Overview of the Taxation of Foreign Currency
© William R. Skinner, Fenwick & West LLP
wrskinner@fenwick.com
(650) 335-7669
Last Updated February 21, 2015 1
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William R. Skinner is a partner in the Tax Group of Fenwick & West LLP. Mr.
Skinner focuses his practice on U.S. international and corporate taxation, including international
tax planning, tax controversies, Federal tax matters and the taxation of corporate / financial
transactions. Prior to joining Fenwick & West LLP, Mr. Skinner clerked for the Honorable
Carlos T. Bea of the Ninth Circuit Court of Appeals. He teaches international taxation as an
adjunct professor in San Jose State University’s MST program, and speaks and writes frequently
on international tax issues. Mr. Skinner graduated with a J.D., with distinction from Stanford
Law School in 2005, where he was a member of the Stanford Law Review. He received a B.A.
in history in 2001 from the University of California, Berkeley.
Table of Contents
Page
Foreign Currency:
1. Determination of the Functional Currency and Definition of a “QBU” ................................. 1
A. Functional currency is determined at the “qualified business unit” level........................... 1
B. Definition of a Qualified Business Unit.............................................................................. 1
C. § 985 – Selection of the Functional Currency .................................................................... 2
D. Changes in Functional Currency......................................................................................... 6
2. Section 988 — Non Functional Currency Transactions ......................................................... 7
A. Separate transaction principle ............................................................................................. 7
B. Definition of § 988 Transaction .......................................................................................... 8
C. Timing of Recognition of Foreign Exchange Gain or Loss .............................................. 11
D. Character and Source of Section 988 Gain or Loss .......................................................... 18
E. Reg. § 1.6011-4 Reporting (Form 8886). ......................................................................... 21
3. Section 986 — Translation Rules for Earnings and Profits and Foreign Income Taxes ...... 23
A. § 986 E&P Translation Rules ........................................................................................... 23
B. Translation of Foreign Income Taxes ............................................................................... 27
4. Section 987 — Translating Branch Income and Loss .......................................................... 32
A. Historical Approaches to Branch Translation ................................................................... 32
B. Section 987........................................................................................................................ 33
C. The 1991 Proposed Regulations ....................................................................................... 35
D. The 2006 Proposed Regulations ....................................................................................... 37
5. Special Considerations for Hyperinflationary Currencies .................................................... 43
A. Definitions......................................................................................................................... 43
B. DASTM (§ 1.985-3).......................................................................................................... 43
C. Use of the Official vs. Free Market Exchange Rate ......................................................... 46
D. Restricted or “Blocked” Currencies .................................................................................. 47
E. Hyperinflationary Debt Instruments. ................................................................................ 49
6. Subpart F Treatment of Foreign Currency Gains and Losses ............................................... 50
A. General rule....................................................................................................................... 50
B. Exceptions to Subpart F Treatment................................................................................... 50
C. Subpart F Elections ........................................................................................................... 52
7. Foreign Currency Hedging Transactions .............................................................................. 53
A. Integrated Treatment under § 988(d) and Reg. § 1.988-5................................................. 53
B. § 1221(b)(2) hedging transactions .................................................................................... 55
C. Hedges of Investment in an Entity’s Balance Sheet. ........................................................ 58
1.
Determination of the Functional Currency and Definition of a “QBU”.
A.
Functional currency is determined at the “qualified business unit” level.
B.
Definition of a Qualified Business Unit.
(1)
§ 989(a) defines QBU as a “separate and clearly identified unit of a trade
or business of a taxpayer which maintains separate books and records.”
(2)
Two types of QBUs in § 989(a) regulations:
(a)
(b)
Taxpayers are QBUs. Therefore, corporations are QBUs; and
partnerships, estates and trusts are QBUs of their partners /
beneficiaries. Individuals, however, are not QBUs.
(i)
Prop. Reg. § 1.989(a)-1 (2006) would remove partnerships
from the list of per se QBUs above.
(ii)
Reg. § 1.989(a)-1(e), Example 4. Limited activities of a
French employee, acting as courier for sales by US Parent,
are a QBU if conducted in corporate form.
(iii)
Reg. § 1.989(a)-1(e), Example 5. Netherlands holding
company, whose only activities consist of paying directors
fees, holding stock and making equity investments, is a
QBU because it is a separate CFC.
(iv)
Compare Prop. Reg. § 1.987-2(b)(2) (2006), which would
exclude ownership of stock and borrowing acquisition
financing from a QBU for § 987 purposes.
(v)
A disregarded entity is not in itself a QBU, although its
activities may constitute a QBU. Prop. Reg. § 1.9871(b)(3) (2006).
Activities of a taxpayer are a separate QBU if (i) the activities
constitute a trade or business and (ii) separate books and records
are maintained.
(i)
The QBU does not need to be self-contained; i.e., it may
have a significant interrelationship with the parent
company.
Reg. § 1.989(a)-1(e), Example 2 – Swiss subsidiary
operates through French and German branches that conduct
marketing and distribution functions for US Parent’s
products. Each branch has its own employees, solicits and
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processes orders and maintains separate books and records.
Each branch is a separate QBU.
(ii)
However, the QBU’s activities cannot be merely ancillary
to the taxpayer’s trade or business.
1)
(iii)
C.
Reg. § 1.989(a)-1(e), Example 3 – US Parent hires a
French employee to serve as a courier for sales
documents. Since employee’s activities are merely
ancillary to US Parent’s trade or business, they do
not constitute the QBU.
Activities conducted by agents can also give rise to a QBU.
1)
Reg. § 1.989(a)-1(e), Example 6 – A hires an
independent broker to manage and trade its
investment portfolio. The broker maintains separate
books and records for the portfolio in a foreign
currency. This constitutes a QBU.
2)
FSA 200217002. Corporation B was the principal
to certain derivatives transactions effected regularly
on its behalf by an affiliate, Corporation C. The
Service ruled that: (i) Corporation C’s activities as
agent constituted a trade or business of B and a
QBU; and (ii) Corporation C’s activities would be
imputed to B for subpart J purposes, even if C were
an “independent agent.” The Service also found, as
a factual matter, that B maintained separate books
and records satisfying the requirements of § 989 for
the derivatives trades effected by its agent,
Corporation C.
§ 985 – Selection of the Functional Currency
(1)
The determination of a QBU’s functional currency looks to the facts and
circumstances set out in Reg. § 1.985-1(c)(2)(i). These facts and
circumstances are similar to those listed in FAS 52, Appendix A:
Reg. § 1.985-1(c)(2)
FAS 52, Appendix A
Currencies of QBU’s principal –
place of business
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Reg. § 1.985-1(c)(2)
FAS 52, Appendix A
Currencies of cash flows
Cash flow indicator – Currency of
cash flows; and degree to which the
cash flow currently affects the
parent’s cash flow
Currencies of QBU’s revenues and Sales price indicator – are prices
expenses
affected by exchange rates, or more
driven by market conditions?
Expenses indicator.
Locally
sourced expenses or expenses on
products imported from the parent
company?
Currencies in which QBU borrows Financing indicator. Is financing
and lends
primarily reliant on loans from the
parent and other loans in the
parent’s currency, or does the local
entity generate its own cash flow?
Currencies of QBU’s sales markets
Sales market indicator. Significant
local market? Market primarily in
The currencies in which pricing and parent’s country or set in parent’s
other financial decisions are made
currency?
The duration of the QBU’s business Intercompany transactions and
operations
arrangements indicator. The degree
of relationship with the parent
The significance and/or volume of company’s operations. Also, is the
the QBU’s independent activities
entity a holding company for assets
that could be directly owned by the
parent company?
(2)
2
Congress intended to adopt financial accounting’s functional currency
concept for tax purposes. 2 Under Reg. § 1.985-1(c)(5), the GAAP
determination of the functional currency will ordinarily be accepted for tax
purposes, if based on substantially similar facts and circumstances.
See JCT General Explanation of the 1986 Tax Reform Act, at p. 1086 & n. 36.
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(3)
Examples.
(a)
Reg. § 1.985-1(f), Example 4 – US Dollar Financing Vehicle
Required to Use a US Dollar Functional Currency. CFC is
organized as a financing vehicle primarily for USP and domestic
affiliates. Thus, CFC primarily derives income from borrowing in
US dollars and lending in US dollars back to the US Parent and its
subsidiaries. CFC incurs some local currency expenses. The CFC
has its activities primarily in U.S. dollars and thus is required to
use the U.S. dollar for tax purposes.
(b)
Id., Example 6 – Subsidiary with Dollar as GAAP Functional
Currency, but Possibly LC as Tax Functional Currency. Sub buys
products from related and unrelated parties in LC, derives gross
receipts in LC and pays operating expenses in LC. However, the
sales price is set to determine a set level of dollar profits. Sub has
a US Dollar functional currency for GAAP. However, since the
factors for GAAP and tax are not substantially similar, Sub may
use the LC or the Dollar for tax purposes.
(c)
Id., Example 7 – Treatment of CFC with Branches. CFC has no
operations of its own, but operates solely through Branches X and
Y. Each of the branches is a QBU. CFC must first determine the
functional currency of each of its QBUs, and then determine its
overall functional currency based on its total activities (including
those of its branches X and Y).
Note that a strict application of example 7 would seem to result in
a book-tax difference – e.g., causing a pure holding company that
uses the Dollar for GAAP to have a non-dollar functional currency
for tax based on the activities of its non-Dollar branches.
(d)
Example 12 – Foreign Corp with ECI. Foreign corporation F sells
US real property and earns Effectively Connected income under
§ 897(a). Because F earns ECI, its US real property income is
treated as a separate QBU that must use the US Dollar.
(e)
FSA #0991 (Feb. 1992). The IRS considered the functional
currency of a CFC that used the US dollar for GAAP and tax. The
Examining agent wanted to place the QBU on the local currency
for tax and argued that since the CFCs’ activities were primarily
conducted in local currency, the CFC’s use of the US dollar was
inappropriate.
The FSA illustrates the factual nature of § 985 inquiry. The IRS
noted that it had a strong argument for requiring the CFC to use the
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local currency, if the CFC conducted its activities primarily in that
currency. The IRS also noted that the currency into which the
CFC hedged its exposures was relevant in determining its
functional currency.
(4)
(5)
3
QBUs Required to Use the U.S. Dollar as their Functional Currency (Reg.
§ 1.985-1(b)(1)).
(a)
Individuals;
(b)
QBUs with a principal place of business in the United States, or
any U.S. Possession or other country in which the US dollar is the
standard currency;
(c)
QBUs generating income or loss that is effectively connected with
the conduct of a U.S. trade or business;
(d)
QBUs that operate primarily in U.S. dollars;
(e)
QBUs that do not maintain books and records in a local currency in
which they conduct significant activities.
Procedures for adopting a functional currency.
(a)
To establish a non-dollar functional currency, a QBU must
maintain books and records in that currency.
(b)
Treas. Reg. § 1.964-1(c)(6) provides that no accounting methods
need to be adopted until there is a significant event that makes the
foreign corporation’s earnings relevant. Thus, a CFC should be
considered to adopt a functional currency for tax when it computes
its earnings and profits in that currency, and those earnings and
profits are relevant for U.S. tax purposes. Until that time, the
initial adoption of a functional currency remains open to the CFC
and its QBUs.
(c)
Treas. Reg. § 1.985-1(c)(3) creates a presumption that a QBU
maintains books and records in the currency of the economic
environment in which it operates. Unless there is a substantial
non-tax business reason, the QBU cannot avoid adopting a
functional currency in which it has significant activities by
maintaining its books in another currency. 3
However, consider the use of the U.S. dollar under § 1.985-1(b)(1) by a CFC that does not maintain its books
and records in a currency in which it conducts significant activities. In FSA #0991, as discussed above, the
Service addresses whether a taxpayer can effectively elect the US dollar as a foreign QBU’s functional currency
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D.
Changes in Functional Currency.
(1)
Change in functional currency is a change in accounting method that
requires IRS consent. See § 985(b)(4).
(2)
A change in the functional currency is subject to the automatic consent
procedures of Rev. Proc. 2011-14, Appendix § 29.
(a)
A condition of obtaining automatic consent to change is that there
has been a significant change in the facts and circumstances
underlying the functional currency determination. Reg. § 1.9855(b).
(b)
The general scope limitations of RP 2011-24 also apply, such as
only one change every 5 years.
(c)
The taxpayer must agree to make the adjustments required by Reg.
§ 1.985-5, which are generally effected on a cut-off basis,
including:
(i)
Recognizing § 988 gain or loss on
denominated in the new functional currency
transactions
(ii)
Terminating § 987 QBUs with the same functional
currency as the owner’s new functional currency
(iii)
Translating the old functional currency basis of property
into the new functional currency at the spot rate on the date
of the change
(iv)
Translating the value of a § 987 QBU’s equity pool, if
applicable, into the new functional currency
(v)
Recognizing § 986(c) gain or loss on PTI, if the QBU is a
foreign corporation that is changing its functional currency
to the US dollar.
Note that the above adjustments are made using the spot rate for
the last day of the taxable year preceding the taxable year of the
functional currency change. 4
4
by failing to maintain Local Currency books and records, and could not use the US dollar as a default currency
simply by maintaining dollar books. The IRS argued that the QBU would be required to use Local Currency
because it conducted activities primarily in Local Currency.
Reg. § 1.985-5(a)(1).
