UPDATE: As of the release of this edition of Tax Advisor Weekly, the Treasury Department has issued Notice 2017-38, stating that the Section 987 regulations, among others, may require modification or rescission per President Trump’s April 2017 executive order. An upcoming edition will discuss this notice and its potential implications in more detail.
If the Trump administration believed tax reform to be an easier initiative than health care, the last few weeks have been a rude wake-up call. Disagreement is rife within the GOP over fundamental aspects of reform: the border adjustment, how far to drop the corporate tax rate and what tax preference items should be eliminated, to name a few — not to mention the budgetary accountants who are trying to rub two nickels together to make a trillion dollars.
While creation is proving difficult for the Trump administration, destruction has a certain appeal of simplicity; namely, destruction of regulations issued by the previous administration. In April, President Trump signed an executive order on “Identifying and Reducing Tax Regulatory Burdens.” This order directed Treasury Secretary Steven Mnuchin to review all new tax regulations issued since January 1, 2016 and, within 60 days, identify those that are financially burdensome, overly complex or beyond the authority of the Internal Revenue Service. Within 150 days, the Secretary is directed to prepare a report to the President with specific recommendations, including advice on whether to delay or suspend such regulations. The first of these reports was issued on July 7, 2017 as Notice 2017-38 and has initially identified eight regulations as meeting one of the criteria of the executive order. The specific recommendations are currently anticipated to be released by September 18, 2017.
Not surprisingly, attention was immediately put on the recent anti-inversion and Section 385 regulations, the two most-discussed pieces of tax regulation issued by former Treasury Secretary Jack Lew. But perhaps equally important for many tax practitioners is the potential impact on the finalized Section 987 regulations. Perhaps not surprisingly, both the Section 385 regulations and the Section 987 regulations were identified in Notice 2017-38 as potentially burdensome or complex. However, the uncertain fate of these regulations, as much as any, may direct tax directors’ decision-making over the coming months.
Section 987: An Overview
Picture an old, rusty boat, covered in a patchwork of duct tape meant to clog one leaky hole after another. Such is the state of foreign currency rules under the current tax code. And nowhere is this more prevalent than under Sec. 987. The so-called branch transaction rules, Sec. 987 governs how taxpayers account for profits and losses of branches that operate in different functional currencies (qualified business units, or QBUs). It also applies to foreign subsidiaries of U.S. taxpayers that operate through branches (or entities electing to be treated as branches).
Under the general rules, QBUs must translate their earnings into the functional currency of their owners at the weighted average exchange rate for the tax year. As currencies fluctuate, unrecognized gains or losses accrue at the QBU according to the difference in exchange rates since the time earnings were accrued. When the QBU makes a remittance to its owner, a portion of that unrecognized gain or loss pool is recognized by the QBU owner.
Three bodies of regulation have been issued under Sec. 987: the 1991, 2006 and 2016 regulations. The 1991 regulations offered an equity and basis pool methodology; generally, under this methodology, Sec. 987 gains or losses would be measured as the difference between the value of a QBU’s earnings (translated to the QBU owner’s functional currency) at the time generated versus the time remitted.
In 2006, Treasury issued proposed regulations under Sec. 987 that provided a significantly different approach to applying Sec. 987. Under the 2006 regulations, unrecognized gain or loss pools are measured using a balance-sheet approach. Taxpayers are required to calculate the change in balance-sheet value of monetary assets or liabilities, or “marked” items, and add such change to their unrecognized Sec. 987 gain or loss pool. This methodology added significant complications to the comparatively simple approach offered under the 1991 regulations. As the regulations were only in proposed form, however, many taxpayers have simply continued to apply the earlier rules.
For 10 years, the 2006 regulations existed in a state of limbo, with no certainty as to if and when they would be finalized. Finally, in December of last year, Treasury issued finalized regulations that largely adopted the 2006 proposals. What surprised many practitioners, however, were the stringent transition rules under the finalized regulations.
Transitioning to 2016
How companies with Sec. 987 QBUs will be affected by the 2016 regulations is largely a question of how they have historically complied with the functional currency translation rules. Taxpayers that have continued to apply the 1991 regulations will face the most significant impact under the so-called “fresh-start transition method.”
