Currency Translation & Currency Transactions

CURRENCY TRANSLATION & CURRENCY TRANSACTIONS

I. Foreign Currency Translation

A.  §985—Companies must account for their operations in their functional currency

a.  A U.S. corporation doing business both domestically and through foreign branch operations may have two functional currencies

i.  Domestic activities—U.S. dollar

ii.  Foreign branch—Foreign currency (if QBU)

b.  QBU—conducts a significant part of its business activities in an economic environment in which a foreign currency is used and maintains books and records in that currency.

B.  §§986-989—Translation of functional currency is required to file U.S. income tax return:

a.  §987—Foreign income taxable income translated at the average exchange rate for the taxable year in which income is earned

b.  §986(a)(1) —Foreign-source taxes translated at the average exchange rate for the taxable year to which the taxes relate (for accrual method t/ps)

c.  §989(b)—Remittances to U.S. home office are translated into dollars using the spot rate for the date of remittance.

d.  Gain or loss must be recognized to extent dollar value of remittance does not equal amount recognized as income when remitted income was included on taxpayer’s U.S. income tax return.

C.  CFCs follow same basic procedure:

a.  Income of CFC is maintained in functional currency—translation not required.

b.  Foreign income taxes translated into dollars using average exchange rate for applicable year.

c.  Dividends to U.S. parent translated using spot rate for date of dividend.

d.  Gross-up, however, is calculated using average exchange rate in effect in year to which taxes relate.

II. Foreign Currency Transactions

A.  Similar rules apply when taxpayer accounts for transactions in nonfunctional currency:

a.  Debt instruments—taxpayer lends or borrows funds denominated in nonfunctional currency

b.  Receivables or payables—taxpayer sells or purchases goods or services on account, with payment required in nonfunctional currency

c.  Hedging transactions—taxpayer enters into forward, futures, option contracts or similar hedging transactions.

B.  In such cases, taxpayer accounts for gross profit on transaction in functional currency and treats exchange gain or loss as a separate transaction

C.  Character of exchange gains or losses—ordinary

D.  Sourcing based on residence of taxpayer or QBU

E.  FTC basket—general rule is that exchange gains and losses are assigned to passive income category (exception for qualified hedging transactions).