Section 987 Regulations: Calculation and Elections
As a follow up to “Section 987 Regulations: Key Considerations” and “Section 987 Regulations: Terminology Explained,” this third and final post in this series will focus on the calculation under the final regulations along with some of the potential elections that can be made related to Section 987 branch remittances. As a reminder, final regulations for Section 987 were issued at the end of 2016 regarding how to calculate foreign exchange gain or loss on remittances from a branch to its tax owner. The final regulations measure gain or loss on certain branch assets and liabilities annually, but the gain or loss is not recognized until there is a net remittance or termination of the branch.
In order to calculate Section 987 foreign exchange gain or loss, a Foreign Exchange Exposure Pool (FEEP) needs to be established. The pool is increased or decreased each year by the net unrecognized Section 987 gain or loss on a Section 987 Qualified Business Unit (QBU). The income statement and balance sheet need to be translated appropriately into the owner’s functional currency. For the income statement, most items are translated at the average rate for the year, with cost of goods sold, depreciation, and amortization being an exception. Each asset and liability on the balance sheet must be categorized as a marked or historic item.
As defined in “Section 987 Regulations: Terminology Explained,” marked items include cash, debt, payables, receivables, and foreign currency derivatives. They are generally translated at the current spot rate as of the end of the tax year. Historic items include everything else, such as land, buildings, plant, equipment, and inventory. These items are generally translated at the historic rate, which is the spot rate for the year in which the asset was transferred, acquired, or created.
The most widely applicable exceptions that were indicated above are:
- Cost of Goods Sold – A tax filer can elect either the simplified method (average rate with adjustments) or the historic method (average rate for the year the inventory was acquired).
- Depreciation/Amortization – This is for noninventory goods only, and the tax filer must use the average rate from the year that the underlying asset being depreciated or amortized was transferred, acquired, or created.
- Inventory – A tax filer can elect to use the simplified last in first out (LIFO) method (average rate for the year the LIFO layer arose), otherwise use the average rate for the year in which the inventory itself was transferred, acquired, or created.
- Tangible/Intangible Assets – A tax filer must use the average rate for the year in which the assets were transferred, acquired, or created.
The basic equation for recognized Section 987 gain or loss is relatively straightforward, and is measured in the tax owner’s functional currency.
Section 987 Gain or Loss = Net Unrecognized Gain or Loss x (Remittance / (QBU’s Gross Assets at End of Year + Remittance))
In order to calculate the net unrecognized gain or loss for the year, an eight-step process must be followed:
- Calculate the change in the balance sheet net worth in the tax owner’s functional currency
- Add transfers from the QBU to the tax owner
- Subtract transfers from the tax owner to the QBU
- Add owner liabilities assumed by the QBU
- Subtract QBU liabilities assumed by the owner
- Add current year loss and subtract current year income
- Add nondeductible expenses
- Subtract tax exempt income
In addition to the calculation itself, there are several elections and transition methods available to the taxpayer. One of the most important transition methods is the fresh start method. Unless the taxpayer has been following the 2006 Proposed Regulations, they must use the fresh start transition method to move from an old method (or no method) to a new method. This will result in the taxpayer losing any unrecognized gain or loss established to date.
There are also anti-abuse limitations in place that prevent many planning strategies available to taxpayers if they wanted to recognize any unrecognized Section 987 gain or loss that had been tracked under a different method. Under the fresh start method, the Section 987 QBU is deemed to terminate. No gain or loss is recognized and the tax owner is treated as transferring all assets and liabilities of the QBU to a new Section 987 QBU. The assets and liabilities are translated utilizing the exchange rates on the day the assets were acquired or liabilities were entered into by the QBU. This will result in built-in gain or loss on marked items as reflected on the balance sheet.
One election available to taxpayers to help ease some of the calculation burden is the annual deemed termination election. Under this election, the QBU is deemed to terminate every year and any Section 987 gain or loss will be recognized annually. This is a binding election. It eases some of the tracking requirements related to calculating the cumulative unrecognized Section 987 gain or loss pool; however, it takes away the ability to control the timing of when those gains or losses are recognized. Additionally, this election allows the taxpayer to translate all items at the average exchange rate, instead of having to track historic rates.
Finally, taxpayers need to consider making a grouping election for QBUs. This election is made on an owner-by-owner basis and allows Section 987 QBUs that have the same functional currency to be grouped together. It can help ease some of the tracking and administrative complexity inherent in the calculation.
As indicated throughout this series, Section 987 is a complex topic with quite a bit of terminology and administrative burden. The Trump administration has asked the U.S. Department of Treasury to review these regulations to determine if they are overly complex or burdensome. Treasury should have a response to the request by the end of September 2017. However, even if these regulations are changed or modified, it is important to remember that Section 987 itself has been in existence for a long time and continuing to do nothing regarding branch remittances is risky. Please reach out to your KSM advisors with any questions or concerns regarding Section 987, specifically in regards to branch remittances.
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