AICPA Seeks Reconsideration of Proposed Branch Currency Transaction Regs

Dear Commissioner Everson and Mr. Dorfman:

On September 6, 2006, the Department of the Treasury and the Internal Revenue Service issued proposed regulations under section 987 regarding the determination of income and loss of certain qualified business units using functional currencies that are different from their owners, and the timing, amount, character, and source of section 987 gain or loss. The proposed regulations were published in the September 7, 2006 issue of the Federal Register (71 Fed. Reg. 52876). The preamble to the proposed regulations requests comments concerning various issues raised by the proposed regulations.

The American Institute of Certified Public Accountants offers the attached comments with respect to the proposed regulations. In summary, we suggest the Department of the Treasury and the Internal Revenue Service reconsider the approach of the proposed regulations. We are concerned that the proposed regulations will frustrate the currency reforms made by The Tax Reform Act of 1986 and will pose an unreasonable compliance burden on taxpayers. However, if the approach of the proposed regulations is followed, we suggest that the final regulations:

• Provide an election to make a section 481 adjustment in the transition year. In order to avoid "cherry-picking," the election should be subject to the conformity rule of prop. reg. section 1.987-10(c)(2);

• Provide an election to transition to the method prescribed by the 2006 proposed regulations in any open year;

• Permit a taxpayer to cure any violation of the limitation on the use of the deferral transition method found in prop. reg. section 1.987-10(a)(2) and provide a de minimis exception to the limitation;

• Permit the use of the spot rate to determine the amount of assets and liabilities transferred from the owner to the section 987 qualified business unit (QBU) on the transition date;

• Provide a simplified method for translating inventory;

• Provide an election to translate current assets and liabilities that are section 987 historic assets as section 987 marked items;

• Provide an election to apply a yearly average exchange rate convention to translate all current assets and liabilities that are section 987 historic assets (other than inventory) and property, plant, and equipment;

• Provide an election to treat sales of property and services in the ordinary course of business as regarded transactions;

• Apply to section 987 QBUs that are engaged in the business of lending principally to related parties;

• Allow for grouping by an owner of less than all of its section 987 QBUs with the same functional currency;

• Allow for grouping of QBUs with the same functional currency owned by different members of a consolidated group;

• Provide an election to apply a yearly average exchange rate convention to translate all current liabilities for purposes of section 752;

• Take section 704(c) into account in determining a partner's share of the assets and liabilities of a section 987 QBU held through a partnership;

• Treat a partnership as a QBU for the purpose of determining its taxable income and loss with respect to any assets and liabilities not held in an eligible QBU;

• Permit the adoption or change of translation conventions for any section 987 QBU acquired in a non-terminating transaction from a person not related to the taxpayer before the transaction;

• Eliminate as a termination trigger the loss of controlled foreign corporation (CFC) status;

• Eliminate as a termination trigger the acquisition of a CFC by a non-CFC in a tax-free reorganization;

• Eliminate as termination triggers (1) inbound section 332 liquidations; (2) inbound and outbound tax-free reorganizations; and (3) all section 351 exchanges with the following exceptions: (a) where the functional currency of the distributee or transferee corporation is the same as the functional currency of the section 987 QBU of the distributor or transferor corporation; and (b) in the case of an inbound transaction, where section 987 loss would be recognized; and

• Forgo treating section 987 gain or loss as subpart F income.

The Honorable Eric Solomon, Assistant Secretary (Tax Policy), Treasury Department

John L. Harrington, Acting International Tax Counsel, Treasury Department

Donald L. Korb, Chief Counsel, IRS

Steven A. Musher, Associate Chief Counsel (International), IRS

Bendetta A. Kissel, Deputy Associate Chief Counsel (International), IRS

Steven Jensen, Senior Counsel (Branch 5, CC:INTL:B05), IRS

Theodore D. Setzer, Senior Counsel (Branch 5, CC:INTL:B05), IRS

• Provide an election to make a section 481 adjustment in the transition year. In order to avoid "cherry-picking," the election should be subject to the conformity rule of prop. reg. section 1.987-10(c)(2);

• Provide an election to transition to the method prescribed by the 2006 proposed regulations in any open year;

• Permit a taxpayer to cure any violation of the limitation on the use of the deferral transition method found in prop. reg. section 1.987-10(a)(2) and provide a de minimis exception to the limitation;

• Permit the use of the spot rate to determine the amount of assets and liabilities transferred from the owner to the section 987 qualified business unit (QBU) on the transition date;

• Provide a simplified method for translating inventory;

• Provide an election to translate current assets and liabilities that are section 987 historic assets as section 987 marked items;

• Provide an election to apply a yearly average exchange rate convention to translate all current assets and liabilities that are section 987 historic assets (other than inventory) and property, plant, and equipment;

• Provide an election to treat disregarded sales of property and services in the ordinary course of business as regarded transactions;

• Apply to section 987 QBUs that are engaged in the business of lending principally to related parties;

• Allow for grouping by an owner of less than all of its section 987 QBUs with the same functional currency;

• Allow for grouping of QBUs with the same functional currency owned by different members of a consolidated group;

• Provide an election to apply a yearly average exchange rate convention to translate all current liabilities for purposes of section 752;

• Take section 704(c) into account in determining a partner's share of the assets and liabilities of a section 987 QBU held through a partnership;

• Treat a partnership as a QBU for the purpose of determining its taxable income and loss with respect to any assets and liabilities not held in an eligible QBU;

• Permit the adoption or change of translation conventions for any section 987 QBU acquired in a non-terminating transaction from a person not related to the taxpayer before the transaction;

• Eliminate as a termination trigger the loss of controlled foreign corporation (CFC) status;

• Eliminate as a termination trigger the acquisition of a CFC by a non-CFC in a tax-free reorganization;

• Eliminate as termination triggers (1) inbound section 332 liquidations, (2) inbound and outbound tax-free reorganizations, and (3) all section 351 exchanges with the following exceptions: (a) where the functional currency of the distributee or transferee corporation is the same as the functional currency of the section 987 QBU of the distributor or transferor corporation, and (b) in the case of an inbound transaction, where section 987 loss would be recognized; and

• Forgo treating section 987 gain or loss as subpart F income.

