On December 11, 2024, the IRS and Treasury Department published final regulations (TD 10016) under IRC Section 987 (the Final Regulations) on determining the taxable income or loss and currency gain or loss for a qualified business unit (a QBU) whose functional currency differs from its tax owner (an IRC Section 987 QBU). The IRS and Treasury Department also published proposed regulations (REG-117213-24) (the 2024 Proposed Regulations), which provide an election to simplify the computation of unrecognized IRC Section 987 gain or loss on certain recurring transactions.

The Final Regulations retain the basic approach and structure of the 2023 proposed regulations (the 2023 Proposed Regulations (see Tax Alert 2023-1898)), including the FEEP method, and elections to (1) treat all items of an IRC Section 987 QBU as marked items (subject to a loss suspension rule) (the Current Rate Election), and (2) recognize IRC Section 987 gain or loss for an IRC Section 987 QBU on an annual basis (the Annual Recognition Election). The Final Regulations also introduce new rules on (1) the determination of whether an owner of an IRC Section 987 QBU has applied an eligible pretransition method, (2) the application of loss suspension rules (the Loss-to-the-Extent-of-Gain Rule), (3) the character and source of IRC Section 987 gain or loss, (4) IRC Section 988 transactions of an IRC Section 987 QBU, and (5) IRC Section 988 gain or loss on a net investment hedge of an IRC Section 987 QBU.

Background

Under IRC Section 987(1) and (2), taxpayers must determine taxable income or loss for an IRC Section 987 QBU in the functional currency of the QBU and translate that amount at the average exchange rate for the tax year. Under IRC Section 987(3), taxpayers must make "proper adjustments" for transfers of property between an IRC Section 987 QBU and its owner. Several regulations on the application of these rules have been issued and withdrawn since 1991.

On December 8, 2016, the IRS and the Treasury Department published final (T.D. 9794) (the 2016 Final Regulations), temporary (T.D. 9795) (the 2016 Temporary Regulations), and proposed regulations (REG-128276-12) under IRC Section 987. See Tax Alert 2016-2117. Effective May 13, 2019, Treasury and the IRS finalized certain provisions of the 2016 Temporary Regulations (the 2019 Final Regulations). See Tax Alert 2019-0932.

The 2016 Final Regulations generally adopt the FEEP method for determining IRC Section 987 taxable income or loss and net unrecognized IRC Section 987 gain or loss. Under the FEEP method, the owner of an IRC Section 987 QBU determines all items of income, gain, deduction and loss attributable to the QBU in the QBU's functional currency, and then translates those items into the owner's functional currency. The basis of "historic assets" is translated at the average exchange rate for the tax year during which the asset was acquired. All other items (including the amount realized on a sale or exchange of an historic asset) are translated into the owner's functional currency at the average exchange rate for the tax year.

In addition, the owner of an IRC Section 987 QBU must determine the pool of unrecognized IRC Section 987 gain or loss based on the annual increase or decrease to the QBU's balance sheet that is attributable to exchange rate fluctuations. The IRC Section 987 gain or loss for each year equals the increase or decrease in the basis of assets (net of liabilities) of the IRC Section 987 QBU, measured in the owner's functional currency and adjusted for transfers between the QBU and its owner and for the QBU's taxable income or loss. The bases of historic items are translated at historic exchange rates, while "marked items" are translated at the applicable spot rate. A marked item includes an asset or liability that would generate gain or loss under IRC Section 988 if it were held or entered into directly by the owner, as well as IRC Section 988 transactions of the IRC Section 987 QBU.¹ A historic item is an asset or liability that is not a marked item. Thus, under the FEEP method, IRC Section 987 gain or loss reflects currency fluctuations with respect to marked items and is not imputed to historic items that are not subject to IRC Section 988. An owner generally recognizes IRC Section 987 gain or loss upon a remittance from, or upon a termination of, its IRC Section 987 QBU, subject to the deferral rules of Treas. Reg. Section 1.987-12.

The 2016 Final Regulations originally applied to tax years beginning on or after one year after the first day of the first tax year following December 7, 2016. That date, however, has been deferred every year since the 2016 Final Regulations were released (see Tax Alerts 2017-1621, 2018-1241, 2019-2179, 2020-2291, 2021-1886, 2022-1248). In the absence of final guidance, Treasury and the IRS generally required taxpayers to apply a reasonable method in complying with IRC Section 987(3), such as the earnings and capital method described in the 1991 proposed regulations (the 1991 Proposed Regulations) or an earnings-only method.

IRC Section 987 Final Regulations

The Final Regulations retain the FEEP method (with certain modifications) as the default method for complying with IRC Section 987, while reducing the compliance burden and providing several simplifying elections that more closely align to financial accounting standards and the 1991 Proposed Regulations (e.g., determining whether a transaction is an IRC Section 988 transaction by reference to the functional currency of the IRC Section 987 QBU, as discussed later). Certain elections, however, may restrict loss recognition or the ability to control the timing of gain or loss recognition.

Treas. Reg. Section 1.987-1: Scope, certain definitions, special rules, and election procedures

The Final Regulations generally apply to any individual or C corporation, including entities that were excluded from the 2016 Final Regulations (i.e., banks, insurance companies, leasing companies, finance coordination centers, and regulated investment companies). The Final Regulations do not apply to individuals who are not US persons or to foreign corporations that are either not CFCs or are CFCs in which no US shareholders own (within the meaning of IRC Section 958(a)) stock. The Final Regulations generally do not apply to partnerships and S corporations; however, certain provisions of the regulations (including the loss suspension rules) apply to those entities.

