Treasury Releases Final and Temporary Section 987 Regulations

On December 7, 2016, the treasury released final and temporary Section 987 regulations (“final §987 regulations”), addressing both the determination of taxable income or loss, as well as any §987 gain or loss of a taxpayer associated with a qualified business unit. The final §987 regulations supersede the regulations that were released on September 6, 2006 (“proposed 2006 §987 regulations”). Although the overall structure that was outlined in the proposed 2006 §987 regulations largely remains in place, the final regulations contain a couple of significant modifications.

General §987 overview:

In general, §987 addresses the branch operations of a taxpayer’s qualified business unit (“QBU”) where the QBU has a functional currency that differs from the functional currency of the taxpayer. Code section 987 provides that a taxpayer must include in income the current operations of the QBU by first calculating the income of the QBU in the functional currency of the QBU, using U.S. tax principles, and then by translating into the functional currency of the taxpayer using, for the most part, the average exchange rate for the year. Code section 987 also requires the recognition of gain or loss upon a remittance from the QBU to their tax owner to the extent that the value of the foreign currency remittance, relative to the taxpayer’s functional currency, differs from the value when earned, and included in the taxpayers income.

Final §987 regulations:

Although the final §987 regulations adopted, for the most part, the proposed 2006 §987 regulations, there were a number of significant revisions.

Impacted Taxpayers

The final regulations only apply to individuals and corporations that either own §987 QBUs directly, or indirectly through a §987 aggregate partnership. They do not apply to trusts, estates, S Corporations, or partnerships other than aggregate partnerships. An aggregate partnership is a partnership which is 100% owned by “related persons”.

The final regulations also retain the “flat approach” concept that was outlined in the proposed regulations in regards to tiered QBU’s. Under the flat approach, the QBU is treated as being held by the ultimate tax owner.

Effective Date

Taxpayers will generally be required to adopt the final §987 regulations for taxable years beginning on or after one year after the first day of the first year following the publication of the regulations (i.e., January 1, 2018, for calendar year taxpayers). Taxpayers may instead elect to early-adopt the final regulations for years beginning in 2017.

“Fresh Start”

Solely for purposes of §987, all §987 QBUs that have not previously elected to adopt the proposed 2006 §987 regulations will be deemed to terminate on the day before the adoption date, with the owner of the QBU being deemed to transfer the assets and liabilities of the “old” QBU to a “new” QBU. Under the final §987 regulations, no §987 gain or loss will be recognized as a result of the deemed termination. Under the fresh start transition method, unrecognized §987 gain or loss determined under a prior §987 method is not taken into account, and marked assets and liabilities reflected on a §987 QBU's balance sheet on the transition date are translated using a historic rate.

As a result of the fresh start initiative, and the deferral rules (discussed below), a significant portion of any unrealized gains and losses may be lost. As such, taxpayers will need to evaluate and record, in the quarter encompassing the enactment date [December 2016], the potential financial reporting impact in regards to any recorded §987 deferred tax attributes.

Deferral Rules

The temporary regulations provide a set of deferral rules intended to prevent taxpayers from triggering and accelerating certain §987 gains and losses, resulting from QBU terminations, that occur on or after January 6, 2017. As a result of these new deferral rules, both §987 gains and losses of the transferor can be deferred until the QBU makes a remittance to its owner. To the extent that §987 gains and losses are not recognized prior to the transition date, these deferred gains and losses will be eliminated as a part of the fresh start transition.

One caveat to the above deferral rules comes in the instance in which a QBU’s assets are transferred or deemed transferred by a U.S. owner to a foreign corporation that is a member of the same controlled group. Although any potential §987 losses are disallowed, §987 gains would be recognized.

Controlled Foreign Corporations

The final regulations confirm that a foreign corporation is required to determine the taxable income of a §987 QBU for purposes of calculating earnings and profits. The final regulations also specify that any §987 gain or loss recognized by a CFC is generally treated as Subpart F income in the same proportion that the assets giving rise to the Subpart F income bear to the total assets of the QBU. Finally, the regulations allow for the offsetting of §987 loss against a §988 gain, and vice versa.

Implications

There are several action items on which taxpayers should focus to be in compliance with the finalized §987 regulations.

  1. To the extent a taxpayer has recorded a deferred tax attribute on its financial statements with respect to any unrealized §987 losses or gains and has not formerly elected the proposed 2006 regulations, they may need to reverse the balance through continuing operations in the quarter encompassing the enactment date [December 2016] due to the fresh start method discussed above.
  2. A taxpayer that owns a §987 QBU must keep a copy of its §987 elections and maintain records that sufficiently establish the QBU’s taxable income or loss and any §987 gain or loss. This will require companies to confirm all §987 QBUs in their organizational structures and confirm adequate documentation is in place.
  3. A taxpayer will be required to file detailed “Section 987 Transition Information” with their timely filed return for the first tax year to which the regulations apply, including a description of each §987 QBU to which the rules apply, the QBU’s principal place of business, a description of the prior Section 987 method used by the taxpayer, and any assumptions used for determining the exchange rates used to translate the amount of assets and liabilities transferred to the Section 987 QBU on the transition date.