[Code of Federal Regulations]
[Title 26, Volume 10]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.985-3]

[Page 549-560]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.985-3  United States dollar approximate separate transactions method.

    (a) Scope and effective date--(1) Scope. This section describes the 
United States dollar (dollar) approximate separate transactions method 
of accounting (DASTM). For all purposes of subtitle A, this method of 
accounting must be used to compute the gross income, taxable income or 
loss, or earnings and profits (or deficit in earnings and profits) of a 
QBU (as defined in section 989(a)) that has the dollar as its functional 
currency pursuant to Sec. 1.985-1(b)(2).
    (2) Effective date--(i) In general. This section is effective for 
taxable years beginning after August 24, 1994.
    (ii) DASTM prior-year election. A taxpayer may elect to apply this 
section to any open taxable year beginning after December 31, 1986 
(whether or not

[[Page 550]]

DASTM has been previously elected for some or all of those years). In 
order to make this election, the taxpayer must apply Sec. 1.985-3 to 
that year and all subsequent years. In addition, each person that is 
related (within the meaning of Sec. 1.985-3(e)(2)(vi)) to the taxpayer 
on the last day of any taxable year for which the election is effective 
and that would have been eligible to elect DASTM must also apply these 
rules to that year and all subsequent years. A taxpayer that has not 
previously elected to apply DASTM to its prior taxable years may make 
the DASTM election for the pertinent years by filing amended returns and 
complying with the applicable election procedures of Sec. 1.985-2. Form 
8819 shall be attached to the return for the first year for which the 
election is to be effective. A taxpayer that has elected DASTM for prior 
taxable years and applied the rules under Sec. 1.985-3 (as contained in 
the April 1, 1994 edition of 26 CFR part 1 (1.908 to 1.1000)) may amend 
its returns to apply the rules of this Sec. 1.985-3. In either case, 
the DASTM election for prior taxable years shall be deemed to be made 
with the consent of the Commissioner.
    (b) Statement of method. Under DASTM, income or loss or earnings and 
profits (or a deficit in earnings and profits) of a QBU for its taxable 
year shall be determined in dollars by--
    (1) Preparing an income or loss statement from the QBU's books and 
records (within the meaning of Sec. 1.989(a)-1(d)) as recorded in the 
QBU's hyperinflationary currency (as defined in Sec. 1.985-
1(b)(2)(ii)(D));
    (2) Making the adjustments necessary to conform such statement to 
United States generally accepted accounting principles and tax 
accounting principles (including reversing monetary correction 
adjustments required by local accounting principles);
    (3) Translating the amounts of hyperinflationary currency as shown 
on such adjusted statement into dollars in accordance with paragraph (c) 
of this section; and
    (4) Adjusting the resulting dollar income or loss or earnings and 
profits (or deficit in earnings and profits) and, where necessary, 
particular items of gross income, deductible expense or other amounts, 
in accordance with paragraph (e) of this section to reflect the amount 
of DASTM gain or loss as determined under paragraph (d) of this section.
    (c) Translation into United States dollars--(1) In general. Except 
as otherwise provided in this paragraph (c), the amounts shown on the 
income or loss statement, as adjusted under paragraph (b)(2) of this 
section, shall be translated into dollars at the exchange rate (as 
defined in paragraph (c)(6) of this section) for the translation period 
(as defined in paragraph (c)(7) of this section) to which they relate. 
However, if the QBU previously changed its functional currency to the 
dollar, and the rules of Sec. 1.985-5 (or, if applicable, Sec. 1.985-
5T, as contained in the April 1, 1993 edition of 26 CFR part 1 (1.908 to 
1.1000)) applied in translating its balance sheet amounts into dollars, 
then the spot exchange rate applied under those rules shall be used to 
translate any amount that would otherwise be translated at a rate 
determined by reference to a translation period prior to the change in 
functional currency. For example, depreciation with respect to an asset 
acquired while the QBU had a nondollar functional currency shall be 
translated into dollars at the spot rate on the last day of the taxable 
year before the year of change to a dollar functional currency, rather 
than at the rate for the period in which the asset was acquired.
    (2) Cost of goods sold. The dollar value of cost of goods sold shall 
equal the sum of the dollar values of beginning inventory and purchases 
less the dollar value of closing inventory as these amounts are 
determined under paragraph (c)(3) of this section.
    (3) Beginning inventory, purchases, and closing inventory--(i) 
Beginning inventory. Amounts representing beginning inventory shall be 
translated so as to obtain the same amount of dollars which represented 
such items in the closing inventory balance for the preceding taxable 
year.
    (ii) Purchases. Amounts representing items purchased or otherwise 
first included in inventory during the taxable year shall be translated 
at the exchange rate for the translation period