An IRC Section 987 QBU is an eligible QBU whose functional currency differs from its owner. An eligible QBU is a QBU that is not subject to the dollar-approximate-separate-transaction-method rules of Treas. Reg. Section 1.985-3. A QBU generally refers to the activities of a corporation, partnership, trust, estate or disregarded entity (DE) that constitute a trade or business for which a set of books and records are maintained. An owner is any person having direct ownership in an eligible QBU. An eligible QBU cannot be the owner of another eligible QBU. Solely for purposes of IRC Section 987, an owner may elect to group all IRC Section 987 QBUs with the same functional currency as a single IRC Section 987 QBU. In addition, taxpayers may elect to determine spot rates for certain purposes of the Final Regulations determined by reference to a reasonable period not to exceed three months.

Under the Final Regulations, available elections under IRC Section 987 (an IRC Section 987 election) are made for the owner of the IRC Section 987 QBU and for a tax year and applies to every IRC Section 987 QBU of that owner. Once made, an IRC Section 987 election remains effective until revoked. An IRC Section 987 election is made by the authorized person, as described in the Final Regulations. Consistency rules require IRC Section 987 elections to apply to all members of a US consolidated group, and certain CFCs and foreign partnerships if certain ownership requirements are met.

An IRC Section 987 election generally may not be made or revoked without IRS consent. However, the authorized person may make an IRC Section 987 election without IRS consent on its original, timely filed (including extensions) return for the first tax year of an owner to which the Final Regulations apply. Additionally, the authorized person may make the Current Rate, Annual Recognition, or Section 988 MTM Election (defined later) without IRS consent by filing an election statement with the IRS on or before the first day of the tax year to which the election applies and attaching a copy of the statement to its return. Once made, a Current Rate Election, an Annual Recognition Election, or a Section 988 MTM Election may not be revoked without IRS consent for five years. Once revoked, these elections may not be made again without IRS consent for five years.

Treas. Reg. Section 1.987-2: Attribution of items to eligible QBUs; definition of transfer and related rules

Items are generally attributed to an eligible QBU to the extent they are reflected on the separate set of books and records of the QBU and must be adjusted to conform to US federal income tax principles. Non-portfolio stock, partnership interests, and certain acquisition indebtedness, along with income, gain, deduction or loss arising from these items, generally are not attributable to an eligible QBU.

Solely for purposes of IRC Section 987, an asset or liability is treated as transferred to (or from) an IRC Section 987 QBU or from (or to) its owner if the item is (or is no longer) recorded on its books and records as a result of a disregarded transaction. However, transactions between members of the same grouped IRC Section 987 QBU are not treated as transfers between the IRC Section 987 QBUs and their owner. Certain disregarded transactions, such as combinations and separations of IRC Section 987 QBUs under the same owner, are similarly not treated as transfers. General tax law principles apply for purposes of determining whether there is a transfer of an asset or liability.

The adjusted basis or amount of a marked item transferred to an IRC Section 987 QBU is translated at the spot rate the date of the transfer. In the absence of a Current Rate Election, the adjusted basis or amount of a historic item transferred to an IRC Section 987 QBU is translated at the historic rate, which is generally the yearly average exchange rate applicable to the year the asset was acquired or the year the liability was incurred or assumed.

Treas. Reg. Section 1.987-3: Determination of IRC Section 987 taxable income or loss of an owner of an IRC Section 987 QBU

An IRC Section 987 QBU generally must determine its items of income, gain, deduction and loss in its functional currency under federal income tax principles. Items denominated in (or determined by reference to) a nonfunctional currency (including the functional currency of the owner) generally are translated into the IRC Section 987 QBU's functional currency at the spot rate on the date the item is properly taken into account.

Under the Final Regulations, whether a transaction is an IRC Section 988 transaction is determined by reference to the functional currency of the IRC Section 987 QBU (instead of the owner's functional currency). Further, IRC Section 988 gain or loss on IRC Section 988 transactions of an IRC Section 987 QBU (including transactions denominated in the owner's functional currency) is determined in the functional currency of the IRC Section 987 QBU, and IRC Section 988 transactions are treated as marked items. The Final Regulations allow an IRC Section 987 QBU to elect to apply a mark-to-market method of accounting for all of its IRC Section 988 transactions (IRC Section 988 MTM Election). Under such election, the timing of IRC Section 988 gain or loss on IRC Section 988 transactions of the IRC Section 987 QBU is determined under the principles of IRC Section 1256, only IRC Section 988 gain or loss is taken into account, and any such gain or loss is not subject to the netting rule of Treas. Reg. Section 1.988-2(b)(8).

The owner of an IRC Section 987 QBU generally translates income, gain, deduction, or loss attributable to an IRC Section 987 QBU into its functional currency at the yearly average exchange rate for the tax year. Special rules apply to certain items, such as basis recovery with respect to historic assets and cost of goods sold, where neither the Current Rate Election nor the Annual Recognition Election is in effect.

