International Tax Aspects of Foreign Currency Transactions

Overview of the Taxation of Foreign Currency Gain or Loss© William R. Skinner, Fenwick & West LLPwrskinner@fenwick.com(650) 335-7669Last Updated June 24, 2013 1This publication has been prepared for general guidance on matters of interest only, anddoes not constitute professional advice. You should not act upon the information containedin this publication without obtaining specific professional advice. No representation orwarranty (expressed or implied) is given as to the accuracy or completeness of theinformation contained in this publication, and, to the extent permitted by law, Fenwick &West LLP, its members, employees and agents do not accept or assume any liability,responsibility or duty of care for any consequences of you or anyone else acting, orrefraining to act, in reliance on the information contained in this publication or for anydecision based on it. The views expressed herein are those of the author, and notnecessarily those of Fenwick & West LLP.CIRCULAR 230 DISCLOSURETo ensure compliance with requirements imposed by the IRS, we inform you that any U.S.federal tax advice in this communication is not intended or written by Fenwick & WestLLP to be used, and cannot be used, for the purpose of (i) avoiding penalties under theInternal Revenue Code or (ii) promoting, marketing, or recommending to another partyany transaction or matter addressed herein.1 For the most current version of this outline, please visit my website:http://www.fenwick.com/professionals/Pages/williamskinner.aspx.

William R. Skinner is an associate in the Tax Group of Fenwick & West LLP. Mr.Skinner focuses his practice on U.S. international corporate taxation, including tax planning andtax controversy. He also has substantial experience on taxation of M&A and corporatetransactions and the taxation of financial instruments. Prior to joining Fenwick & West LLP,Mr. Skinner clerked for the Honorable Carlos T. Bea of the Ninth Circuit Court of Appeals. Heteaches international taxation as an adjunct professor in San Jose State University’s MSTprogram, and speaks and writes frequently on international tax issues. Mr. Skinner graduatedwith a J.D., with distinction from Stanford Law School in 2005, where he was a member of theStanford Law Review. He received a B.A. in history in 2001 from the University of California,Berkeley.

Table of ContentsPage1. Determination of the Functional Currency and Definition of a “QBU”..................................1 A. Functional currency is determined at the “qualified business unit” level. ..........................1 B. Definition of a Qualified Business Unit. .............................................................................1 C. § 985 – Selection of the Functional Currency .....................................................................2 D. Changes in Functional Currency .........................................................................................6 2. Section 988 — Non Functional Currency Transactions..........................................................7 A. Separate transaction principle..............................................................................................7 B. Certain Differences between § 988 and GAAP (FAS 52)...................................................7 C. Definition of § 988 Transaction...........................................................................................9 D. Timing of Recognition of Foreign Exchange Gain or Loss; Computing the Amount ofCurrency Gain or Loss from Section 988 Transactions. ...........................................................12 E. Character and Source of Section 988 Gain or Loss...........................................................18 F. Reg. § 1.6011-4 Reporting (Form 8886). ..........................................................................21 3. Section 986 — Translation Rules for Earnings and Profits and Foreign Income Taxes.......22 A. § 986 E&P Translation Rules ............................................................................................22 B. Translation of Foreign Income Taxes................................................................................27 4. Section 987 — Translating Branch Income and Loss ...........................................................33 A. Historical Approaches to Branch Translation ...................................................................33 B. Section 987 ........................................................................................................................35 C. 1991 Proposed Regulations ...............................................................................................36 D. The 2006 Proposed § 987 Regulations ..............................................................................38 5. Special Considerations for Hyperinflationary Currencies.....................................................44 A. Definitions .........................................................................................................................44 B. DASTM (§ 1.985-3) ..........................................................................................................44 C. Use of the Official vs. Free Market Exchange Rate ..........................................................47 D. Restricted or “Blocked” Currencies ..................................................................................48 E. Hyperinflationary Debt Instruments..................................................................................50 6. Subpart F Treatment of Foreign Currency Gains and Losses ...............................................51 A. General rule .......................................................................................................................51 B. Exceptions to Subpart F Treatment ...................................................................................51 C. Subpart F Elections............................................................................................................53 7. Foreign Currency Hedging Transactions...............................................................................54 A. Integrated Treatment under § 988(d) and Reg. § 1.988-5 .................................................54 B. § 1221(b)(2) hedging transactions.....................................................................................56 C. Hedges of Investment in an Entity’s Balance Sheet..........................................................59

1. Determination of the Functional Currency and Definition of a “QBU”.A. Functional currency is determined at the “qualified business unit” level.B. Definition of a Qualified Business Unit.(1) § 989(a) defines QBU as a “separate and clearly identified unit of a tradeor business of a taxpayer which maintains separate books and records.”(2) Two types of QBUs in § 989(a) regulations:(a) Taxpayers are QBUs. Therefore corporations are QBUs.Partnerships, estates and trusts are QBUs of their partners /beneficiaries. Individuals, however, are not QBUs.(i)(ii)Prop. Reg. § 1.989(a)-1 (2006) would remove partnershipsfrom the list of per se QBUs above.Reg. § 1.989(a)-1(e), Example 4. Limited activities of aFrench employee, acting as courier for sales by US Parent,are a QBU if conducted in corporate form.(iii) Reg. § 1.989(a)-1(e), Example 5. Netherlands holdingcompany, whose only activities consist of paying directorsfees, holding stock and making equity investments, is aQBU because it is a separate CFC.(iv)(v)Compare Prop. Reg. § 1.987-2(b)(2) (2006), which wouldexclude ownership of stock and borrowing acquisitionfinancing from a QBU for § 987 purposes.A disregarded entity is not in itself a QBU, although itsactivities may constitute a QBU. Prop. Reg. § 1.987-1(b)(3) (2006).(b)Activities of a taxpayer are a separate QBU if (i) the activitiesconstitute a trade or business and (ii) separate books and recordsare maintained.(i)The QBU does not need to be self-contained; i.e., it mayhave a significant interrelationship with the parentcompany.Reg. § 1.989(a)-1(e), Example 2 – Swiss subsidiaryoperates through French and German branches that conductmarketing and distribution functions for US Parent’sproducts. Each branch has its own employees, solicits and1© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

processes orders and maintains separate books and records.Each branch is a separate QBU.(ii)However, the QBU’s activities cannot be merely ancillaryto the taxpayer’s trade or business.1) Reg. § 1.989(a)-1(e), Example 3 – US Parent hires aFrench employee to serve as a courier for salesdocuments. Since employee’s activities are merelyancillary to US Parent’s trade or business, they donot constitute the QBU.(iii)Activities conducted by agents can also give rise to a QBU.C. § 985 – Selection of the Functional Currency1) Reg. § 1.989(a)-1(e), Example 6 – A hires anindependent broker to manage and trade itsinvestment portfolio. The broker maintains separatebooks and records for the portfolio in a foreigncurrency. This constitutes a QBU.2) FSA 200217002. Corporation B was the principalto certain derivatives transactions effected regularlyon its behalf by an affiliate, Corporation C. TheService ruled that: (i) Corporation C’s activities asagent constituted a trade or business of B and aQBU; and (ii) Corporation C’s activities would beimputed to B for subpart J purposes, even if C werean “independent agent.” The Service also found, asa factual matter, that B maintained separate booksand records satisfying the requirements of § 989 forthe derivatives trades effected by its agent,Corporation C.(1) The determination of a QBU’s functional currency looks to the facts andcircumstances set out in Reg. § 1.985-1(c)(2)(i). These facts andcircumstances are similar to those identified in FAS 52, Appendix A:Reg. § 1.985-1(c)(2)Currencies of QBU’s principalplace of businessFAS 52, Appendix A–2© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

Reg. § 1.985-1(c)(2)Currencies of cash flowsCurrencies of QBU’s revenues andexpensesFAS 52, Appendix ACash flow indicator – Currency ofcash flows; and degree to which thecash flow currently affects theparent’s cash flowSales price indicator – are pricesaffected by exchange rates, or moredriven by market conditions?Expenses indicator. Locallysourced expenses or expenses onproducts imported from the parentcompany?Currencies in which QBU borrowsand lendsCurrencies of QBU’s sales marketsThe currencies in which pricing andother financial decisions are madeThe duration of the QBU’s businessoperationsThe significance and/or volume ofthe QBU’s independent activitiesFinancing indicator. Is financingprimarily reliant on loans from theparent and other loans in theparent’s currency, or does the localentity generate its own cash flow?Sales market indicator. Significantlocal market? Market primarily inparent’s country or set in parent’scurrency?Intercompany transactions andarrangements indicator. The degreeof relationship with the parentcompany’s operations. Also, is theentity a holding company for assetsthat could be directly owned by theparent company?(2) Congress intended to adopt financial accounting’s functional currencyconcept for tax purposes. 2 Under Reg. § 1.985-1(c)(5), the GAAPdetermination of the functional currency will ordinarily be accepted for taxpurposes, if based on substantially similar facts and circumstances.2See JCT General Explanation of the 1986 Tax Reform Act, at p. 1086 & n. 36.3© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(3) Examples.(a)(b)(c)Reg. § 1.985-1(f), Example 4 – US Dollar Financing VehicleRequired to Use a US Dollar Functional Currency. CFC isorganized as a financing vehicle primarily for USP and domesticaffiliates. Thus, it primarily derives income from borrowing in USdollars and lending in US dollars back to the US Parent and itssubsidiaries. It incurs some local currency expenses. The CFC hasits activities primarily in U.S. dollars and thus is required to use theU.S. dollar for tax purposes.Id., Example 6 – Subsidiary with Dollar as GAAP FunctionalCurrency, but Possibly LC as Tax Functional Currency. Sub buysproducts from related and unrelated parties in LC, derives grossreceipts in LC and pays operating expenses in LC. However, salesprice is set to determine a set level of dollar profits. Sub has a USDollar functional currency for GAAP. However, since the factorsfor GAAP and tax are not substantially similar, Sub may use theLC or the Dollar for tax purposes.Id., Example 7 – Treatment of CFC with Branches. CFC has nooperations of its own, but operates solely through Branches X andY. Each of the branches is a QBU. CFC must first determine thefunctional currency of each of its QBUs, and then determine itsoverall functional currency based on its total activities (includingthose of its branches X and Y).Note that a strict application of example 7 can readily result in abook-tax difference – e.g., causing a pure holding company thatuses the Dollar for GAAP to have a non-dollar functional currencyfor tax based on the activities of its non-Dollar branches.(d)Example 12 – Foreign Corp with ECI. Foreign corporation F sellsUS real property and earns Effectively Connected income under§ 897(a). Because F earns ECI, its US real property income istreated as a separate QBU that must use the US Dollar.(e) FSA #0991 (Feb. 1992). The IRS considered the functionalcurrency of a CFC that used the US dollar for GAAP and tax. TheExamining agent wanted to place the QBU on the local currencyfor tax and argued that since the CFCs’ activities were primarily inlocal currency, the CFC’s use of the US dollar was inappropriate.The FSA illustrates the factual nature of § 985 inquiry. The IRSnoted that it had a strong argument for requiring the CFC to use thelocal currency, if the CFC conducted its activities primarily in that4© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

currency. The IRS also noted that the currency into which theCFC hedged its exposures was relevant in determining itsfunctional currency.(4) QBUs Required to Use the U.S. Dollar as their Functional Currency (Reg.§ 1.985-1(b)(1)).(a)(b)(c)(d)(e)Individuals;QBUs with a principal place of business in the United States, orany U.S. Possession or other country in which the US dollar is thestandard currency;QBUs generating income or loss that is effectively connected withthe conduct of a U.S. trade or business;QBUs that operate primarily in U.S. dollars;QBUs that do not maintain books and records in a local currency inwhich they conduct significant activities.(5) Procedures for adopting a functional currency.(a)(b)(c)To establish a non-dollar functional currency, a QBU mustmaintain books and records in that currency.Treas. Reg. § 1.964-1(c)(6) provides that no accounting methodsneed to be adopted until there is a significant event that makes theforeign corporation’s earnings relevant. Thus, a CFC should beconsidered to adopt a functional currency for tax when it computesits earnings and profits in that currency, and those earnings andprofits are relevant for U.S. tax purposes. Until that time, theinitial adoption of a functional currency remains open to the CFCand its QBUs.Treas. Reg. § 1.985-1(c)(3) creates a presumption that a QBUmaintains books and records in its economic currency. Unlessthere is a substantial non-tax business reason, the QBU cannotavoid adopting a functional currency in which it has significantactivities by maintaining its books in another currency. 33However, consider the use of the U.S. dollar under § 1.985-1(b)(1) by a CFC that does not maintain its booksand records in a currency in which it conducts significant activities. In FSA #0991, the Service addresseswhether a taxpayer can effectively elect the US dollar as a foreign QBU’s functional currency by failing tomaintain Local Currency books and records. The IRS argued that the QBU would be required to use LocalCurrency because it conducted activities primarily in Local Currency.5© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

