the U.S. trading partners with which there are income tax treaties, the liability of the branch to local tax depends on whether the branch constitutes a permanent establishment within that country and whether the income in question derives from that permanent establishment.
Calculating income of a foreign branch
In a manner similar to the net profit method, foreign branches that are QBUs must compute their net income as if the branch had a closed balance sheet like that of a separate corporation. Also, certain QBUs must keep their books on the basis of the U.S. dollar. However, some QBUs, meeting certain qualifications, may keep their books on the basis of a foreign currency and must follow specific rules for computing taxable income on that basis.
Only a QBU is entitled to elect to keep its books in terms of a foreign currency. A QBU is a business operation that is a “separate and clearly identified” unit of a company. The regulations provide that a QBU must be a complete business including every operation that ordinarily forms a part of that particular business. A QBU may not perform one or more functions that merely are a part of another business. A corporation may have more than one QBU.
Functional currency
The currency in which a foreign branch keeps its books is called its functional currency. Although the functional currency of a foreign branch is generally the U.S. dollar, a QBU may elect to use a foreign currency as its functional currency if a significant part of its operations takes place in a commercial environment in which the foreign currency is used. Analysis of the commercial environment is based on the following:
The currency of the country in which a QBU is formed
The currency of a QBU’s cash flows
The currency in which a QBU typically borrows and lends
The currency received by a QBU from the sale of goods
The currency of a QBU’s principal items of income and expense
The duration of a QBU’s business operations
The size and nature of a QBU’s independent operations
Notwithstanding qualifying to use a foreign currency as its functional currency, a QBU may elect to use the U.S. dollar as its functional currency if it keeps its books in U.S. dollars and if it uses a separate transaction method of accounting. This U.S. dollar election is made on Form 8819.
Foreign currency issues as applied to branches, or QBUs
The value of one currency in terms of another varies over time; consequently, so will the dollar value of foreign property, foreign debts, and gains and losses from property dispositions. Therefore, foreign currency exchange issues must be considered in any transaction involving two different currencies, such as the USD and the GBP (British pound). Generally, a transaction must be recorded at the agreed-upon rate, but any gain or loss in a foreign exchange will be recognized when the payment is actually made.
A currency exchange calculation may be necessary for the following types of transactions if it involves a foreign currency:
Purchase or sale of goods, services, or property
Collection of foreign receivables
Payment of foreign payables
Foreign tax credits
Recognition of gain or loss from foreign branches of domestic businesses
However, foreign exchange rates do not need to be considered if all of the transactions are in USD, even if the transaction is with a foreign company or occurs in a foreign country.
Three important notes to remember when dealing with foreign currency: (a) gain or loss is recognized only when the transaction is closed; (b) foreign currency is treated as property rather than money (that is, foreign currency is not U.S. legal tender); and (c) the sale and or disposition of goods is recorded at the sale price, but the gain or loss on the foreign currency transaction is recognized on the payment date.
When a taxable item involves foreign currency exchange, then the following issues must be analyzed regarding the gain or loss: (a) ordinary or capital; (b) recognition date; and (c) the country in which the transaction occurred.
To reduce the number of currency conversions required, the tax code uses the standard of FAS 52, which is the FASB standard for foreign currency conversions (now codified as FASB Accounting Standards Codification 830, Foreign Currency Matters). This allows the business to record most of its transactions in
Section 985 requires that all tax determinations be made in the taxpayer’s functional currency, which, for most businesses, is the U.S. dollar. However, a QBU, what Section 989(a) refers to as a separate and clearly identifiable unit of the taxpayer’s business that operates in a foreign country and maintains its own books and records, must adapt the foreign currency as the functional currency. Note, however, that an individual cannot be a QBU, although a business unit operated by an individual, such as a sole proprietorship, can be a QBU.
A QBU that uses foreign currency as its functional currency must calculate its profit or loss in the foreign currency for each tax year, then translate it to U.S. dollars, so that the U.S. owner can include the income on its tax return. The profit or loss without accounting for remittances is converted to U.S. dollars by using the average exchange rate for the taxable year, which simplifies the currency translation. However, the gain or loss on remittances is calculated on the remittance date. U.S. tax liabilities are calculated and paid in U.S. dollars. When U.S. taxpayers transact in a foreign currency, foreign currency amounts must be translated into U.S. dollars. In addition, for tax purposes, a U.S. business must account for gain or loss resulting from changes in relative values of the dollar and a foreign transactional currency while the U.S. business owns or has a position in a foreign transactional currency.
Generally, transactions are reported for tax purposes in the taxpayer’s functional currency. The functional currency of a U.S. citizen or resident or a domestic corporation is usually the U.S. dollar. A foreign currency is the functional currency if the economic environment of the business’ QBU is in a foreign currency.
A U.S. entity arranging all international transactions so that payments and receipts are made entirely in U.S. currency will have no currency exchange gains or losses. When the taxpayer has operations conducted through a foreign branch or owns stock in a CFC, the results of those operations usually are denominated in a foreign currency, called the functional currency. Economic gains and losses may be realized because of changes in the relative value of that functional currency, the U.S. dollar between the date income from such operations is recognized for U.S. tax purposes, and the date remittances are converted into U.S. currency.
In addition to