Treas. Reg. Section 1.987-4: Determination of net unrecognized IRC Section 987 gain or loss of an IRC Section 987 QBU

An owner generally must determine the net unrecognized IRC Section 987 gain or loss of an IRC Section 987 QBU on an annual basis. The net unrecognized IRC Section 987 gain or loss equals the sum of the IRC Section 987 QBU's net accumulated unrecognized IRC Section 987 gain or loss determined in all prior tax years and the unrecognized IRC Section 987 gain or loss in the current tax year. Net accumulated unrecognized IRC Section 987 gain or loss for all prior tax years is reduced by the IRC Section 987 gain or loss recognized, amounts treated as deferred IRC Section 987 gain or loss, and suspended IRC Section 987 loss. Thus, net accumulated unrecognized IRC Section 987 gain or loss is not reduced when deferred IRC Section 987 gain or loss or suspended IRC Section 987 loss is recognized.

A taxpayer generally determines its unrecognized IRC Section 987 gain or loss for any tax year using a 10-step process. In step 1, the taxpayer determines the change in owner functional currency net value (OFCNV) by subtracting the OFCNV on the last day of the preceding tax year from the OFCNV on the last day of the tax year. The OFCNV of an IRC Section 987 QBU equals the aggregate amount of functional currency and the adjusted basis of each other asset on the IRC Section 987 QBU's tax basis balance sheet, less the aggregate amount of each liability on the IRC Section 987 QBU's tax basis balance sheet. In each case, marked items are translated into the owner's functional currency at the spot rate on the last day of the relevant tax year, and historic items are translated into the owner's functional currency at the historic rate. If a Current Rate Election is in effect, the OFCNV on the last day of the tax year equals the QBU net value translated into the owner's functional currency at the spot rate on such date.

The Final Regulations allow taxpayers that make a Current Rate Election to use certain elements of the earnings and capital method in lieu of preparing a tax basis balance sheet. Under that alternative, the QBU net value on the last day of a tax year equals the QBU net value at the end of the preceding tax year, adjusted by transfers of assets and liabilities between the IRC Section 987 QBU and its owner and by income or loss of the IRC Section 987 QBU (each determined in the functional currency of the IRC Section 987 QBU), translated into the owner's functional currency at the spot rate on such date.

The change in OFCNV following step 1 is then generally adjusted as follows to determine the unrecognized IRC Section 987 gain or loss for a tax year:

• Increased or decreased for assets and liabilities transferred between the IRC Section 987 QBU and its owner (steps 2-5)
• Decreased or increased by the IRC Section 987 taxable income or loss for the year, determined under Treas. Reg. Section 1.987-3 (step 6)
• Increased or decreased by certain expenses, losses, income or gains that are not deductible from or included in the computation of IRC Section 987 taxable income or loss (steps 7-8)
• Increased or decreased by any income or gain, or any deduction or loss, that does not impact the IRC Section 987 QBU's balance sheet (step 9)
• Decreased or increased by any amounts that increased or decreased the IRC Section 987 QBU's net assets that were not previously taken into account under steps 2-9 (step 10) (this residual step is intended to ensure that non-currency-related changes to the balance sheet do not artificially increase or decrease the pool of net unrecognized IRC Section 987 gain or loss)

Special rules apply to determine the net accumulated unrecognized IRC Section 987 gain or loss for combining and separating QBUs. If a Current Rate Election is in effect, taxpayers must apply only steps 1-5 and step 10.

Treas. Reg. Section 1.987-5: Recognition of IRC Section 987 gain or loss

In general, an owner recognizes IRC Section 987 gain or loss upon remittances from an IRC Section 987 QBU. A remittance is determined in the QBU's functional currency on the last day of the tax year and equals the excess of the amounts transferred from the IRC Section 987 QBU to the owner during the tax year over the amounts transferred from the owner to the IRC Section 987 QBU during the year.

For these purposes, the aggregate amount transferred from the IRC Section 987 QBU to the owner is the aggregate amount of functional currency and the aggregate adjusted basis of other assets transferred, determined in the IRC Section 987 QBU's functional currency. Liabilities transferred from the owner to the IRC Section 987 QBU are treated as transfers of assets from the IRC Section 987 QBU to the owner with an adjusted basis equal to the liability. The amount of transfers from the owner to the IRC Section 987 QBU is determined in a similar manner. In general, the owner's adjusted basis and liabilities are translated into the owner's functional currency at the spot rate on the date of the transfer (for marked items) or the historic rate (for historic items).

Taxpayers may compute the remittances using an alternative calculation intended to reduce the burden of tracking disregarded transfers while preserving consistency with the text and purposes of IRC Section 987. First, the taxpayer determines the difference between the QBU net value on the last day of the tax year and the QBU net value on the last day of the preceding tax year. The QBU net value on the last day of the preceding tax year is zero in the first tax year in which the IRC Section 987 QBU exists. This amount is then adjusted (including below zero) for income or loss of the IRC Section 987 QBU, except for items that do not impact the tax basis balance sheet. The remittance is determined by multiplying this amount by negative one. If the amount determined under this formula is less than zero, the remittance is zero. Mathematically, the formula is intended to produce an amount equaling the aggregate net transfer from the IRC Section 987 QBU to its owner for the tax year.

The owner's IRC Section 987 gain or loss recognized equals the product of (1) the owner's net unrecognized IRC Section 987 gain or loss on the last day of the tax year, and (2) the owner's remittance proportion. The owner's remittance proportion equals the remittance divided by the sum of (1) the total adjusted basis of the IRC Section 987 QBU's assets attributable to the IRC Section 987 QBU at the end of the year, determined in the functional currency of the IRC Section 987 QBU, and (2) the remittance.

