Treasury, IRS Issue Section 987 Regulations on Foreign Currency Gain or Losses

The U.S Treasury Department and the IRS on December 10, 2024, issued final and proposed regulations under Internal Revenue Code Section 987. The Section 987 regulations provide guidance for determining taxable income or loss or earnings and profits of a taxpayer with respect to a qualified business unit (QBU) that uses a different functional currency than its owner. 

The 325-page final regulations, which adopt the regulations proposed in November 2023 with some modifications,  apply to any individual or corporation that owns a Section 987 QBU. Partnerships and S corporations are not subject to the transition rules, as described below; however, certain provisions of the final regulations do apply to partnerships and S corporations.

The proposed regulations include an election that is intended to reduce the compliance burden of accounting for certain disregarded transactions between a QBU and its owner. 

The final regulations are effective December 10, 2024, and apply to tax years beginning after December 31, 2024. The effective date, however, is immediate for QBUs that terminated after November 9, 2023. 

The following alert focuses on the most immediate concerns related to these final regulations, which largely consist of the transition rules and the calculation of the pretransition gain or loss that must be calculated as of December 31, 2024.  

Transition Rules

The owner of a QBU must adopt the Section 987 regulations as of the transition date -- January 1, 2025 -- for calendar year taxpayers (or the day of a termination event after November 9, 2023).  Pretransition gain or loss must be computed as if each QBU were terminated the day before the transition date. The method for computing the pretransition gain or loss depends on whether the taxpayer has applied an eligible method for computing Section 987 gains and losses in prior years. 

Pretransition Gain or Loss - Eligible Method

The pretransition gain or loss amount, in general, is the amount of Section 987 gain or loss that would have been recognized by the owner under the eligible method if the Section 987 QBU terminated on the transition date and transferred all of its assets and liabilities to the owner.   

Pretransition Gain or Loss – No Eligible Method

The pretransition gain or loss amount, in general, is the amount of the “annual unrecognized section 987 gain or loss” computed each year that the owner held the QBU after September 7, 2006, and before the transition date (“transition period”). This total amount is adjusted for the amount of Section 987 gain or loss recognized by the owner of such QBU for all of those years. 

The annual unrecognized Section 987 gain or loss is the amount of Section 987 gain or loss computed under Reg. §1.987-4(d) as though a current rate election was in effect for each year of the transition period. A current rate election is an election to treat all balance sheet items as a marked item that is translated at the end-of-year spot rate rather than a historic rate. Reg. §1.987-1(h). The calculation under Reg. §1.987-4(d) is modified for this purpose by applying only Reg. §1.987-4(d)(1) and (10) (Step 1 and Step 10). 

The calculation would be performed as follows for each year of the transition period:

Step 1:  Translate the net equity of the local currency tax basis balance sheet at the end of the year at the spot exchange rate at the end of the year, reduced by the net equity of the local currency tax basis balance sheet at the beginning of the year at the spot exchange rate at the beginning of the year. This will determine the change in net equity of the QBU denominated in the owner’s functional currency. 

Step 10: Adjust the above amount by translating the change in net equity of the QBU in the QBU’s functional currency for the year from the QBU’s functional currency to the owner’s functional currency at the average exchange rate for the year. If the net equity increased during the year, then this adjustment will decrease the number calculated in Step 1.  If the net equity decreased during the year, then this adjustment will increase the number calculated in Step 1.  

The sum of the amounts from Steps 1 and 10 would then be adjusted for any amount of Section 987 gain or loss recognized by the owner for that year in the transition period. This adjusted amount represents the unrecognized Section 987 gain or loss for one year in the transition period. The sum of these numbers for all years of the transition period is the amount of pretransition Section 987 gain or loss. A taxpayer may elect to recognize its pretransition gain over 10 years. If the election is made, the pretransition gain is not rated as net accumulated unrecognized Section 987 gain or loss.

In response to comments regarding the unavailability of tax basis balance sheets, the Section 987 regulations provide an alternative method for computing QBU net value for purposes of Reg. §1.987-4(d), but only when a current rate election is made. Thus, this alternative approach may be applied for purposes of computing pretransition gain or loss when an eligible method has not been previously applied, as a current rate election is deemed made for the transition period.  

The steps of the alternative approach are as follows (with each step computed in the functional currency of the QBU):

• Determine the QBU net value as of the last day of the preceding taxable year. This amount is generally determined by preparing an adjusted balance sheet; however, in the first tax year the net value of the QBU is zero;
• Adjust the amount above for transfers between the QBU and the owner; and
• Adjust the amounts above for income (increase) or loss (decrease) of the QBU.

The resulting amount of the above three steps would be used in Step 1 above and thus translated at the spot rate at the end of the year. The change in QBU net value (in the functional currency of the Section 987 QBU) would be translated at the average rate for the year to determine the amount for Step 10 above. 

Definition of “Eligible Pretransition Method”

The Section 987 regulations provide that an eligible method includes an earnings and capital method, which is defined as a method that requires Section 987 gain or loss to be determined and recognized with respect to both the earnings of the Section 987 QBU and capital contributed to the Section 987 QBU. This method generally is consistent with the method provided in the 1991 Section 987 proposed regulations. 

The Section 987 regulations further provide that another reasonable method could also qualify as an eligible method if it produces the same total amount of income over the life of the owner of a Section 987 QBU as the earnings and capital method described above. An earnings-only method would qualify, but only if the owner of the QBU tracked a capital pool generally at historic exchange rates such that, at some point, the capital invested in the QBU would result in Section 987 gain or loss. 

