United States

Proposed regulations expand hedge and mark-to-market accounting


In a Notice of Proposed Rulemaking released Dec. 18, 2017, the IRS and Treasury issued proposed regulations that would provide guidance on certain issues related to foreign currency gains or losses, the timing of their recognition, and the ability of controlled foreign corporations (CFCs) to exclude them from foreign personal holding company income (FPHCI) under the business needs exception. A discussion of the FPHCI effects of these proposed regulations is available in the concurrently issued alert, IRS proposes new regulations regarding foreign currency gain or loss.

From a tax accounting methods perspective, the proposed regulations include two primary changes to existing guidance:

1.     The Section 1.446-4 hedge timing rules would expand to cover “bona fide hedging transactions” (BFHTs), which includes hedges of Section 988 foreign currency transactions and transactions involving Section 1231 property.

2.     A new regulation would be created, Section 1.988-7, under which taxpayers could elect mark-to-market treatment for their section 988 foreign currency gains and losses.

Taxpayers likely to benefit from these proposed changes are those with (1) CFCs acting as treasury centers, and (2) CFCs with qualified business units.

Treasury Centers

A treasury center is a CFC that serves as a financing center for a multinational group. A common set of transactions for treasury centers is the financing of their inter-group lending activities by issuing their own debt denominated in the same nonfunctional currency as the acquired debt. These transactions and their respective recognition rules under current law are described further in the chart below:


1 - Debt Acquisition

2 - Debt Issuance


Treasury center acquires related-party debt denominated in a nonfunctional currency.

Treasury center finances these debt acquisitions by issuing its own debt denominated in the same nonfunctional currency.


By borrowing and lending in the same nonfunctional currency, the treasury center effects a natural hedge of the exchange-rate risk associated with these transactions.

Stand-alone treatment (current rules)

Frequent debt purchases typically qualify treasury centers as “dealers” under Section 475. As such the treasury center would apply the mark-to-market method (MTM), recognizing foreign currency gain or loss annually.

Debt issued by a Section 475 dealer is not a “security” for which section 475 allows MTM treatment. Instead, treasury centers recognize foreign currency gain or loss as principal and interest is paid.

Treatment as a hedge (current rules)

Prohibited.  Section 1.446-4 allows for a Section 1221 hedging transaction to be recognized in the same manner as the transaction being hedged; however, the Section 1221 regulations exclude the purchase or sale of a debt instrument from the definition of “hedging transaction” and, correspondingly, from the scope of section 1.446-4.

The proposed regulations allow for better a matching between these transactions through the following modifications to existing guidance:

1.     Expansion of section 1.446-4 hedge-timing rules:  The proposed regulations both extend Section 1.446-4 to apply to “bona fide hedging transactions” and expand that definition to include the acquisition of a debt instrument by a CFC. As such, a CFC’s debt acquisition (transaction 1, above) can now qualify as a Section 1.446-4 hedge of the exchange-rate risk on its debt issuance denominated in nonfunctional currency (transaction 2, above) thereby permitting the application of the hedge timing rules to transaction 1.

2.     New mark-to-market election for section 988 transactions: Because the proposed regulations characterize transaction 1 as a hedge of the exchange-rate risk associated with transaction 2 (and not the other way around), the controlling method under Section 1.446-4 would be recognition upon payment of the issued debt rather than the MTM treatment generally available for dealers under Section 475. This result is avoided by making the proposed election to apply the MTM method to Section 988 foreign currency transactions. The election is available for all Section 988 transactions that are not (1) transactions for which MTM treatment is either required or prohibited under other code sections, (2) Section 987 transactions, or (3) transactions involving hyperinflationary activity. The election is to be made by filing a statement with the taxpayer’s return (or with the controlling shareholder’s return in the case of a CFC). The election is permanent until revoked, and once revoked, may only be changed once every six taxable years.

Qualified Business Unit

CFCs often have divisions or disregarded entities known as qualified business units (QBUs).   When QBUs have a different functional currency than that of the CFC parent, financial accounting rules often require the CFC to translate the QBU’s activity into the CFCs functional currency, with foreign currency gains or losses recorded to shareholder’s equity. Because of this, CFCs often enter into transactions to manage the exchange-rate risk connected to their investment in QBUs. As such, CFCs often have two different categories of foreign currency gains or losses associated with QBUs:


Hedged activity: QBU activity/ value of QBU investment

Hedging activity: CFC’s “financial statement hedge” of the QBU investment

Current recognition rules

A QBU’s activities in its own functional currency do not qualify as Section 988 transactions for the CFC.  Under Section 987, foreign currency gain or loss is taken into account upon remittances from the QBU.

Financial statement hedges are not Section 1221 hedging transactions and, therefore, do not fall under the Section 1.446-4 hedge timing rules.  Therefore the recognition of associated gains or losses is controlled by the general accounting methods of the CFC.

Under Section 1.987-8T(d) taxpayers may elect to treat QBUs as terminated, and their assets remitted to the CFC, as of the last day of the tax year.  If this election is made, foreign currency gains and losses associated with the QBU would be taken into account during the yearly remittance. Unfortunately, however, this election does not alter the CFC’s recognition of foreign currency gains and losses on its hedging activities related to the QBU. As stated above, such financial statement hedges are not qualified hedging transactions under current Section 1.446-4. Further, while itself a Section 988 transaction, a CFC’s financial statement hedge is not a hedge of a Section 988 transaction. As such, it is excluded from the definition of bona fide hedging transaction, and the proposed expansion of Section 1.446-4 to include bona fide hedging transactions is irrelevant. 

What is relevant to financial statement hedges is the proposed MTM election for Section 988 foreign currency transactions. As financial statement hedges generally qualify as Section 988 transactions, the election would allow associated foreign currency gains and losses to be recognized on a yearly basis as a result of the marking up or down to market.  While the proposed regulations exclude Section 987 transactions from the mark-to-market election, if Section 1.987-8T(d) election discussed above is made, both QBU-related foreign currency gains and losses (both the hedge and the hedged transaction) would be recognized on a yearly basis.


These newly proposed regulations concerning foreign currency gains and losses have the potential to rectify many of the timing mismatches taxpayers experience when hedging exchange-rate risk. Taxpayers, especially CFCs with QBUs or those acting as treasury centers, should plan ahead by consulting their tax advisers concerning the potential effects of these regulations and develop a plan to take advantage of any opportunities that may become available upon publication of final guidance.


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