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United States | Proposed regulations on qualified business units include simplified elections for determining IRC Section 987 gain or loss, but restrict the recognition of losses
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On November 9, 2023, the IRS and Treasury Department released proposed regulations (REG-132422-17 (pdf)) under IRC Section 987 (the Proposed Regulations) with guidance on determining taxable income or loss and currency gain or loss with respect to a qualified business unit whose functional currency differs from its tax owner (an IRC Section 987 QBU).
The Proposed Regulations retain the basic approach and structure of the regulations finalized in 2016 and 2019, including the foreign exchange exposure pool (FEEP) method, while adopting simplifications, including elections to (1) treat all items of an IRC Section 987 QBU as marked items (subject to a loss suspension rule) (the Current Rate Election), and (2) recognize all foreign currency gain or loss with respect to an IRC Section 987 QBU on an annual basis (the Annual Recognition Election). The Proposed Regulations also include new transition rules, which require the computation and disclosure of pretransition IRC Section 987 gain or loss, but generally delay the recognition of any such pretransition gains and losses.
With the Proposed Regulations, the IRS and the Treasury Department apparently seek to strike a balance between reducing the compliance burden on taxpayers while addressing concerns over the selective recognition of IRC Section 987 losses.
Background
Under IRC Section 987(1) and (2), a taxpayer must determine its taxable income or loss with respect to an IRC Section 987 QBU in the functional currency of the QBU, and translate that amount at the average exchange rate for the year. IRC Section 987(3) requires taxpayers to make "proper adjustments" for transfers of property between an IRC Section 987 QBU and its owner. Several proposed regulations on the application of these rules have been issued and withdrawn since 1991.
On December 8, 2016, the IRS and the Treasury Department published final (T.D. 9794) (the 2016 Final Regulations), temporary (T.D. 9795) (the 2016 Temporary Regulations), and proposed regulations (REG-128276-12) (the 2016 Proposed Regulations) under IRC Section 987. See Tax Alert 2016-2117. Effective May 13, 2019, Treasury and the IRS finalized certain provisions of the 2016 Temporary Regulations (the 2019 Final Regulations). See Tax Alert 2019-0932.
The 2016 Final Regulations and the 2019 Final Regulations generally adopt the FEEP method as the rule for determining IRC Section 987 taxable income or loss and net unrecognized IRC Section 987 gain or loss. Under the FEEP Method, the owner of an IRC Section 987 QBU determines all items of income, gain, deduction and loss attributable to the IRC Section 987 QBU in the QBU's functional currency, and then translates those items into the owner's functional currency. The basis of "historic assets" is translated at the average exchange rate for the tax year during which the asset was acquired. All other items (including the amount realized on a sale or exchange of an historic asset) are translated into the owner's functional currency at the average exchange rate for the tax year.
In addition, the owner of an IRC Section 987 QBU must determine the pool of unrecognized IRC Section 987 gain or loss based on the annual increase or decrease to the IRC Section 987 QBU's balance sheet that is attributable to foreign exchange rate fluctuations. The amount of IRC Section 987 gain or loss for each year equals the increase or decrease in the basis of assets (net of liabilities) of the IRC Section 987 QBU, measured in the owner's functional currency and adjusted for transfers between the IRC Section 987 QBU and its owner and IRC Section 987 taxable income or loss. The bases of historic items are translated at historic exchange rates, while "marked items" are translated at the applicable spot rate. A marked item is an asset or liability that would generate gain or loss under IRC Section 988 if it were held or entered into directly by the owner, but is not an IRC Section 988 transaction with respect to the IRC Section 987 QBU itself.
IRC Section 988 transactions include debt instruments, accounts payable and receivable, derivative financial instruments, and currency denominated in (or determined by reference to) a nonfunctional currency. A historic item is an asset or liability that is not a marked item. Thus, under the FEEP method, IRC Section 987 gain or loss reflects currency fluctuations with respect to marked items and is not imputed to historic items that are not subject to IRC Section 988. An owner generally recognizes IRC Section 987 gain or loss upon a remittance from, or upon a termination of, its IRC Section 987 QBU, subject to the deferral rules of Treas. Reg. Section 1.987-12.
