New DASTM regulations may create phantom taxable profits in hyperinflationary economies.

• Author: Major, Bill
• Position: Dollar approximate separate transactions method

Estimating the U.S. income tax effects of controlled foreign corporations (CFCs) to U.S. shareholders based on the unadjusted local currency books of the foreign corporation has always been a risky business. New rules first affecting calendar-year taxpayers in 1995 make the likelihood of estimation errors far more likely, and the U.S. tax consequences of estimation errors more severe. These rules affect how a foreign subsidiary operating in a hyperinflationary environment may have to determine its earnings and profits (E&P) in U.S. dollars using the "dollar approximate separate transactions method" (DASTM).

U.S. entities are taking advantage of increasing equity investment opportunities arising in the expanding economies of Eastern Europe, Latin America and Asia. With the rapid growth of some of these economies come high levels of inflation. Hyperinflation occurs when there has been cumulative inflation of at least 100% over a 36-month period. The financial accounting rules under SFAS 52 conclude that the U.S. dollar should be the functional currency in a hyperinflationary environment.

Unlike SFAS 52, the original functional currency regulations under Sec. 985 did not automatically impose the U.S. dollar as the functional currency on a corporation operating in a hyperinflationary economy unless the corporation conducted its activities primarily in U.S. dollars; the corporation was resident in a location using the U.S. dollar as the standard currency; the corporation did not maintain books and records in the currency of any significant environment in which a significant part of its activities were conducted; or the corporation produced U.S. effectively connected income or loss. However, Regs. Sec. 1.985-1(b)(2)(ii) now requires the U.S. dollar to be the functional currency of CFCs otherwise required to use a hyperinflationary currency as its functional currency, effective for tax years beginning after Aug. 24, 1994. In addition, the CFC must follow the DASTM rules of Regs. Sec. 1.985-3 to determine its gross income, taxable income or loss, or E&P.

U.S. Taxpayer-Controlled Foreign Subsidiary DASTM Workpapers (fiscal year

ending 12/31/94)

12/31/94 Using DASTM method Income statement LC Rate USD Sales 1,000,000,000 Avg. $33,675,000 Cost of goods sold Beginning inventory (55,000,000) 0.0500 (2,750,000) Purchases (950,000,000) Avg. (33,475,500) Ending inventory 55,000,000 0.0230 1,265,000 Net cost of goods sold (950,000,000) (34,960,500)...