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(3)
2.
Effect of § 381 Transactions.
(a)
Reg. § 1.367(b)-2(j)(1) provides that, if a QBU changes its
functional currency as a result of a § 381 transaction, then it will be
deemed to change its functional currency immediately before the
§ 381 transaction.
(b)
Example. CFC1 is a French corporation with Euro activities.
CFC2 operates a French branch that uses the US dollar as its
functional currency. CFC1 merges into CFC2, and the branches
are combined. Under § 985(b), the combined branch uses the Euro
as its functional currency. Accordingly, CFC1 is deemed to
undergo a functional currency change immediately before the
merger. 5
Section 988 — Non Functional Currency Transactions.
A.
Separate transaction principle.
(1)
Foreign currency gain or loss attributable to a § 988 transaction is treated
as ordinary income or deduction. § 988(a)(1).
(2)
Gain or loss on property purchased with a foreign currency is taken into
account by translating the basis and amount realized into functional
currency, separately from any loan used to acquire the property. See Rev.
Rul. 78-201; Reg. § 1.988-1(a)(6), Example 6.
(a)
Example. Foreign currency gain on satisfaction of a £ loan
payable used to acquire inventory was separately reported despite
the taxpayer’s loss on the sale of inventory. See Church’s English
Shoes, Ltd. v. Commissioner, 56-1 USTC para. 9271 (2d Cir.
1956).
A second example. Taxpayer borrows £ to purchase real estate.
Later, when the currency has appreciated, the Taxpayer sells the
property for £, and retires the debt. Taxpayer recognizes gain on
sale of property that reflects the increased $ value of the £ received
on the sale of the real estate. Under the separate transaction
principle, the taxpayer recognizes a separate § 988 loss on
retirement of the debt.
5
Although not discussed in the regulations cited above, the determination of the combined QBU’s single
functional currency presumably is made under the standards set out in § 381(c)(4) (carryover of accounting
methods in a § 381 transactions).
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(3)
Netting Rule.
(a)
B.
(i)
Reg. § 1.988-2(b)(9), Example 4. X holds a £ 10,000 loan
receivable with a $13,000 tax basis. At a time when $1.4 =
£ 1 X, but the loan receivable has a £ 9,800 FMV, X
disposes of the loan receivable. X recognizes a $720
foreign currency gain under § 988 (£ 9,800 * 1.4 $13,000), and no capital loss.
(ii)
The netting rule takes into account changes in value of the
debt instrument from interest rate movements as well as the
issuer’s insolvency. See Reg. § 1.988-2(b)(9), Example 5.
(iii)
The netting rule may also apply to the issuer so that, in
effect, the issuer’s repurchase premium under § 1.163-7 is
netted against an exchange gain on retirement of the debt.
See Reg. § 1.988-2(b)(13)(iv), Example 4(ii).
(b)
All gain or loss on foreign currency financial instruments
described in § 988(c)(1)(B)(iii) is foreign currency gain or loss.
§ 988(b)(3).
(c)
Consider how broadly the “transaction” is defined for purposes of
the netting rule. For example, if the borrower’s liability on a
mortgage is assumed in a § 1001 sale of the underlying property, is
the borrower’s § 988 gain is netted against a loss on the property
being sold? One commentator to address the issue concludes no,
on the theory that the sale of the property is a separate transaction
from the borrowing. 6
Definition of § 988 Transaction.
(1)
6
However, foreign currency gain or loss is limited to overall gain or
loss from the § 988 transaction. See § 988(b)(1) & § 988(b)(2).
That is, any market loss on the § 988 transaction is netted against
the § 988 gain, or vice versa (the netting rule).
Section 988 transactions include any of the following, entered into the
QBU’s non-functional currency:
(a)
Units of foreign currency
(b)
Debt instruments
See Greer Phillips, “What Is The Amount Realized On The Assumption Of A Foreign Currency- Denominated
Liability?,” 93 TNT 149-76 (July 12, 1993).
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(c)
(i)
Only applies if the transaction is indebtedness for U.S. tax
purposes.
(ii)
Multi-currency instruments. Under Reg. § 1.988-6(d), the
Taxpayer generally must determine the predominant
currency of the instrument’s payments and translate all
payments under the instrument into that currency.
(iii)
Rev. Rul. 2008-1. Prepaid forward contract providing for
payment of amount determined by reference to $ : €
exchange rates was, in substance, €-denominated
indebtedness rather than a foreign currency forward
contract.
(iv)
Preferred stock (including NQPS). § 988(c)(4) provides
unexercised regulatory authority to include preferred stock
in the definition of “debt instrument” for § 988 purposes.
This authority has not been exercised.
Accruing an account payable or receivable.
(i)
Executory contracts – Reg. § 1.988-1(a)(6), Example 6
illustrates that a contractual commitment does not
constitute a § 988 transaction until it results in an accrued
expense or income item.
Reg. § 1.988-5(b) allows currency risk on executory
contracts to be hedged prior to the accrual of the expense /
income.
(ii)
Accrued foreign income tax payables are § 988
transactions, unless taxes are incurred by a U.S. dollar
QBU of a domestic taxpayer. See Reg. § 1.988-1(a)(2)(ii);
see also Reg. § 1.905-3T(b) (rules for translating payments
of foreign income taxes for purposes of determining the
amount of the foreign tax credit under § 905(c)).
(iii)
Rev. Proc. 99-32 provides for an election to treat the
amount of a § 482 adjustment as an account payable
established as of the last day of the taxable year to which
the § 482 adjustment relates. The IRS National office has
advised that the Rev. Proc. 99-32 is a § 988 transaction to
the extent it is denominated in a non-functional currency
under Rev. Proc. 99-32 rules.
See FSA 200139008.
Section 4.01(3) of the Rev. Procedure provides rules for
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determining the denomination currency of the Rev. Proc.
99-32 account, which will generally be the U.S. dollar.
In a § 367(d) outbound transfer, the U.S. transferor also is
permitted to establish a non-interest bearing account
receivable that is either satisfied by the CFC through
payments or deemed satisfied and contributed to capital on
the third anniversary of the inclusion. See Reg. § 1.367(d)1T(g)(1). The § 367(d) regulations do not contain rules to
specify the currency of the § 367(d) account receivable.
(d)
(2)
Foreign currency financial instruments, such as forward contracts,
futures, notional principal contracts, etc.
(i)
Certain § 1256 contracts. Regulated futures contracts and
non-equity options are carved out of § 988 if such contracts
are marked to market under § 1256, unless the taxpayer
elects to have § 988 apply to all such transactions. See
Reg. § 1.988-1(a)(7). This allows the holder of such
contracts to obtain 60/40 treatment, if desired.
(ii)
Qualified Funds. § 988(c)(1)(E) provides a carve-out for
all contracts marked to market under § 1256 that are held
by certain qualified investment funds.
(iii)
Certain contracts held as capital assets. § 988(a)(1)(B)
allows the taxpayer to elect to designate certain foreign
currency forward contracts, futures contracts, and options
that are held as capital assets (and not part of a straddle) as
giving rise to capital gain or loss on disposition. The
election is made by a same-day identification of the
specific contract.
Intra-taxpayer transactions.
(a)
Transactions between a taxpayer and its QBUs are not § 988
transactions. See Reg. § 1.988-1(a)(10)(i). This rule is an
extension of the general principle that a taxpayer cannot enter into
transactions with itself. See Reg. § 1.446-3(c)(1); Rev. Rul. 80228.
(b)
A classic case of this fact pattern is an intercompany loan between
a Parent and its Disregarded Entity (DRE). The loan is disregarded
for tax, and so is not a § 988 transaction. Rather, the currency
exposure is taken into account under § 987 as remittances when
cash payments are made on the loan. Prop. Reg. § 1.987-2(d)(3),
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Ex. 4 (1991); Prop. Reg. § 1.987-2(b)(9), Examples 1 and 2
(2006).
(c)
C.
However, if the loan is made to a DRE by another affiliate separate
from the corporate owner of the DRE, then it will be a regarded
§ 988 transaction for the owner. Example – USP lends money to
US Sub’s € QBU. Cf. Prop. Reg. § 1.987-2(b)(9), Example 4
(2006). In this case where P and S are members of the same
consolidated group, the loan will be an intercompany transaction.
Timing of Recognition of Foreign Exchange Gain or Loss.
(1)
(2)
Foreign currency gain or loss is taken into account when the § 988
transaction is settled or otherwise disposed of – i.e., when the taxpayer
realizes and recognizes gain or loss on the overall transaction. See Treas.
Regs. §§ 1.988-2(a) through (d). Typically, this occurs through realization
events such as—
(a)
Making or receiving payment
(b)
Disposing of units of non-functional currency
(c)
Selling a loan receivable to another taxpayer
(d)
Transferring property in settlement of a loan payable
Step-in-the-shoes rule.
(a)
If a right or obligation under a § 988 transaction is transferred in a
non-recognition transaction, any foreign currency gain or loss is
generally not recognized on such a transfer.
(b)
In such a case, the transferee inherits the transferor’s functional
currency tax basis in the § 988 transaction, so that § 988 gain or
loss is preserved for future recognition. See §§ 988(b)(1) and
988(b)(2); Regs. §§ 1.988-2(b)(5) and 1.988-2(b)(6).
(c)
Example. CFC1 is a $USD taxpayer that holds a € loan receivable
from CFC2. CFC1’s $USD basis in the € loan receivable is
$1,500. At a time when the spot rate value of the receivable is
$1,250, CFC1 liquidates into a member of the US group in a § 332
liquidation. The US transferee inherits CFC1’s $1,500 basis in the
loan receivable.
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(3)
Overriding non-recognition treatment. 7
(a)
Branch transfers. Reg. § 1.988-1(a)(10)(ii) provides that § 988
gain or loss is immediately recognized on a transfer of a § 988
transaction between QBUs of a single taxpayer, if the transfer
would cause the § 988 transaction to lose its character as a nonfunctional currency transaction or if the source of any § 988 gain
or loss could be altered.
Gain or loss is computed, without regard to 1.988-2(b)(8) (the
netting rule), as if the transferor QBU sold the units of property at
FMV immediately before the transfer.
(b)
(i)
Example. X is a US dollar taxpayer with two branches, Y
and Z, operating in the €. Y holds $25 in cash with a 20 €
tax basis and 23 € fair market value. If Y transfers the $25
of cash to X, it appears that this will cause Y to recognize 3
€ of § 988 gain under the branch transfer rule. The transfer
also would have § 987 consequences as a transfer of
property by Y to X.
(ii)
Example 2. Same, except that Y transfers the $25 to Z,
which is a € branch. In this case, since Z can step in the
shoes of Y, the branch transfer rule does not apply.
(iii)
It should not be overlooked that the same rule can also
apply to a transfer of a § 988 transaction from one QBU to
another QBU with the same functional currency but a
different place of business, because of the change to the
source due to the residence of the taxpayer rule.
Debt-for-stock rule.
(i)
7
An exchange of debt for stock triggers § 988 gain or loss.
The same rule also applies to the Parent’s capitalization of
a loan through a contribution to capital. See Reg. § 1.9882(b)(13). However, the amount of exchange gain or loss
recognized by the holder or obligor is limited to its overall
gain or loss in the transaction (i.e., the netting rule applies).
See Reg. § 1.988-2(b)(13), Example 4.
The author acknowledges others’ work in so helpfully classifying and examining these rules. See L.G. Harter,
“Code Sec. 988 and the Nonrecognition Provisions— Part I: Transfers of Foreign Currency Loans Receivable,”
International Tax Journal (Mar. / Apr. 2009); L.G. Harter & R.E. Lee, “Code Sec. 988 and the Nonrecognition
Provisions—Part II: Assumptions of Foreign Currency Denominated Liabilities,” International Tax Journal (July
/ Aug. 2009).
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(c)
(d)
(ii)
The holder adjusts its basis in the stock received in
exchange for any § 988 gain or loss recognized on the
exchange. See Reg. § 1.988-2(b)(13), Example 1.
(iii)
The obligor of a non-functional currency loan payable
recognizes § 988 gain or loss on the satisfaction of the loan
with stock. The issue price of the debt is then adjusted
before calculating any § 108 / COD consequences of the
capitalization. See id., Example 2.
Change in functional currency of holder / obligor.
(i)
If a party to a § 988 transaction changes its functional
currency to the currency in which the § 988 transaction is
denominated, that party recognizes § 988 gain or loss under
§ 1.985-5(b).
(ii)
Such a functional currency change may occur by virtue of a
reorganization in which two or more QBUs are combined
into a single QBU. See Reg. § 1.367(b)-2(j).
Outbound transfers.
(i)
Reg. § 1.367(a)-4T(d) provides that § 988 gain or loss is
recognized on any non-functional currency transferred to a
foreign corporation.
1)
(e)
Exception where (A) currency is denominated in the
currency of the country in which transferee is
located, and (B) the § 988 transaction was entered
into the ordinary course of business.
Analogous authority? Recently proposed regulations under § 453B
(REG-109187-11 (Dec. 23, 2014) governing dispositions of
installment obligations) provide a dichotomy between nonrecognition transactions in general, such as § 351 or § 721 / § 731
dispositions of an installment note, and non-recognition
transactions that involve satisfaction of the installment note, such
as the issuer’s satisfaction of the receivable with its own stock or
partnership equity. Section 453B gain would be triggered in the
latter case due to the fact that the unrealized installment gain
would otherwise disappear.