[[Page 551]]

in which the cost of such items was incurred.
    (iii) Closing inventory--(A) In general. Amounts representing items 
included in the closing inventory balance shall be translated at the 
exchange rate for the translation period in which the cost of such items 
was incurred. However, if amounts representing items included in the 
closing inventory balance are either valued at market or written down to 
market value, they shall be translated at the exchange rate existing on 
the last day of the taxable year. For purposes of determining lower of 
cost or market, items of inventory included in the closing inventory 
balance shall be translated into dollars at the exchange rate for the 
translation period in which the cost of such items was incurred and 
compared with market as determined in the QBU's hyperinflationary 
currency translated into dollars at the exchange rate existing on the 
last day of the taxable year.
    (B) Determination of translation period. The method used to 
determine the translation period of amounts representing items of 
closing inventory for purposes of paragraph (c)(3)(iii)(A) of this 
section may be based upon reasonable approximations and averages, 
including rates of turnover, provided that the method is used 
consistently from year to year.
    (4) Depreciation, depletion, and amortization. Amounts representing 
allowances for depreciation, depletion, or amortization shall be 
translated at the exchange rate for the translation period in which the 
cost of the underlying asset was incurred, except as provided in 
paragraph (c)(1) of this section.
    (5) Prepaid expenses or income. Amounts representing expense or 
income paid or received in a prior taxable year shall be translated at 
the exchange rate for the translation period during which they were paid 
or received.
    (6) Exchange rate. The exchange rate for a translation period may be 
determined under any reasonable method, provided that the method is 
consistently applied to all translation periods and conforms to the 
taxpayer's method of financial accounting. Reasonable methods include 
the average of beginning and ending exchange rates for the translation 
period and the spot rate on the last day of the translation period. Once 
chosen, a method for determining an exchange rate can be changed only 
with the consent of the district director.
    (7) Translation period--(i) In general. Except as provided in 
paragraphs (c)(3)(iii)(B) and (c)(7)(ii) of this section, a translation 
period shall be each month within a QBU's taxable year.
    (ii) Exception. A taxpayer may divide its taxable year into 
translation periods of equal length (with not more than one short period 
annually) that are less than one month. Once such a translation period 
is established, it may not be changed without the consent of the 
district director.
    (8) Dollar transactions--(i) In general. Except as provided in 
paragraph (c)(8)(ii) of this section, no DASTM gain or loss is realized 
with respect to dollar transactions since the dollar is the functional 
currency of the QBU. Thus, the amount of any payment or receipt of 
dollars shall be reflected in the income or loss statement by the amount 
of such dollars. Also, the income or loss attributable to any 
transaction in which the amount that a QBU is entitled to receive (or is 
required to pay) by reason of such transaction is denominated in terms 
of the dollar, or is determined by reference to the value of the dollar, 
must be computed transaction by transaction. For example, if a foreign 
corporation lends 20 LC when 20 LC=$20 and is entitled to receive the LC 
equivalent of $20 at maturity plus a market rate of interest in dollars 
(or its LC equivalent), the loan is a dollar transaction. Similarly, 
this paragraph applies to any transaction that is determined to be a 
dollar transaction under section 988.
    (ii) Non-dollar functional currency. If pursuant to Sec. 1.985-
1(b)(2)(ii)(B)(1), a QBU is required to use a functional currency other 
than the dollar, then that currency shall be substituted for the dollar 
in applying paragraph (c)(8)(i) of this section.
    (9) Third currency transactions.--A taxpayer may use any reasonable 
method of accounting for transactions described in sections 988(c)(1)(B) 
and

[[Page 552]]

(C) that are denominated in, or determined by reference to, a currency 
other than the QBU's hyperinflationary currency or the dollar (third 
currency transactions) so long as such method is consistent with its 
method of financial accounting.
    (10) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. S is an accrual basis QBU that is required to use the 
dollar as its functional currency for its first taxable year beginning 
in 1994. S's hyperinflationary currency is the ``h.'' During 1994, S 
accrues 100 dollars attributable to dollar-denominated sales. Because 
this is a dollar transaction under paragraph (c)(8) of this section, S's 
income or loss for 1994 shall reflect the 100 dollars (not the 
hyperinflationary value of such dollars when accrued).
    Example 2. (i) S is an accrual basis QBU that is required to use the 
dollar as its functional currency for its first taxable year beginning 
in 1994. S's hyperinflationary currency is the ``h.'' During 1994, S's 
sales amounted to 240,000,000h, its currently deductible expenses were 
26,000,000h, and its total inventory purchases amounted to 100,000,000h. 
During January and February of 1994, S purchased depreciable assets for 
80,000,000h and was allowed depreciation of 4,000,000h. At the end of 
1994, S's closing inventory was 23,000,000h. No election to use a 
translation period other than the month is made, S had no transactions 
described in paragraph (c)(8) or (c)(9) of this section, and S's closing 
inventory was computed on the first-in, first-out inventory method. S's 
adjusted income or loss statement for 1994 is translated into dollars as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                                  Hyperinflationary   Exchange    United States
                                                                       currency         rate         dollars
----------------------------------------------------------------------------------------------------------------
                              Sales

