Treatment of Income and Expense From Certain Hyperinflationary, Nonfunctional Currency Transactions and Certain Notional Principal Contracts

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8860]

RIN 1545-AP78

Treatment of Income and Expense From Certain Hyperinflationary,

Nonfunctional Currency Transactions and Certain Notional Principal

Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations regarding the

treatment of income and deductions arising from certain foreign

currency transactions denominated in hyperinflationary currencies and

coordinates section 988 with the section 446 regulations pertaining to

significant nonperiodic payments. These regulations are intended to

prevent distortions in computing income and deductions of taxpayers who

enter into certain transactions in hyperinflationary currencies, and

nonfunctional currency, notional principal contracts with significant

nonperiodic payments.

DATES: These regulations are effective February 14, 2000.

FOR FURTHER INFORMATION CONTACT: Roger M. Brown at (202) 622-3830 (not

a toll-free number) of the Office of the Associate Chief Counsel

(International) within the Office of the Chief Counsel, Room 4554, 1111

Constitution Avenue, NW., Washington, DC. 20224.

SUPPLEMENTARY INFORMATION:

Background

On March 17, 1992, proposed regulations were published in the

Federal Register at 57 FR 9217 (INTL-15-91). The IRS received two

written comments on the proposed regulations, which are discussed

below. No public hearing was held and no requests to speak were

received. Having considered the comments, the IRS and Treasury

Department adopt the proposed regulations, as modified by this Treasury

decision.

Explanation of Provisions

I. Hyperinflationary Instruments

A. Proposed Regulations

The proposed regulations under Sec. 1.988-2(b)(15) generally

provided that currency gain or loss on debt instruments and demand

deposits entered into or acquired when the currency in which the item

was denominated was hyperinflationary must be realized annually under a

mark-to-market methodology. For purposes of determining the character

and source (or allocation) of such currency gain or loss, the gain or

loss was generally treated as an increase in, or a reduction of,

interest income or expense.

The proposed Sec. 1.988-2(b)(15) regulations excluded instruments

described in section 988(a)(3)(C) (relating to non-dollar, related-

party loans where the rate of interest is at least 10 percentage points

higher than the Federal mid-term rate) from these rules. Proposed

regulations Sec. 1.988-2(d)(5) and (e)(7) generally provided that

currency gain or loss realized with respect to section 988 forward

contracts, futures contracts, option contracts and similar items (such

as currency swap contracts) entered into or acquired when the currency

in which such an item is denominated was hyperinflationary was

[[Page 2027]]

recognized annually under a mark-to-market methodology.

B. Discussion of Comments and Final Regulations

1. Comments and the Treasury and IRS's Responses

One of the comments responding to the proposed regulations

criticized the exclusion of loans described in section 988(a)(3)(C)

from the rules of proposed regulation Sec. 1.988-2(b)(15). The comment

noted that it was inappropriate to treat related-party loans

differently from loans between unrelated parties in this context.

Proposed regulation Sec. 1.988-2(b)(15) excluded loans subject to

section 988(a)(3)(C) from the mark-to-market rule of the proposed

regulations because the loans were already subject to mark-to-market

treatment under section 988(a)(3)(C), which was enacted to prevent

manipulation of the section 904(a) foreign tax credit limitation

through related party loans with artificially high interest rates. See

H. Conf. Rep. No. 841, 99th Cong., 2d Sess. 668 (1986). However, due to

interest income's U.S. source treatment under section 988(a)(3)(C)(ii),

mark-to-market treatment under section 988(a)(3)(C), rather than

Sec. 1.988-2(b)(15), would be, in most cases, more unfavorable to

taxpayers.

Since the rules of proposed regulation Sec. 1.988-2(b)(15) were

consistent with the approach of section 988(a)(3)(C) and prevented

manipulation of the type Congress addressed in that section, the IRS

and Treasury agree that transactions described in section 988(a)(3)(C)

should not be excluded from the mark-to-market rule of the final

regulations. The IRS and Treasury also have concluded that to the

extent a debt instrument is subject to the rules of Sec. 1.988-

2(b)(15), the application of section 988(a)(3)(C)'s resourcing rule is

not necessary. The final regulations reflect these changes.