Prior to the enactment of the Act, a taxpayer that kept the books and records of a foreign branch in foreign currency was permitted to determine the taxable income or loss of the branch under either the profit and loss method or the net worth method.

Under the profit and loss method, taxable income or loss was determined in foreign currency and then was translated into dollars at the year-end spot rate. If the branch made a remittance of earnings during the year, the remittance was translated into dollars at the spot rate on the date of the remittance and the balance of the earnings were translated at the year-end spot rate.¹

Under the net worth method, taxable income or loss was determined by comparing the dollar net worth of the branch at the beginning and end of the year. Current assets and liabilities were translated at the year-end spot rate. Long-term assets and liabilities were translated at historic exchange rates -- the exchange rates at the time the assets were acquired or liabilities incurred. A remittance was added back to the dollar year end net worth. In contrast to the profit and loss method, taxable income and loss under the net worth method included exchange gains and losses on current assets and liabilities.²

For purposes of subpart F of the Internal Revenue Code (Code), the earnings and profits (E&P) of a foreign corporation were generally determined under the "full subpart F" method. Under this method, profit or loss was first determined in foreign currency and then translated at the "appropriate exchange rate." Generally, the appropriate exchange rate was an average exchange rate for the year. However, items such as inventory and depreciation were translated at historic exchange rates. The profit or loss so computed was then adjusted for exchange gain or loss. Exchange gain or loss was determined by comparing the dollar retained earnings of the foreign corporation at the beginning and end of the year. Financial assets were translated at the year-end spot rate. Items such as inventory and physical assets were translated at historic exchange rates. Short-term liabilities were translated at the year-end spot rate. Long-term liabilities were translated at historic exchange rates. The dollar difference was adjusted for distributions and profit or loss for the year.³

For purposes of section 902, the E&P of a foreign corporation could not be determined under the full subpart F method, but could be determine under the "limited subpart F" method. Under this method, E&P was determined in foreign currency.⁴

The Act provided a comprehensive set of rules for transactions involving foreign currency that harmonized the computation of taxable income and E&P. The Act introduced the concept of functional currency and a qualified business unit (QBU). Moreover, the Act required the use of the profit and loss method for determining both taxable income and E&P. Indeed, the legislative history to the Act specifically rejected the use of the net worth method for computing taxable income and loss. These rules were by and large based on Statement of Financial Accounting Standards No. 52 (FAS 52). Under FAS 52, the income or loss of a foreign entity, including a branch, is determined in its functional currency (i.e., the currency of the economic environment in which the entity operates) and is translated into the functional currency of the owner at a single exchange rate -- the average rate for the year. Exchange gain or loss is measured by comparing the net worth of the entity at the beginning and end of the year. All items on the balance sheet are translated at the year end rate. Exchange gain or loss is an adjustment to shareholders' equity; it does not figure into net income.

The legislative history of the Act provides the following reasons, among others, for the change:

• A profit and loss method is more consistent with the functional currency concept;⁵

• A profit and loss method results in earnings that bear a close relationship to taxable income for foreign tax purposes;⁶

• A profit and loss method minimizes compliance by eliminating the item-by-item translations that are required under a net worth method;⁷ and

• The net worth method is inconsistent with general federal income tax principles in that it results in the recognition of gain and loss before such gain or loss is realized. Specifically, the net worth method results in unrealized gains and losses on balance sheet items being taken into account in computing taxable income and loss and E&P.⁸

The government expressed concerns in Notice 2000-20, 2001 C.B. 851, that the 1991 proposed regulations permitted taxpayers to claim non-economic currency gain and loss. The preamble to the 2006 proposed regulations indicates that the 1991 proposed regulations were withdrawn principally for that reason.

Under the 2006 proposed regulations, the taxable income of a section 987 QBU is generally computed in the functional currency of the QBU and then translated into the functional currency of the owner at the yearly average exchange rate. However, depreciation and the basis of section 987 historic assets (generally assets that are not denominated in the functional currency of the QBU) are translated at historic exchange rates (generally the spot rate on the date the QBU acquired the asset or incurred the liability).

Also under the 2006 proposed regulations, exchange gain or loss is determined under the "foreign exchange exposure pool" method. Under this method, exchange gain or loss is determined by comparing the beginning and end of year dollar net worth of a section 987 QBU. Section 987 marked items -- generally assets and liabilities denominated in the functional currency of the QBU -- are translated at the year-end spot rate. Section 987 historic assets, including inventory and property, plant, and equipment (PPE), and section 987 historic liabilities are translated at their historic exchange rates. The change in net worth is then adjusted for the taxable income or loss of the QBU for the year and transfers of assets and liabilities to and from the QBU to arrive at the unrecognized section 987 gain or loss for the year. That amount is added to the foreign exchange exposure pool. The unrecognized section 987 gain or loss in the pool is recognized on remittances.

II. General Comments Concerning the 2006 Proposed Regulations

We are concerned that the 2006 proposed regulations will frustrate the reforms made by the Act for the following reasons:

• The method of computing taxable income and loss under the 2006 proposed regulations is not a profit and loss method as envisioned by Congress. As noted above, Congress followed FAS 52 in adopting the profit and loss method. Under FAS 52, income and loss is determined in the functional currency of a foreign entity and then translated into the currency of the owner at a single exchange rate;¹⁰

• Taxable income or loss computed under the 2006 proposed regulations will not bear a close relationship to taxable income or loss computed for foreign tax purposes because depreciation and the adjusted basis of section 987 historic assets will not be computed in local currency;¹¹

• The computation of taxable income or loss under the proposed regulations will require item-by-item translations; and

• The method for computing section 987 gain or loss is a net worth method. Technically, Congress rejected the net worth method only for computing taxable income and loss. Nevertheless, in light of the reasons it rejected the net worth method for computing taxable income and loss, it clearly did not envision that a net worth method would be used to determined section 987 gain or loss. As is noted above, the net worth method was rejected, in part, because it required item-by-item translations and resulted in the recognition of gain or loss before such gain or loss was realized. The method under the 2006 proposed regulations entails item-by-item translations and results in the recognition of gain or loss on marked assets (upon remittances) before such gain or loss is realized.