D. Changes in Functional Currency.(1) Change in functional currency is a change in accounting method thatrequires IRS consent. See § 985(b)(4).(2) A change in the functional currency is subject to the automatic consentprocedures of Rev. Proc. 2011-14, Appendix § 29.(a)(b)(c)A condition of obtaining automatic consent to change is that therehas been a significant change in the facts and circumstancesunderlying the functional currency determination. Reg. § 1.985-5(b).The general scope limitations of RP 2011-24 also apply, such asonly one change every 5 years.The taxpayer must agree to make the adjustments required by Reg.§ 1.985-5, which are generally effected on a cut-off basis,including:(i) Recognizing § 988 gain or loss on transactionsdenominated in the new functional currency(ii)(iii)(iv)(v)Terminating § 987 QBUs with the same functionalcurrency as the owner’s new functional currencyTranslating the old functional currency basis of propertyinto the new functional currency at the spot rate on the dateof the changeTranslating the value of a § 987 QBU’s equity pool, ifapplicable, into the new functional currencyRecognizing § 986(c) gain or loss on PTI, if the QBU is aforeign corporation that is changing its functional currencyto the US dollar.Note that the above adjustments are made using the spot rate forthe last day of the taxable year preceding the taxable year of thefunctional currency change. 4(3) Effect of § 381 Transactions.(a)Reg. § 1.367(b)-2(j)(1) provides that, if a QBU changes itsfunctional currency as a result of a § 381 transaction, then it will be4Reg. § 1.985-5(a)(1).6© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

deemed to change its functional currency immediately before the§ 381 transaction.(i)The adjustments under § 1.985-5 must be made at that time.(b) Example. CFC1 is a French corporation with Euro activities.CFC2 operates a French branch that uses the US dollar as itsfunctional currency. CFC1 merges into CFC2, and the branchesare combined. Under § 985(b), the combined branch uses the Euroas its functional currency. Accordingly, CFC1 is deemed toundergo a functional currency change immediately before themerger. The last day of the year preceding the year of change forpurposes of §1.985-5 presumably is the closing date of the merger.2. Section 988 — Non Functional Currency Transactions.A. Separate transaction principle.(1) Foreign currency gain or loss attributable to a § 988 transaction is to betreated as ordinary income or expense. § 988(a)(1).(2) Gain or loss on property purchased with a foreign currency is taken intoaccount by translating the basis and amount realized into functionalcurrency, separately from any loan used to acquire the property. See Rev.Rul. 78-201; Reg. § 1.988-1(a)(6), Example 6.(a) Example. Foreign currency gain on satisfaction of a £ loanpayable used to acquire inventory was separately reported despitethe taxpayer’s loss on the sale of inventory. See Church’s EnglishShoes, Ltd. v. Commissioner, 56-1 USTC para. 9271 (2d Cir.1956).A second example. Taxpayer borrows £ to purchase a personalresidence. Later, when the currency has appreciated, the individualsells the property for £, and retires the debt. Taxpayer recognizesgain on sale of property that reflects the increased $ value of the £received on the sale of the home. Under the separate transactionprinciple, the taxpayer recognizes a separate § 988 loss onretirement of the debt. 5B. Certain Differences between § 988 and GAAP (FAS 52).5Since the purchase of a home is a personal transaction, however, such loss may be disallowed under § 165(c).See Quijano v. Commissioner, 96-2 USTC 50,441 (1 st Cir.); Rev. Rul. 90-79. This appears to create a potentialwhipsaw in that § 988(e)(2) requires foreign currency gains attributable to personal transactions to be recognizedif in excess of $200, while any losses on such transactions are disallowed as non-business losses under § 165(c).7© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(1) Application of Mark-to-market.(a)(b)FAS 52, 15, provides for re-measurement and recognition offoreign currency gain or loss on certain types of foreign currencytransactions at each balance sheet date.Under § 988, by contrast, foreign currency gain or loss is takeninto account only as gain or loss is realized and recognized fromunderlying transaction. See § 988(b). In 1992, the IRS proposedregulations to permit the taxpayer to elect to treat all § 988transactions as MTM items. See Prop. Reg. § 1.988-5(f).However, unlike FAS 52, there is no exception for long-term itemsfrom this MTM requirement. In addition, the taxpayer and allrelated parties must conform to the same election.(2) Treatment of Intercompany Loans.(a)(b)Under FAS 52, 20(b), foreign exchange gain or loss from longterm,intercompany loans may be treated as a component of thecumulative translation adjustment (CTA) account.Under § 988, loans to affiliates are subject to the normal rulesgoverning § 988 transactions and trigger taxable income or losswhen gain or loss from those transactions is recognized.(3) Net investment hedges.(a)(b)Under FAS 52, 20(a), foreign currency contracts intended tohedge a subsidiary’s net balance sheet may be treated as acomponent of the CTA account with respect to that entity’s.For tax purposes, contracts entered into to hedge a net investmentin stock of a subsidiary are generally not eligible for hedgeaccounting. See Hoover Co. v. Commissioner, 72 T.C. 206 (1979);Barnes Group, Inc. v. United States, 697 F. Supp. 591 (D. Conn.1988). 6 However, if the net investment hedge relates to aDisregarded Entity (DRE), then it may be eligible for hedgeaccounting to the extent that it reduces risk with respect to ordinaryproperty or ordinary liabilities under the normal § 1221(b)(2) rules.6Losses on such contracts will generally not be treated as part of a “straddle” including the subsidiary’s stock, orsubject to deferral under § 1092, unless the subsidiary’s stock is itself actively traded personal property. SeePLR 9640023.8© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

C. Definition of § 988 Transaction.(1) Section 988 transactions include any of the following, entered into theQBU’s non-functional currency:(a)(b)Acquisition or Disposition of Units of Foreign CurrencyNon-Functional Currency Debt Instruments(i)Only applies if the transaction is indebtedness for U.S. taxpurposes.(ii) Multi-currency instruments. Under Reg. § 1.988-6(d),generally must determine the predominant currency of theinstrument’s payments and translate all payments under theinstrument into the denomination currency.(iii)(iv)Rev. Rul. 2008-1. Prepaid forward contract providing forpayment of amount determined by reference to $ : €exchange rates was, in substance, €-denominatedindebtedness rather than a foreign currency forwardcontract.Preferred stock (including NQPS). § 988(c)(4) providesunexercised regulatory authority to include preferred stockin the definition of “debt instrument” for § 988 purposes.This authority has not been exercised.(c)Accruing an account payable or receivable.(i) Executory contracts – Reg. § 1.988-1(a)(6), Example 6illustrates that a contractual commitment does notconstitute a § 988 transaction until it results in an accruedexpense or income item.Reg. § 1.988-5(b) allows currency risk on executorycontracts to be hedged prior to the accrual of the expense /income. Cf. FAS 52, para. 21 (rules for hedging ofcurrency exposure with respect to unrecognized firmcommitments). Absent this tax hedging rule, the gain orloss on the hedge would be recognized into taxable income,whereas the offsetting movements with respect to theexecutory obligation would adjust the income or expenseitem (for example, increase tax basis in the acquiredproperty).9© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(ii) Accrued foreign income tax payables are § 988transactions, unless taxes are incurred by a U.S. dollarQBU of a domestic taxpayer. See Reg. § 1.988-1(a)(2)(ii);see also Reg. § 1.905-3T(b) (rules for translating paymentsof foreign income taxes for purposes of determining theamount of the foreign tax credit under § 905(c)).According to the preamble, this change was intended toconform the treatment of taxes paid in a non-functionalcurrency to the treatment of branch taxes of a U.S. taxpayerunder Notice 89-74, infra. See TD 8400.(iii)Rev. Proc. 99-32 provides for an election to treat theamount of a § 482 adjustment as an account payableestablished as of the last day of the taxable year to whichthe § 482 adjustment relates. As indebtedness and accountreceivable, the Rev. Proc. 99-32 would appear to be a § 988transaction to the extent it is denominated in a nonfunctionalcurrency under Rev. Proc. 99-32 rules.See FSA 200139008. Section 4.01(3) of the Rev.Procedure provides rules for determining the denominationcurrency of the Rev. Proc. 99-32 account, which willgenerally be the U.S. dollar.By contrast, note that the § 367(d) regulations permittingthe taxpayer to establish a similar account receivable toreflect a deemed royalty inclusion do not specify thedenomination currency of the account. See Reg.§ 1.367(d)-1T(g)(1).(d)Foreign currency financial instruments, such as forward contracts,futures, notional principal contracts, etc. that relate to a foreigncurrency exposure. § 988(c)(1)(B)(iii).(i)(ii)Sec. 988 transactions include forward contracts, regulatedfutures contracts, options, or similar financial instruments ifthe underlying property to which the contract relates is anon-functional currency. See Reg. 1.988-1(a)(2)(iii)(A).Financial instruments that provide for payments in a nonfunctionalcurrency, but relate to some other underlyingproperty, are not Section 988 transactions. See, e.g., Reg.§ 1.988-1(a)(6), Example 11 (Yen-denominated equityindex option not a § 988 transaction). Note that all gain orloss from a foreign financial instrument is treated asexchange gain or loss. See § 988(b)(3). Thus, only10© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

contracts that relate primarily to currency exposure shouldbe included within the scope of § 988.(iii)A notional principal contract is a Sec. 988 transaction to theextent the payments are determined by reference to a nonfunctional currency notional principal amount are § 988transactions. See Reg. § 1.988-1(a)(2)(iii)(B)(1). Thisobviously covers cross-currency swaps, but also includeinterest rate swaps where both legs relate to a nonfunctionalcurrency. See Reg. § 1.988-1(a)(6), Example 10(fixed-for-floating interest rate swap with respect to theYen).(2) Intra-taxpayer transactions.(a) Transactions between a taxpayer and its QBUs are not § 988transactions. See Reg. § 1.988-1(a)(10)(i). This rule is anextension of the general principle that a taxpayer cannot enter intotransactions with itself. See Reg. § 1.446-3(c)(1); Rev. Rul. 80-228.(b)(c)A classic case of this fact pattern is an intercompany loan betweena Parent and its Disregarded Entity (DRE). The loan is disregardedfor tax, and so is not a § 988 transaction. Rather, the currencyexposure is taken into account under § 987 as remittances whencash payments are made on the loan. Prop. Reg. § 1.987-2(d)(3),Ex. 4 (1991); Prop. Reg. § 1.987-2(b)(9), Examples 1 and 2(2006).However, if the loan is made to a DRE by another affiliate separatefrom the corporate owner of the DRE, then it will be a regarded§ 988 transaction for the owner. Example – USP lends money toUS Sub’s € QBU. Cf. Prop. Reg. § 1.987-2(b)(9), Example 4(2006). In this case where P and S are members of the sameconsolidated group, the loan will be a consolidated returntransaction.(d) Branch transfers. Reg. § 1.988-1(a)(10)(ii) provides that § 988gain or loss is immediately recognized on a transfer of a § 988transaction between QBUs of a single taxpayer, if the transferwould cause the § 988 transaction to lose its character as a nonfunctionalcurrency transaction or if the source of any § 988 gainor loss could be attained.11© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

Gain or loss is computed, without regard to 1.988-2(b)(8) (thenetting rule), as if the transferor QBU sold the units of property atFMV immediately before the transfer.(i)Example. X is a US dollar taxpayer with two branches, Yand Z, operating in the €. Y holds $25 in cash with a 20 €tax basis and 23 € fair market value. If Y transfers the $25of cash to X, this will cause Y to recognize 3 € of § 988gain under the branch transfer rule. The transfer also has§ 987 consequences as a transfer of property by Y to X.(ii) Example 2. Same, except that Y transfers the $25 to Z,which is also a € branch. In this case, since Z can step inthe shoes of Y, the branch transfer rule does not apply.The same rule can also apply to a transfer of a § 988 transactionfrom a foreign QBU to a U.S. QBU, or vice versa, because of thechange to the source of exchange gain or loss on the item.D. Timing of Recognition of Foreign Exchange Gain or Loss; Computing theAmount of Currency Gain or Loss from Section 988 Transactions.(1) General Principles. Foreign currency gain or loss is taken into accountwhen the § 988 transaction is settled or otherwise disposed of – i.e., whenthe taxpayer realizes and recognizes gain or loss on the overall transaction.See Treas. Regs. §§ 1.988-2(a) through (d). Typically, this occurs throughrealization events such as—(a)(b)(c)(d)Making or receiving paymentDisposing of units of non-functional currencySelling a loan receivable to another taxpayerTransferring property in settlement of a loan payableThis transaction-by-transaction, realization-based approach to computingexchange gain or loss contrasts sharply with GAAP’s mark-to-marketrules. At one time, the IRS considered allowing taxpayers to elect a bookconformity method that would mark-to-market all § 988 transactions (noless frequently than quarterly) consistent with financial accountingtreatment. See INTL-0015-91 (May 16, 1992), Prop. Reg. § 1.988-5(f).However, this proposal was not adopted. Perhaps the IRS and Treasuryquestioned their authority to extend mark-to-market accounting across theboard for § 988 transactions.12© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(2) Dispositions of Units of Functional Currency.(a)Disposition of units of non-functional currency generally results inrecognition of exchange gain or loss. Reg. § 1.988-2(a)(1)(iii)provides that certain technical “dispositions” of currency areignored for § 988 purposes: exchanging some units of a currencyfor other units of the same currency; deposit or withdraw ofcurrency from a bank; surrendering or acquiring a certificate ofdeposit from a bank.Taxpayers may any reasonable method to determine the basis of itsunits of nonfunctional currency taken out of a bank account.See Reg. § 1.988-2(a)(2)(iii). The Example illustrates that use ofaggregate dollar basis will be considered a reasonable method, ifconsistently applied. Presumably, other consistently used methods(FIFO, LIFO) would also be considered reasonable.(b) Trade Date / Settlement Date Differences. In certaincircumstances, Regs. §§ 1.988-2(a)(2)(iv) & (v) allow taxpayers toignore exchange rate movements between the execution andsettlement of trades of stocks and securities traded on anestablished securities market. For cash method taxpayers,fluctuations between the trade date and settlement date areautomatically ignored in computing amount realized and costbasis. Accrual method taxpayers can make a one-time bindingelection to apply this rule instead of taking into accountfluctuations between the trade date and settlement date.(3) Payables and Receivables.(a)(b)Payables and Receivables denominated in a non-functionalcurrency give rise to § 988 gain or loss based on differencesbetween the spot rates on the booking date and payment date.Taxpayers are allowed to account for payables and receivablesusing a “spot rate convention” of one quarter or shorter in duration.See Reg. § 1.988-1(d)(3). The use of a spot rate convention mayreduce the administrative burden of separate computation ofsection 988 gain or loss from the transactions. The conventionmust be applied consistently by the taxpayer for all of its nonfunctionalcurrency payables and receivables, and the conventionadopted must be consistently with the taxpayer’s financialaccounting. Change of a spot rate convention requires IRSconsent. See, e.g., PLR 200542002 (example of a requestedchange in spot rate conventions).13© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(4) Rules Applicable to Debt Instruments in a Non-Functional Currency.(a)Accrual and Translation of Interest. Interest accrued on a nonfunctionalcurrency debt instrument generally is translated into thetaxpayer’s functional currency at the average exchange rate for theperiod. 7 However, if interest is not required to be accrued beforepayment / receipt (i.e., the taxpayer is on the cash method), interestis translated at the date of payment. As illustrated by Reg. § 1.988-2(b)(9), Examples 1 and 2, this rule is generally limited to a cashmethod taxpayer. 8 An accrual method taxpayer may elect totranslate interest on the last date in the accrual period. 9 In the caseof interest that is paid currently, this election may eliminate thetaxpayer’s recognition of translation gain or loss on interest.With respect to original issue discount (OID) and other accrued,but unpaid interest, payments are ordered for § 988 purposes firstfrom any qualified stated interest (QSI) on the note, second fromaccrued but unpaid interest (with the oldest accrual deemed paidfirst), and lastly from principal. See Reg. § 1.988-2(b)(7).(b) Netting Rule. Foreign currency gain or loss from a § 988transaction is limited to overall gain or loss from the § 988transaction. See § 988(b)(1) & § 988(b)(2). That is, any marketloss on the § 988 transaction is netted against the § 988 gain, orvice versa (the netting rule). See also Reg. § 1.988-2(b)(8)(including the netting rule for debt instruments).Reg. § 1.988-2(b)(9), Example 4. X holds a £ 10,000 loanreceivable with a $13,000 tax basis. At a time when $1.4 = £ 1 X,but the loan receivable has a £ 9,800 FMV, X disposes of the loanreceivable. X recognizes a $720 foreign currency gain under § 988(£ 9,800 * 1.4 - $13,000), and no capital loss.The netting rule takes into account changes in value of the debtinstrument from interest rate movements as well as the issuer’sinsolvency. See Reg. § 1.988-2(b)(9), Example 5.The netting rule may also apply to the issuer so that, in effect, theissuer’s repurchase premium under § 1.163-7 is netted against anexchange gain on retirement of the debt instrument. See Reg.§ 1.988-2(b)(13)(iv), Example 4(ii).7 Reg. § 1.988-2(b)(2)(ii)(A).8 Query whether interest paid by a U.S. subsidiary on a loan received from its foreign parent, which may be subjectto a cash method of accounting under § 267(a)(3), is translated under the above regulation.9 Reg. § 1.988-2(b)(2)(iii)(B).14© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

