[Federal Register Volume 65, Number 9 (Thursday, January 13, 2000)]
[Rules and Regulations]
[Pages 2026-2030]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-644]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8860]
RIN 1545-AP78
Treatment of Income and Expense From Certain Hyperinflationary,
Nonfunctional Currency Transactions and Certain Notional Principal
Contracts
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations regarding the
treatment of income and deductions arising from certain foreign
currency transactions denominated in hyperinflationary currencies and
coordinates section 988 with the section 446 regulations pertaining to
significant nonperiodic payments. These regulations are intended to
prevent distortions in computing income and deductions of taxpayers who
enter into certain transactions in hyperinflationary currencies, and
nonfunctional currency, notional principal contracts with significant
nonperiodic payments.
DATES: These regulations are effective February 14, 2000.
FOR FURTHER INFORMATION CONTACT: Roger M. Brown at (202) 622-3830 (not
a toll-free number) of the Office of the Associate Chief Counsel
(International) within the Office of the Chief Counsel, Room 4554, 1111
Constitution Avenue, NW., Washington, DC. 20224.
SUPPLEMENTARY INFORMATION:
Background
On March 17, 1992, proposed regulations were published in the
Federal Register at 57 FR 9217 (INTL-15-91). The IRS received two
written comments on the proposed regulations, which are discussed
below. No public hearing was held and no requests to speak were
received. Having considered the comments, the IRS and Treasury
Department adopt the proposed regulations, as modified by this Treasury
decision.
Explanation of Provisions
I. Hyperinflationary Instruments
A. Proposed Regulations
The proposed regulations under Sec. 1.988-2(b)(15) generally
provided that currency gain or loss on debt instruments and demand
deposits entered into or acquired when the currency in which the item
was denominated was hyperinflationary must be realized annually under a
mark-to-market methodology. For purposes of determining the character
and source (or allocation) of such currency gain or loss, the gain or
loss was generally treated as an increase in, or a reduction of,
interest income or expense.
The proposed Sec. 1.988-2(b)(15) regulations excluded instruments
described in section 988(a)(3)(C) (relating to non-dollar, related-
party loans where the rate of interest is at least 10 percentage points
higher than the Federal mid-term rate) from these rules. Proposed
regulations Sec. 1.988-2(d)(5) and (e)(7) generally provided that
currency gain or loss realized with respect to section 988 forward
contracts, futures contracts, option contracts and similar items (such
as currency swap contracts) entered into or acquired when the currency
in which such an item is denominated was hyperinflationary was
[[Page 2027]]
recognized annually under a mark-to-market methodology.
B. Discussion of Comments and Final Regulations
1. Comments and the Treasury and IRS's Responses
One of the comments responding to the proposed regulations
criticized the exclusion of loans described in section 988(a)(3)(C)
from the rules of proposed regulation Sec. 1.988-2(b)(15). The comment
noted that it was inappropriate to treat related-party loans
differently from loans between unrelated parties in this context.
Proposed regulation Sec. 1.988-2(b)(15) excluded loans subject to
section 988(a)(3)(C) from the mark-to-market rule of the proposed
regulations because the loans were already subject to mark-to-market
treatment under section 988(a)(3)(C), which was enacted to prevent
manipulation of the section 904(a) foreign tax credit limitation
through related party loans with artificially high interest rates. See
H. Conf. Rep. No. 841, 99th Cong., 2d Sess. 668 (1986). However, due to
interest income's U.S. source treatment under section 988(a)(3)(C)(ii),
mark-to-market treatment under section 988(a)(3)(C), rather than
Sec. 1.988-2(b)(15), would be, in most cases, more unfavorable to
taxpayers.
Since the rules of proposed regulation Sec. 1.988-2(b)(15) were
consistent with the approach of section 988(a)(3)(C) and prevented
manipulation of the type Congress addressed in that section, the IRS
and Treasury agree that transactions described in section 988(a)(3)(C)
should not be excluded from the mark-to-market rule of the final
regulations. The IRS and Treasury also have concluded that to the
extent a debt instrument is subject to the rules of Sec. 1.988-
2(b)(15), the application of section 988(a)(3)(C)'s resourcing rule is
not necessary. The final regulations reflect these changes.
