IRS issues new version of foreign currency regulations

The IRS on Nov. 9 released the latest iteration of proposed rules for calculating foreign currency gains or losses under Section 987 in what has become a decades-long saga to rewrite the regulations.

The newly proposed regulations (REG-132422-17) largely adhere to the general framework established by the suspended 2016 final regulations, maintaining the utilization of the Foreign Exchange Exposure Pool (FEEP) approach. However, notable enhancements have been incorporated, specifically targeting simplification measures. Beyond this, the proposed regulations would expand the scope of covered taxpayers and address ancillary issues such as partnerships and consolidated group treatment.

The newly proposed regulations represent the latest in a string of attempts to rewrite the rules dating back to 1991. The IRS originally proposed regulations in 1991 (56 FR 48457) only to withdraw and repropose a new version in 2006 (71 FR 52876). The 2006 regulations were finalized (56 FR 48457) along with new temporary and proposed (REG-128276-12) in 2016, but these regulations were quickly suspended by executive order and then by a series of notices. The IRS in 2019 issued new final regulations (TD 9857) that have also been partially suspended.      

The 2023 proposed regulations provide a few modifications to the FEEP method, which has been criticized for being overly complex as compared to other previously accepted methods for complying with Section 987, such as the rules contained in the 1991 proposed regulations or the so called “earnings-only” method. However, the regulations provide two elections that were developed in response to taxpayer request for a simplified approach in determining the Section 987 gain or loss for each Section 987 Qualified Business Unit (QBU):

1. Current-rate election, which treats all items on the balance sheet as marked items and requires taxpayers to translate all items of income, gain, deduction, and loss at the annual average exchange rate for the current year.
2. Annual-recognition election, which can be made in conjunction with the current-rate election and would recognize all items of income, gain, deduction, and loss of a QBU annually.

These simplifying elections are combined with a series to rules to prevent abuses and the acceleration of losses, including the suspension of Section 987 loss until a taxable year in which the owner recognizes Section 987 gain that has the same source and character as the suspended Section 987 loss, referred to as the “loss-to-the-extent-of-gain rule” in the preamble.

If finalized, the regulations would generally be effective for taxpayers with tax years beginning on or after Jan. 1, 2025, which would end a decades-long administrative delay in the implementation of new rules. Affected taxpayers should assess their existing Section 987 methods and the potential impact of adopting the proposed regulations early.

Background

The Section 987 regulations originally date back to 1991, when the first draft of proposed regulations (56 FR 48457) was released. The 1991 proposed regulations would have required that tax owners maintain equity and basis pools in the QBU’s functional currency (FC) and the tax owner’s FC, respectively. The Section 987 gain or loss was the difference between the equity and basis pools on the spot date of any Section 987 triggering event. Triggering events include a remittance from the QBU or termination of the QBU.

In 2000, the IRS issued Notice 2000-20, which expressed concern over abusive transactions that involved a circular flow of funds between a QBU and its tax owner. The notice requested comments and introduced several concepts the IRS was considering, including netting property transferred in and out of the QBU during the course of the year.

In 2006, the IRS withdrew the 1991 proposed regulations over concerns that taxpayers were able to strategically manage Section 987 gains and losses by timing remittances and termination of QBUs when rate fluctuations created favorable paper losses. The IRS instead proposed a new version that introduced the FEEP method.

In 2016, the IRS released final regulations that adopted the FEEP method from the 2006 proposed regulations with a few modifications, and also released proposed and temporary regulations addressing a variety of issues. These regulations included a new annual deemed termination election, rules addressing Section 988 transactions of a Section 987 QBU, and rules addressing partnerships.  

In 2017, President Donald Trump signed an executive order (E.O. 13789) that instructed the Treasury Secretary to review all regulations issued on or after Jan. 1, 2016, that imposed an undue financial burden to U.S. taxpayers or added undue complexity to federal laws. The executive order, in conjunction with a series of deferral notices (most recently, Notice 2022-34, also covered in our Aug. 2022 Tax Hot Topics) have effectively delayed the implementation of the 2016 final and temporary regulations. 

New proposed regulations

The newly proposed regulations cover various aspects of Section 987, including rules for determining taxable income or loss and foreign currency gain or loss with respect to a QBU. They also introduce new options, including elections to treat all items of a QBU as marked items (subject to a loss suspension rule) and recognize all foreign currency gain or loss related to a QBU on an annual basis. They also offer a transition rule.

