When Congress enacted Sec. 987, it would be approximately another ten years before the check-the-box ("CTB") regulations were finalized. With the advent of the CTB regulations, a taxpayer can exercise entity transformation for tax purposes in a matter of minutes for an eligible entity. A taxpayer can even retroactively, up to 75-days, change the classification of an eligible entity. This flexibility has allowed many companies to rely on traditional planning techniques that use multiple CTB entities. For example, since the enactment of the CTB regulations it is fairly common to see multiple CTB entities in super-holding-company and hybrid financing structures.
One often overlooked result of the use of CTB entities is the increased volume of transactions that are potentially subject to Sec. 987. Depending on a taxpayer's fact pattern, the increased use of CTB entities coupled with the weakness of the U.S. dollar might result in losses to be reported on the taxpayer's U.S. tax return or the hyping of foreign tax credits. For example, if the Sec. 987 gain or loss resides at the controlled foreign corporation ("CFC") level, perhaps because the CFC owns a disregarded entity ("DE") whose functional currency is different than that of the CFC, then the Sec. 987 gain or loss will impact the CFC's earnings and profits. This, in turn, can potentially impact the effective tax-rate pool at the CFC level. If we take this scenario further forward, there is a potential impact on a taxpayer's foreign tax credit position and a corresponding potential impact on the taxpayer's effective tax rate.
Examples of transactions with potentially surprising Sec. 987 implications include dividends, loan payments, restructuring transactions and inter-company purchases. Especially in light of the significant Sec. 965 dividend activity last year (and the subsequent replacement planning), taxpayers should refresh their understanding of the underlying Sec. 987 rules and analyze its application to existing and proposed structures.
Sec. 987 applies when the taxpayer operates in a branch form (such as a DE or a partnership) and such branch is a qualified business unit ("QBU") with a functional currency different than that of its owner.
As a general overview, a taxpayer is required to maintain two "pools." For a U.S. owner, the first pool is maintained in U.S. dollars and is the owner's "basis pool." The second pool is maintained in the QBU's functional currency and is referred to as the "equity pool." Generally, when a QBU makes a "remittance" to its owner, gain or loss is determined by comparing the two pools. If the equity pool is greater than the basis pool at the time of remittance, then a gain is triggered under Sec. 987 and vice versa. A Sec. 987 gain or loss can also arise from a termination of the QBU, which typically involves a transfer or disposal of substantially all the QBU's assets.
Basic Example for Determining Sec. 987 Gain/Loss
USP owns DE (or "QBU")
USP functional currency = U.S. Dollar
DE functional currency = Euro
Yr. 1 QBU earnings = €100
Yr. 1 €100 = $100
Yr. 3 QBU distributes €100 to USP
Yr. 3 €100 = $150
Under proposed Sec. 987 regulations, USP recognizes $50 foreign source ordinary gain.
Hidden Gains or Losses?
In cases where companies have contributed significant assets into QBUs, any subsequent remittance could trigger surprising results due to the application of Sec. 987. For example, the contribution of stock of a controlled foreign corporation into a CTB branch, where hybrid financing is used, typically creates large equity and basis pools. Over the course of a few years, the underlying losses could be very significant, and create very surprising results. The argument can be made that the application of the pools to capital contributions was not the original intent of the rules. However, a counterargument can be made that companies have the ability to apply the regulations as written and thereby trigger substantial losses. It is important to note that a full analysis should be done to determine the Sec. 987 impact on the company's entire structure prior to a position being taken as a company will likely be held to a consistency standard across all its operations with respect to this position. It is also noteworthy that typically, where there are substantial losses that can be freed up there are also potential gains that can be triggered.
Proposed Regulations Revisited
In 1991, proposed regulations were issued under Sec. 987. These regulations have not been finalized. In Notice 2000-20, the Treasury and IRS announced that they are going to review the proposed Sec. 987 regulations and were seeking comments about the possible replacement of the proposed regulations. At a recent ABA meeting at the Georgetown University Law Center, Steven Musher, Acting Associate Chief Counsel (International), mentioned that June 30, 2006 was a "good bet" for some Sec. 987 guidance and that this is a "big priority" for the government. We shall wait and see.
According to the instructions to Form 8858, "U.S. persons that are tax owners of FDEs or that own certain interests in foreign tax owners of FDEs must file Form 8858." Form 8858 is the first form that provides for the disclosure of certain information under Sec. 987 (See Sch. C-1 of Form 8858).
What does this all mean?
A taxpayer may have hidden Sec. 987 gains or losses and not even realize it. The proliferation of DEs causes a need for taxpayers to be cognizant of the potential positive or negative implications on U.S. taxable income that could result from Sec. 987 gains or losses. These gains or losses may be embedded and not otherwise readily apparent and could represent a planning or refund opportunity. Further, Form 8858 provides for the reporting of Sec. 987 transactions. As most calendar year taxpayers begin to "gear-up" for compliance season, this is a good time to revisit Sec. 987 for any potential opportunities. Finally, in addition to hidden potential cash tax benefits that may be lurking around, Sec. 987 could have potential effective tax rate benefits depending on the Company's actual facts and circumstances. We caution, however, that the financial statement implications is an area where a taxpayer wants to tread lightly, given the number of restatements and "404" deficiencies reported last year, a significant amount of which relate to tax.
What should you do?
Due to the vagueness in the existing rules, opportunities (or potential exposures) exist that could warrant a review of past transactions specifically for Sec. 987 implications. In particular, taxpayers should review recent dividend activity, loan payments, any inter-company sales, and restructuring transactions. Taxpayers should also review existing structures to understand the potential built-in gains and built-in losses in QBUs. Lastly, taxpayers should consider creating automatic tracking procedures that serve dual purposes of monitoring the equity and basis pools and simultaneously satisfying internal control requirements under Sarbanes-Oxley Section 404.
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