In a Technical Advice Memorandum (TAM) issued in February, the IRS determined which of two currencies was the correct functional currency to calculate any foreign currency exchange gain or loss under Internal Revenue Code Section 988.
The TAM revolved around payments of principal and interest made by a taxpayer on loans during the tax years at issue.
Section 988 Background
Under Section 988, a foreign currency gain is any gain from a Section 988 transaction to the extent the gain doesn’t exceed gain realized because of changes in exchange rates on or after the booking date and before the payment date.
A foreign currency loss is any loss from a Section 988 transaction to the extent the loss doesn’t exceed the loss realized because of changes in exchange rates on or after the booking date and before the payment date.
A Sec. 988 transaction is any transaction described in Section 988(c)(1)(B) if the amount that the taxpayer is required to receive or pay because of the transaction is:
- Denominated in terms of a nonfunctional currency, or
- Determined by reference to the value of one or more nonfunctional currencies.
The acquisition of a debt instrument or becoming an obligor under a debt instrument is a transaction included under Sec. 988(c)(1)(B).
Under Code Sec. 985(b), a functional currency is defined as the dollar or, in the case of a qualified business unit (QBU), the currency of the economic environment in which a significant part of the QBU’s activities are conducted and that’s used by the business in keeping its books and records.
Under Sec. 989(a), a QBU is any separate and clearly identified unit of a trade or business of a taxpayer that maintains separate books and records. (One former regulation, effective before December 7, 2016, provided, in part, that a partnership is a QBU of a partner.)
Facts of the case
The taxpayer at issue in the TAM is a Country A corporation. It entered into an agreement with the seller, a Country B publicly traded company, to buy the Corp A group.
The Corp A group owned and operated property internationally under a brand name.
According to the sale agreement, the taxpayer would acquire Corp B, which owned a percentage of Corp C (the parent company of the Corp A group’s Country A consolidated group).
Additionally, the agreement provided that the taxpayer would directly acquire the remaining interest in Corp C from the seller.
The taxpayer formed a new wholly owned subsidiary, the entity, to serve as a financing and acquisition vehicle that was treated as a disregarded entity for U.S. federal income tax purposes.
The taxpayer entered into an agreement with the Country B publicly traded company, the seller, to buy the Corp A group.
The taxpayer paid the seller for the stock of Corp B, which owned a percentage of Corp C and a direct interest in Corp C.
The taxpayer financed the cash portion of the purchase price with bank debt.
The entity borrowed the Currency A equivalent of the total amount, consisting of a term loan with:
- Currency B,
- Currency C,
- Currency D tranches,
- A term loan denominated in Currency A, and
- A revolving line of credit primarily denominated in Currency A.
The taxpayer borrowed the remaining acquisition debt in Currency A from the same revolving line of credit.
After the Corp A group acquisition, the entity:
- Held stock in Corp B and Corp C,
- Received distributions from subsidiaries acquired in the Corp A group acquisition,
- Incurred and serviced debt incurred to carry out the Corp A group acquisition, and
- Participated in a single hedging transaction with Corp C.
After the acquisition of the Corp A group, the taxpayer contributed the stock of the entity to a Country C partnership, which is treated as a partnership for U.S. federal income tax purposes.
The partnership was equally owned by Corp D and Corp E, two subsidiaries of the taxpayer.
Corp E was wholly owned by Corp D, and Corp D and Corp E had Currency A as their functional currencies.
Enter the LLC
Corp E converted from a corporation to a U.S. limited liability company (LLC).
The conversion caused Corp E to be treated as a disregarded entity of Corp D for U.S. federal income tax purposes.
The conversion of Corp E to an LLC caused the partnership to become a single member entity disregarded for U.S. federal income tax purposes.
Because of the conversion, the entity was treated as a disregarded entity owned by Corp D for U.S. federal income tax purposes.
The partnership’s sole operating asset was a management agreement for an asset in Country C, and its activities related solely to management of this asset.
