Final currency rules for foreign branches focus on simplification

The IRS on Dec. 11 published final and proposed regulations addressing the taxation of foreign currency gains and losses of qualified business units (QBUs) under Section 987. Although the package is aimed at achieving simplification, the final rules remain complex and will present taxpayers with compliance challenges. Certain elections were provided to help the rules and those are discussed below.

The final regulations (T.D. 10016) largely adhere to the general framework established in prior versions of the regulations, maintaining the utilization of the Foreign Exchange Exposure Pool (FEEP) approach. However, notable changes from the 2023 proposed regulations were incorporated, specifically targeting simplification measures. These final regulations include elections to treat all items of a qualified business unit as marked items (subject to a loss suspension rule) and to recognize all foreign currency gain or loss with respect to a qualified business unit on an annual basis. The final regulations also offer a new transition rule. See our prior coverage of the 2023 proposed regulations here.

The new 2024 proposed regulations (REG 117213-24) would provide an election intended to reduce the compliance burden of accounting for certain disregarded transactions between a qualified business unit and its owner.

Subject to some special rules for terminating QBUs discussed further below, the final regulations generally apply to taxable years beginning after Dec. 31, 2024, consistent with the effective date proposed in the 2023 proposed regulations. 

Background

The Section 987 regulations date back to 1991, when the first proposed regulations (56 FR 48457) were issued. That version required tax owners to maintain equity and basis pools in both the QBUs and the tax owner’s functional currencies, respectively. Section 987 gain or loss was determined by comparing these pools on a defined date, such as a QBU remittance or termination.

In 2000, the IRS issued Notice 2000-20, raising concerns about abusive transactions involving circular fund flows between a QBU and its tax owner. The notice sought comments and proposed netting property transfers during the year. In 2006, the IRS withdrew the 1991 proposed regulations due to concerns about taxpayers managing Section 987 gains and losses through strategic remittances. The IRS introduced a new FEEP method in revised proposed regulations.

Final regulations were issued in 2016 (T.D. 9794), adopting the FEEP method with adjustments, along with proposed and temporary rules addressing Section 988 transactions, partnerships, and a new annual deemed termination election.

In 2017, the Trump administration issued Executive Order 13789 directing the Treasury to review regulations issued since Jan. 1, 2016, for undue financial burdens or complexity. Subsequent deferral notices, including Notice 2022-34, delayed implementation of the 2016 regulations citing the Executive Order. 

In 2023, the IRS proposed simplification measures in response to the Executive Order. These new, final and proposed regulations build on these efforts, incorporating key simplifications, and implementing aspects of the previously deferred regulations.

Key highlights 

FEEP method

The final regulations preserve the FEEP method that was introduced in the 2006 proposed regulations, modified in 2016, and then re-introduced in the 2023 proposed regulations. The FEEP method continues to be the default rule for a taxpayer to determine their Section 987 gain or loss for a taxable year.

The FEEP method uses a balance sheet approach to determine exchange gain or loss. Such gain or loss is not recognized until the Section 987 QBU makes a remittance. Under the FEEP method, exchange gain or loss with respect to “marked items” is determined annually but is pooled and deferred until a remittance is made or certain other events trigger a recognition. A marked item generally includes an asset or liability that would otherwise 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. The balance sheet approach also uses historic rates for “historic items” (generally defined as assets or liabilities that are not marked items). This approach allows taxpayers to distinguish between items whose value is subject to fluctuations in currency (i.e., foreign exchange exposure) and those that are not. Additionally, all items of income, gain, deduction, and loss by a QBU are translated into the tax owner’s functional currency at the average exchange rate for the taxable year.

Under the FEEP method, a taxpayer computes its Section 987 gain or loss under a 10-step approach. Step 1 requires a taxpayer to compute the change in owner functional currency net value (OFCNV) for the taxable year, which is determined by preparing a tax basis balance sheet that reflects a Section 987 QBU’s assets and liabilities using U.S. income tax principles and translated at the appropriate exchange rates as provided under the regulations. The other steps make adjustments for changes to OFCNV that are not attributable to changes in the exchange rate.

Steps 2 through 5 relate to transfers of assets and liabilities between a Section 987 QBU and its owner. Steps 6 through 9 relate to income or loss of the Section 987 QBU. Step 10 is a residual adjustment for any increase or decrease to the Section 987 QBU’s balance sheet that is not otherwise accounted for.

Available elections

The final regulations retain the two simplifying elections that were proposed in 2023: the current rate election and the annual recognition, as well as the election to amortize pretransition gain or loss. The final regulations include additional simplifying elections that were developed in response to the executive order and comments that prior versions of the regulations were administratively burdensome for taxpayers. Taxpayers that make any of the simplifying elections under the final regulations are generally required to maintain the elections for a period of 60 months and cannot revoke a election unless they obtain the Commissioner’s consent. 