The other comment identified the need for coordinating the mark-to-
market regime for hyperinflationary instruments under proposed
regulation Sec. 1.988-2(b)(15), and the mark-to-market election under
proposed regulation Sec. 1.988-5(f) for all section 988 transactions.
The final regulations do not include a rule coordinating these two
mark-to-market regimes because the mark-to-market election for all
section 988 transactions is still in proposed form. Accordingly, the
IRS and Treasury have decided that consideration of the proper
coordination is most appropriate when the regulations relating to the
general mark-to-market election for all section 988 transactions are
finalized.
2. Other Changes to the Final Regulations
(a) Source and Character of Gain or Loss
The proposed regulations provided that any exchange gain or loss
realized upon marking to market a debt instrument or a demand deposit
under proposed regulation Sec. 1.988-2(b)(15)(i) was to be directly
allocable to the interest income or interest expense from the debt
instrument or deposit. Accordingly, the gain or loss reduced or
increased the amount of interest income or interest expense paid or
accrued during that year with respect to that instrument or deposit.
Additionally, if realized exchange gain exceeded interest expense of an
issuer, or realized exchange loss exceeded interest income of a holder
or depositor, the character and source of such excess amount were to be
determined under the general rules of Secs. 1.988-3 and 1.988-4.
The assumption underlying this proposed treatment was that in
hyperinflationary conditions, high nominal interest rates perform two
functions: compensate lenders for currency loss attributable to the
repayment of the principal with a devalued currency, and account for
borrowers' currency gain on the repayment of the principal with a
devalued currency. In instances, however, where hyperinflationary
conditions are subsiding and a lender would actually have currency gain
on principal repayment (and the borrower would have currency loss on
principal repayment), these assumptions are no longer appropriate. For
example, if a lender has currency gain on the marking to market (for
currency fluctuations only) of the principal of a debt instrument, high
nominal interest rates would not be compensating the lender for the
decline in the value of the principal as there would be a gain on the
principal.
Accordingly, the final regulations retain the source and character
rule of the proposed regulations (direct allocation of the exchange
gain or loss against interest expense or income, respectively) when
hyperinflationary conditions result in exchange loss to lenders or
exchange gain to borrowers on the principal amount of a debt instrument
or deposit. However, where a lender has exchange gain or a borrower has
exchange loss on the debt instrument--which may occur as
hyperinflationary conditions subside--the final regulations clarify
that the exchange gain or loss is not allocated against interest
expense or income. Rather, the exchange gain or loss is treated under
the normal currency character and source rules of Secs. 1.988-3 and
1.988-4. Thus, for example, if an issuer has both interest expense and
currency loss, the currency loss is sourced and characterized under
section 988 and does not affect the determination of interest expense.
(b) Synthetic, Non-hyperinflationary Currency Debt Instruments
The final regulations also make clear that when a debt instrument
has interest and principal payments that are to be made by reference to
a non-hyperinflationary currency or item (commonly known as interest
and principal protection features), the instrument is not marked to
market under the final section 988 regulations. This is because the
instrument is, in substance, a synthetic non-hyperinflationary
instrument and does not experience the distortions associated with a
hyperinflationary instrument.
(c) Treatment of Hyperinflationary Contracts
Proposed regulation Sec. 1.988-2(d)(5) generally provided that
currency gain or loss on derivative contracts described in Sec. 1.988-
1(a)(2)(iii) and denominated in a currency that was hyperinflationary
at the time the contract was entered into was to be realized annually
under a mark-to-market methodology. This proposed regulation was issued
prior to promulgation of the Sec. 1.446-4 regulations (published in the
Federal Register on July 18, 1994) which requires that, to clearly
reflect income, the timing of income, deduction, gain or loss on a
hedge must match the timing of income, deduction, gain or loss on the
item being hedged. The final regulations modify proposed regulation
Sec. 1.988-2(d)(5) by providing that Sec. 1.446-4, to the extent
applicable, will take precedence over proposed regulation Sec. 1.988-
2(d)(5). This is because the IRS and Treasury believe that a clearer
reflection of income is present where the income and deductions arising
from an item hedged under Sec. 1.446-4 is matched with the income and
deductions arising from the hedge. See Sec. 1.446-4(b).
