The new proposed section 987 regulations.

• Author: Wiener, Howard A.

On September 6, 2006, the U.S. Department of the Treasury and the Internal Revenue Service released proposed regulations under section 987 of the Internal Revenue Code (the "2006 proposed regulations"), which provide rules for determining income, gain, and loss attributable to a U.S. taxpayer's "Section 987 qualified business unit" ("Section 987 QBU"). The 2006 regulations, which are expected to become effective in 2009, withdraw previously proposed regulations issued in 1991 because of "serious concerns" about the extent to which taxpayers could recognize foreign currency loss under those rules.

Pending the promulgation of final regulations, the Treasury Department and IRS will treat positions consistent with the 2006 proposed regulations to be reasonable constructions of section 987. Moreover, because the 1991 proposed regulations have been withdrawn, certain section 987 positions may no longer be acceptable to the IRS, even if consistent with the 1991 proposed regulations. Therefore, taxpayers should take this opportunity to reconsider their section 987 methods, before the 2006 proposed regulations are issued in final form, and determine what changes, if any, may be necessary to the manner in which they account for their Section 987 QBUs. To this end, this article describes the 2006 proposed regulations and discusses what steps taxpayers should consider after their issuance. Part I describes who is subject to the 2006 proposed regulations, discussing in particular the rules as they apply to partnerships and the exclusion for financial institutions. Parts II and III discuss the determinations of section 987 taxable income, gain, and loss, and compare the methods provided for under the 2006 proposed regulations with the 1991 proposed regulations. Part IV describes the treatment of terminating Section 987 QBUs. Finally, Part V describes what transition methods are available to taxpayers who adopt the new rules.

Overview

Broadly speaking, a Section 987 QBU is a trade or business conducted in a currency different from its owner's currency, and for which a separate set of books and records is kept, on which the assets and liabilities of the trade or business are recorded. For example, a trade or business in Switzerland that a U.S. corporation conducts through either a branch, a disregarded entity, or even a partnership could be a Section 987 QBU, depending on the currency in which the activities are conducted.

Income, gain, or loss attributable to a Section 987 QBU typically is determined by reference to two different components. First, there is the taxable income or loss of the Section 987 QBU, determined by reference to U.S. tax principles, which a U.S. owner must immediately recognize. Both Section 987 and the 1991 proposed regulations require the taxable income or loss of a Section 987 QBU be computed in its functional currency and then translated at the average exchange rate (generally, an average of the daily exchange rates) into the functional currency of its owner. When translating the taxable income or loss of the Section 987 QBU into the functional currency of its owner, however, the 2006 proposed regulations do not translate the bottom line net taxable income or loss of the Section 987 QBU. Instead, the 2006 proposed regulations use an item by item approach. While most items are translated at the average exchange rate, there are some important exceptions for which a historic rate is used, such as cost of goods sold, depreciation and amortization deductions.

The second component of income--section 987 gain or loss--generally can be described as the portion of currency gain or loss recognized upon remittance from a Section 987 QBU. According to section 987's legislative history, taxpayers should adjust taxable income or loss to the extent the value of the local currency at the time of remittance differs from the value when the amount was earned or otherwise recorded in the QBU's capital.

To implement this adjustment, the 1991 proposed regulations required taxpayers to maintain both equity and basis pools. The equity pool consisted of both the earnings of the QBU and contributed capital, and was maintained in the functional currency of the QBU. The basis pool tracked the earnings and capital in the functional currency of the owner, based on the relevant rate at the time the amounts were earned by, or contributed to, the QBU. The 1991 proposed regulations generally measured currency gain or loss by the difference between the amount of the remittance from the QBU, translated into the taxpayer's functional currency at the spot rate on the date of remittance, and the portion of the basis pool attributable to the remittance. The portion of the basis pool attributable to the remittance was determined based on the amount of remittance relative to the equity of the QBU.

By pooling the foreign currency gains and losses of all assets together with earnings, in the equity pool, the 1991 proposed regulations effectively required recognition of currency gain or loss on all the assets of the QBU, including nonfinancial assets. The recognition of exchange-based gain or loss with respect to nonfinancial assets was problematic because, in the view of the IRS and Treasury, movements in exchange rates with respect to these assets often do not result in currency gains or losses to their owners.] To address this problem, the 2006 proposed regulations no longer take into account foreign currency gain or loss with respect to all assets for purposes of determining Section 987 gain or loss. Instead, foreign currency gain or loss is determined only with respect to financial assets and liabilities (e.g., local currency, a receivable, or a bond), and exchange rate movements with respect to nonfinancial assets and liabilities generally are disregarded.

Moreover, although the 2006 proposed regulations still require a taxpayer to recognize section 987 foreign currency gain or loss only as remittances are made, unrecognized foreign currency gain or loss is recognized only in the same proportion as the remittance bears to all of the assets of the Section 987 QBU. By contrast, the 1991 proposed regulations generally recognized foreign currency gain or loss based on the proportion of the remittance to the QBU's equity pool. Consequently, the approach provided for in the 2006 proposed regulations will generally result in less foreign exchange gain or loss, as compared with the approach in the 1991 proposed regulations.

Who Is Subject to the 2006 Section 987 Regulations?

Section 987 QBUs Generally

The 2006 proposed regulations generally apply to a "Section 987 QBU," which is defined to mean an entity that conducts trade or business activities in a functional currency different from the functional currency of its individual or corporate owner. (2) The functional currency of the QBU generally is determined by reference to the currency in which it derives its revenues and incurs its expenses, so most QBUs of a U.S. taxpayer that operate outside the United States will have a functional currency other than the U.S. dollar, and therefore different from their owner (3)

Generally, items of assets, liabilities, income, gain, or loss are attributable to a Section 987 QBU to the extent those items are reflected on its books and records, and therefore taken into account for purposes of determining income, gain, or loss of the Section 987 QBU. (4) There are, however, a few exceptions.

First, an interest in another corporation or partnership; related liabilities incurred to acquire those interests; and any related items of income, deduction, or loss are excluded from the items attributable...