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U.S. IRS Publishes Practice Unit on Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument — Orbitax Tax News & Alerts

The U.S. IRS has published a practice unit on Limitation of Exchange Gain or Loss on Payment or Disposition of Debt Instrument. The general overview of the practice unit is as follows:

The determination of foreign currency (FX) gains and losses under IRC Section 988 is one of the major strategic priorities for the Foreign Currency Practice Network (PN) on the Crossover portion of the International Matrix. In a global economy, many U.S. Multinational Enterprises (MNEs) are doing business in currencies other than the U.S. dollar (USD). These transactions may be one-time transactions (e.g., a loan denominated in an FX), or as part of the ongoing operations of a business unit (e.g., payable and receivable denominated in an FX). To the extent that the transactions are denominated in a currency other than the USD for a U.S. corporation (or are determined by reference to the value of one or more nonfunctional currencies for foreign corporations), MNEs may have FX fluctuation risk. The values of many foreign currencies and the associated exchange rates can change dramatically over a period of years. Depending upon whether the MNE taxpayer has any nonfunctional currency denominated assets or liabilities which are Section 988 covered transactions, there may be gains and/or losses due to the currency fluctuations.

The purpose of this Unit is to cover some basic FX principles related to the currency transactions that MNEs may enter into during the course of its business and show how changes in exchange rates will impact an MNE. Two issues must be considered in the early stages of the examination for planning purposes: (1) whether the MNE has nonfunctional currency denominated transactions that are covered under Section 988; and (2) the direction of the exchange rates for the foreign currencies during the period under examination which determine whether the section 988 transactions will have a gain or loss.

As the value of the currencies in which the transactions are denominated increases or decreases relative to the USD, the MNE will have unrealized exchange gains or losses. When these unrealized exchange gains and losses are eventually recognized for tax purposes, MNE's taxable income will be affected. Certain FX transactions that are denominated in terms of a nonfunctional currency or are determined by reference to the value of one or more nonfunctional currencies, may generate exchange gains or losses which are subject to IRC Section 988 ("section 988 transactions").

For example, if the MNE has a nonfunctional currency denominated loan or note receivable and the exchange rate of the nonfunctional currency rate has appreciated against the USD, then the MNE will have an exchange gain because of the fluctuations in the exchange rate; conversely, if the exchange rate/value of the nonfunctional currency has depreciated against the USD, the MNE will have an exchange loss on the loan or note receivable because of fluctuations in the exchange rate/value. If the MNE has a loan or note payable which is denominated in a nonfunctional currency and the nonfunctional currency appreciates against the USD, it would cost the MNE more in USD to pay off the loan at maturity and therefore result in an exchange loss; any depreciation of the nonfunctional currency against the USD would result in a lower cost to the MNE to pay off the loan at maturity and therefore would result in an exchange gain.

The Practice Units on Qualified Business Units (QBUs), 988 Transactions, and Functional Currency (FC) should also be considered in order to understand the basic terms used in FX transactions. Fluctuations in the FX exchange rate also impact Section 987 covered transactions, which will be covered in a future Practice Unit.

Click the following link for the International Practice Units page on the IRS website.