Change From Dollar Approximate Separate Transactions Method of Accounting (DASTM) to the Profit and Loss Method of Accounting/Change From the Profit and Loss Method to DASTM

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8765]

RIN 1545-AL24; 1545-AS68

Change From Dollar Approximate Separate Transactions Method of

Accounting (DASTM) to the Profit and Loss Method of Accounting/Change

From the Profit and Loss Method to DASTM

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final Income Tax Regulations relating

to adjustments required when a qualified business unit (QBU) that used

the profit and loss method of accounting (P&L) in a post-1986 year

begins to use the dollar approximate separate transaction method of

accounting (DASTM) and adjustments required when a QBU that used DASTM

begins using P&L. The regulations provide rules for taxpayers to

construct an opening dollar balance sheet for the QBU and require

income adjustments in certain cases.

DATES: These regulations are effective April 6, 1998.

FOR FURTHER INFORMATION CONTACT: Howard Wiener at (202) 622-3870 (not a

toll-free number) of the office of Chief Counsel (International) within

the Office of Chief Counsel, Internal Revenue Service, 1111

Constitution Avenue, N.W. Washington, DC 20224.

SUPPLEMENTARY INFORMATION:

Background

On January 5, 1993 and July 25, 1994, the IRS published proposed

amendments to Sec. 1.985-7 in the Federal Register at 58 FR 300 (INTL-

0045-92) and Sec. 1.985-1 in the Federal Register at 59 FR 37733 (INTL-

0066-92), respectively. No public hearing was held and few comments

were received. After consideration of these comments, the regulations

are adopted as a Treasury Decision with modifications as described

below.

Explanation of Provisions

I. Proposed Rules for Changing From P&L to DASTM (Sec. 1.985-7)

1. The Proposed Regulations

The proposed regulations under Sec. 1.985-7 set forth transition

rules for QBUs changing from the profit and loss method of accounting

(P&L) to DASTM in tax years after 1987. Section 1.985-6 provides the

translation rules for QBUs using DASTM in 1987. Generally, when a QBU

changes its functional currency, two basic issues arise: (1) How should

the QBU translate its balance sheet accounts into the new functional

currency in a way that preserves any unrecognized currency gain or loss

which accrued in the old functional currency; and (2) whether income

adjustments need to be made to recognize any currency gain or loss

which accrued in the old functional currency that cannot be preserved.

Section 1.985-5 provides rules that generally apply when a QBU

changes its functional currency. Under Sec. 1.985-5 balance sheet

accounts are translated using the spot rate on the last day prior to

the taxable year of change. In addition, Sec. 1.985-5 generally

requires recognition of unrealized exchange gain or loss on instruments

and other accounts that were maintained in the functional currency to

which the QBU is changing.

The proposed regulations issued under Sec. 1.985-7 were issued in

response to taxpayer comments that Sec. 1.985-5 resulted in significant

distortions when a QBU either elected or was required to use DASTM.

Applying the spot rate on the last day prior to the year in which the

QBU begins to use DASTM (the ``taxable year of change'') to translate

fixed assets typically results in a significant loss of basis in dollar

terms and does not take into account certain income and expense

distortions that occur in the period immediately preceding the taxable

year of change.

In response to taxpayers' comments, the proposed regulations

provide for use of the translation rules provided under Sec. 1.985-3.

These rules generally translate fixed assets at the historical exchange

rate and other assets and liabilities at the current exchange rate. To

correct for distortions that would result from applying historic

exchange rates for fixed assets while applying the current year's spot

rate for other balance sheet accounts, the proposed regulations provide

for income adjustments in the case of a controlled foreign corporation

(CFC) and a branch that reflect amounts that would have been included

in income under DASTM.

In the case of a CFC, the proposed regulations provide for a

shareholder level income adjustment to the extent subpart F income

realized during the period after 1986 until the taxable year of change

differs from subpart F income that would have been realized if the CFC

had used DASTM throughout this period. In the case of a branch, the

regulations provide that any difference between the branch's local

currency

[[Page 10773]]

equity translated into dollars at the spot exchange rate on the last

day prior to the taxable year of change and the taxpayer's dollar basis

pool on that day is included in income over three taxable years

beginning with the taxable year of change. For purposes of translating

the balance sheet of noncontrolled section 902 corporations, the

proposed regulations apply historic exchange rates for fixed assets. In

such case, no shareholder level income adjustments are required.