Consider how broadly the “transaction” is defined for purposes ofthe netting rule. For example, if the borrower’s liability on amortgage is assumed in a § 1001 sale of the underlying property, isthe borrower’s § 988 gain is netted against a loss on the propertybeing sold? One commentator to address the issue concludes that,no, the netting rule does not apply there, on the theory that the saleof the property is a separate transaction from the borrowing. 10(c)Non-Recognition Transactions Involving Debt instruments.If a right or obligation under a § 988 transaction is transferred in anon-recognition transaction, any foreign currency gain or loss isgenerally not recognized on such a transfer under normallyapplicable non-recognition principles. See Regs. §§ 1.988-2(b)(5)and 1.988-2(b)(6) (last sentence). In this case, the transferee of thedebt instrument (or obligation thereunder) inherits the transferor’sfunctional currency tax basis in the § 988 transaction, so that § 988gain or loss is preserved for future recognition. See id.Example of Non-Recognition Treatment. CFC1 is a $USDtaxpayer that holds a € loan receivable from CFC2. CFC1’s $USDbasis in the € loan receivable is $1,500. At a time when the spotrate value of the receivable is $1,250, CFC1 liquidates into amember of the US group in a § 332 liquidation. The US transfereeinherits CFC1’s $1,500 basis in the loan receivable.(d)Debt-for-stock rule.An exchange of debt for stock triggers § 988 gain or loss. Thesame rule also applies to the Parent’s capitalization of a loanthrough a contribution to capital. See Reg. § 1.988-2(b)(13).However, the amount of exchange gain or loss recognized by theholder or obligor is limited to its overall gain or loss in thetransaction (i.e., the netting rule applies). See Reg. § 1.988-2(b)(13), Example 4. In applying the netting rule, one unresolvedquestion is whether the capitalized debt is treated as satisfied at itsfair market value or at the holder’s basis (by analogy to §108(e)(6)).The holder adjusts its basis in the stock received in exchange forany § 988 gain or loss recognized on the exchange. See Reg.§ 1.988-2(b)(13), Example 1.10See Greer Phillips, “What Is The Amount Realized On The Assumption Of A Foreign Currency- DenominatedLiability?,” 93 TNT 149-76 (July 12, 1993).15© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

The obligor of a non-functional currency loan payable recognizes§ 988 gain or loss on the satisfaction of the loan with stock. Theissue price of the debt is then adjusted before calculating any § 108/ COD consequences of the capitalization. See id., Example 2.(e)Special Timing Rules for Non-Functional Currency DebtInstruments.Change to debt’s denomination currency. Prop. Reg. § 1.988-2(b)(14)(i) (1992) would authorize the IRS to defer foreigncurrency gain or loss that would otherwise be recognized on adebt-for-debt exchange if the IRS determines that “the new debthas in effect been replaced with other debt denominated in adifferent currency.” This rule predates § 1.1001-3, and it is unclearhow the two rules interact.§ 267(f).Generally, a sale or exchange giving rise to a currency loss,including a payment or deemed disposition of a note, will besubject to deferral Section 267(f). The deferred loss is taken intoaccount under Reg. § 1.1502-13 matching / acceleration ruleprinciples.Section 267(f)(3)(c) and Reg. § 1.267(f)-1(e) provide an exceptionto loss deferral for losses recognized by the lender on certainintercompany loans made in a non-functional currency.Specifically, the exception applies to non-functional currency debtinstruments, not issued in a hyperinflationary currency, where “thetransaction does not have as a significant purpose the avoidance ofFederal income tax.” Although nothing definitive is on point, “thetransaction” has been read to refer to entering into the loan (orperhaps modifying its terms), rather than the sale or exchangetriggering the loss. See FSA #003184.It is unclear how to apply the matching rule or acceleration rule fora loss recognized on a foreign currency transaction. For example,if the currency used to repay the loan is disposed of by the lenderoutside of the group, does this trigger the acceleration rule?For an interesting application of the § 267(f) matching rule in thecontext of hedging, see PLR 200945026. There, the IRS addressedthis issue in the context of hedging contracts between USConsolidated Group and Foreign Affiliates (under a foreignparent). Based on a number of representations as to the businessmotivated nature of the hedging, the IRS ruled that losses on16© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

currency hedging contracts that were treated as a sale or exchangeof property would be deferred until the relevant Foreign Affiliateincluded the corresponding item of income under its method ofaccounting. None of the foreign affiliates conducted a US trade orbusiness and “some or all” of their gross income on the hedges wasexempt from US tax. Thus, the foreign affiliate’s accounting forthe transaction was not directly relevant for U.S. tax purposes.Nonetheless, the Service appears to have permitted the taxpayer’sforeign affiliates to adopt a U.S. tax method of accounting(presumably consistent with their financial accounting) solely forpurposes of taking into account the U.S. affiliates’ losses under the§ 267(f) matching rule.The § 267(f) exception for losses recognized on non-functionalcurrency loans does not address the treatment of the obligor. Onepossible explanation for this omission is that, under the Fairbanksdoctrine, the obligor is not treated as making a “sale or exchange”of property when it pays off a debt. 11(5) Timing for Foreign Currency Financial Instruments.(a) Options, Forwards and Futures Contracts. Generally, therealization of gain or loss on foreign currency contracts isgoverned by normal tax accounting rules, including § 1256.However, Reg. § 1.988-2(d) contains certain currency-specifictiming rules for these financial instruments, discussed below:(i)(ii)Realization by Offset. If the taxpayer locks in its gain in acurrency position by entering into an offsetting position andderives an economic benefit from doing so (e.g., byborrowing against the appreciated position), the § 988regulations treat this as a constructive sale of theappreciated position. Note that currency is not an“appreciated financial position” subject to the analogousprinciples under § 1259.Physical Delivery on a Contract. Generally, making ortaking delivery on a forward contract merely closes the saletransaction transaction and is not a separate taxable event.However, for § 988 purposes, physical settlement of such acontract is deemed to be a taxable event. See § 988(c)(5);Reg. § 1.988-2(d)(4)(ii).11 See Chip Harter & Michael Harper article, International Tax Journal.17© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(iii) Rollover of an Existing Contract. Where the taxpayerextends the maturity date of a contract, and the built-in gainor loss on the old contract is reflected in the price of thenew contract, this transaction is treated as a taxable eventwith respect to the old contract. However, to the extentthere is a significant time value of money component to theprice adjustment in the contract, the time value of moneycomponent is amortized over the life of the contract as if itwere interest income or expense.(b)Notional Principal Contracts under Reg. § 1.988-4(e).The § 988 regulations compute currency gain or loss on currencyswap by treating each party as if it actually borrowed and lent thenotional principal amounts of the underlying reference currency.The taxpayer accrues interest on a hypothetical borrowing /lending of the notional principal, and then translates the interest forexchange gain or loss purposes based on the normally applicablerules for debt instruments. This translated interest income orexpense determines the amount of currency gain or loss on theperiodic payments. Further, the taxpayer recognizes currency gainor loss with respect to the swap principal at the termination of thetermination of the swap.E. Character and Source of Section 988 Gain or Loss.(1) General Rule of Ordinary Character.(a)Foreign currency gain or loss under § 988 is generally ordinary incharacter. See § 988(a)(1)(A). Gain or loss on a § 988 transactionnot attributable to currency gain or loss (i.e., market gain or loss)remains capital gain or loss. However, such capital gain or lossmay be offset by ordinary income or deduction attributable tocurrency movements under the netting rule. See Reg. § 1.988-2(b)(8) (discussed above).(2) General Rule of Residence Sourcing.(a)Gain or loss from a § 988 transaction is generally sourced to theresidence of the relevant QBU. See § 988(a)(3)(A).Residence of a corporation or a partnership is generally its place oforganization. Reg. § 1.988-4(d). Thus, residence of a foreignpartnership generally is determined on an entity basis. See Reg.§ 1.988-4(d)(2). However, where a partnership is formed or18© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

availed of to alter the source of any item, it may be treated as anaggregate for tax purposes. See id.(b)Residence of a QBU is where its principal place of business islocated. See Reg. § 1.988-4(d)(2). Thus, a US taxpayer’s § 988gains or losses attributable to items booked in a foreign QBUwould be foreign-source.(3) Currency Gain or Loss Allocated and Apportioned in the Same Manner asInterest Expense.(a)(b)Reg. § 1.861-9T(b) contains three sets of rules that may apply tocause currency gain or loss associated with a borrowing (or ahedge thereof) to be allocated and apportioned under § 861 in thesame manner as interest. These rules do not apply for purposes ofwithholding tax under § 871 or § 1441. See Reg. § 1.988-4(g).Reg. § 1.861-9T(b)(1) – interest equivalents. “Any loss or expense. . . incurred in a transaction or series of integrated or relatedtransactions in which the taxpayer secures the use of funds for aperiod of time shall be subject to allocation and apportionment . . .if such expense or loss is substantially incurred in consideration ofthe time value of money.” This rule only applies to “loss orexpense” and does not re-source gains or income.Example 2. US Dollar taxpayer borrows £ sterling at a highinterest rate, and enters a cross-currency swap to hedge itscurrency exposure.Even if the transactions are not integrated into a synthetic dollarborrowing under § 988(d), any net currency loss on the swap maybe allocated and apportioned in the same manner as interest.Note that this Example sunset with the 3-year expiration date ofthe 1989 temporary regulations. However, the Service may arguethat the same result is inherent in the text of -9T(b)(1) which wasincluded in the 1988 temporary regulations that predated the sunsetrule. See FSA #003260 (discussed below).Reg. § 1.861-9T(b)(2) – hedged strong currency borrowings. If ataxpayer borrows in a non-functional currency at a lower interestrate than the AFR (or the equivalent rate in functional currency),and enters a transaction that “substantially diminishes currency riskwith respect to the borrowing or interest expense thereon,” the netgain or loss on the transaction will be presumed to be allocated andapportioned in the same manner as interest expense. The taxpayer19© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

can rebut this presumption by showing that the other transactionhedged other ordinary business risks.Example 1. Taxpayer borrows in a foreign currency at a rate of3% (less than the AFR). Taxpayer has no QBUs operating in thatcurrency. Taxpayer enters a swap that covers most, but not all, ofits currency risk on the borrowing. The net currency loss on theborrowing adjusted for the swap is allocated and apportioned in thesame manner as interest.Example 2. Same as above, except that the taxpayer borrows intwo functional currencies and enters a swap in a single currencythat reduces currency risk on both borrowings. The above ruleapplies to both loans.Reg. § 1.861-9T(b)(6) – hedges of the taxpayer’s interest bearingdebt. Financial products that alter the taxpayer’s borrowing costs,such as interest rate hedges, options, caps, collars, etc., may becontemporaneously identified as hedges. In this case, gain or losson the financial product is allocated and apportioned in the samemanner as interest. 12 Both the borrowing and the hedge must be ina single currency and the rule does not apply to the extentotherwise provided in § 988. Thus, this rule would seem to havelimited impact on currency hedging.However, in the following Chief Counsel memorandum, the IRSsuggested that this regulation or at least § 1.861-9T(b)(1) mightapply to re-source a currency loss on a hedge of a non-functionalcurrency borrowing as interest. That is, the IRS continued to applyExample 2 from the expired 1989 temporary regulations.FSA #003260 – the taxpayer borrowed € in order to effect aforeign acquisition, and entered a € : $ swap to hedge its exposure.Later, the taxpayer borrowed $ to refinance the € indebtedness. Itwas required to make a termination payment to be released from itscurrency swap. The IRS National Office interpreted 1.861-9T(b)(6) to apply to gain or loss with respect to the taxpayer’scurrency hedge, but advised that the amendments that added§ 1.861-9T(b)(6) and Example 2 of § 1.861-9T(b)(1) to theregulations had expired under the sunset rule of § 7805(e)(2).Therefore, these rules were no longer in force. However, the IRSfound that the loss on the currency swap fell within the general rule12If the taxpayer fails to identify the hedge, then loss alone is allocated and apportioned as interest, while gainremains 100% U.S. source. See Reg. § 1.861-9T(b)(6)(iv)(B); TD 8257.20© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

