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All of the three-year cumulative inflation rates commonly used to evaluate Argentina's inflation exceeded 100% as of June 30, 2018. Consequently, entities with operations in Argentina were expected to begin accounting for Argentina's economy as highly inflationary no later than reporting periods beginning after June 30, 2018 for US GAAP.¹

For US tax purposes, the determination of whether a currency is hyperinflationary is generally made on a calendar-year basis (e.g., as of January 1, 2019), based on changes in the consumer price index (CPI) as reported by the International Monetary Fund (IMF) for the 36 calendar months immediately preceding the first day of the calendar year. In certain circumstances, the US GAAP determination regarding hyperinflation may be used in determining whether a currency is hyperinflationary for US federal income tax purposes.

All US taxpayers with subsidiary, partnership, or branch operations in a hyperinflationary environment generally must: 1) use the US dollar as the functional currency for these operations; and 2) account for these operations using the US dollar approximate separate transaction method of accounting (DASTM) as described in Treasury Reg. Section 1.985-3. These requirements are designed to reduce the distortions that can result from operating in a hyperinflationary environment. US taxpayers and their qualified business units must make certain adjustments made upon adopting the US dollar and DASTM. These adjustments could affect the recognition of gain or loss under Section 987 and/or Section 988, Subpart F income, global intangible low-taxed income (GILTI), earnings and profits (E&P), and foreign tax credits.

In addition, taxpayers with nonfunctional currency transactions denominated in the Argentine peso will need to consider special hyperinflationary currency rules and exceptions contained in the US federal income tax regulations.²

The IMF has not reported CPI data for Argentina for the 36 month-period ended on December 31, 2018, to determine whether the Argentine peso should be considered hyperinflationary for US tax purposes for tax years beginning on or after January 1, 2019. Given the fact that the Argentine peso is considered highly inflationary for US GAAP and hyperinflationary for IFRS purposes as of July 2018 and assuming the economic environment remains constant or inflation increases through the end of 2018, taxpayers and other qualified business units that have been using the Argentine peso as their functional currency for US federal income tax purposes likely will be required to make complex transition adjustments and begin accounting for their Argentine operations in US dollars under DASTM for tax years beginning on or after January 1, 2019.

Detailed discussion

Overview

Generally, Treas. Reg. Section 1.985-1 requires a taxpayer and each of its qualified business units (QBUs) to make all US federal income tax determinations in its respective functional currency. Any taxpayer or QBU that would otherwise be required to use a hyperinflationary currency as its functional currency, however, must instead use the US dollar as its functional currency and compute income or loss or E&P under DASTM as described in Treas. Reg. Section 1.985-3.³

US dollar functional currency

A country's currency is considered hyperinflationary if the country has experienced cumulative compounded inflation of at least 100% during the three preceding calendar years.⁴ Because all of the three-year cumulative inflation rates commonly used to evaluate Argentina's inflation exceeded 100% as of June 30, 2018, entities with operations in Argentina were expected to begin accounting for Argentina's economy as highly inflationary no later than reporting periods beginning after June 30, 2018 for US GAAP. Taxpayers and QBUs that use the Argentine peso as their functional currency for US federal income tax purposes likely will be required to adopt the US dollar as their functional currency in 2019, beginning on the first day of their 2019 tax year. This change is considered made with the consent of the Commissioner and does not require the filing of a Form 3115, as would ordinarily be the case with a change in functional currency.

DASTM

To reduce the distortion related to the use of a hyperinflationary currency to report earnings, US tax law requires the application of DASTM as a method of accounting rather than the profit and loss method. The goal of the DASTM rules is to simulate the use of the US dollar as functional currency by requiring the translation of all balance sheet and income statement items from local currency to US dollars at various rates. In general, the translation process involves: preparation of a local currency balance sheet reflecting US income tax principles; translation of assets and liabilities at various rates, depending on when the asset or liability was acquired or incurred and whether it is monetary or non-monetary; translation of income statement items relating to assets and liabilities at the rates used to translate the corresponding items on the balance sheet; translation of other income statement items, depending on when they were earned or incurred; and translation of dividends at the rate in effect on the date of payment.

This translation process is performed to the beginning and end of the tax year balance sheets. The difference between the net equity computed at the beginning-of-the-year and the end-of-the-year balance sheets represents the change in net worth, which constitutes the amount of E&P (or taxable income if the Argentine entity is a Section 987 QBU) for the current year.

The difference between the income statement translated into US dollars, in accordance with the DASTM rules, and the change in net worth represents the amount of DASTM gain or loss for the current year. The DASTM gain or loss is then allocated to various classes of gross income earned by the foreign operation. This allocation process potentially affects the amount of Subpart F income or GILTI included in taxable income by US shareholders.