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(4)
Other special timing rules for § 988 transactions.
(a)
Change to debt’s denomination currency. Prop. Reg. § 1.9882(b)(14)(i) (1992) would authorize the IRS to defer foreign
currency gain or loss that would otherwise be recognized on a
debt-for-debt exchange if the IRS determines that “the new debt
has in effect been replaced with other debt denominated in a
different currency.” This rule predates Treas. Reg. § 1.1001-3, and
it is unclear how the two rules are intended to interact.
(b)
§ 267(f) Issues.
(i)
Reg. § 1.267(f)-1(e) applies to intercompany loans made in
a non-functional currency with respect to the lender.
1)
If “the transaction does not have a significant
purpose the avoidance of Federal income tax,” then
the lender’s § 988 loss with respect to the loan is
not subject to deferral under § 267(f).
2)
FSA #003184 analyzed a transaction as the entry
into loan and subsequent re-denomination of the
loan in a new currency.
3)
It is unclear how to apply the § 1.1502-13 / § 267(f)
matching rule and acceleration rule where a loss is
recognized with respect to a foreign currency
transaction. For example, in PLR 200945026, the
IRS addressed this issue in the context of hedging
contracts between US Consolidated Group and
Foreign Affiliates (under a foreign parent). Based
on a number of representations as to the business
motivated nature of the hedging, the IRS ruled that
losses on currency hedging contracts that were
treated as a sale or exchange of property would be
deferred until the relevant Foreign Affiliate
included the corresponding item of income under its
method of accounting. It is unclear what method of
accounting was involved (presumably, the financial
accounting method), since none of the foreign
affiliates conducted a US trade or business and
“some or all” of their gross income on the hedges
was exempt from US tax. The Service appeared to
permit the taxpayer’s foreign affiliates to apply
§ 267(f) by hypothetically assuming their U.S. tax
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method of accounting conformed to their financial
accounting methods.
4)
(c)
Section 267(f) arguably does not apply to defer a
loss recognized by the obligor on the loan payable
because there is no “sale or exchange” of property,
including currency, when a debt is repaid. This
position stems from the Fairbanks / extinguishment
doctrine. Importantly, under pre-1986 law, the Tax
Court relied on Fairbanks to conclude that an
obligor’s currency loss on repayment of a nonfunctional currency loan payable was ordinary. See
National Standard Co. v. Commissioner, 80 T.C.
551 (1983), aff’d 749 F.2d 369 (6th Cir. 1984). The
dissent in National Standard argued that an obligor
should be characterized as entering into and closing
a short sale of currency. The majority of the Tax
Court and the Sixth Circuit on appeal did not agree
with the latter argument. 8
Financial Products Code Sections That May Affect Timing of
Foreign Currency Gain or Loss.
(i)
§ 1256.
1)
Requires annual mark-to-market (MTM) of foreign
currency contracts that are § 1256 contracts:
a)
Regulated futures contracts traded on or
subject to a futures exchange
b)
“Foreign currency contracts” – forward
contracts, etc. on “major currencies” that are
traded through a regulated futures exchange
c)
Exchange-traded
currencies. 9
options
on
foreign
8
See also FSA #003330 (Dec. 1996) (holding that, even if § 267(f) did apply to the debtor’s satisfaction of the
loan, deferral would not apply under § 267(f)(2) because the transferred FX units were converted immediately
into $USD by the creditor); Reg. § 1.988-2(b)(16)(ii) (reserving on treatment of the debtor on an FX loan).
9
The IRS position has changed over time with respect to whether foreign currency options not traded on an
exchange are § 1256 contracts under the “foreign currency contract” category. It ultimately concluded that nonlisted currency options are not § 1256 contracts, a position the Tax Court has upheld. See Notice 2007-71,
revoking Notice 2003-81. Summit v. Commissioner, 134 T.C. No. 12 (2010)
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2)
(ii)
§ 1256 affects mark-to-market timing, but does not
necessarily change the character of currency gain or
loss to 60/40 long-term / short-term capital gain or
loss. While § 1256 generally mandates capital
treatment
of
currency
contracts,
section
988(c)(1)(D) allows the taxpayer to elect to treat all
of its regulated futures contracts and listed currency
options as ordinary positions.
§ 475.
1)
(iii)
Positions with respect to foreign currency generally
are “securities” within the scope of MTM rules
under § 475(c)(1)(E).
a)
Exclusion for § 1256 contracts (which are
marked anyway under § 1256; exclusion
from § 475 allows securities dealers and
traders to preserve 60/40 character). See
§ 475(c)(1) (flush language).
b)
Is a non-functional currency debt obligation
is a position with respect to currency under
§ 475(c)(1)(E) (i.e., the equivalent of a short
sale of currency), or excluded from § 475 by
Reg.
§ 1.475(c)-1(a)(2)
(taxpayer’s
indebtedness is not a “security” marked
under § 475)? For further discussion of this
issue, see generally NYSBA Report on
Subpart F Issues Involving Currency Gain
and Loss (June 2013).
c)
Is physical cash denominated in a
functional currency considered to
“security” for § 475 as an “evidence
interest
in
…
currency”
§ 475(c)(1)(E))?
nonbe a
of an
(see
§ 1092.
1)
The so-called straddle rules defer loss from either
leg of offsetting or successor foreign currency
positions that are “actively traded personal
property.”
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2)
(iv)
a)
Actively traded is presumed to be met if
there is an “active interbank market” for the
currency. § 1092(d)(7)(B).
b)
Obligor on a non-functional currency debt
instrument deemed to have a short position
in the currency for § 1092 purposes.
See § 1092(d)(7)(A).
The borrower’s
obligation is seen as economically
equivalent to a short position. 10
c)
For purposes of identifying offsetting
positions, all members of the consolidated
group are treated as a single entity. See
§ 1092(d)(4). CFCs’ positions, however, are
not combined with those of the U.S.
shareholder.
Loss is deferred to the extent of unrecognized gain
on offsetting position(s) at the end of the year.
However, gains are recognized under the normally
applicable rules (§ 1256 or § 1001), even though
offset by an unrecognized loss.
Hedge timing rules (§ 1.446-4).
1)
Applies a matching rule for currency gain or loss
with respect to a currency position used to enter a
§ 1221(b)(2) hedge of a business risk.
Conceptually, hedge timing is similar to the straddle
rules, but is a two-way street.
a)
Substantive risk reduction test must be met,
and contract must hedge a qualifying
§ 1221(b)(2) risk.
b)
Hedge identification generally not necessary
to apply matching rule for eligible
§ 1221(b)(2) hedges. See Rev. Rul. 2003127.
i)
10
However, for § 1256 contracts, IRS’s
view appears to be that proper
identification is required to qualify
See 1986 TRA Bluebook, at p. 1108.
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for the § 1256 hedging exception and
to override statutory mark-to-market
rule so as to defer a MTM gain. 11
(5)
D.
Determining the Spot Rate.
(a)
Foreign currency gain or loss under § 988 is computed using “the
spot rates” on the relevant booking date and the payment date.
(b)
Spot rate is generally calculated using the free market exchange
rate, rather than the official government exchange rate. 12 Consider
implications for countries with government-controlled currencies.
(c)
Taxpayers are allowed to account for payables and receivables
using a consistent “spot rate convention” of one quarter or shorter
in duration, to the extent consistent with their financial reporting
conventions. 13 Adoption of a spot rate convention is a binding
election that may only be changed with IRS consent.
(d)
Taxpayers are allowed to ignore the “disposition” of currency that
results whenever money is moved in or out of the bank (i.e.,
through settlement of a deposit). 14 Taxpayers may also use any
reasonable method to determine the basis of its units of
nonfunctional currency taken out of a bank account. 15
(e)
Regs. §§ 1.988-2(a)(2)(iv) & (v) allow taxpayers to ignore
exchange rate movements between the execution and settlement of
trades with respect to publicly traded securities.
Character and Source of Section 988 Gain or Loss.
(1)
Character.
(a)
Foreign currency gain or loss under § 988 is generally ordinary in
character. See § 988(a)(1)(A).
(i)
11
12
13
14
15
Certain § 1256 contracts (§ 988(c)(1)(D)) and certain other
identified contracts (§ 988(a)(1)(B)) may have a capital
character if the taxpayer plans correctly.
See CCA 201024049 (June 9, 2009); ECC 201034018.
See Treas. Reg. § 1.988-1(d)(4).
Treas. Reg. § 1.988-1(d)(3).
Treas. Reg. § 1.988-2(a)(1)(iii).
See Treas. Reg. § 1.988-2(a)(2)(iii)(B).
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(ii)
(2)
Gain or loss on a § 988 transaction not attributable to
currency gain or loss (i.e., market gain or loss) remains
capital gain or loss. However, such capital gain or loss
may be offset by ordinary income or deduction attributable
to currency movements under the netting rule. See Reg.
§ 1.988-2(b)(8) (discussed above).
Source.
(a)
Gain or loss from a § 988 transaction is generally sourced to the
residence of the relevant QBU. See § 988(a)(3)(A).
(i)
Residence of a corporation or a partnership is generally its
place of organization. Reg. § 1.988-4(d). Thus, residence
of a foreign partnership is determined on an entity basis.
1)
(ii)
Exception – where a partnership is formed or
availed of to manipulate foreign currency
consequences, it may be treated as an aggregate.
See id.
Residence of a QBU is where its principal place of business
is located. See Reg. § 1.988-4(d)(2). Thus, a US
taxpayer’s § 988 gains or losses attributable to items
booked in a foreign QBU would be foreign-source.
(b)
Special rule for hyper-inflationary loans – see Section on
Hyperinflationary Currency issues below.
(c)
Currency Gain or Loss Allocated and Apportioned as Interest
Expense.
(i)
Reg. § 1.861-9T(b) contains three sets of rules that may
apply to cause currency gain or loss associated with a
borrowing (or a hedge thereof) to be allocated and
apportioned under § 861 in the same manner as interest.
(ii)
These rules do not apply for purposes of withholding tax
under § 871 or § 1441. See Reg. § 1.988-4(g).
(iii)
Reg. § 1.861-9T(b)(1) – interest equivalents. “Any loss or
expense . . . incurred in a transaction or series of integrated
or related transactions in which the taxpayer secures the use
of funds for a period of time shall be subject to allocation
and apportionment . . . if such expense or loss is
substantially incurred in consideration of the time value of
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money.” This rule only applies to “loss or expense” and
does not re-source gains or income.
1)
Example 2. US Dollar taxpayer borrows £ sterling
at a high interest rate, and enters a cross-currency
swap to hedge its currency exposure.
Even if the transactions are not integrated into a
synthetic dollar borrowing under § 988(d), any net
currency loss on the swap may be allocated and
apportioned in the same manner as interest.
Note that this Example sunset with the 3-year
expiration date of the 1989 temporary regulations.
However, the Service may argue that the same
result is inherent in the text of -9T(b)(1) which was
included in the 1988 temporary regulations that
predated the sunset rule.
See FSA #003260
(discussed below).
(iv)
Reg. § 1.861-9T(b)(2) – hedged strong currency
borrowings. If a taxpayer borrows in a non-functional
currency at a lower interest rate than the AFR (or the
equivalent rate in functional currency), and enters a
transaction that “substantially diminishes currency risk with
respect to the borrowing or interest expense thereon,” the
net gain or loss on the transaction will be presumed to be
allocated and apportioned in the same manner as interest
expense. The taxpayer can rebut this presumption by
showing that the other transaction hedged other ordinary
business risks.
1)
Example 1. Taxpayer borrows in a foreign currency
at a rate of 3% (less than the AFR). Taxpayer has
no QBUs operating in that currency. Taxpayer
enters a swap that covers most, but not all, of its
currency risk on the borrowing. The net currency
loss on the borrowing adjusted for the swap is
allocated and apportioned in the same manner as
interest.
2)
Example 2. Same as above, except that the
taxpayer borrows in two functional currencies and
enters a swap in a single currency that reduces
currency risk on both borrowings. The above rule
applies to both loans.
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(v)
Reg. § 1.861-9T(b)(6) – hedges of the taxpayer’s interest
bearing debt. Financial products that alter the taxpayer’s
borrowing costs, such as interest rate hedges, options, caps,
collars, etc., may be contemporaneously identified as
hedges. In this case, gain or loss on the financial product is
allocated and apportioned in the same manner as interest. 16
Both the borrowing and the hedge must be in a single
currency and the rule does not apply to the extent otherwise
provided in § 988. Thus, this rule would seem to have
limited impact on currency hedging.
However, in the following Chief Counsel memorandum,
the IRS suggested that this regulation or at least § 1.8619T(b)(1) might apply to re-source a currency loss on a
hedge of a non-functional currency borrowing as interest.
That is, the IRS continued to apply Example 2 from the
expired 1989 temporary regulations.
1)
(vi)
E.
The IRS National Office interpreted 1.861-9T(b)(6) to
apply to gain or loss with respect to the taxpayer’s currency
hedge, but advised that the amendments that added § 1.8619T(b)(6) and Example 2 of § 1.861-9T(b)(1) to the
regulations had expired under the sunset rule of §
7805(e)(2). Therefore, these rules were no longer in force.
However, the IRS found that the loss on the currency swap
fell within the general rule of § 1.861-9T(b)(1)
(promulgated before the effective date of § 7805(e)(2)).
