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UPDATED: IRS Updates Final and Proposed Regulations Related to Foreign Gains and Losses Under Section 987 by Jairan Shirazi

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Posted on December 23, 2024 by Jairan Shirazi

One of the more challenging tax reporting requirements for multinational businesses is the translation of gains and losses of their foreign branch offices and qualified business units (QBUs) into their home country’s functional currency. This process is often complicated by exchange rate fluctuations, including currency devaluations, that can have a material impact on the principal businesses’ assets and liabilities and their ultimate recognition of a loss or taxable gain on their financial statements.

Background

Internal Revenue Code Section 987 addresses the taxation of foreign currency translation gains or losses with respect to QBUs. The activities of a corporation, partnership, trust, estate, or individual rise to the level of a QBU if they constitute a trade or business and maintain a separate set of books.

U.S. taxpayers must calculate their QBUs’ foreign currency income, gains, deductions and losses annually and translate those amounts into U.S. dollars at the average exchange rate in effect for that tax year. Additionally, when a QBU transfers money or other property to its U.S. owner or one of the owner’s other QBUs, the U.S. owner must recognize the exchange gains or losses on its U.S. tax return as a remittance of the QBUs’ accumulated earnings. In other words, U.S. taxpayers will record a gain taxed as ordinary income or a deductible loss based on the exchange rate in place when they receive a remittance or terminate a QBU.

These regulations have been suspended and rewritten several times between 2006 and 2023 due to their complexity and the undue burden they placed on taxpayers. However, on Dec. 10, 2024, the IRS and U.S. Treasury again attempted to simplify this process by issuing final and proposed regulations to apply to tax years beginning after Dec. 31, 2024.

FEEP Method of Accounting

The final regulations adopt a modified foreign exchange exposure pool (FEEP) method for taxpayers to account for currency exchange gains or losses at the end of each year. First introduced in 2006, the FEEP method is based on a balance sheet approach that relies on two different methods for the parent company to covert its QBUs’ foreign currency transactions into its home country’s functional currency for purposes of reporting its financial position and performance and position.

Previously, the law required the gains or losses of “marked items,” including financial assets and liabilities such as debt instruments, accounts payable and receivables, to be translated into the owner’s functional currency at the spot rate as of the last day of the tax year. However, taxpayers could defer the recognition of those amounts until they receive a remittance from their QBUs or another triggering event takes place. By contrast, taxpayers were required to translate their QBUs’ nonfinancial “historic items,” such as land, fixed assets, property, plant and equipment and their related depreciation and amortization deductions, at the historic average exchange rate in place during the tax year in which the asset was acquired.

Recognizing the complexity of this method, the final regulations include a series of elections intended to make it less burdensome for taxpayers to apply for reporting purposes.

Special Elections

The final rules retain two special elections introduced in 2023 and two new elections that will alter taxpayers’ compliance requirements and result in different calculations for Section 987 gains or losses of their QBUs.

Multinational businesses must recognize that these elections, whether made together or separately, apply to all the QBUs they own and generally remain in effect for at least five years before taxpayers may revoke them. At that point, taxpayers may not make another election for another five years.

Additionally, taxpayers must prepare for the impact of these elections. For example, a current rate election may result in a large pool of potential losses, which the proposed regulations require taxpayers to suspend until a taxable year in which they have an equal or greater gain. However, if taxpayers make annual recognition elections in addition to the current rate election, they may deduct losses in the current year.

Expanded Scope of Compliance

The final regulations apply solely to individuals and corporations that are U.S. persons and CFCs in which U.S. shareholders own stock. However, the IRS and Treasury expect to release additional guidance in the future for partnerships and S corporations that are subject to “certain parts of the section 987 regulations, including the rules relating to suspension of section 987 loss and recognition of suspended section 987 loss” and for trusts and estates whose functional currency is different from their beneficiaries.

It behooves owners of multinational businesses and CFCs to meet with their trusted advisors to understand the regulations’ impact on their financial reporting and how they may minimize any resulting burden on their finances and operations.

About the Author: Jairan Shirazi is a senior manager of Tax Services with Berkowitz Pollack Brant, where she helps individuals and businesses grow while complying with international tax laws. She can be reached at the CPA firm’s Miami office at (305) 379-7000 or info@bpbcpa.com.