PROPOSED REGULATIONS FOR CALCULATING INCOME ATTRIBUTABLE TO A QBU.

[Editor's Note: The following text incorporates corrections published by the IRS on November 26, 1991.]

[Editor's Note: At 71 F.R. 52876-52918, Sept. 7, 2006, the IRS published new proposed regs (REG-208270-86) and withdraw the following proposed regs.]

ACTION. Notice to proposed rulemaking.

SUMMARY: This document contains proposed Income Tax Regulations relating to the calculation of income (including currency gain or loss on remittances) attributable to a qualified business unit of a taxpayer that uses the profit and loss method of accounting. Changes to the applicable tax law were made by the Tax Reform Act of 1986.

DATES: Written comments must be received by November 25, 1991. Requests to appear and outlines of oral comments to be presented at the hearing scheduled for December 9, 1991, must be received by November 25, 1991. See the notice of hearing published elsewhere in this issue of the Federal Register.

ADDRESSES: Send comments and requests for a public hearing to: Internal Revenue Service, P.O. Box 7604, Ben Franklin Station Attention: CC:CORP:T:R (INTL-965-86), Room 5228, Washington, D.C. 20044.

FOR FURTHER INFORMATION CONTACT: Carol Murphy of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224, Attention: CC:CORP:T:R (INTL-965-86) (202- 566-6795, not a toll-free call).

SUPPLEMENTARY INFORMATION:

BACKGROUND

This document contains proposed regulations under section 987 of the Internal Revenue Code of 1986 relating to the calculation of income (including currency gain or loss on remittances and terminations) attributable to a QBU branch of a taxpayer that uses the profit and loss method of accounting.

EXPLANATION OF PROVISIONS

These regulations provide guidance to taxpayers (foreign or domestic) with a qualified business unit branch (QBU branch) that has a functional currency different from that of the taxpayer. Generally the regulations require a taxpayer with a QBU branch to compute the branch's taxable income using the profit and loss method of accounting. Rules are provided for determining the currency gain or loss (section 987 gain or loss) of the taxpayer attributable to a QBU branch's earnings and capital. Section 987 gain or loss is recognized by the taxpayer when a QBU branch makes a remittance to the taxpayer or when the QBU branch terminates. Rules are also provided for characterizing section 987 gain or loss for purposes of applying the foreign tax credit limitations. The discussion that follows describes the significant portions of the proposed regulations.

Under the profit and loss method of accounting, the QBU branch's income is computed in its functional currency, adjustments are made to conform it to U.S. income tax principles, and the result is translated into the taxpayer's functional currency generally using the average exchange rate for the tax year.

Special rules are provided to account for actual and deemed dividends (such as sale or exchange of stock treated as a dividend under section 1248), collectively referred to as dividend amounts. Under section 1.987-1(b)(1)(iv), dividend amounts are translated into the taxpayer's functional currency at the exchange rate on the date when they are included in income. This is consistent with the translation of these amounts under section 989(b)(1) and (2). Income described in section 951(a) and income from a qualified electing fund are not included in the QBU branch's income. That income is translated (if necessary) directly into the taxpayer's functional currency. This is intended to allow the rules of section 986(c), relating to foreign currency gain or loss on previously taxed earnings and profits, to apply at the "taxpayer" rather than the "branch" level. Any other rule could convert section 986 gain or loss into section 987 gain or loss.

Section 1.987-1(b)(2) incorporates the rules stated in Notice 89-74, 1989-1 C.B. 739. These rules generally provide that a domestic taxpayer with a QBU branch must include in income, after taking into account adjustments under section 905(c), the dollar amount of foreign income taxes attributable to the branch (the tax equivalent amount) that the taxpayer credits under section 901. Under section 1.987-1(b)(2)(iii), the tax equivalent amount does not produce section 987 gain or loss.

Section 1.987-1(b)(4) provides that section 987 does not prevent a taxpayer from taking into account annual losses incurred by a QBU branch. However, losses in excess of the taxpayer's positive basis in the QBU branch (generally the amount of the basis pool) are subject to recapture upon a remittance or when the branch terminates.

