A Section 988 transaction includes a disposition of nonfunctional currency and certain transactions if the amount the taxpayer is entitled to receive or pay because of the transaction is denominated in terms of a nonfunctional currency or is determined by reference to the value of one or more nonfunctional currencies. These Section 988 transactions include the following:
The taxpayer disposes of nonfunctional currency, which includes coin, currency, nonfunctional currency-denominated demand or time deposits, and similar instruments issued by a bank or other financial institution. These transactions are treated as Section 988 transactions for the purpose of establishing the taxpayer’s basis in the currency and determining exchange gains or losses.
The taxpayer acquires a debt instrument or becomes an obligor under a debt instrument.
The taxpayer accrues or otherwise considers any item of expense or gross income or receipts that is to be paid or received after the date on which it is so accrued or considered.
The taxpayer enters into or acquires any forward contract, futures contract, option, or similar financial instrument (which includes a notional principal contract). This provision covers a forward contract, futures contract, option, warrant, or similar property only if the underlying property to which the instrument ultimately relates is a nonfunctional currency or is a payable or receivable. For example, a forward contract to purchase wheat denominated in a nonfunctional currency is not covered, whereas a forward contract to purchase a nonfunctional currency is covered (Treasury Regulation1.988-1(a)(2)(iii)(A)). A notional principal contract means an interest rate swap, cap, floor, collar, or similar financial instrument that provides for the payment of amounts by one party to another at specific intervals measured by interest rates and notional principal amounts in exchange for specific consideration or a promise to pay similar amounts. It also includes a currency swap.
Knowledge check
1 Regarding a Section 988 transaction, the booking date is notThe date of the acquisition.The date on which the taxpayer becomes the obligor.The date a position is entered into or acquired.The date on which payment is made or received.
Dispositions of nonfunctional currency
Recognition and computation of exchange gain or loss
Generally, the recognition of gain or loss upon the sale or other disposition of nonfunctional currency is governed by the recognition provision in the IRC that applies to the sale or disposition of property. With respect to Section 1031, a nonfunctional currency exchange is not considered “like kind” property. However, the following transactions are not considered recognition events:
An exchange of units of nonfunctional currency for different units of the same nonfunctional currency
The deposit of nonfunctional currency in a demand or time deposit, or similar instrument (such as a certificate of deposit [CD]) issued by a bank or other financial institution if such instrument is denominated in such currency
The withdrawal of nonfunctional currency from a demand or time deposit or similar instrument if such instrument is denominated in such currency
The receipt of nonfunctional currency from a bank or other financial institution from which the taxpayer purchased a certificate of deposit or similar instrument denominated in such nonfunctional currency, by reason of the maturing or other termination of such instrument
The transfer of nonfunctional currency from a demand or time deposit or similar instrument issued by a bank or other financial institution to another demand or time deposit or similar instrument denominated in the same nonfunctional currency issued by a bank or other financial institution.
X is a corporation on the accrual method of accounting, with the U.S. dollar as its functional currency. On January 1, 20X2, X acquires 1,500 British pounds for $2,250 (£1 = $1.50). On January 3, 20X2, when the spot rate is £1 = $1.49, X deposits the £1,500 with a British financial institution in a non-interest-bearing demand account. On February 1, 20X2, when the spot rate is £1 = $1.45, X withdraws the £1,500. On February 5, 20X2, when the spot rate is £1 = $1.42, X purchases inventory in the amount of £1,500. No exchange loss is realized until February 5, 20X2, when X disposes of the £1,500 for inventory. At that time, X realizes exchange loss in the amount of $120. The loss is not an adjustment to the cost of the inventory (Treasury Regulation 1.988-2(a)(1)(iv), example).
Exchange gain or loss realized from the sale or other disposition of nonfunctional currency is the difference between the amount realized and the adjusted basis of such currency. If, however, the taxpayer uses a spot rate conversion to determine exchange gain or loss with respect to a receivable, that taxpayer shall determine the adjusted basis for any nonfunctional currency received in satisfaction of the receivable in a consistent manner.
The exchange of nonfunctional currency for property is treated as (a) an exchange of nonfunctional currency for units of functional currency at the spot rate on the date of the exchange and (b) the purchase or sale of the property for such units of functional currency.
G is a U.S. corporation with the U.S. dollar as its functional currency. On January 1, 20X0, G enters into a contract to purchase a paper-manufacturing machine for 10,000,000 British pounds for delivery on January 1, 20X2. On January 1, 20X2, when G exchanges £10,000,000 (which G purchased for $12,000,000) for the machine, the fair market value of the machine is £17,000,000. On January 1, 20X2, the spot exchange rate is £1 = $1.50. The transaction is treated as an exchange of £10,000,000 for $15,000,000 and the purchase of the machine for $15,000,000. Accordingly, in computing G’s exchange gain of $3,000,000 on the disposition of the £10,000,000, the amount realized is $15,000,000. G’s basis in the machine is $15,000,000. No gain is recognized on the bargain purchase of the machine (Treasury Regulation 1.988-2(a)(2)(ii)(C), example).
Translations with respect to debt instruments
Interest income
Interest income that is received with respect to a demand account with a bank or other financial institution and that is denominated in (or whose payments are determined by reference to) a nonfunctional currency is translated into functional currency at the spot rate on the date received or accrued or pursuant to any reasonable spot rate convention consistently applied by the taxpayer to all taxable years and to all accounts denominated in nonfunctional currency in the same financial institution. For example, the taxpayer may translate interest received with respect to a nonfunctional currency demand account on the last day of each month of the taxable year, on the last day of each quarter of the taxable year, on the last day of each half of the taxable year, or on the last day of the taxable year. No exchange gain or loss is recognized on the receipt or accrual of the interest income.
Translated interest income or expense on Section 988 debt instruments when all payments are denominated in, or determined with reference to, a single nonfunctional currency is determined in units of nonfunctional currency and translated into functional currency at either the spot rate at the time of payment if accrual was not required or, if accrued, at the average rate (simple average of the spot rates) for the interest accrual period. For taxable years beginning after March 17, 1992, a taxpayer may elect to translate interest income and expense at the spot rate on the last day of the accrual period.
The holder of a debt instrument will realize gain or loss with respect to the accrued interest income on the date the accrued interest is received, or the instrument is disposed of. The amount of exchange gain or loss realized with respect to accrued interest