Treasury Issues Proposed Regulations Under Section 987

On November 9, 2023, the Treasury Department and the IRS issued proposed regulations providing guidance under Internal Revenue Code Section 987 and related provisions under Sections 861, 985 through 989, and 1502 relating to the determination of taxable income or loss and foreign currency gain or loss with respect to a qualified business unit that has a functional currency different from its owner (a “Section 987 QBU”). 

The 2023 proposed regulations include an election to treat all items of a Section 987 QBU as marked items (subject to a loss suspension rule), an election to recognize all foreign currency gain or loss with respect to a Section 987 QBU on an annual basis, and a new transition rule.

Background

In September 1991, Treasury and the IRS issued proposed regulations under Section 987. The 1991 proposed regulations adopted an equity and basis pool method for the computation of Section 987 gain or loss under which foreign currency gain or loss was imputed to all equity on a Section 987 QBU’s balance sheet. In September 2006, Treasury and the IRS withdrew the 1991 proposed regulations and issued new proposed regulations based on a different methodology known as the foreign exchange exposure pool (FEEP) method. 

Under the FEEP method, historic items (assets or liabilities the value of which is not directly impacted by currency fluctuations) are translated at historic exchange rates, while marked items (assets or liabilities the value of which is directly impacted by currency fluctuations) are translated at the current year exchange rates. As a result, the FEEP method does not impute Section 987 gain or loss to historic items.

On December 2016, Treasury and the IRS finalized the 2006 proposed regulations with minor revisions. On the same day, Treasury and the IRS issued proposed and temporary regulations under Section 987. On May 13, 2019, Treasury and the IRS finalized parts of the 2016 temporary and proposed regulations.

The 2016 final regulations were criticized by taxpayers and tax practitioners as too complex and burdensome. Executive Order 13789, issued in April 2017, instructed the Secretary of the Treasury to review all significant tax regulations issued on or after January 1, 2016, and to take concrete actions on regulations that impose an undue financial burden on U.S. taxpayers or add undue complexity. The IRS concluded that the 2016 final regulations met these criteria. Since then, the IRS has been postponing the effective date of the 2016 final regulations. The latest IRS Notice (2022-34) delayed the applicability date of the 2016 final regulations to taxable years beginning after December 7, 2023.

2023 Proposed Regulations

The 2023 proposed regulations retain the basic approach and structure of the 2016 final regulations while (a) providing several simplifying elections that permit Section 987 to be applied in a way that more closely conforms to the financial accounting rules and reduce the compliance burden and (b) providing additional guidance regarding the determination of Section 987 taxable income or loss and Section 987 gain or loss. The 2023 proposed regulations do not include an election to use the 1991 proposed regulations’ method.

Below is a high-level summary of some of the key rules included in the 2023 proposed regulations. 

Current Rate Election

The 2023 proposed regulations provide an election to treat all items that are properly reflected on the books and records of a Section 987 QBU as marked items (the “current rate election”). Taxpayers that make this election will not need to use historic exchange rates for their historic items. This election reflects taxpayers’ comments that the historic rate requirement under the 2016 final regulations created a compliance burden. This election is intended to alleviate this compliance burden. However, taxpayers that make this election will be subject to a loss suspension rule. The government was concerned that, without such a rule, taxpayers could selectively trigger large Section 987 losses in excess of economic loss. Under the loss suspension rule, Section 987 losses are deferred until a year in which an equal or greater amount of Section 987 gain is recognized or certain other events occur (the loss-to-the-extent-of-gain rule).

Annual Recognition Election

The 2023 proposed regulations provide taxpayers with an “annual recognition election” under which an owner will recognize the full amount of net unrecognized Section 987 gain or loss on an annual basis. This election is similar to the “annual deemed termination election” that was provided under the 2016 temporary and proposed regulations (but that expired in 2019.) If an owner makes both an annual recognition election and a current rate election for a taxable year, the loss suspension rules generally do not apply.

