Income and Currency Gain or Loss With Respect to a Qualified Business Unit

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-132422-17]

RIN 1545-BO07

Income and Currency Gain or Loss With Respect to a Qualified Business Unit

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Notice of proposed rulemaking and partial withdrawal of notice of proposed rulemaking.

SUMMARY:

This document contains proposed regulations relating to the determination of taxable income or loss and foreign currency gain or loss with respect to a qualified business unit. These proposed regulations include an election to treat all items of a qualified business unit as marked items (subject to a loss suspension rule), an election to recognize all foreign currency gain or loss with respect to a qualified business unit on an annual basis, and a new transition rule.

DATES:

Written or electronic comments and requests for a public hearing must be received by February 12, 2024.

ADDRESSES:

Commenters are strongly encouraged to submit public comments electronically via the Federal eRulemaking Portal at

https://www.regulations.gov

(indicate IRS and REG-132422-17) by following the online instructions for submitting comments. Requests for a public hearing must be submitted as prescribed in the “Comments and Requests for a Public Hearing” section. Once submitted to the Federal eRulemaking Portal, comments cannot be edited or withdrawn. The Department of the Treasury (Treasury Department) and the IRS will publish for public availability any comments submitted to the IRS's public docket. Send paper submissions to: CC:PA:01:PR (REG-132422-17), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044.

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed regulations generally, Raphael J. Cohen at (202) 317-6938; concerning consolidated groups, Jeremy Aron-Dine at (202) 317-6847; concerning submissions of comments, requests for a public hearing, and access to a public hearing, Vivian Hayes at (202) 317-5306 (not toll-free numbers) or by email to

publichearings@irs.gov

(preferred).

SUPPLEMENTARY INFORMATION:

Background

I. Overview

This document contains proposed regulations (the “proposed regulations”) under section 987 and related provisions under sections 861, 985 through 989, and 1502 of the Internal Revenue Code (“Code”). Section 987 applies to any taxpayer that has a qualified business unit (“QBU”) with a functional currency other than the dollar. Section 987(1) and (2) provide rules for determining and translating taxable income or loss (“section 987 taxable income or loss”) with respect to the QBU. In addition, foreign currency gain or loss must be determined under section 987(3) (“section 987 gain or loss”), which requires proper adjustments (as prescribed by the Secretary) for transfers of property between QBUs of the taxpayer having different functional currencies. Section 989(c) authorizes the Secretary to prescribe necessary and appropriate regulations, including regulations limiting the recognition of foreign currency loss on certain remittances from QBUs.

II. Regulations Addressing the Application of Section 987

A. 1991 Proposed Regulations and Notice 2000-20

On September 25, 1991, the Treasury Department and the IRS published in the

Federal Register

proposed regulations under section 987 (56 FR 48457, September 25, 1991) (“1991 proposed regulations”). The 1991 proposed regulations provided that section 987 taxable income or loss is computed in the QBU's functional currency and is translated into the taxpayer's functional currency at the weighted average exchange rate for the taxable year. For purposes of determining section 987 gain or loss, taxpayers were required to maintain an equity pool in the QBU's functional currency and a basis pool in the taxpayer's functional currency. The equity and basis pools were increased by the QBU's earnings and by capital contributed to the QBU, and they were reduced by remittances, losses, and other transfers from the QBU. Taxpayers recognized section 987 gain or loss at the time of a remittance or upon a termination of the QBU. The amount of section 987 gain or loss recognized was equal to the difference between the value of the remittance in the taxpayer's functional currency (translated at the applicable spot rate) and the portion of the basis pool attributable to the remittance. Thus, under the 1991 proposed regulations, section 987 gain or loss was determined by reference to a taxpayer's entire equity interest in a QBU. The 1991 proposed regulations reserved on the treatment of partnerships.

On April 3, 2000, the Treasury Department and the IRS issued Notice 2000-20, 2000-1 C.B. 851. The Notice expressed concern that the 1991 proposed regulations may not have achieved their goal of providing administrable rules that result in foreign currency gain and loss recognition under the appropriate circumstances. The Notice also identified certain abusive transactions that could inappropriately accelerate recognition of section 987 loss under the 1991 proposed regulations.

B. 2006 Proposed Regulations

1. Concerns Relating to the 1991 Proposed Regulations

On September 7, 2006, the Treasury Department and the IRS withdrew the 1991 proposed regulations and published in the

Federal Register

new proposed regulations under section 987 (71 FR 52876, September 7, 2006) (“2006 proposed regulations”). The preamble to the 2006 proposed regulations explained that the IRS had identified many cases in which taxpayers inappropriately claimed substantial section 987 losses resulting from the application of the 1991 proposed regulations when a QBU's functional currency depreciated relative to the functional currency of its owner. The 1991 proposed regulations also could create a “trap for the unwary” by requiring recognition of large section 987 gains when a QBU's functional currency appreciated.

These results arose because the 1991 proposed regulations imputed section 987 gain or loss to all assets and liabilities of a QBU, regardless of whether those assets and liabilities were economically exposed to currency fluctuations or had been subject to a realization event, and because the 1991 proposed regulations did not limit the selective recognition of section 987 losses. Consequently, under the 1991 proposed regulations, exchange rate fluctuations that, at most, had only an uncertain and remote effect on the economic results experienced by the owner of a QBU could give rise to substantial section 987 gains and losses that taxpayers could selectively recognize by strategically timing remittances or causing a termination of the QBU. For example, the 1991 proposed regulations provided taxpayers with substantial flexibility to

recognize section 987 losses selectively by causing QBUs with a weak functional currency to make remittances while avoiding remittances from QBUs with a strong functional currency that would give rise to gains.

2. Foreign Exchange Exposure Pool Method

To address the concerns relating to the 1991 proposed regulations, the 2006 proposed regulations provided a new method of applying section 987, referred to as the foreign exchange exposure pool (“FEEP”) method. Under the FEEP method, the owner of a QBU that is subject to section 987 (“section 987 QBU”) determines all items of income, gain, deduction, and loss attributable to the QBU in the QBU's functional currency, and then translates those items into the owner's functional currency. For this purpose, the basis of certain assets (referred to as “historic assets”) is translated at the exchange rate for the date on which the asset was acquired (the “historic rate”). For example, cost recovery deductions, such as depreciation, in respect of historic assets are translated at the historic rate. Other items (including the amount realized on a sale or exchange of a historic asset) are translated into the owner's functional currency at the average exchange rate for the taxable year.

In addition, the owner of a section 987 QBU must determine the pool of unrecognized section 987 gain or loss (“net unrecognized section 987 gain or loss”) based on the annual increase or decrease to the section 987 QBU's balance sheet that is attributable to foreign exchange rate fluctuations. The amount of section 987 gain or loss that is added to the pool each year is equal to the increase or decrease in the basis of assets (net of the amount of liabilities) of the section 987 QBU, measured in the owner's functional currency and adjusted for transfers between the section 987 QBU and its owner and section 987 taxable income or loss.

See

§ 1.987-4(d) of the 2006 proposed regulations. For this purpose, certain assets and liabilities (referred to as “historic items”) are translated into the owner's functional currency at the historic rate, while others (referred to as “marked items”) are translated into the owner's functional currency at the applicable spot rate. As a result, when translated into the owner's functional currency, the balance sheet value of marked items fluctuates when the QBU's functional currency strengthens or weakens, but the balance sheet value of historic items does not.

Marked items and historic items are defined by reference to section 988. A marked item is an asset or liability that would generate gain or loss under section 988 if it were held or entered into directly by the owner of the section 987 QBU but is not a section 988 transaction with respect to the QBU itself. A historic item is an asset or liability that is not a marked item. Thus, under the FEEP method, section 987 gain or loss reflects currency fluctuations with respect to marked items, which would be subject to section 988 in the hands of the QBU's owner. By contrast, section 987 gain or loss is not imputed to historic items that are not subject to section 988.

As a result of the use of a balance sheet approach, together with the use of historic rates for historic items, the FEEP method distinguishes between those items whose value is highly correlated with exchange rates and those items for which exchange rate fluctuations have no effect on value, or only an uncertain or remote effect that is more appropriately recognized upon a realization event with respect to that item. Unlike the 1991 proposed regulations, which imputed section 987 gain or loss to all assets and liabilities of a QBU, section 987 gain or loss under the FEEP method relates to those assets and liabilities that are economically exposed to currency fluctuations. The FEEP method also minimizes a taxpayer's ability to recognize large section 987 losses unrelated to its economic exposure and, thus, the need for a limitation on the selective recognition of such losses.

3. Partnerships

The 2006 proposed regulations applied section 987 to partnerships using an aggregate approach. Under this approach, an individual or corporation that is a partner in a partnership is treated as an indirect owner of a portion of the assets and liabilities of the partnership for purposes of section 987. If the partner indirectly owns a QBU with a functional currency different from that of the partner, the QBU is a section 987 QBU, and the partner determines and recognizes section 987 gain or loss with respect to the section 987 QBU under the FEEP method. An elective de minimis exception was provided for partners with a less than five percent interest in a partnership.

4. Transition Rules

The 2006 proposed regulations provided two alternative methods for taxpayers to transition from their prior method of applying section 987: the “deferral transition method” and the “fresh start transition method.” Under both transition methods, all the taxpayer's section 987 QBUs were deemed to terminate on the day before the transition date, and the owner was treated as having transferred each section 987 QBU's assets and liabilities to a new section 987 QBU on the transition date. The transition date was defined as the first day of the first taxable year to which the 2006 proposed regulations apply to a taxpayer.

Under the deferral transition method, section 987 gain or loss determined on the date of the deemed termination (under the taxpayer's prior method) was treated as net unrecognized section 987 gain or loss of the new section 987 QBU, which could be recognized on a remittance (or termination) in subsequent taxable years. The assets and liabilities that were deemed transferred to the section 987 QBU on the transition date (including marked assets and liabilities) were translated using historic rates, increased or decreased to take into account any amount treated as net unrecognized section 987 gain or loss determined with respect to the deemed termination. The deferral transition method thus preserved the taxpayer's section 987 gain or loss computed under its prior method and adjusted the applicable exchange rates to avoid double counting.

Under the fresh start transition method, section 987 gain or loss that would have been recognized under the taxpayer's prior method as a result of the deemed termination was neither recognized nor carried forward as net unrecognized section 987 gain or loss. The assets and liabilities that were deemed transferred to the section 987 QBU on the transition date (including marked assets and liabilities) were translated using historic rates without adjustment.

The fresh start transition method was designed to prevent recognition of non-economic section 987 gain or loss that was not recognized before the transition date. Because marked assets and liabilities were translated at historic rates under the fresh start transition method, any section 987 gain or loss inherent in those assets and liabilities would be added to the pool of net unrecognized section 987 gain or loss in the taxable year beginning on the transition date. However, exchange rate fluctuations with respect to historic items would not give rise to section 987 gain or loss. In addition, section 987 gain or loss attributable to items that were no longer reflected on the section 987 QBU's balance sheet on the transition date (for example, assets that

had been sold before the transition date) would never be taken into account.

Only taxpayers that were applying section 987(3) using a reasonable method before the transition date were permitted to use the deferral transition method. A taxpayer whose prior method was unreasonable, or that failed to make required determinations under section 987 in prior years, was required to use the fresh start transition method.

For this purpose, the preamble to the 2006 proposed regulations explained that the method of applying section 987 provided in the 1991 proposed regulations would be treated as a reasonable method. The preamble to the 2006 proposed regulations further stated that the use of an “earnings only” method would be treated as a reasonable method. Under an “earnings only” method, section 987 gain or loss is recognized on a distribution out of a QBU's earnings, but not on a distribution in excess of earnings (which represents a return of capital).

C. 2016 Final Regulations

On December 8, 2016, the Treasury Department and the IRS published final regulations (TD 9794) in the

Federal Register

(81 FR 88806, December 8, 2016) (the “2016 final regulations”). The 2016 final regulations largely adopt the FEEP method contained in the 2006 proposed regulations but modify those regulations to make the FEEP method easier for the IRS to administer and for taxpayers to apply. For example, the 2016 final regulations permit taxpayers to use the yearly average exchange rate as the historic rate applicable to historic items.

See

§ 1.987-3(c)(3). The 2016 final regulations also modify the computation of net unrecognized section 987 gain or loss for a taxable year by requiring adjustments for nondeductible expenses and tax-exempt income.

See

§ 1.987-4(d)(7) and (8).

The 2016 final regulations maintain the aggregate approach of the 2006 proposed regulations for partnerships. However, in response to comments relating to the complexity of the aggregate approach, the 2016 final regulations apply only to partnerships that are wholly owned by related persons (“section 987 aggregate partnerships”). The preamble to the 2016 final regulations indicated that the treatment of other partnerships under section 987 would be addressed separately and such partnerships might be subject to a different approach.

The 2016 final regulations require taxpayers to transition using the fresh start transition method.

See

§ 1.987-10. The Treasury Department and the IRS were concerned that an election between two transition methods (as permitted under the 2006 proposed regulations) would result in a whipsaw to the fisc, because each taxpayer could choose the method that produces more section 987 loss and less section 987 gain (as was noted by comments on the 2006 proposed regulations). The Treasury Department and the IRS were also concerned about administrative difficulties and planning opportunities associated with adjustments to the translation rate under the deferral transition method.

Section 1.987-11(a) provides that the 2016 final regulations generally apply to taxable years beginning on or after one year after the first day of the first taxable year following December 7, 2016. However, taxpayers could choose to apply them to an earlier taxable year under § 1.987-11(b).

D. 2016 Temporary and Proposed Regulations

On December 8, 2016, the Treasury Department and the IRS published Treasury Decision 9795 (the “temporary regulations”) in the

Federal Register

(81 FR 88854, December 8, 2016) and published a notice of proposed rulemaking (81 FR 88882, December 8, 2016) (the “2016 proposed regulations”) in the

Federal Register

by cross-reference to the temporary regulations. The temporary regulations (other than § 1.987-12T) had the same applicability date as the 2016 final regulations.

The temporary regulations and the 2016 proposed regulations include: (1) rules relating to the recognition and deferral of section 987 gain or loss in connection with certain QBU terminations and certain other transactions involving partnerships; (2) an annual deemed termination election; (3) an elective method, available to taxpayers that make the annual deemed termination election, for translating all items of income or loss with respect to a section 987 QBU at the yearly average exchange rate; (4) rules regarding the treatment of section 988 transactions of a section 987 QBU; (5) rules regarding QBUs with the U.S. dollar as their functional currency; (6) rules regarding combinations and separations of section 987 QBUs; (7) rules regarding the translation of income used to pay creditable foreign income taxes; (8) rules regarding the allocation of assets and liabilities of certain partnerships for purposes of section 987; and (9) rules requiring the deferral of certain section 988 loss that arises with respect to related-party loans.

Under the annual deemed termination election provided in the temporary regulations, a taxpayer could elect to deem all of its section 987 QBUs to terminate on the last day of each taxable year, resulting in the recognition of all net unrecognized section 987 gain or loss on an annual basis.

See

§ 1.987-8T(d). The assets and liabilities of a section 987 QBU subject to the election were deemed to be distributed to the owner pursuant to the deemed termination on the last day of each taxable year and recontributed on the first day of the following taxable year. The temporary regulations further provided that a taxpayer who made an annual deemed termination election could elect to translate all items of section 987 taxable income or loss at the yearly average exchange rate.

See

§ 1.987-3T(d).