Reg. § 1.6011-4 Reporting (Form 8886).
(1)
16
FSA #003260 – the taxpayer borrowed € in order to
effect a foreign acquisition, and entered a € : $ swap
to hedge its exposure. Later, the taxpayer borrowed
$ to refinance the € indebtedness. It was required to
make a termination payment to be released from its
currency swap.
Since § 988 transactions give rise to ordinary income or expense, a loss on
§ 988 transaction can give rise to a reporting obligation under § 6011.
Certain listed transactions have exploited the ordinary treatment of
currency losses to abusive results.
If the taxpayer fails to identify the hedge, then loss alone is allocated and apportioned as interest, while gain
remains 100% U.S. source. See Reg. § 1.861-9T(b)(6)(iv)(B); TD 8257.
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(2)
Reg. § 1.6011-4(b)(5) generally requires Form 8886 reporting for loss
transactions where, in the case of a corporation, the transaction results in a
loss of $10 mm in one year or $20 mm over multiple taxable years.
(3)
Rev Proc. 2004-66, amplified by Rev. Proc. 2013-11 provides relief for
certain types of losses.
(a)
Specifically, losses attributable to a “qualifying basis” as described
Sec. 4.02 of the revenue procedure. A qualifying basis is generally
a basis attributable to a payment of cash, accrual of interest
income, and not transferred in a reorganization transaction.
However, the exception for losses attributable to qualifying basis
does not apply to losses treated as ordinary under § 988, unless the
taxpayer is a bank under § 581. Thus, this relief provision is fairly
limited in its application.
(b)
Sec. 4.03 of Rev. Proc. 2013-11 also provides exceptions
potentially applicable to certain § 988 transactions:
(i)
Losses from mark-to-market of an item under § 475(a) or
§ 1256
(ii)
Losses under § 475(f), from legging out of integrated
treatment under § 1.988-5 or § 1.1275-6, and certain other
MTM provisions.
(iii)
Losses from properly identified § 1221(b)(2) hedging
transactions.
This places a premium on proper
identification of hedging transactions.
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3.
Section 986 — Translation Rules for Earnings and Profits and Foreign Income
Taxes.
A.
§ 986 E&P Translation Rules.
(1)
A foreign corporation must maintain its E&P in its functional currency
and translate E&P into dollars at “the appropriate exchange rate” on the
date of a distribution or deemed distribution. § 986(b)(1).
(a)
(2)
(3)
If the foreign corporation operates non-functional currency QBUs,
those QBUs’ earnings must be translated into the foreign
corporation’s E&P under § 987. See Reg. § 1.985-1(f), Example 9.
§ 989(b) appropriate exchange rates:
(a)
Spot rate on date of distribution for an actual distribution
(b)
Spot rate on the last day of the year for a § 956 inclusion
(c)
Average yearly exchange rate for a subpart F inclusion
(d)
Spot rate on date of sale of stock for § 1248 deemed dividend
income
§ 986(c) – Exchange Gain or Loss on PTI.
(a)
The US shareholder shall recognize currency gain or loss
attributable to the fluctuation in exchange rates between the date of
a PTI inclusion and the date of the actual distribution. § 986(c)(1).
(b)
Notice 88-71, § 2 on Computing § 986(c) Gain or Loss. § 986(c)
gain is computed on an aggregate pooled basis for all post-1986
PTI. Similarly, the legislative history indicated that Congress
generally intended for § 986(c) gain or loss to be computed on a
pooled basis. 17
(c)
Prop. Reg. § 1.959-3(b)(3) (2006) on Computing § 986(c) Gain or
Loss.
(i)
17
General rule. Shareholder maintains annual layers of (c)(1)
and (c)(2) PTI. § 986(c) gain or loss is calculated based on
the category and layer of PTI from which the distribution is
sourced under normal § 959 ordering rules.
1986 TRA Bluebook, at p. 1090.
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(ii)
(d)
Dollar-basis pooling election. The shareholder elects to
maintain a single aggregate basis pool for all (c)(1) and
(c)(2) PTI. This is the same approach as in Notice 88-71.
It would seem that dollar basis pooling, rather than tracing,
should be the default rule, as it will be simpler to apply for
many taxpayers.
Events Triggering Recognition of § 986(c) Gain or Loss.
(i)
Actual distributions of PTI to the United States
shareholder.
Note that under the 2006 Proposed Regulations, an interCFC distribution of PTI excluded under § 959(b) is not an
occasion to recognize § 986(c) currency gains and losses.
Rather, the U.S. shareholder continues to retain a carryover
$USD basis in the PTI account. 18
Also, under the Proposed Regulations, the re-classification
of the shareholder’s § 959(c)(2) PTI as § 959(c)(1) PTI as a
result of a § 956 investment does not trigger recognition of
§ 986(c) gain or loss. 19
(ii)
§ 1248 sale of CFC stock. See Notice 88-71, § 2(c). The
shareholder’s basis in the CFC’s stock is adjusted for the
§ 986(c) gain or loss that is deemed distributed
immediately before the § 1248 stock sale. This rule has
some logical justification because the § 986(c) gain or loss
has economically accrued to the seller. Interestingly, the
2006 Proposed Regulations do not contain the same rule or
address this issue. 20
In FSA 199949001, a taxpayer transferred stock of a CFC
with PTI cross chain in a § 304 transaction. Relying on the
above-cited provision of Notice 88-71, the Taxpayer argued
that the § 986(c) gain increased the basis of its CFC’s stock
for purposes of § 301(c)(2) basis recovery in the § 304
transaction. The IRS rejected this position and concluded
that the Notice was limited to § 1248 transactions. The
§ 986(c) gain did not result in an adjustment to the basis of
the CFC stock.
18
19
20
See Prop. Regs. §§ 1.959-3(e)(3)(ii)(B) and 1.959-3(e)(6), Example 7.
Prop. Reg. § 1.959-3(e)(2)(v).
Prop. Reg. § 1.959-3(e)(6), Example 8.
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(e)
(iii)
Change of CFC’s functional currency to the US dollar. See
Reg. § 1.985-5(e)(2).
(iv)
Shareholder recognizes a § 367(b) inclusion. See Reg.
§ 1.367(b)-2(j)(2). As in the case of § 1248 deemed
dividends under Notice 88-71, the shareholder’s basis in
the stock is adjusted for the § 986(c) gain or loss
immediately before the § 367(b) transaction.
Translation of Section 961(a) and (b) Basis Adjustments.
(i)
(4)
21
TAM 200141003 – the IRS addressed the translation of
positive § 961(a) basis adjustments attributable to an
inclusion of subpart F income, and negative § 961(b) basis
adjustments attributable to a distribution of PTI. In each
case, the IRS advised that the historic US Dollar cost of the
PTI would be used for the basis adjustment, rather than the
current US Dollar value of the PTI when distributed. See
also Prop. Reg. § 1.961-2(b)(2) (similarly providing that
adjustments to stock basis use historical cost).
Translation of Asset Basis for Assets Entering the United States.
(a)
One issue that arises is how asset basis should be translated into a
taxpayer’s functional currency where the acquisition cost was
incurred in a non-functional currency. Under Rev. Rul. 78-281, a
U.S. dollar taxpayer takes a historic U.S. dollar basis in property
acquired using a non-functional currency.
If, however, a
taxpayer’s functional currency changed subsequent to acquisition
(e.g., a foreign subsidiary liquidated into a U.S. parent, or
underwent a § 381 transaction with another foreign subsidiary), the
question is how its asset basis should be translated. 21
(b)
PLR 8749008 – a foreign corporation 50% owned by a U.S.
shareholder used a depreciable asset outside the United States, and
then put it to use in a trade or business in the United States. The
IRS ruled that (1) the asset had a depreciable basis reduced by
allowable depreciation during the period the property was used
outside the U.S., citing Gutwirth v. Commissioner, 40 T.C. 631
(1963), and (2) the Dollar basis of the property was its original cost
determined using the exchange rate on the date the asset was
originally acquired, citing Rev. Rul. 78-281.
Several excellent articles have addressed this topic. See, e.g., Robert Katcher, Back to Basis: Crossing the U.S.
Frontier, 2002 TNT 209-27 (Oct. 25, 2002).
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(c)
Reg. § 1.367(b)-3(b)(3)(iii) reserves with respect to the U.S.
shareholder’s recognition of exchange gain or loss on its capital
investment in a foreign subsidiary in an inbound liquidation. As
stated in the Preamble, the Proposed Regulation providing for this
was intended to link the translation of asset basis at current spot
rate values to the recognition of all FX gain / loss on both E&P and
the paid-in-capital account under Reg. § 1.985-5 (see below). The
proposed regulation regarding the paid-in-capital account was
withdrawn due to administration concerns. See TD 8882.
However, no corresponding change was made to the § 1.985-5
regulations.
(d)
Reg. §§ 1.985-5(c) and -5(e). On a change in functional currency
of a corporation, its E&P and “paid in capital” account (see above)
are translated into the new currency at the spot rate. Similarly, its
functional currency basis of its assets and liabilities are translated
at the spot rate on the last day of the year before the year of
change. See Reg. § 1.985-5(b). These two rules applied in tandem
would cause the FX gain or loss to be recognized through a new
FMV basis, coupled with a corresponding adjustment to the
taxpayer’s E&P and paid-in-capital.
(e)
FSA 199935019 – F Corp transferred a non-Dollar note to US Sub.
In determining US Sub’s basis in the note, the IRS applied Reg.
§ 1.988-2(b)(6) and ruled that the Dollar basis in the Note would
be computed by translating the units of principal at the spot rate on
the date that the Subsidiary acquired the note. See also FSA
003297 (Aug. 1997) (citing Gutwirth for the proposition that “U.S.
tax concepts apply to determine the tax consequences of events,
even if those events occur outside of the United States, and even if
those events result from activities conducted by foreign persons,”
including tax basis); Treas. Reg. § 1.1296-1(d)(5)(ii), Ex. (where
NRA becomes a resident alien, its basis in stock for PFIC purposes
is its original cost basis as of the date of acquisition during the
NRA period).
(f)
CCA 200303021 (Oct. 1, 2002). Following the IRS’s victory in
Traveler’s Insurance Co. v. United States, 303 F.3d 1373 (Fed.
Cir. 2002), the IRS issued this Chief Counsel advice requiring
translation of basis of stock acquired in a § 368(a)(1)(B)
reorganization at historic exchange rates. There, the US Parent
acquired stock in a CFC from minority shareholders in a tax-free
§351 / § 368(a)(1)(B) overlap transaction. The IRS reasoned that
U.S. tax concepts govern the computation of $USD basis by a non26
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U.S. taxpayer. The IRS apparently viewed Rev. Rul. 78-281,
supra., and the related case law as controlling.
The situation at issue in the CCA, however, may be distinguishable
from a § 381 transaction involving a change in the taxpayer’s
functional currency. In that case, the application of Reg. § 1.985-5
may cause the taxpayer’s old functional currency basis to be
translated at the current spot rate on the effective date of its change
in functional currency.
B.
Translation of Foreign Income Taxes.
(1)
General rule. Translate foreign income taxes (and any adjustments
thereto) at the average exchange rate for the taxable year to which the
taxes relate. The general rule was intended to limit the need for § 905(c)
redeterminations arising from exchange rate fluctuations between the
accrual date and payment date. 22
Under the general rule, any adjustments to accrued taxes (including
refunds) are translated at the average exchange rate for the year.
(2)
22
23
Exceptions Requiring Spot Rate Translation.
(a)
Two-year rule. Taxes paid more than 2 years after the end of the
taxable year to which they relate. See § 986(a)(1)(B)(i).
(b)
Taxes paid before the beginning of the U.S. taxable year to which
they relate.
(i)
Estimated taxes. In TAM 8943003, the IRS ruled that
monthly estimated tax payments made during the taxable
year should be treated as payments of tax (rather than
merely deposits) and translated for § 905(c) purposes at the
spot rate on the date of payment. The legislative history of
the 1986 TRA also indicates that Congress intended for
prepayments of estimated tax to be translated at the spot
rate prevailing on the date of payment. 23 The fact that the
currency had been devalued by the end of the year did not
result in an adjustment to the taxpayer’s foreign tax credit.
(ii)
Under current law, however, these estimated tax payments
made during the U.S. taxable year of the CFC would be
translated under the general rule of § 986(a)(1). This
See Conference Committee Report on P.L. 105-34 (Section 1102 of the 1997 Taxpayer Relief Act).
1986 TRA Bluebook at p. 1110.
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exception is limited to cases where the estimated taxes are
paid before the beginning of the U.S. taxable year to which
they relate.
(c)
Taxes denominated in an inflationary currency.
(d)
Taxes for which the taxpayer makes a one-time binding election to
translate at the spot rate on the date of payment.
See
§ 986(a)(1)(D). Under the spot rate election, in the case of accrued
but unpaid taxes, the translation is done using the spot rate for the
last day of the year. Reg. § 1.905-3T(b)(1)(ii)(D).
The election may be made either for all foreign income taxes, or
only non-functional currency taxes attributable to US dollar QBUs.
2007 Temp. Reg. § 1.905-3T(b)(1)(ii)(D). See also Notice 200647, § 4 (interim guidance with respect to election). The election
can be made in any year, but once made, it continues to apply
absent IRS consent to revoke the election. See id.
