Sec. 1.986(a)-1 Translation of foreign income taxes for purposes of the foreign tax credit.
(a) Translation of foreign income taxes taken into account when accrued.
(1) In general. For purposes of this section, the term section 901 taxpayer means the “taxpayer” described in §1.901-2(f)(1) and so includes a partnership or a specified 10-percent owned foreign corporation (as defined in section 245A(b)) that has legal liability under foreign law for foreign income tax. Except as provided in paragraph (a)(2) of this section, in the case of a section 901 taxpayer that takes foreign income taxes (as defined in section 986(a)(4) (including taxes described in section 903)) into account when accrued, the amount of any foreign income taxes denominated in foreign currency that has been paid or accrued, including additional tax liability denominated in foreign currency, foreign income taxes withheld in foreign currency, or estimated foreign income taxes paid in foreign currency, are translated into dollars using the weighted average exchange rate (as defined in §1.989(b)-1) (the “average exchange rate”) for the section 901 taxpayer's U.S. taxable year (as defined in §1.960-1(b)(37)) to which such foreign income taxes relate. See section 986(a)(1)(A). See section 988 and §§1.988-1(a)(2)(ii) and 1.988-2(c) for rules for determining whether and the extent to which there is a foreign currency gain or loss when an accrued functional currency amount of foreign income tax denominated in nonfunctional currency differs from the functional currency amount paid.
(2) Exceptions.
(i) Foreign income taxes not paid within 24 months. Any foreign income taxes denominated in foreign currency that are paid more than 24 months after the close of the section 901 taxpayer's U.S. taxable year to which they relate are translated into dollars using the spot rate on the date of payment of the foreign income taxes. See section 986(a)(1)(B)(i) and (a)(2)(A). For purposes of this section and §1.905-3, the term spot rate has the meaning provided in §1.988-1(d). To the extent any accrued foreign income taxes denominated in foreign currency remain unpaid more than 24 months after the close of the taxable year to which they relate, see §1.905-3 and paragraph (c) of this section for the required adjustments.
(ii) Foreign income taxes paid before taxable year begins. Any foreign income taxes denominated in foreign currency that are paid before the beginning of the section 901 taxpayer's U.S. taxable year to which such taxes relate are translated into dollars using the spot rate on the date of payment of the foreign income taxes. See section 986(a)(1)(B)(ii) and (a)(2)(A).
(iii) Inflationary currency. Any foreign income taxes denominated in a foreign currency that is an inflationary currency in the section 901 taxpayer's U.S. taxable year to which the foreign income taxes relate, or in any subsequent taxable year up to and including the taxable year in which the taxes are paid, are translated into dollars using the spot rate on the date of payment of such taxes. For purposes of section 986(a)(1)(C) and this paragraph (a)(2)(iii), the term inflationary currency means the currency of a country in which there is cumulative inflation during the base period of at least 30 percent, as determined under the principles of §1.985-1(b)(2)(ii)(D), where the base period, with respect to any taxable year, is the 36 months ending on the last day of such taxable year (in lieu of the base period described in §1.985-1(b)(2)(ii)(D), which ends on the last day of the preceding calendar year). Accrued but unpaid foreign income taxes denominated in a foreign currency that is an inflationary currency in the taxable year accrued are translated into dollars at the spot rate on the last day of the section 901 taxpayer's U.S. taxable year to which such taxes relate (provisional year-end rate). However, a U.S. taxpayer that claims a foreign tax credit under section 901 may choose to translate accrued but unpaid foreign income taxes (including foreign income taxes deemed paid under section 960) denominated in a foreign currency that is an inflationary currency into dollars at the spot rate on the date of payment, in lieu of the provisional year-end rate, if such taxes are paid prior to the due date (with extensions) of the original Federal income tax return for the taxable year for which the credit is claimed and such return is timely filed. In all other cases, see §1.905-3 and paragraph (c) of this section for required adjustments upon payment of accrued foreign income taxes denominated in an inflationary currency.