Moreover, we are concerned that the proposed regulations will pose an unreasonable compliance burden on taxpayers. Most companies keep only a single set of books for foreign operations in local currency. Therefore, these companies will need to undertake a major overhaul in the way in which they keep their books and records. (This compliance burden is discussed in greater detail below.) We note in this regard that the rules under the 2006 proposed regulations concerning section 987 partnerships will present significant compliance difficulties. Under the 2006 proposed regulations, a partnership cannot be an owner of a section 987 QBU. Instead, each partner is treated as owning its shares of the assets and liabilities of a section 987 QBU of the partnership. Where the partners have different functional currency, multiple translations will be required for the same historic assets. We also note that the proposed regulations present significant book-tax differences that will add to the overall compliance burden.

We believe that the compliance costs required by the 2006 proposed regulations are not warranted. We believe that far simpler and less costly means are available to the government for avoiding inappropriate results of the 1991 proposed regulations.

In view of the foregoing, we strongly suggest that the government reconsider the approach of the 2006 proposed regulations. We would be glad to discuss with you at your convenience other proposals for determining section 987 gain and loss.¹³

III. Specific Comments Concerning the 2006 Proposed Regulations

Under prop. reg. section 1.987-10, a taxpayer that is the owner of a section 987 QBU on the transition date must transition from the method previously used by such taxpayer to comply with section 987 to the method prescribed by the 2006 proposed regulations (the New Method) under either the "deferral transition method" or the "fresh start transition method." The transition date is the first day of the first taxable year to which the final regulations apply to a taxpayer. Proposed reg. section 1.987-10(a)(2) provides a limitation on the use of the deferral method. Under the limitation, if the method previously used by the taxpayer was unreasonable, the taxpayer must use the fresh start transition method. If a taxpayer failed to make the determinations required by section 987 for any open year, the taxpayer must use the fresh start transition method.

The preamble to the 2006 proposed regulations states that the method prescribed by the 1991 proposed regulations (the Old Method) or an earnings only method will be considered to be reasonable methods. Moreover, the preamble states that the recognition of section 987 gain or loss with respect to stock under any method where the gain or loss does not reflect economic gain or loss derived from the movements in exchange rates will be carefully scrutinized by the IRS and may be considered unreasonable based on all the facts and circumstances of the particular case.

In general, the deferral transition method requires an owner to determine its section 987 gain or loss under its prior section 987 method as if all of its QBUs subject to section 987 terminated on the last day of the taxable year preceding the transition date. Any section 987 gain or loss on the deemed termination is not recognized but is considered to be net unrecognized section 987 gain or loss of the section 987 QBU in the first taxable year for which the final regulations are effective. This unrecognized gain or loss is recognized on remittances under the New Method. The owner of a QBU that is deemed to terminate under this rule is then treated as transferring all of the assets and liabilities attributable to such QBU to a new section 987 QBU on the transition date.

The exchange rates used to determine the amount of assets and liabilities transferred from the owner to the section 987 QBU on the transition date for purposes of applying the New Method will be determined with reference to the historic exchange rates on the day the assets were acquired or liabilities entered into by the QBU deemed terminated, adjusted to take into account any gain or loss on the deemed termination. Where an owner used the Old Method, the assets and liabilities deemed transferred to the section 987 QBU should be translated at the spot rate on the date of the deemed transfer. We would expect that an owner with overall unrealized section 987 loss under the Old Method would elect to use the deferral transition method in order to preserve that loss in its new foreign exchange exposure pools.¹⁴

The fresh start transition method is the same as the deferral method, except that (1) the section 987 gain or loss will not be rolled over into the foreign exchange exposure pools, and (2) the exchange rates used to determine the amount of assets and liabilities transferred from the owner to the section 987 QBU on the transition date will be determined with reference to the historic exchange rates on the day the assets were acquired or liabilities entered into by the QBU deemed terminated without adjustments for any gain or loss on the deemed termination. We would expect that an owner with overall unrealized section 987 gain under the Old Method would elect to use the fresh start transition method in order to eliminate that gain. An owner electing this method will start out under the New Method with built-in section 987 gain or loss on its section 987 marked items.¹⁵

Proposed reg. section 1.987-10(c)(2) provides a conformity rule. Under the conformity rule, a taxpayer, including all members that file a consolidated return that includes the taxpayer, and any CFC in which the taxpayer owns more than 50 percent of the voting power or stock must consistently apply the same transition method for each QBU subject to section 987 owned on the transition date.¹⁶

The AICPA commends the government for adopting these flexible transition rules. We believe that taxpayers that have used the Old Method or some other reasonable method should be permitted to elect to begin the New Method with either (a) its section 987 unrealized gains or losses under that method preserved or (b) a fresh start. This election prevents unfairness. For example, a taxpayer that has unrealized section 987 gain using some reasonable method should be permitted to elect the fresh start transition method to eliminate its section 987 gain under the Old Method as such taxpayers should not be worse off than taxpayers that have not used a reasonable method or any method. On the other hand, taxpayers that have unrealized section 987 losses relying on the 1991 proposed regulations or have attempted to comply with section 987 using some other reasonable method clearly should be permitted to preserve their losses.¹⁷

Nevertheless, we believe that the following additional effective date and transition rules should be incorporated in the final regulations:

• The AICPA recommends that the final regulations allow a taxpayer to elect a section 481 adjustment in the transition year. In order to avoid "cherry-picking," the election should be subject to the above conformity rule; and

• The AICPA recommends that the final regulations allow a taxpayer to transition to the New Method in any open year.

