By Anthony Diosdi
Internal Revenue Code Section 987 states the rule for dealing with a foreign branch that is a Qualified Business Unit (“QBU”) which utilizes a foreign functional currency. On December 6, 2019, the U.S. Department of the Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) announced Notice 2019-65 stating that they intend to amend the final Section 987 regulations. As of this date, the Treasury and IRS have yet to issue final regulations to Section 987. This means that in the meantime taxpayers must compute Section 987 gains or losses under a reasonable method. A reasonable method would be to utilize the regulations that were previously promulgated by the Treasury and the IRS.
This article will walk through a basic QBU foreign currency transaction utilizing the regulations previously promulgated by the Treasury and the IRS. To determine the profit or loss of a foreign branch, the branch prepares a profit and loss statement from the branch’s books and records, makes adjustments necessary to conform the statement to U.S. tax principles (called the “adjusted statement”) and translates the amount shown on the adjusted statement into U.S. dollars at the average exchange rate for the tax year. The branch must translate any amount shown on the adjusted statement attributed to actual dividends or deemed dividends under Internal Revenue Code Section 1248 into U.S. dollars at the spot rate when the amount is included income.
When there is a remittance from the foreign branch to the U.S. domestic parent corporation, the domestic corporation recognizes gain or loss to the extent that the dollar value of the foreign currency at the time of its remittance differs from its dollar value when earned. The Section 987 gain or loss represents the currency gain or loss attributable to the foreign branches’s undistributed earnings and capital.
To calculate Section 987 gain or loss on remittance, the domestic parent corporation may establish and maintain two pools (terminology used prior to the enactment of the 2017 Tax Cuts and Jobs Act) for the branch: the equity pool and the basis pool. The equity pool is the domestic parent corporation’s investment in the branch maintained in the branch’s functional currency. The basis pool is the domestic parent corporation’s in the foreign branch maintained in its functional currency. See Pro. Reg. Section 1.987-2(a)(1), (c).
The domestic parent corporation has Section 987 gain or loss on a remittance from the foreign branch to the extent that the amount of the remittance translated into U.S. dollars at the spot rate on the date of the remittance exceeds or is less than the portion of the basis pool attributable to the remittance. Expressed formulaically:
amount of remittance
(in the branch’s basis pool reduced
functional currency) x by prior
equity pool balance remittances
Reduced by prior
remittances
For example, assume that DC, a U.S. corporation, has the dollar as its functional currency. It operates a branch in Country M, which has the “p” as its functional currency. During year 1, DC transfers 4,000p to the branch when 2p = $1. Also, in year 1, DC transfers $2,000 to the branch when 3p = $1. As a result of these transfers, the DC’s equity pool in the branch is 10,000p and its basis pool is $4,000. During year 1, the Country M branch has a profit of 10,000p, which is translated into U.S. dollars at the average exchange rate of year 1 of 2p = $1, i.e., $5,000. Thus, DC’s equity pool in the branch is increased to 20,000p and its basis pool is increased to $9,000. In year 1, the Country M branch remits 5,000p to DC’s home when 2p = $1. DC has Section 987 gain to the extent of the amount of remittance into U.S. dollars at the spot rate on the date of remittance ($2,500) exceeds the portion of the basis pool that is attributable under the above formula:
5,000p x $9,000 = $2,250
20,000p
Consequently, DC’s Section 987 gain is $250, and DC has a basis of $2,500 in the 5,000p remitted. At the end of year 1, DC’s equity pool is 15,000p (20,000p , minus 5,000p remittance) and its basis pool is $6,750 ($9,000 minus the $2,250 portion of that pool attributable to the remittance). See example at pg. 726 Taxation of International Transactions, Thompson West, Charles H. Guastafson, Robert J. Peroni, and Richard Crawford Pugh (2006).
Conclusion
Until the Treasury and IRS promulgate regulations for Section 987, domestic parent corporations must compute Internal Revenue Code Section 987 gain or loss under a reasonable method. The basic approach is to determine profit or loss of the foreign branch for the tax year in its functional currency and then to translate the profit or loss at an “appropriate exchange rate.” This is typically the average rate for the tax year. Domestic parent corporations will also need to consider the effect of Section 987 gains or losses on its own Section 951A GILTI inclusions and subpart F income tax consequences.
We provide international compliance assistance and international tax planning services to domestic corporations. We also assist other tax professionals who need guidance regarding international tax compliance matters.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.