[Federal Register Volume 71, Number 173 (Thursday, September 7, 2006)]
[Proposed Rules]
[Pages 52876-52918]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 06-7250]



[[Page 52875]]

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Part II





Department of the Treasury





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Internal Revenue Service



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26 CFR Part 1



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

  Federal Register / Vol. 71, No. 173 / Thursday September 7, 2006 / 
Proposed Rules  

[[Page 52876]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-208270-86]
RIN 1545-AM12


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

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Withdrawal of notice of proposed rulemaking, notice of proposed 
rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations that provide 
guidance under section 987 of the Internal Revenue Code (Code) 
regarding the determination of the items of income or loss of a 
taxpayer with respect to a section 987 qualified business unit (section 
987 QBU) as well as the timing, amount, character and source of any 
section 987 gain or loss. It withdraws proposed regulations under 
section 987 that were published in the Federal Register on September 
25, 1991 (56 FR 48457). These regulations are necessary to provide 
guidance under section 987. Taxpayers affected by these regulations are 
corporations and individuals with qualified business units subject to 
section 987.

DATES: Written or electronic comments must be received by December 6, 
2006. Outlines of topics to be discussed at the public hearing 
scheduled for November 21, 2006, must be received by October 31, 2006.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-208270-86), Internal 
Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 
20044. Submissions may be sent electronically, via the IRS Internet 
site at http://www.irs.gov/regs or via the Federal eRulemaking Portal 
at http://www.regulations.gov (IRS REG-208270-86).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Sheila Ramaswamy at (202) 622-3870; concerning submissions of comments, 
Kelly Banks at (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of Treasury, Office of Information and Regulatory Affairs, 
Washington, DC 20503, with copies to the Internal Revenue Service, 
Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 
20224. Comments on the collection of information should be received by 
November 6, 2006.
    Comments are requested specifically concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the Internal Revenue Service, 
including whether the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
     How the burden of complying with the proposed collection of 
information may be minimized, including through the application or 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of service to provide information.
    The collection of information in these proposed regulations is in 
Sec. Sec.  1.987-1(b)(1)(ii),1.987-1(b)(2)(ii), 1.987-1(c)(1)(ii), 
1.987-1(f), 1.987-3(b)(1), 1.987-9, 1.987-10 and 1.987-11. Section 
1.987-1(b)(1)(ii) allows a partner to make an election not to take 
section 987 gain or loss into account. Section 1.987-1(b)(2)(ii) allows 
a taxpayer to make an election to group certain QBUs with the same 
functional currency as a single QBU. Sections 1.987-1(c)(1)(ii) and -
3(b)(1) allow a taxpayer to make an election to use a convention for 
exchange rates. Section 1.987-11(b) allows a taxpayer to elect to apply 
these regulations to taxable years beginning after the date of 
publication of a Treasury decision adopting this rule as a final 
regulation in the Federal Register. The preceding elections are to be 
made pursuant to Sec.  1.987-1(f) by attaching a statement to the 
taxpayer's tax return describing the election to be made. Section 
1.987-9 contains recordkeeping rules to establish a qualified business 
unit's income and section 987 gain or loss. This collection of 
information is required to establish the qualified business unit's 
income, gain, deduction or loss and assets and liabilities as well as 
exchange rates used for foreign currency translation purposes. Section 
1.987-10 provides rules for transitioning to the method provided under 
the new proposed regulations for determining section 987 gain or loss 
and provides certain corresponding reporting rules. The collection of 
information contained in this regulation facilitates the identification 
of the prior method used by the taxpayer to determine section 987 gain 
or loss. The collections of information are mandatory. The likely 
respondents are taxpayers with foreign qualified business units.
    Estimated total annual reporting burden: 12,000.
    Estimated average annual burden hours per respondent: 12.
    Estimated number of respondents: 1,000.
    Estimated annual frequency of responses: annually.
    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

A. Overview

    As part of the Tax Reform Act of 1986, Public Law 99-514, 100 Stat. 
2085 (October 22, 1986), 1986-3 CB Vol.1, 1, see Sec.  601.601(d)(2), 
Congress enacted comprehensive reforms to the tax treatment of foreign 
currency transactions by adding new subpart J. Those reforms included, 
among other things, the introduction of the functional currency 
concept, which generally distinguishes taxpayers on the basis of the 
primary currency in which they keep their books and records and conduct 
their business. Reforms also included the addition of the qualified 
business unit (QBU) concept, which generally provides a basis for 
allowing a taxpayer with a separate unit that conducts business and 
keeps books and records in a currency other than the functional 
currency of the taxpayer to account for the results of operation of the 
separate unit in the unit's own functional currency. Against that 
conceptual background, section 988 provides rules for the treatment of 
transactions in a currency other than the

[[Page 52877]]

taxpayer's functional currency. Section 986 generally provides rules 
for translating into U.S. dollars the earnings and profits and foreign 
taxes of a foreign corporation whose functional currency is not the 
U.S. dollar (dollar). Section 987, in turn, generally provides rules 
for determining and translating income and currency gain and loss with 
respect to operations of a branch whose functional currency is other 
than the functional currency of the taxpayer. As discussed below, an 
already complex area of law was made even more complicated when the 
entity classification rules under Sec.  301.7701-1 through 301.7701-3 
(the ``check the box'' regulations) were promulgated in 1997.
    On September 25, 1991, the IRS and the Treasury Department issued 
proposed regulations under section 987 (the 1991 proposed regulations). 
See 56 FR 48457. In light of subsequent IRS experience with taxpayer 
claims of large non-economic currency losses under section 987, the IRS 
and the Treasury Department issued Notice 2000-20 (2000-1 CB 851). See 
Sec.  601.601(d)(2). This notice expressed serious concern that the 
1991 proposed regulations had not fully achieved the original goal of 
facilitating recognition of true economic foreign currency gain and 
loss under appropriate circumstances and requested comments on this 
issue and other matters.
    This document withdraws the 1991 proposed regulations and provides 
new proposed regulations based on the ``foreign exchange exposure 
pool'' method. The IRS and the Treasury Department believe that this 
method more accurately reflects foreign currency gain and loss than the 
1991 proposed regulations and does so in a manner consistent with 
statutory authority and legislative intent. These new proposed 
regulations are designed to prescribe more precisely foreign currency 
gain and loss that is economically realized, while minimizing or 
eliminating the realization of non-economic currency gain and loss.
    The following background discussion describes section 987, its 
legislative history, the 1991 proposed regulations, Notice 2000-20, and 
the general approach that provides the basis for the foreign exchange 
exposure pool method.

B. The Statute

    Section 987 generally provides that in the case of a taxpayer 
having a QBU with a functional currency other than that of the 
taxpayer, the taxable income of the taxpayer with respect to the QBU is 
determined by computing the taxable income or loss of the QBU 
separately 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 treating post-1986 remittances from each such unit as made on 
a pro rata basis out of post-1986 accumulated earnings; 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.

C. The Legislative History

1. Prior Law
    As described in the applicable legislative history,\1\ section 987 
was enacted against a background of, and partly in reaction to, 
perceived shortcomings with prevailing law. The prevailing law at that 
time was fairly limited. It consisted primarily of two revenue rulings 
that provided alternative methods for calculating branch taxable 
income.
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    \1\ H. Rep. No. 99-426, 99th Cong., 1st Sess. (1985); 1986-3 CB 
Vol 2, 449. S. Rep. No 99-313, 99th Cong., 2d Sess. (1986); 1986-3 
CB Vol. 3, 443. H.R. Conf. Rep. No. 99-841, 99th Cong., 2d Sess. 
(1986); 1986-3 CB Vol. 4, 659. Later citations are to the Cumulative 
Bulletin. See Sec.  601.601(d)(2).
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    Rev. Rul. 75-106 (1975-1 CB 31), see Sec.  601.601(d)(2), provides 
for the use of a ``net worth'' method. Under this method, taxable 
income of a branch of a domestic corporation engaged in business in a 
foreign country is defined generally as the difference between the 
branch's opening and closing net worth as reflected on the branch's 
balance sheets for the taxable year. Under this method, the branch's 
balance sheet is translated into U.S. dollars. In general, the values 
of current items (such as cash or cash flows denominated in foreign 
currency) are translated at the year-end exchange rate, and the values 
of historical items (such as equipment) are translated at the exchange 
rate for the period in which the item was acquired or incurred. The 
translation of an item at the year-end rate causes changes in the 
item's value due to currency fluctuations to be taken into account 
annually, and the translation of an item at the historical rate 
generally precludes recognition of fluctuations in value due to 
changing exchange rates. In this way, the net worth method was able to 
identify items considered economically exposed to fluctuations in 
exchange rates. The total change in net worth identified by the net 
worth method is equal to the sum of the operating profit or loss of the 
branch and the exchange gain or loss on current items. However, the net 
worth method does not identify separate items of income and expense 
because it is based solely on a balance sheet comparison and does not 
use a profit and loss statement.
    Rev. Rul. 75-107 (1975-1 CB 32), see Sec.  601.601(d)(2), provides 
for the use of a ``profit and loss'' method. Under this method, the 
branch computes taxable income by translating the local currency profit 
and loss statement (adjusted for U.S. tax principles) into dollars. Any 
portion of the profit and loss remitted to the home office during the 
year is translated at the exchange rate on the date of the remittance, 
and the remainder is translated at the year-end exchange rate. No 
exchange gain or loss is recognized on a remittance.
    The net worth method of Rev. Rul. 75-106 and the profit and loss 
method of Rev. Rul. 75-107 each suffered from infirmities. The net 
worth method resulted in the realization of foreign currency gain and 
loss that was not consistent with the general realization principles of 
the Code; it also failed to accurately characterize items of income, 
gain, deduction or loss of the branch. The profit and loss method, in 
turn, did not take into account foreign currency gain and loss inherent 
in the assets and liabilities on the balance sheet as part of such 
method. Both methods failed to account for foreign currency gain or 
loss in the event of a remittance.
    The legislative history states that under section 987, a taxpayer 
with a QBU whose functional currency is other than the functional 
currency of the taxpayer will be required to use a profit and loss 
method, rather than the net worth method (as this method was understood 
at the time). House Report (1986-3 CB Vol. 2, 479); Senate Report 
(1986-3 CB Vol. 3, 470); and Conference Report (1986-3 CB Vol. 4, 675). 
See Sec.  601.601(d)(2). However, this legislative history is not 
properly read as an explicit rejection of the net worth method in its 
entirety. Instead, it is more accurately viewed as a rejection of 
certain aspects of the law prevailing at that time. Importantly, the 
method provided in section 987 as enacted actually represents a blend 
of the separate methods, as it has aspects of both a net worth method 
and a profit and loss method. It also has at least one feature absent 
from each method--that is, section 987 includes the remittance 
recognition concept. Consistent with a profit and loss method, sections 
987(1) and (2) generally determine the items of income or loss of a QBU 
based on its profit and loss statement as determined in its functional 
currency. Such items are then translated into the taxpayer's

[[Page 52878]]

functional currency at the appropriate rate.\2\ Consistent with a net 
worth method, section 987(3) requires that exchange gain or loss be 
computed with respect to certain branch assets and liabilities (as 
prescribed by the Secretary). Unlike either method, section 987(3)(A) 
provides that exchange gain or loss is recognized upon a remittance.
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    \2\ Section 989(b)(4) provides that, ``except as provided in 
regulations,'' the appropriate exchange rate is the average exchange 
rate for the taxable year of the QBU.
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    The blending of features of both a profit and loss method and of a 
net worth method in section 987 is significant. Together with more 
specific principles identified in the legislative history, this 
blending of methods informs the Congressionally stated preference for 
the profit and loss method. The House Report states:

    A profit and loss method can be viewed as being more consistent 
with the functional currency concept than a net worth method. Under 
a profit and loss method, the functional currency is used as the 
measure of income or loss, so that earnings determined for U.S. tax 
purposes would bear a close relation to taxable income computed by 
the foreign jurisdiction. In contrast, a net worth method takes 
unrealized exchange gains and losses into account. Further, a profit 
and loss method minimizes the accounting procedures that otherwise 
would be required to make the item-by-item translations under a net 
worth method. Finally, in the case of a branch, the net worth method 
as applied under present law fails to characterize accurately items 
of income or loss that are subject to special U.S. tax rules. For 
example, although there are limitations on the deductibility of 
long-term capital losses, such a loss incurred by a branch would be 
given tax effect because it would be reflected as an adjustment to 
the balance sheet.

House Report at 469.
    The House and Senate reports are generally uniform in describing 
Congressional intent with regard to the computations required under 
section 987 as illustrated by the Senate Report.

    Under the bill, a taxpayer with a branch whose functional 
currency is a currency other than the U.S. dollar will be required 
to use the profit and loss method to compute branch income. Thus, 
the net worth method will no longer be an acceptable method of 
computing income or loss of a foreign branch for tax purposes, and 
only realized exchange gains and losses on branch capital will be 
reflected in taxable income.

    For each taxable year, the taxpayer will compute income or loss 
separately for each qualified business unit in the business unit's 
functional currency, converting this amount to U.S. dollars using 
the weighted average exchange rate for the taxable period over which 
the income or loss accrued. This amount will be included in income 
without reduction for remittances from the branch during the year. 
The committee anticipates that regulations will provide rules that 
will limit the deduction of branch losses to the taxpayer's dollar 
basis in the branch (that is, the original dollar investment plus 
subsequent capital contributions and unremitted earnings).

    A taxpayer will recognize exchange gain or loss on remittances 
(without regard to whether or when the remittances are converted to 
dollars), to the extent the value of the currency at the time of the 
remittance differs from the value when earned. Remittances of 
foreign branch earnings (and interbranch transfers involving 
branches with different functional currencies) after 1986 will be 
treated as paid pro rata out of post-1986 accumulated earnings of 
the branch. The committee anticipates that, for purposes of 
calculating exchange gain or loss on remittances, the value of the 
currency will be determined by translating the currency at the rate 
in effect on the date of remittance. Exchange gains and losses on 
such remittances will be deemed to be ordinary and domestic source.

    Senate Report (1986-3 CB Vol. 3, 470). Importantly, the Conference 
Report modifies the House and Senate reports by stating that a 
remittance by a QBU ``will trigger exchange gain or loss inherent in 
accumulated earnings or branch capital.'' Conference Report, 1986-3 CB 
Vol. 4, 675.

    From section 987 and the foregoing legislative history, several 
principles emerge:
    1. A branch profit and loss computation is required in order to 
properly characterize items of branch income or loss, which is taken 
into account in the year earned.
    2. Exchange gain or loss is recognized upon a remittance, in an 
amount prescribed by the Secretary.
    3. Both branch earnings and branch capital can give rise to 
exchange gain or loss under section 987.
    4. Regulations under section 987 should seek to minimize 
complexity regarding item-by-item translations.
    5. The currency gain or loss taken into account under section 
987 is only the economic gain or loss ``inherent in'' the assets and 
liabilities of a QBU.
2. Relationship Between Section 986(c) and 987
    Comments to the IRS and the Treasury Department have suggested that 
the computation under section 987 of exchange gain or loss for a branch 
is intended to operate in the same manner as the computation under 
section 986(c) of certain exchange gain or loss of a foreign 
corporation. In general, section 986(c) provides for the recognition of 
exchange gain or loss only with respect to distributions of previously 
taxed earnings and profits (as described in section 959 or 1293(c)). 
The Conference Report includes the following general statement about 
the translation rules:

    The same translation rule applies to the earnings and profits of 
a foreign corporation and the income or loss of a branch or other 
QBU. An entity that uses a nonfunctional currency to measure the 
results of operation is required to use a profit and loss method to 
translate income or loss into functional currency. * * * These 
translation rules apply without regard to the form of enterprise 
through which the taxpayer conducts business (e.g., sole 
proprietorship, partnership, or corporation) as long as such form of 
enterprise rises to the level of a QBU.

    Conference Report, 1986-3 CB Vol. 4, 670. See Sec.  601.601(d)(2). 
The suggestion in comments is to apply this general principle such that 
section 987 would require the recognition of exchange gain or loss only 
with respect to branch earnings and not with respect to contributed 
capital.
    Despite the broad statements of principle quoted above, Congress 
provided more specific guidance regarding the treatment of branches in 
this regard. The Conference Report states that a remittance by a QBU 
``will trigger exchange gain or loss inherent in accumulated earnings 
or branch capital.'' Conference Report, 1986-3 CB Vol. 4, 675. See 
Sec.  601.601(d)(2). Similarly, despite the stated requirement that 
QBUs must use a notional profit and loss method to determine branch 
taxable income, the specific method actually provided in section 987 
and described in the legislative history represents a blend of a net 
worth method and a profit and loss method. Accordingly, the IRS and the 
Treasury Department believe that the more specific statements made by 
Congress regarding the treatment of branch exchange gain or loss 
reflect an intention that the methodologies of section 986(c) and 
section 987 not be identical.

D. The 1991 Proposed Regulations

    The 1991 proposed regulations provide generally that the net income 
of a QBU having a functional currency different than the taxpayer is 
determined annually. Such determination is 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 provide for the recognition of 
exchange gain or loss upon a remittance from the QBU's equity pool. In 
general, the equity pool consists of the undistributed capital and 
earnings of the QBU, determined in the QBU's functional currency. The 
1991 proposed regulations also provide for a basis pool, which consists 
of the basis

[[Page 52879]]

of the capital and earnings in the equity pool, expressed in the 
functional currency of the taxpayer. The portion of the basis pool, 
expressed in the functional currency of the taxpayer, that is 
attributable to a remittance is generally determined according to the 
following formula:
[GRAPHIC] [TIFF OMITTED] TP07SE06.000

    Section 987 gain or loss is 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 the remittance is made, less the 
basis associated with the remittance as determined above. One important 
consequence of the equity pool paradigm is that all branch equity gives 
rise to exchange gain or loss, regardless of whether or not that equity 
is held in a form that actually exposes the QBU's owner to currency 
fluctuations (compare assets such as cash or indebtedness to assets 
such as equipment).
    Under the 1991 proposed regulations, a taxpayer must determine the 
source and character of section 987 gain or loss for all purposes of 
the Code, including sections 904(d), 907, and 954, by using the same 
method the taxpayer uses to allocate and apportion its interest expense 
under section 861, with certain modifications.

E. Concerns Regarding the 1991 Proposed Regulations; Notice 2000-20

    Effective January 1, 1997, the IRS and the Treasury Department 
issued the check the box regulations implementing new elective entity-
classification rules. These regulations made it possible for certain 
entities with a single owner to be treated for federal income tax 
purposes as an entity disregarded as separate from its owner (a 
disregarded entity or DE). As a result, businesses that had previously 
operated through subsidiaries could operate through structures treated 
for tax purposes as branches. The effect of the check the box 
regulations was a dramatic increase in the number of branches resulting 
from DE elections that are subject to section 987. This increase has 
greatly exacerbated the already existing problems of the 1991 proposed 
regulations, especially the ability of taxpayers to trigger non-
economic losses (and the corresponding trap for the unwary taxpayer 
with non-economic gains).
    As indicated above, the equity pool paradigm in the 1991 proposed 
regulations imputes currency gain or loss to all equity of a QBU 
whether or not the assets of the QBU are economically exposed to 
changes in the value of the functional currency of the QBU. The IRS has 
faced many cases in which taxpayers have claimed substantial non-
economic exchange losses largely on the basis of the 1991 proposed 
regulations. An example may be instructive. Assume that a domestic 
corporation (US Corp) with the dollar as its functional currency forms 
a foreign corporation in Country X and then elects under the check the 
box regulations to treat that corporation as a DE. The DE conducts 
mineral extraction and owns all the necessary equipment. The equipment 
owned by the DE was contributed by US Corp. The DE has no employees and 
contracts with a subsidiary of US Corp for the employees needed in the 
business of extraction. US Corp, as the entity's sole owner, claims 
that the DE is a QBU for purposes of section 987. The DE has minimal 
financial assets and conducts no activities other than mineral 
extraction. US Corp claims that the DE's functional currency is Country 
X currency. A decline in the value of Country X currency relative to 
the dollar does not produce any economic loss for US Corp because the 
assets of the DE are not financial assets subject to currency 
fluctuation. Nevertheless, US Corp claims under the 1991 proposed 
regulations that the equity of the DE, which consists almost 
exclusively of equipment, gives rise to a substantial non-economic 
exchange loss and that terminating the DE (for example, by another 
check the box election) triggers recognition of such loss. Taxpayers 
have claimed similar results under other fact patterns. The IRS and the 
Treasury Department have serious concerns about these types of 
transactions.
    Although the foregoing example concerns the claiming of non-
economic losses, the equity pool approach in the 1991 proposed 
regulations can also give rise to non-economic gains. Recently, the 
value of the US dollar has declined against many foreign currencies. It 
is likely that under these circumstances, taxpayers subject to section 
987 may have large non-economic gains built into the equity pool. The 
IRS and the Treasury Department believe that Congress did not intend 
for section 987 to generate non-economic foreign currency gains or 
losses.
    In light of the entity-classification rules and the potential for 
the equity pool paradigm to generate non-economic currency gains and 
losses, the IRS and the Treasury Department issued Notice 2000-20, 
2000-1 CB 851. See Sec.  601.601(d)(2). Among other things, the notice 
indicated that the IRS and the Treasury Department were concerned that 
the proposed regulations may not have achieved their original goal of 
recognizing economic exchange gains and losses under appropriate 
circumstances. The notice requested comments on this and other issues.
    Several comments were received in response to the notice and raised 
a number of important points. Two of those comments suggested replacing 
the equity pool paradigm in the 1991 proposed regulations with a 
paradigm that recognizes exchange gain or loss only on the earnings of 
a QBU and not its capital. As described above, the IRS and the Treasury 
Department believe that such an approach is inconsistent with 
Congressional intent as expressed in the legislative history to section 
987. An earnings-only approach also would fail to address the core 
problem of distinguishing between items that economically give rise to 
exchange gain and loss and those that do not. Additionally, an 
earnings-only approach would produce different results for QBUs with 
the same net assets, depending upon whether the net assets were funded 
with capital or earnings. Finally, an earnings-only approach fails to 
take into account any foreign currency exposure on capital and so could 
disadvantage banks and other financial institutions, much of whose 
QBUs' capital may be subject to such exposure.

F. The Foreign Exchange Exposure Pool Method

    The IRS and the Treasury Department believe that Congress did not 
intend

[[Page 52880]]

section 987 to permit the largely uninhibited recognition of non-
economic exchange gain or loss. The 1991 proposed regulations, together 
with the check the box regulations, have combined to permit taxpayers 
to trigger non-economic losses with relative ease. Accordingly, the 
1991 proposed regulations are withdrawn and are replaced with new 
proposed regulations that adopt the ``foreign exchange exposure pool 
method.'' In general, the foreign exchange exposure pool method 
provides that the income of a QBU that is subject to section 987 
(``section 987 QBU'') is determined by reference to the items of 
income, gain, deduction and loss booked to the QBU in its functional 
currency, adjusted to reflect US tax principles. With certain 
exceptions, items of income, gain, deduction and loss of a section 987 
QBU are translated into the functional currency of the QBU's owner at 
the average exchange rate for the year. However, the basis of historic 
assets and deductions for depreciation, depletion, and amortization of 
such assets are translated at the historic exchange rate. Translating 
these items at the historic exchange rate differs from the approach 
taken in the 1991 proposed regulations, which instead uses the average 
exchange rate. Although using the average exchange rate for translating 
such items might be simpler than using the historic exchange rate, it 
leads to the generation of non-economic foreign currency gains or 
losses described in this preamble.
    The foreign exchange exposure pool method uses a balance sheet 
approach to determine exchange gain or loss, which is then recognized 
upon a remittance. Use of a balance sheet approach allows taxpayers and 
the IRS to distinguish between those items whose value fluctuates with 
respect to changes in the functional currency of the owner and those 
which do not. Under this method, exchange gain or loss with respect to 
``marked items'' is identified annually but is pooled and deferred 
until a remittance is made. The IRS and the Treasury Department believe 
that section 988(c) identifies the items that should be treated as 
giving rise to exchange gain or loss for purposes of section 987. 
Accordingly, a marked item is generally defined as an asset or 
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.
    When a section 987 QBU makes a remittance, a portion of the pooled 
and deferred exchange gain or loss is recognized. In general, the 
amount taken into account is an amount equal to the product of the 
owner's portion of the section 987 QBU's net unrecognized exchange gain 
or loss, multiplied by the owner's remittance proportion. The owner's 
remittance proportion generally is equal to the quotient of the amount 
of the remittance, divided by the aggregate basis of the section 987 
QBU's gross assets (as reflected on its year-end balance sheet), 
without reduction for the remittance.
    The source and character of exchange gain or loss recognized under 
section 987 for all purposes of the Code, including sections 904(d), 
907 and 954, is determined by reference to the source and character of 
the income derived from the section 987 QBU's assets.
    The IRS and the Treasury Department believe that the foreign 
exchange exposure pool method is consistent with section 987 and 
legislative intent for several reasons. First, the foreign exchange 
exposure pool method uses a profit and loss statement to determine the 
items of income, gain, deduction and loss of a section 987 QBU in its 
functional currency. This allows proper characterization of items of 
income, gain, deduction and loss. Second, exchange gain or loss must be 
taken into account only with respect to items of branch capital and 
earnings whose value fluctuates with changes in exchange rates by 
reference to the owner's functional currency. This comports both with 
Congressional intent that taxpayers recognize exchange gain or loss 
(but only economic exchange gain or loss) inherent in branch capital 
and branch earnings and with authority granted under section 987(3) to 
identify appropriate translation rates. Third, exchange gain or loss is 
recognized under section 987 only upon a remittance. Finally, the 
foreign exchange exposure pool method is an appropriate interpretation 
of the ``blended'' approach of section 987--that is, it incorporates 
certain aspects of the profit and loss method and the net worth method.

Explanation of Provisions

A. Section 1.987 1 Scope, Definitions and Special Rules

1. Scope in General
    The proposed regulations provide rules for determining the section 
987 taxable income or loss of a taxpayer with respect to a section 987 
QBU as well as the timing, amount, character, and source of section 987 
gain or loss recognized with respect to such QBU. The proposed 
regulations do not apply to banks, insurance companies, and similar 
financial entities (including, solely for this purpose, leasing 
companies, finance coordination centers, regulated investment 
companies, and real estate investment trusts). The IRS and the Treasury 
Department plan to apply the foreign exchange exposure pool method 
adopted in the proposed regulations to such entities in subsequent 
guidance but believe it is appropriate to request comments regarding 
how the rules of the proposed regulations need to be precisely tailored 
to address issues unique to financial entities. Financial entities are 
urged to make necessary comments to help tailor the planned extension 
of the foreign exchange exposure pool method to such entities.
    Specifically, in the context of banks, the IRS and the Treasury 
Department request comments on whether special rules are needed for the 
global dealing of currencies and securities. Comments are also 
requested on the relationship of sections 987 and 988 for banks. 
Finally, comments are requested on whether the use of exchange rate 
conventions is appropriate for banks and finance entities and, if so, 
how such conventions should be determined. In the context of insurance 
companies, the IRS and the Treasury Department request comments on the 
proper treatment of insurance reserves, surplus, and investment assets 
held by the separate trades or business of an insurance company. In 
particular, comments are requested on the proper treatment of stock 
held in separate accounts of a section 987 QBU of a life insurance 
company and the related insurance reserves established for those 
separate accounts. In the context of leasing companies, comments are 
requested regarding the treatment of stock in other leasing companies 
recorded on the books and records of a section 987 QBU and how the 
rules of sections 986 and 987 can be reconciled if stock is treated as 
a ``marked asset'' in this setting. Until regulations are issued 
applying the foreign exchange exposure pool method to financial 
entities, such entities must comply with section 987 under a reasonable 
method, consistently applied. For this purpose, reasonable methods 
include using the method described in the 1991 proposed regulations and 
a method that imputes section 987 gain or loss to earnings but not 
capital.
    The proposed regulations also do not apply to trusts, estates and S 
corporations. The IRS and the Treasury Department plan to apply the 
foreign exchange exposure pool method adopted in the proposed 
regulations to such entities but believe it is appropriate to request 
comments

