[Federal Register: September 7, 2006 (Volume 71, Number 173)]
[Proposed Rules]
[Page 52875-52918]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr07se06-18]
[[Page 52875]]
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Part II
Department of the Treasury
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Internal Revenue Service
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26 CFR Part 1
Income and Currency Gain or Loss With Respect to a Section 987 QBU;
Proposed Rule
[[Page 52876]]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-208270-86]
RIN 1545-AM12
Income and Currency Gain or Loss With Respect to a Section 987
QBU
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Withdrawal of notice of proposed rulemaking, notice of proposed
rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations that provide
guidance under section 987 of the Internal Revenue Code (Code)
regarding the determination of the items of income or loss of a
taxpayer with respect to a section 987 qualified business unit (section
987 QBU) as well as the timing, amount, character and source of any
section 987 gain or loss. It withdraws proposed regulations under
section 987 that were published in the Federal Register on September
25, 1991 (56 FR 48457). These regulations are necessary to provide
guidance under section 987. Taxpayers affected by these regulations are
corporations and individuals with qualified business units subject to
section 987.
DATES: Written or electronic comments must be received by December 6,
2006. Outlines of topics to be discussed at the public hearing
scheduled for November 21, 2006, must be received by October 31, 2006.
ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-208270-86), Internal
Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC
20044. Submissions may be sent electronically, via the IRS Internet
site at http://www.irs.gov/regs or via the Federal eRulemaking Portal at http://www.regulations.gov (IRS REG-208270-86).
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
Sheila Ramaswamy at (202) 622-3870; concerning submissions of comments,
Kelly Banks at (202) 622-7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in this notice of proposed
rulemaking has been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act of 1995 (44
U.S.C. 3507(d)). Comments on the collection of information should be
sent to the Office of Management and Budget, Attn: Desk Officer for the
Department of Treasury, Office of Information and Regulatory Affairs,
Washington, DC 20503, with copies to the Internal Revenue Service,
Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC
20224. Comments on the collection of information should be received by
November 6, 2006.
Comments are requested specifically concerning:
Whether the proposed collection of information is necessary for the
proper performance of the functions of the Internal Revenue Service,
including whether the information will have practical utility;
The accuracy of the estimated burden associated with the proposed
collection of information (see below);
How the quality, utility, and clarity of the information to be
collected may be enhanced;
How the burden of complying with the proposed collection of
information may be minimized, including through the application or
automated collection techniques or other forms of information
technology; and
Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of service to provide information.
The collection of information in these proposed regulations is in
Sec. Sec. 1.987-1(b)(1)(ii),1.987-1(b)(2)(ii), 1.987-1(c)(1)(ii),
1.987-1(f), 1.987-3(b)(1), 1.987-9, 1.987-10 and 1.987-11. Section
1.987-1(b)(1)(ii) allows a partner to make an election not to take
section 987 gain or loss into account. Section 1.987-1(b)(2)(ii) allows
a taxpayer to make an election to group certain QBUs with the same
functional currency as a single QBU. Sections 1.987-1(c)(1)(ii) and -
3(b)(1) allow a taxpayer to make an election to use a convention for
exchange rates. Section 1.987-11(b) allows a taxpayer to elect to apply
these regulations to taxable years beginning after the date of
publication of a Treasury decision adopting this rule as a final
regulation in the Federal Register. The preceding elections are to be
made pursuant to Sec. 1.987-1(f) by attaching a statement to the
taxpayer's tax return describing the election to be made. Section
1.987-9 contains recordkeeping rules to establish a qualified business
unit's income and section 987 gain or loss. This collection of
information is required to establish the qualified business unit's
income, gain, deduction or loss and assets and liabilities as well as
exchange rates used for foreign currency translation purposes. Section
1.987-10 provides rules for transitioning to the method provided under
the new proposed regulations for determining section 987 gain or loss
and provides certain corresponding reporting rules. The collection of
information contained in this regulation facilitates the identification
of the prior method used by the taxpayer to determine section 987 gain
or loss. The collections of information are mandatory. The likely
respondents are taxpayers with foreign qualified business units.
Estimated total annual reporting burden: 12,000.
Estimated average annual burden hours per respondent: 12.
Estimated number of respondents: 1,000.
Estimated annual frequency of responses: annually.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.
Books and records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Background
A. Overview
As part of the Tax Reform Act of 1986, Public Law 99-514, 100 Stat.
2085 (October 22, 1986), 1986-3 CB Vol.1, 1, see Sec. 601.601(d)(2),
Congress enacted comprehensive reforms to the tax treatment of foreign
currency transactions by adding new subpart J. Those reforms included,
among other things, the introduction of the functional currency
concept, which generally distinguishes taxpayers on the basis of the
primary currency in which they keep their books and records and conduct
their business. Reforms also included the addition of the qualified
business unit (QBU) concept, which generally provides a basis for
allowing a taxpayer with a separate unit that conducts business and
keeps books and records in a currency other than the functional
currency of the taxpayer to account for the results of operation of the
separate unit in the unit's own functional currency. Against that
conceptual background, section 988 provides rules for the treatment of
transactions in a currency other than the
[[Page 52877]]
taxpayer's functional currency. Section 986 generally provides rules
for translating into U.S. dollars the earnings and profits and foreign
taxes of a foreign corporation whose functional currency is not the
U.S. dollar (dollar). Section 987, in turn, generally provides rules
for determining and translating income and currency gain and loss with
respect to operations of a branch whose functional currency is other
than the functional currency of the taxpayer. As discussed below, an
already complex area of law was made even more complicated when the
entity classification rules under Sec. 301.7701-1 through 301.7701-3
(the ``check the box'' regulations) were promulgated in 1997.
On September 25, 1991, the IRS and the Treasury Department issued
proposed regulations under section 987 (the 1991 proposed regulations).
See 56 FR 48457. In light of subsequent IRS experience with taxpayer
claims of large non-economic currency losses under section 987, the IRS
and the Treasury Department issued Notice 2000-20 (2000-1 CB 851). See
Sec. 601.601(d)(2). This notice expressed serious concern that the
1991 proposed regulations had not fully achieved the original goal of
facilitating recognition of true economic foreign currency gain and
loss under appropriate circumstances and requested comments on this
issue and other matters.
This document withdraws the 1991 proposed regulations and provides
new proposed regulations based on the ``foreign exchange exposure
pool'' method. The IRS and the Treasury Department believe that this
method more accurately reflects foreign currency gain and loss than the
1991 proposed regulations and does so in a manner consistent with
statutory authority and legislative intent. These new proposed
regulations are designed to prescribe more precisely foreign currency
gain and loss that is economically realized, while minimizing or
eliminating the realization of non-economic currency gain and loss.
The following background discussion describes section 987, its
legislative history, the 1991 proposed regulations, Notice 2000-20, and
the general approach that provides the basis for the foreign exchange
exposure pool method.
B. The Statute
Section 987 generally provides that in the case of a taxpayer
having a QBU with a functional currency other than that of the
taxpayer, the taxable income of the taxpayer with respect to the QBU is
determined by computing the taxable income or loss of the QBU
separately and translating such income or loss at the appropriate
exchange rate. Section 987 further requires the taxpayer to make
``proper adjustments'' (as prescribed by the Secretary) for transfers
of property between QBUs 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; treating
section 987 gain or loss as ordinary income or loss; and sourcing such
gain or loss by reference to the source of the income giving rise to
post-1986 accumulated earnings.
C. The Legislative History
1. Prior Law
As described in the applicable legislative history,\1\ section 987
was enacted against a background of, and partly in reaction to,
perceived shortcomings with prevailing law. The prevailing law at that
time was fairly limited. It consisted primarily of two revenue rulings
that provided alternative methods for calculating branch taxable
income.
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\1\ H. Rep. No. 99-426, 99th Cong., 1st Sess. (1985); 1986-3 CB
Vol 2, 449. S. Rep. No 99-313, 99th Cong., 2d Sess. (1986); 1986-3
CB Vol. 3, 443. H.R. Conf. Rep. No. 99-841, 99th Cong., 2d Sess.
(1986); 1986-3 CB Vol. 4, 659. Later citations are to the Cumulative
Bulletin. See Sec. 601.601(d)(2).
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Rev. Rul. 75-106 (1975-1 CB 31), see Sec. 601.601(d)(2), provides
for the use of a ``net worth'' method. Under this method, taxable
income of a branch of a domestic corporation engaged in business in a
foreign country is defined generally as the difference between the
branch's opening and closing net worth as reflected on the branch's
balance sheets for the taxable year. Under this method, the branch's
balance sheet is translated into U.S. dollars. In general, the values
of current items (such as cash or cash flows denominated in foreign
currency) are translated at the year-end exchange rate, and the values
of historical items (such as equipment) are translated at the exchange
rate for the period in which the item was acquired or incurred. The
translation of an item at the year-end rate causes changes in the
item's value due to currency fluctuations to be taken into account
annually, and the translation of an item at the historical rate
generally precludes recognition of fluctuations in value due to
changing exchange rates. In this way, the net worth method was able to
identify items considered economically exposed to fluctuations in
exchange rates. The total change in net worth identified by the net
worth method is equal to the sum of the operating profit or loss of the
branch and the exchange gain or loss on current items. However, the net
worth method does not identify separate items of income and expense
because it is based solely on a balance sheet comparison and does not
use a profit and loss statement.
Rev. Rul. 75-107 (1975-1 CB 32), see Sec. 601.601(d)(2), provides
for the use of a ``profit and loss'' method. Under this method, the
branch computes taxable income by translating the local currency profit
and loss statement (adjusted for U.S. tax principles) into dollars. Any
portion of the profit and loss remitted to the home office during the
year is translated at the exchange rate on the date of the remittance,
and the remainder is translated at the year-end exchange rate. No
exchange gain or loss is recognized on a remittance.
The net worth method of Rev. Rul. 75-106 and the profit and loss
method of Rev. Rul. 75-107 each suffered from infirmities. The net
worth method resulted in the realization of foreign currency gain and
loss that was not consistent with the general realization principles of
the Code; it also failed to accurately characterize items of income,
gain, deduction or loss of the branch. The profit and loss method, in
turn, did not take into account foreign currency gain and loss inherent
in the assets and liabilities on the balance sheet as part of such
method. Both methods failed to account for foreign currency gain or
loss in the event of a remittance.
The legislative history states that under section 987, a taxpayer
with a QBU whose functional currency is other than the functional
currency of the taxpayer will be required to use a profit and loss
method, rather than the net worth method (as this method was understood
at the time). House Report (1986-3 CB Vol. 2, 479); Senate Report
(1986-3 CB Vol. 3, 470); and Conference Report (1986-3 CB Vol. 4, 675).
See Sec. 601.601(d)(2). However, this legislative history is not
properly read as an explicit rejection of the net worth method in its
entirety. Instead, it is more accurately viewed as a rejection of
certain aspects of the law prevailing at that time. Importantly, the
method provided in section 987 as enacted actually represents a blend
of the separate methods, as it has aspects of both a net worth method
and a profit and loss method. It also has at least one feature absent
from each method--that is, section 987 includes the remittance
recognition concept. Consistent with a profit and loss method, sections
987(1) and (2) generally determine the items of income or loss of a QBU
based on its profit and loss statement as determined in its functional
currency. Such items are then translated into the taxpayer's
[[Page 52878]]
functional currency at the appropriate rate.\2\ Consistent with a net
worth method, section 987(3) requires that exchange gain or loss be
computed with respect to certain branch assets and liabilities (as
prescribed by the Secretary). Unlike either method, section 987(3)(A)
provides that exchange gain or loss is recognized upon a remittance.
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\2\ Section 989(b)(4) provides that, ``except as provided in
regulations,'' the appropriate exchange rate is the average exchange
rate for the taxable year of the QBU.
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The blending of features of both a profit and loss method and of a
net worth method in section 987 is significant. Together with more
specific principles identified in the legislative history, this
blending of methods informs the Congressionally stated preference for
the profit and loss method. The House Report states:
A profit and loss method can be viewed as being more consistent
with the functional currency concept than a net worth method. Under
a profit and loss method, the functional currency is used as the
measure of income or loss, so that earnings determined for U.S. tax
purposes would bear a close relation to taxable income computed by
the foreign jurisdiction. In contrast, a net worth method takes
unrealized exchange gains and losses into account. Further, a profit
and loss method minimizes the accounting procedures that otherwise
would be required to make the item-by-item translations under a net
worth method. Finally, in the case of a branch, the net worth method
as applied under present law fails to characterize accurately items
of income or loss that are subject to special U.S. tax rules. For
example, although there are limitations on the deductibility of
long-term capital losses, such a loss incurred by a branch would be
given tax effect because it would be reflected as an adjustment to
the balance sheet.
House Report at 469.
The House and Senate reports are generally uniform in describing
Congressional intent with regard to the computations required under
section 987 as illustrated by the Senate Report.
Under the bill, a taxpayer with a branch whose functional
currency is a currency other than the U.S. dollar will be required
to use the profit and loss method to compute branch income. Thus,
the net worth method will no longer be an acceptable method of
computing income or loss of a foreign branch for tax purposes, and
only realized exchange gains and losses on branch capital will be
reflected in taxable income.
For each taxable year, the taxpayer will compute income or loss
separately for each qualified business unit in the business unit's
functional currency, converting this amount to U.S. dollars using
the weighted average exchange rate for the taxable period over which
the income or loss accrued. This amount will be included in income
without reduction for remittances from the branch during the year.
The committee anticipates that regulations will provide rules that
will limit the deduction of branch losses to the taxpayer's dollar
basis in the branch (that is, the original dollar investment plus
subsequent capital contributions and unremitted earnings).
A taxpayer will recognize exchange gain or loss on remittances
(without regard to whether or when the remittances are converted to
dollars), to the extent the value of the currency at the time of the
remittance differs from the value when earned. Remittances of
foreign branch earnings (and interbranch transfers involving
branches with different functional currencies) after 1986 will be
treated as paid pro rata out of post-1986 accumulated earnings of
the branch. The committee anticipates that, for purposes of
calculating exchange gain or loss on remittances, the value of the
currency will be determined by translating the currency at the rate
in effect on the date of remittance. Exchange gains and losses on
such remittances will be deemed to be ordinary and domestic source.
Senate Report (1986-3 CB Vol. 3, 470). Importantly, the Conference
Report modifies the House and Senate reports by stating that a
remittance by a QBU ``will trigger exchange gain or loss inherent in
accumulated earnings or branch capital.'' Conference Report, 1986-3 CB
Vol. 4, 675.
From section 987 and the foregoing legislative history, several
principles emerge:
1. A branch profit and loss computation is required in order to
properly characterize items of branch income or loss, which is taken
into account in the year earned.
2. Exchange gain or loss is recognized upon a remittance, in an
amount prescribed by the Secretary.
3. Both branch earnings and branch capital can give rise to
exchange gain or loss under section 987.
4. Regulations under section 987 should seek to minimize
complexity regarding item-by-item translations.
5. The currency gain or loss taken into account under section
987 is only the economic gain or loss ``inherent in'' the assets and
liabilities of a QBU.
2. Relationship Between Section 986(c) and 987
Comments to the IRS and the Treasury Department have suggested that
the computation under section 987 of exchange gain or loss for a branch
is intended to operate in the same manner as the computation under
section 986(c) of certain exchange gain or loss of a foreign
corporation. In general, section 986(c) provides for the recognition of
exchange gain or loss only with respect to distributions of previously
taxed earnings and profits (as described in section 959 or 1293(c)).
The Conference Report includes the following general statement about
the translation rules:
The same translation rule applies to the earnings and profits of
a foreign corporation and the income or loss of a branch or other
QBU. An entity that uses a nonfunctional currency to measure the
results of operation is required to use a profit and loss method to
translate income or loss into functional currency. * * * 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 such form of
enterprise rises to the level of a QBU.
Conference Report, 1986-3 CB Vol. 4, 670. See Sec. 601.601(d)(2).
The suggestion in comments is to apply this general principle such that
section 987 would require the recognition of exchange gain or loss only
with respect to branch earnings and not with respect to contributed
capital.
Despite the broad statements of principle quoted above, Congress
provided more specific guidance regarding the treatment of branches in
this regard. The Conference Report states that a remittance by a QBU
``will trigger exchange gain or loss inherent in accumulated earnings
or branch capital.'' Conference Report, 1986-3 CB Vol. 4, 675. See
Sec. 601.601(d)(2). Similarly, despite the stated requirement that
QBUs must use a notional profit and loss method to determine branch
taxable income, the specific method actually provided in section 987
and described in the legislative history represents a blend of a net
worth method and a profit and loss method. Accordingly, the IRS and the
Treasury Department believe that the more specific statements made by
Congress regarding the treatment of branch exchange gain or loss
reflect an intention that the methodologies of section 986(c) and
section 987 not be identical.
D. The 1991 Proposed Regulations
The 1991 proposed regulations provide generally that the net income
of a QBU having a functional currency different than the taxpayer is
determined annually. Such determination is based on the profit and loss
appearing on the QBU's books and records, adjusted to conform to U.S.
tax principles, and translated into the functional currency of the
taxpayer using the weighted average exchange rate for the taxable year.
The 1991 proposed regulations also provide for the recognition of
exchange gain or loss upon a remittance from the QBU's equity pool. In
general, the equity pool consists of the undistributed capital and
earnings of the QBU, determined in the QBU's functional currency. The
1991 proposed regulations also provide for a basis pool, which consists
of the basis
[[Page 52879]]
of the capital and earnings in the equity pool, expressed in the
functional currency of the taxpayer. The portion of the basis pool,
expressed in the functional currency of the taxpayer, that is
attributable to a remittance is generally determined according to the
following formula:
[GRAPHIC] [TIFF OMITTED] TP07SE06.000
Section 987 gain or loss is the difference between the value of the
remittance from the QBU translated into the taxpayer's functional
currency at the spot rate on the date the remittance is made, less the
basis associated with the remittance as determined above. One important
consequence of the equity pool paradigm is that all branch equity gives
rise to exchange gain or loss, regardless of whether or not that equity
is held in a form that actually exposes the QBU's owner to currency
fluctuations (compare assets such as cash or indebtedness to assets
such as equipment).
Under the 1991 proposed regulations, a taxpayer must determine the
source and character of section 987 gain or loss for all purposes of
the Code, including sections 904(d), 907, and 954, by using the same
method the taxpayer uses to allocate and apportion its interest expense
under section 861, with certain modifications.
E. Concerns Regarding the 1991 Proposed Regulations; Notice 2000-20
Effective January 1, 1997, the IRS and the Treasury Department
issued the check the box regulations implementing new elective entity-
classification rules. These regulations made it possible for certain
entities with a single owner to be treated for federal income tax
purposes as an entity disregarded as separate from its owner (a
disregarded entity or DE). As a result, businesses that had previously
operated through subsidiaries could operate through structures treated
for tax purposes as branches. The effect of the check the box
regulations was a dramatic increase in the number of branches resulting
from DE elections that are subject to section 987. This increase has
greatly exacerbated the already existing problems of the 1991 proposed
regulations, especially the ability of taxpayers to trigger non-
economic losses (and the corresponding trap for the unwary taxpayer
with non-economic gains).
As indicated above, the equity pool paradigm in the 1991 proposed
regulations imputes currency gain or loss to all equity of a QBU
whether or not the assets of the QBU are economically exposed to
changes in the value of the functional currency of the QBU. The IRS has
faced many cases in which taxpayers have claimed substantial non-
economic exchange losses largely on the basis of the 1991 proposed
regulations. An example may be instructive. Assume that a domestic
corporation (US Corp) with the dollar as its functional currency forms
a foreign corporation in Country X and then elects under the check the
box regulations to treat that corporation as a DE. The DE conducts
mineral extraction and owns all the necessary equipment. The equipment
owned by the DE was contributed by US Corp. The DE has no employees and
contracts with a subsidiary of US Corp for the employees needed in the
business of extraction. US Corp, as the entity's sole owner, claims
that the DE is a QBU for purposes of section 987. The DE has minimal
financial assets and conducts no activities other than mineral
extraction. US Corp claims that the DE's functional currency is Country
X currency. A decline in the value of Country X currency relative to
the dollar does not produce any economic loss for US Corp because the
assets of the DE are not financial assets subject to currency
fluctuation. Nevertheless, US Corp claims under the 1991 proposed
regulations that the equity of the DE, which consists almost
exclusively of equipment, gives rise to a substantial non-economic
exchange loss and that terminating the DE (for example, by another
check the box election) triggers recognition of such loss. Taxpayers
have claimed similar results under other fact patterns. The IRS and the
Treasury Department have serious concerns about these types of
transactions.
Although the foregoing example concerns the claiming of non-
economic losses, the equity pool approach in the 1991 proposed
regulations can also give rise to non-economic gains. Recently, the
value of the US dollar has declined against many foreign currencies. It
is likely that under these circumstances, taxpayers subject to section
987 may have large non-economic gains built into the equity pool. The
IRS and the Treasury Department believe that Congress did not intend
for section 987 to generate non-economic foreign currency gains or
losses.
In light of the entity-classification rules and the potential for
the equity pool paradigm to generate non-economic currency gains and
losses, the IRS and the Treasury Department issued Notice 2000-20,
2000-1 CB 851. See Sec. 601.601(d)(2). Among other things, the notice
indicated that the IRS and the Treasury Department were concerned that
the proposed regulations may not have achieved their original goal of
recognizing economic exchange gains and losses under appropriate
circumstances. The notice requested comments on this and other issues.
Several comments were received in response to the notice and raised
a number of important points. Two of those comments suggested replacing
the equity pool paradigm in the 1991 proposed regulations with a
paradigm that recognizes exchange gain or loss only on the earnings of
a QBU and not its capital. As described above, the IRS and the Treasury
Department believe that such an approach is inconsistent with
Congressional intent as expressed in the legislative history to section
987. An earnings-only approach also would fail to address the core
problem of distinguishing between items that economically give rise to
exchange gain and loss and those that do not. Additionally, an
earnings-only approach would produce different results for QBUs with
the same net assets, depending upon whether the net assets were funded
with capital or earnings. Finally, an earnings-only approach fails to
take into account any foreign currency exposure on capital and so could
disadvantage banks and other financial institutions, much of whose
QBUs' capital may be subject to such exposure.
F. The Foreign Exchange Exposure Pool Method
The IRS and the Treasury Department believe that Congress did not
intend
[[Page 52880]]
section 987 to permit the largely uninhibited recognition of non-
economic exchange gain or loss. The 1991 proposed regulations, together
with the check the box regulations, have combined to permit taxpayers
to trigger non-economic losses with relative ease. Accordingly, the
1991 proposed regulations are withdrawn and are replaced with new
proposed regulations that adopt the ``foreign exchange exposure pool
method.'' In general, the foreign exchange exposure pool method
provides that the income of a QBU that is subject to section 987
(``section 987 QBU'') is determined by reference to the items of
income, gain, deduction and loss booked to the QBU in its functional
currency, adjusted to reflect US tax principles. With certain
exceptions, items of income, gain, deduction and loss of a section 987
QBU are translated into the functional currency of the QBU's owner at
the average exchange rate for the year. However, the basis of historic
assets and deductions for depreciation, depletion, and amortization of
such assets are translated at the historic exchange rate. Translating
these items at the historic exchange rate differs from the approach
taken in the 1991 proposed regulations, which instead uses the average
exchange rate. Although using the average exchange rate for translating
such items might be simpler than using the historic exchange rate, it
leads to the generation of non-economic foreign currency gains or
losses described in this preamble.
The foreign exchange exposure pool method uses a balance sheet
approach to determine exchange gain or loss, which is then recognized
upon a remittance. Use of a balance sheet approach allows taxpayers and
the IRS to distinguish between those items whose value fluctuates with
respect to changes in the functional currency of the owner and those
which do not. Under this method, exchange gain or loss with respect to
``marked items'' is identified annually but is pooled and deferred
until a remittance is made. The IRS and the Treasury Department believe
that section 988(c) identifies the items that should be treated as
giving rise to exchange gain or loss for purposes of section 987.
Accordingly, a marked item is generally defined as an asset or
liability that would generate section 988 gain or loss if such asset or
liability were held or entered into directly by the owner of the
section 987 QBU.
When a section 987 QBU makes a remittance, a portion of the pooled
and deferred exchange gain or loss is recognized. In general, the
amount taken into account is an amount equal to the product of the
owner's portion of the section 987 QBU's net unrecognized exchange gain
or loss, multiplied by the owner's remittance proportion. The owner's
remittance proportion generally is equal to the quotient of the amount
of the remittance, divided by the aggregate basis of the section 987
QBU's gross assets (as reflected on its year-end balance sheet),
without reduction for the remittance.
The source and character of exchange gain or loss recognized under
section 987 for all purposes of the Code, including sections 904(d),
907 and 954, is determined by reference to the source and character of
the income derived from the section 987 QBU's assets.
The IRS and the Treasury Department believe that the foreign
exchange exposure pool method is consistent with section 987 and
legislative intent for several reasons. First, the foreign exchange
exposure pool method uses a profit and loss statement to determine the
items of income, gain, deduction and loss of a section 987 QBU in its
functional currency. This allows proper characterization of items of
income, gain, deduction and loss. Second, exchange gain or loss must be
taken into account only with respect to items of branch capital and
earnings whose value fluctuates with changes in exchange rates by
reference to the owner's functional currency. This comports both with
Congressional intent that taxpayers recognize exchange gain or loss
(but only economic exchange gain or loss) inherent in branch capital
and branch earnings and with authority granted under section 987(3) to
identify appropriate translation rates. Third, exchange gain or loss is
recognized under section 987 only upon a remittance. Finally, the
foreign exchange exposure pool method is an appropriate interpretation
of the ``blended'' approach of section 987--that is, it incorporates
certain aspects of the profit and loss method and the net worth method.
Explanation of Provisions
A. Section 1.987 1 Scope, Definitions and Special Rules
1. Scope in General
The proposed regulations provide rules for determining the section
987 taxable income or loss of a taxpayer with respect to a section 987
QBU as well as the timing, amount, character, and source of section 987
gain or loss recognized with respect to such QBU. The proposed
regulations do not apply to banks, insurance companies, and similar
financial entities (including, solely for this purpose, leasing
companies, finance coordination centers, regulated investment
companies, and real estate investment trusts). The IRS and the Treasury
Department plan to apply the foreign exchange exposure pool method
adopted in the proposed regulations to such entities in subsequent
guidance but believe it is appropriate to request comments regarding
how the rules of the proposed regulations need to be precisely tailored
to address issues unique to financial entities. Financial entities are
urged to make necessary comments to help tailor the planned extension
of the foreign exchange exposure pool method to such entities.
Specifically, in the context of banks, the IRS and the Treasury
Department request comments on whether special rules are needed for the
global dealing of currencies and securities. Comments are also
requested on the relationship of sections 987 and 988 for banks.
Finally, comments are requested on whether the use of exchange rate
conventions is appropriate for banks and finance entities and, if so,
how such conventions should be determined. In the context of insurance
companies, the IRS and the Treasury Department request comments on the
proper treatment of insurance reserves, surplus, and investment assets
held by the separate trades or business of an insurance company. In
particular, comments are requested on the proper treatment of stock
held in separate accounts of a section 987 QBU of a life insurance
company and the related insurance reserves established for those
separate accounts. In the context of leasing companies, comments are
requested regarding the treatment of stock in other leasing companies
recorded on the books and records of a section 987 QBU and how the
rules of sections 986 and 987 can be reconciled if stock is treated as
a ``marked asset'' in this setting. Until regulations are issued
applying the foreign exchange exposure pool method to financial
entities, such entities must comply with section 987 under a reasonable
method, consistently applied. For this purpose, reasonable methods
include using the method described in the 1991 proposed regulations and
a method that imputes section 987 gain or loss to earnings but not
capital.
The proposed regulations also do not apply to trusts, estates and S
corporations. The IRS and the Treasury Department plan to apply the
foreign exchange exposure pool method adopted in the proposed
regulations to such entities but believe it is appropriate to request
comments
[[Page 52881]]
regarding how the rules of the proposed regulations should be applied
to such entities. The IRS and the Treasury Department request comments
regarding whether principles similar to those applied to partnerships
should apply to these entities.
2. Taxpayers Subject to Section 987 and Related Definitions
The IRS and the Treasury Department believe that section 987 should
only apply where an individual or corporation (whether foreign or
domestic) has activities that constitute a trade or business under
Sec. 1.989(a)-1(c) and the trade or business has a functional currency
different from the individual or corporation. In such cases, the
individual or corporation will be subject to the rules of the proposed
regulations if the individual or corporation is the owner of a section
987 QBU. A section 987 QBU is defined in Sec. 1.987-1(b)(2) as an
eligible QBU that has a functional currency different from its owner.
An eligible QBU is defined in Sec. 1.987-1(b)(3) of the proposed
regulations. Generally, an eligible QBU is an activity of an
individual, corporation, partnership or DE that is a trade or business
as defined in Sec. 1.989(a)-1(c); maintains separate books and records
as defined in Sec. 1.989(a)-1(d) and assets and liabilities used in
conducting such activities are reflected on such books and records; and
the activities are not subject to the dollar approximate separate
transaction (DASTM) rules of Sec. 1.985-3. A corporation is not an
eligible QBU. An individual is not a QBU under Sec. 1.989(a)-
1(b)(2)(i) and therefore cannot be an eligible QBU. In addition, and as
discussed in this preamble, neither a partnership nor a DE is an
eligible QBU.
In the case of ownership other than through a partnership (that is,
direct ownership), the individual or corporation is treated as the
owner of an eligible QBU if the individual or corporation is the tax
owner of the assets and liabilities of the eligible QBU. For purposes
of determining direct ownership, an individual or corporation will be
treated as a direct owner of the assets and liabilities of an eligible
QBU if it owns a DE that holds an eligible QBU. In such case, because
the DE is not recognized as a separate entity, it cannot be a QBU under
section 989 and, therefore, is not treated as an eligible QBU under the
proposed regulations. However, the activities of the DE, which are
treated for purposes of the Code as carried on directly by its owner,
can qualify as an eligible QBU of the DE's owner.
With respect to partnerships, the IRS and the Treasury Department
recognize that issues often arise as to whether the international tax
provisions of the Code operate on an aggregate or an entity basis. The
legislative history of subchapter K of chapter 1 of the Code provides
that, for purposes of interpreting Code provisions outside of that
subchapter, a partnership may be treated as either an entity separate
from its partners or an aggregate of its partners, depending on which
characterization is more appropriate to carry out the purpose of the
particular section under consideration. H.R. Conf. Rep. No. 2543, 83rd
Cong. 2d. Sess. 59 (1954).
In the case of section 987, the calculations under the foreign
exchange exposure pool method would differ dramatically based on
whether an aggregate or an entity approach is adopted. For example, if
the foreign exchange exposure pool method is applied at the entity
level, the partnership will make the method's calculations by reference
to the partnership's functional currency. Under this approach, any
foreign currency gain or loss will be an item of the partnership and
will be allocated among the partners in accordance with the partnership
agreement, to the extent such allocation is consistent with the
provisions of subchapter K. If, in the alternative, the foreign
exchange exposure pool method is applied under an aggregate approach,
each partner will make its own foreign exchange exposure pool
calculations by reference to the partner's functional currency and such
amounts will not be subject to separate allocation under subchapter K.
The IRS and the Treasury Department believe that, on balance, an
aggregate approach is more appropriate for section 987 purposes.
Applying the foreign exchange exposure pool method directly at the
partner level will more appropriately preserve the correct amounts of
exchange gain or loss. In addition, such approach will measure the
foreign currency exposure by reference to the functional currencies of
the persons who generally bear the economic risk from such exposure. As
a result, the proposed regulations provide that for purposes of
applying the foreign exchange exposure pool method each individual or
corporation that is a partner in a partnership will be considered to
own indirectly an eligible QBU consisting of a portion of the assets
and liabilities of the partnership allocated to it under Sec. 1.987-7.
If such eligible QBU has a different functional currency from the
partner and therefore is a section 987 QBU, the foreign exchange
exposure pool method is applied with respect to those assets and
liabilities. In addition, the proposed regulations provide rules for
converting the items of section 987 taxable income or loss of a section
987 QBU into the functional currency of the partner (when necessary),
and rules coordinating this aggregate approach with other provisions of
subchapter K.
Section 1.987-1(b)(2)(ii) allows an owner to elect to treat certain
section 987 QBUs with the same functional currency as a single section
987 QBU. The purpose of this rule is to simplify section 987
calculations by reducing the number of interbranch transactions that
would be considered as ``transfers'' of assets and liabilities. This
election applies only to certain section 987 QBUs of the owner. The IRS
and the Treasury Department request comments regarding whether such
election should be available to treat section 987 QBUs of owners that
are members of a consolidated group as a single section 987 QBU and how
this should be technically effectuated.
Section 1.987-1(b)(5) provides that the term ``owner'' for section
987 purposes does not include an eligible QBU or section 987 QBU of an
owner. Under this rule, a tiered ownership structure of eligible QBUs
and/or section 987 QBUs will not be respected as distinct tiers of QBUs
for purposes of section 987. Rather, tiers of eligible and/or section
987 QBUs will be treated as a ``flat'' structure, with each QBU in the
tier considered as owned directly by the ultimate non-QBU owner. For
example, if a domestic corporation is the holder of the interests in a
section 987 DE (section 987 DE1) and that DE owns the interests in
another section 987 DE (section 987 DE2) for purposes other than U.S.
tax law, the structure will not be treated as a tier of QBUs for
purposes of section 987. Rather, the domestic corporation will be
considered the direct holder of the interests in the section 987
branches of section 987 DE1 and DE2. This flat structure, which is
consistent with the general approach taken in the proposed dual
consolidated loss regulations (70 FR 29868-29907), is expected to be
easier to administer for both taxpayers and the IRS and to provide more
appropriate results under the section 987 rules.
