   LB&I Concept Unit   Unit NameLimitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument   Primary UIL Code9470.02-01Recognition and computation of exchange gain or loss - general      Library LevelTitle  Knowledge BaseInternational  ShelfCrossover  BookForeign Currency  ChapterRecognition and Computation of Exchange Gain or Loss - General     Document Control Number (DCN)INT-C-242  Date of Last Update09/02/2021        Note: This document is not an official pronouncement of law, and cannot be used, cited or relied upon as such. Further, this document may not contain a comprehensive discussion of all pertinent issues or law or the IRS's interpretation of current law.  Table of Contents       (View this PowerPoint in “Presentation View” to click on the links below) General Overview Detailed Explanation of the Concept Examples of the Concept Index of Referenced Resources Training and Additional Resources Glossary of Terms and Acronyms Index of Related Practice Units                 2  General Overview          Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument The determination of foreign currency (FX) gains and losses under IRC Section 988 is one of the major strategic priorities for the Foreign Currency Practice Network (PN) on the Crossover portion of the International Matrix. In a global economy, many U.S. Multinational Enterprises (MNEs) are doing business in currencies other than the U.S. dollar (USD). These transactions may be one-time transactions (e.g., a loan denominated in an FX), or as part of the ongoing operations of a business unit (e.g., payable and receivable denominated in an FX). To the extent that the transactions are denominated in a currency other than the USD for a U.S. corporation (or are determined by reference to the value of one or more nonfunctional currencies for foreign corporations), MNEs may have FX fluctuation risk. The values of many foreign currencies and the associated exchange rates can change dramatically over a period of years. Depending upon whether the MNE taxpayer has any nonfunctional currency denominated assets or liabilities which are Section 988 covered transactions, there may be gains and/or losses due to the currency fluctuations. The purpose of this Unit is to cover some basic FX principles related to the currency transactions that MNEs may enter into during the course of its business and show how changes in exchange rates will impact an MNE. Two issues must be considered in the early stages of the examination for planning purposes: (1) whether the MNE has nonfunctional currency denominated transactions that are covered under Section 988; and (2) the direction of the exchange rates for the foreign currencies during the period under examination which determine whether the section 988 transactions will have a gain or loss. As the value of the currencies in which the transactions are denominated increases or decreases relative to the USD, the MNE will have unrealized exchange gains or losses. When these unrealized exchange gains and losses are eventually recognized for tax purposes, MNE’s taxable income will be affected. Certain FX transactions that are denominated in terms of a nonfunctional currency or are determined by reference to the value of one or more nonfunctional currencies, may generate exchange gains or losses which are subject to IRC Section 988 (“section 988 transactions”).           Back to Table of Contents3  General Overview (cont’d)          Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument For example, if the MNE has a nonfunctional currency denominated loan or note receivable and the exchange rate of the nonfunctional currency rate has appreciated against the USD, then the MNE will have an exchange gain because of the fluctuations in the exchange rate; conversely, if the exchange rate/value of the nonfunctional currency has depreciated against the USD, the MNE will have an exchange loss on the loan or note receivable because of fluctuations in the exchange rate/value. If the MNE has a loan or note payable which is denominated in a nonfunctional currency and the nonfunctional currency appreciates against the USD, it would cost the MNE more in USD to pay off the loan at maturity and therefore result in an exchange loss; any depreciation of the nonfunctional currency against the USD would result in a lower cost to the MNE to pay off the loan at maturity and therefore would result in an exchange gain. The Practice Units on Qualified Business Units (QBUs), 988 Transactions, and Functional Currency (FC) should also be considered in order to understand the basic terms used in FX transactions. Fluctuations in the FX exchange rate also impact Section 987 covered transactions, which will be covered in a future Practice Unit.                        