Under the fresh-start method, taxpayers’ QBUs will be deemed to terminate and transfer their assets and liabilities to a new QBU upon the effective date of the 2016 regulations (January 1, 2018, for calendar-year taxpayers). However, this deemed termination will not trigger any Sec. 987 gain or loss. Rather, historical Sec. 987 gain or loss pools will be wiped clean, except to the extent that the pools are related to marked assets and liabilities still held in the QBU on the transition date. Therefore, gain or loss pools previously generated by assets and liabilities no longer held in the QBU are wiped clean. Depending on the composition of these pools, this could be either a gift or pain point for taxpayers.
For those taxpayers that would seek to salvage their Sec. 987 loss pools before the transition, the transition rules also contain significant limitations on the ability to trigger those losses. In general, these rules defer losses (and gains) triggered by transactions involving members of the same controlled group. For example, if the assets of a Sec. 987 QBU are transferred between related parties in a transaction that would otherwise trigger a Sec. 987 loss, that loss may be deferred until an actual remittance takes place. Further, that deferred loss may be eliminated entirely if it is not recognized before the effective date of the 2016 regulations.
Taxpayers that have already bitten the bullet and adopted the 2006 regulations may be less affected by the transition rules. As these taxpayers have already substantially adopted the provisions finalized in 2016, the transition rules do not require the fresh-start rules to be applied.
Here Today, Gone Tomorrow?
Many taxpayers were required to recognize the impact of the finalized regulations for book purposes as of the date they were published in December 2016, including any adjustments mandated under the transition rules. However, the executive order issued in April has raised the question whether the finalized regulations will even survive to become effective. If the Trump administration were to repeal the finalized regulations, taxpayers might be required to reverse the adjustments recognized in December.
Despite the confusion, the imminent transition has also generated an opportunity for taxpayers, especially those that have not yet adopted the 2006 regulations. Identifying where historical Sec. 987 gain or loss pools reside may allow taxpayers to identify transactions that take advantage of the transition rules. For example, taxpayers with significant unrecognized losses that may be eliminated under the finalized regulations may be inclined to accelerate remittances in order to utilize those losses. Contrarily, transactions that would otherwise trigger gains may be deferred until such pools are reduced under the transition rules.
Given the uncertainty about the fate of the final regulations, taxpayers should identify where they have flexibility on transactions that carry Sec. 987 consequences. Take, for example, a taxpayer with significant unrecognized foreign exchange losses who may seek to trigger such losses prior to their reduction under the fresh-start method. That remittance event could carry significant non-U.S. income and withholding tax consequences, all for the sake of preserving a U.S. loss. On the other hand, if the regulations are repealed, that unrecognized loss pool would likely survive, and the taxpayer would not need to go through the often painful process of triggering the Sec. 987 loss.
Consider an alternative example: a taxpayer with a Sec. 987 unrecognized gain pool has proactively decided to leave that QBU untouched until the fresh-start method wipes it clean. However, should the gain survive as a result of regulatory action, that taxpayer may be forgoing the current-year benefit of foreign source income associated with that gain, such as additional foreign tax credit limitation. Further, the final regulations could recharacterize that gain as passive basket income, potentially limiting future foreign tax credit utilization.
There is no one-size-fits-all approach for considering the impact of the Treasury Department’s potential repeal of the final regulations. However, their uncertain fate means that taxpayers should be considering today what transactions that may trigger gain or loss are flexible in terms of timing, and what the impact might be if those regulations are rolled back.
Alvarez & Marsal Taxand Says:
For many taxpayers, Sec. 987 may have been a nuisance that was not given the attention it deserves. Rather, companies may have simply converted branch income at the appropriate exchange rate but done little to analyze the impact of remittances. For such companies, the rapidly approaching effective date of the 2016 regulations provides an opportunity to start on a fresh footing.
We are helping clients today understand how the final regulations will affect them and what decisions they should be prepared to make if the regulations are repealed. These efforts include modelling the impact of contemplated transactions under the multitude of scenarios that the executive order has created.
While comprehensive reform has understandably drawn the most attention on the tax front, significant changes are also on the regulatory horizon. We are eagerly awaiting the contents of Treasury’s response to the executive order (should they choose to publicize anything), as it may have as significant an impact on many companies as any of the reform proposals.
Even knowing that these regulations were addressed as part of the Treasury Department’s initial response to the President, building the necessary tools today will give taxpayers significant flexibility to respond to an uncertain tax landscape. Tax directors should be re-examining what action they’ve already taken to comply with the final regulations, what gain or loss triggering events could occur over the next year, and how their conclusions may change if the regulations are eliminated.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.
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