The 1991 proposed regulations were proposed to be effective prospectively. However, those regulations generally did require taxpayers to follow their principles before they were finalized. We understand that many taxpayers have not complied with the 1991 proposed regulations. As is pointed out in Notice 2000-20, the 1991 proposed regulations may not have achieved their original goal of recognizing economic exchange gains and loss under appropriate circumstances. In light of these concerns, taxpayers may have been justified in not complying. Moreover, we understand that the government has generally not been enforcing section 987(3). In light of these circumstances, we believe that taxpayers that have recognized section 987 gain or loss under the 1991 proposed regulations may be treated unfairly in relation to taxpayers that have not followed the principles of those regulations. Therefore, we believe that the final regulations should allow a taxpayer to elect a section 481 adjustment to at least partially rectify this disparate treatment.¹⁹

If the Old Method is not a method of accounting, then a taxpayer should be permitted to adopt the New Method in any open year.²⁰ The premise of the New Method is that it is a reasonable interpretation of the statute.²¹ Therefore, if the Old Method is not a method of accounting, we see no legal bar to a taxpayer adopting the New Method in any open year.

The Old Method has the hallmarks of an accounting method: it determines the timing of income and loss, although it determines source and character as well. However, we understand that significant differences of opinion exist concerning this question. Because we believe the question cannot be definitely resolved at this juncture, we believe taxpayers should be allowed to transition to the New Method in any open year.

We understand that the effective date and transition rules are creating a fair amount of uncertainty for taxpayers. Specifically, we understand that pending finalization of the 2006 proposed regulations taxpayers are not clear (a) in the event they have been determining section 987 gain or loss, whether they can change to the New Method, and if so, whether they need the permission of the Internal Revenue Service to do so; (b) in the event they have not been determining section 987 gain or loss, whether they can adopt the New Method; and (c) if they are changing to the New Method, whether they will be entitled to a section 481 adjustment or will be required to follow the transition rules of the 2006 proposed regulations. Our recommendations would eliminate these questions. Moreover, our recommendations would eliminate any disparate treatment between taxpayers that change to the New Method before the 2006 proposed regulations are finalized and taxpayers that change to the New Method afterwards.

As is discussed above, prop. reg. section 1.987-10(a)(2) provides a limitation on the use of the deferral method. Under the limitation, if the method previously used by the taxpayer was unreasonable, the taxpayer must use the fresh start transition method. Moreover, if a taxpayer failed to make the determinations required by section 987 for any open year, the taxpayer must use the fresh start transition method. As is also discussed above, prop. reg. section 1.987-10(c)(2) provides a conformity rule. Under the conformity rule, a taxpayer, including all members that file a consolidated return that includes the taxpayer, and any CFC in which the taxpayer owns more than 50 percent of the voting power or stock must consistently apply the same transition method for each QBU subject to section 987 owned on the transition date.

• The AICPA recommends that the final regulations permit a taxpayer to cure any violation of the limitation on the use of the deferral transition method found in prop. reg. section 1.987-10(a)(2) and provide ade minimisexception to the limitation.

• The AICPA recommends that the final regulations allow the use of the spot rate to determine the amount of assets and liabilities transferred from an owner to a section 987 QBU on the transition date.

If the foregoing recommendation is not adopted, we recommend that taxpayers be permitted to use very flexible conventions, such as yearly average exchange rates or multi-year average exchange rates, for this purpose. Moreover, we recommend that taxpayers be permitted to use statistical sampling for purposes of determining when assets were acquired and liabilities incurred.

Proposed reg. section 1.987-1 generally defines the historic exchange rate, in the case of an asset, as the spot rate on the day the asset was acquired by the section 987 QBU, and in the case of a liability, as the spot rate on the day the liability was entered into by the section 987 QBU.

• The AICPA recommends that the final regulations allow a taxpayer to translate inventory using a simplified method.

We understand that United States tax departments of taxpayers (even tax departments of major multinational corporations) receive, in most cases, only limited general ledger financial information relating to foreign operations (all in local currency) together with certain other limited information necessary to make adjustments necessary for United States tax purposes. Detailed inventory accounts are not typically provided. Even if these records were provided, translating them off-line would be an enormous task. There could be thousands of items figuring into the calculation of inventory. In view of the foregoing, we believe that requiring taxpayers to translate current assets (especially inventory) and liabilities at historic exchange rates will, in most cases, be unworkable.

Under a simplified method for translating FIFO inventory, section 471 costs and additional section 263A expenses incurred during the year (other than depreciation) would be translated at the yearly average exchange rate. The total depreciation of the section 987 QBU translated at historic exchange rates (as discussed below) would be treated as a section 471 cost or an additional section 263A expense based on the "depreciation absorption ratio." The depreciation absorption ratio would be the ratio of the section 471 and section 263A depreciation of the QBU to the total depreciation of the QBU computed in its functional currency. The depreciation (in the owner's functional currency) treated as a section 471 cost or additional section 263A expense would then be allocated to ending inventory based on the "ending inventory depreciation absorption ratio." That ratio would be the ratio of ending inventory to the total section 471 costs and additional section 263A expenses computed in the functional currency of the QBU. The other section 471 costs and additional section 263A expenses of the section 987 QBU in its functional currency would be allocated to ending inventory based on the "ending inventory other cost ratio." That ratio would be the ratio of the section 471 costs and additional section 263A expenses other than depreciation to total section 471 costs and additional section 263A expenses computed in the functional currency of the QBU. The amount allocated to ending inventory would be translated at the yearly average exchange rate. Ending inventory would be the total of the allocable depreciation and other section 471 costs and additional section 263A expenses computed in the functional currency of the owner. Beginning inventory in the functional currency of the owner would be the prior year's ending inventory in that currency.²²

A similar simplified method would need to be worked out for LIFO inventory.

• The AICPA recommends that the final regulations allow a taxpayer to elect to translate current assets and liabilities that are section 987 historic assets as section 987 marked items.

• The AICPA recommends that the final regulations permit a taxpayer to use a yearly average exchange rate convention to translate all current assets (other than inventory) and liabilities that are section 987 historic assets and PPE.

• The AICPA recommends that the final regulations allow a taxpayer to elect to treat disregarded sales of property and services in the ordinary course of business as regarded transactions.

• The AICPA recommends that the final regulations apply to section 987 QBUs that are engaged in the business of lending principally to related parties.

• The AICPA recommends that the final regulations allow an owner to group less than all of its section 987 QBUs with the same functional currency.

