11/ While the functional currency of most taxpayers is the U.S.
dollar, in certain cases the functional currency of a "qualified
business unit" may be the currency of the economic environment in
which a significant part of the unit's activities are conducted.
March 25, 1992
TO: TAX MEMBERS NO. 19-92
ACCOUNTING/TREASURERS MEMBERS NO. 16-92
CLOSED-END FUND MEMBERS NO. 16-92
INTERNATIONAL COMMITTEE NO. 8-92
RE: IRS REGULATIONS ON SECTION 988 FOREIGN CURRENCY TRANSACTIONS
__________________________________________________________
Attached are two sets of regulations, one proposed and one
final, relating to the taxation of gain or loss under Code
section 988 arising from certain foreign currency transactions.
In general, section 988 and the related regulations provide rules
under which exchange gain or loss is realized, on a transaction-
by-transaction basis, whenever the amount to be paid or received
with respect to three types of transactions -- (i) the
acquisition of a debt instrument, (ii) the accrual of any item of
expense, income or receipt which is paid or received after the
accrual date and (iii) the entering into or acquisition of
forward contracts, futures contracts, options or similar
financial instruments -- is denominated in or determined by
reference to a nonfunctional currency. 1/1 Rules are also provided
for the computation, timing, character and source of gain or loss
that is due to fluctuations in exchange rates and for certain
integrated hedging transactions.
The final regulations replace temporary and proposed
regulations under section 988 that were issued in 1989. (See
Institute Memorandum to Tax Members No. 39-89, Closed-End Fund
Members No. 53-89, International Funds Task Force No. 17-89 and
Accounting/Treasurers Committee No. 45-89, dated October 10,
1989.) As you may know, in 1989 a subcommittee of the Tax
Committee identified three concerns with the proposed and
temporary regulations; the Institute submitted written comments
expressing these concerns. (See Institute Memorandum to Tax
Committee No. 19-89, Closed-End Fund Committee No. 51-89,
22/ The final regulations do not adopt the Institute's third
suggestion, that RICs be permitted to treat (at least
retroactively) the acquisition of a foreign-currency-denominated
certificate of deposit ("CD") as a recognition event. Instead,
Treas. Reg. Sec. 1.988-2(a)(iii) retains the rule in the proposed
and temporary regulations issued in 1989 that no exchange gain or
loss is generally recognized on the deposit of nonfunctional
currency into a CD, the withdrawal of nonfunctional currency from
a CD, the receipt of nonfunctional currency by reason of the
maturity or other termination of a CD, or the transfer of
nonfunctional currency from one CD to another.
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International Funds Task Force No. 19-89 and Accounting/
Treasurers Committee No. 50-89, dated November 21, 1989.)
The three suggestions made by the Institute in 1989 were as
follows. First, the Institute proposed that a convention be
provided to eliminate the creation of foreign currency gains and
losses attributable to unhedged payables and receivables arising
from the purchase and sale by a regulated investment company
("RIC") of foreign-currency-denominated stock and securities.
Second, the Institute suggested that the hedging rules under the
section 988 regulations be expanded to encompass hedges of
payables and receivables arising from the purchase and sale by
RICs of stock and securities. Finally, although it did not
appear to be a problem of widespread concern, the Institute urged
that RICs that may have treated the acquisition of a foreign-
currency-denominated certificate of deposit as a recognition
event be permitted to continue that practice, or at a minimum
that the nonrecognition treatment set forth in the regulations
not be applied retroactively.
We are pleased to inform you that the Institute's two
principal concerns have generally been resolved by the final
regulations.2/2 First, the final regulations permit accrual basis
taxpayers (for taxable years beginning after March 17, 1992) to
elect to translate units of nonfunctional currency, paid or
received with respect to purchases or sales of stock or
securities traded on an established securities market, into
functional currency at the spot rate on the settlement date of
the purchase or sale. Treas. Reg. Sec. 1.988-2(a)(2)(iv) and
(v). Previously, the ability to translate foreign currency using
the spot rate on the settlement date was limited to cash basis
taxpayers. Under the final regulations, accrual basis taxpayers
may elect this spot rate method by filing a statement with the
taxpayer's first tax return in which the election is effective
clearly indicating that the election has been made. If the
election is made, it must be applied consistently from year to
year and cannot be changed without the consent of the
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Commissioner.
Second, the final regulations permit all taxpayers to
integrate hedges of payables and receivables that are created
when a taxpayer purchases or sells stocks or securities which are
traded on an established securities market. Treas. Reg. Sec.
- 3 -
1.988-5(c). Under the regulations, the hedge may be for any part
of the period beginning on the trade date and ending on the
settlement date. The hedge must be identified by entering into a
record before the close of the date the hedge is entered into a
clear description of the executory contract and the hedge.
Treas. Reg. Sec. 1.988-5(b)(3). A hedge includes a deposit of
nonfunctional currency in a hedging account, defined in Treas.
Reg. Sec. 1.988-5(b)(2)(iii)(D) as "an account with a bank or
other financial institution used exclusively for deposits of
nonfunctional currency used to hedge executory contracts." These
hedging rules apply to trade date/settlement date hedges entered
into on or after September 21, 1989, even if the transaction
being hedged was entered into or acquired prior to such date.
The final regulations make numerous other changes, some of
which may affect RICs. For example, Treas. Reg. Sec. 1.988-1(d)
has been expanded to permit the spot rate convention to be
determined at intervals of one quarter year or less (rather than
one month or less) for purposes of computing exchange gain or
loss with respect to payables and receivables denominated in a
nonfunctional currency that are incurred in the ordinary course
of business with respect to the acquisition or sale of goods or
the obtaining or performance of services. This change is
effective for taxable years beginning after December 31, 1986.
Similarly, Treas. Reg. Sec. 1.988-2(b)(2)(ii) and (iii)(B) permit
accrual basis taxpayers to elect to translate interest income and
expense at the spot rate on the last day of the interest accrual
period (and in the case of a partial accrual period, the spot
rate on the last day of the taxable year). This change is
effective for taxable years beginning after March 17, 1992. In
addition, the final regulations provide that the Commissioner may
issue an advance ruling addressing the income tax consequences of
taxpayer systems for hedging net nonfunctional currency exposure
and anticipatory hedges of items of income or expense.
Simultaneously with the issuance of the final regulations,
the Treasury has issued proposed regulations which would provide
additional guidance regarding the treatment of a variety of
instruments, including contingent payment debt instruments, dual
currency debt instruments, debt instruments denominated in
hyperinflationary currencies and forward contracts, futures
contracts, option contracts and currency contracts where payments
to be made or received are denominated in hyperinflationary
currencies.
In addition, proposed Treas. Reg. Sec. 1.988-5(f) would
provide a mark-to-market method of accounting for section 988
transactions. Any taxpayer making the mark-to-market election
would be required to use the method to account for all section
988 transactions, other than those subject to the special hedging
rules of Treas. Reg. Sec. 1.988-5. Under the mark-to-market
method, taxpayers would realize for the taxable year exchange
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gain or loss on section 988 transactions resulting from changes
in exchange rates between the dates a financial period begins and
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closes (but no less frequently than quarterly), provided that
such treatment is consistent with the taxpayer's method of
accounting for financial reporting purposes (and the method
conforms to U.S. generally accepted accounting principles).
Comments and requests for a public hearing on the proposed
regulations must be received by May 18, 1992. Please inform the
undersigned by May 1, 1992 of any comments that you would like
the Institute to submit on these regulations.
We will keep you informed of developments.
Keith D. Lawson
Associate Counsel - Tax
Attachments