Recognizing the administrative burden of making income adjustments

for all post-1986 tax years in the case of a CFC, the preamble to the

proposed regulations requested comments regarding three alternative

transition rules as follows: (1) Requiring shareholder level

adjustments for the three-year base period used to determine the

hyperinflationary status of the local currency (in which case the

general rule of Sec. 1.985-5 would be applied in preparing the balance

sheet for the first year of the base period); (2) treating a portion of

retained earnings as subpart F income based on an average historical

rate of subpart F income to total earnings and profits, and (3) using

the spot rate on the last day prior to the taxable year of change to

translate balance sheet items with special rules to allow historical

exchange rates to translate fixed assets to the extent of unrealized

exchange loss on paid-in capital.

2. Reasons for Change

The IRS is concerned that the approach of the proposed regulations

could create a significant administrative burden for shareholders of

CFCs. The administrative burden results from the requirement that

shareholders recompute subpart F income for all of the CFC's post 1986

taxable years. If the functional currency of a CFC becomes

hyperinflationary in a year that is significantly distant from the

CFC's first post-1986 taxable year, records supporting the required

recomputation may be unavailable.

Further, the required recomputation under the proposed regulations

is generally inconsistent with the policy of sections 986 and 987 that

the income of branches with a functional currency different than that

of the taxpayer and the earnings and profits of foreign corporations be

computed under a profit and loss method, except in the case of

hyperinflation. See S. Rep. No. 99-313, 99th Cong., 2d Sess., 454

(1986). The recomputation under the proposed regulation would put the

CFC on DASTM for non-hyperinflationary years. Accordingly, the rules in

the proposed regulations have been modified as described below.

II. Final Regulations for Changing From P&L to DASTM (Sec. 1.985-7)

1. General Rule

The approach employed in the final regulations has the general

effect of treating a QBU as if it had applied Sec. 1.985-5 on the last

day of the last taxable year prior to the base period for determining

whether a currency is hyperinflationary (transition date) and had

applied DASTM during the taxable years beginning after the transition

date until the taxable year of change (look-back period). This approach

addresses the problems of applying Sec. 1.985-5 in the taxable year of

change for purposes of translating fixed assets by applying the

historical exchange rate to the extent fixed assets were acquired

during the look-back period. Assets acquired prior to the look-back

period are translated by applying the spot rate on the transition date.

This approach also corrects distortions in income and expense

(generally interest income and expense) that occur during the look-back

period.

The final regulations respond to taxpayers' comments and provide an

appropriate rule for translating the adjusted basis of fixed assets

into dollars by applying an exchange rate in effect prior to the

hyperinflationary period. Moreover, this method more accurately

reflects Congressional intent for QBUs to apply the profit and loss

method except in the case of hyperinflation. In addition, this approach

decreases the administrative burden of changing to DASTM.

2. Foreign Corporations

In the case of a foreign corporation which is either required or

elects to use DASTM, four basic corporate level adjustments are

required as follows. (1) The balance sheet is translated by treating

the corporation as if it had changed its functional currency to the

dollar for the first post-transition date taxable year and had applied

the rules of Sec. 1.985-5(c) on the transition date. Assets acquired

and liabilities incurred in the functional currency during the look-

back period are translated by applying the rules of Sec. 1.985-3. (2)

The unrealized gain or loss on dollar denominated section 988

transactions as determined on the transition date are treated as if

recognized on that date (and actual gain or loss recognized on dollar

denominated section 988 transactions during the look-back period is

reversed). (3) The dollar value of the pre-1987 E&P of the corporation

as stated on the transition date in the functional currency is

translated into U.S. dollars at the spot rate in effect on the

transition date. (4) The dollar value of the post-1986 E&P is computed

by translating the post-1986 E&P as stated on the transition date in

the functional currency at the spot rate on such date and adding to it

the E&P for the years during the look-back period as computed under

DASTM.

