The Fundamentals of Foreign
Currency Conversion Transactions
John Golding
President
International Monetary Specialists
Basic Principles: Cash, Conversion and Delivery
• What is cash?
• The cash delivery market.
• Cash denominated in FX it is treated as a
commodity.
• How do the foreign currency exchange
markets work?
• Point of conversion (POC).
• Foreign currency exchange rates.
Point of Conversion: Gold Illustration
The Point of Conversion (POC)
Modifies the Value
There is an economic cost at the
point of conversion.
POC
Refinery
+
POC Report
• The POC report provided after the gold
refinery process is very detailed and describes
all the other components of the gold ore that
were extracted upon the conversion process.
• Such other components have value!
• There is no comparable report in the case of
foreign currency conversions.
Common Cases
• Company A: US based parent company with
foreign sales subsidiaries
• Company B: UK based parent company that is
selling products in the US using a US based
sales subsidiary
• Company C: US based company imports
products from the UK into the US.
Example: Company A
• Company A is a US corporation selling widgets worldwide.
• Overseas sales are handled using foreign subsidiaries (e.g.,
in the UK).
• Sales proceeds are denominated in the local subsidiary’s
currency (GBP).
• The subsidiary need to repatriate the money to its parent in
USD.
• Conversion from GBP to USD needs to be made to
repatriate.
Example: Company B
• Company B is a resident of the UK and is the
business of producing and selling widgets.
• The UK parent establishes a subsidiary in the
US to sell the widgets in the US.
• Sales proceeds are denominated in USD.
• The subsidiary needs to repatriate the money
to UK in GBP.
Example: Company C
• US based company that is importing products
from the UK into to the US.
• The US company purchases the products from
its subsidiary in the UK and needs to wire
money denominated in GBP to the foreign
subsidiary.
How Does Conversion Work?
http://www.MonetarySpecialists.com
The Conversion Process
• Vast majority of currency conversion transactions are
conducted through banks.
• The banks created their own primary market for conversion
transactions.
• When Company A, B and C need to convert GBP to USD or
vice versa, they typically get exchange rates quotes from three
different banks, and use the best quoted rate.
• However, exchange rates are not the only cost involved in a
foreign currency transaction.
Cost and Transparency
• When the cash is being channeled through the various
intermediaries at the bank, it is almost impossible to keep track
on the various costs involved.
• The ultimate client may not know how his or her money was
channeled through the various divisions in the bank, until he or
she receives the converted cash.
• It presents a challenge for clients who are trying to account for
gains and losses in a transaction.
• According to the BIS, there is a daily GAP in currency trade
Contact Information
John Golding
President, IMS
888.990.9895
jgolding@monetaryspecialists.com
U.S. Tax Consequences of Foreign
Currency Exchange Transactions
Contact:
Yoram Keinan  Shareholder  keinany@gtlaw.com  (212) 801-6826
GREENBERG TRAURIG, LLP  ATTORNEYS AT LAW  WWW.GTLAW.COM
©2009. All rights reserved.
Basic Principles
 Foreign currency (FX) is treated as personal
property for US tax purposes.
 As such, disposition of FX is subject to the
general realization principles.
 Thus, when FX is acquired, its basis is the
cost.
 When the FX is disposed of, the resulting
gain or loss equals the amount realized
minus basis.
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Functional Currency
 Currency transactions with the taxpayer’s functional
currency are generally not taxable events. For
example, use of functional currency to purchase
property denominated in functional currency does
not result in FX gain or loss.
 Thus, it is important to determine what is the
taxpayer’s functional currency.
 The taxpayer’s functional currency is determined by
reference to either the taxpayer itself or the
taxpayer’s identifiable separate business operation
entitled “qualified business operation (“QBU”).
 Each QBU of the taxpayer has its own functional
currency.
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Functional Currency (Cont.)
 The USD is the functional currency of a US
taxpayer, or of the taxpayer’s QBU, if its
activities are mostly conducted in USD.
 Any effectively connected income to a US trade
or business of a foreign taxpayer is generally
treated as a separate QBU with the USD as its
functional currency.
 Taxpayers can generally elect to treat the USD
as their functional currency.
 Functional currency is treated as a “method of
accounting.”
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Books and Records
 A crucial factor in the functional currency
determination is the books and records.
 It is accepted that a QBU is deemed to
maintain its books and records in the
currency of the “economic environment”
in which a significant part of its activities
are conducted.
