On November 9, 2023, in a seemingly endless (but hopefully not fruitless) effort to address a daunting responsibility delegated to them back in 1986, Treasury and the IRS released a new set of proposed regulations (REG-132422-17) for determining taxable income or loss and foreign currency gain or loss with respect to a “qualified business unit” (QBU) with a different functional currency (FC) from that of its owner. Such QBUs are commonly referred to as foreign branches, but it is important to note that these rules also apply to QBUs of partnerships in which the taxpayer is a partner.
The proposed regulations will affect taxpayers that conduct operations through one or more QBUs whose functional currency is different than that of the taxpayer. That impact is likely to be substantial for QBUs whose functional currency has fluctuated significantly versus the U.S. dollar.
As part of the Tax Reform Act of 1986, Congress added a comprehensive set of provisions to the Internal Revenue Code (the Code) dealing with foreign currency gains and losses. Included in those provisions is section 987, which deals with tax accounting for foreign branch operations and is the subject matter of these new proposed regulations. Treasury had previously released several different sets of proposed, temporary, and final regulations on this subject matter in 1991, 2006, 2016, 2017, and 2019, little of which has ever come into effect.
This alert provides some context for understanding the proposed regulations, delves into selected aspects of the rules, and highlights potential implications some taxpayers could face in transitioning to the new rules.
Before delving into specific aspects of the proposed rules, it is important to note that the terms “taxable income or loss” and “foreign currency gain or loss,” with respect to the proposed rules, refer to two different things. Taxable income or loss refers to the current year taxable income or loss of the foreign branch, which is translated from the FC of the branch to the FC of its owner (typically the U.S. dollar) at current year exchange rates. Foreign currency gain or loss refers to the increase or decrease in the U.S. dollar value of the branch’s net equity that is attributable to fluctuations in exchange rates.
The new proposed rules for determining taxable income or loss of foreign branches are relatively straight forward and non-controversial, as they mirror the clear and fairly simple requirements contained in subsections (1) and (2) of section 987 since its enactment in 1986.
In contrast, the rules for determining foreign currency translation gain or loss with respect to foreign QBUs were not set forth in the Code. Instead, Congress delegated (some would say “abdicated”) the authority and responsibility to devise those rules to Treasury by way of subsection (3) of section 987. These rules have turned out to be complex and controversial.
This ongoing saga relates entirely to the foreign currency gain or loss rules and would appear to be a classic example of a situation in which lawmakers have allowed “the perfect to become the enemy of the good.” Before 1986, a reasonably good (but admittedly imperfect) set of rules dealing with this area had been developed by case law and rulings but the 1986 Congress believed that those rules were not good enough.
As noted above, Treasury has used the authority bestowed upon it by section 987(3) several times since 1986. In its first set of proposed regulations in 1991, Treasury produced what many thought to be a good and practical, but still imperfect, set of rules. In fact, many taxpayers still apply the approach of the 1991 regulations. With each subsequent attempt at new or revised rules, the regulations became more perfect, but also exceedingly more complicated.
This new set of proposed regulations appears to be an attempt to retain (at least in theory) the level of perfection achieved in the pre-existing final and temporary regulations, but to allow taxpayers to avoid the resulting compliance burden associated with perfection by making certain elections to simplify the calculations (at the cost of somewhat reduced perfection).
The new proposed regulations would retain the basic approach and structure of the existing final regulations. Central to that approach is a requirement to use the “foreign exchange exposure pool” (FEEP) method of accounting for currency translation gains and losses, which was originally included in the 2006 proposed regulations and later adopted in the 2016 final regulations.
Under the FEEP method, the balance sheet of a QBU whose FC is different than that of its owner is translated to the owner’s FC at the end of every year. Certain “historic assets” are translated at the historic exchange rate for the year of acquisition. Historic assets would typically be non-financial assets, such as land, buildings, and equipment. Other assets, typically financial assets, are referred to as “marked assets” and are translated at the exchange rate for the taxable year.