• The AICPA recommends that the final regulations allow the grouping of section 987 QBUs with the same functional currency owned by different members of a consolidated group.

Any recognized section 987 gain or loss of a member would be included as part of the investment adjustment with respect to the stock of the member under reg. section 1.1502-32. If the combined pool has net unrecognized gain, but a separate foreign exchange exposure pool of a section 987 QBU of one or more members has a loss, the loss would be treated as recognized by the member with the QBU generating the loss solely for purposes of applying the investment adjustment rules. The loss would be apportioned to the foreign exchange exposure pools of the section 987 QBUs of the other participating members with net unrealized gain in proportion to that gain. Those members would be treated as recognizing section 987 gain solely for purposes of applying the investment adjustment rules.²⁸ If a section 987 QBU of a member terminated and the member still had unrealized section 987 gain or loss in its separate foreign exchange exposure, the gain or loss would be recognized on the termination. If a member left the group, it would take its separate pool with it.²⁹

Similar mechanics could apply to permit the grouping of section 987 QBUs owned directly by an owner with section 987 QBUs owned indirectly by the owner through partnerships.

Proposed reg. section 1.987-7 provides rules to coordinate the 2006 proposed regulations with subchapter K. Under that regulation, a partner's adjusted basis in its partnership interest is maintained in the functional currency of that partner. Moreover, a partner's share of the items of income, gain, deduction, and loss taken into account in calculating section 987 taxable income or loss of a section 987 QBU held indirectly through a section 987 partnership is treated as income or loss of the section 987 partnership. As a result, the partner's allocable share of the items of the income, gain, deduction or loss taken into account in calculating section 987 taxable income or loss of the section 987 QBU is taken into account, following conversion into the partner's functional currency, in determining the appropriate adjustments to the partner's adjusted basis in its partnership interest under section 705.

Proposed reg. section 1.987-7(c)(iv) provides that for purposes of determining the amount of any increase in a partner's share of the liabilities of a partnership (or any increase in the partner's individual liabilities by reason of the assumption by such partner of a liability of the partnership) that are liabilities of a section 987 QBU of the partnership and are denominated in a functional currency different from the partner's, the amount of such liabilities is to be translated into the functional currency of the partner using the spot rate on the date of the increase. For purposes of determining the amount of any decrease in a partner's share of the liabilities of the partnership that are denominated in a functional currency different from the partner's functional currency, the amount of such liabilities are to be translated into the functional currency of the partner using the historic exchange rate for the date on which such liabilities increased the partner's adjusted basis in its partnership interest under section 752.

• The AICPA recommends that the final regulations permit a taxpayer to use a yearly average exchange rate convention to translate all current liabilities for purposes of section 752.

Proposed reg. section 1.987-7(b) provides, as a general rule, that a partner's share of the assets and liabilities of a section 987 QBU held through a partnership are to be determined in a manner that is consistent with the manner in which the partners have agreed to share the economic benefits and burdens (if any) corresponding to the assets and liabilities taking into account the rules and principles of section 701 through 761 and the applicable regulations, including section 704(b) and reg. section 1.701-2. The 2006 proposed regulations do not specifically address property subject to section 704(c).

• The AICPA recommends that the final regulations permit a partner to take section 704(c) into account in determining its share of the assets and liabilities of a section 987 QBU held through a partnership.

In order to eliminate these transfers, a partner should be allowed to determine the transfers to and from a section 987 QBU held through a partnership by reference to the book value of the assets held by the section 987 QBU. Alternatively, if transfers are determined by tax basis, a partner should be entitled to an adjustment to eliminate these artificial transfers.³³

The preamble to the proposed regulations states that the government is considering a safe harbor under which the assets and liabilities of an eligible QBU would be deemed to be allocated in a manner that appropriately reflects each partner's share of the economic benefits and burdens if certain conditions are satisfied. The preamble provides as an example that the safe harbor could provide that the assets and liabilities will be deemed to be allocated in a manner consistent with each partner's share of the underlying economic benefits and burdens provided the assets (1) to the extent of a partner's share of partnership capital, are allocated in accordance with such capital and (2) any excess assets (assets in excess of partnership capital) are allocated consistent with the manner in which the partners have agreed to share the economic burden of the liabilities incurred to acquire such assets. We believe that assets and liabilities would ordinarily be allocated in this manner. (Excess assets subject to non-recourse liabilities would ordinarily be allocated consistent with the manner in which the related non- recourse deductions would be allocated.) We suggest that the final regulations contain examples that address partnerships with recourse and non-recourse debt.³⁴

Proposed reg. section 1.987-2(c)(3)(i) provides that for purposes of section 987, an asset will be treated as transferred to an indirectly owned section 987 QBU if, and to the extent, the asset is contributed to the section 987 partnership that carried on the section 987 QBU provided that immediately following such contribution, the asset is reflected on the books and records of the section 987 QBU. The regulation further provides that for purposes of this paragraph deemed contributions under section 752 are to be disregarded. Proposed reg. section 1.987-2(c)(3)(ii) addresses distributions from partnerships and provides that for purposes of this paragraph deemed distributions under section 752 are to be disregarded. We find these rules concerning section 752 to be confusing.

For example, assume A and B, each with the dollar as its functional currency, are partners in PRS, a pound section 987 QBU. PRS incurred a #£50 liability from a third party to purchase non- depreciable real estate. A guaranteed the debt. The partnership has no other assets or liabilities. A should be allocated the asset and the liability for purposes of section 987 because A bears the economic burden of the liability. If PRS refinanced the non-recourse liability with a recourse liability, A's QBU should be deemed to transfer #£25 of assets and #£25 of liability to A, and B should be deemed to transfer #£25 of assets and #£25 of liability to its QBU. The proposed regulations should make this clear.

• The AICPA recommends that a partnership be treated as a QBU for the purpose of determining its taxable income and loss with respect to any assets and liabilities not held in an eligible QBU.

