Income and Currency Gain or Loss With Respect to a Section 987 QBU, 52876-52918 [06-7250]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 71, Number 173 (Thursday, September 7, 2006)]
[Proposed Rules]
[Pages 52876-52918]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 06-7250]



[[Page 52875]]

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Part II





Department of the Treasury





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Internal Revenue Service



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26 CFR Part 1



Income and Currency Gain or Loss With Respect to a Section 987 QBU; 
Proposed Rule

Federal Register / Vol. 71, No. 173 / Thursday September 7, 2006 / 
Proposed Rules

[[Page 52876]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-208270-86]
RIN 1545-AM12


Income and Currency Gain or Loss With Respect to a Section 987 
QBU

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Withdrawal of notice of proposed rulemaking, notice of proposed 
rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations that provide 
guidance under section 987 of the Internal Revenue Code (Code) 
regarding the determination of the items of income or loss of a 
taxpayer with respect to a section 987 qualified business unit (section 
987 QBU) as well as the timing, amount, character and source of any 
section 987 gain or loss. It withdraws proposed regulations under 
section 987 that were published in the Federal Register on September 
25, 1991 (56 FR 48457). These regulations are necessary to provide 
guidance under section 987. Taxpayers affected by these regulations are 
corporations and individuals with qualified business units subject to 
section 987.

DATES: Written or electronic comments must be received by December 6, 
2006. Outlines of topics to be discussed at the public hearing 
scheduled for November 21, 2006, must be received by October 31, 2006.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-208270-86), Internal 
Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 
20044. Submissions may be sent electronically, via the IRS Internet 
site at https://www.irs.gov/regs or via the Federal eRulemaking Portal 
at https://www.regulations.gov (IRS REG-208270-86).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Sheila Ramaswamy at (202) 622-3870; concerning submissions of comments, 
Kelly Banks at (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of Treasury, Office of Information and Regulatory Affairs, 
Washington, DC 20503, with copies to the Internal Revenue Service, 
Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 
20224. Comments on the collection of information should be received by 
November 6, 2006.
    Comments are requested specifically concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the Internal Revenue Service, 
including whether the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
     How the burden of complying with the proposed collection of 
information may be minimized, including through the application or 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of service to provide information.
    The collection of information in these proposed regulations is in 
Sec. Sec.  1.987-1(b)(1)(ii),1.987-1(b)(2)(ii), 1.987-1(c)(1)(ii), 
1.987-1(f), 1.987-3(b)(1), 1.987-9, 1.987-10 and 1.987-11. Section 
1.987-1(b)(1)(ii) allows a partner to make an election not to take 
section 987 gain or loss into account. Section 1.987-1(b)(2)(ii) allows 
a taxpayer to make an election to group certain QBUs with the same 
functional currency as a single QBU. Sections 1.987-1(c)(1)(ii) and -
3(b)(1) allow a taxpayer to make an election to use a convention for 
exchange rates. Section 1.987-11(b) allows a taxpayer to elect to apply 
these regulations to taxable years beginning after the date of 
publication of a Treasury decision adopting this rule as a final 
regulation in the Federal Register. The preceding elections are to be 
made pursuant to Sec.  1.987-1(f) by attaching a statement to the 
taxpayer's tax return describing the election to be made. Section 
1.987-9 contains recordkeeping rules to establish a qualified business 
unit's income and section 987 gain or loss. This collection of 
information is required to establish the qualified business unit's 
income, gain, deduction or loss and assets and liabilities as well as 
exchange rates used for foreign currency translation purposes. Section 
1.987-10 provides rules for transitioning to the method provided under 
the new proposed regulations for determining section 987 gain or loss 
and provides certain corresponding reporting rules. The collection of 
information contained in this regulation facilitates the identification 
of the prior method used by the taxpayer to determine section 987 gain 
or loss. The collections of information are mandatory. The likely 
respondents are taxpayers with foreign qualified business units.
    Estimated total annual reporting burden: 12,000.
    Estimated average annual burden hours per respondent: 12.
    Estimated number of respondents: 1,000.
    Estimated annual frequency of responses: annually.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books and records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

A. Overview

    As part of the Tax Reform Act of 1986, Public Law 99-514, 100 Stat. 
2085 (October 22, 1986), 1986-3 CB Vol.1, 1, see Sec.  601.601(d)(2), 
Congress enacted comprehensive reforms to the tax treatment of foreign 
currency transactions by adding new subpart J. Those reforms included, 
among other things, the introduction of the functional currency 
concept, which generally distinguishes taxpayers on the basis of the 
primary currency in which they keep their books and records and conduct 
their business. Reforms also included the addition of the qualified 
business unit (QBU) concept, which generally provides a basis for 
allowing a taxpayer with a separate unit that conducts business and 
keeps books and records in a currency other than the functional 
currency of the taxpayer to account for the results of operation of the 
separate unit in the unit's own functional currency. Against that 
conceptual background, section 988 provides rules for the treatment of 
transactions in a currency other than the