Section 1.987-2 provides rules for determining when a taxpayer must recognize gain or loss under section 987 when property is transferred from a QBU branch to the taxpayer. Generally, section 987 gain or loss is triggered when there is a remittance of property. A remittance occurs under section 1.987-2(b)(4) when a QBU branch having a positive balance in its equity pool (defined below) transfers property to the taxpayer. Under section 1.987-2(b)(2), property includes functional currency and liabilities.

Whether there has been a transfer to or from a QBU branch is determined daily. If on any day contributions (or distributions) exceed distributions (or contributions) the excess is treated as a transfer to (or from) the branch. A transfer is translated into the taxpayer's functional currency using the spot rate. For this and certain other purposes a taxpayer may use a spot rate convention as described in section 1.988-1T(d)(3).

The daily netting of contributions and distributions and use of a spot rate convention to calculate the section 987 gain or loss on a distribution from a QBU branch deviate from the rule for distributions from corporations. Thus, the total amount of foreign source income of a business will vary slightly depending on whether the business is conducted in branch or corporate form. These rules are proposed to simplify compliance with section 987. The Service is interested in receiving comments on how these rules could be simplified further while generally maintaining parity between the taxation of branches and subsidiaries.

Section 1.987-2(c) provides rules for computing the equity pool (maintained in the functional currency of the QBU branch) and the basis pool (maintained in the taxpayer's functional currency). These pools are used to determine the amount of section 987 gain or loss a taxpayer recognizes when a QBU branch makes a remittance or terminates. The equity pool is described in section 1.987-2(c)(1). It generally represents the amount of branch equity (adjusted basis of assets less liabilities). Thus, for example, a branch borrowing does not increase or decrease the equity pool. On the other hand, branch income and transfers from the taxpayer to the QBU branch increase the equity pool, while branch losses and transfers from the branch reduce the equity pool. The basis pool, described in section 1.987-2(c)(2), generally represents the taxpayer's basis in the equity pool, which is essentially the taxpayer's basis in the branch. The basis pool is increased (decreased) by branch earnings (losses) generally translated at the average rate for the year. Spot rate translation rules are provided for dividend amounts and previously taxed amounts (such as previously taxed subpart F income).

Section 1.987-2(d) provides rules for calculating section 987 gain or loss. Generally, section 987 gain or loss equals the difference between (1) the value of a remittance (generally computed by reference to the QBU branch's functional currency basis in the property remitted) translated into the taxpayer's functional currency at the spot rate on the date of the remittance and (2) the portion of the taxpayer's basis pool (which can be negative) attributable to the property. A formula for determining the attributable portion of the basis pool is provided in section 1.987-2(d).

Under section 1.987-2(f), a taxpayer ordinarily must use the same method it uses to allocate and apportion interest expense under section 861 to determine the source and character of section 987 gain or loss. While the Code provides rules for characterizing other types of "currency gain or loss" for purposes of sections 904(d) and 954, there is no specific rule provided for section 987 gain or loss except that it be sourced "by reference to the source of the income giving rise to post-1986 accumulated earnings". However, section 987 gain or loss is attributable not only to post-1986 earnings but also contributions by the taxpayer to the branch and unremitted earnings from pre-1987 years. Therefore reliance upon post-1986 accumulated earnings would be inadequate. The "interest expense" method was chosen to avoid substantial complications in trying to determine the portion of the section 987 gain or loss attributable to transfers to the branch and pre-1987 earnings and how to allocate and apportion these amounts for purposes of sections 904(d) and 954. Using an interest expense method promotes the goal of regulation simplification by eliminating the need to maintain separate section 904(d) or subpart F "baskets" (and associated basis amounts) which are not otherwise needed or maintained for each branch. A special rule in section 1.987-2(f)(2) is intended to provide relief where the "interest expense method" results in a substantial distortion. This could result where in a particular year, the assets of a QBU branch of a domestic taxpayer are not representative of the historical composition of the QBU branch's assets.

Under section 1.989(a)-1(b)(2), a partnership is a QBU branch of each of its partners. Thus, for example, a remittance from a partnership with one functional currency to a partner with a different functional currency will result in section 987 gain or loss. It is anticipated that section 987 will operate independently from the general rules in subchapter K. Thus, for example, a remittance from a partnership to a partner may result in section 987 gain or loss to the partner even though the remittance is not otherwise taxable under section 731. The Service is particularly interested in suggestions on how section 987 can best be coordinated with the partnership provisions.