Back to Table of Contents4  Detailed Explanation of the Concept          Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument Depending upon whether the MNE has a transaction denominated in an FX which is a Section 988 transaction, changes in the FX exchange rates may result in an exchange gain or loss to the MNE.       AnalysisResources   The diagram below is meant to illustrate the potential impact of changes in the exchange rates of FX denominated assets and liabilities. It is intended for general informational purposes, context and risk analysis purposes only. (It should not be interpreted to mean that if one side of a transaction has a gain, the other side will have a loss). GENERAL INFORMATION: Exchange Gain/Loss Chart (for U.S. taxpayer with a nonfunctional currency loan or note):                       Back to Table of Contents5  Detailed Explanation of the Concept (cont’d)           Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument  AnalysisResources        CONSULTATION: Consider consulting with the Financial Institutions & Products (FIP) Financial Institutions & Products        PN which has substantial experience in debt instruments, derivatives and otherKnowledge Base - IRS Virtual Library   financial assets or liabilities that may be involved with transactions covered in this Unit.         Also, visit the Financial Institutions & Products Knowledge Base.                                        Back to Table of Contents6  Examples of the Concept            Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument Example: Steps in Calculating an Exchange Gain or Loss and Overall Gain or Loss The following steps should be taken to calculate the exchange gain or loss when a U.S. Taxpayer lends or borrows in a nonfunctional currency, and the exchange rate changes from the origination date of the loan to the repayment date resulting in an exchange gain or loss: Step 1: Calculate the amount of the exchange gain or loss. Step 2: Calculate the total overall gain or loss on the transaction. Step 3: Compare the amount of the exchange gain or loss to the total overall gain or loss on the transaction. An exchange gain or loss on the payment/disposition of debt instruments should be recognized only to the extent of the total overall gain or loss on the transaction. When a debt instrument is denominated in a nonfunctional currency (as described in Treas. Reg. 1.988-2(b)(2)(i)) and is paid, disposed of, or transferred to another person, the exchange gain or loss realized shall be realized only to the extent of the total gain or loss realized on the transaction. Treas. Reg. 1.988-2(b)(8) Likewise, if a taxpayer’s right to receive income or an obligation to pay an expense is settled, transferred or modified in a transaction in which a gain or loss would otherwise be recognized, an exchange gain or loss shall be realized and recognized only to the extent of the total gain or loss on the transaction. Treas. Reg. 1.988-2(c)(1)               Back to Table of Contents7  Examples of the Concept (cont’d)            Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument Examples of a Section 988 Exchange Gain or Loss Calculation 1. Example of an Exchange Gain Limited by Total Gain 2. Example of a Market Loss and an Exchange Gain 3. Example of a Market Loss and an Exchange Loss                                   Back to Table of Contents8  Examples of the Concept (cont’d) 2            Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument Example of an Exchange Gain Limited by Total Gain EXAMPLE FACTS 1. The FC of Taxpayer X is the USD. 2. On January 1, 20X2, X loans 10,000 Local Currency (LC). 3. X has a USD basis in the loan of $13,000 (10,000 LC X $1.30 spot rate on January 1, 20X2). 4. The terms of the loan provide that Y will repay X's 10,000 LC principal on December 31, 20X4. 5. X sells the loan for 9,821 LC on December 31, 20X3. 6. Assume the spot rates (LC to USDs) for the pertinent dates are as follows: January 1, 20X2, 1 LC = $1.30 December 31, 20X3, 1 LC = $1.40 December 31, 20X4, 1 LC = $1.45                        Back to Table of Contents9  Examples of the Concept (cont’d)3            Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument Example of an Exchange Gain Limited by Total Gain                                          Back to Table of Contents10  Examples of the Concept (cont’d) 4            Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument Example of a Market Loss and an Exchange Gain EXAMPLE FACTS 1. The FC of Taxpayer X is the US dollar. 2. On January 1, 20X2, X loans 10,000 Local Currency (LC) to Y for 3 years. 3. X has a basis in the 10,000 LC loaned to Y of $13,000 calculated at the spot rate of 1 LC=$1.30 on January 1, 20X2. 