The owner of the QBU is then required to determine an amount referred to as the “net unrecognized section 987 gain or loss” for the tax year, which is based on the annual increase or decrease to the QBU’s balance sheet that is attributable to foreign exchange rate fluctuations. By using historic exchange rates for the historic assets and the current year exchange rate for marked assets, the FEEP method only accounts for the impact of exchange rate fluctuations on assets that are most likely to be affected by exchange rate fluctuations.
Next, the owner of the QBU is required to compute its “section 987 gain or loss recognized” for the tax year. Generally, this amount is equal to the cumulative pool of net unrecognized section 987 gain or loss multiplied by the “remittance proportion.” The remittance proportion is the percentage that the aggregate remittances for the tax year bear to the year-end translated total assets of the QBU adjusted upward by the amount of remittances for the year. Any section 987 gain or loss for the year that remains after reduction for remittances during the year is added to the pool of unrecognized section 987 gain or loss as of the end of the prior year and is carried forward into the next year.
Rather than recognizing only a portion of the net unrecognized section 987 gain or loss, the owner may make an “annual recognition election,” under which it recognizes the entire net unrecognized section 987 gain or loss currently each year. In that case, no pool of unrecognized section 987 gain or loss remains at the end of the year to carry forward.
To alleviate the compliance burden of determining and using historic exchange rates, the proposed regulations would permit taxpayers to make a “current rate election,” under which all items of the QBU are translated at the year-end spot rate, subject to a generally taxpayer unfavorable restriction on resulting section 987 losses. Treasury declined to allow taxpayers to elect to apply the method required by the 1991 proposed regulations instead of the FEEP method (as recommended by commenters) but suggested in the preamble that the current rate election is a compromise, as it is “expected to produce an amount of section 987 gain or loss and section 987 taxable income or loss that is similar to the amounts determined under the 1991 proposed regulations.”
Out of a concern that the current rate election might permit the recognition of non-economic losses, the proposed regulations provide that a section 987 loss under a current rate election is temporarily suspended. In general, the QBU owner would recognize a suspended section 987 loss in a later taxable year in which it recognizes section 987 gain that has the same source and character as the suspended section 987 loss (the “loss-to-the-extent-of-gain rule”). Further restrictions require the gain to be in the same foreign tax credit limitation category as the suspended loss.
As a general rule, losses that would otherwise be suspended as a result of a current rate election are allowed to be deducted currently if the taxpayer has also made an annual recognition election. Exceptions to that rule are included to prevent certain perceived abuses.
Special rules are provided for the termination of a QBU. If there is deemed to be a successor QBU, any suspended losses of the terminated QBU become suspended losses of the successor QBU. If there is no successor QBU, the owner of the terminated QBU recognizes any suspended section 987 loss at the time of the termination.
As a theoretical matter, Treasury has always indicated a belief that the aggregate theory provides for a more perfect result than the entity theory in the context of determining foreign currency gains and losses incurred through partnerships.
Under the aggregate theory, foreign currency gain or loss would be determined at the partner level, based on its share of the assets and liabilities of any QBUs of the partnership with a functional currency different than that of the partner. But given the extreme compliance burden and resulting outcry from commenters, the 2016 final regulations confined the use of the aggregate theory to what it called “section 987 aggregate partnerships,” which are partnerships owned entirely by closely related persons. The 2016 final regulations reserved on the treatment of other partnerships.
The new proposed regulations would retain the aggregate theory for section 987 aggregate partnerships and would apply the entity theory to all other partnerships. Under the entity theory, foreign currency gains or losses are determined at the partnership level, with the resulting gain or loss amounts then allocated to the partners. S corporations and their shareholders would be treated similar to partnerships and their partners under the proposed rules.
Complex rules are proposed in other areas, including:
The new proposed regulations would apply to many types of entities that were excluded from the application of the pre-existing final and temporary regulations (e.g., banks, insurance companies, regulated investment companies, real estate investment trusts, and, as discussed above, most partnerships).
For purposes of determining unrecognized section 987 gain or loss for the first taxable year to which the regulations apply, the assets and liabilities reflected on a section 987 QBU’s balance sheet at the end of the previous year would be translated into the owner’s FC at the spot rate on the day before the transition date (regardless of whether the asset being translated is a historic asset or a marked asset).
