IRS issues key foreign currency tax regulations
Treasury regulations apply to non-U.S. branch operations
TAX ALERT |
The IRS has issued proposed, temporary and final regulations (hereinafter, the 2016 regulations) critical in determining the amount of income taxpayers must recognize from foreign branch operations and the amount of foreign currency gain or loss associated with the balance sheets of a foreign branch. The 2016 regulations are highly complex, contain a variety of elections, and will apply to all dollar-based taxpayers that use a non-dollar currency to account for their non-U.S. business activities. These rules significantly differ from the approach taken for financial accounting purposes and they will require taxpayers to engage in separate calculations to comply with them. Key points include:
- Beginning with the 2018 tax year, calendar year taxpayers with foreign operations must apply the 2016 regulations including taxpayers who applied the proposed version of the 2016 regulations or any reasonable method. Taxpayers who applied no method at all must also adopt the 2016 regulations. Taxpayers may elect to apply the 2016 regulations to the 2017 year.
- The 2016 regulations provide certain elections that may be beneficial and could simplify compliance and minimize the tax (and related financial statement) impact of accounting for balance sheet exchange gains and losses from year to year.
The 2016 regulations will have a far reaching impact. They will have a direct impact on calculation of foreign earnings and profits, the foreign tax credit, the amount of ‘deemed’ income taxpayers have from their foreign stock and will likely affect many other critical calculations in the international tax area. Taxpayers will be required to maintain detailed records supporting the amount of profit or loss, and balance sheet foreign exchange gains and losses, from their foreign operations. We strongly recommend that taxpayers with non-U.S. operations or investments assess the impact of the 2016 regulations as soon as possible, especially taxpayers with businesses operating in currencies that have fluctuated significantly against the dollar, e.g., the euro or the pound sterling.
As part of the Tax Reform Act of 1986, Congress required taxpayers to use the profit and loss method of accounting to calculate income or loss from foreign business operations. In 1991, the IRS issued proposed regulations setting forth a complex interpretation of the profit and loss method. Many taxpayers adopted the 1991 regulations or adopted certain other reasonable methods (e.g., the ‘earnings’ method). In 2006, the IRS withdrew the 1991 regulations and issued new proposed regulations. The 2016 regulations modify and finalize the 2006 proposed regulations and set forth new temporary and proposed regulations that contain new rules of importance to taxpayers with non-U.S. operations. The 2016 regulations generally require taxpayers to (1) use a specific method of accounting to calculate profit or loss from a foreign branch, and (2) use a detailed multistep method to calculate and recognize foreign exchange gains and losses associated with the balance sheet of the branch.
Key highlights of the 2016 regulations include:
- Liberal use of simplifying exchange rate conventions. Under the 2006 proposed regulations, taxpayers were generally required to translate income statement items associated with many assets using a historic exchange rate. For example, this method required taxpayers to use a separate exchange rate to translate each repair, modification or improvement to an asset or to calculate the cost of goods sold relative to inventory manufactured over time in multiple steps. Taxpayers roundly criticized the requirement to use historic exchange rates because keeping track of rates on daily basis was too burdensome. To address this concern, the final regulations allow taxpayers to use non-specific historic exchange rate conventions (e.g., the average rate for the year) in a variety of situations, and provide an election to use spot rates if desired. In addition, the final regulations provide a special simplified method of translating inventory to compute cost of goods sold, which should ease the burden for taxpayers required to use an inventory method of accounting.
- Significant recordkeeping requirements are imposed. The 2006 proposed regulations required taxpayers to maintain records sufficient to document the balance sheet exchange gain or loss of each foreign branch of the taxpayer. In particular, taxpayers must calculate the specific amount of such gain or loss every year with respect to each branch. The final regulations reaffirm and retain this requirement and specifically require taxpayers to maintain records supporting its calculations. In addition, the final regulations allow, but do not as of yet, require use of a special IRS form (yet to be issued) for this purpose. Taxpayers who have taken a lax approach to compliance in this area will need to sharpen their focus because failure to keep sufficient records will likely result in denial of elections and adjustments to income by the IRS, although no specific penalties would apply other than the standard litany of penalties that apply to recordkeeping failure in the international area.
- Regulations expand scope. Compared to the 2006 proposed regulations, the final regulations expand the scope of items that give rise to balance sheet foreign exchange gains and losses. For example, taxpayers must now include prepaid expenses and liabilities in this calculation.