Section 1.987-3 deals with the termination of a QBU branch. Generally, when a branch terminates all of the QBU branch's unrealized section 987 gain or loss is triggered. The amount of section 987 gain or loss that the taxpayer must recognize is determined under rules essentially the same as those in section 1.987-2, except for two points: (1) the QBU branch's profit and loss is computed through the termination date; and (2) a final accounting is done to reflect the branch's deemed distribution of its assets to the taxpayer. A special adjustment must be made if the equity pool is negative upon termination: the taxpayer is deemed to make a transfer to the equity pool in an amount necessary to bring the pool up to zero, and the taxpayer must recognize section 987 gain (or loss) equal to any negative (or positive) balance in the basis pool.

Generally, a QBU branch terminates when either (1) the branch transfers substantially all of its assets to the taxpayer or (2) the taxpayer disposes of substantially all of the branch's assets. Thus, for example, a deemed asset sale under section 338 terminates a QBU branch. In general, the transfer of a QBU branch's assets in a section 332 liquidation or a tax-free reorganization does not terminate the QBU branch, subject to certain exceptions. For consistency and compliance reasons, many of the exceptions coordinate with exceptions to the nonrecognition rules found in the regulations under sections 367(a), 367(b), and 367(e). A QBU branch is also considered terminated if the transferee (or distributee) of the QBU branch's assets and the QBU branch have the same functional currency. Generally, a sale or exchange described in section 1248 of 10% or more of the stock in a foreign corporation over a twelve-month period also will result in a termination. Consideration was given to requiring only the selling (or redeeming) shareholder in a section 1248 transaction to realize his pro rata share of the unrealized section 987 gain or loss of a QBU branch of a CFC, rather than treating a section 1248 transaction as a termination event, which affects all shareholders. The pro-rata approach was rejected in the interest of simplicity. The Service welcomes comments on how a pro- rata approach might be implemented in a manner that would not be unduly burdensome to most taxpayers.

The treatment under section 987 of United States QBU branches of foreign taxpayers is reserved. However, it is anticipated that these rules will be substantially similar to the rules for foreign QBU branches.

The Service is studying recharacterizing a portion of the QBU's interest expense (but not its interest income) as principal under the authority of section 989(b). This would serve as an alternative to requiring QBUs operating in a hyperinflationary environment to use the dollar approximate separate transactions method of accounting.

The Service is interested in receiving comments concerning the application of 987 to various "special industries," including life insurance companies and regulated investment companies.

SPECIAL ANALYSES

It has been determined that these proposed rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, an initial Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, these regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

COMMENTS AND REQUEST FOR A PUBLIC HEARING

Before adopting these proposed regulations, consideration will be given to any written comments that are submitted (preferably a signed original and eight copies) to the Commissioner of Internal Revenue. All comments will be available for public inspection and copying. A public hearing will be held on December 9, 1991. See notice of public hearing published elsewhere in this issue of the Federal Register.

DRAFTING INFORMATION

The principal author of these regulations is Carol Murphy of the Office of Associate Chief Counsel (International) within the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and the Treasury Department participated in developing the regulations.

LIST OF SUBJECTS IN 26 CFR SECTIONS 1.985-0 THROUGH 1.989(c)-1T

Income taxes, Reporting and recordkeeping requirements.

PROPOSED AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority for part 1 continues to read in part:

Authority: Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805 * * *

Par. 2. The text of sections 1.987-1 through 1.987-3 is added and the heading of section 1.987-3 is revised to read as follows:

SECTION 1.987-1 PROFIT AND LOSS METHOD OF ACCOUNTING FOR A QUALIFIED BUSINESS UNIT OF A TAXPAYER HAVING A DIFFERENT FUNCTIONAL CURRENCY FROM THE TAXPAYER.

(a) GENERAL RULE -- (1) APPLICATION. Section 987 applies to a qualified business unit of a taxpayer that --

(i) Has a functional currency that is different from that of the taxpayer; and

(ii) Does not use the dollar approximate separate transactions method of accounting (as defined in section 1.985-3).

