Key issues under the new proposed foreign currency regulations

In brief

Treasury and the IRS on November 9 released proposed regulations (2023 proposed regulations) under Section 987 on the taxation of foreign currency translation gains or losses arising from qualified business units (QBUs) that operate in a currency other than the currency of their owner. The 2023 proposed regulations largely retain the methodology of the 2016 final but not yet effective Section 987 regulations. The proposed regulations offer an election to utilize a methodology similar to the Section 987 regulations proposed in 1991—by treating all items of a QBU as marked items, subject to a loss suspension rule—and an election to recognize all Section 987 gain or loss with respect to a QBU on an annual basis.

The new regulations generally are proposed to be effective for tax years beginning on or after December 31, 2024. Certain provisions primarily related to the deferral of Section 987 gains and losses are proposed to be effective for branch terminations (or certain check-the-box elections) occurring on or after November 9, 2023. Transition rules are provided to offer guidance on the future recognition of pre-transition unrealized Section 987 gains and losses. Comments are due by February 12, 2024 on both the 2023 proposed regulations and the previously issued 2016 proposed regulations.

The takeaway: Companies should analyze the impact of the new proposed regulations on any current planning that involves terminating a QBU, as realized Section 987 losses may be deferred or disallowed if the regulations are finalized as proposed. Further, they should model the overall impact of the 2023 proposed regulations on their QBUs with and without the newly proposed elections, as the elections would affect both the quantitative results of the regulations and the data required to be tracked. Companies should also consider providing comments during the comment period. Finally, companies should evaluate the potential financial reporting impact of the 2023 proposed regulations and their impact if finalized as proposed.

New elections and loss limitation rules

Current rate election

To address comments on the FEEP method, the 2023 proposed regulations would provide an election (1) to treat all assets and liabilities that are properly reflected on the books and records of a Section 987 QBU as marked items (translated at the year-end spot rate) and (2) to translate all items of income, gain, deduction, or loss with respect to a Section 987 QBU at the average exchange rate for the current tax year (the 'current rate election'). Making such an election would be expected to produce a result close to that reached by applying the method in the 1991 proposed regulations and more closely aligned with financial reporting, except that the 2023 proposed regulations exclude most stock and partnership interests (and the liabilities, if any, to acquire them) from the Section 987 pools.

Observation: Under the 2016 final regulations and the 2023 proposed regulations, most stock and liabilities to acquire such stock are not treated as assets and liabilities of the Section 987 QBU and thus are excluded from Section 987 gain or loss calculations. Accordingly, even after making a current rate election, the result reached might differ significantly from that reached under the 1991 proposed regulations.

Annual recognition election

The 2023 proposed regulations contain an election (the ‘annual recognition election’) under which a Section 987 QBU owner would recognize all net unrecognized Section 987 gain or loss at the end of each year. The Section 987 QBU also must translate all items of income, gain, deduction, or loss with respect to a Section 987 QBU at the average exchange rate for the current tax year but continue to translate marked items at the year-end spot rate and historic items at their historic rates. This election would replace the annual deemed termination election in the 2016 final regulations.

Observation: The annual recognition election, when made without making the current rate election, could result in the conversion of a portion of the owner’s taxable income from a Section 987 QBU into Section 987 gain or loss. Companies should consider modeling the consequences of these elections, particularly in light of the loss deferral rules discussed below, in seeking to make informed decisions on post-effective date elections.

Suspension of Section 987 loss

There are multiple Section 987 loss deferral rules in the 2023 proposed regulations.

Loss-to-the-extent-of-gain rule. Because the current rate election is expected to increase the magnitude of a Section 987 QBU’s net unrealized Section 987 gain or loss, the 2023 proposed regulations include a rule that suspends the recognition of the Section 987 loss of a Section 987 QBU that has made the current rate election. Suspended Section 987 loss could only be recognized to the extent that, for the tax year in question, the owner of the Section 987 QBU recognizes Section 987 gain that has the same character, source, Section 904 treatment, and/or subpart F characterization as the Section 987 loss realized (the 'loss-to-the-extent-of-gain' rule). The loss-to-the-extent-of-gain rule applies at the owner level (rather than the QBU level); as a result, gain from one Section 987 QBU could offset loss from another (in the same recognition grouping). Suspended Section 987 loss that is not recognized is carried over to the owner’s next tax year, but prior Section 987 gains recognized do not permit the recognition of losses on a look-back basis.

Observation: For purposes of applying the loss-to-the-extent-of-gain rule, all members of a consolidated group would be treated as a single owner. As a result, a consolidated group may recognize more or less suspended Section 987 loss in a particular year than the members of that group would individually recognize in such year in the aggregate if they did not file as a consolidated group.

Deferral events and outbound loss events. The 2023 proposed regulations generally would retain the principles of the 2019 final regulations for deferral events and outbound loss events with certain modifications. For a discussion of the 2019 final regulations, see our prior PwC Insight. The de minimis threshold of $5 million (which previously applied on a QBU-by-QBU basis) would apply to the total deferred Section 987 gain or loss of the owner with respect to all of its Section 987 QBUs that otherwise would be deferred by the owner in a single tax year.