3. De Minimis Rule for Certain Indirectly Owned Section 987 QBUs
The IRS and the Treasury Department recognize that it may be
administratively burdensome for taxpayers to apply certain aspects of
the proposed regulations to section 987 QBUs indirectly owned through
[[Page 52882]]
relatively small interests in partnerships. As a result, the proposed
regulations provide a de minimis election for certain indirectly owned
section 987 QBUs. Under this rule, an individual or corporation that
owns a section 987 QBU indirectly through a partnership may elect not
to take into account the section 987 gain or loss of such section 987
QBU, provided such individual or corporation owns, directly or
indirectly, less than five percent of the section 987 partnership.
Constructive ownership rules apply for purposes of determining whether
the less than five percent ownership threshold is satisfied.
This de minimis exception only applies to recognition of section
987 gain or loss with respect to a section 987 QBU. Thus, owners of
section 987 QBUs that qualify under the de minimis exception must
comply with all other aspects of the proposed regulations, including
the requirement to take into account the section 987 taxable income or
loss with respect to such section 987 QBUs.
An individual or corporation that qualifies for the election (that
is, because they owned less than five percent of a section 987
partnership) subsequently may fail to qualify as a result of an
increase in their interest in a section 987 partnership. In such a
case, taxpayers must begin taking into account the section 987 gain or
loss with respect to section 987 QBUs owned through such partnerships.
Similarly, taxpayers that were required to take into account section
987 gain or loss with respect to an indirectly owned section 987 QBU
may reduce their ownership such that they become eligible for the de
minimis exception and, as a result, may elect to no longer take into
account section 987 gain or loss. The IRS and the Treasury Department
recognize that transition issues will arise when interests in section
987 partnerships change such that individuals or corporations no longer
qualify (or are able to qualify) for the de minimis exception. The IRS
and the Treasury Department are considering such transition rules and
request comments as to their application.
4. Exchange Rates
Section 1.987-1(c)(1)(i) defines the spot rate as the rate
determined under the principles of Sec. 1.988-1(d)(1), (2) and (4) on
the relevant day. Section 1.987-1(c)(1)(ii) allows taxpayers to elect
to use spot rate conventions that reasonably approximate the spot rate
on a particular day. It is anticipated that taxpayers will be able to
conform the spot rate convention for section 987 to the spot rate
conventions used under FAS 52 for financial accounting purposes. This
is intended to simplify the calculations required under section 987.
In a similar attempt to simplify calculations, Sec. 1.987-1(c)(2)
defines the yearly average exchange rate as an average exchange rate
for the taxable year computed under any reasonable method that is
consistently applied.
Finally, Sec. 1.987-1(c)(3) defines the historic exchange rate by
reference to the spot rate on the day that assets are transferred to
(or acquired by) the section 987 QBU, or on the day that liabilities
are assumed (or entered into) by the section 987 QBU. The reference to
the spot rate as defined in Sec. 1.987-1(c)(1)(i) and (ii) allows
taxpayers to elect to use spot rate conventions for these purposes.
5. Definitions of a Section 987 Marked Item and a Section 987 Historic
Item
The definitions of a section 987 marked item and a section 987
historic item are central to the foreign exchange exposure pool method.
When taken into account in the context of the calculation of net
unrecognized section 987 gain or loss under Sec. 1.987-4, the
definitions distinguish those items that generate section 987 gain or
loss from those that do not. The IRS and the Treasury Department
believe that section 988 identifies those items properly treated as
giving rise to exchange gain or loss for purposes of section 987. Thus,
a marked item as defined in Sec. 1.987-1(d) is an asset or liability
reflected on the books and records of the section 987 QBU that both (1)
Would generate section 988 gain or loss if held or entered into
directly by the owner of the section 987 QBU and (2) is not a section
988 transaction to the section 987 QBU. It is important to exclude
section 988 transactions of a section 987 QBU because section 988
already requires the section 987 QBU to recognize gain or loss from
such transactions. Thus, treating such transactions as marked items for
purposes of section 987 would result in double counting. Marked items
give rise to exchange gain or loss under section 987. Historic items,
which are defined in Sec. 1.987-1(e) as items other than marked items,
do not give rise to exchange gain or loss under section 987.
6. Elections Under Section 987
Section 1.987-1(f) provides rules for making elections under
section 987. In general, the elections made under section 987 must be
made by the owner of the section 987 QBU. The elections must be made
with respect to a section 987 QBU for the first taxable year in which
the election is relevant, and must be made by attaching a statement to
a timely filed tax return for such taxable year. Elections under
section 987 are treated as methods of accounting and are governed by
the general rules regarding changes in methods of accounting.
The IRS and the Treasury Department believe that a reasonable cause
standard should be applied to determine whether taxpayers that fail to
make a timely election are eligible for an extension of time to file
elections pursuant to Sec. 1.987-1(f) of the proposed regulations. As
a result, extensions of time under Sec. Sec. 301.9100-1 through
301.9100-3 will not be granted for filings under the proposed
regulations. See Sec. 301.9100-1(d).
Under the reasonable cause standard, if an owner that is permitted
to file an election under the proposed regulations fails to make such a
filing in a timely manner, the owner is considered to have satisfied
the timeliness requirement with respect to such filing if it
demonstrates, to the satisfaction of the Area Director, Field
Examination, Small Business/Self Employed or the Director, Field
Operations, Large and Mid-Size Business (Director) having jurisdiction
of the taxpayer's return for the taxable year, that such failure was
due to reasonable cause and not willful neglect. Once the owner becomes
aware of the failure, the owner must demonstrate reasonable cause and
must satisfy the filing requirement by attaching the election to an
amended tax return (that amends the tax return to which the election
should have been attached). A written statement must be included that
explains the reasons for the failure to comply.
In determining whether the taxpayer has reasonable cause, the
Director shall consider whether the taxpayer acted reasonably and in
good faith. Whether the taxpayer acted reasonably and in good faith
will be determined after considering all the facts and circumstances.
The Director shall notify the person in writing within 120 days of the
filing if it is determined that the failure to comply was not due to
reasonable cause or if additional time will be needed to make such
determination. If the Director fails to notify the owner within 120
days of the filing, the owner shall be considered to have demonstrated
to the Director that such failure was due to reasonable cause and not
willful neglect.
The proposed regulations provide that elections under section 987
cannot be revoked without the consent of the Commissioner. In addition,
the proposed regulations provide that the
[[Page 52883]]
Commissioner will consider allowing revocation of such an election if
the taxpayer demonstrates significantly changed circumstances, or other
circumstances that demonstrate a substantial non-tax business reason
for such revocation. Finally, the IRS and the Treasury Department are
considering an exception to the general revocation rule where a section
987 QBU is acquired in certain transactions that do not result in the
termination of such QBU. Comments are requested as to whether such an
exception is warranted and, if so, the appropriate scope of such an
exception.
B. Section 1.987-2 Attribution of Items to an Eligible QBU; the
Definition of a Transfer, and Related Rules
1. Attribution of Items to an Eligible QBU
i. Overview
A section 987 QBU is not itself a taxpayer and does not have its
own taxable income. Items of income, gain, deduction and loss must
nonetheless be attributed to such section 987 QBU for purposes of
determining the owner's taxable income. The items of income, gain,
deduction and loss attributed to a section 987 QBU are generally
determined in the functional currency of the section 987 QBU and then
translated into the functional currency of the owner. The aggregate
translated amount is the section 987 taxable income or loss of the
section 987 QBU. Thus, attribution rules are necessary to determine
which items of income, gain, deduction and loss are attributed to the
section 987 QBU.
Under section 987(3), assets and liabilities must be attributed to
a section 987 QBU in order to determine the amount of section 987 gain
or loss of such QBU. In some cases, a section 987 QBU of a taxpayer
will not be held through an entity separate from the taxpayer that can
legally own assets and incur liabilities. In addition, not all the
assets and liabilities of an entity that is separate from the taxpayer
may be attributable to a section 987 QBU for purposes of section 987.
Moreover, assets and liabilities may constitute a section 987 QBU of a
taxpayer even when such assets and liabilities are owned or incurred by
separate legal entities. As a result, assets and liabilities of the
taxpayer (or of entities owned by the taxpayer that are not themselves
taxpayers) must be attributed to the section 987 QBU.
Neither section 987 nor the underlying legislative history provides
explicit rules for attributing a taxpayer's items of income, gain,
deduction, or loss to a section 987 QBU to determine the QBU's section
987 taxable income or loss. Similarly, no explicit rules are provided
in the statute or legislative history for attributing a taxpayer's
assets or liabilities to a section 987 QBU to determine the section 987
gain or loss of such QBU.
Other provisions of the Code provide various methods for
attributing or allocating a taxpayer's assets and liabilities, or items
of income, gain, deduction and loss (items) for particular purposes.
These provisions provide complex rules for making such determinations
and, in many cases, require a detailed analysis of various factors and
relationships involving income, assets, and activities of the taxpayer.
For example, section 864(c) and the regulations thereunder provide
rules for determining the income, gain, deduction, or loss of a
nonresident alien individual or foreign corporation which are treated
as effectively connected with the conduct of a trade or business within
the United States. Other examples are Sec. Sec. 1.882-5, 1.861-8 and
1.861-9T through 1.861-13T. These regulations provide rules for the
allocation and apportionment of expenses, losses, and other deductions
of a taxpayer. Finally, section 884(c)(2) and Sec. 1.884-1(d) and (e)
provide rules for determining U.S. assets and U.S. liabilities of a
foreign corporation for purposes of the branch profits tax. As
discussed below, the IRS and the Treasury Department do not believe
these complex methodologies are appropriate for purposes of section
987.
ii. Books and Records Method--General Rule
The IRS and the Treasury Department believe that items should be
attributed to an eligible QBU (and, if all or a portion of such
eligible QBU has a different functional currency than its owner, to a
section 987 QBU of such owner) to the extent they are reflected on the
books and records of the eligible QBU (books and records method). The
IRS and the Treasury Department believe that using a books and records
method for attributing items under section 987 is consistent with other
provisions of the Code involving foreign currency transactions. For
example, it is consistent with the requirement under section 989(a)
that a QBU maintain books and records separate from the taxpayer. It is
also consistent with the requirement under section 985(b)(1) that, in
order to have a functional currency other than the dollar, a QBU must
keep its books and records in such currency. Moreover, the IRS and the
Treasury Department believe the books and records method is
administrable for both taxpayers and the Commissioner. This is the case
because the books and records method should be consistent with the
taxpayer's accounting treatment of the items and, unlike the methods
discussed above, it does not require a complex and factually intensive
analysis of the circumstances and activities of the eligible QBU.
For the reasons described above, the proposed regulations adopt a
books and records method for allocating items to an eligible QBU. The
proposed regulations provide that, subject to certain exceptions, items
are attributable to an eligible QBU to the extent they are reflected on
the separate set of books and records of such eligible QBU, as defined
in Sec. 1.989(a)-1(d). The proposed regulations make clear that these
rules apply solely for purposes of section 987. Thus, for example, the
attribution rules contained in the proposed regulations do not apply
for purposes of allocating and apportioning interest expense under
section 864(e).
iii. Exception for Non-Portfolio Stock, Interests in Partnerships and
Certain Acquisition Indebtedness
As discussed above, the IRS and the Treasury Department believe
that the assets and liabilities reflected on the books and records of
an eligible QBU are a reasonable approximation of the assets and
liabilities that are used in the trade or business of the eligible QBU
and, therefore, should be taken into account for purposes of section
987. However, the IRS and the Treasury Department believe that certain
assets and liabilities should not be attributed to an eligible QBU,
even if such assets and liabilities are reflected on the books and
records of such QBU. The IRS and the Treasury Department believe that
non-portfolio stock and interests in partnerships (and liabilities to
acquire such assets), even if reflected on the books and records of the
eligible QBU, should not be attributed to such QBU for purposes of
section 987. This is consistent with the principle stated above that a
section 987 QBU cannot be an owner of another section 987 QBU.
Excluding non-portfolio stock is also consistent with the principle
that non-portfolio stock cannot be used in, or held for the use in, the
conduct of a trade or business in the United States. See Sec. 1.864-
4(c)(2)(iii).
As a result, the proposed regulations provide that stock of a
corporation (whether domestic or foreign) and an interest in a
partnership (whether domestic or foreign) are not considered to be on
the books and records of an eligible QBU. The proposed regulations
[[Page 52884]]
provide an exception, however, for portfolio stock where the owner of
the eligible QBU owns (directly or constructively) less than ten
percent of the total voting power or value of the stock of such
corporation. The proposed regulations also provide that indebtedness
incurred to acquire stock or a partnership interest that is not treated
as being reflected on the books and records of an eligible QBU should
similarly be excluded from the books and records. Finally, the proposed
regulations provide that items of income, gain, deduction and loss
arising from ownership of stock, a partnership interest, or related
acquisition indebtedness that is excluded from the general books and
records rule, shall similarly not be treated as being on the books and
records of the eligible QBU.
iv. Coordination With Source Rules Under Section 988
Section 988(a)(3) provides that the source of gain or loss
recognized under section 988(a)(1) is determined by reference to the
residence of the taxpayer or the QBU of the taxpayer on whose books the
asset, liability, or item of income or expense is properly reflected.
Section 1.988-4(b)(2) provides that, in general, the determination of
whether an asset, liability, or item of income or expense is properly
reflected on the books of a QBU is a question of fact. The regulations
under section 988 further provide that such items are presumed not to
be properly reflected on the books and records for this purpose if
inconsistent booking practices are employed with respect to the same or
similar items. Finally, the regulations provide that if such items are
not properly reflected on the books of the QBU, the Commissioner may
allocate the item between or among the taxpayer and its QBUs to
properly reflect the source (or realization) of exchange gain or loss.
The IRS and the Treasury Department believe that rules for
determining whether items are properly reflected on the books of a QBU
for purposes of sourcing section 988 gain or loss should be consistent
with the rules for attributing items to an eligible QBU under section
987. As a result, the proposed regulations modify the sourcing rules in
the section 988 regulations to provide that the principles of Sec.
1.987-2(b) apply in determining whether an asset, liability, or item of
income or expense is properly reflected on the books of a QBU.
2. Certain Assets and Liabilities of Partnerships and DEs Not
Attributable to an Eligible QBU
Section 988 applies to certain transactions described in section
988(c) if the transaction is denominated (or determined by reference
to) a currency that is not the functional currency of the taxpayer or
QBU of the taxpayer. Thus, in order to determine if a transaction is
subject to section 988, it must be determined whether a transaction is
attributable to the taxpayer or a QBU of the taxpayer.
Under the current section 989 regulations, a partnership is a QBU
even if it does not have activities that constitute a trade or business
(``per se QBU''). As a result, a partnership may have a functional
currency different than its partners and section 988 is applied at the
partnership level with respect to section 988 transactions properly
attributable to the partnership. These regulations propose to amend
section 989 to provide that a partnership is no longer a per se QBU of
its partners, but instead the activities of such partnership may be
treated as a QBU.
As discussed above, the IRS and the Treasury Department will
generally apply either an entity or an aggregate approach with respect
to partnerships depending on which approach more appropriately carries
out the purpose of the particular Code section under consideration.
Following the amendments made by the proposed regulations, and because
only certain activities of a partnership (and not the partnership
itself) can qualify as a section 987 QBU, the IRS and the Treasury
Department believe that it is appropriate, in cases where an asset or
liability of a partnership is not reflected on the books and records of
an eligible QBU of the partnership, to determine whether section 988
applies by reference to the functional currencies of the partners. The
IRS and the Treasury Department believe that this rule will have
limited application and will apply, for example, where the only
activity of a partnership is the incurrence of a liability used to
acquire stock that is held by the partnership. The proposed regulations
provide examples illustrating the application of this rule.
As discussed above, the proposed regulations provide that a DE
itself is not an eligible QBU and, instead, certain activities of the
DE will be treated as an eligible QBU of the owner to the extent a
separate set of books and records with respect to such activities are
maintained. Thus, an issue similar to that discussed above with respect
to partnerships will arise where the DE is the local law owner of
certain assets or the local law obligor on certain liabilities, which
are not reflected on the books and records of an eligible QBU held by
the DE. The proposed regulations provide that the determination of
whether section 988 (rather than section 987) applies with respect to
transactions involving assets and liabilities of a DE that are not
attributable to an eligible QBU is determined by reference to the
functional currency of the owner of such DE.
3. Definition of a Transfer
i. Overview
Section 987(3) provides, in part, that taxable income of a taxpayer
shall be determined by making proper adjustments (as prescribed by the
Secretary) for transfers of property between qualified business units
of the taxpayer having different functional currencies. Similarly, the
legislative history to section 987 refers to contributions to, and
remittances from, QBUs. See, H.R. Conf. Rep. No. 841, 99th Cong. 2d.
Sess. II 673-76 (1986). However, neither the statute nor the
legislative history defines the terms ``transfer,'' ``contribution,''
or ``remittance.''
As noted above, section 987 QBUs can be divisions of an owner that
have no legal distinction separate from their owner. Section 987 QBUs
can also be owned indirectly through partnerships, where they have
legal distinction separate from their owners. Moreover, as a result of
the entity classification regulations, a section 987 QBU held through a
DE can have legal distinction separate from its owner, even though the
section 987 QBU is treated as a division of the owner for federal
income tax purposes. As a result, assets and liabilities can be
transferred between an owner and a section 987 QBU in a manner that has
legal significance (that is, a distribution from a section 987
partnership), or in a manner that has no legal significance because the
transfers are simply between divisions of the same legal entity (that
is, a transfer involving divisions of a taxpayer that is reflected
through accounting entries).
ii. Disregarded Transactions
The definition of a transfer under the proposed regulations
includes transactions that are regarded for both legal and tax
purposes, and transactions that are regarded for legal purposes, but
disregarded as transactions for tax purposes (``disregarded
transactions''). For this purpose, the term disregarded transaction is
treated as including the
[[Page 52885]]
recording of an asset or liability on one set of books and records, if
the recording is the result of such asset or liability being removed
from another set of books and records of the same person or entity
(including a DE or partnership).
The proposed regulations provide that an asset or liability is
treated as transferred to or from a section 987 QBU if, as a result of
a disregarded transaction, such asset or liability is reflected, or is
not reflected, respectively, on the books and records of the section
987 QBU. For example, if an owner of a section 987 DE loans cash to the
section 987 QBU held by the section 987 DE, the loan is disregarded for
Federal income tax purposes. However, as a result of such disregarded
transaction, the loaned cash is reflected on the books and records of
the section 987 QBU and, therefore, is treated as transferred to such
section 987 QBU.
iii. Certain Contributions to, and Distributions From, Partnerships
The proposed regulations also provide that transfers to and from
section 987 QBUs include certain contributions of assets to, or
distributions of assets from, a section 987 partnership. For example,
an asset contributed by a partner to a section 987 partnership is
treated as transferred to an indirectly owned section 987 QBU of the
partner if the asset is reflected on the section 987 QBU's books and
records following such contribution. The proposed regulations provide
similar rules for assumptions of liabilities between a section 987
partnership and its partners.
iv. Certain Acquisitions and Dispositions of Interests in DEs and
Partnerships
The proposed regulations also provide that transfers to or from a
section 987 QBU may occur as a result of certain acquisitions
(including by contribution) and dispositions of interests in DEs and
partnerships. For example, if a partner in a section 987 partnership
sells a portion of its interest in such partnership, the sale results
in a transfer from the partner's indirectly owned section 987 QBU to
the extent assets and liabilities are not reflected on the books and
records of such QBU as a result of such sale.
v. Change in Form of Ownership
The owner of a section 987 QBU can change its form of ownership in
all or a portion of such section 987 QBU. Such changes in form of
ownership often occur in a manner that does not affect the operation of
the eligible QBU (or its status as an eligible QBU), but rather only
changes the owner's interest in its section 987 QBU. For example, a
direct owner of a section 987 QBU that is owned through a section 987
DE can change to being an indirect owner of all or a portion of such
section 987 QBU, if the interests in the section 987 DE are transferred
to a partnership.
Changes in form of ownership of a section 987 QBU can occur through
actual or deemed transactions involving the section 987 QBU itself, or
actual or deemed transactions involving interests in a section 987 DE
or section 987 partnership that owns such QBU. For example, certain
conversions of DEs to partnerships, or partnerships to DEs, result in
deemed transactions pursuant to Rev. Ruls. 99-5, 1999-1 CB 434, and 99-
6, 1999-1 CB 432. See Sec. 601.601(d)(2). Deemed transactions with
respect to partnerships also occur pursuant to section 708(b) and the
regulations thereunder.
The IRS and the Treasury Department believe that changes in form of
ownership should result in a transfer only to the extent such change
affects the assets and liabilities attributable to the section 987 QBU
of the owner. As a result, the proposed regulations provide that a mere
change in form of ownership of a section 987 QBU does not result in a
transfer to or from the section 987 QBU. Instead, the proposed
regulations provide that the determination of whether a transfer has
occurred in such cases should be made under the general transfer rules,
discussed above. Moreover, the proposed regulations clarify that deemed
transactions (for example, pursuant to Rev. Ruls. 99-5 and 99-6) shall
not be taken into account for purposes of determining whether there is
a transfer.
vi. General Tax Law Principles
The proposed regulations clarify that general tax law principles,
including the circular cash flow, step-transaction, and substance-over-
form doctrines apply for purposes of determining whether there is a
transfer of an asset or liability to or from a QBU. For example, if a
shareholder of a corporation that directly owns a section 987 QBU
transfers property to the corporation and the property is recorded on
the books and records of the corporation's section 987 QBU, the
shareholder is first treated as transferring the property to the
corporation, and then the corporation is treated as transferring the
property to the section 987 QBU in a disregarded transaction.
4. Adjustments to Items Reflected on the Books and Records
As noted above, a section 987 QBU of a taxpayer may not be an
entity separate from the taxpayer that can legally own assets and incur
liabilities. As a result, recording (or failing to record) an asset or
liability on the books and records may, other than for purposes of
section 987, have little significance for tax or legal purposes. In
addition, transfers between section 987 QBUs of the same owner that are
divisions of the same legal entity may have no legal significance and
are accomplished only through journal entries on the books and records
of such section 987 QBUs. As a result, the IRS and the Treasury
Department are concerned that, in certain circumstances, transfers to
or from a section 987 QBU may be structured solely to achieve
advantages under section 987, especially given that such transfers may
have little or no significance from a legal or business perspective.
In Notice 2000-20, the IRS and the Treasury Department expressed
similar concerns in connection with taxpayers taking positions that
certain contributions and distributions triggered foreign currency
losses prematurely with respect to transactions that were undertaken
for tax purposes, but lacked meaningful non-tax economic consequences.
The notice provided that the IRS and the Treasury Department believe
that circular cash flows and similar transactions lacking economic
substance will not result in recognition of foreign currency losses
under general tax principles because such transactions are not properly
treated as transfers or remittances under section 987.
The IRS and the Treasury Department continue to be concerned about
transactions that are undertaken for tax purposes and lack meaningful
non-tax economic consequences. As a result, the proposed regulations
provide the Commissioner the ability to allocate assets and
liabilities, and items of income, gain, deduction and loss, where a
principal purpose of recording (or failing to record) an item on the
books and records of an eligible QBU (including an eligible QBU owned
indirectly through a partnership) is the avoidance of U.S. tax under
section 987. The proposed regulations also provide various factors that
indicate whether recording (or failing to record) an item on books and
records has as a principal purpose the avoidance of U.S. tax under
section 987. For example, factors indicating that such tax avoidance
was not a principal purpose of recording (or not recording) an item
include doing so
[[Page 52886]]
for a substantial and bona fide business purpose, or in a manner that
is consistent with the economics of the underlying transaction.
5. Translation of Items Transferred to a Section 987 QBU
The proposed regulations provide translation rules for the transfer
of assets and liabilities to a section 987 QBU. Under the proposed
regulations, if an asset or a liability is transferred to a section 987
QBU, such items are translated into the QBU's functional currency at
the spot rate on the day of transfer. No translation is required for
assets or liabilities denominated in the functional currency of the
section 987 QBU.
The proposed regulations provide special rules for items
transferred to a section 987 QBU where such items are denominated in
(or determined by reference to) the owner's functional currency. Such
items are not translated and instead are carried on the balance sheet
in the owner's functional currency since no foreign currency exposure
with respect to the owner is created by such items.
6. Interaction With Other Foreign Currency Provisions
The IRS and the Treasury Department are considering whether the
attribution and transfer rules provided under the proposed regulations
should apply with respect to other foreign currency provisions in the
Code. For example, the IRS and the Treasury Department are considering
whether the attribution rules under the proposed regulations should
apply to determine the functional currency of a QBU under section 985.
As a result, comments are requested on the interaction of these rules
with other foreign currency provisions.
C. Section 1.987-3 Determination of the Items of Aection 987 Taxable
Income or Loss of an Owner of a Section 987 QBU
In general, the term ``section 987 taxable income'' refers to the
items of income, gain, deduction or loss attributed to the section 987
QBU under Sec. 1.987-2(b), translated into the functional currency of
the owner. The allocation of expenses such as interest under other
provisions are not taken into account for this purpose. Section 987
taxable income is calculated by determining each item of income, gain,
deduction or loss in the section 987 QBU's functional currency under
Sec. 1.987-3(a), and then translating those items into the owner's
functional currency using the exchange rates provided in Sec. 1.987-
3(b). Items of income, gain, deduction or loss of a section 987 QBU
that are denominated in (or determined by reference to) the functional
currency of the owner are not translated and are not treated as section
988 transactions to the section 987 QBU. Transactions denominated in
(or determined by reference to) a currency that is neither the
functional currency of the owner nor of the section 987 QBU are subject
to the generally applicable rules under section 988 determined with
respect to the functional currency of the section 987 QBU.
When basis recovery is required with respect to an historic asset,
either in computing gain or loss on the sale or exchange of such asset,
or in determining cost recovery deductions (such as depreciation or
depletion), the proposed regulations require the use of the historical
exchange rate associated with the particular asset. Thus, for example,
where a section 987 QBU sells an historic asset, the amount realized
will be translated into the owner's functional currency using the
yearly average exchange rate (or, if properly elected, the spot rate),
but the adjusted basis will be translated using the historic exchange
rate associated with that asset. The use of different exchange rates
for amount realized and adjusted basis is designed to more closely
reflect the economic gain or loss to the owner of the section 987 QBU
than the 1991 proposed regulations. The same is true for depreciation
or other cost recovery deductions that are claimed with respect to
historic assets of a section 987 QBU.
Special translation rules are provided with respect to the
disposition of marked assets (other than functional currency cash of
the section 987 QBU). Generally, the amount realized and basis are
translated at the same exchange rates. The purpose of these special
rules is to assure that foreign currency gain or loss (as opposed to
gain or loss not related to movements in exchange rates) is reflected
through the balance sheet calculations of Sec. 1.987-4 and not through
the profit and loss calculations of Sec. 1.987-3. Cash is not included
in these special rules because the disposition of cash cannot generate
profit or loss to the section 987 QBU for purposes of Sec. 1.987-3.
D. Section 1.987-4 Determination of Net Unrecognized Section 987 Gain
or Loss of a Section 987 QBU
Section 1.987-4 provides the mechanics for determining ``net
unrecognized section 987 gain or loss'' and, when combined with Sec.
1.987-5, form the mathematical core of the foreign exchange exposure
pool method. In summary, Sec. 1.987-4 uses a balance sheet to
distinguish the items of a section 987 QBU that give rise to section
987 gain or loss (section 987 marked items) from those that do not
(section 987 historic items). This approach avoids the distortions
caused by the 1991 proposed regulations that impute section 987 gain or
loss to all assets of a section 987 QBU, even those assets the value of
which does not fluctuate with currency movements. Generally, annual
comparison of the change in the value of section 987 marked items on
the opening and closing balance sheets due to changes in exchange rates
gives rise to unrecognized section 987 gain or loss. This unrecognized
section 987 gain or loss is aggregated with similar amounts determined
for prior years (to the extent not previously taken into account) and
is taken into account by the owner under the rules of Sec. 1.987-5
upon a remittance by the section 987 QBU.
Under Sec. 1.987-4(a) and (b), net unrecognized section 987 gain
or loss is computed annually and is equal to the sum of the
``unrecognized section 987 gain or loss for the current taxable year''
and the ``net accumulated unrecognized section 987 gain or loss for all
prior taxable years.'' A section 987 QBU's net accumulated unrecognized
section 987 gain or loss for all prior taxable years is the aggregate
of the unrecognized section 987 gain or loss determined under Sec.
1.987-4(d) for all prior taxable years (to which these regulations
apply) reduced by the amounts taken into account under Sec. 1.987-5
upon a remittance for all such taxable years. For section 987 QBUs in
existence prior to the effective date of these regulations, a section
987 QBU's net accumulated unrecognized section 987 gain or loss
includes amounts taken into account under the transition rules of Sec.
1.987-10.
Unrecognized section 987 gain or loss is determined under a seven
step calculation. Under the first step in Sec. 1.987-4(d)(1), the
``owner functional currency net value'' of the section 987 QBU is
determined under Sec. 1.987-1(e) at the close of the taxable year in
the functional currency of the owner. This is a balance sheet
calculation under which the basis (or amount, in the case of a
liability) of each section 987 marked item is translated into the
owner's functional currency at the spot rate on the last day of the
taxable year. Section 987 historic items are translated into the
owner's functional currency at the historic exchange rate and,
therefore, do not give rise to exchange gain or loss. The amount of
liabilities determined in the owner's functional currency is subtracted
from the value of the assets
[[Page 52887]]
determined in the owner's functional currency to result in the owner
functional currency net value of the section 987 QBU at the close of
the taxable year. The owner functional currency net value of the
section 987 QBU at the close of the preceding taxable year is
subtracted from the owner functional currency net value of the section
987 QBU at the close of the current taxable year to yield the change in
owner functional currency net value of the section 987 QBU for the
taxable year expressed in the owner's functional currency.
Generally, three components are reflected in the change in owner
functional currency net value of the section 987 QBU for a taxable
year. First, taxable income or loss of the section 987 QBU will result
in increases or decreases in net assets, and will therefore affect net
value. Second, transfers of assets or liabilities to or from the
section 987 QBU will affect net value. Finally, any remaining change in
net value (as measured in the owner's functional currency) results from
changes in the value of the section 987 QBU's marked assets and
liabilities. In order to isolate the change in value due to foreign
currency movements with respect to section 987 marked assets and
liabilities, the other changes must be reversed out. That is the
function of steps 2 through 7 of Sec. 1.987-4(d).
The unrecognized section 987 gain or loss when aggregated with
similar amounts for prior years (that were not previously taken into
account) yields a pool of ``net unrecognized section 987 gain or loss''
all or part of which is to be triggered upon a remittance or
termination.
E. Section 1.987-5 Recognition of Section 987 Gain or Loss
Section 1.987-5 of the proposed regulations provides the method for
determining the amount of section 987 gain or loss a taxpayer must
recognize in a taxable year. Generally, the amount of section 987 gain
or loss recognized in a taxable year equals the net unrecognized
section 987 gain or loss of the section 987 QBU determined under Sec.
1.987-4 on the last day of such taxable year, multiplied by the owner's
remittance proportion. The pool of net unrecognized section 987 gain or
loss includes both unrecognized section 987 gain or loss on marked
items for the current year and unrecognized section 987 gain or loss on
marked items for prior years (that has not yet been taken into
account). A portion of the Sec. 1.987-4 pool of unrecognized section
987 gain or loss is triggered by a net transfer or ``remittance'' to
the owner by a section 987 QBU during the owner's taxable year.
Generally, the owner's remittance proportion is equal to the quotient
of the amount of the remittance divided by the aggregate adjusted basis
of the section 987 QBU's gross assets (as reflected on its year end
balance sheet), without reduction for the remittance.
The 1991 proposed regulations define a remittance as the amount of
any transfer from a QBU branch to the extent the amount of transfers
during the year does not exceed the year end balance of the equity
pool. Transfers are limited in the 1991 proposed regulations by a daily
netting rule that takes into account only the amount of property
distributed from the QBU branch that exceeds the amount of property
transferred by the taxpayer to the QBU branch in a single day. The IRS
and the Treasury Department believe that the daily netting rule of the
1991 proposed regulations is not easily administered and causes
distortions in the amount of a remittance. For example, taxpayers have
taken the position that a remittance followed a short time later by an
equal contribution to a QBU branch can trigger recognition of section
987 gain or loss even though there has been no economic change in
position of the QBU branch. The IRS and the Treasury Department believe
this approach is inappropriate and provides incentives for circular
cash flows used to manipulate amounts of remittances. This daily
netting rule is eliminated in the proposed regulations to reduce
administrative burdens on both the IRS and taxpayers, and to eliminate
both taxpayer favorable and taxpayer unfavorable distortions that it
can create.
Section 1.987-5(c) of the proposed regulations defines a remittance
as the excess of total transfers from the section 987 QBU to the owner
determined in the owner's functional currency on an annual basis over
total transfers from the owner to the section 987 QBU determined on an
annual basis. Solely for purposes of determining the amount of a
remittance under Sec. 1.987-5(c), the amount of liabilities
transferred from the owner to the section 987 QBU is treated as a
transfer of assets from the section 987 QBU to the owner. Similarly,
the amount of liabilities transferred from the section 987 QBU to the
owner is treated as a transfer of assets from the owner to the section
987 QBU. The IRS and the Treasury Department recognize that section 987
QBUs actively engaged in business may have a significant number of
transactions that are treated as transfers to and from the owner
pursuant to Sec. 1.987-2(c). It is anticipated that the annual netting
rule will help to reduce complexity and administrative burden for
taxpayers and the IRS by treating the net amount of transfers as a
single annual remittance. For purposes of determining the annual
remittance, only assets and liabilities considered transferred pursuant
to Sec. 1.987-2(c) will be taken into account.