The preamble to the 2006 proposed regulations states that they do not address the adjustments that would occur under section 752 when a partnership assumes a partner's liability that is denominated in a functional currency different from the partner and that, as a result, is subject to section 988 in the hands of the partner. The preamble requests comments on whether any distribution under section 752(b) should be determined by reference to the spot rate on the date of the assumption or the historic exchange rate on the date the liability was originally incurred by the partner. Because partnerships are ignored under the 2006 proposed regulations for purposes of section 988, it seems to us that the historic exchange rate should be used. The transferring partner should, however, recognize gain or loss under section 988 for any portion of a liability that shifts to another partner as a result of the transfer. The partner should recognize exchange gain or loss under reg. section 1.988-1(a)(10) if the partnership transfers the liability to a QBU with the same currency as the liability. Any gain or loss recognized should be allocated to the transferring partner under the principles of section 704(c). If the partnership is treated as a QBU and is permitted to have a functional currency, reg. section 1.988-1(a)(10) should apply upon the transfer to the partnership. The regulations under sections 988 and 704 may need to be amended to reach these results.³⁵

We note generally in this regard that because partnerships will not have a functional currency, we expect that taxpayers will face extreme difficulty and expense in reporting the result of partnership operations. Proposed reg. section 1.987-3(a)(2) provides that, in general, the taxable income or loss of a section 987 partnership and the distributive share of any owner that is a partner in such partnership will be determined in accordance with the rules of subchapter K.³⁶ However, the partnership must determine each item of income, gain, deduction, or loss of each of its eligible QBUs in the functional currency of the QBU and then allocate such items among the partners under the rules of subchapter K. Each partner adjusts the amounts allocated to it to conform such amounts to United States tax principles and makes the required translations. Evidently under these rules, a partnership will not be able to file a regular Form 1065 or Form 8865 because it will need to file multiple income statements and balance sheets. Moreover, in light of prop. reg. section 1.988-1(a)(4), discussed above, it will need to file additional income statements and balance sheets for section 988 transactions and the other activities of the partnership that are not conducted in a section 987 QBU.

For example, assume a partnership has three partners who have the following functional currencies: (1) the United States dollar; (2) the Canadian dollar; and (3) the Mexican peso. The partnership owns four disregarded entities that are eligible QBUs with the following functional currencies: (1) the euro; (2) the pound, (3) the yen, and (4) the Australian dollar. Moreover, the partnership borrowed in euros but not through any of its QBUs.

As a practical matter, the partnership will need to provide all of the information needed by each partner for it to compute its taxable income and determine its section 987 gain or loss. Thus, the partnership will need to provide four income statements and balance sheets -- one for each eligible QBU -- translated into United States dollars for the United States partner, four income statements and balance sheets translated into the Canadian dollar for the Canadian partner, and four income statements and balance sheets translated into the Mexican peso for the Mexican partner -- 12 income statements and balance sheets in all. Moreover, it will need to provide an additional income statement and balance sheet for each partner to report the euro borrowing. This reporting will be in addition to the other information that will be needed to comply with the regulations -- for instance, information concerning transfers and the foreign exchange exposure pools. Form 1065 and Form 8865 will become unrecognizable from the forms that now exist as they will just become compilations of separate reporting for the various activities of the partnership.³⁷

Proposed reg. section 1.987-1(c)(1)(ii) permits the use of certain spot rate conventions. Proposed reg. section 1.987-1(c)(2) permits an owner to determine the yearly average exchange rate under any reasonable method, but requires that method to be consistently applied.

• The AICPA recommends that the final regulations allow a taxpayer to adopt or change the translation conventions for any section 987 QBU acquired in a non-terminating transaction from a person not related to the taxpayer before the transaction.

• The AICPA recommends that the final regulations eliminate as a termination trigger the loss of CFC status.

We believe this trigger is unwarranted for the following reasons. First, as is discussed below, we do not believe that section 987 gain is subpart F income. Even if section 987 gain could be subpart F income, this rule would trigger all section 987 gain not just section 987 gain allocable to assets giving rise to subpart F income under prop. reg. section 1.987-6. In any event, this trigger would cause a recognition event when no realization event would even have occurred in the CFC: the mere fact that a foreign corporation ceases to be a CFC is not a realization event in the CFC (e.g., stock of CFC sold or issued by a CFC to a foreign person). Moreover, we see no sound policy reason for treating unrealized section 987 QBU gain differently from other unrealized subpart F income.

• The AICPA recommends that the final regulations eliminate as a termination trigger the acquisition of a CFC by a non-CFC in a reorganization.

• The AICPA recommends that the final regulations eliminate as termination triggers (1) inbound section 332 liquidations; (2) inbound and outbound reorganizations; and (3) all section 351 exchanges with the following exceptions: (a) where the functional currency of the distributee or transferee corporation is the same as the functional currency of the section 987 QBU of the distributor or transferor corporation; and (b) in the case of an inbound transaction, where section 987 loss would be recognized.

The preamble states that a transfer of a section 987 QBU in a section 381(a) transaction is generally not treated as termination because the section 987 gain or loss "is analogous in some respects to a tax attribute under section 381." We also see no sound policy reason for treating section 351 transactions differently from section 381(a) transactions. If the government is concerned that a transferee in a section 351 transaction will not succeed to the foreign exchange exposure pool and other section 987 tax attributes of the transferor, it should require the transferor and transferee to agree that the transferee will succeed to those attributes in order to obtain tax- free treatment.

Section 987 is silent on the method of characterizing section 987 gain or loss for purposes of the Code. Nevertheless, the IRS and the Treasury Department believe that it is necessary to characterize section 987 gain or loss for the proper operation of certain other sections of the Code. For example, the character of section 987 gain must be determined for purposes of determining whether all or a portion of such gain qualified as subpart F income under section 954. This characterization is necessary to prevent section 987 from being used as a vehicle to avoid the rules of section 954(c)(1)(D) with respect to certain section 988 transactions.

• The AICPA recommends that the final regulations not treat section 987 gain or loss as subpart F income.

