Regs Governing Changes in Functional Currency

 [4830-01]

 ACTION: Final regulations.

 SUMMARY: This document contains final Income Tax Regulations relating to adjustments and transition rules with respect to a change in functional currency. These regulations are issued under section 985 of the Internal Revenue Code of 1986 (Code), which was added to the Code by the Tax Reform Act of 1986. These regulations provide guidance for taxpayers with qualified business units (QBUs) that change functional currency and provide special rules for taxpayers with QBUs operating in a hyperinflationary environment that elect the dollar as their functional currency for their first post-1986 taxable year.

 EFFECTIVE DATE: These regulations are effective February 4, 1993.

 FOR FURTHER INFORMATION CONTACT: Jacob Feldman of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224 (202-622-3870, not a toll-free call).

SUPPLEMENTARY INFORMATION:

BACKGROUND

On September 20, 1989, proposed and temporary regulations sections 1.985-5T and 1.985-6T were adopted (as part of T.D. 8263) and published in the Federal Register at 54 FR 38649 (September 20, 1989). No public hearing was requested, and none was held. Very few comments were received. The issues raised by these comments are discussed below. After consideration of the comments and related issues with respect to sections 1.985-5T and 1.985-6T, these sections of the proposed regulations are adopted as a Treasury decision effective 3O days after publication, with the modifications discussed below. In addition, in an accompanying notice of proposed rulemaking, section 1.985-7 provides special rules for cases in which a QBU changes from the profit and loss method of accounting (P&L method) to the dollar approximate separate transactions method (DASTM). These revised rules are proposed to be effective in taxable years beginning 30 days after the publication of final regulations.

EXPLANATION OF PROVISIONS

 Section 1.985-5T, which contains adjustments required upon a change in functional currency, is finalized substantially as proposed. However, a new section 1.985-7 is being proposed to apply to a QBU that uses the P&L method in a post-1986 taxable year and that subsequently begins to use the dollar as its functional currency using DASTM accounting. The proposed regulation responds to taxpayers' comments and would permit the use of historical exchange rates to establish the QBU's DASTM balance sheet, rather than the spot rate provided under section 1.985-5, provided that the taxpayer makes a section 481 adjustment. The proposed regulation would permit taxpayers that elected DASTM in an open taxable year beginning before the proposed rule is finalized to use section 1.985-7 instead of the temporary or final versions of section 1.985-5 and section 1.985-6.

 The final regulations contain several clarifying amendments to the temporary regulations. Section 1.985-5T(e)(1), providing for translation of a corporation's earnings and profits into its new functional currency at the spot exchange rate, is expanded to clarify that pre-1987 creditable income taxes and accumulated profits of a foreign corporation maintained in foreign currency for purposes of section 902 also are translated at the spot rate when the foreign corporation changes its functional currency. Pre-1987 earnings and taxes must be translated at the same rate in order to implement the rule of section 902(c)(6) that the tax effects of distributions out of pre-1987 earnings, are governed by pre-1987 law. See Bon Ami Co., 39 B.T.A. 825 (1939).

 One taxpayer suggested that income or loss required to be recognized under the proposed regulations at the time a QBU changes functional currency should be taken into account over several years. See section 1.985-5(b) with respect to section 988 transactions denominated in the new functional currency, section 1.985-5(d)(2) with respect to a deemed branch termination when a branch changes to the taxpayer's functional currency, and section 1.985-5(e)(2) with respect to a deemed distribution of previously taxed earnings and profits when a controlled foreign corporation changes its functional currency to the dollar. This suggestion was not adopted for several reasons.

 In the case of the required section 988 adjustment to the subpart F income and earnings and profits of a foreign corporation changing functional currency, a multi-year spread period would be particularly difficult to implement because of the need for additional information reporting with respect to the foreign corporation, and the administrative complexity that would result from spreading a subpart F inclusion and associated deemed paid foreign tax credits at the shareholder level. Spreading the adjustments resulting from a deemed branch termination and a deemed distribution of previously taxed income also would be particularly complex because, for example, of their effect on the U.S. taxpayer's foreign tax credit. In addition, the Service is concerned that if a spread period were allowed taxpayers could use distributions in connection with a change in functional currency to manipulate the time these amounts are taken into account.

