IRS Issues Final and Temporary Regulations on Reporting Income or Loss of Foreign Branches Operating in Foreign Currencies
Dec. 22, 2016
On Dec. 7, 2016, the IRS and the U.S. Department of the Treasury issued final and temporary regulations under IRC Section 987 regarding how to compute the income or loss of a qualified business unit (QBU) that operates in a functional currency different from that of its owner. On the same day, they also issued temporary and proposed regulations under Section 987 related to deferring certain losses from certain termination events and other partnership transactions.
The final regulations generally adopt proposed regulations previously issued in 2006 and follow the foreign exchange exposure pool (FEEP) approach. In addition, there is a mandatory fresh start under the transition rules whereby any unrealized Section 987 gains or losses existing on the effective date are eliminated.
Under Section 987, a taxpayer that owns one or more QBU (often disregarded entities) operating under a functional currency different from the taxpayer must separately compute the taxable income or loss of each QBU in its respective functional currency and translate such income at the appropriate exchange rate. Generally, the exchange rates for income and expenses are translated at an average exchange rate, except for amortization, depreciation, and depletion, which are translated at the historic rates based on the related assets placed in service date. A QBU is defined in Treasury Regulation Section 1.989(a)-1 as a business unit that does not use the dollar approximate separate transactions method (DASTM) of accounting and is not a corporation or partnership. These entities, however, may own QBUs.
The FEEP approach under the final regulations requires the use of a balance sheet approach where unrecognized currency gains and losses are tracked until a remittance is made from the QBU. Section 987 also provides all transfers of property or money (often referred to as remittances) between a qualified business unit and its owner operating under different functional currencies must result in a recognition of an exchange gain or loss characterized as ordinary.
Additional changes in the final regulations regarding the recognition of Section 987 gains and losses include:
- Expanding the number of items under this method that can be translated using a yearly average exchange rate instead of a spot rate, such as inventory and cost of goods sold
- Implementing the rules from the proposed 2006 regulations disallowing ownership of a QBU by another QBU
The new temporary regulations make several additional changes with regard to Section 987 gain or loss recognition, including:
- They limit the ability to trigger the recognition of Section 987 losses through a termination or deemed termination of a QBU that transfers its assets to another QBU in the same controlled group (also called the deferral rules).
- They provide an anti-abuse rule to address transactions or a series of transactions that are structured to avoid the deferral rules.
- They provide a de minimis rule whereby the deferral rules will not apply if the unrecognized Section 987 gain or loss is less than $5 million.
- They allow for an annual termination, or hybrid method, where an election is made to deem the QBU terminated annually. If elected, this approach must be used for all QBUs owned by the taxpayer and related persons and cannot be revoked.
The final and temporary Section 987 regulations apply to taxpayers for the second taxable year beginning after the publication of the regulations, or 2018 in the case of calendar year taxpayers. Taxpayers may elect to apply the regulations in 2017. The loss limitation rules in the temporary regulations apply to transactions occurring on or after Jan. 6, 2017, unless the principal purpose is recognizing a Section 987 loss, in which case the effective date is Dec. 7, 2016.
The final regulations also apply to QBUs of individuals, corporations, or partnerships whose partners are related under Sections 267(b) or 707(b). Banks, insurance companies, leasing companies, certain finance coordination centers, regulated investment companies, real estate trusts, trusts, estates, S corporations, and partnerships with partners who are not related are exempted from the regulations.