(2) QBU BRANCH. For purposes of section 987 and the regulations thereunder, the term "QBU branch" means a qualified business unit of a taxpayer described in paragraph (a)(1) of this section.

(b) PROFIT AND LOSS METHOD OF ACCOUNTING -- (1) IN GENERAL. A QBU branch must use the profit and loss method of accounting. Under the profit and loss method of accounting, the taxable income or loss and earnings and profits (or deficit in earnings and profits) attributable to a QBU branch, including any exchange gain or loss on intra-taxpayer transactions under section 1.988-1T(a)(7)(ii), is generally computed as of the close of the taxable year by --

(i) Preparing a profit and loss statement from the QBU branch's books and records (within the meaning of section 1.989(a)-1(d)) as recorded in the QBU branch's functional currency (determined under section 985 and section 1.985-1);

(ii) Except as provided in paragraph (b)(2) of this section, making the adjustments necessary to conform the statement to United States tax principles (the adjusted statement);

(iii) Except as provided in paragraph (b)(1)(iv) and paragraph (b)(3) of this section, translating the amount shown on the adjusted statement into the taxpayer's functional currency at the weighted average exchange rate for the taxable year (as defined in section 1.989(b)-1); and

(iv) Translating the amount shown on the adjusted statement attributable to dividend amounts into the taxpayer's functional currency at the spot rate when the amount is included in the taxpayer's income. A dividend amount includes any amount described in section 989(b)(1), relating to dividends, or section 989(b)(2), relating to the translation of deemed dividends under section 1248.

(2) SPECIAL RULE FOR CERTAIN INCOME. Income described in section 951(a) or section 1293(a)(1) is not included in a QBU branch's adjusted profit and loss statement.

(3) APPROPRIATE EXCHANGE RATE FOR CREDITABLE TAXES FOR CERTAIN QBU BRANCHES OF A UNITED STATES TAXPAYER -- (i) PURPOSE. The separate computations in this paragraph (b)(3) ensure that a taxpayer's income reflects the dollar value of its creditable taxes where the taxpayer elects to credit the taxes under section 901.

(ii) COMPUTATION OF TAXABLE INCOME OR LOSS ATTRIBUTABLE TO A QBU BRANCH. If a domestic taxpayer elects to credit (rather than deduct) any creditable tax under section 901, the taxable income or loss attributable to a QBU branch must be computed in the same manner as provided in paragraph (b)(1) of this section, except that the functional currency amount of creditable foreign taxes paid or accrued with respect to the QBU branch's income (the "tax equivalent amount") is translated into U.S. dollars (dollars) at the spot rate on the date the taxes were paid or accrued to the foreign country or possession of the United States. The domestic taxpayer's dollar income or loss includes the dollar tax equivalent amount.

(iii) IMPACT ON POOLS. The functional currency and dollar tax equivalent amounts are excluded from both the equity pool and the basis pool described in section 1.987-1(c)(1) and (2), respectively. See section 1.987-1(b)(6), Example 5.

(4) NO LOSS LIMITATION. A taxpayer may recognize a loss notwithstanding that the balance of either (or both) of the equity pool or basis pool is negative.

(5) QBU BRANCH TERMINATION. If a QBU branch terminates during a taxable year, the calculations in this paragraph (b) are made through the date of termination. (See section 1.987-3 for definition of termination.) Thus, for example, the weighted average exchange rate would relate only to the period of the taxable year ending on that date.

(6) EXAMPLES. The provisions of this paragraph (b) are illustrated by the following examples:

SECTION 1.987-2 ACCOUNTING FOR GAIN OR LOSS ON CERTAIN TRANSFERS OF PROPERTY.

(a) GENERAL RULE -- (1) IN GENERAL. A taxpayer using the profit and loss method of accounting for its QBU branch recognizes gain or loss under section 987 (section 987 gain or loss) upon a remittance (as defined in paragraph (b)(4) of this section) from the QBU branch or when the QBU branch terminates. Section 987 gain or loss generally represents currency gain or loss attributable to the QBU branch's undistributed earnings and capital. To calculate section 987 gain or loss, a taxpayer must establish and maintain two pools for each of its QBU branches. One pool, the equity pool, is maintained in the functional currency of the QBU branch. The second pool, the basis pool, is maintained in the functional currency of the taxpayer. See paragraph (c) of this section to determine the amounts in these pools, and paragraph (d) of this section for how section 987 gain or loss is calculated when there is a remittance.

