Code of Federal Regulations · Section

§ 1.987-3 — -3 Determination Of Section 987 Taxable Income Or Loss Of An Owner Of A Section 987 Qbu

26 C.F.R. § 1.987-3

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(a) In general. This section provides rules for determining the taxable income or loss of an owner of a section 987 QBU (section 987 taxable income or loss). Paragraph (b) of this section provides rules for determining items of income, gain, deduction, and loss in the section 987 QBU's functional currency. Paragraph (c) of this section provides rules for translating each item determined under paragraph (b) of this section into the functional currency of the owner of the section 987 QBU. Paragraph (d) of this section is reserved. Paragraph (e) of this section provides examples illustrating the application of the rules of this section.

(b) Determination of each item of income, gain, deduction, or loss in the section 987 QBU's functional currency—(1) In general. The owner of a section 987 QBU must determine each item of income, gain, deduction, or loss attributable to the section 987 QBU in the section 987 QBU's functional currency under Federal income tax principles.

(2) Translation of items of income, gain, deduction, or loss that are denominated in a nonfunctional currency. Except as otherwise provided in paragraph (b)(4) of this section, an item of income, gain, deduction, or loss (or the item's components and related items, such as gross receipts and amount realized) that is denominated in (or determined by reference to) a nonfunctional currency (including the functional currency of the owner) is translated into the section 987 QBU's functional currency at the spot rate on the date such item is properly taken into account. Paragraphs (e)(1) and (2) of this section (Examples 1 and 2) illustrate the application of this paragraph (b)(2).

(3) [Reserved]

(4) Section 988 transactions—(i) In general. Section 988 and the regulations under section 988 apply to section 988 transactions of a section 987 QBU. The determination of whether an asset or liability of a section 987 QBU is a section 988 transaction is determined by reference to the functional currency of the section 987 QBU. Section 988 gain or loss is determined in, and by reference to, the functional currency of the section 987 QBU. The amount of section 988 gain or loss determined under this paragraph (b)(4)(i) is translated into the owner's functional currency under paragraph (c) of this section.

(ii) Section 988 mark-to-market election—(A) In general. A taxpayer may elect to apply the section 988 mark-to-market method of accounting described in this paragraph (b)(4)(ii) with respect to all section 988 transactions that are properly attributable to a section 987 QBU and that are not otherwise accounted for under a mark-to-market method of accounting under section 475 or section 1256 (other than a section 988 transaction described in paragraph (b)(4)(ii)(B) of this section). Under the section 988 mark-to-market method of accounting, the timing of section 988 gain or loss on section 988 transactions described in the preceding sentence is determined under the principles of section 1256. Only section 988 gain or loss is taken into account under the foreign currency mark-to-market method of accounting. Appropriate adjustments must be made to prevent the section 988 gain or loss from being taken into account again after it is recognized under this paragraph (b)(4)(ii). A section 988 transaction subject to the foreign currency mark-to-market method of accounting is not subject to the netting rule of section 988(b) and § 1.988-2(b)(8) (under which exchange gain or loss is limited to overall gain or loss realized in a transaction) in taxable years before the taxable year in which section 988 gain or loss would be recognized with respect to the section 988 transaction but for this election.

(B) Built-in loss transactions contributed to a section 987 QBU. Paragraph (b)(4)(ii)(A) of this section does not apply to a section 988 transaction if—

(1) The transaction was transferred to the section 987 QBU from its owner (or from another eligible QBU of the owner);

(2) Immediately before the transfer, the transaction was a section 988 transaction in the hands of the owner (or other eligible QBU of the owner) and was not subject to a mark-to-market method of accounting;

(3) If the owner (or other eligible QBU) had disposed of the section 988 transaction immediately before the transfer (and § 1.988-2(b)(8) did not apply), the owner would have recognized section 988 loss; and

(4) Section 988 loss was not recognized in connection with the transfer under § 1.988-1(a)(10).

(c) Translation of items of income, gain, deduction, or loss of a section 987 QBU into the owner's functional currency—(1) In general. Except as otherwise provided in this section, the exchange rate to be used by an owner in translating an item of income, gain, deduction, or loss attributable to a section 987 QBU (or the item's components and related items, such as gross receipts, amount realized, basis, and cost of goods sold) into the owner's functional currency, if necessary, is the yearly average exchange rate for the taxable year.

(2) Exceptions. Except as otherwise provided in paragraph (c)(2)(v) of this section, this paragraph (c)(2) applies only to taxable years for which neither the annual recognition election nor the current rate election is in effect.