The 2016 Final Regulations originally applied to tax years beginning on or after one year after the first day of the first tax year following December 7, 2016. That date, however, has been deferred every year since the 2016 Final Regulations were released (see Tax Alerts 2017-1621, 2018-1241, 2019-2179, 2020-2291, 2021-1886, 2022-1248). The 2019 Final Regulations (with the exception of Treas. Reg. Section 1.987-12) have the same applicability date as the Final 2016 Regulations. In the absence of final guidance, Treasury and the IRS generally required taxpayers to apply a reasonable method in complying with IRC Section 987(3), such as the earnings and capital method described in the 1991 proposed regulations (the 1991 Proposed Regulations) or an earnings-only method.
IRC Section 987 Proposed Regulations
The Proposed Regulations retain the FEEP method (with certain modifications) as the default method for complying with IRC Section 987, while reducing the compliance burden and allowing for several simplifying elections (described in more detail later) that permit IRC Section 987 to be applied in a way that more closely conforms to the financial accounting rules and the 1991 Proposed Regulations. The elections, however, come with restrictions on loss recognition and trade-offs with respect to controlling the timing of gain or loss recognition.
Applicability dates
Once finalized, the Proposed Regulations (and the parts of the 2016 Final Regulations and the 2019 Final Regulations that are not replaced or modified by the Proposed Regulations) would apply to tax years beginning after December 31, 2024. To prevent taxpayers from avoiding the application of the Proposed Regulations by terminating IRC Section 987 QBUs, the Proposed Regulations would apply beginning on the day an IRC Section 987 QBU terminates on or after November 9, 2023. This date would also apply to terminations resulting from an entity classification election that is made on or after November 9, 2023, and effective before that date, if the 2016 Final Regulations and the 2019 Final Regulations would not apply to the IRC Section 987 QBU. Thus, an IRC Section 987 QBU that terminates on or after November 9, 2023, is subject to the loss deferral rules, which will be discussed in more detail. Finally, all taxpayers with IRC Section 987 QBUs are currently subject to the deferral rules of Treas. Reg. Section 1.987-12.
Taxpayers (and each member of their consolidated group) and their controlled foreign corporations (CFCs) may choose to apply the Proposed Regulations in their entirety to a tax year and all subsequent tax years beginning on or before December 31, 2024. Taxpayers (and each member of their consolidated group) and their CFCs may also choose to apply the 2016 Final Regulations and the 2019 Final Regulations to tax years beginning after December 7, 2016, and beginning on or before December 31, 2024, if they:
- First applied the 2016 Final Regulations and the 2019 Final Regulations on their returns filed before November 9, 2023
or
- First apply the 2016 Final Regulations and the 2019 Final Regulations on their returns filed on or after November 9, 2023, and apply the transition rules of Prop. Treas. Reg. Section 1.987-10 in lieu of the fresh start method in the 2016 Final Regulations
Prop. Treas. Reg. Section 1.987-1: Scope, definitions, and special rules
The Proposed Regulations would generally apply to any person (including an individual, corporation, partnership, S corporation, non-grantor trust, or estate), including entities that were excluded from the 2016 Final Regulations (i.e., banks, insurance companies, leasing companies, finance coordination centers, regulated investment companies, real estate investment trusts, trusts, estates, S corporations, and partnerships other than IRC Section 987 aggregate partnerships). The Proposed Regulations would generally continue to exclude:
- Foreign non-grantor trusts and foreign estates, if the aggregate interests of beneficiaries that are US persons were less than 10%
- Foreign partnerships, if the aggregate interests of the partners that are US persons were less than 10% of the capital and profits interests
- An eligible QBU that has the U.S. dollar as its functional currency and would be subject to IRC Section 987 if it had a functional currency other than the U.S. dollar
- Foreign corporations that are not CFCs but have no US shareholders
- Foreign individuals
An IRC Section 987 QBU is an eligible QBU whose functional currency differs from its owner. An eligible QBU generally refers to activities of a corporation, partnership, IRC Section 987 aggregate partnership (i.e., a partnership in which all partners are related), trust, estate or disregarded entity (DE) that constitute a trade or business and for which a separate set of books and records are maintained. An owner is any person having direct or indirect ownership in an eligible QBU. An eligible QBU cannot be the owner of another eligible QBU. An owner may elect to group IRC Section 987 QBUs with the same functional currency as a single IRC Section 987 QBU, with special rules for IRC Section 987 QBUs owned indirectly through an IRC Section 987 aggregate partnership.