In the case of a CFC, there are three shareholder level adjustments

as follows: (1) The U.S. shareholders must take into income exchange

gain or loss on the deemed recognition of the section 988 transactions

as determined at the corporate level to the extent such gain or loss is

subpart F income. (2) The U.S. shareholders must recognize foreign

currency gain or loss as computed under section 986(c) as if all

previously taxed earnings and profits were distributed on the

transition date (however, any actual 986(c) gain or loss recognized

during the look-back period is reversed). (3) The subpart F income of

the CFC is recomputed during the look-back period under DASTM and

compared to the subpart F income as computed under the P&L method. The

difference (positive or negative) is taken into account in the taxable

year of change and spread over four years. Similar rules apply to

United States persons who have made an election under section 1295 to

treat a passive foreign investment company as a qualified electing

fund. In the case of other foreign corporations, no shareholder level

income adjustments are necessary.

4. Branches

In accord with the general approach articulated above, the

regulations treat a branch changing to DASTM as applying the principles

of Sec. 1.985-5 on the transition date. Thus, the balance sheet is

translated by treating the branch as if it had changed its functional

currency to the dollar for the first post-transition date taxable year

and had applied the rules of Sec. 1.985-5(c) on the transition date.

Unrealized gain or loss on dollar denominated section 988 transactions

as stated on the transition date are treated as if recognized on that

date (and any actual gain or loss realized with respect to section 988

transactions during the look-back period is reversed). Further, the

regulations require that the taxpayer recognize gain or loss

attributable to the branch's equity pool (as stated on the transition

date) under the principles of section 987, computed as if the branch

terminated on the transition date. Such gain or loss is reduced by any

section 987 gain and increased by any section 987 loss that was

recognized by the

[[Page 10774]]

taxpayer with respect to remittances during the look-back period.

Finally, branch income shall be determined under Sec. 1.985-3 for each

look-back year and compared to the amount that was taken into account

for each year. The sum of the difference (positive or negative) is

taken into account in the taxable year of change and spread over four

years.

III. Rules for Changing from DASTM to P&L (Sec. 1.985-1)

Under the proposed regulation, a QBU that has been required or had

elected to use DASTM must change functional currency to the currency of

its economic environment in a year in which the currency is no longer

hyperinflationary pursuant to the three-year test under Sec. 1.985-

1(b). These rules provide that when a taxpayer changes from DASTM to

the P&L method of accounting, Sec. 1.985-5 shall apply for purposes of

translating a QBU's balance sheet and for making certain income

adjustments. Because these rules generally do not create distortions

and are administrable, the final regulations adopt these regulations as

proposed.

IV. Other Changes

Various conforming changes have been made to Secs. 1.985-1 and

1.985-5 to account for the addition of Sec. 1.985-7. In addition, the

definition of hyperinflation has been liberalized to provide that for

purposes of determining whether a currency is hyperinflationary for

income tax purposes, United States generally accepted accounting

principles will be accepted provided that the determination is based on

criteria that is substantially similar to the general rules provided in

the regulations, the method of determination is applied consistently

from year to year, and the same method is applied to all related

persons.

Special Analysis

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

does not apply to these regulations, and because the notice of proposed

rulemaking preceding the regulations was issued prior to March 29,

1996, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Accordingly, a regulatory flexibility analysis is not required.

Pursuant to section 7805(f) of the Code, the notice of proposed

rulemaking preceding these regulations was submitted to the Small

Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Howard A. Wiener of

the Office of the Associate Chief Counsel (International). Other

personnel from the IRS and Treasury Department also participated in

their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

part as follows:

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

Par. 2. Section 1.985-1 is amended by:

1. Revising paragraph (b)(2)(ii)(C).

2. Adding a sentence to the end of paragraph (b)(2)(ii)(D).

3. Adding paragraph (b)(2)(ii)(E).

The additions and revision reads as follows:

Sec. 1.985-1 Functional currency.