4. The terms of the loan provide that Y will repay X's 10,000 LC principal on December 31, 20X4. 5. X settles the loan to Y for 8,000 LC on 12/31/20X4. 6. Assume the spot rates (LC to USDs) for the pertinent dates are as follows: January 1, 20X2 1, LC = $1.30 December 31, 20X4, 1 LC = $1.45                          Back to Table of Contents11  Examples of the Concept (cont’d) 5            Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument Example of a Market Loss and an Exchange Gain                                        Back to Table of Contents12   Examples of the Concept (cont’d) 6            Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument Example of a Market Loss and an Exchange Loss EXAMPLE FACTS 1. The FC of Taxpayer X is the US dollar. 2. On January 1, 20X2, X loans 10,000 Local Currency (LC) to Y for 3 years. 3. X has a basis in the 10,000 LC loaned to Y of $13,000 calculated at the spot rate of 1 LC=$1.30 on January 1, 20X2. 4. The terms of the loan provide that Y will repay X's 10,000 LC principal on December 31, 20X4. 5. X settles the loan to Y for 8,000 LC on 12/31/2004. 6. Assume the spot rates (LC to USDs) for the pertinent dates are as follows: January 1, 20X2, 1 LC = $1.30 December 31, 20X4, 1 LC = $1.25                          Back to Table of Contents13  Examples of the Concept (cont’d) 7            Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument Example of a Market Loss and an Exchange Loss                                        Back to Table of Contents14   Index of Referenced Resources              Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument IRC 987 IRC 988 Treas. Reg. 1.988-2(b)(8) Treas. Reg. 1.988-2(c)(1) Financial Institutions & Products Knowledge Base - IRS Virtual Library                               Back to Table of Contents15  Training and Additional Resources        Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument  Type of ResourceDescription(s) Reference Materials BNA Tax Management Int’l Portfolio 921-2nd   Bittker and Lokken - Fundamentals of International Taxation Para 74.2   Keyes - Federal Taxation of Financial Instruments and Transactions, Chapter 15   Mertens - Law of Federal Income Taxation, Chapter 45C    Other Training Materials IE Phase III: IRC 985 and 989: Foreign Currency Terms and Definitions   IE Phase III: Section 986 Translation Rules   IE Phase III: Sec 987 - Branch Rules and CTB Rules   IE Phase III: Foreign Currency Section 988 Transactions   IE Phase III: Foreign Currency Hedging   IE Phase III: Financial Products Basics - Four Major Categories   IE Phase I: Module E - Lesson 1 Foreign Currency   IE Phase III, Module D - Interaction of International and Financial Products Issues   FP Phase 1: Lesson 9 - Foreign Currency   FP Phase III: Lesson 4 - Foreign Currency                    Back to Table of Contents16  Glossary of Terms and Acronyms    Term/AcronymDefinitionFCFunctional Currency  FIPFinancial Institutions & Products  FXForeign Currency  LCLocal Currency  MNEU.S. Multi-national Enterprise  PNPractice Network  QBUQualified Business Unit  USDUnited States Dollar                        Back to Table of Contents17  Index of Related Practice Units    Associated UIL(s)Related Practice Unit9470Change in Functional Currency Section 985 Procedural Matters and Calculation  9470Character of Exchange Gain or Loss  9470Definition of Appropriate Exchange Rate Overview  9470Disposition of a Portion of an Integrated Hedge  9470Exchange Gains or Losses on Payables and Receivables  9470Functional Currency Determination  9470How to Assess Penalties for Failure to File a Form 8886 Disclosing IRC 988 Losses  9470Official vs Free Market Exchange Rate  9470Overview of IRC Section 988 Nonfunctional Currency Transactions  9470Overview of Qualified Business Units QBUs  9470Sourcing of Exchange Gains or Losses in Currency Transactions  9470Functional Currency of a QBU  9470Disposition of Nonfunctional Currency  9470Computation and Review of IRC 986(c) Gain or Loss – Pre-TCJA  9470Overview of IRC 986(c) Gain or Loss Prior to Tax Cuts and Jobs Act of 2017        Back to Table of Contents18

<p>IRS Issues Practice Unit on Foreign Currency Transactions</p>

IRS Issues Practice Unit on Foreign Currency Transactions

Internal Revenue Service

The IRS has issued a practice unit covering some basic foreign currency principles regarding currency transactions that multinational enterprises may enter and how changes in exchange rates will affect an MNE.

<p>The IRS has issued a practice unit covering some basic foreign currency principles regarding currency transactions that multinational enterprises may enter and how changes in exchange rates will affect an MNE.</p>