(iv) Election to translate foreign income taxes using the spot rate as of date of payment.
(A) Eligibility to make election. An individual or corporate taxpayer (including a specified 10-percent owned foreign corporation) that is otherwise required to translate foreign income taxes that are denominated in foreign currency using the average exchange rate may elect to translate foreign income taxes described in this paragraph (a)(2)(iv) into dollars using the spot rate on the date of payment of the foreign income taxes, provided that the liability for such taxes is denominated in nonfunctional currency. For purposes of section 986(a)(1)(D) and this paragraph (a)(2)(iv), whether the currency in which a tax liability attributable to a qualified business unit (within the meaning of section 989(a)) (QBU) is denominated is a nonfunctional currency is determined by reference to the functional currency of the individual or corporate taxpayer and not that of the QBU of the taxpayer. Accrued but unpaid foreign income taxes subject to the election under this paragraph (a)(2)(iv) are translated at the provisional year-end rate. However, a taxpayer that claims a foreign tax credit under section 901 may choose to translate accrued but unpaid foreign income taxes (including foreign taxes deemed paid under section 960 with respect to a specified 10-percent owned foreign corporation that has made an election under this paragraph (a)(2)(iv)) into dollars at the spot rate on the date of payment, in lieu of the provisional year-end rate, if such taxes are paid prior to the due date (with extensions) of the original return for the taxable year for which the credit is claimed and such return is timely filed. In all other cases, see §1.905-3 and paragraph (c) of this section for required adjustments upon payment of accrued foreign income taxes that are translated into dollars at the spot rate on the date of payment.
(B) Scope of election. In general, an individual taxpayer may make an election under this paragraph (a)(2)(iv) for all foreign income taxes denominated in nonfunctional currency, or only for those foreign income taxes that are denominated in nonfunctional currency and that are attributable to the individual's non-QBU activities and all QBUs with dollar functional currencies. A corporate taxpayer may make an election under this paragraph (a)(2)(iv) for all foreign income taxes that are denominated in nonfunctional currency, or only for those foreign income taxes that are denominated in nonfunctional currency and that are attributable to all QBUs (including the corporate taxpayer) with dollar functional currencies. Therefore, an election under this paragraph (a)(2)(iv) may not be made for foreign income taxes that are denominated in a nonfunctional currency of the taxpayer and attributable to QBUs with non-dollar functional currencies, except as part of an election to translate all taxes denominated in nonfunctional currency at the spot rate on the date of payment. For purposes of this paragraph (a)(2)(iv)(B), foreign income tax is attributable to a QBU if the tax is properly recorded on the books and records of the QBU in accordance with sections 985 through 989. An election under this paragraph (a)(2)(iv) by a domestic corporation (or an individual that has made an election under section 962) does not apply to any taxes paid or accrued by foreign corporations with respect to which the individual or corporation is a United States shareholder. However, an election may be made on behalf of a foreign corporation to translate either all of the foreign corporation's foreign income taxes denominated in nonfunctional currency, or only the foreign income taxes denominated in nonfunctional currency that are attributable to the foreign corporation's QBUs with dollar functional currencies, using the spot rate on the date of payment. Such an election is made using the procedures under §1.964-1(c)(3) that apply to permit controlling domestic shareholders to make or change a tax accounting election on behalf of a foreign corporation.
(C) Time and manner of election. The election under this paragraph (a)(2)(iv) must be made by attaching a statement to the taxpayer's timely filed Federal income tax or information return (including extensions) for the first taxable year to which the election applies. The statement must identify whether the election under this paragraph (a)(2)(iv) is made for all foreign income taxes denominated in nonfunctional currency or only for those foreign income taxes that are denominated in nonfunctional currency and that are either attributable to the taxpayer's QBUs with dollar functional currencies or, in the case of an individual, attributable to non-QBU activities. Once made, the election under this paragraph (a)(2)(iv) applies for the taxable year for which made and all subsequent taxable years unless revoked with the consent of the Commissioner.