Under the Proposed Regulations, an IRC Section 987 election would be made for the owner and for a taxa year and would apply to every IRC Section 987 QBU owned by the owner while the election is effective. Once made, an IRC Section 987 election remains effective until revoked. The Proposed Regulations would permit a Current Rate Election or an Annual Recognition Election to be made without the Commissioner's consent; however, these elections cannot be revoked for five years without the Commissioner's consent. Similarly, once revoked, these elections cannot be made again for five years without the Commissioner's consent.
Taxpayers may make a Current Rate Election to treat all assets and liabilities of the IRC Section 987 QBU as marked assets and liabilities. The Current Rate Election is intended to align more closely to the 1991 Proposed Regulations. As explained in more detail later, however, certain loss suspension rules apply when a Current Rate Election is in effect.
Prop. Treas. Reg. Section 1.987-2: Attribution of items to eligible QBUs; definition of transfer and related rules
Items would generally be attributed to an eligible QBU to the extent they were recorded on a separate set of books and records of the eligible QBU. Non-portfolio stock, interests in partnerships, and certain acquisition indebtedness would not be attributed to an eligible QBU.
The adjusted basis of a marked asset, or the amount of a marked liability, transferred to an IRC Section 987 QBU would be translated at the spot rate on the date of the transfer. In the absence of a Current Rate Election, the adjusted basis of a historic asset, or the amount of a historic liability, transferred to an IRC Section 987 QBU, would be translated into the IRC Section 987 QBU's functional currency at the historic rate, which is generally the yearly average exchange rate applicable to the year the asset was acquired or the year the liability is incurred or assumed.
An item would be considered transferred to or from an IRC Section 987 QBU from or to its owner if the item were or were no longer recorded on its books and records as a result of a disregarded transaction. General tax law principles apply for purposes of determining whether there is a transfer of an item.
Prop. Treas. Reg. Section 1.987-3: Determination of IRC Section 987 taxable income or loss of an owner of an IRC Section 987 QBU
An IRC Section 987 QBU generally would be required to determine its items of income, gain, deduction or loss in its functional currency under Federal income tax principles. Items denominated in (or determined by reference to) a nonfunctional currency (including the functional currency of the owner) generally would be translated into the IRC Section 987 QBU's functional currency at the spot rate on the date the item is properly taken into account. The owner of an IRC Section 987 QBU would generally translate items of income, gain, deduction, or loss attributable to the IRC Section 987 QBU into the owner's functional currency at the average exchange rate for the tax year if an Annual Recognition Election or Current Rate Election were in effect. Absent application of one of the elections, basis recovery items with respect to historic assets (such as inventory and fixed assets) would be translated at the applicable historic rate. The taxable income or loss of an IRC Section 987 aggregate partnership, and the distributive share of any owner that is a partner in the partnership, would be determined under the principles of subchapter K.
Prop. Treas. Reg. Section 1.987-4: Determination of net unrecognized section 987 gain or loss of an IRC Section 987 QBU
One of the fundamental aspects of the FEEP method is determining IRC Section 987 gain or loss based on a change in the beginning-of-the-year and end-of-the-year balance sheet. An owner applying the FEEP method must annually calculate the unrecognized IRC Section 987 gain or loss of its IRC Section 987 QBUs.
The Proposed Regulations would generally determine unrecognized IRC Section 987 gain or loss using a 10-step process. The difference between the IRC Section 987 QBU's opening and closing value as reflected on its balance sheet would be determined (step 1) and:
- Adjusted for amounts transferred between the IRC Section 987 QBU and its owner (steps 2-5)
- Decreased or increased by the amount of IRC Section 987 taxable income or loss determined under Prop. Treas. Reg. Section 1.987-3 (step 6)
- Increased or decreased by items of income or expense that are not included in or deductible from the computation of IRC Section 987 taxable income or loss (steps 7-8)
- Increased or decreased by items that do not increase the basis of assets or reduce the amount of liabilities on the IRC Section 987 QBU's balance sheet (step 9)
- Increased or decreased by any amounts not previously taken into account under steps 2-9 (step 10)
Step 10 would ensure that non-currency-related changes to the balance sheet did not artificially increase or decrease the pool of net unrecognized IRC Section 987 gain or loss. The unrecognized IRC Section 987 gain or loss would then be added to the IRC Section 987 QBU's net accumulated unrecognized IRC Section 987 gain or loss for all prior tax years to determine the net unrecognized IRC Section 987 gain or loss.