(2) ANTI-ABUSE RULE. If a contribution to or a distribution from (or series of contributions to or distributions from) a QBU branch or a termination of a QBU branch does not have a significant business purpose, the District Director or the Assistant Commissioner (International) may, in his or her discretion, make appropriate adjustments to clearly reflect the income of the taxpayer.

(b) DEFINITIONS. The following definitions apply for purposes of section 987.

(1) PROPERTY. The term "property" includes property whether tangible or intangible. Property includes liabilities and functional currency.

(2) TRANSFER -- (i) GENERAL RULE. Except as provided in paragraph (b) (2) (ii) of this section, the term "transfer" means the net amount of property that, on any day, either is distributed from a QBU branch to the taxpayer (or to any other QBU branch of the taxpayer) or is contributed by the taxpayer (or by any other QBU branch of the taxpayer) to the QBU branch. The amount of property is determined by reference to its basis (or in the case of a liability the amount of the liability) immediately prior to the transfer, adjusted to reflect any gain or loss recognized under section 988. For example, assume that on August 14 a dollar taxpayer with a Swiss franc functional currency QBU branch contributes 5,000 Swiss francs to that QBU branch. That day the QBU branch also distributes 2,400 Swiss francs to the taxpayer. The amount of the transfer by the taxpayer to the QBU branch on August 14 is 2,600 Swiss francs (5,000- 2,400).

(ii) SPECIAL RULE FOR RECEIPT OF CERTAIN PREVIOUSLY TAXED AMOUNTS. A transfer does not include any previously taxed amount (PTA) received by a QBU branch. PTA includes amounts attributable to income described in section 951(a) or section 1293(a)(1).

(iii) TRANSFEREE'S BASIS. A transferee's basis in property that it receives as the result of a contribution or distribution equals the transferor's basis (adjusted to reflect gain or loss recognized under section 988) translated (if necessary) into the transferee's functional currency at the spot rate (as defined in paragraph (b)(3) of this section) for the day on which the property is contributed or distributed. Translation is not necessary when a transfer is made between two QBU branches with the same functional currency.

(iv) TRANSFER OF LIABILITIES. A contribution of a liability by the taxpayer (or any other QBU branch of the taxpayer) to a QBU branch is treated as a distribution by the QBU branch, and a distribution of a liability from a QBU branch to the taxpayer (or any other QBU branch of the taxpayer) is treated as a contribution to the QBU branch.

(3) SPOT RATE. The term "spot rate" has the meaning given to that term in section 1.988-1T(d)(1) and (2). For purposes of computing a transferee's basis (under paragraph (b)(2)(ii) of this section), the balance in a QBU branch's basis pool (under paragraph (c)(2) of this section) and section 987 gain or loss (under paragraph (d) of this section) a taxpayer may use a spot rate convention as defined in section 1.988-1T(d)(3).

(4) REMITTANCE. The term "remittance" means the amount of any transfer from a QBU branch to the extent that the aggregate amount of such transfers during the taxable year does not exceed the positive year-end balance of the equity pool determined without regard to the decreases described in paragraph (c)(1)(iii)(B) of this section. If a QBU branch makes more than one transfer during a taxable year, remittances must be determined using a reasonable method, consistently applied from year to year. The same method must be applied to all of the taxpayer's QBU branches.

(c) COMPUTATION OF QBU BRANCH EQUITY AND BASIS POOLS. This paragraph (c) describes how the balances in the equity pool and the basis pool are determined. The equity pool is maintained in the functional currency of the QBU branch, and the basis pool is maintained in the taxpayer's functional currency.

(1) EQUITY POOL -- (i) OPENING BALANCE. The opening balance of the equity pool for certain QBU branches that operated before 1987 is determined under paragraph (c)(1)(A) of this section. Generally, these branches were subject to the transition rules of section 1.987- 5 or section 1.989(c)-1. The opening balance of the equity pool for any other QBU branch is determined under paragraph (c)(1)(B) of this section.