A termination of an IRC Section 987 QBU under Treas. Reg. Section 1.987-8 is treated as a remittance of all the gross assets of the IRC Section 987 QBU to the owner on the date of the termination. Alternatively, a taxpayer may annually recognize all of its unrecognized IRC Section 987 gain or loss by making an Annual Recognition Election; however, certain loss suspension rules may apply, as discussed later.

Treas. Reg. Section 1.987-6: Character and source of IRC Section 987 gain or loss

IRC Section 987 gain or loss is ordinary income or loss. Under the Final Regulations, the character and source of IRC Section 987 gain or loss is determined for all purposes of the IRC, including IRC Sections 904(d), 907, and 954. This determination is based on an initial assignment of the IRC Section 987 gain or loss in the earliest tax year in which (1) net unrecognized IRC Section 987 gain or loss is recognized; (2) the net unrecognized IRC Section 987 loss or pretransition loss becomes IRC Section 987 suspended loss; or (3) the net unrecognized IRC Section 987 gain or loss becomes deferred IRC Section 987 gain or loss. For pretransition gain or loss subject to the 10-year amortization election (described later), the initial assignment occurs in the tax year that includes the transition date.

The initial assignment is made under the asset method in Treas. Reg. Section 1.861-9(g) and Temp. Treas. Reg. Section 1.861-9T(g) using the tax book value of the assets that are attributable to the IRC Section 987 QBU. The initial assignment is made after applying the income attribution rules or principles of Treas. Reg. Sections 1.904-4(f)(2)(vi) or 1.951A-2(c)(7)(ii)(B)(2), but before allocating and apportioning expenses to gross income, and before applying provisions that require a net income computation.

However, IRC Section 987 gain or loss may be reassigned if required after applying provisions that require a net income computation. For example, if an item of IRC Section 987 gain is initially assigned to tentative tested income, it will be reassigned to tested income or residual income depending on whether the taxpayer has made the GILTI high-tax exclusion election and, if so, whether the item is subject to a high rate of tax. In addition, the Final Regulations retain the rule from the 2023 Proposed Regulations that treated IRC Section 987 gain or loss as a single tentative tested income item that is separate from the CFC's other tested units.

The characterization of IRC Section 987 gain or loss is determined under the general rule by assigning IRC Section 987 gain or loss to specific subpart F income groups, rather than as foreign currency gain or loss not eligible for the business needs exception. Thus, for example, if an IRC Section 987 QBU's assets generate only foreign base company sales income, the IRC Section 987 gain or loss will be characterized as foreign base company sales income. Taxpayers may, however, elect to treat IRC Section 987 gain or loss that would otherwise be characterized as passive foreign personal holding company income (passive FPHCI) as foreign currency gain or loss of the CFC owner and ineligible for the business needs exception. The election would allow such a CFC to net its IRC Section 987 and 988 gains and losses to the extent both are characterized as passive FPHCI. Moreover, the election may reduce the number of recognition groupings (described later), which would simplify application of and compliance with the Loss-to-the-Extent-of-Gain Rule.

Treas. Reg. Section 1.987-7: Application of the Final Regulations to partnerships and S corporations

In a significant change from the 2023 Proposed Regulations, the Final Regulations generally do not apply to a partnership, and do not apply to an eligible QBU if a partnership owns the eligible QBU's assets and liabilities. However, taxpayers must apply IRC Sections 987 and 989(a) to partnerships and eligible QBUs of partnerships in a reasonable manner using a method applied consistently from year to year.

Notwithstanding this general exclusion, the following rules apply to (1) an eligible QBU, if a partnership owns the eligible QBU's assets and liabilities and either (A) the partnership (or partner) treats the eligible QBU as an IRC Section 987 QBU of the partnership (i.e., under an entity approach), or (B) a partner in the partnership treats all or a portion of the eligible QBU as an IRC Section 987 QBU of the partner (i.e., under an aggregate approach), and (2) a partnership, if a partner in the partnership treats the partnership itself (or an interest in the partnership) as an IRC Section 987 QBU:

• The character and sourcing rules under Treas. Reg. Section 1.987-6
• The information reporting requirements under Treas. Reg. Section 1.987-9
• The Loss-to-the-Extent of Gain Rule under Treas. Reg. Section 1.987-11, subject to certain exceptions described in the Final Regulations
• The deferral rules under Treas. Reg. Section 1.987-12
• The recognition of IRC Section 987 suspended loss rules under Treas. Reg. 1.987-13
• The Annual Recognition Election, subject to certain modifications and adjustments described in the Final Regulations
• The IRC Section 988 MTM Election

Partnerships must adapt these rules as necessary to recognize IRC Section 987 gain or loss in a manner consistent with the principles of those provisions. These rules also apply to a Terminating QBU (defined later), though the transition rules in Treas. Reg. Section 1.987-10 (described later) do not apply. Treasury and the IRS requested comments on how IRC Section 987 should apply to partnerships, including whether an entity, aggregate or hybrid approach should be adopted for purposes of IRC Section 987.

S corporations are treated in the same manner as partnerships, and shareholders of S corporations are treated in the same manner as partners of partnerships for purposes of the Final Regulations.

