On October 2, 2017, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued Notice 2017-57 (the Notice) announcing that Treasury and the IRS:
- Are considering changes to the final regulations under section 987 contained in T.D. 9794, 81 F.R. 88806 (the Final Regulations), which would allow taxpayers to elect to apply (i) alternative rules to the “fresh-start” transition method required by the Final Regulations, and (ii) alternative rules for determining section 987 gain or loss; and
- Intend to defer the applicability date of the Final Regulations, and certain provisions of the temporary regulations under section 987 contained in T.D. 9795, 81 F.R. 88854 (the Temporary Regulations), by one year.
The Notice follows a report from Treasury, dated October 2, 2017, (the Treasury Report) setting forth its recommendations for specific actions to mitigate the burden imposed by the eight significant regulations identified in Notice 2017-38, including recommendations with respect to the Final Regulations and the Temporary Regulations. While Notice 2017-38 only identified the Final Regulations, the Notice helpfully provides guidance with respect to the related Temporary Regulations as well.
The Final Regulations provide rules for (i) translating income of a qualified business unit (QBU) into its owner’s functional currency; (ii) calculating foreign currency gain or loss with respect to a QBU’s assets and liabilities; and (iii) recognizing such gain or loss when the QBU transfers property to its owner. The Temporary Regulations address several technical issues, including (i) combinations and separations of section 987 QBUs; (ii) the translation of income used to pay creditable foreign income taxes; and (iii) the allocation of assets and liabilities of aggregate partnerships for purposes of section 987. The Temporary Regulations also provide (i) immediately effective rules that defer losses, and in certain cases gains, with respect to certain QBU terminations and certain transactions involving partnerships; (ii) an election to cause an annual deemed termination of a QBU subject to section 987; and (iii) a further election to translate all items of income or loss with respect to a QBU subject to section 987 at the yearly average exchange rate if the annual deemed termination election has been made. See our Legal Alert.
Proposed Modifications to the Final Regulations:
In the Notice, Treasury and the IRS announced that they are considering (i) alternative rules to the “fresh-start” transition method required by the Final Regulations, and (ii) alternative rules for determining section 987 gain or loss because of the undue administrative burdens resulting from those rules. Additionally, the Treasury Report notes that:
- The “fresh-start” transition method required by the Final Regulations imposes an undue financial burden because it disregards losses calculated for years prior to the transition but not previously recognized; and
- The method prescribed by the Final Regulations for calculating foreign currency gain or loss with respect to a QBU’s assets and liabilities is unduly complex and financially burdensome to apply, particularly where such calculations differ from applicable financial accounting rules.
As alternatives to the methods in the Final Regulations, Treasury and the IRS are considering simplified rules for determining section 987 gain or loss, including possibly permitting annual recognition of section 987 gain or loss based on mark-to-market valuation of the assets and liabilities of the section 987 QBU (the Simplified Method). According to the Treasury Report, the Simplified Method generally would result in determinations of amounts of section 987 gain or loss that are consistent with amounts of translation gain or loss that would be determined under applicable financial accounting rules and under proposed section 987 regulations issued in 1991 (the 1991 Proposed Regulations), subject to certain limitations on the timing of recognition of section 987 loss.
Eversheds Sutherland Observation: In 2006, Treasury and the IRS withdrew and replaced the 1991 Proposed Regulations with new proposed regulations (the 2006 Proposed Regulations), while indicating that a method for calculating foreign currency gain or loss with respect to a QBU’s assets and liabilities consistent with the 1991 Proposed Regulations generally would be considered a reasonable method except in certain cases where such method would give rise to non-economic gains or losses. Accordingly, prior to the issuance of the Final Regulations, many taxpayers were utilizing methods based on the 1991 Proposed Regulations, modified to eliminate recognition of non-economic gains or losses. Thus, for many taxpayers, the Simplified Method may result in the continuation of their prior method of accounting for their section 987 QBUs.
The Treasury Report provides two examples of potential loss recognition timing limitations that may accompany the Simplified Method:
- A base limitation, where taxpayers would be permitted to recognize net section 987 losses only to the extent of net section 987 gains recognized in prior or subsequent years; and
- A possible additional approach, under which the electing taxpayer would defer recognition of all section 987 losses and gains until the earlier of (i) the year that the trade or business conducted by the section 987 QBU ceases to be performed by any member of its controlled group or (ii) the year substantially all of the assets and activities of the QBU are transferred outside of the controlled group.
The Treasury Report also indicates that alternative transition rules are under consideration. Specifically, the transition rules may:
- Allow taxpayers that elect to apply the loss limitations applicable to the Simplified Method to carry forward unrealized section 987 gains and losses, measured as of the transition date with appropriate adjustments, and subject to such loss limitations; or
- Allow taxpayers adopting the Final Regulations to elect to translate all items on the QBU’s opening balance sheet on the transition date at the spot exchange rate, but not carry forward any unrealized section 987 gains or losses.
Eversheds Sutherland Observation: These proposed transition rules are similar to the transition rules in the 2006 Proposed Regulations and the Final Regulations. Specifically, the transition rule described in the first point above is similar to the alternative “deferral” transition method included in the 2006 Proposed Regulations, and the transition rule described in the second point is similar to the “fresh-start” transition method in the Final Regulations. It remains to be seen whether the second alternative will ultimately contain any distinguishing features (e.g., whether net unrecognized section 987 gain or loss with respect to historic assets and previously held marked assets for taxpayers applying the 1991 Proposed Regulations will be eliminated).
Delayed Effective Date: The Notice bumps the effective date for certain rules in the Final Regulations and the Temporary Regulations to taxable years beginning on or after two years after the first day of the first taxable year following December 7, 2016 (i.e., 2019 for calendar-year taxpayers). The Notice also preserves the ability of taxpayers to apply the Final Regulations and related Temporary Regulations to taxable years beginning after December 7, 2016, subject to a requirement to apply them consistently.
Eversheds Sutherland Observation: The delayed effective date may provide only limited relief for public companies that already have been required to take into account the regulations for financial reporting purposes.
As originally promulgated, the Final Regulations generally did not apply until the first taxable year after the taxable year beginning after December 7, 2016 (i.e., 2018 for calendar-year taxpayers). Taxpayers could elect to apply the Final Regulations to taxable years beginning after December 7, 2016, subject to a requirement to apply them consistently.
The Notice also defers the effective date of provisions of the Temporary Regulations that had the same effective date as the Final Regulations. The provisions of the Temporary Regulations that were immediately effective remain in effect, without change (at least for the moment).
The delayed effective date under the Notice will permit Treasury and the IRS additional time to consider comments and issue new regulations as appropriate.