(A) CERTAIN QBU BRANCHES THAT OPERATED BEFORE 1987. A taxpayer with a QBU branch must determine the opening balance of the QBU branch's equity pool using the rules of section 1.985-5, if the QBU branch used a profit and loss method of accounting for the last taxable year beginning before 1987. If the QBU branch used a net worth method for the last taxable year beginning before 1987, the taxpayer must use the rules of section 1.989(c)-1 to determine the opening balance of the QBU branch's equity pool.

(B) ALL OTHER QBU BRANCHES. The opening balance of the equity pool of a QBU branch not described in paragraph (c)(1)(i)(A) of this section is determined under this paragraph (c)(1)(i)(B). The opening balance of the QBU branch equals the adjusted basis of the QBU branch's assets, less the amount of the QBU branch's liabilities on the date the QBU branch first uses the profit and loss method of accounting. An example is a qualified business unit of a domestic corporation with a dollar functional currency that changes its functional currency. See section 1.985-5T, relating to changes in functional currency.

(ii) INCREASES TO THE POOL. The equity pool is increased by --

(A) The positive amount (after excluding the tax equivalent amount, if any) determined under section 1.987-1(b)(1)(i) and (ii);

(B) The amount of any transfer to the QBU branch during the taxable year; and

(C) The amount of PTA received during the taxable year.

(iii) DECREASES TO THE POOL. The equity pool is decreased by --

(A) The loss (after excluding the tax equivalent amount, if any) determined under section 1.987-1(b)(1)(i) and (ii); and

(B) The amount of each transfer from the QBU branch during the taxable year.

(2) BASIS POOL -- (i) OPENING BALANCE. The opening balance of the basis pool for certain QBU branches that operated before 1987 is determined under paragraph (c)(2)(i)(A) of this section. Generally, these branches were either subject to the transition rules of section 1.987-5 or section 1.989(c)-1. The opening balance of the basis pool for any other QBU branch is determined under paragraph (c)(2)(i)(B) of this section.

(A) CERTAIN EXISTING QBU BRANCHES. To compute the basis pool of a QBU branch described in paragraph (c)(1)(i)(A) of this section, see section 1.987-5 and section 1.989(c)-1.

(B) ALL OTHER QBU BRANCHES. The opening balance of the basis pool of a QBU branch described in paragraph (c)(1)(i)(B) of this section equals the opening balance of the QBU branch's equity pool translated into the taxpayer's functional currency at the spot rate on the date the QBU branch first uses a profit and loss method of accounting.

(ii) INCREASES TO THE POOL. The following amounts increase the basis pool --

(A) The positive amount (after excluding the tax equivalent amount, if any) determined under section 1.987-1 (b);

(B) The amount of each transfer to the QBU branch during the taxable year translated into the taxpayer's functional currency at the spot rate on the date of the transfer;

(C) Each amount of PTA received during the taxable year translated into the taxpayer's functional currency at the spot rate on the date the PTA is received; and

(D) The portion of the negative basis pool attributable to any remittance made during the taxable year determined under paragraph (d) of this section.

(iii) DECREASES TO THE POOL. The following amounts decrease the basis pool --

(A) The loss (after excluding the tax equivalent amount, if any) determined under section 1.987-1(b);

(B) The portion of the positive basis pool attributable to any remittance made during the taxable year, determined under paragraph (d) of this section; and

(C) The amount of each transfer from the QBU branch (other than a remittance) during the taxable year translated into the taxpayer's functional currency at the spot rate on the date of the transfer.

(d) CALCULATION OF SECTION 987 GAIN OR LOSS -- (1) GENERAL RULE. Section 987 gain or loss equals the difference between --

(i) The amount of a remittance from a QBU branch translated into the taxpayer's functional currency at the spot rate on the date the remittance is made, and

(ii) The portion of the basis pool attributable to the remittance.

(2) FORMULA FOR DETERMINING THE BASIS OF A REMITTANCE. The following is the formula for determining the portion of the basis pool attributable to a remittance:

      amount of remittance (in the QBU

                     (1,000FC / 2,500FC) x $4,000

           $2,000 (1000FC at the     -     $1,600     =     $400

(D) X'S BASIS IN TRANSFERRED PROPERTY. X has a $2,000 basis in the 1,000FC transferred (1,000FC translated at 1FC=$2).

