In the global economy, companies operate foreign business in various currencies. U.S. taxpayers must translate their foreign currency transactions into U.S. dollars. Many times the rules are misunderstood. On Dec. 7, 2016, new regulations were issued to provide guidance on how individual and corporate owners of a qualified business unit (QBU) subject to Section 987 of the Internal Revenue Code must determine the QBU’s taxable income or loss, as well as the timing, amount, character, and source of any Section 987 gain or loss.
The new rules don’t apply to banks, insurance companies, leasing companies, finance coordinating centers, regulated investment companies, real estate investment trusts, trusts and estates, S corporations, and partnerships (other than partnerships that are owned by related parties). These excluded entities can use a reasonable method for applying these rules (which is undefined), though future guidance is expected.
The Tax Reform Act of 1986 included Section 987 to address currency gain and loss when remittances are made from QBUs using different functional currencies. The Treasury Department issued proposed regulations in 1991 and again in 2006, and the new final regulations retain most of the fundamental mechanics of the 2006 proposal.
When a taxpayer owns and operates one or more QBU with a functional currency that is different than its owner, the taxable income or loss of each QBU is computed separately in the QBU’s functional currency and then translated at the yearly average exchange rate (or at the spot rate if so elected) or at the historic rates for historic assets (such as for depreciation and amortization). Section 987 gain or loss is deferred, and is recognized on remittances from the QBU during the year determined based on a complex eight-step process.
In general, the final regulations apply to calendar-year taxpayers beginning Jan. 1, 2018. Taxpayers can elect to apply the regulations beginning in 2017, but only if the taxpayer consistently applies the regulations to all Section 987 QBUs directly or indirectly owned.
A taxpayer must transition to the final regulations on the first day of the first tax year to which the final regulations apply to the taxpayer. The QBU is deemed to terminate on the day before the transition date. The 2006 proposal generally allowed taxpayers to elect either the deferral-transition method or the fresh-start method. The deferral method generally preserved previously unrecognized Section 987 gain or loss, while the fresh-start method did not. A key change from the 2006 proposed regulations is that the now-final regulations do not permit using the deferral method. For many taxpayers their deferred Section 987 losses will disappear.
The Treasury Department has provided certain alternatives that allow taxpayers to avoid the application of the deferral event (and outbound loss event rules). Taxpayers can make the annual deemed termination election where the QBU is marked to market at year-end provided they have adopted the 2006 proposed regulations. However, the election must be made for all QBUs. Cherry-picking is not allowed.
Section 987 gain or loss results when a QBU terminates. But there are instances where Section 987 gains and losses are deferred in either a “deferral event” or an “outbound loss event.” A deferral event generally occurs when there is a transfer of substantially all of the assets or an interest in a QBU to a member of the controlled group. The deferral is recognized when there is a remittance or when the successor ceases to be a member of the controlled group. An outbound loss event generally occurs when a U.S. person transfers substantially all of the QBU assets to a foreign corporation that is a member of the controlled group, resulting in the loss being deferred (but not a gain). This rule prevents the taxpayer from incorporating a QBU to trigger Section 987 losses before the new regulations are effective. In addition, there is a $5 million de minimus exception.
A major change from prior treatment is that Section 987 gains of a controlled foreign corporation (CFC), which is a foreign corporation that is more than 50 percent owned by U.S. persons, will now be considered subpart F income. Under subpart F, certain types of income earned by a CFC are taxable to the CFC’s U.S. shareholders in the year earned as if the CFC distributes that income to its shareholders in that year. To the extent that assets of a Section 987 QBU of a CFC generate subpart F income, it would be taxable in the year earned rather than when distributed to the U.S. shareholder.
Due to the fresh-start transition method provided by the final regulations, taxpayers who adopted the 2006 temporary regulations may need to adjust deferred taxes previously recorded on unrealized foreign currency gains or losses. Although the final regulations have a prospective effective date, the impact on deferred taxes is a discrete event in the period of enactment.
Andrew M. Bernard Jr., CPA, is managing director of Andersen Tax in Philadelphia and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org.
William Long is a senior manager with Andersen Tax in Boston. He can be reached at email@example.com.