Executive summary:
Section 987 proposed regulations
On Nov. 9, 2023, the IRS and Treasury released proposed regulations (REG-132422-17) under section 987 regarding the taxation of foreign currency translation gains or losses with respect to qualified business units (QBUs) that operate in a currency other than the currency of their owner. A QBU is any separate and clearly identified unit of a trade or business of a taxpayer that maintains separate books and records. A correction to the proposed regulations was published on Dec. 6, 2023.
The proposed regulations largely retain the approach taken in the 2016 and 2019 final regulations but seek to simplify the method of calculating section 987 gain or loss while providing additional guidance at the same time. The proposed regulations contain two elections, (1) an election to treat all items of a QBU as marked items and (2) an election to recognize all foreign currency gain or loss with respect to a QBU on an annual basis, and also provide a new transition rule.
Once finalized, the regulations will apply to taxable years beginning after Dec. 31, 2024 (subject to certain exceptions). Taxpayers may rely on the proposed regulations for taxable years ending after Nov. 9, 2023, as long as they are consistent in their approach.
Section 987 proposed foreign currency regulations may impact QBUs
Background
Under section 987, which was added to the Internal Revenue Code in 1986, if a QBU transfers money or other property to its owner or another QBU of the owner, or if substantially all the assets of the QBU are transferred to the owner or sold, then those transfers may constitute a “remittance.” A remittance by the QBU may require that the owner recognize foreign currency gain or loss under section 987. The rationale behind these rules is that foreign currency is property, and that the owner should recognize gain or loss when the value of the remittance differs from its basis.
Section 987 provides a general framework for determining the taxable income or loss of an owner with respect to a QBU, as well as the timing, amount, character and source of any foreign currency gain or loss. Sections 987(1) and (2) provide that when a taxpayer owns one or more QBUs with a functional currency other than the U.S. dollar and such functional currency is different than that of the taxpayer, the taxable income or loss of the taxpayer with respect to each QBU is determined by computing the taxable income or loss of each QBU separately in its functional currency, using U.S. tax principles, and then translating such income or loss to the QBU owner’s functional currency using the appropriate exchange rate (generally, the average exchange rate for the year). Section 987(3) addresses the calculation of translation gains and losses and the timing of such gains or loss.
To date, multiple regulation packages have been issued to implement section 987 including:
- The 1991 proposed regulations (56 FR 48457) and Notice 2000-20;
- The 2006 proposed regulations (71 FR 52876);
- The 2016 final regulations (T.D. 9794);
- The 2016 temporary (T.D. 9795) and proposed regulations (81 FR 88882); and
- The 2019 final regulations (T.D. 9857).
The IRS and Treasury have issued several notices delaying and deferring the applicability dates of the 2016 final regulations, 2016 temporary regulations and 2019 final regulations due to their complexity. Most recently, Notice 2022-34 defers the applicability date of the 2016 final regulations and 2019 final regulations (together, the final regulations) to taxable years beginning after Dec. 7, 2023. The 2016 temporary regulations have since expired.
Foreign exchange exposure pool (FEEP) method
The proposed regulations retain the foreign exchange exposure pool (FEEP) method (as outlined in the 2016 final regulations) with modifications and will be the default rule for determining section 987 taxable income or loss and net unrecognized section 987 gain and loss. However, the IRS and Treasury admit these rules may be burdensome and thus, the proposed regulations provide “several simplifying elections that permit section 987 to be applied in a way that more closely conforms to the financial accounting rules and reduces the compliance burden.”
Current rate election
To alleviate the compliance burden of having to translate the basis of each historic asset using a different historic rate (including for purposes of depreciation) in determining section 987 taxable income or loss, Prop. Reg. section 1.987-1(d)(2) would provide an election “to treat all items that are properly reflected on the books and records of a section 987 QBU as marked items (the “current rate election”).”
Taxpayers making the current rate election would:
- Use the yearly average exchange rate for purposes of computing section 987 taxable income or loss; and
- Use the year-end spot rate for purposes of computing section 987 gain or loss.
These rates would be used to translate all items (i.e., income, gain, deduction, and loss) of a section 987 QBU for the current taxable year. However, taxpayers considering making this election should plan carefully due to the suspended loss rules.
The proposed regulations suspend the recognition of section 987 loss when a current rate election is in effect. According to the IRS and Treasury, they are “concerned that without appropriate limitation, the current rate election would facilitate the abuses and inappropriate outcomes that occurred under the 1991 proposed regulations, including the potential for taxpayers to choose to recognize significant, and potentially uneconomic, section 987 losses while avoiding or deferring section 987 gains.” Generally, a taxpayer must suspend the loss until a taxable year in which they recognize an equal or greater amount of section 987 gain (that has the same source and character as the loss) or until the occurrence of certain recognition events.
Annual recognition election
Under the proposed regulations, the annual recognition election would replace the “difficult to apply” annual deemed termination election. Taxpayers making the annual recognition election would recognize the full amount of net unrecognized section 987 gain or loss each year, just like with the annual deemed termination election. However, making the proposed election would not result in:
- A deemed termination of a section 987 QBU; and
- A deemed remittance of its assets or a deemed contribution to the section 987 QBU.