Current rate election

The current rate election treats all assets and liabilities attributable to a Section 987 QBU as marked items and thus would not be required to track historic exchange rates. Under the election, taxpayers are required to translate all items of income, gain, deduction, and loss at the annual average exchange rate for the current year. If a current rate election is in effect, taxpayers are required to apply only steps 1 through 5 and step 10 of the FEEP method described above.

Additionally, when a current rate election is in place, the final regulations provide that the OFCNV can be computed by determining the aggregate basis of the QBU’s assets, net of liabilities in the functional currency of the Section 987 QBU and translate the aggregate basis into the owner’s functional currency at the year-end spot rate. Under this approach, the QBU net value on the last day of the taxable year is equal to the QBU net value at the end of the preceding taxable year, adjusted by transfers of assets and liabilities between the Section 987 QBU and its owner and by income or loss of the Section 987 QBU. The result is that QBU net value can be determined without a tax basis balance sheet.

When this election is made and the annual recognition election is not made, the regulations impose a loss suspension rule, discussed further below, which is intended to prevent taxpayers from selectively recognizing Section 987 losses when a current rate election is in effect.

Annual recognition election

Taxpayers that make an annual recognition election would recognize all unrecognized Section 987 gain or loss on an annual basis and would not be required to calculate the amount of a remittance with respect to a Section 987 QBU. Taxpayers that make the annual recognition election generally would not be subject to the deferral and loss suspension rules. Consistent with the 2023 proposed regulations, the annual recognition election can be made separately (or in conjunction with) the current rate election.

Election to amortize pretransition gain or loss

In general, under the 2023 proposed regulations, pretransition gain was treated as net unrecognized Section 987 gain, while pretransition loss was treated as suspended Section 987 loss. Alternatively, taxpayers could elect to amortize pretransition gain or loss. The final regulations retain the 10-year amortization period included in the 2023 proposed regulations, which allows for taxpayers to elect to amortize their pretransition Section 987 gain or loss beginning on the transition date.

Section 988 elections

The final regulations provide taxpayers with two new elections that assist in coordinating Section 988. First, the Section 988 Mark-to-Market (MTM) election applies to Section 987 hedging transactions. A Section 987 hedging transaction is generally defined as a financial instrument entered into by the owner of a Section 987 QBU for the purpose of managing exchange rate risk with respect to the owner’s net investment in the Section 987 QBU as part of the normal course of the owner’s trade or business. Under this election, which is subject to several requirements, Section 988 gain or loss that would otherwise be recognized on a Section 987 hedging transaction is instead taken into account in adjusting the owner’s unrecognized Section 987 gain or loss for the taxable year.

The second Section 988 election addresses the characterization of Section 987 gain or loss for purposes of Subpart F. In the case of Section 987 gain or loss that would otherwise be characterized as passive foreign personal holding company income, the election would treat the Section 987 gain or loss as foreign currency gain or loss of the CFC-owner that is attributable to Section 988 transactions not directly related to the business needs of the CFC. This election is intended to benefit taxpayers because it would generally allow for better matching of character and allow a CFC-owner to net its foreign currency gains and losses from Section 988 transactions with the Section 987 gain or loss from its QBUs.

Other highlights

Treatment of Section 987 in determining GILTI high-tax exclusion 

The IRS has determined that Section 987 gains and losses are likely to be taxed at a different tax rate than other income generally subject to tax and therefore should reasonably be grouped and tested as a separate item of income for this purpose. For purposes of applying the GILTI high-tax exclusion, all Section 987 gain and loss in a tentative tested income group that is recognized by a CFC in a taxable year is treated as a single tentative tested income item that is recognized by a tested unit separate from the CFC’s other tested units. As a result, Section 987 gain or loss is not taken into account in applying the GILTI high-tax exclusion with respect to the CFC’s other items of tentative tested income. Instead, the GILTI high-tax exclusion is applied separately to Section 987 gain and loss and, as a result, Section 987 gain or loss generally will not be eligible for the GILTI high-tax exclusion unless the CFC is subject to foreign tax on currency gain recognized with respect to its interest in the QBU under the applicable foreign tax rules.

Section 987 loss rules

The final regulations retain and modify the loss suspension rule that was originally included in the 2023 proposed regulations. The loss suspension rules apply to any taxable year in which a current rate election is in effect (and an annual recognition election is not in effect).

Any Section 987 loss that would otherwise be recognized as a result of a remittance or termination would be treated as a suspended Section 987 loss. The rule, referred to as the loss-to-the-extent-of-gain rule, provides that a Section 987 QBU owner can only recognize suspended losses to the extent that it recognizes Section 987 gain in the same grouping, or when certain events occur, preventing taxpayers from selectively recognizing Section 987 losses while deferring gains. A pretransition loss is also treated as a Section 987 suspended loss subject to the loss-to-the-extent-of-gain rule.

