A Basic Overview of the Rules Governing Foreign Currency Conversions

We received a significant number of questions regarding computing the proper exchange rate for income tax reporting purposes. This article is designed to provide an overview regarding currency conversions for income tax purposes for select transactions.

Foreign Currency Translation

We will begin this article with a basic overview of the rules governing currency conversions in U.S. transactions conducted through corporations and related entities.

Under the basic rules governing cross-border transactions, a  taxpayer generally must make all of its U.S. tax determinations in its functional currency. A taxpayer’s functional currency is the U.S. dollar, except for a qualified business unit (“QBU”) that conducts a significant part of its activities in an economic environment in which a foreign currency is used and maintains its books and records in that foreign country. The foreign branches and subsidiaries of U.S. companies often conduct business and maintain their books and records in the currency of the host country. A corporation is always considered to be a QBU. In addition, a branch of a corporation can qualify as a QBU if the branch is a separate and clearly identified unit of a trade or business of the corporation for which separate books and records are maintained. See IRC Section 989(a).

Whether a branch operation constitutes a separate trade or business of the corporation is a question of fact. For this purpose, a trade or business is a specific unified group of activities that constitutes an independent economic activity carried on for profit. This group of activities ordinarily includes every operation which is part of the process by which an enterprise earns a profit, including the collection of income and the payment of expenses. Unlike a corporation, an individual is not a QBU. Moreover, activities of an individual conducted as an employee do not constitute a QBU. However, activities of an individual conducted as a sole proprietor do constitute a QBU if they satisfy the separate trade or business and separate books and records requirements discussed above.

Functional Currency

A QBU’s functional currency is the dollar, unless the QBU conducts a significant part of its activities in which a foreign currency is used and maintains its books and records in that foreign currency. See IRC Section 985(b)(1). For this purpose, a QBU is presumed to keep its books and records in the currency of the economic environment in which a significant part of its activities are conducted. The taxpayer must consider all of the facts and circumstances in identifying the relevant economic environment, including the currency of the country in which the QBU is a resident, as well as the currencies in which the QBU realizes its cash flows, generates its expenses, borrows and lends, sells it products, and makes its pricing and other financial decisions. If a QBU has more than one currency that satisfies these requirements, then the QBU may choose any of those currencies as its functional currency.

Special rules apply to any QBU that would otherwise be required to use a hyperinflationary currency as its functional currency. Such QBUs must use the U.S. dollar as their functional currency and must compute their taxable income (and earnings and profits) using the dollar approximate separate transactions method. See Treas. Reg. Section 1.985-1(b)(2)(ii)(A). A hyperinflationary currency is defined as the currency of a foreign country in which there is a cumulative compounded rate of inflation of at least 100% during the 36-month period immediately before the start of the current taxable year. See Treas. Section 1.985-1(b)(2)(ii)(D).

Foreign Income Taxes

Taxpayers that account for foreign taxes on an accrual basis generally should translate foreign income taxes accrued into U.S. dollars at the average exchange rate for the tax year to which the taxes relate. However, this rule does not apply to (1) foreign taxes actually paid more than two years from the close of such tax year; (2) foreign taxes paid in a tax year prior to the year to which they relate; and (3) foreign taxes paid in a hyperinflationary currency. All foreign taxes not accounted for on the accrual basis must be translated using the exchange rate on the date of the payment. In addition, any adjustment to the amount of the taxes is translated using the exchange rate at the time the adjustment is paid to the foreign country. In the case of any refund or credit of foreign taxes, taxpayers must use the exchange rate in effect at the time when the original payment of the foreign taxes was made. However, the IRS has the authority to issue regulations that would allow these foreign tax payments to be translated into U.S. dollar amounts using an average exchange rate for a specified period. IRC Section 986(a). The Internal Revenue Code permits a taxpayer to make an election to translate foreign income taxes paid on an accrual basis using the exchange rate on the particular date of the foreign income tax accrual.

Under Internal Revenue Code Section 986, a taxpayer that uses the accrual method to account for foreign taxes for purposes of the foreign tax credit generally translates foreign income taxes accrued into U.S. dollars at the average exchange rate for the tax year to which the taxes relate (rather than at the exchange rate for the date of payment). See IRC Section 986(a)(1)(A). This rule does not apply to 1) any foreign income taxes paid more than two years after the close of the tax year to which the taxes relate; 2) any foreign income taxes paid before the start of the tax year to which the taxes relate; or 3) any foreign income taxes the liability for which is denominated in any inflationary currency. This rule also does not apply to a taxpayer that uses the cash method to account for foreign taxes. All foreign taxes that do not qualify for translation at the average exchange rate for the year must be translated at the exchange rate in effect for the date of payment of the taxes to the foreign country. See IRC Section 986(a)(2)(A).

The 2004 JOBS Act added Section 986(a)(1)(D) to the Internal Revenue Code. Section 986(a)(1)(D) provides an election for a taxpayer that otherwise is required under Internal Revenue Code Section 986(a)(1)(A) to translate foreign taxes into U.S. dollars using the average exchange rate for the tax year. This election applies to “any foreign income taxes the liability for which is denominated in any currency other than in the taxpayer’s functional currency.” Under this provision, such a taxpayer may elect to use the exchange rate at the time that the foreign taxes are paid instead of the average exchange rate for the tax year. Once made, the election applies to the tax year for which it was made and all later tax years unless revoked with the Service’s consent.