(i) Recovery of basis with respect to historic assets. Except as otherwise provided in this paragraph (c)(2), the exchange rate to be used by the owner in translating any recovery of basis (whether through a sale or exchange; deemed sale or exchange; cost recovery deduction such as depreciation, depletion or amortization; or otherwise) with respect to a historic asset is the historic rate for the property to which such recovery of basis is attributable.

(ii) through (iii) [Reserved]

(iv) Cost of goods sold computation—(A) General rule—simplified inventory method. Except as otherwise provided in paragraph (c)(2)(iv)(B) of this section, cost of goods sold (COGS) for a taxable year is translated into the functional currency of the owner at the yearly average exchange rate for the taxable year in which the sale of inventory occurs (or the COGS is otherwise taken into account in computing taxable income) and adjusted as provided in paragraph (c)(3) of this section.

(B) Election to use the historic inventory method. In lieu of using the simplified inventory method described in paragraph (c)(2)(iv)(A) of this section, the owner of a section 987 QBU may elect under this paragraph (c)(2)(iv)(B) to translate inventoriable costs (including current-year inventoriable costs and costs that were capitalized into inventory in prior years) that are included in COGS at the historic rate for each such cost.

(v) Translation of income to account for certain foreign income tax claimed as a credit. The owner of a section 987 QBU claiming a credit under section 901 for foreign income taxes, other than foreign income taxes deemed paid under section 960, that are properly reflected on the books and records of the section 987 QBU (the creditable tax amount) must determine section 987 taxable income or loss attributable to the section 987 QBU by reducing the amount of section 987 taxable income or loss that otherwise would be determined under this section by an amount equal to the creditable tax amount, translated into U.S. dollars using the yearly average exchange rate for the taxable year in which the creditable tax is accrued, and by increasing the resulting amount by an amount equal to the creditable tax amount, translated using the same exchange rate that is used to translate the creditable taxes into U.S. dollars under section 986(a). This paragraph (c)(2)(v) applies whether or not a current rate election or an annual recognition election is in effect. See paragraph (e)(14) of this section (Example 14) for an illustration of this rule.

(3) Adjustments to COGS required under the simplified inventory method. This paragraph (c)(3) applies only to taxable years for which neither the annual recognition election nor the current rate election is in effect.

(i) In general. An owner of a section 987 QBU that uses the simplified inventory method described in paragraph (c)(2)(iv)(A) of this section must make the adjustment described in paragraph (c)(3)(ii) of this section. In addition, the owner must make the adjustment described in paragraph (c)(3)(iii) of this section with respect to any inventory for which the section 987 QBU does not use the LIFO inventory method and must make the adjustment described in paragraph (c)(3)(iv) of this section with respect to any inventory for which the section 987 QBU uses the LIFO inventory method. An owner of a section 987 QBU that uses the simplified inventory method must make all of the applicable adjustments described in paragraphs (c)(3)(ii) through (iv) of this section with respect to the section 987 QBU even in taxable years in which the amount of COGS is zero.

(ii) Adjustment for cost recovery deductions included in inventoriable costs—(A) In general. The translated COGS amount computed under paragraph (c)(2)(iv)(A) of this section is increased or decreased (as appropriate) by the amount described in paragraph (c)(3)(ii)(B) of this section. The adjustment is included as an adjustment to translated COGS computed under paragraph (c)(2)(iv)(A) of this section in full in the year to which the adjustment relates and is not allocated between COGS and ending inventory.

(B) Amount of adjustment. With respect to each cost recovery deduction attributable to a historic asset that is included in inventoriable costs for a taxable year, the adjustment is equal to—

(1) The amount of the cost recovery deduction included in inventoriable costs, translated at the historic rate for the property to which the deduction is attributable; less

(2) The amount of the cost recovery deduction included in inventoriable costs, translated at the yearly average exchange rate for the current taxable year.

(iii) Adjustment for beginning inventory for non-LIFO inventory—(A) In general. In the case of non-LIFO inventory, the translated COGS amount computed under paragraph (c)(2)(iv)(A) of this section is increased or decreased (as appropriate) by the amount described in paragraph (c)(3)(iii)(B) of this section.

(B) Amount of adjustment. The adjustment is equal to—

(1) The ending non-LIFO inventory included on the closing balance sheet for the preceding taxable year, translated at the exchange rate described in paragraph (c)(3)(iii)(C) of this section (which is generally the yearly average exchange rate for the preceding taxable year); less

(2) The ending non-LIFO inventory included on the closing balance sheet for the preceding taxable year, translated at the yearly average exchange rate for the current taxable year.

