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Coordinating Subchapter K and the Branch Currency Regulations

Posted on July 1, 2019
[Editor's Note:

This article originally appeared in the July 1, 2019, issue of Tax Notes Federal.

]

Michael Kohler is a managing director in the passthroughs group in the National Tax Office of Deloitte Tax LLP. He thanks Jennifer Alexander, Ari Berk, Erich Hahn, Michael Mou, Eric Rausch, and Aziza Yuldasheva for their comments on a prior draft.

In this series of three reports, Kohler addresses the challenges of coordinating subchapter K and section 987 with regulations issued in 2016 that adopt an aggregate approach to related-party partnerships.

Copyright 2019 Deloitte Tax LLP.
All rights reserved.

I. Introduction

A. Introduction

Like Tolstoy’s unhappy families, every partnership may be said to be unhappy in its own way with the complexities presented by section 987. Section 987, governing many nonfunctional currency branch transactions, was enacted by the Tax Reform Act of 1986, which added subpart J to the code.1 There is almost no binding guidance on how the section applies to partnerships, yet compliance with section 987 is not optional. The long absence of binding guidance has obliged partners and partnerships to navigate the complexities of section 987 for themselves, which has likely resulted in inconsistency and potential unfairness between similarly situated taxpayers.

The history of attempts to promulgate regulations under section 987 has not diminished the likelihood of inconsistent compliance. This history suggests the inherent challenges that section 987 presents, both in general and with respect to partnerships in particular. Regulations under section 987 were first proposed in 1991.2 Those regulations applied section 987 to partnerships using an entity approach, whereby partnerships were treated as having their own functional currencies and recognizing foreign currency gain or loss under section 987. Regulations promulgated in 1990 under section 989(a) minimally anticipated the adoption of an entity approach by providing that a partnership is a qualified business unit (QBU) of a partner.3

In 2006 the 1991 proposed regulations were withdrawn, and a second set of regulations was proposed.4 The 2006 proposed regulations abandoned the entity approach and adopted an aggregate approach. Under the aggregate approach, foreign currency gain or loss under section 987 was not treated as an item of partnership gain or loss; instead, the partners (and not the partnerships) were treated as recognizing foreign currency gain or loss under section 987 directly for partnership business operations. As Treasury and the IRS recognized at that time, the calculation of gain or loss under section 987 would differ dramatically based on whether an aggregate or an entity approach was adopted.5

In 2016 the 2006 proposed regulations were withdrawn, and final regulations were promulgated6 along with temporary and proposed regulations7 to address aspects of the application of section 987 not addressed in the final regulations. (Hereafter these 2016 final and temporary regulations will be referred to as the “new regulations.”) The new regulations adopted an aggregate approach similar to that proposed in 2006, but they applied that approach only to partnerships that were wholly owned by related persons. The application of section 987 to all other partnerships was reserved, and in the preamble to the new regulations Treasury and the IRS suggested that the entity approach would be considered for those partnerships.8

The bulk of the new regulations would have become effective for tax years generally beginning after December 7, 2017.9 In July 2017, however, the final regulations under section 987 were identified as significant tax regulations requiring additional review.10 In October 2017 Treasury and the IRS announced their intention to delay the application of the new regulations for one year (while allowing early application for some taxpayers11), and in June 2018 those effective dates were further postponed by another two years.12 In May Treasury and the IRS finalized sections of the 2016 temporary regulations regarding combinations and separations of QBUs and the recognition and deferral of foreign currency gain or loss in connection with some QBU terminations and some transactions involving partnerships.13

At that time Treasury and the IRS withdrew reg. section 1.987-7T, which had answered important questions about how partnerships would apply the aggregate approach prescribed elsewhere in the regulations. The preamble to the Treasury decision stated that until new regulations are proposed and finalized to replace reg. section 1.987-7T, taxpayers may use any reasonable method to make specified computations required when section 987 is applied to partnerships on an aggregate basis.14 Absent further action by Treasury and the IRS, other sections of the temporary regulations will sunset before ever reaching their effective date.15

Further, under various executive orders, Treasury and the IRS have repeatedly announced their intention to consider ways to substantially revise the new regulations to reduce their complexity and the burden they impose on taxpayers.16 In effect, the new regulations (which in any case apply only to partnerships wholly owned by related persons) have been suspended though a long-delayed effective date and are now under the threat of substantial revision.17 Thus, taxpayers have had for the past 30 years, and may have for the foreseeable future, no binding regulatory guidance on the application of section 987 to partnerships.

Moreover, attempts at regulation have been inconsistent. The 1991 proposed regulations adopted an entity approach for all partnerships, and existing regulations under section 989(a) seem to mandate some manner of entity approach as a baseline. The 2006 proposed regulations adopted an aggregate approach for all partnerships, and the new regulations — which are now effectively suspended except for elective early application — adopted an aggregate approach for partnerships that were wholly owned by related persons and suggested that an entity approach might be appropriate for all others.

This history has forced many partnerships to develop their own methods of compliance with section 987, usually based on the bare statutory framework of subpart J and elements of the government’s three prior but inconsistent attempts to provide regulatory guidance.

B. Summary of Argument

In a broad sense, this series of reports tries to move the discussion forward by addressing the challenges of coordinating subchapter K and section 987 through the lens of the new regulations, which adopt the aggregate approach. This series argues that the aggregate approach will require moderately complex coordination rules to prevent inappropriate results in light of some of the basic principles of subchapter K.

In a more limited sense, and for the most part, these reports undertake the more workmanlike goal of describing rules that would coordinate subchapter K and the new regulations in a manner that should be considered reasonable. As Treasury and the IRS prudently acknowledged by withdrawing reg. section 1.987-7T, inappropriate results were possible under some interpretations of the new regulations in their original form.18 Although the withdrawal of reg. section 1.987-7T and the decision to allow taxpayers the flexibility to apply important elements of the new regulations using any reasonable method are welcome, relatively little guidance was given about what those reasonable methods might look like. This series tries to fill in that gap by examining some fundamental challenges presented by the aggregate approach and describing a set of coordination rules that would allow partnerships to apply the new regulations in a reasonable manner. Other methods may also be reasonable, of course, but to keep the discussion as focused as possible, these reports do not try to describe alternative ways to address the challenges described,19 which are not fundamentally new.20

Thus, this extended discussion might be said to validate Treasury and the IRS’s assertion in the preamble to the new regulations that it’s “feasible” to adopt the aggregate approach for partnerships wholly owned by related persons.21 That said, the effort to better coordinate the new regulations and subchapter K is not to be understood as indicating support, or lack of support, for the new regulations themselves. Whether the complexity entailed by the aggregate approach is justified is not addressed, although these reports suggest, through a series of simplified yet representative examples, that the complexity will be significant.

Further, these reports do not address the potential costs of a continued absence of binding guidance, including the risk of inconsistent compliance with section 987 between similarly situated partnerships. Inconsistent compliance with section 987 may not itself be a problem; as Treasury and the IRS have observed regarding section 951A and the cost-benefit analysis required by executive orders 13563 and 12866, the choice to promulgate regulations for important statutory changes can be analyzed under a cost-benefit analysis using as a baseline “the way the world would look in the absence of the proposed regulations.”22 All these important and more fundamental questions are beyond the scope of this discussion.

The principal recommendations in this series can be summarized as follows:

  • For section 987 gain or loss, taxpayers would apply the new regulations in a reasonable manner if they adopted the liquidation value method prescribed by reg. section 1.987-7T and followed two additional rules. (See discussion below and Part 2 of this series.) The computation of section 987 gain or loss for partners under the aggregate approach requires a method for determining each partner’s deemed share of the assets and liabilities reflected on a QBU’s books and records. Reg. section 1.987-7T prescribed such a method, but absent additional coordination rules, that method would seemingly have caused the recognition of artificial section 987 gain or loss (that is, gains or losses not attributable to fluctuations in exchange rates) in many circumstances. Two coordination rules — termed the initial tax capital transfer rule and the current tax capital transfer rule — would prevent those artificial section 987 gains and losses, and thus enable taxpayers to apply the liquidation value method prescribed by reg. section 1.987-7T in a manner that should be considered reasonable.

  • For section 987 income or loss, taxpayers would apply the new regulations in a reasonable manner if they computed items attributable to historical assets in a manner that prevents gain or loss attributable to pre-contribution exchange rate movements from being shifted between partners. (See Part 2 of this series.)

  • For outside basis, taxpayers would apply the new regulations in a reasonable manner if they adjusted each partner’s outside basis to reflect section 987 gain or loss.23 (See Part 3 of this series.)

Part 3 of this series contains an extended “capstone” example that applies the proposals made in these reports to a more moderately representative situation, in which a foreign operating partnership has disregarded transactions between QBU subsidiaries with different functional currencies, a modestly complex capital structure, and required allocations under section 704(c). Before addressing the coordination rules, however, it’s helpful to review the basics of the new regulations as applicable to section 987 aggregate partnerships.

II. Background

Section 987 generally provides that for any taxpayer having one or more QBUs with a functional currency other than the U.S. dollar, the taxable income of that taxpayer will be determined by (1) computing the taxable income or loss separately for each such unit in its functional currency, (2) translating the income or loss separately for each unit at the appropriate exchange rate, and (3) making proper adjustments (as prescribed by the Treasury secretary) for transfers of property between QBUs of the taxpayer having different functional currencies.