An owner of a section 987 QBU would also be required to determine the amount of section 987 gain or loss that has accrued before the transition date (“pretransition gain or loss”). In the first taxable year in which the regulations apply, pretransition gain would be treated as net unrecognized section 987 gain, and therefore would be recognized in current and future years based on the “remittance proportions” (explained above) for those years. In contrast, pretransition loss would be treated as suspended section 987 loss.
Alternatively, the proposed regulations would permit taxpayers to elect to amortize pretransition gain or loss over a period of ten years beginning on the transition date.
The determination of pretransition gain or loss would differ depending on whether the taxpayer had previously applied an “eligible pretransition method [of accounting]” for foreign currency gains and losses. The regulations define that term to include “any reasonable method of applying section 987 before the transition date that fully accounts for foreign currency gain or loss attributable to the assets and liabilities of a section 987 QBU.” That includes any of the methods contained in the prior versions of section 987 regulations and, in some circumstances, the so-called “earnings only method.”
For taxpayers that had applied an eligible pretransition method, the pretransition gain or loss would generally be equal to the amount of section 987 gain or loss that would have been recognized under the eligible pretransition method if the QBU had terminated on the day before the transition date.
For taxpayers that did not apply an eligible pretransition method (including those that did not apply any method), the pretransition gain or loss would be equal to the sum of the annual amounts of unrecognized section 987 gain or loss for each taxable year since the section 987 QBU’s inception, reduced by any section 987 gain or loss recognized before the transition date. The annual amounts of unrecognized section 987 gain or loss would generally be required to be calculated under the FEEP method.
Except for section 1.987-12 (discussed below), the existing final regulations have yet to become effective (except for taxpayers that elected early application). Their effective date has been postponed several times, most recently to the first tax year beginning after December 7, 2023. Once finalized, the new proposed regulations (and the parts of the final regulations that are not replaced or modified by the proposed regulations) would apply to taxable years beginning after December 31, 2024. Because the proposed regulations would replace or modify parts of the existing final regulations, those final regulations are not expected to become applicable in their current form. However, in the absence of new authority (e.g., a formal IRS notice), the existing 2016 and 2019 final regulations will come into effect in 2024, pursuant to their effective dates as deferred by the most recent IRS notice.
A taxpayer may also choose to apply the final version of the proposed regulations and the parts of the final regulations that are not replaced or modified by the proposed regulations (the “new final regulations”) for taxable years ending after the date these regulations are published in the Federal Register.
The previous final regulations included section 1.987-12, which had already taken effect. This section provides rules that defer the recognition of section 987 gain or loss that, but for this section, would be recognized in connection with certain QBU terminations and certain other transactions involving partnerships. Taxpayers are required to continue to apply the existing rules until the new proposed regulations take effect, which include a new section 1.987-12.
It remains to be seen whether these new proposed regulations strike an acceptable balance between perfection and practicality. In that regard, it seems reasonable that this almost 40-year saga may soon be drawing to a conclusion. But if past is prologue, we could still have miles to go before we sleep.
In Treasury’s quest for perfection, it appears to have focused more on gains than on losses. The proposed regulations include several “anti-abuse” rules that prevent or at least defer the recognition of losses that would otherwise result from a purer application of the FEEP method.
For taxpayers that had not previously adopted a reasonable method for applying section 987(3), the only penalty (but a potentially very large one) would be the added compliance burden of applying a far more complicated transition rule (discussed above), as compared to the rule for taxpayers that heeded Treasury’s longstanding advice to adopt a reasonable method in the absence of regulations under section 987(3). It is conceivable that some previously noncompliant taxpayers who find this compliance penalty to be overly burdensome may seek to challenge its validity based on the theory that section 987(3) did not impose any obligation on taxpayers to account for foreign branch translation gains or losses in the absence of regulations.
On the bright side, the new proposed regulations do appear to alleviate some of the seemingly unbearable compliance burden posed by the pre-existing final and temporary regulations. Perhaps the good news is that the new effective date provides taxpayers with a bit more breathing room to assess the impact of the regulations and available elections. But as we all know, time flies. So, it is not too early to begin that process. We at A&M Tax are here to assist.