[[Page 52881]]

regarding how the rules of the proposed regulations should be applied 
to such entities. The IRS and the Treasury Department request comments 
regarding whether principles similar to those applied to partnerships 
should apply to these entities.
2. Taxpayers Subject to Section 987 and Related Definitions
    The IRS and the Treasury Department believe that section 987 should 
only apply where an individual or corporation (whether foreign or 
domestic) has activities that constitute a trade or business under 
Sec.  1.989(a)-1(c) and the trade or business has a functional currency 
different from the individual or corporation. In such cases, the 
individual or corporation will be subject to the rules of the proposed 
regulations if the individual or corporation is the owner of a section 
987 QBU. A section 987 QBU is defined in Sec.  1.987-1(b)(2) as an 
eligible QBU that has a functional currency different from its owner.
    An eligible QBU is defined in Sec.  1.987-1(b)(3) of the proposed 
regulations. Generally, an eligible QBU is an activity of an 
individual, corporation, partnership or DE that is a trade or business 
as defined in Sec.  1.989(a)-1(c); maintains separate books and records 
as defined in Sec.  1.989(a)-1(d) and assets and liabilities used in 
conducting such activities are reflected on such books and records; and 
the activities are not subject to the dollar approximate separate 
transaction (DASTM) rules of Sec.  1.985-3. A corporation is not an 
eligible QBU. An individual is not a QBU under Sec.  1.989(a)-
1(b)(2)(i) and therefore cannot be an eligible QBU. In addition, and as 
discussed in this preamble, neither a partnership nor a DE is an 
eligible QBU.
    In the case of ownership other than through a partnership (that is, 
direct ownership), the individual or corporation is treated as the 
owner of an eligible QBU if the individual or corporation is the tax 
owner of the assets and liabilities of the eligible QBU. For purposes 
of determining direct ownership, an individual or corporation will be 
treated as a direct owner of the assets and liabilities of an eligible 
QBU if it owns a DE that holds an eligible QBU. In such case, because 
the DE is not recognized as a separate entity, it cannot be a QBU under 
section 989 and, therefore, is not treated as an eligible QBU under the 
proposed regulations. However, the activities of the DE, which are 
treated for purposes of the Code as carried on directly by its owner, 
can qualify as an eligible QBU of the DE's owner.
    With respect to partnerships, the IRS and the Treasury Department 
recognize that issues often arise as to whether the international tax 
provisions of the Code operate on an aggregate or an entity basis. The 
legislative history of subchapter K of chapter 1 of the Code provides 
that, for purposes of interpreting Code provisions outside of that 
subchapter, a partnership may be treated as either an entity separate 
from its partners or an aggregate of its partners, depending on which 
characterization is more appropriate to carry out the purpose of the 
particular section under consideration. H.R. Conf. Rep. No. 2543, 83rd 
Cong. 2d. Sess. 59 (1954).
    In the case of section 987, the calculations under the foreign 
exchange exposure pool method would differ dramatically based on 
whether an aggregate or an entity approach is adopted. For example, if 
the foreign exchange exposure pool method is applied at the entity 
level, the partnership will make the method's calculations by reference 
to the partnership's functional currency. Under this approach, any 
foreign currency gain or loss will be an item of the partnership and 
will be allocated among the partners in accordance with the partnership 
agreement, to the extent such allocation is consistent with the 
provisions of subchapter K. If, in the alternative, the foreign 
exchange exposure pool method is applied under an aggregate approach, 
each partner will make its own foreign exchange exposure pool 
calculations by reference to the partner's functional currency and such 
amounts will not be subject to separate allocation under subchapter K.
    The IRS and the Treasury Department believe that, on balance, an 
aggregate approach is more appropriate for section 987 purposes. 
Applying the foreign exchange exposure pool method directly at the 
partner level will more appropriately preserve the correct amounts of 
exchange gain or loss. In addition, such approach will measure the 
foreign currency exposure by reference to the functional currencies of 
the persons who generally bear the economic risk from such exposure. As 
a result, the proposed regulations provide that for purposes of 
applying the foreign exchange exposure pool method each individual or 
corporation that is a partner in a partnership will be considered to 
own indirectly an eligible QBU consisting of a portion of the assets 
and liabilities of the partnership allocated to it under Sec.  1.987-7. 
If such eligible QBU has a different functional currency from the 
partner and therefore is a section 987 QBU, the foreign exchange 
exposure pool method is applied with respect to those assets and 
liabilities. In addition, the proposed regulations provide rules for 
converting the items of section 987 taxable income or loss of a section 
987 QBU into the functional currency of the partner (when necessary), 
and rules coordinating this aggregate approach with other provisions of 
subchapter K.
    Section 1.987-1(b)(2)(ii) allows an owner to elect to treat certain 
section 987 QBUs with the same functional currency as a single section 
987 QBU. The purpose of this rule is to simplify section 987 
calculations by reducing the number of interbranch transactions that 
would be considered as ``transfers'' of assets and liabilities. This 
election applies only to certain section 987 QBUs of the owner. The IRS 
and the Treasury Department request comments regarding whether such 
election should be available to treat section 987 QBUs of owners that 
are members of a consolidated group as a single section 987 QBU and how 
this should be technically effectuated.
    Section 1.987-1(b)(5) provides that the term ``owner'' for section 
987 purposes does not include an eligible QBU or section 987 QBU of an 
owner. Under this rule, a tiered ownership structure of eligible QBUs 
and/or section 987 QBUs will not be respected as distinct tiers of QBUs 
for purposes of section 987. Rather, tiers of eligible and/or section 
987 QBUs will be treated as a ``flat'' structure, with each QBU in the 
tier considered as owned directly by the ultimate non-QBU owner. For 
example, if a domestic corporation is the holder of the interests in a 
section 987 DE (section 987 DE1) and that DE owns the interests in 
another section 987 DE (section 987 DE2) for purposes other than U.S. 
tax law, the structure will not be treated as a tier of QBUs for 
purposes of section 987. Rather, the domestic corporation will be 
considered the direct holder of the interests in the section 987 
branches of section 987 DE1 and DE2. This flat structure, which is 
consistent with the general approach taken in the proposed dual 
consolidated loss regulations (70 FR 29868-29907), is expected to be 
easier to administer for both taxpayers and the IRS and to provide more 
appropriate results under the section 987 rules.
3. De Minimis Rule for Certain Indirectly Owned Section 987 QBUs
    The IRS and the Treasury Department recognize that it may be 
administratively burdensome for taxpayers to apply certain aspects of 
the proposed regulations to section 987 QBUs indirectly owned through

[[Page 52882]]

relatively small interests in partnerships. As a result, the proposed 
regulations provide a de minimis election for certain indirectly owned 
section 987 QBUs. Under this rule, an individual or corporation that 
owns a section 987 QBU indirectly through a partnership may elect not 
to take into account the section 987 gain or loss of such section 987 
QBU, provided such individual or corporation owns, directly or 
indirectly, less than five percent of the section 987 partnership. 
Constructive ownership rules apply for purposes of determining whether 
the less than five percent ownership threshold is satisfied.
    This de minimis exception only applies to recognition of section 
987 gain or loss with respect to a section 987 QBU. Thus, owners of 
section 987 QBUs that qualify under the de minimis exception must 
comply with all other aspects of the proposed regulations, including 
the requirement to take into account the section 987 taxable income or 
loss with respect to such section 987 QBUs.
    An individual or corporation that qualifies for the election (that 
is, because they owned less than five percent of a section 987 
partnership) subsequently may fail to qualify as a result of an 
increase in their interest in a section 987 partnership. In such a 
case, taxpayers must begin taking into account the section 987 gain or 
loss with respect to section 987 QBUs owned through such partnerships. 
Similarly, taxpayers that were required to take into account section 
987 gain or loss with respect to an indirectly owned section 987 QBU 
may reduce their ownership such that they become eligible for the de 
minimis exception and, as a result, may elect to no longer take into 
account section 987 gain or loss. The IRS and the Treasury Department 
recognize that transition issues will arise when interests in section 
987 partnerships change such that individuals or corporations no longer 
qualify (or are able to qualify) for the de minimis exception. The IRS 
and the Treasury Department are considering such transition rules and 
request comments as to their application.
4. Exchange Rates
    Section 1.987-1(c)(1)(i) defines the spot rate as the rate 
determined under the principles of Sec.  1.988-1(d)(1), (2) and (4) on 
the relevant day. Section 1.987-1(c)(1)(ii) allows taxpayers to elect 
to use spot rate conventions that reasonably approximate the spot rate 
on a particular day. It is anticipated that taxpayers will be able to 
conform the spot rate convention for section 987 to the spot rate 
conventions used under FAS 52 for financial accounting purposes. This 
is intended to simplify the calculations required under section 987.
    In a similar attempt to simplify calculations, Sec.  1.987-1(c)(2) 
defines the yearly average exchange rate as an average exchange rate 
for the taxable year computed under any reasonable method that is 
consistently applied.
    Finally, Sec.  1.987-1(c)(3) defines the historic exchange rate by 
reference to the spot rate on the day that assets are transferred to 
(or acquired by) the section 987 QBU, or on the day that liabilities 
are assumed (or entered into) by the section 987 QBU. The reference to 
the spot rate as defined in Sec.  1.987-1(c)(1)(i) and (ii) allows 
taxpayers to elect to use spot rate conventions for these purposes.
5. Definitions of a Section 987 Marked Item and a Section 987 Historic 
Item
    The definitions of a section 987 marked item and a section 987 
historic item are central to the foreign exchange exposure pool method. 
When taken into account in the context of the calculation of net 
unrecognized section 987 gain or loss under Sec.  1.987-4, the 
definitions distinguish those items that generate section 987 gain or 
loss from those that do not. The IRS and the Treasury Department 
believe that section 988 identifies those items properly treated as 
giving rise to exchange gain or loss for purposes of section 987. Thus, 
a marked item as defined in Sec.  1.987-1(d) is an asset or liability 
reflected on the books and records of the section 987 QBU that both (1) 
Would generate section 988 gain or loss if held or entered into 
directly by the owner of the section 987 QBU and (2) is not a section 
988 transaction to the section 987 QBU. It is important to exclude 
section 988 transactions of a section 987 QBU because section 988 
already requires the section 987 QBU to recognize gain or loss from 
such transactions. Thus, treating such transactions as marked items for 
purposes of section 987 would result in double counting. Marked items 
give rise to exchange gain or loss under section 987. Historic items, 
which are defined in Sec.  1.987-1(e) as items other than marked items, 
do not give rise to exchange gain or loss under section 987.
6. Elections Under Section 987
    Section 1.987-1(f) provides rules for making elections under 
section 987. In general, the elections made under section 987 must be 
made by the owner of the section 987 QBU. The elections must be made 
with respect to a section 987 QBU for the first taxable year in which 
the election is relevant, and must be made by attaching a statement to 
a timely filed tax return for such taxable year. Elections under 
section 987 are treated as methods of accounting and are governed by 
the general rules regarding changes in methods of accounting.
    The IRS and the Treasury Department believe that a reasonable cause 
standard should be applied to determine whether taxpayers that fail to 
make a timely election are eligible for an extension of time to file 
elections pursuant to Sec.  1.987-1(f) of the proposed regulations. As 
a result, extensions of time under Sec. Sec.  301.9100-1 through 
301.9100-3 will not be granted for filings under the proposed 
regulations. See Sec.  301.9100-1(d).
    Under the reasonable cause standard, if an owner that is permitted 
to file an election under the proposed regulations fails to make such a 
filing in a timely manner, the owner is considered to have satisfied 
the timeliness requirement with respect to such filing if it 
demonstrates, to the satisfaction of the Area Director, Field 
Examination, Small Business/Self Employed or the Director, Field 
Operations, Large and Mid-Size Business (Director) having jurisdiction 
of the taxpayer's return for the taxable year, that such failure was 
due to reasonable cause and not willful neglect. Once the owner becomes 
aware of the failure, the owner must demonstrate reasonable cause and 
must satisfy the filing requirement by attaching the election to an 
amended tax return (that amends the tax return to which the election 
should have been attached). A written statement must be included that 
explains the reasons for the failure to comply.
    In determining whether the taxpayer has reasonable cause, the 
Director shall consider whether the taxpayer acted reasonably and in 
good faith. Whether the taxpayer acted reasonably and in good faith 
will be determined after considering all the facts and circumstances. 
The Director shall notify the person in writing within 120 days of the 
filing if it is determined that the failure to comply was not due to 
reasonable cause or if additional time will be needed to make such 
determination. If the Director fails to notify the owner within 120 
days of the filing, the owner shall be considered to have demonstrated 
to the Director that such failure was due to reasonable cause and not 
willful neglect.
    The proposed regulations provide that elections under section 987 
cannot be revoked without the consent of the Commissioner. In addition, 
the proposed regulations provide that the

[[Page 52883]]

Commissioner will consider allowing revocation of such an election if 
the taxpayer demonstrates significantly changed circumstances, or other 
circumstances that demonstrate a substantial non-tax business reason 
for such revocation. Finally, the IRS and the Treasury Department are 
considering an exception to the general revocation rule where a section 
987 QBU is acquired in certain transactions that do not result in the 
termination of such QBU. Comments are requested as to whether such an 
exception is warranted and, if so, the appropriate scope of such an 
exception.

B. Section 1.987-2 Attribution of Items to an Eligible QBU; the 
Definition of a Transfer, and Related Rules

1. Attribution of Items to an Eligible QBU
i. Overview
    A section 987 QBU is not itself a taxpayer and does not have its 
own taxable income. Items of income, gain, deduction and loss must 
nonetheless be attributed to such section 987 QBU for purposes of 
determining the owner's taxable income. The items of income, gain, 
deduction and loss attributed to a section 987 QBU are generally 
determined in the functional currency of the section 987 QBU and then 
translated into the functional currency of the owner. The aggregate 
translated amount is the section 987 taxable income or loss of the 
section 987 QBU. Thus, attribution rules are necessary to determine 
which items of income, gain, deduction and loss are attributed to the 
section 987 QBU.
    Under section 987(3), assets and liabilities must be attributed to 
a section 987 QBU in order to determine the amount of section 987 gain 
or loss of such QBU. In some cases, a section 987 QBU of a taxpayer 
will not be held through an entity separate from the taxpayer that can 
legally own assets and incur liabilities. In addition, not all the 
assets and liabilities of an entity that is separate from the taxpayer 
may be attributable to a section 987 QBU for purposes of section 987. 
Moreover, assets and liabilities may constitute a section 987 QBU of a 
taxpayer even when such assets and liabilities are owned or incurred by 
separate legal entities. As a result, assets and liabilities of the 
taxpayer (or of entities owned by the taxpayer that are not themselves 
taxpayers) must be attributed to the section 987 QBU.
    Neither section 987 nor the underlying legislative history provides 
explicit rules for attributing a taxpayer's items of income, gain, 
deduction, or loss to a section 987 QBU to determine the QBU's section 
987 taxable income or loss. Similarly, no explicit rules are provided 
in the statute or legislative history for attributing a taxpayer's 
assets or liabilities to a section 987 QBU to determine the section 987 
gain or loss of such QBU.
    Other provisions of the Code provide various methods for 
attributing or allocating a taxpayer's assets and liabilities, or items 
of income, gain, deduction and loss (items) for particular purposes. 
These provisions provide complex rules for making such determinations 
and, in many cases, require a detailed analysis of various factors and 
relationships involving income, assets, and activities of the taxpayer. 
For example, section 864(c) and the regulations thereunder provide 
rules for determining the income, gain, deduction, or loss of a 
nonresident alien individual or foreign corporation which are treated 
as effectively connected with the conduct of a trade or business within 
the United States. Other examples are Sec. Sec.  1.882-5, 1.861-8 and 
1.861-9T through 1.861-13T. These regulations provide rules for the 
allocation and apportionment of expenses, losses, and other deductions 
of a taxpayer. Finally, section 884(c)(2) and Sec.  1.884-1(d) and (e) 
provide rules for determining U.S. assets and U.S. liabilities of a 
foreign corporation for purposes of the branch profits tax. As 
discussed below, the IRS and the Treasury Department do not believe 
these complex methodologies are appropriate for purposes of section 
987.
ii. Books and Records Method--General Rule
    The IRS and the Treasury Department believe that items should be 
attributed to an eligible QBU (and, if all or a portion of such 
eligible QBU has a different functional currency than its owner, to a 
section 987 QBU of such owner) to the extent they are reflected on the 
books and records of the eligible QBU (books and records method). The 
IRS and the Treasury Department believe that using a books and records 
method for attributing items under section 987 is consistent with other 
provisions of the Code involving foreign currency transactions. For 
example, it is consistent with the requirement under section 989(a) 
that a QBU maintain books and records separate from the taxpayer. It is 
also consistent with the requirement under section 985(b)(1) that, in 
order to have a functional currency other than the dollar, a QBU must 
keep its books and records in such currency. Moreover, the IRS and the 
Treasury Department believe the books and records method is 
administrable for both taxpayers and the Commissioner. This is the case 
because the books and records method should be consistent with the 
taxpayer's accounting treatment of the items and, unlike the methods 
discussed above, it does not require a complex and factually intensive 
analysis of the circumstances and activities of the eligible QBU.
    For the reasons described above, the proposed regulations adopt a 
books and records method for allocating items to an eligible QBU. The 
proposed regulations provide that, subject to certain exceptions, items 
are attributable to an eligible QBU to the extent they are reflected on 
the separate set of books and records of such eligible QBU, as defined 
in Sec.  1.989(a)-1(d). The proposed regulations make clear that these 
rules apply solely for purposes of section 987. Thus, for example, the 
attribution rules contained in the proposed regulations do not apply 
for purposes of allocating and apportioning interest expense under 
section 864(e).
iii. Exception for Non-Portfolio Stock, Interests in Partnerships and 
Certain Acquisition Indebtedness
    As discussed above, the IRS and the Treasury Department believe 
that the assets and liabilities reflected on the books and records of 
an eligible QBU are a reasonable approximation of the assets and 
liabilities that are used in the trade or business of the eligible QBU 
and, therefore, should be taken into account for purposes of section 
987. However, the IRS and the Treasury Department believe that certain 
assets and liabilities should not be attributed to an eligible QBU, 
even if such assets and liabilities are reflected on the books and 
records of such QBU. The IRS and the Treasury Department believe that 
non-portfolio stock and interests in partnerships (and liabilities to 
acquire such assets), even if reflected on the books and records of the 
eligible QBU, should not be attributed to such QBU for purposes of 
section 987. This is consistent with the principle stated above that a 
section 987 QBU cannot be an owner of another section 987 QBU. 
Excluding non-portfolio stock is also consistent with the principle 
that non-portfolio stock cannot be used in, or held for the use in, the 
conduct of a trade or business in the United States. See Sec.  1.864-
4(c)(2)(iii).
    As a result, the proposed regulations provide that stock of a 
corporation (whether domestic or foreign) and an interest in a 
partnership (whether domestic or foreign) are not considered to be on 
the books and records of an eligible QBU. The proposed regulations

[[Page 52884]]

provide an exception, however, for portfolio stock where the owner of 
the eligible QBU owns (directly or constructively) less than ten 
percent of the total voting power or value of the stock of such 
corporation. The proposed regulations also provide that indebtedness 
incurred to acquire stock or a partnership interest that is not treated 
as being reflected on the books and records of an eligible QBU should 
similarly be excluded from the books and records. Finally, the proposed 
regulations provide that items of income, gain, deduction and loss 
arising from ownership of stock, a partnership interest, or related 
acquisition indebtedness that is excluded from the general books and 
records rule, shall similarly not be treated as being on the books and 
records of the eligible QBU.
iv. Coordination With Source Rules Under Section 988
    Section 988(a)(3) provides that the source of gain or loss 
recognized under section 988(a)(1) is determined by reference to the 
residence of the taxpayer or the QBU of the taxpayer on whose books the 
asset, liability, or item of income or expense is properly reflected. 
Section 1.988-4(b)(2) provides that, in general, the determination of 
whether an asset, liability, or item of income or expense is properly 
reflected on the books of a QBU is a question of fact. The regulations 
under section 988 further provide that such items are presumed not to 
be properly reflected on the books and records for this purpose if 
inconsistent booking practices are employed with respect to the same or 
similar items. Finally, the regulations provide that if such items are 
not properly reflected on the books of the QBU, the Commissioner may 
allocate the item between or among the taxpayer and its QBUs to 
properly reflect the source (or realization) of exchange gain or loss.
    The IRS and the Treasury Department believe that rules for 
determining whether items are properly reflected on the books of a QBU 
for purposes of sourcing section 988 gain or loss should be consistent 
with the rules for attributing items to an eligible QBU under section 
987. As a result, the proposed regulations modify the sourcing rules in 
the section 988 regulations 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 of a QBU.
2. Certain Assets and Liabilities of Partnerships and DEs Not 
Attributable to an Eligible QBU
    Section 988 applies to certain transactions described in section 
988(c) if the transaction is denominated (or determined by reference 
to) a currency that is not the functional currency of the taxpayer or 
QBU of the taxpayer. Thus, in order to determine if a transaction is 
subject to section 988, it must be determined whether a transaction is 
attributable to the taxpayer or a QBU of the taxpayer.
    Under the current section 989 regulations, a partnership is a QBU 
even if it does not have activities that constitute a trade or business 
(``per se QBU''). As a result, a partnership may have a functional 
currency different than its partners and section 988 is applied at the 
partnership level with respect to section 988 transactions properly 
attributable to the partnership. These regulations propose to amend 
section 989 to provide that a partnership is no longer a per se QBU of 
its partners, but instead the activities of such partnership may be 
treated as a QBU.
    As discussed above, the IRS and the Treasury Department will 
generally apply either an entity or an aggregate approach with respect 
to partnerships depending on which approach more appropriately carries 
out the purpose of the particular Code section under consideration. 
Following the amendments made by the proposed regulations, and because 
only certain activities of a partnership (and not the partnership 
itself) can qualify as a section 987 QBU, the IRS and the Treasury 
Department believe that it is appropriate, in cases where an asset or 
liability of a partnership is not reflected on the books and records of 
an eligible QBU of the partnership, to determine whether section 988 
applies by reference to the functional currencies of the partners. The 
IRS and the Treasury Department believe that this rule will have 
limited application and will apply, for example, where the only 
activity of a partnership is the incurrence of a liability used to 
acquire stock that is held by the partnership. The proposed regulations 
provide examples illustrating the application of this rule.
    As discussed above, the proposed regulations provide that a DE 
itself is not an eligible QBU and, instead, certain activities of the 
DE will be treated as an eligible QBU of the owner to the extent a 
separate set of books and records with respect to such activities are 
maintained. Thus, an issue similar to that discussed above with respect 
to partnerships will arise where the DE is the local law owner of 
certain assets or the local law obligor on certain liabilities, which 
are not reflected on the books and records of an eligible QBU held by 
the DE. The proposed regulations provide that the determination of 
whether section 988 (rather than section 987) applies with respect to 
transactions involving assets and liabilities of a DE that are not 
attributable to an eligible QBU is determined by reference to the 
functional currency of the owner of such DE.
3. Definition of a Transfer
i. Overview
    Section 987(3) provides, in part, that taxable income of a taxpayer 
shall be determined by making proper adjustments (as prescribed by the 
Secretary) for transfers of property between qualified business units 
of the taxpayer having different functional currencies. Similarly, the 
legislative history to section 987 refers to contributions to, and 
remittances from, QBUs. See, H.R. Conf. Rep. No. 841, 99th Cong. 2d. 
Sess. II 673-76 (1986). However, neither the statute nor the 
legislative history defines the terms ``transfer,'' ``contribution,'' 
or ``remittance.''
    As noted above, section 987 QBUs can be divisions of an owner that 
have no legal distinction separate from their owner. Section 987 QBUs 
can also be owned indirectly through partnerships, where they have 
legal distinction separate from their owners. Moreover, as a result of 
the entity classification regulations, a section 987 QBU held through a 
DE can have legal distinction separate from its owner, even though the 
section 987 QBU is treated as a division of the owner for federal 
income tax purposes. As a result, assets and liabilities can be 
transferred between an owner and a section 987 QBU in a manner that has 
legal significance (that is, a distribution from a section 987 
partnership), or in a manner that has no legal significance because the 
transfers are simply between divisions of the same legal entity (that 
is, a transfer involving divisions of a taxpayer that is reflected 
through accounting entries).
ii. Disregarded Transactions
    The definition of a transfer under the proposed regulations 
includes transactions that are regarded for both legal and tax 
purposes, and transactions that are regarded for legal purposes, but 
disregarded as transactions for tax purposes (``disregarded 
transactions''). For this purpose, the term disregarded transaction is 
treated as including the

[[Page 52885]]

recording of an asset or liability on one set of books and records, if 
the recording is the result of such asset or liability being removed 
from another set of books and records of the same person or entity 
(including a DE or partnership).
    The proposed regulations provide that an asset or liability is 
treated as transferred to or from a section 987 QBU if, as a result of 
a disregarded transaction, such asset or liability is reflected, or is 
not reflected, respectively, on the books and records of the section 
987 QBU. For example, if an owner of a section 987 DE loans cash to the 
section 987 QBU held by the section 987 DE, the loan is disregarded for 
Federal income tax purposes. However, as a result of such disregarded 
transaction, the loaned cash is reflected on the books and records of 
the section 987 QBU and, therefore, is treated as transferred to such 
section 987 QBU.
iii. Certain Contributions to, and Distributions From, Partnerships
    The proposed regulations also provide that transfers to and from 
section 987 QBUs include certain contributions of assets to, or 
distributions of assets from, a section 987 partnership. For example, 
an asset contributed by a partner to a section 987 partnership is 
treated as transferred to an indirectly owned section 987 QBU of the 
partner if the asset is reflected on the section 987 QBU's books and 
records following such contribution. The proposed regulations provide 
similar rules for assumptions of liabilities between a section 987 
partnership and its partners.
iv. Certain Acquisitions and Dispositions of Interests in DEs and 
Partnerships
    The proposed regulations also provide that transfers to or from a 
section 987 QBU may occur as a result of certain acquisitions 
(including by contribution) and dispositions of interests in DEs and 
partnerships. For example, if a partner in a section 987 partnership 
sells a portion of its interest in such partnership, the sale results 
in a transfer from the partner's indirectly owned section 987 QBU to 
the extent assets and liabilities are not reflected on the books and 
records of such QBU as a result of such sale.
v. Change in Form of Ownership
    The owner of a section 987 QBU can change its form of ownership in 
all or a portion of such section 987 QBU. Such changes in form of 
ownership often occur in a manner that does not affect the operation of 
the eligible QBU (or its status as an eligible QBU), but rather only 
changes the owner's interest in its section 987 QBU. For example, a 
direct owner of a section 987 QBU that is owned through a section 987 
DE can change to being an indirect owner of all or a portion of such 
section 987 QBU, if the interests in the section 987 DE are transferred 
to a partnership.
    Changes in form of ownership of a section 987 QBU can occur through 
actual or deemed transactions involving the section 987 QBU itself, or 
actual or deemed transactions involving interests in a section 987 DE 
or section 987 partnership that owns such QBU. For example, certain 
conversions of DEs to partnerships, or partnerships to DEs, result in 
deemed transactions pursuant to Rev. Ruls. 99-5, 1999-1 CB 434, and 99-
6, 1999-1 CB 432. See Sec.  601.601(d)(2). Deemed transactions with 
respect to partnerships also occur pursuant to section 708(b) and the 
regulations thereunder.
    The IRS and the Treasury Department believe that changes in form of 
ownership should result in a transfer only to the extent such change 
affects the assets and liabilities attributable to the section 987 QBU 
of the owner. As a result, the proposed regulations provide that a mere 
change in form of ownership of a section 987 QBU does not result in a 
transfer to or from the section 987 QBU. Instead, the proposed 
regulations provide that the determination of whether a transfer has 
occurred in such cases should be made under the general transfer rules, 
discussed above. Moreover, the proposed regulations clarify that deemed 
transactions (for example, pursuant to Rev. Ruls. 99-5 and 99-6) shall 
not be taken into account for purposes of determining whether there is 
a transfer.
vi. General Tax Law Principles
    The proposed regulations clarify that general tax law principles, 
including the circular cash flow, step-transaction, and substance-over-
form doctrines apply for purposes of determining whether there is a 
transfer of an asset or liability to or from a QBU. For example, if a 
shareholder of a corporation that directly owns a section 987 QBU 
transfers property to the corporation and the property is recorded on 
the books and records of the corporation's section 987 QBU, the 
shareholder is first treated as transferring the property to the 
corporation, and then the corporation is treated as transferring the 
property to the section 987 QBU in a disregarded transaction.
4. Adjustments to Items Reflected on the Books and Records
    As noted above, a section 987 QBU of a taxpayer may not be an 
entity separate from the taxpayer that can legally own assets and incur 
liabilities. As a result, recording (or failing to record) an asset or 
liability on the books and records may, other than for purposes of 
section 987, have little significance for tax or legal purposes. In 
addition, transfers between section 987 QBUs of the same owner that are 
divisions of the same legal entity may have no legal significance and 
are accomplished only through journal entries on the books and records 
of such section 987 QBUs. As a result, the IRS and the Treasury 
Department are concerned that, in certain circumstances, transfers to 
or from a section 987 QBU may be structured solely to achieve 
advantages under section 987, especially given that such transfers may 
have little or no significance from a legal or business perspective.
    In Notice 2000-20, the IRS and the Treasury Department expressed 
similar concerns in connection with taxpayers taking positions that 
certain contributions and distributions triggered foreign currency 
losses prematurely with respect to transactions that were undertaken 
for tax purposes, but lacked meaningful non-tax economic consequences. 
The notice provided that the IRS and the Treasury Department believe 
that circular cash flows and similar transactions lacking economic 
substance will not result in recognition of foreign currency losses 
under general tax principles because such transactions are not properly 
treated as transfers or remittances under section 987.
    The IRS and the Treasury Department continue to be concerned about 
transactions that are undertaken for tax purposes and lack meaningful 
non-tax economic consequences. As a result, the proposed regulations 
provide the Commissioner the ability to allocate assets and 
liabilities, and items of income, gain, deduction and loss, where a 
principal purpose of recording (or failing to record) an item on the 
books and records of an eligible QBU (including an eligible QBU owned 
indirectly through a partnership) is the avoidance of U.S. tax under 
section 987. The proposed regulations also provide various factors that 
indicate whether recording (or failing to record) an item on books and 
records has as a principal purpose the avoidance of U.S. tax under 
section 987. For example, factors indicating that such tax avoidance 
was not a principal purpose of recording (or not recording) an item 
include doing so

[[Page 52886]]

for a substantial and bona fide business purpose, or in a manner that 
is consistent with the economics of the underlying transaction.
5. Translation of Items Transferred to a Section 987 QBU
    The proposed regulations provide translation rules for the transfer 
of assets and liabilities to a section 987 QBU. Under the proposed 
regulations, if an asset or a liability is transferred to a section 987 
QBU, such items are translated into the QBU's functional currency at 
the spot rate on the day of transfer. No translation is required for 
assets or liabilities denominated in the functional currency of the 
section 987 QBU.
    The proposed regulations provide special rules for items 
transferred to a section 987 QBU where such items are denominated in 
(or determined by reference to) the owner's functional currency. Such 
items are not translated and instead are carried on the balance sheet 
in the owner's functional currency since no foreign currency exposure 
with respect to the owner is created by such items.
6. Interaction With Other Foreign Currency Provisions
    The IRS and the Treasury Department are considering whether the 
attribution and transfer rules provided under the proposed regulations 
should apply with respect to other foreign currency provisions in the 
Code. For example, the IRS and the Treasury Department are considering 
whether the attribution rules under the proposed regulations should 
apply to determine the functional currency of a QBU under section 985. 
As a result, comments are requested on the interaction of these rules 
with other foreign currency provisions.

