By Anthony Diosdi
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. This creates a currency translation problem for the domestic parent corporation, which must restate into U.S. dollars the results from its foreign operations. Tax attributes that require translation include the taxable income or loss of a foreign branch, earnings remittances from a foreign branch, actual and deemed distributions from a foreign corporation, and foreign income taxes. Foreign currency translation would be the only issue if currency exchange did not fluctuate. However, the U.S. dollar floats freely against other currencies, and this results in currency exchange gains and losses on assets and liabilities denominated in other currencies. Translational exchange gains and losses arise when a foreign branch or subsidiary that has a functional currency other than the U.S. dollar repatriates earnings that were previously taxed to the U.S. parent and the exchange rate has changed since the parent included those earnings in U.S. taxable income. Transactional exchange gain and losses arise when, for example, a U.S. company enters into a transaction denominated in a foreign currency and the exchange rate fluctuates between the time the transaction is entered into and the time the transaction closes.
Determining the Functional Currency
A taxpayer generally must make all of its U.S. tax determination in its functional currency. A taxpayer’s functional currency is the U.S. dollar, except for a qualified business unit or (“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 currency. 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.
Whether a branch operation constitutes a separate trade or business of the corporation is a question of fact. A trade or business for this purpose generally “is a specific unified group of activities that constitutes (or could constitute) an independent economic enterprise entered into for profit” if the expenses related to the activities are deductible under Internal Revenue Code Sections 162 or 212. To be a trade or business for this purpose, “a group of activities must ordinarily include (1) every operation which forms a part of, or a step in, a process by which an enterprise may earn income or profit and (2) the collection of income and the payment of expenses.” A vertical, functional or geographic division of the same trade or business may qualify as a trade or business, and, hence, a separate QBU. An individual is generally not a QBU and must, therefore, use the dollar as the functional currency.
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 the rates have changed frequently over a long period of time and the profit and loss method is applied.
In the case of transactions of a taxpayer, other than a QBU using a foreign functional currency, the transaction of foreign currency into dollars generally 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, Internal Revenue Code Section 989(b) provides that the “appropriate exchange rate” means:
1) In the case of actual dividend distribution from a corporation, the “spot rate” on the date that the distribution is included in income. See IRC Section 989(b)(1);
2) In the case of a sale or exchange of stock in a foreign corporation treated as a dividend under Internal Revenue Code Section 1248, the spot rate on the date that the deemed dividend is included in income. See IRC Section 989(b)(2);
3) In the case of constructive dividend inclusions, the average exchange rate for the tax year of the foreign corporation. See IRC Section 989(b)(3).
4) In the case of any other QBU of a taxpayer, the average exchange rate for the tax year of the QBU. See IRC Section 989(b)(4).
The Income Tax Regulations define “spot rate” as one “demonstrated to the satisfaction of the Internal Revenue Service (“IRS”) to reflect a fair market rate of exchange available to the public for currency under a spot contract in a free market and involving representative amounts.” In the absence of such a showing by the taxpayer, the Income Tax Regulations permit the IRS to make a determination in its “sole discretion.” See Treas. Reg. Section 1.988-1(d)(1); Taxation of International Transactions,Thompson West (2006), Charles H. Gustafson, Robert J. Peroni, Richard Crawford Pugh.
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. 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 percent during the 36-month period immediately before the start of the currency taxable year. Hyperinflationary currency creates significant problems with the conventional methods for translating the results of a foreign operation into U.S. dollars. For example, in a hyperinflationary environment, these conventional methods do not provide an accurate comparison of current-year inflated revenues to the costs of prior-year investments in property, plant, and equipment. The dollar approximate separate transaction method attempts to mitigate these problems by translating the QBU’s taxable income (and earnings and profits) on at least a monthly basis, and by annually recognizing certain unrealized exchange gains and losses. The adoption of a functional currency is treated as a method of accounting. As a consequence, the functional currency used in that year of adoption must be used for all subsequent taxable years unless permission to change is granted by the IRS.
Receipt of Income in Foreign Currency
When income is received by a cash method taxpayer in the form of foreign currency, there is no need to apply special rules. Income under Internal Revenue Code Section 61 is equal to the dollar value at the spot rate of the foreign currency at the time it is received. When income is received in a foreign currency by an accrual method taxpayer, such as a corporation, the same principle applies at the time of the accrual. However, when the account receivable is in fact collected, the dollar value may differ from the amount accrued as income. Any difference between the amount reported as income and the dollar value of the foreign currency at the time it is collected will be treated as a foreign currency gain or loss.
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 a 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 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.
Foreign Currency Contracts
Special rules apply for purposes of determining the amount, timing, chapter, and source of currency exchange gains and losses under Internal Revenue Code Section 988. Section 988 transactions include the following:
1) dispositions of a nonfunctional currency, and
2) The following three categories of transactions where the amount the taxpayer is entitled to receive or required to pay is denominated in a nonfunctional currency:
a) Debt instruments– this includes transactions where the taxpayer lends or borrows funds through the use of a bond, debenture, note, certification, 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 data, including a payable or receivable relating to capital expenditure.
c) Forward, futures, and option contracts- This includes transactions where the taxpayer enters into or acquires a forward contract, futures contract, option, warrant, or similar financial instrument.
