SERVICE PREVIEWS FOREIGN CURRENCY TRANSLATION REGULATIONS.

Notice 89-74

This notice provides guidance relating to the amendments made to the foreign currency rules by the Tax Reform Act of 1986, 1986-3 (Vol. 1) C.B. 1 (the Act), as amended by the Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647, 100 Stat. 3342. Specifically, this notice provides rules for translating the income of a foreign branch of a United States taxpayer (a qualified business unit (QBU) that has a functional currency other than the U.S. dollar when the taxpayer credits, rather than deducts, foreign taxes.

Section 1261(a) of the Act added sections 985 through 989 of the Internal Revenue Code of 1986 to provide rules for the treatment of foreign currency transactions. Section 985(a) provides that, unless otherwise provided in regulations, all determinations under subtitle A of the Code shall be made in the taxpayer's functional currency (as defined in section 985(b)). Under section 987, a taxpayer with one or more QBUs with functional currency other than the dollar must compute the taxable income or loss of each QBU separately in the functional currency of the QBU before translating such income into dollars at the appropriate exchange rate. Under section 989(b)(4), the appropriate exchange rate for translating branch income is, except as provided in regulations, the weighted average exchange rate for the taxable year.

A taxpayer may elect either to credit or to deduct foreign taxes paid or accrued. In order to prevent a double benefit, section 275(a)(4) of the Code and section 1.901-1(c) of the Income Tax Regulations provide that a taxpayer is not allowed to deduct foreign income taxes if the taxpayer chooses to credit such taxes. Therefore, if a taxpayer credits foreign taxes, taxable income (or loss) attributable to a branch consists of two elements: a functional currency amount equal to the foreign taxes paid on branch income for which no deduction is allowed (the "tax equivalent amount") and a functional currency amount of "earnings" (or "deficit"). For these purposes the "earnings" (or "deficit") equal taxable income (or loss) minus taxes paid or accrued.

The regulations will provide that when a United States taxpayer with a foreign branch that has a functional currency other than the dollar credits rather than deducts the branch's foreign taxes, the taxpayer must translate the tax equivalent amount into dollars using the exchange rate at the time of payment of such taxes to a foreign country or possession of the United States. The regulations will also provide that the taxpayer will translate the branch's "earnings" (or "deficit") into dollars using the weighted average exchange rate.

In addition, to the extent there is a foreign tax redetermination, as defined in section 1.905-3T(c) of the Temporary Income Tax Regulations, the taxpayer will be required to recompute the taxable income, the "tax equivalent amount," and "earnings" attributable to the branch using the translation rules of this notice.

The following examples illustrate the rules of this notice. Assume in each example that all of X's income is income generated by M that is foreign source general limitation income (income described in section 904(d)(1)(I) of the Code).

Example (1). M is a foreign branch of a calendar year domestic corporation X, that for 1988 credits its foreign taxes paid. M operates in foreign country R and is a QBU. R's currency is the u and M's functional currency is the u. In 1988, M has 100u of taxable income. M pays 20u of tax on that income to country R on December 31, 1988. For 1988, the weighted average exchange rate is 1u/$1. On December 31, 1988, the exchange rate is 1u/$1.2. The 20u of foreign tax is a creditable tax under section 901 of the Code and the regulations thereunder.

In 1988, X's 100u of income attributable to M consists of 80u of earnings and 20u of a tax equivalent amount. The 80u of earnings is translated at the weighted average exchange rate for 1988 (1u/$1) to $80 and 20u is translated at the exchange rate when the taxes are paid (1u/$1.2) to $24. For 1988, X, therefore, has taxable income of $104 ($80 + $24) attributable to its branch M and has paid $24 of foreign taxes with respect to that income.

EXAMPLE (2). The facts are the same as in EXAMPLE 1, except that in 1989, there is a foreign tax redetermination with respect to M's 1988 income that results in a 10u refund. Therefore, under section 1.905-3T(d) of the temporary regulations, X must determine its tax liability for 1988. The redetermination results in a change in the dollar amount of the taxable income of X attributable to M. X has 100u of taxable income attributable to M which, after the redetermination, consists of 90u of earnings and 10u of a tax equivalent amount. The 90u of earnings is translated at the weighted average exchange rate (1u/$1) to $90 and 10u is translated at the exchange rate on December 31, 1988, the time of the original payment of the foreign tax (1u/$1.2) to $12. Section 986(a)(1)(B)(ii) of the Code. X, therefore, has taxable income of $102 ($90 + $12) attributable to its branch M and has paid $12 of foreign taxes with respect to that income.

EXAMPLE (3). The facts are the same as in EXAMPLE 1, except that in 1988 X accrues, rather than pays, the 20u of foreign taxes. The December 31, 1988 rate (1u/$1.2) is the rate used to translate the accrued taxes in 1988. Section 1.905-3T(b)(1) of the temporary regulations. In 1989, when X pays the 20u of foreign taxes attributable to 1988, the exchange rate is 1u/$1.4. The difference in the dollar value of foreign taxes accrued and foreign taxes paid is a foreign tax redetermination. Section 1.905-3T(c)(3) of the temporary regulations. The redetermination results in a change in the dollar amount of X's taxable income attributable to M. X has 100u of taxable income attributable to M, which after the redetermination consists of 80u of earnings translated at the 1u/$1 rate to $80 and 20u of a tax equivalent amount equal to foreign taxes paid translated at the 1u/$1.4 rate to $28. X, therefore, has taxable income of $108 ($80 + $28) attributable to M and has paid $28 of foreign taxes with respect to that income.

EXAMPLE (4). The facts are the same as in EXAMPLE 1, except that in 1989 there is a foreign tax redetermination within the meaning of section 1.905-3T(c) of the temporary regulations that results from an additional tax payment of 5u on M's 1988 income. In 1989 X pays the additional 5u in foreign tax when the exchange rate is 1u/$1.4. The foreign tax redetermination results in a change in the dollar amount of X's taxable income attributable to M. After the redetermination, M has 75u of earnings and 25u a tax equivalent amount. The 75u of earnings is translated at the 1u/$1 rate to $75. 20u is translated at the 1u/$1.2 rate to $24, and 5u is translated at the 1u/$1.4 rate to $7. Section 986(a)(1)(B)(i) of the Code. X, therefore, has taxable income of $106 ($75 + $24 + $7) attributable to M in 1988 and has paid $31 ($24 + $7) of foreign taxes with respect to that income.

EXAMPLE (5). The facts are the same as in EXAMPLE 1, except that M has 10u of taxable income and country R imposes 30u of tax on that income. X, therefore, has 10u of a taxable income that consists of 30u of a tax equivalent amount and a deficit of 20u (taxable income minus foreign taxes). X translate 30u at the exchange rate as of the date of the payment of the taxes (1u/$1.2) to $36 and translates the 20u deficit at the weighted average rate (1u/$1) to <$20>. X has $16 ($36 + <20>) of taxable income attributable to branch M and has paid $36 of foreign taxes with respect to that income.

PROCEDURAL INFORMATION

The rules contained in this notice will be incorporated in regulations to be issued under the Act. This document serves as an "administrative pronouncement" as that term is described in section 1.6661-3(b)(2) of the regulations and may be relied on to the same extent as a revenue ruling or revenue procedure.

DRAFTING INFORMATION

The principle author of this notice is Carolyn DuPuy of the Office of the Associate Chief Counsel (International). For further information about the notice, call Ms. DuPuy at (202) 566-6284 (not a toll-free call).