(C) Exchange rate—(1) In general. Except as provided in paragraph (c)(3)(iii)(C)(2) of this section, the exchange rate used to translate non-LIFO inventory under paragraph (c)(3)(iii)(B)(1) of this section is the yearly average exchange rate for the preceding taxable year.

(2) Revocation of current rate election or taxable year beginning on the transition date. In the first taxable year in which a current rate election is revoked or otherwise ceases to be in effect (or in the taxable year beginning on the transition date), the exchange rate used to translate non-LIFO inventory under paragraph (c)(3)(iii)(B)(1) of this section is the spot rate applicable to the last day of the preceding taxable year.

(iv) Adjustment for year of LIFO liquidation—(A) In general. In the case of inventory with respect to which a section 987 QBU uses the LIFO inventory method, the translated COGS amount computed under paragraph (c)(2)(iv)(A) of this section is increased or decreased (as appropriate) by the amount described in paragraph (c)(3)(iv)(B) of this section.

(B) Amount of adjustment. With respect to each LIFO layer liquidated in whole or in part during the taxable year, the adjustment is equal to:

(1) The amount of the LIFO layer liquidated during the taxable year, translated at the historic rate that is used for translating the LIFO layer (which is generally the yearly average exchange rate for the year the LIFO layer arose); less

(2) The amount of the LIFO layer liquidated during the taxable year, translated at the yearly average exchange rate for the taxable year.

(d) [Reserved]

(e) Examples. The following examples illustrate the application of this section. For purposes of the examples, U.S. Corp is a domestic corporation that uses the calendar year as its taxable year and has the U.S. dollar as its functional currency. Except as otherwise indicated, U.S. Corp is the owner of Business A, a section 987 QBU with the euro as its functional currency, and U.S. Corp elects under paragraph (c)(2)(iv)(B) of this section to use the historic inventory method with respect to Business A but does not make any other elections.

(1) Example 1: Item of income denominated in nonfunctional currency. Business A accrues £100 of income from the provision of services. Under paragraph (b)(2) of this section, the £100 is translated into €90 at the spot rate on the date of accrual, without the use of a spot rate convention. In determining U.S. Corp's taxable income, the €90 of income is translated into dollars at the yearly average exchange rate under paragraph (c)(1) of this section.

(2) Example 2: Asset sold for nonfunctional currency. Business A sells a historic asset consisting of non-inventory property for £100. Under paragraph (b)(2) of this section, the £100 amount realized is translated into €85 at the spot rate on the sale date without the use of a spot rate convention. In determining U.S. Corp's taxable income, the €85 is translated into dollars at the yearly average exchange rate under paragraph (c)(1) of this section. The euro basis of the property is translated into dollars at the historic rate under paragraph (c)(2)(i) of this section.

(3) Example 3: Historic inventory method—(i) Facts. Business A uses a first-in, first-out (FIFO) method of accounting for inventory. Business A sells 1,200 units of inventory in year 2 for €3 per unit. The yearly average exchange rate is €1 = $1.02 for year 1 and €1 = $1.05 for year 2.

(ii) Analysis—(A) Gross sales. Business A's gross sales are translated under paragraph (c)(1) of this section at the yearly average exchange rate for the year of the sale. Business A's dollar gross sales will be computed as follows:

Table 1 to Paragraph (e)(3)(ii)(A)—Gross Sales

[Year 2]

(B) Translated basis of inventory. The purchase price for each inventory unit was €1.50. Under § 1.987-1(c)(3)(i) and paragraph (c)(2)(iv)(B) of this section, the basis of each item of inventory is translated into dollars at the yearly average exchange rate for the year the inventory was acquired.

Table 2 to Paragraph (e)(3)(ii)(B)—Opening Inventory and Purchases

[Year 2]

(C) COGS. Because Business A uses a FIFO method for inventory, Business A is considered to have sold in year 2 the 100 units of opening inventory purchased in year 1 ($153.00), the 300 units purchased in January year 2 ($472.50), the 300 units purchased in April year 2 ($472.50), the 300 units purchased in July year 2 ($472.50), and 200 of the 300 units purchased in November year 2 ($315.00). Accordingly, Business A's translated dollar COGS for year 2 is $1,885.50. Business A's opening inventory for year 3 is 100 units of inventory with a translated dollar basis of $157.50.

(D) Gross sales income. Accordingly, for purposes of section 987, Business A has gross income in dollars of $1,894.50 ($3,780.00−$1,885.50) from the sale of inventory in year 2.