However, Internal Revenue Code Section 988 transactions do not include regulated futures contracts and non-equity options, any transaction entered into by an individual unless the transaction is related to a business or investment activity, and certain transactions between or among a taxpayer and/or QBUs of that taxpayer.
The entire amount of gain or loss arising from a disposition of a nonfunctional currency is treated as an exchange gain or loss. The same is true of any gain or loss arising from a currency forward, futures, or option contract. In contrast, a 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 payment is made or received, whereas the booking 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.
A special rule applies to simplify the accounting for trade receivables and trade payables. If an average exchange rate is consistent with the taxpayer’s financial accounting, the taxpayer can elect to use it, based on intervals of one quarter year or less, to both accrue and record the receipt and payment of amounts in satisfaction of trade receivables and payables that are denominated in a nonfunctional currency. For example, a taxpayer may use the average exchange rate for the month of January to accrue all payables and receivables incurred during January. The same average rate also would be used to record all payments made and amounts received in satisfaction of payables and receivables during January.
Amount and Timing of Taxable Gains and Losses
The taxation of exchange gains and losses is based on the premise that, for U.S. tax purposes, only U.S. dollars are money. As a consequence, currencies other than the U.S. dollar are treated as “property” that has a tax basis independent of its specific denomination. One implication of this approach is that exchange gains and losses arising from a Section 988 transaction involving debt instruments, receivables, or payables generally are accounted for separately from the gain or loss on the underlying transaction. For example,if a domestic corporation with the U.S. dollar as its functional currency makes a sale on an account that is denominated in a foreign currency, the gross profit from the sale is recognized separately from any exchange gain or loss on the receivable denominated in the foreign currency.
Below, please see Illustration 1 which demonstrates a Section 988 transaction.
Illustration 1.
USAco is an accrual basis, domestic corporation with the U.S. dollar as its functional currency. On January 1, USAco makes an export sale denominated in Kronor (K). The sales price is K2,000. The foreign customer remits the K2,000 on April 1 and USAco converts the K2,000 into U.,S. dollars on April 10. The kronor was worth $1.50 on January 1, $1.45 on April 1, and $1.43 on April 10. Therefore, on January 1, USAco recognizes sales revenues of $3,000 [K2,000 x $1.50]. In addition, because the kronor weakened against the dollar between the booking date (January 1) and the payment date (april 1), USAco realizes an exchange loss upon the collection of the receivable. The loss is $100, which represents the difference between the value of the kronor received in payment of $2,900 [K2,000 x $1.45] and USAco’s basis in the related account receivable of $3,000 [K2,000 x $1.50]. See Treas. Reg. Section 1.988-2(c)(2). USAco also must recognize an exchange loss upon converting the kronor into dollars. The loss is $40, which represents the difference between the amount realized from the sale of the kronor of $2,860 [K2,00 x $1.43] and USAco’s basis in the marks of $2,900 [K2,000 x $1.45]. See Treas. Reg. Section 1.988-2(a)(2)(i); Practical Guide to U.S. Taxation of International Transactions, CCH (2007), Robert J. Misery, Jr, Michael S. Schadewald.
Character and Source of Exchange Gains and Losses
Exchange gains and losses attributable to a Section 988 transaction are treated as ordinary income or loss and are sourced by reference to the residence of the taxpayer or the QBU of the taxpayer on whose books the underlying asset, liability, or item of income or expense is properly reflected. For purposes of this source rule, a U.S. resident is any corporation, partnership, trust, or estate that is a U.S. person, as well as any individual who has a tax home in the United States. An individual’s tax home is his or her regular or principal place of business, provided that an individual is not treated as having a tax home in a foreign country during any period in which the taxpayer’s abode is in the United States. A foreign resident is any corporation, partnership, trust, or estate that is a foreign person, as well as any individual who has a tax home in a foreign country. The residence of any QBU of the taxpayer is the country in which the QBU’s principal place of business is located.
Hedging Transactions
Special rules are provided for in the Internal Revenue Code with respect to “Section 988 hedging transactions.” To the extent provided in Treasury Regulation Section 1.988-5, such transactions are “integrated and treated as a single transaction” with the underlying transaction being hedged. Foreign currency gains or losses in such situations are, accordingly, merged with the results of the underlying transaction, the nature of which will normally determine the character and source of the overall gain or loss. A hedging transaction is one in which the taxpayer seeks primarily to reduce the risk of currency fluctuations with respect to property held or to be held by the taxpayer or with respect to borrowing or lending made or to be made by the taxpayer. Hedging transactions must, however, be identified as such to the IRS when they are initiated. A taxpayer cannot await the result of the transaction and then decide whether it is to be treated under the hedging rules.
A taxpayer can reduce or eliminate the currency exchange risk component of a transaction through the use of a variety of financial instruments, such as currency forward, futures, and options contracts.