C. Section 1.987-3 Determination of the Items of Aection 987 Taxable 
Income or Loss of an Owner of a Section 987 QBU

    In general, the term ``section 987 taxable income'' refers to the 
items of income, gain, deduction or loss attributed to the section 987 
QBU under Sec.  1.987-2(b), translated into the functional currency of 
the owner. The allocation of expenses such as interest under other 
provisions are not taken into account for this purpose. Section 987 
taxable income is calculated by determining each item of income, gain, 
deduction or loss in the section 987 QBU's functional currency under 
Sec.  1.987-3(a), and then translating those items into the owner's 
functional currency using the exchange rates provided in Sec.  1.987-
3(b). Items of income, gain, deduction or loss of a section 987 QBU 
that are denominated in (or determined by reference to) the functional 
currency of the owner are not translated and are not treated as section 
988 transactions to the section 987 QBU. Transactions denominated in 
(or determined by reference to) a currency that is neither the 
functional currency of the owner nor of the section 987 QBU are subject 
to the generally applicable rules under section 988 determined with 
respect to the functional currency of the section 987 QBU.
    When basis recovery is required with respect to an historic asset, 
either in computing gain or loss on the sale or exchange of such asset, 
or in determining cost recovery deductions (such as depreciation or 
depletion), the proposed regulations require the use of the historical 
exchange rate associated with the particular asset. Thus, for example, 
where a section 987 QBU sells an historic asset, the amount realized 
will be translated into the owner's functional currency using the 
yearly average exchange rate (or, if properly elected, the spot rate), 
but the adjusted basis will be translated using the historic exchange 
rate associated with that asset. The use of different exchange rates 
for amount realized and adjusted basis is designed to more closely 
reflect the economic gain or loss to the owner of the section 987 QBU 
than the 1991 proposed regulations. The same is true for depreciation 
or other cost recovery deductions that are claimed with respect to 
historic assets of a section 987 QBU.
    Special translation rules are provided with respect to the 
disposition of marked assets (other than functional currency cash of 
the section 987 QBU). Generally, the amount realized and basis are 
translated at the same exchange rates. The purpose of these special 
rules is to assure that foreign currency gain or loss (as opposed to 
gain or loss not related to movements in exchange rates) is reflected 
through the balance sheet calculations of Sec.  1.987-4 and not through 
the profit and loss calculations of Sec.  1.987-3. Cash is not included 
in these special rules because the disposition of cash cannot generate 
profit or loss to the section 987 QBU for purposes of Sec.  1.987-3.

D. Section 1.987-4 Determination of Net Unrecognized Section 987 Gain 
or Loss of a Section 987 QBU

    Section 1.987-4 provides the mechanics for determining ``net 
unrecognized section 987 gain or loss'' and, when combined with Sec.  
1.987-5, form the mathematical core of the foreign exchange exposure 
pool method. In summary, Sec.  1.987-4 uses a balance sheet to 
distinguish the items of a section 987 QBU that give rise to section 
987 gain or loss (section 987 marked items) from those that do not 
(section 987 historic items). This approach avoids the distortions 
caused by the 1991 proposed regulations that impute section 987 gain or 
loss to all assets of a section 987 QBU, even those assets the value of 
which does not fluctuate with currency movements. Generally, annual 
comparison of the change in the value of section 987 marked items on 
the opening and closing balance sheets due to changes in exchange rates 
gives rise to unrecognized section 987 gain or loss. This unrecognized 
section 987 gain or loss is aggregated with similar amounts determined 
for prior years (to the extent not previously taken into account) and 
is taken into account by the owner under the rules of Sec.  1.987-5 
upon a remittance by the section 987 QBU.
    Under Sec.  1.987-4(a) and (b), net unrecognized section 987 gain 
or loss is computed annually and is equal to the sum of the 
``unrecognized section 987 gain or loss for the current taxable year'' 
and the ``net accumulated unrecognized section 987 gain or loss for all 
prior taxable years.'' A section 987 QBU's net accumulated unrecognized 
section 987 gain or loss for all prior taxable years is the aggregate 
of the unrecognized section 987 gain or loss 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 a remittance for all such taxable years. For section 987 QBUs in 
existence prior to the effective date of these regulations, a section 
987 QBU's net accumulated unrecognized section 987 gain or loss 
includes amounts taken into account under the transition rules of Sec.  
1.987-10.
    Unrecognized section 987 gain or loss is determined under a seven 
step calculation. Under the first step in Sec.  1.987-4(d)(1), the 
``owner functional currency net value'' of the section 987 QBU is 
determined under Sec.  1.987-1(e) at the close of the taxable year in 
the functional currency of the owner. This is a balance sheet 
calculation under which the basis (or amount, in the case of a 
liability) of each section 987 marked item is translated into the 
owner's functional currency at the spot rate on the last day of the 
taxable year. Section 987 historic items are translated into the 
owner's functional currency at the historic exchange rate and, 
therefore, do not give rise to exchange gain or loss. The amount of 
liabilities determined in the owner's functional currency is subtracted 
from the value of the assets

[[Page 52887]]

determined in the owner's functional currency to result in the owner 
functional currency net value of the section 987 QBU at the close of 
the taxable year. The owner functional currency net value of the 
section 987 QBU at the close of the preceding taxable year is 
subtracted from the owner functional currency net value of the section 
987 QBU at the close of the current taxable year to yield the change in 
owner functional currency net value of the section 987 QBU for the 
taxable year expressed in the owner's functional currency.
    Generally, three components are reflected in the change in owner 
functional currency net value of the section 987 QBU for a taxable 
year. First, taxable income or loss of the section 987 QBU will result 
in increases or decreases in net assets, and will therefore affect net 
value. Second, transfers of assets or liabilities to or from the 
section 987 QBU will affect net value. Finally, any remaining change in 
net value (as measured in the owner's functional currency) results from 
changes in the value of the section 987 QBU's marked assets and 
liabilities. In order to isolate the change in value due to foreign 
currency movements with respect to section 987 marked assets and 
liabilities, the other changes must be reversed out. That is the 
function of steps 2 through 7 of Sec.  1.987-4(d).
    The unrecognized section 987 gain or loss when aggregated with 
similar amounts for prior years (that were not previously taken into 
account) yields a pool of ``net unrecognized section 987 gain or loss'' 
all or part of which is to be triggered upon a remittance or 
termination.

E. Section 1.987-5 Recognition of Section 987 Gain or Loss

    Section 1.987-5 of the proposed regulations provides the method for 
determining the amount of section 987 gain or loss a taxpayer must 
recognize in a taxable year. Generally, the amount of section 987 gain 
or loss recognized in a taxable year equals the net unrecognized 
section 987 gain or loss of the section 987 QBU determined under Sec.  
1.987-4 on the last day of such taxable year, multiplied by the owner's 
remittance proportion. The pool of net unrecognized section 987 gain or 
loss includes both unrecognized section 987 gain or loss on marked 
items for the current year and unrecognized section 987 gain or loss on 
marked items for prior years (that has not yet been taken into 
account). A portion of the Sec.  1.987-4 pool of unrecognized section 
987 gain or loss is triggered by a net transfer or ``remittance'' to 
the owner by a section 987 QBU during the owner's taxable year. 
Generally, the owner's remittance proportion is equal to the quotient 
of the amount of the remittance divided by the aggregate adjusted basis 
of the section 987 QBU's gross assets (as reflected on its year end 
balance sheet), without reduction for the remittance.
    The 1991 proposed regulations define a remittance as the amount of 
any transfer from a QBU branch to the extent the amount of transfers 
during the year does not exceed the year end balance of the equity 
pool. Transfers are limited in the 1991 proposed regulations by a daily 
netting rule that takes into account only the amount of property 
distributed from the QBU branch that exceeds the amount of property 
transferred by the taxpayer to the QBU branch in a single day. The IRS 
and the Treasury Department believe that the daily netting rule of the 
1991 proposed regulations is not easily administered and causes 
distortions in the amount of a remittance. For example, taxpayers have 
taken the position that a remittance followed a short time later by an 
equal contribution to a QBU branch can trigger recognition of section 
987 gain or loss even though there has been no economic change in 
position of the QBU branch. The IRS and the Treasury Department believe 
this approach is inappropriate and provides incentives for circular 
cash flows used to manipulate amounts of remittances. This daily 
netting rule is eliminated in the proposed regulations to reduce 
administrative burdens on both the IRS and taxpayers, and to eliminate 
both taxpayer favorable and taxpayer unfavorable distortions that it 
can create.
    Section 1.987-5(c) of the proposed regulations defines a remittance 
as the excess of total transfers from the section 987 QBU to the owner 
determined in the owner's functional currency on an annual basis over 
total transfers from the owner to the section 987 QBU determined on an 
annual basis. Solely for purposes of determining the amount of a 
remittance under Sec.  1.987-5(c), the amount of liabilities 
transferred from the owner to the section 987 QBU is treated as a 
transfer of assets from the section 987 QBU to the owner. Similarly, 
the amount of liabilities transferred from the section 987 QBU to the 
owner is treated as a transfer of assets from the owner to the section 
987 QBU. The IRS and the Treasury Department recognize that section 987 
QBUs actively engaged in business may have a significant number of 
transactions that are treated as transfers to and from the owner 
pursuant to Sec.  1.987-2(c). It is anticipated that the annual netting 
rule will help to reduce complexity and administrative burden for 
taxpayers and the IRS by treating the net amount of transfers as a 
single annual remittance. For purposes of determining the annual 
remittance, only assets and liabilities considered transferred pursuant 
to Sec.  1.987-2(c) will be taken into account.
    The remittance is divided by the total adjusted basis of section 
987 gross assets, expressed in the functional currency of the owner, 
reflected on the section 987 QBU balance sheet pursuant to Sec.  1.987-
2 (increased by the amount of the remittance) to determine the 
remittance proportion. The IRS and the Treasury Department considered a 
number of different measures for determining the amount of section 987 
gain or loss triggered upon a remittance. The adjusted basis of gross 
section 987 QBU assets was selected as the measure because it avoids 
administrative concerns raised by alternative methods and limits the 
potential volatility associated with the recognition of section 987 
gain or loss. In particular, the adjusted basis of gross section 987 
QBU assets measure avoids the significant administrative burdens 
associated with a section 987 QBU accumulated earnings approach that 
would require taxpayers to maintain post-1986 accumulated earnings 
pools for each section 987 QBU. The IRS and the Treasury Department 
also considered the use of net section 987 QBU assets as a potential 
measure. Although the net section 987 QBU assets measure does not raise 
the same administrative burdens as an earnings based approach, the IRS 
and the Treasury Department were concerned about the volatility of 
recognizing section 987 gain or loss using a net asset measure. For 
example, if a section 987 QBU's gross assets are equal to its 
liabilities, section 987 gain or loss would be deferred. On the other 
hand, a small amount of income could increase section 987 QBU net 
assets slightly above zero and all accumulated section 987 gains or 
losses could be triggered with a very small remittance. The IRS and the 
Treasury Department believe that gross assets is a reasonable proxy for 
post-1986 accumulated earnings in this context, can be administered 
relatively easily, and will reduce the volatility and potential for 
distortion described in this preamble.

F. Section 1.987-6 Character and Source

    Section 987(3)(B) requires that a taxpayer make proper adjustments 
(as prescribed by the Secretary) for certain transfers of property 
between QBUs of

[[Page 52888]]

the taxpayer, including treating section 987 gain or loss as ordinary 
income or loss and sourcing such gain or loss by reference to the 
source of income giving rise to post-1986 accumulated earnings. Section 
987 is silent on the method of characterizing section 987 gain or loss 
for purposes of the Code. Nevertheless, the IRS and the Treasury 
Department believe that it is necessary to characterize section 987 
gain or loss for the proper operation of certain other sections of the 
Code. For example, the character of section 987 gain must be determined 
for purposes of determining whether all or a portion of such gain 
qualifies as subpart F income under section 954. This characterization 
is necessary to prevent section 987 from being used as a vehicle to 
avoid the rules of section 954(c)(1)(D) with respect to certain section 
988 transactions. In addition, section 987 gain or loss must be 
characterized for purposes of determining the foreign tax credit 
limitation under section 904(d). As a result, and pursuant to sections 
987(3) and 989(c)(5), the proposed regulations characterize section 987 
gain or loss for all purposes of the Code, including for purposes of 
sections 904(d), 907 and 954.
    In accordance with section 987(3)(B), Sec.  1.987-6(a) provides 
that section 987 gain or loss is ordinary income or loss. Moreover, the 
IRS and the Treasury Department believe that rules governing the source 
and character of section 987 gain or loss for other Code sections 
should be consistent. The IRS and the Treasury Department are 
concerned, however, that sourcing and characterizing section 987 gain 
or loss by reference to post-1986 accumulated earnings would give rise 
to substantial complexity by requiring taxpayers to track the earnings 
of section 987 QBUs in section 904(d) categories over prolonged 
periods. The compliance burden would be considerable for taxpayers with 
large numbers of section 987 QBUs. Accordingly, the IRS and the 
Treasury Department believe that it is appropriate to use the average 
tax book value of assets in the year of remittance as determined under 
Sec.  1.861-9T(g) as a proxy for post-1986 accumulated earnings in the 
context of section 987.\3\ In the context of section 987, use of a 
single year's assets should generally reflect the activities of a 
section 987 QBU that give rise to a section 987 QBU's accumulated 
earnings and will significantly minimize complexity. The tax book value 
method set forth in Sec.  1.861-9T(g) as applied to section 987 QBUs 
has been amended to provide greater consistency with the proposed 
regulations. The modified gross income method described in Sec.  1.861-
9T(j) cannot be used to characterize section 987 gain or loss as the 
IRS and the Treasury Department believe that gross income earned in a 
single year is not a sufficient proxy for accumulated earnings.
---------------------------------------------------------------------------

    \3\ Notably, because section 987 gain or loss may be derived 
from assets acquired with earnings and capital of a section 987 QBU 
(or from liabilities entered into by the QBU), using post-1986 
accumulated earnings to characterize exchange gain or loss under 
section 987 may not reflect all items giving rise to such gain or 
loss.
---------------------------------------------------------------------------

    The IRS and the Treasury Department recognize that the 
characterization rule contained in the proposed regulations applies to 
provisions other than the international tax rules. In addition, the IRS 
and the Treasury Department recognize that special considerations may 
arise in connection with applying this characterization rule to various 
domestic provisions. For example, special considerations may arise when 
characterizing section 987 gain or loss for rules that apply to 
regulated investment companies (RICs) and real estate investment trusts 
(REITs). The IRS and the Treasury Department are studying the 
application of the characterization rules to these other provisions and 
request comments. As a result, the proposed regulations reserve on the 
method for characterizing and sourcing section 987 gain or loss for 
purposes of RICs and REITs.

G. Section 1.987-7 Partnership Rules

1. Scope
    Section 1.987-7 provides rules for determining a partner's share of 
the assets and liabilities of an eligible QBU held indirectly through a 
section 987 partnership. It also provides rules coordinating the 
application of section 987 with subchapter K of chapter 1 of the Code.
2. Allocation of Assets and Liabilities
    In order to apply the foreign exchange exposure pool method at the 
partner level, as discussed above, each partner must determine its 
share of the assets and liabilities of an eligible QBU and, to the 
extent applicable, a section 987 QBU owned indirectly through the 
section 987 partnership. Section 1.987-7 provides a general rule that 
requires the allocation of the assets and liabilities of the 
partnership's eligible QBUs to the partners in a manner that is 
consistent with the manner in which the partners have agreed to share 
the economic benefits and burdens corresponding to such assets and 
liabilities, taking into account the rules and principles of sections 
701 through 761 and the regulations thereunder, including section 
704(b) and Sec.  1.701-2.
    The IRS and the Treasury Department believe that this general rule 
is appropriate because it will allocate the assets and liabilities 
consistent with the partners' economic arrangement. The IRS and the 
Treasury Department recognize that any rule which attempted to allocate 
the assets and liabilities without regard to such economic arrangement 
would have the effect of distorting each partner's section 987 gain or 
loss attributable to its section 987 QBU and, as a result, would be 
inappropriate. Moreover, the IRS and the Treasury Department are 
concerned that taxpayers could attempt to inappropriately shift a 
partner's share of the underlying assets and liabilities of a section 
987 QBU owned indirectly through a section 987 partnership to distort 
the partner's section 987 gain or loss. As a result, the Commissioner 
may review such allocations to ensure that they are consistent with the 
economic arrangement of the partners and the principles of subchapter K 
of Chapter 1 of the Code and the applicable regulations, including 
section 704(b) and Sec.  1.701-2.
    Moreover, the IRS and the Treasury Department are considering 
whether it would be appropriate, when these regulations are finalized, 
to provide a safe harbor. Under such a safe harbor, the assets and 
liabilities of an eligible QBU would be deemed to be allocated in a 
manner which appropriately reflects each partner's share of the 
economic benefits and burdens if certain conditions are satisfied. For 
example, the safe harbor could provide that the assets and liabilities 
are deemed to be allocated in a manner consistent with each partner's 
share of the underlying economic benefits and burdens provided the 
assets, to the extent of a partner's share of partnership capital, are 
allocated in accordance with such capital and any excess assets (assets 
in excess of partnership capital) are allocated consistent with the 
manner in which the partners have agreed to share the economic burden 
of the liabilities incurred to acquire such assets. The IRS and the 
Treasury Department request comments as to whether a safe harbor should 
be included and, if so, what form such safe harbor should take.
3. Coordination with subchapter K
    A partner must take into account its share of the items of income, 
gain, deduction, or loss of its section 987 QBU owned indirectly 
through a partnership and, under Sec.  1.987-3, must convert such items 
into its functional

[[Page 52889]]

currency. In addition, a partner must take into account any section 987 
gain or loss of the section 987 QBU determined in the partner's 
functional currency. In both situations, the partner's adjusted basis 
in its partnership interest must be adjusted in order to avoid the 
duplication of income or loss attributable to the section 987 QBU. 
Section 1.987-7 provides a rule regarding the appropriate adjustments 
which must be made to the partner's adjusted basis in the section 987 
partnership to ensure that no such duplication occurs.
    A partner is also required under section 752 to adjust its basis in 
its interest in the section 987 partnership to take into account 
liabilities of the section 987 partnership. As a result, the proposed 
regulations provide rules for determining the appropriate adjustments 
to such basis required under section 752 in the case of an increase or 
a decrease in such partner's share of the liabilities of the 
partnership reflected on the books and records of a section 987 QBU. In 
addition, the proposed regulations provide rules for determining the 
amount of such liability, as determined in the partner's functional 
currency, which must be taken into account on the sale or exchange of a 
partnership interest under section 752(d).
    The proposed regulations also clarify, consistent with section 
985(a), that a partner's adjusted basis in its partnership interest is 
determined in the functional currency of the partner. Moreover, the 
proposed regulations provide that the fluctuations between the 
partner's functional currency and the functional currency of the 
section 987 QBU do not affect such partner's adjusted basis in its 
partnership interest. Instead, such fluctuations are taken into account 
under the foreign exchange exposure pool method of Sec.  1.987-4.
4. Comments
    The proposed regulations do not address the adjustments which would 
occur under section 752 when there is an assumption by a partnership of 
a partner's liability that is denominated in a functional currency 
different from the partner and which, as a result, is subject to 
section 988 in the hands of the partner. In such cases, the partner 
will be deemed to receive a distribution of money, under section 
752(b), regardless of whether, following the assumption, the liability 
is reflected on the books and records of the partnership's qualified 
business unit. In such cases, it is unclear whether the amount of the 
distribution should be determined by reference to the spot rate (on the 
date of assumption) or the historic exchange rate (on the date the 
liability was originally incurred by the partner). In addition, this 
issue raises concerns as to how section 988 would operate upon such 
assumption. The IRS and Treasury Department request comments on this 
issue and whether provisions should be included in section 988 to 
better coordinate the operation of section 987 and section 988 in this 
context. In addition, comments are requested on whether provisions 
should be included in section 988 in order to coordinate the aggregate 
approach, adopted in these proposed regulations, with respect to 
certain assets and liabilities that are not reflected on an eligible 
QBU of the partnership.
    In addition to the issues specifically addressed in the proposed 
regulations, the IRS and the Treasury Department request comments on 
additional provisions which should be included to coordinate the 
provisions of section 987 with subchapter K of chapter 1 of the Code. 
Specifically, comments are requested as to how capital accounts 
maintained under section 704 should be adjusted to take into account 
section 987 gain or loss. In addition, comments are requested as to 
whether section 987 loss should be subject to the limitation provided 
under section 704(d) and, if so, how such limitation might be applied. 
Finally, comments are requested as to any other provisions of 
subchapter K of chapter 1 of the Code on which guidance should be 
provided.

H. Section 1.987-8 Termination of a Section 987 QBU

1. General termination rules
    The proposed regulations set forth circumstances in which a section 
987 QBU will terminate. For purposes of Sec.  1.987-5, a termination of 
a section 987 QBU is treated as a remittance of all the gross assets of 
the section 987 QBU to its owner. The termination rules recognize that 
an owner carries on a trade or business through its section 987 QBU and 
when the owner stops conducting that trade or business through its 
section 987 QBU, any section 987 gain or loss should be recognized in 
full. Thus, a termination generally occurs when: (1) The activities of 
the section 987 QBU cease; (2) substantially all of the assets (as 
defined in section 368(a)(1)(C)) of the section 987 QBU are transferred 
to its owner; or (3) the owner of the section 987 QBU ceases to exist.
    In addition, a termination occurs when a foreign corporation that 
is a controlled foreign corporation (CFC) that is the owner of a 
section 987 QBU ceases to be a CFC because at that point any section 
987 gain or loss cannot be subpart F income and may be deferred 
indefinitely.
2. Exceptions for Certain Section 381 Transactions
    Section 987 gain or loss generally arises during the period that an 
owner has a section 987 QBU. The section 987 gain or loss is analogous 
in some respects to a tax attribute under section 381. As a result, the 
proposed regulations provide that a termination does not generally 
occur when other tax attributes under section 381 are carried over in a 
liquidation under section 332 or an asset reorganization under section 
368(a). However, inbound and outbound liquidations and reorganizations 
terminate a section 987 QBU because these transactions materially 
change the circumstances in which section 987 gain or loss is taken 
into account.
3. Treatment of Inbound Liquidations and Inbound Asset Reorganizations
    Although the proposed regulations treat inbound liquidations under 
section 332 and inbound asset reorganizations under section 368(a) as 
terminations, the IRS and the Treasury Department are considering 
whether such treatment is appropriate in all cases.
    The IRS and the Treasury Department believe that the better view, 
taking into account various policies, is to support the treatment of 
inbound transactions as terminations. For example, such treatment may 
prevent the importation of a tax attribute that was generated offshore. 
Concerns over such attribute importation are similar to those that were 
addressed in Sec.  1.367(b)-3(e) and (f) and section 362(e). In 
addition, treating inbound asset transactions as terminations is 
consistent with the results that would obtain if the foreign currency 
gain or loss attributable to the QBU were taken into account under 
section 988, rather than section 987.
    The IRS and the Treasury Department acknowledge, however, that 
other policies may support the position that such inbound transactions 
should not be terminations. One of the reasons the proposed regulations 
treat certain section 381 transactions as terminations is because 
amounts taken into account under section 987 (that is, section 987 
taxable income or loss, and section 987 gain or loss) generally become 
subject to a lesser degree of U.S. taxation after the section 381 
transaction than was the case before the transaction (that is, when the 
section 987 QBU goes from being owned by a domestic corporation to 
being owned by a foreign corporation). This is not the case in

[[Page 52890]]

certain inbound transactions because amounts taken into account under 
section 987 are generally subject to a greater degree of U.S. taxation 
after the inbound transaction (when the section 987 QBU is owned by a 
domestic corporation) than was the case before the transaction (when 
the section 987 QBU was owned by a foreign corporation).
    The IRS and the Treasury Department request comments on whether it 
is appropriate to treat these inbound asset transactions as 
terminations. Such comments should take into account the policy 
concerns discussed in this preamble.
4. Section 351 Exchanges and Transactions Within a Consolidated Group
    The proposed regulations provide that a termination occurs when the 
owner of a section 987 QBU transfers the QBU to another corporation in 
exchange for stock in a transaction qualifying under section 351. The 
termination occurs because the owner no longer has a section 987 QBU.
    The IRS and the Treasury Department are studying ways to apply the 
intercompany transaction rules of Sec.  1.1502-13 to section 987 
transactions within a consolidated group. For example, the IRS and the 
Treasury Department are considering whether transfers qualifying under 
section 351 which would trigger a remittance or termination under the 
proposed regulations should qualify for deferral under Sec.  1.1502-13. 
The IRS and the Treasury Department request comments on the interplay 
between Sec.  1.1502-13 and the proposed regulations and the timing of 
the inclusion of the deferred section 987 gain or loss.

I. Section 1.987-9 Recordkeeping Rules

    Given the detailed nature of the calculations required under these 
regulations, Sec.  1.987-9 articulates the records that taxpayers must 
keep. A taxpayer must keep such records as are sufficient to establish 
the section 987 QBU's section 987 taxable income or loss, its section 
987 gain or loss, and the transition method used for section 987 QBUs 
under Sec.  1.987-10. Section 1.987-9(b) lists supplemental records 
that must be maintained.

J. Section 1.987-10 Transition Rules

    The transition rules of Sec.  1.987-10 apply to a taxpayer that is 
the owner of a section 987 QBU on the transition date. Such a taxpayer 
must transition to the foreign exchange exposure pool method of these 
regulations whether or not such taxpayer made determinations required 
under section 987 in prior years. A taxpayer that failed to make 
required determinations under section 987 in prior years or that used 
an unreasonable method in prior years can only use the fresh start 
transition method of Sec.  1.987-10(c)(4) as described in this 
preamble. Generally, use of the 1991 proposed section 987 regulations 
method (see, Examples 1 and 3 of Sec.  1.987-10(d)) or an ``earnings 
only'' section 987 method (see, Example 2 of Sec.  1.987-10(d)) will be 
considered a reasonable method for purposes of Sec.  1.987-10. However, 
for example, the recognition of section 987 gain or loss with respect 
to stock under any method, where the gain or loss does not reflect 
economic gain or loss derived from the movements in exchange rates, 
will be carefully scrutinized by the IRS and may be considered 
unreasonable based on the facts and circumstances of the particular 
case.
    The transition date is the first day of the first taxable year to 
which these section 987 regulations apply.
    Comments are requested on the application of these transition rules 
to partnerships which were, under the current proposed regulations, 
treated as qualified business units for purposes of section 987. 
Comments are also requested on the treatment of qualified business 
units of such partnerships.
    Generally, Sec.  1.987-10(c) allows a taxpayer to transition to the 
foreign exchange exposure pool method set forth in these regulations 
under one of two methods (the ``deferral transition method'' or the 
``fresh start transition method''). Under the conformity rules of Sec.  
1.987-10(c)(2), this election must be applied with respect to all 
members that file a consolidated return with the taxpayer and any 
controlled foreign corporation as defined in section 957 in which the 
taxpayer owns more than 50 percent of the voting power or stock (as 
determined in section 957(a)). This conformity rule is necessary to 
prevent taxpayers and certain related entities from taking inconsistent 
positions with respect to qualified business units which have 
unrecognized section 987 gains and losses. The IRS and the Treasury 
Department request comments on concerns that may arise by the inclusion 
of certain controlled foreign corporations in the conformity rule.
    Under the deferral transition method of Sec.  1.987-10(c)(3), 
section 987 gain or loss is determined under the taxpayer's prior 
section 987 method on the transition date as if all qualified business 
units of the taxpayer terminated on the last day of the taxable year 
preceding the transition date. The deemed termination is solely for 
purposes of measuring section 987 gain or loss in order to transition 
to the foreign exchange exposure pool method and does not apply for any 
other purpose. Section 987 gain or loss determined on the deemed 
termination is not immediately recognized. Rather, it is deferred by 
treating it as net unrecognized section 987 gain or loss of the 
relevant section 987 QBU. Such gain or loss will be recognized under 
the remittance rules of Sec.  1.987-5 for periods after the transition 
date. The owner of a qualified business unit that is deemed to 
terminate under these rules is treated as having transferred all of the 
assets and liabilities attributable to the qualified business unit to a 
new section 987 QBU on the transition date. In order to avoid double 
counting, Sec.  1.987-10(c)(3)(ii) provides that the exchange rates 
used to determine the amount of an asset or liability transferred from 
the owner to the new section 987 QBU on the transition date (that is, 
for purposes of making later calculations under Sec.  1.987-4) is 
determined with reference to the historic exchange rates on the day the 
asset was acquired or liability entered into by the qualified business 
unit deemed terminated. That exchange rate is then adjusted to take 
into account an allocation of section 987 gain or loss determined under 
the deferral transition method. If the taxpayer is not able to trace an 
historic exchange rate to a particular asset or liability, then the 
exchange rate must be determined under a reasonable allocation method, 
consistently applied, that takes into account an allocation of the 
aggregate basis and an allocation of the deferred section 987 gain or 
loss.
    Under the fresh start transition method of Sec.  1.987-10(c)(4), on 
the transition date all qualified business units of the taxpayer 
subject to section 987 are deemed terminated on the last day of the 
taxable year preceding the transition date. As under the deferral 
transition method, this deemed termination is solely for purposes of 
transitioning to the foreign exchange exposure pool method under 
section 987 and does not apply for any other purpose. Under the fresh 
start transition method, no section 987 gain or loss is determined or 
recognized on such deemed termination. Rather, the exchange rates used 
to determine the total amount of assets and liabilities deemed 
transferred from the owner to the section 987 QBU for the section 987 
QBU's first taxable year are determined solely with reference to the 
historic exchange rates on the day the assets were acquired or 
liabilities entered into

[[Page 52891]]

by the qualified business unit that was deemed terminated. Like the 
deferral transition method, if the taxpayer is not able to trace an 
exchange rate to a particular asset or liability, then the exchange 
rate must be determined under a reasonable allocation method, 
consistently applied, that takes into account the aggregate basis of 
the QBU's assets (and amount of liabilities). The fresh start method is 
designed to prevent recognition of non-economic currency gain or loss 
with respect to unremitted assets that are attributable to the 
qualified business unit. In the first taxable year when the foreign 
exchange exposure pool method applies, the deemed contribution of 
marked assets to a section 987 QBU at the historic exchange rate when 
originally acquired potentially gives rise to section 987 gain or loss 
while the historic assets (also translated at the historic exchange 
rate) will not.
    The transition method adopted by the taxpayer must be disclosed in 
accordance with the rules provided in Sec.  1.987-10(c)(6).

Proposed Effective Date

    These regulations are proposed to be effective as follows. These 
regulations shall generally apply to taxable years beginning one year 
after the first day of the first taxable year following the date of 
publication of a Treasury decision adopting this rule as a final 
regulation in the Federal Register. A taxpayer may elect to apply these 
regulations to taxable years beginning after the date of publication of 
a Treasury decision adopting this rule as a final regulation in the 
Federal Register. Such election is binding on all members that file a 
consolidated return with the taxpayer and any controlled foreign 
corporation, as defined in section 957, in which the taxpayer owns more 
than 50 percent of the voting power or stock (as determined in section 
957(a)). Pending finalization, the IRS and the Treasury Department 
would consider positions consistent with these proposed regulations to 
be reasonable constructions of the statute.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations. It is hereby 
certified that the collection of information contained in this 
regulation will not have a significant economic impact on a substantial 
number of small entities. Accordingly, a regulatory flexibility 
analysis is not required. The proposed section 987 regulations will 
generally only affect large United States corporations with business 
units operating in foreign jurisdictions. Thus, the number of affected 
small entities will not be substantial and any economic impact on those 
entities in complying with the collection of information would be 
minimal. Pursuant to section 7805(f) of the Internal Revenue Code, this 
notice of proposed rulemaking will be submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on its 
impact on small businesses.

