Section 987 Regulations: Terminology Explained
As a follow up to our “Section 987 Regulations: Key Considerations,” this blog post will help define many of the complex terms included within these regulations. The regulations relate to the methods a taxpayer must use to account for fluctuations in the foreign currency exchange rates when they have business operations that are denominated in a functional currency different than their own. Section 987 regulations are generally not effective until a taxpayer’s second full tax year following Dec. 7, 2016 (effective date Jan. 1, 2018 for calendar-year taxpayers).
It is important to remember the new regulations apply to individuals and C-Corporations (not to S-Corporations or most partnerships) that are owners of a Section 987 qualified business unit (QBU). A few important general terms related to these regulations include:
- Functional Currency – The currency in which all determinations for U.S. income tax purposes are made (IRC 985). The functional currency is not necessarily the same as the local currency, but it is often the same as the local currency where the QBU’s primary business activities are located.
- Eligible QBU – The activities of an individual, corporation, partnership or disregarded entity if the activities constitute a trade or business. Such activities are accounted for with a separate set of books and records that are denominated in a different functional currency, and where the activities are not subject to the U.S. dollar approximate separate transactions method of accounting (DASTM) rules under Treasury Regulations 1.985-3 (relating to hyperinflationary currency).
- Section 987 QBU – An eligible QBU that has a functional currency different than its owner.
All items of income, gain, deduction or loss must be translated. Additionally, the assets and liabilities of the Section 987 QBU must be categorized as marked or historic and then translated at the appropriate rate.
- Marked Items – Include cash, debt, payables, receivables and foreign currency derivatives.
- Historic Items – Include all items other than marked items (i.e., land, buildings, plant, equipment and inventory).
- Spot Rate – A rate that reflects a fair market rate of exchange available to the public for currency under a spot contract in a free market on a specific date.
- Yearly Average Exchange Rate – The rate determined by the owner under a reasonable method that represents an average exchange rate for the tax year. This rate is used to translate all items of income, gain, deduction or loss.
- Historic Rate – Generally this is the yearly average exchange rate in the year an asset was transferred or acquired by the Section 987 QBU. (There is some complexity when looking at different inventory methods that are outside the scope of this blog article.)
All of the income statement and balance sheet items are translated appropriately and tracked in a foreign exchange exposure pool (FEEP). When there is a remittance, a portion of the FEEP will be recognized.
- Remittance – The extent to which amounts transferred from the Section 987 QBU to the owner exceed amounts transferred from the owner to the Section 987 QBU during the tax year. This calculation is determined using the owner’s functional currency and is done on the last day of the owner’s tax year or on the date of the Section 987 QBU’s termination. The idea of a transfer between an owner and its Section 987 QBU can be hard to define and track. It includes actual distributions as well as intercompany transactions. Additionally, it includes transfers between multiple Section 987 QBUs of the same owner.
The Section 987 regulations do not apply to partnerships unless they are Section 987 aggregate partnerships.
- Section 987 Aggregate Partnership – Partnerships that are wholly owned by related persons and the partnership has more than one eligible QBUs, at least one of which would be a Section 987 QBU with respect to a partner if the partner owned the eligible QBU directly.
The Section 987 regulations will apply whenever a QBU terminates. A Section 987 QBU will be deemed to terminate if any of the following occur:
- it ceases its trade or business;
- most, if not all, of its assets are transferred to its owner;
- an owner that is a controlled foreign corporation (CFC) ceases to be a CFC via the acquisition of interests in the owner by related persons; or
- the owner of the Section 987 QBU ceases to exist.
A termination of a Section 987 QBU is treated as a remittance of all the gross assets of the Section 987 QBU to its owner on the termination date.
There are many definitions and terminology that need to be addressed before the complicated calculation can be explained, and implementing and accounting for the regulation will be a complex task. The final part in this series will cover making this calculation and relevant elections companies may take.
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