The temporary regulations (other than those finalized or withdrawn in 2019, as described in part II.E of this Background section) expired on December 6, 2019. The Treasury Department and the IRS intend to remove the temporary regulations from the

Federal Register

when the proposed regulations are finalized.

The following parts of the 2016 proposed regulations remain outstanding: (1) rules regarding the treatment of section 988 transactions of a section 987 QBU (

see

§§ 1.987-1, 1.987-3, and 1.988-1 of the 2016 proposed regulations); (2) rules regarding QBUs with the U.S. dollar as their functional currency (

see

§§ 1.987-1 and 1.987-6 of the 2016 proposed regulations); (3) rules regarding the translation of income used to pay creditable foreign income taxes (

see

§ 1.987-3 of the 2016 proposed regulations); and (4) rules requiring the deferral of certain section 988 loss that arises with respect to related-party loans (

see

§ 1.988-2 of the 2016 proposed regulations). A notice reopening the comment period for the parts of the 2016 proposed regulations that remain outstanding is published in this issue of the

Federal Register

.

E. 2019 Final Regulations

On May 13, 2019, the Treasury Department and the IRS published Treasury Decision 9857 (84 FR 20790, May 13, 2019) (the “2019 final regulations” and, collectively with the 2016 final regulations, the “final regulations”) in the

Federal Register

. The 2019 final regulations finalized parts of the 2016 proposed regulations relating to combinations and separations of section 987 QBUs and the recognition and deferral of section 987 gain or loss in connection with certain QBU terminations and certain other transactions involving partnerships. The 2019 final regulations also withdrew

§ 1.987-7T of the temporary regulations, relating to the allocation of assets and liabilities of a section 987 aggregate partnership to its partners for purposes of section 987, in response to comments noting that these rules could cause distortions in the computation of section 987 gain or loss. The 2019 final regulations (other than § 1.987-12) have the same applicability date as the 2016 final regulations.

III. Executive Order 13789 and Interim Report to the President

Executive Order 13789, issued on April 21, 2017, instructs the Secretary of the Treasury (the “Secretary”) to review all significant tax regulations issued on or after January 1, 2016, and to take action to mitigate the burden of regulations that, in relevant part, impose an undue financial burden on U.S. taxpayers or add undue complexity to the Federal tax laws. The Executive order further instructs the Secretary to submit two reports to the President: an interim report that identifies regulations that meet the criteria described in the Executive order; and a report that recommends specific actions to mitigate the burden imposed by regulations identified in the interim report.

In an interim report to the President dated June 22, 2017, the Treasury Department identified eight regulations, including the 2016 final regulations, as meeting at least one of the criteria described in the Executive order. In Notice 2017-38, 2017-30 I.R.B. 147, which was published on July 24, 2017, the Treasury Department and the IRS requested comments on whether the regulations identified in the interim report (including the 2016 final regulations) should be rescinded or modified and, if not rescinded, how the regulations should be modified to reduce the burden and complexity.

The Treasury Department and the IRS received several comments in response to Notice 2017-38. In addition, one comment was submitted in response to Notice 2017-57, 2017-42 I.R.B. 325 (which was the first of the deferral notices described in part V of this Background section). The comments that are relevant to the proposed regulations are discussed in the Explanation of Provisions.

IV. Second Report to the President on Identifying and Reducing Tax Regulatory Burdens

On October 16, 2017, the Secretary published a report (the “Report”) in the

Federal Register

(82 FR 48013, October 16, 2017) recommending specific actions to mitigate the burden imposed by the regulations identified in the interim report. The Report stated that the Treasury Department and the IRS intend to propose modifications to the 2016 final regulations and to issue guidance permitting taxpayers to elect to defer the application of §§ 1.987-1 through 1.987-10.

In particular, the Report stated that, in response to comments, the Treasury Department and the IRS intend to propose rules that would permit taxpayers to elect to adopt a simplified method of calculating section 987 gain or loss and translating section 987 taxable income or loss, subject to certain limitations on the recognition of section 987 loss. One simplified method discussed in the Report would allow a taxpayer to treat all assets and liabilities of a section 987 QBU as marked items and to translate all items of income and expense at the average exchange rate for the taxable year. Under this method, the amount of section 987 gain or loss would generally be consistent with the amount determined under the 1991 proposed regulations and would more closely conform to the applicable financial accounting rules.

The Report also noted that the Treasury Department and the IRS were considering limitations on the recognition of section 987 loss that would apply to taxpayers using the simplified method. Two potential limitations were mentioned in the Report: (1) a rule that would allow the electing taxpayer to recognize net section 987 loss only to the extent of net section 987 gain recognized in prior or subsequent years; and (2) a rule that would defer the recognition of all section 987 gain or loss until the earlier of (i) the year that the trade or business conducted by the section 987 QBU ceases to be performed by any member of its controlled group or (ii) the year that substantially all of the assets and activities of the QBU are transferred outside of the controlled group.

Finally, the Report stated that the Treasury Department and the IRS were considering alternative transition rules. One alternative would allow taxpayers to carry forward unrealized section 987 gains and losses (measured on the transition date with appropriate adjustments), and a second alternative would allow taxpayers to translate all items of the section 987 QBU at the spot rate on the transition date without carrying forward any unrecognized section 987 gain or loss.

V. Deferral Notices

The Treasury Department and the IRS have issued several notices stating that future guidance would defer the applicability dates of the 2016 final regulations, §§ 1.987-2(c)(9) and 1.987-4(c)(2) and (f) of the 2019 final regulations (the “related 2019 final regulations”), and §§ 1.987-1T (other than §§ 1.987-1T(g)(2)(i)(B) and (g)(3)(i)(H)) through 1.987-4T, 1.987-6T, 1.987-7T, 1.988-1T, and 1.988-2T(i) of the temporary regulations. Most recently, on August 22, 2022, Notice 2022-34, 2022-34 I.R.B. 150, announced that future guidance would defer the applicability date of the 2016 final regulations and the related 2019 final regulations by one additional year to taxable years beginning after December 7, 2023. Thus, following the amendments described in that Notice, the 2016 final regulations and the related 2019 final regulations would first apply to the taxable year beginning on January 1, 2024, for calendar year taxpayers. The applicability date of § 1.987-12 would not be affected by these amendments.

VI. Financial Accounting Rules

The rules of the final regulations under section 987 differ from the U.S. generally accepted accounting principles (“U.S. GAAP”) relating to foreign currency translation gain or loss.

1

For financial accounting purposes, the consolidated financial statements of a reporting entity may include operations denominated or measured in currencies other than the reporting currency (each such operation, a foreign entity),

2

resulting in the need to translate those operations into the reporting currency of the reporting entity. FASB, 2023, ASC par. 830-10-10-1. The assets and liabilities and other elements, such as revenues and expenses, of the financial statements of a foreign entity are translated to the reporting currency using a current exchange rate. FASB, 2023, ASC pars. 830-30-45-3 through 830-30-45-5. For example, assets and liabilities of the foreign entity are translated into the reporting currency using the spot rate on the balance sheet date. Translation adjustments resulting from the process of translating a foreign entity's financial statements to the reporting currency are not included in determining net income

but are reported in the cumulative translation adjustment (CTA), which is part of other comprehensive income, included in the in the equity section of the reporting entity's consolidated balance sheet. FASB, 2023, ASC par. 830-30-45-12. Upon the sale or liquidation of the investment in the foreign entity, the CTA attributable to that foreign entity is removed from equity and is reported as part of the gain or loss on the sale or liquidation of the investment. FASB, 2023, ASC par. 830-30-40-1.

1

The relevant U.S. GAAP financial accounting rules are contained in Financial Accounting Standards Board (“FASB”), Accounting Standards Codification (“ASC”), Foreign Currency Matters, Topic 830 (formerly known as FASB Statement No. 52, Foreign Currency Translation).

2

A foreign entity is an operation, including a subsidiary, division, and branch, whose financial statements are both (a) prepared in a currency other than the reporting currency of the reporting entity, and (b) combined or consolidated with or accounted for on the equity basis in the financial statements of the reporting entity. FASB, 2023, ASC sec. 830-10-20.

The treatment of translation gain or loss under FASB, ASC Topic 830, under which translation gain or loss is deferred until a sale or liquidation, differs from the requirements of section 987(3), under which a taxpayer is required to make proper adjustments for the transfer of property between QBUs of a taxpayer by including section 987 gain or loss in income upon a remittance. Further, in contrast to the translation adjustments in the financial accounting rules, which apply to all assets and liabilities of a foreign entity, the FEEP method imputes section 987 gain or loss only to marked items of a section 987 QBU and requires the basis of historic assets to be translated at historic rates for purposes of computing section 987 taxable income or loss.

Explanation of Provisions

The proposed regulations retain the basic approach and structure of the final regulations, while adopting a number of the simplifications discussed in the Report and providing additional guidance regarding the determination of section 987 taxable income or loss and section 987 gain or loss.

I. FEEP Method

As explained in parts II.B and II.C of the Background section, the final regulations provide that section 987 gain or loss and section 987 taxable income or loss are determined under the FEEP method. This method uses a balance sheet approach to determine section 987 gain or loss. In addition, historic items are translated at historic rates (both for purposes of determining section 987 gain or loss and for purposes of translating recovery of basis with respect to historic assets in computing section 987 taxable income or loss). As a result, the FEEP method does not impute section 987 gain or loss to historic items, for which exchange rate changes have only an uncertain or remote effect on value that is more appropriately recognized upon a realization event.

Several comments asserted that the FEEP method is overly complex and presents significant compliance burdens, primarily related to the treatment of historic items. Comments stated that, because the requirement to use historic rates to translate historic items diverges from financial accounting rules, taxpayers would need to keep a separate set of books with respect to each section 987 QBU and to develop costly reporting systems to maintain information that is not used for any other purpose.

Comments recommended that, to reduce the complexity and administrative burden of the final regulations, taxpayers should be permitted to apply a method similar to that provided in the 1991 proposed regulations. Comments noted that this method could be coupled with rules to prevent the selective recognition of section 987 losses, as discussed in part III of this Explanation of Provisions.

The proposed regulations retain the FEEP method of the 2016 final regulations, with modifications discussed in this Explanation of Provisions, as the default rule for determining section 987 taxable income or loss and net unrecognized section 987 gain and loss.

See

proposed §§ 1.987-3 and 1.987-4. The FEEP method is an appropriate default rule because it generally provides a more precise measure of section 987 gain or loss. Moreover, the enactment of the Tax Cuts and Jobs Act, Public Law 115-97, 131 Stat. 2054 (2017), on December 22, 2017, has made it even more important to accurately calculate taxable income with respect to a section 987 QBU. For example, section 951A, relating to global intangible low-taxed income (“GILTI”), has significantly expanded the scope of taxable income of a controlled foreign corporation (“CFC”) that is subject to current U.S. taxation.

3

3

Previously, section 987 gain or loss recognized by a CFC generally would be taken into account in determining a U.S. shareholder's taxable income only if a portion of the section 987 gain or loss affected the calculation of subpart F income or when the earnings of the CFC were relevant, such as on a distribution or sale.

In addition, because the 2016 final regulations permit the yearly average exchange rate to be used as the historic rate, a taxpayer that knows the year in which an asset was acquired or placed in service can determine the applicable historic rate based on publicly available information. Information relating to the year in which an asset was acquired or placed in service is often tracked for other reasons, including for purposes of computing depreciation and amortization. For example, in computing a CFC's qualified business asset investment, section 951A(d)(3)(A) now requires the adjusted basis of assets to be determined using the alternative depreciation system under section 168(g).

However, the Treasury Department and the IRS acknowledge that in some cases it may be burdensome to translate the basis of each historic asset using a different historic rate (including for purposes of depreciation) in determining section 987 taxable income or loss. Accordingly, as described in parts II and IV of this Explanation of Provisions, the proposed regulations provide several simplifying elections that permit section 987 to be applied in a way that more closely conforms to the financial accounting rules and reduces the compliance burden. Taxpayers who make these elections would still compute section 987 gain or loss by reference to the year-end balance sheet of the section 987 QBU (though the computation would be modified, as described in part V of this Explanation of Provisions). The proposed regulations do not include an election to use the method prescribed in the 1991 proposed regulations, because the use of fundamentally different computational methods by different taxpayers (or by the same taxpayer in different years) would increase the complexity of the section 987 regulations and make them more difficult to administer.

II. Current Rate Election

As discussed in part I of this Explanation of Provisions section, comments noted that the compliance burden associated with the FEEP method relates primarily to the treatment of historic items. Under the 2016 final regulations, taxpayers are required to track the historic rate for historic items and to use the historic rate for purposes of computing section 987 taxable income or loss and section 987 gain or loss.

To alleviate this compliance burden, proposed § 1.987-1(d)(2) would provide an election to treat all items that are properly reflected on the books and records of a section 987 QBU as marked items (the “current rate election”). If a current rate election applies, all items of income, gain, deduction, and loss with respect to a section 987 QBU would be translated at the yearly average exchange rate for the current taxable year for purposes of computing section 987 taxable income or loss.

See

proposed § 1.987-3(c)(2). In addition, all items of a section 987 QBU would be translated at the year-end spot rate for purposes of computing section 987 gain or loss.

The current rate election is expected to produce an amount of section 987

gain or loss and section 987 taxable income or loss that is similar to the amounts determined under the 1991 proposed regulations. If a current rate election is made, all assets and liabilities of a section 987 QBU would generate section 987 gain or loss, in conformity with the approach used for financial reporting purposes and the 1991 proposed regulations.

In general, a current rate election would increase the pool of net unrecognized section 987 gain or loss with respect to a section 987 QBU (relative to the pool that would be determined without the current rate election). In addition, under a current rate election amounts in the pool may substantially exceed any economic gain or loss attributable to currency fluctuations. The Treasury Department and the IRS are concerned that without appropriate limitation, the current rate election would facilitate the abuses and inappropriate outcomes that occurred under the 1991 proposed regulations, including the potential for taxpayers to choose to recognize significant, and potentially uneconomic, section 987 losses while avoiding or deferring section 987 gains. Accordingly, the proposed regulations include a rule that would suspend the recognition of section 987 loss when a current rate election is in effect. See part III of this Explanation of Provisions.

III. Suspension of Section 987 Loss Under a Current Rate Election

Comments discussed several options for addressing the potential for selective recognition of section 987 losses. First, comments asserted that certain rules provided in the 2016 final regulations (for example, the annual netting of contributions and distributions to determine the amount of a remittance under § 1.987-5(c)) would be sufficient to prevent abuse. Alternatively, comments recommended that the recognition of section 987 gain or loss be deferred until a QBU is terminated or its assets are sold to an unrelated party, consistent with the financial accounting rules. Comments also suggested that section 987 loss could be deferred until the owner recognizes an equal or greater amount of section 987 gain from the same QBU. Finally, some comments proposed a “lookback” approach, under which section 987 loss would be deferred only to the extent that the loss exceeded section 987 gain previously recognized with respect to the same section 987 QBU.

The Treasury Department and the IRS are concerned that, notwithstanding the annual netting rule of § 1.987-5(c) and the other rules provided in the 2016 final regulations, taxpayers generally have a significant degree of control over whether and when their section 987 QBUs make remittances and, therefore, could still selectively recognize section 987 losses. In addition, because taxpayers that make a current rate election are expected to have substantial pools of net unrecognized section 987 gain or loss, special rules are needed to prevent the selective recognition of losses.