 Section 1.985-6T, which contains transition rules for QBUs that use DASTM accounting for their first taxable year beginning in 1987, is finalized essentially as proposed, except that a new paragraph (d)(1) provides for a spot exchange rate translation of pre-1987 section 902 accumulated profits and deficits as well as foreign income taxes attributable to such accumulated profits. In addition, new paragraph (d)(2) provides that only the translated amount of a pre-1987 section 902 deficit in accumulated profits is carried over into the foreign corporation's post-1986 undistributed earnings pool. The amount of any pre-1987 deficit in retained earnings determined under section 1.964-1(e) is not carried over. These rules are the same as those applicable under Notice 87-54, 1987-2 C.B. 363, and Notice 88-70, 1988-2 C.B. 369, to QBUs whose functional currency in 1987 is the same currency in which the taxpayer kept the QBU's books and records for purposes of section 902 prior to 1987.

 One commentator suggested that in the case of a DASTM CFC, a pre-1987 section 964 accumulated deficit (and not a section 902 deficit) should be carried forward into the post-1986 undistributed earnings pool. This suggestion was not adopted because under section 902(c)(6) of the Internal Revenue Code the tax effects of distributions out of pre-1987 accumulated profits must be determined under pre-1987 law. Accordingly, the total amount of earnings and profits available for distribution as a dividend from a controlled foreign corporation that begins to use DASTM accounting in 1987 is the sum of (1) the pre-1987 accumulated profits (or deficit) computed in foreign currency under a P&L method in accordance with the rules of section 902 prior to amendment in 1986 and translated into dollars in 1987 in accordance with the principles of Notice 88-70, and (2) the post-1986 undistributed earnings pool, consisting of earnings and profits computed in dollars under the DASTM method in post-1986 years. The Service believes that reducing the post-1986 undistributed earnings pool (which is the denominator of the section 902 fraction) by a pre-1987 deficit computed in dollars for purposes of section 964 would contravene the rule that the pre-1987 section 964 amounts are not relevant for purposes of determining the tax effects of dividend inclusions. Similarly, excluding a pre-1987 section 902 deficit from the post-1986 undistributed earnings pool would be inconsistent with the rule referring to (positive) pre-1987 accumulated profits in determining the effect of a distribution in excess of the post-1986 pool.

 A rule bringing forward a pre-1987 section 964 deficit into the post-1986 pool of a DASTM CFC would also create a difference in treatment between a DASTM CFC and a CFC with a dollar functional currency that uses a separate transactions profit and loss method. Finally, the commentators' proposed rule, to the extent it created a negative post-1986 pool, could increase the incidence of inclusions without credits should the foreign corporation realize subpart F income or pay a "nimble dividend" in a post-1986 year.

 Paragraphs (d) and (e) of section 1.985-6T are renumbered as paragraphs (e) and (f), respectively, in the final regulations. An alternative transition rule for a branch that used a profit and loss method of accounting in pre-1987 taxable years and that now uses DASTM because the taxpayer elected to use the dollar as the branch's functional currency in its first post-1986 taxable year is provided in the accompanying notice of proposed rulemaking.

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. Although this Treasury decision was preceded by a notice of proposed rulemaking that solicited public comments, it has been determined that the notice was not required by 5 U.S.C. 553 since the regulations proposed in that notice and adopted by this Treasury decision are interpretative. Therefore, a final Regulatory Flexibility Analysis is not required by the Regulatory Flexibility Act (5 U.S.C. chapter 6).

DRAFTING INFORMATION

 Personnel from the Internal Revenue Service and Treasury Department participated in developing these regulations.

