Federal Register, Volume 81 Issue 236 (Thursday, December 8, 2016)


[Federal Register Volume 81, Number 236 (Thursday, December 8, 2016)]
[Rules and Regulations]
[Pages 88806-88852]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-28381]



[[Page 88805]]

Vol. 81

Thursday,

No. 236

December 8, 2016

Part III





Department of the Treasury





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Internal Revenue Service





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26 CFR Parts 1 and 602





Income and Currency Gain or Loss With Respect to a Section 987 QBU;
Final Rule

Federal Register / Vol. 81 , No. 236 / Thursday, December 8, 2016 /
Rules and Regulations

[[Page 88806]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9794]
RIN 1545-AM12


Income and Currency Gain or Loss With Respect to a Section 987
QBU

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations that provide guidance
under section 987 of the Internal Revenue Code (Code) regarding the
determination of the taxable income or loss of a taxpayer with respect
to a qualified business unit (QBU) subject to section 987, as well as
the timing, amount, character, and source of any section 987 gain or
loss. Taxpayers affected by these regulations are corporations and
individuals that own QBUs subject to section 987. In addition,
published elsewhere in this issue of the Federal Register, temporary
and proposed regulations (the temporary regulations) are being issued
under section 987 to address aspects of the application of section 987
not addressed in these final regulations.

DATES: Effective date: These regulations are effective on December 7,
2016.
Applicability dates: For dates of applicability, see Sec. 1.987-
11.

FOR FURTHER INFORMATION CONTACT: Sheila Ramaswamy at (202) 317-6938
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations
has been reviewed and approved by the Office of Management and Budget
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C.
3507(d)) under control number 1545-2265. Responses to this collection
of information are mandatory.
The collection of information in these final regulations is in
Sec. Sec. 1.987-1(b)(2)(ii), 1.987-1(c)(1)(ii), 1.987-1(c)(1)(iii),
1.987-1(g)(3)(i)(A), 1.987-1(g)(3)(i)(B), 1.987-1(g)(3)(i)(C), 1.987-
1(g)(3)(i)(D), 1.987-3(c)(2)(iv)(B), 1.987-9, and 1.987-10(e). This
collection of information is required to establish the taxable income
or loss of a taxpayer with respect to a QBU subject to section 987, as
well as the timing, amount, character, and source of any section 987
gain or loss and the exchange rates used for foreign currency
translation purposes.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.
Books and records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

This document contains final regulations relating to the
determination of the taxable income or loss of a taxpayer with respect
to a QBU subject to section 987 of the Code, as well as the timing,
amount, character, and source of any section 987 gain or loss. The
final regulations also amend existing regulations under sections 861,
985, 988, and 989.
On September 6, 2006, the Treasury Department and the IRS published
a notice of proposed rulemaking (REG-208270-86, 71 FR 52876) that
proposed new regulations under section 987 (the 2006 proposed
regulations) and withdrew proposed regulations under section 987
published on September 25, 1991 (INTL-965-86, 56 FR 48457) (the 1991
proposed regulations). The Treasury Department and the IRS received
many written comments in response to the 2006 proposed regulations.
After consideration of all the comments, the 2006 proposed regulations,
as revised by this Treasury decision, are adopted as final regulations.
Temporary regulations (TD 9795) and proposed regulations (REG-128276-
12) under section 987 are being published contemporaneously with these
final regulations.

Summary of Comments and Explanation of Revisions

I. Background

Section 987 generally provides that, when a taxpayer owns one or
more QBUs with a functional currency other than the U.S. dollar and
such functional currency is different than that of the taxpayer, the
taxable income or loss of the taxpayer with respect to each QBU is
determined by computing the taxable income or loss of each QBU
separately in its functional currency and translating such income or
loss at the appropriate exchange rate. Section 987 further requires the
taxpayer to make ``proper adjustments'' (as prescribed by the
Secretary) for transfers of property between QBUs having different
functional currencies, including by treating post-1986 remittances from
each such QBU as made on a pro rata basis out of post-1986 accumulated
earnings and by treating section 987 gain or loss as ordinary income or
loss and sourcing such gain or loss by reference to the source of the
income giving rise to post-1986 accumulated earnings.\1\ Section
989(b)(4) provides that, ``[e]xcept as provided in regulations,'' the
appropriate exchange rate with respect to a QBU means ``the average
exchange rate for the taxable year'' of the QBU. Additionally, section
989(c)(5) directs the Secretary to ``prescribe such regulations as may
be necessary or appropriate to carry out the purposes of [subpart J],
including regulations . . . providing for the appropriate treatment of
related party transactions (including transactions between qualified
business units of the same taxpayer) . . . .''
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\1\ The legislative history of section 987 is discussed
extensively in the preamble to the 2006 proposed regulations. See 71
FR 52876.
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A. 1991 Proposed Regulations

The 1991 proposed regulations generally provided that the net
income of a QBU with a functional currency other than that of the
taxpayer was determined annually. Such determination was based on the
profit and loss appearing on the QBU's books and records, adjusted to
conform to U.S. tax principles, and translated into the functional
currency of the taxpayer using the weighted average exchange rate for
the taxable year. The 1991 proposed regulations also provided for the
recognition of exchange gain or loss upon a remittance from the QBU's
equity pool. In general, the equity pool consisted of the contributed
capital and earnings of the QBU, reduced by remittances, determined in
the QBU's functional currency. The 1991 proposed regulations also
provided for a basis pool, which consisted of the basis of the capital
and earnings in the equity pool, expressed in the functional currency
of the taxpayer. The portion of the basis pool that was attributable to
a remittance generally was determined according to the following
formula:

[[Page 88807]]

[GRAPHIC] [TIFF OMITTED] TR08DE16.002

Under the 1991 proposed regulations, section 987 gain or loss was
the difference between the value of the remittance from the QBU,
translated into the taxpayer's functional currency at the spot rate on
the date of the remittance, and the basis associated with the
remittance.
One important consequence of the equity pool paradigm was that all
branch equity gave rise to exchange gain or loss, regardless of whether
the equity was invested in assets that actually exposed the QBU's owner
to currency fluctuations. For example, both cash denominated in the
QBU's functional currency and mobile equipment equally gave rise to
exchange gain or loss. As a result, under the 1991 proposed
regulations, exchange rate changes that, at most, had only an uncertain
and remote effect on the economic results experienced by the owner of a
QBU gave rise to substantial exchange gains and losses that taxpayers
selectively could recognize by strategically timing remittances or
causing a termination of the QBU. Given these distortions, the Treasury
Department and the IRS withdrew the 1991 proposed regulations and
proposed new regulations on September 6, 2006.

B. 2006 Proposed Regulations

The 2006 proposed regulations adopted a different paradigm referred
to as the foreign exchange exposure pool (FEEP) method. In general, the
FEEP method provides that, as under the 1991 proposed regulations, the
income of a QBU that is subject to section 987 (a section 987 QBU) is
determined by reference to the items of income, gain, deduction, and
loss booked to the section 987 QBU in its functional currency, adjusted
to reflect U.S. tax principles. Items of income and deduction generally
are translated, consistent with the 1991 proposed regulations, into the
functional currency of the section 987 QBU's owner at the average
exchange rate for the year. However, the basis of certain ``historic
assets'' and the deductions for depreciation, depletion, and
amortization of such assets are translated at the historic rates for
such assets. Translating these items at historic rates represents a
major difference from the 1991 proposed regulations and prevents the
imputation of foreign currency gains or losses to such assets.
Additionally, the 2006 proposed regulations required the adjusted basis
and amount realized with respect to marked assets to be translated
using a spot rate, which for assets acquired in a prior taxable year
would be the spot rate for the closing balance sheet of the prior
taxable year.
Consistent with the 1991 proposed regulations, the FEEP method uses
a balance sheet approach to determine exchange gain or loss, which is
not recognized until the section 987 QBU makes a remittance. Under the
FEEP method, exchange gain or loss with respect to ``marked items'' is
determined annually but is pooled and deferred until a remittance is
made. A marked item generally is defined under the 2006 proposed
regulations as an asset (marked asset) or liability (marked liability)
that would generate section 988 gain or loss if such asset or liability
were held or entered into directly by the owner of the section 987 QBU.
The balance sheet approach, together with the use of historic rates for
historic items (generally defined as an asset or liability that is not
a marked item), allows taxpayers and the IRS to distinguish between
items whose value is highly responsive to changes in the functional
currency of the owner and items for which exchange rate changes have no
effect on value, or only an uncertain or remote effect that is more
appropriately recognized upon a realization event with respect to the
item.
The 2006 proposed regulations define a remittance as a net transfer
of amounts from a section 987 QBU to its owner during a taxable year,
determined in the owner's functional currency. When a section 987 QBU
makes a remittance, a portion of the pooled exchange gain or loss is
recognized. In general, the amount taken into account equals the
section 987 QBU's net unrecognized exchange gain or loss multiplied by
the owner's remittance proportion. The owner's remittance proportion
generally equals the amount of the remittance divided by the aggregate
basis of the section 987 QBU's gross assets reflected on its year-end
balance sheet, determined in the owner's functional currency, without
reduction for the remittance.

II. Summary of Comments and Changes

Many comments were received in response to the 2006 proposed
regulations. This Part II discusses those comments and the changes made
in response to them. Certain comments received in response to the 2006
proposed regulations are addressed in the temporary regulations and are
discussed in the preamble to the temporary regulations rather than in
this preamble.

A. General Comments Regarding the FEEP Method, Including Regarding
Administrability

A number of comments suggested that the FEEP method, in particular
Sec. Sec. 1.987-3 and -4 of the 2006 proposed regulations, would be
difficult to administer. Some of those comments expressed a preference
to more closely align regulations under section 987 with the financial
accounting rules under Accounting Standards Codification, Foreign
Currency Matters, section 830 (ASC 830).\2\
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\2\ ASC 830 codifies Financial Accounting Standard No. 52.
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ASC 830 adopts a functional currency paradigm in which assets,
liabilities, and operations of a foreign entity are measured using the
entity's functional currency \3\ and then translated into the reporting
currency (generally, the U.S. dollar) of a U.S. enterprise using a
current exchange rate.\4\ Thus, revenues, expenses, gains, and losses
of the foreign entity, translated into U.S. dollars using a weighted
average exchange rate for the reporting period, are included in the
consolidated profit and loss statement of the U.S. enterprise,\5\ and
the assets and liabilities of the foreign entity, translated into U.S.
dollars using the spot rate on the balance sheet date, are included in
the consolidated balance sheet of the U.S. enterprise.\6\ Foreign
currency ``translation'' gain or loss of a foreign entity with a
functional currency other than the U.S. dollar is determined with
respect to all assets and liabilities on the entity's balance sheet at
the end of a

[[Page 88808]]

reporting period and reported in the cumulative translation adjustment
(CTA) account. The CTA account is a sub-account in the equity section
of the balance sheet.\7\ It is not reflected in profit or loss until
the occurrence of a sale or a complete or substantially complete
liquidation of the entity.\8\ ASC 830 \9\ explains the rationale for
accounting for translation gain or loss in equity and not income:
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\3\ The functional currency of a foreign entity is defined in
ASC 830 as the currency of the primary economic environment in which
the entity operates.
\4\ ASC 830-30-45-3.
\5\ ASC 830-10-55-10-11,830-30-45-3.
\6\ ASC 830-30-45-3.
\7\ ASC 830-30-45-12.
\8\ ASC 830-30-40-1.
\9\ ASC 830-230-45-1.

Translation adjustments are solely a result of the translation
process and have no direct effect on reporting currency cash flows.
Exchange rate changes have an indirect effect on the net investment
that may be realized upon sale or liquidation, but that effect is
related to the net investment and not to the operations of the
investee. Prior to sale or liquidation, that effect is so uncertain
and remote as to require that translation adjustments arising
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currently should not be reported as part of operating results.

The treatment of translation gains and losses can be contrasted
with the financial accounting treatment of transactions denominated in
a currency other than the entity's functional currency. Changes in
exchange rates between the functional currency of the foreign entity
and the currency in which such transactions are denominated give rise
to changes in expected cash flows in the functional currency, resulting
in ``transaction'' gains or losses. The financial accounting rules
require the inclusion of transaction gains and losses in net income for
the period in which the exchange rate changes occur.\10\ The category
of foreign currency transactions that give rise to transaction gains
and losses under generally accepted accounting principles overlaps
considerably with the definition of a section 988 transaction for tax
purposes.
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\10\ ASC 830-20-35-1.
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Some comments suggested that, in enacting section 987, Congress
intended to substantially adopt the financial accounting rules for
foreign currency translation for tax purposes. The Treasury Department
and the IRS do not find support for this position in the legislative
history to section 987 and, to the contrary, find the position belied
by the significant discontinuities between section 987 and the
financial accounting rules, particularly regarding the recognition of
foreign currency gains and losses. Under Financial Accounting Standard
No. 52 (FAS 52), translation gain or loss is deferred in an equity
account until a sale or liquidation of the foreign entity, at which
point the economic effects of the aggregate translation gain or loss
can be measured against a real economic event. The ``equity pool''
paradigm of the 1991 proposed regulations determined the amount of
section 987 gain or loss in a manner that was similar to the
determination of translation gain or loss under FAS 52 by imputing
foreign currency gain or loss to all assets and liabilities on the
balance sheet. In contrast with the accounting rules under FAS 52,
however, the translation gain or loss was not sequestered in an equity
account but rather was included in income upon a remittance as required
by the section 987 statute, making the consequences of imputing foreign
currency gain or loss to all assets and liabilities substantially
greater.
As expressed in the preamble to the 2006 proposed regulations, the
administrative convenience achieved by generally adopting the FAS 52
computational methodology in the 1991 proposed regulations gave rise to
many cases in which the section 987 gain or loss taken into account on
a remittance deviated substantially from the economic results
experienced by the QBU. For example, currency loss was imputed with
respect to assets (such as a commercial building or an oil rig) for
which, due to the mobility of investment capital or the assets
themselves, exchange rate fluctuations would have, at most, only a
remote and uncertain effect on asset value. Moreover, because
remittances could be funded from other assets, such loss could be
recognized without regard to any realization event with respect to the
assets that gave rise to the speculative or noneconomic section 987
loss.
Given the inappropriate economic and timing results attributable to
adopting the FAS 52 translation methodology in the 1991 proposed
regulations and the significant differences between the purposes of the
FAS 52 computation of CTA and the computation of unrecognized section
987 gain or loss, the Treasury Department and the IRS remain of the
view that the FAS 52 model is not appropriate for tax purposes.
Similarly, the Treasury Department and the IRS have determined that an
approach based on consistency with FAS 52 computations modified to
address abuses, as suggested in some comments, is inappropriate because
such a system would impute foreign currency gain or loss to all assets
and liabilities on the balance sheet and generally allow for the
recognition of such gains and losses based on remittances without
regard to the owner's actual economic exposure to the QBU's functional
currency. Rather, the Treasury Department and the IRS have determined
that an approach premised on consistency with section 988, modified to
take into account administrability and policy considerations unique to
section 987, will carry out the purposes of section 987 most
appropriately.
Other comments recommended a hybrid approach that would combine the
methodology of the 1991 proposed regulations for computing a section
987 QBU's net income with the methodology of the 2006 proposed
regulations for computing section 987 gain or loss. Under the proposed
hybrid approach, section 987 gain or loss generally would be determined
under the method of the 2006 proposed regulations, but taxable income
or loss would be translated into the owner's functional currency at the
yearly average exchange rate without any adjustments. A consequence of
this hybrid approach is that a different exchange rate would be used to
translate recovered basis with respect to historic assets in
determining taxable income or loss than would be used to translate such
basis to determine section 987 gain or loss. These comments generally
favored the FEEP method for determining section 987 gain or loss
because it avoids imputing section 987 gain or loss to all assets and
liabilities on the balance sheet, as under the 1991 proposed
regulations, but asserted that determining taxable income or loss in
the functional currency of the section 987 QBU and translating that
amount into the owner's functional currency at the yearly average
exchange rate without any adjustments is more administrable and more
consistent with sections 987(1) and (2) and the legislative history of
section 987.
The Treasury Department and the IRS have concluded that the
proposed hybrid approach would not achieve the goal of ensuring
remittances trigger only ``exchange gain or loss inherent in
accumulated earnings or branch capital,'' as contemplated by Congress,
and inappropriately would cause offsetting exchange rate effects to be
reflected in section 987 taxable income or loss and in the FEEP. (H.R.
Conf. Rep. No. 99-841, at 675 (1986)). Although a hybrid approach would
simplify the calculation of section 987 taxable income or loss, the
simplification would cause basis recovery deductions with respect to
depreciable and amortizable assets that are included in section 987
taxable income or loss to reflect exchange rate fluctuations with
respect to the asset (for which exchange rate fluctuations may have, at
most, only a remote and uncertain effect on value). If the asset is
retained on the closing

[[Page 88809]]

balance sheet, the FEEP would reflect equal and offsetting exchange
rate fluctuations with respect to the asset, to the extent of any
accumulated depreciation or amortization that was included in taxable
income and translated at current exchange rates. This is because, in
determining section 987 gain or loss under Sec. 1.987-4 of the 2006
proposed regulations, section 987 taxable income or loss is subtracted
from the change in the owner functional currency net value (OFCNV) of
the section 987 QBU, which is determined using historic exchange rates
for historic items. Accordingly, the distortion in the determination of
section 987 taxable income or loss with respect to historic assets
would cause an offsetting distortion in the FEEP.
An example illustrates the equal and offsetting exchange rate
effects that can arise with respect to a historic asset under the
hybrid approach. Consider the situation of a section 987 QBU (euro QBU)
that has the euro as its functional currency and that has an owner that
has the dollar as its functional currency. If euro QBU acquires
depreciable equipment for [euro]100 on the last day of year 1, when the
historic exchange rate is [euro]1 = $1, and takes into account [euro]10
of depreciation with respect to the equipment in year 2, when the
yearly average exchange rate is [euro]1 = $1.50, the [euro]10 of
depreciation would be translated at the year 2 average exchange rate
into $15 under the hybrid approach rather than $10, as would happen if
depreciation were translated at the [euro]1 = $1 historic rate under
the 2006 proposed regulations. As a result, section 987 taxable income
of euro QBU is $5 lower under the hybrid approach than it would be
under the 2006 proposed regulations.
In this example, the FEEP, in turn, would be higher by $5 under the
hybrid approach than it would be under the 2006 proposed regulations.
This is because, in determining the change to the FEEP for a taxable
year, section 987 taxable income is subtracted from the change in OFCNV
of euro QBU, which is computed by translating the adjusted basis of
historic assets using the historic exchange rate for each asset. For
euro QBU, solely with reference to the depreciable equipment, year 2
depreciation causes a $10 reduction in OFCNV, because in computing the
change in OFCNV, the [euro]10 change in equipment basis during year 2
is translated at the [euro]1 = $1 historic rate (year 2 closing balance
sheet of $90 adjusted basis, less year 1 closing balance sheet of $100
adjusted basis). In order to compute the change to the FEEP for year 2
with respect to the depreciable equipment, section 987 taxable income
with respect to the equipment is subtracted from the $10 reduction in
OFCNV. Thus, the net effect of the depreciation in the FEEP is to
increase section 987 gain reflected in the FEEP by $5 (negative $10
change in OFCNV, less $15 depreciation deduction).
Considering all of these effects together, under the hybrid
approach, the appreciation of the euro decreases section 987 taxable
income by $5 and increases section 987 gain reflected in the FEEP by
$5. In other words, the FEEP reflects currency gain or loss with
respect to the depreciable asset that is offset by an amount that was
included in section 987 taxable income. This effect on the FEEP
persists even after the asset is sold.
The Treasury Department and the IRS have determined that the
offsetting effects in section 987 taxable income or loss and in the
FEEP under the hybrid approach raise concerns similar to the concerns
that Congress addressed, albeit in a different context, in enacting
section 1092. In particular, section 1092 reflects a policy concern
regarding inconsistent timing of recognition of gains and losses from
offsetting positions. Under the hybrid approach, the exchange rate
effect with respect to historic assets would be reflected in section
987 taxable income or loss to the extent of any cost recovery
deductions with respect to those assets, but equal and offsetting
amounts would be reflected in the FEEP and would not be recognized
until there are remittances. Thus, offsetting effects arising from a
single asset would be taken into account at different times.
Accordingly, the Treasury Department and the IRS have determined that
it would be inappropriate for regulations under section 987 to permit
distortions to section 987 taxable income or loss, for the sake of
enhancing administrability, that have the effect of causing offsetting
amounts of gain or loss to be reflected in the FEEP with respect to the
same asset, where the latter amounts would be recognized only upon
voluntary remittances from the QBU. Rather, consistent with the
discussion in the preamble to the 2006 proposed regulations, the
Treasury Department and the IRS have determined that, in order to carry
out the purposes of section 987(3) as indicated by the legislative
history, as well as sections 987(1) and (2), and taking into account
the authority granted in sections 989(b) and (c), it is appropriate to
account for recovered basis for historic assets at the relevant
historic rate in determining taxable income or loss of a section 987
QBU. This result could be accomplished by translating recovered basis
at the historic rate in the first instance or by translating taxable
income or loss determined in the section 987 QBU's functional currency
at the yearly average exchange rate and adjusting that amount to
properly account for recovered basis, as under the simplified inventory
method described in Part II.A.3 of this preamble.
Nonetheless, the Treasury Department and the IRS acknowledge the
observations about the complexity and administrability of the 2006
proposed regulations that underlie the recommendation of the hybrid
approach. The concerns about offsetting amounts recognized at different
times under the hybrid approach would not arise for taxpayers that make
the deemed annual termination election set forth in Sec. 1.987-8T(d)
of the temporary regulations. Accordingly, as described in the preamble
to the temporary regulations, a taxpayer that makes the deemed annual
termination election may also elect under Sec. 1.987-3T(d) to apply
the hybrid approach. Additionally, the Treasury Department and the IRS
have made several changes in these final regulations in response to
comments expressing concern about the complexity and administrability
of the 2006 proposed regulations.
In addition to the comments recommending a hybrid approach under
which taxable income would be translated at a single exchange rate
without any adjustments, other comments expressed more particular
concerns regarding the complexity and administrability of the FEEP
paradigm specifically with respect to inventory and certain other high-
volume, low-value assets. Comments suggested that treating items that
turn over quickly, such as inventory, or that have low value as marked
items would facilitate administration and compliance while introducing
little distortion into the FEEP calculation. The Treasury Department
and the IRS do not agree with these specific recommendations to expand
the scope of marked assets, because even assets that turn over quickly
or have low-value individually could inappropriately give rise to
significant amounts of section 987 gain or loss in the aggregate over
time. The Treasury Department and the IRS do, however, acknowledge the
general points about complexity and administrability reflected in these
suggestions, which are similar to the concerns expressed in the
comments recommending the hybrid approach.
In order to reduce complexity and improve administrability, the
final

[[Page 88810]]

regulations modify the 2006 proposed regulations in several significant
ways, including by permitting more items to be treated as section 987
marked items, simplifying the treatment of marked items so that net
income attributable to such items is translated at the average exchange
rate, and simplifying the adjustments that are required to translate
basis recovery for historic items at the historic rate. These changes
balance the administrability benefits of simplifying the final
regulations and bringing them into closer conformity with financial
accounting rules against the need to minimize the distortions that
would result from permitting taxpayers to include uncertain and remote
foreign currency gains and losses in taxable income. In particular, the
final regulations allow taxpayers to (a) use the yearly average
exchange rate as the historic rate, (b) treat prepaid expenses and
liabilities for advance payments of unearned income as section 987
marked items, (c) apply a simplified method with respect to inventory,
and (d) translate both basis recovery and amount realized with respect
to marked assets at the yearly average exchange rate. Additionally, as
described in the preamble to the temporary regulations, the temporary
regulations treat certain section 988 transactions as marked items and
permit taxpayers to elect to more closely conform the treatment of
certain section 988 transactions entered into by a section 987 QBU with
their treatment for financial accounting purposes.
1. Yearly Average Exchange Rate as the Historic Rate
Under Sec. Sec. 1.987-1(c)(3)(i) and 1.987-2(d) of the 2006
proposed regulations, the historic rate used to translate the basis of
historic assets was the spot rate on the date on which the asset was
transferred to, or otherwise acquired by, a section 987 QBU. Thus, when
assets were acquired by a section 987 QBU on multiple days during a
single taxable year, the 2006 proposed regulations required taxpayers
to track multiple historic spot rates. A comment observed that taxpayer
systems often only identify the date an asset is placed in service and
recommended that taxpayers be permitted to use a yearly average
exchange rate in lieu of a spot rate in translating historic items.
The Treasury Department and the IRS agree that using the yearly
average exchange rate rather than a spot rate to translate historic
items would reduce complexity and improve administrability without
introducing significant distortions into the determination of section
987 taxable income or loss or section 987 gain or loss. Accordingly,
Sec. 1.987-1(c)(3)(i) generally provides that the historic rate is the
yearly average exchange rate for the taxable year when a historic asset
is acquired, or a historic liability is incurred, by a section 987 QBU.
Taxpayers that prefer to use the spot rate as the historic rate, as
under the 2006 proposed regulations, may so elect under Sec. 1.987-
1(c)(1)(iii). A taxpayer that makes this election is deemed to also
make the historic inventory election under Sec. 1.987-3(c)(2)(iv)(B)
that is described in Part II.A.3 of this preamble.
In addition, to further improve administrability, Sec. 1.987-
1(c)(3)(iii) permits a section 987 QBU that acquires depreciable or
amortizable property in one year and places the asset in service in
another year to determine the historic rate for the property based on
the date the property is placed in service rather than the year the
property was acquired, provided that this convention is consistently
applied for all such property attributable to that section 987 QBU.
2. Prepaid Expenses and Liabilities Treated as Section 987 Marked Items
Comments suggested that prepaid expenses and liabilities for
advance payments of unearned income should be treated as section 987
marked items because they typically have a short duration and often
concern small amounts. The Treasury Department and the IRS have
determined that treating these items as marked items generally would
promote administrability without introducing significant distortions in
the determination of section 987 gain or loss. Accordingly, the
definition of marked item under Sec. 1.987-1(d) includes prepaid
expenses and liabilities for an advance payment of unearned income
where such items have an original term of one year or less.
3. Cost of Goods Sold/Inventory
Under the 2006 proposed regulations, inventory was treated as a
historic item. As a result, to determine section 987 taxable income or
loss with respect to a section 987 QBU under proposed Sec. 1.987-3,
cost of goods sold (COGS) had to be translated at a historic spot rate
that corresponded to the date the liquidated inventory was acquired or
manufactured. A historic spot rate also had to be used to determine the
OFCNV of the QBU under proposed Sec. 1.987-4 with respect to inventory
that was reflected on the section 987 QBU's year-end balance sheet. For
these purposes, the cost basis of inventory purchased for resale
generally would have been translated into the owner's functional
currency at the spot rate on the date of purchase. With respect to
inventory that was manufactured by the section 987 QBU, it would have
been necessary to translate individually the various components of COGS
at the appropriate historic spot rate for each cost component,
resulting in an effective historic rate for manufactured inventory that
was a blend of the historic rates applicable to such components. That
is, labor, materials and other inventoriable costs would have been
translated at the spot rate on the date the cost was incurred or, in
the case of depreciation, the date the relevant depreciable asset was
acquired. Comments suggested that translating inventoriable costs at
their historic spot rates presented significant administrative
difficulties. In addition to the comments requesting that certain high
volume property be treated as a marked asset, one comment requested
that a simplified method be provided to deal with the administrative
difficulties in applying the 2006 proposed regulations to inventory.
In response to comments, these final regulations simplify the
translation of COGS and ending inventory in two significant ways.
First, the use under Sec. 1.987-1(c)(3) of the yearly average exchange
rate rather than a spot rate as the historic rate will significantly
simplify the translation of COGS and ending inventory. This change
makes it possible to translate all inventory purchased in a given year,
and all costs incurred in the production of inventory in a given year
(other than depreciation, which is always translated at the historic
rate for the year the depreciated property was acquired or placed in
service, regardless of whether it is an inventoriable cost), using a
single exchange rate. Second, Sec. 1.987-3(c)(2)(iv)(A) prescribes a
simplified inventory method under which (i) COGS is translated into the
functional currency of the section 987 QBU's owner at the yearly
average exchange rate for the current taxable year with a requirement
to make only two discrete adjustments to the translated COGS amount,
and (ii) a simplified historic rate is used for purposes of determining
the OFCNV under Reg. Sec. 1.987-4 for inventory to which the
simplified inventory method applies. A taxpayer that prefers the
inventory method under the 2006 proposed regulations can elect under
Sec. 1.987-3(c)(2)(iv)(B) to translate inventoriable costs that are
included in COGS or ending inventory at the historic rate for each such
cost and, if they wish, can further elect under

[[Page 88811]]

Sec. 1.987-1(c)(1)(iii) to use the spot rate as the historic rate.
a. Translation of COGS Under the Simplified Inventory Method
Under the simplified inventory method, a section 987 QBU determines
COGS in its functional currency and translates that amount at the
yearly average exchange rate for the taxable year rather than
translating each inventoriable cost at the appropriate historic rate.
Taxpayers applying the simplified inventory method must make two
adjustments to COGS described in Sec. 1.987-3(c)(3). These adjustments
mitigate the consequences of translating COGS at the yearly average
exchange rate, as if inventory were a marked asset, rather than
translating the inventoriable costs reflected in inventory sold during
the taxable year at the appropriate historic rates, as under the 2006
proposed regulations. In particular, the adjustments generally prevent
inventory from giving rise to section 987 gain or loss reflected in the
FEEP. The adjustments also cause section 987 taxable income or loss to
correspond over time to the section 987 taxable income or loss that
would have resulted if inventoriable costs were translated at historic
rates.
The first adjustment requires the translated COGS amount to be
adjusted to reverse the effect of translating (as part of the
translation of COGS) cost recovery deductions treated as inventoriable
costs at the current yearly average exchange rate rather than at the
appropriate historic rates. For a particular cost recovery deduction,
this adjustment is calculated as the portion of the deduction treated
as an inventoriable cost, computed in the functional currency of the
QBU, multiplied by the amount (whether positive or negative) that is
determined by subtracting the yearly average exchange rate at which
COGS was translated from the historic rate applicable to the property
whose cost is being recovered. For example, in a period in which the
functional currency of a section 987 QBU has strengthened against its
owner's functional currency, the adjustment would reduce the amount of
COGS determined in the owner's functional currency to correspond to the
amount that would have been determined if cost recovery deductions that
are inventoriable costs had been translated at the historic rate, as
other cost recovery deductions are translated. To enhance
administrability and respond to comments received, this adjustment is
taken into account in determining COGS in full in the taxable year in
which the inventoriable cost recovery deductions are allowed,
regardless of whether a portion of such costs is capitalized into
ending inventory.
The second adjustment required under the simplified inventory
method differs for inventory accounted for under the last-in, first-out
(LIFO) method and for non-LIFO inventory, to reflect the different cost
flow assumptions under these accounting methods. For both non-LIFO and
LIFO inventory, the adjustment generally causes the amount of section
987 taxable income or loss taken into account by the owner of a section
987 QBU to correspond over time to the amount that would be taken into
account if inventoriable costs were translated at their respective
historic rates rather than at the yearly average exchange rate. For
non-LIFO inventory, the adjustment is made on an annual basis with
respect to beginning inventory. For LIFO inventory, the adjustment is
made only when a LIFO layer is liquidated or partially liquidated.
i. Adjustment for Non-LIFO Inventory
For non-LIFO inventory, the second adjustment required under the
simplified inventory method is an adjustment with respect to beginning
inventory. The adjustment, which must be made annually, corrects the
distortion that arises from translating beginning inventory at the
current yearly average exchange rate as part of translating COGS, after
the same inventory was translated in the immediately preceding year
(when the inventory represented ending inventory in the cost of goods
calculation) at the yearly average exchange rate for that year. This
adjustment to COGS is calculated as the amount of beginning inventory,
computed in the functional currency of the QBU, multiplied by the
amount (whether positive or negative) that is determined by subtracting
the yearly average exchange rate for the current taxable year from the
yearly average exchange rate for the immediately preceding taxable
year. For example, in a period in which the functional currency of a
section 987 QBU has strengthened against the owner's functional
currency, this adjustment would reduce the amount of COGS determined in
the owner's functional currency by the difference between beginning
inventory translated at the current yearly average exchange rate and at
the yearly average exchange rate for the immediately preceding taxable
year.
Over time, this adjustment generally causes the owner of a section
987 QBU to take into account the same amount of section 987 taxable
income or loss as would have occurred under the 2006 proposed
regulations if the yearly average exchange rate had been used as the
historic rate. Additionally, because this adjustment is reflected in
section 987 taxable income or loss, which is a component of the Sec.
1.987-4 calculation of section 987 gain or loss with respect to the
section 987 QBU, the adjustment ultimately has the effect of preventing
non-LIFO inventory on the year-end balance sheet from giving rise to
section 987 gain or loss, notwithstanding that the historic rate at
which it is translated each year is the yearly average exchange rate.
ii. Adjustment for LIFO Inventory
For LIFO inventory, the second adjustment required under the
simplified inventory method is an adjustment with respect to LIFO
layers liquidated in whole or part during the year. The adjustment,
which must be made only in taxable years in which a LIFO layer is
partially or fully liquidated, compensates for the translation of COGS
attributable to a liquidated LIFO layer at the current yearly average
exchange rate rather than at the historic rate associated with the
taxable year in which the inventory layer arose. The adjustment is
calculated as the amount of each LIFO layer that has been fully or
partially liquidated during the year multiplied by the amount (whether
positive or negative) that is determined by subtracting the yearly
average exchange rate for the current taxable year from the yearly
average exchange rate for the taxable year to which the liquidated
layer relates.
As a result of this adjustment, each LIFO layer is treated as
having a single historic rate, which is the yearly average exchange
rate for the taxable year in which the layer arose.
b. Determination of the OFCNV of Inventory Under the Simplified Method
For purposes of determining section 987 gain or loss under Sec.
1.987-4 with respect to inventory that is reflected on the section 987
QBU's year-end balance sheet, Sec. 1.987-1(c)(3)(i)(B) provides a
simplified historic rate for inventory to which the simplified
inventory method applies. Under Sec. 1.987-1(c)(3)(i)(B), the
simplified historic rate for inventory differs depending on whether the
inventory is accounted for under the LIFO method. If the inventory is
accounted for under the LIFO method, the historic rate is the average
exchange rate for the taxable year in which the relevant LIFO layer
arose. If the

[[Page 88812]]

inventory is accounted for under a non-LIFO method, the historic rate
is the average exchange rate for the taxable year for which the
determination of the historic rate is relevant. Accordingly, for
purposes of determining section 987 gain or loss with respect to non-
LIFO inventory reflected on a section 987 QBU's year-end balance sheet,
the inventory is translated at the average exchange rate for that
taxable year. Thus, although non-LIFO inventory subject to the
simplified method is nominally a historic asset, it is translated at a
current exchange rate each year similar to a marked asset, but using
the yearly average exchange rate rather than the year-end spot rate.
4. Translation Rates Used for the Sale of a Marked Asset by a Section
987 QBU
The 2006 proposed regulations provided special rules for
translating the adjusted basis and amount realized upon a disposition
of a marked asset. For a marked asset that was held by a section 987
QBU on the first day of a taxable year, the required translation rate
for the adjusted basis and amount realized with respect to the asset
was the rate used to translate the basis of such asset from the section
987 QBU's functional currency into the owner's functional currency in
determining the owner functional currency net value of the section 987
QBU for the preceding taxable year under Sec. 1.987-4. For a marked
asset acquired during the taxable year, the adjusted basis and amount
realized were translated at the spot rate on the date the asset was
acquired. In response to general comments on the complexity of
administering the 2006 proposed regulations, and considering the
relatively minor distortion that would arise from eliminating these
special translation rules, the final regulations do not include a
special rule for translating the adjusted basis or amount realized with
respect to marked assets. Accordingly, the gain or loss on marked
assets generally is determined in the functional currency of the
section 987 QBU and translated into the owner's functional currency at
the yearly average exchange rate for the year of disposition.