(iii) 1993 EQUITY AND BASIS POOL CALCULATION, CALCULATION OF SECTION 987 GAIN ON REMITTANCE, AND X'S BASIS IN TRANSFERRED PROPERTY -- (A) POOL CALCULATION. B's equity pool and basis pool at the and of 1993 equal:

                                    Equity(FC)          Basis($)

                (2,500FC / 2,500FC) x $6,400

           $7,500 (2,500FCs at the     -     $6,400     =     $1,100

(f) SOURCE AND CHARACTER OF SECTION 987 GAIN OR LOSS IS ALLOCATED LIKE INTEREST -- (1) GENERAL RULE. Except as otherwise provided in paragraph (f)(2) of this section, a taxpayer must determine the source and character of section 987 gain or loss for all purposes of the Code, including sections 904(d), 907 and 954, by using the same method the taxpayer uses to allocate and apportion its interest expense under 861, modified as follows.

(i) ASSET BASED ALLOCATION. If the taxpayer uses the asset method described in section 1.861-9T(g), it must take into account only the assets of the QBU branch. The allocation and apportionment must be made without regard to the exceptions to fungibility set forth in section 1.861-10T.

(ii) INCOME BASED ALLOCATION. If the taxpayer uses the modified gross income method described in section 1.861-9T(j) to allocate and apportion its interest expense, it must take into account only the QBU branch's gross income.

(2) EXCEPTION TO PREVENT SIGNIFICANT DISTORTION. If the method for sourcing and characterizing section 987 gain or loss described in paragraph (f)(1) of this section would result in a significant distortion, the district director can require (or allow) a taxpayer to use a method that clearly reflects income. For example, if in tax year 1992 the asset composition of a QBU branch of a domestic corporation differs significantly from the historical composition of the QBU's assets, the district director may require (or allow) the taxpayer to source and characterize section 987 gain or loss for 1992 in a manner that more clearly reflects the historical composition of the branch's assets.

(3) EXAMPLES. The provisions of this paragraph (f) are illustrated by the following examples.

(h) EFFECTIVE DATE. Section 1.987-2 (other than section 1.987- 2(a)(2) and section 1.987-2(e)) is effective for taxable years beginning after [DATE THAT IS 30 DAYS AFTER THIS REGULATION IS PUBLISHED AS A FINAL REGULATION]. Section 1.987-2(a)(2) and section 1.987-2(e) are effective for taxable years beginning after December 31, 1986. For taxable years beginning after December 31, 1986, but before [DATE THAT IS 31 DAYS AFTER THIS REGULATION IS PUBLISHED AS A FINAL REGULATION], a taxpayer must use any reasonable method to calculate and characterize for foreign tax credit purposes section 987 gain or loss that is consistent with the principles set forth in this section 1.987-2.

SECTION 1.987-3 TERMINATION OF A QBU BRANCH.

(a) TERMINATION. Generally, a QBU branch terminates when its activities cease. Thus, a QBU branch terminates upon a transfer to the taxpayer of substantially all of the QBU branch's assets. Except as provided in paragraph (b) of this section, a termination also occurs when a taxpayer sells or otherwise disposes of substantially all of the assets of a QBU branch, including the deemed sale that occurs pursuant to an election under section 338.

(b) TRANSACTIONS DESCRIBED IN SECTION 381(a) -- (1) LIQUIDATIONS. Generally a termination does not occur when substantially all of the assets of a QBU branch are distributed in a liquidation described in section 332, except in the following cases --

(i) The distributor is a domestic corporation and the distributee is a foreign corporation;

(ii) The distributor is a foreign corporation and the distributee is a domestic corporation;

(iii) The distributor and the distributee are both foreign corporations and the functional currency of the distributee is the same as the functional currency of the distributor's QBU branch.

(2) REORGANIZATIONS. Generally a termination does not occur when substantially all of the assets of a QBU branch are transferred in a reorganization described in section 381(a)(2), except in the following cases --

(i) A reorganization described in section 367(a);

(ii) A reorganization described in section 367(b) in which the functional currency of the transferee is the same as the functional currency of the transferor's QBU branch;

(iii) A reorganization described in section 367(b) in which at least one of the U.S. shareholders of the transferor is required to include in income either a section 1248 amount or an all earnings and profits amount.

