is a calendar-year corporation with the dollar as its functional currency. X is on the accrual method of accounting. On January 15, 20X2, X sells inventory for CAD 10,000. The spot rate on January 15, 20X2, is CAD 1 = USD 0.55. On February 23, 20X2, when X receives payment of the CAD 10,000, the spot rate is CAD 1 = USD 0.50. On February 23, 20X2, X will realize exchange loss. X’s loss is computed by multiplying the CAD 10,000 by the spot rate on the date the CAD 10,000 are received (CAD 10,000 × .50 = USD 5,000) and subtracting from that the amount computed by multiplying the CAD 10,000 by the spot rate on the booking date (CAD 10,000 × .55 = USD 5,500). Therefore, X’s exchange loss on the transaction is USD 500 (USD 5,000 – USD 5,500).
Exchange gain or loss on a forward, futures, and option contract (but not a spot contract to buy or sell nonfunctional currency unless the spot contract is disposed of prior to making or taking delivery of the currency) is realized and recognized.
Gain or loss on these contracts is realized. In general, exchange gain or loss is not realized solely because another transaction or transactions offset the transaction. If, however, the economic benefit is derived in any offset transaction, any gain inherent in the offset positions is recognized.
Exchange gain or loss on these contracts is determined by subtracting the amount paid (or deemed paid), if any, for the contract from the amount received or deemed received from the contract. This rule also applies if the taxpayer makes or takes delivery in connection with these contracts. Gain or loss is recognized as if the contract was sold for its fair market value on the delivery date.
X, a calendar-year corporation whose functional currency is the dollar, entered into a forward contract on October 1, 20X1, to purchase Q100,000 for delivery on March 1, 20X2. The six-month forward rate was $.4907. On March 1, 20X2, X takes delivery of the Q100,000 when the spot rate is $.48. X is treated as if it sold the contract for its fair market value when it takes delivery of nonfunctional currency under the forward contract. Therefore, X has an exchange loss of $1,070 ([$.48 × Q100,000] − [$.4907 × Q100,000]) and a basis of $48,000 in the Q100,000 (Treasury Regulation 1.988-2(d)(4)(iii), example (1)).
Character of gains or losses
In general, foreign currency gain or loss attributable to a Section 988 transaction is computed separately and treated as ordinary income or loss. Capital gain or loss treatment may be elected for forward contracts, futures contracts, and options that constitute capital assets in the hands of the taxpayer that are not marked to market, are not parts of a tax straddle, and meet the identification requirements. In some Section 988 transactions, foreign currency gain or loss will be treated as interest income or expense.
Source of gains or losses
In general, foreign currency gain or loss attributable to a Section 988 transaction that is treated as ordinary income will have its source determined by reference to the residence of the taxpayer or the QBU of the taxpayer on whose books the asset, liability, or item of income or expense is properly reflected. An individual’s residence is the country in which the person’s tax home is located. The residence of a U.S. corporation, partnership, estate, or trust is the United States. The residence of a foreign corporation, partnership, estate, or trust is considered not to be in the United States. In the case of a QBU, the residence of each unit is the country in which it is located. The residency of a partner in a partnership not engaged in a U.S. trade or business is determined at the partner level.
There is a special sourcing rule for loans made by a U.S. person or a related person, to a 10%-owned foreign corporation, when the loan is denominated in a currency other than the dollar and bears an interest rate at least 10 percentage points higher than the federal midterm rate at the time the loan is made. In this case, for purposes of Section 904 only, the affected loans are marked to market on an annual basis and interest income earned on the loan during the year is treated as domestic source income to the extent of any loss on the loan.
Any gain or loss realized on a Section 988 transaction that is treated as interest income or expense must be sourced or allocated and apportioned between U.S. and foreign-source income and expense. The allocation and apportionment of exchange gain or loss does not affect the source of exchange gain or loss.
U.S. dollar approximate separate transactions method
A QBU must adopt the U.S. dollar approximate separate transactions method (DASTM) if its functional currency would otherwise be a hyperinflationary currency (for example, Venezuela at times), that is, a currency in which cumulative inflation was at least 100% over the 36-month period immediately preceding the tax year. Cumulative inflation is determined with compounding. If inflation in a particular currency over the relevant 36-month period is 29%, 25%, and 30%, the cumulative rate of inflation is 109.6% (129% of 125% of 130%, less 100%), not 84% (sum of 29, 25, and 30). The inflation rate is based on the consumer price index for the country issuing the currency, as given in International Financial Statistics (a publication of the International Monetary Fund).
Assume U.S. corporation D has a branch in country Z for which the functional currency is the country Z u. Country Z has experienced substantial inflation, and extraordinarily high interest rates reflect an expectation of continued inflation. D borrows 1000u from a country Z lender at 45% interest. If corporation D is allowed to calculate branch taxable income under the profit-and-loss method, D would be allowed to deduct annual interest expense of 450u translated at the average exchange rate for the year. Most of the interest is effectively compensation to the country Z lender for erosion of the lender’s principal through inflation. If cumulative inflation in the u is 40% during the year, the value of the principal falls by 40% during the year, and the interest cost in constant u’s is only 50u (450u nominal interest less 400u decrease in value of principal).
A change to DASTM required by the regulations is deemed made with IRS consent. If a QBU is required to use DASTM for any year, DASTM becomes a method of accounting that can be changed only with IRS consent, except that the QBU must return to the profit-and-loss method, using the currency of its economic environment as functional currency, once that currency has not been hyperinflationary for three successive years.
If a dollar election is made by a QBU whose functional currency is a hyperinflationary currency, the dollar will be the functional currency of the QBU. This method of accounting must be used to compute profits and losses. The translated amount of income and earnings and profits is a combination of operating profits plus exchange gains or losses for each taxable period. The computation is accomplished in a four-step procedure listed in the following material:
1 Prepare financial statements from the books regularly maintained by the QBU as recorded in the QBU’s hyperinflationary currency.
2 Adjust these statements to conform with U.S. generally accepted accounting and tax principles.
3 Translate the income statement accounts into U.S. dollars, and compute the profit in U.S. dollars.
4 Compute the foreign exchange gain or loss.
Chapter 3 Determining Source of Income
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