A. Structure of the New Regulations

Under the new regulations, the term “section 987 income or loss” refers to an owner’s income, gain, deduction, or loss attributable to an eligible QBU but expressed in the owner’s functional currency.24 Reg. section 1.987-3(b) principally controls the computation of each partner’s section 987 income or loss when a QBU is deemed owned “through” a partnership.

The term “section 987 gain or loss,” in contrast, refers to gain or loss that arises (in theory) solely from transfers of property from eligible QBUs.25 The computation of each partner’s section 987 gain or loss is determined through a comparative tax capital balance sheet approach that is principally controlled by reg. section 1.987-4 and -5.

Thus, the core computational paradigm of the new regulations is found in reg. section 1.987-3, -4, and -5. Other sections play supporting roles and are only briefly discussed here. For instance:

  • Reg. section 1.987-1 defines many of the key terms and concepts, including the critical rules for the exchange rates used to translate items expressed in a nonfunctional currency into the taxpayer’s functional currency.

  • Reg. section 1.987-2 controls how the tax capital balance sheets for QBUs are established and then modified over time (including as a result of transfers to and from QBUs that are deemed to occur solely for purposes of section 987).

  • Reg. section 1.987-6 controls the character of section 987 gain or loss.

  • Reg. section 1.987-7 controls the application of section 987 to partnerships, but this section is largely reserved. The now-withdrawn reg. section 1.987-7T — which is still available to some taxpayers — prescribes the liquidation value percentage (LVP) approach (as defined and described later) for the measurement of each partner’s share of the tax capital of eligible QBUs owned by section 987 aggregate partnerships.

  • Reg. section 1.987-8 addresses the termination of eligible QBUs.

  • Reg. section 1.987-9, -10, and -11 prescribe recordkeeping requirements, transition rules, and effective dates, respectively.

  • Finally, broad and relatively complex deferral rules are provided in reg. section 1.987-12.

B. Section 987 Aggregate Partnerships

As noted, not all partnerships fall within the scope of the new regulations.26 The new regulations apply only to section 987 aggregate partnerships, which are partnerships that meet two criteria: (1) all partnership capital and profits are owned, directly or indirectly, by persons related to each other within the meaning of section 267(b) or 707(b); and (2) the partnership owns eligible QBUs, at least one of which would be a section 987 QBU for a partner if the partner owned the QBU directly.27

Because the discussion in this report is addressed solely to section 987 aggregate partnerships, every reference to a “partnership” should hereafter be understood as a reference to a section 987 aggregate partnership. Each reference to “partner” should be understood to include the term “owner,” as defined in reg. section 1.987-1(b)(4), with respect to eligible QBUs owned for other tax purposes by the partnership. And each reference to a “QBU” should be understood as a reference to a section 987 QBU of an owner (owning either directly or indirectly through the partnership), except when a partner has the same functional currency as the QBU.28

The fundamental consequences of a partnership’s classification as a section 987 aggregate partnership are twofold. First, income or loss attributable to QBUs owned for federal tax purposes by the partnership must be shared by the partners and translated into the partners’ respective functional currencies under the rules of reg. section 1.987-3. Second, each partner’s gain or loss attributable to currency exchange rate movements between its own functional currency and the functional currency of partnership-owned QBUs is determined under reg. section 1.987-4 and -5.29

C. Section 987 Income or Loss

The new regulations are fairly clear regarding the computation of each partner’s share of taxable income attributable to eligible QBUs owned by a partnership. In general, the regulations provide that, except as otherwise provided in reg. section 1.987-3(b)(3), the taxable income or loss of a section 987 aggregate partnership, and the distributive share of any owner that is a partner in that partnership, will be determined in accordance with the provisions of subchapter K.

The regulations also mandate certain ordering procedures for determining section 987 income or loss. First, each item of income, gain, deduction, or loss reflected on the books and records of each of the partnership’s eligible QBUs is determined in the functional currency of each such QBU.30 Thus, the computation starts with a statement of each item of income or loss expressed in the QBU’s functional currency. Next, the partnership allocates the QBU’s items of income, gain, deduction, or loss among the partners in accordance with each partner’s distributive share of that item as determined under subchapter K.31 Finally, after that allocation, each partner’s share of each item is translated into the partner’s functional currency as provided by the currency translation rules of reg. section 1.987-3(c).32

Under reg. section 1.987-3(c), the rates used to translate items into the partner’s functional currency depend on the nature of the item being translated. Under the general rule, items of income, gain, deduction, or loss attributable to a section 987 QBU are translated into the owner’s functional currency using the average exchange rate for the tax year.33

Depreciation or other cost recovery for historical assets is translated using the historical rate.34 For an asset other than inventory that is acquired by a section 987 QBU (including through a transfer), the historical rate is the yearly average exchange rate applicable to the year of acquisition.35 A historical asset is any asset that is properly reflected on the books and records of a section 987 QBU and that is not a marked item. Marked items are assets (or liabilities) denominated in, or determined by reference to, the functional currency of the QBU; are not section 988 transactions of the QBU; and would be section 988 transactions if they were held or entered into directly by the owner of the QBU (or for a section 987 aggregate partnership, the indirect owner of the QBU).36 For instance, cash is a marked item, and most financial assets and liabilities (including accounts receivable) would be marked items. Items of income and loss for marked items fall under the general translation rule (including elective exceptions to that rule) and are generally translated into the partner’s functional currency using the average annual rate. Cost of goods sold is subject to special translation rules.37

While apparently straightforward, the requirement to translate cost recovery for historical assets using the historical rate presents difficult challenges.38 The rules of subchapter K are clear about how depreciation and amortization are allocated among the partners.39 For this reason, the initial two steps in determining a partner’s section 987 income or loss are not in doubt. First, the amount of depreciation and amortization is computed in the QBU’s functional currency.40 Second, this amount is allocated to the partners in accordance with subchapter K.41 Although section 704(c) is not expressly invoked, it is a foundational element of subchapter K; therefore, given the absence of any contrary indication, section 704(c) principles should be taken into account in allocating depreciation and amortization under reg. section 1.987-3(b)(3)(iii). After depreciation and amortization have been allocated to the partners, however, the use of the historical rate as defined in reg. section 1.987-1(c)(3) could result in odd consequences.

For example, assume Corp. X with a euro functional currency owns an eligible QBU with a Japanese yen functional currency. The QBU acquires a depreciable asset in 2017. In 2025 the QBU is contributed to a partnership in a fully nontaxable exchange, and another partner has a functional currency of the Australian dollar. When that partner is allocated depreciation denominated in Japanese yen, what historical rate should it use to translate that depreciation into Australian dollars? Should the average exchange rate between the Australian dollar and the Japanese yen from 2017 be used? This would be odd. The partner with the Australian dollar functional currency became exposed to the Japanese yen only in 2025; why should it take into account movement in the exchange rate between the Japanese yen and the Australian dollar before 2025? Should it use the average exchange rate in 2025? The definition of historical rate in reg. section 1.987-1(c)(3) can be read to support both views.42

As illustrated in examples 6 and 7 in Part 2 of this series, the use of the same vintage historical rate when computing a noncontributing partner’s section 987 income or loss results in potentially significant distortions; however, the use of fresh historical rates for noncontributors has several collateral implications that should be considered. This challenge — generally, the appropriate vintage of a historical rate — is discussed at length in Part 2 of this series.

The historical rate vintage conundrum is not the only ambiguity raised by the requirement to translate cost recovery for historical assets using the historical rate. For example, when an eligible QBU sells a historical asset, basis recovery must be translated into the owner’s functional currency using an exchange rate that is different from the rate used to translate “amount realized.” In effect, as illustrated in Example 2 of reg. section 1.987-3(e), the regulations require that gain or loss under section 1001 for historical assets be computed through a process involving two distinct steps.43 First, amount realized is translated into the owner’s functional currency using one rate.44 Then, any tax basis that is recovered is translated into the owner’s functional currency using the historical rate.45

Although this special translation rule is straightforward, it poses a challenge for partnerships because the rules of subchapter K, and particularly section 704(c), control the allocation of gain or loss, not amount realized and basis recovery. In fact, somewhat elaborate rules are required to approximate each partner’s share of basis recovery in some contexts.46 Those rules are required because neither subchapter K nor, typically, the agreement of the partners says anything directly about the allocation of amount realized or basis recovery.47 Potential coordination rules for basis recovery are discussed in Part 2 of this series.

D. Section 987 Gain or Loss

Section 987 gain or loss is determined through a comparative tax capital balance sheet approach. This method is broadly consistent with the foreign exchange exposure pool method prescribed in the 2006 proposed regulations and their aggregate approach to determining a partner’s exposure to gain or loss resulting from foreign currency exchange rate movements.48

1. Comparative tax capital.

Put simply, section 987 gain or loss is measured through comparisons of the aggregate amount of tax capital deemed invested in a QBU (and thereby exposed to fluctuations in the value of the nonfunctional currency relative to the owner’s functional currency) from time to time.49 The regulations use a specialized term to describe tax capital as applied in the context of a QBU: owner functional currency net value (OFCNV) of the section 987 QBU.50 OFCNV is defined as the aggregate amount of functional currency and the adjusted basis of each asset on the section 987 QBU’s balance sheet as of the last day of the tax year, less the aggregate amount of each liability on the section 987 QBU’s balance sheet on that day, in each case translated into the owner’s functional currency as provided in reg. section 1.987-4(e)(2)51 — in other words, tax basis less liabilities. OFCNV denotes QBU tax capital expressed in the functional currency of the owner. Because tax capital is a readily intuitive concept for most tax practitioners, this report often speaks in terms of tax capital rather than OFCNV.