B. Excluded Entities

The 2006 proposed regulations provided that banks, insurance
companies, and similar financial entities would not be subject to the
regulations. In addition, the 2006 proposed regulations identified
leasing companies, finance coordination centers, regulated investment
companies, and real estate investment trusts as ``similar financial
entities.'' A comment requested that the final regulations clarify the
meaning of ``similar financial entities.'' Comments also suggested
excluding entities from the scope of ``similar financial entity'' (and
therefore making such entities subject to the final regulations) if
they primarily engage in transactions with related parties that are not
themselves financial entities. A comment noted that it would be
anomalous to apply the final regulations with respect to all of the
operating entities transacting with a related finance coordination
center but not apply the final regulations to the center itself.
The Treasury Department and the IRS agree that the reference to
``similar financial entities'' in the 2006 proposed regulations is
unclear and agree that entities primarily engaged in transactions with
related persons that are not themselves financial entities should be
subject to the final regulations. Accordingly, Sec. 1.987-1(b)(1)(ii)
omits the reference to ``similar financial entities,'' and replaces it
with specific references to the entities that the 2006 proposed
regulations explicitly identified as ``similar financial entities.''
Additionally, the exception from the application of the final
regulations is revised based on the comment received to not apply (such
that the final regulations do apply) to entities that engage in
transactions primarily with persons that are related within the meaning
of sections 267(b) or 707(b) and that are not themselves entities
identified in Sec. 1.987-1(b)(1)(ii).
The preamble to the 2006 proposed regulations requested comments on
the application of the FEEP method to entities excluded from the scope
of the 2006 proposed regulations. The Treasury Department and the IRS
are still considering how section 987 should apply to excluded entities
and request additional comments regarding the appropriate design of
rules applying section 987 to excluded entities in light of the rules
contained in these final regulations and the temporary regulations.
Until regulations providing rules for applying section 987 with respect
to such excluded entities are effective, the excluded entities must use
a reasonable method to comply with section 987 and cannot rely on these
final regulations.

C. Election To Apply Section 988 in Lieu of Section 987

A comment recommended allowing an owner of a section 987 QBU that
has a relatively small amount of marked items to elect to not apply
section 987 with respect to the QBU and instead to apply section 988
with respect to the items that would be considered marked items of the
QBU if section 987 applied. The same comment recommended that the
Treasury Department and the IRS consider providing such an election
more generally without regard to the relative amount of marked items
held by an eligible QBU. The Treasury Department and the IRS have
determined that the proposed election would create substantial
administrative difficulties for the IRS, particularly given that an
electing QBU would maintain books and records in its functional
currency but would determine tax consequences by reference to the
functional currency of the owner. Accordingly, the recommendation to
allow an election not to apply section 987 has not been adopted.

D. Definition of Portfolio Stock

Under Sec. 1.987-2(b)(2) of the 2006 proposed regulations, stock
other than portfolio stock is not attributed to an eligible QBU even if
it is reflected on the books and records of the eligible QBU. For this
purpose, the 2006 proposed regulations provided that stock is portfolio
stock if the owner of the eligible QBU owns (directly, indirectly, or
constructively) less than 10 percent of the voting power or value of
all classes of stock of the corporation. A comment recommended that
this rule be based solely on value because voting power should not be a
relevant factor in determining whether items of income, gain,
deduction, and loss arising from stock are included in section 987
taxable income or loss. The Treasury Department and the IRS agree with
this recommendation, which is reflected in Sec. 1.987-2(b)(2).

E. Consistency of Attribution Rules and QBU Concept Across Subpart J

A comment observed that the 2006 proposed regulations provide rules
for attributing assets and liabilities, and items of income or expense,
to an eligible QBU and that those rules should apply for purposes of
sections 985, 987, and 989 to avoid inconsistencies across subpart J.
Accordingly, Sec. 1.989(a)-1(d)(3) is revised to provide that the
principles of Sec. 1.987-2(b) apply in determining whether an asset,
liability, or item of income or expense is properly reflected on the
books and records of a QBU.
To further enhance consistency, the definition of an eligible QBU
in Sec. 1.987-1(b)(3) is revised to cross-reference the QBU definition
under Sec. 1.989-1(a). The 1991 proposed regulations generally would
have applied to a QBU within the

[[Page 88813]]

meaning of Sec. 1.989(a)-1 that has a functional currency different
than the functional currency of its owner. The 2006 proposed
regulations, in contrast, did not refer directly to the Sec. 1.989-
1(a) QBU definition. Rather, the 2006 regulations generally defined an
eligible QBU as activities that constitute a trade or business as
defined in Sec. 1.989(a)-1(c) for which a separate set of books and
records are maintained. By relying on the definition of a QBU in Sec.
1.989(a)-1, as the 1991 proposed regulations did, the final regulations
avoid inadvertently introducing inconsistencies across subpart J in the
definition of a QBU.

F. Offsetting Positions

Under Sec. 1.987-2(b)(3)(iii)(C) of the 2006 proposed regulations,
if a principal purpose of recording (or failing to record) an item on
the books and records of an eligible QBU was the avoidance of U.S. tax
under section 987, the Commissioner could reallocate any item between
or among the eligible QBU, its owner, and other persons, entities, or
eligible QBUs. One relevant factor identified in the 2006 proposed
regulations as indicating tax avoidance as a principal purpose of
recording (or failing to record) an item on the books and records of an
eligible QBU was the presence or absence of an item on such books and
records that results in the taxpayer (or a person related to the
taxpayer as defined in section 267(b) or 707(b)) having offsetting
positions in the functional currency of a section 987 QBU. The
``offsetting position'' concern might arise, for example, when a home
office borrows funds denominated in the functional currency of a
section 987 QBU and then onlends those funds to its section 987 QBU.
Since the intra-taxpayer loan is not recognized, the funding
transaction booked to the home office will be a section 988 transaction
and the cash booked to the section 987 QBU derived from the funding
transaction will be subject to section 987. A comment recommended that
the Treasury Department and the IRS restrict the parameters of the
``offsetting position'' factor, particularly in the context of banks.
As discussed in Part II.B of this preamble, these regulations do
not apply to banks. Accordingly, this comment will be reconsidered when
regulations applying section 987 to banks and other financial entities
are developed. Outside of the financial entity context, the Treasury
Department and the IRS have determined that the ``offsetting position''
factor in Sec. 1.987-2(b)(3)(iii)(C) is necessary to prevent the use
of transactions involving offsetting gains and losses to selectively
recognize losses without recognition of gain. Accordingly, the
recommendation to restrict the parameters of the ``offsetting
position'' factor has not been adopted.

G. Exclusion of Ordinary-Course Transactions From the Definition of a
Transfer

Several comments recommended that transactions entered into between
two section 987 QBUs of the same taxpayer, or by a section 987 QBU and
its home office, in the ordinary course of business should not be
considered ``transfers'' that are taken into account in determining the
amount of a remittance. These comments noted the complexity associated
with tracking a large number of ordinary-course transactions and
contended that such transactions were not appropriate occasions to
recognize section 987 gain or loss.
The Treasury Department and the IRS have determined that it is not
feasible to define the parameters of an ordinary-course exception to
the definition of a transfer with sufficient clarity to avoid abuse and
permit effective enforcement given the potentially high volume and
variety of transactions between a section 987 QBU and its home office.
More significantly, determining the net transfer to or from a section
987 QBU, without regard to whether transfers occur in the ordinary
course of business, is essential for appropriately determining section
987 gain or loss under Sec. 1.987-4 because all transfers affect the
OFCNV of the section 987 QBU. Furthermore, the Treasury Department and
the IRS have determined that the annual netting convention of Sec.
1.987-5, which simplifies the calculation of a remittance relative to
the 1991 proposed regulations by taking into account only the net
transfer to or from a section 987 QBU during a taxable year,
appropriately limits the extent to which ordinary course transactions
between a section 987 QBU and its home office give rise to a
remittance. Accordingly, the recommendation to include an ordinary-
course exception to the definition of transfer has not been adopted.
A comment also recommended that the final regulations permit
taxpayers to elect to treat disregarded sales of property and services
in the ordinary course of business as regarded transactions. The
Treasury Department and the IRS have determined that this
recommendation, which would result in income or loss recognition on
intra-taxpayer transactions, is inconsistent with the paradigm of
section 987 and the entity classification regulations under section
7701. Accordingly, the recommendation has not been adopted.

H. Extension of the Grouping Rules

Section 1.987-1(b)(2)(ii) of the 2006 proposed regulations allows a
taxpayer to elect to treat all of its directly owned section 987 QBUs
with the same functional currency as a single QBU for purposes of
section 987. This rule, however, does not allow different members of a
consolidated group to group their section 987 QBUs with the same
currency into a single QBU. In the preamble to the 2006 proposed
regulations, the Treasury Department and the IRS requested comments on
whether a grouping election should be allowed with respect to section
987 QBUs owned by different members of a consolidated group and how
this election should be technically effectuated.
Several comments recommended extending the grouping rules to
corporations that file a consolidated return so that a consolidated
group could make transfers among section 987 QBUs without causing a
remittance. However, based on the comments received, the Treasury
Department and the IRS have been unable to reconcile in a satisfactory
manner the timing of section 987 gain or loss and section 987 taxable
income or loss under the final regulations with the principles of Sec.
1.1502-13, including separate entity accounting for consolidated group
members. As a result, this recommendation has not been adopted in the
final regulations. The Treasury Department and the IRS continue to
welcome comments with specific recommendations regarding how grouping
of section 987 QBUs owned by different consolidated group members could
be achieved in a manner consistent with the consolidated return
regulations.
A comment requested an election to group section 987 QBUs that are
directly owned with section 987 QBUs that are indirectly owned through
section 987 aggregate partnerships. The Treasury Department and the IRS
have determined that allowing grouping of directly and indirectly owned
section 987 QBUs would be inconsistent with the treatment of
transactions between a partnership and its partner (and between
eligible QBUs of the partnership and of the partner) as regarded
transactions for Federal income tax purposes. Additionally, it is
unclear how the treatment of directly and indirectly owned section 987
QBUs as a single section 987 QBU could be reconciled with the general
requirement under sections 702 and 703 that a

[[Page 88814]]

partnership determine its income separately. Due to the uncertainties
about how directly and indirectly owned section 987 QBUs could be
grouped in a manner consistent with the principles of subchapter K, the
recommendation has not been adopted.
A comment requested that an owner be permitted to elect to group
less than all of its section 987 QBUs with the same functional
currency. The Treasury Department and the IRS observe that it is
possible for an owner to have section 987 gain with respect to some of
its section 987 QBUs and section 987 loss with respect to other section
987 QBUs with the same functional currency. In light of this
possibility, the Treasury Department and the IRS are concerned that the
ability to group section 987 QBUs without the constraint of a
consistency requirement for all section 987 QBUs with the same
functional currency could inappropriately facilitate the recognition of
section 987 losses coupled with the deferral of section 987 gains.
Accordingly, the recommendation has not been adopted.

I. Adjustment of the Computation of Net Unrecognized Exchange Gain or
Loss for Tax-Exempt Income and Non-Deductible Expenses

Section 1.987-4 of the 2006 proposed regulations provided a seven-
step process for determining the unrecognized section 987 gain or loss
of a section 987 QBU for a taxable year. Comments noted that this
calculation did not take into account the effects of tax-exempt income
and non-deductible expenses on a section 987 QBU's cash flows. The
comments advised that this omission would introduce distortions into
the calculation of unrecognized section 987 gain or loss for a taxable
year since these items affect a section 987 QBU's balance sheet. In
response to these comments, Sec. 1.987-4(d) reflects additional steps
in the calculation of unrecognized section 987 gain or loss that
account for nondeductible expenses (Step 7) and tax-exempt income (Step
8). Step 7 also now explicitly accounts for foreign taxes claimed as a
credit, which must be translated at the same rate at which such taxes
were translated under section 986(a).

J. Clarification That the Rules of Sec. Sec. 1.987-3 and -4 Apply for
Determining the E&P of a Corporation

Comments indicated that the 2006 proposed regulations did not
clearly specify whether the rules provided for determining section 987
taxable income or loss applied for purposes of determining the earnings
and profits of a foreign corporation. Accordingly, Sec. 1.987-3(a)
clarifies that a foreign corporation that owns a section 987 QBU must
apply Sec. 1.987-3 in determining earnings and profits with respect to
the section 987 QBU.

K. FEEP Annual Calculation Requirement

Section 1.987-4(a) of the 2006 proposed regulations required the
determination of the net unrecognized section 987 gain or loss of a
section 987 QBU by the owner annually. In addition, Sec. 1.987-9 of
the 2006 proposed regulations required the taxpayer to keep annual
records that are sufficient to establish each section 987 QBU's section
987 gain or loss. A comment requested elimination of these annual
calculations and recordkeeping requirements. The Treasury Department
and the IRS remain of the view that the annual calculation and
recordkeeping requirements are necessary for IRS examiners to verify
taxpayer compliance with the final regulations. Based on its experience
examining taxpayer positions that relate to events in prior years, the
IRS has determined that contemporaneous recordkeeping and calculation
requirements provide a significantly more reliable basis for verifying
compliance than calculations performed years after the relevant events,
which in many cases would be performed by individuals without direct
access to the individuals most familiar with the underlying facts or
responsible for producing and maintaining the records. Accordingly, the
annual requirements have been retained.

L. Character and Source of Section 987 Gain or Loss

Consistent with the 1991 proposed regulations, the 2006 proposed
regulations required the owner of a section 987 QBU to determine the
character and source of section 987 gain or loss for all purposes of
the Code, including for determining the extent to which section 987
gain or loss gives rise to subpart F income. In particular, Sec.
1.987-6(b)(2) of the 2006 proposed regulations required the owner to
use the asset method under Sec. 1.861-9T(g) in the year of a
remittance to characterize and source section 987 gain or loss for all
purposes by reference to the assets of the section 987 QBU.
A comment recommended an exception that would allow a taxpayer to
elect to trace identified amounts of section 987 gain or loss to
particular assets or liabilities and to characterize such gain or loss
by reference to the income or expense derived (or to be derived) from
such items. The Treasury Department and the IRS have determined that
tracing section 987 gain or loss to particular assets and liabilities
is inconsistent with the FEEP method, which aggregates and pools
section 987 gain and loss for all assets and liabilities and for all
years prior to a remittance. Accordingly, the Treasury Department and
the IRS decline to adopt this comment.
A comment questioned whether section 987(3), which refers to
sourcing section 987 gain or loss by reference to post-1986 accumulated
earnings, provided a sufficient basis for characterizing section 987
gain or loss as subpart F income. The comment recommended against
treating section 987 gain as subpart F income but also recommended
that, if it were so treated, the final regulations provide a business
needs exception similar to that under section 954(c)(1)(D). Another
comment acknowledged the Treasury Department's authority under section
989(c)(5) to characterize section 987 gain as subpart F income but
questioned the consistency of the requirement in the 2006 proposed
regulations to use the asset method of Sec. 1.861-9T to characterize
section 987 gain or loss with the reference in section 987(3) to
sourcing section 987 gain or loss by reference to post-1986 accumulated
earnings. The comment recommended that the character and source of
section 987 gain or loss be determined by reference to post-1986
accumulated earnings.
The Treasury Department and the IRS have determined that sourcing
and characterizing section 987 gain or loss with direct reference to
post-1986 accumulated earnings would give rise to substantial
complexity and compliance burdens, including the need to track earnings
of a section 987 QBU in separate categories over a long period of time.
This approach also presents conceptual difficulties, given that section
987 gain or loss arises from marked assets and liabilities rather than
accumulated earnings, and allows for planning opportunities if there
are deficits in post-1986 accumulated earnings. The Treasury Department
and the IRS continue to believe that, as noted in the preamble to the
2006 proposed regulations, the average tax book value of assets is a
reasonable proxy for post-1986 accumulated earnings in the context of
section 987. For these reasons, the Treasury Department and the IRS
decline to adopt this recommendation. Pursuant to sections 987(3) and
989(c)(5), these regulations follow the approach of the 2006 proposed
regulations in requiring the owner to use the asset method of Sec.
1.861-9T(g) to characterize and source

[[Page 88815]]

section 987 gain or loss. The final regulations, however, do clarify
that in applying the asset method, an owner must consistently determine
the value of a section 987 QBU's assets on the basis of either the tax
book value or the fair market value of the assets.
Additionally, given the significant symmetry (other than timing)
between the FEEP paradigm and section 988, the Treasury Department and
the IRS have determined that, for purposes of determining the excess of
foreign currency gains over foreign currency losses characterized as
foreign personal holding company income under section 954(c)(1)(D), it
is appropriate for taxpayers to treat section 987 gain or loss that is
characterized by reference to assets that give rise to subpart F income
as foreign currency gain or loss attributable to section 988
transactions not directly related to the business needs of the
controlled foreign corporation (CFC). This policy, which has been
adopted in Sec. 1.987-6(b)(3), will allow taxpayers to offset a
section 987 net loss characterized by reference to assets that give
rise to subpart F income against a section 988 net gain, and vice
versa, in determining subpart F income. Section 987 gain or loss
characterized by reference to assets that give rise to subpart F income
is treated as attributable to section 988 transactions not directly
related to the business needs of the CFC because the Treasury
Department and the IRS have determined that using the asset method of
Sec. 1.861-9T(g) to characterize and source section 987 gain or loss
effectively carries out the purpose of the business needs exclusion of
section 954(c)(1)(D). In particular, because the asset method
characterizes section 987 gain or loss based on whether assets give
rise to subpart F income, section 987 gain or loss will not enter into
the determination of foreign personal holding company income to the
extent assets of the section 987 QBU do not give rise to subpart F
income.

M. Partnerships

The 2006 proposed regulations applied to all partnerships based on
an approach (the aggregate approach) that treated a partnership as an
aggregate of its partners, rather than as an entity separate from its
partners. As explained in the preamble to the 2006 proposed
regulations, the Treasury Department and the IRS proposed the aggregate
approach because it appropriately determines section 987 gain or loss
with respect to partnership assets and liabilities by reference to the
functional currencies of the partners that ultimately bear the economic
exposure to fluctuations in the exchange rate between their own
functional currency and the functional currency of the activities of
the partnership. Accordingly, under Sec. Sec. 1.989(a)-1(b)(2)(i) of
the 2006 proposed regulations, a partnership itself was not treated as
a section 987 QBU, but certain activities of a partnership that
constituted a trade or business could qualify as a QBU that is an
eligible QBU of a partner. Thus, a partner generally was treated as
owning an eligible QBU consisting of a share of the assets and
liabilities held in the partnership's trade or business. Such an
eligible QBU could qualify as a section 987 QBU if it had a functional
currency different from that of the partner.
Comments requested that the Treasury Department and the IRS
reconsider this aggregate approach and that final regulations instead
treat a partnership as a separate entity with its own functional
currency. The comments generally were premised on the concern that the
aggregate approach was overly complex and that minority partners would
not have the power to compel a partnership to provide them with the
information needed to make the calculations required under the
aggregate approach. One comment acknowledged the economic rationale for
the aggregate approach but, in light of its complexity, recommended
that it apply only in cases in which a partner's interest in
partnership capital or profits exceeds a certain threshold, such as 10
percent.
The Treasury Department and the IRS acknowledge the concerns
expressed about the complexity of applying the aggregate approach in
the context of partnerships with partners that are unrelated to each
other. Nonetheless, consistent with the comment recommending the
aggregate approach for partners with substantial partnership interests,
the Treasury Department and the IRS have determined that it is feasible
to administer the aggregate approach with respect to a partnership that
is wholly owned by related persons. Moreover, adopting the aggregate
approach in that context is important for preventing planning
opportunities that would arise if the interposition of a partnership
within a group of related parties could significantly alter the results
that the group otherwise would experience under section 987 without
meaningfully altering the group's economic position. Accordingly, the
final section 987 regulations retain the aggregate approach of the 2006
proposed regulations only for so-called ``section 987 aggregate
partnerships,'' which are defined in Sec. 1.987-1(b)(5) as
partnerships for which all of the capital and profits interests are
owned, directly or indirectly, by persons that are related within the
meaning of section 267(b) or 707(b). The final regulations reflect a
conforming amendment to the definition of a QBU at Sec. 1.989(a)-
1(b)(2)(i)(C), which now provides that a partnership, other than a
section 987 aggregate partnership, is a QBU.
The 2006 proposed regulations provided a rule for determining a
partner's share of the assets and liabilities of an eligible QBU owned
indirectly through a partnership. Specifically, Sec. 1.987-7(b)
provided that a partner's share of assets and liabilities reflected on
the books and records of the eligible QBU must be determined in a
manner consistent with how the partners have agreed to share the
economic benefits and burdens corresponding to partnership assets and
liabilities, taking into account the rules and principles of subchapter
K. One comment noted that this rule for allocating assets and
liabilities to a partner's indirectly owned section 987 QBU was
ambiguous and that the rules and principles of subchapter K do not
provide sufficient guidance in this regard. Accordingly, as discussed
in the preamble to the temporary regulations, the temporary regulations
provide more specific rules for determining a partner's share of the
assets and liabilities reflected on the books and records of an
eligible QBU owned indirectly through a section 987 aggregate
partnership.
As previously discussed in this section, comments recommended that
the Treasury Department and the IRS consider adopting an entity
approach with respect to partnerships. Under the recommended entity
approach, a partnership would have its own functional currency and
would apply section 987 with respect to each of its section 987 QBUs to
determine its taxable income or loss and section 987 gain or loss in
that functional currency. Each partner then would be required to take
into account its share of the section 987 taxable income or loss and
section 987 gain or loss of the partnership, translated into the
partner's functional currency at the average exchange rate for the
partner's taxable year.
Although the Treasury Department and the IRS have determined that
the aggregate approach is appropriate for applying section 987 to
section 987 aggregate partnerships, the Treasury Department and the IRS
anticipate that regulations for applying section 987 to other
partnerships (non-aggregate partnerships) will be developed under a
separate project and may adopt a different approach. Accordingly, the

[[Page 88816]]

Treasury Department and the IRS request comments describing how an
entity approach might apply to non-aggregate partnerships, including
comments on (1) whether and how section 987 should apply to marked
items denominated in the non-aggregate partnership's functional
currency, (2) the information reporting that would be necessary to
apply an entity approach, (3) whether a distinction should be made
regarding how section 987 applies with respect to partnerships in which
significant U.S. partners and CFCs together own more than 50 percent of
the capital and profits interests in the partnership, and (4) the rules
that would be needed to coordinate with subchapter K.

N. Terminations

Under the 2006 proposed regulations, a section 987 QBU terminates
when the activities of the section 987 QBU cease, substantially all of
the assets of the section 987 QBU are transferred to its owner, a CFC
owner of a section 987 QBU ceases being a CFC, or the owner of the
section 987 QBU ceases to exist in a transaction other than certain
liquidations and reorganizations described in section 381(a). The
preamble to the 2006 proposed regulations requested comments on whether
transfers of some or all of the assets of a section 987 QBU from one
member of a consolidated group to another member of the group should
result in a remittance or termination, respectively. Several comments
supported a rule under which a section 351 transfer of some or all of
the assets of a section 987 QBU to other members of a consolidated
group would not cause a remittance or termination where those assets
continue to be held in a section 987 QBU following the transaction.
The Treasury Department and the IRS remain of the view that a
transfer of substantially all of a section 987 QBU's assets and
liabilities under section 351 should result in a termination under
Sec. 1.987-8(b)(2) because the owner ceases to be subject to section
987 with respect to the section 987 QBU and has no successor in a
section 381(a) transaction. Nonetheless, the Treasury Department and
the IRS agree that it is appropriate in certain circumstances to defer
section 987 gain or loss that otherwise would be recognized as a result
of certain transactions, including terminations, that result in deemed
transfers from a section 987 QBU where some or all of the assets of the
section 987 QBU continue to be reflected on the books and records of a
section 987 QBU in the same controlled group. Additionally, the
Treasury Department and the IRS have determined that combinations and
separations of section 987 QBUs of the same owner generally should not
result in recognition of section 987 gain or loss. As discussed in the
preamble to the temporary regulations, the temporary regulations
provide rules under which certain section 987 gain or loss that
otherwise would be recognized upon a combination, separation,
termination, or other event with respect to a section 987 QBU is
deferred and recognized upon a subsequent event to the extent assets of
the section 987 QBU continue to be reflected on the books and records
of a section 987 QBU in the same controlled group. Under these rules, a
section 351 transfer of some or all of the assets of a section 987 QBU
within a consolidated group generally would not result in recognition
of section 987 gain or loss, provided the transferred assets continue
to be reflected on the books and records of a section 987 QBU.
Comments recommended eliminating the rule in the 2006 proposed
regulations under which a section 987 QBU terminates upon its owner
ceasing to be a CFC. The comments indicated that the rule is
inconsistent with the policy of subpart F and section 1248. One of the
comments questioned the authority under subpart J for such a rule. A
comment also recommended that the final regulations eliminate the rule
under which a section 987 QBU terminates when it is acquired by a non-
CFC from a CFC owner in a reorganization in which the CFC owner goes
out of existence but has a successor under section 381(a). The Treasury
Department and the IRS acknowledge that the policy concern motivating
these rules pertains primarily to situations in which a section 987 QBU
ceases to be owned by a CFC but continues to be owned by related
persons within the meaning of section 267(b). Accordingly, consistent
with section 989(c)(5), a section 987 QBU will terminate under Sec.
1.987-8(b)(3), (b)(4) and (c) only in that circumstance.
Comments indicated that it was unclear under the 2006 proposed
regulations whether a check-the-box election to treat a foreign
disregarded entity that legally owns a section 987 QBU as a corporation
for U.S. tax purposes would cause the section 987 QBU to terminate. To
provide greater clarity, Example 6 in Sec. 1.987-8(f) illustrates that
when a foreign disregarded entity that legally owns a section 987 QBU
elects to be treated as a corporation under the check-the-box
regulations in Sec. 301.7701-3, the section 987 QBU terminates due to
the deemed transfer of assets from the section 987 QBU to the owner
immediately prior to the deemed transfer of assets from the owner to
the transferee corporation under section 351. Additionally, Sec.
1.987-2(c)(2)(ii) clarifies that if an asset or liability of a section
987 QBU is sold or exchanged (including in a nonrecognition
transaction) for an asset or liability that is not attributable to the
section 987 QBU immediately after the exchange (for example, non-
portfolio stock deemed to be received in a section 351 exchange), the
exchanged asset is treated as transferred from the section 987 QBU to
its owner in a disregarded transaction immediately before the exchange.
This transfer would be taken into account in determining the amount of
the remittance from the section 987 QBU under Sec. 1.987-5.
Under the 2006 proposed regulations, a section 987 QBU terminates
when its activities cease, such that it no longer meets the definition
of an eligible QBU under Sec. 1.987-1(b)(3). For administrative
convenience, Sec. 1.987-8(b)(1) reflects a new provision allowing the
owner of a section 987 QBU that ceases its trade or business to
continue to treat the section 987 QBU as a section 987 QBU for a
reasonable period during the wind-up of the trade or business, which
period may not exceed two years from the date the section 987 QBU
ceases its activities carried on for profit.

O. Transition Rules

Under the 2006 proposed regulations, a taxpayer that used a
reasonable method to comply with section 987 prior to transitioning to
the final regulations could choose between the deferral transition
method and the fresh start transition method. The deferral transition
method generally preserved section 987 gain or loss determined under
the taxpayer's prior method, whereas the fresh start method did not.
Under the deferral transition method, a taxpayer would determine
section 987 gain or loss under the taxpayer's prior method as if all
section 987 QBUs of the taxpayer terminated on the last day of the
taxable year preceding the transition date. Such section 987 gain or
loss was not recognized but rather was considered as net unrecognized
section 987 gain or loss of new section 987 QBUs for purposes of
applying section 987 to the taxable year that begins on the transition
date. The owner of a section 987 QBU that was deemed terminated under
this rule was treated as having transferred all of the assets and
liabilities attributable to such section 987 QBU to the new section 987
QBU on the transition date. Exchange rates for translating the amounts
of assets and liabilities transferred to the

[[Page 88817]]

new section 987 QBU were determined with reference to the historic spot
rates for such assets and liabilities, adjusted to take into account
gain or loss determined on the deemed termination.
Under the fresh start transition method, the same deemed
transactions would be deemed to occur as under the deferral transition
method, but no section 987 gain or loss would be determined upon the
deemed termination. Exchange rates for translating the amounts of
assets and liabilities deemed transferred to the new section 987 QBU
were determined with reference to the historic spot rates for such
assets and liabilities without adjustment. Accordingly, section 987
gain or loss determined under the owner's prior method was not taken
into account. Except to the extent of any previously recognized section
987 gain or loss, the effect of the fresh start method is as if the
assets and liabilities on the books and records of a section 987 QBU on
the transition date had been the only assets and liabilities held by
the QBU from its inception.
The Treasury Department and the IRS received several comments
recommending changes to the transition rules under Sec. 1.987-10 of
the 2006 proposed regulations. One comment recommended that the
deferral transition method be eliminated. The comment stated that the
availability of two transition methods seemed overly generous to
taxpayers and that the fresh start method was sufficient. The comment
further noted that the effect of the elections made by taxpayers would
be very one-sided in a manner detrimental to the fisc. Another comment
recommended that taxpayers be permitted to elect a ``true fresh start''
method that would translate all assets and liabilities on the first
opening balance sheet after the transition at the spot rate on the date
of transition and therefore disregard any section 987 gain or loss
attributable to the assets and liabilities of the QBU for periods prior
to the transition date.
The Treasury Department and the IRS agree with the comment that
suggested that the fresh start method is sufficient and that the
availability of an election between two different transition methods is
unnecessary and detrimental to the fisc. By requiring the translation
of assets and liabilities of transitioning QBUs at historic rates,
unlike the ``true fresh start'' method suggested by a comment, the
fresh start transition method appropriately takes into account the
applicability of section 987 prior to the issuance of final
regulations. Allowing an election to use the deferral method would
allow taxpayers with substantial overall section 987 losses determined
under their prior method, which may not correspond to economic losses,
to preserve those losses while taxpayers with substantial overall
section 987 gains determined under their prior method could avoid
taking some of those gains into account by using the fresh start
method. Such an election effectively would operate as a one-time
election for certain taxpayers to reduce Federal income tax liability.
Additionally, the Treasury Department and the IRS have determined that
there would be considerable administrative difficulty, as well as
potential for opportunistic planning, associated with determining the
appropriate translation rates for transitioning under the deferral
method from a section 987 method other than the method of the 1991
proposed regulations. Accordingly, the final regulations do not include
an election to use the deferral method. Additionally, the final
regulations do not include an election to use a ``true fresh start''
method, since that method would fail to account in any way for the
applicability of section 987 prior to the transition date with respect
to assets and liabilities held by a section 987 QBU on the transition
date.
A comment recommended that the final regulations provide further
guidance on the application of the fresh start method where a taxpayer
cannot trace historic spot exchange rates. In response to this comment,
Sec. 1.987-10(b)(3) provides that, if a taxpayer cannot reliably
determine the historic rate for a particular asset or liability, the
historic rate must be determined based on reasonable assumptions
consistently applied. In addition, the general rules of Sec. 1.987-
1(c)(3)(i)(A) and (D) ease this burden by providing that the historic
rate for assets and liabilities is the relevant yearly average exchange
rate, rather than the spot rate.
A comment recommended that taxpayers be permitted to elect
retroactively to apply the final regulations to all open years. Such an
election effectively would operate as one-time election to reduce
Federal income tax liability. Additionally, consistent with the
discussion in Part II.K of this preamble about the need for
contemporaneous recordkeeping, the Treasury Department and the IRS have
determined that retroactive application of the final regulations would
present significant administrative and compliance difficulties, given
that it would be necessary in many cases to make determinations under
the final regulations based on facts that may not be readily
ascertainable or verifiable in hindsight. Accordingly, this
recommendation has not been adopted.
A comment asserted that taxpayers that recognized section 987 gain
or loss under the principles of the 1991 proposed regulations may be
treated unfairly relative to taxpayers that did not follow those
proposed regulations. To address this perceived unfairness, the comment
recommended that taxpayers be permitted to elect to include a section
481(a) adjustment to account for the difference between the amount of
section 987 gain or loss that was taken into account under the
taxpayer's prior method and the amount that would have been determined
under the method in the final regulations. As an initial matter, it is
not evident to the Treasury Department and the IRS that any inequity
could result from a taxpayer's chosen method of applying section 987,
given that, in the absence of applicable regulations, taxpayers have
been permitted to apply section 987 using any reasonable method.
Regardless of any perceived inequity, however, as discussed earlier in
this Part II.O of the preamble, the Treasury Department and the IRS
have determined that the fresh start transition method is the
appropriate method for transitioning section 987 QBUs to the final
regulations. Under the fresh start transition method, unrecognized
section 987 gain or loss determined under a prior section 987 method is
not taken into account, and marked assets and liabilities reflected on
a section 987 QBU's balance sheet on the transition date are translated
using a historic rate. These rules, together with the requirement under
Sec. 1.987-10(d) to adjust unrecognized section 987 gain or loss to
prevent double counting, have a similar effect as allowing a section
481(a) adjustment with respect to section 987 gain or loss arising from
assets and liabilities reflected on a section 987 QBU's transition date
balance sheet. Additionally, it is unclear how a section 481(a)
adjustment could apply with respect to section 987 gain or loss arising
from assets and liabilities that are no longer on the balance sheet on
the transition date, absent a requirement to redetermine section 987
gain or loss as if the final regulations had applied from the inception
of the QBU. For the reasons described in Part II.K of this preamble,
the Treasury Department and the IRS have determined that such a
requirement would be inadministrable. Furthermore, the Treasury
Department and the IRS are concerned that an election to compute a full
section 481(a) adjustment, like an election to use the

[[Page 88818]]

deferral method, effectively would operate as a one-time election to
reduce Federal income tax liability. Accordingly, for the foregoing
reasons, this recommendation has not been adopted.
The Treasury Department and the IRS recognize that certain
taxpayers have adopted a section 987 method based on a reasonable
application of the 2006 proposed regulations (2006 method). Taxpayers
that adopted the 2006 method generally already transitioned to that
method in accordance with the principles Sec. 1.987-10 of the 2006
proposed regulations. Because the final regulations adopt the 2006
proposed regulations without fundamental changes, it is not necessary
or appropriate for taxpayers to transition from the 2006 method to the
final regulations under the fresh start method. However, Sec. 1.987-
10(c)(2) provides rules clarifying how net unrecognized section 987
gain or loss with respect to a QBU that was subject to the 2006 method
is determined under the final regulations. Additionally, because the
2006 proposed regulations required the use of a spot rate for the
historic rate and the final regulations specify as a general rule that
the historic rate is the yearly average exchange rate, Sec. 1.987-
10(c)(3) permits taxpayers to use historic rates determined under their
prior 2006 method for assets and liabilities reflected on the balance
sheet of a transitioning QBU on the transition date.

