IRS Updates Guidance Related to Foreign Gains and Losses Under Section 987 by Jairan Shirazi

2024-08-07

One of the more challenging tax reporting requirements for multinational businesses is the translation of gains and losses of their foreign branch offices and qualified business units (QBUs) into their home country’s functional currency. This process is often complicated by exchange rate fluctuations, including currency devaluations, that can have a material impact on the principal businesses’ assets and liabilities and their ultimate recognition of a loss or taxable gain on their financial statements.

Background

Internal Revenue Code Section 987 addresses the taxation of foreign currency translation gains or losses with respect to QBUs. The activities of a corporation, partnership, trust, estate, or individual rise to the level of a QBU if they constitute a trade or business and maintain a separate set of books.

U.S. taxpayers must calculate their QBUs’ foreign currency income, gains, deductions and losses annually and translate those amounts into U.S. dollars at the average exchange rate in effect for that tax year. Additionally, when a QBU transfers money or other property to its U.S. owner or one of the owner’s other QBUs, the U.S. owner must recognize the exchange gains or losses on its U.S. tax return as a remittance of the QBUs’ accumulated earnings. In other words, U.S. taxpayers will record a gain taxed as ordinary income or a deductible loss based on the exchange rate in place when they receive a remittance or terminate a QBU.

These regulations have been suspended and rewritten several times between 2006 and 2021 due to their complexity and the undue burden they placed on taxpayers. However, in November 2023, the IRS and U.S. Treasury again attempted to simplify this process with the issuance of another round of proposed regulations, which are scheduled to go into effect for tax years after Dec. 31, 2024.

FEEP Method of Accounting

The most recent round of regulation guidance adopts a modified foreign exchange exposure pool (FEEP) method for taxpayers to account for currency exchange gains or losses at the end of each year. First introduced in 2006 and modified by final regulations in 2016, the FFEP method is based on a balance sheet approach that relies on two different methods for the parent company to covert its QBUs’ foreign currency transactions into its home country’s functional currency for purposes of reporting its financial position and performance and position.

Previously, the law required the gains or losses of “marked items,” including financial assets and liabilities such as debt instruments, accounts payable and receivables, to be translated into the owner’s functional currency at the spot rate as of the last day of the tax year. However, taxpayers could defer the recognition of those amounts until they receive a remittance from their QBUs or another triggering event takes place. By contrast, taxpayers were required to translate their QBUs’ nonfinancial “historic items,” such as land, fixed assets, property, plant and equipment and their related depreciation and amortization deductions, at the historic average exchange rate in place during the tax year in which the asset was acquired.

Recognizing the complexity of this method, the IRS includes in its 2023 proposed regulations a series of elections intended to make it less burdensome for taxpayers to apply for reporting purposes.

Special Elections

The 2023 proposed regulations retain the FEEP method while providing taxpayers with simplified methods for determining the Section 987 gains or losses of their QBU using special elections, which include the following:

• A “current rate election” in which U.S. taxpayers treat all balance sheet items as “marked” and therefore requires the translation of all items of income, gain, deduction and loss at the annual average exchange rate for the tax current year and the year-end spot rate for computing the Section 987 gain or loss; and

• An “annual recognition election” for which U.S. taxpayers will recognize all foreign currency gains or losses with respect to an IRC Section 987 QBU on an annual basis and translate all items of income, gain, deduction or loss at the average exchange rate for the current tax year and continue to translate marked items at the year-end spot rate and historic items at their historic rates.

Multinational businesses must recognize that both elections, whether made together or separately, apply to all the QBUs they own and remain in effect for all tax years until taxpayers revoke them. Elections must remain in effect for five years before taxpayers may revoke them. Once an election is revoked, taxpayers are prohibited from making a current rate election or annual recognition elections for another five years.

Additionally, taxpayers must prepare for the impact of these elections. For example, a current rate election may result in a large pool of potential losses, which the proposed regulations require taxpayers to suspend until a taxable year in which they have an equal or greater gain. However, if taxpayers make annual recognition elections in addition to the current rate election, they may deduct losses in the current year.

Expanded Scope of Compliance

The 2023 proposed regulations apply to individuals, corporations, partnerships, S corporations, non-grantor trusts and estates as well as entities previously excluded from the 2016 final regulations. This includes banks, insurance companies, leasing companies, real estate investment trusts (REITs) and regulated investment trusts (RICs).

Entities excluded from the proposed regulations include foreign individuals, foreign corporations with U.S. shareholders, and certain foreign non-grantor trusts, foreign estates and foreign partnerships in which a U.S. person holds less than 10 percent interest of the capital and profits interests.

Whether the proposed regulations, set to take effect on Jan. 1, 2025, will become law and finally resolve a nearly 50-year challenge remains to be seen. In the meantime, it behooves owners of multinational businesses and CFCs to meet with their trusted advisors to understand the regulations’ impact on their financial reporting and how they may minimize any resulting burden on their finances and operations.

About the Author: Jairan Shirazi is a senior manager of Tax Services with Berkowitz Pollack Brant, where she helps individuals and businesses grow while complying with international tax laws. She can be reached at the CPA firm’s Miami office at (305) 379-7000 or info@bpbcpa.com.

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