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KPMG LLP Suggests Alternative to Computation Method in Proposed Branch Currency Transaction Regs

JUN. 7, 2007

KPMG LLP Suggests Alternative to Computation Method in Proposed Branch Currency Transaction Regs

DATED JUN. 7, 2007
DOCUMENT ATTRIBUTES

 

June 4, 2007

 

 

The Honorable Kevin M. Brown

 

Acting Commissioner of the Internal Revenue Service

 

Room 5203

 

P.O. Box 7604

 

Ben Franklin Station

 

Washington, DC 20044

 

Attn: International, Room 4562, CC:INTL:BR5

 

 

Mr. Eric Solomon

 

Assistant Secretary (Tax Policy)

 

Department of the Treasury

 

1500 Pennsylvania Ave., NW

 

Room 3104 MT

 

Washington, DC 20220

 

 

Mr. John Harrington

 

International Tax Counsel (Acting)

 

Department of the Treasury

 

1500 Pennsylvania Ave., NW

 

Room 3054 MT

 

Washington, DC 20220

 

 

Mr. Steven A. Musher

 

Associate Chief Counsel (International)

 

Office of the Chief Counsel

 

Internal Revenue Service

 

1111 Constitution Ave., NW

 

Room 4619 IR, CC:INTL

 

Washington, DC 20224

 

 

Re: Comments on Proposed Treasury Regulations Providing Guidance under Section 987 Regarding the Determination of the Items of Income or Loss and Currency Gain or Loss with respect to a Section 987 Qualified Business Unit (REG-208270-86).

Dear Acting Commissioner Brown and Messrs. Solomon, Harrington, and Musher:

On behalf of KPMG LLP, we are responding to your request for comments on proposed regulations (REG-208270-86) (the "Proposed Regulations") dealing with the determination of the items of income or loss and currency gain or loss with respect to a section 987 qualified business unit ("QBU"). The Proposed Regulations, which were issued on September 7, 2006, withdraw proposed regulations under section 987 that were issued on September 25, 1991 (the "1991 Regulations").

I. Background

We understand that the IRS and Treasury were concerned that the 1991 Regulations allowed taxpayers to claim non-economic section 987 currency losses.1 In particular, we understand that the IRS and Treasury were concerned that under the 1991 Regulations, the equity pool used to determine exchange gain or loss recognized upon a remittance from a QBU included tangible property the value of which would not be affected by fluctuations in the value of the functional currency of the QBU.2 As a result, for example, terminating a QBU that held minimal financial assets but substantial operating assets could result in the recognition of substantial exchange losses or gains even though most of the QBU's assets were not economically exposed to currency changes.3

To address this aspect of the 1991 Regulations, the Proposed Regulations adopt the "foreign exchange exposure pool method." As under the 1991 Regulations, the foreign exchange exposure pool method would generally require taxpayers to compute income or loss with respect to a QBU by determining the QBU's income or loss in the QBU's functional currency and then translating that amount into the taxpayer's functional currency using the average exchange rate for the taxable year. In addition, like the 1991 Regulations, unrecognized exchange gains or losses inherent in a QBU would be "pooled" and, upon a remittance from the QBU, recognized on a pro rata basis. However, unlike the 1991 Regulations, the foreign exchange exposure pool method uses a balance sheet approach to determine exchange gain or loss and includes exchange gain or loss only with respect to "marked items" whose values fluctuate with currency changes.4 In addition, taxpayers would be required in computing income or loss with respect to a QBU under the foreign exchange exposure pool method to translate the bases of certain assets that do not qualify as marked items, and therefore to calculate deductions for depreciation, depletion, and amortization relating to such assets, using historical exchange rates.5

