Foreign currency gain or loss realized by a holder on foreign currency-denominated debt generally is thought to be ordinary in character. However, when a holder disposes of such an instrument, the entire gain or loss realized on the transaction is not necessarily related to exchange-rate fluctuation. Sec. 988 and its regulations acknowledge this principle by providing that the foreign currency element of a transaction must be computed and taken into account separately from gain or loss on the underlying transaction. Taxpayers and practitioners need to remember that both ordinary and capital character may result from the disposition of a foreign currency-denominated debt instrument.
Computing Overall and Foreign Currency Gain or Loss
Sec. 988(a)(1)(A) generally provides that a taxpayer’s foreign currency gain or loss attributable to a Sec. 988 transaction is computed separately and treated as ordinary income or loss. A “Sec. 988 transaction” includes the acquisition of a debt instrument denominated in terms of a nonfunctional currency; see Sec. 988(c)(1)(A) and (B). The term “foreign currency gain or loss” refers to any gain (or loss) from a Sec. 988 transaction to the extent it does not exceed the gain (or loss) realized by reason of changes in exchange rates on or after the booking date and before the payment date. Stated differently, if there is gain or loss on the underlying transaction, as well as offsetting foreign currency loss or gain, the two should be netted; only the excess foreign currency loss or gain (if any) should be reported separately under Sec. 988(a)(1)(A).
Regs. Sec. 1.988-2(b) describes the mechanics of computing gain or loss on the underlying transaction (i.e., market gain or loss) and that on movements in the value of the foreign currency (i.e., exchange gain or loss), as well as the process by which the two are netted. A holder of a foreign currency-denominated debt instrument may have exchange gain or loss as to the principal amount when the instrument is paid or disposed of, computed as the principal amount in nonfunctional currency units, translated into functional currency at the spot rate on the date payment is received or the instrument is disposed of, less the nonfunctional currency principal amount translated at the spot rate for the date the taxpayer acquired the instrument; see Regs. Sec. 1.988-2(b)(5). In computing exchange gain or loss, the “principal amount” of a debt instrument refers to the amount received by the holder in nonfunctional currency units; see Regs. Sec. 1.988-2(b)(6). A holder also can have gain or loss on the underlying transaction if interest rates or the credit of the issuer of the debt instrument shifts.
Examples
These rules can be illustrated by a series of examples that assume that the taxpayer (T) is a nondealer calendar-year corporation on the accrual method, with a U.S. dollar functional currency.
Example 1—overall economic gain attributable to foreign exchange: On Jan. 1, 2001, T purchases a €1,000 bond for €1,000. Under Regs. Sec. 1.988-2(b)(5), the principal amount is €1,000 (regardless of whether there is a difference between the purchase price and the face amount due to original issue discount, market discount or some combination thereof). When T purchases the bond, €1 equals $0.70; when T disposes of the bond, €1 equals $0.75.
TP has a $50 overall economic gain at the time of disposition—the principal amount at the spot rate for date of sale (€1,000 × $0.75) less the principal amount at the spot rate for date of purchase (€1,000 × $0.70). The $50 overall economic gain is entirely attributable to exchange gain; thus, it is ordinary gain.
Regs. Sec. 1.988-2(b)(8) provides that a holder’s exchange gain or loss on the payment or disposition of a foreign currency-denominated debt instrument, including gain or loss as to both principal and interest, may not exceed the holder’s total economic gain or loss on the payment or disposition (the “netting rule”). In other words, while a holder’s exchange gain or loss must be computed on the entire principal amount, it must then be compared to the overall economic gain or loss realized on the disposition to determine if the netting rule applies. If the economic gain or loss exceeds the ceiling, it is bifurcated between exchange and other gain or loss.
Example 2—foreign exchange gain exceeds overall economic gain: The facts are the same as in Example 1, except that T purchases a €1,000 bond for €1,000 and sells it for €950, when €1 equals $0.75. This result might occur because the bond has a fixed interest rate and interest rates have increased, or the issuer’s credit has weakened.
Under the general rules, T’s exchange gain is $50. However, the overall economic gain on the sale is $12.50—the amount realized on the sale (€950 × $0.75, or $712.50) less the bond’s adjusted basis (€1,000 × $0.70, or $700). Under the netting rule, T’s exchange gain is limited to $12.50; see Regs. Sec. 1.988-2(b)(9), Example (4). The $12.50 exchange gain is ordinary gain.
Example 3—foreign exchange loss exceeds overall economic gain: The facts are the same as in Example 1, except that T sells the bond for €1,100 when €1 equals $0.65. This result might occur because the bond has a fixed interest rate and interest rates have decreased, or the issuer’s credit has strengthened.
Under the general rules, T’s exchange loss is $50. However, the sale results in an overall $15 economic gain—the amount realized on the sale (€1,100 × $0.65, or $715) less the bond’s adjusted basis (€1,000 × $0.70, or $700). Under the netting rule, T’s exchange loss is realized only to the extent of the total loss on the sale. Here, T realizes a $15 overall economic gain; thus, T will realize no exchange loss and a $15 market gain (capital gain); see Regs. Sec. 1.988-2(b)(9), Example (5)(i).
Example 4—foreign exchange loss less than overall economic loss: The facts are the same as in Example 1, except that T sells the bond for €950 when €1 equals $0.65.
Under the general rules, T’s exchange loss is $50 ((€1,000 × $0.70) less the principal amount at the spot rate for date of purchase (€1,000 × $0.65)). However, the overall economic loss on the sale is $82.50—the amount realized (€950 × $0.65, or $617.50) less the bond’s adjusted basis (€1,000 × $0.70, or $700). Thus, under the netting rule, T’s $82.50 overall economic loss consists of $50 ordinary exchange loss and a $32.50 market loss, which is capital in character; see Regs. Sec. 1.988-2(b)(9), Example (5)(ii).
Observations
There are several implications of the often-ignored netting rule under Regs. Sec. 1.988-2(b)(8). First, portfolio investors (e.g., hedge funds) may need to bifurcate their overall economic gain or loss into its separate exchange and market components. The result of such character bifurcation may be beneficial or detrimental, depending on the results and profile of the individual investor. Second, although the examples illustrated above relate solely to long positions in foreign currency-denominated debt instruments, the same principles appear equally applicable to short sales of such instruments. To the extent the market gain or loss resulting from a short sale exceeds the netting rule, it should be subject to the Sec. 1233 rules. Finally, to the extent a taxpayer (e.g., a nondealer financial institution) holds a foreign currency-denominated debt instrument to which Prop. Regs. Sec. 1.1221-1(e)(1) applies, the netting rule raises the issue of whether such taxpayer can have a qualified Regs. Sec. 1.1221-2 hedging transaction as to such instrument. To avoid this issue, it might be advisable instead to identify such a hedge as a hedge of the value of the foreign currency to be received on payment of the debt instrument. In that case, gain or loss on a disposition of such currency would be entirely ordinary in character.
From Wei-Chin (Michael) Mou, J.D., LL.M., and Brian Ciszczon, CPA, LL.M., Washington, DC
EditorsNotes
Annette B. Smith, CPA, Washington National Tax Services PricewaterhouseCoopers LLP, Washington, DC.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers, LLP.
If you would like additional information about these items, contact Ms. Smith at (202) 414–1048 or annette.smith@us.pwc.com.