* * * * *

(b) * * *

(2) * * *

(ii) * * *

(C) Change in functional currency. If a QBU is required to change

its functional currency to the dollar under paragraph (b)(2)(ii)(A) of

this section, or chooses or is required to change its functional

currency to the dollar for any open taxable year (and all subsequent

taxable years) under Sec. 1.985-3(a)(2)(ii), the change is considered

to be made with the consent of the Commissioner for purposes of

Sec. 1.985-4. A QBU changing functional currency must make adjustments

described in Sec. 1.985-7 if the year of change (as defined in

Sec. 1.481-1(a)(1)) begins after 1987, or the adjustments described in

Sec. 1.985-6 if the year of change begins in 1987. No adjustments under

section 481 are required solely because of a change in functional

currency described in this paragraph (b)(2)(ii)(C).

(D) * * * In making the determination whether a currency is

hyperinflationary, the determination for purposes of United States

generally accepted accounting principles may be used for income tax

purposes provided the determination is based on criteria that is

substantially similar to the rules previously set forth in this

paragraph (b)(2)(ii)(D), the method of determination is applied

consistently from year to year, and the same method is applied to all

related persons as defined in Sec. 1.985-3(e)(2)(vi).

(E) Change in functional currency when currency ceases to be

hyperinflationary--(1) In general. A QBU that has been required to use

the dollar as its functional currency under paragraph (b)(2) of this

section, or has elected to use the dollar as its functional currency

under paragraph (b)(2)(ii)(B)(2) of this section or Sec. 1.985-2, must

change its functional currency as of the first day of the first taxable

year that follows three consecutive taxable years in which the currency

of its economic environment, determined under paragraph (c)(2) of this

section, is not a hyperinflationary currency. The functional currency

of the QBU for such year shall be determined in accordance with

paragraph (c) of this section. For purposes of Sec. 1.985-4, the change

is considered to be made with the consent of the Commissioner. See

Sec. 1.985-5 for adjustments that are required upon a change in

functional currency.

(2) Effective Date. This paragraph (b)(2)(ii)(E) of this section

applies to taxable years beginning after April 6, 1998.

Par. 3. Section 1.985-5(a) is amended by adding the following

sentence to the end of the paragraph:

Sec. 1.985-5 Adjustments required upon change in functional currency.

(a) * * * However, a QBU that changes to the dollar pursuant to

Sec. 1.985-1(b)(2) after 1987 shall apply Sec. 1.985-7.

* * * * *

Par. 4. Section 1.985-7 is added as follows:

Sec. 1.985-7 Adjustments required in connection with a change to

DASTM.

(a) In general. If a QBU begins to use the dollar approximate

separate transactions method of accounting set forth in Sec. 1.985-3

(DASTM) in a taxable year beginning after April 6, 1998, adjustments

shall be made as provided by this section. For the rules with respect

to foreign corporations, see paragraph (b) of this section. For the

rules with respect to adjustments to the income of United States

shareholders of controlled foreign corporations, see paragraph (c) of

this section. For the rules with respect to adjustments relating to QBU

branches, see paragraph (d) of this section. For the effective date of

this section, see paragraph (e). For purposes of applying this section,

the look-back period shall be the period

[[Page 10775]]

beginning with the first taxable year after the transition date and

ending on the last day prior to the taxable year of change. The term

transition date means the later of the last day of the last taxable

year ending before the base period as defined in Sec. 1.985-

1(b)(2)(ii)(D) or the last day of the taxable year in which the QBU

last applied DASTM. The taxable year of change shall mean the taxable

year of change as defined in Sec. 1.481-1(a)(1). The application of

this paragraph may be illustrated by the following examples:

Example 1. A calendar year QBU that has not previously used

DASTM operates in a country in which the functional currency of the

country is hyperinflationary as defined under Sec. 1.985-

1(b)(2)(ii)(D) for the QBU's 1999 tax year. The look-back period is

the period from January 1, 1996 through December 31, 1998, the

transition date is December 31, 1995, and the taxable year of change

is the taxable year beginning January 1, 1999.