The other comment identified the need for coordinating the mark-to-

market regime for hyperinflationary instruments under proposed

regulation Sec. 1.988-2(b)(15), and the mark-to-market election under

proposed regulation Sec. 1.988-5(f) for all section 988 transactions.

The final regulations do not include a rule coordinating these two

mark-to-market regimes because the mark-to-market election for all

section 988 transactions is still in proposed form. Accordingly, the

IRS and Treasury have decided that consideration of the proper

coordination is most appropriate when the regulations relating to the

general mark-to-market election for all section 988 transactions are

finalized.

2. Other Changes to the Final Regulations

(a) Source and Character of Gain or Loss

The proposed regulations provided that any exchange gain or loss

realized upon marking to market a debt instrument or a demand deposit

under proposed regulation Sec. 1.988-2(b)(15)(i) was to be directly

allocable to the interest income or interest expense from the debt

instrument or deposit. Accordingly, the gain or loss reduced or

increased the amount of interest income or interest expense paid or

accrued during that year with respect to that instrument or deposit.

Additionally, if realized exchange gain exceeded interest expense of an

issuer, or realized exchange loss exceeded interest income of a holder

or depositor, the character and source of such excess amount were to be

determined under the general rules of Secs. 1.988-3 and 1.988-4.

The assumption underlying this proposed treatment was that in

hyperinflationary conditions, high nominal interest rates perform two

functions: compensate lenders for currency loss attributable to the

repayment of the principal with a devalued currency, and account for

borrowers' currency gain on the repayment of the principal with a

devalued currency. In instances, however, where hyperinflationary

conditions are subsiding and a lender would actually have currency gain

on principal repayment (and the borrower would have currency loss on

principal repayment), these assumptions are no longer appropriate. For

example, if a lender has currency gain on the marking to market (for

currency fluctuations only) of the principal of a debt instrument, high

nominal interest rates would not be compensating the lender for the

decline in the value of the principal as there would be a gain on the

principal.

Accordingly, the final regulations retain the source and character

rule of the proposed regulations (direct allocation of the exchange

gain or loss against interest expense or income, respectively) when

hyperinflationary conditions result in exchange loss to lenders or

exchange gain to borrowers on the principal amount of a debt instrument

or deposit. However, where a lender has exchange gain or a borrower has

exchange loss on the debt instrument--which may occur as

hyperinflationary conditions subside--the final regulations clarify

that the exchange gain or loss is not allocated against interest

expense or income. Rather, the exchange gain or loss is treated under

the normal currency character and source rules of Secs. 1.988-3 and

1.988-4. Thus, for example, if an issuer has both interest expense and

currency loss, the currency loss is sourced and characterized under

section 988 and does not affect the determination of interest expense.

(b) Synthetic, Non-hyperinflationary Currency Debt Instruments

The final regulations also make clear that when a debt instrument

has interest and principal payments that are to be made by reference to

a non-hyperinflationary currency or item (commonly known as interest

and principal protection features), the instrument is not marked to

market under the final section 988 regulations. This is because the

instrument is, in substance, a synthetic non-hyperinflationary

instrument and does not experience the distortions associated with a

hyperinflationary instrument.

(c) Treatment of Hyperinflationary Contracts

Proposed regulation Sec. 1.988-2(d)(5) generally provided that

currency gain or loss on derivative contracts described in Sec. 1.988-

1(a)(2)(iii) and denominated in a currency that was hyperinflationary

at the time the contract was entered into was to be realized annually

under a mark-to-market methodology. This proposed regulation was issued

prior to promulgation of the Sec. 1.446-4 regulations (published in the

Federal Register on July 18, 1994) which requires that, to clearly

reflect income, the timing of income, deduction, gain or loss on a

hedge must match the timing of income, deduction, gain or loss on the

item being hedged. The final regulations modify proposed regulation

Sec. 1.988-2(d)(5) by providing that Sec. 1.446-4, to the extent

applicable, will take precedence over proposed regulation Sec. 1.988-

2(d)(5). This is because the IRS and Treasury believe that a clearer

reflection of income is present where the income and deductions arising

from an item hedged under Sec. 1.446-4 is matched with the income and

deductions arising from the hedge. See Sec. 1.446-4(b).