The remittance is divided by the total adjusted basis of section
987 gross assets, expressed in the functional currency of the owner,
reflected on the section 987 QBU balance sheet pursuant to Sec. 1.987-
2 (increased by the amount of the remittance) to determine the
remittance proportion. The IRS and the Treasury Department considered a
number of different measures for determining the amount of section 987
gain or loss triggered upon a remittance. The adjusted basis of gross
section 987 QBU assets was selected as the measure because it avoids
administrative concerns raised by alternative methods and limits the
potential volatility associated with the recognition of section 987
gain or loss. In particular, the adjusted basis of gross section 987
QBU assets measure avoids the significant administrative burdens
associated with a section 987 QBU accumulated earnings approach that
would require taxpayers to maintain post-1986 accumulated earnings
pools for each section 987 QBU. The IRS and the Treasury Department
also considered the use of net section 987 QBU assets as a potential
measure. Although the net section 987 QBU assets measure does not raise
the same administrative burdens as an earnings based approach, the IRS
and the Treasury Department were concerned about the volatility of
recognizing section 987 gain or loss using a net asset measure. For
example, if a section 987 QBU's gross assets are equal to its
liabilities, section 987 gain or loss would be deferred. On the other
hand, a small amount of income could increase section 987 QBU net
assets slightly above zero and all accumulated section 987 gains or
losses could be triggered with a very small remittance. The IRS and the
Treasury Department believe that gross assets is a reasonable proxy for
post-1986 accumulated earnings in this context, can be administered
relatively easily, and will reduce the volatility and potential for
distortion described in this preamble.
F. Section 1.987-6 Character and Source
Section 987(3)(B) requires that a taxpayer make proper adjustments
(as prescribed by the Secretary) for certain transfers of property
between QBUs of
[[Page 52888]]
the taxpayer, including treating section 987 gain or loss as ordinary
income or loss and sourcing such gain or loss by reference to the
source of income giving rise to post-1986 accumulated earnings. Section
987 is silent on the method of characterizing section 987 gain or loss
for purposes of the Code. Nevertheless, the IRS and the Treasury
Department believe that it is necessary to characterize section 987
gain or loss for the proper operation of certain other sections of the
Code. For example, the character of section 987 gain must be determined
for purposes of determining whether all or a portion of such gain
qualifies as subpart F income under section 954. This characterization
is necessary to prevent section 987 from being used as a vehicle to
avoid the rules of section 954(c)(1)(D) with respect to certain section
988 transactions. In addition, section 987 gain or loss must be
characterized for purposes of determining the foreign tax credit
limitation under section 904(d). As a result, and pursuant to sections
987(3) and 989(c)(5), the proposed regulations characterize section 987
gain or loss for all purposes of the Code, including for purposes of
sections 904(d), 907 and 954.
In accordance with section 987(3)(B), Sec. 1.987-6(a) provides
that section 987 gain or loss is ordinary income or loss. Moreover, the
IRS and the Treasury Department believe that rules governing the source
and character of section 987 gain or loss for other Code sections
should be consistent. The IRS and the Treasury Department are
concerned, however, that sourcing and characterizing section 987 gain
or loss by reference to post-1986 accumulated earnings would give rise
to substantial complexity by requiring taxpayers to track the earnings
of section 987 QBUs in section 904(d) categories over prolonged
periods. The compliance burden would be considerable for taxpayers with
large numbers of section 987 QBUs. Accordingly, the IRS and the
Treasury Department believe that it is appropriate to use the average
tax book value of assets in the year of remittance as determined under
Sec. 1.861-9T(g) as a proxy for post-1986 accumulated earnings in the
context of section 987.\3\ In the context of section 987, use of a
single year's assets should generally reflect the activities of a
section 987 QBU that give rise to a section 987 QBU's accumulated
earnings and will significantly minimize complexity. The tax book value
method set forth in Sec. 1.861-9T(g) as applied to section 987 QBUs
has been amended to provide greater consistency with the proposed
regulations. The modified gross income method described in Sec. 1.861-
9T(j) cannot be used to characterize section 987 gain or loss as the
IRS and the Treasury Department believe that gross income earned in a
single year is not a sufficient proxy for accumulated earnings.
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\3\ Notably, because section 987 gain or loss may be derived
from assets acquired with earnings and capital of a section 987 QBU
(or from liabilities entered into by the QBU), using post-1986
accumulated earnings to characterize exchange gain or loss under
section 987 may not reflect all items giving rise to such gain or
loss.
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The IRS and the Treasury Department recognize that the
characterization rule contained in the proposed regulations applies to
provisions other than the international tax rules. In addition, the IRS
and the Treasury Department recognize that special considerations may
arise in connection with applying this characterization rule to various
domestic provisions. For example, special considerations may arise when
characterizing section 987 gain or loss for rules that apply to
regulated investment companies (RICs) and real estate investment trusts
(REITs). The IRS and the Treasury Department are studying the
application of the characterization rules to these other provisions and
request comments. As a result, the proposed regulations reserve on the
method for characterizing and sourcing section 987 gain or loss for
purposes of RICs and REITs.
G. Section 1.987-7 Partnership Rules
1. Scope
Section 1.987-7 provides rules for determining a partner's share of
the assets and liabilities of an eligible QBU held indirectly through a
section 987 partnership. It also provides rules coordinating the
application of section 987 with subchapter K of chapter 1 of the Code.
2. Allocation of Assets and Liabilities
In order to apply the foreign exchange exposure pool method at the
partner level, as discussed above, each partner must determine its
share of the assets and liabilities of an eligible QBU and, to the
extent applicable, a section 987 QBU owned indirectly through the
section 987 partnership. Section 1.987-7 provides a general rule that
requires the allocation of the assets and liabilities of the
partnership's eligible QBUs to the partners in a manner that is
consistent with the manner in which the partners have agreed to share
the economic benefits and burdens corresponding to such assets and
liabilities, taking into account the rules and principles of sections
701 through 761 and the regulations thereunder, including section
704(b) and Sec. 1.701-2.
The IRS and the Treasury Department believe that this general rule
is appropriate because it will allocate the assets and liabilities
consistent with the partners' economic arrangement. The IRS and the
Treasury Department recognize that any rule which attempted to allocate
the assets and liabilities without regard to such economic arrangement
would have the effect of distorting each partner's section 987 gain or
loss attributable to its section 987 QBU and, as a result, would be
inappropriate. Moreover, the IRS and the Treasury Department are
concerned that taxpayers could attempt to inappropriately shift a
partner's share of the underlying assets and liabilities of a section
987 QBU owned indirectly through a section 987 partnership to distort
the partner's section 987 gain or loss. As a result, the Commissioner
may review such allocations to ensure that they are consistent with the
economic arrangement of the partners and the principles of subchapter K
of Chapter 1 of the Code and the applicable regulations, including
section 704(b) and Sec. 1.701-2.
Moreover, the IRS and the Treasury Department are considering
whether it would be appropriate, when these regulations are finalized,
to provide a safe harbor. Under such a safe harbor, the assets and
liabilities of an eligible QBU would be deemed to be allocated in a
manner which appropriately reflects each partner's share of the
economic benefits and burdens if certain conditions are satisfied. For
example, the safe harbor could provide that the assets and liabilities
are deemed to be allocated in a manner consistent with each partner's
share of the underlying economic benefits and burdens provided the
assets, to the extent of a partner's share of partnership capital, are
allocated in accordance with such capital and any excess assets (assets
in excess of partnership capital) are allocated consistent with the
manner in which the partners have agreed to share the economic burden
of the liabilities incurred to acquire such assets. The IRS and the
Treasury Department request comments as to whether a safe harbor should
be included and, if so, what form such safe harbor should take.
3. Coordination with subchapter K
A partner must take into account its share of the items of income,
gain, deduction, or loss of its section 987 QBU owned indirectly
through a partnership and, under Sec. 1.987-3, must convert such items
into its functional
[[Page 52889]]
currency. In addition, a partner must take into account any section 987
gain or loss of the section 987 QBU determined in the partner's
functional currency. In both situations, the partner's adjusted basis
in its partnership interest must be adjusted in order to avoid the
duplication of income or loss attributable to the section 987 QBU.
Section 1.987-7 provides a rule regarding the appropriate adjustments
which must be made to the partner's adjusted basis in the section 987
partnership to ensure that no such duplication occurs.
A partner is also required under section 752 to adjust its basis in
its interest in the section 987 partnership to take into account
liabilities of the section 987 partnership. As a result, the proposed
regulations provide rules for determining the appropriate adjustments
to such basis required under section 752 in the case of an increase or
a decrease in such partner's share of the liabilities of the
partnership reflected on the books and records of a section 987 QBU. In
addition, the proposed regulations provide rules for determining the
amount of such liability, as determined in the partner's functional
currency, which must be taken into account on the sale or exchange of a
partnership interest under section 752(d).
The proposed regulations also clarify, consistent with section
985(a), that a partner's adjusted basis in its partnership interest is
determined in the functional currency of the partner. Moreover, the
proposed regulations provide that the fluctuations between the
partner's functional currency and the functional currency of the
section 987 QBU do not affect such partner's adjusted basis in its
partnership interest. Instead, such fluctuations are taken into account
under the foreign exchange exposure pool method of Sec. 1.987-4.
4. Comments
The proposed regulations do not address the adjustments which would
occur under section 752 when there is an assumption by a partnership of
a partner's liability that is denominated in a functional currency
different from the partner and which, as a result, is subject to
section 988 in the hands of the partner. In such cases, the partner
will be deemed to receive a distribution of money, under section
752(b), regardless of whether, following the assumption, the liability
is reflected on the books and records of the partnership's qualified
business unit. In such cases, it is unclear whether the amount of the
distribution should be determined by reference to the spot rate (on the
date of assumption) or the historic exchange rate (on the date the
liability was originally incurred by the partner). In addition, this
issue raises concerns as to how section 988 would operate upon such
assumption. The IRS and Treasury Department request comments on this
issue and whether provisions should be included in section 988 to
better coordinate the operation of section 987 and section 988 in this
context. In addition, comments are requested on whether provisions
should be included in section 988 in order to coordinate the aggregate
approach, adopted in these proposed regulations, with respect to
certain assets and liabilities that are not reflected on an eligible
QBU of the partnership.
In addition to the issues specifically addressed in the proposed
regulations, the IRS and the Treasury Department request comments on
additional provisions which should be included to coordinate the
provisions of section 987 with subchapter K of chapter 1 of the Code.
Specifically, comments are requested as to how capital accounts
maintained under section 704 should be adjusted to take into account
section 987 gain or loss. In addition, comments are requested as to
whether section 987 loss should be subject to the limitation provided
under section 704(d) and, if so, how such limitation might be applied.
Finally, comments are requested as to any other provisions of
subchapter K of chapter 1 of the Code on which guidance should be
provided.
H. Section 1.987-8 Termination of a Section 987 QBU
1. General termination rules
The proposed regulations set forth circumstances in which a section
987 QBU will terminate. For purposes of Sec. 1.987-5, a termination of
a section 987 QBU is treated as a remittance of all the gross assets of
the section 987 QBU to its owner. The termination rules recognize that
an owner carries on a trade or business through its section 987 QBU and
when the owner stops conducting that trade or business through its
section 987 QBU, any section 987 gain or loss should be recognized in
full. Thus, a termination generally occurs when: (1) The activities of
the section 987 QBU cease; (2) substantially all of the assets (as
defined in section 368(a)(1)(C)) of the section 987 QBU are transferred
to its owner; or (3) the owner of the section 987 QBU ceases to exist.
In addition, a termination occurs when a foreign corporation that
is a controlled foreign corporation (CFC) that is the owner of a
section 987 QBU ceases to be a CFC because at that point any section
987 gain or loss cannot be subpart F income and may be deferred
indefinitely.
2. Exceptions for Certain Section 381 Transactions
Section 987 gain or loss generally arises during the period that an
owner has a section 987 QBU. The section 987 gain or loss is analogous
in some respects to a tax attribute under section 381. As a result, the
proposed regulations provide that a termination does not generally
occur when other tax attributes under section 381 are carried over in a
liquidation under section 332 or an asset reorganization under section
368(a). However, inbound and outbound liquidations and reorganizations
terminate a section 987 QBU because these transactions materially
change the circumstances in which section 987 gain or loss is taken
into account.
3. Treatment of Inbound Liquidations and Inbound Asset Reorganizations
Although the proposed regulations treat inbound liquidations under
section 332 and inbound asset reorganizations under section 368(a) as
terminations, the IRS and the Treasury Department are considering
whether such treatment is appropriate in all cases.
The IRS and the Treasury Department believe that the better view,
taking into account various policies, is to support the treatment of
inbound transactions as terminations. For example, such treatment may
prevent the importation of a tax attribute that was generated offshore.
Concerns over such attribute importation are similar to those that were
addressed in Sec. 1.367(b)-3(e) and (f) and section 362(e). In
addition, treating inbound asset transactions as terminations is
consistent with the results that would obtain if the foreign currency
gain or loss attributable to the QBU were taken into account under
section 988, rather than section 987.
The IRS and the Treasury Department acknowledge, however, that
other policies may support the position that such inbound transactions
should not be terminations. One of the reasons the proposed regulations
treat certain section 381 transactions as terminations is because
amounts taken into account under section 987 (that is, section 987
taxable income or loss, and section 987 gain or loss) generally become
subject to a lesser degree of U.S. taxation after the section 381
transaction than was the case before the transaction (that is, when the
section 987 QBU goes from being owned by a domestic corporation to
being owned by a foreign corporation). This is not the case in
[[Page 52890]]
certain inbound transactions because amounts taken into account under
section 987 are generally subject to a greater degree of U.S. taxation
after the inbound transaction (when the section 987 QBU is owned by a
domestic corporation) than was the case before the transaction (when
the section 987 QBU was owned by a foreign corporation).
The IRS and the Treasury Department request comments on whether it
is appropriate to treat these inbound asset transactions as
terminations. Such comments should take into account the policy
concerns discussed in this preamble.
4. Section 351 Exchanges and Transactions Within a Consolidated Group
The proposed regulations provide that a termination occurs when the
owner of a section 987 QBU transfers the QBU to another corporation in
exchange for stock in a transaction qualifying under section 351. The
termination occurs because the owner no longer has a section 987 QBU.
The IRS and the Treasury Department are studying ways to apply the
intercompany transaction rules of Sec. 1.1502-13 to section 987
transactions within a consolidated group. For example, the IRS and the
Treasury Department are considering whether transfers qualifying under
section 351 which would trigger a remittance or termination under the
proposed regulations should qualify for deferral under Sec. 1.1502-13.
The IRS and the Treasury Department request comments on the interplay
between Sec. 1.1502-13 and the proposed regulations and the timing of
the inclusion of the deferred section 987 gain or loss.
I. Section 1.987-9 Recordkeeping Rules
Given the detailed nature of the calculations required under these
regulations, Sec. 1.987-9 articulates the records that taxpayers must
keep. A taxpayer must keep such records as are sufficient to establish
the section 987 QBU's section 987 taxable income or loss, its section
987 gain or loss, and the transition method used for section 987 QBUs
under Sec. 1.987-10. Section 1.987-9(b) lists supplemental records
that must be maintained.
J. Section 1.987-10 Transition Rules
The transition rules of Sec. 1.987-10 apply to a taxpayer that is
the owner of a section 987 QBU on the transition date. Such a taxpayer
must transition to the foreign exchange exposure pool method of these
regulations whether or not such taxpayer made determinations required
under section 987 in prior years. A taxpayer that failed to make
required determinations under section 987 in prior years or that used
an unreasonable method in prior years can only use the fresh start
transition method of Sec. 1.987-10(c)(4) as described in this
preamble. Generally, use of the 1991 proposed section 987 regulations
method (see, Examples 1 and 3 of Sec. 1.987-10(d)) or an ``earnings
only'' section 987 method (see, Example 2 of Sec. 1.987-10(d)) will be
considered a reasonable method for purposes of Sec. 1.987-10. However,
for example, the recognition of section 987 gain or loss with respect
to stock under any method, where the gain or loss does not reflect
economic gain or loss derived from the movements in exchange rates,
will be carefully scrutinized by the IRS and may be considered
unreasonable based on the facts and circumstances of the particular
case.
The transition date is the first day of the first taxable year to
which these section 987 regulations apply.
Comments are requested on the application of these transition rules
to partnerships which were, under the current proposed regulations,
treated as qualified business units for purposes of section 987.
Comments are also requested on the treatment of qualified business
units of such partnerships.
Generally, Sec. 1.987-10(c) allows a taxpayer to transition to the
foreign exchange exposure pool method set forth in these regulations
under one of two methods (the ``deferral transition method'' or the
``fresh start transition method''). Under the conformity rules of Sec.
1.987-10(c)(2), this election must be applied with respect to all
members that file a consolidated return with the taxpayer and any
controlled foreign corporation as defined in section 957 in which the
taxpayer owns more than 50 percent of the voting power or stock (as
determined in section 957(a)). This conformity rule is necessary to
prevent taxpayers and certain related entities from taking inconsistent
positions with respect to qualified business units which have
unrecognized section 987 gains and losses. The IRS and the Treasury
Department request comments on concerns that may arise by the inclusion
of certain controlled foreign corporations in the conformity rule.
Under the deferral transition method of Sec. 1.987-10(c)(3),
section 987 gain or loss is determined under the taxpayer's prior
section 987 method on the transition date as if all qualified business
units of the taxpayer terminated on the last day of the taxable year
preceding the transition date. The deemed termination is solely for
purposes of measuring section 987 gain or loss in order to transition
to the foreign exchange exposure pool method and does not apply for any
other purpose. Section 987 gain or loss determined on the deemed
termination is not immediately recognized. Rather, it is deferred by
treating it as net unrecognized section 987 gain or loss of the
relevant section 987 QBU. Such gain or loss will be recognized under
the remittance rules of Sec. 1.987-5 for periods after the transition
date. The owner of a qualified business unit that is deemed to
terminate under these rules is treated as having transferred all of the
assets and liabilities attributable to the qualified business unit to a
new section 987 QBU on the transition date. In order to avoid double
counting, Sec. 1.987-10(c)(3)(ii) provides that the exchange rates
used to determine the amount of an asset or liability transferred from
the owner to the new section 987 QBU on the transition date (that is,
for purposes of making later calculations under Sec. 1.987-4) is
determined with reference to the historic exchange rates on the day the
asset was acquired or liability entered into by the qualified business
unit deemed terminated. That exchange rate is then adjusted to take
into account an allocation of section 987 gain or loss determined under
the deferral transition method. If the taxpayer is not able to trace an
historic exchange rate to a particular asset or liability, then the
exchange rate must be determined under a reasonable allocation method,
consistently applied, that takes into account an allocation of the
aggregate basis and an allocation of the deferred section 987 gain or
loss.
Under the fresh start transition method of Sec. 1.987-10(c)(4), on
the transition date all qualified business units of the taxpayer
subject to section 987 are deemed terminated on the last day of the
taxable year preceding the transition date. As under the deferral
transition method, this deemed termination is solely for purposes of
transitioning to the foreign exchange exposure pool method under
section 987 and does not apply for any other purpose. Under the fresh
start transition method, no section 987 gain or loss is determined or
recognized on such deemed termination. Rather, the exchange rates used
to determine the total amount of assets and liabilities deemed
transferred from the owner to the section 987 QBU for the section 987
QBU's first taxable year are determined solely with reference to the
historic exchange rates on the day the assets were acquired or
liabilities entered into
[[Page 52891]]
by the qualified business unit that was deemed terminated. Like the
deferral transition method, if the taxpayer is not able to trace an
exchange rate to a particular asset or liability, then the exchange
rate must be determined under a reasonable allocation method,
consistently applied, that takes into account the aggregate basis of
the QBU's assets (and amount of liabilities). The fresh start method is
designed to prevent recognition of non-economic currency gain or loss
with respect to unremitted assets that are attributable to the
qualified business unit. In the first taxable year when the foreign
exchange exposure pool method applies, the deemed contribution of
marked assets to a section 987 QBU at the historic exchange rate when
originally acquired potentially gives rise to section 987 gain or loss
while the historic assets (also translated at the historic exchange
rate) will not.
The transition method adopted by the taxpayer must be disclosed in
accordance with the rules provided in Sec. 1.987-10(c)(6).
Proposed Effective Date
These regulations are proposed to be effective as follows. These
regulations shall generally apply 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. A taxpayer may elect to apply these
regulations to taxable years beginning after the date of publication of
a Treasury decision adopting this rule as a final regulation in the
Federal Register. Such election is binding on all members that file a
consolidated return with the taxpayer and any controlled foreign
corporation, as defined in section 957, in which the taxpayer owns more
than 50 percent of the voting power or stock (as determined in section
957(a)). Pending finalization, the IRS and the Treasury Department
would consider positions consistent with these proposed regulations to
be reasonable constructions of the statute.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It has also
been determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations. It is hereby
certified that the collection of information contained in this
regulation will not have a significant economic impact on a substantial
number of small entities. Accordingly, a regulatory flexibility
analysis is not required. The proposed section 987 regulations will
generally only affect large United States corporations with business
units operating in foreign jurisdictions. Thus, the number of affected
small entities will not be substantial and any economic impact on those
entities in complying with the collection of information would be
minimal. Pursuant to section 7805(f) of the Internal Revenue Code, this
notice of proposed rulemaking will be submitted to the Chief Counsel
for Advocacy of the Small Business Administration for comment on its
impact on small businesses.
Comments and Public Hearing
Before the proposed regulations are adopted as final regulations,
consideration will be given to any written (a signed original and eight
(8) copies) or electronic comments that are submitted timely to the
IRS. The IRS and the Treasury Department request comments on the
clarity of the proposed rules and how they can be made easier to
understand. All comments will be available for public inspection and
copying.
A public hearing has been scheduled for November 21, 2006,
beginning at 10 a.m. in the Auditorium, Internal Revenue Service, New
Carrollton Federal Building, 5000 Ellin Road, Lanham, MD 20706. In
addition, all visitors must present photo identification to enter the
building. Because of access restrictions, visitors will not be admitted
beyond the immediate entrance area more than 30 minutes before the
hearing starts. For information about having your name placed on the
building access list to attend the hearing, see the FOR FURTHER
INFORMATION CONTACT section of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments must submit electronic or written
comments by December 6, 2006 and an outline of the topics to be
discussed and time to be devoted on each topic (a signed original and
eight (8) copies) by October 31, 2006. A period of 10 minutes will be
allotted to each person for making comments. An agenda showing the
scheduling of the speakers will be prepared after the deadline for
receiving outlines has passed. Copies of the agenda will be available
free of charge at the hearing.
Drafting Information
The principal authors of the proposed regulations are Jeffrey
Dorfman and Theodore Setzer of the Office of Associate Chief Counsel
(International).
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Withdrawal of Notice of Proposed Rulemaking
Accordingly, under the authority of 26 U.S.C. 7805, the notice of
proposed rulemaking (REG-208270-86) that was published in the Federal
Register on September 25, 1991 (56 FR 48457) is withdrawn.
Proposed Amendment to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 987, 989(c), 6601 and 7805 * * *
Par. 2. Section 1.861-9T is amended as follows:
1. Paragraph (g)(2)(ii)(A)(1) is revised.
2. Paragraph (g)(2)(vi) is added.
The revisions read as follows:
Sec. 1.861-9T Allocation and apportionment of interest expense
(temporary).
* * * * *
(g) * * *
(2) * * *
(ii) * * * (A) * * *
(1) Section 987 QBU. In the case of a section 987 QBU, the tax book
value shall be determined by applying the rules of paragraphs (g)(2)(i)
and (3) of this section to the beginning of year and end of year
functional currency amount of assets. The beginning of year functional
currency amount of assets shall be determined by reference to the
functional currency amount of assets computed under Sec. 1.987-
4(d)(1)(i)(B) and (e) on the last day of the preceding taxable year.
The end of year functional currency amount of assets shall be
determined by reference to the functional currency amount of assets
computed under Sec. 1.987-4(d)(1)(i)(A) and (e) on the last day of the
current taxable year. The beginning of year and end of year functional
currency amount of assets, as so determined within each grouping must
then be averaged as provided in paragraph (g)(2)(i) of this section.
* * * * *
[[Page 52892]]
(vi) Effective date. Generally, paragraph (g)(2)(ii)(A)(1) of this
section shall apply 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. If a taxpayer makes an election under Sec. 1.987-
11(b), then the effective date of paragraph (g)(2)(ii)(A)(1) of this
section with respect to the taxpayer shall be consistent with such
election.
* * * * *
Par. 3. Section 1.985-1 is amended as follows:
1. Paragraph (d)(2), second sentence; and paragraph (f), Example 9
and Example 10(i), ninth sentence are revised.
2. Paragraph (f), Example 11 is removed.
3. Paragraph (f), Example 12 is redesignated as Example 11.
4. Paragraph (g) is added.
The revisions and addition read as follows:
Sec. 1.985-1 Functional currency.
* * * * *
(d) * * *
(2) * * * The amount of income or loss or earnings and profits (or
deficit in earnings and profits) of each QBU in its functional currency
shall then be translated into the foreign corporation's functional
currency under the principles of section 987.
* * * * *
(f) Examples. * * *
Example (9). (i) The facts are the same as in Example (7). In
addition, assume that in 1987 branch A has items of earnings of 100
FC and branch B has items of earnings of 100 LC as determined under
section 987. S translates branch A's and branch B's items of
earnings and profits into its functional currency under the
principles of section 987.
Example (10). (i) * * * Assume that B's items of income of 200
DCs when properly translated under the principles of section 987 is
equal to 100 LCs. * * *
* * * * *
(g) Effective date. Generally, the revisions to the second sentence
of paragraph (d)(2), Example 9, and Example 10 shall apply 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. If a taxpayer makes
an election under Sec. 1.987-11(b), then the effective date of these
revisions with respect to the taxpayer shall be consistent with such
election.
Par 4. Section 1.985-5 is revised to read as follows:
Sec. 1.985-5 Adjustments required upon change in functional currency.
(a) In general. This section applies in the case of a taxpayer,
qualified business unit (QBU) or section 987 QBU as defined in Sec.
1.987-1(b)(2) changing from one functional currency (old functional
currency) to another functional currency (new functional currency). A
taxpayer, QBU, or section 987 QBU subject to the rules of this section
shall make the adjustments set forth in the 3-step procedure described
in paragraphs (b) through (e) of this section. Except as otherwise
provided in this section, the adjustments shall be made on the last day
of the taxable year ending before the year of change as defined in
Sec. 1.481-1(a)(1). Gain or loss required to be recognized under
paragraphs (b), (d)(2), (e)(2), and (e)(4)(iii) of this section is not
subject to section 481 and, therefore, the full amount of the gain or
loss must be included in income or earnings and profits on the last day
of the taxable year ending before the year of change. Except as
provided in Sec. 1.985-6, a QBU or section 987 QBU with a functional
currency for its first taxable year beginning in 1987 that is different
from the currency in which it had kept its books and records for United
States accounting and tax accounting purposes for its prior taxable
year shall apply the principles of this section for purposes of
computing the relevant functional currency items, such as earnings and
profits, basis of an asset, and amount of a liability, as of the first
day of a taxpayer's first taxable year beginning in 1987. However, a
QBU that changes to the dollar pursuant to Sec. 1.985-1(b)(2) after
1987 shall apply Sec. 1.985-7.
(b) Step 1 Taking into account exchange gain or loss on certain
section 988 transactions. The taxpayer, QBU or section 987 QBU shall
recognize or otherwise take into account for all purposes of the
Internal Revenue Code the amount of any unrealized exchange gain or
loss attributable to a section 988 transaction (as defined in section
988(c)(1)(A), (B), and (C)) that, after applying section 988(d), is
denominated in terms of or determined by reference to the new
functional currency. The amount of such gain or loss shall be
determined without regard to the limitations of section 988(b) (that
is, whether any gain or loss would be realized on the transaction as a
whole). The character and source of such gain or loss shall be
determined under section 988.
(c) Step 2 Determining the new functional currency basis of
property and the new functional currency amount of liabilities and any
other relevant items. Except as otherwise provided in this section, the
new functional currency adjusted basis of property and the new
functional currency amount of liabilities and any other relevant items
(for example, items described in section 988(c)(1)(B)(iii)) shall equal
the product of the amount of the old functional currency adjusted basis
or amount multiplied by the new functional currency/old functional
currency spot exchange rate on the last day of the taxable year ending
before the year of change (spot rate).
(d) Step 3A Additional adjustments that are necessary when a QBU or
section 987 QBU changes functional currency--(1) QBU changing to a
functional currency other than the owner's functional currency--(i)
Rule. If a QBU or section 987 QBU changes to a functional currency
other than the owner's functional currency, the owner and section 987
QBU shall make the adjustments set forth in either paragraph (d)(1)(ii)
or (d)(1)(iii) of this section for purposes of section 987.
(ii) Where prior to the change the section 987 QBU and owner had
different functional currencies. If the section 987 QBU and the owner
had different functional currencies prior to the change, the owner and
section 987 QBU shall make the following adjustments in the year of
change.
(A) Determining the owner functional currency net value of the
section 987 QBU under Sec. 1.987-4(d)(1)(i)(B)--(1) Historic items.
For purposes of determining the owner functional currency net value of
the section 987 QBU for the year of change under Sec. 1.987-
4(d)(1)(i)(B), the owner or section 987 QBU shall first translate the
section 987 historic items from the QBU's old functional currency into
its owner's functional currency using the historic exchange rate as
defined in Sec. 1.987-1(c)(3). The owner or section 987 QBU shall then
translate the section 987 historic items as defined in Sec. 1.987-1(e)
from the owner's functional currency into the QBU's new functional
currency using the spot exchange rate between the section 987 QBU's new
functional currency and the owner's functional currency on the last day
of the taxable year ending before the year of change.
(2) Marked items. For purposes of determining the owner functional
currency net value of the section 987 QBU for the year of change under
Sec. 1.987-4(d)(1)(i)(B), the owner or section 987 QBU shall translate
the section 987 QBU's section 987 marked items as defined in Sec.
1.987-1(d) from the section 987 QBU's old functional currency into the
QBU's new functional
[[Page 52893]]
currency using the new functional currency/old functional currency spot
exchange rate on the last day of the taxable year ending before the
year of change.
(B) Net unrecognized section 987 gain or loss. No adjustment to the
owner's net unrecognized section 987 gain or loss is necessary.
(iii) Where prior to the change the QBU and the taxpayer had the
same functional currency. If a QBU with the same functional currency of
the taxpayer is changing to a new functional currency different from
the taxpayer, and as a result of the change the taxpayer will be an
owner of a section 987 QBU (see Sec. 1.987-1), the taxpayer and
section 987 QBU shall become subject to section 987 for the year of
change and subsequent years.
(2) Section 987 QBU changing to the owner's functional currency. If
a section 987 QBU changes its functional currency to its owner's
functional currency, the section 987 QBU shall be treated as if it
terminated on the last day of the taxable year ending before the year
of change. See Sec. Sec. 1.987-5 and 1.987-8 for the effect of a
termination.
(e) Step 3B Additional adjustments that are necessary when a
taxpayer/owner changes functional currency (1) Corporations. The amount
of a corporation's new functional currency earnings and profits and the
amount of its new functional currency paid-in capital shall equal the
product of the old functional currency amounts of such items multiplied
by the spot rate. The foreign income taxes and accumulated profits or
deficits in accumulated profits of a foreign corporation that were
maintained in foreign currency for purposes of section 902 and that are
attributable to taxable years of the foreign corporation beginning
before January 1, 1987, also shall be translated into the new
functional currency at the spot rate.
(2) Collateral consequences to a United States shareholder of a
corporation changing to the United States dollar as its functional
currency. A United States shareholder (within the meaning of section
951(b) or section 953(c)(1)(A)) of a controlled foreign corporation
(within the meaning of section 957 or section 953(c)(1)(B)) changing
its functional currency to the dollar shall recognize foreign currency
gain or loss computed under section 986(c) as if all previously taxed
earnings and profits, if any, (including amounts attributable to pre-
1987 taxable years that were translated from dollars into functional
currency in the foreign corporation's first post-1986 taxable year)
were distributed immediately prior to the change. Such a shareholder
shall also recognize gain or loss attributable to the corporation's
paid-in capital to the same extent, if any, that such gain or loss
would be recognized under the regulations under section 367(b) if the
corporation was liquidated completely.
(3) Taxpayers that are not corporations. [Reserved].
(4) Adjustments to a section 987 QBU's balance sheet and net
accumulated unrecognized section 987 gain or loss when an owner changes
functional currency--(i) Owner changing to a functional currency other
than the section 987 QBU's functional currency. If an owner changes to
a functional currency that differs from the functional currency of its
section 987 QBU, the owner shall make the following adjustments in the
year of change.
(A) Determining the owner functional currency net value of the
section 987 QBU under Sec. 1.987-4(d)(1)(i)(B)--(1) Historic items.
For purposes of determining the owner functional currency net value of
the section 987 QBU for the year of change under Sec. 1.987-
4(d)(1)(i)(B), the owner shall first translate the QBU's section 987
historic items into the owner's old functional currency at the historic
exchange rate as defined in Sec. 1.987-1(c)(3). The owner shall then
translate the section 987 historic items into its new functional
currency using the new functional currency/old functional currency spot
rate on the last day of the taxable year ending before the year of
change.
