The functional currency of a QBU that is not required to use the dollar will be the currency of its economic environment in which a significant part if its activities are conducted, provided the QBU keeps its books and records in that currency. The economic environment in which a significant part of a QBU’s activities are conducted is a facts and circumstances determination. These facts and circumstances may include, among others, the currency of the country in which the QBU is a resident, the principal currency of the QBU’s cash flows, the principal currency in which the QBU generates revenues and incurs expenses, the principal currency in which the borrowing or lending of the QBU is conducted, the currency of the QBU’s principal sales market, the duration of the QBU’s business operations, and the significance or volume of the QBU’s independent activities. If, for purposes of generally accepted accounting principles (GAAP), a determination of functional currency is made based on these same facts and circumstances, that currency ordinarily will be accepted as the functional currency for income tax purposes.
A QBU is presumed to keep books in the currency of the economic environment in which a significant part of its activities are conducted. This presumption may be overcome by demonstrating to the satisfaction of the District Director of the IRS that a substantial nontax purpose exists for not keeping any books and records in the currency of that environment. A QBU that has more than one currency that satisfies the functional currency tests may choose any such currency as its functional currency.
A foreign corporation that has more than one QBU, all of which do not have the same functional currency, will be treated as having a single functional currency as a whole that may be different from the functional currency of one or more of its QBUs. The determination of such a corporation’s functional currency is done by applying the following two steps: (a) determine the functional currency of each QBU and (b) determine the functional currency of the foreign corporation as a whole.
The income or loss of a foreign corporation with one or more of its QBUs having a different functional currency is determined by calculating the income or loss, or earnings and profits, or deficit in earnings and profits, of each QBU in its functional currency using the profit-and-loss method described in Section 987. The amount of each QBU’s income or loss, or earnings and profits, or deficit in earnings and profits, is then translated into the foreign corporation’s functional currency using the appropriate exchange rate for determining the corporation’s income or earnings and profits.
Notice to amend final Section 987 regulations
Notice 2017-57 announced that the Treasury and the IRS intend to amend the regulations under Section 987 to defer the applicability date of the final regulations, as well as certain provisions of the temporary regulations, under Section 987 by one year. The final regulations under Section 987 were identified in Notice 2017-38 as significant tax regulations requiring additional review pursuant to Executive Order 13789.
On January 9, 2017, the Treasury Department and the IRS published Treasury Decision 9794, which contains final regulations relating to the determination of the taxable income or loss of a taxpayer with respect to a QBU subject to Section 987 (a Section 987 QBU); the timing, amount, character, and source of any Section 987 gain or loss; and other regulations (the final regulations). On that same date, Treasury Decision 9795 was published. The decision contains temporary regulations under Section 987, including the following: rules relating to the recognition and deferral of foreign currency gain or loss under Section 987 in connection with certain QBU terminations and certain other transactions; an annual deemed termination election for a Section 987 QBU; an elective method, available to taxpayers that make the annual deemed termination election, for translating all items of income or loss with respect to a Section 987 QBU at the yearly average exchange rate; rules regarding the treatment of Section 988 transactions of a Section 987 QBU; rules regarding QBUs with the U.S. dollar as their functional currency; rules regarding combinations and separations of Section 987 QBUs; rules regarding the translation of income used to pay creditable foreign income taxes; and rules regarding the allocation of assets and liabilities of aggregate partnerships for purposes of Section 987 (the temporary Section 987 regulations). Treasury Decision 9795 also contains temporary regulations under Section 988, requiring the deferral of certain Section 988 loss that arises with respect to related party loans.
Knowledge check
1 Section 987 gain or loss is recognized wheneverProperty of a QBU branch is transferred to another branch of a subsidiary of the U.S. business or when the branch terminates.The foreign QBU sends a remittance to the United States, and the exchange rate prevailing on the date of the remittance differs from the weighted average exchange rate for the tax year.The foreign QBU sends remittances to the United States.Both the first and second answer choices.
Sharp, Ltd., a foreign corporation organized in country X, is wholly owned by Palico, Inc., a domestic corporation. Sharp, Ltd. conducts all of its operations through two branches. Branch A is located in country A and branch B is located in country B. Sharp, Ltd., branch A and branch B are QBUs. The currency of country A is the Q and the currency of country B is the R. The functional currencies of Sharp, Ltd, branch A, and branch B are determined using a two-step process:
1 The functional currency of branches A and B. Branch A and branch B both conduct all of their activities in their respective local currencies. The Q is the currency of branch A and the R is the currency of branch B under GAAP. After applying the principles in the regulations, it is determined that the functional currency of branch A is the Q and the functional currency of branch B is the R.
2 The functional currency of Sharp, Ltd. Sharp, Ltd.’s functional currency is determined by disregarding the fact that A and B are branches. When A’s activities and B’s activities are viewed as a whole, Sharp, Ltd. determines that it conducts only significant activities in the R. Therefore, Sharp, Ltd.’s functional currency is the R.
During the current year, branch A had income of Q3,000 and branch B had income of R50,000 as determined under Section 987. The weighted average exchange rate for the year is Q1 = R20. Branch A’s income is translated into R60,000 for purposes of computing Sharp, Ltd.’s income and earnings and profits for the year. Therefore, the total earnings and profits of Sharp, Ltd. from branch A and branch B is R110,000 (Treasury Regulation 1.985-1(f), examples (7) and (9)).
The use of a functional currency is treated as a method of accounting. Therefore, any change in the functional currency is treated as a change in the taxpayer’s method of accounting. Permission to change functional currencies generally will not be granted unless significant changes in the facts and circumstances of the QBU’s economic environment occur. If the principles used to determine the functional currency for GAAP are substantially similar to those required for income tax purposes, permission to change functional currencies will ordinarily not be granted unless the taxpayer also changes to the new functional currency for GAAP.
Election to use the dollar as functional currency of a qualified QBU
A QBU with a functional currency other than the U.S. dollar may elect to use the dollar as its functional currency subject to regulatory guidelines. The regulations state that only eligible QBU’s are permitted to make this election. An eligible QBU means a QBU whose functional currency is (without an election) a hyperinflationary currency (Treasury Regulation 1.985-2(b)(1)). A hyperinflationary currency is the currency of a country in which the cumulative inflation during a base period is at least 100%, as determined by reference to the consumer price index of the country