Accordingly, if a current rate election is in effect, the proposed regulations generally would suspend the recognition of section 987 loss until a taxable year in which an equal or greater amount of section 987 gain is recognized (as described in part III.A of this Explanation of Provisions) or until the occurrence of certain recognition events (as described in part III.B of this Explanation of Provisions).

A. General Rules Relating to Suspended Section 987 Loss

1. In General

In a taxable year in which a current rate election applies, any section 987 loss that would otherwise be recognized as a result of a remittance (including a deemed remittance resulting from the termination of a section 987 QBU) is treated as suspended section 987 loss. Proposed § 1.987-11(c). In general, an owner of a section 987 QBU would recognize suspended section 987 loss in a taxable year in which the owner recognizes section 987 gain that has the same source and character as the suspended section 987 loss (the “loss-to-the-extent-of-gain rule”). Proposed § 1.987-11(e). Whether section 987 gain has the same source and character as suspended section 987 loss would be determined on the basis of the initial assignment in proposed § 1.987-6(b)(2)(i).

See

proposed § 1.987-11(e)(1) and (f).

The Treasury Department and the IRS considered applying the loss-to-the-extent-of-gain rule at the QBU level, such that suspended section 987 loss with respect to a section 987 QBU would be recognized only to the extent of section 987 gain recognized with respect to the same section 987 QBU (as was recommended by some comments). However, the Treasury Department and the IRS were concerned that a QBU-level limitation would be overly restrictive. Moreover, if an owner has suspended section 987 loss with respect to one QBU, the concern of selective loss recognition may be mitigated to the extent that the same owner recognizes section 987 gain with respect to another QBU.

Therefore, under the proposed regulations, the loss-to-the-extent-of-gain rule applies at the owner level. An owner of a section 987 QBU recognizes suspended section 987 loss to the extent that it recognizes section 987 gain, regardless of which QBU generates the gain. However, because this rule applies at the owner level, the Treasury Department and the IRS were concerned that an owner might trigger the recognition of section 987 gain that is not subject to residual U.S. tax (or is taxed at a low rate) to release suspended section 987 loss of a different source or character. Accordingly, proposed § 1.987-11(e)(1) provides that an owner does not recognize suspended section 987 loss until it recognizes section 987 gain in the same recognition grouping as the suspended section 987 loss.

In general, section 987 gain and suspended section 987 loss are in the same recognition grouping if they are both initially assigned to U.S. source income or to foreign source income in the same section 904 category. Proposed § 1.987-11(f)(1). In addition, if the owner of a section 987 QBU is a CFC, in order to be in the same recognition grouping, section 987 gain and suspended section 987 loss must both be initially assigned to the same statutory and residual grouping of subpart F income, tentative tested income, income described in section 952(b) (certain income that is effectively connected with the conduct of a trade or business within the United States (“ECI”) and excluded from subpart F income), or other income.

4

Proposed § 1.987-11(f)(2).

4

See part VI of this Explanation of Provisions (requesting comments concerning the treatment of section 987 gain or loss as ECI).

Suspended section 987 loss that is not recognized in a taxable year is recognized in the next taxable year in which (and to the extent that) the owner recognizes section 987 gain in the same recognition grouping. The Treasury Department and the IRS also considered a lookback rule, under which suspended section 987 loss could be recognized to the extent that section 987 gain was recognized in a prior taxable year. However, a lookback rule would permit taxpayers to selectively trigger section 987 gain in taxable years in which such gain would not give rise to additional U.S. tax (for example, because the gain is offset by losses or because the additional U.S. tax is offset with foreign tax credits). In light of these concerns, the Treasury Department and the IRS request comments regarding, if a lookback rule were to be adopted, how to prevent section 987 gain that has no

net effect on U.S. tax from releasing suspended section 987 loss that reduces U.S. tax.

2. Suspension of Section 987 Loss When an Annual Recognition Election Is Made

In general, a taxpayer who makes an annual recognition election will recognize the full amount of net unrecognized section 987 gain or loss that is added to the pool each year. If an annual recognition election and a current rate election are both in effect for a taxable year, section 987 loss generally would not be suspended under proposed § 1.987-11(c). See part IV of this Explanation of Provisions.

The Treasury Department and the IRS are concerned that taxpayers who are subject to a current rate election might seek to avoid the application of the loss-to-the-extent-of-gain rule by making an annual recognition election after net unrecognized section 987 loss has accrued. Similarly, the Treasury Department and the IRS are concerned that taxpayers that have not made a current rate election, but which have substantial pools of net unrecognized section 987 loss, might make an annual recognition election to recognize the loss without the need for a remittance. Accordingly, the proposed regulations would treat any net accumulated unrecognized section 987 loss and deferred section 987 loss as suspended section 987 loss in the first year in which an annual recognition election takes effect if either (1) a current rate election was in effect in the previous year or (2) the owner had more than $5 million of net section 987 losses. Proposed § 1.987-11(d).

3. Recognition of Suspended Section 987 Loss When an Annual Recognition Election Is in Effect

The proposed regulations also contain a special rule relating to the recognition of suspended section 987 loss when a current rate election and an annual recognition election are both in effect. The Treasury Department and the IRS are concerned that, absent a modification to the general loss-to-the-extent-of-gain rule in proposed § 1.987-11(e)(1), taxpayers that have suspended section 987 loss would get an unwarranted benefit from making an annual recognition election. Specifically, absent a modification, these taxpayers would be able to recognize suspended section 987 loss even if they had net losses on a cumulative basis for the taxable years to which the annual recognition election applied.

For example, assume that an owner of a section 987 QBU has suspended section 987 loss of $400 that arose in prior years (for example, under a current rate election). The owner's functional currency is the U.S. dollar, and the section 987 QBU's functional currency is the euro. In year 1, the owner makes an annual recognition election. The euro weakens in year 1 and partially recovers in year 2. As a result of the annual recognition election, the owner recognizes section 987 loss of $200 in year 1 and recognizes section 987 gain of $150 in year 2. Under the general loss-to-the-extent-of-gain rule in § 1.987-11(e)(1), even though the owner recognized net section 987 loss of $50 on a cumulative basis (over years 1 and 2), the owner would recognize suspended section 987 loss equal to the section 987 gain in the same recognition grouping that it recognizes in year 2. Assuming all of the section 987 gain or loss is in the same recognition grouping, the owner would recognize $350 of total section 987 loss (equal to $200 of section 987 loss recognized under the annual recognition election in year 1 and $150 of suspended section 987 loss recognized under the loss-to-the-extent-of-gain rule in year 2), even though it recognizes only $150 of section 987 gain.

Accordingly, if a taxpayer makes both an annual recognition election and a current rate election, the loss-to-the-extent-of-gain rule would apply by reference to the net cumulative amount of section 987 gain in each recognition grouping that is recognized by the taxpayer during the relevant testing period (rather than the gross amount recognized each taxable year). Proposed § 1.987-11(e)(2). The testing period generally is the period in which section 987 loss is suspended and both a current rate election and an annual recognition election are in effect. Proposed § 1.987-11(e)(2)(iii). The Treasury Department and the IRS request comments on whether any modifications to the limitation in proposed § 1.987-11(e)(2) would allow for simplification while preventing inappropriate outcomes.

B. Suspended Section 987 Loss Recognized or Attributed to a Successor on Termination

The proposed regulations provide a successor rule that applies when a section 987 QBU with suspended section 987 loss terminates. Under the successor rule, suspended section 987 loss is not recognized in the taxable year of termination, but instead becomes attributable to a successor suspended loss QBU.

For this purpose, an eligible QBU is treated as a successor of a section 987 QBU if it holds a significant portion of the assets of the section 987 QBU following its termination, is engaged in the same trade or business, and is owned by the owner of the section 987 QBU or a member of the owner's controlled group. Proposed § 1.987-13(b)(1). For this purpose, any eligible QBU may qualify as a successor, whether or not it is a section 987 QBU (that is, whether or not it has a different functional currency than its owner). Thus, for example, if an owner of a section 987 QBU with suspended section 987 loss contributes the assets of the section 987 QBU to a subsidiary where they are held by an eligible QBU of the subsidiary that uses them in the same trade or business (the “subsidiary QBU”), the subsidiary QBU is a successor suspended loss QBU even if it is not a section 987 QBU. Similar principles apply when a successor terminates. Proposed § 1.987-13(c)(1).

If a section 987 QBU (or its successor) terminates without a successor, the original owner of the section 987 QBU recognizes all of its suspended section 987 loss with respect to the section 987 QBU (or its successor). Proposed § 1.987-13(b)(2) and (c)(2). Therefore, an owner generally would recognize suspended section 987 loss when it transfers the section 987 QBU's assets to an unrelated party or the section 987 QBU ceases its trade or business (such that there is no successor suspended loss QBU). These events are similar to the events that result in a release of the CTA for financial reporting purposes. Moreover, the Treasury Department and the IRS expect that taxpayers would be less likely to sell or wind up the trade or business of a section 987 QBU for the purpose of selectively recognizing section 987 losses and, accordingly, there is less of a need for continued suspension of section 987 loss after these events occur.

In addition, suspended section 987 loss is recognized if the owner of the successor ceases to be related to the original owner of the suspended loss QBU due to a direct or indirect transfer of interests in the owner of the successor. Proposed § 1.987-13(d). If the owner of a successor suspended loss QBU ceases to be related to the original owner of the section 987 QBU for a different reason (for example, due to a transfer of interests in the original owner of the suspended loss QBU), the successor suspended loss QBU is no longer treated as a successor, and suspended section 987 loss can no longer be recognized in connection with a termination (though it can still be recognized under the loss-to-the-extent-of-gain rule). Proposed § 1.987-13(e).

This rule is intended to prevent taxpayers from transferring the stock of the original owner out of its controlled group for the purpose of selectively recognizing suspended section 987 loss, while leaving behind the assets and activities of the section 987 QBU in the hands of a different controlled group member.

Similarly, suspended section 987 loss is not recognized when the owner of a section 987 QBU liquidates in a transaction described in section 331. Proposed § 1.987-13(f). Instead, suspended section 987 loss that is not recognized in the taxable year of the liquidation is eliminated and will never be recognized. This rule is intended to prevent taxpayers from entering into section 331 transactions in order to trigger the recognition of suspended section 987 loss. For example, a U.S. shareholder could cause an upper-tier CFC that owns a section 987 QBU with suspended section 987 loss to transfer all of its assets and liabilities to a lower-tier CFC in a section 351 contribution, and then cause the upper-tier CFC to liquidate in a transaction described in section 331 in order to recognize the suspended loss. The Treasury Department and the IRS are aware that similar transactions have been used to claim large section 987 losses under current law.

In the case of a combination or separation, the suspended section 987 loss of a combined or separated QBU is determined under rules similar to those applicable to net accumulated unrecognized section 987 gain or loss under proposed § 1.987-4(f). Proposed § 1.987-11(b)(2) and (3). Therefore, the suspended section 987 loss of a separating QBU is allocated to the separated QBUs in proportion to the assets properly reflected on the books and records of each separated QBU after the separation. Proposed § 1.987-11(b)(3)

C. Special Rule for Inbound Liquidations and Reorganizations

Under the proposed regulations, if a foreign corporation liquidates or merges into a domestic corporation in a section 381(a) transaction, the domestic corporation does not succeed to or take into account any unused suspended section 987 loss of the foreign corporation. Proposed § 1.987-13(g). This rule is intended to prevent the importation of suspended section 987 loss that was generated offshore. Due to differences in how income of a CFC is taxed to its U.S. shareholders, these losses may relate to income subject to tax at a significantly reduced effective rate. For example, a suspended section 987 loss that is allocated and apportioned to the other income grouping under proposed § 1.987-6 may effectively reduce only earnings that would typically not be subject to current U.S. tax, and which may be eligible for a dividends received deduction under section 245A upon distribution. As a result, depending on the particular facts, such losses may have little or no impact on the U.S. tax liability of a CFC's U.S. shareholder when they are recognized and are generally not equivalent to the section 987 gains or losses typical of a domestic corporation.

Furthermore, even if the domestic corporation could, in theory, succeed to the suspended section 987 loss, the loss may have been assigned to an income group, such as the tested income group, that is not relevant to a domestic corporation, in which case, it would be highly unlikely that the suspended section 987 loss could ever be used (absent a subsequent outbound asset transfer by the domestic corporation to a foreign successor) under the loss-to-the-extent-of-gain rule because the domestic corporation would not recognize section 987 gain in the same recognition grouping.

D. Rejection of Financial Accounting Deferral Rule

The Treasury Department and the IRS also considered a rule that would defer the recognition of all section 987 gain and loss of a section 987 QBU until a taxable year in which the section 987 QBU's trade or business ceases to be performed by any member of the controlled group or substantially all of the assets and activities of the QBU are transferred outside of the controlled group. This approach would more closely parallel the rules for determining when the CTA is released for financial accounting purposes.

However, the loss limitation rule provided in the proposed regulations is more consistent with the statutory provisions of section 987(3), which contemplates the recognition of section 987 gain or loss at the time of a remittance, and section 989(c)(2), which authorizes regulations limiting the recognition of foreign currency loss on certain remittances. Moreover, the Treasury Department and the IRS are concerned that a rule that defers the recognition of all section 987 gain or loss may be difficult to administer. For example, as a practical matter, taxpayers might not properly track section 987 gain or loss on an annual basis if it is not expected to be recognized in the foreseeable future and the sale or liquidation of a section 987 QBU might occur many years after the accrual of section 987 gain or loss (at which time the necessary records may no longer be available).

IV. Annual Recognition Election

A. Annual Deemed Termination Election Provided in the 2016 Temporary and Proposed Regulations

As explained in part II.D of the Background section, the 2016 temporary and proposed regulations contained an annual deemed termination election. Under this election, a section 987 QBU would be deemed to terminate on the last day of each taxable year, resulting in the remittance of all the gross assets of the section 987 QBU to its owner and the recognition of all net unrecognized section 987 gain or loss on an annual basis.

See

§§ 1.987-8T(d) and 1.987-8(e). The assets and liabilities of a section 987 QBU subject to the election would then be deemed to be contributed to the section 987 QBU on the first day of the following taxable year.

See

§ 1.987-8T(d).

A comment asserted that it was difficult to apply the rules under the annual deemed termination election. If the election was made, a section 987 QBU's historic assets and the amount of its historic liabilities would be translated at the end of each year into the owner's functional currency using historic rates (due to the deemed termination and remittance); the historic rate would generally be the yearly average exchange rate for the year of the deemed termination. The assets and liabilities would then be retranslated into the section 987 QBU's functional currency at the beginning of the following taxable year at the yearly average exchange rate for the following taxable year (due to the deemed contribution).

See

§§ 1.987-2(d)(2) and 1.987-5(f)(3). As a result, the basis of a section 987 QBU's assets and the amount of its liabilities (determined in the section 987 QBU's functional currency) generally would change from one year to the next, which would increase the compliance burden of applying the section 987 regulations.

B. Annual Recognition Election Provided in the Proposed Regulations

The proposed regulations would replace the annual deemed termination election with an annual recognition election. Like the annual deemed termination election, an owner that makes the annual recognition election would recognize the full amount of net unrecognized section 987 gain or loss each year. However, the proposed annual recognition election does not result in a deemed termination of a

section 987 QBU and a deemed remittance of its assets or a deemed contribution to the section 987 QBU. Instead, the owner of a section 987 QBU simply recognizes the full amount of its net unrecognized section 987 gain or loss on an annual basis. Therefore, the annual recognition election would not alter the functional currency basis of a section 987 QBU's assets, the amount of its liabilities, or their historic exchange rates.