(d) Demand and Time Deposits

The proposed regulations applied the mark-to-market rules to demand

deposits denominated in a currency that was hyperinflationary at the

time the deposit was entered into. Under the final regulations, the

mark-to-market rules apply to demand and time deposits that provide for

payments denominated in or by reference to a currency which is

hyperinflationary at

[[Page 2028]]

the time the taxpayer enters into or otherwise acquires the deposit, or

whose interest rate reflects hyperinflationary conditions in a country.

Similar clarifications have been made with respect to the definitions

of hyperinflationary debt instruments and currency swap contracts.

3. Abusive Transactions

The Treasury and the IRS are concerned about the use of

hyperinflationary currencies in transactions motivated by tax

considerations. Because the direction of exchange rates is relatively

predictable in hyperinflation economies, some taxpayers have attempted

to use such currencies in transactions lacking economic substance. See,

e.g., Agro Science Co. v. Commissioner, T.C. Memo. 1989-687, aff'd, 927

F.2d 213 (5th Cir.), cert. denied, 502 U.S. 907 (1991). However,

section 988 may be applied by the IRS in a manner that reflects the

proper timing, source, and character of income, gain, loss, or expense

arising from a transaction whose form is not in accordance with its

economic substance. Secs. 1.988-1(a)(11) and 1.988-2(f); Agro Science

Co. v. Commissioner, supra. Accordingly, the rules contained in this

Treasury decision will be applied within the framework of these general

economic substance principles.

II. Significant Non-periodic Payments and Currency Swaps

The proposed regulations coordinated section 988 with the section

446 regulations pertaining to significant nonperiodic payments. The

final regulations maintain this coordination and clarify that exchange

gain or loss may be realized on the principal and interest components

of a significant nonperiodic payment.

III. Proposed Change to Base Period in Notice of Proposed Rulemaking

Elsewhere in this issue of the Federal Register, the IRS and

Treasury are publishing a notice of proposed rulemaking that proposes

to change the period during which inflation rates are measured in the

determination of whether a currency is hyperinflationary for purposes

of section 988 (base period). The effect of this change to Sec. 1.988-

1(f) (defining hyperinflationary currency for purposes of section 988)

is to take into account current year, hyperinflationary conditions,

rather than determining whether a currency is hyperinflationary based

on the three years prior to the current year. The proposed change

relates only to section 988 and not to the dollar approximate separate

transactions method of Sec. 1.985-3 (DASTM). However, other sections,

such as Sec. 1.267(f)-1(e) (relating to application of the loss

disallowance rule of section 267(a)(1) as applied to related party,

nonfunctional currency loans), which make reference to the section 988

definition of hyperinflation will be affected.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in Executive Order 12866.

Therefore, a regulatory assessment is not required. It has also been

determined that section 553(b) of the Administrative Procedure Act (5

U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter

6) do not apply to these regulations, and, therefore, a Regulatory

Flexibility Analysis is not required. Pursuant to section 7805(f) of

the Internal Revenue Code, the notice of proposed rulemaking preceding

these regulations was submitted to the Small Business Administration

for comment on its impact on small businesses.

Drafting Information: The principal author of these regulations is

Roger M. Brown of the Office of the Associate Chief Counsel

(International). However, other personnel from the IRS and Treasury

Department also participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of the Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read,

in part, as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.988-0 in the Table of Contents is amended by:

1. The entry for Sec. 1.988-2(b)(14)-(15) is removed.

2. An entry for Sec. 1.988-2(b)(14) is added.

3. An entry for Sec. 1.988-2(b)(15) is added.

4. The entry for Sec. 1.988-2(d)(5) is revised.

5. The entry for Sec. 1.988-2(e)(7) is revised.

The revisions and additions read as follows:

Sec. 1.988-0 Taxation of gain or loss from a section 988 transaction;

Table of Contents.