In addition, the proposed election would not alter the functional currency basis of a section 987 QBU’s assets, liabilities, or historic exchange rates.
Taxpayers making the annual recognition election (but not the current rate election) would:
- Use the yearly average exchange rate for purposes of computing section 987 taxable income or loss; and
- Use historic rates for purposes of computing the section 987 gain or loss.
Special rules apply when both elections are in effect
A taxpayer can choose to make the current rate election, the annual recognition election, both elections or no election for a taxable year (subject to the consistency requirement outlined below). However, special rules would apply when both elections are in effect.
The proposed regulations confirm that taxpayers would generally not be subject to the loss suspension rules of section 987 to the extent both elections remain in effect. A loss limitation should not be needed because the annual recognition election requires both gains and losses to be recognized without regard to whether a remittance occurs, and thus, selective recognition of losses is not possible.
An exception to this general rule exists to combat situations where “taxpayers that have not made a current rate election, but which have substantial pools of net unrecognized section 987 loss, might make an annual recognition election to recognize the loss without the need for a remittance.” Proposed regulation section 1.987-11(d) treats any net accumulated unrecognized section 987 loss and deferred section 987 loss as suspended section 987 loss in the first year in which an annual recognition election takes effect if either:
- A current rate election was in effect in the previous year; or
- The owner had more than $5 million of net section 987 losses.
Proposed regulation section 1.987-11(e)(2) limits the amount of suspended loss a taxpayer can recognize in a taxable year when both elections are in effect through the loss-to-the-extent-of-gain rule. The loss-to-the-extent-of-gain rule applies by reference to the net cumulative amount of section 987 gain in each recognition grouping that is recognized by the taxpayer during the relevant testing period (rather than the gross amount recognized each taxable year). Also, a suspended section 987 loss can only be recognized to the extent section 987 gain, with the same source and character as the loss, is recognized.
The loss-to-the-extent-of-gain rule applies at the owner, rather than QBU, level.
Taxpayers making both the current rate election and annual recognition election would:
- Use the yearly average exchange rate for purposes of computing section 987 taxable income or loss; and
- Use the year-end spot rate for purposes of computing section 987 gain or loss.
New transition rule
The proposed regulations provide a new transition rule that will replace the fresh start transition method. The new transition rule would account for any unrecognized section 987 gain or loss accrued prior to the transition date via a simplified computation. Under proposed regulation section 1.987-10, the computation will consist of translating a section 987 QBU’s assets and liabilities at the spot rate on the day before the transition date, eliminating the need to determine actual historic rates. Generally, pretransition items will be treated as follows:
- Any pretransition gain will be treated as net unrecognized section 987 gain; and
- Any pretransition loss will be treated as suspended section 987 loss.
Proposed regulation section 1.987-10(e)(5)(ii) would allow taxpayers to elect to amortize pretransition gain or loss over a period of ten years beginning on the transition date.
The actual computation of pretransition gain or loss would be computed differently for taxpayers that applied section 987 before the transition date depending on whether they used an “eligible pretransition method” or not.
Under proposed regulation section 1.987-10(e)(2), taxpayers that applied section 987 before the transition date using an “eligible pretransition method” would use that method to compute pretransition gain or loss. An eligible pretransition method generally includes any “reasonable method of applying section 987 before the transition date that fully accounts for foreign currency gain or loss attributable to the assets and liabilities of a section 987 QBU (including foreign currency gain or loss that is recognized in computing taxable income with respect to the section 987 QBU or its owner).”
Taxpayers that applied section 987 before the transition date using a method other than an “eligible pretransition method” would be required to compute pretransition gain or loss under proposed regulation section 1.987-10(e)(3). Under this method, taxpayers are required to look-back and calculate unrecognized section 987 gain or loss for each taxable year since section 987 QBU’s inception. The sum of these annual amounts less any section 987 gain or loss recognized before the transition date will be the pretransition gain or loss.
Expanded scope
The proposed regulations significantly expand the scope of entities subject to section 987 regulations. The newly in-scope entities include:
- Banks
- Insurance companies
- Leasing companies
- Finance coordination centers
- Regulated investment companies (RICs)
- Most real estate investment trusts (REITs)
- Trusts
- Estates
- S corporations
- Partnerships other than section 987 aggregate partnerships
According to the IRS and Treasury, “applying a consistent set of rules to all taxpayers facilitates the fair and effective administration of the tax law by treating similarly situated taxpayers similarly as well as eliminating subjectivity and uncertainty.”
Foreign non-grantor trusts and foreign estates if the aggregate interests of beneficiaries that are United States persons is less than 10%, and foreign partnerships if the aggregate interests of the partners that are United States persons is less than 10% of the capital and profits interests will generally remain excluded entities.
Source and character of section 987 gain or loss
In general, the proposed regulations provide that the character and source of section 987 gain or loss is determined based on an initial assignment of the section 987 gain or loss in the year the gain or loss is recognized, deferred, or suspended. Reassignment rules do exist in limited scenarios.
