The interest parity doctrine asserts that covered yields in two countries must always be nearly the same. Because it ignores tax factors, however, this assertion is incorrect.

The yield on foreign instruments includes both an interest component, taxable in both Canada and the U.S. at the ordinary income rate, and a foreign exchange gain or loss, which can come in the form of a hedged premium or discount if the foreign currency proceeds are sold on the forward market, or an unhedged gain or loss if the proceeds are sold in the spot market. Since all capital gains in Canada and all long-term capital gains in the U.S. are subject to diminished taxes, the key question is whether exchange gains are capital gains or ordinary income.

Whether investment in the foreign instrument is hedged or unhedged makes little difference to its tax treatment. What does matter is whether the investor’s business and investment transactions qualify his securities for capital asset treatment. Canadian tax authorities treat the gain or loss on forward contracts as falling within the capital account, and accord foreign investments capital gains treatment unless they constitute “an adventure in the nature of trade.” While practice in the U.S. is less clear-cut, one court concluded that transactions involving capital assets are themselves of a capital nature, and the U.S. tax code defines investments and securities as capital assets.

Because of tax factors, a U.S. investor may find a Canadian instrument more attractive, even though its pre-tax yield is below that on a comparable U.S. investment. (Of course since both U.S. and Canadian investors can write off capital losses only against capital gains, the after-tax yield on a covered transaction depends on the investor’s circumstances.) As a general rule, corporations that select their money market instruments without regard to tax considerations are likely to forego substantial tax savings.