(2) Marked items. For purposes of determining the owner functional
currency net value of the section 987 QBU for the year of change under
Sec. 1.987-4(d)(1)(i)(B), the owner or section 987 QBU shall translate
the QBU's section 987 marked items from the owner's old functional
currency into the owner's new functional currency using the new
functional currency/old functional currency spot exchange rate on the
last day of the taxable year ending before the year of change.
(B) Translation of net unrecognized section 987 gain or loss. The
owner shall translate any net unrecognized section 987 gain or loss
determined under Sec. 1.987-4 from its old functional currency into
its new functional currency using the new functional currency/old
functional currency spot exchange rate on the last day of the taxable
year ending before the year of change.
(ii) Taxpayer with the same functional currency as its QBU changing
to a different functional currency. If a taxpayer with the same
functional currency as its QBU changes to a new functional currency and
as a result of the change the taxpayer will be an owner of a section
987 QBU (see Sec. 1.987-1), the taxpayer and section 987 QBU shall
become subject to section 987 for the year of change and subsequent
years.
(iii) Owner changing to the same functional currency as the section
987 QBU. If an owner changes to the same functional currency as its
section 987 QBU, such section 987 QBU shall be treated as if it
terminated on last day of the taxable year ending before the year of
change. See Sec. Sec. 1.987-5 and 1.987-8 for the effect of a
termination.
(f) Examples. The provisions of this section are illustrated by the
following example:
Example. S, a calendar year foreign corporation, is wholly owned
by domestic corporation P. The Commissioner granted permission to
change S's functional currency from the LC to the FC beginning
January 1, 1993. The LC/FC exchange rate on December 31, 1992, is 1
LC/2 FC. The following shows how S must convert the items on its
balance sheet from the LC to the FC.
------------------------------------------------------------------------
LC 1 2 FC
------------------------------------------------------------------------
Assets:
Cash on hand........................ 40,000 80,000
Accounts Receivable................. 10,000 20,000
Inventory........................... 100,000 200,000
100,000 FC Bond (100,000 LC \1\ 50,000 100,000
historical basis)..................
Fixed assets:
Property............................ 200,000 400,000
Plant............................... 500,000 1,000,000
Accumulated Depreciation........ (200,000) (400,000)
Equipment........................... 1,000,000 2,000,000
[[Page 52894]]
Accumulated Depreciation........ (400,000) (800,000)
-------------------------------
Total Assets................ 1,300,000 2,600,000
Liabilities:
Accounts Payable.................... 50,000 100,000
Long-term Liabilities............... 400,000 800,000
Paid-in-Capital..................... 800,000 1,600,000
Retained Earnings................... \2\ 50,000 100,000
-------------------------------
Total Liabilities and Equity 1,300,000 2,600,000
------------------------------------------------------------------------
\1\ Under paragraph (b) of this section, S will recognize a 50,000 LC
loss (100,000 LC basis--50,000 LC value) on the bond resulting from
the change in functional currency. Thus, immediately before the
change, S's basis in the FC bond (taking into account the loss) is
50,000 LC.
\2\ The amount of S's LC retained earnings reflects the 50,000 LC loss
on the bond.
(g) Effective date. Generally, this regulation shall apply 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. If a
taxpayer makes an election under Sec. 1.987-11(b), then the effective
date of this regulation with respect to the taxpayer shall be
consistent with such election.
Par. 5. Sections 1.987-1 through 1.987-4 and Sec. Sec. 1.987-6
through 1.987-11 are added and Sec. 1.987-5 is revised to read as
follows:
Sec. 1.987-1 Scope, definitions and special rules.
(a) In general. These regulations provide rules for determining the
taxable income or loss of a taxpayer with respect to a section 987
qualified business unit (section 987 QBU) as defined in paragraph
(b)(2) of this section. Further, these regulations provide rules for
determining the timing, amount, character and source of section 987
gain or loss recognized with respect to a section 987 QBU. This section
addresses the scope of these regulations and provides certain
definitions and special rules. Section 1.987-2 provides rules for
attributing assets and liabilities and items of income, gain,
deduction, and loss to an eligible QBU and a section 987 QBU. It also
provides rules regarding transfers and the translation of items
transferred to a section 987 QBU. Section 1.987-3 provides rules for
determining and translating the section 987 taxable income or loss of a
taxpayer with respect to a section 987 QBU. Section 1.987-4 provides
rules for determining net unrecognized section 987 gain or loss.
Section 1.987-5 provides rules regarding the recognition of section 987
gain or loss. Section 1.987-6 provides rules regarding the character
and source of section 987 gain or loss. Section 1.987-7 provides rules
with respect to partnerships and rules necessary to coordinate the
provisions of section 987 with subchapter K. Section 1.987-8 provides
rules regarding the termination of a section 987 QBU. Section 1.987-9
provides rules regarding the recordkeeping required under section 987.
Section 1.987-10 provides transition rules. Section 1.987-11 provides
the effective date of these regulations.
(b) Scope of section 987 and definitions--(1) Taxpayers subject to
section 987--(i) In general. Except as provided in paragraphs
(b)(1)(ii) and (iii) of this section, an individual or corporation is
subject to section 987 if such person is an owner (as defined in
paragraphs (b)(4) and (5) of this section) of an eligible QBU (as
defined in paragraph (b)(3) of this section) that is a section 987 QBU
(as defined in paragraph (b)(2) of this section). Such individual or
corporation, and any section 987 QBU owned by such person, must comply
with these regulations.
(ii) De minimis rule for certain indirectly owned section 987 QBUs.
An individual or corporation that owns a section 987 QBU indirectly
through a section 987 partnership may elect not to apply these
regulations for purposes of taking into account the section 987 gain or
loss of such section 987 QBU if the individual or corporation owns,
directly or indirectly, less than five percent of either the total
capital or the total profits interest in the section 987 partnership as
determined on the date of acquisition of such interest or on the date
such interest is increased or decreased. For purposes of this paragraph
(b)(1)(ii), ownership of a capital or profits interest in a partnership
shall be determined in accordance with the rules for constructive
ownership of stock provided in section 267(c), other than section
267(c)(3). See Sec. 1.987-3 for purposes of determining the section
987 taxable income or loss attributable to such section 987 QBU.
(iii) Inapplicability to certain entities. These regulations do not
apply to banks, insurance companies and similar financial entities
(including, solely for purposes of section 987, leasing companies,
finance coordination centers, regulated investment companies and real
estate investment trusts). Further, these rules do not apply to trusts,
estates and S corporations.
(2) Definition of a section 987 QBU--(i) In general. A section 987
QBU is an eligible QBU, as defined in paragraph (b)(3) of this section,
that has a functional currency different from its owner. The functional
currency of an eligible QBU shall be determined under Sec. 1.985-1,
taking into account all of the QBU's activities before the application
of Sec. 1.987-7.
(ii) Section 987 QBU grouping election--(A) In general. Except as
provided in paragraphs (b)(2)(ii)(B)(1) through (3) of this section, an
owner may elect pursuant to paragraph (f) of this section to treat,
solely for purposes of section 987, all section 987 QBUs with the same
functional currency as a single section 987 QBU.
(B) Special grouping rules for section 987 QBUs owned indirectly
through a partnership--(1) In general. An owner may elect to treat all
section 987 QBUs with the same functional currency owned indirectly
though a single section 987 partnership as a single section 987 QBU.
(2) Election not available to group section 987 QBUs owned
indirectly through different partnerships. An owner cannot elect to
treat multiple section 987 QBUs with the same functional currency as a
single section 987 QBU if such QBUs are owned indirectly through
different section 987 partnerships.
(3) Election not available to group section 987 QBUs owned directly
and indirectly. An owner cannot elect to treat multiple section 987
QBUs with the same functional currency owned directly, and indirectly
through a section 987 partnership, as a single section 987 QBU.
(3) Definition of an eligible QBU--(i) In general. The term
eligible QBU means activities of an individual, corporation,
[[Page 52895]]
partnership, or an entity disregarded as an entity separate from its
owner for U.S. Federal income tax purposes (DE), if--
(A) The activities constitute a trade or business as defined in
Sec. 1.989(a)-1(c);
(B) A separate set of books and records is maintained as defined in
Sec. 1.989(a)-1(d) with respect to the activities, and assets and
liabilities used in conducting such activities are reflected on such
books and records under Sec. 1.987-2(b); and
(C) The activities are not subject to the Dollar Approximate
Separate Transactions Method (DASTM) rules of Sec. 1.985-3.
(ii) Exclusion of DEs and certain QBUs. A DE itself is not an
eligible QBU (even though a DE may have activities that qualify as an
eligible QBU). In addition, an eligible QBU shall include a QBU defined
in Sec. 1.989(a)-1(b) only if the requirements contained in paragraphs
(b)(3)(i)(A) through (C) of this section are satisfied with respect to
such QBU. Thus, for example, neither a corporation nor a partnership
itself is an eligible QBU (even though a corporation and a partnership
may have activities that qualify as an eligible QBU).
(4) Definition of the term ``owner''. For purposes of section 987,
only an individual or corporation may be an owner of an eligible QBU.
An individual or corporation is an owner of an eligible QBU if--
(i) Direct ownership. The individual or corporation is the tax
owner of the assets and liabilities of an eligible QBU as defined in
paragraph (b)(3) of this section; or
(ii) Indirect ownership. In the case of an individual or
corporation that is a partner in a partnership, the individual or
corporation is allocated, under Sec. 1.987-7, all or a portion of the
assets and liabilities of an eligible QBU of such partnership.
(5) Exception with respect to an eligible QBU or section 987 QBU of
an owner. The term owner for section 987 purposes does not include an
eligible QBU or a section 987 QBU of an owner. For example, a section
987 branch, as defined in paragraph (b)(6)(i) of this section is not an
owner of another section 987 branch, regardless of its functional
currency.
(6) Other definitions. Solely for purposes of section 987, the
following definitions shall apply.
(i) Section 987 branch. A section 987 branch is an eligible QBU of
an individual, partnership, DE, or corporation, all or a portion of
which is a section 987 QBU. Assets and liabilities of an eligible QBU
of a partnership that are allocated to a partner under Sec. 1.987-7
are considered to be a section 987 QBU of such partner, provided such
partner has a functional currency different from that of such eligible
QBU.
(ii) Section 987 partnership. A section 987 partnership is a
partnership that has one or more section 987 branches.
(iii) Section 987 DE. A section 987 DE is a DE that has one or more
section 987 branches.
(7) Examples. The following examples illustrate the principles of
paragraph (b) of this section. Except as otherwise provided, the
following facts are assumed for purposes of these examples. X is a
domestic corporation, has the U.S. dollar as its functional currency,
and uses the calendar year as its taxable year. Business A and Business
B are eligible QBUs, maintain books and records that are separate from
the books and records of the entity that owns such eligible QBUs, and
have the euro and the Japanese yen, respectively, as their functional
currencies. Finally, DE1 and DE2 are entities that are disregarded as
entities separate from their owner for U.S. tax purposes, have no
assets or liabilities, and conduct no activities.
Example 1. (i) Facts. X owns Business A and the interests in
DE1. DE1 maintains a separate set of books and records that are kept
in British pounds. DE1 owns British pounds and 100% of the stock of
a foreign corporation, FC. DE1 is liable on a pound-denominated
obligation to a lender that was incurred to acquire the stock of FC.
The FC stock, the pounds, and the liability incurred to acquire the
FC stock are recorded on DE1's separate books and records. DE1 has
no other assets or liabilities and conducts no activities (other
than holding the FC stock and servicing its liability).
(ii) Analysis. (A) Pursuant to paragraph (b)(4)(i) of this
section, X is the direct owner of Business A because it is the tax
owner of the assets and liabilities of such business. Because
Business A is an eligible QBU with a functional currency that is
different from the functional currency of its owner, X, Business A
is a section 987 QBU, as defined in paragraph (b)(2) of this
section. As a result, X and its section 987 QBU, Business A, are
subject to section 987.
(B) Holding the stock of FC and pounds, and servicing a single
liability, does not constitute a trade or business within the
meaning of Sec. 1.989(a)-1(c). Because the activities of DE1 do not
constitute a trade or business within the meaning of Sec. 1.989(a)-
1(c), such activities are not an eligible QBU. In addition, pursuant
to paragraph (b)(3)(ii) of this section, DE1 is not an eligible QBU.
As a result, neither DE1 nor its activities qualify as a section 987
QBU of X. Therefore, neither the activities of DE1 nor DE2 are
subject to section 987. For the foreign currency treatment of
payments on DE1's pound-denominated liability, see Sec. Sec. 1.987-
2(b)(4) and 1.988-1(a)(4).
Example 2. (i) Facts. X owns the interests in DE1. DE1 owns
Business A and the interests in DE2. The only activities of DE1 are
Business A activities and holding the interests in DE2. DE2 owns
Business B and Business C. For purposes of this example, Business B
does not maintain books and records that are separate from its
owner, DE2. Instead, the activities of Business B are reflected on
the books and records of DE2, which are maintained in Japanese yen.
In addition, Business C has the U.S. dollar as its functional
currency, maintains books and records that are separate from the
books and records of DE2, and is an eligible QBU.
(ii) Analysis. (A) Pursuant to paragraph (b)(3)(ii) of this
section, DE1 and DE2 are not eligible QBUs. Pursuant to paragraph
(b)(3)(i) of this section, the Business B and Business C activities
of DE2, and the Business A activities of DE1, are eligible QBUs.
Moreover, pursuant to paragraph (b)(4) of this section, DE1 is not
the owner of the Business A, Business B, or Business C eligible
QBUs, and DE2 is not the owner of the Business B or Business C
eligible QBUs. Instead, pursuant to paragraph (b)(4)(i) of this
section, X is the direct owner of the Business A, Business B, and
Business C eligible QBUs.
(B) Because Business A and Business B are eligible QBUs with
functional currencies that are different than the functional
currency of X, Business A and Business B are section 987 QBUs as
defined in paragraph (b)(2) of this section. Therefore, X, and these
QBUs, are subject to section 987. Under paragraph (b)(6)(iii) of
this section, DE1 and DE2 are section 987 DEs.
(C) The Business C eligible QBU has the same functional currency
as X. Therefore, the Business C eligible QBU is not a section 987
QBU. As a result, X is not subject to section 987 with respect to
its Business C eligible QBU.
Example 3. (i) Facts. X owns DE1. DE1 owns Business A and
Business B. For purposes of this example, assume Business B has the
euro as its functional currency.
(ii) Analysis. (A) Pursuant to paragraph (b)(3)(ii) of this
section, DE1 is not an eligible QBU. Moreover, pursuant to paragraph
(b)(4) of this section, DE1 is not the owner of the Business A or
Business B eligible QBUs. Instead, pursuant to paragraph (b)(4)(i)
of this section, X is the direct owner of the Business A and
Business B eligible QBUs.
(B) Business A and Business B constitute two separate eligible
QBUs with the euro as their respective functional currency.
Accordingly, Business A and Business B are section 987 QBUs of X. X
may elect to treat Business A and Business B as a single section 987
QBU pursuant to paragraph (b)(2)(ii)(A) of this section. If such
election is made, pursuant to paragraph (b)(4)(i) of this section, X
is the direct owner of the Business AB section 987 QBU that includes
the activities of both the Business A section 987 QBU and the
Business B section 987 QBU. In addition, pursuant to paragraph
(b)(4) of this section, DE1 is not treated as the owner of the
Business AB section 987 QBU. X, and its AB section 987 QBU, are
subject to section 987. Under paragraph (b)(6)(iii) of this section,
DE1 is a section 987 DE.
Example 4. (i) Facts. X is a partner in P, a partnership. FC, a
controlled foreign corporation (as defined in section 957(a)) of
[[Page 52896]]
X with the Japanese yen as its functional currency, is the only
other partner in P. P owns DE1 and Business A. DE1 owns Business B.
(ii) Analysis. (A) Pursuant to paragraph (b)(3)(ii) of this
section, P and DE1 are not eligible section 987 QBUs. Moreover,
pursuant to paragraph (b)(4) of this section, neither P nor DE1 is
the owner of the Business A eligible QBU or the Business B eligible
QBU for section 987 purposes. Instead, pursuant to paragraph
(b)(4)(ii) of this section, X and FC are indirect owners of the
Business A eligible QBU and the Business B eligible QBU to the
extent they are allocated assets and liabilities of such businesses
under Sec. 1.987-7. Under paragraphs (b)(6)(ii) and (iii) of this
section, respectively, P is a section 987 partnership and DE1 is a
section 987 DE.
(B) Because Business A and Business B are eligible QBUs with a
different functional currency than X, the portions of Business A and
Business B allocated to X under Sec. 1.987-7 are section 987 QBUs
of X. As a result, X and its section 987 QBUs are subject to section
987.
(C) Because the Business A eligible QBU has a different
functional currency than FC, the portion of the Business A eligible
QBU that is allocated to FC under Sec. 1.987-7 is a section 987
QBU, and FC and its section 987 QBU are subject to section 987.
However, the Business B eligible QBU has the same functional
currency as FC. Therefore, the portion of the Business B eligible
QBU that is allocated to FC, under Sec. 1.987-7, is not a section
987 QBU. As a result, FC is not subject to section 987 with respect
to its Business B eligible QBU.
Example 5. (i) Facts. X owns all of the interests in DE1. DE1
owns Business A. DE1 owns all of the interests in DE2. DE2 owns
Business B. DE2 owns all of the interests in DE3, an entity
disregarded as an entity separate from its owner. DE3 owns Business
C, which is an eligible QBU with the Russian ruble as its functional
currency.
(ii) Analysis. Pursuant to (b)(3)(ii) of this section, DE1, DE2
and DE3 are not eligible QBUs. Pursuant to paragraph (b)(3)(i) of
this section, the Business A, Business B and Business C activities
are eligible QBUs. Moreover, pursuant to paragraph (b)(4) of this
section, X is the direct owner of the Business A, Business B and
Business C eligible QBUs. Pursuant to paragraph (b)(5) of this
section, an eligible QBU is not an owner of another eligible QBU.
Accordingly, the Business A eligible QBU is not the owner of the
Business B eligible QBU, and the Business B eligible QBU is not the
owner of the Business C eligible QBU. Since the Business A, Business
B, and Business C eligible QBUs each has a different functional
currency than X, such eligible QBUs are section 987 QBUs of X. As a
result, X and its section 987 QBUs are subject to section 987. Under
paragraphs (b)(6)(iii) of this section, DE1, DE2 and DE3 are section
987 DEs.
(c) Exchange rates. Solely for purposes of section 987, the
following definitions shall apply.
(1) Spot rate--(i) In general. Except as otherwise provided in this
section, the spot rate means the rate determined under the principles
of Sec. 1.988-1(d)(1), (2) and (4) on the relevant day.
(ii) Election to use a spot rate convention--(A) In general. In
lieu of the spot rate determined in paragraph (c)(1)(i) of this
section, an owner may elect under paragraph (f) of this section to use
a spot rate convention that reasonably approximates the rate in
paragraph (c)(1)(i) of this section. A spot rate convention may be
determined with respect to a rate at the beginning of a reasonable
period, the end of a reasonable period, an average of spot rates for a
reasonable period, or by reference to spot and forward rates for a
reasonable period. For example, in lieu of the spot rate determined in
paragraph (c)(1)(i) of this section, the spot rate for all transactions
during a monthly period can be determined pursuant to the following
conventions: the spot rate at the beginning of the current month or at
the end of the preceding month; the monthly average of daily spot rates
for the current or preceding month; or an average of the beginning and
ending spot rates for the current or preceding month. Similarly, in
lieu of the spot rate determined in paragraph (c)(1)(i) of this
section, the spot rate can be determined pursuant to an average of the
spot rate and the 30-day forward rate on a day of the preceding month.
Use of a spot rate convention that is consistent with the owner's
convention used for financial accounting purposes is presumed to
reasonably approximate the rate in paragraph (c)(1)(i) of this section.
The Commissioner can rebut this presumption if use of such a convention
results in a significant distortion of income or loss under the facts
and circumstances.
(B) Election does not apply with respect to section 988
transactions. The election to use a spot rate convention set forth in
paragraph (c)(1)(ii)(A) of this section does not apply to section 988
transactions of a section 987 QBU.
(2) Yearly average exchange rate. Notwithstanding Sec. 1.989(b)-1,
for purposes of section 987, the yearly average exchange rate is a rate
determined by the owner that represents an average exchange rate for
the taxable year (or, if the section 987 QBU is sold or terminated
prior to the close of the taxable year, such portion of the taxable
year) computed under any reasonable method. For example, an owner may
determine the yearly average exchange rate based on a daily, monthly or
quarterly averaging convention, whether weighted or unweighted, and may
take into account forward rates for a period not to exceed three
months. The method for determining the yearly average exchange rate
must be consistently applied by the taxpayer.
(3) Historic exchange rate--(i) In general. Except as otherwise
provided in these regulations, the historic exchange rate shall be--
(A) In the case of an asset that is transferred to a section 987
QBU, the spot rate as defined in paragraphs (c)(1)(i) and (ii) of this
section on the day of transfer;
(B) In the case of an asset that is acquired by a section 987 QBU
(other than by a transfer to a section 987 QBU described in paragraph
(c)(3)(i)(A) of this section), the spot rate as defined in paragraphs
(c)(1)(i) and (ii) of this section on the day the asset is acquired;
(C) In the case of a liability that is entered into by a section
987 QBU, the spot rate as defined in paragraphs (c)(1)(i) and (ii) of
this section on the day the liability is entered into; and
(D) In the case of a liability that is transferred to a section 987
QBU, the spot rate as defined in paragraphs (c)(1)(i) and (ii) of this
section on the day the liability is transferred.
(ii) Changed functional currency. In the case of a section 987 QBU
that previously changed its functional currency, Sec. 1.985-5 shall be
taken into account in determining the historic exchange rate for an
item.
(d) Section 987 marked item. A section 987 marked item is an asset
(section 987 marked asset) or liability (section 987 marked liability)
that--
(1) Is reflected on the books and records of a section 987 QBU
under Sec. 1.987-2(b);
(2) Would be a section 988 transaction if such item were held or
entered into directly by the owner of the section 987 QBU; and
(3) Is not a section 988 transaction with respect to the section
987 QBU.
(e) Section 987 historic item--(1) In general. A section 987
historic item is an asset (section 987 historic asset) or liability
(section 987 historic liability) that--
(i) Is reflected on the books and records of a section 987 QBU
under Sec. 1.987-2(b); and
(ii) Is not a section 987 marked item as defined in paragraph (d)
of this section.
(2) Example. The following example illustrates the application of
paragraphs (d) and (e) of this section:
Example. X is a domestic corporation with the dollar as its
functional currency. X owns all the interests in UK DE, a section
987 DE that owns a section 987 branch having the pound as its
functional currency. Items reflected on the branch's balance sheet
include [pound]100 of cash, $25 of cash, a building
[[Page 52897]]
with a basis of [pound]1,000, a truck with a basis of [pound]75, a
computer with a basis of [pound]10, a 60 day receivable for [yen]15
and a note payable of [pound]500. Under paragraph (d) of this
section, the [pound]100 of cash and the [pound]500 note payable are
section 987 marked items. The other items are section 987 historic
items under this paragraph (e).
(f) Elections--(1) In general. Elections made under section 987
shall be treated as methods of accounting and, except as otherwise
provided in this paragraph (f), are governed by the general rules
concerning changes in methods of accounting.
(2) Persons making the election--(i) In general. Except as provided
in paragraphs (f)(2)(ii) and (iii) of this section, elections regarding
section 987 shall be made by the owner as defined in paragraph (b)(4)
of this section.
(ii) Controlled foreign corporations. Where a section 987 QBU is
held by a controlled foreign corporation, elections shall be made in
accordance with Sec. Sec. 1.952-2(c)(2)(iv) and 1.964-1(c) by its
controlling U.S. shareholders.
(iii) Foreign corporations that are not controlled foreign
corporations. Where a section 987 QBU is held by a foreign corporation
that is not a controlled foreign corporation, elections shall be made
in accordance with the principles of Sec. 1.964-1(c) by the majority
domestic corporate shareholders.
(3) When elections must be made. An election under section 987 must
be made with respect to a section 987 QBU for the first taxable year in
which the election is relevant in determining the section 987 taxable
income or loss, or section 987 gain or loss, of the section 987 QBU.
(4) Manner of making elections. Elections shall be made under
section 987 by attaching a statement to the timely filed tax return of
the owner, or other applicable person, for the first taxable year in
which the owner intends the election to be effective. The statement
must be dated and titled ``Election(s) Under Section 987,'' must
indicate the regulation section that authorizes the election(s), and
must clearly describe the election(s) being made. Each section 987
election must remain a part of the books and records of the taxpayer
and be available to the IRS upon request.
(5) Consent of the Commissioner. Elections made in accordance with
the rules of this paragraph (f) shall be considered made with the
consent of the Commissioner.
(6) Failure to make election. If an owner is permitted to file an
election pursuant to this paragraph (f), but fails to make such
election in a timely manner, the owner shall be considered to have
satisfied the timeliness requirement with respect to such election if
the owner is able to demonstrate to the Area Director, Field
Examination, Small Business/Self Employed or the Director, Field
Operations, Large and Mid-Size Business (Director) having jurisdiction
of the taxpayer's return for the taxable year, that such failure was
due to reasonable cause and not willful neglect. The previous sentence
shall only apply if, once the owner becomes aware of the failure, the
owner attaches the election, as well as a written statement setting
forth the reasons for the failure to timely comply, to an amended
income tax return that amends the return to which the election should
have been attached under the rules of this paragraph (f). In
determining whether the owner has reasonable cause, the Director shall
consider whether the taxpayer acted reasonably and in good faith.
Whether the taxpayer acted reasonably and in good faith will be
determined after considering all the facts and circumstances. The
Director shall notify the owner in writing within 120 days of the
filing if it is determined that the failure to comply was not due to
reasonable cause, or if additional time will be needed to make such
determination. If the Director fails to notify the owner within 120
days of the filing, the owner shall be considered to have demonstrated
to the Director that such failure was due to reasonable cause and not
willful neglect.
(7) Revocation of election--(i) In general. Elections under section
987 cannot be revoked without the consent of the Commissioner. The
Commissioner will consider allowing the revocation of an election if
the taxpayer can demonstrate significantly changed circumstance or such
other circumstances that in the judgment of the Commissioner clearly
demonstrates a substantial non-tax business reason for revoking the
election.
(ii) Exception in the case of certain acquisitions. [Reserved].
Sec. 1.987-2 Attribution of items to a section 987 QBU; the
definition of a transfer and related rules.
(a) Scope and general principles. Paragraph (b) of this section
provides rules for attributing assets and liabilities, and items of
income, gain, deduction, and loss, to an eligible QBU and a section 987
QBU. Assets and liabilities are attributed to an eligible QBU, all or a
portion of which is a section 987 QBU for purposes of section 987.
Items of income, gain, deduction, and loss are attributed to an
eligible QBU all or a portion of which is a section 987 QBU for
purposes of computing the section 987 taxable income of such section
987 QBU, and of the owner of such section 987 QBU. Paragraph (c) of
this section defines a transfer for purposes of section 987. Paragraph
(d) of this section provides translation rules for transfers to a
section 987 QBU.
(b) Attribution of items to an eligible QBU--(1) General rules.
Except as provided in paragraphs (b)(2) and (3) of this section, items
are attributable to an eligible QBU to the extent they are reflected on
the separate set of books and records, as defined in Sec. 1.989(a)-
1(d), of the eligible QBU. For purposes of this section, the term
``item'' refers to assets and liabilities, and items of income, gain,
deduction, and loss. Items that are attributed to an eligible QBU
pursuant to this section must be adjusted to conform to U.S. tax
principles as provided in Sec. 1.987-4(e). These attribution rules
apply solely for purposes of section 987. For example, the allocation
and apportionment of interest expense under section 864(e) is
independent of the rules under section 987.
(2) Exceptions for non-portfolio stock, interests in partnerships,
and certain acquisition indebtedness--(i) General rule. Except as
provided in paragraph (b)(2)(ii) of this section, the following shall
not be considered to be on the books and records of a an eligible QBU:
(A) Stock of a corporation (whether domestic or foreign).
(B) An interest in a partnership (whether domestic or foreign).
(C) A liability that was incurred to acquire the stock or an
interest in a partnership described in paragraphs (b)(2)(i)(A) or (B)
of this section, respectively.
(D) Income, gain, deduction, or loss arising from the items
described in paragraphs (b)(2)(i)(A) through (C) of this section. For
example, a section 951 inclusion with respect to stock of a foreign
corporation that is described in paragraph (b)(2)(i)(A) of this section
shall not be considered to be on the books and records of the eligible
QBU.
(ii) Portfolio stock. Paragraph (b)(2)(i)(A) of this section shall
not apply to stock of a corporation (whether domestic or foreign)
reflected on the books and records, within the meaning of paragraph
(b)(1) of this section, of an eligible QBU provided the owner of the
eligible QBU owns less than 10 percent of the total voting power or
value of all classes of stock of such corporation. For purposes of this
paragraph (b)(2)(ii), section 318(a) shall be applied in determining
ownership, except that in applying section 318(a)(2)(C), the phrase
[[Page 52898]]
``10 percent'' is used instead of the phrase ``50 percent.''
(3) Adjustments to items reflected on the books and records--(i)
General rule. If a principal purpose of recording (or failing to
record) an item on the books and records of an eligible QBU is the
avoidance of U.S. tax under section 987, the Commissioner may allocate
any item between or among the eligible QBU, the owner of such eligible
QBU, and any other persons, entities (including disregarded entities),
or other QBUs within the meaning of Sec. 1.989(a)-1(b) (including
eligible QBUs). A transaction may have such a principal purpose even
though the tax avoidance purpose is outweighed by other purposes when
taken together. For purposes of this paragraph (b)(3)(i), relevant
factors for determining whether such U.S. tax avoidance is a principal
purpose of recording (or failing to record) an item on the books and
records of an eligible QBU shall include, but are not limited to, the
factors set forth in paragraphs (b)(3)(ii) and (iii) of this section.
The presence or absence of any factor, or of a particular number of
factors, is not determinative. Moreover, the weight given to any factor
(whether or not set forth in paragraphs (b)(3)(ii) and (iii) of this
section) depends on the particular case.
(ii) Factors indicating no tax avoidance. For purposes of paragraph
(b)(3)(i) of this section, relevant factors which may indicate that the
recording (or failing to record) an item on the books and records of an
eligible QBU does not have as a principal purpose the avoidance of U.S.
tax under section 987 include the recording (or not recording) of an
item:
(A) For a significant and bona fide business purpose.
(B) In a manner that is consistent with the economics of the
underlying transaction.
(C) In accordance with generally accepted accounting principles (or
similar comprehensive body of professional accounting standards).
(D) In a manner that is consistent with the treatment of similar
items from year to year.
(E) In accordance with accepted conditions or practices in the
particular trade or business of the eligible QBU.
(F) In a manner that is consistent with an explanation of existing
internal accounting policies that is evidenced by documentation
contemporaneous with the timely filing of a return for the taxable
year.
(G) As a result of a transaction between legal entities (that is,
the transfer of an asset, or the assumption of a liability), even if
such transaction is not regarded for Federal tax purposes (that is, a
transaction between a DE and its owner).
(iii) Factors indicating tax avoidance. For purposes of paragraph
(b)(3)(i) of this section, relevant factors which may indicate that a
principal purpose of recording (or failing to record) an item on the
books and records of an eligible QBU is the avoidance of U.S. tax under
section 987 are--
(A) The presence or absence of an item on the books and records
that is disregarded as transitory due to a circular flow of cash or
other property;
(B) The presence or absence of an item on the books and records
that is the result of one or more transactions that do not have
economic substance;
(C) The presence or absence of an item on the books and records
that results in the taxpayer (or person related to the taxpayer as
defined in section 267(b) or 707(b)) having offsetting positions in the
functional currency of a section 987 QBU; and
(D) The absence of any or all of the factors listed in paragraphs
(b)(3)(ii)(A) through (E) of this section.
(4) Assets and liabilities of a partnership or DE that are not
attributed to an eligible QBU. Neither a partnership nor a DE is an
eligible QBU and, thus, cannot be a section 987 QBU. See Sec. 1.987-
1(b)(2) and (3). As a result, a partnership or DE may own assets and
liabilities that are not attributed to an eligible QBU (or a section
987 QBU) as provided under this paragraph (b) and, therefore, are not
subject to section 987. For the foreign currency treatment of such
assets or liabilities, see Sec. 1.988-1(a)(4).
(c) Transfers to and from section 987 QBUs--(1) In general. The
following rules apply for purposes of determining whether there is a
transfer of an asset or a liability from the owner to a section 987
QBU, or from such section 987 QBU to the owner. These rules apply
solely for purposes of section 987.
(2) Disregarded transactions--(i) General rule. Solely for purposes
of section 987, an asset or liability shall be treated as transferred
to a section 987 QBU if, as a result of a disregarded transaction, such
asset or liability is reflected on the books and records of the section
987 QBU within the meaning of paragraph (b) of this section. Similarly,
an asset or liability shall be treated as transferred from a section
987 QBU if, as a result of a disregarded transaction, such asset or
liability is not reflected on the books and records of the section 987
QBU within the meaning of paragraph (b) of this section.
(ii) Definition of a disregarded transaction. For purposes of this
section, the term disregarded transaction means a transaction that is
not regarded for U.S. Federal tax purposes. For purposes of this
paragraph (c), a disregarded transaction shall be treated as including
the recording of an asset or liability on one set of books and records,
if the recording is the result of such asset or liability being removed
from another set of books and records of the same person or entity
(including a DE or partnership).