As discussed previously, DASTM constitutes a method of accounting and must be used until the local currency qualifies as non-hyperinflationary for three consecutive years.⁵ Recall that hyperinflationary status is determined based upon the previous three-year base period. For Argentina, assuming the Argentine peso is determined to be hyperinflationary for the 36-month period ending on December 31, 2018, this means that the Argentine peso would have to be non-hyperinflationary for the years 2019, 2020 and 2021 before taxpayers could transition from DASTM to the profit-and-loss method of accounting and adopt the Argentine peso as functional currency for the tax year 2022. Tax year 2022 would be the earliest year taxpayers could transition their Argentine operations off DASTM.

Adoption of DASTM

Proposed regulations issued in January 1993 required US taxpayers to apply DASTM to all post-1986 years once a local currency was determined to be hyperinflationary. The IRS alleviated concerns regarding the record keeping required to comply with the proposed regulations and several other concerns by establishing certain adjustments that must be made upon the adoption of DASTM. These adjustments are designed to treat a QBU that operates in a country that has become hyperinflationary as subject to DASTM as of the transition date and are similar to the adjustments required upon a change in functional currency as provided in Treas. Reg. Section 1.985-5. The transition date is defined as the later of: 1) the last day of the tax year ending before the three-year base period used to determine hyperinflationary status; or 2) the last day of the tax year that the QBU applied DASTM.⁶ The period between the transition date and the date a currency is hyperinflationary is called the look-back period.⁷ For calendar-year taxpayers and QBUs that use the Argentine peso as their functional currency, the transition date likely will be December 31, 2015 and the look-back period likely will consist of tax years 2016, 2017, and 2018.

Separate adjustments must be made for controlled foreign corporations (CFCs), US shareholders, and QBU branches and partnerships upon the adoption of DASTM.

CFC level adjustments

Treas. Reg. Section 1.985-7 provides three types of CFC level adjustments: 1) Section 988 transactions denominated in US dollars; 2) opening balance sheet; and 3) E&P adjustments.

A foreign corporation must adjust E&P as of the transition date to reflect any unrealized exchange gain or loss with respect to Section 988 transactions denominated in the US dollar. This amount, however, is reduced by any gain or increased by any loss recognized during the look-back period with respect to such Section 988 transactions. Thus, for Argentine-peso CFCs, Section 988 gain or loss likely will be recognized as of December 31, 2015, for US dollar-denominated Section 988 transactions. This amount is adjusted for Section 988 gains and losses recognized with respect to US dollar transactions during the years 2016, 2017, and 2018 of the Argentine CFC.

The regulations provide that the tax basis balance sheet is translated into US dollars using the spot exchange rate on the transition date.⁸ Thus, the balance sheet of Argentine-peso CFCs likely will need to be translated at the spot exchange rate on December 31, 2015. Assets and liabilities acquired during the look-back period (i.e., 2016–2018) are translated into US dollars using the exchange rate on the acquisition date.⁹

Additionally, the regulations provide that the post-1986 undistributed E&P of a foreign corporation adopting DASTM consists of the sum of: 1) the corporation's post-1986 undistributed E&P determined on the transition date and translated into US dollars using the spot exchange rate on the transition date; and 2) the sum of the E&P for each year in the look-back period as determined under DASTM, reduced by any distributions of post-1986 E&P during the look-back period.¹⁰

Therefore, the amount of Argentine-peso E&P existing as of December 31, 2015, likely will need to be translated into US dollars at the spot exchange rate on that date. Further, DASTM likely will need to be applied to the years 2016–2018 to determine E&P for each of those years. The sum of the December 31, 2015 US dollar E&P and the US dollar E&P amounts computed for the years 2016 through 2018 under DASTM will be the balance of US dollar E&P as of January 1, 2019.

US shareholder level adjustments

US shareholders of CFCs adopting DASTM are subject to three types of adjustments: 1) US shareholders may recognize Subpart F income related to exchange gains on Section 988 transactions calculated at the foreign corporation level; 2) US shareholders must recognize any exchange gain or loss related to previously taxed income (PTI) as if all PTI were distributed on the transition date; this amount, however, is reduced by any exchange gain or loss recognized with respect to PTI received during the look-back period; and 3) US shareholders must take into account any difference in Subpart F income resulting from the recalculation of E&P for the look-back period. This positive or negative adjustment is reflected over four years beginning with the year of change, which likely will be the 2019 tax year for Argentine-peso QBUs. Such amounts retain their character for all US federal income tax purposes (including Section 902, 959, 960, 961, 1248, and 6038). If an adjustment results in a loss for the tax year in a separate category, the overall foreign loss recapture rules of Section 904(f) and its regulations may apply. Additionally, the amount of foreign taxes deemed paid under Section 960 for any additional Subpart F income is calculated with reference to the pools of earnings and taxes as of the CFC's first day of the tax year in which DASTM applies.¹¹

Further, a US shareholder's GILTI inclusion amount likely will need to be recomputed for tax years beginning in 2018 to the extent a CFC or a QBU branch of a CFC must adopt DASTM.