C. Special Rules That Apply When a Current Rate Election and an Annual Recognition Election Are Both in Effect

The annual recognition election is available to owners whether or not they make a current rate election. If an owner makes both an annual recognition election and a current rate election for a taxable year, the loss suspension rule described in part III of this Explanation of Provisions does not apply to net unrecognized section 987 loss accrued while the election is in effect. Because the annual recognition election requires both gains and losses to be recognized without regard to whether a remittance occurs, selective recognition of losses is not possible and, accordingly, a loss limitation should not be needed. However, see part III.A.3 of this Explanation of Provisions regarding the application of the loss-to-the-extent-of-gain rule when an annual recognition election is in effect.

D. Translation of Taxable Income Under an Annual Recognition Election When a Current Rate Election Is Not in Effect

If an owner of a section 987 QBU makes an annual recognition election, but does not make a current rate election, section 987 taxable income or loss is determined by translating all items at the yearly average exchange rate. Unlike under the 2016 temporary and proposed regulations, this rule is mandatory (rather than elective). Use of the yearly average exchange rate simplifies the determination of section 987 taxable income or loss without sacrificing accuracy and is consistent with financial accounting principles. Therefore, an election to use historic rates for this purpose should not be needed.

E. Consequences of Making an Annual Recognition Election if a Current Rate Election Is Not in Effect

As described in part IV.D of this Explanation of Provisions, if an owner of a section 987 QBU makes an annual recognition election, and does not make a current rate election, the owner would use the yearly average exchange rate for purposes of determining section 987 taxable income or loss. However, the owner would use historic rates to translate historic items for purposes of determining section 987 gain or loss. Thus, the same historic item would be translated at different exchange rates for different purposes. Under the mechanics of the FEEP method, if a historic asset is sold or depreciated during the taxable year, the difference between the historic rate basis and the current year average rate basis would be added to the pool of unrecognized section 987 gain or loss (and recognized pursuant to the annual recognition election).

The effect of these rules is that—with respect to historic assets of a section 987 QBU—an owner that does not make a current rate election would recognize the same total amount of taxable income each year regardless of whether it makes an annual recognition election. For example, assume a section 987 QBU has the euro as its functional currency, and its owner is a calendar year taxpayer with the U.S. dollar as its functional currency. At the end of year 1, the section 987 QBU owns a non-depreciable historic asset (Asset A) with a basis of 100 euros, and the historic rate for Asset A is €1=$1. The yearly average exchange rate in year 2 and the spot rate on December 31, year 2 is €1=$2. In year 2, the section 987 QBU sells Asset A for 150 euros and holds the 150 euros on its balance sheet until the end of year 2.

If the owner does not make an annual recognition election, the owner will have section 987 taxable income of $200 for year 2. This reflects the excess of the amount realized (150 euros, translated at the yearly average exchange rate of €1=$2 into $300) over the basis of Asset A (100 euros, translated at the historic rate of €1=$1 into $100). The owner will have no unrecognized section 987 gain or loss for the taxable year under § 1.987-4(d). A comparison of the year 2 and year 1 year-end balance sheets under § 1.987-4(d)(1) will reflect an increase of $200 (the excess of 150 euros held at the end of year 2, translated at the year 2 year-end spot rate of €1=$2 into $300, over the €100 basis of Asset A, which was held at the end of year 1, translated at the historic rate of €1=$1 into $100). However, this increase is fully offset by the negative adjustment for taxable income of $200 under § 1.987-4(d)(6).

By contrast, if the owner makes an annual recognition election, the owner will have section 987 taxable income in year 2 of only $100 (50 euros of taxable income, translated at the yearly average exchange rate of €1=$2). The owner will also have unrecognized section 987 gain for the taxable year of $100 under § 1.987-4(d), which reflects the balance sheet increase of $200 (computed under § 1.987-4(d)(1) as described in the preceding paragraph) reduced by the negative adjustment for taxable income of $100. Thus, the difference between Asset A's basis translated at the yearly average exchange rate (which is $200) and its basis translated at the historic rate (which is $100) is added to the pool of unrecognized section 987 gain or loss and this amount is recognized in year 2 due to the annual recognition election.

The example illustrates that, whether or not the annual recognition election is made, the owner recognizes the same amount of total income with respect to Asset A (that is, $200). However, the annual recognition election has the effect of converting a portion of the owner's income into section 987 gain or loss. Because section 987 gain or loss is subject to special source and character rules under proposed § 1.987-6, the annual recognition election can change the source and character of an owner's taxable income.

F. Impact of an Annual Recognition Election on the Timing of Recognition With Respect to Marked and Historic Items

Under an annual recognition election, section 987 gain or loss with respect to marked items would be recognized annually (whereas, in the absence of an annual recognition election, section 987 gain or loss would be deferred until the section 987 QBU makes a remittance). Therefore, with respect to marked items, an annual recognition election would accelerate the recognition of section 987 gain or loss. If a current rate election is in effect, all items of the section 987 QBU will be treated as marked items generating section 987 gain or loss; this gain or loss would be accelerated if an annual recognition election is made.

However, if a current rate election is not in effect, the annual recognition election would not accelerate the recognition of income with respect to historic assets. As explained in part IV.E of this Explanation of Provisions, in the absence of a current rate election, the owner of a section 987 QBU recognizes the same amount of total income with respect to historic assets whether or not an annual recognition election is in effect (though the annual recognition election has the effect of changing the portion of the income that is section 987 gain or loss and the portion that is section 987 taxable income or loss). In addition, as explained in part IV.D of this Explanation of Provisions, an annual recognition election is expected to simplify the computation of section

987 taxable income or loss (because all items would be translated at the yearly average exchange rate). Therefore, for section 987 QBUs that do not have a significant amount of marked assets or liabilities, the election is expected to reduce the compliance burden on taxpayers without materially accelerating the recognition of income.

V. Changes to the Computation of Unrecognized Section 987 Gain or Loss for a Taxable Year

The proposed regulations contain several changes to the computation of unrecognized section 987 gain or loss for a taxable year under § 1.987-4(d) (that is, the amount added to the pool of net unrecognized section 987 gain or loss each year).

5

These modifications are intended to ensure that section 987 gain or loss is attributable only to exchange rate fluctuations. For example, the proposed regulations would modify the adjustments for tax-exempt income and non-deductible expenses to cover all items of income, gain, deduction, or loss that affect the section 987 QBU's balance sheet but are not taken into account in determining section 987 taxable income or loss for the taxable year. Proposed § 1.987-4(d)(7) and (8). The proposed regulations would also require an adjustment for items of income, gain, deduction, or loss that are taken into account in determining section 987 taxable income or loss but do not affect the section 987 QBU's balance sheet for the taxable year. Proposed § 1.987-4(d)(9).

5

Proposed § 1.987-4(g) contains new examples illustrating the proposed modifications to the computation of unrecognized section 987 gain or loss under proposed § 1.987-4(d). The Treasury Department and the IRS intend to make conforming changes to the existing examples in § 1.987-4 of the final regulations when the proposed regulations are finalized.

Thus, the proposed regulations would account for deferred items that are expected to be taken into account in computing taxable income in a subsequent year by taking them into account in the year in which they impact the section 987 QBU's balance sheet and effectively backing them out in the future year when they impact taxable income but do not change the balance sheet. For example, if a section 987 QBU incurs an expense in year 1, but the deduction associated with the expense is deferred until year 5, proposed § 1.987-4(d)(7) would treat the expense as a non-deductible expense in year 1, increasing the year 1 unrecognized section 987 gain or loss. In year 5, the deduction would have no net effect on unrecognized section 987 gain or loss, since the deduction would result in a positive adjustment under proposed § 1.987-4(d)(6) (because the deduction reduces taxable income, and taxable income is a negative adjustment to unrecognized section 987 gain or loss), and an offsetting negative adjustment under proposed § 1.987-4(d)(9) (since the deduction represents a taxable deduction that does not affect the balance sheet). As a result, the expense would impact the calculation of section 987 gain or loss in the same manner as if it had been deductible in year 1.

In addition, the proposed regulations require an adjustment to unrecognized section 987 gain or loss for any residual increase or decrease to the adjusted balance sheet of the section 987 QBU (determined in the functional currency of the section 987 QBU) that is not accounted for under the other computational steps. Proposed § 1.987-4(d)(10). This residual amount is translated into the owner's functional currency at the yearly average exchange rate. The residual increase or decrease is computed by applying the other computational steps described in proposed § 1.987-4(d) (steps 1 through 9) in the functional currency of the section 987 QBU. Because these steps must already be performed in the owner's functional currency, determining the residual increase or decrease to the adjusted balance sheet under proposed § 1.987-4(d)(10) is not expected to significantly increase the burden of determining net unrecognized section 987 gain or loss.

The application of proposed § 1.987-4(d)(10) would ensure that non-currency-related changes to the balance sheet do not artificially increase or decrease the pool of net unrecognized section 987 gain or loss. However, if the computational steps are applied correctly in the functional currency of a section 987 QBU, there should not be any residual increase or decrease to the balance sheet under proposed § 1.987-4(d)(10) (unless a current rate election or an annual recognition election is made). Rather, the year-over-year increase (or decrease) to the functional currency balance sheet (step 1) should equal the functional currency amount of net transfers to the section 987 QBU (steps 2 through 5) and income of the section 987 QBU (steps 6 through 8), after backing out items of income that do not impact the balance sheet (step 9). By contrast, when these steps are applied in owner functional currency, they serve to identify the balance sheet change attributable to currency movements.

For taxpayers that make a current rate election or an annual recognition election, the proposed regulations provide that steps 6 through 9 of the computation (relating to income, gain, deduction, or loss) do not need to be applied. For these taxpayers, all items of income, gain, deduction, or loss would be taken into account as a residual increase or decrease to the section 987 QBU's balance sheet and translated at the yearly average exchange rate. The Treasury Department and the IRS request comments on whether any additional adjustments are needed for section 988 gain or loss of a section 987 QBU that is subject to a current rate election or an annual recognition election. See part XV of this Explanation of Provisions (requesting comments as to whether section 988 gain or loss of a section 987 QBU should be determined in the owner's functional currency or the section 987 QBU's functional currency).

VI. Source and Character of Section 987 Gain or Loss

The final regulations provide that the source and character of section 987 gain or loss is determined in the year of a remittance using the asset method of §§ 1.861-9(g) and 1.861-9T(g).

See

§ 1.987-6(b)(2). For this purpose, only the assets of the section 987 QBU are taken into account. The proposed regulations would generally retain this character and source rule, subject to certain modifications, and would further provide that taxpayers must apply only the tax book value method in characterizing the assets under proposed §§ 1.861-9(g) and 1.861-9T(g).

6

See

proposed § 1.987-6(b)(2)(i)(A).

6

The proposed regulations would also make a clarifying change to § 1.861-9T(g)(2)(ii)(A)(

1

) to clarify that the references to beginning-of-year and end-of-year functional currency amounts are to the owner functional currency amounts and to move certain provisions from § 1.861-9T to proposed § 1.861-9.

Proposed § 1.987-6(b)(2)(i) would provide special rules for the application of the tax book value method for initially characterizing section 987 gain or loss. Under these proposed regulations, the assets of the section 987 QBU would be initially assigned to statutory and residual groupings under the tax book value method. However, to prevent circularity, the proportions in which the tax book value of the assets would be initially assigned to the statutory and residual groups are determined without regard to section 987 gain or loss. Proposed § 1.987-6(b)(2)(i)(B). The initial assignment would occur after the application of the income attribution rules of § 1.904-4(f)(2)(vi) or 1.951A-2(c)(7) (or the

principles of these rules), but before expenses are allocated and apportioned to gross income and before the application of provisions that require a net income computation, such as the high-tax exception to passive category income in § 1.904-4(c), the high-tax exception to foreign base company income in § 1.954-1(d), and the high-tax exclusion from tested income in § 1.951A-2(c)(7).

In addition, because, at the time of the initial assignment, a taxpayer may not yet know whether a GILTI high-tax election will be in effect in the taxable year in which the section 987 gain or loss is recognized (since deferred section 987 gain or loss and suspended section 987 loss may be recognized in future year), the proposed regulations would initially assign all of the section 987 gain or loss that would have been assigned to a tested income group if no GILTI high-tax election was in effect to a tentative tested income group.

See

proposed § 1.987-6(b)(2)(i)(D).

The initial assignment would generally be made in the taxable year in which section 987 gain or loss is treated as recognized, deferred, or suspended under proposed § 1.987-6(b)(1). Then, in the taxable year in which the section 987 gain or loss is recognized (which may be the same taxable year as the year in which the initial assignment was made or a future taxable year), any section 987 gain or loss that was initially assigned to a tentative tested income group would be reassigned to a tested income group or residual group based on whether the GILTI high-tax election is in effect in that taxable year and, if so, whether the income is high-tax. The initial characterization under proposed § 1.987-6(b)(2)(i) would be used for purposes of applying the loss-to-the-extent-of-gain rule in proposed § 1.987-11(e) and (f), and also applies as the starting point for net income calculations required for other provisions such as the high-tax exception to passive category income under § 1.904-4(c) and the GILTI and subpart F high-tax exceptions under §§ 1.954-1(d) and 1.951A-2(c)(7). Proposed § 1.987-6(b)(2)(ii).

Proposed § 1.987-6(b)(2)(iii) would also provide that if a GILTI high-tax election is made under § 1.951A-2(c)(7)(viii), it applies to all of the section 987 gain or loss in a tentative tested income group that is recognized by the CFC in the taxable year as if the section 987 gain and loss were all assigned to its own separate tested unit of the CFC. In other words, all section 987 gain or loss recognized by the CFC in that taxable year in the same section 904 category would be treated as a single tentative tested income item for purposes of applying the GILTI high-tax exclusion.

For example, if section 987 gain and loss in a section 904 category is initially assigned to a tentative tested income group under proposed § 1.987-6(b)(i) and a GILTI high-tax election is in effect in the year in which the section 987 gain or loss is recognized, the section 987 gain or loss in the section 904 category would be treated as its own tentative tested income item for purposes of determining whether it is excluded from tested income under § 1.951A-2(c)(7), after which the section 987 gain or loss will be reassigned to a tested income group (if the item is not excluded from tested income) or to the residual category (if the item is excluded from tested income). Because foreign countries generally do not impose tax on section 987 gain, allocation and apportionment of a foreign income tax to section 987 gain under § 1.861-20 and proposed § 1.987-6(b)(3) will likely be uncommon. As a result, a tentative tested income item consisting of section 987 gain may often have a zero percent effective rate of foreign tax and, therefore, would generally not qualify for the GILTI high-tax exclusion.

As described above, the proposed regulations would provide that, for purposes of determining the source and character of section 987 gain and loss, the initial assignment of suspended section 987 loss and deferred section 987 gain and loss is generally made in the taxable year it becomes suspended or deferred (generally in the year of a remittance or the year the section 987 QBU is transferred to a related party), rather than the taxable year in which it is recognized. Proposed § 1.987-6(b)(1). The Treasury Department and the IRS anticipate that making the initial assignment in the year of suspension or deferral, rather than the year the section 987 gain or loss is recognized, will generally result in determining the source and character in a year closer in time to the year in which the section 987 loss originated, and therefore will tend to be more accurate. In addition, making an initial assignment in the taxable year of deferral or suspension means that the source and character are determined by reference to the assets of the section 987 QBU while they are still owned by the owner, rather than after they have been transferred, which would be both administratively difficult and more likely to introduce distortions to the determination.