(Jan.-Feb.).....................................................       10,000,000h     \1\ 20:1        $500,000
(Mar.-Apr.).....................................................        20,000,000         21:1         952,381
(May.-June.)....................................................        50,000,000         22:1       2,272,727
(July)..........................................................        50,000,000         23:1       2,173,913
(August)........................................................        20,000,000         26:1         769,231
(Sept.).........................................................        20,000,000         28:1         714,286
(Oct.)..........................................................        20,000,000         29:1         689,655
(Nov.)..........................................................        20,000,000         30:1         666,667
(Dec.)..........................................................        30,000,000         31:1         967,742
                                                                 -------------------            ----------------
      Total.....................................................      240,000,000h   ..........       9,706,602

                       Cost of Goods Sold

Opening Inventory Purchases:                                                     0   ..........               0
    (Jan.-Feb.).................................................       15,000,000h         20:1         750,000
    (Mar.-Apr.).................................................        10,000,000         21:1         476,190
    (May-June)..................................................        30,000,000         22:1       1,363,636
    (July)......................................................        20,000,000         23:1         869,565
    (August)....................................................        10,000,000         26:1         384,615
    (Sept.).....................................................         5,000,000         28:1         178,571
    (Oct.)......................................................         5,000,000         29:1         172,414
    (Nov.)......................................................         2,500,000         30:1          83,333
    (Dec.)......................................................         2,500,000         31:1          80,645
Less Closing Inventory..........................................      (23,000,000)        (\2\)        (822,655)
                                                                 -------------------            ----------------
                                                                       77,000,000h   ..........       3,536,314
----------------------------------------------------------------------------------------------------------------
\1\ Where multiple months are indicated, the exchange rate applies for all months.
\2\ See paragraph (ii) of this Example.

    (ii) Since S uses the first-in, first-out inventory method, the 
closing inventory is assumed to consist of purchases made during the 
most recent translation period as follows:

----------------------------------------------------------------------------------------------------------------
                                                               Hyperinflationary                   United States
                                                                    currency       Exchange rate      dollars
----------------------------------------------------------------------------------------------------------------
December.....................................................        2,500,000h             31:1        $ 80,645
November.....................................................         2,500,000             30:1          83,333
October......................................................         5,000,000             29:1         172,414
September....................................................         5,000,000             28:1         178,571
August.......................................................         8,000,000             26:1         307,692
                                                              -------------------                ---------------
      Total..................................................       23,000,000h   ..............         822,655
                                                              ===================                ===============


[[Page 553]]


                   Non-Capitalized Expenses

(Jan.-Feb.)..................................................        4,000,000h             20:1         200,000
(Mar.-Apr.)..................................................         2,500,000             21:1         119,048
(May-June)...................................................         2,500,000             22:1         113,636
(July).......................................................         2,000,000             23:1          86,957
(August).....................................................         3,000,000             26:1         115,385
(Sept.)......................................................         3,000,000             28:1         107,143
(Oct.).......................................................         2,000,000             29:1          68,966
(Nov.).......................................................         3,000,000             30:1         100,000
(Dec.).......................................................         4,000,000             31:1         129,032
                                                              -------------------                ---------------
      Total..................................................       26,000,000h   ..............       1,040,167
Depreciation.................................................        4,000,000h             20:1         200,000
      Total Cost & Expenses..................................      107,000,000h   ..............       4,776,481
                                                              -------------------                ---------------
Operating Profit.............................................      133,000,000h   ..............       4,930,121
                                                              ===================                ===============
----------------------------------------------------------------------------------------------------------------

    (d) Computation of DASTM gain or loss--(1) Rule. DASTM gain or loss 
of a QBU equals--
    (i) The net worth of the QBU (as determined under paragraph (d)(2) 
of this section) at the end of the taxable year minus the net worth of 
the QBU at the end of the preceding taxable year; plus
    (ii) The dollar amount of the items described in paragraph (d)(3) of 
this section and minus the dollar amount of the items described in 
paragraph (d)(4) of this section; minus
    (iii) The amount of dollar income or earnings and profits (or plus 
the amount of any dollar loss or deficit in earnings and profits) as 
determined for the taxable year pursuant to paragraphs (b)(1) through 
(b)(3) of this section.
    (2) Net worth. Net worth of a QBU at the end of any taxable year 
equals the aggregate dollar amount representing assets on the QBU's 
balance sheet at the end of the taxable year less the aggregate dollar 
amount representing liabilities on the balance sheet. Notwithstanding 
any other provision in this paragraph (d)(2), the district director may 
adjust the amount of any asset or liability if a purpose for acquiring 
(or disposing of) the asset or incurring (or discharging) the liability 
is to manipulate the composition of the balance sheet for any period 
during the taxable year in order to avoid tax. The taxpayer shall 
determine net worth by--
    (i) Preparing a balance sheet as of the end of the taxable year from 
the QBU's books and records (within the meaning of Sec. 1.989(a)-1(d)) 
as recorded in the QBU's hyperinflationary currency;
    (ii) Making adjustments necessary to conform such balance sheet to 
United States generally accepted accounting principles and tax 
accounting principles (including reversing monetary correction 
adjustments required by local accounting principles); and
    (iii) Translating the asset and liability amounts shown on the 
balance sheet into United States dollars in accordance with paragraph 
(d)(5) of this section.
    (3) Positive adjustments. The items described in this paragraph 
(d)(3) are dividend distributions for the taxable year and any items 
that decrease net worth for the taxable year but that generally do not 
affect income or loss or earnings and profits (or a deficit in earnings 
and profits). Such items include a transfer to the home office of a QBU 
branch and a return of capital. Except as otherwise provided by ruling 
or administrative pronouncement, the amount of a transfer to the home 
office of a QBU branch, a dividend, or a distribution that is a return 
of capital shall be translated into dollars at the exchange rate on the 
date the amount is paid.
    (4) Negative adjustments. The items described in this paragraph 
(d)(4) are items that increase net worth for the taxable year but that 
generally do not affect income or loss or earnings and profits (or a 
deficit in earnings and profits). Such items include a capital 
contribution or a transfer from a home

