Final foreign currency regulations

ARTICLE | February 12, 2025

Authored by RSM US LLP

Executive summary:

Treasury and the IRS have released final regulations (T.D. 10016) regarding the taxable income or loss of a taxpayer with respect to a qualified business unit (QBU) subject to section 987. The final regulations are effective Dec. 10, 2024 and retain the basic approach of the 2023 proposed regulations with some notable modifications. A correction to the regulations was published on Jan. 17, 2024.

The regulations will apply to taxable years beginning after Dec. 31, 2024, with special rules requiring early adoption for terminating QBUs. Taxpayers may also choose to rely on the regulations for taxable years ending after Nov. 9, 2023, as long as they are consistent in their approach.

Concurrently with the publication of the final regulations, Treasury and the IRS have published proposed regulations (REG-117213-24). The proposed regulations include an election that is intended to reduce the compliance burden of accounting for certain disregarded transactions between a QBU and its owner and also includes a request for comments relating to the treatment of partnerships and controlled foreign corporations (CFCs).

The proposed regulations would apply to taxable years beginning after the date these regulations become final and are published in the Federal Register. Taxpayers may rely on these proposed regulations for a taxable year in which the final regulations (that is, the final regulations that are being published concurrently with the proposed regulations) apply, subject to a consistency requirement.

Foreign exchange exposure pool (FEEP) method maintained

The final regulations are clear in their approach. The final regulations do not permit taxpayers to use the earnings and capital method described in the 1991 proposed regulations. The final regulations retain the foreign exchange exposure pool (FEEP) method, and this will be the default rule for determining section 987 taxable income or loss and net unrecognized section 987 gain and loss.

However, to ease the transition and minimize the compliance burden, “the final regulations modify the existing framework of Reg. section 1.987-4 to allow taxpayers that make a current rate election to use certain elements of the earnings and capital method in lieu of preparing a tax basis balance sheet.” This means that a QBU’s net value can be calculated without a tax basis balance sheet, but only to the extent a current rate election is made.

Softened transition rule

The final regulations retain the new transition rule, subject to a few modifications.

For taxpayers that did not apply section 987 using an eligible pretransition method, Treasury and the IRS recognize that calculating annual unrecognized section 987 gain or loss for all years since a QBU’s inception can be burdensome for long-operating QBUs. Therefore, the final regulations set a cutoff date of Sept. 7, 2006, the publication date of the 2006 proposed section 987 regulations. Taxpayers who did not use an eligible pretransition method must still compute pretransition gain or loss, but only for taxable years beginning on or after Sept. 6, 2006.

The final regulations introduce a de minimis rule to ease the compliance burden on small businesses with section 987 QBUs. This rule allows qualifying taxpayers to elect to treat all QBUs below a certain threshold (similar to the small business exception in section 163(j)(3)) as having no pretransition gain or loss. To qualify, the section 987 QBU owner must have gross receipts of $25 million or less (adjusted for inflation and averaged over the past three years). If this condition is met, the de minimis rule applies to any section 987 QBU with gross assets under $10 million, averaged over the same period and considering all QBUs in the same country owned by the same owner or a member of its controlled group.

The final regulations clarify and expand the definition of an eligible pretransition method. According to Treasury and the IRS, “the definition is intended broadly to include any method that complies with the statutory requirements of section 987 in a reasonable manner.” In general, a taxpayer is considered to have used an eligible pretransition method even if there were errors in its application or it was not applied in all taxable years of owning the section 987 QBU. However, taxpayers must calculate pretransition gain or loss under Reg. section 1.987-10(e)(2) as if the method had been applied correctly in all previous taxable years.

Consistent with the 2023 proposed regulations, the final regulations provide that a method of applying section 987 is not an eligible pretransition method unless it was applied on at least one tax return filed before Nov. 9, 2023 (the date the 2023 proposed regulations were released).

New mark-to-market election

To reduce the potential for selective recognition of losses relating to section 988 transactions, the final regulations will allow taxpayers to make a section 988 mark-to-market election. According to Treasury and the IRS, “this election is expected to result in consistent treatment of section 988 transactions for tax and financial reporting purposes.”

This election is subject to the same timing and consistency requirements as a current rate election or an annual recognition election.

Narrowed scope

The final regulations narrow the scope of entities subject to section 987 regulations. Generally, the final regulations only apply with respect to corporations, including CFCs and individuals.

The section 987 regulations do not apply to trusts or estates “because additional guidance may be needed to apply section 987 to these entities.” In addition, the section 987 regulations generally do not apply to partnerships and S corporations.