The change in the IRC Section 987 QBU's net value (the owner functional currency net value) would be determined on the last day of the tax year and equal the aggregate amount of functional currency and the adjusted basis of the IRC Section 987 QBU's assets less the aggregate amount of the IRC Section 987 QBU's liabilities. Marked items would be translated into the owner's functional currency at the spot rate on the last day of the relevant tax year. Absent a Current Rate Election, historic items would be translated into the owner's functional currency at the historic rate.
Prop. Treas. Reg. Section 1.987-5: Recognition of IRC Section 987 gain or loss
A taxpayer would generally recognize IRC Section 987 gain or loss upon remittances from an IRC Section 987 QBU. For these purposes, the remittance would be determined in the owner's functional currency on the last day of the tax year and equal the excess of all transfers from the IRC Section 987 QBU to the owner over the transfers from the owner to the IRC Section 987 QBU. The owner's IRC Section 987 gain or loss would equal the product of (1) the owner's net unrecognized IRC Section 987 gain or loss on the last day of the tax year, and (2) the owner's remittance proportion. The owner's remittance proportion would equal the remittance divided by the sum of (1) the total adjusted basis of the IRC Section 987 QBU's assets (determined in the owner's functional currency), and (2) the remittance. A termination of an IRC Section 987 QBU under Prop. Treas. Reg. Section 1.987-8 would be treated as a remittance of all the gross assets of the IRC Section 987 QBU to the owner on the date of the termination.
Under the Annual Recognition Election, an owner would recognize the full amount of net unrecognized IRC Section 987 gain or loss each year. If a Current Rate Election were not in place, the taxpayer would determine IRC Section 987 taxable income or loss by translating all items at the yearly average exchange rate. However, taxpayers would use the historic rate to translate historic items for purposes of computing IRC Section 987 gain or loss. This election would not result in a deemed transfer of the IRC Section 987 QBU's assets to its owner. As a result, the election would not alter the IRC Section 987 QBU's basis in its assets, the amount of its liabilities, or their historic exchange rates.
As explained in more detail later, certain loss deferral rules may apply when an Annual Recognition Election is in effect.
Prop. Treas. Reg. Section 1.987-6: Character and source of IRC Section 987 gain or loss
IRC Section 987 gain or loss is ordinary income or loss. The character and source of IRC Section 987 gain or loss for each IRC Section 987 QBU would be determined under the Proposed Regulations for all purposes of the Internal Revenue Code (the Code), including IRC Sections 904(d), 907, and 954. This determination would be based on an initial assignment of the IRC Section 987 gain or loss in the year the gain or loss is recognized, deferred, or suspended. The initial assignment would be made to the statutory and residual groupings using a modified asset method under the principles of Treas. Reg. Section 1.861-9(g) and Temp. Treas. Reg. Section 1.861-9T(g). For purposes of applying this method, only assets attributable to the IRC Section 987 QBU would be taken into account, and taxpayers would be required to apply only the tax book value method in characterizing the assets.
IRC Section 987 gain or loss 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 was in effect and, if so, whether the income was high-tax. The initial assignment would be made without regard to IRC Section 987 gain or loss, and used for purposes of applying the Loss-to-the-Extent-of-Gain Rule (defined later), and would also apply as the starting point for net income calculations required for other provisions (e.g., the GILTI and subpart F high-tax exceptions). If a GILTI high-tax election were made, the election would apply to all of the IRC Section 987 gain or loss that is in a tentative tested income group and recognized by the CFC in the tax year as if the IRC Section 987 gain or loss were all assigned to its own separate tested unit of the CFC. Any IRC Section 987 gain or loss assigned to a subpart F income group would be treated as foreign currency gain or loss attributable to IRC Section 988 transactions not directly related to the CFC's business needs , and thus, taken into account in determining passive foreign personal holding company income under IRC Section 954(c)(1)(D).