Comments and Public Hearing

    Before the proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and the Treasury Department request comments on the 
clarity of the proposed rules and how they can be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for November 21, 2006, 
beginning at 10 a.m. in the Auditorium, Internal Revenue Service, New 
Carrollton Federal Building, 5000 Ellin Road, Lanham, MD 20706. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 30 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments must submit electronic or written 
comments by December 6, 2006 and an outline of the topics to be 
discussed and time to be devoted on each topic (a signed original and 
eight (8) copies) by October 31, 2006. A period of 10 minutes will be 
allotted to each person for making comments. An agenda showing the 
scheduling of the speakers will be prepared after the deadline for 
receiving outlines has passed. Copies of the agenda will be available 
free of charge at the hearing.

Drafting Information

    The principal authors of the proposed regulations are Jeffrey 
Dorfman and Theodore Setzer of the Office of Associate Chief Counsel 
(International).

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Withdrawal of Notice of Proposed Rulemaking

    Accordingly, under the authority of 26 U.S.C. 7805, the notice of 
proposed rulemaking (REG-208270-86) that was published in the Federal 
Register on September 25, 1991 (56 FR 48457) is withdrawn.

Proposed Amendment to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

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

    Authority: 26 U.S.C. 987, 989(c), 6601 and 7805 * * *

    Par. 2. Section 1.861-9T is amended as follows:
    1. Paragraph (g)(2)(ii)(A)(1) is revised.
    2. Paragraph (g)(2)(vi) is added.
    The revisions 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, the tax book 
value shall be determined by applying the rules of paragraphs (g)(2)(i) 
and (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.
* * * * *

[[Page 52892]]

    (vi) Effective date. Generally, paragraph (g)(2)(ii)(A)(1) of this 
section shall apply to taxable years beginning one year after the first 
day of the first taxable year following the date of publication of a 
Treasury decision adopting this rule as a final regulation in the 
Federal Register. If a taxpayer makes an election under Sec.  1.987-
11(b), then the effective date of paragraph (g)(2)(ii)(A)(1) of this 
section with respect to the taxpayer shall be consistent with such 
election.
* * * * *
    Par. 3. Section 1.985-1 is amended as follows:
    1. Paragraph (d)(2), second sentence; and paragraph (f), Example 9 
and Example 10(i), ninth sentence are revised.
    2. Paragraph (f), Example 11 is removed.
    3. Paragraph (f), Example 12 is redesignated as Example 11.
    4. Paragraph (g) is added.
    The revisions and addition read as follows:


Sec.  1.985-1  Functional currency.

* * * * *
    (d) * * *
    (2) * * * The amount of income or loss or earnings and profits (or 
deficit in earnings and profits) of each QBU in its functional currency 
shall then be translated into the foreign corporation's functional 
currency under the principles of section 987.
* * * * *
    (f) Examples. * * *

    Example (9).  (i) The facts are the same as in Example (7). In 
addition, assume that in 1987 branch A has items of earnings of 100 
FC and branch B has items of earnings of 100 LC as determined under 
section 987. S translates branch A's and branch B's items of 
earnings and profits into its functional currency under the 
principles of section 987.
    Example (10). (i) * * * Assume that B's items of income of 200 
DCs when properly translated under the principles of section 987 is 
equal to 100 LCs. * * *
* * * * *
    (g) Effective date. Generally, the revisions to the second sentence 
of paragraph (d)(2), Example 9, and Example 10 shall apply to taxable 
years beginning one year after the first day of the first taxable year 
following the date of publication of a Treasury decision adopting this 
rule as a final regulation in the Federal Register. If a taxpayer makes 
an election under Sec.  1.987-11(b), then the effective date of these 
revisions with respect to the taxpayer shall be consistent with such 
election.
    Par 4. 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, 
qualified business unit (QBU) or 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, QBU, or section 987 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 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 or earnings and profits on the last day 
of the taxable year ending before the year of change. Except as 
provided in Sec.  1.985-6, a QBU or section 987 QBU with a functional 
currency for its first taxable year beginning in 1987 that is different 
from the currency in which it had kept its books and records for United 
States accounting and tax accounting purposes for its prior taxable 
year shall apply the principles of this section for purposes of 
computing the relevant functional currency items, such as earnings and 
profits, basis of an asset, and amount of a liability, as of the first 
day of a taxpayer's first taxable year beginning in 1987. However, a 
QBU that changes to the dollar pursuant to Sec.  1.985-1(b)(2) after 
1987 shall apply Sec.  1.985-7.
    (b) Step 1 Taking into account exchange gain or loss on certain 
section 988 transactions. The taxpayer, QBU or section 987 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), (B), and (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 amount of the old functional currency adjusted basis 
or amount multiplied by the new functional currency/old functional 
currency spot exchange rate on the last day of the taxable year ending 
before the year of change (spot rate).
    (d) Step 3A Additional adjustments that are necessary when a QBU or 
section 987 QBU changes functional currency--(1) QBU changing to a 
functional currency other than the owner's functional currency--(i) 
Rule. If a QBU or section 987 QBU changes to a functional currency 
other than the owner's functional currency, the owner and section 987 
QBU shall make the adjustments set forth in either paragraph (d)(1)(ii) 
or (d)(1)(iii) of this section for purposes of section 987.
    (ii) Where prior to the change the section 987 QBU and owner had 
different functional currencies. If the section 987 QBU and the owner 
had different functional currencies prior to the change, the owner and 
section 987 QBU shall make the following adjustments in the year of 
change.
    (A) Determining the owner functional currency net value of the 
section 987 QBU under Sec.  1.987-4(d)(1)(i)(B)--(1) Historic items. 
For purposes of determining the owner functional currency net value of 
the section 987 QBU for the year of change under Sec.  1.987-
4(d)(1)(i)(B), the owner or section 987 QBU shall first translate the 
section 987 historic items from the QBU's old functional currency into 
its owner's functional currency using the historic exchange rate as 
defined in Sec.  1.987-1(c)(3). The owner or section 987 QBU shall then 
translate the section 987 historic items as defined in Sec.  1.987-1(e) 
from the owner's functional currency into the QBU's new functional 
currency using the spot exchange rate between the section 987 QBU's new 
functional currency and the owner's functional currency on the last day 
of the taxable year ending before the year of change.
    (2) Marked items. For purposes of determining the owner functional 
currency net value of the section 987 QBU for the year of change under 
Sec.  1.987-4(d)(1)(i)(B), the owner or section 987 QBU shall translate 
the section 987 QBU's section 987 marked items as defined in Sec.  
1.987-1(d) from the section 987 QBU's old functional currency into the 
QBU's new functional

[[Page 52893]]

currency using the new functional currency/old functional currency spot 
exchange rate on the last day of the taxable year ending before the 
year of change.
    (B) Net unrecognized section 987 gain or loss. No adjustment to the 
owner's net unrecognized section 987 gain or loss is necessary.
    (iii) Where prior to the change the QBU and the taxpayer had the 
same functional currency. If a QBU with the same functional currency of 
the taxpayer is changing to a new functional currency different from 
the taxpayer, and as a result of the change the taxpayer will be an 
owner of a section 987 QBU (see Sec.  1.987-1), the taxpayer and 
section 987 QBU shall become subject to section 987 for the year of 
change and subsequent years.
    (2) Section 987 QBU changing to the owner's functional currency. If 
a section 987 QBU changes its functional currency to its owner's 
functional currency, the section 987 QBU shall be treated as if it 
terminated on the last day of the taxable year ending before the year 
of change. See Sec. Sec.  1.987-5 and 1.987-8 for the effect of a 
termination.
    (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 
product of the old functional currency amounts of such items multiplied 
by the spot rate. 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. Such a shareholder 
shall also recognize gain or loss attributable to the corporation's 
paid-in capital to the same extent, if any, that such gain or loss 
would be recognized under the regulations under section 367(b) if the 
corporation was liquidated completely.
    (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 changes to 
a functional currency that differs from the functional currency of its 
section 987 QBU, the owner shall make the following adjustments in the 
year of change.
    (A) Determining the owner functional currency net value of the 
section 987 QBU under Sec.  1.987-4(d)(1)(i)(B)--(1) Historic items. 
For purposes of determining the owner functional currency net value of 
the section 987 QBU for the year of change under Sec.  1.987-
4(d)(1)(i)(B), the owner shall first translate the QBU's section 987 
historic items into the owner's old functional currency at the historic 
exchange rate as defined in Sec.  1.987-1(c)(3). The owner shall then 
translate the section 987 historic items into its new functional 
currency using the new functional currency/old functional currency spot 
rate on the last day of the taxable year ending before the year of 
change.
    (2) Marked items. For purposes of determining the owner functional 
currency net value of the section 987 QBU for the year of change under 
Sec.  1.987-4(d)(1)(i)(B), the owner or section 987 QBU shall translate 
the QBU's section 987 marked items from the owner's old functional 
currency into the owner's new functional currency using the new 
functional currency/old functional currency spot exchange rate on the 
last day of the taxable year ending before the year of change.
    (B) Translation of net unrecognized section 987 gain or loss. The 
owner shall translate any net unrecognized section 987 gain or loss 
determined under Sec.  1.987-4 from its old functional currency into 
its new functional currency using the new functional currency/old 
functional currency spot exchange rate on the last day of the 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 of the change the taxpayer will be an owner of a section 
987 QBU (see Sec.  1.987-1), the taxpayer and 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 to the same functional currency as its 
section 987 QBU, such section 987 QBU shall be treated as if it 
terminated on last day of the taxable year ending before the year of 
change. See Sec. Sec.  1.987-5 and 1.987-8 for the effect of a 
termination.
    (f) Examples. The provisions of this section are illustrated by the 
following example:

    Example. S, a calendar year foreign corporation, is wholly owned 
by domestic corporation P. The Commissioner granted permission to 
change S's functional currency from the LC to the FC beginning 
January 1, 1993. The LC/FC exchange rate on December 31, 1992, is 1 
LC/2 FC. The following shows how S must convert the items on its 
balance sheet from the LC to the FC.

------------------------------------------------------------------------
                                              LC 1 2            FC
------------------------------------------------------------------------
Assets:
    Cash on hand........................          40,000          80,000
    Accounts Receivable.................          10,000          20,000
    Inventory...........................         100,000         200,000
    100,000 FC Bond (100,000 LC               \1\ 50,000         100,000
     historical basis)..................
Fixed assets:
    Property............................         200,000         400,000
    Plant...............................         500,000       1,000,000
        Accumulated Depreciation........       (200,000)       (400,000)
    Equipment...........................       1,000,000       2,000,000

[[Page 52894]]

 
        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...................      \2\ 50,000         100,000
                                         -------------------------------
            Total Liabilities and Equity       1,300,000      2,600,000
------------------------------------------------------------------------
\1\ Under paragraph (b) of this section, S will recognize a 50,000 LC
  loss (100,000 LC basis--50,000 LC value) on the bond resulting from
  the change in functional currency. Thus, immediately before the
  change, S's basis in the FC bond (taking into account the loss) is
  50,000 LC.
\2\ The amount of S's LC retained earnings reflects the 50,000 LC loss
  on the bond.

    (g) Effective date. Generally, this regulation shall apply to 
taxable years beginning one year after the first day of the first 
taxable year following the date of publication of a Treasury decision 
adopting this rule as a final regulation in the Federal Register. If a 
taxpayer makes an election under Sec.  1.987-11(b), then the effective 
date of this regulation with respect to the taxpayer shall be 
consistent with such election.
    Par. 5. Sections 1.987-1 through 1.987-4 and Sec. Sec.  1.987-6 
through 1.987-11 are added and Sec.  1.987-5 is revised to read as 
follows:


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

    (a) In general. These regulations provide rules for determining the 
taxable income or loss of a taxpayer with respect to a section 987 
qualified business unit (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 and special rules. Section 1.987-2 provides rules for 
attributing assets and liabilities and items of income, gain, 
deduction, and loss to an eligible QBU and a section 987 QBU. It also 
provides rules regarding transfers and the translation of items 
transferred to a section 987 QBU. Section 1.987-3 provides rules for 
determining and translating the section 987 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. 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 partnerships and rules necessary to coordinate the 
provisions of section 987 with subchapter K. 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 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 (iii) of this section, an individual or corporation is 
subject to section 987 if such person is an owner (as defined in 
paragraphs (b)(4) and (5) 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). Such individual or 
corporation, and any section 987 QBU owned by such person, must comply 
with these regulations.
    (ii) De minimis rule for certain indirectly owned section 987 QBUs. 
An individual or corporation that owns a section 987 QBU indirectly 
through a section 987 partnership may elect not to apply these 
regulations for purposes of taking into account the section 987 gain or 
loss of such section 987 QBU if the individual or corporation owns, 
directly or indirectly, less than five percent of either the total 
capital or the total profits interest in the section 987 partnership as 
determined on the date of acquisition of such interest or on the date 
such interest is increased or decreased. For purposes of this paragraph 
(b)(1)(ii), ownership of a capital or profits interest in a partnership 
shall be determined in accordance with the rules for constructive 
ownership of stock provided in section 267(c), other than section 
267(c)(3). See Sec.  1.987-3 for purposes of determining the section 
987 taxable income or loss attributable to such section 987 QBU.
    (iii) Inapplicability to certain entities. These regulations do not 
apply to banks, insurance companies and similar financial entities 
(including, solely for purposes of section 987, leasing companies, 
finance coordination centers, regulated investment companies and real 
estate investment trusts). Further, these rules do not apply to trusts, 
estates and S corporations.
    (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 owner. The functional 
currency of an eligible QBU shall be determined under Sec.  1.985-1, 
taking into account all of the QBU's activities before the application 
of Sec.  1.987-7.
    (ii) Section 987 QBU grouping election--(A) In general. Except as 
provided in paragraphs (b)(2)(ii)(B)(1) through (3) of this section, an 
owner may elect pursuant to paragraph (f) of this section to treat, 
solely for purposes of section 987, all section 987 QBUs with the same 
functional currency as a single section 987 QBU.
    (B) Special grouping rules for section 987 QBUs owned indirectly 
through a partnership--(1) In general. An owner may elect to treat all 
section 987 QBUs with the same functional currency owned indirectly 
though a single section 987 partnership as a single section 987 QBU.
    (2) Election not available to group section 987 QBUs owned 
indirectly through different partnerships. An owner cannot elect to 
treat multiple section 987 QBUs with the same functional currency as a 
single section 987 QBU if such QBUs are owned indirectly through 
different section 987 partnerships.
    (3) Election not available to group section 987 QBUs owned directly 
and indirectly. An owner cannot elect to treat multiple section 987 
QBUs with the same functional currency owned directly, and indirectly 
through a section 987 partnership, as a single section 987 QBU.
    (3) Definition of an eligible QBU--(i) In general. The term 
eligible QBU means activities of an individual, corporation,

[[Page 52895]]

partnership, or an entity disregarded as an entity separate from its 
owner for U.S. Federal income tax purposes (DE), if--
    (A) The activities constitute a trade or business as defined in 
Sec.  1.989(a)-1(c);
    (B) A separate set of books and records is maintained as defined in 
Sec.  1.989(a)-1(d) with respect to the activities, and assets and 
liabilities used in conducting such activities are reflected on such 
books and records under Sec.  1.987-2(b); and
    (C) The activities are not subject to the Dollar Approximate 
Separate Transactions Method (DASTM) rules of Sec.  1.985-3.
    (ii) Exclusion of DEs and certain QBUs. A DE itself is not an 
eligible QBU (even though a DE may have activities that qualify as an 
eligible QBU). In addition, an eligible QBU shall include a QBU defined 
in Sec.  1.989(a)-1(b) only if the requirements contained in paragraphs 
(b)(3)(i)(A) through (C) of this section are satisfied with respect to 
such QBU. Thus, for example, neither a corporation nor a partnership 
itself is an eligible QBU (even though a corporation and a partnership 
may have activities that qualify as an eligible QBU).
    (4) Definition of the term ``owner''. For purposes of section 987, 
only an individual or corporation may be an owner of an eligible QBU. 
An individual or corporation is an owner of an eligible QBU if--
    (i) Direct ownership. The individual or corporation is the tax 
owner of the assets and liabilities of an eligible QBU as defined in 
paragraph (b)(3) of this section; or
    (ii) Indirect ownership. In the case of an individual or 
corporation that is a partner in a partnership, the individual or 
corporation is allocated, under Sec.  1.987-7, all or a portion of the 
assets and liabilities of an eligible QBU of such partnership.
    (5) Exception with respect to an eligible QBU or section 987 QBU of 
an owner. The term owner for section 987 purposes does not include an 
eligible QBU or a section 987 QBU of an owner. For example, a section 
987 branch, as defined in paragraph (b)(6)(i) of this section is not an 
owner of another section 987 branch, regardless of its functional 
currency.
    (6) Other definitions. Solely for purposes of section 987, the 
following definitions shall apply.
    (i) Section 987 branch. A section 987 branch is an eligible QBU of 
an individual, partnership, DE, or corporation, all or a portion of 
which is a section 987 QBU. Assets and liabilities of an eligible QBU 
of a partnership that are allocated to a partner under Sec.  1.987-7 
are considered to be a section 987 QBU of such partner, provided such 
partner has a functional currency different from that of such eligible 
QBU.
    (ii) Section 987 partnership. A section 987 partnership is a 
partnership that has one or more section 987 branches.
    (iii) Section 987 DE. A section 987 DE is a DE that has one or more 
section 987 branches.
    (7) Examples. The following examples illustrate the principles of 
paragraph (b) of this section. Except as otherwise provided, the 
following facts are assumed for purposes of these examples. X is a 
domestic corporation, has the U.S. dollar as its functional currency, 
and uses the calendar year as its taxable year. Business A and Business 
B are eligible QBUs, maintain books and records that are separate from 
the books and records of the entity that owns such eligible QBUs, and 
have the euro and the Japanese yen, respectively, as their functional 
currencies. Finally, DE1 and DE2 are entities that are disregarded as 
entities separate from their owner for U.S. tax purposes, have no 
assets or liabilities, and conduct no activities.

    Example 1. (i) Facts. X owns Business A and the interests in 
DE1. DE1 maintains a separate set of books and records that are kept 
in British pounds. DE1 owns British pounds and 100% of the stock of 
a foreign corporation, FC. DE1 is liable on a pound-denominated 
obligation to a lender 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, X is the direct owner of Business A because it is the tax 
owner of the assets and liabilities of such business. Because 
Business A is an eligible QBU with a functional currency that is 
different from the functional currency of its owner, X, Business A 
is a section 987 QBU, as defined in paragraph (b)(2) of this 
section. As a result, X and its section 987 QBU, Business A, are 
subject to section 987.
    (B) Holding the stock of FC and pounds, and servicing a single 
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 is not an eligible QBU. 
As a result, neither DE1 nor its activities qualify as a section 987 
QBU of X. Therefore, neither the activities of DE1 nor DE2 are 
subject to section 987. For the foreign currency treatment of 
payments on DE1's pound-denominated liability, see Sec. Sec.  1.987-
2(b)(4) and 1.988-1(a)(4).
    Example 2. (i) Facts. X owns the interests in DE1. DE1 owns 
Business A and 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, X 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 X, Business A and Business B are section 987 QBUs as 
defined in paragraph (b)(2) of this section. Therefore, X, and these 
QBUs, are subject to section 987. Under paragraph (b)(6)(iii) of 
this section, DE1 and DE2 are section 987 DEs.
    (C) The Business C eligible QBU has the same functional currency 
as X. Therefore, the Business C eligible QBU is not a section 987 
QBU. As a result, X is not subject to section 987 with respect to 
its Business C eligible QBU.
    Example 3. (i) Facts. X owns 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, X is the direct owner of the Business A and 
Business B eligible QBUs.
    (B) Business A and Business B constitute two separate eligible 
QBUs with the euro as their respective functional currency. 
Accordingly, Business A and Business B are section 987 QBUs of X. X 
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, X 
is the direct owner of the Business AB section 987 QBU that includes 
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 is not treated as the owner of the 
Business AB section 987 QBU. X, and its AB section 987 QBU, are 
subject to section 987. Under paragraph (b)(6)(iii) of this section, 
DE1 is a section 987 DE.
    Example 4. (i) Facts. X is a partner in P, a partnership. FC, a 
controlled foreign corporation (as defined in section 957(a)) of

[[Page 52896]]

X with the Japanese yen as its functional currency, is the only 
other partner in P. P owns DE1 and Business A. DE1 owns Business B.
    (ii) Analysis. (A) Pursuant to paragraph (b)(3)(ii) of this 
section, P and DE1 are not eligible section 987 QBUs. Moreover, 
pursuant to paragraph (b)(4) of this section, neither P nor DE1 is 
the owner of the Business A eligible QBU or the Business B eligible 
QBU for section 987 purposes. Instead, pursuant to paragraph 
(b)(4)(ii) of this section, X and FC are indirect owners of the 
Business A eligible QBU and the Business B eligible QBU to the 
extent they are allocated assets and liabilities of such businesses 
under Sec.  1.987-7. Under paragraphs (b)(6)(ii) and (iii) of this 
section, respectively, P is a section 987 partnership and DE1 is a 
section 987 DE.
    (B) Because Business A and Business B are eligible QBUs with a 
different functional currency than X, the portions of Business A and 
Business B allocated to X under Sec.  1.987-7 are section 987 QBUs 
of X. As a result, X and its section 987 QBUs are subject to section 
987.
    (C) Because the Business A eligible QBU has a different 
functional currency than FC, the portion of the Business A eligible 
QBU that is allocated to FC under Sec.  1.987-7 is a section 987 
QBU, and FC and its section 987 QBU are subject to section 987. 
However, the Business B eligible QBU has the same functional 
currency as FC. Therefore, the portion of the Business B eligible 
QBU that is allocated to FC, under Sec.  1.987-7, is not a section 
987 QBU. As a result, FC is not subject to section 987 with respect 
to its Business B eligible QBU.
    Example 5. (i) Facts. X owns all of the interests in DE1. DE1 
owns Business A. DE1 owns all of the interests in DE2. DE2 owns 
Business B. DE2 owns 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 (b)(3)(ii) of this section, DE1, DE2 
and DE3 are not eligible QBUs. Pursuant to paragraph (b)(3)(i) of 
this section, the Business A, Business B and Business C activities 
are eligible QBUs. Moreover, pursuant to paragraph (b)(4) of this 
section, X is the direct owner of the Business A, Business B and 
Business C eligible QBUs. Pursuant to paragraph (b)(5) 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. Since the Business A, Business 
B, and Business C eligible QBUs each has a different functional 
currency than X, such eligible QBUs are section 987 QBUs of X. As a 
result, X and its section 987 QBUs are subject to section 987. Under 
paragraphs (b)(6)(iii) of this section, DE1, DE2 and DE3 are section 
987 DEs.

    (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 day.
    (ii) Election to use a spot rate convention--(A) In general. In 
lieu of the spot rate determined in paragraph (c)(1)(i) of this 
section, an owner may elect under paragraph (f) of this section to use 
a spot rate convention that reasonably approximates the rate in 
paragraph (c)(1)(i) of this section. A spot rate convention may be 
determined with respect to a rate at the beginning of a reasonable 
period, the end of a reasonable period, an average of spot rates for a 
reasonable period, or by reference to spot and forward rates for a 
reasonable period. 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 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 owner's 
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 use of such a convention 
results in a significant distortion of income or loss under the facts 
and circumstances.
    (B) Election does not apply with respect to section 988 
transactions. The election to use a spot rate convention set forth in 
paragraph (c)(1)(ii)(A) of this section does not apply to section 988 
transactions of a section 987 QBU.
    (2) Yearly average exchange rate. Notwithstanding Sec.  1.989(b)-1, 
for purposes of section 987, the yearly average exchange rate is a rate 
determined by the owner that represents an average exchange rate for 
the taxable year (or, if the section 987 QBU is sold or terminated 
prior to the close of the 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. The method for determining the yearly average exchange rate 
must be consistently applied by the taxpayer.
    (3) Historic exchange rate--(i) In general. Except as otherwise 
provided in these regulations, the historic exchange rate shall be--
    (A) In the case of an asset that is transferred to a section 987 
QBU, the spot rate as defined in paragraphs (c)(1)(i) and (ii) of this 
section on the day of transfer;
    (B) In the case of an asset that is acquired by a section 987 QBU 
(other than by a transfer to a section 987 QBU described in paragraph 
(c)(3)(i)(A) of this section), the spot rate as defined in paragraphs 
(c)(1)(i) and (ii) of this section on the day the asset is acquired;
    (C) In the case of a liability that is entered into by a section 
987 QBU, the spot rate as defined in paragraphs (c)(1)(i) and (ii) of 
this section on the day the liability is entered into; and
    (D) In the case of a liability that is transferred to a section 987 
QBU, the spot rate as defined in paragraphs (c)(1)(i) and (ii) of this 
section on the day the liability is transferred.
    (ii) Changed functional currency. In the case of a section 987 QBU 
that previously changed its functional currency, Sec.  1.985-5 shall be 
taken into account in determining the historic exchange rate for an 
item.
    (d) Section 987 marked item. A section 987 marked item is an asset 
(section 987 marked asset) or liability (section 987 marked liability) 
that--
    (1) Is reflected on the books and records of a section 987 QBU 
under Sec.  1.987-2(b);
    (2) Would be a section 988 transaction if such item were held or 
entered into directly by the owner of the section 987 QBU; and
    (3) Is not a section 988 transaction with respect to the section 
987 QBU.
    (e) Section 987 historic item--(1) In general. A section 987 
historic item is an asset (section 987 historic asset) or liability 
(section 987 historic liability) that--
    (i) Is reflected on the books and records of a section 987 QBU 
under Sec.  1.987-2(b); and
    (ii) Is not a section 987 marked item as defined in paragraph (d) 
of this section.
    (2) Example. The following example illustrates the application of 
paragraphs (d) and (e) of this section:

    Example. X is a domestic corporation with the dollar as its 
functional currency. X owns all the interests in UK DE, a section 
987 DE that owns a section 987 branch having the pound as its 
functional currency. Items reflected on the branch's balance sheet 
include [pound]100 of cash, $25 of cash, a building

[[Page 52897]]

with a basis of [pound]1,000, a truck with a basis of [pound]75, a 
computer with a basis of [pound]10, a 60 day receivable for [yen]15 
and a note payable of [pound]500. Under paragraph (d) of this 
section, the [pound]100 of cash and the [pound]500 note payable are 
section 987 marked items. The other items are section 987 historic 
items under this paragraph (e).

    (f) Elections--(1) In general. Elections made under section 987 
shall be treated as methods of accounting and, except as otherwise 
provided in this paragraph (f), are governed by the general rules 
concerning changes in methods of accounting.
    (2) Persons making the election--(i) In general. Except as provided 
in paragraphs (f)(2)(ii) and (iii) of this section, elections regarding 
section 987 shall be made by the owner as defined in paragraph (b)(4) 
of this section.
    (ii) Controlled foreign corporations. Where a section 987 QBU is 
held by a controlled foreign corporation, elections shall be made in 
accordance with Sec. Sec.  1.952-2(c)(2)(iv) and 1.964-1(c) by its 
controlling U.S. shareholders.
    (iii) Foreign corporations that are not controlled foreign 
corporations. Where a section 987 QBU is held by a foreign corporation 
that is not a controlled foreign corporation, elections shall be made 
in accordance with the principles of Sec.  1.964-1(c) by the majority 
domestic corporate shareholders.
    (3) When elections must be made. An election under section 987 must 
be made with respect to a section 987 QBU 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.
    (4) Manner of making elections. Elections shall be made under 
section 987 by attaching a statement to the timely filed tax return of 
the owner, or other applicable person, for the first taxable year in 
which the owner intends the election to be effective. The statement 
must be dated and titled ``Election(s) Under Section 987,'' must 
indicate the regulation section that authorizes the election(s), and 
must clearly describe the election(s) being made. Each section 987 
election must remain a part of the books and records of the taxpayer 
and be available to the IRS upon request.
    (5) Consent of the Commissioner. Elections made in accordance with 
the rules of this paragraph (f) shall be considered made with the 
consent of the Commissioner.
    (6) Failure to make election. If an owner is permitted to file an 
election pursuant to this paragraph (f), but fails to make such 
election in a timely manner, the owner shall be considered to have 
satisfied the timeliness requirement with respect to such election if 
the owner is able to demonstrate to the Area Director, Field 
Examination, Small Business/Self Employed or the Director, Field 
Operations, Large and Mid-Size Business (Director) having jurisdiction 
of the taxpayer's return for the taxable year, that such failure was 
due to reasonable cause and not willful neglect. The previous sentence 
shall only apply if, once the owner becomes aware of the failure, the 
owner attaches the election, as well as a written statement setting 
forth the reasons for the failure to timely comply, to an amended 
income tax return that amends the return to which the election should 
have been attached under the rules of this paragraph (f). In 
determining whether the owner has reasonable cause, the Director shall 
consider whether the taxpayer acted reasonably and in good faith. 
Whether the taxpayer acted reasonably and in good faith will be 
determined after considering all the facts and circumstances. The 
Director shall notify the owner in writing within 120 days of the 
filing if it is determined that the failure to comply was not due to 
reasonable cause, or if additional time will be needed to make such 
determination. If the Director fails to notify the owner within 120 
days of the filing, the owner shall be considered to have demonstrated 
to the Director that such failure was due to reasonable cause and not 
willful neglect.
    (7) Revocation of election--(i) In general. Elections under section 
987 cannot be revoked without the consent of the Commissioner. The 
Commissioner will consider allowing the revocation of an election if 
the taxpayer can demonstrate significantly changed circumstance or such 
other circumstances that in the judgment of the Commissioner clearly 
demonstrates a substantial non-tax business reason for revoking the 
election.
    (ii) Exception in the case of certain acquisitions. [Reserved].


