The IRS and Treasury recently released long-awaited guidance under Section 987 that may result in the permanent elimination of unrealized foreign currency exchange gains or losses under the transition rules. This could impact many taxpayer financial statements.
When transitioning to the new regulations, taxpayers are generally required to use the “fresh start” method (discussed in more detail below). Given the relative strength of the U.S. dollar, the fresh start method may eliminate unrealized foreign currency exchange gains or losses determined under the prior method used by the taxpayer.
Unrealized foreign currency exchange gains or losses generally may impact a subsequent period’s income tax expense, and thus are often recorded on financial statements as deferred tax items under ASC 740. As the new regulations are a change in law, taxpayers will need to assess and record any deferred tax adjustments arising from the law change as a discrete item in the period that includes December 2016 (i.e., the period of enactment).
On Dec. 7, 2016, the IRS and Treasury issued final (TD 9794
), temporary (TD 9795
) and proposed (REG-128276-12
) regulations under Section 987. These new regulations are the culmination of guidance that has been proposed in various forms over the past 25 years.
Proposed regulations under Section 987 were originally released in September 1991 (the 1991 proposed regulations). In September 2006, Treasury and the IRS withdrew the 1991 proposed regulations and released new proposed regulations (the 2006 proposed regulations). The final regulations are markedly similar to the 2006 proposed regulations, and largely adopt the paradigm referred to as the foreign exchange exposure pool (FEEP) method.
The final regulations generally contain guidance relating to the determination of taxable income or loss (or earnings and profits) of a taxpayer with respect to a qualified business unit (QBU) subject to Section 987 (a Section 987 QBU), as well as timing, character and the source of any Section 987 gain or loss. The temporary regulations provide guidance relating to the recognition and deferral of foreign currency gain or loss under Section 987 with respect to a QBU in connection with certain QBU terminations and certain other transactions involving partnerships, as well as other elections and operating rules.
The regs at a glance
The final and temporary regulations include extensive operating rules and other guidance relating to Section 987. The final and temporary regulations, along with the preamble, are comprehensive and exceed 260 pages. Although the new regulations contain extensive new guidance to which taxpayers must adhere, some of the most notable developments are briefly highlighted below.
The final regulations have certain scope limitations limiting their application to specific types of entities. The rules generally apply to corporations and individuals. However, the regulations generally do not apply to banks, insurance companies, leasing companies, finance coordination centers, regulated investment companies or real estate investment trusts. With some exceptions, these regulations also do not apply to trusts, estates, S corporations and certain partnerships other than “Section 987 aggregate partnerships” (i.e., a partnership where all the capital and profits interests are owned by related persons under Sections 267(b) or 707(b)).
The preamble states that until regulations providing rules for applying Section 987 with respect to such excluded entities are effective, the excluded entities must use a reasonable method to comply with Section 987 and cannot rely on these final regulations.
Fresh start method
Under the 2006 proposed regulations, a taxpayer that used a reasonable method to comply with Section 987 prior to transitioning to the ﬁnal regulations could choose between the “deferral” transition method and the “fresh start” transition method. The deferral transition method generally preserved Section 987 gains or losses determined under the taxpayer's prior method, whereas the fresh start method did not. Under the new regulations, taxpayers are required to use the fresh start method to transition to the new regulations.
The fresh start transition method provides that, solely for purposes of Section 987, a taxpayer’s QBU is deemed to terminate on the last day of the taxable year preceding the transition date. All assets and liabilities are deemed transferred to the new Section 987 QBU and are translated using historic exchange rates. However, no Section 987 gain or loss would be determined upon the deemed termination, and any unrecognized Section 987 gains and losses computed under prior methods would be eliminated.
There are certain exceptions and special rules provided for taxpayers who have already adopted the 2006 proposed regulations. The preamble provides that because the ﬁnal regulations adopt the 2006 proposed regulations without fundamental changes, it is not necessary or appropriate for taxpayers to transition from the 2006 method to the ﬁnal regulations under the fresh start method. However, there are additional transition rules that must be considered in such cases.