of § 1.861-9T(b)(1) (promulgated before the effective date of§ 7805(e)(2)).(4) Capital Treatment for Certain Excluded Contracts.(a)(b)(c)Certain § 1256 contracts. Regulated futures contracts and nonequityoptions are carved out of § 988 if such contracts are markedto market under § 1256, unless the taxpayer elects to have § 988apply to all such transactions. See Reg. § 1.988-1(a)(7). Thisallows traders and investors in such contracts to obtain 60/40 longterm/ short-term capital gain treatment, if desired. On the otherhand, it is imperative on a corporate taxpayer desiring ordinarytreatment of currency contracts (e.g., for hedging reasons) to electout of this exception.Qualified Funds. Section 988(c)(1)(E) provides a carve-out for allcontracts marked to market under § 1256 held by certain qualifiedinvestment funds that meet several statutory requirements. Thisexclusion is broader than the foregoing exclusion in that it is notlimited to exchange-traded § 1256 contracts.Identified capital assets. Section 988(a)(1)(B) allows the taxpayerto elect on a contract-by-contract basis to designate certain foreigncurrency forward contracts, futures contracts, and options that areheld as capital assets (and not part of a straddle) as giving rise tocapital gain or loss on disposition. The election is made by asame-day identification of the specific contract.F. Reg. § 1.6011-4 Reporting (Form 8886).(1) Since § 988 transactions give rise to ordinary income or expense, a loss on§ 988 transaction can give rise to a reporting obligation under § 6011.Certain listed transactions have exploited the ordinary treatment ofcurrency losses to abusive results.(2) Reg. § 1.6011-4(b)(5) generally requires Form 8886 reporting for losstransactions where, in the case of a corporation, the transaction results in aloss of $10 mm in one year or $20 mm over multiple taxable years. In thecase of individuals and flow-through entities with individual members, thethreshold is reduced generally to $2 mm / $4 mm. In addition, a § 988transaction causing an individual a loss of $50K or more in any one year isalso a reportable transaction.(3) Rev Proc. 2004-66, amplified by Rev. Proc. 2013-11 provides relief forcertain types of losses.21© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(a)(b)Specifically, losses attributable to a “qualifying basis” as describedSec. 4.02 of the revenue procedure. A qualifying basis is generallya basis attributable to a payment of cash, accrual of interestincome, and not transferred in a reorganization transaction.However, the exception for losses attributable to qualifying basisdoes not apply to losses treated as ordinary under § 988, unless thetaxpayer is a bank under § 581. Thus, this relief provision is fairlylimited in its application.Sec. 4.03 of Rev. Proc. 2013-11 also provides exceptionspotentially applicable to certain § 988 transactions:(i)(ii)(iii)Losses from mark-to-market of an item under § 475(a) or§ 1256Losses under § 475(f), from legging out of integratedtreatment under § 1.988-5 or § 1.1275-6, and certain otherMTM provisions.Losses from properly identified § 1221(b)(2) hedgingtransactions. This places a premium on properidentification of hedging transactions.3. Section 986 — Translation Rules for Earnings and Profits and Foreign IncomeTaxes.A. § 986 E&P Translation Rules.(1) A foreign corporation must maintain its E&P in its functional currencyand translate E&P into dollars at “the appropriate exchange rate” on thedate of a distribution or deemed distribution. § 986(b)(1).(a)If the foreign corporation operates non-functional currency QBUs,those QBUs’ earnings must be translated into the foreigncorporation’s E&P under § 987. See Reg. § 1.985-1(f), Example 9.(2) § 989(b) appropriate exchange rates:(a)(b)(c)Spot rate on date of distribution for an actual distributionSpot rate on the last day of the year for a § 956 inclusionAverage yearly exchange rate for a subpart F inclusion22© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(d)Spot rate on date of sale of stock for § 1248 deemed dividendincome(3) § 986(c) – Exchange Gain or Loss on PTI.(a)(b)The US shareholder shall recognize currency gain or lossattributable to the fluctuation in exchange rates between the date ofa PTI inclusion and the date of the actual distribution. § 986(c)(1).Notice 88-71, § 2 on Computing § 986(c) Gain or Loss. § 986(c)gain is computed on an aggregate pooled basis for all post-1986PTI in each separate § 904(d) category (i.e., passive and general).The legislative history indicated that Congress generally intendedfor § 986(c) gain or loss to be computed on a pooled basis, whichprovides some support for the Notice’s use of an aggregate dollarbasis pool for PTI. 13At the same time, § 959 and the current final regulations allocatedistributions of PTI to the most recently accumulated previouslytaxed earnings. See Reg. § 1.959-3(b). Consistent with thisprinciple, Notice 88-71 provides for the general and passive basketcategories of PTI to be maintained in annual layers. Upon adistribution of PTI, the distribution is sourced from the most recentlayers of PTI first. Since passive and general basket layers aremaintained separately, this allocation changes the passive andgeneral basket mix of the PTI distribution.(c)Prop. Reg. § 1.959-3(b)(3) (2006) on Computing § 986(c) Gain orLoss.General rule. Shareholder maintains annual layers of (c)(1) and(c)(2) PTI. § 986(c) gain or loss is calculated based on thecategory and layer of PTI from which the distribution is sourcedunder normal § 959 ordering rules.Dollar-basis pooling election. The shareholder elects to maintain asingle aggregate basis pool for all (c)(1) and (c)(2) PTI. This is thesame approach as in Notice 88-71. It would seem that dollar basispooling, rather than tracing, should be the default rule, as it will besimpler to apply for many taxpayers.(d)Events Triggering Recognition of § 986(c) Gain or Loss.131986 TRA Bluebook, at p. 1090.23© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(i)Actual distributions of PTI to the United Statesshareholder.Note that under the 2006 Proposed Regulations, an inter-CFC distribution of PTI excluded under § 959(b) is not anoccasion to recognize § 986(c) currency gains and losses.Rather, the U.S. shareholder continues to retain a carryover$USD basis in the PTI account. 14 If the distribution weremade to a CFC that uses the U.S. dollar as its functionalcurrency, it would seem necessary for the U.S. shareholderto recognize § 986(c) gain or loss on the distribution toprevent this gain or loss from disappearing.Also, under the Proposed Regulations, the re-classificationof the shareholder’s § 959(c)(2) PTI as § 959(c)(1) PTI as aresult of a § 956 investment does not trigger recognition of§ 986(c) gain or loss. 15(ii)§ 1248 sale of CFC stock. See Notice 88-71, § 2(c). Theshareholder’s basis in the CFC’s stock is adjusted for the§ 986(c) gain or loss that is deemed distributedimmediately before the § 1248 stock sale. This rule hassome logical justification because the § 986(c) gain or losshas economically accrued to the seller. Interestingly, the2006 Proposed Regulations do not contain the same rule oraddress this issue. 16In FSA 199949001, a taxpayer transferred stock of a CFCwith PTI cross chain in a § 304 transaction. Relying on theabove-cited provision of Notice 88-71, the Taxpayer arguedthat the § 986(c) gain increased the basis of its CFC’s stockfor purposes of § 301(c)(2) basis recovery in the § 304transaction. The IRS rejected this position and concludedthat the Notice was limited to § 1248 transactions. The§ 986(c) gain did not result in an adjustment to the basis ofthe CFC stock.(iii)Change of CFC’s functional currency to the US dollar. SeeReg. § 1.985-5(e)(2).(iv) Shareholder recognizes a § 367(b) inclusion. See Reg.§ 1.367(b)-2(j)(2). As in the case of § 1248 deemed141516See Prop. Regs. §§ 1.959-3(e)(3)(ii)(B) and 1.959-3(e)(6), Example 7.Prop. Reg. § 1.959-3(e)(2)(v).Prop. Reg. § 1.959-3(e)(6), Example 8.24© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

dividends under Notice 88-71, the shareholder’s basis inthe stock is adjusted for the § 986(c) gain or lossimmediately before the § 367(b) transaction.(e)Translation of Section 961(a) and (b) Basis Adjustments.TAM 200141003 – the IRS addressed the translation of positive§ 961(a) basis adjustments attributable to an inclusion of subpart Fincome, and negative § 961(b) basis adjustments attributable to adistribution of PTI. In each case, the IRS advised that the historicUS Dollar cost of the PTI would be used for the basis adjustment,rather than the current US Dollar value of the PTI whendistributed. See also Prop. Reg. § 1.961-2(b)(2) (similarlyproviding that adjustments to stock basis use historical cost).(4) Translation of Asset Basis for Assets Entering the United States.(a)(b)(c)One issue that arises is how asset basis should be translated into ataxpayer’s functional currency where the acquisition cost wasincurred in a non-functional currency. Under Rev. Rul. 78-281, aU.S. dollar taxpayer takes a historic U.S. dollar basis in propertyacquired using a non-functional currency. If, however, ataxpayer’s functional currency changed subsequent to acquisition(e.g., a foreign subsidiary liquidated into a U.S. parent, orunderwent a § 381 transaction with another foreign subsidiary), thequestion is how its asset basis should be translated. 17PLR 8749008 – a foreign corporation 50% owned by a U.S.shareholder used a depreciable asset outside the United States, andthen put it to use in a trade or business in the United States. TheIRS ruled that (1) the asset had a depreciable basis reduced byallowable depreciation during the period the property was usedoutside the U.S., citing Gutwirth v. Commissioner, 40 T.C. 631(1963), and (2) the Dollar basis of the property was its original costdetermined using the exchange rate on the date the asset wasoriginally acquired, citing Rev. Rul. 78-281.Reg. § 1.367(b)-3(b)(3)(iii) reserves with respect to the U.S.shareholder’s recognition of exchange gain or loss on its capitalinvestment in a foreign subsidiary in an inbound liquidation. Asstated in the Preamble, the Proposed Regulation providing for thiswas intended to link the translation of asset basis at current spotrate values to the recognition of all FX gain / loss on both E&P and17Several excellent articles have addressed this topic. See, e.g., Robert Katcher, Back to Basis: Crossing the U.S.Frontier, 2002 TNT 209-27 (Oct. 25, 2002).25© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

the paid-in-capital account under Reg. § 1.985-5 (see below). Theproposed regulation regarding the paid-in-capital account waswithdrawn due to administration concerns. See TD 8862.However, no corresponding change was made to the § 1.985-5regulations.(d)(e)(f)Reg. §§ 1.985-5(c) and -5(e). On a change in functional currencyof a corporation, its E&P and “paid in capital” account (see above)are translated into the new currency at the spot rate. Similarly, itsfunctional currency basis of its assets and liabilities are translatedat the spot rate on the last day of the year before the year ofchange. See Reg. § 1.985-5(b). These two rules applied in tandemwould cause the FX gain or loss to be recognized through a newFMV basis, coupled with a corresponding adjustment to thetaxpayer’s E&P and paid-in-capital.FSA 199935019 – F Corp transferred a non-Dollar note to US Sub.In determining US Sub’s basis in the note, the IRS applied Reg.§ 1.988-2(b)(6) and ruled that the Dollar basis in the Note wouldbe computed by translating the units of principal at the spot rate onthe date that the Subsidiary acquired the note. See also FSA003297 (Aug. 1997) (citing Gutwirth for the proposition that “U.S.tax concepts apply to determine the tax consequences of events,even if those events occur outside of the United States, and even ifthose events result from activities conducted by foreign persons,”including tax basis); Treas. Reg. § 1.1296-1(d)(5)(ii), Ex. (whereNRA becomes a resident alien, its basis in stock for PFIC purposesis its original cost basis as of the date of acquisition during theNRA period).CCA 200303021 (Oct. 1, 2002). Following the IRS’s victory inTraveler’s Insurance Co. v. United States, 303 F.3d 1373 (Fed.Cir. 2002), the IRS issued this Chief Counsel advice requiringtranslation of basis of stock acquired in a § 368(a)(1)(B)reorganization at historic exchange rates. There, the US Parentacquired stock in a CFC from minority shareholders in a tax-free§351 / § 368(a)(1)(B) overlap transaction. The IRS reasoned thatU.S. tax concepts govern the computation of $USD basis by a non-U.S. taxpayer. The IRS apparently viewed Rev. Rul. 78-281,supra., and the related case law as controlling.The situation at issue in the CCA, however, may be distinguishablefrom a § 381 transaction involving a change in the taxpayer’sfunctional currency. In that case, the application of Reg. § 1.985-5may cause the taxpayer’s old functional currency basis to be26© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

