On December 18, 2017, the Treasury Department and the Internal Revenue Service issued proposed regulations under Sections 446, 954(c)(1)(D) and 988 (the Proposed Regulations) that provide new guidance on the subpart F treatment and timing of foreign currency gain or loss attributable to Section 988 transactions of a controlled foreign corporation (CFC). The Proposed Regulations also provide a new election for all taxpayers, including CFCs, to use a mark-to-market method of accounting for certain Section 988 transactions and would clarify certain issues for which no previous guidance existed. The proposed amendments generally are proposed to apply to tax years ending on or after the date the Proposed Regulations are published as final regulations in the Federal Register. Taxpayers may, however, rely on the proposed amendments for bona fide hedging transactions, provided the taxpayer consistently applies the proposed amendments to all bona fide hedging transactions entered on or after the date the Proposed Regulations are published in the Federal Register. Additionally, a taxpayer may rely on all other proposed amendments of the Proposed Regulations for tax years ending on or after the date the Proposed Regulations are published in the Federal Register, provided the taxpayer applies the proposed amendment for all such tax years that end before the first tax year ending on or after the date the Proposed Regulations are published as final.

Background

Section 954(c)(1)(D) and final regulations under Section 954 generally treat the excess of foreign currency gains over foreign currency losses attributable to any Section 988 transactions¹ of a CFC as foreign personal holding company income (FPHCI). For this purpose, however, amounts that arise from a transaction (including certain qualifying hedging transactions) directly related to the business needs of the CFC are not taken into account (the so-called Business Needs Exclusion). In addition, final regulations under Section 954 contain a special rule for the treatment of foreign currency gain or loss from an interest-bearing liability of a CFC, and provide alternative elections to treat foreign currency gain or loss of a CFC as attributable to a specific category of subpart F income, or to treat all Section 988 gains and losses as FPHCI.²

Since the enactment of subpart J and the promulgation of Section 988 rules nearly 30 years ago, taxpayers and commentators have become increasingly aware of US federal income tax timing and subpart F asymmetries that result from the interaction of the Section 954 foreign currency rules with ordinary course financing and risk management activities of CFCs, particularly with respect to the activities of treasury center CFCs. As discussed later, the Proposed Regulations, once applicable, may alleviate some of the more common tax asymmetries. The noteworthy provisions of the Proposed Regulations are addressed next.

Expansion of the business needs exclusion

The current Section 954 regulations generally do not allow any Section 988 gain or loss arising from a transaction or property (or an associated bona fide hedging transaction) to qualify for the Business Needs Exclusion if the underlying transaction or property being hedged gives rise to (or can reasonably be expected to give rise to) any amount of subpart F income (other than foreign currency gain or loss), resulting in an all-or-nothing "cliff effect."

Further, under current law, there is uncertainty as to whether the Business Needs Exclusion applies to risk management transactions a CFC may enter to manage risk of currency fluctuations with respect to its net investment in a qualified business unit (QBU) that is disregarded as an entity separate from the CFC. For financial accounting purposes, the CFC may record gain or loss arising from these transactions to a cumulative translation adjustment account on the CFC's balance sheet, which does not currently impact earnings.

The Proposed Regulations would modify the Business Needs Exclusion to eliminate the all-or-nothing "cliff effect" and exclude foreign currency gain or loss amounts that are properly allocable to non-subpart F income, and that would otherwise satisfy the requirements of the Business Needs Exclusion, from a CFC's FPHCI.³ The Proposed Regulations also provide that the "qualifying portion"⁴ of any foreign currency gain or loss that arises from a "financial statement hedging transaction"⁵ with respect to a QBU and that is allocable to non-subpart F income⁶ is directly related to the business needs of the CFC, and thus would be excluded from the CFC's FPHCI.⁷

Guidance regarding interest-bearing liabilities

Under current law, foreign currency gain or loss arising from an interest-bearing liability does not qualify for the Business Needs Exclusion. Instead, a special rule provides that foreign currency gain or loss on interest-bearing liabilities is allocated between subpart F and non-subpart F income in the same manner that interest expense associated with the liability is allocated between subpart F and non-subpart F income under Temp. Treas. Reg. Sections 1.861-9T and -12T. No corresponding rule exists under Treas. Reg. Section 1.954-2(g), however, for allocating the foreign currency gain or loss on a hedge of an interest-bearing liability between subpart F and non-subpart F income.

