Increased Compliance Burden under New Sec. 987 Prop. Regs.
In September 2006, the IRS issued new proposed regulations (REG-208270-86, 9/7/06) (2006 Prop. Regs.) that provide guidance under Sec. 987 in determining foreign currency gains and losses of qualified business units (QBUs) operating in a functional currency other than their owner’s. The 2006 Prop. Regs. are a drastic change from the 1991 proposed regulations (1991 Prop. Regs.) and, if finalized as currently written, would impose significant recordkeeping and tax compliance burdens.
In general, the 2006 Prop. Regs. are proposed to apply starting with the first tax year beginning one year after the first day of the tax year following the date the rules are adopted as final. It is not anticipated that the new rules would be applicable before calendar-year 2009; however, taxpayers would be able to elect to apply the 2006 Prop. Regs. to tax years beginning after the date the rules are adopted as final regulations; see the preamble to REG-208270-86.
On finalization of the 2006 Prop. Regs., taxpayers would be required to adopt the new regulations as prescribed under transition rules in Prop. Regs. Sec. 1.987-10. In the meantime, taxpayers that currently account for Sec. 987 gains or losses under the 1991 Prop. Regs. or another reasonable method may continue to do so until the 2006 Prop. Regs. are finalized.
1991 Prop. Regs.
The 1991 Prop. Regs. (now withdrawn) used the profit and loss (P&L) method to determine branch income. The QBU’s P&L is maintained in its functional currency and adjusted to conform to GAAP. The adjusted P&L is then translated into the taxpayer’s functional currency using the average exchange rate for the year; see 1991 Prop. Regs. Sec. 1.987-1(b).
Under 1991 Prop. Regs. Sec. 1.987-2(c), the taxpayer has to maintain an “equity pool” and a “basis pool” for the QBU. The equity pool is maintained in the QBU’s functional currency and is adjusted for the QBU’s P&L, as well as for transfers to and from the QBU. The basis pool is adjusted by the QBU’s P&L translated into the taxpayer’s functional currency at the annual average rate; transfers to and from the QBU are translated into the taxpayer’s functional currency at the spot rate on the transfer date.
A Sec. 987 gain or loss must be recognized when there is a net “remittance” of cash or property from the QBU to the taxpayer. A remittance occurs when there is an excess of the amounts transferred from the QBU to the taxpayer over the amounts transferred from the taxpayer to the QBU. The basis of the remittance is calculated by dividing the remittance by the balance of the equity pool reduced by prior remittances and multiplying the resulting ratio by the basis pool reduced by prior remittances. The Sec. 987 gain or loss is the difference between the basis of the remittance and the remittance translated into the taxpayer’s functional currency at the spot rate on the transfer date. The taxpayer must report its QBU’s Sec. 987 gain or loss as a component of its taxable income each year; see 1991 Prop. Regs. Sec. 1.987-5.
2006 Prop. Regs.
The 2006 Prop. Regs. would also require taxpayers to recognize a Sec. 987 gain or loss on net remittances; however, they require a different method to calculate such gain or loss. In contrast to the P&L method of the 1991 Prop. Regs., the 2006 Prop. Regs. would use a balance-sheet approach to calculate the Sec. 987 gain or loss.
Under 2006 Prop. Regs. Sec. 1.987-4, taxpayers must use the “foreign exchange exposure pool” method, which generally would require them to track foreign exchange gains or losses on certain “marked” items using a seven-step balance-sheet approach. According to 2006 Prop. Regs. Sec. 1.987-1(d), “marked” items typically include cash and other monetary assets and liabilities; they are carried on the balance sheet at year-end spot rates. Under 2006 Prop. Regs. Sec. 1.987-1(e), “historic” items are all other non-marked items; they are carried on the balance sheet at historic exchange rates.
Annually, a taxpayer would be required to compare the fluctuation between the beginning and ending balance sheets. The change in the marked assets due to currency movements would be determined by backing out those balance-sheet changes not due to currency movements, such as the QBU’s income or loss, and any asset and liability transfers to or from the QBU. The isolated change in marked assets would result in the QBU’s “net unrecognized Sec. 987 gain or loss”; see 2006 Prop. Regs. Sec. 1.987-4.
As noted earlier, a taxpayer must recognize a Sec. 987 gain or loss when there is a net remittance from the QBU. The net remittance is translated into the taxpayer’s functional currency at the year-end spot rate. A “remittance proportion” is calculated by dividing the net remittance in the taxpayer’s functional currency by the year-end adjusted basis of the QBU’s gross assets (including the net remittance amount) in the taxpayer’s functional currency. To calculate the Sec. 987 gain or loss for the tax year, the remittance proportion is multiplied by the net unrecognized Sec. 987 gain or loss. The taxpayer must include its Sec. 987 gain or loss in its taxable income for each year; see 2006 Prop. Regs. Sec. 1.987-5.
The 2006 Prop. Regs. have generated concern among tax professionals. For example, tax advisers have noted that requiring taxpayers to track and maintain the basis of historic assets is likely to create substantial recordkeeping burdens and increased compliance challenges.
In addition, members of the District of Columbia Bar have expressed concern that a taxpayer’s adoption of the 2006 Prop. Regs. would constitute an accounting-method change and, thus, potentially trigger the rules associated with such a change; see 44 Tax Notes Int’l 938 (12/18/06). The IRS has not announced whether adoption of the new regulations would be considered an accounting-method change.
Notably, the AICPA has suggested to the IRS that it revise its approach under the new rules, stating in a March 29, 2007, letter that the 2006 Prop. Regs. as written “will frustrate the currency reforms made by the Tax Reform Act of 1986 and will pose an unreasonable compliance burden on taxpayers”; see “AICPA Comments on Proposed Section 987 Foreign Currency Transaction Regs,” available at http://tax.aicpa.org/Resources/International/Regulation+and+Administration/AICPA+Comments+on+Proposed+Section+987+Foreign+Currency+Transaction+Regs.htm. If the 2006 Prop. Regs. are finalized as written, the AICPA has suggested that the Service incorporate nearly 20 changes into the finalized rules.
It will be crucial to monitor the 2006 Prop. Regs. for changes and finalization, to ensure that taxpayers will be in compliance with the new rules in both current and future years.
From Trinity Keil, CPA, Washington, DC
Annette B. Smith, CPA, Washington National Tax Services PricewaterhouseCoopers LLP, Washington, DC.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers, LLP.
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