Treas. Reg. Section 1.987-8: Termination of an IRC Section 987 QBU

An IRC Section 987 QBU generally terminates when (1) the IRC Section 987 QBU ceases its business operations; (2) the IRC Section 987 QBU transfers substantially all (within the meaning of IRC Section 368(a)(1)(C)) of its assets to its owner; (3) a CFC owning the IRC Section 987 QBU is no longer a CFC; (4) the IRC Section 987 QBU's owner ceases to exist; (5) the IRC Section 987 QBU ceases to be an eligible QBU with a functional currency different from its owner; and (6) certain changes occur in the form of ownership of an eligible QBU (e.g., when an individual or owner of an IRC Section 987 QBU ceases to be the direct owner of the IRC Section 987 QBU because the assets of the IRC Section 987 QBU are transferred to a partnership). In addition, an IRC Section 987 QBU terminates upon the occurrence of certain inbound and outbound liquidations and reorganizations under IRC Sections 332 and 381(a)(2), as well as in foreign-to-foreign liquidations or reorganizations where the functional currency of the distributee/acquiring corporation is the same as the distributor's/transferor's IRC Section 987 QBU.

The termination of an IRC Section 987 QBU results in the remittance of all of the IRC Section 987 QBU's gross assets to its owner immediately before the termination. Thus, a termination generally results in the recognition of any net unrecognized IRC Section 987 gain or loss (subject to the loss suspension and deferral rules).

Treas. Reg. Section 1.987-9: Recordkeeping requirements

An owner must keep a copy of each IRC Section 987 election made by the owner or on its behalf, as well as reasonable records sufficient to establish the IRC Section 987 QBU's taxable income or loss and IRC Section 987 gain or loss. The Final Regulations describe specific categories of information that must be maintained to meet these requirements. The information must be maintained and kept available for inspection by the IRS as long as it may be relevant in administering the Code. Taxpayers could satisfy these obligations to the extent they provide the specific information required on Form 8858 (or its successor) or another form prescribed by the IRS for this purpose.

Treas. Reg. Section 1.987-10: Transition rules

Taxpayers transitioning to the Final Regulations must compute pretransition gain or loss on the day before the transition date (i.e., on the day before the first day of the tax year to which the Final Regulations apply). Special transition rules apply to a QBU that terminated on or after November 9, 2023, including as a result of an entity classification election filed after November 9, 2023, but effective before that date (a Terminating QBU). Specifically, a Terminating QBU must apply these rules immediately before the termination. The consequences of the termination are determined under the Final Regulations after applying this section. Until the general transition date (i.e., the first day of the tax year beginning after December 31, 2024), the owner of the Terminating QBU must apply the Final Regulations to a Terminating QBU (and only the Terminating QBU) without regard to any IRC Section 987 elections, other than the election to treat IRC Section 987 gain or loss as foreign currency gain or loss that is not eligible for the business needs exception. In addition, certain taxpayers may be eligible for a new small business election, under which the owner may elect to treat all of its IRC Section 987 QBUs as having no pretransition gain or loss.

How a taxpayer computes its pretransition gain or loss depends on whether the taxpayer applied an eligible pretransition method. An eligible pretransition method means the following methods, but only if the owner applied the method to an IRC Section 987 QBU on a return filed before November 9, 2023:

• The earnings and capital method described in the 1991 Proposed Regulations
• Any method producing the same total amount of income over the life of the owner of the IRC Section 987 QBU as the earnings-and-capital method
• A method that computes IRC Section 987 gain or loss with respect to earnings but not capital (the other earnings-only method) and does not meet the standard described previously if (1) the owner first applied the method on a return filed before November 9, 2023; (2) the method was applied consistently to all of the owner's IRC Section 987 QBUs; and (3) the owner otherwise applies IRC Section 987 in a reasonable manner.

A method that defers the recognition of IRC Section 987 gain or loss until the IRC Section 987 QBU is terminated, sold or liquidated is not a reasonable method; an anti-abuse rule applies if the owner changed its pretransition method with a principal purpose of reducing its pretransition gain or increasing its pretransition loss. In a significant clarification to the 2023 Proposed Regulations, taxpayers may still be treated as applying an eligible pretransition method under the Final Regulations even if they made errors in the application of an IRC Section 987 method or did not apply the method to every tax year since the QBU's inception. For an error, pretransition gain or loss must be determined as though the eligible pretransition method was applied without error since the IRC Section 987 QBU's inception. In addition, the Final Regulations do not treat consistent practices (such as the use of a yearly average exchange rate rather than the applicable spot rate to certain transfers) as errors. In that case, the consistent practice is taken into account in determining pretransition gain or loss.

If an owner applied an eligible pretransition method, any pretransition gain or loss equals the IRC Section 987 gain or loss that the owner would have recognized under its existing method as if the IRC Section 987 QBU terminated on the day before transition date (ignoring application of the deferral and loss suspension rules), plus the owner's functional currency net value adjustment. This adjustment could be either positive or negative and generally equals the difference between (1) the bases of the assets, reduced by the liabilities, that are attributable to the IRC Section 987 QBU on the day before the transition date and translated into the owner's functional currency at the spot rate on that date, and (2) the same amount translated into the owner's functional currency at the pretransition translation rate. The pretransition translation rate is the rate that would be used under the eligible pretransition method to determine the basis of an asset or amount of a liability in the hands of the owner of the IRC Section 987 QBU.