* * * * *

Sec. 1.988-2 Recognition and computation of exchange gain or loss

* * * * *

(b) * * *

(14) [Reserved]

(15) Debt instruments and deposits denominated in

hyperinflationary currencies.

* * * * *

(d) ***

(5) Hyperinflationary contracts.

(e) * * *

(7) Special rules for currency swap contracts in

hyperinflationary currencies.

* * * * *

Par. 3. Section 1.988-2 is amended by:

1. Adding paragraph (b)(15).

2. Adding paragraph (d)(5).

3. Adding paragraph (e)(3)(iv).

4. Adding paragraph (e)(7).

The additions read as follows:

Sec. 1.988-2 Recognition and computation of exchange gain or loss.

* * * * *

(b) * * *

(14) [Reserved]

(15) Debt instruments and deposits denominated in hyperinflationary

currencies--(i) In general. If a taxpayer issues, acquires, or

otherwise enters into or holds a hyperinflationary debt instrument (as

defined in paragraph (b)(15)(vi)(A) of this section) or a

hyperinflationary deposit (as defined in paragraph (b)(15)(vi)(B) of

this section) on which interest is paid or accrued that is denominated

in (or determined by reference to) a nonfunctional currency of the

taxpayer, then the taxpayer shall realize exchange gain or loss with

respect to such instrument or deposit for its taxable year determined

by reference to the change in exchange rates between--

(A) The later of the first day of the taxable year, or the date the

instrument was entered into (or an amount deposited); and

(B) The earlier of the last day of the taxable year, or the date

the instrument (or deposit) is disposed of or otherwise terminated.

(ii) Only exchange gain or loss is realized. No gain or loss is

realized under paragraph (b)(15)(i) by reason of factors other than

movement in exchange rates, such as the creditworthiness of the debtor.

(iii) Special rule for synthetic, non-hyperinflationary currency

debt instruments--(A) General rule. Paragraph (b)(15)(i) does not apply

to a debt instrument that has interest and principal payments that are

to be made by reference to a currency or item that does not reflect

hyperinflationary conditions in a country (within the meaning of

Sec. 1.988-1(f)).

[[Page 2029]]

(B) Example. Paragraph (b)(15)(iii)(A) is illustrated by the

following example:

Example. When the Turkish lira (TL) is a hyperinflationary

currency, A, a U.S. corporation with the U.S. dollar as its

functional currency, makes a 5 year, 100,000 TL-denominated loan to

B, an unrelated corporation, at a 10% interest rate when 1,000 TL

equals $1. Under the terms of the debt instrument, B must pay

interest annually to A in amount of Turkish lira that is equal to

$100. Also under the terms of the debt instrument, B must pay A upon

maturity of the debt instrument an amount of Turkish lira that is

equal to $1,000. Although the principal and interest are payable in

a hyperinflationary currency, the debt instrument is a synthetic

dollar debt instrument and is not subject to paragraph (b)(15)(i) of

this section.

(iv) Source and character of gain or loss--(A) General rule for

hyperinflationary conditions. The rules of this paragraph

(b)(15)(iv)(A) shall apply to any taxpayer that is either an issuer of

(or obligor under) a hyperinflationary debt instrument or deposit and

has currency gain on such debt instrument or deposit, or a holder of a

hyperinflationary debt instrument or deposit and has currency loss on

such debt instrument or deposit. For purposes of subtitle A of the

Internal Revenue Code, any exchange gain or loss realized under

paragraph (b)(15)(i) of this section is directly allocable to the

interest expense or interest income, respectively, from the debt

instrument or deposit (computed under this paragraph (b)), and

therefore reduces or increases the amount of interest income or

interest expense paid or accrued during that year with respect to that

instrument or deposit. With respect to a debt instrument or deposit

during a taxable year, to the extent exchange gain realized under

paragraph (b)(15)(i) of this section exceeds interest expense of an

issuer, or exchange loss realized under paragraph (b)(15)(i) of this

section exceeds interest income of a holder or depositor, the character

and source of such excess amount shall be determined under Secs. 1.988-

3 and 1.988-4.