P. Elections

Several elections have been included in the final regulations to
mitigate potential complexity or administrative burden associated with
complying with these regulations. Section 1.987-1(g) provides rules for
making elections. As under the 2006 proposed regulations, elections
must be made by the owner and must be made for the first taxable year
in which the election is relevant in determining the section 987
taxable income or loss or section 987 gain or loss of the section 987
QBU. Elections may not be revoked or changed without the consent of the
Commissioner or his delegate. A revocation will be considered if the
taxpayer can demonstrate significantly changed circumstances or other
circumstances that demonstrate a substantial non-tax business reason
for revoking the election.
A comment recommended that the final regulations allow a taxpayer,
without the consent of the Commissioner, to adopt or change the
translation conventions for any section 987 QBU acquired from an
unrelated person in a transaction that does not cause the QBU to
terminate. The Treasury Department and the IRS have determined that
requiring Commissioner consent to change an election in this
circumstance promotes the ability of the IRS to administer the final
regulations and does not create an undue burden. Accordingly, this
recommendation has not been adopted.
With one exception, the elections under the final regulations are
made on a QBU-by-QBU basis. As provided under the 2006 proposed
regulations and described in Part II.H of this preamble, an owner must
make the grouping election described in Sec. 1.987-1(b)(2)(ii) with
respect to all of its section 987 QBUs that have the same functional
currency.
The 2006 proposed regulations described elections made under
section 987 as methods of accounting but provided procedures for making
and revoking such elections that were inconsistent with treating the
elections as methods of accounting. This inconsistency is resolved in
the final regulations, which do not follow the 2006 proposed
regulations in identifying all section 987 elections as methods of
accounting and clarify at Sec. 1.987-1(g)(4) that an election under
section 987 is not governed by the general rules concerning changes in
methods of accounting.
Under Sec. 1.987-1(f) of the 2006 proposed regulations, an
election was made by attaching a statement to the timely filed tax
return for the first taxable year in which the owner intends the
election to be effective. If the owner failed to make an election in a
timely manner, the owner was considered to have satisfied the
timeliness requirement if (1) the owner was able to demonstrate that
the failure was due to reasonable cause and not willful neglect; and
(2) once the owner became aware of the failure, the owner attached the
election as well as a written statement setting forth the reasons for
the failure to timely comply to an amended tax return. The Director of
Field Operations had 120 days following the filing to respond if it
determined that the failure to comply was not due to reasonable cause
or if additional time was needed to make a determination. If the
Director did not respond to the taxpayer within 120 days of filing, the
owner was deemed to have demonstrated that such failure to timely file
was due to reasonable cause.
The Treasury Department and the IRS have determined, in part based
on the experience of the IRS in administering other regulations, that
the procedures described in the 2006 proposed regulations may
inappropriately shift to the IRS a burden that arises in the first
instance as a result of a taxpayer's failure to make a timely election.
Accordingly, those procedures are not included in the final
regulations, and taxpayers who fail to make a timely election may seek
relief in accordance with the general rules described in Sec.
301.9100-1 for requesting an extension of time to make an election.

Q. Other Changes

The final regulations reflect other modifications to the language
and structure of the 2006 proposed regulations, as well as the
inclusion of additional examples, to enhance clarity. The Treasury
Department and the IRS do not intend these changes to be interpreted as
substantive changes to the 2006 proposed regulations.

Special Analyses

Certain IRS regulations, including these, are exempt from the
requirements of Executive Order 12866, as supplemented and reaffirmed
by Executive Order 13563. Therefore, a regulatory assessment is not
required. It is hereby certified that these regulations will not have a
significant economic impact on a substantial number of small entities
within the meaning of section 601(6) of the Regulatory Flexibility Act
(5 U.S.C. chapter 6). Accordingly, a regulatory flexibility analysis is
not required. This certification is based on the fact that these
regulations will primarily affect U.S. corporations that have foreign
operations, which tend to be larger businesses. Pursuant to section
7805(f) of the Internal Revenue Code, the NPRM preceding this
regulation was submitted to the Chief Counsel for Advocacy of the Small
Business Administration for comment on its impact on small business.

Drafting Information

The principal authors of these final regulations are Mark E. Erwin,
Steven D. Jensen and Sheila Ramaswamy of the Office of Associate Chief
Counsel (International). However, other personnel from the IRS and the
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Amendment to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

[[Page 88819]]


0
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:

Authority: 26 U.S.C. 987, 989(c), and 7805 * * *


0
Par. 2. Section 1.861-9T is amended by revising paragraph
(g)(2)(ii)(A)(1) and adding paragraph (g)(2)(vi) to read as follows:


Sec. 1.861-9T Allocation and apportionment of interest expense
(temporary).

* * * * *
(g) * * *
(2) * * *
(ii) * * *
(A) * * *
(1) Section 987 QBU. In the case of a section 987 QBU (as defined
in Sec. 1.987-1(b)(2)), the tax book value shall be determined by
applying the rules of paragraphs (g)(2)(i) and (g)(3) of this section
to the beginning-of-year and end-of-year functional currency amount of
assets. The beginning-of-year functional currency amount of assets
shall be determined by reference to the functional currency amount of
assets computed under Sec. 1.987-4(d)(1)(i)(B) and (e) on the last day
of the preceding taxable year. The end-of-year functional currency
amount of assets shall be determined by reference to the functional
currency amount of assets computed under Sec. 1.987-4(d)(1)(i)(A) and
(e) on the last day of the current taxable year. The beginning-of-year
and end-of-year functional currency amount of assets, as so determined
within each grouping, must then be averaged as provided in paragraph
(g)(2)(i) of this section.
* * * * *
(vi) Effective/applicability date. Generally, paragraph
(g)(2)(ii)(A)(1) of this section shall apply to taxable years beginning
on or after one year after the first day of the first taxable year
following December 7, 2016. If pursuant to Sec. 1.987-11(b) a taxpayer
applies Sec. Sec. 1.987-1 through 1.987-11 beginning in a taxable year
prior to the earliest taxable year described in Sec. 1.987-11(a), then
paragraph (g)(2)(ii)(A)(1) of this section shall apply to taxable years
beginning on or after the first day of such prior taxable year.
* * * * *

0
Par 3. Section 1.985-5 is revised to read as follows:


Sec. 1.985-5 Adjustments required upon change in functional currency.

(a) In general. This section applies in the case of a taxpayer or
qualified business unit (QBU) (including a section 987 QBU (as defined
in Sec. 1.987-1(b)(2)) changing from one functional currency (old
functional currency) to another functional currency (new functional
currency). A taxpayer or QBU subject to the rules of this section shall
make the adjustments set forth in the 3-step procedure described in
paragraphs (b) through (e) of this section. Except as otherwise
provided in this section, the adjustments shall be made on the last day
of the last taxable year ending before the year of change (as defined
in Sec. 1.481-1(a)(1)). Gain or loss required to be recognized under
paragraphs (b), (d)(2), (e)(2), and (e)(4)(iii) of this section is not
subject to section 481 and, therefore, the full amount of the gain or
loss must be included in income on the last day of the last taxable
year ending before the year of change.
(b) Step 1--Taking into account exchange gain or loss on certain
section 988 transactions. The taxpayer or QBU shall recognize or
otherwise take into account for all purposes of the Internal Revenue
Code the amount of any unrealized exchange gain or loss attributable to
a section 988 transaction (as defined in section 988(c)(1)(A) through
(C)) that, after applying section 988(d), is denominated in terms of or
determined by reference to the new functional currency. The amount of
such gain or loss shall be determined without regard to the limitations
of section 988(b) (that is, whether any gain or loss would be realized
on the transaction as a whole). The character and source of such gain
or loss shall be determined under section 988.
(c) Step 2--Determining the new functional currency basis of
property and the new functional currency amount of liabilities and any
other relevant items. Except as otherwise provided in this section, the
new functional currency adjusted basis of property and the new
functional currency amount of liabilities and any other relevant items
(for example, items described in section 988(c)(1)(B)(iii)) shall equal
the product of the old functional currency adjusted basis or liability
and the new functional currency/old functional currency spot rate on
the last day of the last taxable year ending before the year of change.
(d) Step 3A--Additional adjustments that are necessary when a QBU
changes functional currency--(1) QBU changing to a functional currency
other than the owner's functional currency--(i) Rule. If a QBU changes
its functional currency, and after the change the QBU is a section 987
QBU that is subject to Sec. Sec. 1.987-1 through 1.987-11 pursuant to
Sec. 1.987-1(b)(1), then the adjustments described in either paragraph
(d)(1)(ii) or (d)(1)(iii) of this section shall be taken into account
for purposes of section 987.
(ii) QBU and the owner had different functional currencies prior to
the change. If the QBU and the owner of the QBU had different
functional currencies prior to the change and as a result the QBU was a
section 987 QBU prior to the change, then the adjustments described in
paragraphs (d)(1)(ii)(A) and (d)(1)(ii)(B) of this section shall be
taken into account.
(A) Determining new historic rates. The historic rate (as defined
in Sec. 1.987-1(c)(3)) for the year of change and subsequent taxable
years with respect to a historic item (as defined in Sec. 1.987-1(e))
reflected on the balance sheet of the section 987 QBU immediately prior
to the year of change shall be equal to the historic rate prior to the
year of change (that is, a rate that translates the section 987 QBU's
old functional currency into the owner's functional currency) divided
by the spot rate (as defined in Sec. 1.987-1(c)(1)) for translating an
amount denominated in the section 987 QBU's old functional currency
into the section 987 QBU's new functional currency on the last day of
the last taxable year ending before the year of change. For example, if
a taxpayer with a U.S. dollar (USD) functional currency owns a section
987 QBU that changes from a British pound (GBP) functional currency to
a euro (EUR) functional currency, the historic rate for translating a
specific historic item of this section 987 QBU from GBP to USD is 1.50,
and the spot rate for translating GBP to EUR on the last day of the
last taxable year before the change is 1.30, then the new historic rate
for translating this historic item from EUR to USD is 1.15 (1.50/1.30).
(B) Determining the owner functional currency net value of the QBU
on the last day of the last taxable year ending before the year of
change under Sec. 1.987-4(d)(1)(i)(B). For purposes of determining the
owner functional currency net value of the section 987 QBU on the last
day of the last taxable year ending before the year of change under
Sec. 1.987-4(d)(1)(i)(B) and Sec. 1.987-4(e), the section 987 QBU's
marked items (as defined in Sec. 1.987-1(d)) shall be translated from
the section 987 QBU's old functional currency into the owner's
functional currency using the spot rate on the last day of the last
taxable year ending before the year of change.
(iii) QBU and the taxpayer had the same functional currency prior
to the change. If a QBU that has the same functional currency as a
taxpayer changes its functional currency to a new functional currency
that is different

[[Page 88820]]

than the functional currency of the taxpayer, and as a result the
taxpayer becomes an owner of a section 987 QBU (see Sec. 1.987-1), the
taxpayer and section 987 QBU will become subject to section 987 for the
year of change and subsequent years.
(2) QBU changing to the owner's functional currency. If a section
987 QBU changes its functional currency to the functional currency of
its owner, the section 987 QBU shall be treated as if it terminated on
the last day of the last taxable year ending before the year of change.
See Sec. Sec. 1.987-5 and 1.987-8 for the effect of a termination of a
section 987 QBU that is subject to Sec. Sec. 1.987-1 through 1.987-11.
(e) Step 3B--Additional adjustments that are necessary when a
taxpayer/owner changes functional currency--(1) Corporations. The
amount of a corporation's new functional currency earnings and profits
and the amount of its new functional currency paid-in capital shall
equal the old functional currency amounts of such items multiplied by
the spot rate for translating an amount denominated in the
corporation's old functional currency into the corporation's new
functional currency on the last day of the last taxable year ending
before the year of change. The foreign income taxes and accumulated
profits or deficits in accumulated profits of a foreign corporation
that were maintained in foreign currency for purposes of section 902
and that are attributable to taxable years of the foreign corporation
beginning before January 1, 1987, also shall be translated into the new
functional currency at the spot rate.
(2) Collateral consequences to a United States shareholder of a
corporation changing to the United States dollar as its functional
currency. A United States shareholder (within the meaning of section
951(b) or section 953(c)(1)(A)) of a controlled foreign corporation
(within the meaning of section 957 or section 953(c)(1)(B)) changing
its functional currency to the dollar shall recognize foreign currency
gain or loss computed under section 986(c) as if all previously taxed
earnings and profits, if any, (including amounts attributable to pre-
1987 taxable years that were translated from dollars into functional
currency in the foreign corporation's first post-1986 taxable year)
were distributed immediately prior to the change.
(3) Taxpayers that are not corporations. [Reserved].
(4) Adjustments to a section 987 QBU's balance sheet and net
accumulated unrecognized section 987 gain or loss when an owner changes
functional currency--(i) Owner changing to a functional currency other
than the section 987 QBU's functional currency. If an owner of a
section 987 QBU, subject to Sec. Sec. 1.987-1 through 1.987-11
pursuant to Sec. 1.987-1(b)(1), changes to a functional currency other
than the functional currency of the section 987 QBU, the adjustments
described in paragraphs (e)(4)(i)(A) through (C) of this section shall
be taken into account for purposes of section 987.
(A) Determining new historic rates. The historic rate (as defined
in Sec. 1.987-1(c)(3)) for the year of change and subsequent taxable
years with respect to a historic item (as defined in Sec. 1.987-1(e))
reflected on the balance sheet of the section 987 QBU immediately prior
to the year of change shall be equal to the historic rate prior to the
year of change (that is, a rate that translates the section 987 QBU's
functional currency into the owner's old functional currency) divided
by the spot rate for translating an amount denominated in the owner's
new functional currency into the owner's old functional currency on the
last day of the last taxable year ending before the year of change. For
example, if a taxpayer that owns a section 987 QBU with a British pound
functional currency changes from a U.S. dollar functional currency to a
euro functional currency, and the historic rate for translating a
specific item of the section 987 QBU from GBP to USD is 1.50 and the
spot rate for translating EUR to USD on the last day of the last
taxable year before the change is 1.10, then the new historic rate for
translating this historic item from GBP to EUR is 1.36 (1.50/1.10).
(B) Determining the owner functional currency net value of the
section 987 QBU on the last day of the last taxable year ending before
the year of change under Sec. 1.987-4(d)(1)(i)(B). For purposes of
determining the change in the owner functional currency net value of
the section 987 QBU on the last day of the last taxable year preceding
the year of change under Sec. Sec. 1.987-4(d)(1)(i)(B) and 1.987-4(e),
the section 987 QBU's marked items shall be translated into the owner's
new functional currency at the spot rate on the last day of the last
taxable year ending before the year of change.
(C) Translation of net accumulated unrecognized section 987 gain or
loss. Any net accumulated unrecognized section 987 gain or loss
determined under Sec. 1.987-4 shall be translated from the owner's old
functional currency into the owner's new functional currency using the
spot rate for translating an amount denominated in the owner's old
functional currency into the owner's new functional currency on the
last day of the last taxable year ending before the year of change.
(ii) Taxpayer with the same functional currency as its QBU changing
to a different functional currency. If a taxpayer with the same
functional currency as its QBU changes to a new functional currency and
as a result the taxpayer becomes an owner of a section 987 QBU (see
Sec. 1.987-1), the taxpayer and the section 987 QBU shall become
subject to section 987 for the year of change and subsequent years.
(iii) Owner changing to the same functional currency as the section
987 QBU. If an owner changes its functional currency to the functional
currency of its section 987 QBU, the section 987 QBU shall be treated
as if it terminated on the last day of the last taxable year ending
before the year of change. See Sec. Sec. 1.987-5 and 1.987-8 for the
consequences of a termination of a section 987 QBU that is subject to
Sec. Sec. 1.987-1 through 1.987-11.
(f) Example. The provisions of this section are illustrated by the
following example:

Example. (i) Facts. FC, a foreign corporation, owns all of the
stock of DC, a domestic corporation. The Commissioner granted
permission to change FC's functional currency from the British pound
to the euro beginning January 1, 2020. The EUR/GBP exchange rate on
December 31, 2019, is [euro]1:[pound]0.50.
(ii) Determining new functional currency basis of property and
liabilities. The following table shows how FC must convert the items
on its balance sheet from the British pound to the euro on December
31, 2019.

------------------------------------------------------------------------
GBP EUR
------------------------------------------------------------------------
Assets:
Cash on hand........................ [pound]40,000 [euro]80,000
Accounts Receivable................. 10,000 20,000
Inventory........................... 100,000 200,000
[euro]100,000 Euro Bond 50,000 100,000
([pound]100,000 historical basis)..
Fixed assets:

[[Page 88821]]


Property............................ 200,000 400,000
Plant............................... 500,000 1,000,000
Accumulated Depreciation........ (200,000) (400,000)
Equipment........................... 1,000,000 2,000,000
Accumulated Depreciation........ (400,000) (800,000)
-------------------------------
Total Assets................ 1,300,000 2,600,000
Liabilities:
Accounts Payable.................... 50,000 100,000
Long-term Liabilities............... 400,000 800,000
Paid-in-Capital..................... 800,000 1,600,000
Retained Earnings................... 50,000 100,000
-------------------------------
Total Liabilities and 1,300,000 2,600,000
Equity.................
------------------------------------------------------------------------

(iii) Exchange gain or loss on section 988 transactions. Under
paragraph (b) of this section, FC will recognize a [pound]50,000
loss ([pound]50,000 current value minus [pound]100,000 historical
basis) on the Euro Bond resulting from the change in functional
currency because, after the change, the Euro Bond will no longer be
an asset denominated in a non-functional currency. The amount of
FC's retained earnings on its December 31, 2019, balance sheet
reflects the [pound]50,000 loss on the Euro Bond.

(g) Effective/applicability date. Generally, this regulation shall
apply to taxable years beginning on or after one year after the first
day of the first taxable year following December 7, 2016. If pursuant
to Sec. 1.987-11(b) a taxpayer applies Sec. Sec. 1.987-1 through
1.987-11 beginning in a taxable year prior to the earliest taxable year
described in Sec. 1.987-11(a), then this section shall apply to
taxable years of the taxpayer beginning on or after the first day of
such prior taxable year.

0
Par. 4. Section 1.987-0 is added and Sec. Sec. 1.987-1 through 1.987-5
are revised to read as follows:
* * * * *
Sec.
1.987- Section 987; Table of contents.
.987-1 Scope, definitions and special rules.
1.987-2 Attribution of items to eligible QBUs; definition of a
transfer and related rules.
1.987-3 Determination of section 987 taxable income or loss of an
owner of a section 987 QBU.
1.987-4 Determination of net unrecognized section 987 gain or loss
of a section 987 QBU.
1.987-5 Recognition of section 987 gain or loss.
* * * * *


Sec. 1.987-0 Section 987; table of contents.

This section lists captioned paragraphs contained in Sec. Sec.
1.987-1 through 1.987-11.

Sec. 1.987-1 Scope, definitions and special rules.

(a) In general.
(b) Scope of section 987 and definitions.
(1) Taxpayers subject to section 987.
(2) Definition of section 987 QBU.
(3) Definition of an eligible QBU.
(4) Definition of owner.
(5) Section 987 aggregate partnership.
(6) [Reserved].
(7) Examples illustrating paragraph (b) of this section.
(c) Exchange rates.
(1) Spot rate.
(2) Yearly average exchange rate.
(3) Historic rate.
(d) Marked item.
(e) Historic item.
(f) [Reserved].
(g) Elections.
(1) In general.
(2) Exceptions to the general rules.
(3) Manner of making elections.
(4) No change in method of accounting.
(5) Revocation of an election.

Sec. 1.987-2 Attribution of items to eligible QBUs; definition of a
transfer and related rules.

(a) Scope and general principles.
(b) Attribution of items to an eligible QBU.
(1) General rules.
(2) Exceptions for non-portfolio stock, interests in
partnerships, and certain acquisition indebtedness.
(3) Adjustments to items reflected on the books and records.
(4) Assets and liabilities of a section 987 aggregate
partnership or DE that are not attributed to an eligible QBU.
(c) Transfers to and from section 987 QBUs.
(1) In general.
(2) Disregarded transactions.
(3) Transfers of assets to and from section 987 QBUs owned
through section 987 aggregate partnerships.
(4) Transfers of liabilities to and from section 987 QBUs owned
through section 987 aggregate partnerships.
(5) Acquisitions and dispositions of interests in DEs and
section 987 aggregate partnerships.
(6) Changes in form of ownership.
(7) Application of general tax law principles.
(8) Interaction with Sec. 1.988-1(a)(10).
(9) [Reserved].
(10) Examples.
(d) Translation of items transferred to a section 987 QBU.
(1) Marked items.
(2) Historic items.

Sec. 1.987-3 Determination of section 987 taxable income or loss of
an owner of a section 987 QBU.

(a) In general.
(b) Determination of each item of income, gain, deduction, or
loss in the section 987 QBU's functional currency.
(1) In general.
(2) Translation of items of income, gain, deduction, or loss
that are denominated in a nonfunctional currency.
(3) Determination in the case of a section 987 QBU owned through
a section 987 aggregate partnership.
(4) [Reserved].
(c) Translation of items of income, gain, deduction, or loss of
a section 987 QBU into the owner's functional currency.
(1) In general.
(2) Exceptions.
(3) Adjustments to COGS required under the simplified inventory
method.
(d) [Reserved].
(e) Examples.

Sec. 1.987-4 Determination of net unrecognized section 987 gain or
loss of a section 987 QBU.

(a) In general.
(b) Calculation of net unrecognized section 987 gain or loss.
(c) Net accumulated unrecognized section 987 gain or loss for
all prior taxable years.
(1) In general.
(2) [Reserved].
(d) Calculation of unrecognized section 987 gain or loss for a
taxable year.
(1) Step 1: Determine the change in the owner functional
currency net value of the section 987 QBU for the taxable year.
(2) Step 2: Increase the amount determined in step 1 by the
amount of assets transferred from the section 987 QBU to the owner.
(3) Step 3: Decrease the amount determined in steps 1 and 2 by
the amount of assets transferred from the owner to the section 987
QBU.
(4) Step 4: Decrease the amount determined in steps 1 through 3
by the amount of liabilities transferred from the section 987 QBU to
the owner.
(5) Step 5: Increase the amount determined in steps 1 through 4
by the amount of liabilities transferred from the owner to the
section 987 QBU.
(6) Step 6: Decrease or increase the amount determined in steps
1 through 5 by the

[[Page 88822]]

section 987 taxable income or loss, respectively, of the section 987
QBU for the taxable year.
(7) Step 7: Increase the amount determined in steps 1 through 6
by any expenses that are not deductible in computing the section 987
taxable income or loss of the section 987 QBU for the taxable year.
(8) Step 8: Decrease the amount determined in steps 1 through 7
by the amount of any tax-exempt income.
(e) Determination of the owner functional currency net value of
a section 987 QBU.
(1) In general.
(2) Translation of balance sheet items into the owner's
functional currency.
(f) [Reserved].
(g) Examples.

Sec. 1.987-5 Recognition of section 987 gain or loss.

(a) Recognition of section 987 gain or loss by the owner of a
section 987 QBU.
(b) Remittance proportion.
(c) Remittance.
(1) Definition.
(2) Day when a remittance is determined.
(3) Termination.
(d) Aggregate of all amounts transferred from the section 987
QBU to the owner for the taxable year.
(e) Aggregate of all amounts transferred from the owner to the
section 987 QBU for the taxable year.
(f) Determination of owner's adjusted basis in transferred
assets.
(1) In general.
(2) Marked asset.
(3) Historic asset.
(g) Example.

Sec. 1.987-6 Character and source of section 987 gain or loss.

(a) Ordinary income or loss.
(b) Character and source of section 987 gain or loss.
(1) In general.
(2) Method required to characterize and source section 987 gain
or loss.
(3) Coordination with section 954.
(c) Examples.

Sec. 1.987-7 Section 987 aggregate partnerships.

(a) In general.
(b) [Reserved].
(c) Coordination with subchapter K.

Sec. 1.987-8 Termination of a section 987 QBU.

(a) Scope.
(b) In general.
(1) Trade or business ceases.
(2) Substantially all assets transferred.
(3) Owner no longer a CFC.
(4) Owner ceases to exist.
(c) Transactions described in section 381(a).
(1) Liquidations.
(2) Reorganizations.
(d) [Reserved].
(e) Effect of terminations.
(f) Examples.

Sec. 1.987-9 Recordkeeping requirements.
(a) In general.
(b) Supplemental information.
(c) Retention of records.
(d) Information on a dedicated section 987 form.

Sec. 1.987-10 Transition rules.
(a) Scope.
(b) Fresh start transition method.
(1) In general.
(2) Application of Sec. 1.987-4.
(3) Determination of historic rate.
(4) Example.
(c) Transition of section 987 QBUs that applied the method set
forth in the 2006 proposed section 987 regulations.
(1) In general.
(2) Application of Sec. 1.987-4.
(3) Use of prior historic rate.
(4) Example.
(d) Adjustments to avoid double counting.
(e) Reporting.
(1) In general.
(2) Attachments not required where information is reported on a
form.

Sec. 1.987-11 Effective/applicability date.

(a) In general.
(b) Application of these regulations to taxable years beginning
after December 7, 2016.
(c) Transition date.


Sec. 1.987-1 Scope, definitions, and special rules.

(a) In general. These regulations under section 987 (Sec. Sec.
1.987-1 through 1.987-11) provide rules for determining the taxable
income or loss of a taxpayer with respect to a section 987 QBU (as
defined in paragraph (b)(2) of this section). Further, these
regulations provide rules for determining the timing, amount,
character, and source of section 987 gain or loss recognized with
respect to a section 987 QBU. This section addresses the scope of these
regulations and provides certain definitions, special rules, and the
procedures for making the elections provided for in the regulations.
Section 1.987-2 provides rules for attributing assets and liabilities
and items of income, gain, deduction, and loss to an eligible QBU. It
also provides rules regarding the translation of items transferred to a
section 987 QBU. Section 1.987-3 provides rules for determining and
translating the taxable income or loss of a taxpayer with respect to a
section 987 QBU. Section 1.987-4 provides rules for determining net
unrecognized section 987 gain or loss. Section 1.987-5 provides rules
regarding the recognition of section 987 gain or loss. It also provides
rules for determining an owner's basis in assets transferred from a
section 987 QBU. Section 1.987-6 provides rules regarding the character
and source of section 987 gain or loss. Section 1.987-7 provides rules
with respect to section 987 aggregate partnerships. Section 1.987-8
provides rules regarding the termination of a section 987 QBU. Section
1.987-9 provides rules regarding the recordkeeping required under
section 987. Section 1.987-10 provides transition rules. Section 1.987-
11 provides the effective/applicability date of these regulations.
(b) Scope of section 987 and definitions--(1) Taxpayers subject to
section 987--(i) In general. Except as provided in paragraphs
(b)(1)(ii) and (b)(6) of this section, an individual or corporation is
subject to these regulations under section 987 if such person is an
owner (as defined in paragraph (b)(4) of this section) of an eligible
QBU (as defined in paragraph (b)(3) of this section) that is a section
987 QBU (as defined in paragraph (b)(2) of this section).
(ii) Inapplicability to certain entities. Except as otherwise
provided in paragraph (b)(1)(iii) of this section, these regulations
under section 987 do not apply to specified entities described in this
paragraph (b)(1)(ii), other than specified entities that engage in
transactions primarily with related persons within the meaning of
section 267(b) or section 707(b) that are not themselves specified
entities. For this purpose, specified entities means banks, insurance
companies, leasing companies, finance coordination centers, regulated
investment companies, or real estate investment trusts. Further, except
as otherwise provided in paragraph (b)(1)(iii) of this section, these
regulations do not apply to trusts, estates, S corporations, and
partnerships other than section 987 aggregate partnerships (as defined
in paragraph (b)(5) of this section).
(iii) [Reserved].
(2) Definition of a section 987 QBU--(i) In general. A section 987
QBU is an eligible QBU (as defined in paragraph (b)(3) of this section)
that has a functional currency different from its direct owner. A
section 987 QBU also includes the assets and liabilities of an eligible
QBU that are considered under paragraph (b)(5)(ii) of this section to
be a section 987 QBU of a partner in a section 987 aggregate
partnership (as defined in paragraph (b)(5) of this section). A section
987 QBU will continue to be treated as a section 987 QBU of the owner
until a sale or other termination of the section 987 QBU as described
in Sec. 1.987-8(b). Except as provided in paragraph (b)(2)(ii) of this
section, the functional currency of an eligible QBU shall be determined
under Sec. 1.985-1.
(ii) Section 987 QBU grouping election--(A) In general. Except as
provided in paragraph (b)(2)(ii)(B) of this section, an owner may elect
to treat, solely for purposes of section 987, all section 987 QBUs with
the same functional currency that it directly owns as a single section
987 QBU.

[[Page 88823]]

(B) Special grouping rules for section 987 QBUs owned indirectly
through a section 987 aggregate partnership. An owner may elect to
treat all section 987 QBUs with the same functional currency owned
indirectly through a single section 987 aggregate partnership (as
defined in paragraph (b)(5) of this section) as a single section 987
QBU. An owner may not treat section 987 QBUs as a single section 987
QBU if such QBUs are owned indirectly through different section 987
aggregate partnerships. Additionally, an owner may not treat section
987 QBUs that are owned both directly and indirectly through a section
987 aggregate partnership as a single section 987 QBU.
(3) Definition of an eligible QBU--(i) In general. Eligible QBU
means a qualified business unit, as defined in Sec. 1.989(a)-1, that
is not subject to the Dollar Approximate Separate Transactions Method
rules of Sec. 1.985-3.
(ii) Exclusion of certain entities. A corporation, partnership,
trust, estate, or entity disregarded as an entity separate from its
owner for Federal income tax purposes as described in Sec. 301.7701-
2(c)(2) (hereafter referred to as a ``DE'') is not an eligible QBU
(even though such an entity may have activities that qualify as an
eligible QBU).
(4) Definition of owner. For purposes of these regulations under
section 987, an owner is any person having direct or indirect ownership
in an eligible QBU. Only an individual or corporation may be an owner
of an eligible QBU. The term owner for section 987 purposes does not
include an eligible QBU. For example, a section 987 QBU (QBU1) is not
an owner of another section 987 QBU (QBU2) even if QBU1 owns the stock
of QBU2.
(i) Direct ownership. An individual or a corporation is a direct
owner of an eligible QBU if the individual or corporation is the owner
for Federal income tax purposes of the assets and liabilities of the
eligible QBU.
(ii) Indirect ownership. An individual or corporation that is a
partner in a section 987 aggregate partnership (as defined in paragraph
(b)(5) of this section) and is allocated, under Sec. 1.987-7, all or a
portion of the assets and liabilities of an eligible QBU of such
partnership is an indirect owner of the eligible QBU.
(5) Section 987 aggregate partnership--(i) In general. A
partnership is a section 987 aggregate partnership if:
(A) All of the interests in partnership capital and profits are
owned, directly or indirectly, by persons related to each other within
the meaning of sections 267(b) or 707(b). For purposes of this
paragraph (b)(5), ownership of an interest in partnership capital or
profits is determined in accordance with the rules for constructive
ownership provided in section 267(c), other than section 267(c)(3); and
(B) The partnership has one or more eligible QBUs, at least one of
which would be a section 987 QBU with respect to a partner if the
partner owned the eligible QBU directly.
(ii) Section 987 QBU of a partner. The assets and liabilities of an
eligible QBU owned through a section 987 aggregate partnership and
allocated to a partner under the principles of Sec. 1.987-7(b) are
considered to be a section 987 QBU of such partner if the partner has a
functional currency different from that of the eligible QBU.
(iii) Certain unrelated partners disregarded. In determining
whether a partnership is a section 987 aggregate partnership, the
interest of an unrelated partner shall be disregarded if the
acquisition of such interest has as a principal purpose the avoidance
of this paragraph (b)(5).
(6) [Reserved].
(7) Examples illustrating paragraph (b) of this section. The
following examples illustrate the principles of paragraph (b) of this
section. U.S. Corp is a domestic corporation, has the U.S. dollar as
its functional currency, and uses the calendar year as its taxable
year. Except as otherwise provided, (i) Business A and Business B are
eligible QBUs and have the euro and the Japanese yen, respectively, as
their functional currencies and (ii) DE1 and DE2 are DEs, have no
assets or liabilities, and conduct no activities.