- Excluded taxpayers. The final regulations do not apply certain financial entities, including leasing companies, finance coordination centers, regulated investment companies and real estate investments trusts. Treasury requests comments on how the rules should apply to financial entities leading us to believe the rules may apply to such entities in the future. That said, the exclusion of such entities from the final regulations does not excuse these entities from having to use a profit and loss method of accounting to compute income from their foreign operations or from taking into account balance sheet foreign exchange gains and losses because these computations are required under the Internal Revenue Code. Such taxpayers are still under statutory requirement to do these calculations but they are not required, as of yet, to apply the final regulations.
- Treatment of partnerships. Under the 2006 proposed regulations, partners in a partnership were treated as owning their allocable share of a foreign business operation owned by the partnership and had to apply the 2006 proposed regulations to their share. However, the final regulations take this approach only with respect to partnerships where the partners are related and otherwise do not require partners in a partnership to apply the final regulations to their allocable share of a foreign branch operation owned by a partnership. However, the IRS intends to apply these final regulations to such partners in the future and asks for public comment on how best to do so. Therefore, this exemption may be short-lived.
- Transition rules. The 2006 proposed regulations provided two distinct rules for taxpayers transitioning from a prior method to the method of accounting set forth in those regulations. One of these deferred the recognition of balance sheet exchange gains and losses while the other eliminated such gains and losses as of the transition date. These rules provided a bit of a bonanza for taxpayers who sought private rulings allowing them to early adopt the 2006 proposed regulations because taxpayers could eliminate balance sheet gains while deferring (but preserving) losses. The final regulations eliminate this choice and require taxpayers to use the so-called fresh start transition method which generally eliminates balance sheet exchange gains and losses as of the transition date. In addition, taxpayers must disclose specific information with their returns for the first taxable year to which the final regulations apply regarding each branch and the assumption made in performing the calculations required under the final regulations. Taxpayers who used a previous method (or who used no specific method at all) to compute the profit and loss, and balance sheet exchange gain or loss, of a foreign branch must apply the final regulations.
- Effective dates. The final regulations are effective for taxable years beginning on or after one year after the first day of the first taxable year following Dec. 7, 2016. Thus, calendar year taxpayers must begin to apply the final regulation in the 2018 year. However, taxpayers may elect to apply the final regulations to the 2017 tax year.
- Annual deemed termination election. The temporary regulations set forth a special election to recognize balance sheet exchange gains and losses on an annual basis. This would allow taxpayers to moderate the tax impact of long-term exchange rate fluctuations by taking them into account periodically. In addition, taxpayers who make the deemed termination election may also elect to use an average rate of exchange to translate their profit and loss for the year. This latter election could simplify the taxpayer’s calculation of profit and loss significantly because all items of income and expense would be translated at a single rate. However, this convenience would be offset by having to calculate balance sheet foreign exchange gain or loss every year rather than upon an actual termination or sale of the foreign operation. Calendar year taxpayers may apply these elections to the 2017 tax year.
- Deferral of balance sheet foreign exchange gains and losses. Under the temporary regulations, the transfer of a foreign branch to an entity could trigger recognition of built-in balance sheet exchange gains and losses. However, the temporary regulations provide a series of complex anti-abuse rules that would require taxpayer to defer recognition. These rules could apply to a wide variety of common transactions and should be considered in the context of a transfer of the operations of a foreign branch. These rules are effective for transactions that occur on or after Jan. 6, 2017. These rules would not apply if the taxpayer makes the annual election described in the previous paragraph.
The 2016 regulations are a significant development for all taxpayers with foreign operations. The calculations required will impact many other tax significant computations, such as the calculation of foreign earnings and profits, the amount of deemed income taxpayers must recognize under the so-called Subpart F rules, the amount of the foreign tax credit and many other calculations affected by the amount of a taxpayer’s foreign earnings. Because the 2016 regulations will form the basis many calculations in the international tax area, we cannot overstate their impact or importance.
Taxpayers will have to adopt the 2016 regulations by 2018 or may choose to apply them earlier, and they must comply with significant document requirements that may be more detailed than they have been accustomed to maintaining in the past. Taxpayers should carefully assess the impact of the 2016 regulations on their compliance burdens and develop a strategy for coming into compliance. Further, taxpayers should assess whether to apply the 2016 regulations for the 2017 taxable year. For example, taxpayers who have used a prior method of accounting for the profit and loss, and balance sheet foreign exchange gains and losses, of a foreign branch may wish to adopt the 2016 regulations in order to simplify their calculation going forward. In addition, taxpayers operating in depreciating currencies may wish to make the annual election to recognize balance sheet foreign exchange gains and losses. Because the 2016 regulations are likely to be impactful in a variety of areas, thoughtful analysis is advisable before charting a course