On November 9, 2023, the U.S. Department of the Treasury and IRS issued proposed regulations (Overview of IRC 987 and Branch Operations in a Foreign Currency (irs.gov)) under Internal Revenue Code Section 987 (2023 Proposed Regulations), providing additional guidance for taxpayers in determining taxable income or loss with respect to a qualified business unit (QBU) that has a different functional currency than its tax owner. The 2023 Proposed Regulations include simplifying elections for computing QBU taxable income and Section 987 currency gain or loss, a new transition rule, and a new hybrid entity approach for partnerships and S corporations.
Background
Section 987 is, in part, designed to capture currency gains and losses from foreign branches or foreign flow-through entities—called “qualified business units” or QBUs—caused by fluctuations in exchange rates between the time a U.S. owner recognizes the foreign QBU’s income in its U.S. taxable income and when the foreign branch or flow-through entity later remits the previously taxed income to the U.S. tax owner. Section 987 similarly captures currency gains and losses in the earnings and profits of a controlled foreign corporation (CFC) when it owns a QBU having a different functional currency than the CFC tax owner.
The 2016 and 2019 final Section 987 regulations (2016 and 2019 Final Regulations) require U.S. owners to compute foreign currency gain or loss under a balance sheet method—known as the Foreign Exchange Exposure Pool or “FEEP” method—whereby tax basis of financial QBU assets and liabilities is translated to U.S. dollars at an end-of-year spot exchange rate, but tax basis of nonfinancial QBU assets and liabilities such as fixed assets, intangible assets, and long-term liabilities is translated to U.S. dollars at historical exchange rates. U.S. owners must also translate depreciation and amortization deductions from a QBU to U.S. dollars at historical exchange rates. A CFC applies the same rules in translating QBU balance sheet items to the CFC’s functional currency.
Commenters had expressed concerns that the method of computing currency gain or loss under the 2016 and 2019 Final Regulations is unduly complex and costly to comply with, and that the transition method of the regulations imposes an undue financial burden on taxpayers because it permanently disregards unrealized currency losses generated in years prior to the transition.
The IRS has issued a series of deferrals of the effective date of the 2016 and 2019 final regulations, most recently with Notice 2022-34 deferring the effective date to tax years beginning after December 7, 2023, intended to give the Treasury and IRS sufficient time to consider changes to the final regulations as part of a review required by executive order that may allow taxpayers to elect alternative rules for transitioning to the final regulations and alternative rules for determining Section 987 currency gain or loss.
2023 Proposed Regulations
The 2023 Proposed Regulations largely retain the FEEP method approach of the 2016 and 2019 Final Regulations as the default rule for determining currency gain or loss under Section 987, but with certain simplifying elections and a different transition method.
Simplifying Elections
To reduce the burden of the FEEP method, the 2023 Proposed Regulations provide two simplifying elections: (1) Current Rate Election; and (2) Annual Recognition Election:
- Current Rate Election: Election to treat all items that are properly reflected on the books and records of a Section 987 QBU as marked items.
- For purposes of computing taxable income or loss, all QBU items of income, gain, deduction, and loss are translated to the QBU owner’s functional currency at the yearly average exchange rate for the current taxable year.
- For purposes of computing Section 987 currency gain or loss, all items are translated to the QBU owner’s functional currency at the year-end spot rate. For example, in computing the pool of unrecognized Section 987 gain or loss under the FEEP method, all assets and liabilities of a QBU are translated at the year-end spot rate.
- Under the current rate election, the proposed regulations generally suspend the recognition of Section 987 loss until a taxable year in which an equal or greater amount of Section 987 gain is recognized, or until the occurrence of certain recognition events.
- Annual Recognition Election: Election to recognize the full amount of a QBU owner’s net unrecognized Section 987 gain or loss on an annual basis.
- For purposes of computing taxable income or loss, all QBU items of income, gain, deduction, and loss are translated to the QBU owner’s functional currency at the yearly average exchange rate for the current taxable year.