(4) Example 4: Simplified inventory method—(i) Facts. The facts are the same as in paragraph (e)(3) of this section (Example 3), except that U.S. Corp does not elect to use the historic inventory method with respect to Business A.

(ii) Analysis. Because U.S. Corp does not elect to use the historic inventory method, the simplified inventory method under paragraph (c)(2)(iv)(A) of this section applies.

(A) Gross sales. Business A's dollar gross sales will be computed as described in paragraph (e)(3)(ii)(A) of this section (Example 3). Therefore, Business A has gross sales of $3,780.

(B) COGS. Business A sold 1,200 units of inventory in year 2, and the purchase price for each unit was €1.50. The total purchase price for the inventory sold in year 2 was €1,800. Under the simplified inventory method provided in paragraph (c)(2)(iv)(A) of this section, COGS for a taxable year is translated into the functional currency of the owner at the yearly average exchange rate for the taxable year in which the sale of inventory occurs. Therefore, before making the adjustments required under paragraph (c)(3) of this section, Business A's dollar COGS for year 2 is equal to $1,890 (the purchase price for the inventory sold in year 2 (€1,800), translated at the yearly average exchange rate of €1 = $1.05).

(C) Adjustments required. Because the simplified inventory method applies, Business A's COGS must be adjusted under paragraph (c)(3) of this section. No adjustment is required under paragraph (c)(3)(ii) of this section because no cost recovery deduction attributable to a historic asset is included in inventoriable costs for year 2. However, an adjustment for beginning inventory is required under paragraph (c)(3)(iii)(A) of this section because Business A uses a FIFO method of accounting for inventory.

(D) Adjustment for beginning inventory. The adjustment required under paragraph (c)(3)(iii)(A) of this section is equal to: the ending non-LIFO inventory included on Business A's closing balance sheet for the preceding taxable year (€150), translated at the yearly average exchange rate for year 1 (€1 = $1.02), which is $153; less the ending non-LIFO inventory included on Business A's closing balance sheet for the preceding taxable year (€150), translated at the yearly average exchange rate for year 2 (€1 = $1.05), which is $157.50. Therefore, there is a negative adjustment to COGS of $4.50. Business A's COGS for year 2 is reduced from $1,890 to $1,885.50.

(E) Gross sales income. Accordingly, for purposes of section 987, Business A has gross income in dollars of $1,894.50 ($3,780.00−$1,885.50) from the sale of inventory in year 2.

(5) Example 5: Depreciation expense that is not an inventoriable cost. The facts are the same as in paragraph (e)(3) of this section (Example 3) except that during year 2, Business A incurred €100 of depreciation expense with respect to a truck. No portion of the depreciation expense is an inventoriable cost. The truck was purchased on January 15, year 1. The yearly average exchange rate for year 1 was €1 = $1.02. Under paragraph (c)(2)(i) of this section, the €100 of depreciation is translated into dollars at the historic rate. The historic rate is the yearly average exchange rate for year 1. Accordingly, U.S. Corp takes into account depreciation of $102 with respect to Business A in year 2.

(6) Example 6: Translation of depreciation expense that is an inventoriable cost (historic inventory method). The facts are the same as in paragraph (e)(5) of this section (Example 5) except that the €100 of depreciation expense incurred during year 2 with respect to the truck is an inventoriable cost. As a result, the depreciation expense is capitalized into the 1,200 units of inventory purchased by Business A in year 2. Of those 1,200 units, 1,100 units are sold during the year, and 100 units become ending inventory. The portion of depreciation expense capitalized into inventory that is sold during year 2 is reflected in Business A's euro COGS and is translated at the €1 = $1.02 yearly average exchange rate for year 1, the year in which the truck was purchased. The portion of the depreciation expense capitalized into the 100 units of ending inventory is not taken into account in year 2 but rather, will be taken into account in the year the ending inventory is sold, translated at the €1 = $1.02 yearly average exchange rate for year 1.

(7) Example 7: Sale of land. Business A purchased raw land on October 16, year 1, for €8,000 and sold the land on November 1, year 2, for €10,000. The yearly average exchange rate was €1 = $1.02 for year 1 and €1 = $1.05 for year 2. Under paragraph (c)(1) of this section, the amount realized is translated into dollars at the yearly average exchange rate for year 2 (€10,000 × $1.05 = $10,500). Under paragraph (c)(2)(i) of this section, the basis is translated at the historic rate for year 1, which is the yearly average exchange rate under section § 1.987-1(c)(3)(i) (€8,000 × $1.02 = $8,160). Accordingly, the amount of gain reported by U.S. Corp on the sale of the land is $2,340 ($10,500−$8,160).