Prop. Treas. Reg. Section 1.987-7A: Partnerships and S corporations that own IRC Section 987 QBUs
The Proposed Regulations would generally treat non-aggregate IRC Section 987 partnerships and S corporations as an entity, and therefore as a potential owner of an IRC Section 987 QBU, but then apply a hybrid approach to entity treatment. Under this hybrid method, the determination of unrecognized IRC Section 987 gain or loss would be made under Prop. Reg. Section 1.987-4(d) at the partnership level by reference to the functional currency of the partnership and the IRC Section 987 QBU. The partnership would then allocate that gain or loss to each partner annually. This allocation would be based on the partner's distributive share of profits and losses attributable to the IRC Section 987 QBU. Each partner would then translate its share of the gain or loss into its functional currency at the average exchange rate for the year.
The portion of the net unrecognized IRC Section 987 gain or loss recognized would be determined based on the partnership's remittance proportion with respect to the IRC Section 987 QBU. For example, if the partnership's IRC Section 987 QBU remitted 20% of its gross assets, each partner that had net unrecognized IRC Section 987 gain or loss would recognize 20% of that gain or loss. The Loss-to-the-Extent-of-Gain Rule would apply at the partner level. The Proposed Regulations would allow for basis adjustments under the principles of IRC Section 705 when a partner recognizes, defers or suspends IRC Section 987 gain or loss attributable to the partnership.
Treasury and the IRS withdrew rules on applying IRC Section 987 to aggregate partnerships in the 2019 Final Regulations. Until additional guidance is provided, taxpayers may continue to use any reasonable method for determining a partner's share of assets and liabilities reflected on the books and records of an eligible QBU owned indirectly through an IRC Section 987 aggregate partnership (see Tax Alert 2019-0932).
Prop. Treas. Reg. Section 1.987-8: Termination of an IRC Section 987 QBU
An IRC Section 987 QBU would generally terminate when (1) the IRC Section 987 QBU ceases its business operations; (2) the IRC Section 987 QBU transfers substantially all of its assets to its owner; (3) the CFC owning the IRC Section 987 QBU is no longer a CFC; or (4) the IRC Section 987 QBU's owner ceases to exist. An IRC Section 987 QBU would also terminate if it ceased to be an eligible QBU whose functional currency differed from its owner, or the owner of the IRC Section 987 QBU changed its form of ownership with respect to the IRC Section 987 QBU. In addition, an IRC Section 987 QBU would terminate upon the occurrence of inbound and outbound liquidations and reorganizations under IRC Sections 332 and 381(a)(2), as well as in foreign-to-foreign liquidations or reorganizations where the functional currency of the distributee/acquiring corporation was the same as the distributor's/transferor's IRC Section 987 QBU.
Prop. Treas. Reg. Section 1.987-9: Recordkeeping requirements
An owner would be required to keep a copy of each IRC Section 987 election made by or on behalf of an owner, and reasonable records sufficient to establish the IRC Section 987 QBU's taxable income or loss and IRC Section 987 gain or loss. The Proposed Regulations describe specific categories of information that must be maintained to meet these requirements. The information would have to be maintained and kept available for inspection by the IRS as long as it may be relevant in administering the Code. Taxpayers could satisfy these obligations to the extent they provide the specific information required on Form 8858 (or its successor) or another form prescribed by the IRS for this purpose.
Prop. Treas. Reg. Section 1.987-10: Transition rules
Taxpayers transitioning to the Proposed Regulations would first determine whether they have applied an eligible pretransition method to their IRC Section 987 QBUs. An eligible pretransition method means any reasonable method of applying IRC Section 987 that a taxpayer applied consistently to each tax year preceding the transition date. For these purposes, a reasonable method includes (1) the earnings and capital method described in the 1991 Proposed Regulations; and (2) any method producing the same total amount of income over the life of the owner of the IRC Section 987 QBU as the earnings-and-capital method. An earnings-only method that does not meet this standard could still qualify as an eligible pretransition method if (1) the method was first applied by the owner on a return filed before November 9, 2023; (2) the method was applied consistently to all IRC Section 987 QBUs of the owner; and (3) the owner otherwise reasonably applies IRC Section 987. For this purpose, a method would not be reasonable unless the owner recognized IRC Section 987 gain or loss upon a transfer of property from the IRC Section 987 QBU to the owner. An anti-abuse rule would apply if the owner changed its pretransition method with a principal purpose of reducing its pretransition gain or increasing its pretransition loss.