(d) Demand and Time Deposits
The proposed regulations applied the mark-to-market rules to demand
deposits denominated in a currency that was hyperinflationary at the
time the deposit was entered into. Under the final regulations, the
mark-to-market rules apply to demand and time deposits that provide for
payments denominated in or by reference to a currency which is
hyperinflationary at
[[Page 2028]]
the time the taxpayer enters into or otherwise acquires the deposit, or
whose interest rate reflects hyperinflationary conditions in a country.
Similar clarifications have been made with respect to the definitions
of hyperinflationary debt instruments and currency swap contracts.
3. Abusive Transactions
The Treasury and the IRS are concerned about the use of
hyperinflationary currencies in transactions motivated by tax
considerations. Because the direction of exchange rates is relatively
predictable in hyperinflation economies, some taxpayers have attempted
to use such currencies in transactions lacking economic substance. See,
e.g., Agro Science Co. v. Commissioner, T.C. Memo. 1989-687, aff'd, 927
F.2d 213 (5th Cir.), cert. denied, 502 U.S. 907 (1991). However,
section 988 may be applied by the IRS in a manner that reflects the
proper timing, source, and character of income, gain, loss, or expense
arising from a transaction whose form is not in accordance with its
economic substance. Secs. 1.988-1(a)(11) and 1.988-2(f); Agro Science
Co. v. Commissioner, supra. Accordingly, the rules contained in this
Treasury decision will be applied within the framework of these general
economic substance principles.
II. Significant Non-periodic Payments and Currency Swaps
The proposed regulations coordinated section 988 with the section
446 regulations pertaining to significant nonperiodic payments. The
final regulations maintain this coordination and clarify that exchange
gain or loss may be realized on the principal and interest components
of a significant nonperiodic payment.
III. Proposed Change to Base Period in Notice of Proposed Rulemaking
Elsewhere in this issue of the Federal Register, the IRS and
Treasury are publishing a notice of proposed rulemaking that proposes
to change the period during which inflation rates are measured in the
determination of whether a currency is hyperinflationary for purposes
of section 988 (base period). The effect of this change to Sec. 1.988-
1(f) (defining hyperinflationary currency for purposes of section 988)
is to take into account current year, hyperinflationary conditions,
rather than determining whether a currency is hyperinflationary based
on the three years prior to the current year. The proposed change
relates only to section 988 and not to the dollar approximate separate
transactions method of Sec. 1.985-3 (DASTM). However, other sections,
such as Sec. 1.267(f)-1(e) (relating to application of the loss
disallowance rule of section 267(a)(1) as applied to related party,
nonfunctional currency loans), which make reference to the section 988
definition of hyperinflation will be affected.
Special Analyses
It has been determined that this Treasury decision 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) and the Regulatory Flexibility Act (5 U.S.C. chapter
6) do not apply to these regulations, and, therefore, a Regulatory
Flexibility Analysis is not required. Pursuant to section 7805(f) of
the Internal Revenue Code, the notice of proposed rulemaking preceding
these regulations was submitted to the Small Business Administration
for comment on its impact on small businesses.
Drafting Information: The principal author of these regulations is
Roger M. Brown of the Office of the Associate Chief Counsel
(International). However, other personnel from the IRS and Treasury
Department also participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of the Amendments to the Regulations
Accordingly, 26 CFR part 1 is 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. 7805 * * *
Par. 2. Section 1.988-0 in the Table of Contents is amended by:
1. The entry for Sec. 1.988-2(b)(14)-(15) is removed.
2. An entry for Sec. 1.988-2(b)(14) is added.
3. An entry for Sec. 1.988-2(b)(15) is added.
4. The entry for Sec. 1.988-2(d)(5) is revised.
5. The entry for Sec. 1.988-2(e)(7) is revised.
The revisions and additions read as follows:
Sec. 1.988-0 Taxation of gain or loss from a section 988 transaction;
Table of Contents.
