Applying proposed section 987 regulations can generate significant benefits
TAX ALERT |
U.S. taxpayers conducting foreign operations through branch form (or through a disregarded entity) have an important choice to make that could have a significant financial statement impact. Specifically, taxpayers should decide whether to apply rules contained in proposed regulations issued in 2006 (the new rules) under section 987 to calculate income from non-U.S. business activities. As discussed below, taxpayers that changetheir method of accounting by adopting these rules can, in certain cases, eliminate U.S. tax on certain balance sheet gains relating to foreign exchange rate movements. While still in proposed form, the new rules may be applied currently if the taxpayer requests permission to change its method of accounting for income or loss from foreign branch operations. Taxpayers that have never attempted to use a specific method to account for such gains may also benefit from applying the proposed rules and may be able to do so without requesting a method change.
U.S. taxpayers doing business abroad typically conduct business in one or more non-U.S. currencies, creating exposure to exchange rate fluctuations between those currencies and their reporting currency, typically the U.S. dollar. Under section 987, taxpayers must recognize exchange gains and losses whenever money or property is transferred (i.e., a remittance is made) to the U.S. or to another branch located in a different foreign country. Thus, U.S. taxpayers that lend money to foreign disregarded entities are generally required to recognize exchange gain or loss upon each payment of loan interest and principal. In addition, transactions between branches, such as sales between disregarded entities in two countries, could also trigger recognition of exchange gains and losses with respect to either, or both, of the disregarded entities.
In 1991, the IRS issued proposed rules (the old rules) outlining the method to be used to calculate these gains and losses. For many years, most taxpayers applied the old rules, applied another reasonable method, or did nothing at all. Under the old rules, taxpayers with significant fixed assets often obtained strange results. For example, the old rules required taxpayers to calculate exchange rate gains and losses with respect to fixed assets even where exchange rates did not affect the value of such assets. This could result in significant distortions to current income in years when the taxpayer remitted or transferred money or property from its foreign branch operation either to the U.S. or to other branches located in other countries.
In 2006, the IRS withdrew the old rules and issued the new rules, making significant improvements and changes. Under the new rules, taxpayers must recognize only exchange rate gains and losses associated with financial assets and liabilities. The new rules provide that fixed assets do not affect the pool of balance sheet exchange gains and losses. Thus, the new rules may present planning opportunities depending on the taxpayer’s facts. For example, a taxpayer doing business in a strong currency may have significant unrecognized balance sheet exchange gains. By filing an accounting method change request, it may be possible to obtain permission to transition onto the new rules in a way that would eliminate balance sheet exchange gains relating to fixed assets. On the other hand, a taxpayer that instead has a balance sheet exchange loss relating to fixed assets may preserve such loss by adopting the new rules, but only if the taxpayer had used a reasonable method in prior years. Taxpayers that to date have not applied any reasonable method to compute balance sheet exchange gains or losses can only apply a transition method under which built-in losses and gains with respect to fixed assets are eliminated; such taxpayers cannot preserve built-in losses for future use. In any event, because the new rules are only proposed, taxpayers should get permission to apply the new rules, including these transition rules. Impacted companies should work with their tax advisors to determine the optimal approach and submit any necessary method change or ruling requests to the IRS.