Tax Consequences of Foreign Currency Transactions
The value of one currency in terms of another varies over time; consequently, so will the dollar value of foreign property, foreign debts, and gains and losses from property dispositions. Thus, foreign currency exchange issues must be considered in any transaction involving 2 different currencies. Generally, a transaction must be recorded at the agreed-upon rate, but any gain or loss in a foreign exchange will be recognized when the payment is actually made.
A currency exchange calculation may be necessary for the following types of transactions if it involves a foreign currency:
- purchase or sale of goods, services, or property;
- collection of foreign receivables;
- payment of foreign payables;
- foreign tax credits;
- recognition of gain or loss from foreign branches of domestic businesses.
However, foreign exchange rates do not need to be considered if all the transactions are in United States (US) dollars, even if the transaction is with a foreign company or occurs in a foreign country.
There are 3 important concepts to remember when dealing with foreign currency transactions:
- gain or loss is only recognized when the transaction is closed;
- foreign-currency is treated as property rather than money;
- the disposition of goods is recorded at the sale price, but the gain or loss on the foreign currency transaction is recognized on the payment date.
When a taxable item involves foreign currency exchange, then the following must be noted of the gain or loss:
- ordinary or capital
- recognition date
- the country in which the transaction occurred
To reduce the number of currency conversions required, the tax code uses the standard of FAS 52, which is the Financial Accounting Standards Board standard for foreign currency conversions. This allows the business to record most of its transactions in terms of its functional currency (FC), the currency generally used by businesses in the locale of the foreign unit or entity. Under FAS 52, fluctuations in currency rates do not have to be accounted for unless the fluctuations change the cash flow for the business. In most transactions of a foreign business unit in a foreign country, cash flows are not affected by currency fluctuations. However, transactions between the parent company and its foreign subsidiary will result in cash flow changes. As a consequence, gain or loss on the currency exchange must be included when calculating net income.
IRC §985 requires that all tax determinations be made in the taxpayer's functional currency, which, for most businesses, is the US dollar. However, a qualified business unit (QBU), what IRC §989(a) refers to as a separate and clearly identifiable unit of the taxpayer's business that operates in a foreign country and maintains its own books and records, must adapt the foreign currency as the functional currency. Note, however, that an individual cannot be a QBU, although a business unit operated by an individual, such as a sole proprietorship, can be.
A QBU that uses foreign currency as its functional currency must calculate its profit or loss in the foreign currency for each tax year, then translate it to US dollars, so that the US owner can include the income on its tax return. The profit or loss without accounting for remittances is converted to US dollars by using the average exchange rate for the taxable year, which simplifies the currency translation. However, the gain or loss on remittances is calculated on the remittance date.
Basis and Equity Pool
The basis pool is the tax basis, in United States (US) dollars (USD), of the taxpayer's initial investment in the QBU, increased by taxable income plus the USD value of contributed property on the transfer date, and is decreased by branch losses and branch remittances, which are translated to USD at the spot rate on the remittance date. In the following equation, all terms are expressed in USD:
Basis Pool = Initial Capitalization of Branch + Contributions to Branch + Undistributed Profits − Remittances − Losses
The equity pool is the owner's interest in the branch in terms of the functional currency of the QBU. Like the basis pool, the equity pool is adjusted by the income or loss of the branch and by any transfers or remittances denominated in the QBU's functional currency. In the following equation, all terms are expressed in the QBU's functional currency:
Equity Pool = Initial Capitalization of Branch + Contributions to Branch + Undistributed Profits − Losses − Remittances
As can be seen from the above 2 equations, the basis pool is the owner's interest as expressed in US dollars, while the equity pool is that same owner's interest, expressed in the QBU's functional currency.
Any exchanged gain or loss is ordinary and sourced according to the remittance. The USD amount of the remittance at the exchange rate in effect on the remittance date is compared with the USD value of the basis pool multiplied by the equity of the remittance in the functional currency divided by the equity pool. Any gain or loss is a foreign exchange gain or loss taxed as ordinary income and sourced accordingly. IRC §987
|Basis of Remittance||=||Equity of Remittance |
|×||Total Basis Pool|
Foreign Exchange Gain or Loss = Remittance in USD at Spot Rate − Basis of Remittance
Distributions from Foreign Corporations
Distributions of earnings and profit (E&P) to a US taxpayer is paid at the exchange rate on the distribution date, so no gain or loss is recognized. However, deemed dividend distributions, which are considered taxable income under Subpart F even though they are not actually distributed, are translated at the average exchange rate for the corporation's tax year, since there is no actual distribution to fix the exchange rate. However, when a distribution is actually made from income that has already been taxed as Subpart F income, then a gain or loss is recognized as the difference between the distribution actually received and the distribution amount subject to tax.
To determine the foreign tax credit, foreign taxes are calculated based on the average exchange rate for the taxable year. However, any paid foreign taxes must be translated at the exchange rate when paid. If foreign taxes accrue but are paid in a later tax year, then the foreign currency exchange rate may differ when the taxes are paid from when the tax amount was calculated to determine the foreign tax credit. If the taxes are paid within 2 years of being accrued, then any foreign exchange fluctuation between the accrual rate and the paid rate is disregarded. If more than 2 years have elapsed, then the difference between the accrual rate and the paid rate must be recognized.
Section 988 Transactions
Any foreign exchange gain or loss from a functional currency transaction is separate from the gain or loss in the underlying transaction, and is treated as an ordinary gain or loss; it is not characterized as interest income or expenses. Moreover, gains from personal transactions are not taxable if the gain is less than $200. A personal transaction is defined as one in which there are no deductible expenses in regard to the transaction.
With respect to §988 transactions, the taxpayer may elect capital gain or loss treatment for forward and futures contracts, and options that would otherwise be capital assets to the taxpayer. The gain or loss of the transaction is sourced according to the taxpayer's residence.