II. Summary of Comments

Although we are concerned about the significant compliance burdens that the foreign exchange exposure pool method would impose, we appreciate that any method that seeks to avoid the recognition of non-economic section 987 gains or losses with respect to certain classes of assets necessitates some form of asset and basis tracing and therefore will impose greater administrative burdens. We share the concerns of other commentators who have questioned whether the increased compliance burden is warranted where the overarching purpose of the regulations is to narrow the economic activities that may be subject to the recognition of gain or loss under section 987. Nevertheless, even if one accepts the approach of the Proposed Regulations in computing section 987 gain and loss, we do not believe that requiring taxpayers to use historical bases for purposes of computing a QBU's income or loss is necessary to avoid the recognition of non-economic gain or loss under section 987. Moreover, we submit that the approach under the 1991 Regulations for computing a QBU's income or loss results in a more accurate assessment of the true economic income or loss of a QBU. We also submit that the manner in which a QBU's income or loss is computed under the foreign exchange exposure pool method is inconsistent with the statutory language of section 987 and the U.S. tax policy goal described in the legislative history of section 987 of promoting parity between the taxation of branches and subsidiaries.

III. Example

We discuss these points in more detail below in the context of the following example.

 

X, a domestic corporation, starts a new Business A in a foreign country at the beginning of year 1. Business A qualifies as a QBU and has the euro as its functional currency. X transfers to Business A a truck with a basis of $100 and inventory with a basis of $100. The truck is subject to straight line depreciation over five years. The spot rate at the time of the contribution is €1 = $1. During year 1, Business A sells 20 percent of its inventory for €50. The yearly average exchange rate for year 1 is €1 = $.80. The spot rate at the end of year 1 is €1 = $.75. During year 2, Business A sells another 20 percent of its inventory for €60. The yearly average exchange rate for year 2 is €1 = $.60. The spot rate at the end of year 2 is €1 = $.50. During year 3, Business A sells no inventory, but sells its truck for €100. On the last day of year 3, X terminates Business A. The yearly average exchange rate for year 3 and the spot rate on the last day of year 3 is €1 = $.50.

 

Under the 1991 Regulations, Business A computes its net income for each year as follows:
  • For year 1, Business A subtracts from its gross sales of €50, its cost of goods sold of €20 and €20 of depreciation deductions. Business A therefore has net income of €10, which translates into $8 using the yearly average exchange rate.

  • In year 2, Business A has net income of €20 (€60 gross sales less €20 cost of goods sold less €20 depreciation), which translates into $12.

  • For year 3, Business A has net income of €40 (€100 amount realized on the sale of the truck less €60 basis in the truck), which translates into $20.

 

When Business A is terminated, it transfers inventory with a basis of €60 and cash of €210 to X. The adjusted basis of the inventory equals $30, and X's remaining basis in Business A is $210.

The section 987 gain or loss realized upon the termination of Business A is computed by subtracting X's $210 remaining basis in Business A from the value of the cash transferred to X by Business A, which is $105 using the spot rate. Thus, X recognizes a section 987 loss upon the termination of Business A of $105. X's total net income or loss with respect to its investment in Business A, as computed under the 1991 Regulations, is therefore a net loss of $65 (sum of $40 of income over 3 years and $105 section 987 loss). X also presumably has a built-in gain in the inventory property of $30.

Under the Proposed Regulations, because Business A's truck and inventory are not marked items, the bases of those assets must be translated using the historical exchange rate (the exchange rate at the time those assets were transferred to Business A) in computing the net income of Business A. The net income of Business A would thus be computed under the Proposed Regulations as follows:

 Year 1                           Translation Rate

 

 

 Gross Sales     €50          €1 = $.80 (average)                $40

 

 COGS           (€20)         €1 =$1 (historic)                 ($20)

 

 Depreciation   (€20)         €1 =$1 (historic)                 ($20)

 

 Net income                                                       $0

 

 

 Year 2                           Translation Rate

 

 

 Gross Sales     €60          €1 = $.60 (average)                  $36

 

 COGS           (€20)         €1 = $1 (historic)                  ($20)

 

 Depreciation   (€20)         €1 = $1 (historic)                  ($20)

 

 Net income                                                      ($4)

 

 

 Year 3                           Translation Rate

 

 

 Amount Realized €100  €1 = $.50 (average)                        $50

 

 Adjusted Basis (€60)  €1 = $  1 (historic)                      ($60)

 

 Net income                                                    ($10)

 

 