(B) Special rule for subsiding hyperinflationary conditions. If the

taxpayer is an issuer of (or obligor under) a hyperinflationary debt

instrument or deposit and has currency loss, or if the taxpayer is a

holder of a hyperinflationary debt instrument or deposit and has

currency gain, then for purposes of subtitle A of the Internal Revenue

Code, the character and source of the currency gain or loss is

determined under Secs. 1.988-3 and 1.988-4. Thus, if an issuer has both

interest expense and currency loss, the currency loss is sourced and

characterized under section 988, and does not affect the determination

of interest expense.

(v) Adjustment to principal or basis. Any exchange gain or loss

realized under paragraph (b)(15)(i) of this section is an adjustment to

the functional currency principal amount of the issuer, functional

currency basis of the holder, or the functional currency amount of the

deposit. This adjusted amount or basis is used in making subsequent

computations of exchange gain or loss, computing the basis of assets

for purposes of allocating interest under Secs. 1.861-9T through 1.861-

12T and 1.882-5, or making other determinations that may be relevant

for computing taxable income or loss.

(vi) Definitions--(A) Hyperinflationary debt instrument. A

hyperinflationary debt instrument is a debt instrument that provides

for--

(1) Payments denominated in or determined by reference to a

currency that is hyperinflationary (as defined in Sec. 1.988-1(f)) at

the time the taxpayer enters into or otherwise acquires the debt

instrument; or

(2) Payments denominated in or determined by reference to a

currency that is hyperinflationary (as defined in Sec. 1.988-1(f))

during the taxable year, and the terms of the instrument provide for

the adjustment of principal or interest payments in a manner that

reflects hyperinflation. For example, a debt instrument providing for a

variable interest rate based on local conditions and generally

responding to changes in the local consumer price index will reflect

hyperinflation.

(B) Hyperinflationary deposit. A hyperinflationary deposit is a

demand or time deposit or similar instrument issued by a bank or other

financial institution that provides for--

(1) Payments denominated in or determined by reference to a

currency that is hyperinflationary (as defined in Sec. 1.988-1(f)) at

the time the taxpayer enters into or otherwise acquires the deposit; or

(2) Payments denominated in or determined by reference to a

currency that is hyperinflationary (as defined in Sec. 1.988-1(f))

during the taxable year, and the terms of the deposit provide for the

adjustment of the deposit amount or interest payments in a manner that

reflects hyperinflation.

(vii) Interaction with other provisions--(A) Interest allocation

rules. In determining the amount of interest expense, this paragraph

(b)(15) applies before Secs. 1.861-9T through 1.861-12T, and 1.882-5.

(B) DASTM. With respect to a qualified business unit that uses the

United States dollar approximate separate transactions method of

accounting described in Sec. 1.985-3, paragraph (b)(15)(i) of this

section does not apply.

(C) Interaction with section 988(a)(3)(C). Section 988(a)(3)(C)

does not apply to a debt instrument subject to the rules of paragraph

(b)(15)(i) of this section.

(D) Hedging rules. To the extent Sec. 1.446-4 or 1.988-5 apply, the

rules of paragraph (b)(15)(i) of this section will not apply. This

paragraph (b)(15)(vii)(D) does not apply if the application of

Sec. 1.988-5 results in hyperinflationary debt instrument or deposit

described in paragraph (b)(15)(vi)(A) or (B) of this section.

(viii) Effective date. This paragraph (b)(15) applies to

transactions entered into after February 14, 2000.