(iii) Items derived from disregarded transactions ignored. For
purposes of section 987, disregarded transactions shall not give rise
to items of income, gain, deduction, or loss that must be taken into
account in determining section 987 taxable income or loss under Sec.
1.987-3.
(3) Transfers of assets to and from indirectly owned section 987
QBUs--(i) Contributions to partnerships. Solely for purposes of section
987, an asset shall be treated as transferred to an indirectly owned
section 987 QBU if, and to the extent, the asset is contributed to the
section 987 partnership that carries on the section 987 QBU provided
that immediately following such contribution, the asset is reflected on
the books and records of the section 987 QBU within the meaning of
paragraph (b) of this section. For purposes of this paragraph
(c)(3)(i), deemed contributions under section 752 shall be disregarded.
(ii) Distributions from partnerships. Solely for purposes of
section 987, an asset shall be treated as transferred from an
indirectly owned section 987 QBU if, and to the extent, the section 987
partnership that carries on the section 987 QBU distributes the asset
to a partner provided that, immediately prior to such distribution, the
asset was reflected on the books and records of such section 987 QBU
within the meaning of paragraph (b) of this section. For purposes of
this paragraph (c)(3)(ii), deemed distributions under section 752 shall
be disregarded.
(4) Transfers of liabilities to and from indirectly owned section
987 QBUs--(i) Assumptions of partner liabilities. Solely for purposes
of section 987, a liability shall be treated as transferred to an
indirectly owned section 987 QBU if, and to the extent, the section 987
partnership assumes such liability, provided that immediately following
such assumption, the liability is reflected on the books and records of
the section 987 QBU within the meaning of paragraph (b) of this
section.
(ii) Assumptions of partnership liabilities. Solely for purposes of
section 987, a liability shall be treated as transferred from an
indirectly owned
[[Page 52899]]
section 987 QBU if, and to the extent, the owner assumes such liability
of the section 987 partnership provided that immediately prior to such
assumption, the liability was reflected on the books and records of the
section 987 QBU within the meaning of paragraph (b) of this section.
(5) Acquisitions and dispositions of interests in DEs and
partnerships. Solely for purposes of section 987, an asset or liability
shall be treated as transferred to a section 987 QBU if, as a result of
an acquisition (including by contribution) or disposition of an
interest in a section 987 partnership or section 987 DE, such asset or
liability is reflected on the books and records of the section 987 QBU.
Similarly, an asset or liability shall be treated as transferred from a
section 987 QBU if, as a result of an acquisition or disposition of an
interest in a section 987 partnership or section 987 DE, the asset or
liability is not reflected on the books and records of the section 987
QBU.
(6) Changes in form of ownership. For purposes of this paragraph
(c), mere changes in form of ownership of an eligible QBU shall not
result in a transfer to or from a section 987 QBU. Instead, the
determination of whether a transfer has occurred in such case shall be
made under paragraph (c)(5) of this section. For example, a transaction
with respect to an eligible QBU that causes a direct owner of the
eligible QBU to become an indirect owner of such eligible QBU, shall
not, except to the extent provided in paragraph (c)(5) of this section,
result in a transfer to or from a section 987 QBU. See for example,
Rev. Rul. 99-5 (1999-1 CB 434), Rev. Rul. 99-6 (1999-1 CB 432), see
Sec. 601.601(d)(2) of this chapter, and section 708 and the applicable
regulations.
(7) Application of general tax law principles. General tax law
principles, including the circular cash flow, step-transaction, and
substance-over-form doctrines, apply for purposes of determining
whether there is a transfer of an asset or liability under this
paragraph (c).
(8) Interaction with Sec. 1.988-1(a)(10). See Sec. 1.988-1(a)(10)
for rules regarding the treatment of an intra-taxpayer transfer of a
section 988 transaction.
(9) Examples. The following examples illustrate the principles of
this paragraph (c). For purposes of these examples, it is assumed that
X and Y are domestic corporations, have the dollar as their functional
currency, and use the calendar year as their taxable year. It is also
assumed that Business A and Business B are eligible QBUs, maintain
books and records that are separate from the books and records of the
entity that owns such eligible QBUs, and have the euro and the yen,
respectively, as their functional currencies. Finally, it is assumed
that DE1 and DE2 are entities that are disregarded as entities separate
from their owner for U.S. tax purposes. For purposes of determining
whether any of the transfers in these examples result in remittances,
see Sec. 1.987-5.
Example 1. Transfer to a directly owned section 987 QBU. (i)
Facts. X owns 100 percent of the interests in DE1. DE1 owns Business
A. X owns [pound]100 that are not reflected on the books and records
of Business A. Business A is in need of additional capital and, as a
result, X loans the [pound]100 to DE1 (to be used in Business A) in
exchange for a note.
(ii) Analysis. (A) The loan from X to DE1 is not regarded for
U.S. federal tax purposes and therefore is a disregarded
transaction. As a result, the Business A note held by X, and the
liability of DE1 under the note, are not taken into account under
this section. However, the [pound]100 of cash that was loaned from X
to DE1 (and used in Business A) pursuant to the note must be taken
into account under this paragraph (c).
(B) The loan of [euro]100 from X to DE1 is a disregarded
transaction and, as a result of such disregarded transaction, the
[euro]100 is reflected on the books and records of Business A.
Therefore, there has been a transfer of [euro]100 from X to Business
A. See Sec. 1.988-1(a)(10)(ii) for the application of section 988
to X as a result of the loan.
Example 2. Transfer to a directly owned section 987 QBU. (i)
Facts. X owns Business A and Business B. X owns equipment that is
used in Business A and is reflected on the books and records of
Business A. Because Business A has excess manufacturing capacity and
X intends to expand the manufacturing capacity of Business B, the
equipment formerly used in Business A discontinues being used in
Business A and begins being used in Business B. As a result of such
equipment being used by Business B, the equipment is removed from
the books and records of Business A, and is recorded on the books
and records of Business B.
(ii) Analysis. As a result of Business B using the equipment
formerly used by Business A, the equipment ceases to be reflected on
the books and records of Business A, and becomes reflected on the
books and records of Business B. As a result, such entries
constitute a disregarded transaction. Therefore, there has been a
transfer of the equipment from the Business A section 987 QBU to X,
and a transfer by X of such equipment to the Business B section 987
QBU.
Example 3. Intercompany sale of property between two section 987
QBUs. (i) Facts. X owns DE1 and DE2. DE1 and DE2 own Business A and
Business B, respectively. DE1 owns equipment that is used in
Business A and is reflected on the books and records of Business A.
For business reasons, DE1 sells a portion of the equipment used in
Business A to DE2 for cash. The cash used by DE2 to acquire the
equipment was generated by Business B and was reflected on Business
B's books and records. Following the sale, the cash and equipment
will be used in Business A and Business B, respectively. As a result
of such sale, the equipment is removed from the books and records of
Business A, and is recorded on the books and records of Business B.
Similarly, as a result of the sale, the cash is removed from the
books and records of Business B, and is recorded on the books and
records of Business A.
(ii) Analysis. (A) The sale of equipment between DE1 and DE2 is
not regarded for Federal tax purposes and therefore is a disregarded
transaction. As a result, such sale is not taken into account under
this section and does not give rise to an item of income, gain,
deduction or loss pursuant to paragraph (c)(2)(iii) of this section.
However, the cash and equipment exchanged by DE1 and DE2 in
connection with the sale must be taken into account under this
paragraph (c).
(B) The sale of the equipment is a disregarded transaction and,
as a result of such disregarded transaction, the equipment ceases to
be reflected on the books and records of Business A, and becomes
reflected on the books and records of Business B. Therefore, there
has been a transfer of the equipment from DE1's Business A section
987 QBU owned by X to X, and a subsequent transfer of such equipment
from X to DE2's Business B section 987 QBU, owned by X.
(C) As a result of the sale of equipment (that is, the
disregarded transaction), the cash proceeds cease to be reflected on
the books and records of Business B, and become reflected on the
books and records of Business A. Therefore, there has been a
transfer of the cash from DE2's Business B section 987 QBU owned by
X to X, and a subsequent transfer of such cash from X to DE1's
Business A section 987 QBU, owned by X.
Example 4. Transactions between directly and indirectly owned
section 987 QBUs. (i) Facts. X owns 50% of the interest in P, a
partnership. Y owns the other 50% interest in P. P owns 100% of the
interests in DE1 and DE2. DE1 owns Business A and DE2 owns Business
B. X and Y each have a 50% allocable share of the assets and
liabilities of Business A and Business B, as determined under Sec.
1.987-7, that constitute section 987 QBUs. In connection with
Business A, DE1 licenses intangible property to both DE2 and X. X
enters into the license agreement in a transaction other than in its
capacity as a partner of P and, therefore, the license is considered
as occurring between P and one who is not a partner within the
meaning of section 707(a). DE2 uses the intangible property in
Business B. Pursuant to the license agreement, X and DE2 pay a
[euro]30 and [euro]50 royalty, respectively, to DE1.
(ii) Analysis. (A) The license from DE2 to DE1 is not regarded
for U.S. tax purposes and, as a result, royalty payments under the
license are disregarded transactions. Thus, neither the payment nor
the receipt of the royalty pursuant to the license agreement gives
rise to an item of income, gain, deduction or loss pursuant to
paragraph (c)(2)(iii) of this section. However, the [euro]50 of cash
that is paid from DE2 to DE1 pursuant to the license agreement must
be taken into account under this paragraph (c).
[[Page 52900]]
(B) As a result of the royalty payment from DE2 to DE1, [euro]50
ceases being reflected on the books and records of Business B, and
becomes reflected on the books and records of Business A.
Accordingly, there has been a transfer of [euro]25 from the Business
B section 987 QBUs of X and Y, to X and Y, respectively. Similarly,
there has been a transfer of [euro]25 from X and Y to their
respective Business A section 987 QBUs.
(C) The [euro]30 royalty payment from X to DE1 is not a
disregarded transaction because it is regarded for U.S. Federal tax
purposes. As a result, it gives rise to an item of income and
deduction that must be taken into account in computing taxable
income or loss of Business A pursuant to Sec. 1.987-3. In addition,
the payment does not give rise to a transfer as defined in this
paragraph (c).
Example 5. Acquisition of an interest in a partnership. (i)
Facts. X owns 50% of the interest in P, a partnership. Y owns the
other 50% interest in P. P owns Business A. X and Y each have a 50%
allocable share of the assets and liabilities of Business A as
determined under Sec. 1.987-7, that constitute section 987 QBUs. On
December 31, year 1, Z, a domestic corporation with the dollar as
its functional currency, contributes cash to P in exchange for a 20%
interest in P. The cash Z contributes to P is not used in Business A
and is not reflected on Business A's books and records (but is
instead reflected on P's books and records). Immediately after Z's
contribution of cash to P, Z has a 20% allocable share of the assets
and liabilities of Business A as determined under Sec. 1.987-7. In
addition, immediately following such contribution X and Y each own a
40% interest in P and have a 40% allocable share of the assets and
liabilities of Business A, as determined under Sec. 1.987-7, that
constitute section 987 QBUs.
(ii) Analysis. (A) As a result of Z's acquisition of an interest
in P, a section 987 partnership, 10% of the assets and liabilities
of Business A ceased being reflected on the books and records of
both X's and Y's section 987 QBUs. As a result, such amounts are
treated as if they are transferred from such section 987 QBUs to X
and Y.
(B) As a result of Z's acquisition of the interest in P, a
section 987 partnership, Z was allocated 20% of the assets and
liabilities of Business A. Because Z and Business A have different
functional currencies, Z's portion of the Business A assets and
liabilities constitutes a section 987 QBU. Moreover, 20% of the
assets and liabilities of Business A are reflected on the books and
records of Z's section 987 QBU as a result of Z's acquisition of the
interest in P. Therefore, 20% of the assets and liabilities of
Business A are treated as transferred from Z to Z's section 987 QBU.
Example 6. Conversion of a DE to a partnership through a sale of
an interest. (i) Facts. X owns 100% of the interests in DE1. DE1
owns Business A. On December 31, year 1, Y acquires 50% of the DE1
interests from X for cash. Immediately after such acquisition, Y has
a 50% allocable share of the assets and liabilities of Business A as
determined under Sec. 1.987-7.
(ii) Analysis. (A) For Federal tax purposes DE1 is converted to
a partnership when Y purchases the 50% interest in DE1. Y's purchase
of 50% of X's interest in DE1 is treated as the purchase of 50% of
Business A, which is treated as held directly by X for Federal tax
purposes. Immediately after the deemed purchase of 50% of Business
A, X and Y are treated as contributing their respective interests in
Business A to a partnership. See Rev. Rul. 99-5 (situation 1),
(1999-1 CB 434). See Sec. 601.601(d)(2) of this chapter. For
purposes of this paragraph (c), these deemed transactions are not
taken into account.
(B) As a result of Y's acquisition of 50% of X's interest in
DE1, a section 987 DE, 50% of the assets and liabilities of Business
A ceased being reflected on the books and records of X's section 987
QBU. As a result, such amounts are treated as if they are
transferred from X's section 987 QBU to X.
(C) As a result of Y's acquisition of 50% of the interest in
DE1, a section 987 DE, Y was allocated 50% of the assets and
liabilities of Business A. Because Y and Business A have different
functional currencies, Y's portion of the Business A assets and
liabilities constitutes a section 987 QBU. Moreover, 50% of the
assets and liabilities of Business A are reflected on the books and
records of Y's section 987 QBU as a result of Y's acquisition of the
50% interest in DE1. Therefore, 50% of the assets and liabilities of
Business A are treated as transferred by Y to Y's section 987 QBU.
Example 7. Conversion of a DE to a partnership through a
contribution. (i) Facts. X owns 100% of the interests in DE1. DE1
owns Business A. On December 31, year 1, Y contributes property to
DE1 in exchange for an interest in DE1. The property transferred by
Y to DE1 is used in Business A and is reflected on the books and
records of Business A. Immediately after such contribution, X and Y
each have a 50% allocable share of the assets and liabilities of
Business A as determined under Sec. 1.987-7.
(ii) Analysis. (A) For Federal tax purposes DE1 is converted to
a partnership when Y contributes property to DE1 in exchange for a
50% interest in DE1. Y's contribution is treated as a contribution
to a partnership in exchange for an ownership interest in the
partnership. X is treated as contributing all of Business A to the
partnership in exchange for a partnership interest. See Rev. Rul.
99-5 (situation 2), (1999-1 CB 434). See Sec. 601.601(d)(2) of this
chapter. For purposes of this paragraph (c), these deemed
transactions are not taken into account.
(B) As a result of Y's acquisition of a 50% interest in DE1, 50%
of the assets and liabilities of Business A ceased being reflected
on the books and records of X's section 987 QBU, and 50% of the
assets contributed by Y to DE1 are reflected on the books and
records of such section 987 QBU. As a result, 50% of the Business A
assets are treated as if they are transferred from X's section 987
QBU to X. Further, 50% of the assets contributed by Y to DE1 are
treated as if they are transferred by X to X's section 987 QBU.
(C) Because Y and Business A have different functional
currencies, Y's portion of the Business A assets and liabilities
(including the property contributed by Y that is used in Business A)
constitutes a section 987 QBU. As a result of Y's acquisition of a
50% interest in DE1, 50% of the assets and liabilities of Business A
are reflected on the books and records of Y's section 987 QBU and,
therefore, are treated as if they are transferred by Y to such
section 987 QBU.
Example 8. Termination of a partnership under section 708(b).
(i) Facts. X owns 60% of the interest in P, a partnership. Y owns
the other 40% interest in P. P owns Business A. X and Y have a 60%
and 40% allocable share of the assets and liabilities of Business A,
respectively, as determined under Sec. 1.987-7, that constitute
section 987 QBUs. On December 31, year 1, X sells a 50% interest in
P to Y. After such sale, X and Y own 10% and 90%, respectively, in
P. In addition, after such sale, X and Y have a 10% and 90%
allocable share of the assets and liabilities of Business A,
respectively, as determined under Sec. 1.987-7.
(ii) Analysis. (A) X's sale of 50% of the interests in P to Y
causes P to terminate pursuant to section 708(b). As a result of
such termination, P is treated as if it contributes all of its
assets and liabilities to a new partnership in exchange for an
interest in the new partnership; and, immediately thereafter, P
distributes 10% and 90% of the interests in the new partnership to X
and Y, respectively, in liquidation of P. See Sec. 1.708-1(b)(4).
For purposes of this paragraph (c), these deemed transactions are
not taken into account.
(B) As a result of Y's acquisition of a 50% interest in P from
X, 50% of the assets and liabilities of Business A ceased being
reflected on the books and records of X's section 987 QBU and become
reflected on the books and records of Y's section 987 QBU. As a
result, 50% of the Business A assets are treated as if they are
transferred from X's section 987 QBU to X. Further, 50% of the
Business A assets are treated as if they are transferred by Y to Y's
section 987 QBU.
Example 9. Transfer of section 987 QBU to a partnership. (i)
Facts. X owns Business A. On December 31, year 1, X and Y form P, a
partnership. X transfers Business A to P in exchange for a 50%
interest in P. Y transfers property to P in exchange for the other
50% interest in P. The property Y transfers to P is not used in
Business A and is not reflected on the books and records of Business
A (but is instead reflected on the books and records of P). After
the formation of P, Business A continues to be an eligible QBU. In
addition, after the formation of P, X and Y each have a 50%
allocable share of the assets and liabilities of Business A,
respectively, as determined under Sec. 1.987-7.
(ii) Analysis. As a result of X contributing Business A to P,
50% of the assets and liabilities of Business A ceased being
reflected on the books and records of X's section 987 QBU, and
became reflected on the books and records of Y's section 987 QBU. As
a result, 50% of the Business A assets are treated as if they are
transferred from X's section 987 QBU to X. Further, 50% of the
Business A assets are treated as if they are transferred from Y to
Y's section 987 QBU.
Example 10. Contribution of assets to a corporation. (i) Facts.
X owns Business A. On
[[Page 52901]]
December 31, year 1, X forms Z, a domestic corporation. X and Z do
not file a consolidated tax return. X contributes 50% of its
Business A assets and liabilities to Z in exchange for 100% of the
stock of Z. The Z stock is recorded on the books and records of
Business A. After the contribution, X continues to operate Business
A, and Business A continues to maintain separate books and records
from X.
(ii) Analysis. Even though the Z stock is recorded on the books
and records of Business A, it is not reflected on the books and
records for purposes of section 987 pursuant to paragraph (b)(2) of
this section. As a result, there has been a transfer of 50% of the
assets and liabilities of Business A to X, and a subsequent transfer
of such assets and liabilities to Z. The answer would be the same
even if X and Z filed a consolidated return.
Example 11. Transfers pursuant to general tax principles. (i)
Facts. X owns 100 percent of the stock of Y. Y owns 100 percent of
the interests in DE1. DE1 owns Business A. X owns [euro]100. Because
Business A is in need of additional capital, X transfers the
[euro]100 to Y as a contribution to capital and, as a result of such
transfer, Business A records [euro]100 on its separate books and
records. Y did not record the [euro]100 on its separate books and
records.
(ii) Analysis. As a result of the contribution of [euro]100 from
X to Y, the [euro]100 is reflected on the books and records of
Business A. Pursuant to paragraph (c)(7) of this section, the
[euro]100 is treated as if it was transferred first from X to Y.
Therefore, the [euro]100 recorded on the books and records of
Business A is treated as a transfer from Y to Business A, even
though there was no transaction between Y and Business A. See also
Sec. 1.988-1(a)(10)(ii) for the application of section 988 to Y as
a result of the transaction.
Example 12. Circular transfers. (i) Facts. X owns Business A. On
December 30, year 1, Business A purports to transfer [euro]100 to X.
On January 2, year 2, X purports to transfer [euro]50 to Business A.
On January 4, year 2, X purports to transfer another [euro]50 to
Business A. As of the end of year 1, X has an unrecognized section
987 loss with respect to Business A, such that a remittance, if
respected, would result in recognition of a foreign currency loss
under section 987.
(ii) Analysis. Because the transfers by Business A are offset by
a transfer from X that occurred in close temporal proximity,
pursuant to paragraph (c) of this section, the IRS will scrutinize
the transaction and may disregard the purported transfers to and
from Business A for purposes of section 987.
Example 13. Transfers without economic substance. (i) Facts. X
owns Business A and Business B. On January 1, year 1, Business A
purports to transfer [euro]100 to X. On January 4, year 1, X
purports to transfer [euro]100 to Business B. The account in which
Business B deposited the [euro]100 is used to pay the operating
expenses and other costs of Business A. As of the end of year 1, X
has an unrecognized section 987 loss with respect to Business A,
such that a remittance, if respected, would result in recognition of
a foreign currency loss under section 987.
(ii) Analysis. Because Business A continues to have use of the
transferred property, pursuant to paragraph (c) of this section, the
IRS will scrutinize the transaction and may disregard the [euro]100
purported transfer from Business A to X for purposes of section 987.
Example 14. Offsetting positions in section 987 QBUs. (i) Facts.
X owns Business A and Business B. Business A and Business B each has
the euro as its functional currency. X has not made a grouping
election under Sec. 1.987-1(b)(2)(ii). On January 1, year 1, X
borrowed [euro]1,000 from a third party lender, recorded the
liability with respect to the borrowing on the books and records of
Business A, and recorded the [euro]1,000 of borrowed cash on the
books and records of Business B. On December 31, year 2, when
Business A has $100 of net unrecognized section 987 loss and
Business B has $100 of net unrecognized section 987 gain resulting
from the change in exchange rates with respect to the liability and
the [euro]1,000 cash, X terminates the Business A section 987 QBU.
(ii) Analysis. Because Business A and Business B have offsetting
positions in the euro, the IRS will scrutinize the transaction to
determine if a principal purpose of recording the euro-denominated
liability and the borrowed euros on the books and records of
Business A and Business B, respectively, was the avoidance of tax
under section 987. If such a principal purpose is present, the
Commissioner may reallocate the items (that is, the euros and the
euro-denominated liability) between Business A, Business B, and X,
to reflect the economic substance of the transaction.
Example 15. Offsetting positions with respect to a section 987
QBU and a section 988 transaction. (i) Facts. X owns DE1, and DE1
owns Business A. On January 1, year 1, X borrows [euro]1,000 from a
third party lender and records the liability with respect to the
borrowing on its books and records. X contributes the [euro]1,000
loan proceeds to DE1 and the [euro]1,000 are reflected on the books
and records of Business A. On December 31, year 2, when Business A
has $100 of net unrecognized section 987 loss resulting from the
[euro]1,000 cash received from the borrowing, and the euro-
denominated borrowing, if repaid, would result in $100 of gain under
section 988, X terminates the Business A section 987 QBU.
(ii) Analysis. Because X and Business A have offsetting
positions in the euro, the Internal Revenue Service will scrutinize
the transaction to determine whether a principal purpose of
recording the borrowed euros on the books and records of Business A,
or not recording the corresponding euro-denominated liability on the
books and records of Business A, was the avoidance of tax under
section 987. If such a principal purpose is present, the
Commissioner may reallocate the items (that is, the euros and the
euro-denominated liability) between Business A and X to reflect the
economic substance of the transaction.
(d) Translation of items transferred to a section 987 QBU--(1) In
general--(i) Assets. Except as otherwise provided in this section, the
adjusted basis of an asset transferred to a section 987 QBU shall be
translated into the section 987 QBU's functional currency at the spot
rate as defined in Sec. 1.987-1(c)(1)(i) and (ii) on the day of
transfer. If the asset transferred is denominated in (or determined by
reference to) the functional currency of the section 987 QBU (for
example, cash or note denominated in the functional currency of the
section 987 QBU), no translation is required.
(ii) Liabilities. Except as otherwise provided in this section, a
liability of the owner that is transferred to a section 987 QBU, shall
be translated into the section 987 QBU's functional currency at the
spot rate (as defined in Sec. 1.987-1(c)(1)(i) and (ii)) on the day of
transfer. If the liability transferred is denominated in (or determined
by reference to) the functional currency of the section 987 QBU, no
translation is required.
(2) Items denominated in the owner's functional currency.
Transactions described in section 988(c)(1)(i) and (ii) and section
988(c)(1)(C) that are denominated in (or determined by reference to)
the owner's functional currency and that are attributable to a section
987 QBU under paragraph (b) of this section, shall not be translated
and shall be carried on the balance sheet described in Sec. 1.987-4(e)
in the owner's functional currency.
Sec. 1.987-3 Determination of section 987 taxable income or loss of
an owner of a section 987 QBU.
(a) Determination of the section 987 taxable income or loss of an
owner of a section 987 QBU. Except as otherwise provided in this
section, the section 987 taxable income or loss of an owner with
respect to a section 987 QBU shall be determined in accordance with
paragraphs (a)(1) and (a)(2) of this section.
(1) In general--(i) Determination of each item of income, gain,
deduction or loss in the section 987 QBU's functional currency. Except
as otherwise provided in this section, the section 987 QBU shall
determine each item of income, gain, deduction or loss attributable to
such QBU under Sec. 1.987-2(b) in its functional currency under U.S.
tax principles.
(ii) Translation of items into the owner's functional currency. The
owner shall translate each item determined under this paragraph (a)(1)
into its functional currency as provided in paragraph (b) of this
section.
(2) Determination in the case of a section 987 QBU owned indirectly
through a partnership--(i) In general. Except as otherwise provided in
this paragraph (a)(2), the taxable income or loss of a section 987
partnership, and the distributive share of any owner that
[[Page 52902]]
is a partner in such partnership, shall be determined in accordance
with the provisions of subchapter K of this chapter.
(ii) Determination of each item of income, gain, deduction or loss
in the eligible QBU's functional currency. Except as otherwise provided
in this section, the section 987 partnership shall determine each item
of income, gain, deduction or loss reflected on the books and records
of each of its eligible QBUs under Sec. 1.987-2(b) in the functional
currency of each such QBU.
(iii) Allocation of items of income, gain, deduction or loss of an
eligible QBU. The section 987 partnership shall allocate the items of
income, gain, deduction or loss of each eligible QBU among its partners
in accordance with each partner's distributive share of such income,
gain, deduction, or loss as determined under subchapter K of this
chapter.
(iv) Translation of items into the owner's functional currency. To
the extent such items are reflected on the books and records of a
section 987 QBU of a partner to whom they are allocated, the partner
shall adjust the items to conform to U.S. tax principles and translate
the items into the partner's functional currency as provided in
paragraph (b) of this section.
(b) Exchange rates to be used in translating items of income, gain,
deduction or loss of a section 987 QBU into the owner's functional
currency--(1) In general. Except as otherwise provided in this section,
the exchange rate to be used by an owner in translating an item of
income, gain, deduction, or loss of a section 987 QBU as determined in
Sec. 1.987-2(b) into the owner's functional currency shall be the
yearly average exchange rate as defined in Sec. 1.987-1(c)(2) for the
taxable year. Alternatively, the owner may elect under Sec. 1.987-1(f)
to use the spot rate as defined in Sec. 1.987-1(c)(1)(i) and (ii) for
the day each item is properly taken into account.
(2) Exceptions--(i) Depreciation, depletion, and amortization
deductions. The exchange rate to be used by the owner in translating
deductions allowable with respect to section 987 historic assets (as
defined in Sec. 1.987-1(e)) for depreciation, depletion, and
amortization under the pertinent provisions of the Code shall be the
historic exchange rate as determined under Sec. 1.987-1(c)(3) for the
property to which such deductions are attributable.
(ii) Gain or loss from the sale of property. In the case of gain or
loss recognized on a sale or other disposition of property that is
reflected on the books and records of a section 987 QBU during the
taxable year, the following exchange rates shall apply with respect to
such sale or other disposition:
(A) Amount realized--(1) In general. Except as otherwise provided
in paragraph (b)(2)(ii)(A)(2), the exchange rate to be used in
translating the amount realized of such property shall be the rate
provided in paragraph (b)(1) of this section for the taxable year.
(2) Certain section 987 marked assets. In the case of a section 987
marked asset (other than cash) that was held on the first day of the
taxable year, the exchange rate to be used in translating the amount
realized shall be the rate used for such asset in determining the owner
functional currency net value of the section 987 QBU under Sec. 1.987-
4(d)(1)(i)(B) for the preceding taxable year. However, in the case of a
section 987 marked asset (other than cash) transferred to the section
987 QBU or acquired by the section 987 QBU during the taxable year, the
exchange rate to be used in translating the amount realized shall be
the spot rate, as defined in Sec. 1.987-1(c)(1)(i) and (ii), for the
day transferred or acquired.
(B) Adjusted basis--(1) In general. Except as otherwise provided in
paragraph (b)(2)(ii)(B)(2), the exchange rate to be used in translating
the adjusted basis of such property shall be the historic exchange rate
as determined under Sec. 1.987-1(c)(3) for such asset.
(2) Certain section 987 marked assets. In the case of a section 987
marked asset (other than cash) that was held on the first day of the
taxable year, the exchange rate to be used in translating its adjusted
basis shall be the rate used for such asset in determining the owner
functional currency net value of the section 987 QBU under Sec. 1.987-
4(d)(1)(i)(B) for the preceding taxable year. However, in the case of a
section 987 marked asset (other than cash) transferred to the section
987 QBU or acquired by the section 987 QBU during the taxable year, the
exchange rate to be used in translating the adjusted basis of such
asset shall be the spot rate, as defined in Sec. 1.987-1(c)(1)(i) and
(ii), for the day transferred or acquired.
(3) Gain or loss on the sale, exchange or other disposition of an
interest in a section 987 partnership. For purposes of determining the
adjusted basis of a partner's interest in a section 987 partnership and
computing gain or loss recognized on the sale, exchange or other
disposition of such interest, see Sec. 1.987-7.
(c) Items of income, gain, deduction or loss that are denominated
in the functional currency of the owner. An item of income, gain,
deduction or loss attributable to a section 987 QBU under Sec. 1.987-
2(b) that is denominated in (or determined by reference to) the owner's
functional currency shall not be translated and shall be taken into
account by the section 987 QBU under U.S. tax principles in the owner's
functional currency.
(d) Items of income, gain, deduction or loss that are denominated
in a nonfunctional currency (other than the functional currency of the
owner). An item of income, gain, deduction or loss attributable to a
section 987 QBU under Sec. 1.987-2(b) that is denominated in (or
determined by reference to) a nonfunctional currency (other than the
owner's functional currency) shall be translated into the section 987
QBU's functional currency at the spot rate as defined in Sec. 1.987-
1(c)(1)(i) and (ii) on the day such item is properly taken into
account.
(e) Section 988 transactions--(1) In general. Except as provided in
paragraph (e)(2) of this section, section 988 shall apply to the
section 988 transactions attributable to a section 987 QBU under Sec.
1.987-2(b), and the timing of any gain or loss shall be determined
under the applicable provisions of the Internal Revenue Code. Such
transactions are section 987 historic items as defined in Sec. 1.987-
1(e).
(2) Certain transactions denominated in (or determined by reference
to) the owner's functional currency are not section 988 transactions.
Transactions described in section 988(c)(1)(A)(i) and (ii) and section
988(c)(1)(C) that are denominated in (or determined by reference to)
the owner's functional currency and that are attributable to a section
987 QBU under Sec. 1.987-2(b) shall not be treated as section 988
transactions to such QBU. Thus, no currency gain or loss shall be
recognized by a section 987 QBU under section 988 with respect to such
items.
(f) Examples. The following examples illustrate the application of
this section:
Example 1. (i) U.S. Corp is a domestic corporation with the
dollar as its functional currency. U.S. Corp owns French DE, a
section 987 DE that has a section 987 branch with the euro as its
functional currency. For purposes of paragraph (b)(1) of this
section, U.S. Corp uses the yearly average exchange rate under Sec.
1.987-1(c)(2) to translate items of income, gain, deduction or loss
where such rate is appropriate. U.S. Corp also properly elects to
use a spot rate convention under Sec. 1.987-1(c)(1)(ii) where the
spot rate is otherwise required. Under this convention, items booked
during a particular month are translated at the average of the spot
rates on the first and last day of the preceding month (the
``convention rate''). Accordingly, gross sales income is translated
at the yearly average exchange rate and under paragraph
(b)(2)(ii)(B) of this section the basis of assets
[[Page 52903]]
acquired during a month is translated into dollars at the convention
rate. Assume that the yearly average exchange rate for 2009 is
[euro]1 = $1.05. For the taxable year 2009, French DE sells 1,200
units of inventory for a sales price of [euro]3 per unit. Assume
that the purchase price for each inventory unit is [euro]1.50. Thus,
French DE's dollar gross sales will be computed as follows:
Gross Sales
----------------------------------------------------------------------------------------------------------------
[euro]/$ 2009
Month of [euro] ave. exchange $
units rate
----------------------------------------------------------------------------------------------------------------
Jan............................................. 100 300 [euro]1=$1.05 315
Feb............................................. 200 600 [euro]1=$1.05 630
March........................................... 0 0 [euro]1=$1.05 0
April........................................... 200 600 [euro]1=$1.05 630
May............................................. 100 300 [euro]1=$1.05 315
June............................................ 0 0 [euro]1=$1.05 0
July............................................ 100 300 [euro]1=$1.05 315
Aug............................................. 100 300 [euro]1=$1.05 315
Sept............................................ 0 0 [euro]1=$1.05 0
Oct............................................. 0 0 [euro]1=$1.05 0
Nov............................................. 100 300 [euro]1=$1.05 315
Dec............................................. 300 900 [euro]1=$1.05 945
---------------------------------------------------------------
1,200 3,600 .............. 3,780
----------------------------------------------------------------------------------------------------------------
Opening Inventory and Purchases
----------------------------------------------------------------------------------------------------------------
[euro]/$
Month of [euro] convention $
units exchange rate
----------------------------------------------------------------------------------------------------------------
Opening inventory from 2008..................... 100 150 [euro]1=$1.00 150
Purchases:
Jan......................................... 300 450 [euro]1=$1.00 450
Feb......................................... 0 0 [euro]1=$1.05 0
March....................................... 0 0 [euro]1=$1.03 0
April....................................... 300 450 [euro]1=$1.02 459
May......................................... 0 0 [euro]1=$1.04 0
June........................................ 0 0 [euro]1=$1.05 0
July........................................ 300 450 [euro]1=$1.06 477
Aug......................................... 0 0 [euro]1=$1.05 0
Sept........................................ 0 0 [euro]1=$1.06 0
Oct......................................... 0 0 [euro]1=$1.07 0
Nov......................................... 300 450 [euro]1=$1.08 486
Dec......................................... 0 0 [euro]1=$1.08 0
---------------------------------------------------------------
Total Purchases......................... 1,200 1,800 .............. 1,872
----------------------------------------------------------------------------------------------------------------
(ii) French DE uses a first in first out method of accounting
for inventory (FIFO). Thus, for 2009, French DE is considered to
have sold the 100 units of opening inventory ($150), the 300 units
purchased in January ($450), the 300 units purchased in April
($459), the 300 units purchased in July ($477) and 200 of the 300
units purchased in November ($324). Thus, French DE's cost of goods
sold is $1,860. French DE's opening inventory for 2010 is 100 units
of inventory with a dollar basis of $162.
