International Taxation - Adnan Islam

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for each accrual period by subtracting, from the translated units of nonfunctional currency interest income received with respect to the accrual period, the amount computed by translating the units of nonfunctional currency interest income accrued with respect to the income received at the average exchange rate for the accrual period.

      The obligor under a debt instrument will realize exchange gain or loss with respect to accrued interest expense on the date such accrued interest expense is paid or the obligation to make payments is transferred or extinguished (including a deemed disposition that results from a material change in terms of the instrument). The amount of exchange gain or loss realized with respect to accrued interest expense is determined for each accrual period using the following procedure: (a) translating the units of nonfunctional currency interest expense accrued at the average rate (or other rate specified) and (b) subtracting from that amount the amount computed by translating the units of nonfunctional currency interest paid (or, if the obligation to make payments is extinguished or transferred, the units accrued) with respect to such accrual period into functional currency at the spot rate (a) on the date payment is made or (b) the obligation is transferred or extinguished (or deemed extinguished).

      An obligor under a debt instrument will realize an exchange gain or loss with respect to the principal amount on the date on which principal is paid or the obligation to make payments is extinguished or transferred. The principal amount of a debt instrument is the amount received by the obligor for the debt instrument in units of nonfunctional currency. If the obligation was acquired in a nontaxable exchange, the nonfunctional currency principal amount of the instrument for the obligor will be the same as that of the transferor. If exchange gain or loss realized is required to be recognized, the amount of gain or loss realized by the obligor is determined by subtracting, from the translated (at the spot rate) units of nonfunctional currency principal on the date the obligor became obligor, the amount computed by translating the units of nonfunctional currency principal at the spot rate on the date payment is made or the obligation is extinguished or transferred.

      Exchange gain or loss

      Exchange gain or loss with respect to gross income or receipts that is to be received after the accrual date is realized on the date payment is made or received. Exchange gain or loss realized is determined by multiplying the units of nonfunctional currency received by the spot rate on the payment date, and subtracting from that the amount determined by multiplying the units of nonfunctional currency received by the spot rate on the booking date. Exchange gain or loss realized on an item of expense is determined by multiplying the units of nonfunctional currency paid by the spot rate on the booking date and subtracting from such amount the amount determined by multiplying the units of nonfunctional currency paid by the spot rate on the payment date.

Example 2-15

      X is a calendar-year corporation with the dollar as its functional currency. X is on the accrual method of accounting. On January 15, 20X2, X sells inventory for CAD 10,000. The spot rate on January 15, 20X2, is CAD 1 = USD 0.55. On February 23, 20X2, when X receives payment of the CAD 10,000, the spot rate is CAD 1 = USD 0.50. On February 23, 20X2, X will realize exchange loss. X’s loss is computed by multiplying the CAD 10,000 by the spot rate on the date the CAD 10,000 are received (CAD 10,000 × .50 = USD 5,000) and subtracting from that the amount computed by multiplying the CAD 10,000 by the spot rate on the booking date (CAD 10,000 × .55 = USD 5,500). Therefore, X’s exchange loss on the transaction is USD 500 (USD 5,000 – USD 5,500).

      Exchange gain or loss on a forward, futures, and option contract (but not a spot contract to buy or sell nonfunctional currency unless the spot contract is disposed of prior to making or taking delivery of the currency) is realized and recognized.

      Gain or loss on these contracts is realized. In general, exchange gain or loss is not realized solely because another transaction or transactions offset the transaction. If, however, the economic benefit is derived in any offset transaction, any gain inherent in the offset positions is recognized.

      Exchange gain or loss on these contracts is determined by subtracting the amount paid (or deemed paid), if any, for the contract from the amount received or deemed received from the contract. This rule also applies if the taxpayer makes or takes delivery in connection with these contracts. Gain or loss is recognized as if the contract was sold for its fair market value on the delivery date.

      

Example 2-16

      X, a calendar-year corporation whose functional currency is the dollar, entered into a forward contract on October 1, 20X1, to purchase Q100,000 for delivery on March 1, 20X2. The six-month forward rate was $.4907. On March 1, 20X2, X takes delivery of the Q100,000 when the spot rate is $.48. X is treated as if it sold the contract for its fair market value when it takes delivery of nonfunctional currency under the forward contract. Therefore, X has an exchange loss of $1,070 ([$.48 × Q100,000] − [$.4907 × Q100,000]) and a basis of $48,000 in the Q100,000 (Treasury Regulation 1.988-2(d)(4)(iii), example (1)).

      Character of gains or losses

      In general, foreign currency gain or loss attributable to a Section 988 transaction is computed separately and treated as ordinary income or loss. Capital gain or loss treatment may be elected for forward contracts, futures contracts, and options that constitute capital assets in the hands of the taxpayer that are not marked to market, are not parts of a tax straddle, and meet the identification requirements. In some Section 988 transactions, foreign currency gain or loss will be treated as interest income or expense.

      In general, foreign currency gain or loss attributable to a Section 988 transaction that is treated as ordinary income will have its source 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. An individual’s residence is the country in which the person’s tax home is located. The residence of a U.S. corporation, partnership, estate, or trust is the United States. The residence of a foreign corporation, partnership, estate, or trust is considered not to be in the United States. In the case of a QBU, the residence of each unit is the country in which it is located. The residency of a partner in a partnership not engaged in a U.S. trade or business is determined at the partner level.

      There is a special sourcing rule for loans made by a U.S. person or a related person, to a 10%-owned foreign corporation, when the loan is denominated in a currency other than the dollar and bears an interest rate at least 10 percentage points higher than the federal midterm rate at the time the loan is made. In this case, for purposes of Section 904 only, the affected loans are marked to market on an annual basis and interest income

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