translated at the current spot rate on the effective date of its changein functional currency.B. Translation of Foreign Income Taxes.(1) General rule. Translate foreign income taxes (and any adjustmentsthereto) at the average exchange rate for the taxable year to which thetaxes relate. The general rule was intended to limit the need for § 905(c)redeterminations arising from exchange rate fluctuations between theaccrual date and payment date. 18Under the general rule, any adjustments to accrued taxes (includingrefunds) are translated at the average exchange rate for the year.(2) Exceptions Requiring Spot Rate Translation.(a)(b)Two-year rule. Taxes paid more than 2 years after the end of thetaxable year to which they relate. See § 986(a)(1)(B)(i).Taxes paid before the beginning of the U.S. taxable year to whichthey relate.(i) Estimated taxes. In TAM 8943003, the IRS ruled thatmonthly estimated tax payments made during the taxableyear should be treated as payments of tax (rather thanmerely deposits) and translated for § 905(c) purposes at thespot rate on the date of payment. The legislative history ofthe 1986 TRA also indicates that Congress intended forprepayments of estimated tax to be translated at the spotrate prevailing on the date of payment. 19 The fact that thecurrency had been devalued by the end of the year did notresult in an adjustment to the taxpayer’s foreign tax credit.(ii)Under current law, however, these estimated tax paymentsmade during the U.S. taxable year of the CFC would betranslated under the general rule of § 986(a)(1). Thisexception is limited to cases where the estimated taxes arepaid before the beginning of the U.S. taxable year to whichthey relate.(c)Taxes denominated in an inflationary currency. See discussion ofBrazilian ORTNs below for the rationale behind this rule.1819See Conference Committee Report on P.L. 105-34 (Section 1102 of the 1997 Taxpayer Relief Act).1986 TRA Bluebook at p. 1110.27© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(d)Taxes for which the taxpayer makes a one-time binding election totranslate at the spot rate on the date of payment. See§ 986(a)(1)(D). Under the spot rate election, in the case of accruedbut unpaid taxes, the translation is done using the spot rate for thelast day of the year. Reg. § 1.905-3T(b)(1)(ii)(D).The election may be made either for all foreign income taxes, oronly non-functional currency taxes attributable to US dollar QBUs.2007 Temp. Reg. § 1.905-3T(b)(1)(ii)(D). See also Notice 2006-47, § 4 (interim guidance with respect to election). The electioncan be made in any year, but once made, it continues to applyabsent IRS consent to revoke the election. See id.(e)Sec. 905(c) Consequences of Spot Rate Election. If the taxpayer isusing the spot rate election, then the Dollar amount of taxesaccrued on the last day of the foreign tax year may differ from theDollar value of taxes actually paid in the subsequent year.If the fluctuations in $USD value of foreign taxes result in a percountrychange of more than the lesser of $10,000 or 2% of the USDollar tax liability, then a § 905(c) redetermination is required for§ 901 direct foreign tax credits. See Reg. § 1.905-3T(d)(1). Noredetermination is required for § 902 credits due to currencyfluctuations, because these § 905(c) adjustments (like other§ 905(c) adjustments affecting a CFC) are generally made to theCFC’s E&P and tax pools. See Reg. § 1.905-3T(d)(2)(i).(3) Translation of Foreign tax refunds.(a)(b)Prior law. “The redetermination should be made by subtractingfrom the original foreign tax credit the dollar value of the refundmeasured at the prevailing exchange rate on the day the refund ismade.” AT&T v. United States, 430 F. Supp. 172 (S.D.N.Y. 1977),aff'd, 567 F.2d 554 (2d Cir. 1978).General Rule of Current Regulations.(i)(ii)Under the average exchange rate translation of § 986(a)(1),the refund should be treated as an “adjustment thereto” thatis translated at the average rate for the year to which the taxrelates. See Reg. § 1.905-3T(b)(3).If the foreign taxes are translated at the spot rate, anyrefund would be translated at the exchange rate used totranslate the original payment of foreign taxes.§ 986(a)(2)(B)(ii); see also Reg. § 1.905-3T(b)(3).28© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(c)Refunds / Additional Payments by a CFC.(i)(ii)Effect on Tax Pool. Since the tax pool is maintained inU.S. dollars, the refund or additional payments is translatedfrom the currency of the payment into $USD using theappropriate exchange rates set out in Reg. § 1.905-3T(b)(3). See Reg. § 1.905-3T(d)(2)(ii)(A). For example,a refund of taxes taken into account under the general ruleof § 986(a)(1) would reduce the tax pool by the same$USD amount of taxes already claimed.Effect on E&P Pool. If the taxes are paid in the CFC’sfunctional currency, a refund or additional assessment willnot require translation to determine the E&P consequences.The receipt of the units of currency in the CFC’s functionalcurrency will not have any income adjustments under § 988or § 987 of the Code. See Reg. § 1.905-3T(b)(5)(iv); Reg.§ 1.905-3T(d)(2)(ii)(D), Ex. 1 (last sentence).However, if the taxes are paid in other than the CFC’sfunctional currency, then the refund of those taxes (orincrease in those taxes) must be translated from thedenomination currency into the CFC’s functional currencyusing the appropriate exchange rate under § 986(a). SeeReg. § 1.905-3T(d)(2)(ii)(C)Additionally, in the case of a refund, the units of nonfunctionalcurrency that are refunded have a functionalcurrency basis to the CFC determined by reference to thehistoric exchange rate used to translate the refund. SeeReg. § 1.905-3T(b)(5)(ii). When these units of currencyare disposed of, the CFC would recognize § 988 income orloss. See Reg. § 1.905-3T(b)(5)(v). The same issue wouldalso arise if the CFC acquired non-functional currency at acurrent spot rate, and disposed of it to satisfy an additionalnon-functional currency tax liability that is translated at thehistoric rate under § 986(a)(1).(4) Notice 89-74 & 1991 Proposed Regulations.Notice 89-74. In the Notice, the IRS addressed the translation offoreign income taxes paid by a QBU directly owned by the U.S.taxpayer. If the taxpayer elects to credit taxes, the portion of thebranch earnings attributable to the foreign taxes (tax equivalentamount) is translated at the same exchange rate used to translatethe tax payments. Under the Notice and pre-1997 § 986, taxes29© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

were typically translated at the spot rate on the date of payment,which differed from the average exchange rate used to translate the§ 987 branch’s P&L more generally.(a)(b)(c)The Notice provides several examples to illustrate the applicationof § 905(c) adjustments. In the examples, an additional taxpayment or a refund results in an adjustment to the tax-equivalentamount and § 987 taxable income translated at the applicable§ 905(c) rate used to translate the taxes.For example, in Example 3, branch taxes for 1988 are translated at1 u : $1.2, where as the branch’s § 987 taxable income is translatedat 1u : $1. The branch earns 100u and pays 20u of taxes. Underthe Notice, the taxpayer initially has $104 of taxable income.When 10u of taxes are refunded, this results in an adjustment of$(2) to the QBU’s income, as the applicable exchange rate forbranch earnings rather than tax equivalent amount would havebeen $10 rather than $12.The 1991 Proposed Regulations generally adopted the principles ofNotice 89-74. Prop. Reg. § 1.987-1(b)(2) (1991) provides thatforeign income taxes paid by a QBU of a US taxpayer that areclaimed as a credit give rise to a “tax equivalent amount” that istranslated separately into dollars for computing the § 987 QBU’staxable income.The Proposed Regulations also provided that the tax equivalentamount is excluded from the branch’s § 987 equity and basis pool,and thus does not affect the amount of § 987 gain or lossrecognized on a remittance of property. See Prop. Reg. § 1.987-1(b)(3)(iii) (1991).1991 Prop. Reg. § 1.987-1, Example 4. This example illustrates acase where there is an additional foreign tax payment relating to1990 in the following year, when the exchange rate has changed.The additional assessment changes the tax equivalent amount, andtherefore, results in a change to the US Dollar taxable incomeattributable to the branch for 1990.1991 Prop. Reg. § 1.987-1, Example 5. B is a QBU branch of X, adomestic corporation. The functional currency of B is the FC. Theexchange rate for 1992 is 1FC:$1 throughout the year. X elects tocredit (rather than deduct) any creditable tax under § 901. In 1992,B has 100FC of income and pays 40FC of creditable tax on thatincome. B adds 60FC to its equity pool and $60 to its basis pool.Under section 1.987-1(b)(3)(iii), the 40FC is excluded from B's30© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

pools; $40 is included in X's income under section 1.987-1(b)(3)(ii).(d)Other Guidance.In two memoranda issued on audit, the IRS national officeaddressed these principles twice in the context of an exceedinglycomplex fact pattern involving redetermination after of a QBUtaxes relating back to the pre-1987 period. See FSA #003814 andCCA #003757. In the latter CCA, the IRS explained Notice 89-74as providing for effectively a “gross-up” of the tax calculation incomputing the branch’s taxable income under § 987. As under§ 78, the IRS advised that gross-up should be translated at thesame exchange rate used to translate the taxes. Further, since theeffect of any exchange rate movements is captured through theresulting income adjustment, it occurs outside of the scope of the§ 987 equity and basis pools. The CCA also provides additionalexamples of the Notice 89-74 and the Taxpayer’s alternativecalculations.The 2006 Proposed Regulations under § 987 and the § 905(c)regulations have not provided any guidance on this question, otherthan Reg. § 1.905-3T(b)(3)(iv), which states that the QBU takes afunctional currency basis in taxes paid in its functional currency.(5) Other foreign currency issues involving creditable foreign income taxes.(a)Taxes Payable and Receivable.Although the general rule of § 986(a)(1) obviates the need for§ 905(c) adjustments resulting from currency movements betweenthe accrual date and the date of payment, this does not eliminatepossible application of § 988. Specifically, a non-functionalcurrency tax payable or receivable generally is within the scope of§ 988. See Reg. § 1.988-1(a)(2)(ii). There is an exception for aDollar QBU’s foreign tax payables related to taxes which areclaimed as a credit under § 901. See Reg. § 1.988-1(a)(2)(ii).According to TD 8400, this exception was intended to provide aU.S. taxpayer’s direct § 901 credit from non-Dollar taxes of aDollar QBU with similar treatment to that of taxes accrued througha § 987 branch subject to Notice 89-74.To the extent this rule applies, the payment or satisfaction of a taxpayable or receivable will give rise to § 988 gain or loss as anincome adjustment.31© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(b)Brazilian ORTNs.During a period of hyper-inflation in Brazil, the Braziliangovernment instituted a “peg” to the taxpayer’s tax liability, whichwas due in 12 monthly installments. The tax was assessed in afixed number of ORTNs at year end. 1/12 of each ORTN was thenconverted into cruzeiros at the spot rate for each month ofpayment. Due to inflation, the total number of cruzeiros actuallypaid exceeded the amount accrued at the end of the year.Rev. Rul. 91-21 & CCA #003802 – the IRS set out its position thatthe amount of “foreign tax liability” for purposes of § 901 and§ 902 was the dollar value of the Cruzeiros when paid at eachmonthly due date.Thus, in the case of a branch, the total § 901 credit equaled theamount of cruzeiros paid, translated at the spot rates on the date ofpayment.In the case of a corporation, under the translation rules then ineffect under § 902, the tax was equal to the dollar value of theORTN liability on the dividend payment date. It was notredetermined to reflect the subsequent inflation in the cruzeiro. Asthe court recognized in AMP, applying § 905(c) to redetermine thetaxes would result in a hyping of the § 902 credit for the year ofthe dividend payment.AMP, Inc. v. United States,185 F.3d 1333 (Fed. Cir. 1999) –Reversing the Court of Claims, the Federal Circuit ruled that the§ 905(c) regulations reference to “units of currency” accrued orpaid meant the Cruzeiro not the ORTN. Therefore, the currencyfluctuation was required to be taken into account.The court noted that the 1986 Act corrected the issue in the case byrequiring hyperinflationary currencies to use the US dollar.Inflationary currencies now must be translated at the spot rate, 20and § 902 credits with respect to inflationary QBUs must beredetermined at the U.S. parent level and not as a poolingadjustment. 21 This causes the implicit currency gain in a paymentof inflationary taxes to be treated as a reduction of the taxes paid.2021§ 986(a)(1)(C).Reg. § 1.905-3T(d)(3)(i).32© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

In the case of non-inflationary taxes, unless the taxpayeraffirmatively elects the spot rate, currency movements between theyear of accrual and date of payment will not be taken into account.4. Section 987 — Translating Branch Income and Loss.A. Historical Approaches to Branch Translation.(1) Net Worth vs. Profit & Loss Method.(a)Rev. Rul. 75-106. The IRS approved the taxpayer’s use of a networth or balance sheet approach to branch translation. Thetaxpayer’s gain or loss for the year was equal to the translationbetween:(i) the opening dollar value of the branch =US dollar basis of current assets and liabilities translated atthe beginning of the year spot rate +US dollar basis of non-current assets and liabilitiestranslated at historic rates and(ii)end of the year dollar value of branch, adjusted for any netremittances or contributions of property during the year =US dollar basis of current assets and liabilities translated atthe end of the year spot rate +US dollar basis of non-current assets and liabilitiestranslated at historic rates +Net Remittances During the Year, or – Net Contributions,as the case may be.The change in net worth resulted in taxable translation gain or lossin each year regardless of whether any property was remitted bythe branch.(b)Rev. Rul. 75-107 – Profit & Loss Method. The IRS approved an“earnings only” approach to translation of branch profits. In thefact pattern addressed by the ruling, the branch earned 10,000 unitsof functional currency. On June 15, when the exchange rate was 3FC : $1, the branch remitted 1,000 units. At the end of the year,the exchange rate was 2.8 FC : $1.33© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

Under the profit and loss method, the 10% of the net profitremitted on June 15 was translated into U.S. dollars at the June 15spot rate (i.e., 3 FC : $1). Any remaining net profits (here, 9000units) was translated into U.S. dollars at the year-end exchange rate(i.e., 2.8 FC : $1).(2) Choice of branch translation method viewed as a method of accounting.(a) American Pad & Textile Co. v. Commissioner, 16 T.C. 1304(1951). The Court noted that the two general approaches inaccounting literature are the profit and loss method and the networth method. Based on the state of the case law prior to the 1986Act, the Court viewed the question of branch translation as “one ofaccounting and not of substantive law.” 22 The court reconciled theinconsistent results of cases on “the theory that a consistentmethod of accounting in a regularized and continuous businessoperation will succeed in reflecting income to a sufficientlyaccurate degree for Federal income tax purposes.” 23 However, onthe facts presented, the taxpayer had failed to apply consistently areasonable method of accounting.(b) GCM 35643 (1974), underlying Rev. Rul. 75-106. The GCMrepresents the Chief Counsel’s reasoning for issuing a rulingallowing the use of the “net worth” method of branch translation.It analyzed the question in terms of whether the net worth methodclearly reflected income within the meaning of § 446.(c)Travelers Insurance Co. v. United States, 303 F.3d 1373 (Fed. Cir.2002), pet. for reh’g den., 319 F.3d 1390 (2002). The taxpayermade an annual exchange adjustment that it contended closelyapproximated the profit and loss method. The IRS disagreed andfound the adjustment not to clearly reflect income under § 446(b).Under controlling § 446(b) standards, the Court of Appeals foundno abuse of discretion by the IRS in deciding that the taxpayer’sparticular method of accounting did not clearly reflect income onthe facts of the case.In the absence of specific guidance on branch translation, § 446(b)is helpful as a legal standard. Under § 446(b), the IRS may notchange a method of accounting that clearly reflects income in favorof another method that the IRS prefers. The taxpayer’s burden isonly to show that its method clearly reflects income; and nothingmore.2223Id. at 1311.Id. (emphasis added).34© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