Specified entities (i.e., banks, insurance companies, leasing companies, finance coordination centers, regulated investment companies (RICSs), real estate investment trusts (REITs)) are still subject to the final regulations. However, the final regulations contain modifications designed to simplify the application of the section 987 rules to these entities.

Partnerships and S corporations

Section 987 applies to partnerships (and S corporations). However, only certain parts of the final regulations apply to partnerships (and S corporations). The applicable provisions, subject to certain modifications, are as follows:

• Reg. section 1.987-6 (character and source of section 987 gain or loss);
• Reg. section 1.987-9(d) (information on a dedicated section 987 form);
• Reg. sections 1.987-11 through 1.987-13 (suspended section 987 loss, deferral of section 987 gain or loss, and suspended section 987 loss upon terminations, respectively); and
• Reg. section 1.987-15 (applicability dates).

The Treasury Department and the IRS are still examining the appropriate treatment of partnerships (and S corporations) under section 987. Consequently, the final regulations do not include detailed rules for determining section 987 taxable income or loss, or section 987 gain or loss for partnerships (and S corporations). Additionally, the final regulations reserve judgment on treating a partnership as a QBU under section 989(a) and Reg. section 1.989(a)-1(b)(2)(i).

Until further guidance is provided, taxpayers must apply sections 987 and 989(a) to partnerships (and S corporations) using a reasonable method that aligns with the statute. Taxpayers will only be deemed to have used a reasonable method if they consistently apply the same method each year for a specific partnership or eligible QBU.

The transition rule does not apply to partnerships (and S corporations).

Alternative calculation for a remittance

The final regulations provide two modifications to the recognition of section 987 gain or loss rules under Reg. section 1.987-5, which are intended to reduce the burden of tracking disregarded transfers while preserving consistency with the text and purpose of section 987.

First, taxpayers may determine the amount of a remittance using an alternative calculation. According to this alternative formula, the remittance amount is the negative change in the net value of the section 987 QBU, calculated in the QBU’s functional currency, and adjusted for the QBU’s income and loss. Mathematically, this results in an amount equivalent to the total net transfer from the section 987 QBU to its owner for the taxable year.

Second, Reg. sections 1.987-5(b) and (c) specify that the numerator and denominator of the remittance proportion (the remittance amount and the section 987 QBU’s gross assets) are calculated in the QBU’s functional currency, not the owner’s. Consequently, there is no need to individually translate each transfer when determining the annual remittance

New section 988 characterization election

The final regulations allow taxpayers to make an election to treat section 987 gains or losses, which would normally be considered passive foreign personal holding company income (FPHCI), as foreign currency gains or losses from section 988 transactions not directly related to the CFC’s business needs.

This election, known as the section 988 characterization election, benefits taxpayers by allowing these gains and losses to be treated as part of a single income item, facilitating netting of gains and losses. It also simplifies the application of the loss-to-the-extent-of-gain rule and reduces the tracking burden for suspended losses.

Loss suspension rule

The final regulations retain the loss suspension rule but limit the scope.

Under Reg. section 1.987-11(c)(2), if a current rate election is in place, section 987 losses are not suspended unless they exceed the lesser of $3 million or 2% of the controlled group’s gross income for the taxable year. This threshold is applied to the combined section 987 losses of the owner and all members of the controlled group. This rule aims to ease the compliance burden of tracking suspended section 987 losses, especially for taxpayers with small section 987 QBUs.

New lookback rule for the loss-to-the-extent-of-gain rule

The final regulations provide a new lookback rule under the loss-to-the-extent-of-gain rule. Treasury and the IRS believe that a lookback rule ensures fair treatment of section 987 gains and losses, especially when gains are recognized in earlier years.

Reg. section 1.987-11(e)(3) provides that suspended section 987 loss is recognized to the extent of net section 987 gain recognized in the current year and the three preceding taxable years. Taxable years before the transition date are excluded from this lookback period due to the significant flexibility taxpayers had in determining the timing, amount, and character of section 987 gains or losses before the final regulations took effect.

Taxpayers making both an annual recognition election and a current rate election are subject to a different lookback period. For these taxpayers, the lookback period encompasses all taxable years during which both elections are continuously in effect.

The loss-to-the-extent-of-gain rule is further subject to an anti-abuse rule.

Reminder: Terminating QBUs are subject to special applicability date

The IRS and Treasury are concerned that taxpayers may terminate certain QBUs prior to the general applicability date of the regulations to avoid these new rules. As such, the regulations provide an earlier applicability date for terminating QBUs to prevent taxpayers from doing so. Reg. section 1.987-1(h) defines a terminating QBU as a section 987 QBU, if both:

• The section 987 QBU terminates on any date on or after Nov. 9, 2023, or the section 987 QBU terminates as a result of an entity classification election made under Reg. section 301.7701-3 that is filed on or after Nov. 9, 2023, and that is effective before Nov. 9, 2023; and
• When the section 987 QBU terminates, neither the section 987 regulations nor the 2016 and 2019 section 987 regulations would apply with respect to the section 987 QBU but for Reg. section 1.987-15(a)(2).