Example 2. A QBU that has not previously used DASTM with a

taxable year ending June 30, operates in a country in which the

functional currency of the country is hyperinflationary for the

QBU's tax year beginning July 1, 1999 as defined under Sec. 1.985-

1(b)(2)(ii)(D) (where the base period is the thirty-six calendar

months immediately preceding the first day of the current calendar

year 1999). The look-back period is the period from July 1, 1995

through June 30, 1999, the transition date is June 30, 1995, and the

taxable year of change is the taxable year beginning July 1, 1999.

(b) Adjustments to foreign corporations--(1) In general. In the

case of a foreign corporation, the corporation shall make the

adjustments set forth in paragraphs (b)(2) through (4) of this section.

The adjustments shall be made on the first day of the taxable year of

change.

(2) Treatment of certain section 988 transactions--(i) Exchange

gain or loss from section 988 transactions unrealized as of the

transition date. A foreign corporation shall adjust earnings and

profits by the amount of any unrealized exchange gain or loss that was

attributable to a section 988 transaction (as defined in sections

988(c)(1)(A), (B), and (C)) that was denominated in terms of (or

determined by reference to) the dollar and was held by the corporation

on the transition date. Such gain or loss shall be computed as if

recognized on the transition date and shall be reduced by any gain and

increased by any loss recognized by the corporation with respect to

such transaction during the look-back period. The amount of such gain

or loss shall be determined without regard to the limitations of

section 988(b) (i.e., whether any gain or loss would be realized on the

transaction as a whole). The character and source of such gain or loss

shall be determined under section 988. Proper adjustments shall be made

to account for gain or loss taken into account by reason of this

paragraph (b)(2). See Sec. 1.985-5(f) Example 1, footnote 1.

(ii) Treatment of a section 988 transaction entered into and

terminated during the look-back period. A foreign corporation shall

reduce earnings and profits by the amount of any gain, and increase

earnings and profits by the amount of any loss, that was recognized

with respect to any dollar denominated section 988 transactions entered

into and terminated during the look-back period.

(3) Opening balance sheet. The opening balance sheet of a foreign

corporation for the taxable year of change shall be determined as if

the corporation had changed its functional currency to the dollar by

applying Sec. 1.985-5(c) on the transition date and had translated its

assets and liabilities under Sec. 1.985-3 during the look-back period.

(4) Earnings and profits adjustments--(i) Pre-1987 accumulated

profits. The foreign income taxes and accumulated profits or deficits

in accumulated profits of a foreign corporation that are attributable

to taxable years beginning before January 1, 1987, as stated on the

transition date, and that were maintained for purposes of section 902

in the old functional currency, shall be translated into dollars at the

spot rate in effect on the transition date. The applicable accumulated

profits shall be reduced on a last-in, first-out basis by the aggregate

dollar amount (translated from functional currency in accordance with

the rules of section 989(b)) attributable to earnings and profits that

were distributed (or treated as distributed) during the look-back

period to the extent such amounts distributed exceed the earnings and

profits calculated under (b)(4)(ii) or (b)(4)(iii), as applicable. See

Sec. 1.902-1(b)(2)(ii). Once translated into dollars, these pre-1987

taxes and accumulated profits or deficits in accumulated profits shall

(absent a change in functional currency) remain in dollars for all

federal income tax purposes.

(ii) Post-1986 undistributed earnings of a CFC. In the case of a

controlled foreign corporation (within the meaning of section 957 or

section 953(c)(1)(B))(CFC) or a foreign corporation subject to the

rules of Sec. 1.904-6(a)(2), the corporation's post-1986 undistributed

earnings in each separate category as defined in Sec. 1.904-5(a)(1) as

of the first day of the taxable year of change (and prior to adjustment

under paragraph (c)(1) of this section) shall equal the sum of--

(A) The corporation's post-1986 undistributed earnings and profits

(or deficit in earnings and profits) in each separate category as

defined in Sec. 1.904-5(a)(1) as stated on the transition date

translated into dollars at the spot rate in effect on the transition

date; and

(B) The sum of the earnings and profits (or deficit in earnings and

profits) in each separate category determined under Sec. 1.985-3 for

each post-transition date taxable year prior to the taxable year of

change.

