2023 Proposed Regulations under IRC Section 987

On Nov. 9, 2023, Treasury and the IRS issued proposed regulations under IRC Section 987 (the 2023 proposed regulations) providing guidance on how to determine income or loss with respect to a qualified business unit (QBU) operating in a functional currency that is different from its owner. Once finalized, the proposed regulations would generally apply to tax years beginning after Dec. 31, 2024. Since the issuance of proposed regulations in 1991 (the 1991 proposed regulations), several final, temporary and proposed regulations under Section 987 have followed, including the final regulations issued in December 2016 (the 2016 final regulations) and the final regulations issued in May 2019 (the 2019 final regulations). The effective dates of these final regulations have been postponed through several deferral notices. 

The 2016 and 2019 final regulations generally adopted the Full Economic Exposure Poll (FEEP) method, which was first introduced in proposed regulations issued in 2006, with modifications as the default rule of computing Section 987 income or loss. The FEEP method aimed to provide a more accurate reflection of a QBU's economic exposure to currency fluctuations with regard to all the financial assets and liabilities of a QBU. Under the FEEP method, taxpayers determine income gain or loss of a QBU attributable to currency fluctuations in the functional currency of the owner using the yearly average exchange rates. In doing so, the basis of historic assets is translated at the average rate for the year acquired. All other items are translated at the average exchange rate for the year of the determination.  

Taxpayers have expressed significant concerns regarding the FEEP method, primarily regarding the burden of information gathering required to determine the exchange rate for historic assets. The 2023 proposed regulations generally retain the FEEP method and offer a couple of simplifying elections to address the taxpayers’ concerns. 

First, the current rate election allows taxpayers to translate all balance sheet items at the year-end spot rate and all items of income, gain or loss at the average rate for the year, thereby resulting in outcomes similar to results under the 1991 proposed regulations. If a current rate election is in effect, a Section 987 loss might be deferred or suspended at the owner’s level until there is an offsetting gain. 

Second, the annual recognition election allows a QBU owner to recognize net unrecognized 987 gain or loss annually at the end of each tax year. Taxpayers may make either a current rate election, an annual recognition election or both. Taxpayers will need to evaluate the potential impact of the FEEP method and the simplifying elections on their planning. 

As noted, these regulations are only proposed and subject to change before finalization. The transition rules, however, are something for taxpayers to take note of currently. The 2023 proposed regulations provide a transition method replacing the fresh start method under the 2016 final regulations. The new transition method requires QBU owners to determine unrecognized Section 987 gain or loss that has accrued prior to the transition date (pretransition gain or loss). If a QBU owner computed its Section 987 gain or loss under an eligible pretransition method, the owner can determine a pretransition gain or loss under that method. Among others, the 2023 proposed regulations provide that the eligible pretransition methods include the earnings and capital method described in the 1991 proposed regulations and the earnings-only method. 

Complying with the 2006 or 2016 regulations would also be eligible methods. QBU owners who have not used an eligible method must determine a pretransition gain or loss using a specified method under the 2023 proposed regulations, including the simplifying elections. To assess the impact of the transition rules under the 2023 proposed regulations, at the outset, taxpayers should identify whether they currently apply an eligible pretransition method to track Section 987 gain or loss exposure. If not, they should examine the information necessary to comply with the transition rules, such as the acquisition dates for historic assets of QBUs. 

In other respects, the 2023 proposed regulations address various Section 987 related issues such as source and character, terminating QBUs, partnerships and consolidated groups.