Upon transition, the owner would determine its pretransition gain or loss. If an owner applied an eligible pretransition method, any pretransition gain or loss would equal the IRC Section 987 gain or loss that the owner would have recognized under its existing method, as if the IRC Section 987 QBU terminated on the transition date, plus the owner's functional currency net value adjustment. This adjustment could be either positive or negative and would equal the difference between (1) the basis of the assets, reduced by the liabilities, that are attributable to the IRC Section 987 QBU on the day before the transition date translated into the owner's functional currency at the spot rate on that date, and (2) the same amount translated into the owner's functional currency at the pre-translation rate. The pre-translation rate is the rate that would be used under the eligible pretransition method to determine the basis of an asset or amount of a liability in the hands of the owner of the IRC Section 987 QBU. For many taxpayers, the pre-translation rate would be the spot rate. As a result, this adjustment generally would equal zero.
A taxpayer that did not use an eligible pretransition method would compute pretransition gain or loss to equal the sum of the owner's annual unrecognized IRC Section 987 gain or loss for all tax years ending before the transition date, reduced by the total net IRC Section 987 gain or loss recognized by the owner in all tax years ending before the transition date. These determinations would be made from the inception of the IRC Section 987 QBU and apply a modified version of the computations described in Prop. Reg. Section 1.987-4(d). Thus, taxpayers that did not apply an eligible pretransition method would likely face substantial compliance requirements leading up to the transition date.
Any pretransition gain would be treated as net accumulated unrecognized IRC Section 987 gain. Pretransition loss would be treated as IRC Section 987 suspended loss (defined later) and thus subject to the Loss-to-the-Extent-of-Gain Rule; however, a taxpayer could elect to recognize pretransition gain or loss ratably over 10 years. Any unrecognized pretransition gain would be immediately recognized when certain inbound and outbound transactions under IRC Section 381(a) occurred.
Taxpayers would also be required to complete a detailed "Section 987 Transition Information" statement and attach the statement to the owner's timely filed return for the tax year beginning on the transition date for each IRC Section 987 QBU subject to transition.
Prop. Treas. Reg. Section 1.987-11: Suspended IRC Section 987 loss relating to certain elections; loss-to-the-extent-of-gain rule
If both a Current Rate Election and an Annual Recognition Election were in place, an IRC Section 987 loss generally would not be suspended. To prevent taxpayers from selectively recognizing large IRC Section 987 losses, however, the Proposed Regulations would generally suspend recognition of any IRC Section 987 loss when a Current Rate Election was in effect and the taxpayer did not make the Annual Recognition Election (IRC Section 987 suspended loss). In addition, any net accumulated unrecognized IRC Section 987 gain or loss would be converted into an IRC Section 987 suspended loss at the beginning of the first year for which the Annual Recognition Election was effective if either:
- A Current Rate Election were in effect for the immediately preceding tax year
or
- A Current Rate Election were not in effect, and, as of the beginning of the tax year, the owner's total unrecognized IRC Section 987 losses exceeded its total unrecognized IRC Section 987 gains by more than $5 million
Finally, any net accumulated unrecognized IRC Section 987 loss would be converted to IRC Section 987 suspended loss in the first year in which a Current Rate election ceased to be effective.