(e)
Sec. 905(c) Consequences of Spot Rate Election. If the taxpayer is
using the spot rate election, then the Dollar amount of taxes
accrued on the last day of the foreign tax year may differ from the
Dollar value of taxes actually paid in the subsequent year.
If the fluctuations in $USD value of foreign taxes result in a percountry change of more than the lesser of $10,000 or 2% of the US
Dollar tax liability, then a § 905(c) redetermination is required for
§ 901 direct foreign tax credits. See Reg. § 1.905-3T(d)(1). No
redetermination is required for § 902 credits due to currency
fluctuations, because these § 905(c) adjustments (like other
§ 905(c) adjustments affecting a CFC) are generally made to the
CFC’s E&P and tax pools. See Reg. § 1.905-3T(d)(2)(i).
(3)
Translation of Foreign tax refunds.
(a)
Prior law. “The redetermination should be made by subtracting
from the original foreign tax credit the dollar value of the refund
measured at the prevailing exchange rate on the day the refund is
made.” AT&T v. United States, 430 F. Supp. 172 (S.D.N.Y. 1977),
aff'd, 567 F.2d 554 (2d Cir. 1978).
(b)
General rule of Current Regulations.
(i)
Under the average exchange rate translation of § 986(a)(1),
the refund should be treated as an “adjustment thereto” that
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is translated at the average rate for the year to which the tax
relates. See Reg. § 1.905-3T(b)(3).
(ii)
(c)
If the foreign taxes are translated at the spot rate, any
refund would be translated at the exchange rate used to
translate the original payment of foreign taxes.
§ 986(a)(2)(B)(ii); see also Reg. § 1.905-3T(b)(3).
Refunds / Additional Payments by a CFC.
(i)
Effect on Tax Pool. Since the tax pool is maintained in
U.S. dollars, the refund or additional payments is translated
from the currency of the payment into $USD using the
appropriate exchange rates set out in Reg. § 1.9053T(b)(3). See Reg. § 1.905-3T(d)(2)(ii)(A). For example,
a refund of taxes taken into account under the general rule
of § 986(a)(1) would reduce the tax pool by the same
$USD amount of taxes already claimed.
(ii)
Effect on E&P Pool. If the taxes are paid in the CFC’s
functional currency, a refund or additional assessment will
not require translation to determine the E&P consequences.
The receipt of the units of currency in the CFC’s functional
currency will not have any income adjustments under § 988
or § 987 of the Code. See Reg. § 1.905-3T(b)(5)(iv); Reg.
§ 1.905-3T(d)(2)(ii)(D), Ex. 1 (last sentence).
However, if the taxes are paid in other than the CFC’s
functional currency, then the refund of those taxes (or
increase in those taxes) must be translated from the
denomination currency into the CFC’s functional currency
using the appropriate exchange rate under § 986(a). See
Reg. § 1.905-3T(d)(2)(ii)(C)
Additionally, in the case of a refund, the units of nonfunctional currency that are refunded have a functional
currency basis to the CFC determined by reference to the
historic exchange rate used to translate the refund. See
Reg. § 1.905-3T(b)(5)(ii). When these units of currency
are disposed of, the CFC would recognize § 988 income or
loss. See Reg. § 1.905-3T(b)(5)(v). The same issue would
also arise if the CFC acquired non-functional currency at a
current spot rate, and disposed of it to satisfy an additional
non-functional currency tax liability that is translated at the
historic rate under § 986(a)(1).
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(4)
Other foreign currency issues involving creditable foreign income taxes.
(a)
Taxes Payable and Receivable.
Although the general rule of § 986(a)(1) obviates the need for
§ 905(c) adjustments resulting from currency movements between
the accrual date and the date of payment, this does not eliminate
possible application of § 988. Specifically, a non-functional
currency tax payable or receivable generally is within the scope of
§ 988. See Reg. § 1.988-1(a)(2)(ii). There is an exception for a
Dollar QBU’s foreign tax payables related to taxes which are
claimed as a credit under § 901. See Reg. § 1.988-1(a)(2)(ii).
According to TD 8400, this exception was intended to provide a
U.S. taxpayer’s direct § 901 credit from non-Dollar taxes of a
Dollar QBU with similar treatment to that of taxes accrued through
a § 987 branch subject to Notice 89-74.
To the extent this rule applies, the payment or satisfaction of a tax
payable or receivable will give rise to § 988 gain or loss as an
income adjustment.
(b)
Brazilian ORTNs.
During a period of hyper-inflation in Brazil, the Brazilian
government instituted a “peg” to the taxpayer’s tax liability, which
was due in 12 monthly installments. The tax was assessed in a
fixed number of ORTNs at year end. 1/12 of each ORTN was then
converted into cruzeiros at the spot rate for each month of
payment. Due to inflation, the total number of cruzeiros actually
paid exceeded the amount accrued at the end of the year.
Rev. Rul. 91-21 & CCA #003802 – the IRS set out its position that
the amount of “foreign tax liability” for purposes of § 901 and
§ 902 was the dollar value of the Cruzeiros when paid at each
monthly due date. on the accrual date.
Thus, in the case of a branch, the total § 901 credit equaled the
amount of cruzeiros paid, translated at the spot rates on the date of
payment.
In the case of a corporation, under the translation rules then in
effect under § 902, the tax was equal to the dollar value of the
ORTN liability on the dividend payment date. It was not
redetermined to reflect the subsequent inflation in the cruzeiro. As
the court recognized in AMP, applying § 905(c) to redetermine the
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taxes would result in a hyping of the § 902 credit for the year of
the dividend payment.
AMP, Inc. v. United States,185 F.3d 1333 (Fed. Cir. 1999) –
Reversing the Court of Claims, the Federal Circuit ruled that the
§ 905(c) regulations reference to “units of currency” accrued or
paid meant the Cruzeiro not the ORTN. Therefore, the currency
fluctuation was required to be taken into account.
The court noted that the 1986 Act corrected the issue in the case by
requiring hyperinflationary currencies to use the US dollar.
Inflationary currencies now must be translated at the spot rate, 24
and § 902 credits with respect to inflationary QBUs must be
redetermined at the U.S. parent level and not as a pooling
adjustment. 25 This causes the implicit currency gain in a payment
of inflationary taxes to be treated as a reduction of the taxes paid.
In the case of non-inflationary taxes, unless the taxpayer
affirmatively elects the spot rate, currency movements between the
year of accrual and date of payment will not be taken into account.
24
25
§ 986(a)(1)(C).
Reg. § 1.905-3T(d)(3)(i).
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4.
Section 987 — Translating Branch Income and Loss.
A.
Historical Approaches to Branch Translation.
(1)
Net Worth vs. Profit & Loss Method.
(a)
Rev. Rul. 75-106. The IRS approved the taxpayer’s use of a net
worth or balance sheet approach to branch translation. The
taxpayer’s gain or loss for the year was equal to the translation
between:
(i)
the opening dollar value of the branch =
US dollar basis of current assets and liabilities translated at
the beginning of the year spot rate +
US dollar basis of non-current assets and liabilities
translated at historic rates and
(ii)
end of the year dollar value of branch, adjusted for any net
remittances or contributions of property during the year =
US dollar basis of current assets and liabilities translated at
the end of the year spot rate +
US dollar basis of non-current assets and liabilities
translated at historic rates +
Net Remittances During the Year, or – Net Contributions,
as the case may be.
The change in net worth resulted in taxable translation gain or loss
in each year regardless of whether any property was remitted by
the branch.
(b)
Rev. Rul. 75-107 – Profit & Loss Method. The IRS approved an
“earnings only” approach to translation of branch profits. In the
fact pattern addressed by the ruling, the branch earned 10,000 units
of functional currency. On June 15, when the exchange rate was 3
FC : $1, the branch remitted 1,000 units. At the end of the year,
the exchange rate was 2.8 FC : $1.
Under the profit and loss method, the 10% of the net profit
remitted on June 15 was translated into U.S. dollars at the June 15
spot rate (i.e., 3 FC : $1). Any remaining net profits (here, 9000
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units) was translated into U.S. dollars at the year-end exchange rate
(i.e., 2.8 FC : $1).
(2)
B.
Choice of branch translation method viewed as a method of accounting.
(a)
American Pad & Textile Co. v. Commissioner, 16 T.C. 1304
(1951). The Court noted that the two general approaches in
accounting literature are the profit and loss method and the net
worth method. Based on the state of the case law prior to the 1986
Act, the Court viewed the question of branch translation as “one of
accounting and not of substantive law.” 26 The court reconciled the
inconsistent results of cases on “the theory that a consistent
method of accounting in a regularized and continuous business
operation will succeed in reflecting income to a sufficiently
accurate degree for Federal income tax purposes.” 27 However, on
the facts presented, the taxpayer had failed to apply consistently a
reasonable method of accounting.
(b)
GCM 35643 (1974), underlying Rev. Rul. 75-106. The GCM
represents the Chief Counsel’s reasoning for issuing a ruling
allowing the use of the “net worth” method of branch translation.
It analyzed the question in terms of whether the net worth method
clearly reflected income within the meaning of § 446.
(c)
Travelers Insurance Co. v. United States, 303 F.3d 1373 (Fed. Cir.
2002), pet. for reh’g den., 319 F.3d 1390 (2002). The taxpayer
made an annual exchange adjustment that it contended closely
approximated the profit and loss method. The IRS disagreed and
found the adjustment not to clearly reflect income under § 446(b).
Under controlling § 446(b) standards, the Court of Appeals found
no abuse of discretion by the IRS in deciding that the taxpayer’s
particular method of accounting did not clearly reflect income on
the facts of the case.
Section 987.
(1)
The Statute. In the case of a taxpayer with a QBU operating in a different
functional currency,
“taxable income of such taxpayer shall be determined
987(1) – by computing the taxable income or loss separately for each such
unit in its functional currency,
26
27
Id. at 1311.
Id. (emphasis added).
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987(2) – by translating the income or loss separately computed under
paragraph (1) at the appropriate exchange rate, and
987(3) – by making proper adjustments (as prescribed by the Secretary)
for transfers of property between qualified business units of the taxpayer
having different functional currencies, including—
treating post-1986 remittances from each such unit as made on a
pro rata basis out of post-1986 accumulated earnings, and
treating gain or loss determined under this paragraph as ordinary
income or loss, respectively, and sourcing such gain or loss by
reference to the source of the income giving rise to post-1986
accumulated earnings.”
(2)
28
29
30
31
Legislative History.
(a)
Congress was concerned by the electivity permitted CFCs and
branches to choose the net worth method for declining currencies
and the profit and loss method for appreciating currencies.
Congress also believed that the net worth method was inconsistent
with the taxation of realized income or loss. 28 Therefore, Congress
repealed the net worth method, so that “only realized exchange
gains and losses on branch capital will be reflected in taxable
income.” 29
(b)
Congress provided for the uniform use of a profit and loss method
for reporting the results of QBUs with non-dollar functional
currencies. 30 “Any entity that uses a nonfunctional currency is
required to measure the untranslated results of operation under a
profit and loss method, and to translate income or loss into the
functional currency at a prescribed (“appropriate”) exchange rate
for a taxable year. . . .These translation rules apply without
regard to the form of enterprise through which the taxpayer
conducts business (e.g., sole proprietorship, partnership, or
corporation), as long as the enterprise rises to the level of a
QBU.” 31
1986 TRA Bluebook, at pp. 1089-1090.
1986 TRA Bluebook, at p. 1109.
Id. at p. 1092.
Id. at p. 1108.
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C.
(c)
Congress intended for regulations to limit the deduction of branch
losses under § 987 to the taxpayer’s total U.S. dollar basis in the
branch. 32
(d)
“Remittances” should include transfers of property between
branches operating in different functional currencies. § 987 gain
or loss should be recognized on any remittance of property, not just
currency and regardless whether the property is converted into US
dollars. 33
The 1991 Proposed Regulations.
(1)
Taxable income (§ 1.987-1).
(a)
(2)
33
(i)
Start with books and records to determine profit and loss
(ii)
Make US tax adjustments to items reflected in the profit
and loss
(iii)
Translate the resulting FC taxable income/loss into owner’s
functional currency at the average exchange rate for the
year
Remittances and Transfers of Property (§ 1.987-2).
(a)
32
The QBU’s taxable income is computed in a similar manner to a
CFC’s computation of earnings and profits:
Basis Pool and Equity Pool.
(i)
The Basis Pool = the US Dollar cost basis of the taxpayer’s
investment in the QBU. The basis pool is increased by the
Dollar taxable income as determined under § 1.987-1; and
by the amount of property contributed to the QBU,
translated into the owner’s functional currency on the date
of the transfer, and decreased by branch losses and the
amount of any remittances from the branch (translated into
the owner’s functional currency at the spot rate or the date
of the remittance).
(ii)
Equity pool = the functional currency value of the owner’s
investment in the branch. The equity pool is adjusted by
the FC taxable income (or loss) of the branch, and the
Id. at p. 1109. The 1991 Proposed Regulations, however, allow the basis pool to become negative, subject to
later recapture. See Prop. Reg § 1.987-1(a)(4).
Id.
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amount of any transfers (or remittances) into and out of the
branch in the QBU’s functional currency.
(b)
Calculation of § 987 Gain or Loss on a Remittance (§ 1.987-2(d)).
(i)
Step 1 – Determine the amount of Equity remitted
(measured in the QBU’s functional currency).
