being missed here. For those not in the trade or business of currency speculation, the fluctuation of the exchange rate is ignored. You do not record or report the effect of your transferring into a foreign currency or back into dollars. On the date you buy the foreign stock, you record the basis in dollars. On the date you sell the foreign stock, you record the amount realized in dollars. That is your capital gain. Period.

That there is a difference in the relative values of the currency, is irrelevant. It does not matter if the change is the variablity between countrys balance of trade, of one countries inflation or deflation, of the moon being higher at night. It doesn't matter until the event is realized.

Now, when you're holding the currency and the event is realized to translate the canadian dollars back into U.S. Dollars, if you determine the money is a capital asset where there is a sale and exchange, in and of itself, then you now do the same calculation as above for that capital asset. It the money is a medium of exchange the slight variations are irrelevant. If it is a capital asset then you have bought and sold that asset. For your situation, while the money may be a capital asset, I don't think it is a sale or exchange of a capital asset and the exchange is not recorded. However, I would need to review all the facts to make a determination.

For a discussion of the issue (Not exactly the same problem but related as a repayment of foreign loans used to buy foreign stock.) see:

National-Standard Co. v. Commissioner, 80 T.C. 551

 

[cacortes]

I think I found my answer, but it disagrees with yours:

Foreign stock taxation-Tax FAQ

Basically, a foreign currency is treated as property not money. When I buy the Canadian stock it is an exchange of property and is a taxable transaction. So in the example, buying 1000 shares of the Canadian company also involves selling 1000 CAD dollars at the current rate. This makes sense because you can't cheat on extra currency gains, and it also deals with the currency sell without a cost basis problem mentioned above. I can't identify these rules clearly from the text of section 988, but the text definitely doesn't let you off the hook for currency gains as such gains can be substantial (think of the currency trader loophole I mentioned above).

Another good article about currency trading that further vets concepts of section 988: FOREX AND TAX TREATMENT.

Thanks again. Cheers.

 

[tranquility]

Read the case. Anything you find is based on it. Apply your facts against the case. That's the way the law works.