Previously, all its assets, liabilities, income and expenses were directly related to those activities. It also held the equity interest in the entity.
The functional currency of the partnership for U.S. Generally Accepted Accounting Principles, as well as for U.S. federal income tax purposes, was Currency B.
The partnership and the entity each maintained separate books of original entry and ledger accounts. The entity’s assets and liabilities weren’t recorded on the partnership’s books.
In addition, the partnership maintained its foreign exchange exposure pools under the methodology prescribed in a 2006 proposed regulation.
During the tax year that ended on Year One, and tax periods that ended on Year Two and Year Three, the entity made principal and interest payments on the various loans.
The taxpayer used Currency A as the functional currency to calculate the Sec. 988 foreign currency gain or loss on those payments.
The taxpayer calculated net foreign exchange losses with respect to Currency B, Currency C and Currency D, resulting from the payment of principal and interest with respect to the Corp A group acquisition financing in later years.
Because of a hedging agreement between the entity and Corp C, however, Corp C reported deductions on its Schedule M-3 for tax year ended Year One and tax period ended Year Two.
The taxpayer also reported a deduction on its Schedule M-3 for the tax period ended Year Three because of the hedging agreement.
Examination and conclusion
An IRS examination determined that the entity’s assets and liabilities should be attributed to the partnership rather than to Corp D and Corp E for purposes of calculating any Sec. 988 foreign currency gain or loss.
Therefore, any Sec. 988 foreign currency gain or loss should be calculated using Currency B, which was the functional currency of the partnership.
The proposed adjustments under the examination were determined using Currency B, resulting in foreign currency gain with respect to the loan payments for tax year ended Year One and tax periods ended Year Two and Year Three, respectively.
In the TAM, the IRS concluded that Currency A was the proper functional currency to use to calculate foreign currency exchange gain or loss under Sec. 988 with respect to payments of principal and interest made on loans during the tax years that ended on Year One, Year Two and Year Three.
The IRS reasoned that, in this case, whether Currency A or Currency B was the correct functional currency to calculate any Sec. 988 gain or loss with respect to the payments of principal and interest made on the loans depended on whether the debt was properly attributed to the books of the partnership or the books of the partners of the partnership.
If the loans were properly reflected in the partnership’s books, Sec. 988 gain or loss had to be calculated with respect to Currency B.
But if the loans were properly reflected in the partners’ books, Sec. 988 gain or loss had to be calculated with respect to Currency A, which is the functional currency of both Corp D and Corp E.
For the years at issue, the versions of the applicable regulations that were in effect before their modification were applicable.
Under one former regulation, the partnership was a per se QBU of its partners because of its status as a partnership.
Under another former regulation, whether an asset, liability or item of income was properly reflected on the books of a QBU was a question of fact.
The partnership’s trade or business consisted of managing the asset in Country B. The loans were used to finance the purchase of stock in Corp B and Corp C.
Accordingly, the Corp B and Corp C stock and the associated acquisition debt weren’t used in the conduct of the trade or business of the partnership.
Under the facts of this case, it was inappropriate to attribute the stock and acquisition debt to the books of the partnership.
The IRS concluded that the loans, which were used to finance the acquisition of the Corp A group, were properly reflected on the books of the partnership’s partners, Corp D and Corp E, rather than on the books of the partnership itself.
The IRS further noted that this conclusion was also consistent with a 2006 proposed regulation.
Under that proposed reg, the loans wouldn’t be attributed to the partnership because they were liabilities incurred to acquire stock.
Under these facts, the debt was properly reflected on the books of Corp D and Corp E.
Accordingly, foreign currency gain or loss on the debt is properly calculated using Currency A as the functional currency.
Conduct and defend
As the outcome of this TAM demonstrates, complex transactions involving multiple business entities and various currencies can draw the attention of the IRS.
Work closely with your tax advisors to conduct and, if necessary, defend any such transaction.