The Proposed Regulations would alleviate the subpart F mismatch that may occur under current law by: (i) expanding the definition of a "bona fide hedging transaction" to include the acquisition of a debt instrument (e.g., an intercompany debt receivable) used to manage foreign currency risk with respect to an interest-bearing liability;⁸ and (ii) allocating foreign currency gain or loss arising from a bona fide hedging transaction of an interest-bearing liability, including an intercompany debt receivable, as subpart F and non-subpart F income in the same manner as allocating foreign currency gain or loss from the interest-bearing liability.⁹

Modifications to certain foreign currency elections

Under current law, taxpayers that make a (g)(3) or (g)(4) election can revoke those elections only upon the consent of the Commissioner.¹⁰ Prop. Treas. Reg. Sections 1.954-2(g)(3)(iii) and -2(g)(4)(iii), would permit the controlling US shareholders of a CFC to unilaterally and automatically revoke either election at any time by filing a revocation statement with the applicable original or amended income tax return. To prevent frequent changes to these elections, the Proposed Regulations would prohibit an election that has been revoked from being subsequently elected until the sixth tax year following the year in which the previous election was revoked, and would prevent a subsequent revocation of that subsequent election from being revoked until the sixth tax year following the subsequent election.

Application of hedge timing rules to all bona fide hedging transactions

Treas. Reg. Section 1.446-4 generally governs the timing of gain or loss recognized with respect to hedging transactions, as defined in Treas. Reg. Section 1.1221-2(b). The Proposed Regulations would extend the hedge timing rules of Treas. Reg. Section 1.446-4 to apply to all bona fide hedging transactions, including those that do not currently qualify as hedging transactions under Treas. Reg. Section 1.1221-2(b), such as hedges of Section 1231 property and certain Section 988 transactions.¹¹ Thus, the Proposed Regulations should eliminate timing mismatches that may arise from bona fide hedging transactions that do not meet the definition of a hedging transaction under the Section 1221 Regulations.

Election to mark-to-market all Section 988 transactions

Under Section 475, certain taxpayers that qualify as dealers in securities generally must mark all of their securities to market at the end of each tax year. Regulations under Section 475, however, exclude a debt instrument issued by the taxpayer from the definition of security.¹² The current mismatch under Section 475 raises significant timing differences, particularly in the context of a treasury center CFC. To address this concern, Prop. Treas. Reg. Section 1.988-7, would permit, subject to certain exceptions,¹³ a taxpayer (including a CFC) to elect to use a mark-to-market method of accounting for foreign currency gain or loss arising from Section 988 transactions, including nonfunctional currency debt issued by the taxpayer.

Effective dates

The proposed amendments generally apply to tax years ending on or after the date the Proposed Regulations are published as final regulations in the Federal Register. However, the proposed amendments to bona fide hedging transactions under Treas. Reg. Sections 1.446-4(a) (extending the hedge timing rules of Treas. Reg. Section 1.446-4 to all bona fide hedging transactions), 1.954-2(a)(4)(ii)(A) (extending bona fide hedge treatment to the acquisition of certain debt instruments), 1.954-2(g)(2)(ii)(C)(1) (extending bona fide hedge treatment to hedges of certain transactions or property that give rise to both subpart F income and non-subpart F income) and 1.954-2(g)(2)(iii) (expanding the special rule for foreign currency gain or loss from an interest-bearing liability to bona fide hedges of an interest bearing liability) are proposed to apply to bona fide hedging transactions entered on or after the date the proposed regulations are published as final regulations in the Federal Register.

The preamble also provides that taxpayers may rely on the Proposed Regulations before finalization. In particular, taxpayers may rely on the Proposed Regulations related to bona fide hedging transactions cited previously for bona fide hedging transactions entered on or after the date the Proposed Regulations are published in the Federal Register, provided the taxpayer consistently applies the proposed amendments to all bona fide hedging transactions entered on or after the date the Proposed Regulations are published in the Federal Register and before the date the Proposed Regulations are published as final. Additionally, the preamble indicates that a taxpayer may rely on all other proposed amendments (e.g., Prop. Treas. Reg. Section 1.988-7) of the Proposed Regulations for tax years ending on or after the date the Proposed Regulations are published in the Federal Register, provided the taxpayer applies the proposed amendment for all such tax years that end before the first tax year ending on or after the date the Proposed Regulations are published as final.

Implications

The Proposed Regulations are largely taxpayer-favorable rules addressing timing and subpart F mismatches from foreign currency transactions, particularly for financing and risk management activities into which treasury center CFCs enter. Notably, the Proposed Regulations would allow taxpayers' treatment of foreign currency transactions to more closely align to the book accounting treatment for such items. As a result, the Proposed Regulations should foster enhanced communication among taxpayers' tax, treasury and accounting departments.