(ii)
Step 2 – Determine the portion of the basis pool attributable
to the remittance by applying the following fraction:
Equity Due to Remittance
--------------------------------
x
Total Basis Pool
Total Equity Pool
(c)
(iii)
The difference between the basis and equity pool amounts
attributable to the remittance constitutes § 987 gain or loss.
(iv)
Following a remittance, the transferee takes a Functional
Currency basis in the remitted property translated at the
current spot rate. See § 1.987-2(b)(2)(iii).
Termination Events (§ 1.987-3).
(i)
Cessation of the QBU’s activities.
(ii)
Taxpayer’s transfer of substantially all of the QBU’s assets
(including by reason of a § 338 deemed asset sale).
(iii)
Most § 1248 sales of stock in a CFC with a § 987 QBU.
(iv)
Exceptions for certain non-recognition transactions:
1)
Most US-to-US and Foreign-to-Foreign Section 332
liquidations
2)
Most
US-to-US
reorganizations
3)
§ 351 Transfers involving a § 367(a) outbound
transfer give rise to a termination; treatment of other
§ 351 transfers is reserved.
and
Foreign-to-Foreign
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D.
The 2006 Proposed Regulations.
(1)
Threshold Issues.
(a)
(b)
(c)
QBUs Excluded from 2006 Proposed Regulations.
(i)
Banks, insurance companies, and financing companies
(including leasing companies, financial coordination
centers, RICs and REITs). 34
(ii)
DREs are not themselves QBUs, although activities
conducted by a DRE may be a QBU of the DRE’s owner.
(§ 1.987-1(b)(3)(ii)).
(iii)
Partnerships are treated as aggregates for § 987 purposes.
(§ 1.987-1(b)(4)(ii)). Thus, each partner has its own,
indirect § 987 QBU, consisting of the non-Functional
Currency activities of the partnership.
(iv)
Pure holding companies. Holding companies whose
balance sheet is limited to stock in a controlled subsidiary
and acquisition indebtedness to acquire such stock. See
Prop. Reg. § 1.987-1(b)(7), Example 1. The Example
appears to be based on the factual premise that owning one
company’s stock and servicing a debt is not a trade or
business. 35
Grouping Election (§ 1.987-1(b)(2)).
(i)
Multiple QBUs of one owner with the same functional
currency may be combined into a single QBU for § 987
purposes by making an one-time, binding grouping
election.
(ii)
The IRS solicits comments on how to apply the grouping
election to QBUs owned by different members of the same
consolidated group.
Flat Approach (§ 1.987-1(b)(4) & 1.987-1(b)(7), Example 2).
(i)
34
35
Tiers of DREs are “flattened” into directly owned § 987
QBUs. Thus, a transfer of property between a lower-tier
parent and subsidiary QBU branch is re-characterized as a
Prop. Reg. § 1.987-1(b)(1)(ii).
Prop. Reg. § 1.987-1(b)(7), Example 1; Prop. Reg. § 1.987-2(b).
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triangular flow of funds up to the parent, and down to the
recipient QBU.
(d)
(e)
Disregarded transactions (§ 1.987-2(c)(2)).
(i)
Items resulting from disregarded transactions are ignored
for § 987 purposes and instead are treated as a remittance
(or contribution) of any related cash property between the
QBUs. See Prop. Treas. Reg. § 1.987-2(c)(2).
(ii)
Example. A loan between a DRE and its owner is
disregarded for § 987 purposes. Payments on the loan are
treated as remittances of cash to the owner.
(iii)
§ 1.987-2(c)(9), Example 3. Interbranch sales of property
between QBUs of a single owner are re-characterized as
separate transfers of cash and property between the QBUs
since cash is a marked asset. If the property purchased
from the other QBU is an historic asset, the difference
between current and historic spot rates can result in a
remittance from one of the two QBUs.
(iv)
§ 1.987-2(c)(9), Example 4. Where there is a regarded
transaction between one entity and another entity’s QBU,
this transaction is taken into account for § 987 purposes.
Partnership issues.
(i)
(2)
§ 1.987-2(c)(5) provides that where an owner of a DRE
suffers a dilution in interest due to another person’s
purchasing an interest in a DRE or contribution of property
to the DRE, that results in a constructive remittance and recontribution of a portion of the underlying QBU’s assets.
Foreign Exchange Exposure Pool Method.
(a)
Distinction between “marked items” and “historic items” is crucial
to operation of the 2006 Proposed Regulations.
(i)
Marked items = assets and liabilities that would be § 988
transactions if not denominated in the QBU’s functional
currency.
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Examples:
i. Cash
ii. Payables and Receivables
iii. Debt instruments
iv. Foreign currency financial instruments
Marked items are translated at the current spot rate for
purposes of measurement of unrecognized § 987 gain or
loss.
(ii)
Historic items = everything other than marked items.
Historic items are translated at all times at the historic spot
rate which does not fluctuate over time.
Examples:
v. Inventory
vi. Equipment and other § 1231 property
vii. Investment assets
(iii)
(b)
Compare net worth method of Rev. Rul. 75-106 and
“temporal method” of applying FAS 52.
Taxable income calculation (§ 1.987-3).
(i)
Translation of income occurs on an item-by-item basis.
(ii)
General rule (§ 1.987-3(b)(1)). Translate items using the
yearly average exchange rate. This general rule applies to
amount realized, income items, and many ordinary
operating expenses.
1)
(iii)
Alternatively, owner may elect to apply the spot
rate for the date the item is incurred to make the
translation of any of the above items. § 1.9873(b)(1)(ii); § 1.987-3(f), Examples 7 and 8.
Exceptions (§ 1.987-3(b)(2)). Translate the following
items using their historic exchange rates:
1)
Depreciation and Amortization
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2)
(c)
Unrecognized § 987 gain or loss (§§ 1.987-4 and 1.987-5).
(i)
§ 1.987-4 sets out a multi-step process for measuring the
unrecognized § 987 gain or loss.
(ii)
As illustrated by Example 1, the unrecognized § 987 gain
or loss under the FEEP method is limited to the translation
adjustments as to the QBU’s marked items.
(iii)
§ 1.987-5 provides rules for measuring remittances that
trigger § 987 gain or loss:
1)
Remittances are computed on an annual net basis.
2)
The amount of a remittance looks to the basis of the
asset in the owner’s functional currency (§ 1.9875(d)).
3)
(d)
Cost basis of property sold or disposed of (including
COGS of inventory – see § 1.987-3(f), Examples 1
and 2).
a)
Historic assets are measured at the historic
exchange rate
b)
Marked assets are measured at the spot
exchange rate on the date of the transfer
(§ 1.987-4(d)(2)(iii)(A)).
The owner takes a carryover functional currency
basis in the assets received in the remittance
(§ 1.987-5(f)).
a)
Historic assets retain their historic cost basis
b)
Marked assets receive a new cost basis
determined using the spot rate on the date of
the transfer.
Termination Rules (§ 1.987-8).
(i)
Termination events.
1)
QBU’s activities cease
2)
Substantially all (within the meaning of
§ 368(a)(1)(C)) of the QBU’s assets are transferred
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(ii)
3)
Owner ceases to exist in a non-§ 381 transaction
(e.g., in a § 338 deemed asset sale)
4)
Foreign owner ceases to be a CFC
Exceptions.
1)
(iii)
Example 2. DC contributes its § 987 QBU to DS, its
wholly owned US subsidiary in a § 351 transaction. This
results in a termination as the transfer of substantially all of
the assets of the QBU.
1)
(iv)
(e)
36
Most U.S.-to-U.S. and foreign-to-foreign § 332
liquidations and reorganization transactions are
excepted from triggering a QBU termination.
The IRS is soliciting comments on whether a QBU
termination should be deemed to occur where the §
351 transfer is between members of the
consolidated group.
Example 5. DC2 becomes a 95% owner of a DRE formerly
wholly owned by DC1. Under the transfer rules above, this
results in a constructive distribution of 95% of the QBU’s
assets to DC1. Since this is substantially all of the QBU’s
assets, DC1’s QBU terminates.
Source and Basket of § 987 Gain or Loss.
(i)
Section 987(3)(B) provides that § 987 gain or loss is to be
sourced and characterized by reference to the underlying
post-1986 earnings of the QBU.
(ii)
Under § 1.987-6(b)(2), § 987 gain or loss is characterized
using the asset method of Treas. Reg. § 1.861-9T(g). A
CFC cannot use the modified gross income method for this
purpose.
(iii)
An example in the 2006 Proposed Regulations illustrates
that the relevant assets are the separate assets of the branch;
however, the rule itself is not explicit on this point. 36
Cf. Treas. Reg. § 1.861-9(f)(2) (providing generally that a domestic corporation allocates and apportions a
branch’s interest expense using the domestic corporation’s overall mix of assets, not the branch’s separate
assets).
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(f)
(g)
Interaction of § 987 Gain or Loss with Branch Loss Recapture &
DCL Rules.
(i)
Reg. § 1.1503(d)-4(c)(4)(v) provides that a DCL is
computed without regard to any § 987 gain or loss
recognized by the owner on remittances out of the branch.
(ii)
The interaction of branch loss recapture would seem to
depend on the taxpayer’s method of applying § 987.
However, depending on the taxpayer’s method of applying
§ 987, the FX gain or loss on QBU termination could result
in an adjustment to the $USD basis of the branch’s assets
immediately before branch loss recapture is calculated.
Transition rules (§ 1.987-10).
(i)
Fresh start method. Taxpayer and all its CFCs eliminate
the § 987 gain or loss and start with a zero opening balance
on the transition to the new regulations.
1)
(ii)
Consider benefits from this method if branches have
significant appreciation under the prior 1991
method.
Deferral Transition Method. If the taxpayer has used a
“reasonable method” of applying § 987 prior to enactment,
the taxpayer may elect to roll over its § 987 balances into
the QBUs at the commencement of the new regulations.
Possible views as to what does or does not constitute a
“reasonable method”:
1)
Examples illustrate that following the 1991
Proposed Regulations would likely be considered
reasonable.
2)
An “earnings only” approach also would appear to
be considered reasonable.
3)
Per the preamble, following the 2006 Proposed
Regulations would also be reasonable.
4)
To what extent is mixing and matching the 1991
and 2006 proposed regulations reasonable? Simply
following GAAP may not be reasonable, because
FAS 52 does not have a remittance concept.
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5.
Special Considerations for Hyperinflationary Currencies.
A.
B.
Definitions.
(1)
“Hyperinflationary” for tax purposes = Country’s consumer price index
shows a 100% cumulative increase over three years. 37
(2)
“Inflationary” as used for § 905(c) purposes = Country’s CPI increases by
a cumulative 30% over three years. Note that “inflationary” taxes must be
translated at the date-of-payment spot rate under § 986.
(3)
DASTM = US Dollar Approximated Separate Transactions Method
(DASTM) for translating results of a QBU operating in a hyperinflationary
currency. Requires the branch to translate its balance sheet back into US
dollars and include the translation adjustment as an adjustment to E&P.
DASTM (§ 1.985-3).
(1)
Theory of DASTM. Profit and loss accounting of §§ 986 and 987 will
create distortions in hyperinflationary environment. Entities with fixed
costs will earn excessive income as inflation increases gross receipts but
not historic costs recovered through COGS and depreciation. Interest
bearing debt will also be distorted, as higher interest coupons offset FX
loss on principal.
To prevent these distortions, DASTM requires a QBU to compute its
earnings in dollars. In addition, the QBU must compute a $USD net worth
at the beginning and end of every period. The change in $USD net worth
is DASTM gain / loss that is included in earnings and profits.
(2)
Profit and Loss translation (Reg. § 1.985-3(c)).
(a)
Items are translated at the exchange rate for the translation period
to which they related. Translation period = any regular period of a
month or less that may be adopted by the taxpayer.
(b)
Depreciation, inventory cost, and other historic cost items are
reflected at the spot rate for the translation period in which they
were incurred.
(i)
37
Special rule under which closing inventory recorded under
the LCM method is re-translated at the end of each year.
Reg. § 1.985-1(c)(2)(ii)(D).
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(3)
(c)
Income is translated at the current rate applicable to the translation
period when earned.
(d)
Reg. § 1.985-3(c)(10) contains an example of the DASTM P&L
calculation.
Reg. § 1.985-3(d) provides rules for re-marking the balance sheet to
market to capture the effect of inflation on the value of the branch’s assets.
Like the 2006 Prop. Regs. under § 987, the DASTM rules mark some
assets, such as cash, A/R, etc., to market, while continuing to carry
business assets at historic rates. Note that closing inventory is effectively
marked-to-market for currency purposes if the taxpayer uses the LCM. 38
Accrued tax liabilities are also marked to market.
The difference between the opening net worth and the closing net worth,
adjusted to reflect dividends, capital contributions, and annual P&L, is
DASTM gain or loss. See Reg. § 1.985-3(d)(1).
(4)
Character of DASTM Gain / Loss – the Nine Step Method (Reg. § 1.9853(e)(3)).
(Note that small QBUs may be eligible to elect a simplified method).
38
(a)
Regulation generally uses the asset method of characterizing assets
(§ 1.861-9T(g)(3)) as subpart F vs. non-subpart F. However, the
dollar value of assets must be calculated using an averaging of the
asset values at the beginning and end of the period. DASTM gain
or loss with respect to assets is then allocated to the QBU’s assets
and treated as income in the same category as the respective assets
produce.
