Planning for the currency gap in dispositions of foreign subsidiaries.

• Author: Arndt, Christopher

Since the beginning of 2002, the U.S. dollar has significantly declined in value relative to other foreign currencies, most notably the European Union (EU) euro ([euro]). In addition, this period was preceded by an economic boom in the U.S. marked by considerable corporate capital investment. As companies continued to grow during the boom, many of their capital investments involved other markets, including foreign jurisdictions. Consequently, many multinational companies are currently holding large unrealized built-in-gains (BIGs) in their foreign investments, attributable to the devaluation of the U.S. dollar.

Example 1: U.S. company, U, contributes $100 to a newly formed EU company (NEWCo) on Jan. 1, 2002 when the conversion rate was approximately $1: 1 [euro]. NEWCo converts the U.S. dollars to euros immediately and purchases a piece of equipment for 100 [euro]. At the end of 2005, the exchange rate is approximately $1.20: 1 [euro]. Thus, the same assets of NEWCo would essentially be worth $120 for an unrealized BIG of $20. Historically, the swing could be as much as a 40% devaluation (i.e., a BIG) because the euro was considerably weaker than the dollar in 1999 and 2000.

To the extent a U.S. corporation invests in a foreign branch or noncorporate joint venture, this unrealized BIG on capital will be taxable on termination or remittance under Sec. 987. However, in the case of an investment in a foreign corporation (which also includes entities that elect to be treated as associations under Temp. Regs. Sec. 1.7701-3), several Code sections and affiliated regulations must be considered. The effect of these sections may minimize the taxability of the gain on recognition.

Example 2: The facts are the same as in Example 1. Under Sec. 985, transactions must be conducted in the taxpayer's (U's) functional currency, which include determinations of basis and gain. As a result:

* U's initial contribution of $100 cash to NEWCo would be tax free under Secs. 351 and 367(a).

* Pursuant to Sec. 358, U (with a U.S. dollar functional currency) would have a substituted basis in the NEWCo stock of $100.

* Absent special circumstances or elections, NEWCo's functional currency will be the euro, generating a tax basis in its assets of 100 [euro] under Sec. 362.

* U.S. tax and earnings and profits (E&P) principles will generally depreciate foreign-located assets using the straight-line method.

There is a five-year life asset for both foreign tax and U.S. E&P...