LIST OF SUBJECTS

 26 CFR 1.985-0 through 1.989(c)-1

 Income taxes, Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

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

Paragraph 1. The authority citation for part 1 is amended by removing the entry for "Sections 1.985-0T through 1.985-5T" and adding a citation to read as follows:

Authority: 26 U.S.C. 7805 * * * Sections 1.985-0 through 1.985-5 also issued under 26 U.S.C. 985. * * *

Par. 2. Sections 1.985-5T and 1.985-6T are removed.

Par. 3. Section 1.985-0 is amended as follows:

1. The introductory text for section 1.985-0 is revised.

2. The section heading in the entry for section 1.985-5T is removed and a section heading for section 1.985-5 is added in its place.

3. The entry for section 1.985-6T is removed and an entry for section 1.985-6 is added.

4. The revisions and additions read as follows:

SECTION 1.985-0 OUTLINE OF REGULATIONS.

This section lists the paragraphs contained in sections 1.985-1 through 1.985-6.

* * * * *

SECTION 1.985-5 ADJUSTMENTS REQUIRED UPON CHANGE IN FUNCTIONAL CURRENCY.

 * * * * *

SECTION 1.985-5 ADJUSTMENTS REQUIRED UPON CHANGE IN FUNCTIONAL CURRENCY.

(a) IN GENERAL. This section applies in the case of a QBU that changes from one functional currency (old functional currency) to another functional currency (new functional currency). A taxpayer or QBU subject to the rules of this section shall make the adjustments set forth in the 3-step procedure described in paragraphs (b) through (e) of this section. The adjustments shall be made on the last day of the taxable year ending before the year of change as defined in section 1.481-1(a)(1). Gain or loss required to be recognized under paragraphs (b), (d)(2), and (e)(2) of this section is not subject to section 481 and, therefore, the full amount of the gain or loss must be included in income or earnings and profits on the last day of the taxable year ending before the year of change. Except as provided in section 1.985-6, a QBU with a functional currency for its first taxable year beginning in 1987 that is different from the currency in which it had kept its books and records for United States accounting and tax accounting purposes for its prior taxable year shall apply the principles of this section 1.985-5 for purposes of computing the relevant functional currency items, such as earnings and profits, basis of an asset, and amount of a liability, as of the first day of a taxpayer's first taxable year beginning in 1987.

(b) STEP 1 -- TAKING INTO ACCOUNT EXCHANGE GAIN OR LOSS ON CERTAIN SECTION 988 TRANSACTIONS. The QBU shall recognize or otherwise take into account for all purposes of the Code the amount of any unrealized exchange gain or loss attributable to a section 988 transaction (as defined in section 988(c)(1)(A), (B), and (C)) that, after applying section 988(d), is denominated in terms of or determined by reference to the new functional currency. The amount of such gain or loss shall be determined without regard to the limitations of section 988(b) (i.e., whether any gain or loss would be realized on the transaction as a whole). The character and source of such gain or loss shall be determined under section 988.

(c) STEP 2 -- DETERMINING THE NEW FUNCTIONAL CURRENCY BASIS OF PROPERTY AND THE NEW FUNCTIONAL CURRENCY AMOUNT OF LIABILITIES AND ANY OTHER RELEVANT ITEMS. The new functional currency adjusted basis of property and the new functional currency amount of liabilities and any other relevant items (e.g., items described in section 988(c)(1)(B)(iii)) shall equal the product of the amount of the old functional currency adjusted basis or amount multiplied by the new functional currency/old functional currency spot exchange rate on the last day of the taxable year ending before the year of change (spot rate).

(d) STEP 3A -- ADDITIONAL ADJUSTMENTS THAT ARE NECESSARY WHEN A BRANCH CHANGES FUNCTIONAL CURRENCY -- (1) BRANCH CHANGING TO A FUNCTIONAL CURRENCY OTHER THAN THE TAXPAYER'S FUNCTIONAL CURRENCY -- (i) RULE. If a QBU that is a branch of a taxpayer changes to a functional currency other than the taxpayer's functional currency, the branch shall make the adjustments set forth in either paragraph (d)(1)(ii) or (d)(1)(iii) of this section for purposes of section 987. See section 1.987-5(d) for rules for computing the branch's equity pool and basis pool.