(c) SECTION 351 TRANSACTIONS -- (1) SECTION 351 TRANSACTIONS DESCRIBED IN SECTION 367(a). A termination occurs when the assets of a QBU branch are transferred in a section 351 transaction described in section 367(a).

(2) OTHER SECTION 351 TRANSACTIONS. [Reserved].

(d) SECTION 1248 TRANSACTIONS. A termination of a QBU branch of a foreign corporation occurs when a U.S. person sells or exchanges (or is treated as exchanging) 10% or more of the stock (measured by vote or value) in the foreign corporation (or in a related corporation) during a twelve-month period in a transaction described in section 1248. The basis pool must be adjusted by the amount of section 987 gain or loss recognized as the result of the termination.

(e) PARTNERSHIPS [Reserved].

(f) ADJUSTMENT OF BASIS POOL IN THE CASE OF NONRECOGNITION EVENTS. If a transaction described in section 381(a) does not result in the termination of a QBU branch then the basis pool of the QBU branch must be translated, if necessary, into the functional currency of the distributee or the transferee at the spot rate on the date of the transaction.

(g) EFFECT OF TERMINATION. The termination of a QBU branch results in recognition of section 987 gain or loss.

(h) PROCEDURE. This paragraph (h) provides a 3-step procedure for determining the amount of section 987 gain or loss recognized upon the termination of a QBU branch. These steps apply regardless of the reason for the termination.

(1) STEP 1 - CALCULATION OF PROFIT AND LOSS. The taxpayer calculates the amount (in the QBU's functional currency) of profit or loss attributable to the QBU branch for the portion of the taxable year through the date of termination. For purposes of the preceding sentence, that amount includes any exchange gain or loss (determined without regard to the limitations set forth in section 988(b)) recognized under the provisions of section 1.988-1T(a)(7).

(2) STEP 2 - POOL ADJUSTMENTS. The taxpayer must make adjustments to the equity pool and the basis pool for the profit or loss determined under Step 1 and any transfers to or from the QBU branch attributable to the portion of the taxable year through the date of termination. The taxpayer must also recognize any section 987 gain or loss on remittances made during that portion of the year.

(3) STEP 3 - ADDITIONAL ADJUSTMENTS NECESSARY UPON TERMINATION. After making the pool adjustments under Step 2, a taxpayer must make the additional adjustments set forth in this paragraph (h)(3).

(i) EQUITY POOL IS GREATER THAN ZERO. If the QBU branch's equity pool is greater than zero, the taxpayer must recognize section 987 gain or loss equal to the difference between the amount of the equity pool translated into the taxpayer's functional currency at the spot rate on the date of the termination and the amount of the QBU branch's basis pool (whether the basis pool is positive or negative).

(ii) EQUITY POOL IS LESS THAN ZERO. If the QBU branch's equity pool is less than zero, the taxpayer is deemed to make a transfer to the QBU branch equal to the negative amount of the equity pool. This results in an increase to the basis pool. The amount of the increase equals the amount of the deemed transfer translated into the taxpayer's functional currency at the spot rate on the date of the termination. The taxpayer must recognize --

(A) Section 987 gain equal to the negative amount of the basis pool (as adjusted), or

(B) Section 987 loss equal to the positive amount of the basis pool (as adjusted).

(iii) EQUITY POOL EQUALS ZERO. If the QBU branch's equity pool equals zero, the taxpayer must recognize section 987 gain or loss under the principles of paragraph (h)(3)(ii) of this section.

(i) EFFECTIVE DATE. Section 1.987-3 (other than section 1.987- 3(g) and section 1.987-3(h)) is effective for taxable years beginning after [DATE THAT IS 30 DAYS AFTER THIS REGULATION IS PUBLISHED AS A FINAL REGULATION]. Section 1.987-3(g) and section 1.987-3(h) are effective for taxable years beginning after December 31, 1986. For taxable years beginning after December 31, 1986, but before [DATE THAT IS 31 DAYS AFTER THIS REGULATION IS PUBLISHED AS A FINAL REGULATION], a taxpayer must determine what constitutes a termination using the principles of section 1.987-3(a).

(j) EXAMPLES. This section is illustrated by the following examples.