[[Page 554]]

office to a QBU branch. Except as otherwise provided by ruling or 
administrative pronouncement, if the contribution or transfer is not in 
dollars, the amount of a capital contribution or transfer shall be 
translated into dollars at the exchange rate on the date made.
    (5) Translation of balance sheet. Asset and liability amounts shown 
on the balance sheet in hyperinflationary currency (adjusted pursuant to 
paragraph (d)(2)(ii) of this section) shall be translated into dollars 
as provided in this paragraph (d)(5). However, if the QBU previously 
changed its functional currency to the dollar and the rules of Sec. 
1.985-5 (or, if applicable, Sec. 1.985-5T, as contained in the April 1, 
1993 edition of 26 CFR part 1 (1.908 to 1.1000)) applied in translating 
its balance sheet amounts into dollars, then the spot exchange rate 
applied under those rules shall be used to translate any amount that 
would otherwise be translated at a rate determined by reference to a 
translation period prior to the change in functional currency. For 
example, the basis of real property acquired while the QBU had a 
nondollar functional currency shall be translated into dollars at the 
spot rate on the last day of the taxable year before the year of change 
to a dollar functional currency, rather than at the rate for the period 
in which the cost was incurred.
    (i) Closing inventory. Amounts representing items of inventory 
included in the closing inventory balance shall be translated in 
accordance with paragraph (c)(3)(iii) of this section.
    (ii) Bad debt reserves. Amounts representing bad debt reserves shall 
be translated at the exchange rate for the last translation period for 
the taxable year.
    (iii) Prepaid income or expense. Amounts representing expenses or 
income paid or received in a prior taxable year shall be translated in 
accordance with paragraph (c)(5) of this section.
    (iv) Hyperinflationary currency. Amounts of the hyperinflationary 
currency and hyperinflationary demand deposit balances shall be 
translated at the exchange rate for the last translation period of the 
taxable year.
    (v) Certain assets--(A) In general. Amounts representing plant, real 
property, equipment, goodwill, and patents and other intangibles shall 
be translated at the exchange rate for the translation period in which 
the cost of the asset was incurred.
    (B) Adjustment to certain assets. Amounts representing depreciation, 
depletion, and amortization reserves shall be translated in accordance 
with paragraph (c)(4) of this section.
    (vi) Hyperinflationary debt obligations. Except as provided in 
paragraph (d)(5)(vii) of this section, amounts representing a 
hyperinflationary debt obligation (including accounts receivable and 
payable) shall be translated at the exchange rate for the last 
translation period for the taxable year.
    (vii) Accrued foreign income taxes. Amounts representing an accrued 
but unpaid foreign income tax shall be translated at the exchange rate 
on the last day of the last translation period of the taxable year of 
accrual.
    (viii) Certain hyperinflationary financial instruments. Amounts 
representing any item described in section 988(c)(1)(B)(iii) (relating 
to forward contracts, futures contracts, options, or similar financial 
instruments) denominated in or determined by reference to the 
hyperinflationary currency shall be translated at the exchange rate for 
the last translation period for the taxable year.
    (ix) Other assets and liabilities. Amounts representing assets and 
liabilities, other than those described in paragraphs (d)(5)(i) through 
(viii) of this section, shall be translated at the exchange rate for the 
translation period in which the cost of the asset or the amount of the 
liability was incurred.
    (6) Dollar transactions. Notwithstanding any other provisions of 
this paragraph (d), where the amount representing an item shown on the 
balance sheet reflects a dollar transaction (described in paragraph 
(c)(8) of this section), the transaction shall be taken into account in 
accordance with that paragraph.
    (7) Third currency transactions. A taxpayer may use any reasonable 
method of accounting for transactions described in section 988(c)(1)(B) 
and (C) that are denominated in, or determined by reference to, a 
currency other than

[[Page 555]]

the QBU's hyperinflationary currency or the dollar (third currency 
transactions), so long as such method is consistent with its method of 
financial accounting.
    (8) Character. The amount of DASTM gain or loss determined under 
paragraph (d)(1) of this section shall be ordinary income or loss.
    (9) Example. The provisions of this paragraph (d) are illustrated by 
the following example:

