There are several possible ways that you can realize a foreign exchange gain (or loss) for income tax purposes.
For example, suppose you buy a property using foreign currency, and later sell it for foreign currency proceeds. For Canadian income tax purposes, the cost of the property must be converted into Canadian dollars (C$) at the time of the purchase. Similarly, you must convert the proceeds into C$ at the time of the sale. As a result, you may have a gain or loss due to the fluctuation of the C$ against the foreign currency, even if the value of the property does not change in terms of the foreign currency.
Example
You bought some US real estate for $200,000 using US dollars, when the US and Canadian dollars were at par. So your adjusted cost base is C$200,000. You sell the property for US$200,000, when the exchange rate is US$1 = C$1.10. Therefore, your proceeds for Canadian income tax purposes are C$220,000.
Even though there is no gain in US dollar terms, you will have a capital gain of $20,000 for income tax purposes. This is a foreign exchange gain. Like other capital gains, only one-half is included in your income as a taxable capital gain.
You can also realize a foreign exchange gain or loss if you incur a debt in foreign currency and repay the principal amount of the debt when foreign exchange rates have changed. If the C$ has increased relative to the foreign currency when you repay the debt, you will have a foreign exchange gain. If the C$ has declined, you will have a foreign exchange loss. Again, only half of such a gain is included in your income for Canadian income tax purposes, and the loss can be used only as a capital loss.
Of course, you can also realize a foreign exchange gain or loss simply by converting Canadian dollars into foreign currency and then re-purchasing Canadian dollars.
Example
You bought US$10,000 when the US and Canadian currencies were trading at par. Subsequently, you sell the US$10,000 back into Canadian dollars, when the exchange rate is US$1 = C$1.10. So you receive C$11,000. The extra $1,000 is a foreign exchange gain.
However, there is a special rule in the Income Tax Act that provides that the first $200 of net foreign exchange gains or loss per year on the disposition of foreign currency are ignored. Thus, for income tax purposes you would report an $800 gain, and half of that would be a taxable capital gain. The $200 rule applies to individuals only but not to other taxpayers.