A taxpayer that did not use an eligible pretransition method must compute pretransition gain or loss using a set of rules prescribed by the regulations. The gain or loss equals the sum of the owner's annual unrecognized IRC Section 987 gain or loss for all tax years ending before the transition date, reduced by the total net IRC Section 987 gain or loss recognized by the owner in those years. The owner's annual unrecognized IRC Section 987 gain is calculated using a simplified version of the computations described in Treas. Reg. Section 1.987-4(d). Thus, taxpayers that did not apply an eligible pretransition method may face substantial compliance requirements in determining the pretransition gain or loss. However, in a significant change from the 2023 Proposed Regulations, these determinations must be made only for tax years beginning after September 7, 2006, rather than from the inception of the IRC Section 987 QBU.

Any pretransition gain is treated as net accumulated unrecognized IRC Section 987 gain, and any pretransition loss is treated as IRC Section 987 suspended loss subject to the Loss-to-the-Extent-of-Gain Rule. In a change from the 2023 Proposed Regulations, pretransition loss with respect to an IRC Section 987 QBU (other than a Terminating QBU) where a Current Rate Election is in effect (but an Annual Recognition Election is not) is treated as net accumulated unrecognized IRC Section 987 loss rather than IRC Section 987 suspended loss. Taxpayers may elect to amortize pretransition gain or loss over 10 years. This amortization election applies at the owner level to each of the owner's IRC Section 987 QBUs. Any unamortized pretransition gain is immediately recognized, and any pretransition loss becomes IRC Section 987 suspended loss, upon certain inbound and outbound transactions described in IRC Section 381(a).

Finally, taxpayers must complete a detailed "Section 987 Transition Information" statement and attach the statement to the owner's timely filed return for the tax year beginning on the transition date for each IRC Section 987 QBU subject to transition.

Treas. Reg. Section 1.987-11: Suspended IRC Section 987 loss relating to certain elections; Loss-to-the-Extent-of-Gain Rule

To prevent taxpayers from selectively recognizing large IRC Section 987 losses, the Final Regulations generally suspend recognition of any IRC Section 987 loss when a Current Rate Election is in effect and the taxpayer did not make an Annual Recognition Election. However, under a de minimis exception, an IRC Section 987 loss will not be suspended unless the amount subject to suspension in the tax year exceeds than the lesser of (1) $3 million, or (2) 2 % of the total gross income of the owner and all members of the owner's controlled group.

Any net accumulated unrecognized IRC Section 987 loss is generally converted into an IRC Section 987 suspended loss at the beginning of the first year for which an Annual Recognition Election is in effect if either:

• A Current Rate Election was in effect for the immediately preceding tax year

or

• A Current Rate Election was not in effect, and, as of the beginning of the tax year, the owner's total unrecognized and deferred IRC Section 987 losses exceeded its total unrecognized and deferred IRC Section 987 gains by more than $5 million

Finally, any net accumulated unrecognized IRC Section 987 loss is generally converted to IRC Section 987 suspended loss in the first year in which a Current Rate election ceases to be effective.

IRC Section 987 suspended loss is generally recognized in a tax year in which an equal or greater IRC Section 987 gain in the same recognition grouping is recognized or when certain recognition events occur (the Loss-to-the-Extent-of-Gain Rule). In a significant change from the 2023 Proposed Regulations, the Final Regulations expand taxpayers' ability to recognize IRC Section 987 suspended loss by comparing the IRC Section 987 suspended loss to the sum of the IRC Section 987 gains in the prior three-year period and the current-year IRC Section 987 gains (rather than only current-year IRC Section 987 gains). These gains are reduced (including below zero) for IRC Section 987 losses recognized, other than IRC Section 987 suspended loss, within the same recognition grouping during the lookback period. When both a Current Rate and Annual Recognition Election are in effect, the lookback period includes all of the owner's prior tax years in which both elections were continuously in effect. If the sum of the current year gain and the lookback gain is negative, the IRC Section 987 suspended loss recognized is zero; special rules apply to transactions described in IRC Section 381(a). The total IRC Section 987 suspended loss recognized cannot exceed the IRC Section 987 gain recognized.

Treas. Reg. Section 1.987-12: Deferral of IRC Section 987 gain or loss

The deferral rules under Treas. Reg. Section 1.987-12 have generally been effective for certain deferral events occurring on or after January 6, 2017. The Final Regulations generally defer recognition of IRC Section 987 gain or loss upon the occurrence of certain related-party transactions in which the assets of the terminating IRC Section 987 QBU are recorded on the balance sheet of a member of the same controlled group (a deferral event). These rules do not apply (1) in a tax year in which an Annual Recognition Election is in effect, or (2) when the aggregate amount of net unrecognized IRC Section 987 gain or loss for all of an owner's IRC Section 987 QBUs that would become deferred does not exceed $5 million.

A deferral event occurs where a transaction or series of transactions meets the following conditions: (1) the IRC Section 987 QBU terminated as a result of a transfer of substantially all its assets, the IRC Section 987 QBU ceased to be an IRC Section 987 QBU, or the owner of the IRC Section 987 changed the form of its ownership interest in the IRC Section 987 QBU; and (2) the assets of the IRC Section 987 QBU are reflected on the books and records of a successor deferral QBU immediately after the transaction or series of transactions.