 A QBU’s economic environment is
determined under a facts and
circumstances test.
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QBU
 “any separate and clearly identified unit of
a trade or business of a taxpayer” if such
unit “maintains separate books and
records.”
 An individual may have a qualified business
unit (QBU) that has a non-dollar functional
currency.
 However, an activity that does not generate
deductible expenses does not qualify as a
QBU.
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QBU (Cont.)
 Corporations, partnerships, trusts and
branches may be considered QBUs.
 Certain activities of the above entities may
qualify as a separate QBU if such activities
(1) constitute a trade or business and (2)
separate books ad records are kept for such
activities.
 The activities or an individual, as an
employee, are generally not considered a
separate QBU.
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Economic Environment Factors
 The currency of the country in which the QBU
is a resident.
 The currencies of the QBU's cash flows.
 The currencies in which the QBU generates
revenues and incurs expenses.
 The currencies in which the QBU borrows and
lends.
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Economic Environment Factors (Cont.)
 The currencies of the QBU's sales markets.
 The currencies in which pricing and other
financial decisions are made.
 The duration of the QBU's business operations.
 The significance and/or volume of the QBU's
independent activities.
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Section 988
 Section 988 and regulations
thereunder provide guidance as to
the timing, character and source of
gains and losses from FX transactions
that are subject to it.
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Section 988: Timing
 Section 988 requires gain or loss from the
overall transaction as a threshold matter.
 The second step is to bifurcate the overall gain
or loss between gain or loss attributable to
changes in the exchange rates and gain or loss
attributed to the underlying transaction.
 The “spot” rate is used to determine the
extent of the FX gain or loss
 If there is gain or loss on the underlying
transaction, and an offsetting FX gain or loss,
the two are netted and only the excess is
recognized.
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Section 988: Character
 As a general rule, FX gain or loss is ordinary
 Upon a taxpayer’s election, FX gains or
losses from certain FX denominated
contracts, including forwards, futures and
options can be treated as capital.
 Some FX gains and losses in connection
with FX denominated debt instrument are
characterized as interest.
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Section 988: Source
 In general, the source of FX gains and
losses is determined by reference to the
taxpayer’s residence or the residence of
the taxpayer’s QBU.
 Exceptions:
□
□
□
□
FX gains/losses in connection with trade or
business
Certain high yield related party FX denominated
loans
FX gains/losses characterized as interest
Integrated FX debt and a hedge.
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Disposition of FX
 A mere decline in the FX’s value does not
result in taxable event, unless the FX was
held in connection with a trade or business
and becomes valueless during the year.
 If a taxpayer disposes of functional
currency, there are no taxable
consequences.
 Sale and other disposition of nonfunctional
currency will give rise to FX gain or loss,
computed under the general principles of
section 1001.
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Exchange of FX for other Currency
 Exchange of functional currency with
functional currency does not give rise to FX
gain or loss.
 Exchange of units of nonfunctional currency
with different units of same nonfunctional
currency is not taxable event.
 Exchange of one nonfunctional currency with
another nonfunctional currency (e.g., Euro to
Yen) is taxable event.
 Exchange of nonfunctional currency with
functional currency is taxable event.
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Exchange of FX for Property
 Treated as a two step transaction:
□ exchange of nonfunctional currency to
functional currency at the spot rate.
□ Purchase of the property for functional
currency.
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Example
 G is a U.S. corporation with the U.S. dollar as
its functional currency.
 On January 1, 1989, G enters into a contract to
purchase a paper manufacturing machine for
10,000,000 British pounds for delivery on
January 1, 1991.
 On January 1, 1991, when G exchanges the BP
10,000,000 (which G purchased for $
12,000,000) for the machine, the fair market
value of the machine is BP17,000,000.
 On January 1, 1991, the spot exchange rate is
BP1 = $ 1.50.
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Example (Cont.)
 The transaction is treated as an exchange
of BP 10,000,000 for $ 15,000,000 and the
purchase of the machine for $ 15,000,000.
 Accordingly, in computing G's exchange
gain of $ 3,000,000 on the disposition of
the BP 10,000,000, the amount realized is
$ 15,000,000.
 G's basis in the machine is $ 15,000,000.
 No gain is recognized on the bargain
purchase of the machine.
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Contact Information
Yoram Keinan
Shareholder, Tax
Greenberg Traurig LLP
200 Park Avenue, New York, NY 10166
212.801.6826
keinany@gtlaw.com
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