International Tax Alert - December 2016
International Tax Alert - December 2016
Final, Temporary and Proposed Regulations for Section 987 Qualified Business Units
The Department of the Treasury (“Treasury”) and the Internal Revenue Service (the “Service”) have issued Final, Temporary and Proposed Regulations under Internal Revenue Code (“IRC”) Section 987. The Final, Temporary and Proposed Regulations contain rules relating to the determination of the taxable income or loss of a taxpayer with respect to a qualified business unit (“QBU”) subject to Section 987, as well as the timing, amount, character, and source of any Section 987 gain or loss. The regulations also provide guidance on the recognition and deferral of foreign currency gain or loss under IRC Section 987 with respect to a QBU that has a different functional currency than that of its owner (a “Section 987 QBU”).
Section 987 generally provides that, when a taxpayer owns one or more QBUs with a functional currency other than the U.S. dollar and such functional currency is different than that of the taxpayer, the taxable income or loss of the taxpayer with respect to each QBU is determined by computing the taxable income or loss of each QBU separately in its functional currency and translating such income or loss at the appropriate exchange rate. Section 987 further requires the taxpayer to make “proper adjustments” (as prescribed by the Secretary) for transfers of property between QBUs having different functional currencies, including by treating post-1986 remittances from each such QBU as made on a pro rata basis out of post-1986 accumulated earnings and by treating Section 987 gain or loss as ordinary income or loss and sourcing such gain or loss by reference to the source of the income giving rise to post-1986 accumulated earnings. Section 989(b)(4) provides that, “[e]xcept as provided in regulations,” the appropriate exchange rate with respect to a QBU means “the average exchange rate for the taxable year” of the QBU. Additionally, Section 989(c)(5) directs the Secretary to “prescribe such regulations as may be necessary or appropriate to carry out the purposes of [subpart J of the IRC], including regulations … providing for the appropriate treatment of related party transactions (including transactions between qualified business units of the same taxpayer) ….”
On September 25, 1991, Treasury and the Service issued Proposed Regulations under Section 987 (the “1991 Proposed Regulations”). The 1991 Proposed Regulations generally provided that the net income of a QBU with a functional currency other than that of the taxpayer was determined annually. Such determination was based on the profit and loss appearing on the QBU's books and records, adjusted to conform to U.S. tax principles, and translated into the functional currency of the taxpayer using the weighted average exchange rate for the taxable year. The 1991 Proposed Regulations also provided for the recognition of exchange gain or loss upon a remittance from the QBU's equity pool. The 1991 Proposed Regulations also provided for a basis pool, which consisted of the basis of the capital and earnings in the equity pool, expressed in the functional currency of the taxpayer. Using these equity and basis pools, the 1991 Proposed Regulations included a formula for calculating the Section 987 gain or loss on a remittance from a Section 987 QBU.
On September 6, 2006, Treasury and the Service published a notice of proposed rulemaking (REG-208270-86, 71 FR 52876) that proposed new regulations under Section 987 (“2006 Proposed Regulations) and withdrew the 1991 Proposed Regulations. The 2006 Proposed Regulations adopted a different paradigm referred to as the foreign exchange exposure pool (“FEEP”) method. In general, the FEEP method provided that, as under the 1991 Proposed Regulations, the income of a Section 987 QBU is determined by reference to the items of income, gain, deduction, and loss booked to the Section 987 QBU in its functional currency, adjusted to reflect U.S. tax principles. However, the basis of certain “historic assets” and the deductions for depreciation, depletion, and amortization of such assets were translated at the historic rates for such assets. Translating these items at historic rates represented a major difference from the 1991 Proposed Regulations and prevented the imputation of foreign currency gains or losses to such assets. Additionally, the 2006 Proposed Regulations required the adjusted basis and amount realized with respect to marked assets to be translated using a spot rate, which for assets acquired in a prior taxable year would be the spot rate for the closing balance sheet of the prior taxable year.
