On December 7, 2016, the US Treasury Department (the Treasury) and the US Internal Revenue Service (the IRS) released final (T.D. 9794), temporary (T.D. 9795), and proposed regulations (REG-128276-12) under Section 987. The long-awaited final regulations provide guidance for taxpayers on determining the taxable income or loss (or earnings and profits (E&P), as applicable) of certain branch operations (known as qualified business units (QBUs)) that use a different functional currency than their owner (Section 987 QBUs). The final regulations also provide guidance on the timing, amount, character and source of any Section 987 gain or loss arising from a QBU. The temporary regulations provide guidance on recognizing and deferring Section 987 gain or loss in connection with certain QBU terminations and transactions involving partnerships, as well as other related elections and special rules. For a detailed analysis of the final, temporary and proposed regulations, see Tax Alert 2016-2117.

The new rules will alter the way many companies compute Section 987 gains or losses with respect to their Section 987 QBUs. In addition, unrecognized Section 987 gains or losses existing on the transition date (January 1, 2018, for calendar-year taxpayers), will be recomputed under the new rules unless a taxpayer was following the foreign exchange exposure pool method (the FEEP method) in accordance with the 2006 proposed regulations or is excluded from the scope of the final regulations.¹

A summary of the key aspects of the new Section 987 regulations and their financial statement implications follows. For financial accounting purposes, the issuance of the final and temporary regulations is considered a change in enacted tax law during the reporting period that includes the date of release, i.e., December 7, 2016, so companies with Section 987 QBUs should consider now the effects of the final and temporary regulations on their financial reporting.

Background of Section 987 and related regulations

Section 987 was added to the Code in 1986 and generally addresses the computation and translation of taxable income or loss of a taxpayer's Section 987 QBU and requires the taxpayer to make "proper adjustments" for transfers of property between Section 987 QBUs.

Proposed regulations under Section 987 were originally published in 1991(the 1991 proposed regulations). The 1991 proposed regulations generally provided that the net income of the QBU was determined annually and translated into the functional currency of the taxpayer at the weighted average exchange rate. The 1991 proposed regulations also provided for the recognition of Section 987 gain or loss by determining exchange gain or loss (by reference to the taxpayer's functional currency) with respect to the "earnings and capital" of a QBU. Under the "earnings and capital" approach, all branch equity (whether it consisted of monetary or non-monetary items) gave rise to Section 987 gain or loss.

In 2006, the Treasury and IRS published new proposed Section 987 regulations (the 2006 proposed regulations) and withdrew the 1991 proposed regulations. The 2006 proposed regulations provided that the income and deductions of the QBU were determined annually, and generally translated at the average exchange rate for the year (similar to the 1991 proposed regulations), but deductions such as depreciation and amortization for so-called historic assets were translated at historic rates. Translating these items at historic rates prevented the imputation of foreign currency gains or losses to such assets.

The 2006 proposed regulations then applied a financial assets and liabilities approach to determine Section 987 gain or loss, called the FEEP method. Under the FEEP method, exchange gain or loss on "marked items" is determined annually but is pooled and deferred until a remittance is made. A marked item is generally defined as currency, payables and receivables, debt and certain currency derivatives denominated in the QBU's functional currency that would give rise to Section 988 gain or loss if held or entered into directly by the QBU's owners. Non-marked items are referred to as "historic items."

Though the 2006 proposed regulations withdrew the 1991 proposed regulations, the proposed 2006 regulations provided that, until final regulations were issued, the earnings and capital method of the 1991 proposed regulations, as well as a simplified "earnings only" method that imputes Section 987 gain or loss to earnings but not capital, were considered reasonable methods for complying with Section 987. As a result, there has been significant diversity in practice in how taxpayers have determined foreign currency gains and losses under Section 987.

The final and temporary regulations

The final regulations apply the FEEP method to determine Section 987 gain or loss and retain most of the fundamental mechanics of the 2006 proposed regulations. In general, the Section 987 regulations apply to a branch, disregarded entity and certain partnership interests if the functional currency of that QBU differs from the owner's functional currency, unless specifically excluded.² Under the final regulations, a Section 987 QBU owner must include in its taxable income (or E&P, as applicable):

1. The income, deduction, gain, or loss of the Section 987 QBU for the year translated into the owner's functional currency at the yearly average exchange rate (or, if so elected, the spot rate) or historic rates with respect to historic assets

2. The amount of Section 987 gain or loss recognized on remittances made by the QBU during the year (determined by a complex eight-step process and a remittance proportion calculation outlined in Reg. Section 1.987-4 and -5, respectively)

An owner of a Section 987 QBU must divide the QBU's balance sheet items into two categories — marked and historic items. The bases of marked items are generally translated into the owner's functional currency at the year-end spot exchange rate. Historic items are generally translated into the owner's functional currency at the historic exchange rate; that is, the exchange rate in effect when the item was originally acquired. Under this approach, only marked items give rise to Section 987 gain or loss. Such Section 987 gain or loss is pooled and deferred from taxation until there is a remittance.

Effective dates and transition rules

In general, the final regulations apply to tax years beginning on or after one year after the first day of the first tax year following December 7, 2016 (i.e., January 1, 2018, for calendar-year taxpayers). If certain criteria are met, however, a taxpayer may apply the final regulations to tax years beginning after December 7, 2016.

