Foreign currency losses attributable to loans.

• Author: Bruno, Erasmo S.

The Service's position had been that foreign currency losses between related parties resulted from the sale or exchange of a capital asset and thus were not allowable under the related-party loss rules (Sec. 267). Therefore, the disallowance of these losses had been an IRS audit target. However, it appears that this position no longer applies.

If a related-party loan is denominated in a foreign currency and an exchange loss attributable to principal repayments is sustained, there is substantial authority that the loss is currently deductible as an ordinary loss. However, if the debt is replaced by another related-party debt denominated in a different foreign currency, the loss is deferred until the new debt is retired.

Background

On Dec. 12, 1984, in National-Standard Co., 749 F2d 369, aff'g 80 TC 551 (1983), the Sixth Circuit held that foreign currency exchange losses attributable to principal repayments were ordinary losses. In that decision, the loan was between a corporation and an unrelated bank. A transaction resulting in a capital loss must involve a "sale or exchange" of a "capital asset." The court concluded that the discharge of the debt was not a "sale or exchange," because the company received nothing in the transaction other than the discharge of its debt. Since there was no "sale or exchange," the court did not decide if the foreign currency was a capital asset in the taxpayer's hands.

In GCM 39294, the Service has taken a position contrary to the Tax Court's National-Standard decision. This memorandum stated that foreign currency is a capital asset and a debt repayment is a sale or exchange of the foreign currency. Therefore, according to the IRS, foreign currency exchange losses attributable to principal repayments were capital losses.

As capital losses, foreign currency loss deductions are subject to the Sec. 1211 limitations. They also are subject to the Sec. 267 related-party loss restrictions.

However, under Sec. 988 (enacted in 1986), certain foreign currency losses are treated as ordinary losses. For instance, if a loan between unrelated parties, such as a corporation and a bank, is denominated in a foreign currency and an exchange loss is sustained on principal repayment, the loss is treated as an ordinary loss and is currently deductible in full.

On the other hand, if there is a similar loan between related parties and a foreign currency exchange loss is sustained on principal repayment, is the loss's current...