ASC 740 consequences
The new regulations represent a significant departure from the GAAP rules provided under ASC 830, Foreign Currency Matters
. ASC 830 provides the accounting and reporting requirements for foreign currency transactions and the translation of financial statements. Given the departure, the new rules will generally result in book to tax differences. As noted above, the fresh start method has the potential to eliminate pre-existing unrealized foreign currency exchange items. This, in combination with the now finalized regulations departing from ASC 830, may have a significant impact on taxpayer’s financial statements.
The effect of a tax law change is reported as a discrete item in continuing operations in the period of enactment. This effect includes any necessary adjustments to existing deferred tax assets and liabilities. Therefore, taxpayers may need to immediately consider the new regulations in the period which includes December 2016 (i.e., the period of enactment).
Annual deemed termination election
In response to a comment on the 2006 proposed regulations, the IRS and Treasury permit an annual election to deem a Section 987 QBU as having terminated at the end of each year, thereby requiring the owner to recognize all Section 987 gains or losses with respect to the QBU on an annual basis. The election is intended to reduce the complexity and administrative cost of complying with Section 987 because taxpayers would not be required to track transactions between an owner and its Section 987 QBU or unrecognized Section 987 gains and losses carried over from previous years.
Complex new deferral rules
The temporary regulations provide for the deferral of certain unrecognized Section 987 gain or loss that otherwise would be recognized in connection with certain events. The new deferral rules are intended to prevent a taxpayer’s selective realization of Section 987 losses through the use of certain planning techniques.
The temporary regulations provide specific rules that operate to prevent loss recognition during a “deferral event” with respect to a Section 987 QBU. A deferral event generally involves terminations that occur as a result of a transfer of substantially all the assets of a Section 987 QBU as well as certain partnership transactions.
The rules also address certain “outbound loss events.” If the deferral event also constitutes an outbound loss event, the amount of loss recognized by the owner may be further limited under the rules applicable to outbound loss events.
Foreign exchange exposure pool
The final regulations adopt the FEEP method, which 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. 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.
The computation under the final regulations uses an eight-step process for isolating this unrecognized foreign currency exchange gain or loss resulting from the marked items.
Generally, the final regulations apply to taxable years beginning on or after one year after the ﬁrst day of the ﬁrst taxable year following Dec. 7, 2016 (i.e., the 2018 tax year for calendar year taxpayers). Accordingly, for calendar year taxpayers, unrecognized Section 987 losses may be eliminated under the fresh start method described above as of Dec. 31, 2017.
The temporary regulations under Treas. Reg. Sec. 1.987-12T generally apply to any deferral event or outbound loss event that occurs on or after Jan. 6, 2017. However, if the deferral event or outbound loss event is undertaken with a principal purpose of recognizing Section 987 loss, the 30-day delayed effective date does not apply and the rules are effective immediately on Dec. 7, 2016.
A taxpayer may elect to apply the final regulations to all tax years beginning after Dec.7, 2016, but only if the taxpayer consistently applies the regulations to all Section 987 QBUs.
The new rules are complex and impose burdensome recordkeeping and compliance requirements on taxpayers. Such compliance may require tracking of Section 987 QBU assets and liabilities on an item-by-item basis. Additionally, now that the regulations are final, taxpayers will need to comply, irrespective of what method they previously employed when computing foreign currency exchange gain or loss with respect to Section 987 QBUs.
The final and temporary regulations represent a significant development. The regulations are likely to impact many taxpayers, both from a tax and GAAP perspective. Taxpayers should carefully analyze the effect of the final and temporary regulations on any Section 987 QBU to understand the financial statement implications, identify and evaluate potential benefits from the various elections, and evaluate the overall implications of the now final operating rules.
Partner, International Tax Services
Washington National Tax Office
T +1 202 861 4104
Manager, International Tax Services
Washington National Tax Office
T +1 202 521 1509
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