Early Application of Proposed §987 Regulations May Be Blessed
by the IRS--But Is It a Good Idea?
By James J. Tobin,
Esq.
Ernst & Young LLP, New York, NY
Reliance on specific provisions of proposed Treasury regulations
can, at times, be perilous, unless, of course, the IRS says you can.
Sometimes, the IRS will sanction reliance on proposed regulations
pending their finalization or indicate that the government won't
challenge positions based on proposed regulations prior to the
issuance of final rules. In the case of the 2006 proposed §987
regulations1--concerning branch
currency gains and losses--the IRS indicated that, pending
finalization, the IRS and the Treasury Department would consider
positions consistent with the proposed regulations to be reasonable
constructions of the statute. Now, the IRS appears to have gone a step
further: It recently allowed a taxpayer to request early adoption of
the proposed regulations using the so-called fresh start transition
rule through a Form 3115 filing and an IRS official has indicated
publicly that they will entertain additional such requests.
Given the number of check-the-box branches out there and the recent
decline in the value of the dollar, this is likely to be especially
interesting to a large number of U.S. companies; depending on a
particular company's situation, early adoption of the proposed
regulations could result in a very significant reduction in a
taxpayer's §987-related tax liability. Appealing as the prospect
may be, whether or not a resource-constrained IRS National Office will
be able to act on a large number of requests to apply the proposed
rules right away remains to be seen.
Background
Decades-old §987, adopted in 1986, when the concept of
“functional currency” and terms such as “QBU”
first began to severely complicate our lives, requires the recognition
of foreign currency gain or loss on a branch's remittances of cash or
property to its home office, as well as upon transfers between two
branches of the same home office when the relevant entities have
different functional currencies from the home office.
While §987 generally requires such foreign currency gain or
loss to be included in the calculation of taxable income, the statute
itself does not elaborate on how to compute the amount of the gain or
loss.
Five years after enactment of §987, the IRS attempted to
address this oversight by issuing proposed regulations that required
foreign currency gain or loss to be determined based on the
fluctuation in value of a branch's earnings and capital. These 1991
proposed regulations2 provided
that the net income of a QBU with a different functional currency than
the taxpayer's must be determined annually, according to the profit
and loss on the QBU's books, and translated into the taxpayer's
functional currency using the weighted average exchange rate for the
taxable year. They also mandated an equity pool--the undistributed
capital and earnings of the QBU, determined in its functional
currency--and a basis pool--the basis of the capital and earnings in
the equity pool, expressed in the taxpayer's functional currency. Gain
or loss had to be recognized on a remittance and the amount of the
gain or loss was the difference between its value translated into the
taxpayer's functional currency at the spot rate on the remittance date
and the basis associated with the remittance.
The only problem was that pretty much everyone thought these
proposed regulations were hopelessly flawed, something the IRS itself
finally admitted in 2000 when it issued Notice
2000-20;3 but first a word or two
about why the 1991 regulations were considered problematic.
In this regard, among other things, the “equity pool”
concept resulted in all QBU net equity giving rise to exchange gain or
loss, regardless of whether that equity was held in a form that
actually exposed the taxpayer to currency fluctuations. The equity
pool included contributions of property to a QBU branch, and all
distributions of property from the QBU branch could be treated as
remittances; as such, they could trigger currency gain or loss, even
if the property distributed was tangible property such as equipment
whose value would not be affected by exchange rate fluctuations.
As a result, the 1991 proposed regulations essentially allowed
taxpayers, in certain cases, to trigger large, non-economic losses,
particularly if a QBU had significant non-financial assets that were
not exposed to currency fluctuations and the functional currency of
the QBU had declined relative to the U.S. dollar. On the other hand,
these regulations exposed other taxpayers to tax on non-economic gains
when the functional currency of a QBU had strengthened relative to the
dollar.
The Dollar's Decline
Of course, the U.S. dollar has depreciated substantially in recent
years, a matter affecting more than the price we pay for black
truffles and Hermes ties. Because many foreign currencies are worth
more in terms of U.S. dollars, a foreign branch whose value is
dependent on the foreign currency used in the environment in which it
operates generally is worth more in terms of U.S. dollars as well.
Many U.S. taxpayers thus have large unrecognized §987 gains
inherent in their foreign branches. As a result, such taxpayers face
significant constraints in tax and business planning because many
common transactions and restructuring opportunities could trigger the
immediate recognition of these gains.
In Notice 2000-20, the IRS acknowledged its concern that the 1991
proposed regulations might trigger non-economic gains or losses. The
Notice also appeared to sanction a modified version of the 1991
proposed regulations based only on the remittances of earnings--the
so-called earnings only method.