For instance, assume a U.S. dollar functional currency taxpayer invests $20 in a new eligible QBU with the Australian dollar as its functional currency. The QBU exchanges $20 for AUD 10 and purchases land for AUD 10. Then the value of the Australian dollar is halved relative to the U.S. dollar. That original $20 investment is no longer worth $20, all else being equal, because if the land were simply sold for its purchase price and the proceeds reconverted into U.S. dollars, that taxpayer would receive only $10. In other words, as a result of exchange rate movement, the taxpayer has a $10 loss embedded in its $20 tax capital. Under the regulations, the owner’s $20 tax capital in the QBU would be called its $20 OFCNV.

The regulations do not have a method of determining section 987 gain or loss that is particular to partnerships. Rather, there is a “one size fits all” method of determining section 987 gain or loss that is applied to partnerships by treating each partner as owning a share of the tax capital of QBUs that are owned, for other federal tax purposes, by the partnership itself.

Determining each partner’s deemed share of a QBU’s tax capital for purposes of applying the comparative balance sheet computation on a partner-by-partner basis (which is the essence of the aggregate approach) is a necessary but conceptually challenging exercise. There is no way to determine a partner’s section 987 gain or loss without some method of dividing up QBU tax capital among the partners.52 After the withdrawal of reg. section 1.987-7T, however, the only guidance provided regarding this computation is in the preamble to the Treasury decision that withdrew that temporary regulation:

Until new regulations are proposed and finalized, taxpayers may use any reasonable method for determining a partner’s share of assets and liabilities reflected on the books and records of an eligible QBU held indirectly through the partnership. For this purpose, taxpayers may rely on subchapter K principles (consistent with the 2006 proposed regulations under section 987) or an approach similar to the liquidation value percentage method set forth in [reg. section] 1.987-7T.53

In other words, although a taxpayer may use any reasonable method to divide up a QBU’s tax capital, two methods are specifically identified as potentially reasonable.

First is a method that is consistent with subchapter K principles as reflected in the 2006 proposed regulations. Those regulations provided that a partner’s share of QBU tax capital was to be determined in a manner consistent with the manner in which the partners agreed to share the economic benefits and burdens (if any) corresponding to the assets and liabilities, taking into account the rules and principles of subchapter K and applicable regulations.54 The 2006 proposed regulations contained no further guidance on how that very general directive should be applied.55

There are several ways to plausibly measure the partner’s agreement regarding economic benefits and burdens corresponding to a QBU’s assets and liabilities, including partnership allocations under section 704(b) attributable to the QBU’s economic activities. Allocations of taxable income attributable to a QBU, which will often diverge from the allocation of section 704(b) income or loss attributable to the QBU, might also be said to reflect the partners’ agreement regarding economic benefits and burdens. Special allocations of tax items — for instance, the recovery of a section 743 adjustment to a QBU asset — might also be taken into account in determining the partners’ agreement regarding economic benefits and burdens. Suffice it to say that directing taxpayers to measure a partner’s deemed share of QBU tax capital by reference to the partners’ economic agreement provides taxpayers considerable scope, which is appropriate given the computational burdens that the new regulations impose on partnerships.56

Second is an approach similar to the LVP method in now-withdrawn reg. section 1.987-7T. Under reg. section 1.987-7T(b), each partner’s share of a QBU’s tax capital is deemed proportionate to the relative liquidation value of the partner’s interest. The liquidation value of a partner’s interest is the amount of cash the partner would receive for the interest if, immediately after the applicable determination date, the partnership sold all its assets for cash equal to the fair market value of those assets (taking into account section 7701(g)), satisfied all its liabilities (other than those described in reg. section 1.752-7), paid an unrelated third party to assume all its reg. section 1.752-7 liabilities in a fully taxable transaction, and then liquidated.57 Each partner’s LVP is established on determination dates as defined in reg. section 1.987-7T(b)(2)(ii), which, for most section 987 aggregate partnerships, will likely occur at the end of each partnership tax year.58 In other words, under the LVP approach, partners measure section 987 gain or loss through a comparative tax capital balance sheet approach based on the fiction that each partner owns, on the relevant dates, a share of QBU tax capital commensurate with the their LVP.

However, the preamble makes clear that an approach similar to the LVP approach would be considered reasonable only under specific circumstances:

The Treasury Department and the IRS do not believe that it would be reasonable to apply the liquidation value percentage method without corresponding adjustments to the determination of net unrecognized section 987 gain or loss. Thus, for example, a taxpayer using the liquidation value percentage method may be required to adjust its determination of net unrecognized section 987 gain or loss of a section 987 QBU that is owned indirectly through a partnership to prevent the determination of unrecognized section 987 gain or loss that is not attributable to fluctuations in exchange rates. These adjustments may include, for example, treating any change in a partner’s owner functional currency net value that is attributable to a change in the partner’s liquidation value percentage as resulting in a transfer to or from an indirectly owned section 987 QBU.59

The preamble offers some explanation of the unreasonable distortions that may result from the application of the LVP approach;60 nonetheless, the reference to “adjustments . . . to prevent the determination of unrecognized section 987 gain or loss that is not attributable to fluctuations in exchange rates” may seem cryptic absent numerical examples. In the following discussion, several simple examples illustrate the distortions to unrecognized section 987 gain or loss that the government was most likely concerned about.

Once each partner’s deemed share of QBU tax capital is established, the procedures set out in reg. section 1.987-4 and -5 are applied on a partner-by-partner basis. Under these rules, section 987 gain or loss is determined as the product of two amounts: (1) net unrecognized section 987 gain or loss and (2) the remittance proportion.61

2. Net unrecognized section 987 gain or loss.

The computation of net unrecognized section 987 gain or loss involves several steps. The computation begins with a determination of OFCNV (that is, tax capital deemed invested in the QBU on the last day of the tax year):

  • Step 1: Determine the change in the OFCNV of the QBU for the tax year, as compared with the OFCNV at the end of the previous tax year. (For the QBU’s first tax year, the previous year’s OFCNV is assumed to be zero.62)

This amount — the amount by which the tax capital invested in the QBU changed during the year — is the starting point for the determination of the amount of the foreign currency gain or loss that is embedded in the tax capital invested in the QBU. All subsequent steps are adjustments to this initial amount to correct for changes to OFCNV that are not attributable to changes in exchange rates. Thus, in theory, the resulting amount should reflect only changes to OFCNV that are attributable to exchange rate movements.

The amount determined in step 1 is then further adjusted as follows:

  • Step 2: Increase the amount determined in step 1 by the amount of assets transferred from the section 987 QBU to the owner during the year.63

  • Step 3: Decrease the amount determined in step 1 by the amount of assets transferred from the owner to the section 987 QBU during the year.64

In other words, steps 2 and 3 reverse out changes to OFCNV attributable to transfers of tax capital from or to the QBU during the year. The computation then continues:

  • Step 4: Decrease the amount determined in steps 1 through 3 by the amount of liabilities transferred from the section 987 QBU to the owner.65

  • Step 5: Increase the amount determined in steps 1 through 4 by the amount of liabilities transferred from the owner to the section 987 QBU.66

Steps 4 and 5 reverse out changes to OFCNV attributable to the assumption of debt by or from the owner. The computation then continues:

  • Step 6: Decrease or increase the amount determined in steps 1 through 5 by the section 987 taxable income or loss, respectively, of the section 987 QBU for the tax year.67

  • Step 7: Increase the amount determined in steps 1 through 6 by any expenses that are not deductible in computing the section 987 taxable income or loss of the section 987 QBU for the tax year, including any foreign income taxes incurred by the section 987 QBU for which the owner claims a credit.68

  • Step 8: Decrease the amount determined in steps 1 through 7 by the amount of any tax-exempt income of the section 987 QBU for the tax year.69

Steps 6, 7, and 8 are critical. They are intended to reverse out changes to OFCNV attributable to current taxable income or loss (step 6) and nontaxable income, nondeductible expenses, or foreign income taxes that are nondeductible by virtue of being claimed as a credit (steps 7 and 8). The intuition behind these steps is that to the extent that tax capital (that is, OFCNV) has increased or decreased because the QBU has recognized net taxable income or loss or nontaxable income or loss, those amounts should be backed out because net unrecognized section 987 gain or loss should reflect only gains or losses attributable to foreign currency movements.

Although steps 6, 7, and 8 operate in a straightforward manner when the owner is treated as owning 100 percent of the balance sheet of the QBU, they can be difficult to apply for section 987 aggregate partnerships. As discussed earlier, partners in section 987 aggregate partnerships are treated as owning only a portion of each QBU’s balance sheet. However, each partner’s share of taxable (or nontaxable) income attributable to QBU operations usually will not be proportionate to whatever measure the partnership adopts to divide up a QBU’s tax capital among the partners.

For instance, although the LVP approach reflects the economic arrangement of the partners (insofar as each partner’s deemed share of QBU tax capital reflects the partners’ relative economic entitlements), a partner’s relative share of the value of partnership equity will generally differ from the partners’ relative share of QBU taxable (or nontaxable) income on a QBU-by-QBU basis. Frequently, for instance, although a partner may be treated as owning 40 percent of the tax capital of a QBU under the LVP approach, it might be allocated 80 percent of the QBU’s net taxable income under the partnership agreement.