Other loss suspension rules. Section 987 losses can be suspended in other ways besides making a current rate election. Section 987 losses arising from certain outbound transfers (e.g., a Section 351 contribution of a Section 987 QBU’s assets) also would be suspended (and thus recognized only pursuant to the loss-to-the-extent-of-gain rule (or termination rules). Further, losses realized as a result of transitioning onto the 2023 proposed regulations’ methodology are considered suspended Section 987 losses.

Outbound Section 987 loss would be treated as suspended Section 987 loss, instead of being added to the basis of stock or recognized solely when the owner of the Section 987 QBU and the related foreign person cease to be related.

If a Section 987 loss is recognized in a QBU termination in which there is a successor QBU, the Section 987 loss is deferred and generally becomes attributable to the successor QBU. This loss is recognized under the loss-to-the-extent-of-gain rule above. A successor QBU need not be a Section 987 QBU, let alone one that earns Section 987 gain of the same recognition grouping, making a deferral an effective disallowance in some cases.

If the owner of a Section 987 QBU or the original owner of a successor Section 987 QBU ceases to be a member of the same controlled group as its successor Section 987 QBU or ceases to exist including as a result of a Section 331 liquidation or inbound Section 332 liquidation or reorganization, all of the owner’s suspended Section 987 loss would be eliminated and never would be recognized.

Observation: Under the 2023 proposed regulations, certain business transactions, such as taxable liquidations and inbound liquidations and reorganizations, could result in the permanent disallowance of a gross economic Section 987 loss notwithstanding that gross Section 987 gains, if any, would be recognized in such transactions. Companies with Section 987 losses should proceed cautiously in undertaking such transactions.

Special rules

Consolidated groups

To implement single entity treatment under the intercompany transaction regulations in Reg. 1.1502-13, the 2023 proposed regulations would treat a transaction between the Section 987 QBU of one member and any other member of the same group (including a Section 987 QBU of that other member) as a combination of (1) an intercompany transaction between the members and (2) a transfer between each Section 987 QBU and its owner as necessary to take into account the effect of the transaction on the assets and liabilities of each Section 987 QBU. For example, if a Euro-functional Section 987 QBU borrows Euros from a member of the US consolidated group other than its owner, the transaction is recharacterized as (1) a Euro-denominated loan between the US consolidated group members and (2) a contribution to the Euro Section 987 QBU.

Observation: This characterization would create a difference between the economic and financial statement foreign currency gain or loss and the tax gain or loss. The recast could impact a company’s hedging strategy as well as creating downstream consequences for corporate alternative minimum tax computations.

Observation: The 2023 proposed regulations would 'match' the consequences (e.g. timing, amount, and character) of the deemed transaction between the members of the consolidated group (thereby resulting in no effect on consolidated taxable income) and would subject the deemed transactions between the relevant consolidated group member and its Section 987 QBU to the rules otherwise applicable to transactions between a Section 987 QBU and its owner. Treasury has requested comments on how rules similar to the separate return limitation year loss rules under Reg. 1.1502-21(c) should apply when a corporation owning a Section 987 QBU with suspended or deferred Section 987 losses joins a consolidated group.

Partnerships

The 2023 proposed regulations would retain an aggregate approach to partnerships between related parties, meaning that each partner computes Section 987 gain or loss on its own QBU comprised of its portion of the partnership’s assets.

The 2023 proposed regulations propose to apply a hybrid approach to partnerships that are not wholly owned by related parties. With respect to a partnership that uses a different functional currency than its partners, the partners must compute Section 987 gain or loss on a QBU comprised of their portions of the assets. The partnership, however, is treated as the owner of any Section 987 QBUs it owns (i.e., an eligible QBU with a functional currency that is different from the functional currency of the partnership). The partnership would allocate each partner a share of the unrecognized Section 987 gain or loss for the tax year with respect to each Section 987 QBU owned by the partnership on an annual basis. Section 987 gain or loss attributable to a Section 987 QBU owned by a partnership would be recognized and taken into account at the partner level. The proposed regulations would treat S corporations in the same manner as partnerships.

Observation: Treasury anticipates publishing a subsequent notice of proposed rulemaking that more thoroughly would address the application of Section 987 to partnerships. The 2023 proposed regulations reserve on the treatment of transfers and redemptions of a partner’s partnership interest.

Expansion of entities covered

The 2023 proposed regulations would apply to certain entities previously excluded from the 2016 final regulations, such as an S corporation, bank, insurance company, leasing company, finance coordination center, regulated investment company (RIC), or real estate investment trust (REIT). The 2023 proposed regulations generally continue to exclude foreign non-grantor trusts and foreign estates if the aggregate interests of beneficiaries that are US persons is less than 10%, and foreign partnerships if the aggregate interests of the partners that are US persons is less than 10% of the capital and profits interests. Foreign individuals, foreign corporations that are not CFCs, and foreign corporations that are CFCs but which have no US shareholders (which are not excluded under the 2016 final regulations) also would continue generally to be excluded.

Observation: Treasury requests comments on whether any additional rules are needed to facilitate the application of the 2023 proposed regulations to the entities that were excluded from the 2016 final regulations, and comments on the application of the 2023 proposed regulations to partnerships and S corporations.