In addition, the section 987 gain or loss recognized by X upon the termination of Business is computed under the Proposed Regulations as follows:

 Year 1                         Translation Rate

 

 

 Opening Balance

 

 

          Truck €100       € 1 = $1 (historic)                   $100

 

          Inventory €100   € 1 = $1(historic)                    $100

 

                                                               $200

 

 

 Closing Balance

 

 

           Truck €80        € 1 = $1 (historic)                   $80

 

          Inventory  680        € 1 = $1 (historic)              $80

 

           Cash      650        € 1 = $.75 (spot)             $37.50

 

                                                            $197.50

 

 

 Unrecognized Section 987 Gain/Loss

 

          Accumulated Gain/Loss                          $0

 

          Change in Net Value                        ($2.50)

 

          QBU Taxable Income                             $0

 

                                                     ($2.50)

 

 

 Year 2                            Translation Rate

 

 

 Closing Balance

 

           Truck       €60     €1 = $1 (historic)                  $60

 

           Inventory   €60     €1 = $1 (historic)                  $60

 

           Cash        €110    €1 =$.50 (spot)                     $55

 

                                                                $175

 

 

 Unrecognized Section 987 Gain/Loss

 

 

               Accumulated Gain/Loss       ($2.50)

 

               Change in Net Value         ($22.50)

 

               QBU Taxable Income               $4

 

                                              ($21)

 

 

 Year 3                            Translation Rate

 

 

 Closing Balance

 

           Inventory    €60     €1 = $1 (historic)                  $60

 

           Cash         €210    €1 = $.50 (spot)                   $105

 

                                                                 $165

 

 Unrecognized Section 987 Gain/Loss

 

           Accumulated Gain/Loss                            $(21)

 

           Change in Net Value                              ($10)

 

           QBU Taxable Income                                $10

 

                                                            ($21)

 

 

Upon the termination of Business A, X recognizes the entire amount of the $21 section 987 loss. Thus, X's total net income or loss with respect to its investment in Business A, as computed under the Proposed Regulations, is a net loss of $35 (sum of $14 of loss over 3 years and $21 section 987 loss). In addition, X's basis in the inventory remitted by Business A is $60, which is presumably equal to the inventory's fair market value. By comparison, under the 1991 Regulations, as described above, X's total net income or loss with respect to its investment in Business A is a net loss of $65, and X also has a built-in gain in the inventory property of $30. The overall result under both sets of rules is thus a net loss of $35.

IV. Detailed Comments

 

A. Impact of Proposed Regulations

 

The above example demonstrates the concern of the IRS and Treasury that under the 1991 Regulations, section 987 exchange gain or loss could be recognized with respect to tangible property the value of which would not be affected by currency fluctuations. Specifically, because under the 1991 Regulations, Business A's basis in its inventory is translated into dollars at the spot rate, rather than at the historical rate, X recognizes an additional currency loss of $30. The Proposed Regulations change that result by requiring taxpayers to maintain the basis of assets that do not qualify as marked items at their historical levels. We believe that change is conceptually justifiable since assets like inventory are not financial assets denominated in a particular currency, and their value should not be affected by currency fluctuations. Thus, it is arguably inappropriate for exchange gain or loss to be recognized with respect to assets like inventory.

However, we do not believe that requiring taxpayers to use historical bases for purposes of computing a QBU's income or loss is necessary to avoid the recognition of exchange gain or loss with respect to assets the values of which do not change with currency fluctuations. We believe that the balance sheet approach for determining exchange gain or loss under the Proposed Regulations achieves that objective by itself. Extending the use of historical bases to assets that do not qualify as marked assets in computing a QBU's income or loss under the Proposed Regulations actually achieves a result that is inconsistent with the stated goal of the Proposed Regulations. That is, using historical bases for purposes of computing a QBU's income or loss results in the accelerated recognition of exchange gain or loss with respect to the recovery of basis in the QBU's historical assets.

