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Al Tax Section987 Jan17.Pdf Tax News and Developments North America Client Alert Treasury Releases Final & Temporary Section 987 January 9, 2017 Branch Currency Translation Regulations Subpart J of the Code governs the recognition of currency gains and losses and translation of certain assets from one currency environment to another. 1 Specifically, under Code Section 989, individuals, corporations, and the "qualified business units" or "QBUs" that they own must have a "functional currency" in which he/she/it computes profit or loss. In broad strokes, Subpart J of the Code attempts to address what happens when a taxpayer or its QBU engages in a transaction that is denominated in a currency other than its functional currency (a.k.a., a "non-functional currency"). Subpart J also addresses what happens when assets, liabilities, profit or loss need to be translated from one functional currency environment to another. EXAMPLE: U.S. Corp is a domestic corporation that owns all of the outstanding shares of a UK private limited company ("UKDRE") that conducts a business and has elected to be treated as a disregarded entity for U.S. tax purposes. UKDRE uses the British pound as its functional currency and UKDRE borrows Euros from an unrelated party bank. In the foregoing example, Code Section 988 governs the computation of UKDRE's recognition of foreign currency gain or loss on the repayment of the Euro borrowing from the bank. This provision measures UKDRE's transaction- based foreign currency gain or loss in pounds. Yet, USCO owns UKDRE, UKDRE's profit and loss flow up to USCO, and USCO has to file its U.S. Form 1120 in United States dollars. To address the fact that UKDRE's profit and loss need to be translated into U.S. dollars so that it can be reported on USCO's tax return, section 987 provides rules to effect that translation. Section 987 also governs how U.S. tax basis is computed when UKDRE distributes (or "remits") assets to USCO and those assets leave the pound balance sheet and need to be reflected on USCO's U.S. dollar balance sheet. On December 7, 2016, the United States Treasury and the Internal Revenue Service (collectively, "Treasury") released over 250 pages of regulations under Subpart J. Although the regulations address a number of issues under subpart J, they are primarily focused on the implementation of section 987 and so we sometimes refer to them collectively as the "Section 987 Regulations". Some of the regulations are final ("Final 987 Regulations") and some are temporary ("Temporary 987 Regulations"). The Section 987 Regulations represent a significant departure from existing practice for the vast majority of U.S.-based multinationals. Although the regulations do provide a transition period, taxpayers would be well-advised to start considering any systems changes they will need to make now. This is because the Section 987 Regulations require the taxpayer to maintain 1 Unless otherwise noted, all Code, section and Treas. Reg. § references are to the United States Internal Revenue Code of 1986, as amended. Baker McKenzie information that is not required for U.S. Generally Accepted Accounting Principles ("GAAP") purposes, or for any other purpose. Thus, unless taxpayers can plan their way out of section 987, compliance with these regulations will likely represent a very significant exercise for many taxpayers. I. History Up to this Point To understand the significance of the Section 987 Regulations, it is important to understand some history. In the 30 years since the enactment of section 987, there have never been final regulations interpreting section 987. Treasury first issued proposed regulations under section 987 in 1991 (the "1991 Proposed Regulations"). The 1991 Proposed Regulations remained in proposed form until they were withdrawn in 2006 at which time Treasury issued new proposed regulations in 2006 (the "2006 Proposed Regulations"). The 2006 Proposed Regulations had a prospective effective date and applied to taxable years beginning one year after the first day of the first taxable year following the date of publication of a Treasury decision adopting this rule as a final regulation in the Federal Register. However, Treasury said that until final regulations were published, it would consider positions consistent with the 1991 Proposed Regulations or the 2006 Proposed Regulations to be reasonable constructions of the statute. Treasury also considered an "earnings only" approach (in which section 987 exchange gain or loss is only recognized on the earnings of a QBU and not its capital) to be a reasonable interpretation of section 987. The 1991 Proposed Regulations Under the 1991 Proposed Regulations, the income or loss of the QBU for the year is calculated in the QBU's functional currency, then that profit or loss amount is translated into the owner's functional currency, to be included in