(ii) WHERE PRIOR TO THE CHANGE THE BRANCH AND TAXPAYER HAD DIFFERENT FUNCTIONAL CURRENCIES. If the branch and the taxpayer had different functional currencies prior to the change, the branch's new functional currency equity pool shall equal the product of the old functional currency amount of the equity pool multiplied by the spot rate. No adjustment to the basis pool is necessary.

(iii) WHERE PRIOR TO THE CHANGE THE BRANCH AND TAXPAYER HAD THE SAME FUNCTIONAL CURRENCY. If the branch and the taxpayer had the same functional currency prior to the change, the branch's basis pool shall equal the difference between the branch's total old functional currency basis of its assets and its total old functional currency amount of its liabilities. The branch's equity pool shall equal the product of the basis pool multiplied by the spot rate.

(2) BRANCH CHANGING TO THE TAXPAYER'S FUNCTIONAL CURRENCY. IF a branch changes its functional currency to the taxpayer's functional currency, the branch shall be treated as if it terminated on the last day of the taxable year ending before the year of change. In such a case, the taxpayer shall realize gain or loss attributable to the branch's equity pool under the principles of section 987.

(e) STEP 3B -- ADDITIONAL ADJUSTMENTS THAT ARE NECESSARY WHEN A TAXPAYER CHANGES FUNCTIONAL CURRENCY -- (1) CORPORATIONS. The amount of a corporation's new functional currency earnings and profits and the amount of its new functional currency paid-in capital shall equal the product of the old functional currency amounts of such items multiplied by the spot rate. The foreign income taxes and accumulated profits or deficits in accumulated profits of a foreign corporation that were maintained in foreign currency for purposes of section 902 and that are attributable to taxable years of the foreign corporation beginning before January 1, 1987, also shall be translated into the new functional currency at the spot rate.

(2) COLLATERAL CONSEQUENCES TO A UNITED STATES SHAREHOLDER OF A CORPORATION CHANGING TO THE UNITED STATES DOLLAR AS ITS FUNCTIONAL CURRENCY. A United States shareholder (within the meaning of section 951(b) or section 953(c)(1)(A)) of a controlled foreign corporation (within the meaning of section 957 or section 953(c)(1)(B)) changing its functional currency to the dollar shall recognize foreign currency gain or loss computed under section 986(c) as if all previously taxed earnings and profits, if any, (including amounts attributable to pre-1987 taxable years that were translated from dollars into functional currency in the foreign corporation's first post-1986 taxable year) were distributed immediately prior to the change. Such a shareholder shall also recognize gain or loss attributable to the corporation's paid-in capital to the same extent, if any, that such gain or loss would be recognized under the regulations under section 367(b) if the corporation was liquidated completely.

(3) TAXPAYERS THAT ARE NOT CORPORATIONS. [Reserved]

(4) ADJUSTMENTS TO A BRANCH'S ACCOUNTS WHEN A TAXPAYER CHANGES FUNCTIONAL CURRENCY -- (i) TAXPAYER CHANGING TO A FUNCTIONAL CURRENCY OTHER THAN THE BRANCH'S FUNCTIONAL CURRENCY. If a taxpayer changes to a functional currency that differs from the functional currency of a branch of the taxpayer, the branch shall adjust its basis pool in the manner prescribed in paragraph (d)(1)(ii) of this section for adjusting the equity pool, if the taxpayer's old functional currency was different from the branch's functional currency. If the taxpayer's old functional currency was the same as the branch's functional currency, the branch shall determine its equity pool and basis pool in the manner set forth in paragraph (d)(1)(iii) of this section for determining the basis pool and equity pool, respectively.

(ii) TAXPAYER CHANGING TO THE SAME FUNCTIONAL CURRENCY AS THE BRANCH. If a taxpayer changes to the same functional currency as a branch of the taxpayer, the taxpayer shall realize gain or loss as set forth in paragraph (d)(2) of this section.