Consistent with the 1991 Proposed Regulations, the FEEP method used a balance sheet approach to determine exchange gain or loss, which was not recognized until the section 987 QBU makes a remittance. Under the FEEP method, exchange gain or loss with respect to “marked items” was determined annually but is pooled and deferred until a remittance is made. A marked item generally is defined under the 2006 Proposed Regulations as an asset (marked asset) or liability (marked liability) that would generate Section 988 gain or loss if such asset or liability were held or entered into directly by the owner of the Section 987 QBU. The balance sheet approach, together with the use of historic rates for historic items (generally defined as an asset or liability that is not a marked item), allowed taxpayers and the Service to distinguish between items whose value is highly responsive to changes in the functional currency of the owner and items for which exchange rate changes have no effect on value, or only an uncertain or remote effect that is more appropriately recognized upon a realization event with respect to the item.
The 2006 Proposed Regulations defined a remittance as a net transfer of amounts from a Section 987 QBU to its owner during a taxable year, determined in the owner's functional currency. When a Section 987 QBU makes a remittance, a portion of the pooled exchange gain or loss was recognized. In general, the amount taken into account equaled the Section 987 QBU's net unrecognized exchange gain or loss multiplied by the owner's remittance proportion. The owner's remittance proportion generally equaled the amount of the remittance divided by the aggregate basis of the section 987 QBU's gross assets reflected on its year-end balance sheet, determined in the owner's functional currency, without reduction for the remittance.
Treasury and the Service received many written comments in response to the 2006 Proposed Regulations. After consideration of the comments, the 2006 Proposed Regulations, as revised by TD 9794, were adopted as Final Regulations. Temporary Regulations (TD 9795) and Proposed Regulations (REG-128276-12) under Section 987 were published contemporaneously with the Final Regulations.
Key Highlights to the Final, Temporary and Proposed Regulations
Discussed below are some of the key items in the Final, Temporary and Proposed Regulations.
The Preamble to the Final Regulations discusses some of the comments received in response to the 2006 Proposed Regulations along with Treasury’s and the Service’s responses to such comments. Such items include:
- Retaining the general framework of the FEEP method despite concerns relating to the administrability of such method, but making several modifications to reduce the complexity, including permitting more items to be treated as Section 987 marked items, simplifying the treatment of marked items so that net income attributable to such items is translated the average exchange rate, and simplifying the adjustments that are required to translate basis recovery for historic items at the historic rate;
- Providing guidance on entities that are not subject to the regulations, including clarifying what types of financial entities are subject to the regulations;
- Declining to adopt a recommendation to apply Section 988 in lieu of Section 987 to an owner of a Section 987 QBU that has a relatively small amount of marked items;
- Revising the definition of “portfolio stock” to be based solely on value;
- Enhancing the consistency of the attribution rules and QBU concept between Section 987 and other parts of subpart J of the IRC;
- Confirming the “offsetting position” factor in Section 1.987-2(b)(3)(ii)(C) of the 2006 Proposed Regulations is necessary to prevent the use of transactions involving offsetting gains and losses to selectively recognize losses without recognition of gain and not restricting the parameters of the offsetting position factor;
- Declining to adopt an ordinary course transaction exception from the definition of “transfer” between two Section 987 QBUs of the same taxpayer or by a Section 987 QBU and its home office that are taken into account in determining the amount of a remittance;
- Declining to extend the “grouping rules” in Section 1.987-1(b)(2)(ii) of the 2006 Proposed Regulations to corporations that file a consolidated return, declining to extend the grouping rule to Section 987 QBUs that are directly owned with Section 987 QBUs that are indirectly owned through Section 987 aggregate partnerships, and declining to permit an owner to elect to group less than all of its Section 987 QBUs with the same functional currency;
- Modifying Section 1.987-4 of the 2006 Proposed Regulations for the computation of net unrecognized exchange gain or loss for tax-exempt income and non-deductible expenses. In addition for Section 1.987-4, explicitly accounting for foreign taxes claimed as a credit, which must be translated at the same rate at which such taxes were translated under Section 986(a);
- Clarifying that a foreign corporation that owns a Section 987 QBU must apply the rules in Section 1.987-3 in determining earnings and profits with respect to the Section 987 QBU;