An IRC Section 987 QBU is a successor deferral QBU if, immediately after the transaction, the potential successor deferral QBU satisfies the following conditions: (1) the books and records of the potential successor deferral QBU reflect assets that were reflected on the books and records of the IRC Section 987 QBU immediately before the transaction; (2) the owner of the potential successor deferral QBU and the owner of the IRC Section 987 QBU are members of the same controlled group; and (3) the owner IRC Section 987 QBU before the deferral event was a US person and the potential successor deferral QBU is owned by a US person.

IRC Section 987 gain or loss is deferred to the extent the assets of the terminating IRC Section 987 QBU are recorded on the books and records of the successor deferral QBU. Deferred IRC Section 987 gain or loss is recognized (subject, as appropriate, to the Loss-to-the-Extent-of-Gain Rule) when the successor deferral QBU makes remittances to the successor deferral QBU owner. This determination is made under Treas. Reg. Section 1.987-5(b) without regard to whether the successor deferral QBU made an Annual Recognition Election. For these purposes, the successor deferral QBU is deemed to transfer all of its assets to the successor deferral QBU owner when it ceases to be owned by a member of the same controlled group that includes the terminated IRC Section 987 QBU's owner.

Treas. Reg. Section 1.987-13: Suspended IRC Section 987 loss upon terminations

The Final Regulations generally prohibit the recognition of any unrecognized IRC Section 987 suspended loss when (1) the IRC Section 987 QBU terminates and, immediately after the termination, a significant portion of its assets are recorded on the books and records of an eligible QBU (but not necessarily an IRC Section 987 QBU) carrying on the same trade or business, and (2) that QBU was owned by the same owner or a member of the original owner's controlled group (Successor Suspended Loss QBU). Instead, the IRC Section 987 suspended loss is carried over to the Successor Suspended Loss QBU. However, no IRC Section 987 suspended loss is carried over in connection with certain inbound non-recognition transactions.

IRC Section 987 suspended loss may be recognized in the following circumstances following application of the Loss-to-the-Extent-of-Gain Rule: (1) no Successor Suspended Loss QBU exists; or (2) the Successor Suspended Loss QBU ceased to be owned by a member of the original QBU owner's controlled group as a result of a transfer or redemption of the Successor Suspended Loss QBU owner. If the original QBU owner ceased to be a member of the Successor Suspended Loss QBU owner's controlled group or ceases to exist where there is no successor (such as via an IRC Section 331 liquidation), any IRC Section 987 suspended loss not recognized after applying the Loss-to-the-Extent-of-Gain Rule is eliminated and cannot be recognized.

The Final Regulations also limit the ability to recognize an IRC Section 987 loss upon the occurrence of so-called outbound loss events when neither a Current Rate Election nor an Annual Recognition Election is in effect. An outbound loss event means any termination of an IRC Section 987 QBU resulting from:

• A US person's transfer of the assets to a foreign person that is a member of the same controlled group immediately before the transaction

or

• A US person's transfer of the assets to a foreign person within the US person's controlled group, where the foreign person did not exist immediately before the transfer (e.g., an entity classification election to treat a foreign IRC Section 987 QBU as a corporation)

In that case, any unrecognized IRC Section 987 loss (including any deferred loss) becomes IRC Section 987 suspended loss.

Treas. Reg. Section 1.987-14: IRC Section 987 hedging transactions

The Final Regulations introduce new rules that apply to certain identified hedging transactions into which the owner of an IRC Section 987 QBU enters. These rules permit symmetrical treatment of currency gain or loss with respect to a net investment hedge and the hedged IRC Section 987 QBU (Section 987 Hedging Transactions).

Under the Final Regulations, IRC Section 988 gain or loss that would ordinarily be recognized on a Section 987 Hedging Transaction is instead taken into account in adjusting the owner's unrecognized IRC Section 987 gain or loss for the tax year (as determined under Treas. Reg. Section 1.987-4(d)). For example, an owner's loss from a Section 987 Hedging Transaction may offset any unrecognized IRC Section 987 gain for the tax year under Treas. Reg. Section 1.987-4(d). However, losses from Section 987 Hedging Transactions cannot reduce unrecognized IRC Section 987 gain for the tax year below zero and gains from Section 987 Hedging Transactions cannot reduce unrecognized IRC Section 987 loss for the tax year below zero. This limitation ensures that hedging gain or loss exceeding the currency exposure generated by the IRC Section 987 QBU for the tax year is not taken into account under IRC Section 987. Any hedging gain that does not reduce unrecognized IRC Section 987 loss is recognized under IRC Section 988.

A Section 987 Hedging Transaction generally is a financial instrument entered by the owner of an IRC Section 987 QBU for the purpose of managing exchange rate risk with respect to the owner's net investment in the IRC Section 987 QBU as part of the normal course of the owner's trade or business. The transaction may be entered with a related or unrelated party and must meet the following requirements. First, the hedge must be identified as a Section 987 Hedging Transaction with respect to the hedged IRC Section 987 QBU on or before the day the owner enters into the hedge, unless the failure to identify is due to inadvertent error. Generally, an owner must hedge on a QBU-by-QBU basis, except for hedges of grouped IRC Section 987 QBUs. Second, a Current Rate Election must be in effect for the tax year. Third, the owner (and any members of the same controlled group that are parties to the hedge) must account for IRC Section 988 gain or loss on the hedge under a mark-to-market method of accounting. Fourth, foreign currency gain or loss on the hedge must be properly accounted for as a cumulative foreign currency translation adjustment to shareholders' equity under US generally accepted accounting principles (US GAAP). Fifth, the owner of the IRC Section 987 QBU must enter into the hedge, not the owner's IRC Section 987 QBU. Finally, under an anti-abuse rule, the hedge or a related transaction may not be entered with a principal purpose of converting IRC Section 987 gain or loss into IRC Section 988 gain or loss.