The Section 987 regulations further provide that an earnings-only method that does not track a capital pool and is truly an earnings-only method may be an eligible method as long as it meets certain criteria:

• The earnings-only method was first applied by the owner on a return filed before November 9, 2023; 
• The earnings-only method was applied consistently to all of the owner’s Section 987 QBUs since the first taxable year in which the owner applied an eligible pretransition method; and 
• The owner of the Section 987 QBU otherwise applied Section 987 in a reasonable manner. 
  
  

The Section 987 regulations provide further guidance regarding errors and other consistent practices and how those may impact whether a method is eligible or not. The final regulations provide that if an owner generally applied an eligible method prior to the transition date but made errors in the application of the method or failed to apply the method to every taxable year since the QBU’s inception, the owner is considered to have applied an eligible pretransition method. However, pretransition gain or loss must be determined as though the eligible pretransition method was applied without error since the Section 987 QBU’s inception.  

The Section 987 regulations provide that if an owner generally applied Section 987 with respect to a Section 987 QBU before the transition date using an eligible method but consistently disregarded transactions between the QBU and the owner, the owner is considered to have applied an eligible method, provided that the owner otherwise accounts for the disregarded transfers in a reasonable manner. For example, an eligible method would include following the 1991 proposed Section 987 regulations by taking into account the disregarded transfers in computing the equity and basis pools, even though no Section 987 gain or loss was computed with respect to such transfers. 

The final Section 987 regulations provide that the deferral of Section 987 gain or loss until termination is not a reasonable method; in other words, the IRS requires that Section 987 gains and losses must be recognized upon remittances from the QBU to the owner. Lastly, the preamble to the Section 987 regulations provides that a method that relies on the cumulative translation adjustment account (CTA) that is determined for financial accounting purposes would not qualify as an eligible pretransition method.  

Recognition of Pretransition Gain or Loss

Pretransition gain is treated as net accumulated unrecognized Section 987 gain, which will be recognized in future years as remittances are made from the Section 987 QBU. Alternatively, taxpayers may elect to recognize pretransition gain ratably over 10 years.    

Pretransition loss is generally treated as suspended Section 987 loss, which means that such loss will be recognized in future years to the extent the QBU generates Section 987 gain. If a current-rate election is in effect on the transition date, then the pretransition loss becomes unrecognized Section 987 loss that will be recognized upon remittances in future years. Alternatively, taxpayers may elect to recognize pretransition loss ratably over 10 years.

In general, the source and character of pretransition gain or loss is determined under the rules of Reg. §1.987-6.  For this purpose, the owner assigns Section 987 gain or loss to the statutory and residual groupings in the same proportion as the tax book value of the assets of the Section 987 QBU is assigned to the groupings under the asset method in Reg. §1.861-9(g) and §1.861-9T(g).  Pretransition gain or loss is assigned to such groupings either: 

• In the taxable year in which the unrecognized Section 987 gain or loss is recognized; 
• The taxable year in which section 987 loss becomes suspended section 987 loss; or 
• If an election is made to recognize Section 987 gain or loss ratably over 10 years, the taxable year that includes the transition date (January 1. 2025). 

Partnerships and S Corporations

Most of the provisions of the Section 987 regulations do not apply to partnerships and S corporations.  For example, the transition rules of Reg. §1.987-10 do not apply. The Section 987 regulations provide that taxpayers must apply a reasonable method to comply with Section 987 based on the statute that was enacted in 1986.  

In applying such a reasonable method, a taxpayer may apply either an entity or an aggregate approach.  For example, assume that domestic corporations DC1 and DC2 each own 50% of Partnership P.  P operates Business A, which qualifies as a Section 987 QBU and uses the British pound as functional currency.  If DC1 and DC2 apply an aggregate approach, then Section 987 would apply as if DC1 and DC2 owned Business A directly.  If DC1 and DC2 apply an entity approach, then Section 987 would apply as if P owned Business A directly and any Section 987 gain or loss would be allocated to DC1 and DC2 from P. Further, if P uses a non-USD functional currency, then DC1 and DC2 could recognize Section 987 gain or loss with respect to P if P is a QBU as defined in Section 989(a).  

Taxpayers will not be considered to have applied a reasonable method unless they apply the same method consistently from year to year with respect to a particular partnership or eligible QBU. Further, members of a controlled group that are partners in the same partnership must apply the same method with respect to a particular partnership or eligible QBU, but unrelated partners are not subject to a consistency requirement.  Reg. §1.987-7(b).  

The provisions of the Section 987 regulations that do apply to partnerships and S corporations include the source and character rules of Reg. §1.987-6. These rules require Section 987 gain or loss to be characterized under the asset allocation and apportionment rules of Reg. §1.861-9(g) and -9T(g). 

Further, the final regulations provide that a Section 987 loss computed under a reasonable method becomes a suspended loss that would generally be recognized to the extent of future Section 987 gains.  The general suspended loss and loss deferral rules in Reg. §1.987-11 through -13 also apply to partnerships and S corporations. The suspended loss and loss deferral rules would not apply to partnerships and S corporations if: 

• The taxpayer makes an annual deemed termination election to recognize all Section 987 gains and losses annually; or 
• The reasonable method that is applied to determine Section 987 gains and losses does not result in historic assets and liabilities generating Section 987 gains and losses. This method would include adopting the foreign exchange exposure pool (FEEP) approach of the final regulations or an earnings-only approach. 
  
  

Other highlights of the final regulations that will be covered in a future alert include:

• Recognition of suspended Section 987 losses to the extent of Section 987 gain recognized in the current year and the three prior tax years;
• An election to treat Section 987 gain or loss that would otherwise be characterized as passive foreign personal holding company income as Section 988 foreign currency gain or loss attributable to Section 988 transactions not directly related to the business needs of the controlled foreign corporation (CFC). This would generally allow the netting of Section 987 and Section 988 gains and losses.
• An election to mark-to-market all Section 988 transactions attributed to a QBU.