Starting in 2018, taxpayers will be subject to new regulations under Code Section 987 that pertain to foreign branch operations of a U.S. taxpayer where utilization of a functional currency is different than the one used by the taxpayer. Under the new regulations, the manner in which currency translation adjustments are incorporated into taxable income may have significant tax and financial reporting implications, including the fact that certain unrealized net gains and losses may disappear.
These changes will impact U.S. taxpayers with foreign flow-through entities or other foreign branch operations (referred to as qualified business units, or QBUs). U.S. taxpayers may have direct ownership of foreign QBUs, or may have ownership determined through Section 987 aggregate partnerships that exist generally when all partners are related. Generally excluded from the new regulations are banks, insurance companies, leasing companies, regulated investment companies, real estate investment trusts, estates, trusts, S corporations, and partnerships with unrelated partners.
Adoption of the new regulations, which take effect Jan. 1, 2018, will require the fresh start transition method to be used, which would eliminate any unrealized net gains or losses from foreign QBUs. Temporary regulations published along with the final regulations may also affect an entity’s ability to terminate existing QBUs for tax reporting purposes. Entities with unrealized losses from foreign QBUs should be prepared for the changes, where the deferred tax benefit from such losses could be lost permanently.
Income generated by a flow-through entity (such as a foreign QBU) is ultimately taxable to its parent company. When the income generated is measured in a different currency, Section 987 guidance comes into play. Taxpayers subject to Section 987 calculate taxable income or loss for each foreign QBU in the functional currency of the foreign QBU, and then translate the foreign income/loss using the parent company’s currency, typically using the balance sheet date (spot) exchange rate. Adjustments are then made for exchange rate fluctuations during the reporting period.
Proposed regulations released in 1991 sought to update the translation calculations by requiring profit or loss in the foreign currency be converted to the parent company’s currency using a weighted average exchange rate for the tax year. The proposed regulations also provided that unrecognized gains or losses would be taxed when they were remitted from the foreign QBU to the owner, or when the foreign QBU terminated.
New proposed regulations were released in 2006 that superseded the 1991 proposed regulations and adopted a different approach with respect to the currency translation calculations—mainly through the use of a foreign exchange exposure pool (FEEP). Under the 2006 proposed regulations, the translation of income or loss would be calculated using the average tax year exchange rate (similar to the 1991 proposed regulations). However, income and deductions related to depreciation and amortization with respect to “historic assets” would be translated at the historic rates for those assets. In addition, the adjusted basis and amount realized in connection with “marked” (i.e., monetary) assets of a foreign QBU would be translated at a spot rate. If those marked assets were acquired in a previous year, the spot rate would be based on the closing balance sheet date of that year.
The 2006 proposed regulations used a balance sheet method for determining whether exchange rate changes produced a gain or loss. Parent companies would not be taxed on the gain or loss until the foreign QBU made a remittance to the parent company and then taxes would be calculated based on a portion of the pooled exchange gain or loss.
In the absence of final regulations, many companies used methodologies from both the 1991 and 2006 proposed regulations to comply with Section 987.
New Section 987 Guidance
Final and temporary regulations published on Dec. 8, 2016 update prior methodologies, defining rules for determining income or loss of a foreign QBU as well as rules for determining the timing, amount, character and sources of the Section 987 gain or loss that the parent company recognizes. They generally adopt the 2006 proposed regulations without significant changes to the accounting for Section 987 arrangements.
Temporary regulations affect the recognition and deferral of Section 987 gains or losses resulting from foreign QBU terminations and outbound loss events. All taxpayers will be affected, including financial institutions, non-Section 987 aggregate partnerships, S corporations and trusts.
The temporary regulations affect transactions on or after Jan. 6, 2017, but they can apply as early as Dec. 7, 2016, to any transaction undertaken with the principal purposes of a recognizing a Section 987 loss. Among the situations subject to the temporary regulations are the following:
- A transfer of a foreign QBU’s assets to a successor foreign QBU that is owned by the same controlled group in defined “deferral transactions.” In this instance, both Section 987 gains and losses of the transferor can be deferred until the successor foreign QBU makes remittance to its owner.
- The recognition of Section 987 losses can no longer be accelerated by a contribution of assets of the foreign QBU by one member of a U.S. consolidated group to another member of the group.
- Section 987 losses are disallowed when a foreign QBU’s assets are transferred by a U.S. owner to a foreign corporation that is a member of the same controlled group. The disallowed loss can increase the basis of the shares received in exchange for the transfer.
Effective Date and Transition Challenges
Taxpayers may adopt the new regulations early to apply them to any tax year beginning after Dec. 7, 2016. Otherwise, the new regulations are applicable to tax years beginning on or after one year after the first day of the first taxable year following Dec. 7, 2016 (i.e., generally applicable beginning with the 2018 calendar year).
Although the 2006 proposed regulations allowed entities to choose between the deferral transition method and a fresh start transition method, entities are required to use the fresh start method under the final regulations. Under the mandatory fresh start transition, all foreign QBUs that have not already implemented the 2006 proposed regulations will be terminated the day before the effective date of the new regulations. No Section 987 gains or losses deferred on the termination date are permitted to be recognized. Consequently, pre-existing Section 987 gains and losses will be eliminated without producing a tax benefit.
Taxpayers utilizing procedures under the 2006 proposed regulations are subject to other rules and exceptions for the transition to the final regulations. It may not be necessary or appropriate for these taxpayers to use the fresh start method, but taxpayers must consider other nuances of the transition from the 2006 proposed regulations to the final regulations in order to make a proper determination.
As a result of the final Section 987 regulations, taxpayers need to evaluate the implication of these rules from both the tax and financial statement perspective as a significant portion of deferred tax benefits on unrealized losses may be lost. Compliance with the new regulations may require tracking of foreign QBU assets and liabilities and application of deferral rules to internal transactions. There are several elections included in the final regulations to mitigate the potential complexity or administrative burden of associated compliance, such as the early adoption election, the annual deemed termination election, the Section 987 grouping election and certain exchange rate elections.
Taxpayers that own a foreign QBU must maintain copies of these elections and maintain records that support the foreign QBU’s taxable income or loss and any Section 987 gain or loss. Implementation of these rules will be a complex and time-consuming endeavor. Therefore, it is important that taxpayers begin their assessment of the impact these regulations will have on their businesses before the 2018 effective date.
For more information on the impact that these regulations will have on your business, please contact your local CBIZ tax professional.
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