    Example. (i) S, an accrual method calendar year foreign corporation, 
uses DASTM. S's hyperinflationary currency is the ``h.'' S's net worth 
at December 31, 1993 was $3,246,495. For 1994, S's operating profit is 
81,340,000h, or $2,038,200. S made a 5,000,000h distribution in April 
and again in December of 1994. S's translation period is the month. None 
of S's assets or liabilities reflect a dollar or third currency 
transaction described in paragraph (c)(8) or (c)(9) of this section, 
respectively. The exchange rate for each month in 1994 is as follows:




                  January                     32h:$1
                  Feb.-Mar.                   33:1
                  April-May                   34:1
                  June                        35:1
                  July                        36:1
                  Aug.-Sept.                  37:1
                  Oct.                        38:1
                  Nov.                        39:1
                  Dec.                        40:1


    (ii) At the end of 1994, S's assets and liabilities, as adjusted and 
translated pursuant to paragraphs (d)(2) and (d)(5) of this section, are 
as follows:

----------------------------------------------------------------------------------------------------------------
                                                                     Hyperin-
                                                                    flationary     Exchange rate    U.S. dollar
----------------------------------------------------------------------------------------------------------------
Hyperinflationary cash on hand..................................         40,000h            40:1          $1,000
  Checking account..............................................         400,000            40:1          10,000
Accounts Receivable- 30 Day Accounts............................      20,000,000        \1\ 40:1         500,000
    60 Day Accounts.............................................      25,000,000            40:1         625,000
Inventory.......................................................      65,000,000           (\2\)       2,500,000
Fixed assets--Property..........................................      90,000,000            27:1       3,333,333
    Plant.......................................................     190,000,000           (\3\)       6,785,714
        Accumulated Depreciation................................       (600,000)           (\3\)        (21,428)
    Equipment...................................................      10,000,000           (\4\)         340,000
        Accumulated Depreciation................................       (400,000)           (\4\)        (13,333)
Common Stock--Stock A...........................................         500,000            34:1          14,706
      Stock B...................................................         400,000            26:1          15,385
Preferred Stock.................................................       1,000,000            32:1          31,250
C.D.s...........................................................       5,000,000            40:1         125,000
      Total Assets..............................................     406,340,000  ..............      14,246,627
Accounts Payable Long-term liabilities:                               35,000,000            40:1         875,000
    Liability A.................................................     150,000,000            40:1       3,750,000
    Liability B.................................................      80,000,000            40:1       2,000,000
    Liability C.................................................      30,000,000            40:1         750,000
                                                                 ----------------                ---------------
      Total Liabilities.........................................    295,000,000h  ..............     $7,375,000
----------------------------------------------------------------------------------------------------------------
\1\ S ages its accounts receivable and groups them into two categories--those outstanding for 30 days and those
  outstanding for 60 days.
\2\ Translated the same as closing inventory under paragraph (c)(3)(iii).
\3\ The cost of S's plant was incurred in several translation periods. Therefore, the dollar cost and dollar
  depreciation reflect several translation rates.
\4\ S has a variety of equipment. Therefore, S's dollar basis represents the sum of the hyperinflationary cost
  of each, translated according to the exchange rate for the translation period incurred.

    (iii) The DASTM gain of S for 1994 is computed as follows:




                  Net worth--1994         ..............      $6,871,627
                  Less--Net worth--1993   ..............      $3,246,495
                  Plus--1994 Dividends:
                   April                        $149,254
                   December                  \1\ 126,582         275,836
                  Less Operating Profit-- ..............       2,038,200
                   1994
                  DASTM Gain              ..............      $1,862,768
                                                         ===============


\1\ The exchange rates on the date of the April and December dividends
  were 33.5h:$1 and 39.5h:$1, respectively.


[[Page 556]]