Expansion of scope

The 2016 final regulations generally did not apply to banks, insurance companies, leasing companies, finance coordination centers, regulated investment companies, or certain real estate investment trusts. Additionally, the 2016 final regulations did not apply to trusts, estates, S corporations, or partnerships other than Section 987 aggregate partnerships. The preamble to the proposed regulations noted that applying a consistent set of rules to all taxpayers facilitates the fair and effective administration of tax law and it eliminated subjectivity and uncertainty. Accordingly, the newly proposed regulations remove the exclusions, making the rules apply to the entities mentioned above. However, the proposed regulations continue to exclude certain other foreign persons, including foreign individuals, foreign non-grantor trusts, and foreign corporations that are not CFCs. 

The FEEP method

The proposed regulations preserve the FEEP method that was introduced in the 2006 proposed regulations and subsequently modified by the 2016 final regulations. The FEEP method is the default rule for a taxpayer to determine their Section 987 gain or loss for a taxable year.

The FEEP method uses a balance sheet approach to determine exchange gain or loss. Such gain or loss is not recognized until the Section 987 QBU makes a remittance. Under the FEEP method, exchange gain or loss with respect to “marked items” is determined annually but is pooled and deferred until a remittance is made or certain other event triggers a recognition. A marked item generally includes an asset or liability that would otherwise generate Section 988 gain or loss if such asset or liability were held or entered into directly by the owner of the Section 987 QBU. The balance sheet approach also uses historic rates for “historic items” (generally defined as assets or liabilities that are not marked items). This approach allows taxpayers to distinguish between items whose value is subject to fluctuations in currency (i.e., foreign exchange exposure) and those that are not. Additionally, all items of income, gain, deduction, and loss by a QBU are translated into the tax owner’s FC at the average exchange rate for the taxable year.

The overall approach and steps related to the FEEP method remain largely consistent with the 2016 final regulations, with only minor adjustments made.

Elections to simplify application of the FEEP method

To ease the administrative and compliance burdens, two elections are available under the proposed regulations.

The “current-rate election” allows a taxpayer to treat all items properly reflected on a Section 987 QBU’s balance sheet as marked items. All marked items are translated using the year-end spot rate. Additionally, all income statement items with respect to a Section 987 QBU would be translated at an annual average foreign exchange rate for the current taxable year. According to the IRS, the current-rate election is expected to produce an outcome that is similar to that determined under the 1991 proposed regulations.

The “annual-recognition election” is available to QBU owners regardless whether they make a current-rate election. This election is effectively a modified version of the deemed termination election included in the 2016 regulations. The annual recognition election requires that the tax owner recognize the full amount of its net unrealized Section 987 gain or loss each taxable year. Absent a current-rate election, the annual recognition election would only include marked items and items of income, gain, deduction, and loss computed under the FEEP method. When paired with a current-rate election, the annual election would allow the entire amount of gain or loss determined under the current-rate election to be recognized on an annual basis.

The proposed regulations include detailed rules for electing and revoking the current rate and annual recognition elections. Absent consent from the IRS Commissioner, neither election may be revoked for five years, and once revoked, cannot be made for another five years. Taxpayers that choose to revoke their current-rate election must convert any net accumulated unrecognized Section 987 loss to a suspended Section 987 loss.

Elections and revocations of both the current rate election and the annual recognition election are subject to consistency rules. For partnerships with Section 987 QBUs, both the current-rate election and the annual recognition election are made by the partnership.

Suspended loss rules

In a taxable year in which a current-rate election applies, any Section 987 loss that would otherwise be recognized as a result of a remittance is treated as suspended Section 987 loss. The IRS is concerned that, absent special rules, taxpayers could use the current-rate election to selectively recognize losses.  In an attempt to mitigate loss-planning strategies, a complex set of loss limitation rules are included in the proposed regulations.  

Under the loss suspension rules, an owner of a Section 987 QBU would recognize suspended Section 987 loss in a taxable year in which the owner recognizes Section 987 gain that has the same source and character as the suspended Section 987 loss (the “loss-to-the-extent-of-gain rule”). The loss-to-the-extent-of-gain rule applies at the owner level and not at the QBU level. Under the rule, an owner does not recognize suspended Section 987 loss until it recognizes Section 987 gain in the same “recognition grouping” as the suspended Section 987 loss. Section 987 gain and suspended Section 987 loss are in the same recognition grouping if they are both initially assigned to U.S. source income or to foreign source income in the same Section 904 category.

