CURRENCY TRANSLATION & CURRENCY TRANSACTIONS
I. Foreign Currency Translation
A. §985—Companies must account for their operations in their functional currency
a. A U.S. corporation doing business both domestically and through foreign branch
operations may have two functional currencies
i. Domestic activities—U.S. dollar
ii. Foreign branch—Foreign currency (if QBU)
b. QBU—conducts a significant part of its business activities in an economic
environment in which a foreign currency is used and maintains books and records
in that currency.
B. §§986-989—Translation of functional currency is required to file U.S. income tax
return:
a. §987—Foreign income taxable income translated at the average exchange rate
for the taxable year in which income is earned
b. §986(a)(1) —Foreign-source taxes translated at the average exchange rate for the
taxable year to which the taxes relate (for accrual method t/ps)
c. §989(b)—Remittances to U.S. home office are translated into dollars using the
spot rate for the date of remittance.
d. Gain or loss must be recognized to extent dollar value of remittance does not
equal amount recognized as income when remitted income was included on
taxpayer’s U.S. income tax return.
C. CFCs follow same basic procedure:
a. Income of CFC is maintained in functional currency—translation not required.
b. Foreign income taxes translated into dollars using average exchange rate for
applicable year.
c. Dividends to U.S. parent translated using spot rate for date of dividend.
d. Gross-up, however, is calculated using average exchange rate in effect in year to
which taxes relate.
II.
Foreign Currency Transactions
A. Similar rules apply when taxpayer accounts for transactions in nonfunctional currency:
a. Debt instruments—taxpayer lends or borrows funds denominated in
nonfunctional currency
b. Receivables or payables—taxpayer sells or purchases goods or services on
account, with payment required in nonfunctional currency
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c. Hedging transactions—taxpayer enters into forward, futures, option contracts or
similar hedging transactions.
B. In such cases, taxpayer accounts for gross profit on transaction in functional currency
and treats exchange gain or loss as a separate transaction
C. Character of exchange gains or losses—ordinary
D. Sourcing based on residence of taxpayer or QBU
E. FTC basket—general rule is that exchange gains and losses are assigned to passive
income category (exception for qualified hedging transactions).