(D) Example.
(1) Facts. USP, a domestic corporation that uses the calendar year as its taxable year, owns a partnership interest in PS, a non-hybrid partnership organized in Country X. USP also owns an equity interest in HPS, a Country X corporation that has filed an entity classification election under §301.7701-3 of this chapter to be treated as a partnership for Federal income tax purposes. USP also owns 100% of CFC, a Country Y controlled foreign corporation that uses the U.S. dollar as its functional currency. PS and HPS each use a fiscal year ending November 30 as its taxable year both for Federal income tax purposes and for Country X tax purposes, and their functional currency is the Euro. HPS is the section 901 taxpayer of foreign income taxes denominated in Euros that it pays to Country X and properly records on its books and records. USP takes its distributive share of the HPS taxes into account under sections 702(a)(6) and 901(b)(5) and §§1.702-1(a)(6) and 1.704-1(b)(4)(viii) in computing its foreign tax credit. USP is the section 901 taxpayer of Euro-denominated foreign income taxes it pays to Country X with respect to its distributive share of the income of PS, and also pays Country X taxes withheld in Euros from distributions from HPS to USP and properly records these taxes on its books and records. Pursuant to §1.985-1(b)(1)(iii), USP's functional currency is the dollar. USP timely elects under §1.986(a)-1(a)(2)(iv) to use the spot rate on the date of payment to translate into dollars its foreign income taxes denominated in nonfunctional currency that are attributable to all QBUs with dollar functional currencies.
(2) Result. The Euro taxes paid by USP with respect to its distributive share of income from PS and the Euro taxes withheld from distributions from HPS are nonfunctional currency taxes attributable to USP, a QBU with a dollar functional currency. Accordingly, these taxes are translated into dollars at the spot rate on the date the taxes are paid. USP's distributive share of the Euro taxes paid by HPS are attributable to HPS, a Euro functional currency QBU of USP. Because these taxes are not attributable to a dollar QBU of USP, they are not covered by USP's election and so are translated into dollars at the average exchange rate for HPS's U.S. taxable year ending on November 30. See §1.986(a)-1(a)(1). Foreign income taxes paid by CFC are not covered by USP's election; however, if USP so chooses it may make a separate election on behalf of CFC to use the spot rate on the date of payment to translate either all of CFC's nonfunctional currency taxes, or only those taxes that are attributable to CFC's dollar QBUs (which includes CFC). If instead USP had elected to use the spot rate on the date of payment to translate all of its foreign income taxes denominated in nonfunctional currency, rather than only those taxes attributable to QBUs with dollar functional currencies, then the spot rate on the date of payment would apply to translate all of the Euro taxes paid or accrued by USP, including its distributive share of taxes paid by HPS. However, this election would still not apply to taxes paid or accrued by CFC. See §1.986(a)-1(a)(2)(iv)(B).
(v) Regulated investment companies. In the case of a regulated investment company (as defined in section 851) which takes into account income on an accrual basis, foreign income taxes paid or accrued with respect to such income are translated into dollars using the spot rate on the date the income accrues. See section 986(a)(1)(E).
(b) Translation of foreign income taxes taken into account when paid. In the case of a section 901 taxpayer that takes foreign income taxes into account when paid, the amount of any foreign income tax liability denominated in foreign currency, including additional income tax liability denominated in foreign currency or estimated foreign income taxes paid in foreign currency, are translated into dollars using the spot rate on the date of payment of such taxes. See section 986(a)(2)(A). Foreign income taxes withheld in foreign currency are translated into dollars using the spot rate on the date on which such taxes were withheld.