* * * * *
Sec. 1.988-2 Recognition and computation of exchange gain or loss
* * * * *
(b) * * *
(14) [Reserved]
(15) Debt instruments and deposits denominated in
hyperinflationary currencies.
* * * * *
(d) ***
(5) Hyperinflationary contracts.
(e) * * *
(7) Special rules for currency swap contracts in
hyperinflationary currencies.
* * * * *
Par. 3. Section 1.988-2 is amended by:
1. Adding paragraph (b)(15).
2. Adding paragraph (d)(5).
3. Adding paragraph (e)(3)(iv).
4. Adding paragraph (e)(7).
The additions read as follows:
Sec. 1.988-2 Recognition and computation of exchange gain or loss.
* * * * *
(b) * * *
(14) [Reserved]
(15) Debt instruments and deposits denominated in hyperinflationary
currencies--(i) In general. If a taxpayer issues, acquires, or
otherwise enters into or holds a hyperinflationary debt instrument (as
defined in paragraph (b)(15)(vi)(A) of this section) or a
hyperinflationary deposit (as defined in paragraph (b)(15)(vi)(B) of
this section) on which interest is paid or accrued that is denominated
in (or determined by reference to) a nonfunctional currency of the
taxpayer, then the taxpayer shall realize exchange gain or loss with
respect to such instrument or deposit for its taxable year determined
by reference to the change in exchange rates between--
(A) The later of the first day of the taxable year, or the date the
instrument was entered into (or an amount deposited); and
(B) The earlier of the last day of the taxable year, or the date
the instrument (or deposit) is disposed of or otherwise terminated.
(ii) Only exchange gain or loss is realized. No gain or loss is
realized under paragraph (b)(15)(i) by reason of factors other than
movement in exchange rates, such as the creditworthiness of the debtor.
(iii) Special rule for synthetic, non-hyperinflationary currency
debt instruments--(A) General rule. Paragraph (b)(15)(i) does not apply
to a debt instrument that has interest and principal payments that are
to be made by reference to a currency or item that does not reflect
hyperinflationary conditions in a country (within the meaning of
Sec. 1.988-1(f)).
[[Page 2029]]
(B) Example. Paragraph (b)(15)(iii)(A) is illustrated by the
following example:
Example. When the Turkish lira (TL) is a hyperinflationary
currency, A, a U.S. corporation with the U.S. dollar as its
functional currency, makes a 5 year, 100,000 TL-denominated loan to
B, an unrelated corporation, at a 10% interest rate when 1,000 TL
equals $1. Under the terms of the debt instrument, B must pay
interest annually to A in amount of Turkish lira that is equal to
$100. Also under the terms of the debt instrument, B must pay A upon
maturity of the debt instrument an amount of Turkish lira that is
equal to $1,000. Although the principal and interest are payable in
a hyperinflationary currency, the debt instrument is a synthetic
dollar debt instrument and is not subject to paragraph (b)(15)(i) of
this section.
(iv) Source and character of gain or loss--(A) General rule for
hyperinflationary conditions. The rules of this paragraph
(b)(15)(iv)(A) shall apply to any taxpayer that is either an issuer of
(or obligor under) a hyperinflationary debt instrument or deposit and
has currency gain on such debt instrument or deposit, or a holder of a
hyperinflationary debt instrument or deposit and has currency loss on
such debt instrument or deposit. For purposes of subtitle A of the
Internal Revenue Code, any exchange gain or loss realized under
paragraph (b)(15)(i) of this section is directly allocable to the
interest expense or interest income, respectively, from the debt
instrument or deposit (computed under this paragraph (b)), and
therefore reduces or increases the amount of interest income or
interest expense paid or accrued during that year with respect to that
instrument or deposit. With respect to a debt instrument or deposit
during a taxable year, to the extent exchange gain realized under
paragraph (b)(15)(i) of this section exceeds interest expense of an
issuer, or exchange loss realized under paragraph (b)(15)(i) of this
section exceeds interest income of a holder or depositor, the character
and source of such excess amount shall be determined under Secs. 1.988-
3 and 1.988-4.