The Treasury Department and the IRS request comments as to whether it would be appropriate to determine the source and character of unrecognized section 987 gain or loss by making the initial assignment in the taxable year in which the section 987 gain or loss is initially included in unrecognized section 987 gain or loss under § 1.987-4(d), rather than in the year of a remittance. Making the initial assignment on an annual basis would require more extensive tracking of section 987 gain or loss in separate categories. However, this approach could avoid distortions that could arise from changes in the bases of a section 987 QBU's assets or shifts in the character of its income or assets between the time unrecognized section 987 gain or loss is added to the pool and the time it is recognized. In addition, this approach could align more closely with the character of income generated by the section 987 QBU's assets at the time of the exchange rate fluctuations that give rise to section 987 gain or loss.

The proposed regulations would not change the rule in the final regulations that section 987 gain or loss that is assigned to a subpart F income group is treated as foreign currency gain or loss attributable to section 988 transactions not directly related to the business needs of the CFC.

See

proposed § 1.987-6(b)(2)(i)(C). The Treasury Department and the IRS request comments as to whether it would be appropriate to eliminate this rule and characterize section 987 gain or loss by reference to subpart F income groups (as defined in § 1.960-1(d)(2)(ii)(B)) or whether to retain this rule generally but apply a different rule to taxpayers that make a current rate election (under which section 987 gain or loss can arise with respect to assets that would not generate section 988 gain or loss in the hands of the owner).

A qualified business unit that produces income or loss that is, or is treated as, ECI is required to use the dollar as its functional currency.

See

§ 1.985-1(b)(1)(v). The 2016 proposed regulations would provide an election under which a qualified business unit with a dollar functional currency may be treated as a section 987 QBU.

See

§ 1.987-1(b)(6)(iii) of the 2016 proposed regulations. The Treasury Department and the IRS also request comments as to whether, and in what circumstances, section 987 gain or loss should be treated as ECI.

VII. Expansion of Entities Covered

In general, the final regulations do not apply to a bank, insurance company, leasing company, finance coordination center, regulated investment company, or real estate investment trust (a “specified entity”), unless it engages in

transactions primarily with related persons within the meaning of section 267(b) or section 707(b) that are not themselves specified entities. Additionally, the final regulations do not apply to trusts, estates, S corporations, and partnerships other than section 987 aggregate partnerships.

See

§ 1.987-1(b)(1)(ii).

The Treasury Department and the IRS are concerned that excluding these entities from the application of the regulations under section 987 would not provide taxpayers with sufficient guidance to ensure these entities are using an appropriate method to calculate their section 987 gain or loss. Furthermore, if these entities are not subject to the regulations under section 987, they may use different methods of applying section 987 that vary in material ways. Applying a consistent set of rules to all taxpayers facilitates the fair and effective administration of the tax law by treating similarly situated taxpayers similarly as well as eliminating subjectivity and uncertainty.

In addition, the Treasury Department and the IRS anticipate that the new current rate election and annual recognition election described in parts II and IV of this Explanation of Provisions would provide sufficient flexibility to permit the entities excluded under the 2016 final regulations to apply the proposed regulations. As discussed in part VIII of this Explanation of Provisions, the proposed regulations also provide new rules relating to partnerships (other than section 987 aggregate partnerships) and S corporations. See part VIII of this Explanation of Provisions. These rules are expected to significantly reduce the administrative burden and complexity of applying section 987 to partnerships as compared to the aggregate rules. Accordingly, proposed § 1.987-1(b)(1)(ii) generally removes the exclusion for entities excluded from the 2016 final regulations, making them subject to the proposed regulations.

The proposed regulations generally continue to exclude foreign non-grantor trusts and foreign estates if the aggregate interests of beneficiaries that are United States persons is less than 10 percent, and foreign partnerships if the aggregate interests of the partners that are United States persons is less than 10 percent of the capital and profits interests. Proposed § 1.987-1(b)(1)(ii). The Treasury Department and the IRS are concerned that the shareholders, partners, and beneficiaries of these entities may not be able to obtain the information needed to apply the regulations to these entities, and it would be difficult for the IRS to administer the regulations with respect to these entities. For the same reason, the proposed regulations generally exclude foreign corporations that are not CFCs and foreign corporations that are CFCs but which have no U.S. shareholders (which are not excluded under the final regulations). Foreign individuals are also generally excluded as they are typically not subject to U.S. tax.

The Treasury Department and the IRS request comments on whether any additional rules are needed to facilitate the application of the proposed regulations to the entities that were excluded from the 2016 final regulations. See also part VIII of this Explanation of Provisions, requesting comments on the application of the proposed regulations to partnerships and S corporations.

VIII. Partnerships

A. Background

As explained in part II.C of the Background section, the 2006 proposed regulations and 2016 final regulations applied aggregate theory to partnerships. As explained in the preamble to the 2006 proposed regulations, the 2006 proposed regulations applied the FEEP method directly at the partner level under aggregate theory with the goal of more appropriately preserving the correct amounts of exchange gain or loss as measured from the perspective of the partner. Measuring the currency gain or loss by reference to the partner, rather than the partnership, was considered preferable because the partners would generally bear the economic risk from the exposure.

Comments to the 2006 proposed regulations requested that the Treasury Department and the IRS reconsider the aggregate approach and instead treat a partnership as a separate entity with its own functional currency. The comments indicated that the aggregate approach was overly complex and that minority partners would not have the power to compel a partnership to provide them with the information needed to make the calculations required under the aggregate approach. One comment acknowledged the economic rationale for the aggregate approach but, in light of its complexity, recommended that it apply only in cases in which a partner's interest in partnership capital or profits exceeds a certain threshold, such as 10 percent.

In the preamble to the 2016 final regulations, the Treasury Department and the IRS acknowledged concerns regarding the complexity of the applying the aggregate approach to partnerships, but determined that it would be feasible to apply an aggregate approach to partnerships that are wholly owned by related persons. Furthermore, the aggregate approach was preserved in order to prevent a group of related parties from holding eligible QBUs through partnerships instead of directly, and thereby altering the section 987 treatment of the eligible QBU without meaningfully altering the group's economic position.

As a result, the 2016 final regulations retained the aggregate approach to partnerships, but applied it only to section 987 aggregate partnerships, as discussed in Part II.C of the Background section. The 2016 final regulations did not address other partnerships.

Under the aggregate approach set forth in the 2016 final regulations, assets and liabilities reflected on the books and records of an eligible QBU of a section 987 aggregate partnership are allocated to each partner, which is considered an indirect owner of the eligible QBU. If the eligible QBU has a different functional currency than its indirect owner, then the assets and liabilities of the eligible QBU that are allocated to the partner are treated as a section 987 QBU of the indirect owner.

B. Method for Determining Share of Assets and Liabilities

The 2006 proposed regulations provided that a partner's share of assets and liabilities reflected on the books and records of an eligible QBU is determined in a manner consistent with how the partners had agreed to share the economic benefits and burdens corresponding to partnership assets and liabilities, taking into account the rules and principles of subchapter K.

7

7

A partner's basis in the partnership was adjusted to take into account any section 987 gain or loss that it recognized on any section 987 QBUs owned indirectly through the partnership.

A comment noted that the rules in the 2006 proposed regulations for allocating assets and liabilities to a partner's indirectly owned section 987 QBU were ambiguous and that the rules and principles of subchapter K do not provide sufficient guidance in this regard. The Treasury Department and the IRS acknowledged the ambiguity in the preamble to the 2016 final regulations, and the 2016 temporary regulations provided more specific rules for determining a partner's share of the assets and liabilities reflected on the books and records of an eligible QBU owned indirectly through a section 987 aggregate partnership.

In particular, the temporary regulations provided that, in any taxable year, a partner's share of each asset and liability of a section 987 aggregate partnership was proportional to the partner's liquidation value percentage with respect to the aggregate partnership. A partner's liquidation value percentage was defined as the ratio of the liquidation value of the partner's interest in the partnership to the aggregate liquidation value of all the partners' interests in the partnership. The liquidation value of the partner's interest in the partnership was defined as the amount of cash the partner would receive with respect to its interest if, immediately following the applicable determination date, the partnership sold all of its assets for cash equal to the fair market value of such assets (taking into account section 7701(g)), satisfied all of its liabilities (other than those described in § 1.752-7), paid an unrelated third party to assume all of its § 1.752-7 liabilities in a fully taxable transaction, and then liquidated.

Comments recommended alternative approaches for determining a partner's share of the assets and liabilities of a section 987 aggregate partnership. Some comments recommended that § 1.987-7 be withdrawn and replaced with the approach of the 2006 proposed regulations under section 987, which provided that a partner's share of assets and liabilities reflected on the books and records of an eligible QBU held indirectly through the partnership must be determined in a manner consistent with how the partners have agreed to share the economic benefits and burdens corresponding to those partnership assets and liabilities, taking into account the rules and principles of subchapter K. A comment indicated that the liquidation value percentage approach was inconsistent with certain principles of subchapter K, resulting in distortions in the calculation of section 987 gain or loss in certain cases.

The Treasury Department and the IRS determined that, in the absence of a more comprehensive set of rules for determining a partner's share of assets and liabilities reflected on the books and records of an eligible QBU held indirectly through the partnership that also articulates the interaction of those rules with applicable rules in subchapter K, a more flexible approach was warranted. Moreover, the Treasury Department and the IRS determined that, in certain instances, the liquidation value percentage methodology set forth in the 2016 temporary regulations could be interpreted as applying in a way that inappropriately distorts the computation of section 987 gain or loss. Specifically, under such an interpretation, certain changes in a partner's liquidation value percentage could introduce distortions in the calculation of net unrecognized section 987 gain or loss under § 1.987-4, giving rise to net unrecognized section 987 gain or loss that is not attributable to fluctuations in exchange rates. For example, an appreciation or depreciation in property value could result in a change in liquidation value percentage that causes a change in owner functional currency net value for purposes of step 1 of the § 1.987-4(d) calculation of unrecognized section 987 gain or loss for a taxable year without creating an offsetting adjustment under step 6 or otherwise that would prevent the change in liquidation value percentage from distorting the calculation of unrecognized section 987 gain or loss. As a result, such unrecognized appreciation or depreciation generally could result in unrecognized section 987 gain or loss for a taxable year being allocated to each partner that indirectly owned a section 987 QBU even when there was no change in exchange rates.

Accordingly, the Treasury Department and the IRS withdrew § 1.987-7T in the 2019 final regulations. The preamble to the 2019 final regulations stated that, until new regulations are proposed and finalized, taxpayers may use any reasonable method for determining a partner's share of assets and liabilities reflected on the books and records of an eligible QBU held indirectly through the partnership. For this purpose, taxpayers may rely on subchapter K principles (consistent with the 2006 proposed regulations) or an approach similar to the liquidation value percentage method set forth in § 1.987-7T. However, it would not be reasonable to apply the liquidation value percentage method in § 1.987-7T without corresponding adjustments to the determination of net unrecognized section 987 gain or loss. Thus, for example, a taxpayer using the liquidation value percentage method may be required to adjust its determination of net unrecognized section 987 gain or loss of a section 987 QBU that is owned indirectly through a partnership to prevent the determination of unrecognized section 987 gain or loss that is not attributable to fluctuations in exchange rates. These adjustments may include, for example, treating any change in a partner's owner functional currency net value that is attributable to a change in the partner's liquidation value percentage as resulting in a transfer to or from an indirectly owned section 987 QBU.

C. The Proposed Regulations Apply Entity Theory to Non-Section 987 Aggregate Partnerships

As previously discussed in part VIII.A of this Explanation of Provisions, although the final regulations applied the aggregate approach to section 987 aggregate partnerships, the final regulations did not provide rules for applying section 987 to other partnerships. The preamble to the 2016 final regulations stated that section 987 regulations would be developed for these other partnerships in a separate project and indicated that a different approach might be taken. To that end, the preamble requested comments on how an entity approach should work for non-section 987 aggregate partnerships.

Several comments were received asserting that the aggregate approach to partnerships under the 2016 final regulations was overly complex. Comments recommended that a partnership be treated as a separate entity with its own functional currency that can be the owner of a section 987 QBU. Comments also indicated that entity treatment would be more consistent with the principles of subchapter K.

The Treasury Department and the IRS agree that treating non-section 987 aggregate partnerships as an entity and therefore potentially an “owner” of section 987 QBUs would be more administrable than an aggregate approach and would reduce the compliance burden on taxpayers and the IRS. However, the Treasury Department and the IRS continue to study whether partners might be able to achieve inappropriate outcomes under entity theory. For example, the Treasury Department and the IRS are concerned that if partnerships maintained section 987 gain and loss pools under a “pure” entity theory paradigm, partners would effectively be able to transfer their share of net unrecognized section 987 gain or loss to another partner, thereby avoiding gain recognition or trafficking in losses. To prevent a partner from transferring its share of net unrecognized section 987 gain or loss to another partner, the proposed regulations would generally apply a hybrid approach to entity theory, under which a partnership's net unrecognized section 987 gain or loss with respect to its section 987 QBUs is allocated to its partners on an annual basis (the “hybrid approach to entity theory”), as described in part VIII.D of this Explanation of Provisions.

The hybrid approach to entity theory may reduce concerns about inappropriate outcomes that might otherwise arise from the transfer of

partnership interests under an entity theory approach. However, as described in part VIII.D and E of this Explanation of Provisions, while the Treasury Department and the IRS study whether the hybrid approach to entity theory (or a variation thereof) is suitable for all partnerships, the proposed regulations maintain the aggregate approach to section 987 aggregate partnerships in the final regulations, as modified by the 2019 final regulations, with minimal changes. Special rules are provided in proposed § 1.987-7C for partnerships that become (or cease to be) section 987 aggregate partnerships. In addition, for consistency with other transfers of a section 987 QBU, the proposed regulations would treat a change in the form of ownership from direct to indirect as a termination of the section 987 QBU under proposed § 1.987-8(b)(6), subject to the deferral rules pursuant to proposed § 1.987-12(g)(1)(i)(A). The Treasury Department and the IRS anticipate publishing a subsequent notice of proposed rulemaking that more thoroughly addresses the application of section 987 to partnerships.

D. The Hybrid Approach to Entity Theory

Under the proposed regulations, a partnership (other than a section 987 aggregate partnership) would be treated as a qualified business unit having its own functional currency.

See

§ 1.989(a)-1(b)(2)(i)(C);

see also

§ 1.985-1(a)(1). If a partnership owns an eligible QBU with a functional currency that is different from the functional currency of the partnership, the eligible QBU would be treated as a section 987 QBU and the partnership (and not the partner) would generally be treated as the owner of the eligible QBU.

See

proposed §§ 1.987-1(b)(4) through (5) and 1.987-7A(b).

A partnership that owns a section 987 QBU would determine its unrecognized section 987 gain or loss for a taxable year under proposed § 1.987-4(d) by reference to the functional currency of the partnership and the section 987 QBU. Proposed § 1.987-7A(b). Under the hybrid approach, the partnership would allocate to each partner a share of the unrecognized section 987 gain or loss for the taxable year with respect to each section 987 QBU owned by the partnership on an annual basis. The partnership would determine a partner's share of the unrecognized section 987 gain or loss for the taxable year for each section 987 QBU based on the partner's distributive share of profits and losses attributable to that section 987 QBU for the taxable year. At the partner level, each partner would translate its share of the unrecognized section 987 gain or loss into its functional currency at the yearly average exchange rate and calculate its net unrecognized section 987 gain or loss with respect to each section 987 QBU of the partnership based on this share. Proposed § 1.987-7A(c)(1).