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

EXAMPLE 1. S, a calendar year foreign corporation, is wholly owned by domestic corporation P. The Commissioner granted permission to change S's functional currency from the LC to the FC beginning January 1, 1993. The LC/FC exchange rate on December 31, 1992 is 1 LC/2 FC. The following shows how S must convert the items on its balance sheet from the LC to the FC.

                                         LC         1:2          FC

SECTION 1.985-6 TRANSITION RULES FOR A QBU THAT USES THE DOLLAR APPROXIMATE SEPARATE TRANSACTIONS METHOD FOR ITS FIRST TAXABLE YEAR BEGINNING IN 1987.

(a) IN GENERAL. This section sets forth transition rules for a QBU that used the dollar approximate separate transactions method of accounting set forth in section 1.985-3 or section 1.985-3T (as contained in the April 1, 1989 edition of 26 CFR part 1 (1.908 to 1.1000)) for its first taxable year beginning in 1987 (DASTM QBU). A DASTM QBU must determine the dollar and hyperinflationary currency basis of its assets and the dollar and hyperinflationary currency amount of its liabilities that were acquired or incurred in taxable years beginning before January 1, 1987. In addition, a DASTM QBU must determine its net worth, including its retained earnings, at the end of the QBU's last taxable year beginning before January 1, 1987. This section provides rules for controlled foreign corporations (as defined in section 957 or section 953(c)(1)(B)), other foreign corporations, and branches of United States persons that must make these determinations.

(b) CERTAIN CONTROLLED FOREIGN CORPORATIONS. If a DASTM QBU was a controlled foreign corporation for its last taxable year beginning before January 1, 1987, and it had a significant event as described in section 1.964-1(c)(6) in a taxable year beginning before January 1, 1987, then the rules of this paragraph (b) shall apply.

(1) BASIS IN ASSETS AND AMOUNT OF LIABILITIES. The hyperinflationary currency adjusted basis of the QBU's assets and the hyperinflationary currency amount of the QBU's liabilities acquired or incurred by the QBU in a taxable year beginning before January 1, 1987, shall be the basis or the amount as determined under section 1.964-1(e) prior to translation under section 1.964-1(e)(4). The dollar adjusted basis of such assets and the dollar amount of such liabilities shall be the adjusted basis or the amount as determined under the rules of section 1.964-1(e) after translation under section 1.964-l(e)(4).

(2) RETAINED EARNINGS. The dollar amount of the QBU's retained earnings at the end of its last taxable year beginning before January 1, 1987, shall be the dollar amount determined under section 1.964-1(e)(3).

(c) ALL OTHER FOREIGN CORPORATIONS. If a foreign corporation is a DASTM QBU that is not described in paragraph (b) of this section, then the hyperinflationary currency and dollar adjusted basis in the QBU's assets acquired in taxable years beginning before January l, 1987, the hyperinflationary currency and dollar amount of the QBU's liabilities acquired or incurred in taxable years beginning before January 1, 1987, and the dollar amount of the QBU's net worth, including its retained earnings, at the end of its last taxable year beginning before January 1, 1987, shall be determined by applying the principles of section 1.985-3T or section 1.985-3. Thus, for example, the dollar basis of plant and equipment shall be determined using the appropriate historical exchange rate.

(d) PRE-1987 SECTION 902 AMOUNTS -- (1) TRANSLATION OF PRE-1987 SECTION 902 ACCUMULATED PROFITS AND TAXES INTO UNITED STATES DOLLARS. The foreign income taxes and accumulated profits or deficits in accumulated profits of a foreign corporation that were maintained in foreign currency for purposes of section 902 and that are attributable to taxable years of the foreign corporation beginning before January 1, 1987, shall be translated into dollars at the spot exchange rate on the first day of its first taxable year beginning after December 31, 1986. Once translated into dollars, these accumulated profits and taxes shall (absent a change in functional currency) remain in dollars for all federal income tax purposes.