QBU adjustments

The adjustments required for a QBU branch adopting DASTM are similar to those made by CFCs.¹² Taxpayers are to take these adjustments into account ratably over four years, beginning in the year of change.¹³ A QBU branch that adopts DASTM must make four categories of adjustments. Three of these four adjustments parallel those adjustments required by CFCs that adopt DASTM. These three adjustments are as follows: 1) QBU branches must recognize any unrealized Section 988 gain or loss with respect to US dollar-denominated transactions held by the QBU branch as of the transition date;¹⁴ 2) the opening balance sheet of a QBU branch is calculated using the same methodology as a CFC that adopts DASTM;¹⁵ and 3) a QBU branch must recalculate its earnings applying the DASTM rules to each year in the look-back period.¹⁶ The positive or negative difference between this cumulative amount and the cumulative earnings as calculated under the profit and loss method of accounting is taken into account by the taxpayer ratably over four tax years beginning in the year of change, which likely will be 2019 for Argentine-peso QBUs.¹⁷

The fourth area of adjustment is unique to QBU branches adopting DASTM in that a QBU branch is treated as terminating on the transition date. The effect of the deemed termination is that any unrecognized Section 987 gain or loss must be recognized as of the transition date. Similar to the Section 988 adjustments, any Section 987 gain or loss recognized during the look-back period is reversed for purposes of calculating the amount as of the transition date.¹⁸

Implications

Argentine-peso taxpayers and QBUs likely will need to adopt the US dollar as their functional currency and comply with the DASTM rules for such QBUs as of January 1, 2019. The transition to DASTM likely will require a recalculation of the January 1, 2019 E&P balance for Argentine-peso CFCs, as well as potential recognition of Section 988 gains and losses related to US dollar-denominated Section 988 transactions, which include: US dollar-denominated cash, accounts payable, accounts receivable, notes payable, notes receivable, and derivatives. This may affect the amount of Subpart F income (which includes the Section 965 inclusion) includible from such CFCs, as well as deemed paid credits. Further, Argentine-peso QBU branches and partnerships likely will be required to adopt DASTM on January 1, 2019, and the result likely will generate Section 987 losses upon the adoption of the US dollar as functional currency. Further, DASTM likely will need to be applied to Argentine-peso QBUs for the 2019 tax year and future years until the Argentine peso is considered non-hyperinflationary for three consecutive years.

The Capital Markets and ITqS contacts below are prepared to assist all EY clients with Argentine Peso CFCs and QBUs in the adoption and application of DASTM.

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ENDNOTES

¹ See EY's To the Point, No. 2018-19, July 12, 2018.

² See, e.g., Treas. Reg. Sections 1.988-2(b)(15), -2(d)5), -2(e)(7), -4(e)(1), -5(a)(2) and 1.267(f)-1(e); Prop. Treas. Reg. Section 1.988-7(b)(4).

³ Treas. Reg. Section 1.985-1(b)(2)(ii).

⁴ Treas. Reg. Section 1.985-1(b)(2)(ii)(D). The three-year base period inflation is determined by reference to the consumer price index of the country, as reported in the monthly issues of the "International Financial Statistics" published by the International Monetary Fund.

⁵ Treas. Reg. Section 1.985-1(b)(2)(ii)(E).

⁶ Treas. Reg. Section 1.985-7(a).

⁷ Id.

⁸ Treas. Reg. Section 1.985-7(b)(3).

⁹ Id.

¹⁰ Treas. Reg. Section 1.985-7(b)(4)(ii).

¹¹ Treas. Reg. Section 1.985-7(c).

¹² Treas. Reg. Section 1.985-7(d).

¹³ Treas. Reg. Section 1.985-7(d)(1).

¹⁴ As in the case of a CFC, the Section 988 gain or loss recognized as of the transition date reflects the reversal of any Section 988 gain or loss recognized during the look-back period for the same Section 988 transactions. Treas. Reg. Section 1.985-7(d)(2).

¹⁵ Treas. Reg. Section 1.985-7(d)(5).

¹⁶ Treas. Reg. Section 1.985-7(d)(4).

¹⁷ Treas. Reg. Section 1.985-7(d)(1) and (4).

¹⁸ Treas. Reg. Section 1.985-7(d)(3).