Section 987 gain or loss attributable to a section 987 QBU owned by a partnership would be recognized and taken into account at the partner level. Notwithstanding that the section 987 gain or loss pools are allocated to the partners and maintained at the partner level, the portion of the net unrecognized section 987 gain or loss that a partner would recognize (or suspend) each year under proposed § 1.987-5(a) would be determined by reference to the partnership's remittance proportion with respect to the section 987 QBU. Proposed § 1.987-7A(c)(3). In other words, if the section 987 QBU is treated as remitting 20 percent of its gross assets to its owner, the partnership, in a taxable year of the partnership, each partner that has net unrecognized section 987 gain or loss with respect to the section 987 QBU would recognize (or suspend) 20 percent of the net unrecognized section 987 gain or loss.

The proposed regulations provide a framework for adjusting a partner's basis in its partnership interest based on the principles of section 705 when a partner recognizes section 987 gain or loss, defers section 987 gain or loss, or suspends section 987 loss attributable to a partnership.

See

proposed § 1.987-7A(d). Similarly, if a partner in an upper-tier partnership (UTP) recognizes section 987 gain or loss, defers section 987 gain or loss, or suspends section 987 loss attributable to a lower-tier partnership (LTP), then the proposed regulations would provide that UTP makes a corresponding basis adjustment to its interest in LTP, with similar rules applying to each successive partnership through which the section 987 gain or loss is attributable. The basis adjustment between UTP and LTP or between LTPs constitutes a basis adjustment solely with respect to the partner that recognizes section 987 gain or loss, defers section 987 gain or loss, or suspends section 987 loss attributable to the partnership. The Treasury Department and the IRS request comments on the coordination of these proposed regulations applicable to partnerships with rules for capital accounts determined and maintained in accordance with § 1.704-1(b)(2)(iv). Additionally, the Treasury Department and the IRS request comments on the appropriate currency in which section 743(b) basis adjustments with respect to assets of a section 987 QBU of a partnership should be maintained.

The proposed regulations would also provide rules for applying proposed §§ 1.987-11 through 1.987-13 (regarding deferred section 987 gain or loss and suspended section 987 loss) to partners and partnerships. Specifically, the application of the loss-to-the-extent-of-gain rule to suspended section 987 loss of the partner is done at the partner level. Proposed § 1.987-7A(c)(4). As a result, any section 987 gain recognized by a partner is taken into account in determining the suspended section 987 loss that may be recognized by the partner under proposed § 1.987-11(e), without regard to whether the section 987 gain was allocated to the partner from that partnership (or any other partnership) or was attributable to a section 987 QBU owned directly by the partner. Other rules under proposed §§ 1.987-11 through 1.987-13 would generally apply with respect to a partnership, but may be applied with respect to a partner that ceases to be a partner in the partnership.

In general, the section 987 elections would be made by the partnership. However, if a partner terminates its partnership interest, any annual recognition election in effect with respect to the partner would apply with respect to its deferred section 987 gain or loss or suspended section 987 loss that had been allocated to the partner by the partnership. The partner would also be permitted to make the election to recognize pretransition section 987 gain or loss ratably over the transition period under the transition rules.

See

proposed §§ 1.987-7A(c)(5)(ii) and 1.987-10(e)(5)(ii).

The Treasury Department and the IRS are studying the appropriate method for determining the portion of a partner's net unrecognized section 987 gain or loss, deferred section 987 gain or loss, and suspended section 987 loss that should be recognized, deferred, or suspended when a portion of a partner's interest in a partnership is transferred or redeemed (or the partner's interest in the partnership is otherwise reduced) and whether any special rules are needed in respect of a transfer or redemption of a partnership interest to account for the recognition of section 987 gain or loss at the partner level. Accordingly, the proposed regulations reserve on the treatment of transfers and redemptions of a partner's partnership interest. The Treasury Department and the IRS request comments on the appropriate method of determining the partner's interest in the partnership and the reduction to its interest in the

partnership, as well as how increases to a partner's partnership interest during the year should be taken into account. In addition, the Treasury Department and the IRS request comments on the appropriate treatment of transfers of a partnership interest between related parties or between member of a consolidated group.

In general, proposed § 1.987-6 would provide rules governing the character and source of section 987 gain or loss. See part VI of this Explanation of Provisions. The proposed regulations reserve on whether any special rules are needed in addition to proposed § 1.987-6 for purposes of determining the character and source of section 987 gain or loss of a partner with respect to a section 987 QBU owned by a partnership. Proposed § 1.987-7A(e). Comments are requested on whether special rules are needed.

The proposed regulations would treat S corporations in the same manner as partnerships. Proposed § 1.987-7A(f). Comments are requested on whether additional guidance is needed with regard to S corporations and whether there are instances in which the rules for S corporations should differ from the rules for partnerships.

The Treasury Department and the IRS also request comments as to whether, under an entity theory of partnerships, section 987 gain or loss could be recognized at the partnership level and then allocated to the partners while preventing the transfer of unrecognized section 987 gain or loss among the partners or between a transferor and transferee partner. Under the hybrid approach in the proposed regulations, a partner's recognition of section 987 gain or loss upon a sale or other disposition of a partnership interest results in the conversion of capital gain or loss to ordinary gain or loss without any remittance from the partnership QBU and without any change in the relationship between the QBU and its owner. Comments are requested on whether special rules are needed to prevent the conversion of capital gain or loss to ordinary gain or loss. In addition, comments are requested on whether the recognition of section 987 gain or loss upon a transfer or redemption of a partnership interest should be limited to the gain or loss that would otherwise be recognized on transfer or redemption, under rules similar to § 1.988-2(b)(8).

E. Expanding the Application of Entity Theory

The Treasury Department and the IRS continue to study the application of entity theory and aggregate theory to partnerships in the section 987 context, including whether it would be appropriate to apply a hybrid approach to entity theory to all partnerships, regardless of whether the partners are related parties. Such an approach would generally result in a partnership generating the same amount of section 987 gain or loss as it would if it were a corporation or an individual.

In connection with these considerations, the Treasury Department and the IRS are studying the concerns expressed in the 2006 proposed regulations and the final regulations that parties could achieve a substantially different section 987 result by owning a section 987 QBU through a partnership, rather than owning the section 987 QBU directly, without meaningfully changing the economic relationship of the parties.

Consider, for example, a domestic corporation that wholly owns two CFCs, each of which use the euro as their functional currency, and which each own fifty percent of an entity treated as a foreign partnership (“P”) that operates a British trade or business for which books and records are maintained in pounds. P also has a smaller separate French trade or business that is an eligible QBU that maintains books and records in euros. If just one CFC owned P, then P would be treated as an entity disregarded from its owner, and the CFC would have section 987 gain or loss with respect to its interest in P's pound operations. However, if an election was made to treat P as a corporation under § 301.7701-3, P would be treated as a CFC that uses the pound as its functional currency and section 987 gain or loss with respect to P's euro operations would be measured against the pound, rather than against the functional currency of P's partners. Accordingly, it could be argued that, for section 987 purposes, when a partnership is held by CFCs, aggregate theory achieves a result that is more akin to treating P as a disregarded entity and entity theory achieves a result more akin to treating P as a corporation.

However, if instead of being owned by two CFCs, P were owned by two domestic corporations that use the dollar as their functional currency, aggregate theory would achieve a result akin to treating P as a disregarded entity, while entity theory may provide a means of allowing the domestic corporations to avoid the application of section 987 to P's pound trade or business without needing to contribute the trade or business to a CFC, which might have other tax consequences.

See, e.g.,

section 367(a) and (d). Accordingly, the Treasury Department and the IRS are concerned that if only entity theory is applied to partnerships, there may be instances in which the business of the partnership should be subject to section 987 but is not, such as when two domestic corporations own a partnership doing business in the pound.

When a partner's functional currency differs from that of the partnership, creating a separate layer of currency exposure, the Treasury Department and the IRS are studying whether it might be possible to achieve a result consistent with aggregate theory without the administrative burden of allocating a portion of a partnership's assets and liabilities to each partner and calculating the income and balance sheets of the partnership in the functional currency of each partner. One such approach might determine a partner's section 987 gain or loss with respect to the partnership by reference to the partner's outside basis in the partnership, rather than its share of the inside asset basis and liabilities (the “outside basis approach”).

The outside basis approach would be layered on top of the hybrid approach to entity theory taken by the proposed regulations. Under this system, a partnership would first determine its section 987 gain or loss with respect to any section 987 QBUs of the partnership, and allocate the pool to the partners, as described in § 1.987-7A of the proposed regulations. If a partner has the same functional currency as the partnership, no additional steps are taken.

If a partner has a different functional currency than the partnership, under one alternative (“alternative 1”), the partner would calculate its section 987 gain or loss with respect to its interest in the partnership (including its interest in the functional currency trade or business of the partnership and its interest in each of the partnership's section 987 QBUs) using a method similar to the calculation of unrecognized section 987 gain or loss for an owner applying the current rate election under proposed § 1.987-4(d) (that is, steps 1 through 5 and 10), but by reference to the partner's adjusted basis in its partnership interest (“outside basis”) in the partnership.

Specifically, the partner's annual section 987 gain or loss attributable to its share of the partnership as a whole would be equal to its outside basis determined as of the end of the partnership's taxable year (after taking into account other adjustments prescribed under section 705 but before any adjustments for section 987 gain or loss recognized under the outside basis approach) and translated into the

partnership's functional currency reduced by its outside basis determined as of the beginning of the same partnership taxable year and translated into the partnership's functional currency (the “partnership functional currency change in value”) (step 1). The partnership functional currency change in value would then be adjusted to subtract the partnership functional currency amounts of contributions to the partnership from the partner and add the partnership functional currency amounts of distributions from the partnership to the partner (steps 2 through 5). The result would then be adjusted to back out the partnership functional currency amount of the partner's allocable share of income, gain, deduction, and loss of the partnership (step 10). The result is the partner's unrecognized section 987 gain or loss attributable to its partnership interest. Under alternative 1, the partner's unrecognized section 987 gain or loss attributable to its partnership interest would be recognized annually and its basis in the partnership would be increased or decreased accordingly. Alternative 1 approximates the result a partner would achieve under aggregate theory if it applied the current rate election and the annual recognition election.

Annual recognition is necessary under alternative 1 to prevent differences in the partnership's adjusted bases in its assets (“inside basis”) attributable to fluctuations in the functional currency of the partnership itself or any section 987 QBUs owned by the partnership and the partners' outside bases (an “inside-outside basis disparity”). By adjusting outside basis for these currency fluctuations, the partner's section 987 gain or loss with respect to the partnership will include section 987 gain or loss on the partnership's owner functional currency net value of the partnership's section 987 QBUs. As a result, the sum of the owner's section 987 gain or loss attributable to its partnership interest under the outside basis approach, plus its allocable share of the partnership's net unrecognized section 987 gain or loss attributable to the partnership's section 987 QBUs should generally be equivalent to the sum of its unrecognized section 987 gain or loss attributable to section 987 QBUs indirectly owned by the partner through the partnership under the aggregate approach (assuming there are no other inside-outside basis disparities).

Alternatively, under another alternative (“alternative 2”), it may not be necessary to require recognition of the partner's section 987 gain or loss annually. Under this approach, the same method is used to determine the partner's section 987 gain or loss with respect to its partnership interest as in alternative 1, except that the partnership functional currency change in value would be determined, not just by reference to the partner's outside basis in the partnership, but to the sum of its outside basis and its net accumulated unrecognized section 987 gain or loss attributable to the partnership and the partnership's section 987 QBUs (that is, the amount that would have been recognized if the partner had been recognizing its section 987 gain and loss attributable to the partnership annually as under alternative 1). Under alternative 2, the partner's unrecognized section 987 gain or loss attributable to its partnership interest might be recognized when it receives a distribution from the partnership or disposes of a portion of its partnership interest.

Both alternative 1 and alternative 2 approximate the result a partner would achieve under aggregate theory if it applied the current rate election to its partnership interest. However, alternative 1, but not alternative 2, requires annual recognition of the partner's net unrecognized section 987 gain or loss. Accordingly, no additional loss limitations may be needed for alternative 1.

See

part IV.C of this Explanation of Provisions. However, it may be appropriate for the partner's net accumulated unrecognized section 987 gain or loss under alternative 2 to be subject to the loss-to-the-extent-of-gain rule in § 1.987-11(e) of the proposed regulations.

Under one variation to these alternative approaches, the partner's net accumulated unrecognized section 987 gain or loss attributable to its partnership interest would net with the partner's net unrecognized section 987 gain or loss with respect to the partnership's section 987 QBUs when one amount reflects section 987 gain and the other reflects section 987 loss.

Comments are requested on whether the outside basis approach or a similar system would achieve results consistent with aggregate theory in a more administrable manner. Furthermore, comments are requested on instances in which this system might inappropriately diverge from aggregate theory and how such divergences might be addressed. For example, if inside basis and outside basis are not equivalent (for example, because a partner acquires a partnership interest in a year in which a section 754 election is not in effect), how the resulting mismatch might be minimized or eliminated for purposes of measuring the partner's currency exposure with respect to the partnership. Comments are also requested on whether the outside basis approach or a similar system should apply to partners of (i) all partnerships, (ii) only those partnerships currently treated as section 987 aggregate partnerships, or (iii) only those partnerships in which the partner owns more than 50 percent of the partnership interest (taking into account constructive ownership).

In addition, comments are also requested on any additional rules that might be necessary to coordinate the outside basis approach or a similar system with the section 987 regulations or with subchapter K, when the functional currency of a partner, the partnership, and the partnership's section 987 QBU differ.

IX. Attribution of Items to the Section 987 QBU

The final regulations provide rules regarding when assets and liabilities, as well as items of income, gain, deduction, and loss are attributable to an eligible QBU, and when a section 987 QBU is treated as making a contribution or distribution to its owner or another eligible QBU of the owner.

See

§ 1.987-2. In general, the proposed regulations retain the rules in the final regulations with minor or clarifying revisions. However, in a change from the final regulations, the proposed regulations would treat a change in the form of ownership of a section 987 QBU as a termination, as discussed above.

In general, the final regulations provide that items are attributable to an eligible QBU if they are reflected on the separate set of books and records of the eligible QBU, as defined in § 1.989(a)-1(d). § 1.987-2(b)(1). The proposed regulations would revise the cross-reference to refer to § 1.989(a)-1(d)(1) or (2), as § 1.989(a)-1(d)(3) refers back to § 1.987-2(b). Proposed § 1.987-2(b)(1).

In addition, the final regulations provide that an eligible QBU is not treated as owning stock of a corporation unless the owner of the eligible QBU owns less than 10 percent of the value of the corporation (after taking into account certain attribution rules). § 1.987-2(b)(2)(i). In order to generally prevent an eligible QBU from owning stock of a CFC, the proposed regulations would expand the exclusion to cover all stock unless the owner owns less 10 percent of both the vote and value of the corporation, and to revise the relevant attribution rules. Proposed § 1.987-2(b)(2)(i). The proposed regulations also provide that any type of basis that does not affect the income and loss of the

eligible QBU, such as section 743(b) basis, would not be treated as included on the books and records of the eligible QBU. Proposed § 1.987-2(b)(5).