Example 1. (i) Facts. U.S. Corp owns Business A and all of the
interests in DE1. DE1 maintains a separate set of books and records
that are kept in British pounds. DE1 owns pounds and all of the
stock of a foreign corporation, FC. DE1 is liable to a lender on a
pound-denominated obligation that was incurred to acquire the stock
of FC. The FC stock, the pounds, and the liability incurred to
acquire the FC stock are recorded on DE1's separate books and
records. DE1 has no other assets or liabilities and conducts no
activities (other than holding the FC stock and servicing its
liability).
(ii) Analysis. (A) Pursuant to paragraph (b)(4)(i) of this
section, U.S. Corp is the direct owner of Business A because it is
the owner of the assets and liabilities of Business A. Because
Business A is an eligible QBU with a functional currency that is
different from the functional currency of its owner, U.S. Corp,
Business A is a section 987 QBU (as defined in paragraph (b)(2) of
this section). As a result, U.S. Corp and its section 987 QBU,
Business A, are subject to section 987.
(B) Holding the stock of FC and pounds and servicing a liability
does not constitute a trade or business within the meaning of Sec.
1.989(a)-1(c). Because the activities of DE1 do not constitute a
trade or business within the meaning of Sec. 1.989(a)-1(c), such
activities are not an eligible QBU. In addition, pursuant to
paragraph (b)(3)(ii) of this section, DE1 itself is not an eligible
QBU. As a result, neither DE1 nor its activities qualify as a
section 987 QBU of U.S. Corp. Therefore, neither the activities of
DE1 nor DE1 itself is subject to section 987. For the foreign
currency treatment of payments on DE1's pound-denominated liability,
see Sec. 1.988-2(b).
Example 2. (i) Facts. U.S. Corp owns all of the interests in
DE1. DE1 owns Business A and all of the interests in DE2. The only
activities of DE1 are Business A activities and holding the
interests in DE2. DE2 owns Business B and Business C. For purposes
of this example, Business B does not maintain books and records that
are separate from its owner, DE2. Instead, the activities of
Business B are reflected on the books and records of DE2, which are
maintained in Japanese yen. In addition, Business C has the U.S.
dollar as its functional currency, maintains books and records that
are separate from the books and records of DE2, and is an eligible
QBU.
(ii) Analysis. (A) Pursuant to paragraph (b)(3)(ii) of this
section, DE1 and DE2 are not eligible QBUs. Pursuant to paragraph
(b)(3)(i) of this section, the Business B and Business C activities
of DE2, and the Business A activities of DE1, are eligible QBUs.
Moreover, pursuant to paragraph (b)(4) of this section, DE1 is not
the owner of the Business A, Business B, or Business C eligible
QBUs, and DE2 is not the owner of the Business B or Business C
eligible QBUs. Instead, pursuant to paragraph (b)(4)(i) of this
section, U.S. Corp is the direct owner of the Business A, Business
B, and Business C eligible QBUs.
(B) Because Business A and Business B are eligible QBUs with
functional currencies that are different than the functional
currency of U.S. Corp, Business A and Business B are section 987
QBUs (as defined in paragraph (b)(2) of this section).
(C) The Business C eligible QBU has the same functional currency
as U.S. Corp. Therefore, the Business C eligible QBU is not a
section 987 QBU.
Example 3. (i) Facts. U.S. Corp owns all of the interests in
DE1. DE1 owns Business A and Business B. For purposes of this
example, assume Business B has the euro as its functional currency.
(ii) Analysis. (A) Pursuant to paragraph (b)(3)(ii) of this
section, DE1 is not an eligible QBU. Moreover, pursuant to paragraph
(b)(4) of this section, DE1 is not the owner of the Business A or
Business B eligible QBUs. Instead, pursuant to paragraph (b)(4)(i)
of this section, U.S. Corp is the direct owner of the Business A and
Business B eligible QBUs.
(B) Business A and Business B constitute two separate eligible
QBUs, each with the euro as its functional currency. Accordingly,
Business A and Business B are section 987 QBUs of U.S. Corp. U.S.
Corp may elect to treat Business A and Business B as a single
section 987 QBU pursuant to paragraph (b)(2)(ii)(A) of this section.
If such election is made, pursuant to paragraph (b)(4)(i) of this
section, U.S. Corp would be the direct owner

[[Page 88824]]

of the Business AB section 987 QBU that would include the activities
of both the Business A section 987 QBU and the Business B section
987 QBU. In addition, pursuant to paragraph (b)(4) of this section,
DE1 would not be treated as the owner of the Business AB section 987
QBU.
Example 4. (i) Facts. U.S. Corp owns all the stock of Y, a U.S.
corporation that is a member of U.S. Corp's consolidated group. U.S.
Corp also owns all the stock of CFC, a controlled foreign
corporation (as defined in section 957(a)) of U.S. Corp with the
Japanese yen as its functional currency. Y and CFC are the only
partners in P, a foreign partnership. P owns DE1 and Business A. DE1
owns Business B.
(ii) Analysis. (A) Under paragraph (b)(5)(i) of this section, P
is a section 987 aggregate partnership because Y and CFC own all the
interests in partnership capital and profits, Y and CFC are related
within the meaning of section 267(b), and the requirements of Sec.
1.987-1(b)(5)(i)(B) are satisfied. Pursuant to paragraph (b)(3)(ii)
of this section, P and DE1 are not eligible QBUs. Moreover, pursuant
to paragraph (b)(4) of this section, for purposes of section 987,
neither P nor DE1 is the owner of the Business B eligible QBU, and P
is not the owner of the Business A eligible QBU. Instead, pursuant
to paragraph (b)(4)(ii) of this section, Y and CFC are indirect
owners of the Business A eligible QBU and the Business B eligible
QBU to the extent they are allocated the assets and liabilities of
such businesses under Sec. 1.987-7.
(B) Because Business A and Business B are eligible QBUs with
different functional currencies than Y, the portions of Business A
and Business B allocated to Y under Sec. 1.987-7 are section 987
QBUs of Y.
(C) Because the Business A eligible QBU has a different
functional currency than CFC, the portion of Business A that is
allocated to CFC under Sec. 1.987-7 is a section 987 QBU, and CFC
and its section 987 QBU are subject to section 987. Because the
Business B eligible QBU has the same functional currency as CFC, the
portion of Business B that is allocated to CFC under Sec. 1.987-7
is not a section 987 QBU of CFC.
Example 5. (i) Facts. U.S. Corp owns all of the interests in
DE1. DE1 owns Business A and all of the interests in DE2. DE2 owns
Business B and all of the interests in DE3, an entity disregarded as
an entity separate from its owner. DE3 owns Business C, which is an
eligible QBU with the Russian ruble as its functional currency.
(ii) Analysis. Pursuant to paragraph (b)(3)(ii) of this section,
DE1, DE2, and DE3 are not eligible QBUs, and the Business A,
Business B, and Business C activities are eligible QBUs. Pursuant to
paragraph (b)(4) of this section, an eligible QBU is not an owner of
another eligible QBU. Accordingly, the Business A eligible QBU is
not the owner of the Business B eligible QBU, and the Business B
eligible QBU is not the owner of the Business C eligible QBU.
Instead, pursuant to paragraph (b)(4) of this section, U.S. Corp is
the direct owner of the Business A, Business B, and Business C
eligible QBUs. Because each of the Business A, Business B, and
Business C eligible QBUs has a different functional currency than
U.S. Corp, such eligible QBUs are section 987 QBUs of U.S. Corp.

(c) Exchange rates. Solely for purposes of section 987, the
following definitions shall apply.
(1) Spot rate--(i) In general. Except as otherwise provided in this
section, the spot rate means the rate determined under the principles
of Sec. 1.988-1(d)(1), (2), and (4) on the relevant date.
(ii) Election to use a spot rate convention--(A) In general--spot
rate convention. An owner may elect to use a spot rate convention that
reasonably approximates the spot rate determined in paragraph (c)(1)(i)
of this section in lieu of such spot rate. A spot rate convention may
be determined with respect to a spot rate at the beginning of a
reasonable period, the end of a reasonable period, as an average of
spot rates for a reasonable period, or by reference to spot and forward
rates for a reasonable period. For this purpose, a reasonable period
shall not exceed three months. For example, in lieu of the spot rate
determined in paragraph (c)(1)(i) of this section, the spot rate for
all transactions during a monthly period can be determined pursuant to
one of the following conventions: The spot rate at the beginning of the
current month or at the end of the preceding month; the monthly average
of daily spot rates for the current or preceding month; or an average
of the beginning and ending spot rates for the current or preceding
month. Similarly, in lieu of the spot rate determined in paragraph
(c)(1)(i) of this section, the spot rate can be determined pursuant to
an average of the spot rate and the 30-day forward rate on a day of the
preceding month. Use of a spot rate convention that is consistent with
the convention used for financial accounting purposes is presumed to
reasonably approximate the rate in paragraph (c)(1)(i) of this section.
The Commissioner can rebut this presumption if the Commissioner
determines that the use of the convention would not clearly reflect
income based on the facts and circumstances available at the time of
the election.
(B) [Reserved].
(iii) Election to use spot rates in lieu of yearly average exchange
rates. A taxpayer may elect under this paragraph (c)(1)(iii) to use
spot rates in lieu of yearly average exchange rates (as defined in
paragraph (c)(2) of this section) for certain purposes. In particular,
a taxpayer that makes this election must use the spot rate for purposes
of determining the historic rate, as provided in paragraph (c)(3)(ii)
of this section, and for purposes of translating items of income, gain,
deduction, or loss of a section 987 QBU into the owner's functional
currency, as described in Sec. 1.987-3(c)(1). Additionally, a taxpayer
that makes this election will be deemed also to elect to use the
historic inventory method described in Sec. 1.987-3(c)(2)(iv)(B).
(2) Yearly average exchange rate. For purposes of section 987, the
yearly average exchange rate is a rate that represents an average
exchange rate for the taxable year (or, if the relevant period is less
than a full taxable year, such portion of the taxable year) computed
under any reasonable method. For example, an owner may determine the
yearly average exchange rate based on a daily, monthly or quarterly
averaging convention, whether weighted or unweighted, and may take into
account forward rates for a period not to exceed three months. Use of
an averaging convention that is consistent with the convention used for
financial accounting purposes is presumed to be a reasonable method.
The Commissioner can rebut this presumption if the Commissioner
determines that the use of the convention would not have been expected
to clearly reflect income based on the facts and circumstances
available at the time of the election.
(3) Historic rate--(i) In general. Except as otherwise provided in
these regulations, the historic rate is determined as described in
paragraphs (c)(3)(i)(A) through (E) of this section.
(A) Assets generally. In the case of an asset other than inventory
that is acquired by a section 987 QBU (including through a transfer),
the historic rate is the yearly average exchange rate applicable to the
year of acquisition.
(B) Inventory under the simplified inventory method. In the case of
inventory with respect to which a taxpayer uses the simplified
inventory method described in Sec. 1.987-3(c)(2)(iv)(A), the historic
rate for inventory accounted for under the last-in, first-out (LIFO)
method of accounting is the yearly average exchange rate applicable to
the year in which the inventory's LIFO layer arose. The historic rate
for all other inventory of such a taxpayer is the yearly average
exchange rate for the taxable year for which the determination of the
historic rate for such inventory is relevant.
(C) Inventory under the historic inventory method. In the case of
inventory with respect to which a taxpayer has elected under Sec.
1.987- 3(c)(2)(iv)(B) to use the historic inventory method, each
inventoriable cost with respect to such inventory may have a different
historic rate. The

[[Page 88825]]

historic rate for each inventoriable cost is the exchange rate at which
such item would be translated under Sec. 1.987-3 if it were not an
inventoriable cost.
(D) Liabilities generally. In the case of a liability that is
incurred or assumed by a section 987 QBU, the historic rate is the
yearly average exchange rate applicable to the year the liability is
incurred or assumed.
(E) [Reserved].
(ii) Historic rate when an election to use spot rates in lieu of
yearly average exchange rates is in effect. A taxpayer that has elected
under paragraph (c)(1)(iii) of this section to use spot rates in lieu
of yearly average exchange rates must determine historic rates under
paragraphs (c)(3)(i)(A) and (c)(3)(i)(D) of this section using the spot
rate (as defined in paragraph (c)(1) of this section) for the date an
asset is acquired by a section 987 QBU or a liability is assumed or
incurred by a section 987 QBU in lieu of using the yearly average
exchange rate.
(iii) Date placed in service for depreciable or amortizable
property. In the case of depreciable or amortizable property, an owner
may determine the historic rate (whether a yearly average exchange rate
or a spot rate, as applicable) by reference to the date such property
is placed in service by the section 987 QBU rather than the date the
property was acquired, provided that this convention is consistently
applied for all such property attributable to that section 987 QBU.
(iv) Changed functional currency. In the case of a section 987 QBU
or an owner of a section 987 QBU that previously changed its functional
currency, Sec. 1.985-5(d)(1)(ii)(A) and Sec. 1.985-5(e)(4)(i)(A),
respectively, shall be taken into account in determining the historic
rate for an item reflected on the balance sheet of the section 987 QBU
immediately prior to the year of change.
(d) Marked item. A marked item is an asset (marked asset) or
liability (marked liability) that is properly reflected on the books
and records of a section 987 QBU under Sec. 1.987-2(b) and that--
(1) Is denominated in, or determined by reference to, the
functional currency of the section 987 QBU, is not a section 988
transaction of the section 987 QBU, and would be a section 988
transaction if such item were held or entered into directly by the
owner of the section 987 QBU;
(2) Is a prepaid expense or a liability for an advance payment of
unearned income, in either case having an original term of one year or
less on the date the prepaid expense or liability for an advance
payment of unearned income arises; or
(3) [Reserved].
(e) Historic item. A historic item is an asset (historic asset) or
liability (historic liability) that is properly reflected on the books
and records of a section 987 QBU under Sec. 1.987-2(b) and that is not
a marked item (as defined in paragraph (d) of this section).
(f) [Reserved].
(g) Elections--(1) In general. This paragraph (g) provides rules
for making elections under section 987. Except as otherwise provided in
paragraph (g)(2) of this section, such elections--
(i) May be made separately for each section 987 QBU;
(ii) Are made by the owner of the section 987 QBU (as defined in
paragraph (b)(4) of this section); and
(iii) Must be made for the first taxable year in which the election
is relevant in determining the section 987 taxable income or loss, or
section 987 gain or loss, of the section 987 QBU and in which the
regulations implementing the election are applicable with respect to
the section 987 QBU.
(2) Exceptions to the general rules--(i) Consistency and timeliness
requirements for certain elections. Notwithstanding paragraph (g)(1)(i)
of this section, the following consistency and timeliness requirements
apply:
(A) Section 987 grouping election. Elections made pursuant to
paragraph (b)(2)(ii) of this section (regarding the grouping of section
987 QBUs) are binding on all section 987 QBUs that are eligible to be
grouped under the particular election (for example, election to group
all euro QBUs owned by the same aggregate partnership), regardless of
whether the section 987 QBU is established or acquired after the
election is made and regardless of whether the section 987 QBU is
identified on the election as required in paragraph (g)(3)(i)(A) of
this section.
(B) [Reserved].
(ii) Persons making elections for QBUs owned by foreign
corporations. Notwithstanding paragraph (g)(1)(ii) of this section, if
a section 987 QBU is owned by a foreign corporation, elections shall be
made in accordance with Sec. 1.964-1(c) by the foreign corporation's
controlling domestic shareholders, as defined under Sec. 1.964-
1(c)(5)(i) (dealing with controlled foreign corporations) and Sec.
1.964-1(c)(5)(ii) (dealing with noncontrolled section 902
corporations).
(3) Manner of making elections--(i) Election made by attaching
statement to a return. Except as provided in paragraph (g)(3)(ii) of
this section, elections shall be made under section 987 for each
section 987 QBU by attaching a statement with the information required
in this paragraph (g)(3)(i) to the timely filed tax return of the owner
or, in the case of a foreign corporation, other applicable person for
the first taxable year in which the election is required to be made
under paragraph (g)(1)(iii) of this section.
(A) Section 987 grouping election. The election provided in
paragraph (b)(2)(ii) of this section must be titled ``Section 987
Grouping Election Under Sec. 1.987-1(b)(2)(ii)'' and provide the
following information:
(1) The name, address, and functional currency of each section 987
QBU that the taxpayer is grouping together; and
(2) The owner's name and address.
(B) Election to use a spot rate convention. An election under
paragraph (c)(1)(ii) of this section to use a spot rate convention must
be titled ``Section 987 Election to Use a Spot Rate Convention Under
Sec. 1.987-1(c)(1)(ii)'' and provide the following information:
(1) A description of the convention; and
(2) The name and address of each section 987 QBU for which the
election is being made.
(C) Election to use spot rates in lieu of yearly average exchange
rates. An election under paragraph (c)(1)(iii) of this section to use
spot rates in lieu of yearly average exchange rates must be titled
``Section 987 Election to Use Spot Rates in Lieu of Yearly Average
Exchange Rates Under Sec. 1.987-1(c)(1)(iii)'' and provide the
following information:
(1) A description of the convention; and
(2) The name and address of each section 987 QBU for which the
election is being made.
(D) Election to use the historic inventory method. An election
under Sec. 1.987-3(c)(2)(iv)(B) to use the historic inventory method
shall be titled ``Section 987 Election to Use the Historic Inventory
Method Under Sec. 1.987-3(c)(2)(iv)(B)'' and must provide the name and
address of each section 987 QBU for which the election is being made.
(ii) Election made by filing a dedicated section 987 form. If the
Commissioner publishes a form that provides the manner in which
elections are made under section 987, the form shall govern the manner
in which elections are made under section 987.
(4) No change in method of accounting. An election under section
987 is not governed by the general rules concerning changes in methods
of accounting. See also paragraph (g)(5) of this section.
(5) Revocation of an election. Elections under section 987 may not
be

[[Page 88826]]

revoked without the consent of the Commissioner or his delegate. The
Commissioner or his delegate will consider allowing a revocation of an
election if the taxpayer can demonstrate significantly changed
circumstances or such other circumstances that clearly demonstrate a
substantial non-tax business reason for revoking the election.


Sec. 1.987-2 Attribution of items to eligible QBUs; definition of a
transfer and related rules.

(a) Scope and general principles. Paragraph (b) of this section
provides rules for attributing assets and liabilities, and items of
income, gain, deduction, and loss, to an eligible QBU. Assets and
liabilities are attributed to a section 987 QBU for purposes of section
987. Items of income, gain, deduction, and loss are attributed to a
section 987 QBU for purposes of computing the section 987 taxable
income of the section 987 QBU and of its owner. Paragraph (c) of this
section defines a transfer to or from a section 987 QBU. Paragraph (d)
of this section provides translation rules for transfers to a section
987 QBU.
(b) Attribution of items to an eligible QBU--(1) General rules.
Except as provided in paragraphs (b)(2) and (3) of this section, items
are attributable to an eligible QBU to the extent they are reflected on
the separate set of books and records, as defined in Sec. 1.989(a)-
1(d), of the eligible QBU. In the case of a section 987 aggregate
partnership, items reflected on the books and records of the
partnership and deemed allocated to an eligible QBU of such partnership
are considered to be reflected on the books and records of such
eligible QBU. For purposes of this section, the term ``item'' refers to
any asset or liability, and any item of income, gain, deduction, or
loss. Items that are attributed to an eligible QBU pursuant to this
section must be adjusted to conform to Federal income tax principles.
Except as provided in Sec. 1.989(a)-1(d)(3), these attribution rules
apply solely for purposes of section 987. For example, the allocation
and apportionment of interest expense under section 864(e) is
independent of the rules under section 987.
(2) Exceptions for non-portfolio stock, interests in partnerships,
and certain acquisition indebtedness. The following items shall not be
considered to be on the books and records of an eligible QBU:
(i) Stock of a corporation (whether domestic or foreign), other
than stock of a corporation reflected on the books and records (within
the meaning of paragraph (b)(1) of this section) of an eligible QBU if
the owner of the eligible QBU owns less than 10 percent of the total
value of all classes of stock of such corporation. For this purpose,
section 318(a) applies in determining ownership, except that in
applying section 318(a)(2)(C), the phrase ``10 percent'' is used
instead of the phrase ``50 percent.''
(ii) An interest in a partnership (whether domestic or foreign).
(iii) A liability that was incurred to acquire stock described in
paragraph (b)(2)(i) of this section or that was incurred to acquire a
partnership interest described in paragraph (b)(2)(ii) of this section.
(iv) Income, gain, deduction, or loss arising from the items
described in paragraphs (b)(2)(i) through (iii) of this section. For
example, a section 951 inclusion with respect to stock of a foreign
corporation described in paragraph (b)(2)(i) of this section shall not
be considered to be on the books and records of an eligible QBU.
(3) Adjustments to items reflected on the books and records--(i)
General rule. If a principal purpose of recording (or failing to
record) an item on the books and records of an eligible QBU is the
avoidance of Federal income tax under, or through the use of, section
987, the item must be allocated between or among the eligible QBU, the
owner of such eligible QBU, and any other persons, entities (including
DEs), or other QBUs within the meaning of Sec. 1.989(a)-1(b)
(including eligible QBUs) in a manner that reflects the substance of
the transaction. For purposes of this paragraph (b)(3)(i), relevant
factors for determining whether such Federal income tax avoidance is a
principal purpose of recording (or failing to record) an item on the
books and records of an eligible QBU shall include, but are not limited
to, the factors set forth in paragraphs (b)(3)(ii) and (iii) of this
section. The presence or absence of any factor or factors is not
determinative. Moreover, the weight given to any factor (whether or not
set forth in paragraphs (b)(3)(ii) and (iii) of this section) depends
on the particular case.
(ii) Factors indicating no tax avoidance. For purposes of paragraph
(b)(3)(i) of this section, factors that may indicate that recording (or
failing to record) an item on the books and records of an eligible QBU
did not have as a principal purpose the avoidance of Federal income tax
under, or through the use of, section 987 include the recording (or not
recording) of an item:
(A) For a significant and bona fide business purpose;
(B) In a manner that is consistent with the economics of the
underlying transaction;
(C) In accordance with generally accepted accounting principles (or
similar comprehensive accounting standard);
(D) In a manner that is consistent with the treatment of similar
items from year to year;
(E) In accordance with accepted conditions or practices in the
particular trade or business of the eligible QBU;
(F) In a manner that is consistent with an explanation of existing
internal accounting policies that is evidenced by documentation
contemporaneous with the timely filing of a Federal income tax return
for the taxable year; and
(G) As a result of a transaction between legal entities (for
example, the transfer of an asset or the assumption of a liability),
even if such transaction is not regarded for Federal income tax
purposes (for example, a transaction between a DE and its owner).
(iii) Factors indicating tax avoidance. For purposes of paragraph
(b)(3)(i) of this section, factors that may indicate that a principal
purpose of recording (or failing to record) an item on the books and
records of an eligible QBU is the avoidance of Federal income tax
under, or through the use of, section 987 include:
(A) The presence or absence of an item on the books and records
that is the result of one or more transactions that are transitory, for
example, due to a circular flow of cash or other property;
(B) The presence or absence of an item on the books and records
that is the result of one or more transactions that do not have
substance;
(C) The presence or absence of an item on the books and records
that results in the taxpayer (or a person related to the taxpayer
within the meaning of section 267(b) or section 707(b)) having
offsetting positions with respect to the functional currency of a
section 987 QBU; and
(D) The absence of any or all of the factors listed in paragraph
(b)(3)(ii) of this section.
(4) Assets and liabilities of a section 987 aggregate partnership
or DE that are not attributed to an eligible QBU. Neither a section 987
aggregate partnership nor a DE is an eligible QBU and, thus, neither
entity can be a section 987 QBU. See Sec. 1.987-1(b)(2) and (3). As a
result, a section 987 aggregate partnership or DE may own assets and
liabilities that are not attributed to an eligible QBU as provided
under this paragraph (b) and, therefore, are not subject to section
987. For the foreign

[[Page 88827]]

currency treatment of such assets or liabilities, see Sec. 1.988-
1(a)(4).
(c) Transfers to and from section 987 QBUs--(1) In general. The
following rules apply for purposes of determining whether there is a
transfer of an asset or a liability from an owner to a section 987 QBU,
or from a section 987 QBU to an owner. These rules apply solely for
purposes of section 987.
(2) Disregarded transactions--(i) General rule. An asset or
liability shall be treated as transferred to a section 987 QBU from its
owner (whether direct owner or indirect owner, as defined in Sec.
1.987-1(b)(4)) if, as a result of a disregarded transaction (as defined
in paragraph (c)(2)(ii) of this section), such asset or liability is
reflected on the books and records of the section 987 QBU within the
meaning of paragraph (b) of this section. Similarly, an asset or
liability shall be treated as transferred from a section 987 QBU to its
owner if, as a result of a disregarded transaction, such asset or
liability is no longer reflected on the books and records of the
section 987 QBU within the meaning of paragraph (b) of this section.
(ii) Definition of a disregarded transaction. For purposes of this
section, a disregarded transaction means a transaction that is not
regarded for Federal income tax purposes (for example, any transaction
between separate section 987 QBUs of the same owner). For purposes of
this paragraph (c), a disregarded transaction shall be treated as
including the recording of an asset or liability on the books and
records of an eligible QBU (as defined in Sec. 1.987-1(b)(3)) of an
owner, if the recording is the result of such asset or liability being
removed from the books and records of a separate eligible QBU of the
same owner, whether such separate eligible QBU is owned directly or is
owned indirectly through the same entity (including through a DE or a
section 987 aggregate partnership). Additionally, if an asset or
liability that is attributable to a section 987 QBU within the meaning
of paragraph (b) of this section is sold or exchanged (including in a
nonrecognition transaction, such as an exchange under section 351) for
an asset or liability that is not attributable to the section 987 QBU
immediately after the sale or exchange, the sold or exchanged asset or
liability that was attributable to the section 987 QBU immediately
before the transaction shall be treated as transferred from the section
987 QBU to its direct or indirect owner in a disregarded transaction
immediately before the sale or exchange for purposes of section 987
(including for purposes of recognizing section 987 gain or loss under
Sec. 1.987-5) and subsequently sold or exchanged by the owner. The
preceding sentence shall not apply with respect to an acquisition or
disposition of an interest in a section 987 aggregate partnership or in
a DE, as described in paragraph (c)(5) of this section.
(iii) Items derived from disregarded transactions ignored. For
purposes of section 987, disregarded transactions shall not give rise
to items of income, gain, deduction, or loss that are taken into
account in determining section 987 taxable income or loss under Sec.
1.987-3.
(3) Transfers of assets to and from section 987 QBUs owned through
section 987 aggregate partnerships--(i) Contributions to section 987
aggregate partnerships. Solely for purposes of section 987, an asset
shall be treated as transferred by an indirect owner (as defined in
Sec. 1.987-1(b)(4)(ii)) to a section 987 QBU of a partner (as defined
in Sec. 1.987-1(b)(5)(ii)) to the extent the indirect owner
contributes the asset to the section 987 aggregate partnership that
carries on the activities of the section 987 QBU, provided that,
immediately prior to the contribution, the asset is not reflected on
the books and records of the section 987 QBU within the meaning of
paragraph (b) of this section and the asset is reflected on the books
and records of the section 987 QBU immediately following such
contribution. For purposes of this paragraph (c)(3)(i), deemed
contributions of money described under section 752 shall be
disregarded. See paragraph (c)(4)(ii) of this section for rules
governing the assumption by a partner of liabilities of a section 987
aggregate partnership.
(ii) Distributions from section 987 aggregate partnerships. Solely
for purposes of section 987, an asset shall be treated as transferred
from a section 987 QBU of a partner to its indirect owner to the extent
the section 987 aggregate partnership that carries on the activities of
the section 987 QBU distributes the asset to the indirect owner,
provided that, immediately prior to such distribution, the asset is
reflected on the books and records of the section 987 QBU within the
meaning of paragraph (b) of this section, and the asset is not
reflected on the books and records of the section 987 QBU immediately
after such distribution. For purposes of this paragraph (c)(3)(ii),
deemed distributions of money described under section 752 shall be
disregarded. See paragraph (c)(4)(i) of this section for rules
governing the assumption by a section 987 aggregate partnership of
liabilities of a partner.
(4) Transfers of liabilities to and from section 987 QBUs owned
through section 987 aggregate partnerships--(i) Assumptions of partner
liabilities. Solely for purposes of section 987, a liability of the
owner of a section 987 aggregate partnership shall be treated as
transferred to a section 987 QBU of a partner if, and to the extent,
the section 987 aggregate partnership assumes such liability, provided
that, immediately prior to the transfer, the liability is not reflected
on the books and records of the section 987 QBU within the meaning of
paragraph (b) of this section, and the liability is reflected on the
books and records of the section 987 QBU immediately following the
transfer.
(ii) Assumptions of section 987 aggregate partnership liabilities.
Solely for purposes of section 987, a liability of a section 987
aggregate partnership shall be treated as transferred from a section
987 QBU of a partner to its indirect owner if, and to the extent, the
indirect owner assumes such liability of the section 987 aggregate
partnership, provided that, immediately prior to such assumption, the
liability is reflected on the books and records of the section 987 QBU
within the meaning of paragraph (b) of this section, and the liability
is not reflected on the books and records of the section 987 QBU
immediately following the transfer.
(5) Acquisitions and dispositions of interests in DEs and section
987 aggregate partnerships. Solely for purposes of section 987, an
asset or liability shall be treated as transferred to a section 987 QBU
from its owner if, as a result of an acquisition (including by
contribution) or disposition of an interest in a section 987 aggregate
partnership or DE, such asset or liability is reflected on the books
and records of the section 987 QBU. Similarly, an asset or liability
shall be treated as transferred from a section 987 QBU to its owner if,
as a result of an acquisition or disposition of an interest in a
section 987 aggregate partnership or DE, the asset or liability is not
reflected on the books and records of the section 987 QBU.
(6) Changes in form of ownership. For purposes of this paragraph
(c), mere changes in the form of ownership of an eligible QBU shall not
result in a transfer to or from a section 987 QBU. Instead, the
determination of whether a transfer has occurred in such case shall be
made under paragraph (c)(5) of this section. For example, a transaction
that causes a direct owner of an eligible QBU to become an indirect
owner of the eligible QBU shall not, except to the extent provided in
paragraph (c)(5) of this section, result in a transfer to or from a
section 987 QBU. See, for example, Rev. Rul. 99-5 (1999-1 CB

[[Page 88828]]

434), Rev. Rul. 99-6 (1999-1 CB 432), Sec. 601.601(d)(2) of this
chapter, and section 708 and the applicable regulations.
(7) Application of general tax law principles. General tax law
principles, including the circular cash flow, step-transaction,
economic substance, and substance-over-form doctrines, apply for
purposes of determining whether there is a transfer of an asset or
liability under this paragraph (c), including a transfer of an asset or
liability pursuant to a disregarded transaction (as defined in
paragraph (c)(2)(ii) of this section).
(8) Interaction with Sec. 1.988-1(a)(10). See Sec. 1.988-1(a)(10)
for rules regarding the treatment of an intra-taxpayer transfer of a
section 988 transaction.
(9) [Reserved].
(10) Examples. The following examples illustrate the principles of
this paragraph (c). For purposes of the examples, X and Y are domestic
corporations, have the U.S. dollar as their functional currency, and
use the calendar year as their taxable years. Furthermore, except as
otherwise provided, Business A and Business B are eligible QBUs that
have the euro and the Japanese yen, respectively, as their functional
currencies, and DE1 and DE2 are DEs. For purposes of determining
whether any of the transfers in these examples result in remittances,
see Sec. 1.987-5.

Example 1. Transfer to a directly owned section 987 QBU. (i)
Facts. X owns all of the interests in DE1. DE1 owns Business A,
which is a section 987 QBU of X. X owns [euro]100 that are not
reflected on the books and records of Business A. Business A is in
need of additional capital and, as a result, X lends the [euro]100
to DE1 for use in Business A in exchange for a note.
(ii) Analysis. (A) The loan from X to DE1 is not regarded for
Federal income tax purposes (because it is an interbranch
transaction) and therefore is a disregarded transaction (as defined
in paragraph (c)(2)(ii) of this section). As a result, the DE1 note
held by X and the liability of DE1 under the note are not taken into
account under this section.
(B) As a result of the disregarded transaction, the [euro]100 is
reflected on the books and records of Business A. Therefore, X is
treated as transferring [euro]100 to its Business A section 987 QBU
for purposes of section 987. This transfer is taken into account in
determining the amount of any remittance for the taxable year under
Sec. 1.987-5(c). See Sec. 1.988-1(a)(10)(ii) for the application
of section 988 to X as a result of the transfer of non-functional
currency to its section 987 QBU.
Example 2. Transfer to a directly owned section 987 QBU. (i)
Facts. X owns Business A and Business B, both of which are section
987 QBUs of X. X owns equipment that is used in Business A and is
reflected on the books and records of Business A. Because Business A
has excess manufacturing capacity and X intends to expand the
manufacturing capacity of Business B, the equipment formerly used in
Business A is transferred to Business B for use by Business B. As a
result of the transfer, the equipment is removed from the books and
records of Business A and is recorded on the books and records of
Business B.
(ii) Analysis. The transfer of the equipment from the books and
records of Business A to the books and records of Business B is not
regarded for Federal income tax purposes (because it is an
interbranch transaction), and therefore it is a disregarded
transaction for purposes of this paragraph (c). Therefore, for
purposes of section 987, the Business A section 987 QBU is treated
as transferring the equipment to X, and X is subsequently treated as
transferring the equipment to the Business B section 987 QBU. These
transfers are taken into account in determining the amount of any
remittance for the taxable year under Sec. 1.987-5(c).
Example 3. Intracompany sale of property between two section 987
QBUs. (i) Facts. X owns all of the interests in DE1 and DE2. DE1 and
DE2 own Business A and Business B, respectively, both of which are
section 987 QBUs of X. DE1 owns equipment that is used in Business A
and is reflected on the books and records of Business A. For
business reasons, DE1 sells a portion of the equipment used in
Business A to DE2 in exchange for a fair market value amount of
Japanese yen. The yen used by DE2 to acquire the equipment was
generated by Business B and was reflected on Business B's books and
records. Following the sale, the yen and the equipment will be used
in Business A and Business B, respectively. As a result of such
sale, the equipment is removed from the books and records of
Business A and is recorded on the books and records of Business B.
Similarly, as a result of the sale, the yen is removed from the
books and records of Business B and is recorded on the books and
records of Business A.
(ii) Analysis. (A) The sale of equipment between DE1 and DE2 is
a transaction that is not regarded for Federal income tax purposes
(because it is an interbranch transaction). Therefore the
transaction is a disregarded transaction for purposes of paragraph
(c) of this section. As a result, the sale is not taken into account
under this section and, pursuant to paragraph (c)(2)(iii) of this
section, the sale does not give rise to an item of income, gain,
deduction, or loss for purposes of determining section 987 taxable
income or loss under Sec. 1.987-3. However, the yen and equipment
exchanged by DE1 and DE2 in connection with the sale must be taken
into account as a disregarded transaction under this paragraph (c).
(B) As a result of the disregarded transaction, the equipment
ceases to be reflected on the books and records of Business A and
becomes reflected on the books and records of Business B. Therefore,
the Business A section 987 QBU is treated as transferring the
equipment to X, and X is subsequently treated as transferring such
equipment to the Business B section 987 QBU.
(C) Additionally, as a result of the disregarded transaction,
the yen currency ceases to be reflected on the books and records of
Business B and becomes reflected on the books and records of
Business A. Therefore, the Business B section 987 QBU is treated as
transferring the yen to X, and X is subsequently treated as
transferring such yen from X to the Business A section 987 QBU. The
transfers among Business A, Business B and X are taken into account
in determining the amount of any remittance for the taxable year
under Sec. 1.987-5(c).
Example 4. Sale of property by a section 987 QBU to a
corporation that is a member of the consolidated group. (i) Facts. X
owns all of the stock of Y and all of the interests in DE1. DE1 owns
Business A. X and Y file a consolidated return. Business A sells
property to Y for [euro]100.
(ii) Analysis. The sale of property by Business A to Y is not
considered a transfer of property to X (and a corresponding transfer
from X to Y) under paragraph (c) of this section because the
transaction is regarded for Federal income tax purposes. Rather, for
purposes of section 987, the transaction is considered to occur
between Business A and Y.
Example 5. Transactions of a section 987 QBU owned through an
aggregate partnership. (i) Facts. (A) X owns all of the stock of Y
and a 50 percent interest in the capital and profits of P, a
partnership. Y owns the other 50 percent interest in P. P owns 100
percent of the interests in DE1 and DE2. DE1 owns Business A and DE2
owns Business B.
(B) In connection with Business A, DE1 licenses intangible
property to both DE2 and X. X enters into the license agreement in a
transaction other than in its capacity as a partner of P and,
therefore, the license is considered as occurring between P and one
who is not a partner within the meaning of section 707(a). X uses
the intangible property in its own trade or business in the U.S. DE2
uses the intangible property in Business B. Pursuant to the license
agreement, X and DE2 pay a [euro]30 and a [euro]50 royalty,
respectively, to DE1.
(ii) Analysis. (A) Under Sec. 1.987-1(b)(5)(i), P is a section
987 aggregate partnership because X and Y own all the interests in
partnership capital and profits, X and Y are related within the
meaning of section 267(b), and the requirements of Sec. 1.987-
1(b)(5)(i)(B) are satisfied. X and Y each have a 50 percent
allocable share of the assets and liabilities of Business A and
Business B, as determined under Sec. 1.987-7. Under Sec. 1.987-
1(b)(5)(ii), the assets and liabilities of Business A allocated to X
are a section 987 QBU of X, and the assets and liabilities of
Business A allocated to Y are a section 987 QBU of Y. Likewise, the
assets and liabilities of Business B allocated to X are a section
987 QBU of X, and the assets and liabilities of Business B allocated
to Y are a section 987 QBU of Y.
(B) The license from DE1 to DE2 is not regarded for Federal
income tax purposes (because it is an interbranch agreement) and, as
a result, royalty payments under the license are disregarded
transactions. Thus, pursuant to paragraph (c)(2)(iii) of this
section, DE1's receipt of the royalty pursuant to the license
agreement does not give rise to