- If a QBU owner makes an annual recognition election but not a current rate election, the owner uses historic rates to translate historic items for purposes of computing Section 987 gain or loss.
Under the 2023 Proposed Regulations, the current rate and annual recognition elections can be made or revoked without IRS consent; however, elections and revocation of elections, once made or revoked, cannot be changed for five years without IRS consent. QBU owners can make either or both the current rate election and the annual recognition election with respect to their QBUs.
The 2023 Proposed Regulations provide a consistency requirement that applies to elections for all members of the same consolidated group and all CFCs, partnerships, non-grantor trusts, and estates in which the ownership interests or beneficiary interests of the U.S. shareholder or members of its consolidated group exceed 50%.
Transition Rule
The 2023 Proposed Regulations would replace the fresh start transition method of the 2016 final Section 987 regulations with a new transition rule that accounts for unrecognized Section 987 gain or loss accrued before the transition date. In addition, the new transition rule does not require taxpayers to retrospectively determine historic rates for items acquired before the transition date.
- Pre-transition unrecognized Section 987 gain under an eligible pre-transition method, such as the earnings and capital method of the 1991 proposed regulations, becomes the beginning net unrecognized Section 987 gain pool upon adoption of the FEEP method.
- Pre-transition unrecognized Section 987 loss under an eligible pre-transition method is treated as a suspended Section 987 loss.
- Taxpayers can elect to amortize pre-transition gain or loss over a period of 10 years beginning on the transition date.
Partnerships & S Corporations
The 2023 Proposed Regulations would adopt a hybrid entity approach to partnerships (other than “Section 987 aggregate partnerships”) and S corporations.
- Under the hybrid entity approach, a partnership or S corporation that is the tax owner of a QBU computes its unrecognized Section 987 gain or loss for the taxable year at the partnership or S corporation level, but then allocates the unrecognized Section 987 gain or loss for the taxable year to its partners or shareholders. Each partner or shareholder would maintain its own separate unrecognized Section 987 gain or loss pool for the QBU. Section 987 elections would generally be made by the partnership or S corporation.
- Section 987 currency gain or loss attributable to a QBU owned by a partnership or S corporation would be recognized and taken into account at the partner or shareholder level by applying the partnership or S corporation’s remittance proportion e.g., the percentage of the QBU’s gross assets remitted to the partnership or S corporation during the year to the partner’s or shareholder’s separately maintained pool of unrecognized Section 987 gain or loss.
- Basis adjustments would be made to a partner’s or shareholder’s outside basis in the partnership interest or S corporation stock to reflect Section 987 currency gain or loss recognized at the partner or shareholder level.
Effective Date
Once finalized, the 2023 Proposed Regulations would apply to tax years beginning after December 31, 2024. Taxpayers and their CFCs may choose to apply the final version of the 2023 Proposed Regulations for tax years ending after the date the regulations are published as final, provided the taxpayer and each member of its consolidated group and CFCs consistently applies the new final regulations in their entirety to the tax year and all subsequent tax years beginning on or before December 31, 2024.
Additionally, taxpayers and each member of its consolidated group, as well as their CFCs, may also choose to apply the 2016 and 2019 Final Regulations to tax years beginning after December 7, 2016, and beginning on or before December 31, 2024, if they first applied the 2016 and 2019 Final Regulations on their returns filed before November 9, 2023, or first apply the 2016 and 2019 Final Regulations on their returns filed on or after November 9, 2023, while also applying the transition rules of the Proposed Regulations under Section 1.987-10.
Taxpayers having foreign branches, foreign disregarded entities, or foreign partnerships should consider the impact of the 2023 Proposed Regulations and transitioning to the regulations. Taxpayers with unrealized currency losses attributable to foreign branches or flow-through entities may want to consider triggering some or all of the loss in the intervening period before the regulations, or their successors, are issued and effective.
If you have any questions or need assistance, please reach out to a professional at Forvis Mazars.