Turning to our example, under the 1991 Regulations, Business A has $8 of net income in year 1, but under the foreign exchange exposure pool method of the Proposed Regulations, Business A has $0 of net income. The $8 difference represents the exchange loss attributable to the €40 of basis recovery in the form of depreciation deductions on the truck and the cost of goods sold. The €40 of basis was originally worth $40, but when the basis was deducted for purposes of computing Business A's income or loss, it was only worth $32 because of the movement in the exchange rate (€40 x $.80 = $32). In other words, if X had been currently funding Business A's expenses (i.e., contributing funds to rent a truck and purchase inventory currently), X would have only been required to contribute $32 to satisfy Business A's expenses. But, because X prepaid those expenses by purchasing the truck and the inventory, it is subject to exposure to exchange gain or loss with respect to its investment in Business A. The effect of using the historical bases of the truck and the inventory for purposes of computing Business A's income or loss under the foreign exchange exposure pool method is to trigger that inherent exchange loss when the basis is deducted.

 

B. Proposed Alternative Approach

 

We submit that there is an alternative approach that would address the concern of the IRS and Treasury regarding taxpayers recognizing exchange gain or loss with respect to assets that do not qualify as marked assets but would not accelerate the recognition of exchange gain or loss with respect to a taxpayer's investment in branch operations. Under such an alternative approach, a QBU's income or loss would be computed as under the 1991 Regulations, but exchange gain or loss would be computed using the foreign exchange exposure pool method. This alternative approach would result in recognition of the same amount of exchange gain or loss as under the Proposed Regulations, but the gain or loss associated with deducted basis would be recognized when the earnings associated with that deducted basis are remitted by the QBU, which we submit represents a more appropriate time to recognize the gain or loss. Turning again to our example, under such an alternative approach, Business A would have income in years 1, 2, and 3 of $8, $12, and $20, respectively, consistent with the results under the 1991 Regulations. The section 987 gain or loss recognized by X upon the termination of Business A would then be computed under such an alternative approach as follows:

 Year 1                             Translation Rate

 

 

 Opening Balance

 

           Truck      €100      €1 = $1 (historic)                  $100

 

          Inventory   €100      €1 = $1 (historic)                  $100

 

                                                                  $200

 

 Closing Balance

 

           Truck      €80       €1 = $1 (historic)                   $80

 

          Inventory   €80       €1 = $1 (historic)                   $80

 

           Cash       €50       €1 = $.75 (spot)                  $37.50

 

                                                               $197.50

 

 Unrecognized Section 987 Gain/Loss

 

          Accumulated Gain/Loss                          $0

 

          Change in Net Value                        ($2.50)

 

          QBU Taxable Income                            ($8)

 

                                                    ($10.50)

 

 

 Year 2                             Translation Rate

 

 

 Closing Balance

 

           Truck      €60    €1 = $1 (historic)                    $60

 

          Inventory   €60    €1 = $1 (historic)                    $60

 

          Cash       €110    €1 = $.50 (spot)                      $55

 

                                                                $175

 

 

 Unrecognized Section 987 Gain/Loss

 

          Accumulated Gain/Loss                     ($10.50)

 

          Change in Net Value                       ($22.50)

 

          QBU Taxable Income                        ($12)

 

                                                    ($45)

 

 

 Year 3                              Translation Rate

 

 

 Closing Balance

 

          Inventory    €60       €1 = $1 (historic)                 $60

 

          Cash         €210      €1 = $.50 (spot)                  $105

 

                                                                 $165

 

 

 Unrecognized Section 987 Gain/Loss

 

          Accumulated Gain/Loss                     $(45)

 

          Change in Net Value                      ($ 10)

 

          QBU Taxable Income                        ($20)

 

                                                    ($75)

 

 

Upon the termination of Business A, X recognizes the entire amount of the $75 section 987 loss. Thus, X's total net income or loss with respect to its investment in Business A, as computed under this alternative approach, is a net loss of $35 (sum of $40 of income over 3 years and $75 section 987 loss). The result is exactly the same as under the Proposed Regulations, but the exchange gain or loss inherent in the recovered basis in the QBU's assets is not recognized until earnings are actually remitted by the QBU. In other words, using average rates for translating the bases of historical assets in computing a QBU's income or loss, but historical rates for translating such bases in computing section 987 gain or loss, does not result in any double-counting of gain or loss. The difference in the amount of a QBU's annual income or loss as computed under the Proposed Regulations and under this alternative approach simply carries over to the computation of unrecognized section 987 gain or loss (reflected in the first and third items under "Unrecognized Section 987 Gain/Loss" in the chart above), and the difference accumulates until it is recognized upon a remittance.