[[Page 88829]]

an item of income, gain, deduction, or loss for purposes of
determining section 987 taxable income or loss under Sec. 1.987-3.
However, the [euro]50 that is paid from DE2 to DE1 pursuant to the
license agreement must be taken into account under paragraph (c) of
this section. Accordingly, [euro]50 ceases to be reflected on the
books and records of Business B and becomes reflected on the books
and records of Business A. As a result, a 50 percent allocable share
of the [euro]50 royalty payment ([euro]25) is treated as transferred
from each of the Business B section 987 QBUs of X and Y, to X and Y,
respectively. And subsequently, X and Y are treated as transferring
their respective receipts of [euro]25 to their respective Business A
section 987 QBUs. These transfers are taken into account in
determining the amount of any remittance to either of X or Y for the
taxable year under Sec. 1.987-5(c).
(C) The [euro]30 royalty payment from X to DE1 is regarded for
Federal income tax purposes (because it is a payment from a
partnership to a separate entity). Accordingly, the royalty payment
is not a disregarded transaction for purposes of this paragraph (c)
and is therefore not treated as a transfer of an asset from an owner
to a section 987 QBU. As a result, the payment is not taken into
account in determining the amount of any remittance for the taxable
year under Sec. 1.987-5(c). Instead, the payment gives rise to an
item of income and deduction that must be taken into account in
computing section 987 taxable income or loss of Business A pursuant
to Sec. 1.987-3.
Example 6. Acquisition of an interest in a partnership. (i)
Facts. (A) X owns all of the stock of Z, a domestic corporation with
the dollar as its functional currency. X also owns all of the stock
of Y and a 50 percent interest in the capital and profits of P, a
partnership. Y owns the other 50 percent interest in P. P owns
Business A, and P owns no other assets or liabilities other than
those of Business A.
(B) Z contributes cash to P in exchange for a 20 percent
interest in the capital and profits of P. The cash Z contributes to
P is used in Business A and is reflected on Business A's books and
records.
(ii) Analysis. (A) Under Sec. 1.987-1(b)(5)(i), P is a section
987 aggregate partnership because X and Y own all the interests in
partnership capital and profits, X and Y are related within the
meaning of section 267(b), and the requirements of Sec. 1.987-
1(b)(5)(i)(B) are satisfied. Prior to the contribution to P by Z, X
and Y each have a 50 percent allocable share of the assets and
liabilities of Business A, as determined under Sec. 1.987-7. Under
Sec. 1.987-1(b)(5)(ii), the assets and liabilities of Business A
allocated to X are a section 987 QBU of X, and the assets and
liabilities of Business A allocated to Y are a section 987 QBU of Y.
(B) Following Z's acquisition of a 20 percent interest in P, P
remains a section 987 aggregate partnership because X, Y and Z own
all the interests in partnership capital and profits; X, Y, and Z
are related within the meaning of section 267(b); and the
requirements of Sec. 1.987-1(b)(5)(i)(B) are satisfied. Z acquires
a 20 percent allocable share of the assets and liabilities of
Business A, as determined under Sec. 1.987-7. Under Sec. 1.987-
1(b)(5)(ii), the assets and liabilities of Business A allocated to Z
are a section 987 QBU of Z (because Z becomes an indirect owner of
Business A and Z and Business A have different functional
currencies).
(C) As a result of Z's contribution of cash to Business A,
through its contribution to P, each of X, Y, and Z are allocated a
share of that Business A asset. Accordingly, under Sec. 1.987-
2(c)(5), Z is treated as contributing its allocable share of the
cash to its Business A section 987 QBU. In addition, Z is treated as
transferring X's and Y's respective allocable shares of the cash to
X and Y, and X and Y are subsequently treated as transferring that
cash to their respective Business A section 987 QBUs.
(D) In addition, as a result of Z's acquisition of its interest
in P and Z's consequent acquisition of a Business A section 987 QBU,
Z's allocable portion of the assets and liabilities of Business A
(other than the cash) cease being reflected on the books and records
of the respective Business A section 987 QBUs of each of X and Y.
Those allocable portions of assets and liabilities from the Business
A section 987 QBUs of X and Y are treated as if they are transferred
from such section 987 QBUs to their respective owners, X and Y.
These assets and liabilities are consequently recorded on the books
and records of Z's Business A section 987 QBU. Accordingly, X and Y
are treated as transferring those assets and liabilities to Z, and Z
is treated as contributing those assets and liabilities to its new
Business A section 987 QBU.
Example 7. Acquisition of an interest in a partnership. (i)
Facts. The facts are the same as in Example 6, except that the cash
that Z contributes to P in exchange for a 20 percent interest in P
is not used in Business A and is not reflected on Business A's books
and records. Instead, the cash is reflected on P's books and
records.
(ii) Analysis. (A) Following Z's acquisition of a 20 percent
interest in P, P remains a section 987 aggregate partnership because
X, Y and Z own all the interests in partnership capital and profits;
X, Y, and Z are related within the meaning of section 267(b); and
the requirements of Sec. 1.987-1(b)(5)(i)(B) are satisfied. Z
acquires a 20 percent allocable share of the assets and liabilities
of Business A, as determined under Sec. 1.987-7. Under Sec. 1.987-
1(b)(5)(ii), the assets and liabilities of Business A allocated to Z
are a section 987 QBU of Z (because Z becomes an indirect owner of
Business A and Z and Business A have different functional
currencies).
(B) As a result of Z's acquisition of its interest in P and Z's
consequent acquisition of a Business A section 987 QBU, Z's
allocable portion of the assets and liabilities of Business A cease
being reflected on the books and records of the respective Business
A section 987 QBUs of each of X and Y. Those allocable portions of
assets and liabilities from the Business A section 987 QBUs of X and
Y are treated as if they are transferred from such section 987 QBUs
to their respective owners, X and Y. These assets and liabilities
are consequently recorded on the books and records of Z's Business A
section 987 QBU. Accordingly, X and Y are treated as transferring
those assets and liabilities to Z, and Z is treated as contributing
those assets and liabilities to its new Business A section 987 QBU.
Example 8. Conversion of a DE to a partnership through a sale of
an interest. (i) Facts. X owns all of the stock of Y and all of the
interests in DE1. DE1 owns Business A. Y acquires 50 percent of the
DE1 interests from X for cash.
(ii) Analysis. (A) DE1 is converted to a partnership when Y
purchases the 50 percent interest in DE1. For Federal income tax
purposes, Y's purchase of 50 percent of X's interest in DE1 is
treated as the direct purchase of 50 percent of the assets of
Business A because DE1 is disregarded and Business A is treated as
held directly by X. Immediately after the sale of 50 percent of
Business A to Y, X and Y are treated as contributing their
respective interests in the assets of Business A to a partnership.
See Rev. Rul. 99-5 (1999-1 CB 434) (situation 1) and Sec.
601.601(d)(2) of this chapter.
(B) For purposes of this paragraph (c), these deemed
transactions are disregarded transactions. Under Sec. 1.987-
1(b)(5)(i), the newly formed partnership is a section 987 aggregate
partnership because X and Y own all the interests in partnership
capital and profits, X and Y are related within the meaning of
section 267(b), and the requirements of Sec. 1.987-1(b)(5)(i)(B)
are satisfied. Because Y is a partner in a section 987 aggregate
partnership that owns Business A and because Y and Business A have
different functional currencies, Y's portion of the Business A
assets and liabilities constitutes a section 987 QBU of Y.
(C) As a result of the conversion of DE1 to a partnership, Y
acquires an allocable share of 50 percent of the assets and
liabilities of Business A, as determined under Sec. 1.987-7.
Accordingly, 50 percent of the assets and liabilities of Business A
cease being reflected on the books and records of X's section 987
QBU. Under Sec. 1.987-2(b)(5), these amounts are treated as if they
are transferred from X's section 987 QBU to X, and X is treated as
transferring these assets and liabilities to Y. Accordingly, the
assets and liabilities of Business A allocated to Y are treated as
transferred by Y to Y's newly formed Business A section 987 QBU.
Example 9. Conversion of a DE to a partnership through a
contribution. (i) Facts. X owns all of the stock of Y and all of the
interests in DE1. DE1 owns Business A. Y contributes property (that
is not then attributed to a section 987 QBU of Y) to DE1 in exchange
for an interest in DE1. The property transferred by Y to DE1 is used
in Business A and is reflected on the books and records of Business
A.
(ii) Analysis. (A) DE1 is converted to a partnership when Y
contributes property to DE1 in exchange for a 50 percent interest in
DE1. For Federal income tax purposes, Y's contribution is treated as
a contribution to a partnership in exchange for an ownership
interest in the partnership. X is treated as contributing all of
Business A to the partnership in exchange for a partnership
interest. See Rev. Rul. 99-5 (situation 2), (1999-1 CB 434) and
Sec. 601.601(d)(2) of this chapter.
(B) For purposes of this paragraph (c), these deemed
transactions are disregarded

[[Page 88830]]

transactions. Under Sec. 1.987-1(b)(5)(i), the newly formed
partnership is a section 987 aggregate partnership because X and Y
own all the interests in partnership capital and profits, X and Y
are related within the meaning of section 267(b), and the
requirements of Sec. 1.987-1(b)(5)(i)(B) are satisfied. Because Y
is a partner in a section 987 aggregate partnership that owns
Business A and because Y and Business A have different functional
currencies, Y's portion of the Business A assets and liabilities
constitutes a section 987 QBU of Y.
(C) As a result of the conversion of DE1 to a partnership, Y
acquires an allocable share of 50 percent of the assets and
liabilities of Business A, as determined under Sec. 1.987-7.
Accordingly, under Sec. 1.987-2(c)(5), Y is treated as contributing
its allocable share of its contributed property to its Business A
section 987 QBU. In addition, Y is treated as transferring X's
allocable share of the contributed property to X, and X is
subsequently treated as transferring that property to its Business A
section 987 QBUs. In addition, Y's allocable share of the original
(pre-conversion) assets and liabilities of Business A cease being
reflected on the books and records of X's section 987 QBU. Under
Sec. 1.987-2(b)(5), these amounts are treated as if they are
transferred from X's section 987 QBU to X, and X is treated as
transferring these assets and liabilities to Y. Y is subsequently
treated as transferring these assets and liabilities to Y's Business
A section 987 QBU.
Example 10. Contribution of assets to a corporation. (i) Facts.
X owns Business A. X forms Z, a domestic corporation, contributing
50 percent of its Business A assets and liabilities to Z in exchange
for all of the stock of Z. X and Z do not file a consolidated tax
return.
(ii) Analysis. Pursuant to paragraph (b)(2) of this section, the
Z stock received in exchange for 50 percent of Business A's assets
and liabilities is not reflected on the books and records of, and
therefore is not attributable to, Business A for purposes of section
987 immediately after the exchange. As a result, pursuant to
paragraph (c)(2)(i) and (ii) of this section, 50 percent of the
assets and liabilities of Business A are treated as transferred from
Business A to X in a disregarded transaction immediately before the
exchange. The result would be the same even if X and Z filed a
consolidated return.
Example 11. Circular transfers. (i) Facts. X owns Business A. On
December 30, 2021, Business A purports to transfer [euro]100 to X.
On January 2, 2022, X purports to transfer [euro]50 to Business A.
On January 4, 2022, X purports to transfer another [euro]50 to
Business A. As of the end of 2021, X has an unrecognized section 987
loss with respect to Business A, such that a remittance, if
respected, would result in recognition of a foreign currency loss
under section 987.
(ii) Analysis. Because the transfer by Business A to X is offset
by the transfers from X to Business A that occurred in close
temporal proximity, the Internal Revenue Service (IRS) may disregard
the purported transfers to and from Business A for purposes of
section 987 pursuant to general tax principles under paragraph
(c)(7) of this section.
Example 12. Transfers without substance. (i) Facts. X owns
Business A and Business B. On January 1, 2021, Business A purports
to transfer [euro]100 to X. On January 4, 2021, X purports to
transfer [euro]100 to Business B. The account in which Business B
deposited the [euro]100 is used to pay the operating expenses and
other costs of Business A. As of the end of 2021, X has an
unrecognized section 987 loss with respect to Business A, such that
a remittance, if respected, would result in recognition of a foreign
currency loss under section 987.
(ii) Analysis. Because Business A continues to have use of the
transferred property, the IRS may disregard the [euro]100 purported
transfer from Business A to X for purposes of section 987 pursuant
to general tax principles under paragraph (c)(7) of this section.
Example 13. Offsetting positions in section 987 QBUs. (i) Facts.
X owns Business A and Business B. Each of Business A and Business B
has the euro as its functional currency. X has not made a grouping
election under Sec. 1.987-1(b)(2)(ii). On January 1, 2021, X
borrows [euro]1,000 from a third party lender, records the liability
with respect to the borrowing on the books and records of Business
A, and records the borrowed [euro]1,000 on the books and records of
Business B. On December 31, 2022, when Business A has $100 of net
unrecognized section 987 loss and Business B has $100 of net
unrecognized section 987 gain resulting from the change in exchange
rates with respect to the liability and the [euro]1,000, X
terminates the Business A section 987 QBU.
(ii) Analysis. Because Business A and Business B have offsetting
positions in the euro, the IRS will scrutinize the transaction under
paragraph (b)(3) of this section to determine if a principal purpose
of recording the euro-denominated liability on the books and records
of Business A and the borrowed euros on the books and records of
Business B was the avoidance of tax under section 987. If such a
principal purpose is present, the IRS may reallocate the items (that
is, the euros and the euro-denominated liability) between Business
A, Business B, and X, under paragraph (c)(7) of this section to
reflect the substance of the transaction.
Example 14. Offsetting positions with respect to a section 987
QBU and a section 988 transaction. (i) Facts. X owns all of the
interests in DE1, and DE1 owns Business A. On January 1, 2021, X
borrows [euro]1,000 from a third party lender and records the
liability with respect to the borrowing on its books and records. X
contributes the [euro]1,000 loan proceeds to DE1 and the [euro]1,000
are reflected on the books and records of Business A. On December
31, 2022, when Business A has $100 of net unrecognized section 987
loss resulting from the change in exchange rates with respect to the
[euro]1,000 received from the borrowing, and when the euro-
denominated borrowing, if repaid, would result in $100 of gain under
section 988, X terminates the Business A section 987 QBU.
(ii) Analysis. Because X and Business A have offsetting
positions in the euro, the IRS will scrutinize the transaction under
paragraph (b)(3) of this section to determine whether a principal
purpose of recording the borrowed euros on the books and records of
Business A, or not recording the corresponding euro-denominated
liability on the books and records of Business A, was the avoidance
of tax under section 987. If such a principal purpose is present,
the Commissioner may reallocate the items (that is, the euros and
the euro-denominated liability) between Business A and X under
paragraph (c)(7) of this section to reflect the substance of the
transaction.
Example 15. Offsetting positions with respect to a section 987
QBU and a section 988 transaction. (i) Facts. X owns all of the
stock of Y and all of the interests in DE1. DE1 owns Business A. X
and Y file a consolidated return. On January 1, 2021, DE1 lends
[euro]1,000 to Y. X records the receivable with respect to the loan
on Business A's books and records. On December 31, 2022, when
Business A has $100 of net unrecognized section 987 gain resulting
from the loan, Y repays the [euro]1,000 liability. The repayment of
the euro-denominated borrowing results in $100 of loss to Y under
section 988. X claims a $100 loss on its consolidated return under
section 988. Business A does not make any remittances to X in 2022,
so the offsetting gain with respect to the loan receivable has not
been recognized by X.
(ii) Analysis. Y, a related party to X, and Business A have
offsetting positions in the euro. The IRS will scrutinize the
transaction under paragraph (b)(3) of this section to determine
whether a principal purpose of recording the euro-denominated
receivable on the books and records of Business A, rather than on
the books and records of X, was to avoid tax through the use of
section 987. If such a principal purpose is present, the IRS may
reallocate the euro-denominated receivable between Business A and X
under paragraph (c)(7) of this section to reflect the substance of
the transaction. Other provisions may also apply to defer or
disallow the loss.
Example 16. Loan by section 987 QBU followed by immediate
distribution to owner. (i) Facts. X owns all of the interests in
DE1. DE1 owns Business A. On January 1, 2021, Business A borrows
[euro]1,000 from a bank. On January 2, 2021, Business A distributes
the [euro]1,000 it received from the bank to X. There are no other
transfers between X and Business A during the year. At the end of
the year, X has net unrecognized section 987 loss with respect to
Business A such that a remittance would result in the recognition of
foreign currency loss under section 987.
(ii) Analysis. Because the proceeds from the loan to Business A
are immediately transferred to X and the distribution from Business
A to X could result in the recognition of section 987 loss, the IRS
may scrutinize the recording of the loan on the books of Business A
and move the loan onto the books of X, resulting in the transfer not
being taken into account for purposes of section 987 under paragraph
(b)(3) of this section.
Example 17. Payment of interest by section 987 QBU on obligation
of owner. (i) Facts. X owns all of the interests in DE1. DE1 owns
business A. On January 1, X borrows [euro]1,000 from a bank. On July
1, Business A pays [euro]20 in interest on X's [euro]1,000
obligation to the bank.

[[Page 88831]]

(ii) Analysis. Under general tax law principles as provided in
paragraph (c)(7) of this section, on July 1, 2021, Business A is
treated for purposes of section 987 as making a transfer of [euro]20
to X, and X is treated as making a [euro]20 interest payment to the
bank.

(d) Translation of items transferred to a section 987 QBU--(1)
Marked items. The adjusted basis of a marked asset, or the amount of a
marked liability, transferred to a section 987 QBU shall be translated
into the section 987 QBU's functional currency at the spot rate (as
defined in Sec. 1.987-1(c)(1)) applicable to the date of transfer. If
the asset or liability transferred is denominated in (or determined by
reference to) the functional currency of the section 987 QBU (for
example, cash or a note denominated in the functional currency of the
section 987 QBU), no translation is required. See Sec. 1.988-
1(a)(10)(ii) for special rules regarding intra-taxpayer transfers.
(2) Historic items. The adjusted basis of a historic asset, or the
amount of a historic liability, transferred to a section 987 QBU shall
be translated into the section 987 QBU's functional currency at the
rate provided in Sec. 1.987-1(c)(3).


Sec. 1.987-3 Determination of section 987 taxable income or loss of
an owner of a section 987 QBU.

(a) In general. This section provides rules for determining the
taxable income or loss, or the earnings and profits, of an owner of a
section 987 QBU (hereafter, section 987 taxable income or loss).
Paragraph (b) of this section provides rules for determining items of
income, gain, deduction, and loss, which generally must be determined
in the section 987 QBU's functional currency. Paragraph (c) of this
section provides rules for translating each item determined under
paragraph (b) of this section into the functional currency of the owner
of the section 987 QBU, if necessary. Paragraph (e) of this section
provides examples illustrating the application of the rules of this
section.
(b) Determination of each item of income, gain, deduction, or loss
in the section 987 QBU's functional currency--(1) In general. Except as
otherwise provided in this section, a section 987 QBU shall determine
each item of income, gain, deduction, or loss of such section 987 QBU
in its functional currency under Federal income tax principles.
(2) Translation of items of income, gain, deduction, or loss that
are denominated in a nonfunctional currency--(i) In general. Except as
otherwise provided in paragraphs (b)(2)(ii) and (b)(4) of this section,
an item of income, gain, deduction, or loss that is denominated in (or
determined by reference to) a nonfunctional currency (including the
functional currency of the owner) shall be translated into the section
987 QBU's functional currency at the spot rate (as defined in Sec.
1.987-1(c)(1)) on the date such item is properly taken into account,
subject to the limitation under Sec. 1.987-1(c)(1)(ii)(B) regarding
the use of a spot rate convention. Examples 1, 2 and 6 of paragraph (e)
of this section illustrate the application of this paragraph (b)(2)(i).
(ii) [Reserved].
(3) Determination in the case of a section 987 QBU owned through a
section 987 aggregate partnership--(i) In general. Except as otherwise
provided in this paragraph (b)(3), the taxable income or loss of a
section 987 aggregate partnership, and the distributive share of any
owner that is a partner in such partnership, shall be determined in
accordance with the provisions of subchapter K of the Internal Revenue
Code.
(ii) Determination of each item of income, gain, deduction, or loss
in the eligible QBU's functional currency. A section 987 aggregate
partnership generally shall determine each item of income, gain,
deduction, or loss reflected on the books and records of each of its
eligible QBUs under Sec. 1.987-2(b) in the functional currency of each
such QBU.
(iii) Allocation of items of income, gain, deduction, or loss of an
eligible QBU. A section 987 aggregate partnership shall allocate the
items of income, gain, deduction, or loss of each eligible QBU among
its partners in accordance with each partner's distributive share of
such income, gain, deduction, or loss as determined under subchapter K
of the Internal Revenue Code.
(iv) Translation of items into the owner's functional currency. To
the extent the items referred to in paragraph (b)(3)(iii) of this
section are allocated to a partner, the partner shall adjust the items
to conform to Federal income tax principles and translate the items
into the partner's functional currency as provided in paragraph (c) of
this section.
(4) [Reserved].
(c) Translation of items of income, gain, deduction, or loss of a
section 987 QBU into the owner's functional currency--(1) In general.
Except as otherwise provided in this section, the exchange rate to be
used by an owner in translating an item of income, gain, deduction, or
loss attributable to a section 987 QBU into the owner's functional
currency, if necessary, shall be the yearly average exchange rate (as
defined in Sec. 1.987-1(c)(2)) for the taxable year. However, an owner
of a section 987 QBU that has elected under Sec. 1.987-1(c)(1)(iii) to
use spot rates in lieu of yearly average exchange rates must use the
spot rate (as defined in Sec. 1.987-1(c)(1)) for the date each item is
properly taken into account.
(2) Exceptions--(i) Recovery of basis with respect to historic
assets. Except as otherwise provided in this section, the exchange rate
to be used by the owner in translating any recovery of basis (whether
through a sale or exchange; deemed sale or exchange; cost recovery
deduction such as depreciation, depletion or amortization; or
otherwise) with respect to a historic asset (as defined in Sec. 1.987-
1(e)) shall be the historic rate as determined under Sec. 1.987-
1(c)(3) for the property to which such recovery of basis is
attributable.
(ii) [Reserved].
(iii) Gain or loss on the sale, exchange or other disposition of an
interest in a section 987 aggregate partnership. [Reserved].
(iv) Cost of goods sold computation--(A) General rule--simplified
inventory method. Cost of goods sold (COGS) for a taxable year shall be
translated into the functional currency of the owner at the yearly
average exchange rate (as defined in Sec. 1.987-1(c)(2)) for the
taxable year and adjusted as provided in paragraph (c)(3) of this
section.
(B) Election to use the historic inventory method. In lieu of using
the simplified inventory method described in paragraph (c)(2)(iv)(A) of
this section, the owner of a section 987 QBU may elect under this
paragraph (c)(2)(iv)(B) to translate inventoriable costs (including
current-year inventoriable costs and costs that were capitalized into
inventory in prior years) that are included in COGS at the historic
rate as determined under Sec. 1.987-1(c)(3) for each such cost. As
described in Sec. 1.987-1(c)(1)(iii), a taxpayer that elects to use
spot rates in lieu of yearly average exchange rates as provided in that
section will be deemed to have made the election described in this
paragraph (c)(2)(iv)(B).
(3) Adjustments to COGS required under the simplified inventory
method--(i) In general. An owner of a section 987 QBU that uses the
simplified inventory method described in paragraph (c)(2)(iv)(A) of
this section must make the adjustment described in paragraph (c)(3)(ii)
of this section. In addition, the owner must make the adjustment
described in paragraph (c)(3)(iii) of this section with respect to any
inventory for which the section 987 QBU does not use the LIFO inventory

[[Page 88832]]

method (as described in section 472) and must make the adjustment
described in paragraph (c)(3)(iv) of this section with respect to any
inventory for which the section 987 QBU uses the LIFO inventory method.
An owner of a section 987 QBU that uses the simplified inventory method
must make all of the applicable adjustments described in paragraphs
(c)(3)(ii) through (iv) with respect to the section 987 QBU even in
taxable years in which the amount of COGS is zero.
(ii) Adjustment for cost recovery deductions included in
inventoriable costs. The translated COGS amount computed under
paragraph (c)(2)(iv)(A) of this section must be increased or decreased
(as appropriate) to reflect the difference between the historic rates
appropriate for translating cost recovery deductions attributable to
other historic assets and the exchange rate used to translate COGS
under paragraph (c)(2)(iv)(A) of this section, to the extent any such
cost recovery deductions are included in inventoriable costs for the
taxable year. The adjustment shall be included as an adjustment to
translated COGS computed under paragraph (c)(2)(iv)(A) of this section
in full in the year to which the adjustment relates and shall not be
allocated between COGS and ending inventory. The adjustment for each
cost recovery deduction shall be computed as the product of:
(A) The cost recovery deduction, expressed in the functional
currency of the section 987 QBU; and
(B) The exchange rate specified in paragraph (c)(2)(i) of this
section for translating the cost recovery deduction (that is, the
historic rate for the property to which such deduction is attributable)
less the exchange rate used to translate COGS under the simplified
inventory method described in paragraph (c)(2)(iv)(A) of this section
(that is, the yearly average exchange rate for the taxable year).
(iii) Adjustment to beginning inventory for non-LIFO inventory. In
the case of inventory with respect to which a section 987 QBU does not
use the LIFO inventory method (non-LIFO inventory), the translated COGS
amount computed under paragraph (c)(2)(iv)(A) of this section must be
increased or decreased (as appropriate) by the product of:
(A) The ending non-LIFO inventory included on the closing balance
sheet for the preceding year, expressed in the functional currency of
the section 987 QBU; and
(B) The exchange rate described in Sec. Sec. 1.987-4(e)(2)(ii) and
1.987-1(c)(3)(i)(C) that is used for translating ending inventory on
the closing balance sheet for the preceding year (that is, the yearly
average exchange rate for the preceding year) less the exchange rate
used to translate COGS under paragraph (c)(2)(iv)(A) of this section
(that is, the yearly average exchange rate for the taxable year).
(iv) Adjustment for year of LIFO liquidation. In the case of
inventory with respect to which a section 987 QBU uses the LIFO
inventory method, for each LIFO layer liquidated in whole or in part
during the taxable year, the translated COGS amount computed under
paragraph (c)(2)(iv)(A) of this section must be increased or decreased
(as appropriate) by the product of:
(A) The amount of the LIFO layer liquidated during the taxable
year, expressed in the functional currency of the section 987 QBU; and
(B) The exchange rate described in Sec. Sec. 1.987-4(e)(2)(ii) and
1.987-1(c)(3)(i)(C) that is used for translating such LIFO layer (that
is, the yearly average exchange rate for the year such LIFO layer
arose) less the exchange rate used to translate COGS under paragraph
(c)(2)(iv)(A) of this section (that is, the yearly average exchange
rate for the taxable year).
(d) [Reserved].
(e) Examples. The following examples illustrate the application of
this section. For purposes of the examples, U.S. Corp is a domestic
corporation that uses the calendar year as its taxable year and has the
U.S. dollar as its functional currency. Except as otherwise indicated,
U.S. Corp is the owner of Business A, a section 987 QBU with the euro
as its functional currency, and elects under paragraph (c)(2)(iv)(B) of
this section to use the historic inventory method with respect to
Business A but does not make any other elections under section 987.
However, where it is specified that U.S. Corp elects to use spot rates
in lieu of yearly average exchange rates under Sec. 1.987-
1(c)(1)(iii), U.S. Corp also elects under Sec. 1.987-1(c)(1)(ii) to
use a spot rate convention. Under this convention, sales booked during
a particular month are translated at the average of the spot rates on
the first and last day of the preceding month (the ``convention
rate''). Exchange rates used in these examples are selected for the
purpose of illustrating the principles of this section. No inference
(for example, whether a currency is hyperinflationary or not) is
intended by their use. See Sec. 1.987-4(g) for an illustration of the
simplified inventory method described in paragraphs (c)(2)(iv)(A) and
(c)(3) of this section.

Example 1. Business A properly accrues [pound]100 of income from
the provision of services. Under paragraph (b)(2)(i) of this
section, the [pound]100 is translated into [euro]90 at the spot rate
(as defined in Sec. 1.987-1(c)(1)) on the date of accrual, without
the use of a spot rate convention. In determining U.S. Corp's
taxable income, the [euro]90 of income is translated into dollars at
the rate provided in paragraph (c)(1) of this section.
Example 2. Business A sells a historic asset consisting of non-
inventory property for [pound]100. Under paragraph (b)(2)(i) of this
section, the [pound]100 amount realized is translated into [euro]85
at the spot rate (as defined in Sec. 1.987-1(c)(1)) on the sale
date without the use of a spot rate convention. In determining U.S.
Corp's taxable income, the [euro]85 is translated into dollars at
the rate provided in paragraph (c)(1) of this section. The euro
basis of the property is translated into dollars at the rate
provided in paragraph (c)(2)(i) of this section (that is, the
historic rate as determined under Sec. 1.987-1(c)(3)).
Example 3. (i) Business A uses a first-in, first-out (FIFO)
method of accounting for inventory. Business A sells 1,200 units of
inventory in 2021 for [euro]3 per unit. Business A's gross sales are
translated under paragraph (c)(1) of this section at the yearly
average exchange rate for the year of the sale. The yearly average
exchange rate is [euro]1 = $1.02 for 2020 and [euro]1 = $1.05 for
2021. Thus, Business A's dollar gross sales will be computed as
follows:

Gross Sales
[2021]
----------------------------------------------------------------------------------------------------------------
[euro]/$
Month Number of Amount in yearly Amount in $
units [euro] average rate
----------------------------------------------------------------------------------------------------------------
Jan............................................. 100 300 [euro]1 = 315.00
$1.05
Feb............................................. 200 600 [euro]1 = 630.00
$1.05
March........................................... 0 0 [euro]1 = 0
$1.05
April........................................... 200 600 [euro]1 = 630.00
$1.05
May............................................. 100 300 [euro]1 = 315.00
$1.05
June............................................ 0 0 [euro]1 = 0
$1.05

[[Page 88833]]


July............................................ 100 300 [euro]1 = 315.00
$1.05
Aug............................................. 100 300 [euro]1 = 315.00
$1.05
Sept............................................ 0 0 [euro]1 = 0
$1.05
Oct............................................. 0 0 [euro]1 = 0
$1.05
Nov............................................. 100 300 [euro]1 = 315.00
$1.05
Dec............................................. 300 900 [euro]1 = 945.00
$1.05
---------------------------------------------------------------
1,200 .............. .............. 3,780.00
----------------------------------------------------------------------------------------------------------------

(ii) The purchase price for each inventory unit was [euro]1.50.
Under Sec. 1.987-1(c)(3)(i) and paragraph (c)(2)(iv)(B) of this
section, the basis of each item of inventory is translated into
dollars at the yearly average exchange rate for the year the
inventory was acquired.

Opening Inventory and Purchases
[2021]
----------------------------------------------------------------------------------------------------------------
[euro]/$
Month Number of Amount in yearly Amount in $
units [euro] average rate
----------------------------------------------------------------------------------------------------------------
Opening inventory (purchased in December 2020) 100 150 [euro]1 = 153.00
$1.02
Purchases in 2021:
Jan......................................... 300 450 [euro]1 = 472.50
$1.05
Feb......................................... 0 0 [euro]1 = 0
$1.05
March....................................... 0 0 [euro]1 = 0
$1.05
April....................................... 300 450 [euro]1 = 472.50
$1.05
May......................................... 0 0 [euro]1 = 0
$1.05
June........................................ 0 0 [euro]1 = 0
$1.05
July........................................ 300 450 [euro]1 = 472.50
$1.05
Aug......................................... 0 0 [euro]1 = 0
$1.05
Sept........................................ 0 0 [euro]1 = 0
$1.05
Oct......................................... 0 0 [euro]1 = 0
$1.05
Nov......................................... 300 450 [euro]1 = 472.50
$1.05
Dec......................................... 0 0 [euro]1 = 0
$1.05
---------------------------------------------------------------
1,200 .............. .............. 1,890.00
----------------------------------------------------------------------------------------------------------------

(iii) Because Business A uses a FIFO method for inventory,
Business A is considered to have sold in 2021 the 100 units of
opening inventory purchased in 2020 ($153.00), the 300 units
purchased in January 2021 ($472.50), the 300 units purchased in
April 2021 ($472.50), the 300 units purchased in July 2021
($472.50), and 200 of the 300 units purchased in November 2021
($315.00). Accordingly, Business A's translated dollar COGS for 2021
is $1,885.50. Business A's opening inventory for 2022 is 100 units
of inventory with a translated dollar basis of $157.50.
(iv) Accordingly, for purposes of section 987 Business A has
gross income in dollars of $1,894.50 ($3,780.00--$1,885.50).
Example 4. (i) The facts are the same as in Example 3 except
that U.S. Corp properly elects under paragraph Sec. 1.987-
1(c)(1)(iii) to use spot rates in lieu of yearly average exchange
rates. As a result, under paragraph (c)(3) of this section, U.S.
Corp uses the convention rate to translate items of income, gain,
deduction, or loss where such rate is appropriate. Thus, Business
A's dollar gross sales will be computed as follows:

Gross Sales
[2021]
----------------------------------------------------------------------------------------------------------------
[euro]/$
Sales Number of Amount in convention Amount in $
units [euro] rate
----------------------------------------------------------------------------------------------------------------
Jan............................................. 100 300 [euro]1 = 300
$1.00
Feb............................................. 200 600 [euro]1 = 630
$1.05
March........................................... 0 0 [euro]1 = 0
$1.03
April........................................... 200 600 [euro]1 = 612
$1.02
May............................................. 100 300 [euro]1 = 312
$1.04
June............................................ 0 0 [euro]1 = 0
$1.05
July............................................ 100 300 [euro]1 = 318
$1.06
Aug............................................. 100 300 [euro]1 = 315
$1.05
Sept............................................ 0 0 [euro]1 = 0
$1.06
Oct............................................. 0 0 [euro]1 = 0
$1.07
Nov............................................. 100 300 [euro]1 = 324
$1.08
Dec............................................. 300 900 [euro]1 = 972
$1.08
---------------------------------------------------------------

[[Page 88834]]


1,200 .............. .............. 3,783
----------------------------------------------------------------------------------------------------------------

(ii) As in Example 3, the purchase price for each inventory unit
was [euro]1.50. Under Sec. 1.987-3(c)(2)(iv)(B), U.S. Corp uses the
convention rate as the historic rate in determining COGS.