Sec.  1.987-2  Attribution of items to a section 987 QBU; the 
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 and a section 987 
QBU. Assets and liabilities are attributed to an eligible QBU, all or a 
portion of which is a section 987 QBU for purposes of section 987. 
Items of income, gain, deduction, and loss are attributed to an 
eligible QBU all or a portion of which is a section 987 QBU for 
purposes of computing the section 987 taxable income of such section 
987 QBU, and of the owner of such section 987 QBU. Paragraph (c) of 
this section defines a transfer for purposes of section 987. 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. For purposes of this section, the term 
``item'' refers to assets and liabilities, and items of income, gain, 
deduction, and loss. Items that are attributed to an eligible QBU 
pursuant to this section must be adjusted to conform to U.S. tax 
principles as provided in Sec.  1.987-4(e). 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--(i) General rule. Except as 
provided in paragraph (b)(2)(ii) of this section, the following shall 
not be considered to be on the books and records of a an eligible QBU:
    (A) Stock of a corporation (whether domestic or foreign).
    (B) An interest in a partnership (whether domestic or foreign).
    (C) A liability that was incurred to acquire the stock or an 
interest in a partnership described in paragraphs (b)(2)(i)(A) or (B) 
of this section, respectively.
    (D) Income, gain, deduction, or loss arising from the items 
described in paragraphs (b)(2)(i)(A) through (C) of this section. For 
example, a section 951 inclusion with respect to stock of a foreign 
corporation that is described in paragraph (b)(2)(i)(A) of this section 
shall not be considered to be on the books and records of the eligible 
QBU.
    (ii) Portfolio stock. Paragraph (b)(2)(i)(A) of this section shall 
not apply to stock of a corporation (whether domestic or foreign) 
reflected on the books and records, within the meaning of paragraph 
(b)(1) of this section, of an eligible QBU provided the owner of the 
eligible QBU owns less than 10 percent of the total voting power or 
value of all classes of stock of such corporation. For purposes of this 
paragraph (b)(2)(ii), section 318(a) shall be applied in determining 
ownership, except that in applying section 318(a)(2)(C), the phrase

[[Page 52898]]

``10 percent'' is used instead of the phrase ``50 percent.''
    (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 U.S. tax under section 987, the Commissioner may allocate 
any item between or among the eligible QBU, the owner of such eligible 
QBU, and any other persons, entities (including disregarded entities), 
or other QBUs within the meaning of Sec.  1.989(a)-1(b) (including 
eligible QBUs). A transaction may have such a principal purpose even 
though the tax avoidance purpose is outweighed by other purposes when 
taken together. For purposes of this paragraph (b)(3)(i), relevant 
factors for determining whether such U.S. 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 of a particular number of 
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, relevant factors which may indicate that the 
recording (or failing to record) an item on the books and records of an 
eligible QBU does not have as a principal purpose the avoidance of U.S. 
tax under 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 body of professional accounting standards).
    (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 return for the taxable 
year.
    (G) As a result of a transaction between legal entities (that is, 
the transfer of an asset, or the assumption of a liability), even if 
such transaction is not regarded for Federal tax purposes (that is, a 
transaction between a DE and its owner).
    (iii) Factors indicating tax avoidance. For purposes of paragraph 
(b)(3)(i) of this section, relevant factors which 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 U.S. tax under 
section 987 are--
    (A) The presence or absence of an item on the books and records 
that is disregarded as transitory 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 
economic substance;
    (C) The presence or absence of an item on the books and records 
that results in the taxpayer (or 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; and
    (D) The absence of any or all of the factors listed in paragraphs 
(b)(3)(ii)(A) through (E) of this section.
    (4) Assets and liabilities of a partnership or DE that are not 
attributed to an eligible QBU. Neither a partnership nor a DE is an 
eligible QBU and, thus, cannot be a section 987 QBU. See Sec.  1.987-
1(b)(2) and (3). As a result, a partnership or DE may own assets and 
liabilities that are not attributed to an eligible QBU (or a section 
987 QBU) as provided under this paragraph (b) and, therefore, are not 
subject to section 987. For the foreign 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 the owner to a section 987 
QBU, or from such section 987 QBU to the owner. These rules apply 
solely for purposes of section 987.
    (2) Disregarded transactions--(i) General rule. Solely for purposes 
of section 987, an asset or liability shall be treated as transferred 
to a section 987 QBU if, as a result of a disregarded transaction, 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 if, as a result of a disregarded transaction, such asset or 
liability is not 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, the term disregarded transaction means a transaction that is 
not regarded for U.S. Federal tax purposes. For purposes of this 
paragraph (c), a disregarded transaction shall be treated as including 
the recording of an asset or liability on one set of books and records, 
if the recording is the result of such asset or liability being removed 
from another set of books and records of the same person or entity 
(including a DE or partnership).
    (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 must be taken into 
account in determining section 987 taxable income or loss under Sec.  
1.987-3.
    (3) Transfers of assets to and from indirectly owned section 987 
QBUs--(i) Contributions to partnerships. Solely for purposes of section 
987, an asset shall be treated as transferred to an indirectly owned 
section 987 QBU if, and to the extent, the asset is contributed to the 
section 987 partnership that carries on the section 987 QBU provided 
that immediately following such contribution, the asset is reflected on 
the books and records of the section 987 QBU within the meaning of 
paragraph (b) of this section. For purposes of this paragraph 
(c)(3)(i), deemed contributions under section 752 shall be disregarded.
    (ii) Distributions from partnerships. Solely for purposes of 
section 987, an asset shall be treated as transferred from an 
indirectly owned section 987 QBU if, and to the extent, the section 987 
partnership that carries on the section 987 QBU distributes the asset 
to a partner provided that, immediately prior to such distribution, the 
asset was reflected on the books and records of such section 987 QBU 
within the meaning of paragraph (b) of this section. For purposes of 
this paragraph (c)(3)(ii), deemed distributions under section 752 shall 
be disregarded.
    (4) Transfers of liabilities to and from indirectly owned section 
987 QBUs--(i) Assumptions of partner liabilities. Solely for purposes 
of section 987, a liability shall be treated as transferred to an 
indirectly owned section 987 QBU if, and to the extent, the section 987 
partnership assumes such liability, provided that immediately following 
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.
    (ii) Assumptions of partnership liabilities. Solely for purposes of 
section 987, a liability shall be treated as transferred from an 
indirectly owned

[[Page 52899]]

section 987 QBU if, and to the extent, the owner assumes such liability 
of the section 987 partnership provided that immediately prior to such 
assumption, the liability was reflected on the books and records of the 
section 987 QBU within the meaning of paragraph (b) of this section.
    (5) Acquisitions and dispositions of interests in DEs and 
partnerships. Solely for purposes of section 987, an asset or liability 
shall be treated as transferred to a section 987 QBU if, as a result of 
an acquisition (including by contribution) or disposition of an 
interest in a section 987 partnership or section 987 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 if, as a result of an acquisition or disposition of an 
interest in a section 987 partnership or section 987 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 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 
with respect to an eligible QBU that causes a direct owner of the 
eligible QBU to become an indirect owner of such 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 434), Rev. Rul. 99-6 (1999-1 CB 432), see 
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, and 
substance-over-form doctrines, apply for purposes of determining 
whether there is a transfer of an asset or liability under this 
paragraph (c).
    (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) Examples. The following examples illustrate the principles of 
this paragraph (c). For purposes of these examples, it is assumed that 
X and Y are domestic corporations, have the dollar as their functional 
currency, and use the calendar year as their taxable year. It is also 
assumed that Business A and Business B are eligible QBUs, maintain 
books and records that are separate from the books and records of the 
entity that owns such eligible QBUs, and have the euro and the yen, 
respectively, as their functional currencies. Finally, it is assumed 
that DE1 and DE2 are entities that are disregarded as entities separate 
from their owner for U.S. tax purposes. 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 100 percent of the interests in DE1. DE1 owns Business 
A. X owns [pound]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 loans the [pound]100 to DE1 (to be used in Business A) in 
exchange for a note.
    (ii) Analysis. (A) The loan from X to DE1 is not regarded for 
U.S. federal tax purposes and therefore is a disregarded 
transaction. As a result, the Business A note held by X, and the 
liability of DE1 under the note, are not taken into account under 
this section. However, the [pound]100 of cash that was loaned from X 
to DE1 (and used in Business A) pursuant to the note must be taken 
into account under this paragraph (c).
    (B) The loan of [euro]100 from X to DE1 is a disregarded 
transaction and, as a result of such disregarded transaction, the 
[euro]100 is reflected on the books and records of Business A. 
Therefore, there has been a transfer of [euro]100 from X to Business 
A. See Sec.  1.988-1(a)(10)(ii) for the application of section 988 
to X as a result of the loan.
    Example 2. Transfer to a directly owned section 987 QBU. (i) 
Facts. X owns Business A and Business B. 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 discontinues being used in 
Business A and begins being used in Business B. As a result of such 
equipment being used by Business B, 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. As a result of Business B using the equipment 
formerly used by Business A, 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. As a result, such entries 
constitute a disregarded transaction. Therefore, there has been a 
transfer of the equipment from the Business A section 987 QBU to X, 
and a transfer by X of such equipment to the Business B section 987 
QBU.
    Example 3. Intercompany sale of property between two section 987 
QBUs. (i) Facts. X owns DE1 and DE2. DE1 and DE2 own Business A and 
Business B, respectively. 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 for cash. The cash 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 cash and 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 cash 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 
not regarded for Federal tax purposes and therefore is a disregarded 
transaction. As a result, such sale is not taken into account under 
this section and does not give rise to an item of income, gain, 
deduction or loss pursuant to paragraph (c)(2)(iii) of this section. 
However, the cash and equipment exchanged by DE1 and DE2 in 
connection with the sale must be taken into account under this 
paragraph (c).
    (B) The sale of the equipment is a disregarded transaction and, 
as a result of such 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, there 
has been a transfer of the equipment from DE1's Business A section 
987 QBU owned by X to X, and a subsequent transfer of such equipment 
from X to DE2's Business B section 987 QBU, owned by X.
    (C) As a result of the sale of equipment (that is, the 
disregarded transaction), the cash proceeds cease to be reflected on 
the books and records of Business B, and become reflected on the 
books and records of Business A. Therefore, there has been a 
transfer of the cash from DE2's Business B section 987 QBU owned by 
X to X, and a subsequent transfer of such cash from X to DE1's 
Business A section 987 QBU, owned by X.
    Example 4.  Transactions between directly and indirectly owned 
section 987 QBUs. (i) Facts. X owns 50% of the interest in P, a 
partnership. Y owns the other 50% interest in P. P owns 100% of the 
interests in DE1 and DE2. DE1 owns Business A and DE2 owns Business 
B. X and Y each have a 50% allocable share of the assets and 
liabilities of Business A and Business B, as determined under Sec.  
1.987-7, that constitute section 987 QBUs. 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). DE2 uses the intangible property in 
Business B. Pursuant to the license agreement, X and DE2 pay a 
[euro]30 and [euro]50 royalty, respectively, to DE1.
    (ii) Analysis. (A) The license from DE2 to DE1 is not regarded 
for U.S. tax purposes and, as a result, royalty payments under the 
license are disregarded transactions. Thus, neither the payment nor 
the receipt of the royalty pursuant to the license agreement gives 
rise to an item of income, gain, deduction or loss pursuant to 
paragraph (c)(2)(iii) of this section. However, the [euro]50 of cash 
that is paid from DE2 to DE1 pursuant to the license agreement must 
be taken into account under this paragraph (c).

[[Page 52900]]

    (B) As a result of the royalty payment from DE2 to DE1, [euro]50 
ceases being reflected on the books and records of Business B, and 
becomes reflected on the books and records of Business A. 
Accordingly, there has been a transfer of [euro]25 from the Business 
B section 987 QBUs of X and Y, to X and Y, respectively. Similarly, 
there has been a transfer of [euro]25 from X and Y to their 
respective Business A section 987 QBUs.
    (C) The [euro]30 royalty payment from X to DE1 is not a 
disregarded transaction because it is regarded for U.S. Federal tax 
purposes. As a result, it gives rise to an item of income and 
deduction that must be taken into account in computing taxable 
income or loss of Business A pursuant to Sec.  1.987-3. In addition, 
the payment does not give rise to a transfer as defined in this 
paragraph (c).
    Example 5. Acquisition of an interest in a partnership. (i) 
Facts. X owns 50% of the interest in P, a partnership. Y owns the 
other 50% interest in P. P owns Business A. X and Y each have a 50% 
allocable share of the assets and liabilities of Business A as 
determined under Sec.  1.987-7, that constitute section 987 QBUs. On 
December 31, year 1, Z, a domestic corporation with the dollar as 
its functional currency, contributes cash to P in exchange for a 20% 
interest in P. The cash Z contributes to P is not used in Business A 
and is not reflected on Business A's books and records (but is 
instead reflected on P's books and records). Immediately after Z's 
contribution of cash to P, Z has a 20% allocable share of the assets 
and liabilities of Business A as determined under Sec.  1.987-7. In 
addition, immediately following such contribution X and Y each own a 
40% interest in P and have a 40% allocable share of the assets and 
liabilities of Business A, as determined under Sec.  1.987-7, that 
constitute section 987 QBUs.
    (ii) Analysis. (A) As a result of Z's acquisition of an interest 
in P, a section 987 partnership, 10% of the assets and liabilities 
of Business A ceased being reflected on the books and records of 
both X's and Y's section 987 QBUs. As a result, such amounts are 
treated as if they are transferred from such section 987 QBUs to X 
and Y.
    (B) As a result of Z's acquisition of the interest in P, a 
section 987 partnership, Z was allocated 20% of the assets and 
liabilities of Business A. Because Z and Business A have different 
functional currencies, Z's portion of the Business A assets and 
liabilities constitutes a section 987 QBU. Moreover, 20% of the 
assets and liabilities of Business A are reflected on the books and 
records of Z's section 987 QBU as a result of Z's acquisition of the 
interest in P. Therefore, 20% of the assets and liabilities of 
Business A are treated as transferred from Z to Z's section 987 QBU.
    Example 6. Conversion of a DE to a partnership through a sale of 
an interest. (i) Facts. X owns 100% of the interests in DE1. DE1 
owns Business A. On December 31, year 1, Y acquires 50% of the DE1 
interests from X for cash. Immediately after such acquisition, Y has 
a 50% allocable share of the assets and liabilities of Business A as 
determined under Sec.  1.987-7.
    (ii) Analysis. (A) For Federal tax purposes DE1 is converted to 
a partnership when Y purchases the 50% interest in DE1. Y's purchase 
of 50% of X's interest in DE1 is treated as the purchase of 50% of 
Business A, which is treated as held directly by X for Federal tax 
purposes. Immediately after the deemed purchase of 50% of Business 
A, X and Y are treated as contributing their respective interests in 
Business A to a partnership. See Rev. Rul. 99-5 (situation 1), 
(1999-1 CB 434). See Sec.  601.601(d)(2) of this chapter. For 
purposes of this paragraph (c), these deemed transactions are not 
taken into account.
    (B) As a result of Y's acquisition of 50% of X's interest in 
DE1, a section 987 DE, 50% of the assets and liabilities of Business 
A ceased being reflected on the books and records of X's section 987 
QBU. As a result, such amounts are treated as if they are 
transferred from X's section 987 QBU to X.
    (C) As a result of Y's acquisition of 50% of the interest in 
DE1, a section 987 DE, Y was allocated 50% of the assets and 
liabilities of Business A. Because Y and Business A have different 
functional currencies, Y's portion of the Business A assets and 
liabilities constitutes a section 987 QBU. Moreover, 50% of the 
assets and liabilities of Business A are reflected on the books and 
records of Y's section 987 QBU as a result of Y's acquisition of the 
50% interest in DE1. Therefore, 50% of the assets and liabilities of 
Business A are treated as transferred by Y to Y's section 987 QBU.
    Example 7. Conversion of a DE to a partnership through a 
contribution. (i) Facts. X owns 100% of the interests in DE1. DE1 
owns Business A. On December 31, year 1, Y contributes property 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. Immediately after such contribution, X and Y 
each have a 50% allocable share of the assets and liabilities of 
Business A as determined under Sec.  1.987-7.
    (ii) Analysis. (A) For Federal tax purposes DE1 is converted to 
a partnership when Y contributes property to DE1 in exchange for a 
50% interest in DE1. 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). See Sec.  601.601(d)(2) of this 
chapter. For purposes of this paragraph (c), these deemed 
transactions are not taken into account.
    (B) As a result of Y's acquisition of a 50% interest in DE1, 50% 
of the assets and liabilities of Business A ceased being reflected 
on the books and records of X's section 987 QBU, and 50% of the 
assets contributed by Y to DE1 are reflected on the books and 
records of such section 987 QBU. As a result, 50% of the Business A 
assets are treated as if they are transferred from X's section 987 
QBU to X. Further, 50% of the assets contributed by Y to DE1 are 
treated as if they are transferred by X to X's section 987 QBU.
    (C) Because Y and Business A have different functional 
currencies, Y's portion of the Business A assets and liabilities 
(including the property contributed by Y that is used in Business A) 
constitutes a section 987 QBU. As a result of Y's acquisition of a 
50% interest in DE1, 50% of the assets and liabilities of Business A 
are reflected on the books and records of Y's section 987 QBU and, 
therefore, are treated as if they are transferred by Y to such 
section 987 QBU.
    Example 8. Termination of a partnership under section 708(b). 
(i) Facts. X owns 60% of the interest in P, a partnership. Y owns 
the other 40% interest in P. P owns Business A. X and Y have a 60% 
and 40% allocable share of the assets and liabilities of Business A, 
respectively, as determined under Sec.  1.987-7, that constitute 
section 987 QBUs. On December 31, year 1, X sells a 50% interest in 
P to Y. After such sale, X and Y own 10% and 90%, respectively, in 
P. In addition, after such sale, X and Y have a 10% and 90% 
allocable share of the assets and liabilities of Business A, 
respectively, as determined under Sec.  1.987-7.
    (ii) Analysis. (A) X's sale of 50% of the interests in P to Y 
causes P to terminate pursuant to section 708(b). As a result of 
such termination, P is treated as if it contributes all of its 
assets and liabilities to a new partnership in exchange for an 
interest in the new partnership; and, immediately thereafter, P 
distributes 10% and 90% of the interests in the new partnership to X 
and Y, respectively, in liquidation of P. See Sec.  1.708-1(b)(4). 
For purposes of this paragraph (c), these deemed transactions are 
not taken into account.
    (B) As a result of Y's acquisition of a 50% interest in P from 
X, 50% of the assets and liabilities of Business A ceased being 
reflected on the books and records of X's section 987 QBU and become 
reflected on the books and records of Y's section 987 QBU. As a 
result, 50% of the Business A assets are treated as if they are 
transferred from X's section 987 QBU to X. Further, 50% of the 
Business A assets are treated as if they are transferred by Y to Y's 
section 987 QBU.
    Example 9. Transfer of section 987 QBU to a partnership. (i) 
Facts. X owns Business A. On December 31, year 1, X and Y form P, a 
partnership. X transfers Business A to P in exchange for a 50% 
interest in P. Y transfers property to P in exchange for the other 
50% interest in P. The property Y transfers to P is not used in 
Business A and is not reflected on the books and records of Business 
A (but is instead reflected on the books and records of P). After 
the formation of P, Business A continues to be an eligible QBU. In 
addition, after the formation of P, X and Y each have a 50% 
allocable share of the assets and liabilities of Business A, 
respectively, as determined under Sec.  1.987-7.
    (ii) Analysis. As a result of X contributing Business A to P, 
50% of the assets and liabilities of Business A ceased being 
reflected on the books and records of X's section 987 QBU, and 
became reflected on the books and records of Y's section 987 QBU. As 
a result, 50% of the Business A assets are treated as if they are 
transferred from X's section 987 QBU to X. Further, 50% of the 
Business A assets are treated as if they are transferred from Y to 
Y's section 987 QBU.
    Example 10. Contribution of assets to a corporation. (i) Facts. 
X owns Business A. On

[[Page 52901]]

December 31, year 1, X forms Z, a domestic corporation. X and Z do 
not file a consolidated tax return. X contributes 50% of its 
Business A assets and liabilities to Z in exchange for 100% of the 
stock of Z. The Z stock is recorded on the books and records of 
Business A. After the contribution, X continues to operate Business 
A, and Business A continues to maintain separate books and records 
from X.
    (ii) Analysis. Even though the Z stock is recorded on the books 
and records of Business A, it is not reflected on the books and 
records for purposes of section 987 pursuant to paragraph (b)(2) of 
this section. As a result, there has been a transfer of 50% of the 
assets and liabilities of Business A to X, and a subsequent transfer 
of such assets and liabilities to Z. The answer would be the same 
even if X and Z filed a consolidated return.
    Example 11. Transfers pursuant to general tax principles. (i) 
Facts. X owns 100 percent of the stock of Y. Y owns 100 percent of 
the interests in DE1. DE1 owns Business A. X owns [euro]100. Because 
Business A is in need of additional capital, X transfers the 
[euro]100 to Y as a contribution to capital and, as a result of such 
transfer, Business A records [euro]100 on its separate books and 
records. Y did not record the [euro]100 on its separate books and 
records.
    (ii) Analysis. As a result of the contribution of [euro]100 from 
X to Y, the [euro]100 is reflected on the books and records of 
Business A. Pursuant to paragraph (c)(7) of this section, the 
[euro]100 is treated as if it was transferred first from X to Y. 
Therefore, the [euro]100 recorded on the books and records of 
Business A is treated as a transfer from Y to Business A, even 
though there was no transaction between Y and Business A. See also 
Sec.  1.988-1(a)(10)(ii) for the application of section 988 to Y as 
a result of the transaction.
    Example 12. Circular transfers. (i) Facts. X owns Business A. On 
December 30, year 1, Business A purports to transfer [euro]100 to X. 
On January 2, year 2, X purports to transfer [euro]50 to Business A. 
On January 4, year 2, X purports to transfer another [euro]50 to 
Business A. As of the end of year 1, 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 transfers by Business A are offset by 
a transfer from X that occurred in close temporal proximity, 
pursuant to paragraph (c) of this section, the IRS will scrutinize 
the transaction and may disregard the purported transfers to and 
from Business A for purposes of section 987.
    Example 13. Transfers without economic substance. (i) Facts. X 
owns Business A and Business B. On January 1, year 1, Business A 
purports to transfer [euro]100 to X. On January 4, year 1, 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 year 1, 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, pursuant to paragraph (c) of this section, the 
IRS will scrutinize the transaction and may disregard the [euro]100 
purported transfer from Business A to X for purposes of section 987.
    Example 14. Offsetting positions in section 987 QBUs. (i) Facts. 
X owns Business A and Business B. Business A and Business B each 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, year 1, X 
borrowed [euro]1,000 from a third party lender, recorded the 
liability with respect to the borrowing on the books and records of 
Business A, and recorded the [euro]1,000 of borrowed cash on the 
books and records of Business B. On December 31, year 2, 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 cash, 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 to 
determine if a principal purpose of recording the euro-denominated 
liability and the borrowed euros on the books and records of 
Business A and Business B, respectively, 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, Business B, and X, 
to reflect the economic substance of the transaction.
    Example 15. Offsetting positions with respect to a section 987 
QBU and a section 988 transaction. (i) Facts. X owns DE1, and DE1 
owns Business A. On January 1, year 1, 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, year 2, when Business A 
has $100 of net unrecognized section 987 loss resulting from the 
[euro]1,000 cash received from the borrowing, and 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 Internal Revenue Service will scrutinize 
the transaction 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 to reflect the 
economic substance of the transaction.

    (d) Translation of items transferred to a section 987 QBU--(1) In 
general--(i) Assets. Except as otherwise provided in this section, the 
adjusted basis of an asset 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)(i) and (ii) on the day of 
transfer. If the asset transferred is denominated in (or determined by 
reference to) the functional currency of the section 987 QBU (for 
example, cash or note denominated in the functional currency of the 
section 987 QBU), no translation is required.
    (ii) Liabilities. Except as otherwise provided in this section, a 
liability of the owner that is 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)(i) and (ii)) on the day of 
transfer. If the liability transferred is denominated in (or determined 
by reference to) the functional currency of the section 987 QBU, no 
translation is required.
    (2) Items denominated in the owner's functional currency. 
Transactions described in section 988(c)(1)(i) and (ii) and section 
988(c)(1)(C) that are denominated in (or determined by reference to) 
the owner's functional currency and that are attributable to a section 
987 QBU under paragraph (b) of this section, shall not be translated 
and shall be carried on the balance sheet described in Sec.  1.987-4(e) 
in the owner's functional currency.


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

    (a) Determination of the section 987 taxable income or loss of an 
owner of a section 987 QBU. Except as otherwise provided in this 
section, the section 987 taxable income or loss of an owner with 
respect to a section 987 QBU shall be determined in accordance with 
paragraphs (a)(1) and (a)(2) of this section.
    (1) In general--(i) Determination of each item of income, gain, 
deduction or loss in the section 987 QBU's functional currency. Except 
as otherwise provided in this section, the section 987 QBU shall 
determine each item of income, gain, deduction or loss attributable to 
such QBU under Sec.  1.987-2(b) in its functional currency under U.S. 
tax principles.
    (ii) Translation of items into the owner's functional currency. The 
owner shall translate each item determined under this paragraph (a)(1) 
into its functional currency as provided in paragraph (b) of this 
section.
    (2) Determination in the case of a section 987 QBU owned indirectly 
through a partnership--(i) In general. Except as otherwise provided in 
this paragraph (a)(2), the taxable income or loss of a section 987 
partnership, and the distributive share of any owner that

[[Page 52902]]

is a partner in such partnership, shall be determined in accordance 
with the provisions of subchapter K of this chapter.
    (ii) Determination of each item of income, gain, deduction or loss 
in the eligible QBU's functional currency. Except as otherwise provided 
in this section, the section 987 partnership 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. The section 987 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 this 
chapter.
    (iv) Translation of items into the owner's functional currency. To 
the extent such items are reflected on the books and records of a 
section 987 QBU of a partner to whom they are allocated, the partner 
shall adjust the items to conform to U.S. tax principles and translate 
the items into the partner's functional currency as provided in 
paragraph (b) of this section.
    (b) Exchange rates to be used in translating 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 of a section 987 QBU as determined in 
Sec.  1.987-2(b) into the owner's functional currency shall be the 
yearly average exchange rate as defined in Sec.  1.987-1(c)(2) for the 
taxable year. Alternatively, the owner may elect under Sec.  1.987-1(f) 
to use the spot rate as defined in Sec.  1.987-1(c)(1)(i) and (ii) for 
the day each item is properly taken into account.
    (2) Exceptions--(i) Depreciation, depletion, and amortization 
deductions. The exchange rate to be used by the owner in translating 
deductions allowable with respect to section 987 historic assets (as 
defined in Sec.  1.987-1(e)) for depreciation, depletion, and 
amortization under the pertinent provisions of the Code shall be the 
historic exchange rate as determined under Sec.  1.987-1(c)(3) for the 
property to which such deductions are attributable.
    (ii) Gain or loss from the sale of property. In the case of gain or 
loss recognized on a sale or other disposition of property that is 
reflected on the books and records of a section 987 QBU during the 
taxable year, the following exchange rates shall apply with respect to 
such sale or other disposition:
    (A) Amount realized--(1) In general. Except as otherwise provided 
in paragraph (b)(2)(ii)(A)(2), the exchange rate to be used in 
translating the amount realized of such property shall be the rate 
provided in paragraph (b)(1) of this section for the taxable year.
    (2) Certain section 987 marked assets. In the case of a section 987 
marked asset (other than cash) that was held on the first day of the 
taxable year, the exchange rate to be used in translating the amount 
realized shall be the rate used for such asset in determining the owner 
functional currency net value of the section 987 QBU under Sec.  1.987-
4(d)(1)(i)(B) for the preceding taxable year. However, in the case of a 
section 987 marked asset (other than cash) transferred to the section 
987 QBU or acquired by the section 987 QBU during the taxable year, the 
exchange rate to be used in translating the amount realized shall be 
the spot rate, as defined in Sec.  1.987-1(c)(1)(i) and (ii), for the 
day transferred or acquired.
    (B) Adjusted basis--(1) In general. Except as otherwise provided in 
paragraph (b)(2)(ii)(B)(2), the exchange rate to be used in translating 
the adjusted basis of such property shall be the historic exchange rate 
as determined under Sec.  1.987-1(c)(3) for such asset.
    (2) Certain section 987 marked assets. In the case of a section 987 
marked asset (other than cash) that was held on the first day of the 
taxable year, the exchange rate to be used in translating its adjusted 
basis shall be the rate used for such asset in determining the owner 
functional currency net value of the section 987 QBU under Sec.  1.987-
4(d)(1)(i)(B) for the preceding taxable year. However, in the case of a 
section 987 marked asset (other than cash) transferred to the section 
987 QBU or acquired by the section 987 QBU during the taxable year, the 
exchange rate to be used in translating the adjusted basis of such 
asset shall be the spot rate, as defined in Sec.  1.987-1(c)(1)(i) and 
(ii), for the day transferred or acquired.
    (3) Gain or loss on the sale, exchange or other disposition of an 
interest in a section 987 partnership. For purposes of determining the 
adjusted basis of a partner's interest in a section 987 partnership and 
computing gain or loss recognized on the sale, exchange or other 
disposition of such interest, see Sec.  1.987-7.
    (c) Items of income, gain, deduction or loss that are denominated 
in the functional currency of the owner. An item of income, gain, 
deduction or loss attributable to a section 987 QBU under Sec.  1.987-
2(b) that is denominated in (or determined by reference to) the owner's 
functional currency shall not be translated and shall be taken into 
account by the section 987 QBU under U.S. tax principles in the owner's 
functional currency.
    (d) Items of income, gain, deduction or loss that are denominated 
in a nonfunctional currency (other than the functional currency of the 
owner). An item of income, gain, deduction or loss attributable to a 
section 987 QBU under Sec.  1.987-2(b) that is denominated in (or 
determined by reference to) a nonfunctional currency (other than the 
owner's functional currency) shall be translated into the section 987 
QBU's functional currency at the spot rate as defined in Sec.  1.987-
1(c)(1)(i) and (ii) on the day such item is properly taken into 
account.
    (e) Section 988 transactions--(1) In general. Except as provided in 
paragraph (e)(2) of this section, section 988 shall apply to the 
section 988 transactions attributable to a section 987 QBU under Sec.  
1.987-2(b), and the timing of any gain or loss shall be determined 
under the applicable provisions of the Internal Revenue Code. Such 
transactions are section 987 historic items as defined in Sec.  1.987-
1(e).
    (2) Certain transactions denominated in (or determined by reference 
to) the owner's functional currency are not section 988 transactions. 
Transactions described in section 988(c)(1)(A)(i) and (ii) and section 
988(c)(1)(C) that are denominated in (or determined by reference to) 
the owner's functional currency and that are attributable to a section 
987 QBU under Sec.  1.987-2(b) shall not be treated as section 988 
transactions to such QBU. Thus, no currency gain or loss shall be 
recognized by a section 987 QBU under section 988 with respect to such 
items.
    (f) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i) U.S. Corp is a domestic corporation with the 
dollar as its functional currency. U.S. Corp owns French DE, a 
section 987 DE that has a section 987 branch with the euro as its 
functional currency. For purposes of paragraph (b)(1) of this 
section, U.S. Corp uses the yearly average exchange rate under Sec.  
1.987-1(c)(2) to translate items of income, gain, deduction or loss 
where such rate is appropriate. U.S. Corp also properly elects to 
use a spot rate convention under Sec.  1.987-1(c)(1)(ii) where the 
spot rate is otherwise required. Under this convention, items 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''). Accordingly, gross sales income is translated 
at the yearly average exchange rate and under paragraph 
(b)(2)(ii)(B) of this section the basis of assets