As demonstrated in examples 4 and 5, this mismatch generally will lead to the recognition of artificial section 987 gain or loss — the sorts of distortions that Treasury and the IRS were likely concerned about in withdrawing reg. section 1.987-7T.70 This challenge is not particular to the LVP approach. If the partners sought to measure their relative share of QBU tax capital based on their agreement regarding section 704(b) income or loss on a QBU-by-QBU basis, a similar problem could arise whenever allocations of taxable income were determined in part by section 704(c) principles. How distortions potentially introduced in steps 6, 7, and 8 might be corrected is discussed at length later.

The result of steps 1 through 8 is the unrecognized section 987 gain or loss of a section 987 QBU for a tax year. Net accumulated unrecognized section 987 gain or loss is the aggregate of the amounts of all unrecognized section 987 QBU gain or loss for all prior tax years, reduced by the aggregate remittances for all prior tax years.

3. Remittance proportion.

A remittance is defined in reg. section 1.987-5(c) as the excess, if any, of the aggregate of all amounts transferred from the section 987 QBU to the owner during the tax year over the aggregate of all amounts transferred from the owner to the section 987 QBU during the tax year.71 For this purpose, the “amounts” are the sum of functional currency and the tax basis of assets transferred or deemed transferred from or to the QBU.72

The remittance proportion for a section 987 QBU for a tax year equals the remittance for the tax year divided by the sum of (1) the aggregate adjusted basis of the gross assets of the QBU as of the end of the tax year reflected on its year-end balance sheet translated into the owner’s functional currency and (2) the amount of the remittance. In other words, the numerator is the remittance, and the denominator is the gross tax basis balance sheet at the end of the year (expressed in the owner’s functional currency) plus the remittance.73

Regarding each QBU owned through a section 987 aggregate partnership, a partner’s annual section 987 gain or loss equals the remittance proportion multiplied by the net accumulated unrecognized section 987 gain or loss.74

III. Section 987 Gain or Loss

A. Generally

As discussed earlier, the preamble to the Treasury decision withdrawing reg. section 1.987-7T stated that until new regulations are proposed and finalized, taxpayers may use any reasonable method for determining a partner’s share of assets and liabilities reflected on a partnership QBU.75 For this purpose, taxpayers may rely on subchapter K principles consistent with the 2006 proposed regulations, which required that QBU tax capital be shared in a manner consistent with the manner in which the partners have agreed to share the economic benefits and burdens (if any) corresponding to QBU assets and liabilities taking into account the rules and principles of subchapter K and applicable regulations76 or, alternatively, an approach similar to the LVP method set forth in reg. section 1.987-7T.

Arguably, the LVP approach can be an effective way to measure each partner’s economic interest over time, and so might be said to be consistent with the spirit of the 2006 proposed regulations.77 Unfortunately, the LVP approach would have often provided an inaccurate measure of each partner’s share of tax capital invested in partnership-owned QBUs, which is the foundation for determining a partner’s section 987 gain or loss.

For instance, one partner might contribute a QBU with significant value but little tax basis to a partnership, while another partner contributes cash that is then invested by the partnership in the QBU. The partners’ relative claims on partnership net equity value would in this circumstance bear no direct or predictable relationship to the tax capital each has invested in the QBU through the partnership. The LVP approach, which looks only to relative equity value, is problematic because it effectively ignores this reality by presuming that each partner has made an investment in QBU tax capital proportionate to the value of each partner’s equity interest. In other words, while reasonably administrable and consistent with the partner’s overall economic arrangement,78 the LVP approach is in tension with subchapter K.

The rules of subchapter K are generally informed by the notion that each partner in a partnership has its own share of tax capital and that partnerships should not allow tax capital to be shifted between partners, even temporarily.79 For instance, allocations of basis recovery (that is, depreciation and amortization) or basis-derivative items (such as gain or loss upon taxable dispositions) are allocated in a manner that reflects each partner’s relative tax capital for an asset rather than each partner’s claim on an asset’s value. Otherwise stated, the rules of subchapter K generally prevent the sharing of tax capital.

The LVP approach, in contrast, enforces the sharing of tax capital by dividing up a QBU’s tax capital among the partners by relative equity value. This is the core of the problem that appears to have driven the government’s decision to withdraw reg. section 1.987-7T. As demonstrated next, the tension between these two regimes will frequently cause artificial section 987 gain or loss to be recognized. By allowing taxpayers to adopt approaches consistent with the 2006 proposed regulations, Treasury and the IRS suggest that this tension could be resolved by importing subchapter K concepts into the measurement of section 987 gain or loss.80

This report does not address those potential approaches,81 other than by illustrating challenges that might be considered endemic to the aggregate approach to section 987 gain or loss, which those alternative methods would presumably need to overcome. Instead, this report argues that the tension between the LVP approach and subchapter K can be addressed — and the LVP approach applied with reasonable results — if a few relatively straightforward coordination rules are adopted. These coordination rules, which in effect are designed to apply aggregate principles in a more thoroughgoing fashion, respond to the government’s observation that if an approach similar to the LVP approach were adopted, adjustments to the determination of unrecognized section 987 gain or loss would be required.82

B. Preventing Artificial Section 987 Gain or Loss

One challenge in applying section 987 to partnerships through an aggregate approach is the potential for the interaction of the rules of subchapter K and reg. section 1.987-4 and -5 to cause artificial section 987 gain or loss. The following discussion uses a series of simple examples to illustrate these challenges and suggest coordination rules that would allow taxpayers to apply the LVP approach in a reasonable manner that avoids the problems identified by the government.

The chief argument of this section is that only two straightforward coordination rules would be needed if the LVP approach were adopted. For ease of reference, these rules are termed:

  • the initial tax capital transfer rule, which prevents artificial section 987 gains and losses from arising from shifts of QBU tax capital existing at the start of a tax year; and

  • the current tax capital transfer rule, which prevents artificial section 987 gains and losses from arising from shifts of QBU tax capital that is created or recovered during the tax year when taxable income or loss is recognized.

1. When the LVP approach works as apparently intended.

To apply the LVP approach in a manner that avoids the problems identified by the government, it is important to understand the limitations of the new regulations as they were originally promulgated. Starting with an example of the LVP approach applying as apparently intended is a useful point of departure.

For partnerships that are not pro rata, the LVP approach as prescribed by the now-withdrawn reg. section 1.987-7T would have operated effectively whenever changes to the partners’ LVPs were solely attributable to allocations of QBU taxable income. Of course, in many and potentially most section 987 aggregate partnerships, changes in a partner’s LVP will not be solely attributable to the amount of QBU net taxable income allocated to the partner. This will be the case for many possible reasons, the most obvious being that taxable income or loss rarely reflects economic appreciation and depreciation perfectly. As Example 1 below demonstrates, however, as long as the changes in economic entitlements are solely attributable to allocations of QBU taxable income, the LVP approach apparently yields appropriate results.

Example 1: Corp. X owns all the stock of Corp. Y. X and Y are calendar-year taxpayers with the U.S. dollar as their functional currency. On the last day of year 1, each contributes $100 to an eligible entity (PRS) that elects to be classified as a partnership for federal income tax purposes. The $200 is invested by PRS in Business A, an eligible QBU with the euro as its functional currency. On that date, $200 has the same value as €200.

X and Y agree to share the profits and losses of business operations, including appreciation and depreciation of value, as follows: For years 2 through 5, 90 percent to X and 10 percent to Y; after year 5, 30 percent to X and 70 percent to Y. During year 2 Business A has net taxable profits of €40. Business A retains its earnings. At the end of year 2, Business A has a value of €240. If PRS were liquidated after the transaction described in reg. section 1.987-7T(b)(2), X would receive €136 and Y would receive €104 in proceeds.83

The annual average exchange rates for each year are:

Table 1

Base

Quote

Year 1

Year 2

U.S. dollar

Euro

1:1

1:1

The relevant spot rates are shown in Table 2.84

Table 2

Base

Quote

1/1 Year 1

12/31 Year 1

12/31 Year 2

U.S. dollar

Euro

1:1

1:1

1:1

In this example, there are no changes in the relevant exchange rates. When there is no change in the exchange rates between an owner’s functional currency and the currency of the QBU, there should be no change to accumulated unrecognized section 987 gain or loss.

Unrecognized section 987 gain or loss is intended as a measure of the effect of currency movements between tax capital invested in a QBU and the owner’s functional currency. Therefore, if there is no change in exchange rates between the QBU’s functional currency and the owner’s functional currency over the relevant period, the amount of unrecognized section 987 gain or loss should be zero. If it is not zero in these circumstances, there may be an issue, because any change to accumulated unrecognized section 987 gain or loss will eventually be recognized as section 987 gain or loss. Preventing artificial changes to unrecognized section 987 gain or loss is thus the key to preventing eventual recognition of section 987 gain or loss.85

Is there any change in unrecognized section 987 gain or loss in this case? The answer is no. Therefore, the new regulations (as originally promulgated) could be said to be operating effectively. Under the partnership agreement, X is allocated 90 percent of the €40 Business A taxable income in year 2. The partnership does not allocate items of profit or loss in accordance with initial LVPs (50 percent for X and Y each); therefore, there is a determination date at the end of year 2.86 Because PRS retains all €40 of its economic appreciation (that is, it does not distribute these profits to the partners), the partners’ LVPs shift. At the end of year 2, X and Y’s interests in PRS have a value of $136 and $104, respectively; therefore, X’s LVP shifts to 56.7 percent and Y’s to 43.3 percent under reg. section 1.987-7T(b)(2). Importantly, the value of X’s equity in PRS increases by €36, and Y’s increases by €4, which is exactly equal to the amount of net taxable income attributable to Business A that is allocated to each partner.