Opening Inventory and Purchases
[2021]
----------------------------------------------------------------------------------------------------------------
[euro]/$
Month Number of Amount in convention Amount in $
units [euro] rate
----------------------------------------------------------------------------------------------------------------
Opening inventory (purchased in December 2020) 100 150 [euro]1 = 153
$1.02
Purchases in 2021:
Jan......................................... 300 450 [euro]1 = 450
$1.00
Feb......................................... 0 0 [euro]1 = 0
$1.05
March....................................... 0 0 [euro]1 = 0
$1.03
April....................................... 300 450 [euro]1 = 459
$1.02
May......................................... 0 0 [euro]1 = 0
$1.04
June........................................ 0 0 [euro]1 = 0
$1.05
July........................................ 300 450 [euro]1 = 477
$1.06
Aug......................................... 0 0 [euro]1 = 0
$1.05
Sept........................................ 0 0 [euro]1 = 0
$1.06
Oct......................................... 0 0 [euro]1 = 0
$1.07
Nov......................................... 300 450 [euro]1 = 486
$1.08
Dec......................................... 0 0 [euro]1 = 486
$1.08
---------------------------------------------------------------
1,200 .............. .............. 1,872
----------------------------------------------------------------------------------------------------------------

(iii) As set forth in (i), Business A's gross sales are $3,783.
(iv) Because Business A uses a FIFO method for inventory,
Business A is considered to have sold in 2021 the 100 units of
opening inventory purchased in December 2020 ($150), the 300 units
purchased in January 2021 ($450), the 300 units purchased in April
2021 ($459), the 300 units purchased in July 2021 ($477), and 200 of
the 300 units purchased in November 2021 ($324). Thus, Business A's
COGS is $1,860.
(v) Accordingly, Business A has gross income in dollars of
$1,923 ($3,783 - $1,860).
Example 5. The facts are the same as in Example 3 except that
during 2021, Business A incurred [euro]100 of depreciation expense
with respect to a truck. No portion of the depreciation expense is
an inventoriable cost. The truck was purchased on January 15, 2020.
The yearly average exchange rate for 2020 was [euro]1 = $1.02. Under
paragraph (c)(2)(i) of this section, the [euro]100 of depreciation
is translated into dollars at the historic rate. Under Sec. 1.987-
1(c)(3)(i), the historic rate is the yearly average rate for 2020.
Accordingly, U.S. Corp takes into account depreciation of $102 with
respect to Business A in 2021.
Example 6. The facts are the same as in Example 5 except that
the [euro]100 of depreciation expense incurred during 2021 with
respect to the truck is an inventoriable cost. As a result, the
depreciation expense is capitalized into the 1,200 units of
inventory purchased by Business A in 2021. Of those 1,200 units,
1,100 units are sold during the year, and 100 units become ending
inventory. The portion of depreciation expense capitalized into
inventory that is sold during 2021 is reflected in Business A's euro
COGS and is translated at the [euro]1 = $1.02 yearly average
exchange rate for 2020, the year in which the truck was purchased.
The portion of the depreciation expense capitalized into the 100
units of ending inventory is not taken into account in 2021 but,
rather, will be taken into account in the year the ending inventory
is sold, translated at the [euro]1 = $1.02 yearly average exchange
rate for 2020.
Example 7. Business A purchased raw land on October 16, 2020,
for [euro]8,000 and sold the land on November 1, 2021, for
[euro]10,000. The yearly average exchange rate was [euro]1 = $1.02
for 2020 and [euro]1 = $1.05 for 2021. Under paragraph (c)(1) of
this section, the amount realized is translated into dollars at the
yearly average exchange rate for 2021 ([euro]10,000 x $1.05 =
$10,500). Under paragraph (c)(2)(i) of this section, the basis is
determined at the historic rate for 2020, which is the yearly
average rate under section Sec. 1.987-1(c)(3)(i) for such year
([euro]8,000 x $1.02 = $8,160). Accordingly, the amount of gain
reported by U.S. Corp on the sale of the land is $2,340 ($10,500 -
$8,160).
Example 8. The facts are the same as in Example 7 except that
Business A properly elects under paragraph Sec. 1.987-1(c)(1)(iii)
to use spot rates in lieu of yearly average rates. Accordingly, the
amount realized will be translated at the convention rate for the
date of sale, and the basis will be translated at the convention
rate for the date of purchase. The convention rate is [euro]1 =
$1.01 for October 2020 and is [euro]1 = $1.08 for November 2021.
Under these facts, the amount realized, translated into dollars at
the convention rate for November 2021, is $10,800 ([euro]10,000 x
$1.08), and the basis, translated at the convention rate for October
2020, is $8,080 ([euro]8,000 x $1.01). The amount of gain reported
by U.S. Corp on the sale of the land is $2,720 ($10,800 - $8,080).


Sec. 1.987-4 Determination of net unrecognized section 987 gain or
loss of a section 987 QBU.

(a) In general. The net unrecognized section 987 gain or loss of a
section 987 QBU shall be determined by the owner annually as provided
in paragraph (b) of this section in the owner's functional currency.
Only assets and liabilities reflected on the books and records of the
section 987 QBU under Sec. 1.987-2(b) shall be taken into account.
(b) Calculation of net unrecognized section 987 gain or loss. Net
unrecognized section 987 gain or loss of a section 987 QBU for a
taxable year shall equal the sum of:
(1) The section 987 QBU's net accumulated unrecognized section 987
gain or loss for all prior taxable years to

[[Page 88835]]

which these regulations apply as determined in paragraph (c) of this
section, and
(2) The section 987 QBU's unrecognized section 987 gain or loss for
the current taxable year as determined in paragraph (d) of this
section.
(c) Net accumulated unrecognized section 987 gain or loss for all
prior taxable years--(1) In general. A section 987 QBU's net
accumulated unrecognized section 987 gain or loss for all prior taxable
years is the aggregate of the amounts determined under Sec. 1.987-4(d)
for all prior taxable years to which these regulations apply, reduced
by the amounts taken into account under Sec. 1.987-5 upon remittances
for all such prior taxable years.
(2) [Reserved].
(d) Calculation of unrecognized section 987 gain or loss for a
taxable year. The unrecognized section 987 gain or loss of a section
987 QBU for a taxable year shall be determined under paragraphs (d)(1)
through (8) of this section.
(1) Step 1: Determine the change in the owner functional currency
net value of the section 987 QBU for the taxable year--(i) In general.
The change in the owner functional currency net value of the section
987 QBU for the taxable year shall equal--
(A) The owner functional currency net value of the section 987 QBU,
determined in the functional currency of the owner under paragraph (e)
of this section, on the last day of the taxable year; less
(B) The owner functional currency net value of the section 987 QBU,
determined in the functional currency of the owner under paragraph (e)
of this section, on the last day of the preceding taxable year. This
amount shall be zero in the case of the section 987 QBU's first taxable
year.
(ii) Year section 987 QBU is terminated. If a section 987 QBU is
terminated within the meaning of Sec. 1.987-8 during an owner's
taxable year, the owner functional currency net value of the section
987 QBU as provided in paragraph (d)(1)(i)(A) of this section shall be
determined on the date the section 987 QBU is terminated.
(2) Step 2: Increase the amount determined in step 1 by the amount
of assets transferred from the section 987 QBU to the owner--(i) In
general. The amount determined in paragraph (d)(1) of this section
shall be increased by the total amount of assets described in paragraph
(d)(2)(ii) of this section transferred from the section 987 QBU to the
owner during the taxable year translated into the owner's functional
currency as provided in paragraph (d)(2)(ii) of this section.
(ii) Assets transferred from the section 987 QBU to the owner
during the taxable year. The assets transferred from the section 987
QBU to the owner for the taxable year shall equal the sum of:
(A) The amount of the section 987 QBU's functional currency and the
aggregate adjusted basis of all marked assets (as defined in Sec.
1.987-1(d)), after taking into account Sec. 1.988-1(a)(10),
transferred to the owner during the taxable year determined in the
functional currency of the section 987 QBU and translated into the
owner's functional currency at the spot rate (as defined in Sec.
1.987-1(c)(1)) applicable to the date of transfer; and
(B) The aggregate adjusted basis of all historic assets (as defined
in Sec. 1.987-1(e)), after taking into account Sec. 1.988-1(a)(10),
transferred to the owner during the taxable year determined in the
functional currency of the section 987 QBU and translated into the
owner's functional currency at the historic rate for each such asset
(as defined in Sec. 1.987-1(c)(3)).
(3) Step 3: Decrease the amount determined in steps 1 and 2 by the
amount of assets transferred from the owner to the section 987 QBU--(i)
In general. The aggregate amount determined in paragraphs (d)(1) and
(d)(2) of this section shall be decreased by the total amount of assets
transferred from the owner to the section 987 QBU during the taxable
year determined in the functional currency of the owner as provided in
paragraph (d)(3)(ii) of this section.
(ii) Total of all amounts transferred from the owner to the section
987 QBU during the taxable year. The total amount of assets transferred
from the owner to the section 987 QBU for the taxable year shall equal
the aggregate of:
(A) The total amount of functional currency of the owner
transferred to the section 987 QBU during the taxable year; and
(B) The adjusted basis, determined in the functional currency of
the owner, of any asset transferred to the section 987 QBU during the
taxable year (after taking into account Sec. 1.988-1(a)(10)).
(4) Step 4: Decrease the amount determined in steps 1 through 3 by
the amount of liabilities transferred from the section 987 QBU to the
owner. The aggregate amount determined in paragraphs (d)(1) through (3)
of this section shall be decreased by the aggregate amount of
liabilities transferred from the section 987 QBU to the owner during
the taxable year. The amount of such liabilities shall be translated
into the functional currency of the owner at the spot rate (as defined
in Sec. 1.987-1(c)(1)) applicable on the date of transfer.
(5) Step 5: Increase the amount determined in steps 1 through 4 by
the amount of liabilities transferred from the owner to the section 987
QBU. The aggregate amount determined in paragraphs (d)(1) through (4)
of this section shall be increased by the aggregate amount of
liabilities transferred by the owner to the section 987 QBU during the
taxable year. The amount of such liabilities shall be translated into
the functional currency of the owner at the spot rate (as defined in
Sec. 1.987-1(c)(1)) applicable on the date of transfer.
(6) Step 6: Decrease or increase the amount determined in steps 1
through 5 by the section 987 taxable income or loss, respectively, of
the section 987 QBU for the taxable year. The aggregate amount
determined in paragraphs (d)(1) through (5) of this section shall be
decreased or increased by the section 987 taxable income or loss,
respectively, computed under Sec. 1.987-3 for the taxable year.
(7) Step 7: Increase the amount determined in steps 1 through 6 by
any expenses that are not deductible in computing the section 987
taxable income or loss of the section 987 QBU for the taxable year. The
aggregate amount determined under paragraphs (d)(1) through (6) shall
be increased by the amount of any expense or loss attributable to a
section 987 QBU for the taxable year that is not deductible in
computing the section 987 QBU's taxable income or loss for the year,
including any foreign income taxes incurred by the section 987 QBU with
respect to which the owner claims a credit (translated at the same rate
at which such taxes were translated under section 986(a)).
(8) Step 8: Decrease the amount determined in steps 1 through 7 by
the amount of any tax-exempt income. The aggregate amount determined
under paragraphs (d)(1) through (7) shall be decreased by the amount of
any income or gain attributable to a section 987 QBU for the taxable
year that is not included in computing the section 987 QBU's taxable
income or loss for the year.
(e) Determination of the owner functional currency net value of a
section 987 QBU--(1) In general. The owner functional currency net
value of a section 987 QBU on the last day of a taxable year shall
equal the aggregate amount of functional currency and the adjusted
basis of each asset on the section 987 QBU's balance sheet on that day,
less the aggregate amount of each

[[Page 88836]]

liability on the section 987 QBU's balance sheet on that day, in each
case translated into the owner's functional currency as provided in
paragraph (e)(2) of this section. Such amount shall be determined by:
(i) Preparing a balance sheet for the relevant date from the
section 987 QBU's books and records (within the meaning of Sec.
1.989(a)-1(d)), as recorded in the section 987 QBU's functional
currency and showing all assets and liabilities reflected on such books
and records as provided in Sec. 1.987-2(b);
(ii) Making adjustments necessary to conform the items reflected on
the balance sheet described in paragraph (e)(1)(i) of this section to
United States tax accounting principles; and
(iii) Translating the asset and liability amounts on the adjusted
balance sheet described in paragraph (e)(1)(ii) of this section into
the functional currency of the owner in accordance with paragraph
(e)(2) of this section.
(2) Translation of balance sheet items into the owner's functional
currency. The amount of the section 987 QBU's functional currency, the
basis of an asset, or the amount of a liability shall be translated as
follows:
(i) Marked item. A marked item (as defined in Sec. 1.987-1(d))
shall be translated into the owner's functional currency at the spot
rate (as defined in Sec. 1.987-1(c)(1)) applicable to the last day of
the relevant taxable year.
(ii) Historic item. A historic item (as defined in Sec. 1.987-
1(e)) shall be translated into the owner's functional currency at the
historic rate (as defined in Sec. 1.987-1(c)(3)).
(f) [Reserved].
(g) Examples. The following examples illustrate the provisions of
this section. For purposes of the examples, U.S. Corp is a domestic
corporation that uses the calendar year as its taxable year and has the
dollar as its functional currency. Except as otherwise indicated, U.S.
Corp elects under Sec. 1.987-3(c)(2)(iv)(B) to use the historic
inventory method with respect to all of its section 987 QBUs but does
not make other elections under section 987. Exchange rate and tax
accounting (for example, depreciation rate) assumptions used in these
examples are selected for the purpose of illustrating the principles of
this section, and no inference is intended by their use. Additionally,
the examples are not intended to demonstrate when activities constitute
a trade or business within the meaning of Sec. 1.989(a)-1(b)(2)(ii)(A)
and Sec. 1.989(a)-1(c) and therefore whether a section 987 QBU is
onsidered to exist.

Example 1. (i) On July 1, 2021, U.S. Corp establishes Japan
Branch, a section 987 QBU of U.S. Corp that has the yen as its
functional currency, and transfers to Japan Branch $1,000 and raw
land with a basis of $500. Japan Branch immediately exchanges the
$1,000 for [yen]100,000. On the same day, Japan Branch borrows
[yen]10,000. For the taxable year 2021, Japan Branch earns
[yen]2,000 per month (total of [yen]12,000 for the six-month period
from July 1, 2021, through December 31, 2021) for providing services
and incurs [yen]333.33 per month (total of [yen]2,000 when rounded
for the six-month period from July 1, 2021, through December 31,
2021) of related expenses. Assume that the spot rate on July 1,
2021, is $1 = [yen]100; the spot rate on December 31, 2021, is $1 =
[yen]120; and the average rate for the period of July 1, 2021, to
December 31, 2021, is $1 = [yen]110. Thus, the [yen]12,000 of
services revenue when properly translated under Sec. 1.987-3(c)(1)
at the yearly average exchange rate equals $109.09 ([yen]12,000 x
($1/[yen]110)) = $109.09). The [yen]2,000 of expenses translated at
the same yearly average exchange rate equals $18.18 ([yen]2,000 x
($1/[yen]110) = $18.18). Thus, Japan Branch's net income translated
into dollars equals $90.91 ($109.09 - $18.18 = $90.91).
(ii) Under paragraph (a) of this section, U.S. Corp must compute
the net unrecognized section 987 gain or loss of Japan Branch for
2021. Because this is Japan Branch's first taxable year, the net
unrecognized section 987 gain or loss (as defined under paragraph
(b) of this section) is the branch's unrecognized section 987 gain
or loss for 2021 as determined in paragraph (d) of this section. The
calculation under paragraph (d) of this section is made as follows:
(iii) Step 1. Under paragraph (d)(1) of this section, U.S. Corp
must determine the change in the owner functional currency net value
(OFCNV) of Japan Branch for 2021 in dollars. The change in the OFCNV
of Japan Branch for 2021 is equal to the OFCNV of Japan Branch
determined in dollars on the last day of 2021, less the OFCNV of
Japan Branch determined in dollars on the last day of the preceding
taxable year.
(A) The OFCNV of Japan Branch determined in dollars on the last
day of the current taxable year is determined under paragraph (e) of
this section as the sum of the basis of each asset on Japan Branch's
balance sheet on December 31, 2021, less the sum of each liability
on Japan Branch's balance sheet on that date, translated into
dollars as provided in paragraph (e)(2) of this section.
(B) For this purpose, Japan Branch will show the following
assets and liabilities on its balance sheet for December 31, 2021:
(1) [yen]120,000;
(2) Raw land with a basis of [yen]55,000 ($500 translated under
Sec. 1.987-2(d)(2) at the historic rate of $1 = [yen]110); and
(3) Liabilities of [yen]10,000.
(C) Under paragraph (e)(2) of this section, U.S. Corp will
translate these items as follows. The [yen]120,000 is a marked asset
and the [yen]10,000 liability is a marked liability (as each is
defined in Sec. 1.987-1(d)). These items are translated into
dollars on December 31, 2021, using the spot rate on December 31,
2021, of $1 = [yen]120. The raw land is a historic asset (as defined
in Sec. 1.987-1(e)) and is translated into dollars under paragraph
(e)(2)(ii) of this section at the historic rate, which under Sec.
1.987-1(c)(3)(1)(A) is the yearly average exchange rate of $1 =
[yen]110 applicable to the year the land was transferred to the QBU.
Thus, the OFCNV of Japan Branch on December 31, 2021, in dollars is
$1,416.67 determined as follows:

----------------------------------------------------------------------------------------------------------------
Amount in
Assets [yen] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Yen.................................... 120,000 $1 = [yen]120 (spot rate--12/31/21) $1,000.00
Land................................... 55,000 1 = [yen]110 (yearly average rate-- 500.00
2021).
--------------------------------------------------------------------
Total assets....................... .............. ................................... 1,500.00
Liabilities:
Bank Loan.............................. 10,000 1 = [yen]120 (spot rate--12/31/21). 83.33
--------------------------------------------------------------------
Total liabilities.................. .............. ................................... 83.33
2021 ending OFCNV.......................... .............. ................................... 1,416.67
----------------------------------------------------------------------------------------------------------------

(D) Under paragraph (d)(1) of this section, the change in OFCNV
of Japan Branch for 2021 is equal to the OFCNV of the branch
determined in dollars on December 31, 2021, ($1,416.67) less the
OFCNV of the branch determined in dollars on the last day of the
preceding taxable year. Because this is the first taxable year of
Japan Branch, the OFCNV of Japan Branch determined in dollars on the
last day of the preceding taxable year is zero under paragraph
(d)(1)(i)(B) of this section. Accordingly, the change in OFCNV of
Japan Branch for 2021 is $1,416.67.
(iv) Step 2. Under paragraph (d)(2) of this section, the
aggregate amount determined in paragraph (d)(1) of this section
(step 1) is increased by the total amount of assets described in
paragraph (d)(2)(ii) of this section transferred from the section
987 QBU to the owner during the taxable year translated into the
owner's functional currency as provided in paragraph (d)(2)(ii) of
this section. Because no such amounts

[[Page 88837]]

were transferred, there is no change in the $1,416.67 determined in
step 1.
(v) Step 3. Under paragraph (d)(3) of this section, the
aggregate amount determined in paragraphs (d)(1) and (d)(2) of this
section (steps 1 and 2) is decreased by the total amount of assets
transferred from the owner to the section 987 QBU during the taxable
year as determined in paragraph (d)(3)(ii) of this section in
dollars. On July 1, 2021, U.S. Corp transferred to Japan Branch
$1,000.00 (which Japan Branch immediately converted into
[yen]100,000) and raw land with a basis of $500.00 (equal to
[yen]55,000, translated under Sec. 1.987-2(d)(2) at the historic
rate of $1 = [yen]110). Thus, the $1,416.67 determined under steps 1
and 2 is reduced by $1,500.00, resulting in ($83.33).
(vi) Steps 4 and 5. Because no liabilities were transferred by
U.S. Corp to Japan Branch or by Japan Branch to U.S. Corp during the
taxable year, the aggregate amount determined in paragraph (d)(3) of
this section (Step 3) is not increased or decreased.
(vii) Step 6. Under paragraph (d)(6) of this section, the
aggregate amount determined after applying paragraphs (d)(1) through
(5) of this section (steps 1 through 5) is decreased by the section
987 taxable income of Japan Branch of $90.91 from ($83.33) to
($174.24).
(viii) Steps 7 and 8. Paragraphs (d)(7) and (d)(8) do not apply
because Japan Branch does not have any tax-exempt or nondeductible
items. Accordingly, the unrecognized section 987 loss of Japan
Branch for 2021 is ($174.24), the amount determined after applying
step 6.
Example 2. (i) U.S. Corp operates in the United Kingdom through
U.K. Branch, a section 987 QBU of U.S. Corp that has the pound as
its functional currency. U.S. Corp properly elects under Sec.
1.987-1(c)(1)(ii) for U.K. Branch to use a spot rate convention
(when permitted). Under the chosen convention, the spot rate (the
``convention rate'') for any transaction occurring during a month is
the average of the pound spot rate and the 30-day forward rate for
pounds on the next-to-last Thursday of the preceding month. The
yearly average exchange rate was [pound]1 = $0.90 for 2020, [pound]1
= $1.00 for 2021, and [pound]1 = $1.10 for 2022. The closing balance
sheet of U.K. Branch in 2021 reflected the following assets:
(A) [pound]100;
(B) A sales office purchased in 2020 with an adjusted basis of
[pound]1,000;
(C) A delivery truck purchased in 2020 with an adjusted basis of
[pound]200;
(D) Inventory of 100 units purchased in 2021 with a basis of
[pound]100; and
(E) Stock in ABC Corporation purchased in 2021 with a basis of
[pound]150, representing less than 10 percent of the total voting
power and value of all classes of stock of ABC Corporation.
The closing balance sheet of U.K. Branch for 2021 reflected one
liability, [pound]50 of long-term debt entered into in 2020 with F
Bank, an unrelated bank.
The office, truck, stock, and inventory are historic assets (as
defined in Sec. 1.987-1(e)). The [pound]100 and long-term debt are
marked items (as defined in Sec. 1.987-1(d)). Assume that U.S. Corp
translated U.K. Branch's 2021 closing balance sheet as follows:

----------------------------------------------------------------------------------------------------------------
Amount in
Assets [pound] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Pounds................................. 100.00 [pound]1 = $1.05 (convention rate-- 105.00
Dec. 2021).
Office................................. 1,000.00 [pound]1 = $0.90 (historic rate-- 900.00
2020).
Truck.................................. 200.00 [pound]1 = $0.90 (historic rate-- 180.00
2020).
Stock.................................. 50.00 [pound]1 = $1.00 (historic rate-- 150.00
2021).
Inventory.............................. 100.00 [pound]1 = $1.00 (historic rate-- 100.00
2021).
--------------------------------------------------------------------
Total assets....................... .............. ................................... 1,435.00
Liabilities:
Bank Loan.............................. 50.00 [pound]1 = $1.05 (convention rate-- 52.50
Dec. 2021).
--------------------------------------------------------------------
Total liabilities.................. .............. ................................... 52.50
2021 ending OFCNV.......................... .............. ................................... 1,382.50
----------------------------------------------------------------------------------------------------------------

(ii) U.K. Branch uses the first-in, first-out (FIFO) method of
accounting for inventory. In 2022, U.K. Branch sold 100 units of
inventory for a total of [pound]300 and purchased another 100 units
of inventory for [pound]100. There is depreciation of [pound]33 with
respect to the office and [pound]40 with respect to the truck, and
U.K. Branch incurred [pound]30 of business expenses during 2022.
Neither the depreciation nor the business expenses are inventoriable
costs. All items of income earned and expenses incurred during 2022
are received and paid, respectively, in pounds. Under Sec. 1.987-3,
U.K. Branch's section 987 taxable income or loss is determined as
follows:

----------------------------------------------------------------------------------------------------------------
Amount in
Item [pound] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Gross receipts............................. 300.00 [pound]1 = $1.10 (yearly average 330.00
rate--2022).
Less:
COGS................................... (100.00) [pound]1 = $1.00 (historic rate-- (100.00)
2021).
--------------------------------------------------------------------
Gross income....................... .............. ................................... 230.00
Dep:
Office................................. (33.00) [pound]1 = $0.90 (historic rate-- (29.70)
2020).
Truck.................................. (40.00) [pound]1 = $0.90 (historic rate-- (36.00)
2020).
Other expenses............................. (30.00) [pound]1 = $1.10 (yearly average (33.00)
rate--2022).
--------------------------------------------------------------------
Total expenses..................... .............. ................................... (98.70)
Section 987 taxable income................. .............. ................................... 131.30
----------------------------------------------------------------------------------------------------------------

Accordingly, U.K. Branch has $131.30 of section 987 taxable
income in 2022.
(iii) In December 2022, U.K. Branch transferred [pound]30 to
U.S. Corp, and U.S. Corp transferred a computer with a basis of $10
to U.K. Branch. U.S. Corp's net accumulated unrecognized section 987
gain or loss for all prior taxable years as determined in paragraph
(c) of this section is $30.
(iv) The unrecognized section 987 gain or loss of U.K. Branch
for 2022 is determined as follows:
(A) Step 1. Under paragraph (d)(1) of this section, the change
in OFCNV for the taxable year must be determined. This amount is
equal to the OFCNV of U.K. Branch determined under paragraph (e) of
this section on the last day of 2022, less the OFCNV of U.K. Branch
determined on the last day of 2021. The OFCNV of U.K. Branch on
December 31, 2022, and the change in OFCNV for 2022, are determined
as follows:

[[Page 88838]]



----------------------------------------------------------------------------------------------------------------
Amount in
Assets [pound] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Pounds................................. 240.00 [pound]1 = $1.15 (convention rate-- 276.00
Dec. 2022).
Office................................. 967.00 1 = $0.90 (historic rate--2020).... 870.30
Truck.................................. 160.00 [pound]1 = $0.90 (historic rate-- 144.00
2020).
Inventory.............................. 100.00 [pound]1 = $1.10 (historic rate-- 110.00
2022).
Computer............................... 9.09 [pound]1 = $1.10 (historic rate-- 10.00
2022).
Stock.................................. 150.00 [pound]1 = $1.00 (historic rate-- 150.00
2021).
--------------------------------------------------------------------
Total assets....................... .............. ................................... 1,560.30
Liabilities:
Bank Loan.............................. 50.00 [pound]1 = $1.15 (convention rate-- 57.50
Dec. 2022).
--------------------------------------------------------------------
Total liabilities.................. .............. ................................... 57.50
2022 ending OFCNV.......................... .............. ................................... 1,502.80
Less:
2021 ending OFCNV...................... .............. ................................... (1,382.50)
--------------------------------------------------------------------
Change in OFCNV.................... .............. ................................... 120.30
----------------------------------------------------------------------------------------------------------------

(B) Step 2. Under paragraph (d)(2) of this section, the
aggregate amount determined in step 1 must be increased by the total
amount of assets described in paragraph (d)(2)(ii) of this section
transferred from U.K. Branch to U.S. Corp during the taxable year,
translated into U.S. Corp's functional currency as provided in
paragraph (d)(2)(ii) of this section. The amount of assets
transferred from U.K. Branch to U.S. Corp during 2022 is determined
as follows:

----------------------------------------------------------------------------------------------------------------
Amount in
Asset [pound] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
[pound]30.................................. 30.00 [pound]1 = $1.15 (convention rate-- 34.50
Dec. 2022).
----------------------------------------------------------------------------------------------------------------

(C) Step 3: Decrease the aggregate amount described in steps 1
and 2 by the owner's transfers to the section 987 QBU. Under
paragraph (d)(3) of this section, the aggregate amount determined in
steps 1 and 2 must be decreased by the total amount of all assets
transferred from U.S. Corp to U.K. Branch during the taxable year as
determined in paragraph (d)(3)(ii) of this section. The amount of
assets transferred from U.S. Corp to U.K. Branch during 2022 is
determined as follows:

----------------------------------------------------------------------------------------------------------------
Asset Amount in $
----------------------------------------------------------------------------------------------------------------
Computer................................... .............. ................................... 10.00
----------------------------------------------------------------------------------------------------------------

(D) Step 4. Under paragraph (d)(4) of this section, the
aggregate amount determined in steps 1 through 3 must be decreased
by the aggregate amount of liabilities transferred by U.K. Branch to
U.S. Corp. Under these facts, such amount is $0.
(E) Step 5. Under paragraph (d)(5) of this section, the
aggregate amount determined in steps 1 through 4 must be increased
by the aggregate amount of liabilities transferred by U.S. Corp to
U.K. Branch. Under these facts, such amount is $0.
(F) Step 6. Under paragraph (d)(6) of this section, the
aggregate amount determined in steps 1 through 5 is decreased or
increased, respectively, by any section 987 taxable income or loss
of U.K. Branch computed under Sec. 1.987-3 for the taxable year.
The amount of U.K. Branch's taxable income, as determined above, is
$131.30.
(H) Steps 7 and 8: Paragraphs (d)(7) and (d)(8) do not apply
because U.K. Branch does not have any tax-exempt income or
nondeductible expense.
(v) Summary. Taking steps 1 through 8 into account, the amount
of U.S. Corp's unrecognized section 987 gain or loss with respect to
U.K. Branch in 2022 is computed as follows:

------------------------------------------------------------------------
Step Amount in $ Balance
------------------------------------------------------------------------
1....................................... + 120.30 $120.30
2....................................... + 34.50 154.80
3....................................... - 10.00 144.80
4....................................... - 0 144.80
5....................................... + 0 144.80
6....................................... - 131.30 13.50
7....................................... + 0 13.50
8....................................... - 0 13.50
------------------------------------------------------------------------

Thus, U.S. Corp's unrecognized section 987 gain for 2022 with
respect to U.K. Branch is $13.50. As of the end of 2022, before
taking into account the recognition of any section 987 gain or loss
under Sec. 1.987-5, U.S. Corp's net unrecognized section 987 gain
is $43.50 (that is, $30.00 accumulated from prior years, plus $13.50
in 2022).
Example 3. (i) Background. U.S. Corp is the owner of Business A,
a section 987 QBU that has the euro as its functional currency.
Business A uses the FIFO method to account for inventory and uses
the simplified inventory method described in Sec. 1.987-
3(c)(2)(iv)(A). On the last day of 2020, U.S. Corp begins Business A
by contributing to Business A a building with a basis of $780, a
machine with a basis of $300, and $100. On January 1, 2021, Business
A converts the $100 into [euro]100. The tax basis of the building
and machine is translated into euros using the historic rate, which
is the yearly average exchange rate for 2020, the year of the
transfer. Accordingly, the building and the machine have a tax basis
of [euro]780 and [euro]300, respectively, on December 31, 2020. The

[[Page 88839]]

building and machine have annual depreciation of [euro]20 and
[euro]30, respectively. Business A determines that 50 percent of the
building depreciation should be allocated to the cost of goods
manufactured (that is, treated as an inventoriable cost) and 50
percent should be allocated to selling, general and administrative
(SG&A) expenses. The machine is used exclusively to manufacture
inventory. Relevant exchange rates for purposes of this example are
as follows:

------------------------------------------------------------------------
Yearly average December 31
Year exchange rate spot rate
------------------------------------------------------------------------
2020.................................... [euro]1 = [euro]1 =
$1.00 $1.00
2021.................................... [euro]1 = [euro]1 =
$1.50 $2.00
2022.................................... [euro]1 = [euro]1 =
$2.50 $3.00
------------------------------------------------------------------------

(ii) Operations in 2021. During 2021, Business A recognizes
[euro]140 of revenue from sales of finished goods. The related COGS
is [euro]70. Business A pays [euro]10 in salaries allocable to SG&A.
Inventoriable costs in 2021 include [euro]10 of depreciation on the
building and [euro]30 of depreciation on the machine. Business A's
balance sheet on December 31, 2021, shows no liabilities and the
following assets: currency of [euro]160, the building with an
adjusted basis of [euro]760, the machine with an adjusted basis of
[euro]270, and ending inventory with a FIFO cost basis of [euro]40,
comprising raw materials and finished goods.
(A) Determination of income. Under the simplified inventory
method, Business A's income for 2021 is computed as follows:

----------------------------------------------------------------------------------------------------------------
Amount in
Item [euro] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Sales revenue................................. 140 [euro]1 = $1.50 (yearly avg. 210
rate--2021).
COGS before adjustments....................... 70 [euro]1 = $1.50 (yearly avg. 105
rate--2021).
Adjustment for cost recovery deductions .............. ................................ (20)
(see calculation below).
Adjustment for beginning inventory (none). .............. ................................ 0
-----------------------------------------------------------------
Adjusted COGS......................... .............. ................................ 85
SG&A:
Depreciation on building (50%)............ 10 [euro]1 = $1.00 (historic rate-- 10
2020).
Salaries.................................. 10 [euro]1 = $1.50 (yearly avg. 15
rate--2021).
-----------------------------------------------------------------
Total SG&A............................ .............. ................................ 25
Section 987 net income (revenue less COGS and .............. ................................ 100
SG&A).
----------------------------------------------------------------------------------------------------------------

COGS Adjustments.
Adjustment for cost recovery deductions included in
inventoriable costs.

----------------------------------------------------------------------------------------------------------------
Adjustment
2021 yearly Difference in (depreciation
Depreciation amount Historic rate avg. rate translation x change in
rates rates)
----------------------------------------------------------------------------------------------------------------
[euro]10 (building)............................. 1.00 1.50 (0.50) ($5)
[euro]30 (machine).............................. 1.00 1.50 (0.50) (15)
---------------------------------------------------------------
Total adjustment for cost recovery .............. .............. .............. (20)
deductions.................................
----------------------------------------------------------------------------------------------------------------

(B) Determination of OFCNV for 2020 and 2021.
Under the simplified inventory method, the OFCNV of Business A
for 2020 and 2021 is determined under paragraph (e) of this section
as follows:

OFCNV--End of 2021
----------------------------------------------------------------------------------------------------------------
Amount in
Assets [euro] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Euros.................................. 160 [euro]1 = $2.00 (year-end spot 320
rate--2021).
Building............................... 760 [euro]1 = $1.00 (historic rate-- 760
2020).
Machine................................ 270 [euro]1 = $1.00 (historic rate-- 270
2020).
Inventory.............................. 40 [euro]1 = $1.50 (yearly average 60
rate--2021).
--------------------------------------------------------------------
Total assets....................... .............. ................................... 1,410
Liabilities:
Total liabilities.................. .............. ................................... 0
2021 ending OFCNV.......................... .............. ................................... 1,410
----------------------------------------------------------------------------------------------------------------


[[Page 88840]]


OFCNV--End of 2020
----------------------------------------------------------------------------------------------------------------
Amount in
Assets [euro] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Euros.................................. 100 [euro]1 = $1.00 (year-end spot 100
rate--2020).
Building............................... 780 [euro]1 = $1.00 (historic rate-- 780
2020).
Machine................................ 300 [euro]1 = $1.00 (historic rate-- 300
2020).
--------------------------------------------------------------------
Total assets....................... .............. ................................... 1,180
Liabilities:
Total liabilities.................. .............. ................................... 0
2020 ending OFCNV.......................... .............. ................................... 1,180
----------------------------------------------------------------------------------------------------------------

(C) Determination of net unrecognized section 987 gain or loss.
The net unrecognized section 987 gain or loss of Business A is
determined under paragraph (d) of this section as follows (relevant
steps only):
(1) Step 1. Under paragraph (d)(1) of this section, the change
in OFCNV for the taxable year must be determined. This amount is
equal to the OFCNV of Business A determined under paragraph (e) of
this section on the last day of 2021, less the OFCNV of Business A
determined on the last day of 2020.