Expansion of Entities Covered

The 2016 final regulations do not apply to banks, insurance companies, leasing companies, finance coordination centers, regulated investment companies, or real estate investment trusts (unless they engaged in transactions primarily with related persons that are not themselves not such specified entities). Additionally, the 2016 final regulations do not apply to trusts, estates, S corporations, and partnerships other than Section 987 aggregate partnerships. A Section 987 aggregate partnership is a partnership (1) in which all capital and profit interests are owned by persons related to each other; (2) that has one or more eligible QBUs, and (3) whose partner has a different functional currency from the eligible QBU.

The 2023 proposed regulations generally remove the exclusion for these specified entities, thus making them subject to the 2023 proposed regulations. However, the new proposed regulations generally continue to exclude foreign non-grantor trusts and foreign estates if the aggregate interests of beneficiaries that are U.S. persons is less than 10% and foreign partnerships if the aggregate interests of the partners that are U.S. persons is less than 10% of the capital and profits interests. 

Partnerships    

The 2016 final regulations retained the 2006 proposed regulations’ aggregate approach to partnerships, but applied it only to Section 987 aggregate partnerships. Under this aggregate approach, assets and liabilities reflected on the books and records of an eligible QBU of a Section 987 aggregate partnership are allocated to each partner, which is considered an indirect owner of the eligible QBU.  

The 2023 proposed regulations apply a hybrid entity approach to non-Section 987 aggregate partnerships. Under this approach, a partnership (other than a Section 987 aggregate partnership) is treated as a QBU having its own functional currency. If a partnership owns an eligible QBU with a functional currency that is different from the functional currency of the partnership, the eligible QBU is treated as a Section 987 QBU, and the partnership (not the partner) is generally treated as the owner of the eligible QBU. 

Under this approach, the partnership allocates to each partner a share of the unrecognized Section 987 gain or loss for the taxable year with respect to each Section 987 QBU owned by the partnership on an annual basis. The partnership determines a partner’s share of the unrecognized Section 987 gain or loss for the taxable year for each Section 987 QBU based on the partner’s distributive share of profits and losses attributable to that Section 987 QBU for the taxable year. At the partner level, each partner translates its share of the unrecognized Section 987 gain or loss into its functional currency at the yearly average exchange rate and calculates its net unrecognized Section 987 gain or loss with respect to each Section 987 QBU of the partnership based on this share.

Other Changes

The proposed regulations make other changes to the computation of unrecognized Section 987 gain or loss, the rules for determining the source and character of Section 987 gain or loss, the rules relating to deferral events and outbound loss events under Treas. Reg. §1.987-12, the application of Section 987 in a consolidated group, as well as other changes. 

Transition Rule

The 2023 proposed regulations provide a new transition rule that replaces the fresh start transition rule of the 2016 final regulations. The new transition rule applies in the taxable year beginning on the transition date (that is, the first day of the first taxable year in which the 2023 proposed regulations are applicable). For purposes of determining unrecognized Section 987 gain or loss in the first taxable year in which the regulations apply, the assets and liabilities reflected on a Section 987 QBU’s balance sheet at the end of the previous year would be translated into the owner’s functional currency at the spot rate on the day before the transition date. An owner of a Section 987 QBU must determine the amount of Section 987 gain or loss that has accrued before the transition date (“pretransition gain or loss”). In the first taxable year in which the regulations apply, pretransition gain is treated as net unrecognized Section 987 gain, and pretransition loss is treated as suspended Section 987 loss, subject to the rules described above. 

Taxpayers that applied an “eligible pretransition method” under Section 987 before the transition date will use that method to compute their pretransition gain or loss. The 1991 proposed regulations and certain earnings-only methods are eligible pretransition methods. Taxpayers that did not apply an eligible pretransition method must generally determine their pretransition gain or loss under the method in the 2023 proposed regulations.     

Applicability date

Once finalized, the 2023 proposed regulations will be generally applicable for taxable years beginning after December 31, 2024. A taxpayer may choose to apply the proposed regulations -- once published in the Federal Register - for taxable years beginning on or before December 31, 2024, and ending after November 9, 2023. Moreover, a taxpayers may rely on the proposed regulations for taxable years ending after November 9, 2023, under certain conditions.