Reg. section 1.987-15(a)(2) provides that the section 987 regulations apply to the owner of a terminating QBU immediately before the section 987 QBU terminates, but only with respect to the section 987 QBU, any successor deferral QBUs or successor suspended loss QBUs (in their capacity as such), and any net unrecognized section 987 gain or loss, deferred section 987 gain or loss, or suspended section 987 loss with respect thereto.

The early applicability date applies to terminating QBUs only. A taxpayer need not apply the early applicability date to all QBUs, just terminating QBUs.

Common termination events can include: a sale, cessation of business, a change in entity classification, a change in functional currency, a change in form of ownership or a liquidation.

Final regulation implications

Taxpayers should promptly begin planning for these final regulations by:

• Analyzing whether they are an entity subject to the section 987 regulations;
• Identifying section 987 QBUs;
• Determining whether they have applied an eligible pretransition method under section 987 for each of their section 987 QBUs;
• Calculating the amount of pretransition gain or loss and the decision to opt for the 10-year amortization election;
• Developing internal processes to easily collect data necessary to calculate section 987 gain or loss;
• Weighing the benefits associated with making the various post transition elections (e.g., current rate election, annual recognition election), such as a reduced compliance burden, against potential drawbacks, such as the loss-to-the-extent-of-gain rule; and
• Estimating their overall tax impact.

The publication of the final regulations may require that taxpayers re-evaluate historical positions related to section 987 for purposes of ASC 740, particularly with respect to the amount of deferred taxes recorded on any realized gain or loss. While there are multiple views on whether deferred tax should be recorded for these unrealized gains or losses depending on a company’s indefinite reinvestment assertion, an evaluation remains necessary. Taxpayers should take swift action because the regulations, effective Dec. 10, 2024, could impact 2024 provisions.

New election under the proposed regulations

To reduce the compliance burden of accounting for certain disregarded transactions between a QBU and its owner, the proposed regulations will allow taxpayers that make a current rate election to also make a recurring transfer group election. If a recurring transfer group election is in effect, taxpayers can translate assets transferred between a section 987 QBU and its owner using the yearly average exchange rate in lieu of the applicable spot rate.

According to Treasury and the IRS they are of the view that, “in certain cases, a group of frequently recurring transfers between a section 987 QBU and its owner could be translated using the yearly average exchange rate without creating significant distortions.”

The proposed regulations define a recurring transfer group as a group of frequently recurring transfers between a section 987 QBU and its owner (or another eligible QBU of the owner) that are made in the ordinary course of a trade or business. Treasury and the IRS further add that, “only transfers made in connection with sales of inventory, payments for services or rent or royalty transactions in which arm’s length compensation (determined by applying the principles of the arm’s length standard of Reg. section 1.482-1(b)(1)) has been paid would be included in a recurring transfer group.”

This election is subject to the same timing and consistency requirements as a current rate election or an annual recognition election.

Comments requested under the proposed regulations

The Treasury Department and the IRS are still examining the appropriate treatment of partnerships (and S corporations) under sections 987 and 989 and therefore, request comments on the following topics:

• Approach for section 987: Should section 987 be applied to partnerships using an entity, aggregate or hybrid approach?
• Partnership as QBU: Should a partnership be treated as a per se QBU under section 989(a) and related regulations?
• Rules for related parties: Should different rules apply for purposes of sections 987 and 989(a) based on whether the partners are related parties?
• Currency gain or loss: Under an entity approach, how should partners account for currency gain or loss if the partnership’s functional currency differs from that of its partners?

The Treasury Department and the IRS are still examining the application of section 987 to CFCs and therefore, request comments on the following topics:

• Applicability to CFCs and foreign partnerships: Should section 987(3) and related regulations be modified to exclude CFCs and partnerships with only foreign partners?
• Preventing tax avoidance: If section 987(3) does not apply to CFCs and foreign partnerships, what rules are needed to prevent excess asset basis from escaping U.S. taxation in inbound transactions?
• Modifications for CFCs and foreign partnerships: If section 987(3) continues to apply to CFCs and foreign partnerships, are any changes needed in calculating section 987 gain and loss for these entities?

Final reminders

Taxpayers looking for additional information on the 2023 proposed regulations can read RSM's previous tax alert (Section 987 proposed foreign currency regulations may impact QBUs).