2021 ending OFCNV....................................... $1,410
Less: 2020 ending OFCNV................................. (1,180)
---------------
Change in OFCNV..................................... 230


(2) Step 6. Under paragraph (d)(6) of this section, the
aggregate amount determined in steps 1 through 5 must be decreased
by the section 987 taxable income of Business A. The amount of
Business A's taxable income for 2021, as determined above, is $100.

Change in OFCNV......................................... $230
Less: section 987 taxable income........................ (100)
---------------
Unrecognized section 987 gain....................... 130
Plus: Net accumulated unrecognized section 987 gain or 0
loss from prior years..................................
---------------
Net unrecognized section 987 gain................... 130


(iii) Operations in 2022. During 2022, Business A recognizes
[euro]180 of revenue from sales of finished goods. The related COGS
is [euro]96. Business A pays [euro]10 in salaries allocable to SG&A.
Inventoriable costs in 2022 include [euro]30 of depreciation on the
machine and [euro]10 of depreciation on the building. Business A's
balance sheet on December 31, 2022, shows no liabilities and the
following assets: currency of [euro]260, the building with an
adjusted basis of [euro]740, the machine with an adjusted basis of
[euro]240, and ending inventory with a FIFO cost basis of [euro]54,
comprising raw materials and finished goods.
(A) Determination of income. Under the simplified inventory
method, Business A's income for 2022 is computed as follows:

----------------------------------------------------------------------------------------------------------------
Amount in
Item [euro] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Sales revenue................................. 180 [euro]1 = $2.50 (yearly avg. 450
rate--2022).
COGS before adjustments....................... 96 [euro]1 = $2.50 (yearly avg. 240
rate--2022).
Adjustment for cost recovery deductions .............. ................................ (60)
(see calculation below).
Adjustment for beginning inventory (see .............. ................................ (40)
calculation below).
-----------------------------------------------------------------
Adjusted COGS......................... .............. ................................ 140
SG&A:
Depreciation on building (50%)............ 10 [euro]1 = $1.00 (historic rate-- 10
2020).
Salaries.................................. 10 [euro]1 = $2.50 (yearly avg. 25
rate--2022).
-----------------------------------------------------------------
Total SG&A............................ .............. ................................ 35
Section 987 net income (revenue less COGS and .............. ................................ 275
SG&A).
----------------------------------------------------------------------------------------------------------------

COGS Adjustments.
Adjustment for cost recovery deductions.

----------------------------------------------------------------------------------------------------------------
Adjustment
2022 yearly Difference in (depreciation
Depreciation amount Historic rate avg. rate translation x change in
rates rates)
----------------------------------------------------------------------------------------------------------------
[euro]10 (building)............................. 1.00 2.50 (1.50) ($15)
[euro]30 (machine).............................. 1.00 2.50 (1.50) (45)
---------------------------------------------------------------
Total adjustment for cost recovery .............. .............. .............. (60)
deductions.................................
----------------------------------------------------------------------------------------------------------------

Adjustment for beginning inventory.

[[Page 88841]]



----------------------------------------------------------------------------------------------------------------
Adjustment
2021 yearly 2022 yearly Difference in (inventory x
Prior year ending inventory avg. rate avg. rate translation change in
rates rates)
----------------------------------------------------------------------------------------------------------------
[euro]40........................................ 1.50 2.50 (1.00) ($40)
---------------------------------------------------------------
Total adjustment for beginning inventory.... .............. .............. .............. (40)
----------------------------------------------------------------------------------------------------------------

(B) Determination of OFCNV. Under the simplified inventory
method, the OFCNV of Business A for 2022 is determined under
paragraph (e) of this section as follows:

OFCNV--End of 2022
----------------------------------------------------------------------------------------------------------------
Amount in
Assets [euro] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Euros.................................. 260 [euro]1 = $3.00 (year-end spot 780
rate--2022).
Building............................... 740 [euro]1 = $1.00 (historic rate-- 740
2020).
Machine................................ 240 [euro]1 = $1.00 (historic rate-- 240
2020).
Inventory.............................. 54 [euro]1 = $2.50 (yearly average 135
rate--2022).
--------------------------------------------------------------------
Total assets....................... .............. ................................... 1,895
Liabilities:
Total liabilities.................. .............. ................................... 0
2022 ending OFCNV.......................... .............. ................................... 1,895
----------------------------------------------------------------------------------------------------------------

(C) Determination of net unrecognized section 987 gain or loss.
The net unrecognized section 987 gain of Business A is determined
under paragraph (d) of this section as follows (relevant steps
only):
(1) Step 1. Under paragraph (d)(1) of this section, the change
in OFCNV for the taxable year must be determined. This amount is
equal to the OFCNV of Business A determined under paragraph (e) of
this section on the last day of 2022, less the OFCNV of Business A
determined on the last day of 2021.

2022 ending OFCNV....................................... $1,895
Less: 2021 ending OFCNV................................. (1,410)
---------------
Change in OFCNV..................................... 485


(2) Step 6. Under paragraph (d)(6) of this section, the
aggregate amount determined in steps 1 through 5 must be decreased
by the section 987 taxable income of Business A. The amount of
Business A's taxable income for 2022, as determined above, is $275.

Change in OFCNV......................................... $485
Less: Section 987 taxable income........................ (275)
---------------
Unrecognized section 987 gain 2022.................. 210
Plus: Net accumulated unrecognized section 987 gain from 130
prior year.............................................
---------------
Net unrecognized section 987 gain................... 340


Example 4. (i) Background. The background facts about Business
A are the same as in Example 3, except that Business A uses the
dollar-value LIFO method to account for inventory.
(ii) Operations in 2021. The facts about Business A's operations
in 2021 are the same as in Example 3.
(A) Determination of income. Under the simplified inventory
method, Business A's income for 2021 is computed as follows:

----------------------------------------------------------------------------------------------------------------
Amount in
Item [euro] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Sales revenue................................. 140 [euro]1 = $1.50 (yearly avg. 210
rate--2021).
COGS before adjustments....................... 70 [euro]1 = $1.50 (yearly avg. 105
rate--2021).
Adjustment for cost recovery deductions .............. ................................ (20)
(same as Example 1).
Adjustment for LIFO liquidation (none).... .............. ................................ 0
-----------------------------------------------------------------
Adjusted COGS......................... .............. ................................ 85
SG&A:
Depreciation on building (50%)............ 10 [euro]1 = $1.00 (historic rate-- 10
2020).
Salaries.................................. 10 [euro]1 = $1.50 (yearly avg. 15
rate--2021).
-----------------------------------------------------------------
Total SG&A............................ .............. ................................ 25
Section 987 net income (revenue less COGS and .............. ................................ 100
SG&A).
----------------------------------------------------------------------------------------------------------------

(B) Determination of OFCNV for 2020 and 2021. Under the
simplified inventory method, the OFCNV of Business A for 2020 and
2021 is determined under paragraph (e) of this section as follows:

OFCNV--End of 2021
----------------------------------------------------------------------------------------------------------------
Amount in
Assets [euro] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Euros...................................... 160 [euro]1 = $2.00 (year-end spot 320
rate--2021).
Building................................... 760 [euro]1 = $1.00 (historic rate-- 760
2020).

[[Page 88842]]


Machine.................................... 270 [euro]1 = $1.00 (historic rate-- 270
2020).
Inventory.................................. 40 [euro]1 = $1.50 (historic rate-- 60
2021).
--------------------------------------------------------------------
Total assets........................... .............. ................................... 1,410
Liabilities:
Total liabilities...................... .............. ................................... 0
2021 ending OFCNV.......................... .............. ................................... 1,410
----------------------------------------------------------------------------------------------------------------


OFCNV--End of 2020
----------------------------------------------------------------------------------------------------------------
Amount in
Assets [euro] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Euros...................................... 100 [euro]1 = $1.00 (year-end spot 100
rate--2020).
Building................................... 780 [euro]1 = $1.00 (historic rate-- 780
2020).
Machine.................................... 300 [euro]1 = $1.00 (historic rate-- 300
2020).
--------------------------------------------------------------------
Total assets........................... .............. ................................... 1,180
Liabilities:
Total liabilities...................... .............. ................................... 0
2020 ending OFCNV.......................... .............. ................................... 1,180
----------------------------------------------------------------------------------------------------------------

(C) Determination of net unrecognized section 987 gain or loss.
The net unrecognized section 987 gain or loss of Business A for 2021
is determined under paragraph (d) of this section as follows
(relevant steps only):
(1) Step 1. Under paragraph (d)(1) of this section, the change
in OFCNV for the taxable year must be determined. This amount is
equal to the OFCNV of Business A determined under paragraph (e) of
this section on the last day of 2021, less the OFCNV of Business A
determined on the last day of 2020.

2021 ending OFCNV....................................... $1,410
Less: 2020 ending OFCNV................................. (1,180)
---------------
Change in OFCNV..................................... (230)


(2) Step 6. Under paragraph (d)(6) of this section, the
aggregate amount determined in steps 1 through 5 must be decreased
by the section 987 taxable income of Business A. The amount of
Business A's taxable income for 2021, as determined above, is $100.

Change in OFCNV......................................... $230
Less: section 987 taxable income........................ (100)
---------------
Unrecognized section 987 gain....................... 130
Plus: Net accumulated unrecognized section 987 gain or 0
loss from prior years..................................
---------------
Net unrecognized section 987 gain................... 130


(iii) Operations in 2022. The facts about Business A's
operations in 2022 are the same as in Example 3, except that due to
Business A's dollar-value LIFO method of inventory accounting,
Business A's balance sheet on December 31, 2022, reflects a 2021
layer of inventory with a LIFO cost basis of [euro]40 and a 2022
layer of inventory with a LIFO cost basis of [euro]10.80, and
Business A's COGS is [euro]99.20.
(A) Determination of income. Business A's income for 2022 is
computed as follows:

----------------------------------------------------------------------------------------------------------------
Amount in
Item [euro] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Sales revenue................................. 180 [euro]1 = $2.50 (yearly avg. 450
rate--2022).
COGS before adjustments....................... 99.20 [euro]1 = $2.50 (yearly avg. 248
rate--2022).
Adjustment for cost recovery deductions .............. ................................ (60)
(same as Example 3).
Adjustment for LIFO liquidation (none).... .............. ................................ 0
-----------------------------------------------------------------
Adjusted COGS......................... .............. ................................ 188
SG&A:
Depreciation on building (50%)............ 10 [euro]1 = $1.00 (historic rate-- 10
2020).
Salaries.................................. 10 [euro]1 = $2.50 (yearly avg. 25
rate--2022).
-----------------------------------------------------------------
Total SG&A............................ .............. ................................ 35
Section 987 net income (revenue less COGS and .............. ................................ 227
SG&A).
----------------------------------------------------------------------------------------------------------------


OFCNV--End of 2022
----------------------------------------------------------------------------------------------------------------
Amount in
Assets [euro] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Euros...................................... 260.00 [euro]1 = $3.00 (year-end spot 780
rate--2022).
Building................................... 740.00 [euro]1 = $1.00 (historic rate-- 740
2020).
Machine.................................... 240.00 [euro]1 = $1.00 (historic rate-- 240
2020).
Inventory.................................. 10.80 [euro]1 = $2.50 (historic rate-- 27
2022).
40.00 [euro]1 = $1.50 (historic rate-- 60
2021).
--------------------------------------------------------------------
Total assets........................... .............. ................................... 1,847

[[Page 88843]]


Liabilities:
Total liabilities...................... .............. ................................... 0
2022 ending OFCNV.......................... .............. ................................... 1,847
----------------------------------------------------------------------------------------------------------------

(B) Determination of net unrecognized section 987 gain or loss.
The net unrecognized section 987 gain of Business A for 2022 is
determined under paragraph (d) of this section as follows (relevant
steps only):
(1) Step 1. Under paragraph (d)(1) of this section, the change
in OFCNV for the taxable year must be determined. This amount is
equal to the OFCNV of Business A determined under paragraph (e) of
this section on the last day of 2022, less the OFCNV of Business A
determined on the last day of 2021.

2022 ending OFCNV....................................... $1,847
Less: 2021 ending OFCNV................................. (1,410)
---------------
Change in OFCNV..................................... 437


(2) Step 6--Decrease the aggregate amount determined in steps 1
through 5 by the section 987 taxable income of the section 987 QBU
for the taxable year. Under paragraph (d)(6) of this section, the
aggregate amount determined in steps 1 through 5 must be decreased
by the section 987 taxable income of Business A. The amount of
Business A's taxable income for 2022, as determined above, is $227.

Change in OFCNV......................................... $437
Less: section 987 taxable income........................ (227)
---------------
Unrecognized section 987 gain 2022.................. 210
Plus: net accumulated unrecognized section 987 gain from 130
prior years............................................
---------------
Net unrecognized section 987 gain................... 340


(iv) Operations in 2023. During 2023, Business A recognizes
revenue of [euro]252 from sales of finished goods. The related COGS
is [euro]140.80, reflecting a full liquidation of the 2022 inventory
layer with a LIFO cost basis of $10.80 and a partial liquidation of
inventory from the 2021 layer with a LIFO cost basis of $10.00.
Business A pays [euro]10 in salaries allocable to SG&A.
Inventoriable costs in 2023 include [euro]10 of depreciation on the
building and [euro]30 of depreciation on the machine. Business A's
balance sheet on December 31, 2023, shows no liabilities and the
following assets: currency of [euro]422, the building with an
adjusted basis of [euro]720, the machine with an adjusted basis of
[euro]210, and a 2021 layer of ending inventory with a LIFO cost
basis of [euro]30, comprising raw materials and finished goods. The
yearly average exchange rate for 2023 is [euro]1 = $3.50, and the
spot rate on December 31, 2023 is [euro]1 = $4.00.
(A) Determination of income. Business A's income for 2023 is
computed as follows:

----------------------------------------------------------------------------------------------------------------
Amount in
Item [euro] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Sales revenue................................. 252 [euro]1 = $3.50 (yearly avg. 882
rate--2023).
COGS before adjustments....................... 140.80 [euro]1 = $3.50 (yearly avg. 492.80
rate--2023).
Adjustment for cost recovery deductions .............. ................................ (100.00)
(see calculation below).
Adjustment for LIFO liquidation (see .............. ................................ (30.80)
calculation below).
-----------------------------------------------------------------
Adjusted COGS......................... .............. ................................ 362.00
SG&A:
Depreciation on building (50%)............ 10 [euro]1 = $1.00 (historic rate-- 10
2020).
Salaries.................................. 10 [euro]1 = $3.50 (yearly avg. 35
rate--2023).
-----------------------------------------------------------------
Total SG&A............................ .............. ................................ 45
Section 987 net income........................ .............. ................................ 475
----------------------------------------------------------------------------------------------------------------

COGS Adjustments.
Adjustment for cost recovery deductions.

----------------------------------------------------------------------------------------------------------------
Adjustment
Historic 2023 yearly Difference in (depreciation
Depreciation amount rate avg. rate translation x change in
rates rates)
----------------------------------------------------------------------------------------------------------------
[euro]10 (building)............................. 1.00 3.50 (2.50) ($25)
[euro]30 (machine).............................. 1.00 3.50 (2.50) (75)
---------------------------------------------------------------
Total adjustment for cost recovery .............. .............. .............. (100)
deductions.................................
----------------------------------------------------------------------------------------------------------------

Adjustment for LIFO liquidation.

----------------------------------------------------------------------------------------------------------------
Adjustment
Difference in (liquidated
LIFO liquidation layer Historic rate 2023 yearly translation layer x
avg. rate rates change in
rates)
----------------------------------------------------------------------------------------------------------------
[euro]10.80 (2022).............................. 2.50 3.50 (1.00) ($10.80)
[euro]10 (2021)................................. 1.50 3.50 (2.00) (20.00)
---------------------------------------------------------------

[[Page 88844]]


Total adjustment for liquidation of LIFO .............. .............. .............. (30.80)
layers.....................................
----------------------------------------------------------------------------------------------------------------

(B) Determination of OFCNV. The OFCNV of Business A for 2023 is
determined under paragraph (e) of this section as follows:

OFCNV--End of 2023
----------------------------------------------------------------------------------------------------------------
Amount in
Assets [euro] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Euros...................................... 422 [euro]1 = $4.00 (year-end spot 1,688
rate--2023).
Building................................... 720 [euro]1 = $1.00 (historic rate-- 720
2020).
Machine.................................... 210 [euro]1 = $1.00 (historic rate-- 210
2020).
Inventory.................................. 30 [euro]1 = $1.50 (historic rate-- 45
2021).
--------------------------------------------------------------------
Total assets........................... .............. ................................... 2,663
Liabilities:
Total liabilities...................... .............. ................................... 0
2023 ending OFCNV.......................... .............. ................................... 2,663
----------------------------------------------------------------------------------------------------------------

(C) Determination of net unrecognized section 987 gain or loss.
The net unrecognized section 987 gain of Business A is determined
under paragraph (d) of this section as follows (relevant steps
only):
(1) Step 1. Under paragraph (d)(1) of this section, the change
in OFCNV for the taxable year must be determined. This amount is
equal to the OFCNV of Business A determined under paragraph (e) of
this section on the last day of 2023, less the OFCNV of Business A
determined on the last day of 2022.

2023 ending OFCNV....................................... $2,663
Less: 2022 ending OFCNV................................. (1,847)
---------------
Change in OFCNV......................................... 816


(2) Step 6--Decrease the aggregate amount determined in steps 1
through 5 by the section 987 taxable income of the section 987 QBU
for the taxable year. Under paragraph (d)(6) of this section, the
aggregate amount determined in steps 1 through 5 must be decreased
by the section 987 taxable income of Business A. The amount of
Business A's taxable income for 2023, as determined above, is $475.

Change in OFCNV......................................... $816
Less: section 987 taxable income........................ (475)
---------------
Unrecognized section 987 gain 2023.................. 341
Plus: net accumulated unrecognized section 987 gain from 340
prior years............................................
---------------
Net unrecognized section 987 gain................... 681


Sec. 1.987-5 Recognition of section 987 gain or loss.

(a) Recognition of section 987 gain or loss by the owner of a
section 987 QBU. The taxable income of an owner of a section 987 QBU
shall include the owner's section 987 gain or loss recognized with
respect to the section 987 QBU for the taxable year. Except as
otherwise provided, for any taxable year the owner's section 987 gain
or loss recognized with respect to a section 987 QBU shall equal:
(1) The owner's net unrecognized section 987 gain or loss with
respect to the section 987 QBU determined under Sec. 1.987-4 on the
last day of such taxable year (or, if earlier, on the day the section
987 QBU is terminated under Sec. 1.987-8); multiplied by
(2) The owner's remittance proportion for the taxable year, as
determined under paragraph (b) of this section.
(b) Remittance proportion. The owner's remittance proportion with
respect to a section 987 QBU for a taxable year shall equal:
(1) The remittance, as determined under paragraph (c) of this
section, to the owner from the section 987 QBU for such taxable year;
divided by
(2) The sum of
(A) The aggregate adjusted basis of the gross assets of the section
987 QBU as of the end of the taxable year that are reflected on its
year-end balance sheet translated into the owner's functional currency
as provided in Sec. 1.987-4(e)(2) and
(B) The amount of the remittance as determined under paragraph (c)
of this section.
(c) Remittance--(1) Definition. A remittance shall be determined in
the owner's functional currency and shall equal the excess, if any, of:
(i) The aggregate of all amounts transferred from the section 987
QBU to the owner during the taxable year, as determined in paragraph
(d) of this section; over
(ii) The aggregate of all amounts transferred from the owner to the
section 987 QBU during the taxable year, as determined in paragraph (e)
of this section.
(2) Day when a remittance is determined. An owner's remittance from
a section 987 QBU shall be determined on the last day of the owner's
taxable year (or, if earlier, on the day the section 987 QBU is
terminated under Sec. 1.987-8).
(3) Termination. A termination of a section 987 QBU as determined
under Sec. 1.987-8 is treated as a remittance of all the gross assets
of the section 987 QBU to the owner on the date of such termination.
See Sec. 1.987-8(e). Accordingly, the remittance proportion in the
case of a termination is 1.
(d) Aggregate of all amounts transferred from the section 987 QBU
to the owner for the taxable year. For purposes of paragraph (c)(1)(i)
of this section, the aggregate amount transferred from the section 987
QBU to the owner for the taxable year shall be the aggregate amount of
functional currency and the aggregate adjusted basis of the assets
transferred, as determined in the owner's functional currency under
Sec. 1.987-4(d)(2). Solely for this purpose, the amount of liabilities
transferred from the owner to the section 987 QBU, as determined in the
owner's functional currency under Sec. 1.987-4(d)(5), shall be treated
as a transfer of assets from the section 987 QBU to the owner in an
amount equal to the amount of such liabilities.

[[Page 88845]]

(e) Aggregate of all amounts transferred from the owner to the
section 987 QBU for the taxable year. For purposes of paragraph
(c)(1)(ii) of this section, the aggregate of all amounts transferred
from the owner to the section 987 QBU for the taxable year shall be the
aggregate amount of functional currency and the aggregate adjusted
basis of the assets transferred, as determined in the owner's
functional currency under Sec. 1.987-4(d)(3). Solely for this purpose,
the amount of liabilities transferred from the section 987 QBU to the
owner determined under Sec. 1.987-4(d)(4) shall be treated as a
transfer of assets from the owner to the section 987 QBU in an amount
equal to the amount of such liabilities.
(f) Determination of owner's adjusted basis in transferred assets--
(1) In general. The owner's adjusted basis in an asset received in a
transfer from a section 987 QBU (whether or not such transfer is made
in connection with a remittance, as defined in paragraph (c) of this
section) shall be determined in the owner's functional currency under
the rules prescribed in paragraphs (f)(2) and (f)(3) of this section.
(2) Marked asset. The basis of a marked asset shall be the amount
determined by translating the section 987 QBU's functional currency
basis of the asset, after taking into account Sec. 1.988-1(a)(10),
into the owner's functional currency at the spot rate (as defined in
Sec. 1.987-1(c)(1)) applicable to the date of transfer.
(3) Historic asset. The basis of a historic asset shall be the
amount determined by translating the section 987 QBU's functional
currency basis of the asset, after taking into account Sec. 1.988-
1(a)(10), into the owner's functional currency at the historic rate for
the asset (as defined in Sec. 1.987-1(c)(3)).
(g) Example. The following example illustrates the calculation of
section 987 gain or loss under this section:

Example. (i) U.S. Corp, a domestic corporation with the dollar
as its functional currency, operates in the United Kingdom through
Business A, a section 987 QBU with the pound as its functional
currency. During 2021, the following transfers took place between
U.S. Corp and Business A. On January 5, 2021, U.S. Corp transferred
to Business A $300, which Business A used during the year to
purchase services. On March 5, 2021, Business A transferred a
machine to U.S. Corp. The pound adjusted basis of the machine when
properly translated into dollars as described under Sec. 1.987-
4(d)(2)(ii)(B) and paragraph (d) of this section is $500. On
November 1, 2021, Business A transferred pounds to U.S. Corp. The
dollar amount of the pounds when properly translated as described
under Sec. 1.987-4(d)(2)(ii)(A) and paragraph (d) of this section
is $2,300. On December 7, 2021, U.S. Corp transferred a truck to
Business A with an adjusted basis of $2,000.
(ii) At the end of 2021, Business A holds assets, properly
translated into the owner's functional currency pursuant to Sec.
1.987-4(e)(2), consisting of a computer with a pound adjusted basis
equivalent to $500, a truck with a pound adjusted basis equivalent
to $2,000, and pounds equivalent to $2,850. In addition, Business A
has a pound liability entered into in 2020 with Bank A. All such
assets and liabilities are reflected on the books and records of
Business A. Assume that the net unrecognized section 987 gain for
Business A as determined under Sec. 1.987-4 as of the last day of
2021 is $80.
(iii) U.S. Corp's section 987 gain with respect to Business A is
determined as follows:
(A) Computation of amount of remittance. Under paragraphs (c)(1)
and (c)(2) of this section, U.S. Corp must determine the amount of
the remittance for 2021 in the owner's functional currency (dollars)
on the last day of 2021. The amount of the remittance for 2021 is
$500, determined as follows:
Transfers from Business A to U.S. Corp in dollars:

Machine................................................. $500
Pounds.................................................. 2,300
---------------
Aggregate transfers from Business A to U.S. Corp.... 2,800


Transfers from U.S. Corp to Business A in dollars:

U.S. dollars............................................ $300
Truck................................................... 2,000
---------------
Aggregate transfers from U.S. Corp to Business A.... 2,300


Computation of amount of remittance:

Aggregate transfers from Business A to U.S. Corp........ $2,800
Less: aggregate transfers from U.S. Corp to Business A.. (2,300)
---------------
Total remittance.................................... 500


(B) Computation of section 987 QBU gross assets plus remittance.
Under paragraph (b)(2) of this section, Business A must determine
the aggregate basis of its gross assets that are reflected on its
year-end balance sheet translated into the owner's functional
currency and must increase this amount by the amount of the
remittance.

Computer................................................ $500
Pounds.................................................. 2,850
Truck................................................... 2,000
---------------
Aggregate gross assets.............................. 5,350
Remittance.......................................... 500
Aggregate basis of Business A's gross assets at end 5,850
of 2021, increased by amount of remittance.........


(C) Computation of remittance proportion. Under paragraph (b) of
this section, Business A must compute the remittance proportion by
dividing the $500 remittance amount by the $5,850 sum of the
aggregate basis of Business A's gross assets and the amount of the
remittance. The resulting remittance proportion is 0.085.
(D) Computation of section 987 gain or loss. The amount of U.S.
Corp's section 987 gain or loss that must be recognized with respect
to Business A is determined under paragraph (a) of this section by
multiplying the 0.085 remittance proportion by the $80 of net
unrecognized section 987 gain. U.S. Corp's resulting recognized
section 987 gain for 2021 is $6.80.

0
Par. 5. Sections 1.987-6 through 1.987-11 are added to read as follows:
* * * * *
Sec.
1.987-6 Character and source of section 987 gain or loss.
1.987-7 Section 987 aggregate partnerships.
1.987-8 Termination of a section 987 QBU.
1.987-9 Recordkeeping requirements.
1.987-10 Transition rules.
1.987-11 Effective/applicability date.
* * * * *


Sec. 1.987-6 Character and source of section 987 gain or loss.

(a) Ordinary income or loss. Section 987 gain or loss is ordinary
income or loss for Federal income tax purposes.
(b) Character and source of section 987 gain or loss--(1) In
general. With respect to each section 987 QBU, the owner must determine
the character and source of section 987 gain or loss in the year of a
remittance under the rules of this paragraph (b) for all purposes of
the Internal Revenue Code, including sections 904(d), 907, and 954.
(2) Method required to characterize and source section 987 gain or
loss. The owner must use the asset method set forth in Sec. 1.861-
9T(g) to characterize and source section 987 gain or loss. In applying
the asset method, the owner must take into account only the assets of
the section 987 QBU and must consistently determine the value of the
assets on the basis of either the tax book value or the fair market
value of the assets. The modified gross income method described in
Sec. 1.861-9T(j) cannot be used.
(3) Coordination with section 954. Solely for purposes of
determining the excess of foreign currency gains over foreign currency
losses characterized as foreign personal holding company income under
section 954(c)(1)(D), section 987 gain or loss that is characterized
pursuant to paragraph (b)(2) of this section by reference to assets
that give rise to subpart F income shall be treated as foreign currency
gain or foreign currency loss attributable to section 988 transactions
not directly related to the business needs of the controlled foreign
corporation.

[[Page 88846]]

(c) Examples. The following examples illustrate the application of
this section.

Example 1. CFC is a controlled foreign corporation as defined
in section 957 with the Swiss franc (Sf) as its functional currency.
CFC is the owner of Business A, a section 987 QBU that has the euro
as its functional currency. For the year 2021, CFC recognizes
section 987 gain of Sf10,000 under Sec. 1.987-5. Applying the rules
of this section, Business A has average total assets of Sf1,000,000,
which generate income as follows: Sf750,000 of assets that generate
foreign source general limitation income under section 904(d)(1)(A),
none of which is subpart F income under section 952; and Sf250,000
of assets that generate foreign source passive income under section
904(d)(1)(B), all of which is subpart F income. Under paragraph (b)
of this section, Sf7,500 (Sf750,000/Sf1,000,000 x Sf10,000) of the
section 987 gain will be characterized as foreign source general
limitation income that is not subpart F income under section 952,
and Sf2,500 (Sf250,000/Sf1,000,000 x Sf10,000) will be characterized
as foreign source passive income that is characterized as foreign
personal holding company income under section 954(c)(1)(D). All of
the section 987 gain is treated as ordinary income.
Example 2. The facts are the same as in Example 1 except that:
(a) CFC recognizes section 987 loss of Sf40,000, Sf10,000 of which
is characterized under paragraph (b) of this section by reference to
assets that give rise to subpart F income; and (b) CFC otherwise has
Sf12,000 of net foreign currency gain determined under Sec. 1.954-
2(g) that is taken into account in determining the excess of foreign
currency gain over foreign currency losses characterized as foreign
personal holding company income under section 954(c)(1)(D). Under
paragraph (b)(3) of this section, the Sf10,000 section 987 loss
characterized by reference to assets that give rise to subpart F
income is treated as foreign currency loss attributable to section
988 transactions not directly related to the business needs of the
controlled foreign corporation for purposes of determining the
excess of foreign currency gains over foreign currency losses
characterized as foreign personal holding company income under
section 954(c)(1)(D). Accordingly, CFC will aggregate the Sf10,000
section 987 loss with the Sf12,000 net foreign currency gain and
will have Sf2,000 of net foreign currency gain characterized as
foreign personal holding company income under section 954(c)(1)(D).


Sec. 1.987-7 Section 987 aggregate partnerships.

(a) In general. This section provides rules for determining an
owner's share of the assets and liabilities of an eligible QBU that is
owned indirectly, as described in Sec. 1.987-1(b)(4)(ii), through a
section 987 aggregate partnership.
(b) [Reserved].
(c) Coordination with subchapter K. [Reserved].


Sec. 1.987-8 Termination of a section 987 QBU.

(a) Scope. This section provides rules regarding the termination of
a section 987 QBU. Paragraph (b) of this section provides general rules
for determining when a termination occurs. Paragraph (c) of this
section provides exceptions to the general termination rules for
certain transactions described in section 381(a). Paragraph (e) of this
section describes certain effects of terminations. Paragraph (f) of
this section contains examples that illustrate the principles of this
section.
(b) In general. Except as provided in paragraph (c) of this
section, a section 987 QBU terminates if the conditions described in
one of paragraphs (b)(1) through (4) is satisfied.
(1) Trade or business ceases. A section 987 QBU ceases its trade or
business. When a section 987 QBU ceases its trade or business is
determined based on all the facts and circumstances, provided that an
owner may continue to treat a section 987 QBU as a section 987 QBU for
a reasonable period during the winding up of such trade or business,
which period may in no event exceed two years from the date on which
such QBU ceases its activities carried on for profit.
(2) Substantially all assets transferred. The section 987 QBU
transfers substantially all (within the meaning of section
368(a)(1)(C)) of its assets to its owner. For purposes of this
paragraph (b)(2), the amount of assets transferred from the section 987
QBU to its owner as a result of a transaction shall be reduced by the
amount of assets transferred from the owner to the section 987 QBU
pursuant to the same transaction. See Examples 2, 5, and 6 in paragraph
(f) of this section.
(3) Owner no longer a CFC. A foreign corporation that is a
controlled foreign corporation (as defined in section 957) that is the
owner of a section 987 QBU ceases to be a controlled foreign
corporation as a result of a transaction or series of transactions
after which persons that were related to the corporation within the
meaning of section 267(b) immediately before the transaction or series
of transactions collectively own sufficient interests in the
corporation such that the corporation would continue to be considered a
controlled foreign corporation if such persons were United States
shareholders within the meaning of section 951(b).
(4) Owner ceases to exist. The owner of the section 987 QBU ceases
to exist (including in connection with a transaction described in
section 381(a)).
(c) Transactions described in section 381(a)--(1) Liquidations.
Notwithstanding paragraph (b) of this section, a termination does not
occur when the owner of a section 987 QBU ceases to exist in a
liquidation described in section 332, except in the following cases:
(i) The distributor is a domestic corporation and the distributee
is a foreign corporation.
(ii) The distributor is a foreign corporation and the distributee
is a domestic corporation.
(iii) The distributor and the distributee are both foreign
corporations and the functional currency of the distributee is the same
as the functional currency of the distributor's section 987 QBU.
(2) Reorganizations. Notwithstanding paragraph (b) of this section,
a termination does not occur when the owner of the section 987 QBU
ceases to exist in a reorganization described in section 381(a)(2),
except in the following cases:
(i) The transferor is a domestic corporation and the acquiring
corporation is a foreign corporation.
(ii) The transferor is a foreign corporation and the acquiring
corporation is a domestic corporation.
(iii) The transferor is a controlled foreign corporation
immediately before the transfer, the acquiring corporation is a foreign
corporation that is not a controlled foreign corporation immediately
after the transfer, and the acquiring corporation was related to the
transferor within the meaning of section 267(b) immediately before the
transfer.
(iv) The transferor and the acquiring corporation are foreign
corporations and the functional currency of the acquiring corporation
is the same as the functional currency of the transferor's section 987
QBU.
(d) [Reserved].
(e) Effect of terminations. A termination of a section 987 QBU as
determined in this section is treated as a remittance of all the gross
assets of the section 987 QBU to its owner immediately before the
section 987 QBU terminates. Thus, except as otherwise provided in these
regulations under section 987, a termination results in the recognition
of any net unrecognized section 987 gain or loss of the section 987
QBU. See Sec. 1.987-5(c)(3).
(f) Examples. The following examples illustrate the principles of
this section. Except as otherwise provided, U.S. Corp is a domestic
corporation that has the U.S. dollar as its functional currency, and
Business A is a section 987 QBU.