Section 987(3) affords the government authority to treat section 987 gains and losses "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."⁴² However, nothing in the legislative history to section 987 suggests that this authority extend to treating section 987 gain or loss as subpart F income.⁴³

Proposed reg. section 1.987-4(d) calculates the unrecognized section 987 gain or loss for a year by comparing the beginning and end of year owner functional currency net value of a section 987 QBU and then making adjustments to that amount. Two of the adjustments are to subtract the "section 987 taxable income" and add the "section 987 taxable loss" of the section 987 QBU computed under prop. reg. section 1.987-3. Proposed reg. section 1.987-3 provides that, as a general rule, a section 987 QBU determines each item of income, gain, deduction, or loss attributable to a section 987 QBU in its functional currency under United States tax principles. The owner then translates those items into its functional currency. The rules of prop. reg. sections 1.987-3 and 1.987-4 should make it clear that appropriate adjustments should be made when the rules are used to compute E&P and that adjustments should be made for tax-exempt income or non deductible items.

² Rev. Rul. 75-106, 1975-1 C.B. 31; Rev. Rul. 75-134, 1975-1 C.B. 33.

³ Reg. section 1.964-1.

⁴ Reg. section 1.902-3(g)(1); reg. section 1.964-1(a)-(c).

⁵See, e.g., Staff of Joint Comm. On Tax., 99th Cong., General Explanation of the Tax Reform Act of 1986, at 1090 (Comm. Print 1987).

⁶Id. Evidently, Congress was concerned that the use of the net worth method distorted the foreign tax credit limitation.

⁷Id.

⁸Id.

⁹ The government issued reg. sections 1.987-5 and 1.989(c)-1 as final regulations at the same time. These regulations provided a method for determining section 987 gain or loss for branches in existence on January 1, 1987. The method under these regulations required two sets of pools be maintained for each QBU: one set for earnings and another for capital. Remittances were treated as paid from earnings first and then capital. Otherwise, the regulations were similar to the 1991 proposed regulations.

¹⁰ The method of computing taxable income or loss under the 2006 proposed regulations is not consistent with the functional currency concept for the same reason.

¹¹ Consequently, the foreign tax credit limitation will be distorted.

¹²See, e.g., Staff of Joint Comm. On Tax., 99th Cong., General Explanation of the Tax Reform Act of 1986, at 1090-91 (Comm. Print 1987).

¹³ As a general proposition, we are of the view that section 987 determinations should be made under the approach of the 1991 proposed regulations. We outlined our comments on those proposed regulations in our letter to you of August 20, 2003 http://tax.aicpa.org/Resources/Tax+Advocacy+for+Members/International/ AICPA+Comments+on+Foreign+Currency+Transaction+Regulations.htm. Other proposals are being discussed in the tax community.

¹⁴ If a taxpayer with an overall section 987 loss under the Old Method elected to apply the fresh start transition method, it may have a higher basis in the assets of its section 987 QBUs than it would have under the deferral transition method. A taxpayer with an overall section 987 loss under the Old Method might elect the fresh start method if it did not expect its section 987 QBUs with losses to make remittances. In such case, the taxpayer may realize the tax benefits of the higher basis before the tax benefits of the unrecognized section 987 loss.

¹⁵ A taxpayer with an overall section 987 gain under the Old Method might elect the deferral method to obtain a higher basis in the assets of its section 987 QBUs than it would have under the fresh start transition method if it did not expect its section 987 QBUs with gains to make remittances.

¹⁶ The conformity rule may result in a CFC being subject to conflicting transition elections: one shareholder may hold more than 50 percent of the voting power while another may own more than 50 percent of the stock. We suggest that the conformity rule be based solely on voting power.

¹⁷ Proposed reg. section 1.987-10(c)(5) provides an anti-duplication rule. Under this rule, the transition method used by a taxpayer cannot result in taking into account a section 987 gain or loss with respect to an asset or liability attributable to a period prior to the transition date more than once. This rule does not appear to cover all "duplicative" situations. For example, assume a dollar taxpayer contributes land (Property 1) with a $100 basis to a euro QBU when €1.00 = $1.00. The day before the transition date when €1.00 = $2.00, the QBU sells Property 1 for €100 and reinvests the proceeds in other land (Property 2). The QBU recognizes no gain or loss on the sale (€100 amount realized - €100 basis). The taxpayer has $100 of unrealized section 987 gain on the deemed termination. As we read the transition rules, if the taxpayer elects the deferral method, the new section 987 QBU would translate its basis in Property 2 at a historic exchange rate of €1.00 = $2.00 or $200 and would add the $100 of unrealized section 987 gain to that amount for a total dollar basis of $300. If the new section 987 QBU sold Property 2 for €100, it would recognize a $100 loss ((€100 x $2.00) - $300). Because the taxpayer would not recognize section 987 gain more than once, the anti-duplication rule technically would not apply. If the QBU had not sold Property 1, it would translate its basis in that asset at the historic exchange rate of €1.00 = $1.00 or $100 and add $100 of unrealized section 987 gain to that amount for a basis of $200. These situations should have the same results. Our recommendation below to use the spot rate to translate the opening balance sheet would resolve this problem.

¹⁸ We note that prop. reg. section 1.987-1(f) treats elections under section 987 as methods of accounting.

¹⁹ We recognize that a section 481 adjustment is not required. Nevertheless, we believe that a section 481 adjustment should be permitted in the circumstances described above.

²⁰ If the Old Method is not a method of accounting, taxpayers that have been using the Old Method apparently should be entitled to change to an earnings only method in any open year inasmuch as the preamble to the 2006 proposed regulations acknowledges that an earnings only method is a reasonable method. Moreover, taxpayers that have not determined section 987 gain or loss should be entitled to begin using the Old Method or an earnings only method in any open year.

²¹ Indeed, the 2006 proposed regulations state that "[p]ending finalization, the IRS and the Treasury Department would consider positions consistent with the proposed regulation to be reasonable constructions of the statute.

²² See Example 1 in Appendix A. The methodology is based on the simplified methods in the regulations under section 263A. See, e.g., reg. section 1.263A-2(b)(3).

²³ See Example 2 in Appendix A.