IRC Section 987 suspended loss would generally be recognized in a tax year in which an equal or greater amount of IRC Section 987 gain in the same recognition grouping was recognized or until certain recognition events occurred (the Loss-to-the-Extent-of-Gain Rule). Whether the IRC Section 987 gain were within the same recognition grouping as the IRC Section 987 suspended loss would be determined on the basis of the initial assignment described in Prop. Treas. Reg. Section 1.987-6. If, however, a taxpayer made both an Annual Recognition Election and a Current Rate Election, the Loss-to-the-Extent-of-Gain Rule would apply to the net cumulative amount of IRC Section 987 gain in each recognition grouping that the taxpayer recognized during the relevant testing period (rather than the gross amount recognized each tax year). The testing period generally is the period in which IRC Section 987 loss is suspended and both a Current Rate Election and an Annual Recognition Election are in effect. The Loss-to-the-Extent-of-Gain Rule would apply at the owner level, rather than on an individual IRC Section 987 QBU basis. Treasury and the IRS request comments on whether any modifications to this rule would allow for simplification while preventing inappropriate outcomes.
Prop. Treas. Reg. Section 1.987-12: Deferral of IRC Section 987 gain or loss
The Proposed Regulations would generally defer recognition of IRC Section 987 gain or loss upon the occurrence of certain related party transactions in which the assets of the terminating IRC Section 987 QBU are recorded on the balance sheet of a member of the same controlled group (a deferral event). These rules would not apply where the owner has an Annual Recognition Election in place, or the total amount of net unrecognized IRC Section 987 gain or loss with respect to all of the owner's IRC Section 987 QBUs did not exceed $5 million.
A deferral event would occur where a transaction or series of transactions met the following conditions: (1) the IRC Section 987 QBU terminated as a result of a transfer of substantially all its assets, the IRC Section 987 QBU ceased to be an IRC Section 987 QBU, or the owner of the IRC Section 987 changed the form of its ownership interest in the IRC Section 987 QBU; and (2) the assets of the IRC Section 987 QBU were reflected on the books and records of a successor deferral QBU immediately after the transactions.
An IRC Section 987 QBU would be a successor deferral QBU if, immediately after the transactions, the potential successor deferral QBU satisfied the following conditions: (1) the books and records of the potential successor deferral QBU reflect assets that were reflected on the books and records of the IRC Section 987 QBU immediately before the transactions; (2) the owner of the potential successor deferral QBU and the owner of the IRC Section 987 QBU are members of the same controlled group; and (3) a US. person owns the potential successor deferral QBU if a US person owned the IRC Section 987 QBU.
IRC Section 987 gain or loss would be deferred to the extent the assets of the terminating IRC Section 987 QBU were recorded on the books and records of the successor deferral QBU. IRC Section 987 gain or loss would be recognized (subject, as appropriate, to the Loss-to-the-Extent-of-Gain Rule) when the successor deferral QBU owners made remittances to the new owner. This determination would be made under Prop. Reg. Section 1.987-5(b) without regard to whether the successor deferral QBU made an Annual Recognition Election. For these purposes, the successor deferral QBU would be deemed to transfer all of its assets when it ceased to be owned by a member of the same controlled group that includes the terminated IRC Section 987 QBU's owner. An anti-abuse rule would apply to transactions entered with a principal purpose of avoiding the purpose of Prop. Reg. Section 1.987-12.
Prop. Treas. Reg. Section 1.987-13: Suspended IRC Section 987 loss upon terminations
The Proposed Regulations would generally prohibit the recognition of any unrecognized IRC Section 987 loss when (1) the IRC Section 987 QBU terminated and, immediately after the termination, a significant portion of its assets were recorded on the books and records of an eligible QBU (but not necessarily an IRC Section 987 QBU) carrying on the same trade or business, and (2) that QBU was owned by the same owner (successor suspended loss QBU). Instead, the IRC Section 987 suspended loss would be carried over to the successor suspended loss QBU. However, no IRC Section 987 suspended loss would be carried over for certain inbound non-recognition transactions.
The cumulative IRC section 987 suspended loss could be recognized in the following circumstances: (1) no successor suspended loss QBU existed; or (2) the successor suspended loss QBU ceased to be owned by a member of the original QBU owner's controlled group. If the original QBU owner ceased to be a member of the successor suspended loss QBU owner's controlled group, the original IRC Section 987 suspended loss could be recognized under the Loss-to-the-Extent-of-Gain Rule. If, however, the original owner ceased to exist, and there were no successor, any IRC Section 987 suspended loss not recognized after applying the Loss-to-the-Extent-of-Gain Rule could not be recognized and would be extinguished.