The final regulations require all Section 987 QBUs of a taxpayer to transition to the final regulations using a fresh start transition method. Under the fresh start transition method, the Section 987 QBU is deemed to terminate on the day before the transition date. The owner of the QBU is treated as having transferred all of its assets and liabilities attributable to the QBU to a new Section 987 QBU on the transition date. The owner does not determine or recognize Section 987 gain or loss as a result of the deemed termination, so previously unrecognized Section 987 gains and losses will generally disappear upon transition to the fresh start method. Companies that were applying the 2006 proposed regulations and do not have a loss deferral event or an outbound loss event (as described later) should have a Section 987 foreign exchange gain or loss that will continue under the final and temporary regulations.

Example

The following example helps illustrate the transition to the final regulations:

A US corporation (Taxpayer) with a calendar year-end operates a QBU that uses the European euro (EUR) as its functional currency (Euro QBU). Taxpayer has used the earnings only approach to compute Section 987 gain or loss. Euro QBU has unremitted earnings of EUR 100, of which EUR 80 has been invested in land and EUR 20 has been deposited in a bank account. Taxpayer translated Euro QBU's earnings of EUR 100 into $145 at an average rate for the tax year when earned. On December 31, 2016, such unremitted earnings of EUR 100 translated into $105 at the spot rate. Accordingly, Taxpayer had $40 of unrecognized Section 987 loss as a result of the decrease in the USD value of Euro QBU's unremitted earnings.

Assuming no changes to the facts, Euro QBU will be deemed to terminate on December 31, 2017, but Taxpayer will recognize none of the $40 Section 987 loss determined under the "earnings only" approach. On January 1, 2018, Taxpayer will be deemed to transfer the assets of Euro QBU to a new Section 987 QBU at the historic rate on the date the assets were acquired. Accordingly, Taxpayer will be deemed to transfer EUR 80 of land, translated at the historic rate (EUR1:USD1.45), or $116, and the EUR 20 deposit, also translated at the historic rate (EUR1:USD1.45), or $29. Under the FEEP method, the land is an historic item that does not give rise to Section 987 gain or loss; only the EUR deposit is a marked item that will give rise to Section 987 gain or loss. Accordingly, upon transition to the FEEP method, Taxpayer has unrecognized loss of only $8 ($21 value of EUR 20 deposit translated at the spot rate of EUR1:USD1.05 on December 31, 2017, less historic basis of $29).

Deferral of Section 987 gains and losses

The temporary regulations include provisions that are effective immediately and defer from taxation Section 987 losses (and, in limited cases, gains) when a QBU is transferred within a single controlled group in a "deferral event" or an "outbound loss event."³ The deferral rules apply to all taxpayers, including taxpayers that are otherwise excluded from the scope of the final regulations. A deferral event generally occurs when there is a transfer of substantially all of the assets of a QBU or an interest in the QBU to a member of the transferor's controlled group. Deferral events include domestic-to-domestic transfers and foreign-to-foreign transfers (subject to certain exceptions). Section 987 gain or loss resulting from a deferral event must be deferred under the temporary regulations. An outbound loss event generally occurs when a US person transfers substantially all of the assets of a QBU or an interest in the QBU to a foreign person that is a member of the transferor's controlled group. Section 987 loss but not gain resulting from an outbound loss event must be deferred under the temporary regulations.

If the deferral event or the outbound loss event occurs prior to the effective date of the final regulations, adjustments must be made as part of a fresh start transition method under the final regulations. Such adjustments are determined based on the QBU's balance sheet immediately prior to the deferral or outbound loss event and a deemed transition to the final Section 987 regulations immediately before the deferral or outbound loss event. Consequently, taxpayers will need to consider whether any deferred loss (to the extent it has not yet been recognized) would be completely eliminated in the transition tax year.

Tax accounting implications

Companies that have adopted a policy of recording deferred tax assets and liabilities for Section 987 gains and losses under a prior Section 987 method other than the 2006 proposed regulations should consider the effect of the final and temporary regulations on their recorded deferred tax assets and liabilities.

The final regulations change the portion of any prior unrealized foreign exchange gains and losses that may have future tax consequences and change the method for determining the future foreign exchange gains and losses of QBUs that are taxed. During the period including the date of release of the final and temporary regulations (i.e., December 7, 2016), taxpayers conducting activities through one or more Section 987 QBUs should evaluate the effect of the final and temporary Section 987 regulations on their deferred taxes recorded for prior unrealized foreign exchange gains and losses.

Under Accounting Standards Codification 740, the accounting effects of income tax law changes are included in the interim or annual financial statements that include the date of enactment, (i.e., the period including December 7, 2016). The total effect of tax law changes on deferred tax balances is recorded as a component of tax expense related to continuing operations for the period in which the law is enacted, even if the assets and liabilities relate to discontinued operations, a prior business combination or items of accumulated other comprehensive income.

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ENDNOTES

¹ See note 2 infra.

² The final regulations do not apply to banks, insurance companies, leasing companies, finance coordination centers, regulated investment companies or real estate investments trusts, unless those financial entities engage in transactions primarily with related persons that are not financial entities (e.g., in-house banks and treasury centers). Further, the final regulations do not apply to trusts, estates, S corporations and partnerships other than Section 987 aggregate partnerships. Until regulations are issued for those excluded entities, they must use a reasonable method to comply with Section 987 and cannot rely on the final regulations.

³ The temporary regulations provide two possibilities that allow taxpayers to avoid the application of the deferral event and outbound loss event rules. First, those rules do not apply to a QBU for which an annual deemed termination election is in effect. Second, those rules do not apply if the amount of Section 987 gain or loss per QBU that would be deferred is de minimis (defined by the Treasury and IRS as $5 million or less).