To determine each partner’s section 987 income or loss, the amount allocated to X and Y attributable to the QBU’s operations is translated into U.S. dollars under the rules of reg. section 1.987-3(c). In this case, each item comprising the net €36 allocated to X and €4 allocated to Y is translated at the average annual 1:1 rate.87 Accordingly, X recognizes $36 and Y recognizes $4 of section 987 income or loss.

Section 987 gain or loss is then computed using the eight-step procedures set out in reg. section 1.987-4(d). X’s unrecognized section 987 gain or loss is computed using an OFCNV based on 56.7 percent of the balance sheet of Business A. At the end of year 1, X’s OFCNV for Business A was $100 (50 percent of the €200 on the Business A balance sheet on December 31 of year 1). At the end of year 2, X’s OFCNV is $136 (56.7 percent of the €240 aggregate tax capital on the Business A balance sheet on December 31 of year 2, translated at the year 2 historical or end-of-year (EOY) spot rates as applicable). X’s unrecognized section 987 gain or loss for year 2 is therefore computed as follows:

Table 3

Step 1: Change in OFCNV

136 - 100 = 36

Steps 2 through 5

Step 6: Decrease or increase for section 987 taxable income or loss

(36)

Steps 7 and 8

Unrecognized section 987 gain or loss

The result for Y would be similar. For each partner, there is no unrecognized section 987 gain or loss for the year. When there are no changes to the relevant currency exchange rates, the result of the computation required by reg. section 1.987-4(d) should be zero, as it is here.

The result would be similar had the entire amount of the €40 earnings been distributed to the partners ($36 to X and $4 to Y) at the end of year 2. If this distribution had occurred, the LVPs would have remained unchanged at 50 percent each. In that case, the special rule of reg. section 1.987-2(c)(3)(ii) would have applied, and the computation of X’s unrecognized section 987 gain or loss above would be modified as follows:

Table 4

Step 1: Change in OFCNV

100 - 100 = 0

Step 2: Increase for assets transferred from QBU

36

Steps 3 through 5

Step 6: Decrease or increase for section 987 taxable income or loss

(36)

Steps 7 and 8

Unrecognized section 987 gain or loss

And the result for Y would be similar. Thus, as this example illustrates, when changes to each partner’s economic entitlements are solely attributable to their respective share of net taxable income of the partnership’s QBUs, the computation required by reg. section 1.987-4(d) in conjunction with the LVP approach reaches the correct result.

2. When the LVP approach requires additional coordinating adjustments.

The LVP approach causes artificial unrecognized section 987 gain or loss, however, when changes to LVPs are not solely attributable to allocations of QBU taxable income. Changes to the LVPs will not be attributable to allocations of QBU’s taxable income for several reasons, including:

  1. Economic appreciation or depreciation is not solely attributable to (that is, equal in amount to) a QBU’s taxable income or loss.

  2. For a partnership with more than one QBU, the QBUs do not increase or decrease in value in a manner that is strictly proportionate (for example, one QBU gains value while another loses value; one QBU doubles in value and another grows in value by 50 percent).

  3. A QBU has section 704(c) property on the balance sheet. The presence of section 704(c) property on a QBU’s books generally will cause allocations of the QBU net taxable income to diverge at some point from the partners’ sharing of economic appreciation or depreciation.

For many section 987 aggregate partnerships, all three circumstances will likely arise each tax period. Economic appreciation or depreciation in the value of partnership equity will generally not be perfectly matched by taxable income or loss, and most section 987 aggregate partnerships will hold section 704(c) property and have multiple QBUs. The distortions these circumstances will cause are sometimes offsetting and sometimes duplicative, however, which makes it difficult to pinpoint exactly why the computation of unrecognized section 987 gain or loss becomes distortive in a particular case.

There are two principal reasons why artificial section 987 gain or loss is created whenever a change in LVPs is not solely attributable to allocations of taxable income. On one hand, and as addressed next, those changes cause unexplained shifts in QBU tax capital existing at the start of the year. These shifts are the focus of the initial tax capital transfer rule, which is intended to prevent artificial gain or loss arising from shifts in preexisting tax capital. On the other hand, and as addressed in Part 2 of this series, changes to LVPs not attributable to allocations of taxable income can also cause distortions because of unexplained shifts in QBU tax capital arising or declining during the year. These shifts are the focus of the current tax capital transfer rule.

Both the initial tax capital transfer rule and the current tax capital transfer rule should be viewed as authorized by the government’s recognition that the application of reg. section 1.987-4(d) and related provisions would require some adjustments to apply the LVP approach. If these coordination rules are adopted, the LVP approach becomes a reasonable way to approach the challenge of dividing a QBU’s tax capital between partners.

a. Initial tax capital transfer rule.

As the following two examples demonstrate, when LVPs shift as a result of changes in value that are not solely attributable to taxable income, inappropriate unrecognized section 987 gain or loss arises.

Example 2: Same facts as Example 1, except that Business A appreciates in value by €60 (in other words, its value increases by the amount of its €40 net taxable income plus an additional €20). As a result, at the end of year 2, Business A has a value of €260. If PRS were liquidated after the transaction described in reg. section 1.987-7T(b)(2), Corp. X would receive €154 and Corp. Y would receive €106 in proceeds.88

As in Example 1, the relevant exchange rates are $1:€1 at all times.

In this case, the computation required by reg. section 1.987-4(d) is ineffective and creates artificial unrecognized section 987 gain or loss. As in Example 1, because the partnership does not allocate items of profit or loss in accordance with the LVPs, there is a determination date at the end of year 2.89 At the end of year 2, X and Y’s equity in PRS have values of $154 and $106 respectively; therefore, X’s LVP is 59.2 percent and Y’s is 40.8 percent. X is allocated 90 percent and Y is allocated 10 percent of the €40 Business A taxable income in year 2, which under reg. section 1.987-3(c) is translated into U.S. dollars at the average annual 1:1 rate. Accordingly, X recognizes $36 and Y recognizes $4 of section 987 income or loss.

Section 987 gain or loss is then computed using the eight-step procedure of reg. section 1.987-4(d). Because PRS retains all €60 of its economic appreciation, the partners’ LVPs shift. The value of X’s equity in PRS increases by €54 and Y’s increases by €6. Unlike in Example 1, these value shifts no longer reflect each partner’s share of taxable income attributable to Business A.

X’s unrecognized section 987 gain or loss is computed using an OFCNV based on 59.2 percent of the €240 net balance sheet of Business A. At the end of year 1, X’s OFCNV for Business A was $100 (50 percent of the €200 on the Business A balance sheet on December 31 of year 1). At the end of year 2, X’s OFCNV is $142 (59.2 percent of the €240 aggregate tax capital on the Business A balance sheet on December 31 of year 2, translated at the year 2 historical or end-of-year-2 spot rates, as applicable). X’s unrecognized section 987 gain or loss for year 2 is therefore computed as follows:

Table 5

Step 1: Change in OFCNV

142 - 100 = 42

Steps 2 through 5

Step 6: Decrease or increase for section 987 taxable income or loss

(36)

Steps 7 and 8

Unrecognized section 987 gain or loss

6

The result for Y is similar but offsetting. Y’s unrecognized section 987 gain or loss is computed using an OFCNV based on 40.8 percent of the €240 net balance sheet of Business A. At the end of year 1, Y’s OFCNV for Business A was $100 (50 percent of the €200 on the Business A balance sheet on December 31 of year 1). At the end of year 2, Y’s OFCNV is $102 (59.2 percent of the €240 aggregate tax capital on the Business A balance sheet on December 31 of year 2, translated at the year 2 historical or end-of-year-2 spot rates as applicable). X’s unrecognized section 987 gain or loss for year 2 is therefore computed as follows:

Table 6

Step 1: Change in OFCNV

98 - 100 = (2)

Steps 2 through 5

Step 6: Decrease or increase for section 987 taxable income or loss

(4)

Steps 7 and 8

Unrecognized section 987 gain or loss

(6)

There are no changes to the relevant currency exchange rates; therefore, X and Y’s respective unrecognized section 987 gains or losses are artificial and inappropriate. The computation results in artificial and offsetting unrecognized section 987 gain or loss because changes to the partners’ LVPs do not arise solely from each partner’s share of Business A taxable income.

What has happened in Example 2 is straightforward. The change in each partner’s LVP has been reflected in a change to their respective year-end OFCNVs. The change in OFCNVs has, in step 1, resulted in a shift in OFCNV that is not attributable to exchange rate movements but that is never backed out in steps 2 through 8. (As Example 1 demonstrates, if the change in OFCNVs had been attributable solely to allocations of taxable income, this change would have been backed out; however, this is not the case in Example 2.) The result is artificial unrecognized section 987 gain or loss, which will be included in accumulated unrecognized section 987 gain or loss and eventually (upon a remittance) be recognized.

This potential is likely one of the possibilities that the government had in mind when it observed:

The Treasury Department and the IRS have determined that, in certain instances, the liquidation value percentage methodology set forth in [reg. section] 1.987-7T may be interpreted as applying in a way that inappropriately distorts the computation of section 987 gain or loss. Specifically, under such an interpretation, certain changes in a partner’s liquidation value percentage may introduce distortions in the calculation of net unrecognized section 987 gain or loss under [reg. section] 1.987-4, giving rise to net unrecognized section 987 gain or loss that is not attributable to fluctuations in exchange rates. For example, an appreciation or depreciation in property value can result in a change in liquidation value percentage that causes a change in owner functional currency net value for purposes of Step 1 of the [reg. section] 1.987-4(d) calculation of unrecognized section 987 gain or loss for a taxable year without an offsetting adjustment under Step 6 or otherwise that would prevent the change in liquidation value percentage from distorting the calculation of unrecognized section 987 gain or loss.90

While the government identifies a potential distortion caused by the LVP approach, it does not diagnose the source of the distortion. The following example, in conjunction with Example 1 above, demonstrates that the source of the artificial unrecognized section 987 gain and loss illustrated in Example 2 is an unexplained shift in tax capital existing at the start of the tax year.