(8) Example 8: Current rate election. The facts are the same as in paragraph (e)(7) of this section (Example 7), except that U.S. Corp makes a current rate election under § 1.987-1(d)(2). Under paragraph (c)(2) of this section, the exceptions to paragraph (c)(1) of this section generally do not apply in a taxable year for which an annual recognition election or a current rate election is in effect. As a result, all items of income, gain, deduction, and loss with respect to Business A are translated into U.S Corp's functional currency at the yearly average exchange rate under paragraph (c)(1) of this section. Business A's gain on the sale of the land is determined in its functional currency and is equal to €2,000 (amount realized of €10,000 less basis of €8,000). This gain is translated at the yearly average exchange rate for year 2 of €1 = $1.05, and the amount of gain reported by U.S. Corp on the sale of the land is $2,100. The result would be the same if U.S. Corp made an annual recognition election under § 1.987-5(b)(2) (and did not make a current rate election).

(9) -(12) [Reserved]

(13) Example 13: Section 988 transaction—(i) Facts. Business A receives and accrues $100 of income from the provision of services on January 1, 2021. Business A continues to hold the $100 as a U.S. dollar-denominated demand deposit at a bank on December 31, 2021. U.S. Corp has made a section 988 mark-to-market election under paragraph (b)(4)(ii) of this section. The euro-dollar spot rate without the use of a spot rate convention is €1 = $1 on January 1, 2021, and €1 = $2 on December 31, 2021, and the yearly average exchange rate for 2021 is €1 = $1.50.

(ii) Analysis—(A) Under paragraph (b)(2) of this section, the $100 earned by Business A is translated into €100 at the spot rate on January 1, 2021, as defined in § 1.987-1(c)(1) without the use of a spot rate convention. In determining U.S. Corp's taxable income, the €100 of services income is translated into $150 at the yearly average exchange rate for 2021, as provided in paragraph (c)(1) of this section.

(B) Under paragraph (b)(4)(i) of this section, section 988 gain or loss for Business A's section 988 transactions is determined in, and by reference to, the euro, the functional currency of Business A. Accordingly, section 988 gain or loss must be determined on Business A's holding of the $100 demand deposit in, and by reference to, the euro. Under § 1.988-2(a)(2), Business A is treated as having an amount realized of €50 when the $100 is marked to market at the end of 2021 under paragraph (b)(4)(ii) of this section. Marking the dollars to market gives rise to a section 988 loss of €50 (€50 amount realized, less Business A's €100 basis in the $100). In determining U.S. Corp's taxable income, that €50 loss is translated into a $75 loss at the yearly average exchange rate for 2021, as provided in paragraph (c)(1) of this section.

(14) Example 14: Payment of foreign income tax—(i) Facts. Business A earns €100 of revenue from the provision of services and incurs €30 of general expenses and €10 of depreciation expense during 2021. Except as otherwise provided, U.S. Corp uses the yearly average exchange rate described in § 1.987-1(c)(2) to translate items of income, gain, deduction, and loss of Business A. Business A is subject to income tax in Country X at a 25 percent rate. U.S. Corp claims a credit with respect to Business A's foreign income taxes and elects under section 986(a)(1)(D) to translate the foreign income taxes at the spot rate on the date the taxes were paid. The yearly average exchange rate for 2021 is €1 = $1.50. The historic rate used to translate the depreciation expense is €1 = $1.00. The spot rate on the date that Business A paid its foreign income taxes was €1 = $1.60.

(ii) Analysis. Because U.S. Corp has elected to translate foreign income taxes at the spot rate on the date such taxes were paid rather than at the yearly average exchange rate, U.S. Corp must make the adjustments described in paragraph (c)(2)(v) of this section. Accordingly, U.S. Corp determines its section 987 taxable income or loss by reducing the section 987 taxable income or loss that otherwise would be determined under this section by €15, translated into U.S. dollars at the yearly average exchange rate (€1 = $1.50), and increasing the resulting amount by €15, translated using the same exchange rate that is used to translate the creditable taxes into U.S. dollars under section 986(a) (€1 = $1.60). Following these adjustments, Business A's section 987 taxable income for 2021 is $96.50, computed as follows:

Table 3 to Paragraph (e)(14)(ii)

26 C.F.R. § 1.987-2 26 C.F.R. § 1.987-3T

Authorizing Statute