²⁴ Under reg. section 1.964-1, CFCs were required to compute their earnings and profits by translating inventory at historic exchange rates in a manner similar to the 2006 proposed regulations. The method in reg. section 1.964-1 for translating inventory may have made sense in 1964 when reg. section 1.964-1 was issued. However, in light of the proliferation of branches, disregarded entities, and partnerships with foreign operations in modern foreign corporate structures, these rules are no longer practical. We note that under the net worth method of Rev. Rul. 75- 106, current assets, presumably including inventory, and liabilities were translated at the year end spot rate.

²⁵ The use of a yearly average exchange rate would generally be consistent with reg. section 1.964-1. See reg. section 1.964-1(d)(2) (translations for year made using either a simple average exchange rate or weighted average exchange rate).

²⁶ Moreover, this convention would create more income or loss in the section 987 QBU and thus could affect the source of the owner's overall income.

²⁷ Transactions between section 987 QBUs of different members of a consolidated group would not be disregarded transactions, but would be intercompany transactions subject to reg. section 1.1502-13. The final regulations should provide a rule to require the selling member to translate the amount realized using the same exchange rate as the buyer uses to translate the transaction.

²⁸ These proposals generally follow the principles of the rules concerning net operating losses in reg. section 1.1502-21. Permitting grouping among members of a consolidated group is generally consistent with the consolidated return provisions. See e.g., reg. section 1.1502-13 (treating members as divisions of a single corporation for purposes of determining the timing, character, source, and certain other attributes of an inter-company transaction); reg. sec. 1.1502-34 (treating a member as owning stock owned by another member for purposes of applying certain Code provisions).

²⁹ See Example 3 in Appendix A. Where a section 987 QBU is grouped with one or more other QBUs of other members of a consolidated group, a transfer of the QBU to another member of the consolidated group would not be treated as a remittance; it would remain part of the group. A transfer of the QBU outside the consolidated group would be treated as a remittance if the transaction would otherwise be treated as a termination of the QBU. A transfer of the QBU outside the consolidated group in a non- termination transaction would not be treated as a remittance; the transferee would succeed to the separate foreign exchange exposure pool.

³⁰ This recommendation is consistent with prop. reg. section 1.987-7(b)(iv). The recommendation, in effect, assumes that (1) all current liabilities were incurred during the preceding 12 months and are satisfied during the subsequent 12 months and (2) the current liabilities are translated at the average exchange rate when they were incurred to determine the increase in basis and they are translated at the same rate when then are satisfied to determine the decrease in basis. Assume, a euro section 987 partnership with two equal dollar partners incurs €200 of current liabilities in year 1. The average exchange rate for year 1 is €1.00 = $1.00. Each partner would increase its basis by $100 at the end of year 1. The current liabilities at the end of year 2 are still €200. The average exchange rate for year 2 is €1.00 = $1.20. Under the recommendation, each partner would, in effect, decrease its basis by $100 (€100 x $1.00) for the liabilities incurred during year 1 and deemed satisfied in year 2 and would increase its basis by $120 for the liabilities deemed incurred in year 2.

³¹ Similarly, a contribution of property to a partnership that holds section 704(c) property may result in transfers to or from the section 987 QBUs of the partnership.

³² Moreover, when gain or loss is recognized (or depreciation claimed) by the partnership on section 704(c) property reflected on the books and records of a section 987 QBU, deemed transfers to or from the section 987 QBU may also result under the rules of the 2006 proposed regulations.

³³ See Example 4 in Appendix A. The recommendation would not eliminate transfers where the partnership held the transferred QBUs as separate QBUs. Transfers in this case could be avoided through a grouping election if the QBU had the same functional currency. It also would not eliminate transfers where the transferred section 987 QBUs had different functional currencies or in situations similar to those addressed in prop. reg. section 1.987- 1(c)(9), Ex. (5) (change of interest in section 987 partnership as a result of a contribution of property where the property was not held in QBU of the partnership). We question whether it is appropriate to treat transfers resulting from a contribution to a partnership as remittances. Where book values are used to determine transfers, adjustments will be necessary for revaluations under reg. section 1.704-2(f). Where tax basis is used, adjustments will be necessary in the case of basis adjustments under sections 732(d), 734, and 743. We suggest that the proposed regulations contain a general provision allowing taxpayers to make appropriate adjustments to avoid: (1) deemed transfers that are not appropriate under the principles of prop. reg. section 1.987-2 (e.g., deemed transfers not resulting from actual transfers to or from a section 987 QBU or actual shifts in interest in a section 987 QBU or its assets or liabilities); and (2) unrecognized section 987 gains or losses not resulting from changes in the value of marked assets.

³⁴ See Examples 5 and 6 in Appendix A.

³⁵ See Example 6 in Appendix A.

³⁶ Since a partnership will not have a functional currency, we do not understand what this general rule accomplishes.

³⁷ We would expect that the partnership rules under the 2006 proposed regulations will make complying with the already difficult rules addressing capital accounts under section 704 extremely difficult as well.

³⁸ If our recommendations concerning grouping are not adopted, we would recommend that a taxpayer be permitted to revoke a former owner's grouping election applicable to acquired section 987 QBUs and to elect whether or not such acquired section 987 QBUs be subject to any grouping election made by the taxpayer.

³⁹ Where a section 987 QBU is distributed or transferred in a non-termination transaction to a corporation that has a functional currency that is different from distributor or transferor, the final regulations should provide that the distributee or transferee corporation should translate the distributor's or transferor's functional currency amount of assets and liabilities and foreign exchange exposure pool of the section 987 QBU into its functional currency at the spot rate on the date of the distribution or transfer.

⁴⁰ Outbound liquidations would be taxable in any event under section 367(e) and the regulations thereunder.

⁴¹ Reg. section 1.367(a)-5T(d) provides that the exception to gain recognition under section 367(a) for transfers of property for the use in the active conduct of a trade or business does not apply to transfers of foreign currency and other property denominated in foreign currency. These rules pre-date the Tax Reform Act of 1986. We believe these rules need to be updated and coordinated with sections 987 and 988. The updated rules should not provide for the recognition of gain on the transfer of a section 987 QBU.

⁴²See also section 989(c).

⁴³ If our recommendation is not adopted, we suggest that the final regulations provide a business needs exception similar to that under section 954(c)(1)(D).