The Proposed Regulations would also limit the ability to recognize an IRC Section 987 loss upon the occurrence of so-called outbound loss events in which neither a Current Rate Election nor an Annual Recognition Election was in place. An outbound loss event means any termination of an IRC Section 987 QBU resulting from:
- A US person's transfer of the assets to a foreign person that is a member of the same controlled group immediately before the transaction
or
- A US person's transfer of the assets to a foreign person within the US person's controlled group, where the foreign person did not exist immediately before the transfer (e.g., an entity classification election to treat a foreign IRC Section 987 QBU as a corporation).
In that case, any unrecognized IRC section 987 loss (including any deferred loss) would become IRC Section 987 suspended loss.
Prop. Treas. Reg. Section 1.1502-13: Intercompany transactions
An IRC Section 987 QBU of a member of a consolidated group would be a component of that member. Thus, a transaction between that QBU and a different member of the same group would be an intercompany transaction (as defined in Treas. Reg. Section 1.1502-13(b)(1)(i)) and subject to the intercompany transaction rules in Treas. Reg. Section 1.1502-13. To facilitate single-entity treatment and satisfy the matching rule under Treas. Reg. Section 1.1502-13(c), the Proposed Regulations would treat a transaction between an IRC Section 987 QBU of one member and any other member of the same consolidated group as a combination of (1) an intercompany transaction between the members, and (2) a transfer between each IRC Section 987 QBU and its owner as necessary to take into account the effect of the transaction on the assets and liabilities of the IRC Section 987 QBU.
IRC Section 988 transactions
A separate notice reopening the comment period for certain parts of the 2016 Proposed Regulations was also published on November 9, 2023. In particular, the notice re-proposed Prop. Reg. Section 1.988-2(b)(16), which would defer the recognition of IRC Section 988 losses of an issuer of an IRC Section 988 debt instrument to a related party if the transaction resulting in the realization of the loss has as a principal purpose the avoidance of Federal income tax. The loss would be deferred until the end of the term of the loan, determined immediately before the transaction.
Implications
The Proposed Regulations provide welcome guidance on the application of IRC Section 987. Though the regulations would generally not apply until tax years beginning after December 31, 2024 (unless early adopted), taxpayers should begin to take various steps in anticipation of transitioning to the new rules.
First, taxpayers should determine whether they have applied an eligible pretransition method under IRC Section 987 for each of their IRC Section 987 QBUs, calculate the amount of pretransition gain or loss with respect to their IRC Section 987 QBUs, and gather supporting documentation. Taxpayers that have not applied an eligible pretransition method will have to compute annual unrecognized IRC Section 987 gain or loss under the Proposed Regulations for each year since the inception of the IRC Section 987 QBU until the transition date. Taxpayers should begin preparing now to address such a substantial compliance burden. In addition, taxpayers will want to evaluate their options around future recognition of pretransition gains and losses.
Second, taxpayers should carefully monitor whether any IRC Section 987 QBUs are terminated on or after November 9, 2023, including terminations resulting from check-the-box elections made after November 9, 2023, but effective before that date. Such terminating IRC Section 987 QBUs must immediately transition to the Proposed Regulations, which may result in the deferral of IRC Section 987 losses. In contrast, taxpayers should consider whether non-terminating remittances could be made from any IRC Section 987 QBUs to their owners. Those remittances generally are not subject to the Proposed Regulations, including the loss deferral rules.
Taxpayers should also begin to consider whether the default FEEP Method or simplifying elections are the most optimal way of applying the Proposed Regulations. Taxpayers must balance the administrative ease offered by the Current Rate Election and Annual Recognition Election (which generally do not require tracking historic items) against certain limitations (including loss limitation rules and foregoing the ability to control the timing of IRC Section 987 gains and losses) imposed by those elections. We recommend companies begin modeling these varying approaches well in advance of the proposed transition date.
Contact Information
For additional information concerning this Alert, please contact:
Ernst & Young LLP, International Tax Services/Capital Markets
- Lee Holt
- Colleen Zeller
- Tim Kerr
- Tim Wichman
- Doug Chestnut
- Liz Hale
- Bob Leonard
- Huvie Weinreich
- Ravi Manne
Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor
For a full listing of contacts and email addresses, please click on the Tax News Update: Global Edition (GTNU) version of this Alert.