B. Section 987.(1) The Statute. In the case of a taxpayer with a QBU operating in a differentfunctional currency,“taxable income of such taxpayer shall be determined987(1) – by computing the taxable income or loss separately for each suchunit in its functional currency,987(2) – by translating the income or loss separately computed underparagraph (1) at the appropriate exchange rate, and987(3) – by making proper adjustments (as prescribed by the Secretary)for transfers of property between qualified business units of the taxpayerhaving different functional currencies, including—(2) Legislative History.treating post-1986 remittances from each such unit as made on apro rata basis out of post-1986 accumulated earnings, andtreating gain or loss determined under this paragraph as ordinaryincome or loss, respectively, and sourcing such gain or loss byreference to the source of the income giving rise to post-1986accumulated earnings.”(a)(b)Congress was concerned by the electivity permitted CFCs andbranches to choose the net worth method for declining currenciesand the profit and loss method for appreciating currencies.Congress also believed that the net worth method was inconsistentwith the taxation of realized income or loss. 24 Therefore, Congressrepealed the net worth method, so that “only realized exchangegains and losses on branch capital will be reflected in taxableincome.” 25Congress provided for the uniform use of a profit and loss methodfor reporting the results of QBUs with non-dollar functionalcurrencies. 26 “Any entity that uses a nonfunctional currency isrequired to measure the untranslated results of operation under aprofit and loss method, and to translate income or loss into thefunctional currency at a prescribed (“appropriate”) exchange ratefor a taxable year. . . .These translation rules apply without2425261986 TRA Bluebook, at pp. 1089-1090.1986 TRA Bluebook, at p. 1109.Id. at p. 1092.35© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

egard to the form of enterprise through which the taxpayerconducts business (e.g., sole proprietorship, partnership, orcorporation), as long as the enterprise rises to the level of aQBU.” 27(c)(d)Congress intended for regulations to limit the deduction of branchlosses under § 987 to the taxpayer’s total U.S. dollar basis in thebranch. 28“Remittances” should include transfers of property betweenbranches operating in different functional currencies. § 987 gainor loss should be recognized on any remittance of property, not justcurrency and regardless whether the property is converted into USdollars. 29C. 1991 Proposed Regulations.(1) Taxable income calculations (§ 1.987-1).(a)The QBU’s taxable income is computed in a similar manner to aCFC’s computation of earnings and profits:(i)(ii)(iii)Start with books and records to determine profit and lossMake US tax adjustments to items reflected in the profitand lossTranslate the resulting FC taxable income/loss into owner’sfunctional currency at the average exchange rate for theyear(2) Remittances and Transfers of Property (§ 1.987-2).(a)Basis Pool and Equity Pool.(i)The Basis Pool = the US Dollar cost basis of the taxpayer’sinvestment in the QBU. The basis pool is increased by theDollar taxable income as determined under § 1.987-1; andby the amount of property contributed to the QBU,translated into the owner’s functional currency on the dateof the transfer, and decreased by branch losses and theamount of any remittances from the branch (translated into272829Id. at p. 1108.Id. at p. 1109. The 1991 Proposed Regulations, however, allow the basis pool to become negative, subject tolater recapture. See Prop. Reg § 1.987-1(a)(4).Id.36© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

the owner’s functional currency at the spot rate or the dateof the remittance).(ii)Equity pool = the functional currency value of the owner’sinvestment in the branch. The equity pool is adjusted bythe FC taxable income (or loss) of the branch, and theamount of any transfers (or remittances) into and out of thebranch in the QBU’s functional currency.(b)Calculation of § 987 Gain or Loss on a Remittance (§ 1.987-2(d)).(i)(ii)Step 1 – Determine the amount of Equity remitted(measured in the QBU’s functional currency).Step 2 – Determine the portion of the basis pool attributableto the remittance by applying the following fraction:Equity Due to Remittance-------------------------------- x Total Basis PoolTotal Equity Pool(iii)(iv)The difference between the basis and equity pool amountsattributable to the remittance constitutes § 987 gain or loss.Following a remittance, the transferee takes a FunctionalCurrency basis in the remitted property translated at thecurrent spot rate. See § 1.987-2(b)(2)(iii).(c) Termination Events (§ 1.987-3).(i)(ii)(iii)(iv)Cessation of the QBU’s activities.Taxpayer’s transfer of substantially all of the QBU’s assets(including by reason of a § 338 deemed asset sale).Most § 1248 sales of stock in a CFC with a § 987 QBU.Exceptions for certain non-recognition transactions:1) Most US-to-US and Foreign-to-Foreign Section 332liquidations2) Most US-to-US and Foreign-to-Foreignreorganizations37© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

D. The 2006 Proposed § 987 Regulations.(1) Threshold Issues.3) § 351 Transfers involving a § 367(a) outboundtransfer give rise to a termination; treatment of other§ 351 transfers is reserved.(a)QBUs Excluded from 2006 Proposed Regulations.(i)(ii)(iii)Banks, insurance companies, and financing companies(including leasing companies, financial coordinationcenters, RICs and REITs). 30DREs are not themselves QBUs, although activitiesconducted by a DRE may be a QBU of the DRE’s owner.(§ 1.987-1(b)(3)(ii)).Partnerships are treated as aggregates for § 987 purposes.(§ 1.987-1(b)(4)(ii)). Thus, each partner has its own,indirect § 987 QBU, consisting of the non-FunctionalCurrency activities of the partnership.(iv) Pure holding companies. Holding companies whosebalance sheet is limited to stock in a controlled subsidiaryand acquisition indebtedness to acquire such stock. SeeProp. Reg. § 1.987-1(b)(7), Example 1. The Exampleappears to be based on the factual premise that owning onecompany’s stock and servicing a debt is not a trade orbusiness. 31(b)Grouping Election (§ 1.987-1(b)(2)).(i)(ii)Multiple QBUs of one owner with the same functionalcurrency may be combined into a single QBU for § 987purposes by making an one-time, binding groupingelection.The IRS solicits comments on how to apply the groupingelection to QBUs owned by different members of the sameconsolidated group.(c) Flat Approach (§ 1.987-1(b)(4) & 1.987-1(b)(7), Example 2).3031Prop. Reg. § 1.987-1(b)(1)(ii).Prop. Reg. § 1.987-1(b)(7), Example 1; Prop. Reg. § 1.987-2(b).38© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(i) Tiers of DREs are “flattened” into directly owned § 987QBUs. Thus, a transfer of property between a lower-tierparent and subsidiary QBU branch is re-characterized as atriangular flow of funds up to the parent, and down to therecipient QBU.(d)Disregarded transactions (§ 1.987-2(c)(2)).(i)Items resulting from disregarded transactions are ignoredfor § 987 purposes and instead are treated as a remittance(or contribution) of any related cash property between theQBUs. See Prop. Treas. Reg. § 1.987-2(c)(2).(ii) Example. A loan between a DRE and its owner isdisregarded for § 987 purposes. Payments on the loan aretreated as remittances of cash to the owner.(iii)§ 1.987-2(c)(9), Example 3. Interbranch sales of propertybetween QBUs of a single owner are re-characterized asseparate transfers of cash and property between the QBUssince cash is a marked asset. If the property purchasedfrom the other QBU is an historic asset, the differencebetween current and historic spot rates can result in aremittance from one of the two QBUs.(iv) § 1.987-2(c)(9), Example 4. Where there is a regardedtransaction between one entity and another entity’s QBU,this transaction is taken into account for § 987 purposes.(e)Partnership issues.(i)§ 1.987-2(c)(5) provides that where an owner of a DREsuffers a dilution in interest due to another person’spurchasing an interest in a DRE or contribution of propertyto the DRE, that results in a constructive remittance and recontributionof a portion of the underlying QBU’s assets.(2) Foreign Exchange Exposure Pool Method.(a)Distinction between “marked items” and “historic items” is crucialto operation of the 2006 Proposed Regulations.(i) Marked items = assets and liabilities that would be § 988transactions if not denominated in the QBU’s functionalcurrency.39© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

Examples:i. Cashii. Payables and Receivablesiii. Debt instrumentsiv. Foreign currency financial instrumentsMarked items are translated at the current spot rate forpurposes of measurement of unrecognized § 987 gain orloss.(ii)Historic items = everything other than marked items.Historic items are translated at all times at the historic spotrate which does not fluctuate over time.Examples:v. Inventoryvi. Equipment and other § 1231 propertyvii. Investment assets(iii)Compare net worth method of Rev. Rul. 75-106 and“temporal method” of applying FAS 52.(b) Taxable income calculation (§ 1.987-3).(i)(ii)Translation of income occurs on an item-by-item basis.General rule (§ 1.987-3(b)(1)). Translate items using theyearly average exchange rate. This general rule applies toamount realized, income items, and many ordinaryoperating expenses.1) Alternatively, owner may elect to apply the spotrate for the date the item is incurred to make thetranslation of any of the above items. § 1.987-3(b)(1)(ii); § 1.987-3(f), Examples 7 and 8.(iii) Exceptions (§ 1.987-3(b)(2)). Translate the followingitems using their historic exchange rates:1) Depreciation and Amortization40© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

2) Cost basis of property sold or disposed of (includingCOGS of inventory – see § 1.987-3(f), Examples 1and 2).(c) Unrecognized § 987 gain or loss (§§ 1.987-4 and 1.987-5).(i)(ii)(iii)§ 1.987-4 sets out a multi-step process for measuring theunrecognized § 987 gain or loss.As illustrated by Example 1, the unrecognized § 987 gainor loss under the FEEP method is limited to the translationadjustments as to the QBU’s marked items.§ 1.987-5 provides rules for measuring remittances thattrigger § 987 gain or loss:1) Remittances are computed on an annual net basis.2) The amount of a remittance looks to the basis of theasset in the owner’s functional currency (§ 1.987-5(d)).a) Historic assets are measured at the historicexchange rateb) Marked assets are measured at the spotexchange rate on the date of the transfer(§ 1.987-4(d)(2)(iii)(A)).3) The owner takes a carryover functional currencybasis in the assets received in the remittance(§ 1.987-5(f)).(d) Termination Rules (§ 1.987-8).a) Historic assets retain their historic cost basisb) Marked assets receive a new cost basisdetermined using the spot rate on the date ofthe transfer.(i)Termination events.1) QBU’s activities cease2) Substantially all (within the meaning of§ 368(a)(1)(C)) of the QBU’s assets are transferred41© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

3) Owner ceases to exist in a non-§ 381 transaction(e.g., in a § 338 deemed asset sale)4) Foreign owner ceases to be a CFC(ii)Exceptions.1) Most U.S.-to-U.S. and foreign-to-foreign § 332liquidations and reorganization transactions areexcepted from triggering a QBU termination.(iii) Example 2. DC contributes its § 987 QBU to DS, itswholly owned US subsidiary in a § 351 transaction. Thisresults in a termination as the transfer of substantially all ofthe assets of the QBU.1) The IRS is soliciting comments on whether a QBUtermination should be deemed to occur where the§ 351 transfer is between members of theconsolidated group.(iv)Example 5. DC2 becomes a 95% owner of a DRE formerlywholly owned by DC1. Under the transfer rules above, thisresults in a constructive distribution of 95% of the QBU’sassets to DC1. Since this is substantially all of the QBU’sassets, DC1’s QBU terminates.(e)Source and Basket of § 987 Gain or Loss.(i)(ii)(iii)Section 987(3)(B) provides that § 987 gain or loss is to besourced and characterized by reference to the underlyingpost-1986 earnings of the QBU.Under § 1.987-6(b)(2), § 987 gain or loss is characterizedusing the asset method of Treas. Reg. § 1.861-9T(g). ACFC cannot use the modified gross income method for thispurpose.An example in the 2006 Proposed Regulations illustratesthat the relevant assets are the separate assets of the branch;however, the rule itself is not explicit on this point. 3232Cf. Treas. Reg. § 1.861-9(f)(2) (providing generally that a domestic corporation allocates and apportions abranch’s interest expense using the domestic corporation’s overall mix of assets, not the branch’s separateassets).42© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(f)Interaction of § 987 Gain or Loss with Branch Loss Recapture &DCL Rules.(i)(ii)Reg. § 1.1503(d)-4(c)(4)(v) provides that a DCL iscomputed without regard to any § 987 gain or lossrecognized by the owner on remittances out of the branch.The interaction of branch loss recapture would seem todepend on the taxpayer’s method of applying § 987.However, depending on the taxpayer’s method of applying§ 987, the FX gain or loss on QBU termination could resultin an adjustment to the $USD basis of the branch’s assetsimmediately before branch loss recapture is calculated.(g) Transition rules (§ 1.987-10).(i)Fresh start method. Taxpayer and all its CFCs eliminatethe § 987 gain or loss and start with a zero opening balanceon the transition to the new regulations.1) Consider benefits from this method if branches havesignificant appreciation under the prior 1991method.(ii)Deferral Transition Method. If the taxpayer has used a“reasonable method” of applying § 987 prior to enactment,the taxpayer may elect to roll over its § 987 balances intothe QBUs at the commencement of the new regulations.Possible views as to what does or does not constitute a“reasonable method”:1) Examples illustrate that following the 1991Proposed Regulations would likely be consideredreasonable.2) An “earnings only” approach also would appear tobe considered reasonable.3) Per the preamble, following the 2006 ProposedRegulations would also be reasonable.4) To what extent is mixing and matching the 1991and 2006 proposed regulations reasonable?43© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