Such amount shall be reduced by the aggregate dollar amount

(translated from functional currency in accordance with the rules of

section 989(b)) attributable to earnings and profits that were

distributed (or treated as distributed) during the look-back period out

of post-1986 earnings and profits in such separate category. For

purposes of applying this paragraph (b)(4)(ii)(B), the opening balance

sheet for calculating earnings and profits under Sec. 1.985-3 for the

first post-transition year shall be translated into dollars pursuant to

Sec. 1.985-5(c).

(iii) Post-1986 undistributed earnings of other foreign

corporations. In the case of a foreign corporation that is not a CFC or

subject to the rules of Sec. 1.904-6(a)(2), the corporation's post-1986

undistributed earnings shall equal the sum of--

(A) The corporation's post-1986 undistributed earnings (or deficit)

on the transition date translated into dollars at the spot rate in

effect on the transition date; and

(B) The sum of the earnings and profits (or deficit in earnings and

profits) determined under Sec. 1.985-3 for each post-transition date

taxable year (or such later year determined under section 902(c)(3)(A))

prior to the taxable year of change.

Such amount shall be reduced by the aggregate dollar amount

(translated from functional currency in accordance with the rules of

section 989(b)) that was distributed (or treated as distributed) during

the look-back period out of post-1986 earnings and profits. For

purposes of applying this paragraph (b)(4)(iii)(B), the opening balance

sheet for calculating earnings and profits under Sec. 1.985-3 for the

first post-transition year shall be translated into dollars pursuant to

Sec. 1.985-5(c).

(c) United States shareholders of controlled foreign corporations--

(1) In general. A United States shareholder (within the meaning of

section 951(b) or section 953(c)(1)(B)) of a CFC that

[[Page 10776]]

changes to DASTM shall make the adjustments set forth in paragraphs (c)

(2) through (5) of this section on the first day of the taxable year of

change. Adjustments under this section shall be taken into account by

the shareholder (or such shareholder s successor in interest) ratably

over four taxable years beginning with the taxable year of change.

Similar rules shall apply in determining adjustments to income of

United States persons who have made an election under section 1295 to

treat a passive foreign investment company as a qualified electing

fund.

(2) Treatment under subpart F of income recognized on section 988

transactions. The character of amounts taken into account under

paragraph (b)(2) of this section for purposes of sections 951 through

964, shall be determined on the transition date and to the extent

characterized as subpart F income shall be taken into account in

accordance with the rules of paragraph (c)(1) of this section. Such

amounts shall retain their character for all federal income tax

purposes (including sections 902, 959, 960, 961, 1248, and 6038).

(3) Recognition of foreign currency gain or loss on previously

taxed earnings and profits on the transition date. Gain or loss is

recognized under section 986(c) as if all previously taxed earnings and

profits as determined on the transition date, if any, were distributed

on such date. Such gain or loss shall be reduced by any foreign

currency gain and increased by any foreign currency loss that was

recognized under section 986(c) with respect to distributions of

previously taxed earnings and profits during the look-back period. Such

amount shall be characterized in accordance with section 986(c) and

taken into account in accordance with the rules of paragraph (c)(1) of

this section.

(4) Subpart F income adjustment. Subpart F income in a separate

category shall be determined under Sec. 1.985-3 for each look-back

year. For this purpose, the opening DASTM balance sheet shall be

determined under Sec. 1.985-5. The sum of the difference (positive or

negative) between the amount computed pursuant to Sec. 1.985-3 and

amount that was included in income for each year shall be taken into

account in the taxable year of change pursuant to paragraph (c)(1) of

this section. Such amounts shall retain their character for all federal

income tax purposes (including sections 902, 959, 960, 961, 1248, and

6038). For rules applicable if an adjustment under this section results

in a loss for the taxable year in a separate category, see section

904(f) and the regulations thereunder. The amount of previously taxed

earnings and profits as determined under section 959(c)(2) shall be

adjusted (positively or negatively) by the amount taken into account

under this paragraph (c)(4) as of the first day of the taxable year of

change.