Example 1. Cessation of operations. (i) Facts. U.S. Corp is the
owner of Business A,

[[Page 88847]]

a sales office of U.S. Corp in Country X. Business A ceases sales
activities on December 31, 2021. During 2022, Business A sells all
of the assets used in its sales activities and winds up its
business, settling outstanding accounts.
(ii) Analysis. Business A's trade or business ceases on December
31, 2021. The cessation of Business A's trade or business causes a
termination of the Business A section 987 QBU under paragraph (b)(1)
of this section on December 31, 2021, unless U.S. Corp chooses to
continue to treat Business A as a section 987 QBU until completion
of the wind-up activities in 2022. If U.S. Corp chooses to continue
to treat Business A as a section 987 QBU during the wind-up of
Business A, Business A section 987 QBU would terminate under
paragraph (b)(1) of this section upon completion of the wind-up in
2022.
Example 2. Transfer of a section 987 QBU to a member of a
consolidated group. (i) Facts. U.S. Corp, the owner of Business A,
transfers all the assets and liabilities of Business A to DS, a
domestic corporation all of the stock of which is owned by U.S.
Corp, in a transaction qualifying under section 351. U.S. Corp and
DS are members of the same consolidated group.
(ii) Analysis. Pursuant to Sec. 1.987-2(c)(2)(i) and (ii), as a
result of the deemed exchange of the assets and liabilities of
Business A for DS stock in a section 351 transaction, Business A is
treated as transferring its assets and liabilities to U.S. Corp
immediately before the transfer by U.S. Corp of the assets and
liabilities to DS. Because a section 351 transaction is not a
transaction described in section 381(a), the transfer of all of the
assets of Business A to U.S. Corp causes a termination of the
Business A section 987 QBU under paragraph (b)(2) of this section.
Example 3. Cessation of controlled foreign corporation status.
(i) Facts. Foreign parent (FP) is a foreign corporation that owns
all the stock of U.S. Corp, a domestic corporation. U.S. Corp owns
all of the stock of FC, a controlled foreign corporation as defined
in section 957. FC is the owner of Business A. FP contributes cash
to FC in exchange for FC stock representing 60 percent of the voting
power and value of all FC stock. FC no longer constitutes a
controlled foreign corporation after the capital contribution.
(ii) Analysis. Because FC ceases to qualify as a controlled
foreign corporation as a result of a transaction after which persons
that were related to FC within the meaning of section 267(b)
immediately before the transaction collectively own sufficient
interests in FC such that the FC would continue to be considered a
controlled foreign corporation if such persons were United States
shareholders within the meaning of section 951(b), the Business A
section 987 QBU terminates pursuant to paragraph (b)(3) of this
section.
Example 4. Section 332 liquidation. (i) Facts. U.S. Corp owns
all of the stock of FC, a foreign corporation. FC is the owner of
Business A. Pursuant to a liquidation described in section 332, FC
transfers all of its assets and liabilities to U.S. Corp.
(ii) Analysis. FC's liquidation causes a termination of the
Business A section 987 QBU as provided in paragraph (b)(4) of this
section because FC ceases to exist as a result of the liquidation.
The exception for certain section 332 liquidations provided under
paragraph (c)(1) of this section does not apply because U.S. Corp is
a domestic corporation and FC is a foreign corporation. See
paragraph (c)(1)(ii) of this section.
Example 5. Transfers to and from a section 987 QBU pursuant to
the same transaction. (i) Facts. U.S. Corp owns 100 percent of DC1
and DC2, each a domestic corporation. DC1 owns Entity A, a DE that
conducts a business (Business A) in Country X that constitutes a
section 987 QBU of DC1. DC2 subsequently contributes property to
Entity A in exchange for a 95 percent interest in Entity A. The
property DC2 contributes to Entity A is used in the business
conducted by Business A and is reflected on its books and records as
provided under Sec. 1.987-2(b).
(ii) Analysis. (A) For general Federal income tax purposes,
Entity A is converted to a partnership when DC2 contributes property
to Entity A in exchange for a 95 percent interest in Entity A. DC2's
contribution is treated as a contribution to a partnership in
exchange for an ownership interest in the partnership. DC1 is
treated as contributing all of Business A to the partnership in
exchange for a partnership interest. See Rev. Rul. 99-5 (situation
2), (1999-1 CB 434) and Sec. 601.601(d)(2) of this chapter. For
purposes of this section, these deemed transactions are not taken
into account. See Sec. 1.987-2(c) and Sec. 1.987-2(c)(10), Example
9.
(B) Under Sec. 1.987-1(b)(5)(i), Entity A is converted to a
section 987 aggregate partnership when DC2 contributes property to
Entity A in exchange for a 95 percent interest in Entity A because
DC1 and DC2 own all the interests in partnership capital and
profits, DC1 and DC2 are related within the meaning of section
267(b), and the requirements of Sec. 1.987-1(b)(5)(i)(B) are
satisfied. Because DC2 is a partner in a section 987 aggregate
partnership that owns Business A and because DC2 and Business A have
different functional currencies, DC2's portion of the Business A
assets constitutes a section 987 QBU of DC2.
(C) As a result of the conversion of Entity A to a partnership,
DC2 acquires an allocable share of 95 percent of the assets of
Business A, as determined under Sec. 1.987-7. Accordingly, under
Sec. 1.987-2(c)(5), DC2 is treated as contributing 95 percent of
its contributed property to its Business A section 987 QBU. In
addition, DC2 is treated as transferring 5 percent of the
contributed property to DC1, and DC1 is subsequently treated as
transferring that property to DC1's Business A section 987 QBU. In
addition, 95 percent of the original (pre-conversion) assets of
Business A cease being reflected on the books and records of DC1's
section 987 QBU. Under Sec. 1.987-2(b)(5), these amounts are
treated as if they are transferred from DC1's section 987 QBU to
DC1, and DC1 is treated as transferring these assets to DC2. DC2 is
subsequently treated as transferring these assets to DC2's Business
A section 987 QBU. The other 5 percent of the original (pre-
conversion) assets are treated as remaining on the books and records
of DC1's section 987 QBU and are not deemed to be transferred.
(D) For purposes of determining whether substantially all the
assets of Business A were transferred from DC1's section 987 QBU as
provided under paragraph (b)(2) of this section, the amount of
assets transferred from Business A to DC1 under Sec. 1.987-2(c) (95
percent of the assets held by Business A before the contribution by
DC2) must be reduced by the 5 percent of the assets contributed by
DC2, which were treated as transferred from DC2 to DC1 and
subsequently transferred from DC1 to its Business A section 987 QBU,
as a result of the formation of the section 987 aggregate
partnership. Accordingly, the amount of assets transferred from
DC1's section 987 QBU for purposes of paragraph (b)(2) of this
section is equal to 95 percent of the original (pre-conversion)
assets minus 5 percent of DC2's contributed assets.
Example 6. Deemed transfers to a CFC upon a check-the-box
election. (i) Facts. In 2021, U.S. Corp forms an entity in a foreign
country, Entity A. Entity A owns Business A, which has the pound as
its functional currency. Entity A forms Entity B in another foreign
country. Entity B owns Business B, a section 987 QBU that has the
euro as its functional currency. At the time of formation, Entity A
and Entity B elect to be DEs. In 2026, Entity A files an election on
Form 8832 to be classified as a corporation under Sec. 301.7701-
3(g)(1)(iv) and becomes a CFC (FC) owned directly by U.S. Corp. FC
has the pound as its functional currency.
(ii) Analysis. (A) Under Sec. 1.987-1(b)(4)(i), U.S. Corp is
the owner of Business A and Business B. In 2026, when Entity A
elects to be classified as a corporation, U.S. Corp is deemed to
contribute the assets and liabilities of Business A and Business B
to FC under section 351 in exchange for FC stock. Pursuant to Sec.
1.987-2(c)(2)(i) and (ii), as a result of the deemed exchange of the
assets and liabilities of Business A and Business B for FC stock in
a section 351 transaction, Business A and Business B are each
treated as transferring their assets and liabilities to U.S. Corp
immediately before U.S. Corp's transfer of such assets and
liabilities to FC. The transfer of assets from Business A and
Business B to U.S. Corp causes terminations of those section 987
QBUs under paragraph (b)(2) of this section. The assets and
liabilities of Business A and Business B are now owned by FC, but
because FC and Business A have the same functional currency, only
Business B qualifies as a section 987 QBU to which section 987
applies.
(B) Terminations also would have occurred in 2026 if U.S. Corp
had contributed Entity A and Entity B to an existing foreign
corporation owned by U.S. Corp or to a newly created foreign
corporation owned by U.S. Corp pursuant to a section 351 exchange
because the transfer of all of the assets of Business A and Business
B would cause terminations of those section 987 QBUs under paragraph
(b)(2) of this section.
Example 7. Sale of a section 987 QBU to a member of a
consolidated group. (i) Facts. U.S. Corp, the owner of Business A,
sells all of the assets and liabilities of Business A to DS, a
domestic corporation, in exchange for cash. U.S. Corp and DS are
members of the

[[Page 88848]]

same consolidated group. The cash received on the sale is recorded
on the books of U.S. Corp.
(ii) Analysis. Pursuant to Sec. 1.987-2(c)(2)(i) and (ii),
Business A is treated as transferring all of its assets and
liabilities to U.S. Corp immediately before the sale by U.S. Corp to
DS. As a result of this deemed transfer from Business A to U.S.
Corp, the Business A section 987 QBU terminates under paragraph
(b)(2) of this section.


Sec. 1.987-9 Recordkeeping requirements.

(a) In general. A taxpayer that is an owner of a section 987 QBU
shall keep a copy of each election made by the taxpayer in accordance
with the rules of Sec. 1.987-1(g)(3) (if not required to be made on a
form published by the Commissioner regarding section 987) and such
reasonable records as are sufficient to establish the section 987 QBU's
taxable income or loss and section 987 gain or loss.
(b) Supplemental information. An owner's obligation to maintain
records under section 6001 and paragraph (a) of this section is not
satisfied unless the following information is maintained in such
records with respect to each section 987 QBU:
(1) The amount of the items of income, gain, deduction, or loss
attributed to the section 987 QBU in the functional currency of the
section 987 QBU.
(2) The amount of assets and liabilities attributed to the section
987 QBU in the functional currency of the section 987 QBU.
(3) The exchange rates used to translate items of income, gain,
deduction, or loss of the section 987 QBU into the owner's functional
currency and, if a spot rate convention is used, the manner in which
such convention is determined.
(4) The exchange rates used to translate the assets and liabilities
of the section 987 QBU into the owner's functional currency and, if a
spot rate convention is used, the manner in which such convention is
determined.
(5) The amount of the items of income, gain, deduction, or loss
attributed to the section 987 QBU translated into the functional
currency of the owner.
(6) The amount of assets and liabilities attributed to the section
987 QBU translated into the functional currency of the owner.
(7) The amount of assets and liabilities transferred by the owner
to the section 987 QBU determined in the functional currency of the
owner.
(8) The amount of assets and liabilities transferred by the section
987 QBU to the owner determined in the functional currency of the
owner.
(9) The amount of the unrecognized section 987 gain or loss for the
taxable year.
(10) The amount of the net accumulated unrecognized section 987
gain or loss at the close of the taxable year.
(11) If a remittance is made, the computations determined under
Sec. 1.861-9T(g) for purposes of sourcing and characterizing the
remittance under Sec. 1.987-5.
(12) The transition information required to be determined under
Sec. 1.987-10(e).
(c) Retention of records. The records required by this section, or
records that support the information required on a form published by
the Commissioner regarding section 987, must be maintained and kept at
all times available for inspection by the Internal Revenue Service for
so long as the contents thereof may become relevant in the
administration of the Internal Revenue Code.
(d) Information on a dedicated section 987 form. The requirements
of paragraph (b) of this section shall be satisfied if the taxpayer
provides the specific information required on a form published by the
Commissioner for this purpose.


Sec. 1.987-10 Transition rules.

(a) Scope. These transition rules shall apply to any taxpayer that
is an owner of a section 987 QBU pursuant to Sec. 1.987-1(b)(4) on the
transition date (as defined in Sec. 1.987-11(c)). Except as provided
in paragraph (c) of this section, a taxpayer to which this section
applies must transition from the method previously used to comply with
section 987 (the ``prior section 987 method'') to the method prescribed
by these regulations pursuant to the fresh start transition method set
forth in paragraph (b) of this section.
(b) Fresh start transition method--(1) In general. Pursuant to the
fresh start transition method, and solely for purposes of this section,
all section 987 QBUs of a taxpayer, other than section 987 QBUs subject
to paragraph (c) of this section, are deemed to terminate on the day
before the transition date. No section 987 gain or loss is determined
or recognized as a result of the deemed termination. The owner of a
section 987 QBU that is deemed to terminate under this section is
treated as having transferred all of the assets and liabilities
attributable to such QBU to a new section 987 QBU on the transition
date. This deemed transfer of assets and liabilities is taken into
account only for purposes of transitioning to these regulations under
section 987 and shall not be taken into account in determining the
amounts transferred from the owner to the section 987 QBU during the
taxable year for purposes of Sec. 1.987-5(c)(1)(ii).
(2) Application of Sec. 1.987-4. For purposes of applying Sec.
1.987-4 with respect to a section 987 QBU described in paragraph (b)(1)
of this section for the taxable year beginning on the transition date,
the amount of assets and liabilities deemed transferred from the owner
to the section 987 QBU on the transition date pursuant to paragraph
(b)(1) of this section shall be determined by translating such assets
and liabilities (without regard to whether the asset or liability is a
marked item or a historic item) at the historic rate as determined
under paragraph (b)(3) of this section.
(3) Determination of historic rate. For purposes of applying these
regulations with respect to a section 987 QBU described in paragraph
(b)(1) of this section for taxable years beginning on or after the
transition date, the historic rate (as defined in Sec. 1.987-1(c)(3))
for an asset or liability deemed transferred under paragraph (b)(1) of
this section from an owner to the section 987 QBU on the transition
date shall be the historic rate under Sec. 1.987-1(c)(3) determined by
reference to the date the assets were acquired or liabilities entered
into or assumed by the section 987 QBU deemed terminated (that is,
without regard to the deemed termination or transfer described in
paragraph (b)(1) of this section). However, if the owner is not able to
determine reliably the historic rate for a particular asset or
liability, then the historic rate must be determined based on
reasonable assumptions (for example, assumptions about turnover and
aging of accounts receivable), consistently applied.
(4) Example. The provisions of this paragraph (b) are illustrated
by the following example. Exchange rate assumptions used in the example
are selected for the purpose of illustrating the principles of this
section, and no inference is intended by their use. Additionally, the
effect of depreciation is not taken into account for purposes of this
example.

Example. (i) U.S. Corp is a domestic corporation with the dollar
as its functional currency. U.S. Corp owns Business A, a U.K. branch
with the pound as its functional currency. Business A was formed on
January 1, year 1. U.S. Corp uses the method prescribed in the 1991
proposed section 987 regulations to determine the section 987 gain
or loss of Business A. U.S. Corp contributed [pound]6,000 to
Business A on January 1, year 1. On the same day, Business A bought
a truck for [pound]4,000 and a computer for [pound]1,000.

[[Page 88849]]

Business A had profits determined under Sec. 1.987-1(b)(1)(i)
through (iii) of the 1991 proposed section 987 regulations of
[pound]250 in each of year 1, year 2, and year 3, and the yearly
average exchange rate was used in each of those years to translate
Business A's profits under the 1991 proposed section 987
regulations. The yearly average exchange rate was [pound]1 = $1.10
in year 1, [pound]1 = $1.20 in year 2, and [pound]1 = $1.30 in year
3. Business A incurred a [pound]50 loss in each of year 4 and year
5. Business A made no remittances to U.S. Corp in any year.
(ii) On January 1, year 5, Business A transitions to the method
provided in these regulations pursuant to the fresh start transition
method described in paragraph (b) of this section. Pursuant to
paragraph (b)(1) of this section, Business A is deemed to terminate
on December 31, year 4. However, no section 987 gain or loss is
determined or recognized as a result of the deemed termination.
Pursuant to paragraph (b)(2) of this section, for purposes of
applying Sec. 1.987-4 with respect to Business A for year 5, the
amount of assets and liabilities transferred from U.S. Corp to
Business A on the transition date shall be determined by translating
all of Business A's assets at the historic rates for those assets as
determined under Sec. 1.987-1(c)(3) and paragraph (b)(3) of this
section. Because U.S. Corp is not able to determine reliably the
historic rate for the pound currency it is deemed to transfer to
Business A, U.S. Corp determines the historic rate for these pounds
based on a last-in, first-out cash flow assumption. Thus, it is
assumed that the [pound]50 loss in each of year 4 and year 5 first
reduces the [pound]250 earned in year 3. Accordingly, for purposes
of determining the amount of assets and liabilities deemed
transferred from U.S. Corp to Business A on January 1, year 5, U.S.
Corp translates Business A's assets and liabilities as follows:

----------------------------------------------------------------------------------------------------------------
Amount in
Assets [pound] Translation rate Amount in $
----------------------------------------------------------------------------------------------------------------
Pounds........................................ 1,000 [pound]1 = $1.10 (yearly average 1,100
rate--year 1).
Pounds........................................ 250 [pound]1 = $1.10 (yearly average 275
rate--year 1).
Pounds........................................ 250 [pound]1 = $1.20 (yearly average 300
rate--year 2).
Pounds........................................ 150 [pound]1 = $1.30 (yearly average 195
rate--year 3).
Truck......................................... 4,000 [pound]1 = $1.10 (yearly average 4,400
rate--year 1).
Computer...................................... 1,000 [pound]1 = $1.10 (yearly average 1,100
rate--year 1).
-----------------------------------------------------------------
Total assets.............................. .............. ................................ 7,370
Liabilities:
Total liabilities......................... .............. ................................ 0
----------------------------------------------------------------------------------------------------------------


(c) Transition of section 987 QBUs that applied the method set
forth in the 2006 proposed section 987 regulations.--(1) In general.
If, with respect to a particular section 987 QBU, a taxpayer's prior
section 987 method was based on a reasonable application of the method
described in the 2006 proposed section 987 regulations (REG-208270-86,
71 FR 52876), then the taxpayer shall apply these regulations under
section 987 with respect to such section 987 QBU without regard to
paragraph (b) of this section.
(2) Application of Sec. 1.987-4. For purposes of applying Sec.
1.987-4 with respect to a section 987 QBU described in paragraph (c)(1)
for the taxable year beginning on the transition date, the owner
functional currency net value of the section 987 QBU on the last day of
the preceding taxable year under Sec. 1.987-4(d)(1)(B) shall be the
amount that was determined under Sec. 1.987-4(d)(1)(A) of the 2006
proposed section 987 regulations for the preceding taxable year.
Additionally, for purposes of applying Sec. 1.987-4 with respect to a
section 987 QBU described in paragraph (c)(1) for all taxable years
that end after the transition date, the section 987 QBU's net
unrecognized section 987 gain or loss for all prior taxable years under
Sec. 1.987-4(c) shall take into account the aggregate of the amounts
determined under Sec. 1.987-4(d) of the 2006 proposed section 987
regulations for taxable years for which the taxpayer applied the 2006
proposed section 987 regulations, reduced by the amounts taken into
account under Sec. 1.987-5 of the 2006 proposed section 987
regulations upon a remittance for all such prior taxable years.
(3) Use of prior historic rate. For purposes of applying these
regulations under section 987 with respect to historic items (as
defined in Sec. 1.987-1(e)), other than inventory, that are reflected
on the balance sheet of the section 987 QBU on the transition date, a
taxpayer may use the same historic exchange rates as were used under
the taxpayer's application of the 2006 proposed section 987 regulations
in place of the historic rates that otherwise would be determined under
Sec. 1.987-1(c)(3), provided that, for all taxable years that end
after the transition date, the taxpayer does so with respect to all
historic items (other than inventory) that are reflected on the balance
sheet of the section 987 QBU on the transition date.
(4) Example. The provisions of this paragraph (c) are illustrated
by the following example. Exchange rate assumptions used in the example
are selected for the purpose of illustrating the principles of this
section, and no inference is intended by their use. Additionally, the
effect of depreciation is not taken into account for purposes of this
example.

Example. (i) U.S. Corp is a domestic corporation with the dollar
as its functional currency. U.S. Corp owns Business A, a U.K. branch
with the pound as its functional currency. Business A was formed on
January 1, year 1. U.S. Corp uses a reasonable application of the
method described in the 2006 proposed section 987 regulations to
determine the section 987 gain or loss of Business A. On January 1,
year 5, Business A transitions to the method provided in these
regulations pursuant to the method described in this paragraph (c).
Business A's opening balance sheet on January 1, year 5, includes
pounds, a truck acquired in year 2, inventory accounted for under
the FIFO method, and no liabilities. These assets remain on the
balance sheet on December 31, year 5.
(ii) Pursuant to paragraph (c)(3) of this section, U.S. Corp
chooses to use the same historic exchange rates as were used under
its application of the 2006 proposed regulations in place of the
historic rates prescribed under Sec. 1.987-1(c)(3) for purposes of
applying these regulations with respect to historic items (other
than inventory) held on the transition date.
(iii) The pounds are marked items under Sec. 1.987-1(d).
Because the pounds are marked items, for purposes of determining the
owner functional currency net value of Business A on the last day of
year 5 pursuant to Sec. 1.987-4(e), the pounds are translated into
dollars using the spot rate (as defined in Sec. 1.987-1(c)(1))
applicable to the last day of year 5.
(iv) The truck held on Business A's balance sheet on January 1,
year 5, is a historic item under Sec. 1.987-1(e). For purposes of
determining the owner functional currency net value of Business A on
the last day of year 5 pursuant to Sec. 1.987-4(e), the basis of
the truck is translated into dollars using the spot rate on the day
the truck was acquired in year 2, as determined under Sec. 1.987-
1(c)(3) of the 2006 proposed section 987 regulations. If U.S. Corp
had not chosen pursuant to paragraph (c)(3) of this section to use
the same historic exchange rates as were used under its application
of the 2006 proposed regulations, the basis of the truck would have
been translated into dollars using the historic rate described in
Sec. 1.987-1(c)(3), which is the yearly average exchange rate for
year 5.

[[Page 88850]]

(v) The inventory held on Business A's balance sheet on January
1, year 5, is a historic item under Sec. 1.987-1(e). For purposes
of determining the owner functional currency net value of Business A
on the last day of year 5 pursuant to Sec. 1.987-4(e), the FIFO
cost basis of the inventory is translated into dollars using the
historic rate, which pursuant to Sec. 1.987-1(c)(3)(i)(B) is the
yearly average exchange rate for year 5.
(vi) Pursuant to paragraph (c)(3) of this section, for purposes
of applying Sec. 1.987-4 with respect to Business A for year 5, the
owner functional currency net value of Business A on the last day of
year 4 under Sec. 1.987-4(d)(1)(B) is the amount that was
determined under Sec. 1.987-4(d)(1)(A) of the 2006 proposed section
987 regulations for year 4. Additionally, Business A's net
unrecognized section 987 gain or loss for all prior years under
Sec. 1.987-4(c) shall take into account the aggregate of the
amounts determined under Sec. 1.987-4(d) of the 2006 proposed
section 987 regulations for year 1 through year 4, reduced by the
amounts taken into account under Sec. 1.987-5 of the 2006 proposed
section 987 regulations upon a remittance for all such prior taxable
years.

(d) Adjustments to avoid double counting. If a difference between
the treatment of any item under these regulations and the treatment of
the item under the taxpayer's prior section 987 method would result in
income, gain, deduction or loss being taken into account more than
once, then the net unrecognized section 987 gain or loss of the section
987 QBU, as determined under Sec. 1.987-4(b) for the first taxable
year for which these regulations apply, shall be adjusted to account
for the difference.
(e) Reporting--(1) In general. Except as otherwise provided in this
paragraph (e), the taxpayer must attach a statement titled ``Section
987 Transition Information'' to its timely filed return for the first
taxable year to which these regulations under section 987 apply
providing the following information:
(i) A description of each section 987 QBU to which these rules
apply, the section 987 QBU's owner, the section 987 QBU's principal
place of business, and a description of the prior section 987 method
used by the taxpayer to determine section 987 gain or loss with respect
to the section 987 QBU.
(ii) Any assumptions used by the taxpayer for determining the
exchange rates used to translate the amount of assets and liabilities
transferred to the section 987 QBU on the transition date, as provided
in paragraph (b)(3) of this section.
(iii) With respect to each section 987 QBU subject to paragraph (c)
of this section, a statement regarding whether historic items (as
defined in Sec. 1.987-1(c)(3)) are translated pursuant to paragraph
(c)(2) of this section at the same historic rates as were used under
the taxpayer's application of the 2006 proposed regulations or at the
historic rates determined under Sec. 1.987-1(c)(3).
(iv) With respect to each section 987 QBU with respect to which an
adjustment is made pursuant to paragraph (d) of this section, a
description of the adjustment and the basis for the computation of such
adjustments.
(2) Attachments not required where information is reported on a
form. Paragraph (e) of this section shall not apply to the extent the
information described in such paragraph is required to be reported on a
form published by the Commissioner.


Sec. 1.987-11 Effective/applicability date.

(a) In general. Except as otherwise provided in this section,
Sec. Sec. 1.987-1 through 1.987-10 shall apply to taxable years
beginning on or after one year after the first day of the first taxable
year following December 7, 2016.
(b) Application of these regulations to taxable years beginning
after December 7, 2016. A taxpayer may apply these regulations under
section 987 to taxable years beginning after December 7, 2016, provided
the taxpayer consistently applies these regulations to such taxable
years with respect to all section 987 QBUs directly or indirectly owned
by the taxpayer on the transition date (as defined in paragraph (b)(2)
of this section) as well as all section 987 QBUs directly or indirectly
owned on the transition date by members that file a consolidated return
with the taxpayer or by any controlled foreign corporation, as defined
in section 957, in which a member owns more than 50 percent of the
voting power or stock value, as determined under section 958(a).
(c) Transition date. The transition date is the first day of the
first taxable year to which these regulations under section 987 are
applicable with respect to a taxpayer under this section.

0
Par. 6. Section 1.988-0 is amended by adding an entry for Sec. 1.988-
1(a)(4).


Sec. 1.988-0 Taxation of gain or loss from a section 988 transaction;
Table of Contents.

* * * * *


Sec. 1.988-1 Certain definitions and special rules.

(a) * * *
(4) Treatment of assets and liabilities of a section 987 aggregate
partnership or DE that are not attributed to an eligible QBU.
* * * * *

0
Par. 7. Section 1.988-1 is amended by:
0
1. Adding paragraph (a)(4).
0
2. Revising paragraph (a)(10)(ii).
0
3. Adding two sentences to the end of paragraph (i).
The additions and revision read as follows:


Sec. 1.988-1 Certain definitions and special rules.

(a) * * *
(4) Treatment of assets and liabilities of a section 987 aggregate
partnership or DE that are not attributed to an eligible QBU--(i)
Scope. This paragraph (a)(4) applies to assets and liabilities of a
section 987 aggregate partnership as defined in Sec. 1.987-1(b)(5), or
of an entity disregarded as an entity separate from its owner for
Federal income tax purposes (DE), that are not attributable to an
eligible QBU as defined in Sec. 1.987-1(b)(3).
(ii) Section 987 Aggregate Partnerships. For purposes of applying
section 988 and the applicable regulations to transactions involving
assets and liabilities described in paragraph (a)(4)(i) of this section
that are held by a section 987 aggregate partnership, the owners of the
section 987 aggregate partnership (within the meaning of Sec. 1.987-
1(b)(4)) shall be treated as owning their share of such assets and
liabilities. Section 1.987-7(b) shall apply for purposes of determining
an owner's share of such assets or liabilities.
(iii) Disregarded entities. For purposes of applying section 988
and the applicable regulations to transactions involving assets and
liabilities described in paragraph (a)(4)(i) of this section that are
held by a DE, the owner of the DE (within the meaning of Sec. 1.987-
1(b)(4)) shall be treated as owning all such assets and liabilities.
(iv) Example. The following example illustrates the application of
paragraph (a)(4) of this section:

Example. Liability held through a section 987 aggregate
partnership. (i) Facts. P, a foreign partnership, has two equal
partners, X and Y. X is a domestic corporation with the dollar as
its functional currency. Y is a foreign corporation wholly owned by
X that has the yen as its functional currency. P is a section 987
aggregate partnership. On January 1, 2021, P borrowed yen and issued
a note to the lender that obligated P to pay interest and repay
principal to the lender in yen. Also on January 1, 2021, P used the
yen it borrowed from the lender to acquire all of the stock of F, a
foreign corporation, from an unrelated person. P also holds an
eligible QBU (within the meaning of Sec. 1.987-1(b)(3)) that has
the yen as its functional currency. P maintains one set of books and
records. The assets and liabilities of the eligible QBU are
reflected on the books and records of P as provided under Sec.
1.987-2(b). The F stock held by P, and the yen liability incurred to
acquire the F stock, are also recorded on the

[[Page 88851]]

books and records of P but, pursuant to Sec. 1.987-2(b)(2)(i), are
not considered to be reflected on the books and records of the
eligible QBU for purposes of section 987.
(ii) Analysis. X's portion of the assets and liabilities of the
eligible QBU owned by P is a section 987 QBU. Y's portion of the
assets and liabilities of the eligible QBU owned by P is not a
section 987 QBU because Y and the eligible QBU have the same
functional currency. Because the F stock and yen-denominated
liability incurred to acquire such stock are not considered
reflected on the books and records of the eligible QBU, they are not
subject to section 987. In addition, because the F stock and the
yen-denominated liability incurred to acquire such stock are held by
P (but not attributable to P's eligible QBU), X and Y are treated as
owning their respective shares of such stock and liability pursuant
to Sec. 1.988-1(a)(4)(ii) for purposes of applying section 988. As
a result, P's becoming the obligor on the portion of the yen-
denominated note that is treated as an obligation of X is a section
988 transaction pursuant to paragraphs (a)(1)(ii), (a)(2)(ii) and
(a)(3) of this section. Similarly, the dispositions of yen to make
payments of interest and principal on the liability, to the extent
such yen are treated as owned by X under paragraph (a)(4)(ii) of
this section, are section 988 transactions under paragraphs
(a)(1)(i) and (a)(3) of this section. To the extent the yen are
treated as owned by the eligible QBU, see Sec. 1.987-2(c) for the
treatment of the payment of yen as a transfer from the eligible QBU
to X. P's becoming the obligor on Y's portion of the yen-denominated
note, and Y's portion of the yen disposed of in connection with
payments on such note, are not section 988 transactions because Y
has the yen as its functional currency.
* * * * *
(10) * * *
(ii) Certain intra-taxpayer transfers of section 988 transactions
that result in the recognition of section 988 gain or loss--(A) In
general. Exchange gain or loss with respect to nonfunctional currency
or any item described in paragraph (a)(2) of this section entered into
with another taxpayer shall be realized upon a transfer (as defined
under Sec. 1.987-2(c)) of such currency or item from an owner to a
section 987 QBU or from a section 987 QBU to an owner if as a result of
such transfer--
(1) The currency or item loses its character as nonfunctional
currency or as an item described in paragraph (a)(2) of this section;
or
(2) The source of the exchange gain or loss could be altered absent
the application of paragraph (a)(10)(ii)(B) of this section.
(B) Computation of exchange gain or loss. Exchange gain or loss
described in section (a)(10)(ii)(A) of this section shall be computed
in accordance with Sec. 1.988-2 (without regard to Sec. 1.988-
2(b)(8)) as if the nonfunctional currency or item described in
paragraph (a)(2) of this section had been sold or otherwise transferred
at fair market value between unrelated taxpayers. For purposes of the
preceding sentence, a taxpayer must use a translation rate that is
consistent with the translation conventions of the section 987 QBU to
or from which, as the case may be, the item is being transferred. In
the case of a gain or loss incurred in a transaction described in this
paragraph (a)(10)(ii) that does not have a significant business
purpose, the Commissioner may defer such gain or loss.
* * * * *
(i) * * * Generally, the revisions to paragraphs (a)(3), (a)(4),
and (a)(10)(ii) of this section shall apply to taxable years beginning
one year after the first day of the first taxable year following
December 7, 2016. If pursuant to Sec. 1.987-11(b) a taxpayer applies
Sec. Sec. 1.987-1 through 1.987-11 beginning in a taxable year prior
to the earliest taxable year described in Sec. 1.987-11(a), then the
revisions to paragraphs (a)(3), (a)(4), and (a)(10)(ii) of this section
shall apply to taxable years of the taxpayer beginning on or after the
first day of such prior taxable year.

0
Par. 8. Section 1.988-4 is amended by revising paragraph (b)(2) to read
as follows:


Sec. 1.988-4 Source of gain or loss realized on a section 988
transfer.

* * * * *
(b) * * *
(2) Proper reflection on the books of the taxpayer or qualified
business unit--(i) In general. For purposes of paragraph (b)(1) of this
section, the principles of Sec. 1.987-2(b) shall apply in determining
whether an asset, liability, or item of income or expense is reflected
on the books and records of a qualified business unit.
(ii) Effective/applicability date. Generally, paragraph (b)(2)(i)
of this section shall apply to taxable years beginning on or after one
year after the first day of the first taxable year following December
7, 2016. If pursuant to Sec. 1.987-11(b) a taxpayer applies Sec. Sec.
1.987-1 through 1.987-11 beginning in a taxable year prior to the
earliest taxable year described in Sec. 1.987-11(a), then paragraph
(b)(2)(i) of this section shall apply to taxable years of the taxpayer
beginning on or after the first day of such prior taxable year.
* * * * *

0
Par. 9. Section 1.989(a)-1 is amended by revising paragraph (b)(2)(i)
and adding paragraphs (b)(4) and (d)(3) and (4) to read as follows:


Sec. 1.989(a)-1 Definition of a qualified business unit.

(b) * * *
(2) * * *
(i) Persons--(A) Corporations. A corporation is a QBU.
(B) Individuals. An individual is not a QBU.
(C) Partnerships. A partnership, other than a section 987 aggregate
partnership as defined in Sec. 1.987-1(b)(5), is a QBU.
(D) Trusts and estates. A trust or estate is a QBU of a
beneficiary.
* * * * *
(4) Effective/applicability date. Generally, the revisions to
paragraph (b)(2)(i) of this section shall apply to taxable years
beginning on or after one year after the first day of the first taxable
year following December 7, 2016. If pursuant to Sec. 1.987-11(b) a
taxpayer applies Sec. Sec. 1.987-1 through 1.987-11 beginning in a
taxable year prior to the earliest taxable year described in Sec.
1.987-11(a), then the effective date of the revisions to paragraph
(b)(2)(i) of this section with respect to the taxpayer shall apply to
taxable years of the taxpayer beginning on or after the first day of
such prior taxable year.
* * * * *
(d) * * *
(3) Proper reflection on the books of the taxpayer or qualified
business unit. The principles of Sec. 1.987-2(b) shall apply in
determining whether an asset, liability, or item of income or expense
is reflected on the books of a qualified business unit (and therefore
is attributable to such unit).
(4) Effective/applicability date. Generally, the revisions to
paragraph (d)(3) of this section shall apply to taxable years beginning
on or after one year after the first day of the first taxable year
following December 7, 2016. If pursuant to Sec. 1.987-11(b) a taxpayer
applies Sec. Sec. 1.987-1 through 1.987-11 beginning in a taxable year
prior to the earliest taxable year described in Sec. 1.987-11(a), then
the revisions to paragraph (b)(2)(i) of this section shall apply with
respect to taxable years of the taxpayer beginning on or after the
first day of such prior taxable year.
* * * * *


Sec. 1.989(c)-1 [Removed]

0
Par. 10. Section 1.989(c)-1 is removed.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

0
Par. 11. The authority citation for part 602 continues to read as
follows:

Authority: 26 U.S.C. 7805.


[[Page 88852]]



0
Par. 12. In Sec. 602.101, paragraph (b) is amended by adding an entry
in numerical order to the table to read as follows:


Sec. 602.101 OMB Control numbers.

* * * * *
(b) * * *

------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described Control No.
------------------------------------------------------------------------

* * * * *
1.987-1................................................. 1545-2265
1.987-3................................................. 1545-2265
1.987-9................................................. 1545-2265
1.987-10................................................ 1545-2265

* * * * *
------------------------------------------------------------------------


John Dalrymple,
Deputy Commissioner for Services and Enforcement.
Approved: November 14, 2016.
Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2016-28381 Filed 12-7-16; 8:45 am]
BILLING CODE 4830-01-P