If the foreign income tax paid differs from the amount of foreign tax accrued or if the foreign income tax is fully or partially refunded, the taxpayer must notify the IRS, which will redetermine the taxpayer’s U.S. tax liability. See IRC Section 905(c)(1)(A). A redetermination will also take place for any portion of accrued foreign taxes that remain unpaid more than two years after the close of the tax year to which the taxes relate. However, if the foreign income tax is paid within the two-year period, no redetermination will be made even though the actual U.S. dollar value of the foreign tax paid may differ from the accrued amount due to foreign currency fluctuations. See IRC Section 986(a)(1).

What Happens if Foreign Taxes are Refunded or Credited by a Foreign Country?

If foreign taxes are refunded or credited to the taxpayer by a foreign country, the redetermined amount of foreign taxes paid must be translated into U.S. dollars using the exchange rate as of the exchange rate as of the date of the original payment of the foreign taxes. See IRC Section 986(a)(2)(B)(ii). In the case of a direct foreign tax credit, accrued foreign income taxes paid more than two years after the close of the tax year to which the taxes relate are taken into account for the tax year to which the taxes relate, but are translated using the exchange rates in effect as of the time of the payment of the taxes.

For example, suppose that DC, a domestic corporation that uses the accrual method for foreign tax credit purposes accrues in year 1 100 units of foreign tax owing to Country Y. Country Y’s currency is not inflationary. The year 1 Country Y foreign tax is unpaid at the end of year 1. DC does not make an election under Section 986(a)(1)(D). Under Section 986(a)(1), DC translates the 100 units of Country Y foreign tax into U.S. dollars using the average exchange rate of year 1. If DC pays 100 units of Country Y foreign tax in year 2 or year 3, DC is not required to redetermine its foreign tax for year 1 even if the dollar value of the foreign tax paid differs from the accrued amount due to foreign currency fluctuations. If, however, any portion of the accrued Country Y tax for year 1 remains unpaid as the end of year 3, DC must redetermine its accrued foreign tax under Section 905(c) for year 1 to eliminate the accrued but unpaid Country Y tax and reduce its foreign tax credit. If DC pays the disallowed tax in year 4, DC must again redetermine its Country Y foreign tax and foreign tax credit for year 1, but the year 1 tax paid by DC in year 4 is translated into U.S. dollars using the exchange rate in effect for the date of payment in year 4. See H.R. Conf. Rep. No. 220, 105th Cong., 1st Sess. 614-15 (1997).

The Tax Consequences of Foreign Transactions Involving Gains and Losses

Special rules apply for purposes of determining the amount, timing, character, and source of currency exchange gains and losses associated with Section 988 transactions. Section 988 transactions include the following:

(i) Dispositions of a nonfunctional currency, and

(ii) The following three categories of transactions were the amount the taxpayer is entitled to receive or required to pay is denominated into nonfunctional currency:

(a) Debt instruments- This includes transactions where the taxpayer lends or borrows funds through the use of a bond, debenture, note, certificate, or other evidence of indebtedness.

(b) Receivables and payables- This includes transactions where the taxpayer accrues an item of income or expense which will be received or paid at a future date, including a payable or receivable relating to a capital expenditure.

(c) Forward, future, and option contracts- This includes transactions where the taxpayer enters into or acquires a forward contract, futures conduct, option, warrant, or financial instrument. A forward contract is an agreement to buy or sell a given amount of foreign currency on a future date at a specified exchange rate. A futures contract is to buy or sell foreign currency that is traded on a futures exchange. A contract option gives the holder the right to buy or sell a given amount of currency at a specified exchange rate prior to the contract’s expiration date.

The entire amount of gain or loss arising from disposition of nonfunctional currency is treated as an exchange or loss. The same is true of any gain or loss arising from a currency forward, futures, or option contract. In contrast, gain or loss arising from a transaction involving a debt instrument,receivable, or payable is treated as an exchange gain or loss only to the extent it is attributable to a change in exchange rates that occurs between the transaction’s booking date and the payment date. For this purpose, the payment date is the date on which funds are borrowed or lent in the case of a debt instrument or the date on which the item is accrued in the case of a receivable or payable.

Fixing the Exchange Rate

To implement the premises of the foreign currency rules, it is always necessary to determine an appropriate exchange rate. This task is not easy in an era of constantly fluctuating exchange rates. It is particularly difficult when rates have changed frequently over a long period of time. In the case of transactions of a taxpayer, other than a QBU using a foreign functional currency, the translation of foreign currency into dollars is made using the “spot rate” on the date of the transaction. See Treas. Reg. Section 1.988-2. In the case of a QBU using a foreign functional currency, Section 989(b) provides the “appropriate exchange rate” as follows:

1) In the case of an actual dividend distribution from a corporation, the “spot rate” on the date that the distribution is included in income;

2) In the case of a sale or exchange of stock in a foreign corporation treated as a dividend under Section 1248, the spot rate on the date that the deemed dividend is included in income.

3) In the case of any other QBU of a taxpayer, the average exchange rate for the tax year of the QBU.

Transactions in a foreign currency of a taxpayer, other than a QBU using a foreign functional currency, must be translated into dollars on a transaction-by-transaction basis. Most of these transactions in a business context are governed by Section 988 of the Internal Revenue Code.

Conclusion

For U.S. income tax purposes, a taxpayer’s gross income, deductions and tax liability are generally measured and determined in U.S. dollars. Foreign currencies are treated in effect as another form of noncash property, the value of which must be reflected as income, deductions or credits in U.S. dollars equivalents when calculating the taxpayer’s U.S. income tax liability. Because foreign currencies are treated as noncash property, the tax consequences of owning and disposing of foreign currencies may involve the realization of gains and losses in respect of them. Taxpayers that have gains or losses in foreign currencies either individually or through a related entity should consult an international tax attorney to determine the U.S. tax consequences of these gains and losses.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is a frequent author and speaker on international tax topics.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.