Since, according to the preamble, taxpayers may rely on the Proposed Regulations now, taxpayers should assess their current US federal income tax treatment of foreign currency transactions, particularly at the CFC level, to determine the potential benefit of relying on certain aspects of the Proposed Regulations now. In assessing the potential benefit of early application of the Proposed Regulations, taxpayers should take into account any potential impact on tax reform planning as well as potential tax return filing requirements.

In addition to the proposed rulemaking discussed earlier, the Treasury Department and the IRS have requested comments on whether additional amendments to the Business Needs Exclusion are appropriate for a CFC hedging foreign currency risk with respect to a transaction disregarded from a US federal income tax perspective (e.g., foreign currency risk on a disregarded loan between a CFC and its QBU) and for transactions entered by a CFC to hedge foreign currency risk with respect to a CFC's net investment in a subsidiary CFC (i.e., a "net investment hedge" or "Hoover" hedge). Taxpayers are encouraged to provide comments to the extent they deem an expansion of the Business Needs Exclusion for such disregarded transactions and net investment hedging desirable.

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ENDNOTES

¹ Section 988 transactions generally include the following: the accrual of any item of income or expense that is to be paid or received in a nonfunctional currency after the date of accrual; lending or borrowing in a nonfunctional currency; entering into or acquiring a forward, future, option or similar contract denominated in a nonfunctional currency; and the disposition of nonfunctional currency.

² Under Treas. Reg. Section 1.954-2(g)(3)(iii), the taxpayer may elect, under the so-called (g)(3) election, to include foreign currency gain or loss that relates to a specific category of subpart F income or, in the case of foreign base company income (FBCI), a specific category of FBCI, in that category of subpart F income or FBCI, rather than in FPHCI. Under Treas. Reg. Section 1.954-2(g)(4)(iii), the taxpayer may elect, under the so-called (g)(4) election, to include in the computation of FPHCI all foreign currency gain or loss attributable to any Section 988 transaction.

³ See Prop. Treas. Reg. Section 1.954-2(g)(2)(ii)(C)(1). The amount of foreign currency gain or loss treated as satisfying the Business Needs Exclusion would equal the product of the foreign currency gain or loss arising from the transaction or property and the ratio of non-subpart F income over the total amount of income arising from the transaction or property.

⁴ The "qualifying portion" of foreign currency gain or loss is the amount of foreign currency gain or loss arising from a financial statement hedging transaction that is properly accounted for under US generally accepted accounting principles as a cumulative foreign currency translation adjustment to shareholder's equity.

⁵ A "financial statement hedging transaction" is a transaction into which the CFC enters for the purpose of managing foreign currency risk with respect to part or all of that CFC's net investment in a QBU that is included in the consolidated financial statements of a US shareholder of the CFC. The Proposed Regulations would not expand the definition of a bona fide hedging transaction to include financial statement hedging transactions.

⁶ The qualifying portion of any foreign currency gain or loss arising from a financial statement hedging transaction would have to be allocated between subpart F and non-subpart F income using the principles of Treas. Reg. Section 1.987-6(b).

⁷ Prop. Treas. Reg. Section 1.954-2(g)(2)(ii)(C)(2). Foreign currency gain or loss arising from a financial statement hedging transaction would not be subject to the hedge timing rules of Treas. Reg. Section 1.446-4 discussed below and would be taken into account based on a taxpayer's method of accounting. The preamble to the Proposed Regulations solicits comments on this topic.

⁸ Prop. Treas. Reg. Section 1.954-2(a)(4)(ii)(A). This determination generally would be made without regard to Treas. Reg. Section 1.1221-2(d)(5), which prohibits the acquisition of a debt instrument from qualifying as a hedging transaction under Treas. Reg. Section 1.1221-2(b).

⁹ The Proposed Regulations would clarify that this rule applies in lieu of the general Business Needs Exclusion in Treas. Reg. Section 1.954-2(g)(2)(ii).

¹⁰ Treas. Reg. Sections 1.954-2(g)(3)(iii), -2(g)(4)(iii).

¹¹ Prop. Treas. Reg. Section 1.446-4(a).

¹² The treatment of nonfunctional currency liabilities under Section 475, however, was unclear.

¹³ The election under Prop. Treas. Reg. Section 1.988-7 would not apply to: (1) any securities that are marked to market under any other provision of the Code; (2) any securities that, under an election or an identification made by the taxpayer, are excepted from mark-to-market treatment under any other provision of the Code; (3) any transactions of a QBU that is subject to Section 987; or (4) any Section 988 transactions denominated in, or determined by reference to, a hyperinflationary currency.