the owner's income for the year, at the average exchange rate for the year. Assuming the owner's functional currency was the U.S. dollar, the owner was required to maintain a "basis pool" equal to its U.S. dollar tax basis in the assets transferred to the QBU plus the U.S. dollar basis in the QBU's earnings. The owner was also required to maintain an "equity pool" that reflected the QBU's balance sheet in its functional currency. The owner only had to calculate a gain or loss when the QBU made a "remittance" of property to the owner or the QBU terminated. The gain or loss was calculated by translating the value of the remittance into the owner's currency at the spot rate, and then comparing that to a pro rata portion of the owner's tax basis pool. The difference was gain or loss. Importantly, if there was a remittance, there was no attempt under the 1991 Proposed Regulations to calculate a "gain" or "loss" that was unique to a specific item of property. Instead, any remittance of any property (even a recently acquired item of inventory) on the QBU's balance sheet could trigger recognition of section 987 gain or loss. The primary advantage of the 1991 Proposed Regulations was that they were relatively easy to understand and apply. They also relied on information and exchange rates that taxpayers had to assemble anyway for accounting purposes. Specifically, the 1991 Proposed Regulations were "roughly" similar to what taxpayers did for GAAP purposes. When the FASB adopted Financial Accounting Standard ("FAS") 52, it endorsed the "functional currency" approach for determining profit and loss. Under this approach an entity had to choose a 2 Tax News and Developments - Client Alert January 9, 2017 Baker McKenzie functional currency and then compute its profit or loss in its functional currency, whatever that may be. In addition, the relative book values of assets and liabilities are maintained throughout the process, because both monetary and non-monetary assets are translated into U.S. dollars using a single exchange rate – the spot exchange rate as of the balance sheet date. FAS 52 has since been codified as Accounting Standards Classification ("ASC") 830. In Notice 2000-20, Treasury stated that it was concerned that the 1991 Proposed Regulations were susceptible to abuse. The notice referred to a number of concerns. Yet, in particular, Treasury wanted to prevent taxpayers from claiming what it perceived to be unjustified currency losses on non-monetary assets, like equipment and buildings and oil rigs. Rather than modify the 1991 Proposed Regulations, Treasury chose to go back to the drawing board and re-think some of the underlying principles surrounding foreign currency translation. This led to the promulgation of the 2006 Proposed Regulations, which we discuss below. The 2006 Proposed Regulations On September 7, 2006, Treasury issued new proposed regulations that departed from the 1991 Proposed Regulations and adopted a new approach – the "foreign exchange exposure pool method" - for determining section 987 gains or loss. The 2006 Proposed Regulations represented a major shift away from GAAP reporting requirements. In general, the foreign exchange exposure pool method provides that the income of a Section 987 QBU is determined by reference to the items of income, gain, deduction and loss booked to the Section 987 QBU in its functional currency, adjusted to reflect U.S. tax principles, but then translated into the functional currency of the Owner (defined below) at specified exchange rates. The general rule is that items of income, gain, deduction and loss of a Section 987 QBU are translated into the functional currency of the Owner at the average exchange rate for the year. This general rule is no different from the 1991 Proposed Regulations. There is a very significant exception, however, which essentially swallows the rule. Specifically, income, expense (i.e., depreciation expense), gains and losses on what the regulations referred to as Historic Assets (defined below) were calculated using historic exchange rates determined on the dates the assets were transferred to, or otherwise acquired by, the QBU. The rationale for this exception is that Treasury does not want the Owner to recognize section 987 gain or loss with respect to these assets. It is easiest to illustrate with a simple example. EXAMPLE: USCO owns all of the stock of a UK disregarded entity ("UKDRE"). UKDRE has the British pound as its functional currency. USCO uses the calendar year for tax purposes. USCO contributes some equipment to UKDRE on December 31, 2018, with a basis of $1,000,000. The average exchange rate for the year is $2:£1. Thus, the equipment gets translated into the UKDRE's functional currency environment at £500,000. The equipment has a 10 year useful life and so UK DRE takes £50,000 of depreciation deductions for the 2019 tax year.
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