(iii) Accordingly, for purposes of section 987 French DE has
gross income in dollars of $1,920 ($3,780-$1,860).
Example 2. (i) The facts are the same as in Example 1 except
that for purposes of paragraph (b)(1) of this section, U.S. Corp
properly elects to use a spot rate convention under Sec. 1.987-
1(c)(1)(ii) to translate items of income, gain, deduction or loss
where such rate is appropriate. Thus, French DE's dollar gross sales
will be computed as follows:
Gross Sales
----------------------------------------------------------------------------------------------------------------
[euro]/$
Sales of [euro] convention $
units exchange rate
----------------------------------------------------------------------------------------------------------------
Jan............................................. 100 300 [euro]1=$1.00 300
Feb............................................. 200 600 [euro]1=$1.05 630
March........................................... 0 0 [euro]1=$1.03 0
April........................................... 200 600 [euro]1=$1.02 612
May............................................. 100 300 [euro]1=$1.04 312
June............................................ 0 0 [euro]1=$1.05 0
July............................................ 100 300 [euro]1=$1.06 318
Aug............................................. 100 300 [euro]1=$1.05 315
Sept............................................ 0 0 [euro]1=$1.06 0
Oct............................................. 0 0 [euro]1=$1.07 0
Nov............................................. 100 300 [euro]1=$1.08 324
Dec............................................. 300 900 [euro]1=$1.08 972
---------------------------------------------------------------
[[Page 52904]]
1,200 3,600 .............. 3,783
----------------------------------------------------------------------------------------------------------------
(ii) As in Example 1, French DE's cost of goods sold is $1,860.
(iii) Accordingly, for purposes of section 987 French DE has
gross income in dollars of $1,923 ($3,783-$1,860).
Example 3. The facts are the same as in Example 1 except that
French DE sold raw land on November 1, 2009 for [euro]10,000. The
yearly average rate for 2009 was [euro]1=$1.05. The land was
purchased on October 16, 2007 for [euro]8,000 when the convention
rate was [euro]1=$1.00. Under paragraph (a)(1) of this section,
French DE will determine the amount realized and basis in euros.
Under paragraph (a)(1)(ii) of this section, the amount realized is
translated into dollars at the yearly average exchange rate for 2009
as provided in paragraph (b)(2)(ii)(A) of this section ([euro]10,000
x $1.05 = $10,500) and the basis at the convention rate for 2007 as
provided in paragraph (b)(2)(ii)(B) of this section and Sec. 1.987-
1(c)(3) [euro]8,000 x $1 = $8,000). Accordingly, the amount of gain
reported by U.S. Corp on the sale of the land is $2,500 ($10,500-
$8,000).
Example 4. The facts are the same as in Example 3 except that
U.S. Corp properly elects under paragraph (b)(1) of this section to
use the spot rate to translate items of income, gain, deduction or
loss. Accordingly, the amount realized will be translated at the
convention rate on the day of sale. Assume that the convention rate
for November 2009 is [euro]1 = $1.08. Under these facts, the amount
realized is $10,800 ([euro]10,000 x $1.08) and the basis on the day
of purchase $8,000 ([euro]8,000 x $1.00). The amount of gain
reported by U.S. Corp on the sale of the land is $2,800 ($10,800 -
$8,000).
Example 5. The facts are the same as in Example 1 except that on
September 15, 2009, French DE provides services to an unrelated
customer and receives a cash payment of [euro]2,000 on that day.
Under paragraph (b)(1) of this section, U.S. Corp translates the
[euro]2,000 item of income into dollars at the yearly average
exchange rate of [euro]1 = $1.05. Accordingly, U.S. Corp will report
income of $2,100 from providing services.
Example 6. The facts are the same as in Example 5 except that
U.S. Corp properly elects under paragraph (b)(1) of this section to
use the spot rate to translate items of income, gain, deduction or
loss. Assume that the convention rate for September 2009 is [euro]1
= $1.06. Under these facts, U.S. Corp translates the [euro]2,000
item of income into dollars at the convention rate of [euro]1 =
$1.06. Accordingly, U.S. Corp will report income of $2,120 from
providing services.
Example 7. The facts are the same as in Example 1 except that on
March 31, 2009, French DE incurs [euro]500 of rental expense,
[euro]300 of salary expense and [euro]100 of utilities expense.
Under paragraph (b)(1) of this section, U.S. Corp translates these
items of expense at the yearly average exchange rate of [euro]1 =
$1.05. Accordingly the expenses are translated as follows: rental
expense of $525, salary expense of $315 and utilities expense of
$105.
Example 8. The facts are the same as in Example 7 except that
U.S. Corp properly elects under paragraph (b)(1) of this section to
use the spot rate to translate items of income and expense. Assume
that the convention rate for March 2009 is [euro]1 = $1.03. Under
these facts, U.S. Corp translates the [euro]500 of rental expense,
[euro]300 of salary expense and [euro]100 of utilities expense at
the convention rate of [euro]1 = $1.03. Accordingly, the expenses
are translated as follows: rental expense of $515, salary expense of
$309 and utilities expense of $103.
Example 9. The facts are the same as in Example 1 except that
during 2009, French DE incurred [euro]100 of depreciation expense
with respect to a truck. The truck was purchased on January 15,
2008, when the convention rate was [euro]1 = $1.02. Under paragraph
(b)(2)(i) of this section, the [euro]100 of depreciation is
translated into dollars at the historic exchange rate. Since U.S.
Corp has properly elected to use a spot rate convention,
depreciation will be translated in accordance with the convention.
Accordingly, U.S. Corp translates the [euro]100 of depreciation to
equal $102.
Example 10. (i) The facts are the same as in Example 1 except
that on January 12, 2009, French DE performed services for a U.K.
person and received [pound]10,000 in compensation. The exchange rate
on January 12, 2009, was [pound]1 = [euro]1.25. Under paragraph (d)
of this section, French DE will translate such income into euros at
the spot rate on January 12, 2009. Accordingly, French DE will take
into account [euro]12,500 of income from services in 2009. Under
paragraph (b)(1) of this section, U.S. Corp translates the
[euro]12,500 item of income into dollars at the yearly average euro
to dollar exchange rate. Assume that such exchange rate is [euro]1 =
$1.10. Accordingly, U.S. Corp translates the [euro]12,500 income
from services to equal $13,750.
(ii) On October 16, 2009, French DE disposes of the
[pound]10,000 for [euro]10,000. Under section 988(c)(1)(C), the
disposition is a section 988 transaction. Under Sec. 1.988-2(a)(2),
French DE will realize a loss of [euro]2,500 ([euro]10,000 amount
realized less [euro]12,500 basis). Under paragraph (b)(1) of this
section, U.S. Corp translates the [euro]2,500 loss into dollars at
the yearly average euro to dollar exchange rate. Assume that such
exchange rate is [euro]1 = $1.05. Accordingly, U.S. Corp translates
the [euro]2,500 section 988 loss to equal $2,625.
Sec. 1.987-4 Determination of net unrecognized section 987 gain or
loss of a section 987 QBU.
(a) In general. The net unrecognized section 987 gain or loss of a
section 987 QBU shall be determined by the owner annually as provided
in paragraph (b) of this section in the owner's functional currency.
Only assets and liabilities reflected on the books and records of the
section 987 QBU under Sec. 1.987-2(b) shall be taken into account.
(b) Calculation of net unrecognized section 987 gain or loss of a
section 987 QBU. Net unrecognized section 987 gain or loss of a section
987 QBU for a taxable year shall equal the sum of--
(1) The section 987 QBU's net accumulated unrecognized section 987
gain or loss for all prior taxable years to which these regulations
apply as determined in paragraph (c) of this section; and
(2) The section 987 QBU's unrecognized section 987 gain or loss for
the current taxable year as determined in paragraph (d) of this
section.
(c) Net accumulated unrecognized section 987 gain or loss for all
prior taxable years. A section 987 QBU's net accumulated unrecognized
section 987 gain or loss for all prior taxable years is the aggregate
of the amounts determined under paragraph (d) of this section for all
prior years to which these regulations apply, reduced by the amounts
taken into account under Sec. 1.987-5 upon a remittance for all such
prior taxable years. This amount shall include amounts appropriately
considered as net unrecognized exchange gain or loss under the
transition rules of Sec. 1.987-10.
(d) Calculation of unrecognized section 987 gain or loss of a
section 987 QBU for a taxable year. The unrecognized section 987 gain
or loss of a section 987 QBU for a taxable year shall be determined
under paragraphs (d)(1) through (7) of this section as follows:
(1) Step 1: Determine the change in the owner functional currency
net value of the section 987 QBU for the taxable year -(i) In general.
The change in the owner functional currency net value of the section
987 QBU for the taxable year shall equal--
(A) The owner functional currency net value of the section 987 QBU,
determined in the functional currency of the owner under paragraph (e)
of this section, on the last day of the current taxable year; less
[[Page 52905]]
(B) The owner functional currency net value of the section 987 QBU,
determined in the functional currency of the owner under paragraph (e)
of this section on the last day of the preceding taxable year. This
amount shall be zero in the case of the QBU's first taxable year.
(ii) Year section 987 QBU is terminated. If a section 987 QBU is
terminated under the rules of Sec. 1.987-8 during an owner's taxable
year, the owner functional currency net value of the section 987 QBU as
provided in paragraph (d)(1)(i)(A) of this section shall be determined
on the day the section 987 QBU is terminated.
(2) Step 2: Increase the aggregate amount determined in step 1 by
the assets transferred from the section 987 QBU to its owner-(i) In
general. The aggregate amount determined in paragraph (d)(1) of this
section shall be increased by the total amount of assets described in
paragraph (d)(2)(ii) of this section transferred from the section 987
QBU to the owner during the taxable year translated into the owner's
functional currency as provided in paragraph (d)(2)(iii) of this
section.
(ii) Assets transferred from the section 987 QBU to the owner
during the taxable year. The assets transferred from the section 987
QBU to the owner for the taxable year shall equal the aggregate of--
(A) The amount of the section 987 QBU's functional currency and the
adjusted basis of any section 987 marked asset (as defined in Sec.
1.987-1(d)) transferred from the section 987 QBU to the owner during
the taxable year determined in the functional currency of the section
987 QBU and translated into the owner's functional currency as provided
in paragraph (d)(2)(iii)(A) of this section; and
(B) The adjusted basis of any section 987 historic asset (as
defined in Sec. 1.987-1(e)) transferred to the owner during the
taxable year determined in the functional currency of the section 987
QBU and translated into the owner's functional currency as provided in
paragraph (d)(2)(iii)(B) of this section. Such amount shall be adjusted
to take into account the proper translation of depreciation, depletion
and amortization as provided in Sec. 1.987-3(b)(2)(i).
(iii) Translation of amounts transferred from the section 987 QBU
to the owner. In the case of a transfer from the section 987 QBU to an
owner of any asset the following exchange rates shall be used:
(A) In the case of an amount described in paragraph (d)(2)(ii)(A)
of this section, the spot exchange rate, as defined in Sec. 1.987-
1(c)(1), on the day of transfer.
(B) In the case of a transfer of a section 987 historic asset, the
historic exchange rate for such asset as defined in Sec. 1.987-
1(c)(3).
(3) Step 3: Decrease the aggregate amount determined in steps 1 and
2 by the owner's transfers to the section 987 QBU--(i) In general. The
aggregate amount determined in paragraphs (d)(1) and (d)(2) of this
section shall be decreased by the total amount of assets transferred
from the owner to the section 987 QBU during the taxable year
determined in the functional currency of the owner as provided in
paragraph (d)(3)(ii) of this section.
(ii) Total of all amounts transferred from the owner to the section
987 QBU during the taxable year. The total amount of assets transferred
from the owner to the section 987 QBU for the taxable year shall equal
the aggregate of--
(A) The total amount of functional currency of the owner
transferred to the section 987 QBU during the taxable year; and
(B) The adjusted basis, determined in the functional currency of
the owner, of any asset transferred to the section 987 QBU during the
taxable year (after taking into account Sec. 1.988-1(a)(10)).
(4) Step 4: Decrease the aggregate amount determined in steps 1
through 3 by the amount of liabilities transferred from the section 987
QBU to the owner. The aggregate amount determined in paragraphs (d)(1)
through (d)(3) of this section shall be decreased by the aggregate
amount of liabilities transferred from the section 987 QBU to the
owner. The amount of such liabilities shall be translated into the
functional currency of the owner at the spot exchange rate, as defined
in Sec. 1.987-1(c)(1), on the day of transfer.
(5) Step 5: Increase the aggregate amount determined in steps 1
through 4 by amount of liabilities transferred from the owner to the
section 987 QBU. The aggregate amount determined in paragraphs (d)(1)
through (d)(4) of this section shall be increased by the aggregate
amount of liabilities transferred by the owner to the section 987 QBU.
The amount of such liabilities shall be translated into the functional
currency of the owner, if required, at the spot exchange rate, as
defined in Sec. 1.987-1(c)(1)(i) and (ii), on the day of transfer.
(6) Step 6: Increase the aggregate amount determined in steps 1
through 5 by the section 987 taxable loss of the section 987 QBU for
the taxable year. In the case of a section 987 taxable loss of the
section 987 QBU computed under Sec. 1.987-3 for the taxable year, the
aggregate amount determined in paragraphs (d)(1) through (d)(5) of this
section shall be increased by such section 987 taxable loss.
(7) Step 7: Decrease the aggregate amount determined in steps 1
through 5 by the section 987 taxable income of the section 987 QBU for
the taxable year. In the case of section 987 taxable income of the
section 987 QBU computed under Sec. 1.987-3 for the taxable year, the
aggregate amount determined in paragraphs (d)(1) through (d)(5) of this
section shall be decreased by such section 987 taxable income.
(e) Determination of the owner functional currency net value of a
section 987 QBU--(1) In general. The owner functional currency net
value of a section 987 QBU on the last day of a taxable year shall
equal the aggregate amount of the QBU's functional currency and the
basis of each asset on the section 987 QBU's balance sheet on that day,
less the aggregate amount of each liability on the section 987 QBU's
balance sheet on that day translated, if necessary, into the owner's
functional currency as provided in paragraph (e)(2) of this section.
Such amount shall be determined as follows:
(i) The owner, or section 987 QBU on behalf of the owner, shall
prepare a balance sheet for the relevant date from the section 987
QBU's books and records (within the meaning of Sec. 1.989(a)-1(d)) as
recorded in the section 987 QBU's functional currency showing all
assets and liabilities reflected on such books and records as provided
in Sec. 1.987-2(b). Assets and liabilities denominated in the
functional currency of the owner shall be reflected on the balance
sheet in the owner's functional currency.
(ii) The owner, or section 987 QBU on behalf of the owner, shall
make adjustments necessary to conform the items reflected on the
balance sheet described in paragraph (e)(1)(i) of this section to
United States generally accepted accounting principles and tax
accounting principles.
(iii) The owner, or section 987 QBU on behalf of the owner, shall
translate the asset and liability amounts on the adjusted balance sheet
described in paragraph (e)(1)(ii) of this section into the functional
currency of the owner in accordance with paragraph (e)(2) of this
section. Assets and liabilities denominated in the functional currency
of the owner are not translated.
(2) Translation of balance sheet items into the owner's functional
currency. The amount of the section 987 QBU's functional currency, the
basis of an asset, or the amount of a liability (other
[[Page 52906]]
than an asset or liability reflected on the balance sheet in the
functional currency of the owner) shall be translated as follows:
(i) Section 987 marked item. A section 987 marked item as defined
in Sec. 1.987-1(d) shall be translated into the owner's functional
currency at the spot exchange rate as defined in Sec. 1.987-1(c)(1)(i)
and (ii) on the last day of the taxable year.
(ii) Section 987 historic item. A section 987 historic item as
defined in Sec. 1.987-1(e) shall be translated into the owner's
functional currency at the historic exchange rate as defined in Sec.
1.987-1(c)(3).
(f) Examples. The provisions of this section are illustrated by the
following examples. Unless otherwise indicated, all items are assumed
to be reflected on the books and records, within the meaning of Sec.
1.987-2(b), of the relevant section 987 QBU.
Example 1. (i) U.S. Corp is a calendar year domestic corporation
with the dollar as its functional currency. On July 1, 2009, U.S.
Corp establishes Japan Branch that has the yen as its functional
currency. Japan Branch is a section 987 QBU of U.S. Corp. U.S. Corp
properly elects to use a spot rate convention under Sec. 1.987-
1(c)(1)(ii) with respect to Japan Branch. Under this convention, the
spot rate for any transaction occurring during a month is the spot
rate on the first day of the month. U.S. Corp also elects under
Sec. 1.987-3(b)(1) to use this convention to translate items of
income, gain, deduction, or loss into dollars. On July 1, 2009, when
$1 = [yen]100 (or [yen]1 = $0.01), U.S. Corp transfers $1,000 to
Japan Branch and raw land with a basis of $500. Japan Branch
immediately purchases [yen]100,000 with the $1,000. On the same day,
Japan Branch borrows [yen]10,000. Assume that for the taxable year
2009, Japan Branch earns [yen]2,000 per month (total of [yen]12,000
for the six month period from July 1, 2009, through December 31,
2009) for providing services and incurs [yen]333.33 per month (total
of [yen]2,000 when rounded for the six month period from July 1,
2009, through December 31, 2009) of related expenses. Assume that
all items of income earned and expenses incurred by Japan Branch
during 2009 are received and paid, respectively, in yen. Further,
assume that the [yen]12,000 of income when properly translated under
the monthly convention equals $109.08 and that the [yen]2,000 of
related expenses equal $18.18. Thus, Japan Branch's income
translated into dollars equals $90.90. Assume that the spot exchange
rate on the December 1, 2009, is $1 = [yen]120 ([yen]1 = $0.00833).
(ii) Under paragraph (a) of this section, U.S. Corp must compute
the net unrecognized section 987 gain or loss of Japan Branch for
2009. Since this is Japan Branch's first taxable year, the net
unrecognized section 987 gain or loss as defined under paragraph (b)
of this section is the branch's unrecognized section 987 gain or
loss for 2009 as determined in paragraph (d) of this section. The
calculation under paragraph (d) of this section is made as follows:
(iii) Step 1. Under paragraph (d) of this section, U.S. Corp
must determine the change in the owner functional currency net value
of Japan Branch for the year 2009 in dollars. The change in the
owner functional currency net value of Japan Branch for 2009 is
equal to the owner functional currency net value of Japan Branch
determined in dollars on the last day of 2009, less the owner
functional currency net value of Japan Branch determined in dollars
on the last day of the preceding taxable year.
(A) The owner functional currency net value of Japan Branch
determined in dollars on the last day of the current taxable year is
determined under paragraph (e) of this section. Such amount is the
aggregate of the basis of each asset on Japan Branch's balance sheet
on December 31, 2009, less the aggregate of the amount of each
liability on the Japan Branch's balance sheet on that day,
translated into dollars as provided in paragraph (e)(2) of this
section.
(B) For this purpose, Japan Branch will show the following
assets and liabilities on its balance sheet for December 31, 2009:
(1) Cash of [yen]120,000 [($1,000 transferred and immediately
converted to [yen]100,000) + [yen]10,000 borrowed + [yen]12,000
income from services - [yen]2,000 of expenses].
(2) Raw land with a basis of [yen]50,000.
(3) Liabilities of [yen]10,000.
(C) Under paragraph (e)(2) of this section, U.S. Corp will
translate these items as follows. The cash of [yen]120,000 is a
section 987 marked asset and the [yen]10,000 liability is a section
987 marked liability as defined in Sec. 1.987-1(d). These items are
translated into dollars on December 31, 2009, using the spot rate on
December 1, 2009 of [yen]1 =$ 0.00833. The raw land is a section 987
historic asset as defined in Sec. 1.987-1(e) and is translated into
the dollars at the convention rate for the day of transfer ([yen]1 =
$0.01). Thus, the owner functional currency net value of Japan
Branch on December 31, 2009, in dollars is $1,416.60 determined as
follows:
---------------------------------------------------------------------------
\4\ Opening cash of [yen]100,000 + [yen]10,000 borrowed +
[yen]12,000 income from services - [yen]2,000 expenses.
----------------------------------------------------------------------------------------------------------------
Amount in
Asset [yen] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Cash...................................... \4\ 120,000 12/01/09 spot convention rate on 12/31/ 999.60
09 of [yen]1=$0.00833.
Land...................................... 50,000 Historic rate on 7/1/09 of 500.00
[yen]1=$0.01.
-----------------------------------------------------------------
Total assets.......................... ........... ...................................... 1,499.60
Liability:
Bank Loan................................. 10,000 12/01/09 spot convention rate on 12/31/ 83.30
09 of [yen]1 = $0.00833.
-----------------------------------------------------------------
Total liabilities..................... ........... ...................................... 83.30
Owner functional currency net value of Japan ........... ...................................... 1,416.30
Branch on December 31, 2009 in dollars.
----------------------------------------------------------------------------------------------------------------
(D) Under paragraph (d)(1) of this section, the change in owner
functional currency net value of Japan Branch for 2009 is equal to
the owner functional currency net value of the branch determined in
dollars on December 31, 2009 ($1,416.30) less the owner functional
currency net value of the branch determined in dollars on the last
day of the preceding taxable year. Since this is the first taxable
year of Japan Branch, the owner functional currency net value of
Japan Branch determined in dollars on the last day of the preceding
taxable year is zero under paragraph (d)(1)(i)(B) of this section.
Accordingly, the change in owner functional currency net value of
Japan Branch for 2009 is $1,416.30.
(iv) Step 2. Under paragraph (d)(2) of this section, the
aggregate amount determined in paragraph (d)(1) of this section
(step 1) is increased by the total amount of assets described in
paragraph (d)(2)(ii) of this section transferred from the section
987 QBU to the owner during the taxable year translated into the
owner's functional currency as provided in paragraph (d)(2)(iii) of
this section. Since no such amounts were transferred under these
facts, there is no change in the $1,416.30 determined in step 1.
(v) Step 3. Under paragraph (d)(3) of this section, the
aggregate amount determined in paragraphs (d)(1) and (2) of this
section (steps 1-2) is decreased by the total amount of assets
transferred from the owner to the section 987 QBU during the taxable
year as determined in paragraph (d)(3)(ii) of this section in
dollars. On July 1, 2009, U.S. Corp transferred to Japan Branch
$1,000 (which Japan Branch immediately converted into [yen]100,000)
and raw land with a basis of $500 (equal to [yen]50,000 on the day
of transfer).
[[Page 52907]]
Thus, the step 2 amount of $1,416.30 is reduced by $1,500.00 to
equal ($83.70).
(vi) Steps 4, 5 and 6. Since no liabilities were transferred by
U.S. Corp to Japan Branch or vice versa, the amount determined after
applying paragraphs (d)(1) through (d)(5) of this section is
($83.70). Further, paragraph (d)(6) of this section does not apply
since Japan Branch does not have a section 987 taxable loss.
(vii) Step 7. Under paragraph (d)(7) of this section, the
aggregate amount determined after applying paragraphs (d)(1) through
(d)(5) of this section (steps 1-5) is decreased by the section 987
taxable income of Japan Branch of $90.90. Accordingly, the
unrecognized section 987 loss of Japan Branch for 2009 is $174.60 (-
$83.70-$90.90).
Example 2. (i) U.S. Corp, a calendar year domestic corporation
with the dollar as its functional currency, operates in the United
Kingdom through UK Branch. UK Branch has the pound as its functional
currency and is a section 987 QBU. U.S. Corp properly elects to use
a spot rate convention under Sec. 1.987-1(c)(1)(ii). Under this
convention, the spot rate for any transaction occurring during a
month is the average of the pound spot rate and the 30-day forward
rate for pounds on the next-to-last Thursday of the preceding month.
Pursuant to Sec. 1.987-3(b)(1), U.S. Corp uses the yearly average
exchange rate as defined in Sec. 1.987-1(c)(2) to translate items
of income, gain, deduction, or loss into dollars for the taxable
year, where appropriate. The yearly average exchange rate for 2009
was [pound]1 = $1.05. The closing balance sheet of UK Branch for the
prior year (2008) reflected the following assets and liabilities.
With respect to assets, UK Branch held--
(A) Cash of [pound]100;
(B) Plant purchased in May 2007 with an adjusted basis of
[pound]1000;
(C) A machine purchased in May 2007 with an adjusted basis of
[pound]200;
(D) Inventory of 100 units manufactured in December 2008 with a
basis of [pound]100;
(E) Portfolio stock (as defined in Sec. 1.987-2(b)(2)(ii)) in
ABC Corporation purchased in September 2008 with a basis of
[pound]158; and
(F) $50 acquired in 2008 (and held in a non-interest bearing
account).
With respect to liabilities, UK Branch has [pound]50 of long-
term debt entered into in 2007 with F Bank, an unrelated bank. The
plant, machine, inventory, stock and dollars are section 987
historic assets as defined in Sec. 1.987-1(e). The cash of
[pound]100 and long-term debt are section 987 marked items as
defined under Sec. 1.987-1(d). Assume the U.S. Corp translated UK
Branch's 2008 closing balance sheet as follows:
----------------------------------------------------------------------------------------------------------------
Amount in
Assets [pound] Translation Rate Amount in $
----------------------------------------------------------------------------------------------------------------
Cash...................................... 100 Spot convention rate in Dec. 2008 100.00
[pound]1 = $1.
Plant..................................... 1,000 Historic rate-2007 May convention rate 900.00
[pound]1= $0.90.
Machine................................... 200 Historic rate-2007 May convention rate 180.00
[pound]1= $0.90.
Stock..................................... 158 Historic rate-2008 Sept. convention 150.00
rate [pound]1= $.95.
Inventory................................. 100 Historic rate-2008 Dec. convention 100.00
rate [pound]1 = $1.
Dollars................................... $50 Dollars are not translated............ 50.00
-----------------------------------------------------------------
Total assets.......................... ........... ...................................... 1,480.00
Liabilities:
Bank Loan................................. [pound]50 Spot convention rate in Dec. 2008 50.00
[pound]1 = $1.
-----------------------------------------------------------------
Total liabilities..................... ........... ...................................... 50.00
2008 ending owner functional currency net ........... ...................................... 1,430
value (in dollars).
----------------------------------------------------------------------------------------------------------------
(ii) UK Branch uses the first in first out method of accounting
for inventory. In 2009, UK Branch sold 100 units of inventory for a
total of [pound]300 and purchased another 100 units of inventory in
December 2009 for [pound]100. Assume that the dollar basis of the
inventory purchased in December 2009 when translated at the December
2009 monthly convention rate is $110; that depreciation with respect
to the plant is [pound]33 and for the machine [pound]40\5\; and that
UK Branch incurred [pound]30 of business expenses during 2009.
Assume all items of income earned and expenses incurred during 2009
are received and paid, respectively, in pounds. The yearly average
exchange rate for 2009 is [pound]1 = $1.05. Under Sec. 1.987-3, UK
Branch's section 987 taxable income or loss is determined as
follows:
---------------------------------------------------------------------------
\5\ The depreciation assumptions are for illustrative purposes
only and may not be consistent with true depreciation rates.
----------------------------------------------------------------------------------------------------------------
Amount in
Item [pound] Translation Rate Amount in $
----------------------------------------------------------------------------------------------------------------
Gross receipts........................... 300 2009 yearly ave. rate [pound]1 = $1.05..... 315.00
Less:
COGS................................. (100) Historic rate-Dec. 2008 convention rate (100.00)
[pound]1= $1.
----------------------------------------------------------------------
Gross income..................... 200 ........................................... 215.00
Dep:
Plant................................ (33) Historic rate-May 2007 convention rate (29.70)
[pound]1= $0.90.
Machine.............................. (40) Historic rate-May 2007 convention rate (36.00)
[pound]1= $0.90.
Other expenses........................... (30) 2009 yearly ave. rate [pound]1 = $1.05..... (31.50)
----------------------------------------------------------------------
Total expenses................... ........... ........................................... 97.20
Section 987 taxable income............... ........... ........................................... 117.80
----------------------------------------------------------------------------------------------------------------
Accordingly, UK Branch has $117.80 of section 987 taxable
income.
(iii) Assume that in December 2009, UK Branch transferred $20
and [pound]30 to U.S. Corp and that U.S. Corp transferred a computer
with a basis of $10 to UK Branch. The convention exchange rate for
December 2009 is [pound]1 = $1.10. Finally, assume that U.S. Corp's
net accumulated unrecognized section 987 gain or loss for all prior
taxable years as determined in paragraph (c) of this section is $30.
(iv) The unrecognized section 987 gain or loss of UK Branch for
2009 is determined as follows:
(A) Step 1: Determine the change in owner functional currency
net value of UK Branch. Under paragraph (d)(1) of this section, the
[[Page 52908]]
change in owner functional currency net value for the taxable year
must be determined. This amount is equal to the owner functional
currency net value of UK Branch determined under paragraph (e) of
this section on the last day of 2009, less the owner functional
currency net value of UK Branch determined on the last day of 2008.
The owner functional currency net value of UK Branch on December 31,
2009, and the change in owner functional currency net value is
determined as follows:
---------------------------------------------------------------------------
\6\ [pound]100 on the closing 2008 balance sheet plus [pound]300
gross receipts less [pound]100 inventory cost, less [pound]30 of
additional expenses, less [pound]30 transferred to U.S. Corp.
\7\ [pound]1,000 on the closing 2008 balance sheet less
[pound]33 depreciation.
\8\ [pound]200 on the closing 2008 balance sheet less [pound]40
depreciation.
\9\ Dollars are reduced by $20 transferred to U.S. Corp.
----------------------------------------------------------------------------------------------------------------
Amount in
Asset [pound] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Cash.......................................... \6\ 240 Spot convention rate in Dec. 2009 264.00
[pound]1 = $1.10.
Plant......................................... \7\ 967 Historic rate-May 2007 convention rate 870.30
[pound]1 = $0.90.
Machine....................................... \8\160 Historic rate-May 2007 convention rate 144.00
[pound]1 = $0.90.
Inventory..................................... 100 Historic rate--Dec. 2009 convention 110.00
rate [pound]1 = $1.10.
Computer...................................... 9 Historic rate--Dec. 2009 convention 10.00
rate [pound]1 = $1.10.
Stock......................................... 158 Historic rate--Sept. 2008 convention 150.00
rate [pound]1 = $.95.
Dollars....................................... \9\ $ 30 Dollars are not translated............ 30.00
-----------------------------------------------------------------
Total assets.............................. ........... ...................................... 1,578.30
Liability:
Bank Loan................................. [pound]50 Spot convention rate in Dec. 2009 55.00
[pound]1 = $1.10.
-----------------------------------------------------------------
Total liabilities......................... ........... ...................................... 55.00
2009 ending owner functional currency net ........... ...................................... 1,523.30
value (in dollars).
Less: 2008 ending owner functional currency ........... ...................................... ($1,430.00)
net value (in dollars).
-----------------------------------------------------------------
Change in owner functional currency net value. ........... ...................................... 93.30
----------------------------------------------------------------------------------------------------------------
(B) Step 2: Increase the aggregate amount described in step 1 by
each owner's share of assets transferred by the section 987 QBU to
its owners. Under paragraph (d)(2) of this section, the aggregate
amount determined in step 1 must be increased by the total amount of
assets described in paragraph (d)(2)(ii) of this section transferred
from UK Branch to U.S. Corp during the taxable year, translated into
U.S. Corp's functional currency as provided in paragraph (d)(2)(iii)
of this section. The amount of assets transferred from UK Branch to
U.S. Corp during 2009 is determined as follows:
----------------------------------------------------------------------------------------------------------------
Amount in
Asset [pound] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
[pound]30 currency....................... 30 Spot convention rate in Dec. 2009 [pound]1 33.00
= $1.10.