(B) Special rule for subsiding hyperinflationary conditions. If the
taxpayer is an issuer of (or obligor under) a hyperinflationary debt
instrument or deposit and has currency loss, or if the taxpayer is a
holder of a hyperinflationary debt instrument or deposit and has
currency gain, then for purposes of subtitle A of the Internal Revenue
Code, the character and source of the currency gain or loss is
determined under Secs. 1.988-3 and 1.988-4. Thus, if an issuer has both
interest expense and currency loss, the currency loss is sourced and
characterized under section 988, and does not affect the determination
of interest expense.
(v) Adjustment to principal or basis. Any exchange gain or loss
realized under paragraph (b)(15)(i) of this section is an adjustment to
the functional currency principal amount of the issuer, functional
currency basis of the holder, or the functional currency amount of the
deposit. This adjusted amount or basis is used in making subsequent
computations of exchange gain or loss, computing the basis of assets
for purposes of allocating interest under Secs. 1.861-9T through 1.861-
12T and 1.882-5, or making other determinations that may be relevant
for computing taxable income or loss.
(vi) Definitions--(A) Hyperinflationary debt instrument. A
hyperinflationary debt instrument is a debt instrument that provides
for--
(1) Payments denominated in or determined by reference to a
currency that is hyperinflationary (as defined in Sec. 1.988-1(f)) at
the time the taxpayer enters into or otherwise acquires the debt
instrument; or
(2) Payments denominated in or determined by reference to a
currency that is hyperinflationary (as defined in Sec. 1.988-1(f))
during the taxable year, and the terms of the instrument provide for
the adjustment of principal or interest payments in a manner that
reflects hyperinflation. For example, a debt instrument providing for a
variable interest rate based on local conditions and generally
responding to changes in the local consumer price index will reflect
hyperinflation.
(B) Hyperinflationary deposit. A hyperinflationary deposit is a
demand or time deposit or similar instrument issued by a bank or other
financial institution that provides for--
(1) Payments denominated in or determined by reference to a
currency that is hyperinflationary (as defined in Sec. 1.988-1(f)) at
the time the taxpayer enters into or otherwise acquires the deposit; or
(2) Payments denominated in or determined by reference to a
currency that is hyperinflationary (as defined in Sec. 1.988-1(f))
during the taxable year, and the terms of the deposit provide for the
adjustment of the deposit amount or interest payments in a manner that
reflects hyperinflation.
(vii) Interaction with other provisions--(A) Interest allocation
rules. In determining the amount of interest expense, this paragraph
(b)(15) applies before Secs. 1.861-9T through 1.861-12T, and 1.882-5.
(B) DASTM. With respect to a qualified business unit that uses the
United States dollar approximate separate transactions method of
accounting described in Sec. 1.985-3, paragraph (b)(15)(i) of this
section does not apply.
(C) Interaction with section 988(a)(3)(C). Section 988(a)(3)(C)
does not apply to a debt instrument subject to the rules of paragraph
(b)(15)(i) of this section.
(D) Hedging rules. To the extent Sec. 1.446-4 or 1.988-5 apply, the
rules of paragraph (b)(15)(i) of this section will not apply. This
paragraph (b)(15)(vii)(D) does not apply if the application of
Sec. 1.988-5 results in hyperinflationary debt instrument or deposit
described in paragraph (b)(15)(vi)(A) or (B) of this section.
(viii) Effective date. This paragraph (b)(15) applies to
transactions entered into after February 14, 2000.
