New Sec. 987 regulations affect partnerships

By Sarah Schaefer, CPA, and Megan Stoner, J.D., LL.M., Washington

Editor: Annette B. Smith, CPA

The IRS on Dec. 7, 2016, issued final and temporary regulations under Sec. 987 (the 2016 regulations) addressing the taxation of foreign currency translation gains or losses arising from qualified business units (QBUs) that operate in a currency other than the functional currency of their owner (T.D. 9795). While the 2016 regulations clarify certain aspects of the application of Sec. 987 to partnerships, they also pose challenges and raise questions in their application to partnerships.

The FEEP method

The 2016 regulations generally require owners of Sec. 987 QBUs to account for foreign currency translation gains and losses using a balance sheet approach called the foreign-exchange-exposure-pool (FEEP) method, which is derived from a similar method introduced in regulations proposed in 2006. The FEEP method is complicated, but fortunately not all partnerships are subject to it. Generally, any partnership that has at least one meaningful partner that is unrelated to the other partners is not required to apply the FEEP method. Partners of such partnerships, however, must apply a "reasonable" method (discussed below) that takes into account Sec. 987 principles.

Partners (i.e., owners) of partnerships that do not have any meaningful, unrelated partners are less fortunate. Partners of Sec. 987 aggregate partnerships must apply the FEEP method on an aggregate basis by reference to their shares of each partnership asset and liability on the books of Sec. 987 QBUs held by the partnership. A Sec. 987 aggregate partnership is a partnership in which (1) all the capital and profits interests are owned directly or indirectly by related persons (within the meaning of Sec. 267(b) or 707(b) and generally taking into account constructive ownership principles), and (2) there are one or more trades or businesses, at least one of which would be a Sec. 987 QBU if the partner owned that trade or business directly.

Does this mean a partnership can elect out of the FEEP method simply by admitting an unrelated party? Not necessarily. The partnership interest of any unrelated partner will be disregarded if the acquisition of the unrelated interest has "a principal purpose" of avoiding the rules applicable to Sec. 987 aggregate partnerships (see Regs. Sec. 1.987-1(b)(5)(iii)).

Sec. 987 QBUs

Each partner's share of assets and liabilities of an eligible QBU owned through a Sec. 987 aggregate partnership is considered to be a Sec. 987 QBU of that partner if the partner has a functional currency different from that of the eligible QBU. Each partner's share of each partnership asset (including tax basis) and each liability on the books of the Sec. 987 QBU is proportional to the partner's "liquidation value percentage" with respect to the Sec. 987 aggregate partnership for that tax year.

A partner's liquidation value percentage is the partner's relative share of total liquidation value, expressed as a percentage. A partner's share of liquidation value is the amount of cash that the partner would receive for the partner's interest if, immediately following the applicable determination date, the partnership sold all of its assets for cash equal to the fair market value of those assets, satisfied all of its liabilities, paid an unrelated third party to assume all its Regs. Sec. 1.752-7 liabilities in a fully taxable transaction, and then liquidated (see Temp. Regs. Sec. 1.987-7T(b)).


The 2016 regulations' approach to partnerships represents a significant improvement over the approach prescribed in the Sec. 987 regulations proposed in 2006. The 2006 proposed regulations generally would have applied aggregate principles to all partnerships and referred to the rules and principles of Secs. 701 through 761, and the regulations thereunder, for determining partners' shares of partnership assets and liabilities attributable to Sec. 987 QBUs. As a result, one might have thought that Secs. 704(b) and 704(c) principles, Sec. 743(b) basis adjustments, and the Sec. 752 debt-allocation rules would have been relevant for purposes of determining partners' shares of inside tax basis in partnership assets and shares of partnership liabilities.

The 2016 regulations do not take that approach (although they are clear that the liquidation-value-percentage method applies only for Sec. 987 purposes). By focusing on liquidation value, a fair market value concept, they effectively ignore Sec. 704(c) and other Subchapter K principles (other than perhaps Sec. 704(b) principles). Although it is difficult to predict, given the complexity of the coordination of Sec. 987 and Subchapter K principles, one can reasonably expect timing and character differences to emerge from the interaction.

Applying the 2016 regulations

Regardless of the potential for complications, owners (generally, partners) that own a Sec. 987 QBU indirectly through a Sec. 987 aggregate partnership generally must apply the 2016 regulations in two steps.

First, those owners generally are subject to the "fresh start" transition to the FEEP method on the day before the transition date (i.e., Dec. 31, 2017, for calendar-year taxpayers). The fresh-start transition essentially eliminates any unrealized Sec. 987 gain or loss in the QBU(s) attributable to a Sec. 987 aggregate partnership and generally preserves that gain or loss in the tax basis of partnership property (or in the owner's tax basis of partnership interests in certain cases).

After the transition, partners must apply the FEEP method to Sec. 987 QBUs owned indirectly through Sec. 987 aggregate partnerships. Under the FEEP method, the owner of the Sec. 987 QBU first determines the net value of the QBU in the functional currency of the owner by translating "marked items" on the QBU's tax balance sheet at the year-end spot exchange rate and "historic items" at the historic exchange rate. Marked items are assets and liabilities with values that respond directly to changes in currency exchange rates, such as currency, accounts payable and receivable, debt instruments, and other financial instruments. Historic items are all other items, such as machinery and equipment. The owner then subtracts from this amount the "net value" of the QBU at the end of the prior year to determine the change in net value from the prior year.

Once the total change in net value is determined, items that are not attributable to currency fluctuations are reversed, such as the QBU's net income or loss for the year and net transfers of assets and liabilities to or from the QBU. The resulting amount is added to the FEEP and becomes a component of the "net unrecognized section 987 gain or loss." The QBU owner generally takes into account the QBU's net unrecognized Sec. 987 gain or loss as it receives remittances from the QBU or when the QBU terminates (see Regs. Sec. 1.987-4).

Partners in partnerships other than Sec. 987 aggregate partnerships are not required to apply the FEEP method, but they still must apply Sec. 987 using some reasonable approach until additional guidance is provided. Based on comments in the preambles of the 2016 regulations and the 2006 proposed regulations, partners should be able to use the equity-and-basis-pool method described in former proposed Sec. 987 regulations issued in 1991 and an earnings-only method consistent with the Sec. 987 statute, among other possible methods. A partner using the equity-and-basis-pool method also may want to consider whether to maintain the tax basis in partnership interests in the functional currency of the partnership rather than the partner's functional currency. This approach generally simplifies the interaction of Subchapter K and Sec. 987 principles.

Partnerships on alert

In short, the 2016 regulations put partners on notice that Sec. 987 principles generally apply to partnership assets and liabilities, whether under an aggregate FEEP method or any other reasonable method. The complexity inherent in the application of Sec. 987 principles is only magnified when partnerships are involved. Partners and their tax advisers should proceed cautiously and be on the alert for potential traps and opportunities.


Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.

For additional information about these items, contact Ms. Smith at 202-414-1048 or

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.

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