5) Simply following GAAP may not be reasonable,because FAS 52 does not have a remittanceconcept.5. Special Considerations for Hyperinflationary Currencies.A. Definitions.(1) “Hyperinflationary” for tax purposes = Country’s consumer price indexshows a 100% cumulative increase over three years. 33(2) “Inflationary” as used for § 905(c) purposes = Country’s CPI increases bya cumulative 30% over three years. Note that “inflationary” taxes must betranslated at the date-of-payment spot rate under § 986.(3) DASTM = US Dollar Approximated Separate Transactions Method(DASTM) for translating results of a QBU operating in a hyperinflationarycurrency. Requires the branch to translate its balance sheet back into USdollars and include the translation adjustment as an adjustment to E&P.B. DASTM (§ 1.985-3).(1) Theory of DASTM. Profit and loss accounting of §§ 986 and 987 willcreate distortions in hyperinflationary environment. Entities with fixedcosts will earn excessive income as inflation increases gross receipts butnot historic costs recovered through COGS and depreciation. Interestbearing debt will also be distorted, as higher interest coupons offset FXloss on principal.To prevent these distortions, DASTM requires a QBU to compute itsearnings in dollars. In addition, the QBU must compute a $USD net worthat the beginning and end of every period. The change in $USD net worthis DASTM gain / loss that is included in earnings and profits.(2) Profit and Loss translation (Reg. § 1.985-3(c)).(a)(b)Items are translated at the exchange rate for the translation periodto which they related. Translation period = any regular period of amonth or less that may be adopted by the taxpayer.Depreciation, inventory cost, and other historic cost items arereflected at the spot rate for the translation period in which theywere incurred.33Reg. § 1.985-1(c)(2)(ii)(D).44© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(i)Special rule under which closing inventory recorded underthe LCM method is re-translated at the end of each year.(c)(d)Income is translated at the current rate applicable to the translationperiod when earned.Reg. § 1.985-3(c)(10) contains an example of the DASTM P&Lcalculation.(3) Reg. § 1.985-3(d) provides rules for re-marking the balance sheet tomarket to capture the effect of inflation on the value of the branch’s assets.Like the 2006 Prop. Regs. under § 987, the DASTM rules mark someassets, such as cash, A/R, etc., to market, while continuing to carrybusiness assets at historic rates. Note that closing inventory is effectivelymarked-to-market for currency purposes if the taxpayer uses the LCM. 34Accrued tax liabilities are also marked to market.The difference between the opening net worth and the closing net worth,adjusted to reflect dividends, capital contributions, and annual P&L, isDASTM gain or loss. See Reg. § 1.985-3(d)(1).(4) Character of DASTM Gain / Loss – the Nine Step Method (Reg. § 1.985-3(e)(3)).(Note that small QBUs may be eligible to elect a simplified method).(a)(b)(c)Regulation generally uses the asset method of characterizing assets(§ 1.861-9T(g)(3)) as subpart F vs. non-subpart F. However, thedollar value of assets must be calculated using an averaging of theasset values at the beginning and end of the period. DASTM gainor loss with respect to assets is then allocated to the QBU’s assetsand treated as income in the same category as the respective assetsproduce.Liabilities are similarly valued based on an averaging of beginningand end-of-the-year values. The DASTM gain or loss with respectto short-term liabilities such as payables is treated as an adjustmentto the underlying cost (e.g., inventory cost). DASTM gain or losswith respect to interest bearing debt is allocated in the samemanner as interest expense.Any residual DASTM gain or loss not accounted for above isallocated on a gross income method.34Reg. § 1.985-3(c)(4)(iii).45© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(5) Consequences of a Change to DASTM (Reg. § 1.985-7).Consequences generally are similar to a change in functional currencyfrom local currency to $USD. Importantly, Reg. § 1.985-7(a) implementsthe DASTM transition as of the transition date, which is the beginning ofthe 3-year period during which the hyper-inflation began. In the case of aCFC, the following adjustments are prescribed:(a)(b)(c)Section 988 transactions of the CFC denominated in $USD areclosed out.Assets and liabilities are translated into $USD as if the CFC hadapplied DASTM beginning on the transition date and madeadjustments under Reg. § 1.985-3(d)(1) throughout the look-backperiod.Post-1986 earnings are translated by assuming the CFC hadchanged to DASTM on the transition date. Thus, E&P as of thetransition date is translated at the transition date exchange rate.E&P during the intervening look-back period is translated as if theCFC had applied Reg. § 1.985-3 during the period.Note: Given the distortion that DASTM aims to correct, in thecase of an operating company with substantial retained earnings,the change to DASTM would tend to reduce E&P in most cases.US shareholders in CFCs make additional adjustments.(d)First, shareholders increase or reduce subpart F income beginningin the year of change to reflect the fact that the amount of subpart Fincome would have been different. This adjustment, if positive, istreated as an increase to subpart F income that carries a § 960credit as if actually included in income.(e) Gain or loss deemed recognized on close-out of $USD § 988transactions is characterized under the normal subpart F rules.(f)PTI accounts are deemed distributed on the DASTM CFC’sconversion to the $USD as its functional currency.Any gain or loss recognized under the above adjustments is takeninto account under a mandatory 4-year spread period, whetherpositive or negative.Section 987 QBUs converting to DASTM must make similar adjustmentsto CFCs. However, since they are directly owned by another owner, the46© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

change has more immediate impacts. To translate retained earnings (andany § 987 gain or loss with respect to capital), the branch is deemed toterminate on the transition date. It recomputes its income and remittancesduring the interim look-back period as if it had always applied DASTM.Any resulting income adjustment is taken into account over a 4-yearspread period.C. Use of the Official vs. Free Market Exchange Rate.(1) The government in a hyperinflationary currency may attempt to peg anofficial $USD exchange rate lower than the rate on the black market. Onequestion that arises is which rate to use as the “spot rate” for U.S. taxpurposes.(2) Reg. § 1.988-1(d)(1) sets forth the general rule that the spot rate shall bedetermined based on the prices at which the currency freely changes handsin representative amounts. Reg. § 1.988-1(d)(4) provides that the ratewhich “most clearly reflects income” should be used as the spot rate incases in which the government rate and free market rate differ.(a)(b)Id., Example 1 – CFC operating in the LC as its functionalcurrency pays a 100LC dividend to USP at a time when the officialgovernment rate is $1 : 1LC, but the free market exchange rate is$1 : 4LC. USP then donates the 100 LC to charity. It isappropriate to use the free market exchange rate to translate boththe dividend and charitable contribution deduction into US Dollars.Id., Example 2 – where a taxpayer was engaged in arbitrage byacquiring units of non-functional currency at the government rateand selling them on the black market, it was appropriate to use theofficial government rate as the cost basis of the purchased units.(c) FSA #003308. Taxpayer sought to use the LAFISE statisticsrather than the IMF statistics normally relied upon by thegovernment. The IRS rejected the taxpayer’s argument that theLAFISE (free market exchange rate) could be used to compute anannual exchange rate for branch P&L, rather than a spot rate under§ 988. However, in the case of a remittance translated at the spotrate under § 987, the IRS stated that “it generally would beappropriate to use a free market rate rather than an official rate fordetermining the spot rate, provided that the free market rate isconsistently used and further provided that the free market ratemore accurately reflects income than the official rate.”(3) Cases on Mexican Debt-Equity Swaps.47© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(a)Certain cases have addressed a Mexican government program toinduce corporations to retire its Dollar-denominated debt. In eachof the cases, the corporation purchased the debt at a discount onthe open market. Then, the Mexican government exchanged alarger amount of pesos with the company which were restricted foruse inside Mexico.(b) Kohler v. United States, 2006-2 USTC para. 50,611 (7 th Cir.)(Posner, J.). Here, the company bought back $22 mm face value ofdebt for $11 mm. The Mexican government swapped the debt for“restricted” pesos that would be worth $19.5 mm if unrestricted.The Court viewed Kohler as receiving a taxable gain on retirementof the debt. However, contrary to the IRS’ conclusion, the fact thatthe pesos were restricted for use inside Mexico meant that theirFMV must have been less than $19.5 mm. The IRS’sdetermination of a value of $19.5 mm was implausible andarbitrary and capricious.(c)G.M. Trading Corp. v. Commissioner, 121 F.3d 977 (5th Cir.1997). Similar transaction as above. However, the Fifth Circuitanalyzed the transaction as a non-shareholder contribution tocapital under § 118. Thus, the taxpayer received the excessamount of pesos tax-free, but also did not receive tax basis for thatamount of value.D. Restricted or “Blocked” Currencies.(1) Foreign exchange restrictions may completely block a US taxpayer’sability to remit funds from a foreign country. This may create a harshresult under subpart F or § 482 in charging the taxpayer with phantomincome that it cannot by law receive in cash. While case law ruled againstthe taxpayers on this point, 35 the regulations now permit taxpayers to electto defer reporting of income attributable to blocked currency.(2) Reg. § 1.482-1(h)(2).(a)Taxpayers transacting with a subsidiary operating under foreignexchange restriction may elect to defer reporting the incomeattributable to the blocked currency until it can be remitted underforeign law. The election to defer reporting applies to “any portionof the arm’s length amount,” 36 including stated payments.However, if the payments may be remitted through any other3536See Eder v. Commissioner, 138 F.2d 27 (2d Cir. 1944) (“blocked” Colombian pesos could be taxed to anindividual under the foreign personal holding company rules).Reg. § 1.482-1(h)(2)(iv).48© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

means, such as dividend, or have been remitted to the taxpayerthrough an intermediary, the taxpayer can no longer rely on thedeferral method of accounting.(b)Election of the method requires the taxpayer to attach a statementto its return describing that the conditions are met – i.e., thecurrency is truly blocked. Under §§ 1.461-1(a)(4) and 1.905-1(b),tax benefit for any amounts attributable to deferred income are alsodeferred. There would appear to be some complexity inmaintaining a separate suspense account for deferred income.(3) Reg. § 1.964-2.(a)Definition of “blocked” currency:(i)(ii)Income cannot be distributed as a dividend, or convertedinto US dollars or property of a type normally used in theCFC’s trade or business.Restriction must be in place for every day in the 150 dayperiod beginning 90 days before the end of the CFC’staxable year.Thus, the basic subpart F “blocked” currency rule issignificantly more restrictive than the related § 482 rules.(iii)Alternatively, earnings may be blocked to the extentrequired to be held as mandatory reserves (Reg. §1.964-1(b)(5)). However, for this rule to apply, the reserves mustexceed the foreign corporation’s accumulated E&P.(b)(c)As with § 482, the blocked currency results in a deferral of theinclusion of subpart F income by temporarily excluding suchearnings from current E&P for purposes of §952 and § 956. Whenthe restriction is lifted, the taxpayer generally must recapture thebenefit of deferral.The CFC’s distributions out of blocked E&P and other E&P isdetermined under the normal rules of § 1.959-3. See Reg. § 1.964-2(c)(4).(4) Reg. § 1.482-9(l)(5), Examples 10 and 11. The costs of implementing acapital structure change to mitigate foreign exchange controls are properlytreated as shareholder costs under § 482, whether incurred by the Parent orSubsidiary.49© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

E. Hyperinflationary Debt Instruments.(1) Economically, currency values and interest rates are to some extent linked.A loan in a weak currency will carry a higher interest rate to compensatefor the loss of principal. Allowing the currency gain or loss to be deferreduntil maturity and sourced to the residence of the taxpayer, while largerinterest income / expense is taken into account currently, may be distortivefrom both a timing and sourcing perspective.(2) Reg. § 1.988-2(b)(15). This regulation provides special timing, source andcharacter results for hyperinflationary debt instruments to avoid thedistortion inherent in recognizing a currency loss (or gain) that is offset byincreased interest income (or expense).Timing: The currency gain or loss inherent in a hyperinflationary debtinstrument is recognized annually on a mark-to-market basis.Source / Character: The MTM gain or loss (which is the entire gain orloss attributable to currency movements) is treated as an offset to interestincome or expense to the extent of the interest accrued during the period.Any excess is sourced and characterized under the normal § 988 rules.Note that this regulation applies to any hyperinflationary loan, includingbank deposit, including between unrelated parties.(3) Reg. § 1.988-4(e)(1). This regulation provides a more targeted rule at UScompanies lending to related CFCs operating in a weak currency in theCFCs’ weak currency. But for this regulation, and in cases where it doesnot apply, lending in a weak currency at the prevailing local interest ratewill tend to convert the source of income to foreign sources.The regulation applies where the loan is made to a related foreign personand the loan bears an interest rate of at least 10 percentage points abovethe mid-term AFR. Where the regulation applies, then solely for purposesof determining the foreign tax credit limitation under § 904, the CFC’slook-through interest income is re-characterized as U.S. source income tothe extent of the hypothetical FX loss that would be recognized in the yearif the loan had been marked to market during that year.Note that, unlike Reg. § 1.988-2(b)(15), this regulation does not result inan actual recognition of the currency loss on a MTM basis. Rather, itsolely serves the punitive effect of re-sourcing interest to U.S. sources tothe extent of the expected FX loss on maturity of the loan. For example, ifthe shareholder would notionally recognize a FX gain in a subsequentyear, the U.S. lender cannot reverse the prior year’s re-sourcing of income.50© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

6. Subpart F Treatment of Foreign Currency Gains and Losses.A. General rule.(1) Section 954(c)(1)(D) generally treats the excess of a CFC’s currency gainsover its currency losses attributable to § 988 transactions in a taxable yearas foreign personal holding company income (FPHCI).(2) This category of FPHCI does not include foreign currency gains andlosses attributable to certain currency gains and losses (Reg. § 1.954-2(g)(5)):(a)(b)(c)Capital gains or losses on contracts identified as capital assetsunder § 988(a)(1)(B)Currency gain or loss treated as interestExchange traded futures and options that are excluded fromconstituting § 988 transactions by § 988(c)(1)(D)(i) (absentelection to treat such contracts as § 988 transactions). Thepreamble states that such contracts constitute commoditiestransactions, see T.D. 8618, although this seemingly can bequestioned based on the language of the definition of “commodity”within Reg. § 1.954-2(f) as an interest in “tangible property.”(3) Losses in one category of FPHCI (e.g., currency) generally cannot offsetgains in another category of FPHCI (e.g., interest) other than by operationof the earnings limitation. See Reg. § 1.954-1(c)(1)(ii). Therefore, onepriority is to avoid having a trapped currency loss in computing FPHCI.(4) Section 987(3) provides for characterization of § 987 gain (or loss) on aremittance by reference to the QBU’s underlying earnings. Thus, if a§ 987 QBU is engaged in activity that leads to the production of subpart Fincome, a § 987 gain or loss on that QBU’s remittance will result in anadjustment to subpart F income.B. Exceptions to Subpart F Treatment.(1) Business needs transactions.(a)(b)The currency exposure arises from a transaction entered into, orproperty used or held for use, in the normal course of the CFC’sbusiness (§ 1231 property, inventory, trade payables, etc.).The underlying transaction does not itself, and could notreasonably be expected to produce subpart F income.51© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(c)(d)The underlying transaction is not a foreign currency derivative.Such transactions may be excluded from FPHCI as bona fidehedging transactions.The CFC’s records are sufficient to identify the transaction as abusiness needs transaction.(2) Bona Fide Hedging Transactions.(a)(b)(c)A bona fide hedge is defined by Treas. Reg. § 1.954-2(a)(4)(ii) isdefined as a transaction that would qualify for § 1221(b)(2)hedging treatment, except that the exposure being hedged can beeither ordinary property, a § 988 transaction, or § 1231 property.The risk being hedged must arise from the CFC’s own trade orbusiness; i.e., a hedging center cannot hedge another CFC’s risksand rely on the exception. See Reg. § 1.954-2(g)(2)(ii)(D),Example. 37A derivative that constitutes a bona fide hedge with respect to abusiness needs transaction is excluded from FPHC income.(d) A bona fide hedge of a transaction within the scope as a § 1.954-2(g)(3) election is also covered by the election.(e)Effect of erroneous identifications (Reg. § 1.954-2(a)(4)(ii)(C)).(i)(ii)An identification of a transaction as a bona fide hedge isgenerally binding with respect to any loss from thetransaction (non-subpart F). However, gains remaindetermined under the general ruleFailure to identify establishes that the transaction is not abona fide hedge. However, if there is no reasonablegrounds for failure to identify, losses (but not gains) aretreated as if they were the result of a bona fide hedgingtransaction.(iii) Inadvertent error exception may relieve adverseconsequences of failure to identify hedging transactions.(3) Interest Bearing Liabilities.(a)Currency gain or loss on an interest bearing liability of the CFC ischaracterized for subpart F purposes in the same manner as the37See also Reg. § 1.954-2(f)(2)(v), Ex. 2 (example of Treasury center providing commodities hedge).52© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