$20 currency............................. $20 Dollars are not translated................. 20.00
----------------------------------------------------------------------
Total................................ ........... ........................................... 53.00
----------------------------------------------------------------------------------------------------------------
(C) Step 3: Decrease the aggregate amount described in steps 1
and 2 by the owner's transfers to the section 987 QBU. Under
paragraph (d)(3) of this section, the aggregate amount determined in
steps 1 and 2 must be decreased by the total amount of all assets
transferred from U.S. Corp to UK Branch during the taxable year as
determined in paragraph (d)(3)(ii) of this section. The amount of
assets transferred from U.S. Corp to UK Branch is determined as
follows:
----------------------------------------------------------------------------------------------------------------
Amount in
Asset [pound] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Computer................................. [pound]9 Spot convention rate in Dec. 2009 [pound]1 $10.00
= $1.10.
----------------------------------------------------------------------
Total................................ ........... ........................................... 10.00
----------------------------------------------------------------------------------------------------------------
(D) Step 4: Decrease the aggregate amount determined in steps 1
through 3 by the amount of liabilities transferred by the section
987 QBU to the owner. Under paragraph (d)(4) of this section, the
aggregate amount determined in steps 1 through 3 must be decreased
by the aggregate amount of liabilities transferred by UK Branch to
U.S. Corp. Under these facts, such amount is $0.
(E) Step 5: Increase the aggregate amount determined in steps 1
through 4 by the amount of liabilities transferred by the owner to
the section 987 QBU. Under paragraph (d)(5) of this section, the
aggregate amount determined in steps 1 through 4 must be increased
by the aggregate amount of liabilities transferred by U.S. Corp to
UK Branch. Under these facts, such amount is $0.
(F) Step 6: Increase the aggregate amount determined in steps 1
through 5 by the section 987 taxable loss of the section 987 QBU for
the taxable year. Under paragraph (d)(6) of this section, the
aggregate amount determined in steps 1 through 5 must be increased
by the section 987 taxable loss of UK Branch. Since UK Branch had no
such taxable loss in 2009, paragraph (d)(6) of this section does not
apply.
(G) Step 7: Decrease the aggregate amount determined in steps 1
through 5 by the section 987 taxable income of the section 987 QBU
for the taxable year. Under paragraph (d)(7) of this section, the
aggregate amount determined in steps 1 through 5 must be decreased
by the section 987 taxable income of UK Branch. The amount of UK
Branch's taxable income, as determined above, is $117.80.
(v) Summary. Taking steps 1 through 7 into account, the amount
of U.S. Corp's unrecognized section 987 gain or loss with
[[Page 52909]]
respect to UK Branch in 2009 is computed as follows:
------------------------------------------------------------------------
Step Amount in $ Balance
------------------------------------------------------------------------
1....................................... + 93.30 $93.30
2....................................... + 53.00 146.30
3....................................... -10.00 136.30
4....................................... -0 136.30
5....................................... + 0 136.30
6....................................... + 0 136.30
7....................................... -117.80 18.50
------------------------------------------------------------------------
Thus, U.S. Corp's unrecognized section 987 gain in 2009 with
respect to U.K. Branch is $18.50. As of the end of 2009, before
taking into account the recognition of any section 987 gain or loss
under Sec. 1.987-5, U.S. Corp's net unrecognized section 987 gain
is $48.50 (i.e., $30 accumulated from prior years, plus $18.50 in
2009).
Sec. 1.987-5 Recognition of section 987 gain or loss.
(a) Recognition of section 987 gain or loss by the owner of a
section 987 QBU. The taxable income of an owner of a section 987 QBU
shall include the owner's section 987 gain or loss recognized with
respect to the section 987 QBU for the taxable year. For any taxable
year, the owner's section 987 gain or loss recognized with respect to a
section 987 QBU shall be equal to--
(1) The owner's net unrecognized section 987 gain or loss of the
section 987 QBU determined under Sec. 1.987-4 on the last day of such
taxable year (or, if earlier, on the day the section 987 QBU is
terminated under Sec. 1.987-8); multiplied by
(2) The owner's remittance proportion for the taxable year, as
determined under paragraph (b) of this section.
(b) Remittance proportion. The owner's remittance proportion with
respect to a section 987 QBU for a taxable year is the quotient, equal
to--
(1) The remittance, as determined under paragraph (c) of this
section, to the owner from the section 987 QBU for such taxable year;
divided by
(2) The total adjusted basis of the gross assets of the section 987
QBU as of the end of the taxable year (or, if terminated prior to the
end of such taxable year under Sec. 1.987-8, the day of termination)
that are reflected on its year-end balance sheet (or, if terminated
prior to the end of such taxable year under Sec. 1.987-8, the balance
sheet on the day terminated), translated into the owner's functional
currency as provided in Sec. 1.987-4(e)(2) and increased by the amount
of the remittance.
(c) Remittance--(1) Definition. A remittance shall be determined in
the owner's functional currency and shall equal the excess, if any,
of--
(i) The total of all amounts transferred from the section 987 QBU
to the owner during the taxable year, as determined in paragraph (d) of
this section; over
(ii) The total of all amounts transferred from the owner to the
section 987 QBU during the taxable year, as determined in paragraph (e)
of this section.
(2) Day when a remittance is determined. An owner's remittance from
a section 987 QBU shall be determined on the last day of the owner's
taxable year (or, if earlier, on the day the section 987 QBU is
terminated under Sec. 1.987-8).
(3) Termination. A termination of a section 987 QBU as determined
under Sec. 1.987-8 is treated as a remittance of all the gross assets
of the section 987 QBU to the owner on the date of such termination.
See Sec. 1.987-8(d). Accordingly, the remittance proportion in the
case of a termination is 1.
(d) Total of all amounts transferred from the section 987 QBU to
the owner for the taxable year. For purposes of paragraph (c)(1)(i) of
this section, the total of all amounts transferred from the section 987
QBU to the owner for the taxable year shall be determined in the
owner's functional currency under Sec. 1.987-4(d)(2) with reference to
the adjusted basis of the assets transferred. Solely for this purpose,
the amount of liabilities transferred from the owner to the section 987
QBU determined under Sec. 1.987-4(d)(5) shall be treated as a transfer
of assets from the section 987 QBU to the owner in an amount equal to
the amount of such liabilities.
(e) Total of all amounts transferred from the owner to the section
987 QBU for the taxable year. For purposes of paragraph (c)(1)(ii) of
this section, the total of all amounts transferred from the owner to
the section 987 QBU for the taxable year shall be determined in the
owner's functional currency under Sec. 1.987-4(d)(3) with reference to
the adjusted basis of the assets transferred. Solely for this purpose,
the amount of liabilities transferred from the section 987 QBU to the
owner determined under Sec. 1.987-4(d)(4) shall be treated as a
transfer of assets from the owner to the section 987 QBU in an amount
equal to the amount of such liabilities.
(f) Determination of owner's adjusted basis in transferred assets--
(1) In general. The owner's adjusted basis in an asset received in a
transfer from the section 987 QBU (whether or not such transfer is made
in connection with a remittance as defined in paragraphs (c) of this
section) shall be determined under the rules prescribed in paragraphs
(f)(2) through (f)(4) of this section.
(2) Section 987 marked asset. The basis of a section 987 marked
asset shall be determined in the owner's functional currency and shall
be the same as the amount determined under Sec. 1.987-4(d)(2)(ii)(A).
(3) Section 987 historic asset. The basis of a section 987 historic
asset shall be determined in the owner's functional currency and shall
be the same as the amount determined under Sec. 1.987-4(d)(2)(ii)(B).
(4) Partner's adjusted basis in distributed assets. See also
section 732 and Sec. 1.987-7 for purposes of determining an owner's
adjusted basis of an asset distributed from a section 987 QBU owned
indirectly through a section 987 partnership.
(g) Examples. The following examples illustrate the calculation of
section 987 gain or loss under this section:
Example 1. (i) U.S. Corp, a calendar year domestic corporation
with the dollar as its functional currency, operates in the U.K.
through U.K. DE, an entity disregarded as an entity separate from
its owner under Sec. Sec. 301.7701-1 through 301.7701-3 of this
chapter. U.K. DE has a section 987 branch (U.K. section 987 branch)
with the pound as its functional currency. During year 2, the
following transfers took place between U.S. Corp and U.K. section
987 branch. On January 5, year 2, U.S. Corp transferred to U.K.
section 987 branch $300 (which the branch used during the year to
purchase services). On March 5, year 2, U.K. section 987 branch
transferred a machine to U.S. Corp. Assume that the pound adjusted
basis of the machine when properly translated into dollars under
Sec. Sec. 1.987-4(d)(2)(ii)(B) and paragraph (d) of this section is
$500. On November 1, year 2, U.K. section 987 branch transferred
pound cash to U.S. Corp. Assume
[[Page 52910]]
that the dollar amount of the pounds when properly translated under
Sec. 1.987-4(d)(2)(ii)(A) and paragraph (d) of this section is
$2,300. On December 7, year 2, U.S Corp transferred a truck to U.K.
section 987 branch with an adjusted basis of $2,000.
(ii) Assume that at the end of year 2, U.K. section 987 branch
holds assets, properly translated into the owner's functional
currency pursuant to Sec. 1.987-4(e)(2), consisting of a computer
with a pound adjusted basis equivalent to $500, a truck with a pound
adjusted basis equivalent to $2,000, and pound cash equivalent to
$2,850. In addition, assume that U.K. section 987 branch has a pound
liability entered into in year 1 with Bank A. The liability, when
translated into the owner functional currency pursuant to Sec.
1.987-4(e)(2), is equivalent to $200. All such assets and
liabilities are reflected on the books and records of U.K. section
987 branch. Assume that the net unrecognized section 987 gain for
U.K. section 987 branch as determined under Sec. 1.987-4 as of the
last day of year 2 is $80.
(iii) U.S. Corp's section 987 gain with respect to U.K. section
987 branch is determined as follows:
(A) Computation of amount of remittance. Under paragraphs (c)(1)
and (2) of this section, U.S. Corp must determine the amount of the
remittance for year 2 in the owner's functional currency (dollars)
on the last day of year 2. The amount of the remittance for year 2
is $500, determined as follows:
Transfers from U.K. section 987 branch to U.S. Corp in dollars:
Machine...................................................... $500
Cash (U.K. pounds)........................................... 2,300
----------
$2,800
Transfers from U.S. Corp to U.K. section 987 branch in dollars:
Cash (U.S. dollars).......................................... $300
Truck........................................................ 2,000
----------
2,300
Computation of amount of remittance:
Aggregate transfers from U.K. section 987 branch to U.S. Corp $2,800
Less: aggregate transfers from U.S. Corp to U.K. section 987 (2,300)
branch......................................................
----------
Total remittance......................................... 500
(B) Computation of branch gross assets plus remittance. Under
paragraph (b)(2) of this section, U.K. section 987 branch must
determine the total basis of its gross assets that are reflected on
its year-end balance sheet translated into the owner's functional
currency, and must increase this amount by the amount of the
remittance.
Total basis of U.K. section 987 branch's gross assets at end of
year 2 plus remittance in dollars:
Computer..................................................... $500
Cash (U.K. pounds)........................................... 2,850
Truck........................................................ 2,000
----------
Total gross assets....................................... 5,350
Remittance................................................... 500
----------
Total gross assets + remittance...................... 5,850
(C) Computation of remittance proportion. Under paragraph (b) of
this section, U.K. section 987 branch must compute the remittance
proportion as follows:
Amount of remittance......................................... $500
Total basis of U.K. section 987 branch's gross assets at end 5,850
of Year 2, increased by amount of remittance................
Remittance/gross assets...................................... 0.085
Remittance proportion........................................ 0.085
(D) Computation of section 987 gain or loss. The amount of U.S.
Corp's section 987 gain or loss that must be recognized with respect
to U.K. section 987 branch is determined under paragraph (a) of this
section.
Net unrecognized section 987 gain............................ $80
Remittance proportion........................................ x 0.085
----------
U.S. Corp's section 987 gain for Year 2:................. $6.80
Example 2. U.S. Corp, a calendar year domestic corporation with
the dollar as its functional currency, operates in the U.K. through
U.K. DE, an entity disregarded as an entity separate from its owner.
U.K. DE has a section 987 branch (U.K. section 987 branch) with the
pound as its functional currency. During year 2, the following
transfers took place between U.S. Corp and U.K. section 987 branch.
On March 1, year 2, U.S. Corp transferred to U.K. section 987 branch
a computer with a basis of $100. On November 1, year 2, U.K. section
987 branch transferred pounds to U.S. Corp. Assume that the dollar
amount of the pounds when properly translated under Sec. 1.987-
4(d)(2)(ii)(A) and paragraph (d) of this section is $300. On the
same day, U.K. section 987 branch transferred of $20 to U.S. Corp.
(ii) Assume that at the end of year 2, U.K. section 987 branch
holds assets translated (as necessary) into the owner functional
currency pursuant to Sec. 1.987-4(e)(2) consisting of a plant with
a pound adjusted basis equivalent $1,000, pound cash equivalent to
$100, a machine with a pound adjusted basis equivalent to $200,
portfolio stock (within the meaning of Sec. 1.987-2(b)(2)(ii)) in
ABC Corporation with a pound adjusted basis equivalent to $150,
inventory of 100 units with an aggregate pound adjusted basis
equivalent to $100 and a computer with a pound adjusted basis
equivalent to $100. In addition, assume that U.K. section 987 branch
has a pound liability that it entered into with Bank A in year 1.
When properly translated into dollars pursuant to Sec. 1.987-
4(e)(2) the principal amount of the liability is equal to $500. All
such assets and liabilities are reflected on the books and records
of U.K. section 987 branch. Assume that the net unrecognized 987
gain for U.K. section 987 branch as determined under Sec. 1.987-4
as of the last day of year 2 is $100.
(iii) U.S. Corp's section 987 gain with respect to U.K. section
987 branch is determined as follows:
(A) Computation of amount of remittance. Under paragraphs (c)(1)
and (2) of this section, U.S. Corp must determine the amount of the
remittance for year 2 in the owner's functional currency on the last
day of year 2. The amount of the remittance for year 2 is $220
determined as follows:
Transfers from U.K. section 987 branch to U.S. Corp in dollars:
Cash (U.K. pounds)........................................... $300
Cash (U.S. dollars).......................................... 20
----------
320
Transfers from U.S. Corp to U.K. section 987 branch in dollars:
Computer..................................................... $100
Computation of amount of remittance:
Aggregate transfers from U.K. section 987 branch to U.S. Corp $320
Less: aggregate transfers from U.S. Corp to U.K. branch...... ($100)
----------
Total remittance:............................................ $220
Computation of amount of remittance:
Aggregate transfers from U.K. section 987 branch to U.S. Corp $320
Less: aggregate transfers from U.S. Corp to U.K. branch...... 100
----------
Total remittance:........................................ 220
(B) Computation of branch gross assets plus remittance. Under
paragraph (b)(2) of this section, U.K. section 987 branch must
determine the total basis of its gross assets as are reflected on
its year-end balance sheet translated into dollars and must increase
this amount by the amount of the remittance.
Total pound basis of U.K. section 987 branch's gross assets
translated into dollars at end of Year 2:
Plant........................................................ $1,000
Cash (U.K. pounds)........................................... 100
Inventory.................................................... 100
Machine...................................................... 200
Computer..................................................... 100
Portfolio Stock.............................................. 150
----------
Total gross assets....................................... 1,650
Remittance................................................... 220
----------
Total gross assets + remittance.......................... 1,870
(C) Computation of remittance proportion. Under paragraph (b) of
this section, U.K. section 987 branch must compute the remittance
proportion as follows:
Amount of remittance......................................... $220
Total basis of U.K. section 987 branch's gross assets at tend 1,870
of year 2, increased by amount of remittance................
Remittance/gross assets...................................... 0.118
Remittance proportion........................................ 0.118
(D) Computation of section 987 gain or loss. The amount of U.S.
Corp's section 987 gain or loss that must be recognized with respect
to U.K. section 987 branch is determined under paragraph (a) of this
section.
Net unrecognized section 987 gain............................ $100.00
Remittance proportion........................................ x 0.118
----------
[[Page 52911]]
U.S. Corp's section 987 gain for year 2.................. 11.80
Sec. 1.987-6 Character and source of section 987 gain or loss.
(a) Ordinary income or loss. Section 987 gain or loss is ordinary
income or loss for Federal income tax purposes.
(b) Source and character of section 987 gain or loss--(1) In
general. Except as otherwise provided in this section, the owner of a
section 987 QBU must determine the source and character of section 987
gain or loss in the year of a remittance under the rules of this
paragraph (b) for all purposes of the Internal Revenue Code, including
sections 904(d), 907 and 954.
(2) Method required to characterize and source section 987 gain or
loss. The owner must use the asset method set forth in Sec. 1.861-
9T(g) to characterize and source section 987 gain or loss. The modified
gross income method described in Sec. 1.861-9T(j) cannot be used.
(3) Method required to characterize and source section 987 gain or
loss with respect to regulated investment companies and real estate
investment trusts. [Reserved].
(c) Example. The following example illustrates the application of
this section.
Example. CFC is a controlled foreign corporation as defined in
section 957 with the Swiss franc (Sf) as its functional currency. CFC
holds all the interest in a section 987 DE as defined in Sec. 1.987-
1(b)(6)(iii) that has a section 987 branch with significant operations
in Germany (German Branch). German Branch has the euro as its
functional currency. For the year 2009, CFC recognizes section 987 gain
of Sf10,000 under Sec. Sec. 1.987-4 and 1.987-5. Applying the rules of
this section, German Branch has total average assets of Sf1,000,000
which generate income as follows: Sf750,000 of assets that generate
foreign source general limitation income under section 904(d)(1)(I),
none of which is subpart F income under section 952; and Sf250,000 of
assets that generate foreign source passive income under section
904(d)(1)(B), all of which is subpart F income. Under paragraph (b) of
this section, Sf7,500 (Sf750,000/Sf1,000,000 x Sf10,000) of the section
987 gain will be treated as foreign source general limitation income
which is not subpart F income and Sf2,500 (Sf250,000/Sf1,000,000 x
Sf10,000) will be treated as foreign source passive income which is
subpart F income. All of the section 987 gain is treated as ordinary
income.
Sec. 1.987-7 Section 987 partnerships.
(a) In general. In the case of an owner that is a partner in a
section 987 partnership, this section provides rules for determining
the owner's share of assets and liabilities of a section 987 QBU owned
indirectly, as described in Sec. 1.987-1(b)(4)(ii), through a section
987 partnership. In addition, this section provides rules coordinating
these regulations with subchapter K of chapter 1 of the Internal
Revenue Code.
(b) Assets and liabilities of an eligible QBU or a section 987 QBU
held indirectly through a partnership. A partner's share of the assets
and liabilities reflected under Sec. 1.987-2(b) on the books and
records of an eligible QBU or a section 987 QBU owned indirectly
through a partnership shall be determined in a manner that is
consistent with the manner in which the partners have agreed to share
the economic benefits and burdens (if any), corresponding to the assets
and liabilities, taking into account the rules and principles of
sections 701 through 761, and the applicable regulations, including
section 704(b) and Sec. 1.701-2.
(c) Coordination with subchapter K--(1) Partner's adjusted basis in
its partnership interest--(i) In general. Except as provided in this
paragraph, a partner's adjusted basis in its section 987 partnership
interest shall be maintained in the functional currency of that partner
and shall not be adjusted as a result of any fluctuations in the value
of the partner's functional currency and the functional currency of any
section 987 QBU owned indirectly through the section 987 partnership.
(ii) Adjustments for section 987 taxable income or loss and section
987 gain or loss--(A) Section 987 taxable income or loss. A partner's
share of the items of income, gain, deduction or loss taken into
account in calculating section 987 taxable income or loss of a section
987 QBU, determined under Sec. 1.987-3, held indirectly through a
section 987 partnership shall be treated as income or loss of the
section 987 partnership through which the partner indirectly owns the
interest. As a result, the partner's allocable share of the items of
income, gain, deduction or loss taken into account in calculating
section 987 taxable income or loss of the section 987 QBU shall be
taken into account, following conversion into the partner's functional
currency, in determining the appropriate adjustments to the partner's
adjusted basis in its partnership interest under section 705.
(B) Section 987 gain or loss. Solely for purposes of determining
the appropriate adjustments to a partner's adjusted basis in its
interest in a section 987 partnership under section 705, an individual
or corporation that owns a section 987 QBU indirectly through a section
987 partnership shall treat any section 987 gain or loss of such
section 987 QBU as gain or loss of the section 987 partnership. Any
adjustments to the adjusted basis of a partner's interest in such
section 987 partnership required under this paragraph (c)(1)(ii)(B) of
this section shall occur prior to determining the effect under the
Internal Revenue Code of any sale, exchange, distribution or other
event.
(iii) Adjustments for contributions and distributions. For purposes
of making adjustments to the partner's adjusted basis in its interest
in a section 987 partnership, as a result of any contributions or
distributions (including deemed contributions and distributions under
section 752) between the section 987 partnership and the owner of a
section 987 QBU owned indirectly through the partnership, such amounts
will be taken into account in the owner's functional currency.
(iv) Determination of deemed distributions and contributions under
section 752--(A) Increase in partner's liabilities. For purposes of
determining the amount of any increase in a partner's share of the
liabilities of the partnership, or any increase in the partner's
individual liabilities by reason of the assumption by such partner of a
liability of the partnership, which are reflected on the books and
records of a section 987 QBU owned indirectly through such partnership
and which are denominated in a functional currency different from the
partner's, the amount of such liabilities shall be translated into the
functional currency of the partner using the spot rate (as defined in
Sec. 1.987-1(c)(1)(i) and (ii)) on the date of such increase.
(B) Decrease in partner's liabilities. For purposes of determining
the amount of any decrease in a partner's share of the liabilities of
the partnership which were reflected on the books and records of a
section 987 QBU owned indirectly through such partnership and which are
denominated in a functional currency different from the partner's
functional currency, the amount of such liabilities shall be translated
into the functional currency of the partner using the historic rate (as
defined in Sec. 1.987-1(c)(3)) for the date on which such liabilities
increased the partner's adjusted basis in its partnership interest
under section 752.
(2) Special rule for determining gain or loss on the sale, exchange
or other disposition of an interest in a section 987 partnership. For
purposes of determining the amount realized by a
[[Page 52912]]
partner in a section 987 partnership on the sale, exchange, or other
disposition of that partner's interest in such partnership, the amount
of liabilities reflected on the books and records of a section 987 QBU
(in a functional currency different from such partner) from which that
partner is relieved as a result of such disposition, and which are
included in the amount realized pursuant to section 752(d), shall be
translated into the partner's functional currency using the historic
exchange rate (as determined under Sec. 1.987-1(c)(3)) for the date on
which such liabilities increased the partner's adjusted basis in its
partnership interest under section 752.
(d) Examples. The purpose of the following examples is to
illustrate the application of section 987 to partnerships and their
partners. The examples are not meant to be a comprehensive
interpretation of the step-by-step computations involved in computing
net unrecognized section 987 gain or loss. Thus, for the sake of
simplicity, the examples only calculate section 987 gain or loss by
reference to certain identified assets and liabilities, rather than by
all the assets and liabilities of the section 987 QBU (as is required
under these regulations). See Sec. 1.987-4 and the examples therein
for step-by-step computations for determining the unrecognized section
987 gain or loss of the owner of a section 987 QBU.
Example 1. Computation of an owner's net unrecognized section
987 gain or loss. (i) Facts. PRS is a partnership which owns QBUx,
an eligible QBU, operating in the United Kingdom. QBUx has the pound
as its functional currency determined under Sec. 1.985-1 taking
into account all of QBUx's activities before application of this
section. PRS has two equal partners that are domestic corporations,
A and B, each with the U.S. dollar as its functional currency. The
portions of QBUx allocated to A and B under paragraph (b) of this
section are section 987 QBUs of A and B because under Sec. 1.987-
1(b)(2), such portions are allocated from an eligible QBU with a
different functional currency than A and B, respectively. Assume
that PRS has no items of section 987 taxable income or loss for
2007. On January 1, 2007, A and B each contribute $50 to PRS. PRS
immediately converts the $100 into [pound]100. The [pound]100 is
reflected, in accordance with Sec. 1.987-2(b), on the books and
records of QBUx. On January 1, 2007, the spot rate is $1 = [pound]1.
On December 31, 2007, the spot rate is $1.50 = [pound]1. Pursuant to
Sec. 1.987-3(b)(1), A and B use the yearly average exchange rate,
as defined in Sec. 1.987-1(c)(2), to translate items of income,
gain, deduction, or loss into dollars for the taxable year. Assume
the yearly average exchange rate is $1.25 = [pound]1 ($1 =
[pound].80). Under the PRS partnership agreement, A and B each have
an equal interest in all items of partnership income and loss.
(ii) Calculation of net unrecognized section 987 gain or loss.
Under paragraph (b) of this section, A and B are each allocated 50
from eligible QBUx. This amount is reflected on the balance sheet of
the section 987 QBU of A and B, respectively, for purposes of
determining the unrecognized section 987 gain or loss under Sec.
1.987-4. Pursuant to Sec. 1.987-4(d), the net unrecognized section
987 gain of A's section 987 QBU and B's section 987 QBU is $25.
Example 2. Computation of owner's net unrecognized section 987
gain or loss. (i) Facts. The facts are the same as Example 1, except
that in addition to the [pound]100 contributed by A and B, PRS
incurred a [pound]50 recourse liability from an unrelated third
party on January 1, 2007. The liability and the [pound]50 are both
reflected on the books and records of QBUx under Sec. 1.987-2(b).
Under section 752, and the regulations thereunder, A and B bear the
economic risk of loss with respect to the [pound]50 recourse debt
equally.
(ii) Calculation of net unrecognized section 987 gain or loss.
Under paragraph (b) of this section, A and B are each allocated
[pound]75 from QBUx. In addition, under paragraph (b) of this
section, A and B are each allocated [pound]25 of the liability of
QBUx because the economic burden of such liability, taking into
account sections 701 through 761 of the Code, is borne equally by A
and B. Under Sec. 1.987-4(d), A and B each have net unrecognized
section 987 gain of $25.
(iii) Determination of partner's adjusted basis in PRS. Pursuant
to paragraph (c)(1)(i) of this section and section 985(a), A and B
must determine the adjusted basis in their PRS partnership interests
in U.S. dollars. Under sections 722, 752(a) and paragraph
(c)(1)(iv)(A) of this section, the adjusted bases in such interests
are increased by the U.S. dollar amount of a deemed contribution
determined using the spot rate for the date on which such liability
was incurred. Therefore, A and B will increase the adjusted basis in
their PRS partnership interests by $25.
Example 3. Computation of owner's net unrecognized section 987
gain or loss. (i) Facts. The facts are the same as Example 2, except
as follows: On January 1, 2007, instead of incurring a [pound]50
recourse liability, PRS incurred a [pound]50 nonrecourse liability
from an unrelated third party, which was secured by and used to
purchase non-depreciable real property located in the United
Kingdom. Under the partnership agreement, A and B agree to share all
items of partnership income and loss equally, except that A
guaranteed the nonrecourse liability and, in addition, the
partnership agreement provides that A will be allocated any gain
from the sale or exchange of the non-depreciable property. Further,
the partnership agreement provides that in the event the partnership
liquidates prior to satisfying the liability, the non-depreciable
property shall be distributed to A.
(ii) Calculation of net unrecognized section 987 gain or loss.
Under paragraph (b) of this section, A and B are each allocated
[pound]50 from eligible QBUx. In addition, because A bears the
economic burden of the nonrecourse liability incurred by PRS and the
economic benefits of the non-depreciable property securing such
liability, both of which are reflected on the books and records of
QBUx under Sec. 1.987-2(b), A is allocated, for purposes of
applying Sec. 1.987-4(d), both the [pound]50 liability and the non-
depreciable property with an adjusted tax basis of [pound]50. Under
Sec. 1.987-4(d), A's net unrecognized section 987 gain is $0, and
B's net unrecognized section 987 gain is $25.
(iii) Determination of partner's adjusted basis in PRS. Pursuant
to paragraph (c)(1)(i) of this section and section 985(a), A and B
must determine the adjusted bases in their PRS partnership interests
in U.S. dollars. Under sections 722, 752(a) and paragraph (c)(1)(iv)
of this section, A's adjusted basis is increased by the U.S. dollar
amount of the deemed contribution determined using the spot rate for
the date on which such liability was incurred. Therefore, A will
increase the adjusted basis in its PRS partnership interest by $50.
Example 4. Computation of owner's share of items of section 987
taxable income. (i) Facts. The facts are the same as in Example 1,
except that during 2007 PRS earns [pound]50 which are reflected on
the books and records of QBUx. In accordance with the partnership
agreement, the [pound]50 are allocated equally between A and B.
(ii) Calculation of section 987 taxable income or loss. Under
Sec. 1.987-3, A and B's allocable share of the taxable income of
QBUx, as determined by PRS, and adjusted to conform to U.S. tax
principles, is [pound]25 each. Under Sec. 1.987-3, A and B must
convert their allocable share of the [pound]25 into U.S. dollars
using the yearly average exchange rate for the year, in accordance
with Sec. 1.987-1(c)(2). As a result, A and B each take into
account as their respective distributive share of PRS income $31.25.
Under paragraph (c)(1)(ii)(A) of this section, section 985(a) and
section 705, such amounts, as reflected in U.S. dollars, will be
taken into account in determining any adjustments to the adjusted
bases of A's and B's partnership interests. In addition, such
amounts will be taken into account in calculating, under Sec.
1.987-4, the unrecognized section 987 gain or loss of the section
987 QBUs of A and B.
Example 5. Computation of owner's share of items of section 987
taxable income. (i) Facts. The facts are the same as in Example 4,
except A and B agree to allocate the [pound]50 of income to A.
Assume for purposes of this example that such allocation has
substantial economic effect as provided under section 704(b).
(ii) Calculation of section 987 taxable income or loss. Under
Sec. 1.987-3, A and B's allocable share of the taxable income of
QBUx, as determined by PRS, and adjusted to conform to U.S. tax
principles, is [pound]50 and [pound]0, respectively. Under Sec.
1.987-3, A and B must convert their allocable share into U.S.
dollars using the yearly average exchange rate for the year, in
accordance with Sec. 1.987-1(c)(2). As a result, A and B must each
take into account as their respective distributive share of PRS
income $62.50 and $0, respectively. Under paragraph (c)(1)(ii)(A) of
this section, section 985(a) and section 705, such amounts, as
reflected in U.S. dollars,
[[Page 52913]]
will be taken into account in determining any adjustments to the
adjusted bases of A's and B's respective partnership interests. In
addition, such amounts will be taken into account in calculating,
under Sec. 1.987-4, the unrecognized section 987 gain or loss of
the section 987 QBUs of A and B. [FEDREG][VOL]*[/VOL][NO]*[/
NO][DATE]*[/DATE][PRORULES][PRORULE][PREAMB][AGENCY]*[/
AGENCY][SUBJECT]*[/SUBJECT][/PREAMB][SUPLINF][HED]*[/HED]
Example 6. Election by de minimis partner to not take into
account section 987 gain or loss. (i) Facts. The facts are the same
as in Example 1, except assume that A owns, directly or indirectly,
less than 5% of the total capital and profits interest in PRS and,
as a result, is eligible to elect, under Sec. 1.987-1(b)(1)(ii) not
to apply the provisions of the regulations under section 987 for
purposes of taking into account the section 987 gain or loss of A's
section 987 QBU. Assume further that A makes such election. On
January 1, 2008, A sells its interest to an unrelated third party,
C, for $75.
(ii) Determination of partner's adjusted basis in PRS. Pursuant
to paragraph (c)(1)(i) of this section and section 985(a), A must
determine the adjusted basis of its PRS partnership interest in U.S.
dollars. A's basis in PRS is $50, the amount of its contribution to
PRS.
(iii) Sale of partnership interest by A. Under section 1001, A's
amount realized on the sale of the partnership interest to C is $75.
A's adjusted basis of its PRS partnership interest is $50, the
amount of A's contribution to PRS, unadjusted by the fluctuations
between the pound and the U.S. dollar. A's gain on the sale of the
partnership interest is $25.
Sec. 1.987-8 Termination of a section 987 QBU.
(a) Scope. This section provides rules regarding the termination of
a section 987 QBU. Paragraph (b) of this section provides general rules
for determining when a termination occurs. Paragraph (c) of this
section provides exceptions to the general termination rules for
certain transactions described in section 381(a). Paragraph (d) of this
section provides certain effects of terminations. Paragraph (e) of this
section contains examples that illustrate the principles of this
section.
(b) In general. Except as provided in paragraph (c) of this
section, a section 987 QBU terminates when--
(1) Its activities cease, such that it no longer meets the
definition of an eligible QBU as defined in Sec. 1.987-1(b)(3);
(2) Substantially all (within the meaning of section 368(a)(1)(C))
of the section 987 QBU's assets are transferred from such section 987
QBU to its owner, as provided under Sec. 1.987-2(c). For purposes of
this paragraph (b)(2), the amount of assets transferred from the
section 987 QBU to its owner as a result of a transaction (for example,
a contribution of property to a DE or a partnership) as provided under
Sec. 1.987-2(c) shall be reduced by assets that are transferred from
the owner to such section 987 QBU, as provided under Sec. 1.987-2(c),
pursuant to the same transaction;
(3) A foreign corporation that is a controlled foreign corporation
(as defined in section 957) that is the owner of a section 987 QBU
ceases to be a controlled foreign corporation; or
(4) The owner of such section 987 QBU ceases to exist (including in
connection with a transaction described in section 381(a)).
(c) Transactions described in section 381(a)--(1) Liquidations. A
termination does not occur when the owner of a section 987 QBU ceases
to exist in a liquidation described in section 332, except in the
following cases:
(i) The distributor is a domestic corporation and the distributee
is a foreign corporation.
(ii) The distributor is a foreign corporation and the distributee
is a domestic corporation.