    (iv) Thus, total profit = $2,038,200 + $1,862,768 = $3,900,968

    (e) Effect of DASTM gain or loss on gross income, taxable income, or 
earnings and profits--(1) In general. For all purposes of subtitle A, 
the amount of DASTM gain or loss of a QBU determined under paragraph (d) 
of this section is taken into account by the QBU for purposes of 
determining the amount of its gross income, taxable income or loss, 
earnings and profits (or deficit in earnings and profits), and, where 
necessary, particular items of income, expense or other amounts. DASTM 
gain or loss is allocated under one of two methods. Certain small QBUs 
may elect the small QBU DASTM allocation described in paragraph (e)(2) 
of this section. All other QBUs must use the 9-step procedure described 
in paragraph (e)(3) of this section.
    (2) Small QBU DASTM allocation--(i) Election threshold. A taxpayer 
may elect to use the small QBU DASTM allocation described in paragraph 
(e)(2)(iv) of this section with respect to a QBU that has an adjusted 
basis in assets (translated as provided in paragraph (d)(5) of this 
section) of $10 million or less at the end of any taxable year. In 
calculating the $10 million threshold, a QBU shall be treated as owning 
all of the assets of each related QBU (as defined in paragraph 
(e)(2)(vi) of this section) having its residence (as defined in section 
988(a)(3)(B)) in the QBU's country of residence (related same- country 
QBU). For this purpose, appropriate adjustment shall be made to 
eliminate the double counting of assets created in transactions between 
related QBUs resident in the same country. For example, assume QBU-1, 
resident in country X, sells inventory to related QBU-2, also resident 
in country X, in exchange for an account receivable. For purposes of 
determining the assets of QBU-1 under this paragraph (e)(2)(i), the 
taxpayer shall take into account either the inventory shown on the books 
of QBU-2 or QBU-1's receivable from QBU-2 (but not both).
    (ii) Consent to election. The election of the small QBU DASTM 
allocation or subsequent application of the rules of paragraph (e)(3) of 
this section due to an increase in the adjusted basis of the QBU's 
assets shall be deemed to have been made with the consent of the 
Commissioner. Once the election under paragraph (e)(2)(iii) of this 
section is made, it shall apply for all years in which the adjusted 
basis of the assets of the QBU (and any related same-country QBU) is $10 
million or less, unless revoked with the Commissioner's consent. If the 
adjusted basis of the assets of the QBU (and any related same- country 
QBU) exceeds $10 million at the end of any taxable year, the rules of 
paragraph (e)(3) of this section shall apply to that QBU (and any 
related same-country QBU) for such year and each subsequent year unless 
such QBU again qualifies, and applies for and obtains the Commissioner's 
consent, to use the small QBU DASTM allocation. However, if a QBU 
acquires assets with a principal purpose of avoiding the application of 
paragraph (e)(2)(iv) of this section, the Commissioner may disregard the 
acquisition of such assets.
    (iii) Manner of making election--(A) QBUs that are branches of 
United States persons. For the first year in which this election is 
effective, in the case of a QBU branch of a United States person, a 
statement shall be attached to the United States person's timely filed 
Federal income tax return (taking extensions into account). The 
statement shall identify the QBU (or QBUs) for which the election is 
being made by describing its business and its country of residence, 
state the adjusted basis of the assets of the QBU (and any related same-
country QBUs) to which the election applies, and include a statement 
that the election is being made pursuant to Sec. 1.985-3(e)(2).
    (B) Other QBUs. In the case of a QBU other than one described in 
paragraph (e)(2)(iii)(A) of this section, an election must be made in 
the manner prescribed in Sec. 1.964-1. The statement filed with the 
Internal Revenue Service as required under Sec. 1.964-1 must include 
the information required under paragraph (e)(2)(iii)(A) of this section.
    (iv) Effect of election. If a taxpayer elects under this paragraph 
(e)(2) to use the small QBU DASTM allocation, DASTM gain or loss, as 
determined under paragraph (d) of this section, of a small QBU shall be 
allocated ratably to all items of the QBU's gross income

[[Page 557]]

(determined prior to adjustment for DASTM gain or loss). Therefore, for 
purposes of the foreign tax credit, DASTM gain or loss shall be 
allocated on the basis of the relative amounts of gross income in each 
separate category as defined in Sec. 1.904-5(a)(1). In the case of a 
controlled foreign corporation (within the meaning of section 957 or 
953(c)(1)(B)), for purposes of section 952, DASTM gain or loss shall be 
allocated to subpart F income in a separate category in the same ratio 
that the gross subpart F income in that category for the taxable year 
bears to its total gross income in that category for the taxable year.
    (v) Conformity. If a person (or a QBU of such person) makes an 
election under this paragraph (e)(2) to use the small QBU DASTM 
allocation, then each QBU of any related person (as defined in paragraph 
(e)(2)(vi) of this section) that satisfies the threshold requirement of 
paragraph (e)(2)(i) of this section (after application of the 
aggregation rule of paragraph (e)(2)(i) of this section) shall be deemed 
to have made the election.
    (vi) Related person. The term related person means any person with a 
relationship to the QBU (or to the United States or foreign person of 
which the electing QBU is a part) that is defined in section 267(b) or 
section 707(b).
    (3) DASTM 9-step procedure--(i) Step 1--prepare balance sheets. The 
taxpayer shall prepare an opening and a closing balance sheet for the 
QBU for each balance sheet period during the taxable year. The balance 
sheet period is the most frequent period for which balance sheet data 
are reasonably available (but in no event less frequently than 
quarterly). The balance sheet period may not be changed without the 
consent of the district director. The balance sheets must be prepared 
under the principles of paragraph (d)(2) of this section.
    (ii) Step 2--identify certain assets and liabilities. The taxpayer 
shall identify each item on the balance sheet that is described in 
section 988(c)(1)(B) or (C) and that would have been translated under 
paragraph (d)(5) of this section into dollars at the exchange rate for 
the last translation period for the taxable year (or the exchange rate 
on the last day of the last translation period of the taxable year in 
the case of an accrued foreign income tax liability).
    (iii) Step 3--characterize the assets. The taxpayer shall 
characterize and group the assets identified in paragraph (e)(3)(ii) of 
this section (Step 2) according to the source and the type of income 
that they generate, have generated, or may reasonably be expected to 
generate by applying the principles of Sec. 1.861-9T(g)(3) or its 
successor regulation (relating to characterization of assets for 
purposes of interest expense allocation). If a purpose for a taxpayer's 
business practices is to manipulate asset characterization or groupings, 
the district director may allocate or apportion DASTM gain or loss 
attributable to the assets. Thus, if a taxpayer that previously did not 
separately state interest on accounts receivable begins to impose an 
interest charge and a purpose for the change was to manipulate tax 
characterizations or groupings, then the district director may require 
that none of the DASTM gain or loss attributable to those receivables be 
allocated or apportioned to interest income.
    (iv) Step 4--determine DASTM gain or loss attributable to certain 
assets--(A) General rule. The taxpayer shall determine the dollar amount 
of DASTM gain or loss attributable to assets in each group identified in 
paragraph (e)(3)(iii) of this section (Step 3) as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.062

