relate to the timing of recognition, the character, and the geographic source of the gains or losses. Section 988 addresses those issues. Generally, the recognition of foreign currency exchange gain or loss must be separately accounted for; that is, the gain or loss must be accounted for separately from any gain or loss attributable to the underlying transaction. For example, a U.S. company may purchase inventory from a foreign manufacturer. If the purchase price is to be paid in U.S. dollars, the inventory will be recorded at the U.S. dollar cost, and no foreign exchange gain or loss will be recognized regardless of changes in the exchange rate between U.S. currency and the foreign currency. If, on the other hand, the purchase price of the inventory items is to be paid in the currency of the foreign country and the exchange rate changes between the transaction date and the payment date (that is, when the payment in foreign currency is made), gain or loss is recognized on any change in the exchange rate between the date of purchase and the date the payment is made in foreign currency and is treated as ordinary income. The inventory is recorded at the dollar value as of the date of purchase. In addition, there must generally be a closed and completed transaction or realization event, such as the actual payment of a liability.
R. Smith, a U.S. citizen, converted $20,000 into Swiss francs at a time when the exchange rate of Swiss francs to U.S. dollars was 0.33. The 60,000 francs were deposited in a Swiss bank. One year later, when the exchange rate of francs to dollars was 0.25, Smith had not converted the 60,000 francs into other property; therefore, no loss is recognized. If the funds had been converted to U.S. dollars or any property distinguishable from a bank deposit, the loss would be recognized.
Foreign currency gain means any gain from a Section 988 transaction to the extent such gain does not exceed the gain realized because of changes in exchange rates on or after the booking date and before the payment date. A foreign currency loss means any loss from a Section 988 transaction to the extent that such loss does not exceed the loss realized because of changes in the exchange rates on or after the booking date and before the payment date. The booking date is (a) the date of acquisition, (b) the date on which the taxpayer becomes obligor, (c) the date on which an item is accrued or otherwise considered, or (d) the date a position is entered into or acquired. The payment date is the date on which payment is made or received or the date the taxpayer’s rights with respect to the position are terminated.
A taxpayer whose functional currency is the dollar acquires a debt instrument denominated in Qs for Q5,000. The debt is not part of a Section 988 hedging transaction. The exchange rate at the time of the acquisition was Q1 = $.20. If the taxpayer sells the debt instrument for Q6,000 when the exchange rate is Q1 = $.24, of the $440 gain ([Q6,000 × $.24] − [Q5,000 × $.20]), $200 is a foreign currency gain ([$.24 − $.20] × Q5,000). If the taxpayer sells the debt instrument for Q6,000 when the exchange rate is Q1 = $.167, there would be no gain or loss on the Section 988 transaction ([Q6,000 × $.1667] − [Q5,000 × $.20]) and therefore no foreign currency gain or loss. If the exchange rate at the time of the sale was Q1 = $.19, there is a gain of $140 ([Q6,000 × $.19] − [Q5,000 × $.20]) but none of it is a foreign currency gain. If the exchange rate was Q1 = $.15, there is a loss of $100, all of which is a foreign currency loss.
A Section 988 transaction includes a disposition of nonfunctional currency and certain transactions if the amount the taxpayer is entitled to receive or pay because of the transaction is denominated in terms of a nonfunctional currency or is determined by reference to the value of one or more nonfunctional currencies. These Section 988 transactions include the following:
The taxpayer disposes of nonfunctional currency, which includes coin, currency, nonfunctional currency-denominated demand or time deposits, and similar instruments issued by a bank or other financial institution. These transactions are treated as Section 988 transactions for the purpose of establishing the taxpayer’s basis in the currency and determining exchange gains or losses.
The taxpayer acquires a debt instrument or becomes an obligor under a debt instrument.
The taxpayer accrues or otherwise considers any item of expense or gross income or receipts that is to be paid or received after the date on which it is so accrued or considered.
The taxpayer enters into or acquires any forward contract, futures contract, option, or similar financial instrument (which includes a notional principal contract). This provision covers a forward contract, futures contract, option, warrant, or similar property only if the underlying property to which the instrument ultimately relates is a nonfunctional currency or is a payable or receivable. For example, a forward contract to purchase wheat denominated in a nonfunctional currency is not covered, whereas a forward contract to purchase a nonfunctional currency is covered (Treasury Regulation1.988-1(a)(2)(iii)(A)). A notional principal contract means an interest rate swap, cap, floor, collar, or similar financial instrument that provides for the payment of amounts by one party to another at specific intervals measured by interest rates and notional principal amounts in exchange for specific consideration or a promise to pay similar amounts. It also includes a currency swap.
Knowledge check
1 Regarding a Section 988 transaction, the booking date is notThe date of the acquisition.The date on which the taxpayer becomes the obligor.The date a position is entered into or acquired.The date on which payment is made or received.
Dispositions of nonfunctional currency
Recognition and computation of exchange gain or loss
Generally, the recognition of gain or loss upon the sale or other disposition of nonfunctional currency is governed by the recognition provision in the IRC that applies to the sale or disposition of property. With respect to Section 1031, a nonfunctional currency exchange is not considered “like kind” property. However, the following transactions are not considered recognition events:
An exchange of units of nonfunctional currency for different units of the same nonfunctional currency
The deposit of nonfunctional currency in a demand or time deposit, or similar instrument (such as a certificate of deposit [CD]) issued by a bank or other financial institution if such instrument is denominated in such currency
The withdrawal of nonfunctional currency from a demand or time deposit or similar instrument if such instrument is denominated in such currency
The receipt of nonfunctional currency from a bank or other financial institution from which the taxpayer purchased a certificate of deposit or similar instrument denominated in such nonfunctional currency, by reason of the maturing or other termination of such instrument
The transfer of nonfunctional currency from a demand or time deposit or similar instrument issued by a bank or other financial institution to another demand or time deposit or similar instrument denominated in the same nonfunctional currency issued by a bank or other financial institution.
X is a corporation on the accrual method of accounting, with the U.S. dollar as its functional currency. On January 1, 20X2, X acquires 1,500 British pounds for $2,250 (£1 = $1.50). On January