(iii) The distributor and the distributee are both foreign
corporations and the functional currency of the distributee is the same
as the functional currency of the distributor's section 987 QBU.
(2) Reorganizations. A termination does not occur when the owner of
the section 987 QBU ceases to exist in a reorganization described in
section 381(a)(2), except in the following cases:
(i) The transferor is a domestic corporation and the acquiring
corporation is a foreign corporation.
(ii) The transferor is a foreign corporation and the acquiring
corporation is a domestic corporation.
(iii) The transferor is a controlled foreign corporation
immediately before the transfer and the acquiring corporation is a
foreign corporation that is not a controlled foreign corporation
immediately after the transfer.
(iv) The transferor and the acquiring corporation are foreign
corporations and the functional currency of the acquiring corporation
is the same as the functional currency of the transferor's section 987
QBU.
(d) Effect of terminations. A termination of a section 987 QBU as
determined in this section is treated as a remittance of all the gross
assets of the section 987 QBU to its owner. As a result, any net
unrecognized section 987 gain or loss of the section 987 QBU is
recognized. See Sec. 1.987-5. For purposes of the preceding sentence,
the amount of net unrecognized section 987 gain or loss is determined
as of the date of termination by closing the books and records of the
section 987 QBU on that date.
(e) Examples. The following examples illustrate the principles of
this section:
Example 1. Cessation of operations. (i) Facts. DC, a domestic
corporation, has a sales office in Country X (Country X Branch) that
is a section 987 QBU. DC closes its Country X Branch.
(ii) Analysis. The cessation of the activities of the Country X
Branch causes a termination of the section 987 QBU under paragraph
(b)(1) of this section.
Example 2. Incorporation of section 987 QBU. (i) Facts. DC, a
domestic corporation, has a branch in Country X (Country X Branch)
that is a section 987 QBU. DC transfers all the assets and
liabilities of Country X Branch to DS, a domestic corporation, in
exchange for stock of DS in a transaction qualifying under section
351.
(ii) Analysis. Country X Branch terminates pursuant to paragraph
(b)(1) of this section because the Country X Branch ceases to be an
eligible QBU of DC.
Example 3. Cessation of controlled foreign corporation status.
(i) Facts. DC, a domestic corporation, owns all of the stock of FC,
a controlled foreign corporation as defined in section 957. FC has a
section 987 QBU. FA, a foreign corporation owned solely by foreign
persons, purchases all of the FC stock. FC will not constitute a
controlled foreign corporation after the transaction.
(ii) Analysis. Because FC ceases to qualify as a controlled
foreign corporation after the sale of the FC stock, FC's section 987
QBU terminates pursuant to paragraph (b)(3) of this section.?>
Example 4. Section 332 liquidation. (i) Facts. DC, a domestic
corporation, operates in Country X through FC, a wholly-owned
foreign corporation organized under the laws of Country X. FC also
has a branch in Country Y (Country Y Branch) that is a section 987
QBU. Pursuant to a liquidation described in section 332, FC
transfers all of its assets and liabilities to DC.
(ii) Analysis. FC's liquidation is a termination as provided in
paragraph (b)(4) of this section because FC ceases to exist. The
exception for certain section 332 liquidations provided under
paragraph (c)(1) of this section does not apply because DC is a
domestic corporation and FC is a foreign corporation. See paragraph
(c)(1)(ii) of this section.
Example 5. Transfers to and from section 987 QBU pursuant to the
same transaction. (i) Facts. DC1, a domestic corporation, owns
Entity A, a DE. Entity A conducts a business in Country X and that
business is an eligible QBU and a section 987 QBU (Country X QBU) of
DC1. DC2, a domestic corporation, contributes property to Entity A
in exchange for a 95% interest in Entity A. The property DC2
contributes to Entity A is used in the business conducted by the
Country X QBU and is reflected on its books and records as provided
under Sec. 1.987-2(b). Moreover, Entity A is converted to a
partnership as a result of the contribution. See Rev. Rul. 99-5
(situation 2), (1999-1 CB 434). See Sec. 601.601(d)(2) of this
chapter. Also, as a result of the contribution, and pursuant to
Sec. 1.987-2(c)(5), 95% of the assets and liabilities on the books
and records of DC1's section 987 QBU are deemed to be transferred
from such QBU to DC1, and DC1 is deemed to transfer to such QBU 5%
of the
[[Page 52914]]
property, as determined under Sec. 1.987-7, contributed by DC2 to
Entity A.
(ii) Analysis. As a result of the contribution of property from
DC2 to Entity A, assets were transferred from DC1's section 987 QBU
to DC1. Similarly, assets were transferred from DC1 to its section
987 QBU as a result of the contribution. Accordingly, for purposes
of determining whether substantially all the assets of Country X QBU
were transferred from DC1's section 987 QBU as provided under
paragraph (b)(2) of this section, the assets transferred from DC1's
section 987 QBU to DC1 under Sec. 1.987-2(c) are reduced by the
amount of assets transferred from DC1 to such section 987 QBU
pursuant to the contribution.
Sec. 1.987-9 Recordkeeping requirements.
(a) In general. A taxpayer that is an owner of a section 987 QBU
shall keep such reasonable records as are sufficient to establish the
QBU's section 987 taxable income or loss and section 987 gain or loss.
See section 987 and section 6001 and the applicable regulations.
(b) Supplemental information. An owner's obligation to maintain
records under section 6001 and paragraph (a) of this section is not
satisfied unless the following information is maintained in such
records:
(1) The amount of the items of income, gain, deduction or loss
attributed to each section 987 QBU of the owner in the functional
currency of the section 987 QBU.
(2) The amount of assets and liabilities attributed to each section
987 QBU of the owner in the functional currency of the QBU.
(3) The exchange rates used to translate items of income, gain,
deduction or loss of each section 987 QBU into the owner's functional
currency. If a spot rate convention is used, the manner in which such
convention is determined.
(4) The exchange rates used to translate the assets and liabilities
of each section 987 QBU into the owner's functional currency. If a spot
rate convention is used, the manner in which such convention is
determined.
(5) The amount of the items of income, gain, deduction or loss
attributed to each section 987 QBU of the owner translated into the
functional currency of the owner.
(6) The amount of assets and liabilities attributed to each section
987 QBU of the owner translated into the functional currency of the
owner.
(7) The amount of assets and liabilities transferred by the owner
to a section 987 QBU determined in the functional currency of the
owner.
(8) The amount of assets and liabilities transferred by the section
987 QBU to the owner determined in the functional currency of the
owner.
(9) The amount of the unrecognized section 987 gain or loss for the
taxable year.
(10) The amount of the net unrecognized section 987 gain or loss at
the close of the taxable year.
(11) If a remittance is made, the average tax book value of assets
as determined under Sec. 1.861-9T(g).
(12) The transition information required to be determined under
Sec. 1.987-10(c)(2)(v).
(c) Retention of records. The records required by this section must
be kept at all times available for inspection by the Internal Revenue
Service, and shall be retained so long as the contents thereof may
become material in the administration of the Internal Revenue Code.
Sec. 1.987-10 Transition rules.
(a) Scope--(1) In general. These transition rules shall apply to
any taxpayer that is an owner of a section 987 QBU pursuant to Sec.
1.987-1(b)(4) on the transition date (as defined in paragraph (b) of
this section). A taxpayer to whom this section applies must transition
from the method previously used by such taxpayer to comply with section
987 (the ``prior section 987 method'') to the method prescribed by
these regulations pursuant to the rules set forth in paragraph (c) of
this section.
(2) Limitation where the prior method was unreasonable.
Notwithstanding paragraph (a)(1) of this section, if the prior section
987 method was unreasonable (including the case where the taxpayer
failed to make the determinations required under section 987 for any
open taxable year), then the taxpayer must apply the rules of paragraph
(c)(4) of this section (and cannot apply the rules of paragraph (c)(3)
of this section) to transition to the method prescribed by these
regulations.
(b) Transition date. The transition date is the first day of the
first taxable year to which these regulations apply to a taxpayer.
(c) Transition methods and corresponding rules--(1) In general.
Except as provided in paragraph (a)(2) of this section, a taxpayer must
transition from its prior method to the method prescribed by these
regulations under the ``deferral transition method'' of paragraph
(c)(3) of this section or the ``fresh start transition method'' of
paragraph (c)(4) of this section. If a taxpayer fails to comply with
the rules of this section, the Area Director, Field Examination, Small
Business/Self Employed or the Director, Field Operations, Large and
Mid-Size Business having jurisdiction of the taxpayer's return for the
taxable year shall determine the appropriate transition method.
(2) Conformity rules. The taxpayer (including all members that file
a consolidated return that includes that taxpayer), and any controlled
foreign corporation as defined in section 957 in which the taxpayer
owns more than 50 percent of the voting power or stock (as determined
in section 957(a)), must consistently apply the same transition method
for each qualified business unit subject to section 987 owned on the
transition date.
(3) Deferral transition method--(i) In general. Pursuant to the
deferral transition method prescribed by this paragraph (c)(3), section
987 gain or loss must be determined on the transition date under the
taxpayer's prior section 987 method as if all qualified business units
of the taxpayer subject to section 987 (taking into account the
conformity rules of paragraph (c)(2) of this section) terminated on the
last day of the taxable year preceding the transition date. This deemed
termination applies solely for purposes of this section. Any section
987 gain or loss determined with respect to a section 987 QBU under the
preceding sentence shall not be recognized on the transition date but
shall be considered as net unrecognized section 987 gain or loss of the
section 987 QBU in the first taxable year for which these regulations
are effective (in addition to any net unrecognized section 987 gain or
loss otherwise determined for such taxable year). Recognition of net
unrecognized section 987 gain or loss determined under the preceding
sentence is governed by Sec. 1.987-5 for periods after the transition
date. The owner of a qualified business unit that is deemed to
terminate under these rules is treated as having transferred all of the
assets and liabilities attributable to such qualified business unit to
a new section 987 QBU on the transition date.
(ii) Translation rates used to determine the amount of assets and
liabilities transferred from the owner to the section 987 QBU for the
section 987 QBU's first taxable year beginning on the transition date.
The exchange rates used to determine the amount of assets and
liabilities transferred from the owner to the section 987 QBU on the
transition date (for example, for purposes of making calculations under
Sec. 1.987-4) under the deferral transition method in this paragraph
(c)(3) shall be determined with reference to the historic exchange
rates on the day the assets were acquired or liabilities entered into
by the qualified business unit deemed terminated, adjusted to
[[Page 52915]]
take into account any gain or loss determined under paragraph (c)(3)(i)
of this section. See Examples 1 and 2 of paragraph (d) of this section.
(4) Fresh start transition method--(i) In general. Pursuant to the
fresh start transition method prescribed by this paragraph (c)(4), on
the transition date all qualified business units of the taxpayer
subject to section 987 (taking into account the conformity rules of
paragraph (c)(2) of this section) are deemed terminated on the last day
of the taxable year preceding the transition date. This deemed
termination applies solely for purposes of this section. No section 987
gain or loss is determined or recognized on such deemed termination.
The owner of a qualified business unit that is deemed to terminate
under this method is treated as having transferred all of the assets
and liabilities attributable to such qualified business unit to a
section 987 QBU on the transition date.
(ii) Translation rates used to determine the amount of assets and
liabilities transferred from the owner to the section 987 QBU for the
section 987 QBU's first taxable year on the transition date. The
exchange rates used to determine the amount of assets and liabilities
transferred from the owner to the section 987 QBU on the transition
date (for example, for purposes of making calculations under Sec.
1.987-4) under the fresh start transition method of this paragraph
(c)(4) shall be determined with reference to the historic exchange
rates on the day the assets were acquired or liabilities entered into
by the qualified business unit deemed terminated. See Example 3 of
paragraph (d) of this section.
(5) Double counting prohibited. The transition method used by the
taxpayer cannot result in taking into account section 987 gain or loss
with respect to an asset or liability attributable to a period prior to
the transition date more than once.
(6) Reporting. The taxpayer must attach a statement to its return
for the first taxable year beginning on the transition date providing
the following information:
(i) A description of each qualified business unit to which these
rules apply, the qualified business unit's owner and its principal
place of business, and a description of the prior method used by the
taxpayer to determine section 987 gain or loss with respect to such
qualified business unit.
(ii) The transition method used by the taxpayer under paragraph (c)
of this section for each qualified business unit.
(iii) If the taxpayer uses the deferral transition method
prescribed in paragraph (c)(3) of this section with respect to a
qualified business unit, an explanation of the method used to determine
section 987 gain or loss.
(iv) If the taxpayer uses the deferral transition method prescribed
in paragraph (c)(3) of this section with respect to a qualified
business unit, the amount treated as net unrecognized section 987 gain
or loss under paragraph (c)(3)(i) of this section.
(v) The method used by the taxpayer for determining the exchange
rates used to translate the basis of assets and the amount of
liabilities of a section 987 QBU into the functional currency of the
owner on the transition date as provided in paragraphs (c)(3)(ii) and
(c)(4)(ii) of this section for purposes of applying these regulations.
(d) Examples. The principles of this section are illustrated by the
following examples:
Example 1. Deferral transition method. (i) U.S. Corp is a
domestic corporation with the dollar as its functional currency.
U.S. Corp owns UK Branch, a branch with the pound as its functional
currency. UK Branch was formed on January 1, 2006. U.S. Corp uses
the method prescribed in the 1991 proposed section 987 regulations
to determine the section 987 gain or loss of UK Branch. U.S. Corp
contributed [pound]6,000 to UK Branch on January 1, 2006. On the
same day, UK Branch bought a truck for [pound]4,000 and a computer
for [pound]1,000. Assume that the spot rate on January 1, 2006, is
[pound]1 = $1. UK Branch had profits determined under Sec. 1.987-
1(b)(1)(i) through (iii) of the 1991 proposed section 987
regulations of [pound]250 in each taxable year of 2006, 2007, 2008,
and 2009. Assume that the average exchange rates used to translate
UK Branch's profits under the 1991 proposed section 987 regulations
were as follows: 2006--[pound]1 = $1.10; 2007--[pound]1 = $1.20;
2008--[pound]1 = $1.30; 2009--[pound]1 = $1.40. UK Branch makes no
remittances to U.S. Corp in any year. On January 1, 2010, UK Branch
transitions to the method provided in Sec. Sec. 1.987-1 through
1.987-11 of these regulations pursuant to paragraph (a) of this
section. U.S. Corp chooses to use the deferral transition method of
paragraph (c)(3) of this section in transitioning from its prior
section 987 method (the method set forth in the 1991 proposed
section 987 regulations) to the method prescribed in the Sec. Sec.
1.987-1 through 1.987-11 of these regulations. The spot rate on
December 31, 2009, is [pound]1 = $2.
(ii) Pursuant to paragraph (c)(3) of this section, U.S. Corp
must determine UK Branch's section 987 gain or loss on January 1,
2010 using its prior section 987 method (the method prescribed under
the 1991 proposed section 987 regulations), as if UK Branch
terminated on December 31, 2009. On December 31, 2009, UK Branch has
an equity pool of [pound]7,000 and a basis pool of $7,250 determined
under the 1991 proposed section 987 regulations based on the
following amounts:
----------------------------------------------------------------------------------------------------------------
Amount in
Asset [pound] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Cash..................................... [pound]1,00 Spot rate on 1/1/06 of [pound]1=$1......... $1,000
0
Cash..................................... 250 Ave. rate for 2006 of [pound]1=$1.10....... 275
Cash..................................... 250 Ave. rate for 2007 of [pound]1=$1.20....... 300
Cash..................................... 250 Ave. rate for 2008 of [pound]1=$1.30....... 325
Cash..................................... 250 Ave. rate for 2009 of [pound]1=$1.40....... 350
Truck.................................... *4,000 Spot rate on 1/1/06 of [pound]1=$1........ 4,000
Computer................................. *1,000 Spot rate on 1/1/06 of [pound]1=$1........ 1,000
----------------------------------------------------------------------
Total assets......................... 7,000 ........................................... 7,250
Liabilities.............................. 0 ........................................... 0
----------------------------------------------------------------------------------------------------------------
* Depreciation not taken into account for purposes of this example.
Accordingly, under Sec. 1.987-3(h)(3)(i) of the 1991 proposed
section 987 regulations, UK Branch determines its section 987 gain
or loss on December 31, 2009, as follows:
Equity Pool on 12/31/09.................................... [pound]7,00
0
Multiplied by spot rate on date of deemed termination of x$2
[pound]1=$2...............................................
------------
14,000
Spot Value of Equity Pool.................................. 14,000
Less 100% of Basis Pool.................................... (7,250)
------------
Section 987 gain....................................... 6,750
------------------------------------------------------------------------
(iii) Under paragraph (c)(3)(i) of this section, U.S. Corp does
not recognize the $6,750 of section 987 gain determined on the
transition date. Instead, the $6,750 will be treated as net
unrecognized section 987 gain of UK Branch for 2010 and subsequent
years
[[Page 52916]]
(in addition to any net unrecognized section 987 gain or loss
otherwise determined at the close of 2010 and subsequent years).
Recognition of net unrecognized section 987 gain or loss is governed
by Sec. 1.987-5.
(iv) Pursuant to paragraph (c)(3)(ii) of this section, when
computing the exchange rates used to determine the amount of assets
and liabilities transferred from U.S. Corp to UK Branch on the
transition date, U.S. Corp must adjust the historic exchange rates
attributable to such assets to take into account UK Branch's section
987 gain determined under paragraph (c)(3) of this section. Under
these facts, where all of UK Branch's assets are considered to
generate deferred section 987 gain, U.S. Corp takes into account
this section 987 gain by translating the assets deemed contributed
by U.S. Corp to UK Branch on the transition date using the same spot
rate it used to determine UK Branch's section 987 gain on the deemed
termination date of December 31, 2009. Accordingly, on January 1,
2010, U.S. Corp translates the assets deemed contributed (cash is
segregated for ease of illustration) to UK Branch as follows:
----------------------------------------------------------------------------------------------------------------
Amount in
Asset [pound] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Cash..................................... [pound]1,00 Spot rate on 12/31/09 of [pound]1=$2....... $2,000
0
Cash..................................... 250 Spot rate on 12/31/09 of [pound]1=$2....... 500
Cash..................................... 250 Spot rate on 12/31/09 of [pound]1=$2....... 500
Cash..................................... 250 Spot rate on 12/31/09 of [pound]1=$2....... 500
Cash..................................... 250 Spot rate on 12/31/09 of [pound]1=$2....... 500
Truck.................................... 4,000 Spot rate on 12/31/09 of [pound]1=$2....... 8,000
Computer................................. 1,000 Spot rate on 12/31/09 of [pound]1=$2....... 2,000
----------------------------------------------------------------------
Total assets......................... 7,000 ........................................... 14,000
Liabilities.............................. 0 ........................................... 0
----------------------------------------------------------------------------------------------------------------
Example 2. Deferral transition method. (i) The facts are the
same as in Example 1 except that U.S. Corp and UK Branch use an
``earnings only'' approach to determine section 987 gain or loss
prior to the transition date. Under this approach, U.S. Corp
maintains a basis and equity pool for UK Branch's earnings and a
separate basis and equity pool for UK Branch's capital. Section 987
gain or loss is only recognized on remittances of earnings (but not
with respect to capital) under principles similar to those of the
1991 proposed section 987 regulations. Remittances are first
considered as distributed from the earnings equity pool and then
from the capital equity pool. For purposes of this example, this
method is assumed to be a reasonable section 987 method and does not
violate Sec. 1.987-10(a)(2).
(ii) Using principles similar to those set forth in Sec. 1.987-
2 of the 1991 proposed section 987 regulations, the earnings equity
pool of UK Branch is [pound]1,000 ([pound]250 earned in each taxable
year of 2006, 2007, 2008 and 2009) and the corresponding earnings
basis pool is $1,250 ($275 in 2006, $300 in 2007, $325 in 2008 and
$350 in 2009). The capital equity pool is [pound]6,000 and the
corresponding capital basis pool is $6,000 (contributed cash of
[pound]6,000 translated to equal $6,000--which U.S. Corp can trace
to contributed cash remaining of [pound]1,000 with a translated
basis equal to $1,000; a truck of [pound]4,000 with a translated
basis equal to $4,000; and a computer of [pound]1,000 with a
translated basis equal to $1,000).
(iii) Pursuant to paragraph (c)(3)(i) of this section, U.S. Corp
must determine UK Branch's section 987 gain or loss on January 1,
2010, using its prior section 987 method (the ``earnings only''
method), as if UK Branch terminated on December 31, 2009. Using
principles similar to Sec. 1.987-3(h) of the 1991 proposed section
987 regulations with respect to the earnings equity and basis pool,
U.S. Corp would determine $750 of section 987 gain as follows:
Earnings Equity Pool on 12/31/09........................... [pound]1,00
0
Multiplied by spot rate on date of deemed termination of x $2
[pound]1=$2...............................................
------------
$2,000
Spot Value of Earnings Equity Pool......................... $2,000
Less 100% of Earnings Basis Pool........................... ($1,250)
------------
Section 987 gain....................................... $750
------------------------------------------------------------------------
(iv) Under paragraph (c)(3)(i) of this section, U.S. Corp does
not recognize the $750 of section 987 gain determined on the
transition date. Instead, the $750 will be treated as net
unrecognized section 987 gain of UK Branch for 2010 and subsequent
years (in addition to any net unrecognized section 987 gain or loss
otherwise determined at the close of 2010 and subsequent years).
Recognition of net unrecognized section 987 gain or loss is governed
by Sec. 1.987-5.
(v) Pursuant to paragraph (c)(3)(ii) of this section, when
computing the exchange rates used to determine the amount of assets
and liabilities transferred from U.S. Corp to UK Branch on the
transition date, U.S. Corp must adjust the historic exchange rates
attributable to such assets to take into account UK Branch's section
987 gain determined under paragraph (c)(3) of this section. Under
these facts, U.S. Corp may reasonably take into account UK Branch's
section 987 gain by translating those UK Branch's assets that
generated such gain using the same spot rate it used to determine UK
Branch's section 987 gain on the termination date of December 31,
2009 and by determining the translation rate of other assets by
reference to the traced basis of such assets. Accordingly, on
January 1, 2010, U.S. Corp translates the deemed contributions to UK
Branch as follows:
----------------------------------------------------------------------------------------------------------------
Amount in
Asset [pound] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Contributed Cash......................... [pound]1,00 Spot rate on 1/1/06 of [pound]1=$1......... $1,000
0
Cash..................................... 250 Spot rate on 12/31/09 of [pound]1=$2....... 500
Cash..................................... 250 Spot rate on 12/31/09 of [pound]1=$2....... 500
Cash..................................... 250 Spot rate on 12/31/09 of [pound]1=$2....... 500
Cash..................................... 250 Spot rate on 12/31/09 of [pound]1=$2....... 500
Truck.................................... 4,000 Spot rate on 1/1/06 of [pound]1=$1......... 4,000
Computer................................. 1,000 Spot rate on 1/1/06 of [pound]1=$1......... 1,000
----------------------------------------------------------------------
Total assets......................... 7,000 ........................................... 8,000
Liabilities.............................. 0 ........................................... 0
----------------------------------------------------------------------------------------------------------------
(vi) If UK Branch was not able to trace historic dollar basis as
set forth in paragraph (v) of this Example 2, when translating the
assets deemed contributed to UK Branch on January 1, 2010, under
paragraph (c)(3)(ii) of this section, U.S. Corp would be required to
use exchange rates that take into account a reasonable allocation of
the aggregate historic basis and the $750 of deferred section 987
gain to the UK Branch assets.
Example 3. Fresh start transition method. (i) The facts are the
same as in Example 1,
[[Page 52917]]
except that U.S. Corp chooses to use the fresh start transition
method of paragraph (c)(4) of this section in transitioning from the
1991 proposed regulations to the method prescribed in the current
regulations. Pursuant to paragraph (c)(4)(i) of this section, UK
Branch is deemed to terminate on December 31, 2009. However, no
section 987 gain or loss will be determined or recognized. On
January 1, 2010, when translating the assets deemed contributed to
UK Branch, U.S. Corp will use the historic exchange rates existing
on the date the assets were acquired by UK Branch pursuant to
paragraph (c)(4)(ii) of this section. Accordingly, U.S. Corp
translates the assets deemed contributed (cash is segregated for
ease of illustration) to UK Branch as follows:
----------------------------------------------------------------------------------------------------------------
Amount in
Asset [pound] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Contributed Cash......................... [pound]1000 Spot rate on 1/1/06 of [pound]1=$1......... $1,000
Cash..................................... 250 Ave. rate for 2006 of [pound]1=$1.10....... 275
Cash..................................... 250 Ave. rate for 2004 of [pound]1=$1.20....... 300
Cash..................................... 250 Ave. rate for 2005 of [pound]1=$1.30....... 325
Cash..................................... 250 Ave. rate for 2006 of [pound]1=$1.40....... 350
Truck.................................... 4000 Spot rate on 1/1/06 of [pound]1=$1......... 4,000
Computer................................. 1000 Spot rate on 1/1/06 of [pound]1=$1......... 1,000
----------------------------------------------------------------------
Total assets......................... 7000 ........................................... 7,250
Liabilities.............................. 0 ........................................... 0
----------------------------------------------------------------------------------------------------------------
(ii) If UK Branch was not able to trace historic dollar basis as
set forth in paragraph (i) of this Example 3, when translating the
assets deemed contributed to UK Branch on January 1, 2010, under
paragraph (c)(3)(ii) of this section, U.S. Corp would be required to
use exchange rates that take into account a reasonable allocation of
the aggregate historic basis of the UK Branch assets.
Sec. 1.987-11 Effective date.
(a) In general. Except as otherwise provided in this section, these
regulations shall apply 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.
(b) Election to apply these regulations to taxable years beginning
after the date of publication of a Treasury decision adopting this rule
as a final regulation in the Federal Register. A taxpayer may elect to
apply these regulations to taxable years beginning after the date of
publication of a Treasury decision adopting this rule as a final
regulation in the Federal Register. Such election shall be binding on
all members that file a consolidated return with the taxpayer and any
controlled foreign corporation, as defined in section 957, in which the
taxpayer owns more than 50 percent of the voting power or stock (as
determined in section 957(a)). An election made under this paragraph
shall be made in accordance with Sec. 1.987-1(f).
Par. 6. Section 1.988-1 is amended by:
1. Adding paragraphs (a)(3) and (a)(4).
2. Revising paragraph (a)(10)(ii).
3. Adding two sentences to the end of paragraph (i).
The additions and revision read as follows:
Sec. 1.988-1 Certain definitions and special rules.
* * * * *
(a) * * *
(3) Certain transactions of a section 987 QBU denominated in the
functional currency of the owner are not treated as section 988
transactions. Transactions described in Sec. 1.987-3(e)(2) (regarding
certain transactions that are denominated in the functional currency of
the owner of a section 987 QBU) are not treated as section 988
transactions to a section 987 QBU. Thus, no currency gain or loss shall
be recognized by a section 987 QBU under section 988 with respect to
such items.
(4) Treatment of assets and liabilities of a partnership or DE that
are not attributed to an eligible QBU--(i) Scope. This paragraph (a)(4)
applies to assets and liabilities of a partnership, or of an entity
disregarded as an entity separate from its owner for U.S. Federal
income tax purposes (DE), that are not attributable to an eligible QBU
(within the meaning of Sec. 1.987-1(b)(3)) as provided under Sec.
1.987-2(b).
(ii) Partnerships. For purposes of applying section 988 and the
applicable regulations to transactions involving the assets and
liabilities described in paragraph (a)(4)(i) of this section that are
held by a partnership, the owners of the partnership (within the
meaning of Sec. 1.987-1(b)(4)) shall be treated as owning their share
of such assets and liabilities. Section 1.987-7(b) shall apply for
purposes of determining an owner's share of such assets or liabilities.
(iii) Disregarded entities. For purposes of applying section 988
and the applicable regulations to transactions involving the assets and
liabilities described in paragraph (a)(4)(i) of this section that are
held by a DE, the owner of the DE (within the meaning of Sec. 1.987-
1(b)(4)) shall be treated as owning all of such assets and liabilities.
(iv) Example. The following example illustrates the application of
paragraph (a)(4) of this section:
Example. Liability held through a partnership. (i) Facts. P, a
foreign partnership, has two equal partners, X and Y. X is a
domestic corporation with the dollar as its functional currency. Y
is a foreign corporation that has the yen as its functional
currency. On January 1, year 1, P borrowed yen and issued a note to
the lender that obligated P to pay interest and repay principal to
the lender in yen. Also on January 1, year 1, P used the yen it
borrowed from the lender to acquire 100% of the stock of F, a
foreign corporation, from an unrelated person. P also holds an
eligible section 987 QBU (within the meaning of Sec. 1.987-1(b)(3))
that has the yen as its functional currency. P maintains one set of
books and records. The assets and liabilities of the eligible QBU
are reflected on the P books and records as provided under Sec.
1.987-2(b). The F stock held by P, and the yen liability incurred to
acquire the F stock, are also recorded on the books and records of
P, but are not reflected on such books and records for purposes of
section 987 pursuant to Sec. 1.987-2(b)(2)(i)(A) and (C),
respectively.
(ii) Analysis. X's portion of the assets and liabilities of the
eligible QBU owned by P is a section 987 QBU. Y's portion of the
assets and liabilities of the eligible QBU owned by P is not a
section 987 QBU because Y and the eligible QBU have the same
functional currency. Because the F stock and yen-denominated
liability incurred to acquire such stock are not reflected on the
books and records of the eligible QBU, they are not subject to
section 987. In addition, because the F stock and the yen-
denominated liability incurred to acquire such stock are held by P
(but not attributable to P's eligible QBU), X and Y are treated as
owning their share of such stock and liability, determined under
Sec. 1.987-7(b), for purposes of applying section 988. As a result,
P's becoming the obligor under the portion of the yen-denominated
note that is treated as being an obligation of X is a section 988
transaction pursuant to paragraphs (a)(1)(ii), (a)(2)(ii) and (a)(3)
of this section. Similarly, the disposition of yen on payments of
interest and principal on the liability, to the extent such yen are
treated as
[[Page 52918]]
owned by X, are section 988 transactions under paragraphs (a)(1)(i)
and (a)(3) of this section. P's becoming the obligor under Y's
portion of the yen-denominated note, and Y's portion of the yen
disposed of in connection with payments on such note, are not
section 988 transactions because Y has the yen as its functional
currency.
(5) [Reserved].
* * * * *
(10) * * *
(ii) Certain transfers. (A) Exchange gain or loss with respect to
nonfunctional currency or any item described in paragraph (a)(2) of
this section entered into with another taxpayer shall be realized upon
a transfer (as defined under Sec. 1.987-2(c)) of such currency or item
from an owner to a section 987 QBU or from a section 987 QBU to the
owner where as a result of such transfers the currency or other such
item--
(i) Loses its character as nonfunctional currency or an item
described in paragraph (a)(2) of this section; or
(ii) Where the source of the exchange gain or loss could be altered
absent the application of this paragraph (a)(10)(ii).
(B) Such exchange gain or loss shall be computed in accordance with
Sec. 1.988-2 (without regard to Sec. 1.988-2(b)(8) as if the
nonfunctional currency or item described in paragraph (a)(2) of this
section had been sold or otherwise transferred at fair market value
between unrelated taxpayers. For purposes of the preceding sentence, a
taxpayer must use a translation rate that is consistent with the
translation conventions of the section 987 QBU to which or from which,
as the case may be, the item is being transferred. In the case of a
gain or loss incurred in a transaction described in this paragraph
(a)(10)(ii) that does not have a significant business purpose, the
Commissioner, may defer such gain or loss.
* * * * *
(i) * * * Generally, the revisions to paragraphs (a)(3), (a)(4),
(a)(5), and (a)(10)(ii) of this section shall apply 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. If a taxpayer makes
an election under Sec. 1.987-11(b), then the effective date of the
revisions to paragraphs (a)(3), (a)(4), and (a)(10)(ii) of this section
with respect to the taxpayer shall be consistent with such election.
Par. 7. Section 1.988-4 is amended by revising paragraph (b)(2) to
read as follows:
Sec. 1.988-4 Source of gain or loss realized on a section 988
transfer.
* * * * *
(b) * * *
(2) Proper reflection on the books of the taxpayer or qualified
business unit--(i) In general. For purposes of paragraph (b)(1) of this
section, the principles of Sec. 1.987-2(b) shall apply in determining
whether an asset, liability, or item of income or expense is reflected
on the books of a qualified business unit.
(ii) Effective date. Generally, paragraph (b)(2)(i) of this section
shall apply 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. If a taxpayer makes an election under Sec. 1.987-11(b), then
the effective date of paragraph (b)(2)(i) with respect to the taxpayer
shall be consistent with such election.
* * * * *
Par. 8. Section 1.989(a)-1 is amended as follows:
1. The last sentence of paragraph (b)(2)(i) is revised.
2. Paragraph (b)(4) is added.
The revision and addition reads as follows:
Sec. 1.989(a)-1 Definition of a qualified business unit.
(b) * * *
(2) * * *
(i) Persons--* * * A trust or estate is a QBU of the beneficiary.
* * * * *
(4) Effective date. Generally, the revisions to paragraph (b)(2)(i)
of this section shall apply 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. If a taxpayer makes an election
under Sec. 1.987-11(b), then the effective date of the revisions to
paragraph (b)(2)(i) of this section with respect to the taxpayer shall
be consistent with such election.
* * * * *
Sec. 1.989(c)-1 [Removed]
Par. 9. Section 1.989(c)-1 is removed.
Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 06-7250 Filed 9-6-06 8:45 am]
BILLING CODE 4830-01-P