If a taxpayer only makes an annual recognition election, generally the full amount of net unrecognized Section 987 gain or loss that is added to the pool will be recognized each year. However, if an annual recognition election is made and the tax owner has more than $5 million of net Section 987 losses in the first year of the annual recognition election, or if the current-rate election was in effect in the previous year before making the annual recognition election, then the loss would be suspended and subject to the loss-to-the-extent-of-gain rule.

If both a current-rate election and an annual-recognition election are in effect, the proposed regulations provide that the loss-to-the-extent-of-gain rule would apply by reference to the net cumulative amount of Section 987 gain in each recognition grouping that is recognized by the taxpayer during the relevant testing period (rather than the gross amount recognized each taxable year). The testing period generally is the period in which Section 987 loss is suspended and both a current-rate election and an annual recognition election are in effect. 

Partnership rules

The proposed regulations maintain the aggregate approach to Section 987 aggregate partnerships (partnerships wholly owned by related persons) in the final regulations. However, for all other partnerships in scope of the proposed regulations, they apply a “hybrid approach to entity theory.” This approach is intended to prevent a partner from transferring its share of net unrecognized Section 987 gain or loss to another partner. A partnership that owns a Section 987 QBU would determine its unrecognized Section 987 gain or loss at the partnership level and then allocate to each partner their share of the unrecognized Section 987 gain or loss for the year. At the partner level, each partner would translate its share of the unrecognized Section 987 gain or loss into its functional currency at the yearly average exchange rate and calculate its net unrecognized Section 987 gain or loss with respect to each Section 987 QBU of the partnership based on this share. In effect, the Section 987 pools, as applicable, are maintained as the partner level.

Recognized Section 987 gains or losses follow a similar approach to unrecognized Section 987 gains or losses. Each partner would recognize (or suspend) Section 987 gain or loss based on the proportionate size of the remittance to the partnership. For example, if a Section 987 QBU remits 50% of its gross assets to the partnership, each partner with net unrecognized Section 987 gain or loss would recognize (or suspend) 50% of the net unrecognized Section 987 gain or loss. In general, the loss-to-the-extent-of-gain rule is also applied at the partner level.  

The proposed regulations provide a framework for adjusting a partner’s basis in its partnership interest based on the principles of Section 705 when a partner recognizes Section 987 gain or loss, defers Section 987 gain or loss, or suspends section 987 loss attributable to a partnership.

The proposed regulations would also provide that an upper-tier partnership (UTP) adjusts its basis in a lower-tier partnership (LTP) solely with respect to a partner of UTP that either recognizes Section 987 gain or loss, defers Section 987 gain or loss, or suspects Section 987 loss attributable to the LTP.

The IRS requested comments on the coordination of the partner capital account maintenance rules in the Section 704(b) regulations with these proposed regulations, as well as the appropriate currency in which Section 743(b) basis adjustments allocated to assets in a Section 987 QBU should be maintained. Additionally, the IRS continues to study the application of entity theory and aggregate theory to partnerships in the Section 987 context, including whether it would be appropriate to apply a hybrid approach to entity theory to all partnerships, regardless of whether the partners are related parties.

The proposed regulations would treat S corporations in the same manner as partnerships. 

Transition rules

The proposed regulations provide a new transition rule that would replace the “fresh start” transition method in the 2016 final regulations. The new transition rule would account for unrecognized Section 987 gain or loss accrued before the transition date. In addition, the new transition rule would not require taxpayers to retrospectively determine historic rates for items acquired before the transition date. Under the new rule, an owner of a Section 987 QBU would determine the amount of Section 987 gain or loss that has accrued before the transition date, referred to as the “pretransition gain or loss.” In the first taxable year in which the regulations apply, pretransition gain is treated as net unrecognized Section 987 gain, and pretransition loss is treated as suspended Section 987 loss.

Applicability dates

Once finalized, the regulations (and the parts of the 2016 final regulations that are not replaced or modified by the proposed regulations) would apply to taxable years beginning after Dec. 31, 2024. The proposed regulations allow a taxpayer to early adopt these finalized regulations in their entirety (subject to consistency requirements) for taxable years ending after Nov. 9, 2023. The proposed regulations also contain earlier applicability dates for certain transactions to prevent taxpayers from avoiding the rules.