where

bb = the hyperinflationary currency adjusted basis of the assets in the 
group at the beginning of the balance sheet period.
eb = the hyperinflationary currency adjusted basis of the assets in the 
group at the end of the balance sheet period.
er = one dollar divided by the number of hyperinflationary currency 
units that equal one dollar at the end of the balance sheet period.
br = one dollar divided by the number of hyperinflationary currency 
units that equal one dollar at the beginning of the balance sheet 
period.

    (B) Weighting to prevent distortion. If averaging the adjusted basis 
of assets in a group at the beginning and end of

[[Page 558]]

a balance sheet period results in an allocation of DASTM gain or loss 
that does not clearly reflect income, as might be the case in the event 
of a purchase or disposition of an asset that is not in the normal 
course of business, the taxpayer must use a weighting method that 
reflects the time the assets are held by the QBU during the translation 
period.
    (C) Example. The provisions of this paragraph (e)(3)(iv) are 
illustrated by the following example:

    Example. S is a foreign corporation that operates in the 
hyperinflationary currency ``h'' and computes its income or loss or 
earnings and profits under DASTM. S's adjusted basis in a group of 
assets described in section 988(c)(1)(B) or (C) that generate general 
limitation foreign source income (as characterized under paragraph 
(e)(3)(iii) of this section) at the beginning of the balance sheet 
period is 750,000h. S's basis in such assets at the end of the balance 
sheet period is 1,250,000h. The exchange rate at the beginning of the 
balance sheet period is $1 = 200h. The exchange rate at the end of the 
balance sheet period is $1 = 500h. The DASTM loss attributable to the 
assets described above is $3,000, determined as follows:

[(750,000h+1,250,000h)/2]x [($1/500h)-($1/200h)]=($3000)

    (v) Step 5--adjust dollar gross income by DASTM gain or loss from 
assets. The taxpayer shall adjust the dollar amount of the QBU's gross 
income (computed under paragraphs (b)(1) through (b)(3) of this section) 
generated by each group of assets characterized in paragraph (e)(3)(iii) 
of this section (Step 3) by the amount of DASTM gain or loss 
attributable to those assets computed under paragraph (e)(3)(iv) of this 
section (Step 4). Thus, if a group of assets, such as accounts 
receivable, generates both a category of income described in section 
904(d)(1)(I) (relating to general limitation income) that is not foreign 
base company income as defined in section 954 and a DASTM loss under 
paragraph (e)(3)(iv) of this section (Step 4), the amount of the DASTM 
loss would reduce the amount of the QBU's gross income in that category. 
Similarly, if a group of assets, such as short-term bank deposits, 
generates both foreign personal holding company income that is passive 
income (described in sections 954(c)(1)(A) and 904(d)(1)(A)) and a DASTM 
loss under paragraph (e)(3)(iv) of this section (Step 4), the amount of 
the DASTM loss would reduce the amount of the QBU's foreign personal 
holding company income and passive income. See section 904(f) and the 
regulations thereunder in the case where that section would apply and 
DASTM loss attributable to a group of assets exceeds the income 
generated by such assets.
    (vi) Step 6--determine DASTM gain or loss attributable to 
liabilities--(A) General rule. The taxpayer shall determine the dollar 
amount of DASTM gain or loss attributable to liabilities identified in 
paragraph (e)(3)(ii) of this section (Step 2), and described in 
paragraph (e)(3)(vi)(B) of this section as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.063

where

bl = the hyperinflationary currency amount of liabilities at the 
beginning of the balance sheet period.
el = the hyperinflationary currency amount of liabilities at the end of 
the balance sheet translation period.
br = one dollar divided by the number of hyperinflationary currency 
units that equal one dollar at the beginning of the balance sheet 
period.
er = one dollar divided by the number of hyperinflationary currency 
units that equal one dollar at the end of the balance sheet period.