Treas. Reg. Section 1.987-15: Applicability dates

The Final Regulations (and the parts of the 2016 Final Regulations and the 2019 Final Regulations that are not replaced or modified by the Final Regulations) generally apply to tax years beginning after December 31, 2024. To prevent taxpayers from avoiding the rules of the Final Regulations before they generally become applicable, the Final Regulations apply retroactively to Terminating QBUs (i.e., a QBU that terminated on or after November 9, 2023) immediately before the termination. All taxpayers with IRC Section 987 QBUs remain subject to the deferral rules of Treas. Reg. Section 1.987-12.

Taxpayers (and each member of their consolidated group) and their controlled foreign corporations (CFCs) may choose to apply the Final Regulations in their entirety to a tax year beginning on or before December 31, 2024, and ending after November 9, 2023, if they (1) consistently apply the Final Regulations in their entirety to the tax year and all subsequent tax years beginning on or before December 31, 2024, and (2) apply the Final Regulations on their original timely filed (including extensions) returns for the first tax year to which the taxpayer chooses to apply the Final Regulations. In addition, taxpayers (and each member of their consolidated group) and their CFCs may choose to apply the 2016 Final Regulations and the 2019 Final Regulations to tax years beginning after December 7, 2016, and beginning on or before December 31, 2024, provided certain conditions are met (including that those taxpayers first applied the 2016 and 2019 Final Regulations to a tax year ending before November 9, 2023).

Treas. Reg. Section 1.1502-13: Intercompany transactions

The Final Regulations retain the consolidated group reattribution rule from the 2023 Proposed Regulations. To facilitate single-entity treatment and satisfy the matching rule under Treas. Reg. Section 1.1502-13(c), the Final Regulations treat a transaction between an IRC Section 987 QBU of one member and any other member of the same consolidated group as a combination of (1) an intercompany transaction between the members, and (2) a transfer between each IRC Section 987 QBU and its owner as necessary to take into account the effect of the transaction on the assets and liabilities of the IRC Section 987 QBU.

Prop. Treas. Reg. Section 1.987-2(f), Attribution of items to eligible QBUs; definition of a transfer and related rules

In proposed regulations issued contemporaneously with the Final Regulations, taxpayers that have made a Current Rate Election could elect to translate a group of frequently recurring transfers between an IRC Section 987 QBU and its owner using the yearly average exchange rate, rather than the spot rate on the applicable date of each transfer (Recurring Transfer Group Election). A recurring transfer group of transactions means a group of frequently recurring transfers between an IRC Section 987 QBU and its owner (or another eligible QBU of the owner) that are made in the ordinary course of a trade or business. These transactions would only include transfers made in connection with sales of inventory, payments for services, or rent or royalty transactions in which arm's-length compensation has been paid. Exceptions exist for disproportionate transfers. Treasury and the IRS have requested comments on whether other types of transactions (such as intercompany lending transactions of a bank or other financial entity) should be included in the definition of a recurring transfer.

The proposed regulations would apply to tax years beginning after the date they are adopted as final; taxpayers may, however, rely on the proposed regulations for a tax year in which the Final Regulations apply, provided they and each member of their consolidated group and IRC Section 987 electing group consistently follow the proposed regulations consistently and in their entirety.

Implications

The Final Regulations are the first comprehensive set of applicable regulations under IRC Section 987 since its enactment in 1986. Because the Final Regulations apply to tax years beginning after December 31, 2024, taxpayers should immediately consider pretransition and post-transition issues, including:

• The retroactive impact of the Final Regulations on any Terminating QBUs that must apply the Final Regulations as of the termination date (including application of the Loss-to-the-Extent-of-Gain Rule)
• Whether an eligible pretransition method has been applied
• The amount of its pretransition gain or loss and whether to make the 10-year amortization election
• Whether to make one of the various elections offered in the Final Regulations, such as the Current Rate or Annual Recognition Election

Taxpayers must weigh the benefits associated with these elections, such as a reduced compliance burden, with potentially adverse impacts, such as the Loss-to-the-Extent-of-Gain Rule and the inability to control the timing of IRC Section 987 gains and losses.

Taxpayers also must consider several of the critical changes made to the 2023 Proposed Regulations in the Final Regulations. Specifically, taxpayers must determine whether the compliance burden is eased as a result of the introduction of several alternative calculation methods, including the manner in which the OFCNV and remittances may be calculated, as well as new elections offered to mark to market IRC Section 988 transactions of the IRC Section 987 QBU or treat IRC Section 987 gain or loss as foreign currency gain or loss that is ineligible for the business needs exception.

Finally, taxpayers may consider providing comments in response to requests from Treasury and the IRS on the treatment of partnerships for purposes of IRC Sections 987 and 989(a), and the application of IRC Section 987 to CFCs and partnerships with only foreign partners.