Out of the ordinary: capital gain/loss from the sale of a foreign currency-denominated debt instrument.

• Author: Mou, Wei-Chin

Foreign currency gain or loss realized by a holder on foreign currency-denominated debt generally is thought to be ordinary in character. However, when a holder disposes of such an instrument, the entire gain or loss realized on the transaction is not necessarily related to exchange-rate fluctuation. Sec. 988 and its regulations acknowledge this principle by providing that the foreign currency element of a transaction must be computed and taken into account separately from gain or loss on the underlying transaction. Taxpayers and practitioners need to remember that both ordinary and capital character may result from the disposition of a foreign currency-denominated debt instrument.

Computing Overall and Foreign Currency Gain or Loss

Sec. 988(a)(1)(A) generally provides that a taxpayer's foreign currency gain or loss attributable to a Sec. 988 transaction is computed separately and treated as ordinary income or loss. A "Sec. 988 transaction" includes the acquisition of a debt instrument denominated in terms of a nonfunctional currency; see Sec. 988(c)(1)(A) and (B). The term "foreign currency gain or loss" refers to any gain (or loss) from a Sec. 988 transaction to the extent it does not exceed the gain (or loss) realized by reason of changes in exchange rates on or after the booking date and before the payment date. Stated differently, if there is gain or loss on the underlying transaction, as well as offsetting foreign currency loss or gain, the two should be netted; only the excess foreign currency loss or gain (if any) should be reported separately under Sec. 988(a)(1)(A).

Regs. Sec. 1.988-2(b) describes the mechanics of computing gain or loss on the underlying transaction (i.e., market gain or loss) and that on movements in the value of the foreign currency (i.e., exchange gain or loss), as well as the process by which the two are netted. A holder of a foreign currency-denominated debt instrument may have exchange gain or loss as to the principal amount when the instrument is paid or disposed of, computed as the principal amount in nonfunctional currency units, translated into functional currency at the spot rate on the date payment is received or the instrument is disposed of, less the nonfunctional currency principal amount translated at the spot rate for the date the taxpayer acquired the instrument; see Regs. Sec. 1.988-2(b)(5). In computing exchange gain or loss, the "principal amount" of a debt instrument refers to the amount...