* * * * *
(d) * * *
(5) Hyperinflationary contracts--(i) In general. If a taxpayer
acquires or otherwise enters into a hyperinflationary contract (as
defined in paragraph (d)(5)(ii) of this section) that has payments to
be made or received that are denominated in (or determined by reference
to) a nonfunctional currency of the taxpayer, then the taxpayer shall
realize exchange gain or loss with respect to such contract for its
taxable year determined by reference to the change in exchange rates
between--
(A) The later of the first day of the taxable year, or the date the
contract was acquired or entered into; and
(B) The earlier of the last day of the taxable year, or the date
the contract is disposed of or otherwise terminated.
(ii) Definition of hyperinflationary contract. A hyperinflationary
contract is a contract described in paragraph (d)(1) of this section
that provides for payments denominated in or determined by reference to
a currency that is hyperinflationary (as defined in Sec. 1.988-1(f)) at
the time the taxpayer acquires or otherwise enters into the contract.
(iii) Interaction with other provisions--(A) DASTM. With respect to
a qualified business unit that uses the United States dollar
approximate separate transactions method of accounting described in
Sec. 1.985-3, this paragraph (d)(5) does not apply.
(B) Hedging rules. To the extent Sec. 1.446-4 or 1.988-5 apply,
this paragraph (d)(5) does not apply.
(C) Adjustment for subsequent transactions. Proper adjustments must
be made in the amount of any gain or loss subsequently realized for
gain or loss taken into account by reason of this paragraph (d)(5).
[[Page 2030]]
(iv) Effective date. This paragraph (d) (5) is applicable to
transactions acquired or otherwise entered into after February 14,
2000.
(e) * * *
(3) * * *
(iv) Coordination with Sec. 1.446-3(g)(4) regarding swaps with
significant nonperiodic payments. The rules of Sec. 1.446-3(g)(4) apply
to any currency swap with a significant nonperiodic payment. Section
1.446-3(g)(4) applies before this paragraph (e)(3). Thus, if
Sec. 1.446-3(g)(4) applies, currency gain or loss may be realized on
the loan. This paragraph (e)(3)(iv) applies to transactions entered
into after February 14, 2000.
* * * * *
(7) Special rules for currency swap contracts in hyperinflationary
currencies--(i) In general. If a taxpayer enters into a
hyperinflationary currency swap (as defined in paragraph (e)(7)(iv) of
this section), then the taxpayer realizes exchange gain or loss for its
taxable year with respect to such instrument determined by reference to
the change in exchange rates between--
(A) The later of the first day of the taxable year, or the date the
instrument was entered into (by the taxpayer); and
(B) The earlier of the last day of the taxable year, or the date
the instrument is disposed of or otherwise terminated.
(ii) Adjustment to principal or basis. Proper adjustments are made
in the amount of any gain or loss subsequently realized for gain or
loss taken into account by reason of this paragraph (e)(7).
(iii) Interaction with DASTM. With respect to a qualified business
unit that uses the United States dollar approximate separate
transactions method of accounting described in Sec. 1.985-3, this
paragraph (e)(7) does not apply.
(iv) Definition of hyperinflationary currency swap contract. A
hyperinflationary currency swap contract is a currency swap contract
that provides for--
(A) Payments denominated in or determined by reference to a
currency that is hyperinflationary (as defined in Sec. 1.988-1(f)) at
the time the taxpayer enters into or otherwise acquires the currency
swap; or
(B) Payments that are adjusted to take into account the fact that
the currency is hyperinflationary (as defined in Sec. 1.988-1(f))
during the current taxable year. A currency swap contract that provides
for periodic payments determined by reference to a variable interest
rate based on local conditions and generally responding to changes in
the local consumer price index is an example of this latter type of
currency swap contract.
(v) Special effective date for nonfunctional hyperinflationary
currency swap contracts. This paragraph (e)(7) applies to transactions
entered into after February 14, 2000.
* * * * *
Approved: December 13, 1999.
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 00-644 Filed 1-12-00; 8:45 am]
BILLING CODE 4830-01-P