Similarly, the final regulations provide rules regarding when a transaction or the recording of an asset or liability as on (or not on) the books and records of a section 987 QBU is treated as a disregarded transaction between the section 987 QBU and its owner or another eligible QBU of the owner. § 1.987-2(c). The proposed regulations generally retain the substance of these rules but make minor revisions for clarity.

See

proposed § 1.987-2(c).

X. Transition Rules

As explained in part II.C of the Background section, the 2016 final regulations require all owners of section 987 QBUs to apply the fresh start transition method. Under this method, unrecognized section 987 gain or loss determined for years before the transition date generally would not be taken into account under section 987. In addition, for purposes of applying the FEEP method in the first year in which the regulations apply, the assets and liabilities of the section 987 QBU must be translated using historic rates.

Comments stated that the fresh start transition method is difficult to apply because taxpayers did not track historic rates before the transition date and the data needed to determine historic rates for items acquired in prior taxable years is not readily available. In addition, comments asserted that the fresh start transition method imposes an undue financial burden by permanently eliminating unrecognized section 987 losses determined before the transition date.

The Treasury Department and the IRS acknowledge that the fresh start transition method could increase the compliance burden on taxpayers for the initial year in which the regulations apply and would fail to account for section 987 gain or loss that arose before the transition date (to the extent attributable to assets and liabilities that are no longer reflected on the books and records of the section 987 QBU on the transition date). Therefore, the proposed regulations provide a new transition rule that would replace the fresh start transition method.

The new transition rule would account for unrecognized section 987 gain or loss accrued before the transition date. In addition, the new transition rule would not require taxpayers to retrospectively determine historic rates for items acquired before the transition date. As explained in the Applicability Dates section, the fresh start transition method can no longer be applied to any taxable year for which the tax return or information return is filed on or after November 9, 2023.

A. Translation of a Section 987 QBU's Assets and Liabilities at the Spot Rate

The transition rules under proposed § 1.987-10 would apply in the taxable year beginning on the transition date (that is, the first day of the first taxable year in which the regulations apply). For purposes of determining unrecognized section 987 gain or loss in the first taxable year in which the regulations apply, the assets and liabilities reflected on a section 987 QBU's balance sheet at the end of the previous year would be translated into the owner's functional currency at the spot rate on the day before the transition date. Proposed § 1.987-10(d)(1). Similarly, for taxpayers that do not make a current rate election, the historic rate for historic assets and liabilities would generally be the spot rate on the day before the transition date. Proposed § 1.987-10(d)(2). These rules are intended to simplify the application of the FEEP method by eliminating the need to determine actual historic rates in the first taxable year in which the regulations apply.

B. Pretransition Gain or Loss

Under the proposed regulations, an owner of a section 987 QBU must determine the amount of section 987 gain or loss that has accrued before the transition date (“pretransition gain or loss”). Proposed § 1.987-10(e). By default, in the first taxable year in which the regulations apply, pretransition gain is treated as net unrecognized section 987 gain, and pretransition loss is treated as suspended section 987 loss. Proposed § 1.987-10(e)(5)(i). This proposed rule is intended to prevent taxpayers from selectively recognizing pretransition loss (which, like section 987 loss generated under a current rate election, may be computed using a method that results in large section 987 pools) while deferring pretransition gain until a remittance. Alternatively, taxpayers can elect to amortize pretransition gain or loss over a period of ten years beginning on the transition date. Proposed § 1.987-10(e)(5)(ii).

In order to prevent owners subject to this election from offshoring pretransition gain or importing pretransition loss, proposed § 1.987-10(e)(5)(ii)(B) provides that, immediately before an inbound or outbound transaction described in section 381(a), any unrecognized pretransition gain is recognized and any unrecognized pretransition loss is suspended. As a result, the suspended section 987 loss may be recognized, subject to the loss-to-the-extent-of-gain-rule under § 1.987-11(e). In the case of an inbound section 381(a) transaction of a foreign owner with pretransition loss, any suspended section 987 loss that is not recognized before the transaction would not carry over to the domestic acquiring corporation under proposed § 1.987-13(g).

See

part III.C of this Explanation of Provisions.

C. Computation of Pretransition Gain or Loss

Under proposed § 1.987-10(e)(2), a taxpayer that applied section 987 before the transition date using an “eligible pretransition method” (described in part X.D of this Explanation of Provisions) would use that method to compute pretransition gain or loss. Pretransition gain or loss generally is equal to the amount of section 987 gain or loss that would have been recognized under the eligible pretransition method if the QBU terminated on the day before the transition date. Proposed § 1.987-10(e)(2)(i)(A). The amount of pretransition gain or loss must be adjusted to reflect any change to the basis of the section 987 QBU's assets (net of liabilities) that occurs as a result of the transition (for example, where the taxpayer previously used a method that would determine the owner's basis in distributed assets using historic rates). Proposed § 1.987-10(e)(2)(i)(B).

A taxpayer that did not apply an eligible pretransition method before the transition date would determine pretransition gain or loss using the method provided in § 1.987-10(e)(3). Under this method, pretransition gain or loss is equal to the sum of the annual amounts of unrecognized section 987 gain or loss for each taxable year since the section 987 QBU's inception, reduced by any section 987 gain or loss recognized before the transition date. Proposed § 1.987-10(e)(3)(ii).

The amount of unrecognized section 987 gain or loss for each taxable year would be computed using a simplified version of the method provided in § 1.987-4(d). Proposed § 1.987-10(e)(3)(iii). The only information needed to apply this simplified method is the information reflected in the section 987 QBU's opening and closing balance sheets for each year. Because this method does not require the translation of contributions and distributions at the applicable spot rate, it would only approximate the actual amount of section 987 gain or loss accrued before the transition date.

D. Eligible Pretransition Method

1. In General

An eligible pretransition method includes any reasonable method of applying section 987 before the transition date that fully accounts for foreign currency gain or loss attributable to the assets and liabilities of a section 987 QBU (including foreign currency gain or loss that is recognized in computing taxable income with respect to the section 987 QBU or its owner). The method provided in the 1991 proposed regulations, which determines section 987 gain or loss based on currency fluctuations with respect to the earnings and capital of a section 987 QBU (an “earnings and capital” method) is considered an eligible pretransition method, provided that it is applied in a reasonable manner. Proposed § 1.987-10(e)(4)(i). In addition, any other reasonable method of applying section 987 is an eligible pretransition method if it produces the same total amount of income over the life of the owner (taking into account the aggregate of section 987 gain or loss, section 987 taxable income or loss, and gain or loss on the disposition of assets and liabilities transferred by a section 987 QBU to the owner) as a reasonable earnings and capital method. Proposed § 1.987-10(e)(4)(ii). However, a method under which the owner does not recognize section 987 gain or loss at the time of a remittance because the recognition of all section 987 gain or loss is deferred until the section 987 QBU terminates is not considered an eligible pretransition method because it is inconsistent with the statutory requirements under section 987(3). Proposed § 1.987-10(e)(4)(iv).

2. Earnings Only Method

An earnings only method can qualify as an eligible pretransition method under proposed § 1.987-10(e)(4)(ii) if it is applied in a way that produces the same total amount of income as a reasonable earnings and capital method. This can be accomplished by maintaining a separate set of equity and basis pools for the section 987 QBU's capital account and assigning a proportionate amount of the capital basis pool to property distributed out of capital.

See

proposed § 1.987-10(l)(2) (

Example 2

).

The Treasury Department and the IRS are aware that certain taxpayers apply an earnings only method in a manner that creates a permanent difference in their income (as compared to the earnings and capital method). Under this approach, when a section 987 QBU makes a distribution (whether out of earnings or capital), the owner determines its basis in the distributed assets by translating the section 987 QBU's basis into the owner's functional currency at the spot rate applicable on the distribution date (“spot-rate basis”).

See

proposed § 1.987-10(l)(3) (

Example 3

). As a result, the owner's basis may be higher or lower than the actual cost of acquiring the assets (in the owner's functional currency) due to exchange rate fluctuations.

When a section 987 QBU makes a distribution out of earnings, which triggers the recognition of section 987 gain or loss under an earnings only method, the use of a spot-rate basis is appropriate. However, when a section 987 QBU makes a distribution out of capital (on which no section 987 gain or loss is recognized under an earnings only method), the use of a spot-rate basis artificially steps up (or steps down) the basis of the distributed assets in the absence of a recognition event. As a result, if a spot-rate basis is used for capital distributions under an earnings only method, the owner would not recognize the same total amount of income as it would under an earnings and capital method.

The Treasury Department and the IRS are concerned that the use of a spot-rate basis for capital distributions under an earnings only method does not accurately measure an owner's economic income with respect to a section 987 QBU. However, the Treasury Department and the IRS acknowledge that the preamble to the 2006 proposed regulations endorsed the use of an earnings only method without explaining how the basis of distributed assets should be determined. Taxpayers may have misunderstood the preamble to suggest that an owner of a section 987 QBU can take a spot-rate basis in all distributed assets under an earnings only method.

Therefore, the proposed regulations provide that an earnings only method that does not produce the same total amount of income as a reasonable earnings and capital method can qualify as an eligible pretransition method, provided it was first applied on a tax return filed before November 9, 2023 and is consistently applied to all section 987 QBUs of the same owner. Proposed § 1.987-10(e)(4)(iii). A taxpayer that begins applying this method on or after November 9, 2023 or fails to apply this method consistently to all of its section 987 QBUs will not be treated as applying an eligible pretransition method.

XI. Deferral Events and Outbound Loss Events

A. Final Regulations

Section 1.987-12 of the final regulations contains rules that defer the recognition of section 987 gain or loss in connection with two categories of related party transactions: deferral events and outbound loss events. A deferral event is defined to include certain transactions in which a section 987 QBU terminates and its assets are reflected on the books and records of a successor QBU after the termination.

See

§ 1.987-12(b)(2). A successor QBU is a section 987 QBU that is owned by a member of the same controlled group as the original owner (except if the original owner is a U.S. person and the owner of the successor QBU is a foreign person).

See

§ 1.987-12(b)(4). Section 987 gain or loss that is not recognized in connection with a deferral event (“deferred section 987 gain or loss”) is recognized by the original owner of the section 987 QBU when the successor QBU makes a remittance to its owner.

See

§ 1.987-12(c)(2).

An outbound loss event is defined to include a termination of a section 987 QBU that is owned by a U.S. person and has net unrecognized section 987 loss in connection with a transfer of the section 987 QBU's assets to a related foreign person.

See

§ 1.987-12(d)(2). If the transfer is a transaction described in section 351 or section 361, any section 987 loss that is not recognized in connection with the outbound loss event (“outbound section 987 loss”) is added to the basis of stock received by the owner of the section 987 QBU.

See

§ 1.987-12(d)(4). Otherwise, outbound section 987 loss is recognized when the owner of the section 987 QBU and the related foreign person cease to be members of the same controlled group.

See

§ 1.987-12(d)(5).

B. Proposed Regulations

1. Deferral Events

The proposed regulations generally retain the principles of the final regulations relating to deferral events but modify the rules in several respects. For example, the final regulations provide a de minimis rule pursuant to which § 1.987-12 would not apply to a section 987 QBU if the section 987 gain or loss that would not be recognized under § 1.987-12 would not exceed $5 million. § 1.987-12(a)(3)(ii). To prevent the de minimis rule from allowing an owner to recognize more than the threshold by transferring multiple section 987 QBUs to members of its controlled group, the proposed

regulations would retain the de minimis rule but apply the threshold to the total deferred section 987 gain or loss that would otherwise be recognized by the owner in a single taxable year. Proposed § 1.987-12(a)(2)(ii). In addition, because the proposed regulations would apply the suspended section 987 loss rules to outbound loss events, any amount treated as a suspended section 987 loss is not taken into account in determining whether the threshold has been met.

Id.

The final regulations also provide that, if a deferral event results in multiple successor QBUs, the remittance proportion is determined by treating all the successor QBUs as a single successor QBU. § 1.987-12(c)(2)(ii). The Treasury Department and the IRS are concerned that aggregating the contributions and distributions of various successor QBUs in order to treat them as the same successor QBU both increases the administrative burden of determining the remittance proportion and is less precise than determining a remittance proportion for each successor QBU. Therefore, the proposed regulations would apportion an amount of deferred section 987 gain or loss to each successor QBU and recognize (or suspend) a portion of deferred section 987 gain or loss annually with respect to each successor QBU based on the specific successor QBU's remittance proportion and on whether that successor QBU is subsequently transferred. Proposed § 1.987-12(b)(2) and (c).

Although the proposed regulations generally retain the deferral rules of § 1.987-12(b) with respect to those circumstances in which they apply under the final regulations, the Treasury Department and the IRS recognize that this can lead to odd results in certain cases, because similar transactions may sometimes be subject to the deferral rules and other times be subject to no limitation or the suspended loss rules.

For example, if a CFC (“CFC1”) with a euro functional currency owns a section 987 QBU (“QBU1”) with a pound functional currency, and CFC1 transfers QBU1 to a wholly owned subsidiary CFC (“CFC2”), the deferral rules would generally apply if CFC2's functional currency is not the pound. However, if CFC2's functional currency is the pound, the deferral rules would not apply because QBU1 would cease to be a section 987 QBU upon transfer to CFC2, because it would have the same functional currency as its owner. As a result, if CFC1 does not have a current rate election in effect (or has both a current rate election and an annual recognition election in effect), CFC1 would recognize its net unrecognized section 987 gain or loss with respect to QBU1 on the transfer. However, if CFC1 has a current rate election in effect (and does not have an annual recognition election in effect), CFC1 would recognize net unrecognized section 987 gain on the transfer, but net unrecognized section 987 loss would become suspended section 987 loss.

The Treasury Department and the IRS request comments on whether the deferral rules of proposed § 1.987-12 should remain a separate deferral regime or should be modified or combined with the suspended loss rules of proposed §§ 1.987-11 and 1.987-13.

2. Outbound Loss Events

The proposed regulations generally retain the definition of an outbound loss event contained in the final regulations. However, the proposed regulations provide that outbound section 987 loss is treated as suspended section 987 loss, instead of being added to the basis of stock or recognized solely when the owner of the section 987 QBU and the related foreign person cease to be related. This rule is intended to permit the recognition of outbound section 987 loss to the extent the owner recognizes section 987 gain in the same recognition grouping, as described in part III of this Explanation of Provisions. In addition, applying the loss suspension rules to outbound loss events simplifies the proposed regulations by reducing the number of different types of deferral regimes that apply to section 987 losses.

XII. Making and Revoking Elections

The final regulations contain a number of elections relating to section 987. The proposed regulations contain several new elections, including the current rate election, the annual recognition election, and elections under the transition rules.

Under the final regulations, elections generally are made separately for each section 987 QBU.

See

§ 1.987-1(g)(1)(i). Elections cannot be revoked without the Commissioner's consent.

See

§ 1.987-1(g)(5). Under the 2016 temporary and proposed regulations, an annual deemed termination election generally cannot be made (except in the first taxable year in which the election was relevant) if the aggregate net loss that would be recognized by all owners to which the election applied exceeds $5 million.

See

§ 1.987-1T(g)(2)(i)(B). The annual deemed termination election provided in the 2016 temporary and proposed regulations is irrevocable.

