International Tax Aspects of Foreign Currency Transactions

(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