Example 3: Same facts as Example 2, except that Business A recognizes no net taxable income in year 2 but appreciates in value by €20. As a result, at the end of year 2, Business A has a value of €220. If PRS were liquidated after the transaction described in reg. section 1.987-7T(b)(2), X would receive €118 and Y would receive €102 in proceeds.

As in the prior examples, the relevant exchange rates are 1:1 at all times.

In this case, there are no changes to the relevant exchange rates and no net taxable income recognized by the partners. The only thing that happens is that the LVPs change as a result of appreciation in value that is not realized or recognized for federal income tax purposes. Because of this unrealized appreciation in value, X and Y’s respective LVPs shift from 50 percent each to 53.6 for X and 46.4 percent for Y. This shift in LVPs causes artificial changes to the amount of X and Y’s unrecognized section 987 gain or loss. X’s unrecognized section 987 gain or loss for year 2 would be computed as follows:

Table 7

Step 1: Change in OFCNV

107.2 - 100 = 7.2

Steps 2 through 5

Step 6: Decrease or increase for section 987 taxable income or loss

Steps 7 and 8

Unrecognized section 987 gain or loss

7.2

Y has an equal but offsetting amount of unrecognized section 987 loss. Both the gain and the loss are artificial. In effect, these gains and losses result from the interaction between the LVP approach, which divides tax capital invested in a QBU between the partners in accordance with the partner’s relative economic claims on partnership equity, and the comparative balance sheet approach of reg. section 1.987-4 and -5, which measures tax capital invested in nonfunctional currencies of each indirect owner. The computation becomes distortive when the partners’ economic entitlements and deemed share of tax capital do not move in lock step, such as when a change to the partner’s relative economic entitlements is not solely attributable to allocations of QBU taxable income.

In both examples 2 and 3, artificial unrecognized section 987 gains and loses arise because the change in LVPs is reflected in the amounts computed in step 1 of reg. section 1.987-4(d). In step 1, any change in a partner’s LVP is reflected in a change in the partner’s OFCNV. As Example 1 demonstrates, when the change to LVPs is attributable to a partner’s share of QBU net taxable income, the change computed in step 1 will be appropriately reversed in step 6, because step 6 requires the amount computed in step 1 (after adjustment in steps 2 through 5) to be reduced for the partner’s share of net taxable income and increased for the partner’s share of taxable loss attributable to the QBU.

But when changes to a partner’s economic entitlements upon liquidation are not attributable to its share of QBU taxable income, the amount computed in step 1 will incorporate a shift of the initial tax capital invested in a QBU that will not be reversed out in steps 2 through 8. This is demonstrated in Example 3, in which there is no taxable income at all and no change in the currency exchange rates. In Example 3, the LVPs change, and there is no net taxable income recognized by the QBU; therefore, the source of the artificial and offsetting $7.2 unrecognized section 987 gain or loss is an unexplained shift in the net €200 tax capital invested in Business A at the start of the year. The same phenomenon arises in Example 2, but the amount of the relative unexplained shift of the initial €200 of tax capital invested in Business A is different because the change to the partners’ ending claims on liquidation value (which is reflected in LVP) is partially attributable to their shares of QBU taxable income.

A potential solution becomes clear once the source of this artificial gain or loss is identified: Any change in the partners’ share of tax capital invested in a QBU at the beginning of a tax year that is attributable to a shift in LVPs must be reversed out by treating those shifts as transfers from or to the partners’ respective QBUs in a manner arguably similar to that provided by reg. section 1.987-2(c)(5). In effect, these shifts in initial tax capital can be treated as deemed transfers from or to the QBU (that is, deemed contributions or remittances for purposes of reg. section 1.987-4(d)).91

For instance, in Example 3, X’s deemed share of the tax capital invested in Business A increases from $100 (50 percent of €200 translated at the relevant 1:1 rate) to $107.2 (53.6 percent of €200 translated at the 1:1 rate). This change in X’s deemed share of the total tax capital should be treated as though X transferred a net $7.20 to its Business A QBU, which would eliminate the artificial unrecognized section 987 gain. Y, similarly, should be treated as receiving a net transfer of $7.20 from its Business A QBU, which eliminates the artificial unrecognized section 987 loss.

Computing the appropriate amount of these deemed transfers is relatively straightforward. For instance, each partner’s beginning-of-year (BOY) LVP would be multiplied by the tax basis of the aggregate marked assets and each historical asset and liability on the balance sheet of the QBU expressed in the QBU functional currency at the beginning of the year (the product, the partner’s BOY QBU tax capital), and each item then translated into the partner’s functional currency at the appropriate rates. Then, this process would be repeated using each partner’s end-of-year (EOY) LVP. Any excess of BOY LVP multiplied by aggregate BOY QBU tax capital translated into the partner’s functional currency over EOY LVP multiplied by the aggregate BOY QBU tax capital translated into the partner’s functional currency would be deemed a transfer from a QBU to the partner for purposes of step 2 of reg. section 1.987-4(d). Conversely, any excess of EOY LVP multiplied by aggregate BOY QBU tax capital translated into the partner’s functional currency over BOY LVP multiplied by the aggregate BOY QBU tax capital translated into the partner’s functional currency would be deemed a transfer from a partner to the QBU purposes of step 3 of reg. section 1.987-4(d).

The deemed transfers to and from the QBU, which are needed to correct the distortions that arise in Example 3, are illustrated in summary fashion in the following table:

Table 8

 

X

Y

Total

BOY LVP

50%

50%

100%

BOY LVP x BOY QBU Tax Capital [A]

$100

$100

$200

EOY LVP

53.6%

46.4%

100%

EOY LVP x BOY QBU Tax Capital [B]

$107.20

$92.80

$200

Difference [B - A]

$7.20

($7.20)

$0

Positive numbers in the final row of the table above indicate a deemed transfer of tax capital from the partner to the QBU (that is, X is deemed to transfer $7.20 to its Business A QBU). Negative numbers indicate a deemed transfer from the QBU to a partner (that is, Y is deemed to receive a transfer of $7.20 from its Business A QBU).92 This rule — designed to reverse out changes in the partners’ shares of tax capital invested in a QBU at the beginning of a tax year attributable to a shift in LVPs — is the initial tax capital transfer rule, which is the first of two coordination rules needed to prevent distortions that can arise under the LVP approach.

IV. Conclusion to Part 1

With the recent withdrawal of reg. section 1.987-7T, taxpayers applying the new regulations may use any reasonable method to determine a partner’s share of QBU assets and liabilities in computing section 987 gain or loss until new regulations are proposed and finalized. The LVP approach, which was prescribed by the withdrawn temporary regulations, is one method identified as reasonable if taxpayers make specified adjustments to prevent distortions in the computation of unrecognized section 987 gain or loss. The artificial gains or losses that can arise under the LVP approach result in part from shifts in each partner’s deemed share of QBU tax capital existing at the start of the tax year that are never backed out appropriately in the eight-step procedure of reg. section 1.987-4(d). The initial tax capital transfer rule prevents this artificial gain or loss by treating those shifts as the result of transfers from and to the QBU in measuring unrecognized section 987 gain or loss which allows them to be appropriately backed out.

Part 2 of the series takes up this discussion, beginning with a second potential source of distortion in the measurement of section 987 gain or loss in section 987 aggregate partnerships.93

FOOTNOTES

1 P.L. 99-514, section 1261. Before TRA 1986, a taxpayer that kept the books and records of a foreign branch in foreign currency could determine the taxable income or loss of the branch under either a profit and loss method or a comparative balance sheet method, as described in Rev. Rul. 75-106, 1975-1 C.B. 31; Rev. Rul. 75-107, 1975-1 C.B. 32; and Rev. Rul. 75-134, 1975-1 C.B. 33 (each ruling obsoleted by Rev. Rul. 2003-99, 2003-2 C.B. 388). For controlled foreign corporations, the computation of earnings and profits and subpart F income was subject to different rules for branch operations.

2 INTL-965-86, 56 F.R. 48457 (Sept. 25, 1991).

3 T.D. 8279 (promulgating reg. section 1.987(a)-1(b)(2)). This simple rule — that a partnership is a QBU of a partner — is almost the sole binding regulatory guidance that informs the application of section 987 to partnerships in particular. As described later, this rule was slightly modified in 2016 to except “section 987 aggregate partnerships,” which are never QBUs.

4 REG-208270-86, 71 F.R. 52876 (Sept. 7, 2006).

5 Id. at 52881.

6 T.D. 9794, 81 F.R. 88806 (Dec. 8, 2016).

8 See T.D. 9794, 81 F.R. at 88816.

9 Some important provisions of the new regulations are in force. In particular, reg. section 1.987-12, with minor exceptions, applies to any “deferral event” or “outbound loss event” (as defined in reg. section 1.987-12(b)(2) and (d)(2)) that occurs on or after January 6, 2017, or, for transactions undertaken with a principal purpose of recognizing section 987 loss, December 7, 2016. Reg. section 1.987-12(j); see also Notice 2017-7, 2017-3 IRB 423 (announcing expansion of the antiavoidance rule to include some section 987 losses arising from entity classification elections). Taxpayers could also early-adopt the new regulations for tax years starting after December 6, 2016. Reg. section 1.987-11(b); Notice 2017-57, 2017-42 IRB 324.