(2) CARRYFORWARD OF ACCUMULATED DEFICITS IN ACCUMULATED PROFITS FROM PRE-1987 TAXABLE YEARS TO POST-1986 TAXABLE YEARS. For purposes of sections 902 and 960, the post-1986 undistributed earnings of a foreign corporation that is subject to the rules of this section shall be reduced by the dollar amount of the corporation's deficit in accumulated profits, if any, determined under section 902 and the regulations thereunder, that was accumulated at the end of the corporation's last taxable year beginning before January 1, 1987. The dollar amount of the accumulated deficit shall be determined by multiplying the foreign currency amount of such deficit by the spot exchange rate on the last day of the corporation's last taxable year beginning before January 1, 1987, and shall be taken into account on the first day of the corporation's first taxable year beginning after December 31, 1986. Post-1986 undistributed earnings may not be reduced by the dollar amount of a pre-1987 deficit in retained earnings determined under section 1.964-1(e).

(e) NET WORTH BRANCH. If a DASTM QBU is a branch of a United States person and the QBU used a net worth method of accounting for its last taxable year beginning before January 1, 1987, then the rules of this paragraph (e) shall apply. A net worth method of accounting is any method of accounting under which the taxpayer calculates the taxable income of a QBU based on the net change in the dollar value of the QBU's equity (assets minus liabilities) during the course of a taxable year, taking into account any contributions or remittances made during the year. See, e.g., Rev. Rul. 75-106, 1975-1 C.B. 31. (See section 601.601(d)(2)(ii)(b) of this chapter).

(1) BASIS IN ASSETS AND AMOUNT OF LIABILITIES -- (i) HYPERINFLATIONARY AMOUNTS. For the first taxable year beginning in 1987, the hyperinflationary currency adjusted basis of a QBU's assets or the hyperinflationary currency amounts of its liabilities acquired or incurred in a taxable year beginning before January 1, 1987 is the hyperinflationary currency basis or amount at the date when acquired or incurred, as adjusted according to United States generally accepted accounting and tax accounting principles. If a hyperinflationary currency basis or amount was not determined at such date, the dollar basis or amount, as adjusted according to United States generally accepted accounting and tax accounting principles, shall be translated into hyperinflationary currency at the spot exchange rate on the date when the asset or liability was acquired or incurred.

(ii) DOLLAR AMOUNTS. For the first taxable year beginning in 1987, the dollar adjusted basis of the QBU's assets and the amounts of its liabilities shall be those amounts reflected on the QBU's dollar books and records at the end of the taxpayer's last taxable year beginning before January 1, 1987, after adjusting the books and records according to United States generally accepted accounting and tax accounting principles.

(2) ENDING NET WORTH. The dollar amount of the QBU's net worth at the end of its last taxable year beginning before January 1, 1987 shall equal the QBU's net worth at that date as determined under paragraph (e)(1)(ii) of this section.

(f) PROFIT AND LOSS BRANCH. If a DASTM QBU is a branch of a United States person and the QBU used a profit and loss method of accounting for its last taxable year beginning before January 1, 1987, then the United States person shall first apply the transition rules of section 1.987-5 in order to determine the beginning amount and dollar basis of the branch's EQ pool, the hyperinflationary currency basis of the branch's assets, and the hyperinflationary currency amounts of its liabilities. A profit and loss method of accounting is any method of accounting under which the taxpayer calculates the profits of a QBU by computing the QBU's profits in its functional currency and translating the net result into dollars. See, e.g., Rev. Rul. 75-107, 1975-1 C.B. 32. (See section 601.601(d)(2)(ii)(b) of this chapter). The QBU and the taxpayer must then make the adjustments required by section 1.985-5, e.g., the QBU must take into account unrealized exchange gain or loss on dollar- denominated section 988 transactions, the taxpayer must account for the deemed termination of the branch, and the taxpayer must translate the QBU's balance sheet items from hyperinflationary currency into dollars at the spot rate.

/1/ Under section 1.985-5 (b), S will recognize a 50,000 LC loss (100,000 LC basis - 50,000 LC value) on the bond resulting from the change in functional currency. Thus, immediately before the change, S's basis in the FC bond (taking into account the loss) is 50,000 LC.

/2/ The amount of S's LC retained earnings reflects the 50,000 LC loss on the bond.