(b)
Liabilities are similarly valued based on an averaging of beginning
and end-of-the-year values. The DASTM gain or loss with respect
to short-term liabilities such as payables is treated as an adjustment
to the underlying cost (e.g., inventory cost). DASTM gain or loss
with respect to interest bearing debt is allocated in the same
manner as interest expense.
(c)
Any residual DASTM gain or loss not accounted for above is
allocated on a gross income method.
Reg. § 1.985-3(c)(4)(iii).
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(5)
Consequences of a Change to DASTM (Reg. § 1.985-7).
Consequences generally are similar to a change in functional currency
from local currency to $USD. Importantly, Reg. § 1.985-7(a) implements
the DASTM transition as of the transition date, which is the beginning of
the 3-year period during which the hyper-inflation began. In the case of a
CFC, the following adjustments are prescribed:
(a)
Section 988 transactions of the CFC denominated in $USD are
closed out.
(b)
Assets and liabilities are translated into $USD as if the CFC had
applied DASTM beginning on the transition date and made
adjustments under Reg. § 1.985-3(d)(1) throughout the look-back
period.
(c)
Post-1986 earnings are translated by assuming the CFC had
changed to DASTM on the transition date. Thus, E&P as of the
transition date is translated at the transition date exchange rate.
E&P during the intervening look-back period is translated as if the
CFC had applied Reg. § 1.985-3 during the period.
Note: Given the distortion that DASTM aims to correct, in the
case of an operating company with substantial retained earnings,
the change to DASTM would tend to reduce E&P in most cases.
US shareholders in CFCs make additional adjustments.
(d)
First, shareholders increase or reduce subpart F income beginning
in the year of change to reflect the fact that the amount of subpart F
income would have been different. This adjustment, if positive, is
treated as an increase to subpart F income that carries a § 960
credit as if actually included in income.
(e)
Gain or loss deemed recognized on close-out of $USD § 988
transactions is characterized under the normal subpart F rules.
(f)
PTI accounts are deemed distributed on the DASTM CFC’s
conversion to the $USD as its functional currency.
Any gain or loss recognized under the above adjustments is taken
into account under a mandatory 4-year spread period, whether
positive or negative.
Section 987 QBUs converting to DASTM must make similar adjustments
to CFCs. However, since they are directly owned by another owner, the
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change has more immediate impacts. To translate retained earnings (and
any § 987 gain or loss with respect to capital), the branch is deemed to
terminate on the transition date. It recomputes its income and remittances
during the interim look-back period as if it had always applied DASTM.
Any resulting income adjustment is taken into account over a 4-year
spread period.
C.
Use of the Official vs. Free Market Exchange Rate.
(1)
The government in a hyperinflationary currency may attempt to peg an
official $USD exchange rate lower than the rate on the black market. One
question that arises is which rate to use as the “spot rate” for U.S. tax
purposes.
(2)
Reg. § 1.988-1(d)(1) sets forth the general rule that the spot rate shall be
determined based on the prices at which the currency freely changes hands
in representative amounts. Reg. § 1.988-1(d)(4) provides that the rate
which “most clearly reflects income” should be used as the spot rate in
cases in which the government rate and free market rate differ.
(3)
(a)
Id., Example 1 – CFC operating in the LC as its functional
currency pays a 100LC dividend to USP at a time when the official
government rate is $1 : 1LC, but the free market exchange rate is
$1 : 4LC. USP then donates the 100 LC to charity. It is
appropriate to use the free market exchange rate to translate both
the dividend and charitable contribution deduction into US Dollars.
(b)
Id., Example 2 – where a taxpayer was engaged in arbitrage by
acquiring units of non-functional currency at the government rate
and selling them on the black market, it was appropriate to use the
official government rate as the cost basis of the purchased units.
(c)
FSA #003308. Taxpayer sought to use the LAFISE statistics
rather than the IMF statistics normally relied upon by the
government. The IRS rejected the taxpayer’s argument that the
LAFISE (free market exchange rate) could be used to compute an
annual exchange rate for branch P&L, rather than a spot rate under
§ 988. However, in the case of a remittance translated at the spot
rate under § 987, the IRS stated that “it generally would be
appropriate to use a free market rate rather than an official rate for
determining the spot rate, provided that the free market rate is
consistently used and further provided that the free market rate
more accurately reflects income than the official rate.”
Cases on Mexican Debt-Equity Swaps.
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D.
(a)
Certain cases have addressed a Mexican government program to
induce corporations to retire its Dollar-denominated debt. In each
of the cases, the corporation purchased the debt at a discount on
the open market. Then, the Mexican government exchanged a
larger amount of pesos with the company which were restricted for
use inside Mexico.
(b)
Kohler v. United States, 2006-2 USTC para. 50,611 (7th Cir.)
(Posner, J.). Here, the company bought back $22 mm face value of
debt for $11 mm. The Mexican government swapped the debt for
“restricted” pesos that would be worth $19.5 mm if unrestricted.
The Court viewed Kohler as receiving a taxable gain on retirement
of the debt. However, contrary to the IRS’ conclusion, the fact that
the pesos were restricted for use inside Mexico meant that their
FMV must have been less than $19.5 mm.
The IRS’s
determination of a value of $19.5 mm was implausible and
arbitrary and capricious.
(c)
G.M. Trading Corp. v. Commissioner, 121 F.3d 977 (5th Cir.
1997). Similar transaction as above. However, the Fifth Circuit
analyzed the transaction as a non-shareholder contribution to
capital under § 118. Thus, the taxpayer received the excess
amount of pesos tax-free, but also did not receive tax basis for that
amount of value.
Restricted or “Blocked” Currencies.
(1)
Foreign exchange restrictions may completely block a US taxpayer’s
ability to remit funds from a foreign country. This may create a harsh
result under subpart F or § 482 in charging the taxpayer with phantom
income that it cannot by law receive in cash. While case law ruled against
the taxpayers on this point, 39 the regulations now permit taxpayers to elect
to defer reporting of income attributable to blocked currency.
(2)
Reg. § 1.482-1(h)(2).
(a)
39
40
Taxpayers transacting with a subsidiary operating under foreign
exchange restriction may elect to defer reporting the income
attributable to the blocked currency until it can be remitted under
foreign law. The election to defer reporting applies to “any portion
of the arm’s length amount,” 40 including stated payments.
However, if the payments may be remitted through any other
See Eder v. Commissioner, 138 F.2d 27 (2d Cir. 1944) (“blocked” Colombian pesos could be taxed to an
individual under the foreign personal holding company rules).
Reg. § 1.482-1(h)(2)(iv).
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means, such as dividend, or have been remitted to the taxpayer
through an intermediary, the taxpayer can no longer rely on the
deferral method of accounting.
(b)
(3)
Election of the method requires the taxpayer to attach a statement
to its return describing that the conditions are met – i.e., the
currency is truly blocked. Under §§ 1.461-1(a)(4) and 1.905-1(b),
tax benefit for any amounts attributable to deferred income are also
deferred.
There would appear to be some complexity in
maintaining a separate suspense account for deferred income.
Reg. § 1.964-2.
(a)
Definition of “blocked” currency:
(i)
Income cannot be distributed as a dividend, or converted
into US dollars or property of a type normally used in the
CFC’s trade or business.
(ii)
Restriction must be in place for every day in the 150 day
period beginning 90 days before the end of the CFC’s
taxable year.
Thus, the basic subpart F “blocked” currency rule is
significantly more restrictive than the related § 482 rules.
(iii)
(4)
Alternatively, earnings may be blocked to the extent
required to be held as mandatory reserves (Reg. §1.9641(b)(5)). However, for this rule to apply, the reserves must
exceed the foreign corporation’s accumulated E&P.
(b)
As with § 482, the blocked currency results in a deferral of the
inclusion of subpart F income by temporarily excluding such
earnings from current E&P for purposes of §952 and § 956. When
the restriction is lifted, the taxpayer generally must recapture the
benefit of deferral.
(c)
The CFC’s distributions out of blocked E&P and other E&P is
determined under the normal rules of § 1.959-3. See Reg. § 1.9642(c)(4).
Reg. § 1.482-9(l)(5), Examples 10 and 11. The costs of implementing a
capital structure change to mitigate foreign exchange controls are properly
treated as shareholder costs under § 482, whether incurred by the Parent or
Subsidiary.
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E.
Hyperinflationary Debt Instruments.
(1)
Economically, currency values and interest rates are to some extent linked.
A loan in a weak currency will carry a higher interest rate to compensate
for the loss of principal. Allowing the currency gain or loss to be deferred
until maturity and sourced to the residence of the taxpayer, while larger
interest income / expense is taken into account currently, may be distortive
from both a timing and sourcing perspective.
(2)
Reg. § 1.988-2(b)(15). This regulation provides special timing, source and
character results for hyperinflationary debt instruments to avoid the
distortion inherent in recognizing a currency loss (or gain) that is offset by
increased interest income (or expense).
Timing: The currency gain or loss inherent in a hyperinflationary debt
instrument is recognized annually on a mark-to-market basis.
Source / Character: The MTM gain or loss (which is the entire gain or
loss attributable to currency movements) is treated as an offset to interest
income or expense to the extent of the interest accrued during the period.
Any excess is sourced and characterized under the normal § 988 rules.
Note that this regulation applies to any hyperinflationary loan, including
bank deposit, including between unrelated parties.
(3)
Reg. § 1.988-4(e)(1). This regulation provides a more targeted rule at US
companies lending to related CFCs operating in a weak currency in the
CFCs’ weak currency. It applies where the loan is made to a related
foreign person and the loan bears an interest rate of at least 10 percentage
points above the mid-term AFR. Where the regulation applies, then solely
for purposes of determining the foreign tax credit limitation under § 904,
the CFC’s look-through interest income is re-characterized as U.S. source
income to the extent of the hypothetical FX loss that would be recognized
in the year if the loan had been marked to market during that year.
Note that, unlike Reg. § 1.988-2(b)(15), this regulation does not result in
an actual recognition of the currency loss on a MTM basis. Rather, it
solely serves the punitive effect of re-sourcing interest to U.S. sources to
the extent of the expected FX loss on maturity of the loan. For example, if
the shareholder would notionally recognize a FX gain in a subsequent
year, the U.S. lender cannot reverse the prior year’s re-sourcing of income.
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6.
Subpart F Treatment of Foreign Currency Gains and Losses.
A.
B.
General rule.
(1)
Section 954(c)(1)(D) generally treats the excess of a CFC’s currency gains
over its currency losses attributable to § 988 transactions in a taxable year
as foreign personal holding company income (FPHCI).
(2)
This category of FPHCI does not include foreign currency gains and
losses attributable to certain currency gains and losses (Reg. § 1.9542(g)(5)):
(a)
Capital gains or losses on contracts identified as capital assets
under § 988(a)(1)(B)
(b)
Currency gain or loss treated as interest
(c)
Exchange traded futures and options that are excluded from
constituting § 988 transactions by § 988(c)(1)(D)(i) (absent
election to treat such contracts as § 988 transactions). The
preamble states that such contracts constitute commodities
transactions, see T.D. 8618, although this seemingly can be
questioned based on the language of the definition of “commodity”
within Reg. § 1.954-2(f) as an interest in “tangible property.”
(3)
Losses in one category of FPHCI (e.g., currency) generally cannot offset
gains in another category of FPHCI (e.g., interest) other than by operation
of the earnings limitation. See Reg. § 1.954-1(c)(1)(ii). Therefore, one
priority is to avoid having a trapped currency loss in computing FPHCI.
(4)
Section 987(3) provides for characterization of § 987 gain (or loss) on a
remittance by reference to the QBU’s underlying earnings. Thus, if a
§ 987 QBU is engaged in activity that leads to the production of subpart F
income, a § 987 gain or loss on that QBU’s remittance will result in an
adjustment to subpart F income.
Exceptions to Subpart F Treatment.
(1)
Business needs transactions.
(a)
The currency exposure arises from a transaction entered into, or
property used or held for use, in the normal course of the CFC’s
business (§ 1231 property, inventory, trade payables, etc.).
(b)
The underlying transaction does not itself, and could not
reasonably be expected to produce subpart F income.
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(2)
(3)
(c)
The underlying transaction is not a foreign currency derivative.
Such transactions may be excluded from FPHCI as bona fide
hedging transactions.
(d)
The CFC’s records are sufficient to identify the transaction as a
business needs transaction.
Bona Fide Hedging Transactions.
(a)
A bona fide hedge is defined by Treas. Reg. § 1.954-2(a)(4)(ii) is
defined as a transaction that would qualify for § 1221(b)(2)
hedging treatment, except that the exposure being hedged can be
either ordinary property, a § 988 transaction, or § 1231 property.
(b)
The risk being hedged must arise from the CFC’s own trade or
business; i.e., a hedging center cannot hedge another CFC’s risks
and rely on the exception. See Reg. § 1.954-2(g)(2)(ii)(D),
Example. 41
(c)
A derivative that constitutes a bona fide hedge with respect to a
business needs transaction is excluded from FPHC income.
(d)
A bona fide hedge of a transaction within the scope as a § 1.9542(g)(3) election is also covered by the election.
(e)
Effect of erroneous identifications (Reg. § 1.954-2(a)(4)(ii)(C)).
