International Tax Aspects of Foreign Currency Transactions

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