10 Notice 2017-38, 2017-30 IRB 147.

11 Notice 2017-57 (providing that taxpayers may apply the final regulations and the related temporary regulations to tax years beginning after December 7, 2016, if they consistently apply those regulations to those tax years for all section 987 QBUs directly or indirectly owned by them on the transition date, as well as for all section 987 QBUs directly or indirectly owned on the transition date by members that file a consolidated return with the taxpayer or by any CFC, as defined in section 957, in which a member owns more than 50 percent of the voting power or stock value, as determined under section 958(a)).

12 Notice 2018-57, 2018-26 IRB 774 (providing that the final regulations and the related temporary regulations will apply to tax years beginning on or after the date that is three years after the first day of the first tax year following December 7, 2016).

13 T.D. 9857, 84 F.R. 20790 (May 13, 2019).

14 Id. at 20793-20794.

15 See Notice 2018-57.

16 T.D. 9857, 84 F.R. at 20791; Treasury, “2017-2018 Priority Guidance Plan” (Oct. 20, 2017); and Treasury, “Second Report to the President on Identifying and Reducing Tax Regulatory Burdens,” 2018-03004 (Oct. 2, 2017) (issued under Executive Order 13789). See Executive Order 13789; see also Executive Order 13771; Executive Order 13777; Notice 2017-57; and Notice 2017-38.

17 In the second report, supra note 16, Treasury identified three ways (in addition to the delayed effective dates) in which regulatory burdens imposed by the new regulations might be eased. First, Treasury and the IRS intend to propose modifications to the regulations to permit taxpayers to elect to adopt a simplified method of calculating section 987 gain or loss and translating section 987 income and loss, subject to limitations on the timing of recognition of section 987 loss. Id. at 9-10. Second, the IRS and the Treasury Office of Tax Policy are considering alternative loss recognition timing limitations that would apply to electing taxpayers. Id. at 10. Finally, the IRS and the Office of Tax Policy are considering alternatives to the transition rules. Id.

18 T.D. 9857, 84 F.R. at 20793.

19 Other commentators have proposed alternative approaches to the computation of section 987 income or loss and section 987 gain or loss. See, e.g., New York State Bar Association Tax Section, “Report on Notice 2017-57: Alternative Rules for Determining Section 987 Gain or Loss” (Jan. 22, 2018); Tax Executives Institute, “Comments on REG-128276-12 Relating to the Recognition and Deferral of Foreign Currency Gain or Loss Under Section 987 With Respect to a Qualified Business Unit” (Mar. 7, 2017). Although TEI questions the adoption of the aggregate approach, principally on the grounds that it is overly complex, no comments describe in any detail the particular challenges partnerships may face in implementing the new regulations.

20 Comments on the 2006 proposed regulations discussed, in varying degrees of specificity, many of the issues examined here. See, e.g., American Bar Association Section of Taxation, “Comments Concerning Proposed Regulations Under Section 987” (Feb. 24, 2010); and American Institute of CPAs, “Comments on 2006 Proposed Section 987 Regulations” (Mar. 29, 2007). The adoption of the liquidation value percentage (LVP) approach, however, raised some long-recognized problems in a new context and opened up new possibilities to coordinate section 987 with subchapter K.

21 T.D. 9794, 81 F.R. at 88815 (explaining that Treasury and the IRS “acknowledge the concerns expressed about the complexity of applying the aggregate approach to partnerships with partners that are unrelated . . . [but] have determined that it is feasible to administer the aggregate approach with respect to a partnership that is wholly owned by related persons”).

22 Preamble to REG-104390-18, 83 F.R. 51072 at 51085 (Oct. 10, 2018). Among the potential benefits cited by Treasury and the IRS is whether “similarly situated taxpayers might interpret the statutory rules . . . differently, potentially resulting in inequitable outcomes.” Id. One benefit of regulatory guidance cited by Treasury and the IRS is to ensure that taxpayers face more uniform incentives when making economic decisions, a tenet of economic efficiency. Id. at 51085-51086. In the view of Treasury and the IRS, consistent reporting across taxpayers also increases the government’s ability to consistently enforce the tax rules, thus increasing equity and decreasing opportunities for tax evasion. Id. at 51086.

23 Each of these three sets of recommendations is independent of the others. For instance, adopting the methods described as reasonable for section 987 gain or loss would not entail that the methods described for section 987 gain or loss be adopted for a taxpayer to have adopted reasonable approaches to both computations, and vice versa. There are numerous other coordination issues that merit discussion; however, none of them are as significant as, or can be meaningfully discussed without resolving, the basic issues discussed here.

24 Reg. section 1.987-3(b)(i).

25 Section 987 gain or loss can be triggered only by a net remittance, which is a net withdrawal from branch accumulated earnings or branch capital. Cf. T.D. 9794, 81 F.R. at 88808; and H.R. Rep. No. 99-841, at 674-675 (1986) (Conf. Rep.).

26 Cf. T.D. 9794, 81 F.R. at 88815 (addressing the rationale behind making the new regulations applicable only to partnerships wholly owned by related persons).

28 See reg. section 1.987-1(b)(2)(i) (defining section 987 QBU) and (5)(ii) (defining section 987 QBU of a partner). The new regulations are focused on “owners,” not partners. Any person that is regarded for federal income tax purposes can be a partner in a partnership: individuals, corporations, partnerships, or trusts. Only individuals and corporations can recognize section 987 gain or loss. Reg. section 1.987-1(b)(4) and -4(a). It would be cumbersome to discuss the interaction of the new regulations and subchapter K without referring to partners. Thus, for stylistic ease and unless otherwise specified, all references in this report to “partners” should be understood as references to either an individual or a corporation (i.e., to a person that also qualifies as an owner under the new regulations).

29 If a partner in a section 987 aggregate partnership happens to have the same functional currency as a QBU owned by the partnership, the QBU is not a section 987 QBU for that partner, and in that case no computations under reg. section 1.987-3, -4, and -5 are made.

30 Reg. section 1.987-3(b)(3)(ii). This is a specific application of the general rule, which provides that section 987 QBUs, except as otherwise provided, will determine each item of income, gain, deduction, or loss in its functional currency under federal income tax principles, and after that determination, those amounts are translated into the owner’s functional currency. Reg. section 1.987-3(b)(1)-(2).

32 Reg. section 1.987-3(b)(3)(iv). If the partner has the same functional currency, it simply skips the translation step and reports these amounts as its distributive share of taxable income attributable to the QBU.

33 Reg. section 1.987-3(c)(1). The yearly average exchange rate is defined in reg. section 1.987-1(c)(2). Taxpayers may make elections to depart from the general rules described earlier, such as the election to use spot rates in lieu of average annual rates under reg. section 1.987-1(c)(1)(iii), or the deemed termination election provided in reg. section 1.987-8T(d). These elections and all other departures from the general rules provided in the new regulations are beyond the scope of this discussion.

36 Reg. section 1.987-1(d)(1). Marked items also include prepaid expenses or liabilities for an advance payment of unearned income, in either case having an original term of one year or less on the date the prepaid expense or liability for an advance payment of unearned income arises. Reg. section 1.987-1(d)(2).

37 Reg. section 1.987-3(c)(2)(iv). The scope of reg. section 1.987-3(c)(2)(iv) is not entirely clear because this section refers only to “inventory” and “cost of goods sold” without further cross-reference to, for instance, section 263A. The relationship between inventory accounting and section 704(c) is unclear. Cf. Gary Huffman, “704(c) Meets 263A: Contributions of Depreciable Property to Partnerships,” 98 J. Tax’n 149 (2003). The application of reg. section 1.987-3(c)(2)(iv) is beyond the scope of this discussion.

38 Certainly, the mere burden of maintaining tax basis records in sufficient detail and granularity to permit the required computations will frequently be significant. Although not discussed here, Treasury and the IRS should be open to various methods of maintaining basis records, including reasonable shortcuts, if the net result of these approaches will be materially consistent with the use of historical rates to track QBU tax capital invested in historical assets.

42 See, e.g., reg. section 1.987-1(c)(3); and reg. section 1.987-2(c)(10), Example 8.

44 Amount realized can be translated either using the average annual rate or, under a reg. section 1.987-1(c)(1)(iii) election, a spot rate. See reg. section 1.987-3(c)(1); and reg. section 1.987-3(e), Example 2.

46 For instance, the basis of partnership property is not adjusted because of a transfer of an interest in a partnership by sale or exchange unless an election under section 754 is in effect or the partnership has a substantial built-in loss (as defined in section 743(d)) immediately after the transfer. When either of these situations exists, regulations under section 743(b) effectively require that the transferee partner’s share of inside tax capital be determined. This determination is not made directly; instead, the regulations provide for a hypothetical transaction that indirectly expresses the transferee partner’s share of inside tax capital through a determination of the amount of net tax gain or loss that would be allocated to the transferee partner on the disposition of the partnership’s assets, immediately after the transfer of the partnership interest, in a fully taxable transaction for cash equal to the fair market value of the assets. See reg. section 1.743-1(d).