[[Page 52903]]

acquired during a month is translated into dollars at the convention 
rate. Assume that the yearly average exchange rate for 2009 is 
[euro]1 = $1.05. For the taxable year 2009, French DE sells 1,200 
units of inventory for a sales price of [euro]3 per unit. Assume 
that the purchase price for each inventory unit is [euro]1.50. Thus, 
French DE's dollar gross sales will be computed as follows:

                                                   Gross Sales
----------------------------------------------------------------------------------------------------------------
                                                                                   [euro]/$ 2009
                      Month                         of       [euro]       ave. exchange         $
                                                       units                           rate
----------------------------------------------------------------------------------------------------------------
Jan.............................................             100             300   [euro]1=$1.05             315
Feb.............................................             200             600   [euro]1=$1.05             630
March...........................................               0               0   [euro]1=$1.05               0
April...........................................             200             600   [euro]1=$1.05             630
May.............................................             100             300   [euro]1=$1.05             315
June............................................               0               0   [euro]1=$1.05               0
July............................................             100             300   [euro]1=$1.05             315
Aug.............................................             100             300   [euro]1=$1.05             315
Sept............................................               0               0   [euro]1=$1.05               0
Oct.............................................               0               0   [euro]1=$1.05               0
Nov.............................................             100             300   [euro]1=$1.05             315
Dec.............................................             300             900   [euro]1=$1.05             945
                                                 ---------------------------------------------------------------
                                                           1,200           3,600  ..............           3,780
----------------------------------------------------------------------------------------------------------------


                                         Opening Inventory and Purchases
----------------------------------------------------------------------------------------------------------------
                                                                                     [euro]/$
                      Month                         of       [euro]        convention           $
                                                       units                       exchange rate
----------------------------------------------------------------------------------------------------------------
Opening inventory from 2008.....................             100             150   [euro]1=$1.00             150
Purchases:
    Jan.........................................             300             450   [euro]1=$1.00             450
    Feb.........................................               0               0   [euro]1=$1.05               0
    March.......................................               0               0   [euro]1=$1.03               0
    April.......................................             300             450   [euro]1=$1.02             459
    May.........................................               0               0   [euro]1=$1.04               0
    June........................................               0               0   [euro]1=$1.05               0
    July........................................             300             450   [euro]1=$1.06             477
    Aug.........................................               0               0   [euro]1=$1.05               0
    Sept........................................               0               0   [euro]1=$1.06               0
    Oct.........................................               0               0   [euro]1=$1.07               0
    Nov.........................................             300             450   [euro]1=$1.08             486
    Dec.........................................               0               0   [euro]1=$1.08               0
                                                 ---------------------------------------------------------------
        Total Purchases.........................           1,200           1,800  ..............           1,872
----------------------------------------------------------------------------------------------------------------

    (ii) French DE uses a first in first out method of accounting 
for inventory (FIFO). Thus, for 2009, French DE is considered to 
have sold the 100 units of opening inventory ($150), the 300 units 
purchased in January ($450), the 300 units purchased in April 
($459), the 300 units purchased in July ($477) and 200 of the 300 
units purchased in November ($324). Thus, French DE's cost of goods 
sold is $1,860. French DE's opening inventory for 2010 is 100 units 
of inventory with a dollar basis of $162.
    (iii) Accordingly, for purposes of section 987 French DE has 
gross income in dollars of $1,920 ($3,780-$1,860).
    Example 2. (i) The facts are the same as in Example 1 except 
that for purposes of paragraph (b)(1) of this section, U.S. Corp 
properly elects to use a spot rate convention under Sec.  1.987-
1(c)(1)(ii) to translate items of income, gain, deduction or loss 
where such rate is appropriate. Thus, French DE's dollar gross sales 
will be computed as follows:

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

[[Page 52904]]

 
                                                           1,200           3,600  ..............           3,783
----------------------------------------------------------------------------------------------------------------

    (ii) As in Example 1, French DE's cost of goods sold is $1,860.
    (iii) Accordingly, for purposes of section 987 French DE has 
gross income in dollars of $1,923 ($3,783-$1,860).
    Example 3. The facts are the same as in Example 1 except that 
French DE sold raw land on November 1, 2009 for [euro]10,000. The 
yearly average rate for 2009 was [euro]1=$1.05. The land was 
purchased on October 16, 2007 for [euro]8,000 when the convention 
rate was [euro]1=$1.00. Under paragraph (a)(1) of this section, 
French DE will determine the amount realized and basis in euros. 
Under paragraph (a)(1)(ii) of this section, the amount realized is 
translated into dollars at the yearly average exchange rate for 2009 
as provided in paragraph (b)(2)(ii)(A) of this section ([euro]10,000 
x $1.05 = $10,500) and the basis at the convention rate for 2007 as 
provided in paragraph (b)(2)(ii)(B) of this section and Sec.  1.987-
1(c)(3) [euro]8,000 x $1 = $8,000). Accordingly, the amount of gain 
reported by U.S. Corp on the sale of the land is $2,500 ($10,500-
$8,000).
    Example 4. The facts are the same as in Example 3 except that 
U.S. Corp properly elects under paragraph (b)(1) of this section to 
use the spot rate to translate items of income, gain, deduction or 
loss. Accordingly, the amount realized will be translated at the 
convention rate on the day of sale. Assume that the convention rate 
for November 2009 is [euro]1 = $1.08. Under these facts, the amount 
realized is $10,800 ([euro]10,000 x $1.08) and the basis on the day 
of purchase $8,000 ([euro]8,000 x $1.00). The amount of gain 
reported by U.S. Corp on the sale of the land is $2,800 ($10,800 -
$8,000).
    Example 5. The facts are the same as in Example 1 except that on 
September 15, 2009, French DE provides services to an unrelated 
customer and receives a cash payment of [euro]2,000 on that day. 
Under paragraph (b)(1) of this section, U.S. Corp translates the 
[euro]2,000 item of income into dollars at the yearly average 
exchange rate of [euro]1 = $1.05. Accordingly, U.S. Corp will report 
income of $2,100 from providing services.
    Example 6. The facts are the same as in Example 5 except that 
U.S. Corp properly elects under paragraph (b)(1) of this section to 
use the spot rate to translate items of income, gain, deduction or 
loss. Assume that the convention rate for September 2009 is [euro]1 
= $1.06. Under these facts, U.S. Corp translates the [euro]2,000 
item of income into dollars at the convention rate of [euro]1 = 
$1.06. Accordingly, U.S. Corp will report income of $2,120 from 
providing services.
    Example 7. The facts are the same as in Example 1 except that on 
March 31, 2009, French DE incurs [euro]500 of rental expense, 
[euro]300 of salary expense and [euro]100 of utilities expense. 
Under paragraph (b)(1) of this section, U.S. Corp translates these 
items of expense at the yearly average exchange rate of [euro]1 = 
$1.05. Accordingly the expenses are translated as follows: rental 
expense of $525, salary expense of $315 and utilities expense of 
$105.
    Example 8. The facts are the same as in Example 7 except that 
U.S. Corp properly elects under paragraph (b)(1) of this section to 
use the spot rate to translate items of income and expense. Assume 
that the convention rate for March 2009 is [euro]1 = $1.03. Under 
these facts, U.S. Corp translates the [euro]500 of rental expense, 
[euro]300 of salary expense and [euro]100 of utilities expense at 
the convention rate of [euro]1 = $1.03. Accordingly, the expenses 
are translated as follows: rental expense of $515, salary expense of 
$309 and utilities expense of $103.
    Example 9. The facts are the same as in Example 1 except that 
during 2009, French DE incurred [euro]100 of depreciation expense 
with respect to a truck. The truck was purchased on January 15, 
2008, when the convention rate was [euro]1 = $1.02. Under paragraph 
(b)(2)(i) of this section, the [euro]100 of depreciation is 
translated into dollars at the historic exchange rate. Since U.S. 
Corp has properly elected to use a spot rate convention, 
depreciation will be translated in accordance with the convention. 
Accordingly, U.S. Corp translates the [euro]100 of depreciation to 
equal $102.
    Example 10.  (i) The facts are the same as in Example 1 except 
that on January 12, 2009, French DE performed services for a U.K. 
person and received [pound]10,000 in compensation. The exchange rate 
on January 12, 2009, was [pound]1 = [euro]1.25. Under paragraph (d) 
of this section, French DE will translate such income into euros at 
the spot rate on January 12, 2009. Accordingly, French DE will take 
into account [euro]12,500 of income from services in 2009. Under 
paragraph (b)(1) of this section, U.S. Corp translates the 
[euro]12,500 item of income into dollars at the yearly average euro 
to dollar exchange rate. Assume that such exchange rate is [euro]1 = 
$1.10. Accordingly, U.S. Corp translates the [euro]12,500 income 
from services to equal $13,750.
    (ii) On October 16, 2009, French DE disposes of the 
[pound]10,000 for [euro]10,000. Under section 988(c)(1)(C), the 
disposition is a section 988 transaction. Under Sec.  1.988-2(a)(2), 
French DE will realize a loss of [euro]2,500 ([euro]10,000 amount 
realized less [euro]12,500 basis). Under paragraph (b)(1) of this 
section, U.S. Corp translates the [euro]2,500 loss into dollars at 
the yearly average euro to dollar exchange rate. Assume that such 
exchange rate is [euro]1 = $1.05. Accordingly, U.S. Corp translates 
the [euro]2,500 section 988 loss to equal $2,625.


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 of a 
section 987 QBU. 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 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. 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 paragraph (d) of this section for all 
prior years to which these regulations apply, reduced by the amounts 
taken into account under Sec.  1.987-5 upon a remittance for all such 
prior taxable years. This amount shall include amounts appropriately 
considered as net unrecognized exchange gain or loss under the 
transition rules of Sec.  1.987-10.
    (d) Calculation of unrecognized section 987 gain or loss of a 
section 987 QBU 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 (7) of this section as follows:
    (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 current taxable year; less

[[Page 52905]]

    (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 QBU's first taxable year.
    (ii) Year section 987 QBU is terminated. If a section 987 QBU is 
terminated under the rules 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 day the section 987 QBU is terminated.
    (2) Step 2: Increase the aggregate amount determined in step 1 by 
the assets transferred from the section 987 QBU to its owner-(i) In 
general. The aggregate 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)(iii) 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 aggregate of--
    (A) The amount of the section 987 QBU's functional currency and the 
adjusted basis of any section 987 marked asset (as defined in Sec.  
1.987-1(d)) transferred from the section 987 QBU 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 as provided 
in paragraph (d)(2)(iii)(A) of this section; and
    (B) The adjusted basis of any section 987 historic asset (as 
defined in Sec.  1.987-1(e)) 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 as provided in 
paragraph (d)(2)(iii)(B) of this section. Such amount shall be adjusted 
to take into account the proper translation of depreciation, depletion 
and amortization as provided in Sec.  1.987-3(b)(2)(i).
    (iii) Translation of amounts transferred from the section 987 QBU 
to the owner. In the case of a transfer from the section 987 QBU to an 
owner of any asset the following exchange rates shall be used:
    (A) In the case of an amount described in paragraph (d)(2)(ii)(A) 
of this section, the spot exchange rate, as defined in Sec.  1.987-
1(c)(1), on the day of transfer.
    (B) In the case of a transfer of a section 987 historic asset, the 
historic exchange rate for such asset as defined in Sec.  1.987-
1(c)(3).
    (3) Step 3: Decrease the aggregate amount determined in steps 1 and 
2 by the owner's transfers 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 aggregate 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 (d)(3) of this section shall be decreased by the aggregate 
amount of liabilities transferred from the section 987 QBU to the 
owner. The amount of such liabilities shall be translated into the 
functional currency of the owner at the spot exchange rate, as defined 
in Sec.  1.987-1(c)(1), on the day of transfer.
    (5) Step 5: Increase the aggregate amount determined in steps 1 
through 4 by amount of liabilities transferred from the owner to the 
section 987 QBU. The aggregate amount determined in paragraphs (d)(1) 
through (d)(4) of this section shall be increased by the aggregate 
amount of liabilities transferred by the owner to the section 987 QBU. 
The amount of such liabilities shall be translated into the functional 
currency of the owner, if required, at the spot exchange rate, as 
defined in Sec.  1.987-1(c)(1)(i) and (ii), on the day of transfer.
    (6) Step 6: Increase the aggregate amount determined in steps 1 
through 5 by the section 987 taxable loss of the section 987 QBU for 
the taxable year. In the case of a section 987 taxable loss of the 
section 987 QBU computed under Sec.  1.987-3 for the taxable year, the 
aggregate amount determined in paragraphs (d)(1) through (d)(5) of this 
section shall be increased by such section 987 taxable loss.
    (7) Step 7: 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. In the case of section 987 taxable income of the 
section 987 QBU computed under Sec.  1.987-3 for the taxable year, the 
aggregate amount determined in paragraphs (d)(1) through (d)(5) of this 
section shall be decreased by such section 987 taxable income.
    (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 the QBU's functional currency and the 
basis of each asset on the section 987 QBU's balance sheet on that day, 
less the aggregate amount of each liability on the section 987 QBU's 
balance sheet on that day translated, if necessary, into the owner's 
functional currency as provided in paragraph (e)(2) of this section. 
Such amount shall be determined as follows:
    (i) The owner, or section 987 QBU on behalf of the owner, shall 
prepare 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 showing all 
assets and liabilities reflected on such books and records as provided 
in Sec.  1.987-2(b). Assets and liabilities denominated in the 
functional currency of the owner shall be reflected on the balance 
sheet in the owner's functional currency.
    (ii) The owner, or section 987 QBU on behalf of the owner, shall 
make adjustments necessary to conform the items reflected on the 
balance sheet described in paragraph (e)(1)(i) of this section to 
United States generally accepted accounting principles and tax 
accounting principles.
    (iii) The owner, or section 987 QBU on behalf of the owner, shall 
translate 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. Assets and liabilities denominated in the functional currency 
of the owner are not translated.
    (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 (other

[[Page 52906]]

than an asset or liability reflected on the balance sheet in the 
functional currency of the owner) shall be translated as follows:
    (i) Section 987 marked item. A section 987 marked item as defined 
in Sec.  1.987-1(d) shall be translated into the owner's functional 
currency at the spot exchange rate as defined in Sec.  1.987-1(c)(1)(i) 
and (ii) on the last day of the taxable year.
    (ii) Section 987 historic item. A section 987 historic item as 
defined in Sec.  1.987-1(e) shall be translated into the owner's 
functional currency at the historic exchange rate as defined in Sec.  
1.987-1(c)(3).
    (f) Examples. The provisions of this section are illustrated by the 
following examples. Unless otherwise indicated, all items are assumed 
to be reflected on the books and records, within the meaning of Sec.  
1.987-2(b), of the relevant section 987 QBU.

    Example 1. (i) U.S. Corp is a calendar year domestic corporation 
with the dollar as its functional currency. On July 1, 2009, U.S. 
Corp establishes Japan Branch that has the yen as its functional 
currency. Japan Branch is a section 987 QBU of U.S. Corp. U.S. Corp 
properly elects to use a spot rate convention under Sec.  1.987-
1(c)(1)(ii) with respect to Japan Branch. Under this convention, the 
spot rate for any transaction occurring during a month is the spot 
rate on the first day of the month. U.S. Corp also elects under 
Sec.  1.987-3(b)(1) to use this convention to translate items of 
income, gain, deduction, or loss into dollars. On July 1, 2009, when 
$1 = [yen]100 (or [yen]1 = $0.01), U.S. Corp transfers $1,000 to 
Japan Branch and raw land with a basis of $500. Japan Branch 
immediately purchases [yen]100,000 with the $1,000. On the same day, 
Japan Branch borrows [yen]10,000. Assume that for the taxable year 
2009, Japan Branch earns [yen]2,000 per month (total of [yen]12,000 
for the six month period from July 1, 2009, through December 31, 
2009) 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, 
2009, through December 31, 2009) of related expenses. Assume that 
all items of income earned and expenses incurred by Japan Branch 
during 2009 are received and paid, respectively, in yen. Further, 
assume that the [yen]12,000 of income when properly translated under 
the monthly convention equals $109.08 and that the [yen]2,000 of 
related expenses equal $18.18. Thus, Japan Branch's income 
translated into dollars equals $90.90. Assume that the spot exchange 
rate on the December 1, 2009, is $1 = [yen]120 ([yen]1 = $0.00833).
    (ii) Under paragraph (a) of this section, U.S. Corp must compute 
the net unrecognized section 987 gain or loss of Japan Branch for 
2009. Since 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 2009 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) of this section, U.S. Corp 
must determine the change in the owner functional currency net value 
of Japan Branch for the year 2009 in dollars. The change in the 
owner functional currency net value of Japan Branch for 2009 is 
equal to the owner functional currency net value of Japan Branch 
determined in dollars on the last day of 2009, less the owner 
functional currency net value of Japan Branch determined in dollars 
on the last day of the preceding taxable year.
    (A) The owner functional currency net value of Japan Branch 
determined in dollars on the last day of the current taxable year is 
determined under paragraph (e) of this section. Such amount is the 
aggregate of the basis of each asset on Japan Branch's balance sheet 
on December 31, 2009, less the aggregate of the amount of each 
liability on the Japan Branch's balance sheet on that day, 
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, 2009:
    (1) Cash of [yen]120,000 [($1,000 transferred and immediately 
converted to [yen]100,000) + [yen]10,000 borrowed + [yen]12,000 
income from services - [yen]2,000 of expenses].
    (2) Raw land with a basis of [yen]50,000.
    (3) Liabilities of [yen]10,000.
    (C) Under paragraph (e)(2) of this section, U.S. Corp will 
translate these items as follows. The cash of [yen]120,000 is a 
section 987 marked asset and the [yen]10,000 liability is a section 
987 marked liability as defined in Sec.  1.987-1(d). These items are 
translated into dollars on December 31, 2009, using the spot rate on 
December 1, 2009 of [yen]1 =$ 0.00833. The raw land is a section 987 
historic asset as defined in Sec.  1.987-1(e) and is translated into 
the dollars at the convention rate for the day of transfer ([yen]1 = 
$0.01). Thus, the owner functional currency net value of Japan 
Branch on December 31, 2009, in dollars is $1,416.60 determined as 
follows:
---------------------------------------------------------------------------

    \4\ Opening cash of [yen]100,000 + [yen]10,000 borrowed + 
[yen]12,000 income from services - [yen]2,000 expenses.

----------------------------------------------------------------------------------------------------------------
                                                 Amount in
                     Asset                         [yen]                Translation rate             Amount in $
----------------------------------------------------------------------------------------------------------------
    Cash......................................  \4\ 120,000  12/01/09 spot convention rate on 12/31/      999.60
                                                              09 of [yen]1=$0.00833.
    Land......................................       50,000  Historic rate on 7/1/09 of                   500.00
                                                              [yen]1=$0.01.
                                               -----------------------------------------------------------------
        Total assets..........................  ...........  ......................................     1,499.60
Liability:
    Bank Loan.................................       10,000  12/01/09 spot convention rate on 12/31/       83.30
                                                              09 of [yen]1 = $0.00833.
                                               -----------------------------------------------------------------
        Total liabilities.....................  ...........  ......................................        83.30
Owner functional currency net value of Japan    ...........  ......................................     1,416.30
 Branch on December 31, 2009 in dollars.
----------------------------------------------------------------------------------------------------------------

    (D) Under paragraph (d)(1) of this section, the change in owner 
functional currency net value of Japan Branch for 2009 is equal to 
the owner functional currency net value of the branch determined in 
dollars on December 31, 2009 ($1,416.30) less the owner functional 
currency net value of the branch determined in dollars on the last 
day of the preceding taxable year. Since this is the first taxable 
year of Japan Branch, the owner functional currency net value 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 owner functional currency net value of 
Japan Branch for 2009 is $1,416.30.
    (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)(iii) of 
this section. Since no such amounts were transferred under these 
facts, there is no change in the $1,416.30 determined in step 1.
    (v) Step 3. Under paragraph (d)(3) of this section, the 
aggregate amount determined in paragraphs (d)(1) and (2) of this 
section (steps 1-2) 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, 2009, U.S. Corp transferred to Japan Branch 
$1,000 (which Japan Branch immediately converted into [yen]100,000) 
and raw land with a basis of $500 (equal to [yen]50,000 on the day 
of transfer).

[[Page 52907]]

Thus, the step 2 amount of $1,416.30 is reduced by $1,500.00 to 
equal ($83.70).
    (vi) Steps 4, 5 and 6. Since no liabilities were transferred by 
U.S. Corp to Japan Branch or vice versa, the amount determined after 
applying paragraphs (d)(1) through (d)(5) of this section is 
($83.70). Further, paragraph (d)(6) of this section does not apply 
since Japan Branch does not have a section 987 taxable loss.
    (vii) Step 7. Under paragraph (d)(7) of this section, the 
aggregate amount determined after applying paragraphs (d)(1) through 
(d)(5) of this section (steps 1-5) is decreased by the section 987 
taxable income of Japan Branch of $90.90. Accordingly, the 
unrecognized section 987 loss of Japan Branch for 2009 is $174.60 (-
$83.70-$90.90).
    Example 2. (i) U.S. Corp, a calendar year domestic corporation 
with the dollar as its functional currency, operates in the United 
Kingdom through UK Branch. UK Branch has the pound as its functional 
currency and is a section 987 QBU. U.S. Corp properly elects to use 
a spot rate convention under Sec.  1.987-1(c)(1)(ii). Under this 
convention, the spot 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. 
Pursuant to Sec.  1.987-3(b)(1), U.S. Corp uses the yearly average 
exchange rate as defined in Sec.  1.987-1(c)(2) to translate items 
of income, gain, deduction, or loss into dollars for the taxable 
year, where appropriate. The yearly average exchange rate for 2009 
was [pound]1 = $1.05. The closing balance sheet of UK Branch for the 
prior year (2008) reflected the following assets and liabilities. 
With respect to assets, UK Branch held--
    (A) Cash of [pound]100;
    (B) Plant purchased in May 2007 with an adjusted basis of 
[pound]1000;
    (C) A machine purchased in May 2007 with an adjusted basis of 
[pound]200;
    (D) Inventory of 100 units manufactured in December 2008 with a 
basis of [pound]100;
    (E) Portfolio stock (as defined in Sec.  1.987-2(b)(2)(ii)) in 
ABC Corporation purchased in September 2008 with a basis of 
[pound]158; and
    (F) $50 acquired in 2008 (and held in a non-interest bearing 
account).
    With respect to liabilities, UK Branch has [pound]50 of long-
term debt entered into in 2007 with F Bank, an unrelated bank. The 
plant, machine, inventory, stock and dollars are section 987 
historic assets as defined in Sec.  1.987-1(e). The cash of 
[pound]100 and long-term debt are section 987 marked items as 
defined under Sec.  1.987-1(d). Assume the U.S. Corp translated UK 
Branch's 2008 closing balance sheet as follows:

----------------------------------------------------------------------------------------------------------------
                                                 Amount in
                    Assets                        [pound]               Translation Rate             Amount in $
----------------------------------------------------------------------------------------------------------------
    Cash......................................          100  Spot convention rate in Dec. 2008            100.00
                                                              [pound]1 = $1.
    Plant.....................................        1,000  Historic rate-2007 May convention rate       900.00
                                                              [pound]1= $0.90.
    Machine...................................          200  Historic rate-2007 May convention rate       180.00
                                                              [pound]1= $0.90.
    Stock.....................................          158  Historic rate-2008 Sept. convention          150.00
                                                              rate [pound]1= $.95.
    Inventory.................................          100  Historic rate-2008 Dec. convention           100.00
                                                              rate [pound]1 = $1.
    Dollars...................................          $50  Dollars are not translated............        50.00
                                               -----------------------------------------------------------------
        Total assets..........................  ...........  ......................................     1,480.00
Liabilities:
    Bank Loan.................................    [pound]50  Spot convention rate in Dec. 2008             50.00
                                                              [pound]1 = $1.
                                               -----------------------------------------------------------------
        Total liabilities.....................  ...........  ......................................        50.00
2008 ending owner functional currency net       ...........  ......................................        1,430
 value (in dollars).
----------------------------------------------------------------------------------------------------------------

    (ii) UK Branch uses the first in first out method of accounting 
for inventory. In 2009, UK Branch sold 100 units of inventory for a 
total of [pound]300 and purchased another 100 units of inventory in 
December 2009 for [pound]100. Assume that the dollar basis of the 
inventory purchased in December 2009 when translated at the December 
2009 monthly convention rate is $110; that depreciation with respect 
to the plant is [pound]33 and for the machine [pound]40\5\; and that 
UK Branch incurred [pound]30 of business expenses during 2009. 
Assume all items of income earned and expenses incurred during 2009 
are received and paid, respectively, in pounds. The yearly average 
exchange rate for 2009 is [pound]1 = $1.05. Under Sec.  1.987-3, UK 
Branch's section 987 taxable income or loss is determined as 
follows:
---------------------------------------------------------------------------

    \5\ The depreciation assumptions are for illustrative purposes 
only and may not be consistent with true depreciation rates.

----------------------------------------------------------------------------------------------------------------
                                            Amount in
                   Item                      [pound]                  Translation Rate               Amount in $
----------------------------------------------------------------------------------------------------------------
Gross receipts...........................          300  2009 yearly ave. rate [pound]1 = $1.05.....       315.00
Less:
    COGS.................................        (100)  Historic rate-Dec. 2008 convention rate         (100.00)
                                                         [pound]1= $1.
                                          ----------------------------------------------------------------------
        Gross income.....................          200  ...........................................       215.00
Dep:
    Plant................................         (33)  Historic rate-May 2007 convention rate           (29.70)
                                                         [pound]1= $0.90.
    Machine..............................         (40)  Historic rate-May 2007 convention rate           (36.00)
                                                         [pound]1= $0.90.
Other expenses...........................         (30)  2009 yearly ave. rate [pound]1 = $1.05.....      (31.50)
                                          ----------------------------------------------------------------------
        Total expenses...................  ...........  ...........................................        97.20
Section 987 taxable income...............  ...........  ...........................................       117.80
----------------------------------------------------------------------------------------------------------------

    Accordingly, UK Branch has $117.80 of section 987 taxable 
income.
    (iii) Assume that in December 2009, UK Branch transferred $20 
and [pound]30 to U.S. Corp and that U.S. Corp transferred a computer 
with a basis of $10 to UK Branch. The convention exchange rate for 
December 2009 is [pound]1 = $1.10. Finally, assume that 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 UK Branch for 
2009 is determined as follows:
    (A) Step 1: Determine the change in owner functional currency 
net value of UK Branch. Under paragraph (d)(1) of this section, the

[[Page 52908]]

change in owner functional currency net value for the taxable year 
must be determined. This amount is equal to the owner functional 
currency net value of UK Branch determined under paragraph (e) of 
this section on the last day of 2009, less the owner functional 
currency net value of UK Branch determined on the last day of 2008. 
The owner functional currency net value of UK Branch on December 31, 
2009, and the change in owner functional currency net value is 
determined as follows:
---------------------------------------------------------------------------

    \6\ [pound]100 on the closing 2008 balance sheet plus [pound]300 
gross receipts less [pound]100 inventory cost, less [pound]30 of 
additional expenses, less [pound]30 transferred to U.S. Corp.
    \7\ [pound]1,000 on the closing 2008 balance sheet less 
[pound]33 depreciation.
    \8\ [pound]200 on the closing 2008 balance sheet less [pound]40 
depreciation.
    \9\ Dollars are reduced by $20 transferred to U.S. Corp.