(5) Foreign tax credit. A United States shareholder of a CFC shall

compute an amount of foreign taxes deemed paid under section 960 with

respect to any positive adjustments determined under paragraph (c) of

this section. The amount of foreign tax deemed paid shall be computed

with reference to the full amount of the adjustment and to the post-

1986 undistributed earnings determined under paragraph (b)(4) (i) and

(ii) of this section and the post-1986 foreign income taxes of the CFC

on the first day of the taxable year of change (i.e., without taking

into account earnings and taxes for the taxable year of change.) For

purposes of section 960, the associated taxes in each separate category

shall be allocated pro rata among, and deemed paid in, the

shareholder's taxable years in which the income is taken into account.

(No adjustment to foreign taxes deemed paid in prior years is required

solely by reason of a negative adjustment to income under paragraph

(c)(1) of this section.)

(d) QBU branches--(1) In general. In the case of a QBU branch, the

taxpayer shall make the adjustments set forth in paragraphs (d)(2)

through (d)(4) of this section. Adjustments under this section shall be

taken into account by the taxpayer ratably over four taxable years

beginning with the taxable year of change.

(2) Treatment of certain section 988 transactions--(i) Exchange

gain or loss from section 988 transactions unrealized as of the

transition date. A QBU branch shall adjust income by the amount of any

unrealized exchange gain or loss that was attributable to a section 988

transaction (as defined in sections 988(c)(1) (A), (B), and (C)) that

was denominated in terms of (or determined by reference to) the dollar

and was held by the QBU branch on the transition date. Such gain or

loss shall be computed as if recognized on the transition date and

shall be reduced by any gain and increased by any loss recognized by

the QBU branch with respect to such transaction during the look-back

period. The amount of such gain or loss shall be determined without

regard to the limitations of section 988(b) (i.e., whether any gain or

loss would be realized on the transaction as a whole). The character

and source of such gain or loss shall be determined under section 988.

Proper adjustments shall be made to account for gain or loss taken into

account by reason of this paragraph (d)(2). See Sec. 1.985-5(f) Example

1, footnote 1.

(ii) Treatment of a section 988 transaction entered into and

terminated during the look-back period. A QBU branch shall reduce

income by the amount of any gain, and increase income by the amount of

any loss, that was recognized with respect to any dollar denominated

section 988 transactions entered into and terminated during the look-

back period.

(3) Deemed termination income adjustment. The taxpayer shall

realize gain or loss attributable to the QBU branch's equity pool (as

stated on the transition date) under the principles of section 987,

computed as if the branch terminated on the transition date. Such

amount shall be reduced by section 987 gain and increased by section

987 loss that was recognized by such taxpayer with respect to

remittances during the look-back period.

(4) Branch income adjustment. Branch income in a separate category

shall be determined under Sec. 1.985-3 for each look-back year. For

this purpose, the opening DASTM balance sheet shall be determined under

Sec. 1.985-5. The sum of the difference (positive or negative) between

the amount computed pursuant to Sec. 1.985-3 and amount taken into

account for each year shall be taken into account in the taxable year

of change pursuant to paragraph (d)(1) of this section. Such amounts

shall retain their character for all federal income tax purposes.

(5) Opening balance sheet. The opening balance sheet of a QBU

branch for the taxable year of change shall be determined as if the

branch had changed its functional currency to the dollar by applying

Sec. 1.985-5(c) on the transition date and had translated its assets

and liabilities under Sec. 1.985-3 during the look-back period.

(e) Effective date. This section is effective for taxable years

beginning after April 6, 1998. However, a taxpayer may choose to apply

this section to all open taxable years beginning after December 31,

1986, provided each person, and each QBU branch of a person, that is

related (within the meaning of Sec. 1.985-2(d)(3)) to the taxpayer also

applies this section.

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

Approved: February 11, 1998

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

[FR Doc. 98-5470 Filed 3-4-98; 8:45 am]

BILLING CODE 4830-01-U