 

C. Arguments Supporting Alternative Approach

 

We do not believe that the acceleration of exchange gain or loss with respect to a QBU's recovery of basis furthers the articulated goal of the Proposed Regulations, i.e., to prevent the recognition of section 987 exchange gain or loss with respect to tangible property the value of which would not be affected by currency fluctuations. We also do not believe that this acceleration of exchange gain or loss under the Proposed Regulations results in a more accurate reflection of an owner's economic gain or loss with respect to a QBU. Rather, because the QBU is operating outside the United States, measuring both the QBU's gross income and deductions in the QBU's functional currency would seem to produce a more accurate reflection of the QBU's true economic profit or loss. Stated another way, because the income or gain produced by the assets held by a QBU is translated at current exchange rates in connection with computing the QBU's income or loss, such assets are effectively marked, or at least the value of the income or gain they produce is clearly affected by currency fluctuations. Allowing the bases in those assets to likewise float with currency fluctuations for purposes of computing the QBU's income or loss would reflect the economic reality that the taxpayer's overall return on its investment in those assets is subject to currency exposure.

We also submit that it is inconsistent with the statutory framework and the legislative history of section 987 to trigger exchange gain or loss before some portion of the owner's investment in the QBU is recovered in the form of a remittance. Section 987 provides that the taxable income with respect to a QBU shall be determined by first computing the taxable income or loss for a QBU in its functional currency, then translating that amount at the appropriate exchange rate, and finally by making proper adjustments for remittances. The statute seems clear that an owner's taxable income with respect to a QBU is based on two separate measures, one based on the QBU's annual income or loss, computed in the QBU's functional currency and then translated at a single exchange rate, and a second based on exchange gains or losses resulting from remittances. The foreign exchange exposure pool method of the Proposed Regulations is inconsistent with the statutory language in two ways: (1) it would require taxpayers to use multiple exchange rates, rather than a single exchange rate, in computing income or loss of a QBU; and (2) it would trigger exchange gain or loss when historical basis is recovered, even if there has been no remittance from the QBU.

The foreign exchange exposure pool method would also result in measurements of taxable income of a QBU that would differ substantially from measurements of earnings and profits of controlled foreign corporations under section 986(b). In enacting section 987, Congress clearly intended to lessen the disparate treatment of subsidiaries and branches as relates to foreign currency exposure.6 The foreign exchange exposure pool method would violate that legislative intent to the extent it requires taxpayers to compute the income or loss of a QBU differently than a subsidiary.

We would be happy to discuss with you further any of the issues we raise in this letter. Please feel free to contact any of the authors of this letter at the numbers listed below if we can be of any assistance.

Sincerely,

 

 

Ronald A. Dabrowski

 

KPMG LLP

 

Washington, D.C.

 

 

Howard A. Wiener

 

KPMG LLP

 

McLean, VA

 

 

Stephanie A

 

Robinson KPMG LLP

 

Washington, D.C.

 

FOOTNOTES

 

 

1See Preamble to the Proposed Regulations ("Preamble"), 71 Fed. Reg. 52,876, 52,879-52,880; Notice 2000-20, 2000-1 C.B. 851.

2Id.

3See Preamble at 52,879.

4 Prop. Treas. Reg. § 1.987-4(e)(2). "Marked items" are generally defined in Prop. Treas. Reg. § 1.987-1(d) as assets or liabilities that would be section 988 transactions if held or entered into directly by the owner of the QBU, but are not section 988 transactions with respect to the QBU.

5 Prop. Treas. Reg. § 1.987-3(b)(2).

6See H. Rep. No. 99-426, 99th Cong., 1st Sess. (1985), 1986-3 C.B.

 

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