An identification of a transaction as a bona fide hedge is
generally binding with respect to any loss from the
transaction (non-subpart F).
However, gains remain
determined under the general rule
(ii)
Failure to identify establishes that the transaction is not a
bona fide hedge. However, if there is no reasonable
grounds for failure to identify, losses (but not gains) are
treated as if they were the result of a bona fide hedging
transaction.
(iii)
Inadvertent error exception may relieve adverse
consequences of failure to identify hedging transactions.
Interest Bearing Liabilities.
(a)
41
(i)
Currency gain or loss on an interest bearing liability of the CFC is
characterized for subpart F purposes in the same manner as the
See also Reg. § 1.954-2(f)(2)(v), Ex. 2 (example of Treasury center providing commodities hedge).
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CFC allocates and apportions interest expense. See Treas. Reg.
§ 1.954-2(g)(2)(iii).
(b)
C.
Application of similar rule to gains or losses allocated as interest
expense under § 1.861-9 is reserved. See Reg. § 1.954-2(g)(5)(iv).
Subpart F Elections.
(1)
(2)
Reg. § 1.954-2(g)(3) election.
(a)
Transactions giving rise to Foreign Base Company Sales Income,
or other subpart F income, cannot qualify for the business needs
exception even if they occur in the ordinary course of the CFC’s
business.
(b)
Treas. Reg. § 1.954-2(g)(3) permits the CFC to elect to
characterize currency gain or loss arising from such ordinary
course transactions giving rise to general basket subpart F income
(or hedges thereof) as allocable to such category of subpart F
income.
(c)
The benefit of this election is to re-basket foreign currency gains
and losses as general basket for § 904(d) purposes, and net any
losses against foreign base company sales income. See Treas. Reg.
§ 1.954-2(g)(3)(iv), Example
(d)
Also, as illustrated by PLR 201235007 (§ 9100 request), the
election might be used to allocate a currency loss against interest
income from loans made in the ordinary course of business.
Reg. § 1.954-2(g)(4) election.
(a)
This election supersedes the § 1.954-2(g)(3) election with respect
to the CFC. Once made, the election cannot be revoked without
IRS consent. See, e.g., PLR 201226011, for a case where a CFC
was able to revoke a § 1.954-2(g)(4) election based on changed
circumstances that allowed it to trace its foreign currency items.
(b)
The election causes all foreign currency gains and losses from
§ 988 transactions and § 1256 contracts that would be § 988
transactions to be included in computing FPHCI. Thus, the CFC
waives the business needs exception. The intent of the rule is to
allow a CFC to avoid the need to trace gains and losses under the
business needs exception. See TD 8216.
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7.
Foreign Currency Hedging Transactions.
A.
Integrated Treatment under § 988(d) and Reg. § 1.988-5.
(1)
This regulation allows taxpayer to integrate certain non-functional
currency transactions and hedges into synthetic functional currency
transactions.
(2)
Eligible transactions.
(3)
(4)
42
43
(a)
Non-functional currency debt instrument.
(b)
Payables or receivables arising under an executory contract.
(c)
Purchases or sales of publicly traded securities.
Specific requirements for integrated treatment.
(a)
The hedge is entered into with an unrelated party. 42
(b)
Both the § 988 transaction and the hedge are entered into by the
same corporation (the same member of a consolidated group) and
reflected on the books and records of the same QBU.
(c)
The transaction is identified as an integrated hedging transaction
by the end of the date on which the financial instrument is
executed.
Specific Rules for Debt and Executory Contracts.
(a)
In the case of a debt instrument, it is possible to compute a yield to
maturity on the synthetic dollar debt instrument that is created by
combining the debt instrument with the hedge. This would appear
to rule out the use of a series of rolling forward contracts to hedge
the debt.
(b)
Unlike the rules for hedged executory contracts, the regulations
permit the hedge to be entered after the DI is created through
legging in procedures. 43 Gain or loss is recognized on a deemed
sale at the leg-in date, and deferred until the maturity or disposition
of the DI.
In other contexts, i.e., Regs. § 1.1275-6 and § 1.1221-2, the taxpayer may enter into a hedge with a related party
acting as a dealer in securities under § 475. It is unclear why this rule does not also apply for purposes of
§ 988(d).
See Treas. Reg. § 1.988-5(a)(6).
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(c)
(d)
(5)
(6)
If a hedge of DI or executory contract is terminated before
maturity, the taxpayer is deemed to have “legged out” of the
hedge. Both sides of the transaction (not just the leg actually
disposed of) are deemed disposed of, and the net gain or loss is
recognized on that date.
(i)
In TD 9598 (Sept. 6, 2012), the IRS issued new temporary
regulations clarifying the application of the leg-out rules in
cases where one of an interest rate or FX swap was
selectively terminated, where the other hedge remained in
place. In such cases, the taxpayer is deemed to dispose of
all legs of all hedges, as well as the DI, on the leg-out date.
(ii)
Example. TP enters a qualifying DI, interest rate swap, and
FX swap and elects integrated treatment. On a disposition
of the FX swap, the TP’s net gain or loss is determined by
reference to the DI, the FX swap and the interest rate swap,
and not solely the FX swap and the DI.
In the case of a hedged executory contract, the hedge must be
entered after the executory contract is entered into and before the
accrual date, and must hedge all exposure at least through the
accrual date of the payable or receivable. By contrast to the rules
governing debt instruments, there is no leg-in on entry of a hedge
during the executory contract period because the exposure on the
contract is otherwise ignored for tax purposes until the accrual
date.
Identification rules.
(a)
Taxpayer must make a contemporaneous identification of the
instrument on the date of the hedge when the financial instrument
is entered into that clearly identifies the integrated transaction.
(b)
IRS discretion to integrate if, based on the facts and circumstances,
the transaction “is in substance hedged.” The IRS discretion
applies even if the two instruments are held by different taxpayers
and cannot satisfy the requirements for hedge treatment. See Regs.
§§ 1.988-5(a)(8)(iii) and 1.988-5(b)(3)(ii).
Private letter ruling option (§ 1.988-5(e)).
(a)
PLR 200813026.
IRS granted a PLR allowing integrated
transaction treatment for anticipatory hedging program used to
hedge taxpayer’s expected currency exposure under master supply
agreements.
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B.
§ 1221(b)(2) hedging transactions.
(1)
Reg. § 1.1221-2(b) allows the taxpayer to hedge currency exposure with
respect to—
(a)
(b)
“Ordinary property”
(i)
Reg. § 1.1221-2(c)(2) defines as property that could only
give rise to ordinary income or loss under any
circumstances.
(ii)
Issue as to whether a § 988 loan receivable constitutes
“ordinary property,” if the loan itself is held as a capital
asset. In this case, the hedge relates to the FX exposure
(which is ordinary), but embedded in a larger capital
transaction.
Cf. § 1.954-2(a)(4)(ii)’s expansion of
§ 1221(b)(2)’s definition of ordinary property to include,
inter alia, § 988 transactions.
Borrowings and “Ordinary Obligations” of the Taxpayer.
(i)
(c)
“Ordinary obligations” are defined as those obligations, the
performance or termination of which could not give rise to
capital gain or loss in any circumstances. See § 1.12212(c)(2).
Proper and timely identification must be made (§ 1.1221-2(f)).
(i)
Financial instrument must be identified as a hedge when
entered into.
(ii)
Underlying transaction must identified as part of the hedge
on a “substantially contemporaneous” basis (within 35 days
of entering the financial instrument).
(iii)
Reg. § 1.1221-2(f)(4)(ii) – unambiguous ID for tax
required. ID for Financial accounting purposes does not
satisfy this requirement, unless the records indicate that the
ID is also being made for tax purposes.
(iv)
Examples of Forms of ID:
All instruments in a particular account; all instruments of a
particular type; all instruments identified with a particular
legend or designation.
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§ 1256(e)(2) ID also satisfies § 1221(b)(2), although
apparently not the other way around.
(d)
(e)
(f)
(2)
Killer Rule (Reg. § 1.1221-2(g)).
(i)
To prevent selective ID with the benefit of hindsight, if the
TP makes an inadvertent ID, that is binding to treat gain as
ordinary. Losses remain capital. However, the taxpayer
can obtain capital gain for any gains if the taxpayer
establishes inadvertent error for the improper ID. The
taxpayer must treat all transactions consistently with the
error on original or amended returns.
(ii)
Conversely, failure to identify is binding to treat both gains
and losses as capital, unless the taxpayer establishes the
requirements of inadvertent error.
Inadvertent error.
(i)
Does § 1256(e)’s hedging exception incorporate the
inadvertent error rule under § 1221(b)(2)? Compare CCA
201034018 (Apr. 20, 2010) (no inadvertent error exception
in § 1256(e)) with CCA 201046015 (July 14, 2010)
(revising this advice regarding the same taxpayer).
However, in the latter CCA, the IRS ultimately concluded
on the facts that the taxpayer’s inadvertent error exception
was not satisfied.
(ii)
The above CCAs also provide good background on the
types of facts that will relevant in analyzing whether the
taxpayer’s failure to identify was attributable to inadvertent
error. See also PLR 201142020, fn. 7 (advising on
importance of prior year treatment in assessing inadvertent
error).
Capital v. Ordinary Treatment under § 1221(b)(2) Not Critical.
Since § 988 generally deems gains or losses from § 988
transactions to be ordinary, obtaining ordinary treatment under
§ 1221 is not necessary. Conversely, character of the gain or loss
for subpart F purposes, by contrast, may be more significant.
Timing of Gains and Losses on FX Hedges.
(a)
Reg. § 1.446-4 provides the tax accounting principles applicable to
gain or loss from hedging transactions, as described in Reg.
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§ 1.1221-2(b), whether or not the character from such transaction
is provided under the rules of § 1221(b)(2).
(b)
Rules are set forth depending on the type of transaction. For
example: hedges of debt instruments give rise to yield adjustments;
hedges of FX exposure on inventory may be rolled into inventory
accounting; etc.
(c)
Recordkeeping must be maintained to describe the taxpayer’s
hedge accounting methods. Reg. § 1.446-4(d). If book principles
are followed, presumably financial accounting records may suffice
for this purpose.
(d)
Failure to ID may not always be fatal. The IRS has interpreted the
timing rules to be mandatory for all hedging transactions described
in § 1221(b)(2). See Rev. Rul. 2003-127; see also, e.g., PLR
200510028 (Dec. 17, 2004).
(i)
The IRS has argued that this position will not be applied to
certain § 1256 contracts for which no ID is provided
presumably on the theory that § 1256 is mandatory, failing
an identification out under § 1256(e). See CCA 201024049
(June 9, 2009); ECC 201034018.
Thus, the principal question for timing purposes appears to be
whether the hedged FX risk relates to § 1221(b)(2) property. If so,
hedge timing (deferral of both gains and losses) should follow. If
not, then the straddle rules would defer losses, but require
immediate recognition of gains under § 1001 and § 1256.
(e)
Reg. § 1.954-2(g)(4) election.
(i)
Causes all FX gains and losses of the electing CFC from §
988 transactions and § 1256 contracts (which would
otherwise be commodities transactions) to be taken into
account as passive basket subpart F income. Previously, in
the 1988 temporary regulations, the election was mandatory
for all of the taxpayer’s CFCs. See Former Reg. § 4.9542(g)(5).
(ii)
Benefit of election is to allow FX losses to be fully utilized
in reducing other categories of passive FPHC income. In
the case of certain financial entities, the election may have
some benefits in avoiding any issues from “trapped losses.”
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(iii)
C.
Detriment of election is waiver of business needs exception
– election also is one-time and irrevocable.
Hedges of Investment in an Entity’s Balance Sheet.
(1)
Financial accounting rules generally allow balance sheet / net investment
hedges to be recorded as an adjustment to the translation of a subsidiary’s
earnings. Thus, hedging gains and losses would be deferred.
(2)
Tax treatment of hedges of a CFC’s stock.
(a)
Authorities on Ordinary vs. Capital.
(i)
Hoover Co. v. Commissioner, 72 T.C. 206 (1979) – losses
on hedges of taxpayer’s net investment in a subsidiary did
not constitute bona fide hedges under pre-Arkansas Best
case law. Accordingly, under pre-1986 Act law, these
losses produced capital losses.
(ii)
Barnes Group, Inc. v. United States, 697 F. Supp. 591 (D.
Conn. 1988) – reaching same result under post-Arkansas
Best law. Accordingly, the net investment hedges effected
through § 1256 contracts resulted in capital losses to the
taxpayer.
(b)
T.D. 8400 (1992) – revisiting the issue in the context of the
integrated transaction rules of § 1.988-5 and concluding that
balance sheet hedges would not qualify for integrated treatment.
(c)
Prop. Reg. § 1.988-5(d) (1992).
(i)
(3)
If ever finalized, this proposed regulation would have
allowed integration of a hedge with respect to declared, but
unpaid dividends and other qualified payments. This
would have been a limited example of cash flow hedging
under the IRS regulations.
Hedges of a DRE’s Balance Sheet or Items Payable from a DRE.
(a)
Taxpayer may hedge a DRE’s net balance sheet, or may enter into
investment hedges of disregarded transactions from the DRE
(royalties, interest). The item being hedged for financial statement
purposes will not exist for tax purposes. It would appear that the
relevant inquiry is whether the hedge of the underlying exposures
of the DRE qualifies for § 1221(b)(2) / bona fide hedging
treatment.
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