47 Reg. section 1.987-3(b)(3)(iv) provides that to the extent that the items are allocated to a partner under reg. section 1.987-3(b)(3)(iii), “the partner shall adjust the items to conform to Federal income tax principles and translate the items into the partner’s functional currency as provided in Treas. Reg. Section 1.987-3(c).” There is no explanation or illustration of the appropriate adjustment to items of distributive share to conform with federal tax principles; however, for sales and similar transactions, this provision may be sufficient to authorize taxpayers to adopt reasonable methods of splitting a partner’s distributive share of net gain or loss into a share of amount realized and basis recovered to follow the translation rules of reg. section 1.987-3(c)(2).

48 See T.D. 9794, 81 F.R. at 88809-88810 (discussing the modification to the foreign exchange exposure pool method adopted in the final regulations) and 88815 (discussing the aggregate approach to partnerships). A comparative tax capital balance sheet approach to the measurement of currency-related gain or loss for investments in branches operating in a currency other than that of the taxpayer was also arguably adopted by the 1991 proposed regulations, and even before TRA 1986 in the “net worth” or “balance sheet” method described in Rev. Rul. 75-106 and Rev. Rul. 75-134.

49 Tax capital, which is colloquially understood as tax basis of an asset less any encumbrance that is reflected in adjusted tax basis, is a concept that is fundamental to the measurement of section 987 gain or loss. For purposes of this discussion, tax capital simply means a taxpayer’s after-tax investment in an asset, including cash. For instance, if a taxpayer purchases an asset using 10x of its own equity and 90x of borrowed funds, its tax basis in the asset is 100x and its tax capital is 10x. The 10x of equity represents an after-tax amount, and under a system that taxes income, this amount theoretically should not be subject to further tax.

50 Reg. section 1.987-4(e)(1) (defining OFCNV); and reg. section 1.987-4(g), Example 1 (introducing the OFCNV acronym).

52 Specifically, for purposes of section 987, an owner of an eligible QBU is any person having direct or indirect ownership in an eligible QBU. Only an individual or corporation may be an owner of an eligible QBU. Reg. section 1.987-1(b)(4). An individual or corporation that is a partner in a section 987 aggregate partnership would generally have be allocated all or a portion of the assets and liabilities of an eligible QBU of that partnership and will thus be an indirect owner of the eligible QBU. See reg. section 1.987-1(b)(4)(ii). The assets and liabilities of an eligible QBU thus allocated to a partner are considered a section 987 QBU of that partner if the partner has a functional currency different from that of the eligible QBU. Reg. section 1.987-1(b)(5)(ii).

53 T.D. 9857, 84 F.R. at 20794.

54 REG-208270-86, 71 F.R. at 52911.

55 For instance, Example 5 of prop. reg. section 1.987-7(d), 71 F.R. at 52912, illustrates a partnership with a special allocation of income but does not indicate whether or how this special allocation might affect each partner’s share of QBU tax capital.

56 Other methods of determining each partner’s share of QBU tax capital for purposes of this computation have been proposed as well. If Treasury and the IRS preserve the aggregate approach, consideration should be given to providing taxpayers flexibility to adopt, in addition to the LVP method, reasonable methods that depart from the pattern set out in the 2006 proposed regulations.

57 Reg. section 1.987-7T(b)(2) (withdrawn).

58 Under the now-withdrawn reg. section 1.987-7T(b)(2)(i), LVPs are determined on “determination dates.” Reg. section 1.987-7T(b)(2)(ii)(B), which will frequently override the general rule of reg. section 1.987-7T(b)(2)(ii)(A), states that if a partnership agreement provides for the allocation of any item of income, gain, deduction, or loss from partnership property to a partner other than in accordance with the partner’s LVP, the determination date is the last day of the partner’s tax year. Although generalizations are difficult, it is possible that many if not most section 987 aggregate partnerships will allocate profits and losses in a manner other than in accordance with the partners’ LVPs, because an important purpose of those joint ventures is frequently to fine-tune the allocation of risk among partners.

59 T.D. 9857, 84 F.R. at 20794.

60 Id. at 20793-20794.

68 Reg. section 1.987-4(d)(7). The amount of expenses treated as nondeductible include any foreign income taxes incurred by the section 987 QBU for which the owner claims a credit (translated at the same rate at which those taxes were translated under section 986(a)). Id.

70 See T.D. 9857, 84 F.R. at 20793 (acknowledging that under some interpretations, “changes in a partner’s liquidation value percentage may introduce distortions in the calculation of net unrecognized section 987 gain or loss . . . giving rise to net unrecognized section 987 gain or loss that is not attributable to fluctuations in exchange rates”).

72 Reg. section 1.987-5(d) (amounts transferred from a QBU to the owner) and (e) (amounts transferred from an owner to a QBU). The transfer of liabilities is, for this purpose, treated as a reverse transfer of assets. To the extent that a liability is transferred or deemed transferred to an owner, the owner is deemed to transfer assets to the QBU equal to the amount of the liability. Conversely, to the extent that a liability is transferred or deemed transferred to a QBU from an owner, the QBU is deemed to transfer assets to the owner equal to the amount of the liability.

73 As discussed in the preamble to the 2006 proposed regulations, which this rule follows, Treasury and IRS considered several methods for determining the amount of section 987 gain or loss triggered upon a remittance and adopted this approach because it avoided the administrative challenges raised by alternative methods and limited the potential volatility associated with the recognition of section 987 gain or loss. See REG-208270-86, 71 F.R. at 52887 (describing alternative methods).

75 T.D. 9857, 84 F.R. at 20794.

76 REG-208270-86, 71 F.R. at 52911.

77 See id. at 52911 (prop. reg. section 1.987-7(b)).

78 See T.D. 9794, 81 F.R. at 88867 (explaining that the LVP approach was judged administrable and consistent with the partners’ economic interests in the assets and liabilities of the partnership).

79 This general principle is subject to several exceptions, a principal one being the operation of the ceiling rule (reg. section 1.704-3(b)(1)), which effectively allows temporary shifts in tax capital between partners.

80 T.D. 9857, 84 F.R. at 20794.

81 Importing the principles of subchapter K into the measurement of each partner’s share of QBU tax capital would likely be quite complicated under an aggregate vision of partnerships in many circumstances. In 2007, for instance, the AICPA recommended that section 704(c) be taken into account in determining a partner’s share of the assets and liabilities of a section 987 QBU held through a partnership. AICPA, supra note 20, at 17. However, few details were provided in the AICPA comments, other than a suggestion that each partner’s share of the foreign exchange exposure pool be determined with reference to aggregate partnership tax capital and that, in that case, special partner-specific adjustments could be made based on section 704(c) principles to compensate for the fact that the gain or loss upon a taxable disposition of section 704(c) property would not affect each partner in the same way. See AICPA, supra note 20, at Appendix Example 4.

82 T.D. 9857, 84 F.R. at 20794 (allowing taxpayers to adopt an approach similar to the LVP approach but observing that “the Treasury Department and the IRS do not believe that it would be reasonable to apply the liquidation value percentage method without corresponding adjustments to the determination of net unrecognized section 987 gain or loss”).

83 The example is arguably unrealistic; nonetheless, simplified capital structures are adopted for illustrative purposes. Assume in this and the following examples that the capital structures described and related elements of the partnership agreements (such as distribution provisions) are arm’s length and that the allocations will be respected as having substantial economic effect within the meaning of section 704(b).

84 Under reg. section 1.987-1(c)(2), yearly average exchange rates are determined under any reasonable method. The annual and spot rates used in these examples are set to illustrate principles and not with reference to actual exchange rate movements.

85 As demonstrated frequently in these examples, assuming no change in exchange rates between currencies is a useful method to identify when something is going wrong with the section 987 computations.

86 Reg. section 1.987-7T(b)(2)(ii) (withdrawn).

87 To the extent that the QBU has acquired depreciable or amortizable historical assets, the basis recovery would be translated using the year 2 1:1 historical rate.

88 The economic appreciation or depreciation of Business A would be shared upon liquidation, taking into account the partners’ agreement to share all items arising in years 2 through 5, 90 percent to X and 10 percent to Y.

89 Reg. section 1.987-7T(b)(2)(ii) (withdrawn).

90 T.D. 9857, 84 F.R. at 20793.

91 Whether these deemed transfers should also be taken into account in determining each partner’s remittance as defined in reg. section 1.987-5(c) is not answered here. It is unclear whether the deemed transfers computed for the initial tax capital transfer rule should, in a manner similar to the deemed transfer rule of reg. section 1.987-2(c)(5), be taken into account in determining a partner’s remittance proportion. Preventing artificial section 987 gain or loss through the adjustments to the reg. section 1.987-4(d) computations do not hinge on whether the initial tax capital transfer rule has any effect on a partner’s remittance proportion.

92 This computation also works when the functional currencies of the partners are different, because the shift in BOY tax capital attributable to changes in the LVPs during the year is always derived using tax capital expressed in the functional currency of the QBU. This rule, applied to the facts illustrated in Example 2, would similarly prevent any artificial unrecognized gain or loss from arising. In effect, this rule modifies how steps 2 and 3 of reg. section 1.987-4(d) are applied, although if such a rule were to be incorporated into final regulations, the logical place to insert it would be in reg. section 1.987-2(c), which, as discussed later in the series, contains other rules deeming particular transactions to cause transfers between owners and QBUs.

93 This report contains general information only, and Deloitte Tax LLP is not, by means of this report, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This report is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. Deloitte Tax will not be responsible for any loss sustained by any person who relies on this report.

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