By the way, if you're wondering why, after years of letting the
1991 proposed regulations sit out there languishing, the IRS finally
sat up and paid attention to §987 in 2000, perhaps you need look
no further than issuance in December 1996 of the final check-the-box
(CTB) regulations. By 2000, the CTB rules had encouraged a great many
U.S.-based multinationals to adopt holding company structures in which
a number of foreign subsidiaries were checked up into an unchecked
higher-tier foreign holding company, thereby creating a host of
branches with functional currencies different from the “head
office” and, voila, foreign currency gains or losses
subject to §987.
Suddenly, there was a reason for a lot of people to care about
foreign branch currency gains and losses. And suddenly the incidence
of non-economic results under the 1991 proposed regulations,
notwithstanding the tweaking done by Notice 2000-20, greatly
increased. The 1991 proposed regulations just didn't cut the
mustard.
A New Set of Proposed Regulations
Of course, it took the IRS and Treasury until 2006 to withdraw the
1991 proposed regulations and issue a new set of proposed §987
regulations. These would require taxpayers to determine §987 gain
or loss based not on the earnings and capital of the branch, but
rather solely on the monetary assets and liabilities of the branch.
This change could result in a substantial reduction of many taxpayers'
potential §987 gains or losses.
These regulations also contain two alternative transition rules
that seem to recognize the modest level of compliance that the IRS's
earlier attempts at providing guidance had achieved and the need to
get companies to get in line with §987's requirements.
The 2006 proposed regulations, which contain a prospective
effective date, have not been finalized and are not likely to become
effective prior to 2010. In the meantime, the Preamble to the 2006
proposed regulations generally provides that taxpayers should follow a
“reasonable method” of applying §987. While the 2006
proposed regulations do not define a “reasonable method,”
the Preamble does provide that the IRS considers the following to be
reasonable:
• applying the 1991 proposed regulations as written;
•
applying an “earnings only” version of the 1991 proposed
regulations; or
•
applying the 2006 proposed regulations.
Unfortunately, the Preamble provides no guidance as to how to adopt
a reasonable method or whether or not a taxpayer may change their
current method of applying §987.
The Best Way of Getting There?
The IRS recently informally indicated that it will consider
requests on Form 3115, Application for Change in Accounting
Method, for a taxpayer to early adopt the 2006 proposed §987
regulations using the fresh start transition rule. It appears that at
least one such request has been granted and, as noted earlier, the IRS
is encouraging additional requests, but the extent to which the IRS
may be willing, or able (from a resources perspective), to expand its
largess remains to be seen.
On the other hand, following the 3115 path to early adoption of the
proposed regulations may not be the best course for many companies.
For example, some may prefer to adopt earnings only under the 1991
regulations pursuant to the Preamble to the 2006 regulations. And
those companies that adopted a methodology for some or all of their
QBUs to implement §987 while the dollar was heading up could find
it would make sense to file a 3115 to also switch to earnings only or,
alternatively, for early adoption of the 2006 proposed regulations,
both of which would be better than the 1991 regulations. Of course, it
is very uncertain whether the IRS would okay a request to adopt the
earnings only method; after all, the IRS has thus far only indicated
that it would approve early adoption of the 2006 regulations, with the
fresh start rule.
All this also raises the question of whether these various
approaches to implementing §987 rise to the level of methods of
accounting, a point of debate among taxpayers and practitioners and a
matter on which an IRS official has indicated that they have not yet
concluded. For those on the “no” side of the question, a
change to the earnings only “method” (or any other) would
not require the filing of a 3115. On the other hand, those who think
using a particular §987 methodology rises to the level of a
method of accounting would be foreclosed from changing to earnings
only, so the opportunity to early adopt the 2006 regulations by filing
the form might be appealing. And to some, waiting may seem like a
better idea. After all, no one knows for sure whether the 2006
proposed regulations will be finalized in their current form or,
perhaps, get better.
So, in the end, it's your call. Maybe.
This commentary also will appear in the May 9, 2008, issue of
the Tax Management International Journal. For more information,
in the Tax Management Portfolios, see Mulroney, 921 T.M., Tax
Aspects of Foreign Currency, and in Tax Practice Series, see
¶7130, U.S. Persons' Foreign Activities.
1
REG-208270-86, 71 Fed. Reg. 52876 (9/7/06).
2
REG-208270-86, 56 Fed. Reg. 48457 (9/25/91).
3
2000-14 I.R.B. 851 (4/3/2000).
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