CFC allocates and apportions interest expense. See Treas. Reg.§ 1.954-2(g)(2)(iii).(b)Application of similar rule to gains or losses allocated as interestexpense under § 1.861-9 is reserved. See Reg. § 1.954-2(g)(5)(iv).C. Subpart F Elections.(1) Reg. § 1.954-2(g)(3) election.(a)(b)(c)(d)Transactions giving rise to Foreign Base Company Sales Income,or other subpart F income, cannot qualify for the business needsexception even if they occur in the ordinary course of the CFC’sbusiness.Treas. Reg. § 1.954-2(g)(3) permits the CFC to elect tocharacterize currency gain or loss arising from such ordinarycourse transactions giving rise to general basket subpart F income(or hedges thereof) as allocable to such category of subpart Fincome.The benefit of this election is to re-basket foreign currency gainsand losses as general basket for § 904(d) purposes, and net anylosses against foreign base company sales income. See Treas. Reg.§ 1.954-2(g)(3)(iv), ExampleAlso, as illustrated by PLR 201235007 (§ 9100 request), theelection might be used to allocate a currency loss against interestincome from loans made in the ordinary course of business.(2) Reg. § 1.954-2(g)(4) election.(a)This election supersedes the § 1.954-2(g)(3) election with respectto the CFC. Once made, the election cannot be revoked withoutIRS consent.(i)See, e.g., PLR 201226011, for a case where a CFC wasable to revoke a § 1.954-2(g)(4) election based on changedcircumstances that allowed it to trace its foreign currencyitems.(b)The election causes all foreign currency gains and losses from§ 988 transactions and § 1256 contracts that would be § 988transactions to be included in computing FPHCI. Thus, the CFCwaives the business needs exception. The intent of the rule is to53© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

allow a CFC to avoid the need to trace gains and losses under thebusiness needs exception. See TD 8216.7. Foreign Currency Hedging Transactions.A. Integrated Treatment under § 988(d) and Reg. § 1.988-5.(1) This regulation allows taxpayer to integrate certain non-functionalcurrency transactions and hedges into synthetic functional currencytransactions.(2) Eligible transactions.(a)(b)(c)Non-functional currency debt instrument.Payables or receivables arising under an executory contract.Purchases or sales of publicly traded securities.(3) Specific requirements for integrated treatment.(a) The hedge is entered into with an unrelated party. 38(b)(c)Both the § 988 transaction and the hedge are entered into by thesame corporation (the same member of a consolidated group) andreflected on the books and records of the same QBU.The transaction is identified as an integrated hedging transactionby the end of the date on which the financial instrument isexecuted.(4) Specific Rules for Debt and Executory Contracts.(a)(b)In the case of a debt instrument, it is possible to compute a yield tomaturity on the synthetic dollar debt instrument that is created bycombining the debt instrument with the hedge. This would appearto rule out the use of a series of rolling forward contracts to hedgethe debt.Unlike the rules for hedged executory contracts, the regulationspermit the hedge to be entered after the DI is created throughlegging in procedures. 39 Gain or loss is recognized on a deemed3839In other contexts, i.e., Regs. § 1.1275-6 and § 1.1221-2, the taxpayer may enter into a hedge with a related partyacting as a dealer in securities under § 475. It is unclear why this rule does not also apply for purposes of§ 988(d).See Treas. Reg. § 1.988-5(a)(6).54© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

sale at the leg-in date, and deferred until the maturity or dispositionof the DI.(c)If a hedge of DI or executory contract is terminated beforematurity, the taxpayer is deemed to have “legged out” of thehedge. Both sides of the transaction (not just the leg actuallydisposed of) are deemed disposed of, and the net gain or loss isrecognized on that date.(i)(ii)In TD 9598 (Sept. 6, 2012), the IRS issued new temporaryregulations clarifying the application of the leg-out rules incases where one of an interest rate or FX swap wasselectively terminated, where the other hedge remained inplace. In such cases, the taxpayer is deemed to dispose ofall legs of all hedges, as well as the DI, on the leg-out date.Example. TP enters a qualifying DI, interest rate swap, andFX swap and elects integrated treatment. On a dispositionof the FX swap, the TP’s net gain or loss is determined byreference to the DI, the FX swap and the interest rate swap,and not solely the FX swap and the DI.(d)In the case of a hedged executory contract, the hedge must beentered after the executory contract is entered into and before theaccrual date, and must hedge all exposure at least through theaccrual date of the payable or receivable. By contrast to the rulesgoverning debt instruments, there is no leg-in on entry of a hedgeduring the executory contract period because the exposure on thecontract is otherwise ignored for tax purposes until the accrualdate.(5) Identification rules.(a)(b)Taxpayer must make a contemporaneous identification of theinstrument on the date of the hedge when the financial instrumentis entered into that clearly identifies the integrated transaction.IRS discretion to integrate if, based on the facts and circumstances,the transaction “is in substance hedged.” The IRS discretionapplies even if the two instruments are held by different taxpayersand cannot satisfy the requirements for hedge treatment. See Regs.§§ 1.988-5(a)(8)(iii) and 1.988-5(b)(3)(ii).(6) Private letter ruling option (§ 1.988-5(e)).55© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(a) PLR 200813026. IRS granted a PLR allowing integratedtransaction treatment for anticipatory hedging program used tohedge taxpayer’s expected currency exposure under master supplyagreements.B. § 1221(b)(2) hedging transactions.(1) Reg. § 1.1221-2(b) allows the taxpayer to hedge currency exposure withrespect to—(a)“Ordinary property”(i)(ii)Reg. § 1.1221-2(c)(2) defines as property that could onlygive rise to ordinary income or loss under anycircumstances.Issue as to whether a § 988 loan receivable constitutes“ordinary property,” if the loan itself is held as a capitalasset. In this case, the hedge relates to the FX exposure(which is ordinary), but embedded in a larger capitaltransaction. Cf. § 1.954-2(a)(4)(ii)’s expansion of§ 1221(b)(2)’s definition of ordinary property to include,inter alia, § 988 transactions.(b)Borrowings and “Ordinary Obligations” of the Taxpayer.(i)“Ordinary obligations” are defined as those obligations, theperformance or termination of which could not give rise tocapital gain or loss in any circumstances. See § 1.1221-2(c)(2).(c)Proper and timely identification must be made (§ 1.1221-2(f)).(i)(ii)(iii)(iv)Financial instrument must be identified as a hedge whenentered into.Underlying transaction must identified as part of the hedgeon a “substantially contemporaneous” basis (within 35 daysof entering the financial instrument).Reg. § 1.1221-2(f)(4)(ii) – unambiguous ID for taxrequired. ID for Financial accounting purposes does notsatisfy this requirement, unless the records indicate that theID is also being made for tax purposes.Examples of Forms of ID:56© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

All instruments in a particular account; all instruments of aparticular type; all instruments identified with a particularlegend or designation.§ 1256(e)(2) ID also satisfies § 1221(b)(2), althoughapparently not the other way around.(d)Killer Rule (Reg. § 1.1221-2(g)).(i)(ii)To prevent selective ID with the benefit of hindsight, if theTP makes an inadvertent ID, that is binding to treat gain asordinary. Losses remain capital. However, the taxpayercan obtain capital gain for any gains if the taxpayerestablishes inadvertent error for the improper ID. Thetaxpayer must treat all transactions consistently with theerror on original or amended returns.Conversely, failure to identify is binding to treat both gainsand losses as capital, unless the taxpayer establishes therequirements of inadvertent error.(e)Inadvertent error.(i)(ii)Does § 1256(e)’s hedging exception incorporate theinadvertent error rule under § 1221(b)(2)? Compare CCA201034018 (Apr. 20, 2010) (no inadvertent error exceptionin § 1256(e)) with CCA 201046015 (July 14, 2010)(revising this advice regarding the same taxpayer).However, in the latter CCA, the IRS ultimately concludedon the facts that the taxpayer’s inadvertent error exceptionwas not satisfied.The above CCAs also provide good background on thetypes of facts that will relevant in analyzing whether thetaxpayer’s failure to identify was attributable to inadvertenterror. See also PLR 201142020, fn. 7 (advising onimportance of prior year treatment in assessing inadvertenterror).(f)Capital v. Ordinary Treatment under § 1221(b)(2) Not Critical.Since § 988 generally deems gains or losses from § 988transactions to be ordinary, obtaining ordinary treatment under§ 1221 is not necessary. Conversely, character of the gain or lossfor subpart F purposes, by contrast, may be more significant.(2) Timing of Gains and Losses on FX Hedges.57© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(a)(b)(c)(d)Reg. § 1.446-4 provides the tax accounting principles applicable togain or loss from hedging transactions, as described in Reg.§ 1.1221-2(b), whether or not the character from such transactionis provided under the rules of § 1221(b)(2).Rules are set forth depending on the type of transaction. Forexample: hedges of debt instruments give rise to yield adjustments;hedges of FX exposure on inventory may be rolled into inventoryaccounting; etc.Recordkeeping must be maintained to describe the taxpayer’shedge accounting methods. Reg. § 1.446-4(d). If book principlesare followed, presumably financial accounting records may sufficefor this purpose.Failure to ID may not always be fatal. The IRS has interpreted thetiming rules to be mandatory for all hedging transactions describedin § 1221(b)(2). See Rev. Rul. 2003-127; see also, e.g., PLR200510028 (Dec. 17, 2004).(i)The IRS has argued that this position will not be applied tocertain § 1256 contracts for which no ID is providedpresumably on the theory that § 1256 is mandatory, failingan identification out under § 1256(e). See CCA 201024049(June 9, 2009); ECC 201034018.Thus, the principal question for timing purposes appears to bewhether the hedged FX risk relates to § 1221(b)(2) property. If so,hedge timing (deferral of both gains and losses) should follow. Ifnot, then the straddle rules would defer losses, but requireimmediate recognition of gains under § 1001 and § 1256.(e)Reg. § 1.954-2(g)(4) election.(i)(ii)Causes all FX gains and losses of the electing CFC from§ 988 transactions and § 1256 contracts (which wouldotherwise be commodities transactions) to be taken intoaccount as passive basket subpart F income. Previously, inthe 1988 temporary regulations, the election was mandatoryfor all of the taxpayer’s CFCs. See Former Reg. § 4.954-2(g)(5).Benefit of election is to allow FX losses to be fully utilizedin reducing other categories of passive FPHC income. Inthe case of certain financial entities, the election may havesome benefits in avoiding any issues from “trapped losses.”58© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

(iii)Detriment of election is waiver of business needs exception– election also is one-time and irrevocable.C. Hedges of Investment in an Entity’s Balance Sheet.(1) Financial accounting rules generally allow balance sheet / net investmenthedges to be recorded as an adjustment to the translation of a subsidiary’searnings. Thus, hedging gains and losses would be deferred.(2) Tax treatment of hedges of a CFC’s stock.(a)Authorities on Ordinary vs. Capital.(i)(ii)Hoover Co. v. Commissioner, 72 T.C. 206 (1979) – losseson hedges of taxpayer’s net investment in a subsidiary didnot constitute bona fide hedges under pre-Arkansas Bestcase law. Accordingly, under pre-1986 Act law, theselosses produced capital losses.Barnes Group, Inc. v. United States, 697 F. Supp. 591 (D.Conn. 1988) – reaching same result under post-ArkansasBest law. Accordingly, the net investment hedges effectedthrough § 1256 contracts resulted in capital losses to thetaxpayer.(b)T.D. 8400 (1992) – revisiting the issue in the context of theintegrated transaction rules of § 1.988-5 and concluding thatbalance sheet hedges would not qualify for integrated treatment.(c) Prop. Reg. § 1.988-5(d) (1992).(i)If ever finalized, this proposed regulation would haveallowed integration of a hedge with respect to declared, butunpaid dividends and other qualified payments. Thiswould have been a limited example of cash flow hedgingunder the IRS regulations.(3) Hedges of a DRE’s Balance Sheet or Items Payable from a DRE.(a)Taxpayer may hedge a DRE’s net balance sheet, or may enter intoinvestment hedges of disregarded transactions from the DRE(royalties, interest). The item being hedged for financial statementpurposes will not exist for tax purposes. It would appear that therelevant inquiry is whether the hedge of the underlying exposuresof the DRE qualifies for § 1221(b)(2) / bona fide hedgingtreatment.59© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com

60© 2013 William R. Skinner, Esq.Fenwick & West LLPwrskinner@fenwick.com