----------------------------------------------------------------------------------------------------------------
                                                 Amount in
                     Asset                        [pound]               Translation rate             Amount in $
----------------------------------------------------------------------------------------------------------------
Cash..........................................      \6\ 240  Spot convention rate in Dec. 2009            264.00
                                                              [pound]1 = $1.10.
Plant.........................................      \7\ 967  Historic rate-May 2007 convention rate       870.30
                                                              [pound]1 = $0.90.
Machine.......................................       \8\160  Historic rate-May 2007 convention rate       144.00
                                                              [pound]1 = $0.90.
Inventory.....................................          100  Historic rate--Dec. 2009 convention          110.00
                                                              rate [pound]1 = $1.10.
Computer......................................            9  Historic rate--Dec. 2009 convention           10.00
                                                              rate [pound]1 = $1.10.
Stock.........................................          158  Historic rate--Sept. 2008 convention         150.00
                                                              rate [pound]1 = $.95.
Dollars.......................................     \9\ $ 30  Dollars are not translated............        30.00
                                               -----------------------------------------------------------------
    Total assets..............................  ...........  ......................................     1,578.30
Liability:
    Bank Loan.................................    [pound]50  Spot convention rate in Dec. 2009             55.00
                                                              [pound]1 = $1.10.
                                               -----------------------------------------------------------------
    Total liabilities.........................  ...........  ......................................        55.00
2009 ending owner functional currency net       ...........  ......................................     1,523.30
 value (in dollars).
Less: 2008 ending owner functional currency     ...........  ......................................  ($1,430.00)
 net value (in dollars).
                                               -----------------------------------------------------------------
Change in owner functional currency net value.  ...........  ......................................        93.30
----------------------------------------------------------------------------------------------------------------

    (B) Step 2: Increase the aggregate amount described in step 1 by 
each owner's share of assets transferred by the section 987 QBU to 
its owners. 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 UK Branch to U.S. Corp during the taxable year, translated into 
U.S. Corp's functional currency as provided in paragraph (d)(2)(iii) 
of this section. The amount of assets transferred from UK Branch to 
U.S. Corp during 2009 is determined as follows:

----------------------------------------------------------------------------------------------------------------
                                            Amount in
                  Asset                      [pound]                  Translation rate               Amount in $
----------------------------------------------------------------------------------------------------------------
[pound]30 currency.......................           30  Spot convention rate in Dec. 2009 [pound]1         33.00
                                                         = $1.10.
$20 currency.............................          $20  Dollars are not translated.................        20.00
                                          ----------------------------------------------------------------------
    Total................................  ...........  ...........................................        53.00
----------------------------------------------------------------------------------------------------------------

    (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 UK 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 UK Branch is determined as 
follows:

----------------------------------------------------------------------------------------------------------------
                                            Amount in
                  Asset                      [pound]                  Translation rate               Amount in $
----------------------------------------------------------------------------------------------------------------
Computer.................................     [pound]9  Spot convention rate in Dec. 2009 [pound]1        $10.00
                                                         = $1.10.
                                          ----------------------------------------------------------------------
    Total................................  ...........  ...........................................        10.00
----------------------------------------------------------------------------------------------------------------

    (D) Step 4: Decrease the aggregate amount determined in steps 1 
through 3 by the amount of liabilities transferred by the section 
987 QBU to the owner. 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 UK Branch to 
U.S. Corp. Under these facts, such amount is $0.
    (E) Step 5: Increase the aggregate amount determined in steps 1 
through 4 by the amount of liabilities transferred by the owner to 
the section 987 QBU. 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 
UK Branch. Under these facts, such amount is $0.
    (F) Step 6: Increase the aggregate amount determined in steps 1 
through 5 by the section 987 taxable loss 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 increased 
by the section 987 taxable loss of UK Branch. Since UK Branch had no 
such taxable loss in 2009, paragraph (d)(6) of this section does not 
apply.
    (G) Step 7: 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)(7) of this section, the 
aggregate amount determined in steps 1 through 5 must be decreased 
by the section 987 taxable income of UK Branch. The amount of UK 
Branch's taxable income, as determined above, is $117.80.
    (v) Summary. Taking steps 1 through 7 into account, the amount 
of U.S. Corp's unrecognized section 987 gain or loss with

[[Page 52909]]

respect to UK Branch in 2009 is computed as follows:

------------------------------------------------------------------------
                  Step                      Amount in $       Balance
------------------------------------------------------------------------
1.......................................         + 93.30          $93.30
2.......................................         + 53.00          146.30
3.......................................          -10.00          136.30
4.......................................              -0          136.30
5.......................................             + 0          136.30
6.......................................             + 0          136.30
7.......................................         -117.80           18.50
------------------------------------------------------------------------

    Thus, U.S. Corp's unrecognized section 987 gain in 2009 with 
respect to U.K. Branch is $18.50. As of the end of 2009, 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 $48.50 (i.e., $30 accumulated from prior years, plus $18.50 in 
2009).


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. For any taxable 
year, the owner's section 987 gain or loss recognized with respect to a 
section 987 QBU shall be equal to--
    (1) The owner's net unrecognized section 987 gain or loss of 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 is the quotient, equal 
to--
    (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 total adjusted basis of the gross assets of the section 987 
QBU as of the end of the taxable year (or, if terminated prior to the 
end of such taxable year under Sec.  1.987-8, the day of termination) 
that are reflected on its year-end balance sheet (or, if terminated 
prior to the end of such taxable year under Sec.  1.987-8, the balance 
sheet on the day terminated), translated into the owner's functional 
currency as provided in Sec.  1.987-4(e)(2) and increased by the amount 
of the remittance.
    (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 total 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 total 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(d). Accordingly, the remittance proportion in the 
case of a termination is 1.
    (d) Total 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 total of all amounts transferred from the section 987 
QBU to the owner for the taxable year shall be determined in the 
owner's functional currency under Sec.  1.987-4(d)(2) with reference to 
the adjusted basis of the assets transferred. Solely for this purpose, 
the amount of liabilities transferred from the owner to the section 987 
QBU determined 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.
    (e) Total 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 total of all amounts transferred from the owner to 
the section 987 QBU for the taxable year shall be determined in the 
owner's functional currency under Sec.  1.987-4(d)(3) with reference to 
the adjusted basis of the assets transferred. 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 the section 987 QBU (whether or not such transfer is made 
in connection with a remittance as defined in paragraphs (c) of this 
section) shall be determined under the rules prescribed in paragraphs 
(f)(2) through (f)(4) of this section.
    (2) Section 987 marked asset. The basis of a section 987 marked 
asset shall be determined in the owner's functional currency and shall 
be the same as the amount determined under Sec.  1.987-4(d)(2)(ii)(A).
    (3) Section 987 historic asset. The basis of a section 987 historic 
asset shall be determined in the owner's functional currency and shall 
be the same as the amount determined under Sec.  1.987-4(d)(2)(ii)(B).
    (4) Partner's adjusted basis in distributed assets. See also 
section 732 and Sec.  1.987-7 for purposes of determining an owner's 
adjusted basis of an asset distributed from a section 987 QBU owned 
indirectly through a section 987 partnership.
    (g) Examples. The following examples illustrate the calculation of 
section 987 gain or loss under this section:

    Example 1. (i) U.S. Corp, a calendar year domestic corporation 
with the dollar as its functional currency, operates in the U.K. 
through U.K. DE, an entity disregarded as an entity separate from 
its owner under Sec. Sec.  301.7701-1 through 301.7701-3 of this 
chapter. U.K. DE has a section 987 branch (U.K. section 987 branch) 
with the pound as its functional currency. During year 2, the 
following transfers took place between U.S. Corp and U.K. section 
987 branch. On January 5, year 2, U.S. Corp transferred to U.K. 
section 987 branch $300 (which the branch used during the year to 
purchase services). On March 5, year 2, U.K. section 987 branch 
transferred a machine to U.S. Corp. Assume that the pound adjusted 
basis of the machine when properly translated into dollars under 
Sec. Sec.  1.987-4(d)(2)(ii)(B) and paragraph (d) of this section is 
$500. On November 1, year 2, U.K. section 987 branch transferred 
pound cash to U.S. Corp. Assume

[[Page 52910]]

that the dollar amount of the pounds when properly translated under 
Sec.  1.987-4(d)(2)(ii)(A) and paragraph (d) of this section is 
$2,300. On December 7, year 2, U.S Corp transferred a truck to U.K. 
section 987 branch with an adjusted basis of $2,000.
    (ii) Assume that at the end of year 2, U.K. section 987 branch 
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 pound cash equivalent to 
$2,850. In addition, assume that U.K. section 987 branch has a pound 
liability entered into in year 1 with Bank A. The liability, when 
translated into the owner functional currency pursuant to Sec.  
1.987-4(e)(2), is equivalent to $200. All such assets and 
liabilities are reflected on the books and records of U.K. section 
987 branch. Assume that the net unrecognized section 987 gain for 
U.K. section 987 branch as determined under Sec.  1.987-4 as of the 
last day of year 2 is $80.
    (iii) U.S. Corp's section 987 gain with respect to U.K. section 
987 branch is determined as follows:
    (A) Computation of amount of remittance. Under paragraphs (c)(1) 
and (2) of this section, U.S. Corp must determine the amount of the 
remittance for year 2 in the owner's functional currency (dollars) 
on the last day of year 2. The amount of the remittance for year 2 
is $500, determined as follows:
    Transfers from U.K. section 987 branch to U.S. Corp in dollars:

Machine......................................................       $500
Cash (U.K. pounds)...........................................      2,300
                                                              ----------
                                                                  $2,800
 

    Transfers from U.S. Corp to U.K. section 987 branch in dollars:

Cash (U.S. dollars)..........................................       $300
Truck........................................................      2,000
                                                              ----------
                                                                   2,300
 

    Computation of amount of remittance:

Aggregate transfers from U.K. section 987 branch to U.S. Corp     $2,800
Less: aggregate transfers from U.S. Corp to U.K. section 987     (2,300)
 branch......................................................
                                                              ----------
    Total remittance.........................................        500
 

    (B) Computation of branch gross assets plus remittance. Under 
paragraph (b)(2) of this section, U.K. section 987 branch must 
determine the total 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.
    Total basis of U.K. section 987 branch's gross assets at end of 
year 2 plus remittance in dollars:

Computer.....................................................       $500
Cash (U.K. pounds)...........................................      2,850
Truck........................................................      2,000
                                                              ----------
    Total gross assets.......................................      5,350
Remittance...................................................        500
                                                              ----------
        Total gross assets + remittance......................      5,850
 

    (C) Computation of remittance proportion. Under paragraph (b) of 
this section, U.K. section 987 branch must compute the remittance 
proportion as follows:

Amount of remittance.........................................       $500
Total basis of U.K. section 987 branch's gross assets at end       5,850
 of Year 2, increased by amount of remittance................
Remittance/gross assets......................................      0.085
Remittance proportion........................................      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 U.K. section 987 branch is determined under paragraph (a) of this 
section.

Net unrecognized section 987 gain............................        $80
Remittance proportion........................................    x 0.085
                                                              ----------
    U.S. Corp's section 987 gain for Year 2:.................      $6.80
 

    Example 2. U.S. Corp, a calendar year domestic corporation with 
the dollar as its functional currency, operates in the U.K. through 
U.K. DE, an entity disregarded as an entity separate from its owner. 
U.K. DE has a section 987 branch (U.K. section 987 branch) with the 
pound as its functional currency. During year 2, the following 
transfers took place between U.S. Corp and U.K. section 987 branch. 
On March 1, year 2, U.S. Corp transferred to U.K. section 987 branch 
a computer with a basis of $100. On November 1, year 2, U.K. section 
987 branch transferred pounds to U.S. Corp. Assume that the dollar 
amount of the pounds when properly translated under Sec.  1.987-
4(d)(2)(ii)(A) and paragraph (d) of this section is $300. On the 
same day, U.K. section 987 branch transferred of $20 to U.S. Corp.
    (ii) Assume that at the end of year 2, U.K. section 987 branch 
holds assets translated (as necessary) into the owner functional 
currency pursuant to Sec.  1.987-4(e)(2) consisting of a plant with 
a pound adjusted basis equivalent $1,000, pound cash equivalent to 
$100, a machine with a pound adjusted basis equivalent to $200, 
portfolio stock (within the meaning of Sec.  1.987-2(b)(2)(ii)) in 
ABC Corporation with a pound adjusted basis equivalent to $150, 
inventory of 100 units with an aggregate pound adjusted basis 
equivalent to $100 and a computer with a pound adjusted basis 
equivalent to $100. In addition, assume that U.K. section 987 branch 
has a pound liability that it entered into with Bank A in year 1. 
When properly translated into dollars pursuant to Sec.  1.987-
4(e)(2) the principal amount of the liability is equal to $500. All 
such assets and liabilities are reflected on the books and records 
of U.K. section 987 branch. Assume that the net unrecognized 987 
gain for U.K. section 987 branch as determined under Sec.  1.987-4 
as of the last day of year 2 is $100.
    (iii) U.S. Corp's section 987 gain with respect to U.K. section 
987 branch is determined as follows:
    (A) Computation of amount of remittance. Under paragraphs (c)(1) 
and (2) of this section, U.S. Corp must determine the amount of the 
remittance for year 2 in the owner's functional currency on the last 
day of year 2. The amount of the remittance for year 2 is $220 
determined as follows:
    Transfers from U.K. section 987 branch to U.S. Corp in dollars:

Cash (U.K. pounds)...........................................       $300
Cash (U.S. dollars)..........................................         20
                                                              ----------
                                                                     320
 

    Transfers from U.S. Corp to U.K. section 987 branch in dollars:

Computer.....................................................       $100
Computation of amount of remittance:
Aggregate transfers from U.K. section 987 branch to U.S. Corp       $320
Less: aggregate transfers from U.S. Corp to U.K. branch......     ($100)
                                                              ----------
Total remittance:............................................       $220
 

    Computation of amount of remittance:

Aggregate transfers from U.K. section 987 branch to U.S. Corp       $320
Less: aggregate transfers from U.S. Corp to U.K. branch......        100
                                                              ----------
    Total remittance:........................................        220
 

    (B) Computation of branch gross assets plus remittance. Under 
paragraph (b)(2) of this section, U.K. section 987 branch must 
determine the total basis of its gross assets as are reflected on 
its year-end balance sheet translated into dollars and must increase 
this amount by the amount of the remittance.
    Total pound basis of U.K. section 987 branch's gross assets 
translated into dollars at end of Year 2:

Plant........................................................     $1,000
Cash (U.K. pounds)...........................................        100
Inventory....................................................        100
Machine......................................................        200
Computer.....................................................        100
Portfolio Stock..............................................        150
                                                              ----------
    Total gross assets.......................................      1,650
Remittance...................................................        220
                                                              ----------
    Total gross assets + remittance..........................      1,870
 

    (C) Computation of remittance proportion. Under paragraph (b) of 
this section, U.K. section 987 branch must compute the remittance 
proportion as follows:

Amount of remittance.........................................       $220
Total basis of U.K. section 987 branch's gross assets at tend      1,870
 of year 2, increased by amount of remittance................
Remittance/gross assets......................................      0.118
Remittance proportion........................................      0.118
 

    (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 U.K. section 987 branch is determined under paragraph (a) of this 
section.

Net unrecognized section 987 gain............................    $100.00
Remittance proportion........................................    x 0.118
                                                              ----------

[[Page 52911]]

 
    U.S. Corp's section 987 gain for year 2..................      11.80
 

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) Source and character of section 987 gain or loss--(1) In 
general. Except as otherwise provided in this section, the owner of a 
section 987 QBU must determine the source and character 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. The modified 
gross income method described in Sec.  1.861-9T(j) cannot be used.
    (3) Method required to characterize and source section 987 gain or 
loss with respect to regulated investment companies and real estate 
investment trusts. [Reserved].
    (c) Example. The following example illustrates the application of 
this section.
    Example. CFC is a controlled foreign corporation as defined in 
section 957 with the Swiss franc (Sf) as its functional currency. CFC 
holds all the interest in a section 987 DE as defined in Sec.  1.987-
1(b)(6)(iii) that has a section 987 branch with significant operations 
in Germany (German Branch). German Branch has the euro as its 
functional currency. For the year 2009, CFC recognizes section 987 gain 
of Sf10,000 under Sec. Sec.  1.987-4 and 1.987-5. Applying the rules of 
this section, German Branch has total average 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)(I), 
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 treated as foreign source general limitation income 
which is not subpart F income and Sf2,500 (Sf250,000/Sf1,000,000 x 
Sf10,000) will be treated as foreign source passive income which is 
subpart F income. All of the section 987 gain is treated as ordinary 
income.


Sec.  1.987-7  Section 987 partnerships.

    (a) In general. In the case of an owner that is a partner in a 
section 987 partnership, this section provides rules for determining 
the owner's share of assets and liabilities of a section 987 QBU owned 
indirectly, as described in Sec.  1.987-1(b)(4)(ii), through a section 
987 partnership. In addition, this section provides rules coordinating 
these regulations with subchapter K of chapter 1 of the Internal 
Revenue Code.
    (b) Assets and liabilities of an eligible QBU or a section 987 QBU 
held indirectly through a partnership. A partner's share of the assets 
and liabilities reflected under Sec.  1.987-2(b) on the books and 
records of an eligible QBU or a section 987 QBU owned indirectly 
through a partnership shall be determined in a manner that is 
consistent with the manner in which the partners have agreed to share 
the economic benefits and burdens (if any), corresponding to the assets 
and liabilities, taking into account the rules and principles of 
sections 701 through 761, and the applicable regulations, including 
section 704(b) and Sec.  1.701-2.
    (c) Coordination with subchapter K--(1) Partner's adjusted basis in 
its partnership interest--(i) In general. Except as provided in this 
paragraph, a partner's adjusted basis in its section 987 partnership 
interest shall be maintained in the functional currency of that partner 
and shall not be adjusted as a result of any fluctuations in the value 
of the partner's functional currency and the functional currency of any 
section 987 QBU owned indirectly through the section 987 partnership.
    (ii) Adjustments for section 987 taxable income or loss and section 
987 gain or loss--(A) Section 987 taxable income or loss. A partner's 
share of the items of income, gain, deduction or loss taken into 
account in calculating section 987 taxable income or loss of a section 
987 QBU, determined under Sec.  1.987-3, held indirectly through a 
section 987 partnership shall be treated as income or loss of the 
section 987 partnership through which the partner indirectly owns the 
interest. As a result, the partner's allocable share of the items of 
income, gain, deduction or loss taken into account in calculating 
section 987 taxable income or loss of the section 987 QBU shall be 
taken into account, following conversion into the partner's functional 
currency, in determining the appropriate adjustments to the partner's 
adjusted basis in its partnership interest under section 705.
    (B) Section 987 gain or loss. Solely for purposes of determining 
the appropriate adjustments to a partner's adjusted basis in its 
interest in a section 987 partnership under section 705, an individual 
or corporation that owns a section 987 QBU indirectly through a section 
987 partnership shall treat any section 987 gain or loss of such 
section 987 QBU as gain or loss of the section 987 partnership. Any 
adjustments to the adjusted basis of a partner's interest in such 
section 987 partnership required under this paragraph (c)(1)(ii)(B) of 
this section shall occur prior to determining the effect under the 
Internal Revenue Code of any sale, exchange, distribution or other 
event.
    (iii) Adjustments for contributions and distributions. For purposes 
of making adjustments to the partner's adjusted basis in its interest 
in a section 987 partnership, as a result of any contributions or 
distributions (including deemed contributions and distributions under 
section 752) between the section 987 partnership and the owner of a 
section 987 QBU owned indirectly through the partnership, such amounts 
will be taken into account in the owner's functional currency.
    (iv) Determination of deemed distributions and contributions under 
section 752--(A) Increase in partner's liabilities. For purposes of 
determining the amount of any increase in a partner's share of the 
liabilities of the partnership, or any increase in the partner's 
individual liabilities by reason of the assumption by such partner of a 
liability of the partnership, which are reflected on the books and 
records of a section 987 QBU owned indirectly through such partnership 
and which are denominated in a functional currency different from the 
partner's, the amount of such liabilities shall be translated into the 
functional currency of the partner using the spot rate (as defined in 
Sec.  1.987-1(c)(1)(i) and (ii)) on the date of such increase.
    (B) Decrease in partner's liabilities. For purposes of determining 
the amount of any decrease in a partner's share of the liabilities of 
the partnership which were reflected on the books and records of a 
section 987 QBU owned indirectly through such partnership and which are 
denominated in a functional currency different from the partner's 
functional currency, the amount of such liabilities shall be translated 
into the functional currency of the partner using the historic rate (as 
defined in Sec.  1.987-1(c)(3)) for the date on which such liabilities 
increased the partner's adjusted basis in its partnership interest 
under section 752.
    (2) Special rule for determining gain or loss on the sale, exchange 
or other disposition of an interest in a section 987 partnership. For 
purposes of determining the amount realized by a

[[Page 52912]]

partner in a section 987 partnership on the sale, exchange, or other 
disposition of that partner's interest in such partnership, the amount 
of liabilities reflected on the books and records of a section 987 QBU 
(in a functional currency different from such partner) from which that 
partner is relieved as a result of such disposition, and which are 
included in the amount realized pursuant to section 752(d), shall be 
translated into the partner's functional currency using the historic 
exchange rate (as determined under Sec.  1.987-1(c)(3)) for the date on 
which such liabilities increased the partner's adjusted basis in its 
partnership interest under section 752.
    (d) Examples. The purpose of the following examples is to 
illustrate the application of section 987 to partnerships and their 
partners. The examples are not meant to be a comprehensive 
interpretation of the step-by-step computations involved in computing 
net unrecognized section 987 gain or loss. Thus, for the sake of 
simplicity, the examples only calculate section 987 gain or loss by 
reference to certain identified assets and liabilities, rather than by 
all the assets and liabilities of the section 987 QBU (as is required 
under these regulations). See Sec.  1.987-4 and the examples therein 
for step-by-step computations for determining the unrecognized section 
987 gain or loss of the owner of a section 987 QBU.

    Example 1. Computation of an owner's net unrecognized section 
987 gain or loss. (i) Facts. PRS is a partnership which owns QBUx, 
an eligible QBU, operating in the United Kingdom. QBUx has the pound 
as its functional currency determined under Sec.  1.985-1 taking 
into account all of QBUx's activities before application of this 
section. PRS has two equal partners that are domestic corporations, 
A and B, each with the U.S. dollar as its functional currency. The 
portions of QBUx allocated to A and B under paragraph (b) of this 
section are section 987 QBUs of A and B because under Sec.  1.987-
1(b)(2), such portions are allocated from an eligible QBU with a 
different functional currency than A and B, respectively. Assume 
that PRS has no items of section 987 taxable income or loss for 
2007. On January 1, 2007, A and B each contribute $50 to PRS. PRS 
immediately converts the $100 into [pound]100. The [pound]100 is 
reflected, in accordance with Sec.  1.987-2(b), on the books and 
records of QBUx. On January 1, 2007, the spot rate is $1 = [pound]1. 
On December 31, 2007, the spot rate is $1.50 = [pound]1. Pursuant to 
Sec.  1.987-3(b)(1), A and B use the yearly average exchange rate, 
as defined in Sec.  1.987-1(c)(2), to translate items of income, 
gain, deduction, or loss into dollars for the taxable year. Assume 
the yearly average exchange rate is $1.25 = [pound]1 ($1 = 
[pound].80). Under the PRS partnership agreement, A and B each have 
an equal interest in all items of partnership income and loss.
    (ii) Calculation of net unrecognized section 987 gain or loss. 
Under paragraph (b) of this section, A and B are each allocated 50 
from eligible QBUx. This amount is reflected on the balance sheet of 
the section 987 QBU of A and B, respectively, for purposes of 
determining the unrecognized section 987 gain or loss under Sec.  
1.987-4. Pursuant to Sec.  1.987-4(d), the net unrecognized section 
987 gain of A's section 987 QBU and B's section 987 QBU is $25.
    Example 2. Computation of owner's net unrecognized section 987 
gain or loss. (i) Facts. The facts are the same as Example 1, except 
that in addition to the [pound]100 contributed by A and B, PRS 
incurred a [pound]50 recourse liability from an unrelated third 
party on January 1, 2007. The liability and the [pound]50 are both 
reflected on the books and records of QBUx under Sec.  1.987-2(b). 
Under section 752, and the regulations thereunder, A and B bear the 
economic risk of loss with respect to the [pound]50 recourse debt 
equally.
    (ii) Calculation of net unrecognized section 987 gain or loss. 
Under paragraph (b) of this section, A and B are each allocated 
[pound]75 from QBUx. In addition, under paragraph (b) of this 
section, A and B are each allocated [pound]25 of the liability of 
QBUx because the economic burden of such liability, taking into 
account sections 701 through 761 of the Code, is borne equally by A 
and B. Under Sec.  1.987-4(d), A and B each have net unrecognized 
section 987 gain of $25.
    (iii) Determination of partner's adjusted basis in PRS. Pursuant 
to paragraph (c)(1)(i) of this section and section 985(a), A and B 
must determine the adjusted basis in their PRS partnership interests 
in U.S. dollars. Under sections 722, 752(a) and paragraph 
(c)(1)(iv)(A) of this section, the adjusted bases in such interests 
are increased by the U.S. dollar amount of a deemed contribution 
determined using the spot rate for the date on which such liability 
was incurred. Therefore, A and B will increase the adjusted basis in 
their PRS partnership interests by $25.
    Example 3. Computation of owner's net unrecognized section 987 
gain or loss. (i) Facts. The facts are the same as Example 2, except 
as follows: On January 1, 2007, instead of incurring a [pound]50 
recourse liability, PRS incurred a [pound]50 nonrecourse liability 
from an unrelated third party, which was secured by and used to 
purchase non-depreciable real property located in the United 
Kingdom. Under the partnership agreement, A and B agree to share all 
items of partnership income and loss equally, except that A 
guaranteed the nonrecourse liability and, in addition, the 
partnership agreement provides that A will be allocated any gain 
from the sale or exchange of the non-depreciable property. Further, 
the partnership agreement provides that in the event the partnership 
liquidates prior to satisfying the liability, the non-depreciable 
property shall be distributed to A.
    (ii) Calculation of net unrecognized section 987 gain or loss. 
Under paragraph (b) of this section, A and B are each allocated 
[pound]50 from eligible QBUx. In addition, because A bears the 
economic burden of the nonrecourse liability incurred by PRS and the 
economic benefits of the non-depreciable property securing such 
liability, both of which are reflected on the books and records of 
QBUx under Sec.  1.987-2(b), A is allocated, for purposes of 
applying Sec.  1.987-4(d), both the [pound]50 liability and the non-
depreciable property with an adjusted tax basis of [pound]50. Under 
Sec.  1.987-4(d), A's net unrecognized section 987 gain is $0, and 
B's net unrecognized section 987 gain is $25.
    (iii) Determination of partner's adjusted basis in PRS. Pursuant 
to paragraph (c)(1)(i) of this section and section 985(a), A and B 
must determine the adjusted bases in their PRS partnership interests 
in U.S. dollars. Under sections 722, 752(a) and paragraph (c)(1)(iv) 
of this section, A's adjusted basis is increased by the U.S. dollar 
amount of the deemed contribution determined using the spot rate for 
the date on which such liability was incurred. Therefore, A will 
increase the adjusted basis in its PRS partnership interest by $50.
    Example 4. Computation of owner's share of items of section 987 
taxable income. (i) Facts. The facts are the same as in Example 1, 
except that during 2007 PRS earns [pound]50 which are reflected on 
the books and records of QBUx. In accordance with the partnership 
agreement, the [pound]50 are allocated equally between A and B.
    (ii) Calculation of section 987 taxable income or loss. Under 
Sec.  1.987-3, A and B's allocable share of the taxable income of 
QBUx, as determined by PRS, and adjusted to conform to U.S. tax 
principles, is [pound]25 each. Under Sec.  1.987-3, A and B must 
convert their allocable share of the [pound]25 into U.S. dollars 
using the yearly average exchange rate for the year, in accordance 
with Sec.  1.987-1(c)(2). As a result, A and B each take into 
account as their respective distributive share of PRS income $31.25. 
Under paragraph (c)(1)(ii)(A) of this section, section 985(a) and 
section 705, such amounts, as reflected in U.S. dollars, will be 
taken into account in determining any adjustments to the adjusted 
bases of A's and B's partnership interests. In addition, such 
amounts will be taken into account in calculating, under Sec.  
1.987-4, the unrecognized section 987 gain or loss of the section 
987 QBUs of A and B.
    Example 5. Computation of owner's share of items of section 987 
taxable income. (i) Facts. The facts are the same as in Example 4, 
except A and B agree to allocate the [pound]50 of income to A. 
Assume for purposes of this example that such allocation has 
substantial economic effect as provided under section 704(b).
    (ii) Calculation of section 987 taxable income or loss. Under 
Sec.  1.987-3, A and B's allocable share of the taxable income of 
QBUx, as determined by PRS, and adjusted to conform to U.S. tax 
principles, is [pound]50 and [pound]0, respectively. Under Sec.  
1.987-3, A and B must convert their allocable share into U.S. 
dollars using the yearly average exchange rate for the year, in 
accordance with Sec.  1.987-1(c)(2). As a result, A and B must each 
take into account as their respective distributive share of PRS 
income $62.50 and $0, respectively. Under paragraph (c)(1)(ii)(A) of 
this section, section 985(a) and section 705, such amounts, as 
reflected in U.S. dollars,

[[Page 52913]]

will be taken into account in determining any adjustments to the 
adjusted bases of A's and B's respective partnership interests. In 
addition, such amounts will be taken into account in calculating, 
under Sec.  1.987-4, the unrecognized section 987 gain or loss of 
the section 987 QBUs of A and B. [FEDREG][VOL]*[/VOL][NO]*[/
NO][DATE]*[/DATE][PRORULES][PRORULE][PREAMB][AGENCY]*[/
AGENCY][SUBJECT]*[/SUBJECT][/PREAMB][SUPLINF][HED]*[/HED]
    Example 6. Election by de minimis partner to not take into 
account section 987 gain or loss. (i) Facts. The facts are the same 
as in Example 1, except assume that A owns, directly or indirectly, 
less than 5% of the total capital and profits interest in PRS and, 
as a result, is eligible to elect, under Sec.  1.987-1(b)(1)(ii) not 
to apply the provisions of the regulations under section 987 for 
purposes of taking into account the section 987 gain or loss of A's 
section 987 QBU. Assume further that A makes such election. On 
January 1, 2008, A sells its interest to an unrelated third party, 
C, for $75.
    (ii) Determination of partner's adjusted basis in PRS. Pursuant 
to paragraph (c)(1)(i) of this section and section 985(a), A must 
determine the adjusted basis of its PRS partnership interest in U.S. 
dollars. A's basis in PRS is $50, the amount of its contribution to 
PRS.
    (iii) Sale of partnership interest by A. Under section 1001, A's 
amount realized on the sale of the partnership interest to C is $75. 
A's adjusted basis of its PRS partnership interest is $50, the 
amount of A's contribution to PRS, unadjusted by the fluctuations 
between the pound and the U.S. dollar. A's gain on the sale of the 
partnership interest is $25.


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 (d) of this 
section provides certain effects of terminations. Paragraph (e) 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 when--
    (1) Its activities cease, such that it no longer meets the 
definition of an eligible QBU as defined in Sec.  1.987-1(b)(3);
    (2) Substantially all (within the meaning of section 368(a)(1)(C)) 
of the section 987 QBU's assets are transferred from such section 987 
QBU to its owner, as provided under Sec.  1.987-2(c). 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 (for example, 
a contribution of property to a DE or a partnership) as provided under 
Sec.  1.987-2(c) shall be reduced by assets that are transferred from 
the owner to such section 987 QBU, as provided under Sec.  1.987-2(c), 
pursuant to the same transaction;
    (3) 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; or
    (4) The owner of such 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. 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. 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 and the acquiring corporation is a 
foreign corporation that is not a controlled foreign corporation 
immediately after 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) 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. As a result, any net 
unrecognized section 987 gain or loss of the section 987 QBU is 
recognized. See Sec.  1.987-5. For purposes of the preceding sentence, 
the amount of net unrecognized section 987 gain or loss is determined 
as of the date of termination by closing the books and records of the 
section 987 QBU on that date.