    (B) Separate calculation. The calculation shall be made separately 
for interest-bearing liabilities described in paragraph (e)(3)(vii) of 
this section (Step 7) and for each of the classes of non-interest-
bearing liabilities described in paragraph (e)(3)(viii) of this section 
(Step 8).
    (C) Weighting to prevent distortion. Where a distortion would result 
from averaging the amount of liabilities at the beginning and end of a 
balance sheet period, as might be the case where a taxpayer incurs or 
retires a substantial liability, the taxpayer must use a different 
method that more clearly reflects the average amount of liabilities 
weighted to reflect the time the liability was outstanding during the 
balance sheet period.
    (vii) Step 7--adjust dollar income and expense by DASTM gain or loss 
from interest-bearing liabilities--(A) In general.

[[Page 559]]

The taxpayer shall apply the amount of DASTM gain on interest-bearing 
liabilities computed under paragraph (e)(3)(vi) of this section (Step 6) 
to reduce interest expense generated by such liabilities (e.g., prior to 
the application of Sec. 1.861-9T or its successor regulation). To the 
extent DASTM gain on such liabilities exceeds interest expense, it shall 
be sourced or otherwise classified in the same manner that interest 
expense is allocated and apportioned under Sec. 1.861-9T or its 
successor regulation. The amount of DASTM loss on interest-bearing 
liabilities computed under paragraph (e)(3)(vi) of this section (Step 6) 
shall be allocated and apportioned in the same manner that interest 
expense is allocated and apportioned under Sec. 1.861-9T or its 
successor regulation (without regard to the exceptions to fungibility in 
Sec. 1.861-10T or its successor regulation). For purposes of this 
section, an interest-bearing liability is a liability that requires 
payment of periodic interest (whether fixed or variable), has original 
issue discount, or would have interest imputed under subtitle A.
    (B) Allocation of DASTM gain or loss from interest-bearing 
liabilities that generate related person interest expense. DASTM gain or 
loss from interest-bearing liabilities that generate related person 
interest expense (as provided in section 954(b)(5)) shall be allocated 
for purposes of subtitle A (including sections 904 and 952) in the same 
manner that the related person interest expense of that debt is required 
to be allocated under the rules of section 954(b)(5) and Sec. 1.904-
5(c)(2).
    (C) Modified gross income method. In applying the modified gross 
income method described in Sec. 1.861-9T(j) or its successor 
regulation, gross income shall be adjusted for any DASTM gain or loss 
from assets as provided in paragraph (e)(3)(v) of this section (Step 5) 
and any DASTM gain or loss with respect to short-term, non-interest-
bearing trade payables as provided in paragraph (e)(3)(viii)(A) of this 
section.
    (viii) Step 8--adjust dollar income and expense by DASTM gain or 
loss from non-interest bearing liabilities--(A) Short-term, non-
interest-bearing trade payables. The taxpayer shall allocate DASTM gain 
or loss on short-term non-interest-bearing trade payables for purposes 
of subtitle A (including sections 904 and 952) to the same category or 
type of gross income as the cost or expense to which the trade payable 
relates. For this purpose, a short-term, non-interest-bearing trade 
payable is a non-interest-bearing liability with a term of 183 days or 
less that is incurred to purchase property or services to be used by the 
obligor in an active trade or business.
    (B) Excise tax payables. The taxpayer shall allocate DASTM gain or 
loss on excise tax payables for purposes of subtitle A (including 
sections 904 and 952) to the same category or type of gross income as 
would be derived from the activity to which the excise tax relates.
    (C) Other non-interest-bearing liabilities--(1) In general. Except 
as provided in paragraphs (e)(3)(viii)(A), (e)(3)(viii)(B), and 
(e)(3)(viii)(C)(2) of this section, DASTM gain or loss on non-interest-
bearing liabilities shall be allocated under paragraph (e)(3)(ix) of 
this section (Step 9).
    (2) Tracing if substantial distortion of income. DASTM gains and 
losses on liabilities described in paragraph (e)(3)(viii)(C)(1) of this 
section may be attributed to the same section 904(d) separate category 
or subpart F category as the transaction to which the liability relates 
if the taxpayer demonstrates to the satisfaction of the district 
director, or it is determined by the district director, that application 
of paragraph (e)(3)(viii)(C)(1) of this section results in a substantial 
distortion of income.
    (ix) Step 9--allocate residual DASTM gain or loss. If there is a 
difference between the net DASTM gain or loss determined under 
paragraphs (e)(3)(i) through (viii) of this section (Steps 1 through 8) 
and the DASTM gain or loss determined under paragraph (d) of this 
section, the amount of the difference must be allocated for purposes of 
subtitle A (including sections 904 and 952) to the QBU's gross income 
(computed under paragraphs (b)(1) through (3) of this section, as 
adjusted under paragraphs (e)(3)(i) through (viii) of this section 
(Steps 1 through 8)) on the

[[Page 560]]

basis of the relative amounts of each category or type of gross income.

[T.D. 8556, 59 FR 37673, July 25, 1994]