Below, please see Illustration 2 which demonstrates a hedging transaction.
Illustration 2.
For example, on February 1, USAco, a domestic corporation, agrees to pay a Mexican supplier 600,000 pesos for the delivery of some raw materials on July 1. Also on February 1, SSA hedges against the currency exchange risk associated with the purchase agreement with a bank to buy 600,000 pesos for $100,000 on July 1. The forward contract effectively eliminates the currency exchange risk component of the purchase agreement by fixing the purchase price of the raw materials in U.S. dollars at $100,000. On July 1. The forward contract effectively eliminates the currency exchange risk component of the purchase agreement by fixing the purchase price of the raw materials in U.S. dollars at $100,000. Because there is no currency exchange risk associated with a fully hedged transaction, in certain circumstances a taxpayer is allowed to integrate the accounting for the hedge with the accounting for the underlying hedged transaction.
A hedge and hedged transaction qualify for integration treatment only if they meet the definitional requirements of a Section 988 hedging transaction. If these requirements are satisfied, the taxpayer can ignore the nonfunctional currency aspect of the transaction and account for the transaction as if it were denominated in the hedge currency, in which case no exchange gain or loss is recognized. Internal Revenue Code Section 988 includes the following three categories of hedging transactions:
1) Hedged debt instruments- This includes hedges associated with transactions in which the taxpayer lends or borrows funds through the use of a bond, debenture, note, certificate, or other evidence of indebtedness.
2) Hedged executory contracts for goods and services– Thus includes hedges involving executory contracts to pay or receive nonfunctional currency in the future with respect to the sale or purchase of property or services in the ordinary course of the taxpayer’s business.
3) Hedge of the period between the trade and settlement dates on the purchase or sale of a publicly traded stock or security.
Below, please see Illustration 3 for another example of a hedging transaction.
Illustration 3.
USA is an accrual-basis, calendar year domestic corporation with the dollar as its functional currency. On June 1 of the current year, USAco enters into a contract with a German steel manufacturer to buy steel for 200,000 euros for delivery and payment on November 1. USAco hedges against the currency exchange risk associated with this purchase agreement by purchasing 195,000 on June 1 and depositing them in a separate bank account. The account bears interest such that by November 1 the 195,000 have grown to 200,000. On November 1, USAco withdraws 200,000 from the bank account and makes payment in exchange for delivery of the steel. Assume the euro was worth $0.80 on June 1 and $0.85 on November 1 and had an average daily value of $0.82 between June 1 and November 1. The contract to purchase the steel and the simultaneous purchase of euros are part of a single economic transaction. In recognition of this fact, the tax law allow USAco to treat them as an integrated transaction if USAco satisfies certain requirements (e.g., USAco identifies the transaction as a hedging executory contract and deposits the euros in a separate account). Under this approach, USAco treats the $156,000 paid under the hedge (195,000 x $0.80) as an amount paid directly for the steel, and recognizes no gain or loss for the exchange rate fluctuation between June 1 and November 1. USAco treats the 5,000 of interest as part of the hedge and, using the average exchange rate for the interest accrual period to translate the interest into dollars, USAco recognizes interest accrual period to translate the interest into dollars, USAco recognizes interest income of $4,100 (5,000 x $0.82). Because the interest is part of the hedge, USAco recognizes no exchange gain or loss when the interest is used to purchase the steel. USAco’s basis in the steel is $161,100 ($156,000 + $4,100).
Branch Transactions
Internal Revenue Code Section 987 prescribes the regime for dealing with a foreign branch that is a QBU using a foreign functional currency. The basic approach is to determine profit of the foreign branch for the tax year in its functional currency and then to translate the profit and loss at the “appropriate exchange rate.” The appropriate exchange rate is the average exchange rate for the tax year. See IRC Section 989(b)(4). To determine the profit or loss of the branch, the branch should prepare a profit and loss statement from the branch’s books and records, make adjustments necessary to confirm the statement of U.S. tax principles and translate the amount shown on the adjusted statement into U.S. dollars at the average exchange rate for the tax year.
Foreign Subsidiaries
Internal Revenue Code Section 986 discusses the methods to translate earnings and profits of foreign affiliates of U.S. corporations that have a foreign functional currency. If an actual dividend is involved, the amount of the dividend and the amount of earnings and profits out of which it is paid in the foreign corporation’s foreign functional currency are translated into dollars at the spot rate on the date the distribution is included in the shareholder’s income.
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 noncash property, the value of which must be reflected as income, deductions, or credits in U.S. dollar equivalents when calculating the taxpayer’s U.S. income tax liability. The special rules set forth in Internal Revenue Code Sections 985 through 989 effectively prescribe methods of dealing with various circumstances in which currencies other than U.S. dollars are acquired or used in some way. In general, those rules undertake to provide methods for determining when gains and losses in respect of U.S. dollars will be recognized for tax purposes and for determining the character and source of any such gains and losses. If you are planning a cross-border transaction or transactions, make sure that you retain the services of an international tax attorney that understands how foreign currency is treated for U.S. tax purposes.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. 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.