- Retaining the requirements in Section 1.987-4(a) of the 2006 Proposed Regulations requiring the determination of the net unrecognized Section 987 gain or loss of a Section 987 QBU by the owner annually and Section 1.987-9 of the 2006 Proposed Regulations requiring the taxpayer to keep annual records that are sufficient to establish each Section 987 QBU's Section 987 gain or loss;
- Retaining the approach of the 2006 Proposed Regulations in requiring the Section 987 QBU owner to use the asset method of Section 1.861-9T(g) to characterize and source section 987 gain or loss, including for determining the extent to which Section 987 gain or loss gives rise to subpart F income. In addition, including rules which will allow taxpayers to offset a Section 987 net loss characterized by reference to assets that give rise to subpart F income to offset a Section 988 net gain, and vice versa, in determining subpart F income;
- Retaining the approach of the 2006 Proposed Regulations to apply to partnerships based on an approach (the aggregate approach) that treats a partnership as an aggregate of its partners, rather than as an entity separate from its partners but only for so-called “section 987 aggregate partnerships,” which are defined in Section1.987-1(b)(5) as partnerships for which all of the capital and profits interests are owned, directly or indirectly, by persons that are related within the meaning of Section 267(b) or 707(b). Treasury and the Service anticipate that regulations for apply Section 987 to other partnerships (non-aggregate partnerships) will be developed under a separate project and may adopt a different approach;
- Clarifying when a Section 987 QBU terminates and including an example illustrating that when a Section 987 QBU elects to be treated as a corporation under the check-the-box regulations, the Section 987 QBU terminates due to the deemed transfer of assets from the Section 987 QBU to the owner immediately prior to the deemed transfer of assets from the owner to the transferee corporation under Section 351. The Temporary Regulations provide rules under which certain Section 987 gain or loss that otherwise would be recognized upon a combination, separation, termination, or other event with respect to a Section 987 QBU is deferred and recognized upon a subsequent event to the extent assets of the Section 987 QBU continue to be reflected on the books and records of a Section 987 QBU in the same controlled group. Under these rules, a Section 351 transfer of some or all of the assets of a Section 987 QBU within a consolidated group generally would not result in recognition of Section 987 gain or loss, provided the transferred assets continue to be reflected on the books and records of a Section 987 QBU;
- Requiring under a mandatory “fresh start” transition method for all Section 987 QBUs that have not already implemented the 2006 Proposed Regulations to be deemed to terminate before adoption of the new regime (the Final Regulations do not include an election to use the deferral method). Under the fresh start transition method, unrecognized Section 987 gain or loss determined under a prior Section 987 method is not taken into account, and marked assets and liabilities reflected on a Section 987 QBU’s balance sheet on the transition date are translated using a historic rate. Taxpayers that adopted the 2006 method generally already transitioned to that method in accordance with the principles of Section 1.987-10 of the 2006 Proposed Regulations, so it is not necessary or appropriate for taxpayers to transition from the 2006 method to the Final Regulations under the fresh start method, though certain sections of the Final Regulations may still need to be considered (e.g., historic rates, and unrecognized Section 987 gain or loss with respect to a QBU).
- Providing several elections to mitigate potential complexity or administrative burden associated with complying with these regulations. Section 1.987-1(g) provides rules for making the elections;
- Reflecting other modifications to the language and structure of the 2006 Proposed Regulations, as well as the inclusion of additional examples, to enhance clarity. Treasury and the Service do not intend these changes to be interpreted as substantive changes to the 2006 Proposed Regulations.
Temporary and Proposed Regulations
The Temporary Regulations and, by cross reference to, the Proposed Regulations, contain rules relating the recognition and deferral of foreign currency gain or loss with respect to a Section 987 QBU in connection with certain QBU terminations and certain other transactions involving partnerships. The Temporary Regulations also contain rules providing:
- 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 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;
- Rules regarding the allocation of assets and liabilities of certain partnerships for purposes of Section 987.
Also, the Temporary Regulations contain rules under IRC Section 988 requiring the deferral of certain IRC Section 988 losses that arises with respect to related party loans.
For the applicability dates of such regulations, see Treasury Regulation Section 1.987-11 and Temporary Regulations Sections 1.987-1T(h), 1.987-2T(e), 1.987-3T(f), 1.987-4T(h), 1.987-6T(d), 1.987-7T(d), 1.987-8T(g), 1.987-12T(j), 1.988-1T(j) and 1.988-2T(j).
BDO can assist our clients with understanding the complexities of the Final, Temporary and Proposed Regulations under IRC Section 987 and also advise on how these rules will impact income earned through a Section 987 QBU.