The proposed regulations would provide a consistency requirement that applies to both the existing elections under the final regulations and the new elections under the proposed regulations. Under proposed § 1.987-1(g), these elections would be required to be made or revoked consistently for all members of the same consolidated group and all CFCs, partnerships, non-grantor trusts, and estates in which the ownership interests or beneficiary interests of the U.S. shareholder (or members of its consolidated group) exceed 50 percent. The consistency requirement is intended to make the application of the proposed rules less complex and more administrable; in most cases, consistent application of the regulations is also expected to reduce the compliance burden on taxpayers.

The proposed regulations would permit a current rate election or an annual recognition election to be made or revoked without the Commissioner's consent. The Treasury Department and the IRS recognize that these elections can have important consequences for the substantive application of section 987 and the associated compliance burden, and that taxpayers may wish to change these elections in response to changes in the nature and size of their business operations.

However, the current rate and annual recognition elections are proposed to be subject to timing restrictions and a loss suspension rule. If a current rate election or an annual recognition election is made, it cannot be revoked for five years without the Commissioner's consent. Similarly, once revoked, these elections cannot be made again for five years without consent. Proposed § 1.987-1(g)(3)(ii)(B). These timing requirements are intended to make the proposed regulations easier to administer. In addition, because the Commissioner's consent is not required to make or revoke these elections, the timing requirements are needed to prevent taxpayers from opportunistically making or revoking elections in response to exchange rate fluctuations.

Proposed § 1.987-11(d)(2) provides that, in the first year in which a current rate election is revoked, net accumulated unrecognized section 987 loss is converted into suspended section 987 loss. This rule is needed to prevent net unrecognized section 987 loss generated under a current rate election from being recognized without limitation after the election is revoked.

Similarly, if an annual recognition election is made, and either (1) a current rate election was in effect for the previous year or (2) the aggregate accumulated net unrecognized section 987 loss that would be recognized by the owner as a result of the recognition

election exceeds $5 million, net accumulated unrecognized section 987 loss is converted into suspended section 987 loss.

See

§ 1.987-11(d)(1). As discussed in part III.A of this Explanation of Provisions, this rule is intended to prevent a taxpayer from using an annual recognition election to trigger the recognition of net unrecognized section 987 loss that arose in years before the annual recognition election was made.

XIII. Removal of the Election To Use Spot Rates in Lieu of Yearly Average Exchange Rates

As explained in part II.C of the Background section, the historic rate under § 1.987-1(c)(3) of the 2016 final regulations is equal to the yearly average exchange rate for the year in which a historic asset was acquired or a historic liability was entered into. The 2016 final regulations provide an election under § 1.987-1(c)(1)(iii) to use spot rates in lieu of yearly average exchange rates.

The Treasury Department and the IRS understand that this election may not be helpful to taxpayers, as it would increase the compliance burden of applying section 987 due to the need to track historic spot rates for each day in a taxable year on which the section 987 QBU acquires an asset or incurs a liability. In addition, the availability of this election adds to the complexity of the regulations and makes the rules more difficult for the IRS to administer. Accordingly, the proposed regulations remove the election under § 1.987-1(c)(1)(iii) to use spot rates in lieu of yearly average exchange rates.

XIV. Consolidated Groups

A. Intercompany Transactions

A section 987 QBU of a member of a consolidated group is a component of that member. Therefore, a transaction between that QBU and a different member of the same group constitutes an intercompany transaction (as defined in § 1.1502-13(b)(1)(i)) and is subject to the intercompany transaction regulations in § 1.1502-13.

The Treasury Department and the IRS have become aware that achieving single entity treatment under § 1.1502-13 may be difficult for certain intercompany transactions involving section 987 QBUs. Accordingly, to facilitate single entity treatment, the proposed regulations would treat a transaction between the section 987 QBU of one member and any other member of the same group (including a section 987 QBU of that other member) as a combination of (i) an intercompany transaction between the members, and (ii) a transfer between each section 987 QBU and its owner (

see

§ 1.987-2(c)) as necessary to take into account the effect of the transaction on the assets and liabilities of each section 987 QBU.

The purpose of § 1.1502-13 is to provide rules to clearly reflect the taxable income and tax liability of a consolidated group as a whole by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income (CTI) or consolidated tax liability.

See

§ 1.1502-13(a)(1). The matching rule in § 1.1502-13(c) (Matching Rule) is one of the principal mechanisms for achieving this goal.

See

§ 1.1502-13(a)(6)(i).

The Matching Rule is a principle-based rule that redetermines the attributes of a selling member's (S) intercompany item and a buying member's (B) corresponding item to produce the effect of transactions between divisions of a single corporation (single entity treatment).

See

§ 1.1502-13(a)(2). The Matching Rule also can affect the timing of these items so that, whenever possible, the effect of these items on the group's CTI and consolidated tax liability is the same as if S and B were divisions of a single corporation.

See

§ 1.1502-13(c)(1)(i).

For example, assume that S sells land at a gain to B, which later sells that land at a gain to an unrelated person. To achieve the same result as if S and B were divisions of a single corporation, S does not take into account its gain or loss on the sale until B sells the land to the unrelated person, and S's and B's holding periods for the land are aggregated.

See

§ 1.1502-13(a)(2), (c)(1)(ii), and (c)(2);

see also Example 1

in § 1.1502-13(c)(7)(ii)(A).

The Matching Rule relies on an alignment between S's and B's items that may be unclear in transactions involving section 987 QBUs. For example, assume that Lender (that is, S) and Borrower (that is, B) are members of a consolidated group, and Lender has a section 987 QBU (Lender QBU) whose functional currency is the euro. Lender QBU lends €100 to Borrower. If Borrower and Lender were divisions of a single corporation, the loan would be treated as a transfer from Lender QBU when funded and a transfer to Lender QBU when repaid (or when interest is paid). These transfers would be taken into account in determining the amount of a remittance from Lender QBU (potentially triggering the recognition of section 987 gain or loss), and the single corporation might recognize section 988 gain or loss when the loan is repaid.

See

§§ 1.987-5 and 1.988-1(a)(10)(ii)(A).

However, under current law, the foreign currency gain or loss of Lender and Borrower in the foregoing example does not perfectly offset in amount on the group's consolidated return. This is the case because Borrower has foreign currency gain or loss under section 988 when the loan is repaid, whereas Lender's foreign currency gain or loss under section 987 will be taken into account only when Lender QBU makes a remittance.

See

§§ 1.987-5(a) and 1.988-2(b)(6). Because these amounts are calculated at different times based on different exchange rates, and because section 988 applies to individual transactions while section 987 gain or loss is determined on a pooled basis by reference to the assets and liabilities of a section 987 QBU, achieving single entity treatment under § 1.1502-13 may be difficult. In other words, under current law, it may be difficult to “match” Lender's section 987 gain or loss with Borrower's section 988 gain or loss. Similar mismatches would occur with regard to transactions between section 987 QBUs of different consolidated group members.

The proposed regulations would address the matching issue in this example by treating the loan as if it were made directly between Lender and Borrower.

See

proposed § 1.1502-13(j)(9). Thus, when the loan is made, Lender QBU would be treated as transferring €100 to Lender, which in turn would be treated as lending €100 to Borrower in an intercompany transaction. The loan would be treated as a section 988 transaction with respect to both Lender and Borrower. When Borrower pays interest on the loan and repays the loan principal, Lender would be treated as transferring the interest or principal amount it receives from Borrower to Lender QBU. Lender's interest income and Borrower's interest expense, and their section 988 gain and loss with respect to principal and interest, would offset each other in amount, producing no net effect on CTI (thereby achieving single entity treatment). The group would report any foreign currency gain or loss (under section 987 or 988) on the transfers between Lender and Lender QBU (for example, when Lender QBU loans the €100 to Borrower, which is first treated as a remittance of the €100 from Lender QBU to Lender) on the group's consolidated return.

The proposed regulations also would replace Examples 4 and 15 in § 1.987-2(c)(10) with new examples in § 1.1502-13(j) to illustrate the application of the proposed rule. The new examples make clear that the proposed approach applies to reach single entity treatment

for all consolidated groups, regardless of whether the taxpayer had a principal purpose of avoiding tax through the use of section 987.

Cf.

§ 1.987-2(b)(3)(i) and (c)(10), Example 15 (providing that the IRS may reallocate a receivable from a section 987 QBU to its owner if a principal purpose of avoiding tax through the use of section 987 is present).

B. Separate Return Limitation Years

When a corporation joins a consolidated group, the regulations under section 1502 may limit the group's ability to use the corporation's preexisting tax attributes. For example, § 1.1502-21(c) generally restricts the group's ability to use a member's net operating loss (NOL) that arose in a year when the corporation was not a member of the group. In general, § 1.1502-21(c) allows the group to use only the portion of the NOL that does not exceed the member's “cumulative register,” which reflects the member's items of income, gain, deduction, and loss that have been included in the group's CTI.

See

§ 1.1502-21(c)(1)(i).

Under the proposed regulations, a corporation that is the owner of a section 987 QBU may have suspended or deferred section 987 losses when it joins a consolidated group. The Treasury Department and the IRS request comments about how rules similar to the rules of § 1.1502-21(c) should apply to such losses.

XV. Section 988 Transactions of a Section 987 QBU

The temporary regulations provided special rules relating to section 988 transactions of a section 987 QBU, including transactions denominated in the owner's functional currency. Although the temporary regulations have expired, the corresponding provisions of the 2016 proposed regulations remain outstanding.

In general, under the 2016 proposed regulations, whether a transaction is a section 988 transaction is determined by reference to the section 987 QBU's functional currency, but any section 988 gain or loss is determined in the owner's functional currency.

See

§ 1.987-3(b)(4)(i) of the 2016 proposed regulations. In addition, certain section 988 transactions of a section 987 QBU that are denominated in, or determined by reference to, the owner's functional currency (“specified owner functional currency transactions”) are not treated as section 988 transactions of the section 987 QBU.

See

§ 1.987-3(b)(4)(ii) of the 2016 proposed regulations.

The 2016 proposed regulations further provide that section 988 gain or loss with respect to certain short-term section 988 transactions of a section 987 QBU (“qualified short-term section 988 transactions”) that are accounted for under a mark-to-market method of accounting is determined in the functional currency of the section 987 QBU, and not the functional currency of its owner.

See

§ 1.987-3(b)(4)(iii) of the 2016 proposed regulations.

Under the final regulations, a transaction denominated in a currency other than the section 987 QBU's functional currency is a historic item.

See

§ 1.987-1(d) and (e). However, the 2016 proposed regulations provide that a qualified short-term section 988 transaction for which section 988 gain or loss is determined by reference to the functional currency of the section 987 QBU is a marked item.

See

§ 1.987-1(d)(3) of the 2016 proposed regulations.

The Treasury Department and the IRS understand that the rules of the 2016 proposed regulations relating to nonfunctional currency transactions of a section 987 QBU would increase the compliance burden on taxpayers in certain contexts (for example, where the section 987 QBU operates as a treasury center). This compliance burden could potentially be alleviated by treating all transactions (including specified owner functional currency transactions) denominated in a currency other than the functional currency of the section 987 QBU as marked items, determining whether those transactions are section 988 transactions by reference to the functional currency of the section 987 QBU, and determining the section 988 gain or loss with respect to those transactions in the functional currency of the section 987 QBU. However, the Treasury Department and the IRS are concerned that, under this approach, transactions denominated in the owner's functional currency would be treated as section 988 transactions of a section 987 QBU. Therefore, these transactions would give rise to offsetting positions in that currency, enabling taxpayers to recognize losses while deferring the offsetting gains. For example, if a section 987 QBU held assets denominated in its owner's functional currency, and the section 987 QBU's functional currency weakened against that of its owner, the section 987 QBU would have section 988 gain and the owner would have an inverse amount of section 987 loss.

The Treasury Department and the IRS request comments as to whether section 988 gain or loss on nonfunctional currency transactions (including specified owner functional currency transactions) of a section 987 QBU should be determined in the functional currency of the section 987 QBU when a current rate election or annual recognition election is in effect and, if so, what limitations should be imposed to prevent abuse. Comments are also requested on whether the definition of qualified short-term section 988 transactions should be expanded or modified, and whether other exceptions or special rules should be provided for section 987 QBUs engaged in certain activities (for example, treasury centers).

XVI. Definition of a Qualified Business Unit and an Eligible QBU

Under section 985(b), the functional currency of a qualified business unit is generally either the dollar or the currency of the economic environment in which a significant part of its activities are conducted and in which its books and records are kept. Section 985(b); § 1.985-1(b) through (c). Under section 989, a “qualified business unit” means a “separate and clearly identified unit” of a trade or business of a taxpayer, provided that the unit maintains separate books and records. Section 989(a). The regulations describe two types of qualified business units. The activities of a person may be a qualified business unit if the activities constitute a trade or business and a separate set of books and records are maintained with respect to the activities. § 1.989(a)-1(b)(2)(ii). In addition, the so called “per se” qualified business units include any corporation, partnership (other than a section 987 aggregate partnership), trust, or estate. § 1.989(a)-1(b)(2)(i).

A single qualified business unit may only have a single functional currency. Certain qualified business units, such as domestic corporations, are required to use the dollar as their functional currency unless otherwise provided by a ruling or administrative pronouncement. § 1.985-1(b)(1)(iii). No rulings or administrative pronouncements have been issued under this provision other than private letter rulings that can be relied on only by the specific taxpayer for whom they were issued. Accordingly, all domestic corporations are required to use the dollar as their functional currency unless they have obtained a private letter ruling specifically allowing that entity to use a different functional currency.

The Treasury Department and the IRS have become aware of uncertainty regarding whether a per se qualified business unit, such as a corporation, that has only a single trade or business for which it keeps a single set of books and records is one qualified business unit (the corporation and its single trade

or business) or two qualified business units (the corporation itself being one and its single trade or business being the other). If a domestic corporation with a single trade or business for which it keeps a single set of books and records were a single qualified business unit, that would effectively mean that (absent a ruling) the functional currency of the trade or business would be required to be the dollar, even if the currency of the economic environment of the trade or business was the euro and books and records are maintained in euros; whereas another domestic corporation with an identical trade or business may be permitted to use the euro as the functional currency of the trade or business, as long as it had at least one other trade or business that uses the dollar.

To clarify that a per se qualified business unit, such as a domestic corporation, is permitted to have a single trade or business that maintains a single set of books and records, and which uses a functional currency other than the dollar, the proposed regulations modify the definition of eligible QBU. The revised definition clarifies that, if a per se QBU has only a single trade or business for which only a single set of books and records are maintained, only the trade or business (and not the entity itself) would be an eligible QBU. Proposed § 1.987-1(b)(4). The entity itself would be the owner of the eligible QBU. Proposed § 1.987-1(b)(5). As a result, if the eligible QBU has a functional currency other than the functional currency of the owner, the eligible QBU would be a section 987 QBU.

The Treasury Department and the IRS request comments on whether a similar change should be made to § 1.989(a)-1(b). Comments should also consider whether additional changes are needed in the regulations under section 985 regarding functional currency or in other provisions that reference the definition of a qualified business unit, such as § 1.904-4(f)(3)(vii).

XVII. Other Changes and Revisions

In addition to the provisions described in parts I through XVI of this Explanation of Provisions, the proposed regulations include other wording changes, additions, deletions, and organizational changes to the final regulations and the 2016 proposed regulations for purposes of clarifying, conforming, and making minor revision

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