* * * * *

(d) * * *

(5) Hyperinflationary contracts--(i) In general. If a taxpayer

acquires or otherwise enters into a hyperinflationary contract (as

defined in paragraph (d)(5)(ii) of this section) that has payments to

be made or received that are denominated in (or determined by reference

to) a nonfunctional currency of the taxpayer, then the taxpayer shall

realize exchange gain or loss with respect to such contract for its

taxable year determined by reference to the change in exchange rates

between--

(A) The later of the first day of the taxable year, or the date the

contract was acquired or entered into; and

(B) The earlier of the last day of the taxable year, or the date

the contract is disposed of or otherwise terminated.

(ii) Definition of hyperinflationary contract. A hyperinflationary

contract is a contract described in paragraph (d)(1) of this section

that provides for payments denominated in or determined by reference to

a currency that is hyperinflationary (as defined in Sec. 1.988-1(f)) at

the time the taxpayer acquires or otherwise enters into the contract.

(iii) Interaction with other provisions--(A) DASTM. With respect to

a qualified business unit that uses the United States dollar

approximate separate transactions method of accounting described in

Sec. 1.985-3, this paragraph (d)(5) does not apply.

(B) Hedging rules. To the extent Sec. 1.446-4 or 1.988-5 apply,

this paragraph (d)(5) does not apply.

(C) Adjustment for subsequent transactions. Proper adjustments must

be made in the amount of any gain or loss subsequently realized for

gain or loss taken into account by reason of this paragraph (d)(5).

[[Page 2030]]

(iv) Effective date. This paragraph (d) (5) is applicable to

transactions acquired or otherwise entered into after February 14,

2000.

(e) * * *

(3) * * *

(iv) Coordination with Sec. 1.446-3(g)(4) regarding swaps with

significant nonperiodic payments. The rules of Sec. 1.446-3(g)(4) apply

to any currency swap with a significant nonperiodic payment. Section

1.446-3(g)(4) applies before this paragraph (e)(3). Thus, if

Sec. 1.446-3(g)(4) applies, currency gain or loss may be realized on

the loan. This paragraph (e)(3)(iv) applies to transactions entered

into after February 14, 2000.

* * * * *

(7) Special rules for currency swap contracts in hyperinflationary

currencies--(i) In general. If a taxpayer enters into a

hyperinflationary currency swap (as defined in paragraph (e)(7)(iv) of

this section), then the taxpayer realizes exchange gain or loss for its

taxable year with respect to such instrument determined by reference to

the change in exchange rates between--

(A) The later of the first day of the taxable year, or the date the

instrument was entered into (by the taxpayer); and

(B) The earlier of the last day of the taxable year, or the date

the instrument is disposed of or otherwise terminated.

(ii) Adjustment to principal or basis. Proper adjustments are made

in the amount of any gain or loss subsequently realized for gain or

loss taken into account by reason of this paragraph (e)(7).

(iii) Interaction with DASTM. With respect to a qualified business

unit that uses the United States dollar approximate separate

transactions method of accounting described in Sec. 1.985-3, this

paragraph (e)(7) does not apply.

(iv) Definition of hyperinflationary currency swap contract. A

hyperinflationary currency swap contract is a currency swap contract

that provides for--

(A) Payments denominated in or determined by reference to a

currency that is hyperinflationary (as defined in Sec. 1.988-1(f)) at

the time the taxpayer enters into or otherwise acquires the currency

swap; or

(B) Payments that are adjusted to take into account the fact that

the currency is hyperinflationary (as defined in Sec. 1.988-1(f))

during the current taxable year. A currency swap contract that provides

for periodic payments determined by reference to a variable interest

rate based on local conditions and generally responding to changes in

the local consumer price index is an example of this latter type of

currency swap contract.

(v) Special effective date for nonfunctional hyperinflationary

currency swap contracts. This paragraph (e)(7) applies to transactions

entered into after February 14, 2000.

* * * * *

Approved: December 13, 1999.

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

Jonathan Talisman,

Acting Assistant Secretary of the Treasury.

[FR Doc. 00-644 Filed 1-12-00; 8:45 am]

BILLING CODE 4830-01-P