    (e) Examples. The following examples illustrate the principles of 
this section:

    Example 1. Cessation of operations. (i) Facts. DC, a domestic 
corporation, has a sales office in Country X (Country X Branch) that 
is a section 987 QBU. DC closes its Country X Branch.
    (ii) Analysis. The cessation of the activities of the Country X 
Branch causes a termination of the section 987 QBU under paragraph 
(b)(1) of this section.
    Example 2. Incorporation of section 987 QBU. (i) Facts. DC, a 
domestic corporation, has a branch in Country X (Country X Branch) 
that is a section 987 QBU. DC transfers all the assets and 
liabilities of Country X Branch to DS, a domestic corporation, in 
exchange for stock of DS in a transaction qualifying under section 
351.
    (ii) Analysis. Country X Branch terminates pursuant to paragraph 
(b)(1) of this section because the Country X Branch ceases to be an 
eligible QBU of DC.
    Example 3. Cessation of controlled foreign corporation status. 
(i) Facts. DC, a domestic corporation, owns all of the stock of FC, 
a controlled foreign corporation as defined in section 957. FC has a 
section 987 QBU. FA, a foreign corporation owned solely by foreign 
persons, purchases all of the FC stock. FC will not constitute a 
controlled foreign corporation after the transaction.
    (ii) Analysis. Because FC ceases to qualify as a controlled 
foreign corporation after the sale of the FC stock, FC's section 987 
QBU terminates pursuant to paragraph (b)(3) of this section.?>
    Example 4. Section 332 liquidation. (i) Facts. DC, a domestic 
corporation, operates in Country X through FC, a wholly-owned 
foreign corporation organized under the laws of Country X. FC also 
has a branch in Country Y (Country Y Branch) that is a section 987 
QBU. Pursuant to a liquidation described in section 332, FC 
transfers all of its assets and liabilities to DC.
    (ii) Analysis. FC's liquidation is a termination as provided in 
paragraph (b)(4) of this section because FC ceases to exist. The 
exception for certain section 332 liquidations provided under 
paragraph (c)(1) of this section does not apply because DC is a 
domestic corporation and FC is a foreign corporation. See paragraph 
(c)(1)(ii) of this section.
    Example 5. Transfers to and from section 987 QBU pursuant to the 
same transaction. (i) Facts. DC1, a domestic corporation, owns 
Entity A, a DE. Entity A conducts a business in Country X and that 
business is an eligible QBU and a section 987 QBU (Country X QBU) of 
DC1. DC2, a domestic corporation, contributes property to Entity A 
in exchange for a 95% interest in Entity A. The property DC2 
contributes to Entity A is used in the business conducted by the 
Country X QBU and is reflected on its books and records as provided 
under Sec.  1.987-2(b). Moreover, Entity A is converted to a 
partnership as a result of the contribution. See Rev. Rul. 99-5 
(situation 2), (1999-1 CB 434). See Sec.  601.601(d)(2) of this 
chapter. Also, as a result of the contribution, and pursuant to 
Sec.  1.987-2(c)(5), 95% of the assets and liabilities on the books 
and records of DC1's section 987 QBU are deemed to be transferred 
from such QBU to DC1, and DC1 is deemed to transfer to such QBU 5% 
of the

[[Page 52914]]

property, as determined under Sec.  1.987-7, contributed by DC2 to 
Entity A.
    (ii) Analysis. As a result of the contribution of property from 
DC2 to Entity A, assets were transferred from DC1's section 987 QBU 
to DC1. Similarly, assets were transferred from DC1 to its section 
987 QBU as a result of the contribution. Accordingly, for purposes 
of determining whether substantially all the assets of Country X QBU 
were transferred from DC1's section 987 QBU as provided under 
paragraph (b)(2) of this section, the assets transferred from DC1's 
section 987 QBU to DC1 under Sec.  1.987-2(c) are reduced by the 
amount of assets transferred from DC1 to such section 987 QBU 
pursuant to the contribution.


Sec.  1.987-9  Recordkeeping requirements.

    (a) In general. A taxpayer that is an owner of a section 987 QBU 
shall keep such reasonable records as are sufficient to establish the 
QBU's section 987 taxable income or loss and section 987 gain or loss. 
See section 987 and section 6001 and the applicable regulations.
    (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:
    (1) The amount of the items of income, gain, deduction or loss 
attributed to each section 987 QBU of the owner in the functional 
currency of the section 987 QBU.
    (2) The amount of assets and liabilities attributed to each section 
987 QBU of the owner in the functional currency of the QBU.
    (3) The exchange rates used to translate items of income, gain, 
deduction or loss of each section 987 QBU into the owner's functional 
currency. 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 each section 987 QBU into the owner's functional currency. 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 each section 987 QBU of the owner translated into the 
functional currency of the owner.
    (6) The amount of assets and liabilities attributed to each section 
987 QBU of the owner translated into the functional currency of the 
owner.
    (7) The amount of assets and liabilities transferred by the owner 
to a 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 unrecognized section 987 gain or loss at 
the close of the taxable year.
    (11) If a remittance is made, the average tax book value of assets 
as determined under Sec.  1.861-9T(g).
    (12) The transition information required to be determined under 
Sec.  1.987-10(c)(2)(v).
    (c) Retention of records. The records required by this section must 
be kept at all times available for inspection by the Internal Revenue 
Service, and shall be retained so long as the contents thereof may 
become material in the administration of the Internal Revenue Code.


Sec.  1.987-10  Transition rules.

    (a) Scope--(1) In general. 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 paragraph (b) of 
this section). A taxpayer to whom this section applies must transition 
from the method previously used by such taxpayer to comply with section 
987 (the ``prior section 987 method'') to the method prescribed by 
these regulations pursuant to the rules set forth in paragraph (c) of 
this section.
    (2) Limitation where the prior method was unreasonable. 
Notwithstanding paragraph (a)(1) of this section, if the prior section 
987 method was unreasonable (including the case where the taxpayer 
failed to make the determinations required under section 987 for any 
open taxable year), then the taxpayer must apply the rules of paragraph 
(c)(4) of this section (and cannot apply the rules of paragraph (c)(3) 
of this section) to transition to the method prescribed by these 
regulations.
    (b) Transition date. The transition date is the first day of the 
first taxable year to which these regulations apply to a taxpayer.
    (c) Transition methods and corresponding rules--(1) In general. 
Except as provided in paragraph (a)(2) of this section, a taxpayer must 
transition from its prior method to the method prescribed by these 
regulations under the ``deferral transition method'' of paragraph 
(c)(3) of this section or the ``fresh start transition method'' of 
paragraph (c)(4) of this section. If a taxpayer fails to comply with 
the rules of this section, the Area Director, Field Examination, Small 
Business/Self Employed or the Director, Field Operations, Large and 
Mid-Size Business having jurisdiction of the taxpayer's return for the 
taxable year shall determine the appropriate transition method.
    (2) Conformity rules. The taxpayer (including all members that file 
a consolidated return that includes that taxpayer), and any controlled 
foreign corporation as defined in section 957 in which the taxpayer 
owns more than 50 percent of the voting power or stock (as determined 
in section 957(a)), must consistently apply the same transition method 
for each qualified business unit subject to section 987 owned on the 
transition date.
    (3) Deferral transition method--(i) In general. Pursuant to the 
deferral transition method prescribed by this paragraph (c)(3), section 
987 gain or loss must be determined on the transition date under the 
taxpayer's prior section 987 method as if all qualified business units 
of the taxpayer subject to section 987 (taking into account the 
conformity rules of paragraph (c)(2) of this section) terminated on the 
last day of the taxable year preceding the transition date. This deemed 
termination applies solely for purposes of this section. Any section 
987 gain or loss determined with respect to a section 987 QBU under the 
preceding sentence shall not be recognized on the transition date but 
shall be considered as net unrecognized section 987 gain or loss of the 
section 987 QBU in the first taxable year for which these regulations 
are effective (in addition to any net unrecognized section 987 gain or 
loss otherwise determined for such taxable year). Recognition of net 
unrecognized section 987 gain or loss determined under the preceding 
sentence is governed by Sec.  1.987-5 for periods after the transition 
date. The owner of a qualified business unit that is deemed to 
terminate under these rules is treated as having transferred all of the 
assets and liabilities attributable to such qualified business unit to 
a new section 987 QBU on the transition date.
    (ii) Translation rates used to determine the amount of assets and 
liabilities transferred from the owner to the section 987 QBU for the 
section 987 QBU's first taxable year beginning on the transition date. 
The exchange rates used to determine the amount of assets and 
liabilities transferred from the owner to the section 987 QBU on the 
transition date (for example, for purposes of making calculations under 
Sec.  1.987-4) under the deferral transition method in this paragraph 
(c)(3) shall be determined with reference to the historic exchange 
rates on the day the assets were acquired or liabilities entered into 
by the qualified business unit deemed terminated, adjusted to

[[Page 52915]]

take into account any gain or loss determined under paragraph (c)(3)(i) 
of this section. See Examples 1 and 2 of paragraph (d) of this section.
    (4) Fresh start transition method--(i) In general. Pursuant to the 
fresh start transition method prescribed by this paragraph (c)(4), on 
the transition date all qualified business units of the taxpayer 
subject to section 987 (taking into account the conformity rules of 
paragraph (c)(2) of this section) are deemed terminated on the last day 
of the taxable year preceding the transition date. This deemed 
termination applies solely for purposes of this section. No section 987 
gain or loss is determined or recognized on such deemed termination. 
The owner of a qualified business unit that is deemed to terminate 
under this method is treated as having transferred all of the assets 
and liabilities attributable to such qualified business unit to a 
section 987 QBU on the transition date.
    (ii) Translation rates used to determine the amount of assets and 
liabilities transferred from the owner to the section 987 QBU for the 
section 987 QBU's first taxable year on the transition date. The 
exchange rates used to determine the amount of assets and liabilities 
transferred from the owner to the section 987 QBU on the transition 
date (for example, for purposes of making calculations under Sec.  
1.987-4) under the fresh start transition method of this paragraph 
(c)(4) shall be determined with reference to the historic exchange 
rates on the day the assets were acquired or liabilities entered into 
by the qualified business unit deemed terminated. See Example 3 of 
paragraph (d) of this section.
    (5) Double counting prohibited. The transition method used by the 
taxpayer cannot result in taking into account section 987 gain or loss 
with respect to an asset or liability attributable to a period prior to 
the transition date more than once.
    (6) Reporting. The taxpayer must attach a statement to its return 
for the first taxable year beginning on the transition date providing 
the following information:
    (i) A description of each qualified business unit to which these 
rules apply, the qualified business unit's owner and its principal 
place of business, and a description of the prior method used by the 
taxpayer to determine section 987 gain or loss with respect to such 
qualified business unit.
    (ii) The transition method used by the taxpayer under paragraph (c) 
of this section for each qualified business unit.
    (iii) If the taxpayer uses the deferral transition method 
prescribed in paragraph (c)(3) of this section with respect to a 
qualified business unit, an explanation of the method used to determine 
section 987 gain or loss.
    (iv) If the taxpayer uses the deferral transition method prescribed 
in paragraph (c)(3) of this section with respect to a qualified 
business unit, the amount treated as net unrecognized section 987 gain 
or loss under paragraph (c)(3)(i) of this section.
    (v) The method used by the taxpayer for determining the exchange 
rates used to translate the basis of assets and the amount of 
liabilities of a section 987 QBU into the functional currency of the 
owner on the transition date as provided in paragraphs (c)(3)(ii) and 
(c)(4)(ii) of this section for purposes of applying these regulations.
    (d) Examples. The principles of this section are illustrated by the 
following examples:

    Example 1. Deferral transition method. (i) U.S. Corp is a 
domestic corporation with the dollar as its functional currency. 
U.S. Corp owns UK Branch, a branch with the pound as its functional 
currency. UK Branch was formed on January 1, 2006. U.S. Corp uses 
the method prescribed in the 1991 proposed section 987 regulations 
to determine the section 987 gain or loss of UK Branch. U.S. Corp 
contributed [pound]6,000 to UK Branch on January 1, 2006. On the 
same day, UK Branch bought a truck for [pound]4,000 and a computer 
for [pound]1,000. Assume that the spot rate on January 1, 2006, is 
[pound]1 = $1. UK Branch 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 taxable year of 2006, 2007, 2008, 
and 2009. Assume that the average exchange rates used to translate 
UK Branch's profits under the 1991 proposed section 987 regulations 
were as follows: 2006--[pound]1 = $1.10; 2007--[pound]1 = $1.20; 
2008--[pound]1 = $1.30; 2009--[pound]1 = $1.40. UK Branch makes no 
remittances to U.S. Corp in any year. On January 1, 2010, UK Branch 
transitions to the method provided in Sec. Sec.  1.987-1 through 
1.987-11 of these regulations pursuant to paragraph (a) of this 
section. U.S. Corp chooses to use the deferral transition method of 
paragraph (c)(3) of this section in transitioning from its prior 
section 987 method (the method set forth in the 1991 proposed 
section 987 regulations) to the method prescribed in the Sec. Sec.  
1.987-1 through 1.987-11 of these regulations. The spot rate on 
December 31, 2009, is [pound]1 = $2.
    (ii) Pursuant to paragraph (c)(3) of this section, U.S. Corp 
must determine UK Branch's section 987 gain or loss on January 1, 
2010 using its prior section 987 method (the method prescribed under 
the 1991 proposed section 987 regulations), as if UK Branch 
terminated on December 31, 2009. On December 31, 2009, UK Branch has 
an equity pool of [pound]7,000 and a basis pool of $7,250 determined 
under the 1991 proposed section 987 regulations based on the 
following amounts:

----------------------------------------------------------------------------------------------------------------
                                            Amount in
                  Asset                      [pound]                  Translation rate               Amount in $
----------------------------------------------------------------------------------------------------------------
Cash.....................................  [pound]1,00  Spot rate on 1/1/06 of [pound]1=$1.........       $1,000
                                                     0
Cash.....................................          250  Ave. rate for 2006 of [pound]1=$1.10.......          275
Cash.....................................          250  Ave. rate for 2007 of [pound]1=$1.20.......          300
Cash.....................................          250  Ave. rate for 2008 of [pound]1=$1.30.......          325
Cash.....................................          250  Ave. rate for 2009 of [pound]1=$1.40.......          350
Truck....................................       *4,000   Spot rate on 1/1/06 of [pound]1=$1........        4,000
Computer.................................       *1,000   Spot rate on 1/1/06 of [pound]1=$1........        1,000
                                          ----------------------------------------------------------------------
    Total assets.........................        7,000  ...........................................        7,250
Liabilities..............................            0  ...........................................           0
----------------------------------------------------------------------------------------------------------------
* Depreciation not taken into account for purposes of this example.

    Accordingly, under Sec.  1.987-3(h)(3)(i) of the 1991 proposed 
section 987 regulations, UK Branch determines its section 987 gain 
or loss on December 31, 2009, as follows:

Equity Pool on 12/31/09....................................  [pound]7,00
                                                                       0
Multiplied by spot rate on date of deemed termination of             x$2
 [pound]1=$2...............................................
                                                            ------------
                                                                  14,000
Spot Value of Equity Pool..................................       14,000
Less 100% of Basis Pool....................................      (7,250)
                                                            ------------
    Section 987 gain.......................................        6,750
------------------------------------------------------------------------

    (iii) Under paragraph (c)(3)(i) of this section, U.S. Corp does 
not recognize the $6,750 of section 987 gain determined on the 
transition date. Instead, the $6,750 will be treated as net 
unrecognized section 987 gain of UK Branch for 2010 and subsequent 
years

[[Page 52916]]

(in addition to any net unrecognized section 987 gain or loss 
otherwise determined at the close of 2010 and subsequent years). 
Recognition of net unrecognized section 987 gain or loss is governed 
by Sec.  1.987-5.
    (iv) Pursuant to paragraph (c)(3)(ii) of this section, when 
computing the exchange rates used to determine the amount of assets 
and liabilities transferred from U.S. Corp to UK Branch on the 
transition date, U.S. Corp must adjust the historic exchange rates 
attributable to such assets to take into account UK Branch's section 
987 gain determined under paragraph (c)(3) of this section. Under 
these facts, where all of UK Branch's assets are considered to 
generate deferred section 987 gain, U.S. Corp takes into account 
this section 987 gain by translating the assets deemed contributed 
by U.S. Corp to UK Branch on the transition date using the same spot 
rate it used to determine UK Branch's section 987 gain on the deemed 
termination date of December 31, 2009. Accordingly, on January 1, 
2010, U.S. Corp translates the assets deemed contributed (cash is 
segregated for ease of illustration) to UK Branch as follows:

----------------------------------------------------------------------------------------------------------------
                                            Amount in
                  Asset                      [pound]                  Translation rate               Amount in $
----------------------------------------------------------------------------------------------------------------
Cash.....................................  [pound]1,00  Spot rate on 12/31/09 of [pound]1=$2.......       $2,000
                                                     0
Cash.....................................          250  Spot rate on 12/31/09 of [pound]1=$2.......          500
Cash.....................................          250  Spot rate on 12/31/09 of [pound]1=$2.......          500
Cash.....................................          250  Spot rate on 12/31/09 of [pound]1=$2.......          500
Cash.....................................          250  Spot rate on 12/31/09 of [pound]1=$2.......          500
Truck....................................        4,000  Spot rate on 12/31/09 of [pound]1=$2.......        8,000
Computer.................................        1,000  Spot rate on 12/31/09 of [pound]1=$2.......        2,000
                                          ----------------------------------------------------------------------
    Total assets.........................        7,000  ...........................................       14,000
Liabilities..............................            0  ...........................................            0
----------------------------------------------------------------------------------------------------------------

    Example 2. Deferral transition method. (i) The facts are the 
same as in Example 1 except that U.S. Corp and UK Branch use an 
``earnings only'' approach to determine section 987 gain or loss 
prior to the transition date. Under this approach, U.S. Corp 
maintains a basis and equity pool for UK Branch's earnings and a 
separate basis and equity pool for UK Branch's capital. Section 987 
gain or loss is only recognized on remittances of earnings (but not 
with respect to capital) under principles similar to those of the 
1991 proposed section 987 regulations. Remittances are first 
considered as distributed from the earnings equity pool and then 
from the capital equity pool. For purposes of this example, this 
method is assumed to be a reasonable section 987 method and does not 
violate Sec.  1.987-10(a)(2).
    (ii) Using principles similar to those set forth in Sec.  1.987-
2 of the 1991 proposed section 987 regulations, the earnings equity 
pool of UK Branch is [pound]1,000 ([pound]250 earned in each taxable 
year of 2006, 2007, 2008 and 2009) and the corresponding earnings 
basis pool is $1,250 ($275 in 2006, $300 in 2007, $325 in 2008 and 
$350 in 2009). The capital equity pool is [pound]6,000 and the 
corresponding capital basis pool is $6,000 (contributed cash of 
[pound]6,000 translated to equal $6,000--which U.S. Corp can trace 
to contributed cash remaining of [pound]1,000 with a translated 
basis equal to $1,000; a truck of [pound]4,000 with a translated 
basis equal to $4,000; and a computer of [pound]1,000 with a 
translated basis equal to $1,000).
    (iii) Pursuant to paragraph (c)(3)(i) of this section, U.S. Corp 
must determine UK Branch's section 987 gain or loss on January 1, 
2010, using its prior section 987 method (the ``earnings only'' 
method), as if UK Branch terminated on December 31, 2009. Using 
principles similar to Sec.  1.987-3(h) of the 1991 proposed section 
987 regulations with respect to the earnings equity and basis pool, 
U.S. Corp would determine $750 of section 987 gain as follows:

Earnings Equity Pool on 12/31/09...........................  [pound]1,00
                                                                       0
Multiplied by spot rate on date of deemed termination of            x $2
 [pound]1=$2...............................................
                                                            ------------
                                                                  $2,000
Spot Value of Earnings Equity Pool.........................       $2,000
Less 100% of Earnings Basis Pool...........................     ($1,250)
                                                            ------------
    Section 987 gain.......................................         $750
------------------------------------------------------------------------

    (iv) Under paragraph (c)(3)(i) of this section, U.S. Corp does 
not recognize the $750 of section 987 gain determined on the 
transition date. Instead, the $750 will be treated as net 
unrecognized section 987 gain of UK Branch for 2010 and subsequent 
years (in addition to any net unrecognized section 987 gain or loss 
otherwise determined at the close of 2010 and subsequent years). 
Recognition of net unrecognized section 987 gain or loss is governed 
by Sec.  1.987-5.
    (v) Pursuant to paragraph (c)(3)(ii) of this section, when 
computing the exchange rates used to determine the amount of assets 
and liabilities transferred from U.S. Corp to UK Branch on the 
transition date, U.S. Corp must adjust the historic exchange rates 
attributable to such assets to take into account UK Branch's section 
987 gain determined under paragraph (c)(3) of this section. Under 
these facts, U.S. Corp may reasonably take into account UK Branch's 
section 987 gain by translating those UK Branch's assets that 
generated such gain using the same spot rate it used to determine UK 
Branch's section 987 gain on the termination date of December 31, 
2009 and by determining the translation rate of other assets by 
reference to the traced basis of such assets. Accordingly, on 
January 1, 2010, U.S. Corp translates the deemed contributions to UK 
Branch as follows:

----------------------------------------------------------------------------------------------------------------
                                            Amount in
                  Asset                      [pound]                  Translation rate               Amount in $
----------------------------------------------------------------------------------------------------------------
Contributed Cash.........................  [pound]1,00  Spot rate on 1/1/06 of [pound]1=$1.........       $1,000
                                                     0
Cash.....................................          250  Spot rate on 12/31/09 of [pound]1=$2.......          500
Cash.....................................          250  Spot rate on 12/31/09 of [pound]1=$2.......          500
Cash.....................................          250  Spot rate on 12/31/09 of [pound]1=$2.......          500
Cash.....................................          250  Spot rate on 12/31/09 of [pound]1=$2.......          500
Truck....................................        4,000  Spot rate on 1/1/06 of [pound]1=$1.........        4,000
Computer.................................        1,000  Spot rate on 1/1/06 of [pound]1=$1.........        1,000
                                          ----------------------------------------------------------------------
    Total assets.........................        7,000  ...........................................        8,000
Liabilities..............................            0  ...........................................            0
----------------------------------------------------------------------------------------------------------------

    (vi) If UK Branch was not able to trace historic dollar basis as 
set forth in paragraph (v) of this Example 2, when translating the 
assets deemed contributed to UK Branch on January 1, 2010, under 
paragraph (c)(3)(ii) of this section, U.S. Corp would be required to 
use exchange rates that take into account a reasonable allocation of 
the aggregate historic basis and the $750 of deferred section 987 
gain to the UK Branch assets.
    Example 3. Fresh start transition method. (i) The facts are the 
same as in Example 1,

[[Page 52917]]

except that U.S. Corp chooses to use the fresh start transition 
method of paragraph (c)(4) of this section in transitioning from the 
1991 proposed regulations to the method prescribed in the current 
regulations. Pursuant to paragraph (c)(4)(i) of this section, UK 
Branch is deemed to terminate on December 31, 2009. However, no 
section 987 gain or loss will be determined or recognized. On 
January 1, 2010, when translating the assets deemed contributed to 
UK Branch, U.S. Corp will use the historic exchange rates existing 
on the date the assets were acquired by UK Branch pursuant to 
paragraph (c)(4)(ii) of this section. Accordingly, U.S. Corp 
translates the assets deemed contributed (cash is segregated for 
ease of illustration) to UK Branch as follows:

----------------------------------------------------------------------------------------------------------------
                                            Amount in
                  Asset                      [pound]                  Translation rate               Amount in $
----------------------------------------------------------------------------------------------------------------
Contributed Cash.........................  [pound]1000  Spot rate on 1/1/06 of [pound]1=$1.........       $1,000
Cash.....................................          250  Ave. rate for 2006 of [pound]1=$1.10.......          275
Cash.....................................          250  Ave. rate for 2004 of [pound]1=$1.20.......          300
Cash.....................................          250  Ave. rate for 2005 of [pound]1=$1.30.......          325
Cash.....................................          250  Ave. rate for 2006 of [pound]1=$1.40.......          350
Truck....................................         4000  Spot rate on 1/1/06 of [pound]1=$1.........        4,000
Computer.................................         1000  Spot rate on 1/1/06 of [pound]1=$1.........        1,000
                                          ----------------------------------------------------------------------
    Total assets.........................         7000  ...........................................        7,250
Liabilities..............................            0  ...........................................            0
----------------------------------------------------------------------------------------------------------------

    (ii) If UK Branch was not able to trace historic dollar basis as 
set forth in paragraph (i) of this Example 3, when translating the 
assets deemed contributed to UK Branch on January 1, 2010, under 
paragraph (c)(3)(ii) of this section, U.S. Corp would be required to 
use exchange rates that take into account a reasonable allocation of 
the aggregate historic basis of the UK Branch assets.


Sec.  1.987-11  Effective date.

    (a) In general. Except as otherwise provided in this section, these 
regulations shall apply to taxable years beginning one year after the 
first day of the first taxable year following the date of publication 
of a Treasury decision adopting this rule as a final regulation in the 
Federal Register.
    (b) Election to apply these regulations to taxable years beginning 
after the date of publication of a Treasury decision adopting this rule 
as a final regulation in the Federal Register. A taxpayer may elect to 
apply these regulations to taxable years beginning after the date of 
publication of a Treasury decision adopting this rule as a final 
regulation in the Federal Register. Such election shall be binding on 
all members that file a consolidated return with the taxpayer and any 
controlled foreign corporation, as defined in section 957, in which the 
taxpayer owns more than 50 percent of the voting power or stock (as 
determined in section 957(a)). An election made under this paragraph 
shall be made in accordance with Sec.  1.987-1(f).
    Par. 6. Section 1.988-1 is amended by:
    1. Adding paragraphs (a)(3) and (a)(4).
    2. Revising paragraph (a)(10)(ii).
    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) * * *
    (3) Certain transactions of a section 987 QBU denominated in the 
functional currency of the owner are not treated as section 988 
transactions. Transactions described in Sec.  1.987-3(e)(2) (regarding 
certain transactions that are denominated in the functional currency of 
the owner of a section 987 QBU) are not treated as section 988 
transactions to a section 987 QBU. Thus, no currency gain or loss shall 
be recognized by a section 987 QBU under section 988 with respect to 
such items.
    (4) Treatment of assets and liabilities of a partnership or DE that 
are not attributed to an eligible QBU--(i) Scope. This paragraph (a)(4) 
applies to assets and liabilities of a partnership, or of an entity 
disregarded as an entity separate from its owner for U.S. Federal 
income tax purposes (DE), that are not attributable to an eligible QBU 
(within the meaning of Sec.  1.987-1(b)(3)) as provided under Sec.  
1.987-2(b).
    (ii) Partnerships. For purposes of applying section 988 and the 
applicable regulations to transactions involving the assets and 
liabilities described in paragraph (a)(4)(i) of this section that are 
held by a partnership, the owners of the 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 the 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 of such assets and liabilities.
    (iv) Example. The following example illustrates the application of 
paragraph (a)(4) of this section:

    Example. Liability held through a 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 that has the yen as its functional 
currency. On January 1, year 1, 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, year 1, P used the yen it 
borrowed from the lender to acquire 100% of the stock of F, a 
foreign corporation, from an unrelated person. P also holds an 
eligible section 987 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 P books and records 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 books and records of 
P, but are not reflected on such books and records for purposes of 
section 987 pursuant to Sec.  1.987-2(b)(2)(i)(A) and (C), 
respectively.
    (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 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 share of such stock and liability, determined under 
Sec.  1.987-7(b), for purposes of applying section 988. As a result, 
P's becoming the obligor under the portion of the yen-denominated 
note that is treated as being 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 disposition of yen on payments of 
interest and principal on the liability, to the extent such yen are 
treated as

[[Page 52918]]

owned by X, are section 988 transactions under paragraphs (a)(1)(i) 
and (a)(3) of this section. P's becoming the obligor under 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.
    (5) [Reserved].
* * * * *
    (10) * * *
    (ii) Certain transfers. (A) 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 the 
owner where as a result of such transfers the currency or other such 
item--
    (i) Loses its character as nonfunctional currency or an item 
described in paragraph (a)(2) of this section; or
    (ii) Where the source of the exchange gain or loss could be altered 
absent the application of this paragraph (a)(10)(ii).
    (B) Such exchange gain or loss 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 which 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), 
(a)(5), 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 the date of publication of a Treasury decision adopting this 
rule as a final regulation in the Federal Register. If a taxpayer makes 
an election under Sec.  1.987-11(b), then the effective date of the 
revisions to paragraphs (a)(3), (a)(4), and (a)(10)(ii) of this section 
with respect to the taxpayer shall be consistent with such election.
    Par. 7. 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 of a qualified business unit.
    (ii) Effective date. Generally, paragraph (b)(2)(i) of this section 
shall apply to taxable years beginning one year after the first day of 
the first taxable year following the date of publication of a Treasury 
decision adopting this rule as a final regulation in the Federal 
Register. If a taxpayer makes an election under Sec.  1.987-11(b), then 
the effective date of paragraph (b)(2)(i) with respect to the taxpayer 
shall be consistent with such election.
* * * * *
    Par. 8. Section 1.989(a)-1 is amended as follows:
    1. The last sentence of paragraph (b)(2)(i) is revised.
    2. Paragraph (b)(4) is added.
    The revision and addition reads as follows:


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

    (b) * * *
    (2) * * *
    (i) Persons--* * * A trust or estate is a QBU of the beneficiary.
* * * * *
    (4) Effective date. Generally, the revisions to paragraph (b)(2)(i) 
of this section shall apply to taxable years beginning one year after 
the first day of the first taxable year following the date of 
publication of a Treasury decision adopting this rule as a final 
regulation in the Federal Register. If a taxpayer makes an election 
under Sec.  1.987-11(b), then the effective date of the revisions to 
paragraph (b)(2)(i) of this section with respect to the taxpayer shall 
be consistent with such election.
* * * * *


Sec.  1.989(c)-1  [Removed]

    Par. 9. Section 1.989(c)-1 is removed.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 06-7250 Filed 9-6-06 8:45 am]
BILLING CODE 4830-01-P