United States

IRS audit guidance stresses careful review of foreign currency choices

TAX ALERT  | 

The IRS recently issued new audit guidance, see FCU/C/18 03 02-01, aimed at assisting agents in dealing with the complex rules of determining the proper functional currency of a foreign branch operation. Referred to as an internal practice unit, this guidance generally instructs auditors to initially use a facts and circumstances approach to determine the correct functional currency of a foreign business unit for federal income tax purposes. However, this guidance also includes a focus on further analysis of an multinational entities qualified business units (QBUs) when auditing functional currency determinations. The presence of this guidance likely indicates higher scrutiny of foreign currency transactions by IRS agents.

For federal income tax purposes, a QBU is any distinct and clearly identified business unit for which a taxpayer maintains a separate set of books and records. The Internal Revenue Code generally requires QBUs to report activity from their operations in the currency of the economic environment in which a significant portion of their operations are conducted. Under relevant regulations, this determination is made using an ‘all facts and circumstances’ test and points to several factors on which to base this analysis. These factors include such things as the QBU’s country of residency, location of its books and records, location of operations and sales markets to name a few.  

In the new guidance, the all facts and circumstances test is used as the initial approach. However, the guidance goes on to instruct auditors to delve further into the QBU’s environment and obtain additional relevant information when making a determination of functional currency. Specifically, the guide points auditors to look to certain factors related to a QBU, such as business purpose, business management and any prior changes in functional currency in making a functional currency determination.

While this guidance does not stray far from the rules contained in existing rules and regulations, it underscores the need for multinational businesses to thoroughly document the choice of a functional currency for their foreign operations since the IRS is likely to focus on this issue.

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