(c) Refunds or other reductions of foreign income tax liability. In the case of a section 901 taxpayer that takes foreign income taxes into account when accrued, a reduction in the amount of previously-accrued foreign income taxes that is attributable to a refund of foreign income taxes, a credit allowed in lieu of a refund, or a reduction in or other downward adjustment to an accrued amount, including an adjustment on account of accrued foreign income taxes that were not paid by the date 24 months after the close of the U.S. taxable year to which such taxes relate, is translated into dollars using the exchange rate that was used to translate such amount when claimed as a credit or added to PTEP group taxes (as defined in §1.960-3(d)(1)). In the case of foreign income taxes taken into account when accrued but translated into dollars on the date of payment, see §1.905-3(b) for required adjustments to reflect a foreign tax redetermination (as defined in §1.905-3(a)) attributable to a reduction in the amount of previously-accrued foreign income taxes that is attributable to a difference in exchange rates between the date or taxable year of accrual and the date of payment. In the case of a section 901 taxpayer that takes foreign income taxes into account when paid, a refund or other reduction in or downward adjustment to the amount of foreign income taxes is translated into dollars using the exchange rate that was used to translate such amount when claimed as a credit. If a refund or other reduction of foreign income taxes relates to foreign income taxes paid or accrued on more than one date, then the refund or other reduction is deemed to be derived from, and reduces, the payments of foreign income taxes in order, starting with the most recent payment of foreign income taxes first, to the extent thereof.
(d) Allocation of refunds of foreign income taxes. Refunds of foreign income taxes are allocated to the same separate category as the foreign income taxes to which the refunded taxes relate. Refunds are related to foreign income taxes in a separate category if the foreign income tax that was refunded was imposed with respect to that separate category. See §1.904-6 concerning the allocation of foreign income taxes to separate categories of income.
(e) Basis of foreign currency refunded.
(1) Nonfunctional currency tax liability and dollar functional currency. If the functional currency of the QBU that paid the tax and received the refund is the dollar or the person receiving the refund is not a QBU, then the recipient's basis in the foreign currency refunded is the dollar value of the refund determined under paragraph (c) of this section by using the exchange rate that was used to translate such amount into dollars when claimed as a credit or added to PTEP group taxes.
(2) Nonfunctional currency tax liability and non-dollar functional currency. If the functional currency of the QBU receiving the refund is not the dollar and is different from the currency in which the foreign income taxes were paid, then the recipient's basis in the refunded foreign currency is equal to the functional currency value of the nonfunctional currency refund, translated into functional currency at the appropriate exchange rate between the functional currency and the nonfunctional currency. Such exchange rate is determined under the principles of paragraph (c) of this section, substituting the words “functional currency” for the word “dollar” and using the exchange rate that was used to translate such amount into the QBU's functional currency when claimed as a credit or added to PTEP group taxes (as defined in §1.960-3(d)(1)). If a QBU receives a refund of nonfunctional currency tax that is denominated in a currency that was the functional currency of the QBU when the refunded tax was claimed as a credit or added to PTEP group taxes, the QBU's basis in the nonfunctional currency received in the refund is determined by using the exchange rate used under §1.985-5(c) when the QBU's functional currency changed. See §1.905-3(b)(1)(ii)(C) (Example 3).
(3) Functional currency tax liabilities. If the functional currency of the QBU receiving the refund is the currency in which the refund was made, then the recipient's basis in the currency received is the amount of the functional currency received. If the QBU receives a refund of functional currency tax that was denominated in a nonfunctional currency of the QBU when the tax was claimed as a credit or added to PTEP group taxes, the QBU will recognize the section 988 gain or loss that would have been recognized under §1.985-5(b) if the refund had been received immediately before the QBU's functional currency changed.
(4) Foreign currency gain or loss. For rules for determining subsequent foreign currency gain or loss on the disposition of nonfunctional currency, the basis of which is determined under this paragraph (e), see section 988(c)(1)(C).
(f) Applicability dates. This section applies to taxable years ending on or after December 16, 2019, and to taxable years of foreign corporations which end with or within a taxable year of a United States shareholder ending on or after December 16, 2019.
[Added by T.D. 9882, 84 FR 69022-69123, Dec. 17, 2019.]