For all purposes of the Code (including sections 904(d), 907, and 954), the section 987 gain or loss is assigned to the statutory and residual groupings using the asset method of Reg. sections 1.861-9(g) and 1.861-9T(g) and the value of the section 987 QBU’s assets is determined using the tax book value method.
Prop. Reg. section 1.987-6(a) confirms that section 987 gain or loss is ordinary income or loss for Federal income tax purposes.
Making and revoking elections
The proposed regulations provide a consistency requirement when making and revoking elections under section 987 regulations (the section 987 elections). Under proposed regulation section 1.987-1(g), a section 987 election is made for the owner and for a taxable year and applies to every section 987 QBU owned by the owner while the election is in effect. Once made, a section 987 election remains in effect until revoked.
The consistency rules apply to all members of the same consolidated group and all controlled foreign corporations (CFCs), partnerships, non-grantor trusts, and estates in which the ownership interests or beneficiary interests of the U.S. shareholder (or members of its consolidated group) exceed 50%. According to the IRS and Treasury, “the consistency requirement is intended to make the application of the proposed rules less complex and more administrable; in most cases, consistent application of the regulations is also expected to reduce the compliance burden on taxpayers.”
The current rate and annual recognition elections can be made without the Commissioner’s consent. However, these elections cannot be revoked for five years without the Commissioner’s consent. Similarly, once these elections have been revoked, they cannot be made again for five years without the Commissioner’s consent.
Partnerships
The proposed regulations would retain an aggregate approach to section 987 aggregate partnerships and introduce a hybrid approach to non-section 987 aggregate partnerships.
The regulations define a section 987 aggregate partnership as a partnership if both:
- All of the interests in partnership capital and profits are owned, directly or indirectly, by persons related to each other within the meaning of sections 267(b) or 707(b). For this purpose, ownership of an interest in partnership capital or profits is determined in accordance with the rules for constructive ownership provided in section 267(c), other than section 267(c)(3).
- The partnership has one or more eligible QBUs, at least one of which would be a section 987 QBU with respect to a partner if the partner owned the eligible QBU directly.
Under an aggregate approach, “an individual or corporation that is a partner in a partnership is treated as an indirect owner of a portion of the assets and liabilities of the partnership for purposes of section 987. If the partner indirectly owns a QBU with a functional currency different from that of the partner, the QBU is a section 987 QBU, and the partner determines and recognizes section 987 gain or loss with respect to the section 987 QBU under the FEEP method.”
Non-section 987 aggregate partnerships would be required to follow the hybrid approach. Under the hybrid approach, partnerships would generally follow entity theory. In essence, a partnership that owns a section 987 QBU would compute the unrecognized section 987 gain or loss for the taxable year and allocate to each partner their distributive share. The allocation would be based on the partner’s distributive share of profits and losses attributable to that section 987 QBU for the taxable year. At the partner level, each partner would translate their share of the unrecognized section 987 gain or loss into their functional currency at the yearly average exchange rate and calculate their net unrecognized section 987 gain or loss with respect to each section 987 QBU of the partnership based on this share.
According to the IRS and Treasury, they “continue to study the application of entity theory and aggregate theory to partnerships in the section 987 context, including whether it would be appropriate to apply a hybrid approach to entity theory to all partnerships, regardless of whether the partners are related parties.”
Section 987 elections are generally made by the partnership.
The loss-to-the-extent-of-gain rule applies at the partner, as opposed to partnership, level.
Under Prop. Reg. section 1.987-7A(f), S corporations are treated in the same manner as partnerships.
Anti-abuse rule
The IRS and Treasury are concerned that taxpayers may terminate certain QBUs prior to the general applicability date of the proposed regulations to avoid these new rules. As such, the proposed regulations provide an earlier applicability date for terminating QBUs to prevent taxpayers from doing so. Prop. Reg. section 1.987-1(h) defines a terminating QBU as a section 987 QBU, if both:
- The section 987 QBU terminates on any date on or after Nov. 9, 2023, or the section 987 QBU terminates as a result of an entity classification election made under section 301.7701-3 that is filed on or after Nov. 9, 2023, and that is effective before Nov. 9, 2023; and
- When the section 987 QBU terminates, neither the section 987 regulations nor the 2016 and 2019 section 987 regulations would apply with respect to the section 987 QBU but for Reg. section 1.987-14(a)(2).
Proposed regulation section 1.987-14(a)(2) provides that the section 987 regulations apply to the owner of a terminating QBU beginning on the day the section 987 QBU terminates, but only with respect to the section 987 QBU, any successor deferral QBUs or successor suspended loss QBUs (in their capacity as such), and any net unrecognized section 987 gain or loss, deferred section 987 gain or loss, or suspended section 987 loss with respect thereto.
The takeaway
The provisions described in this alert are subject to change in any finally enacted regulation package. Nonetheless, taxpayers should contact their advisors now to better understand how the proposed regulations may affect their tax obligations.