The final regulations add a lookback rule, allowing suspended Section 987 losses to be recognized to the extent of a net Section 987 gain recognized in the current year and the three preceding taxable years, excluding taxable years beginning before the transition date.

De minimis rules

The final regulations provide a de minimis rule to reduce the compliance burden on small businesses with Section 987 QBUs. Under the de minimis rule, a qualifying taxpayer may elect to treat all QBUs that fall below the de minimis threshold as having no pretransition gain or loss.

To qualify for the de minimis rule, the owner of a Section 987 QBU must have gross receipts that fall below the threshold for the small business exception in Section 163(j)(3) (i.e., the owner must have gross receipts of $25 million or less, indexed to inflation and averaged over the prior three-year period). If this test is met, the de minimis rule applies to any Section 987 QBU with gross assets of less than $10 million, averaged over the same 3-year period and taking into account the assets of all Section 987 QBUs in the same country that are owned by the same owner or a member of its controlled group.

The final regulations also include a de minimis exception to the loss suspension rules. Under the de minimis exception, Section 987 loss is not suspended if the amount of Section 987 loss subject to loss suspension rules during the tax year does not exceed the lesser of $3 million or 2% of gross income.

Partnerships

The final regulations generally do not apply to partnerships, nor an eligible QBU if a partnership is the owner of the eligible QBU’s assets and liabilities. However, a taxpayer must still apply Sections 987 and 989(a) to partnerships and eligible QBUs of partnerships in a reasonable manner using a method that is applied consistently from year to year with respect to a particular partnership or eligible QBU.

Despite this general exclusion, portions of the final regulations remain applicable to partnerships. In particular, the loss suspension and deferral rules apply to partnership. Similarly, the rules for determining the source and character of Section 987 gain or loss apply to partnerships, in order to facilitate application of the loss-to-the-extent-of-gain rule.

New proposed regulations

Concurrent with the release of the 2024 final regulations, the IRS also released a new set of proposed Section 987 regulations. The proposed regulations include an election that is intended to reduce the compliance burden of accounting for certain disregarded transactions between a qualified business unit and its owner. The proposed regulations also include a request for comments relating to the treatment of partnerships and controlled foreign corporations.

The new election, referred to as the “recurring transfer group election,” allows taxpayers that have made a current rate election to use the yearly average exchange rate to translate assets that are transferred between a Section 987 QBU and its owner as part of a recurring transfer group. This would prevent the need to translate these amounts at the spot rate on the date of the transfer.

Transition rules

The final regulations largely adopt the transition rules outlined in the 2023 proposed regulations. Taxpayers that have applied an eligible pretransition Section 987 method on at least one tax return filed before Nov. 9, 2023, should use that method to compute a pretransition gain or loss amount equal to the amount of Section 987 gain or loss that it would have recognized if the QBU terminated on the day before the transition date. Taxpayers that did not apply an eligible pretransition method would be required to determine pretransition gain or loss by applying a simplified version of the FEEP computation to determine unrecognized Section 987 gain or loss. The IRS modified the transition rules in the final regulations in several ways including:

• The final regulations add a cut-off date for taxpayers on an ineligible pretransition method. Previously, taxpayers on an ineligible method were required to compute pretransition gain or loss going back to the Section 987 QBU’s inception. The final regulations provide that taxpayers need only to compute pretransition gain or loss for taxable years beginning on or after Sept. 7, 2006 (the date of the 2006 Proposed Regulations were published in the Federal Register). 

• The final regulations add a provision to correct prior period errors. Under the 2023 proposed regulations, an eligible pretransition method required consistent application in prior years. Taxpayer comments indicated a concern that errors in prior periods would be considered an inconsistent application of an otherwise eligible pretransition method. The final regulations provide that a taxpayer is treated as applying an eligible pretransition method even if the taxpayer made an error in the application of its method or did not apply the method in all taxable years in which it was the owner of the section 987 QBU. However, taxpayers are required to compute pretransition gain or loss as though the eligible pretransition method had been applied without error for all prior taxable years.

Applicability dates 

The final regulations generally apply to taxable years beginning after Dec. 31, 2024, consistent with the 2023 proposed regulations. The final regulations also retain the special applicability date providing that the Section 987 regulations apply retroactively to “terminating QBUs” immediately before the termination. In the case of a Section 987 QBU that terminates after Nov. 9, 2023, but before the Section 987 regulations are generally applicable, the 2023 proposed regulations, as finalized, generally would apply immediately before the termination.