[[Page 52877]]

taxpayer's functional currency. Section 986 generally provides rules 
for translating into U.S. dollars the earnings and profits and foreign 
taxes of a foreign corporation whose functional currency is not the 
U.S. dollar (dollar). Section 987, in turn, generally provides rules 
for determining and translating income and currency gain and loss with 
respect to operations of a branch whose functional currency is other 
than the functional currency of the taxpayer. As discussed below, an 
already complex area of law was made even more complicated when the 
entity classification rules under Sec.  301.7701-1 through 301.7701-3 
(the ``check the box'' regulations) were promulgated in 1997.
    On September 25, 1991, the IRS and the Treasury Department issued 
proposed regulations under section 987 (the 1991 proposed regulations). 
See 56 FR 48457. In light of subsequent IRS experience with taxpayer 
claims of large non-economic currency losses under section 987, the IRS 
and the Treasury Department issued Notice 2000-20 (2000-1 CB 851). See 
Sec.  601.601(d)(2). This notice expressed serious concern that the 
1991 proposed regulations had not fully achieved the original goal of 
facilitating recognition of true economic foreign currency gain and 
loss under appropriate circumstances and requested comments on this 
issue and other matters.
    This document withdraws the 1991 proposed regulations and provides 
new proposed regulations based on the ``foreign exchange exposure 
pool'' method. The IRS and the Treasury Department believe that this 
method more accurately reflects foreign currency gain and loss than the 
1991 proposed regulations and does so in a manner consistent with 
statutory authority and legislative intent. These new proposed 
regulations are designed to prescribe more precisely foreign currency 
gain and loss that is economically realized, while minimizing or 
eliminating the realization of non-economic currency gain and loss.
    The following background discussion describes section 987, its 
legislative history, the 1991 proposed regulations, Notice 2000-20, and 
the general approach that provides the basis for the foreign exchange 
exposure pool method.

B. The Statute

    Section 987 generally provides that in the case of a taxpayer 
having a QBU with a functional currency other than that of the 
taxpayer, the taxable income of the taxpayer with respect to the QBU is 
determined by computing the taxable income or loss of the QBU 
separately and translating such income or loss at the appropriate 
exchange rate. Section 987 further requires the taxpayer to make 
``proper adjustments'' (as prescribed by the Secretary) for transfers 
of property between QBUs having different functional currencies 
including treating post-1986 remittances from each such unit as made on 
a pro rata basis out of post-1986 accumulated earnings; treating 
section 987 gain or loss as ordinary income or loss; and sourcing such 
gain or loss by reference to the source of the income giving rise to 
post-1986 accumulated earnings.

C. The Legislative History

1. Prior Law
    As described in the applicable legislative history,\1\ section 987 
was enacted against a background of, and partly in reaction to, 
perceived shortcomings with prevailing law. The prevailing law at that 
time was fairly limited. It consisted primarily of two revenue rulings 
that provided alternative methods for calculating branch taxable 
income.
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    \1\ H. Rep. No. 99-426, 99th Cong., 1st Sess. (1985); 1986-3 CB 
Vol 2, 449. S. Rep. No 99-313, 99th Cong., 2d Sess. (1986); 1986-3 
CB Vol. 3, 443. H.R. Conf. Rep. No. 99-841, 99th Cong., 2d Sess. 
(1986); 1986-3 CB Vol. 4, 659. Later citations are to the Cumulative 
Bulletin. See Sec.  601.601(d)(2).
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    Rev. Rul. 75-106 (1975-1 CB 31), see Sec.  601.601(d)(2), provides 
for the use of a ``net worth'' method. Under this method, taxable 
income of a branch of a domestic corporation engaged in business in a 
foreign country is defined generally as the difference between the 
branch's opening and closing net worth as reflected on the branch's 
balance sheets for the taxable year. Under this method, the branch's 
balance sheet is translated into U.S. dollars. In general, the values 
of current items (such as cash or cash flows denominated in foreign 
currency) are translated at the year-end exchange rate, and the values 
of historical items (such as equipment) are translated at the exchange 
rate for the period in which the item was acquired or incurred. The 
translation of an item at the year-end rate causes changes in the 
item's value due to currency fluctuations to be taken into account 
annually, and the translation of an item at the historical rate 
generally precludes recognition of fluctuations in value due to 
changing exchange rates. In this way, the net worth method was able to 
identify items considered economically exposed to fluctuations in 
exchange rates. The total change in net worth identified by the net 
worth method is equal to the sum of the operating profit or loss of the 
branch and the exchange gain or loss on current items. However, the net 
worth method does not identify separate items of income and expense 
because it is based solely on a balance sheet comparison and does not 
use a profit and loss statement.
    Rev. Rul. 75-107 (1975-1 CB 32), see Sec.  601.601(d)(2), provides 
for the use of a ``profit and loss'' method. Under this method, the 
branch computes taxable income by translating the local currency profit 
and loss statement (adjusted for U.S. tax principles) into dollars. Any 
portion of the profit and loss remitted to the home office during the 
year is translated at the exchange rate on the date of the remittance, 
and the remainder is translated at the year-end exchange rate. No 
exchange gain or loss is recognized on a remittance.
    The net worth method of Rev. Rul. 75-106 and the profit and loss 
method of Rev. Rul. 75-107 each suffered from infirmities. The net 
worth method resulted in the realization of foreign currency gain and 
loss that was not consistent with the general realization principles of 
the Code; it also failed to accurately characterize items of income, 
gain, deduction or loss of the branch. The profit and loss method, in 
turn, did not take into account foreign currency gain and loss inherent 
in the assets and liabilities on the balance sheet as part of such 
method. Both methods failed to account for foreign currency gain or 
loss in the event of a remittance.
    The legislative history states that under section 987, a taxpayer 
with a QBU whose functional currency is other than the functional 
currency of the taxpayer will be required to use a profit and loss 
method, rather than the net worth method (as this method was understood 
at the time). House Report (1986-3 CB Vol. 2, 479); Senate Report 
(1986-3 CB Vol. 3, 470); and Conference Report (1986-3 CB Vol. 4, 675). 
See Sec.  601.601(d)(2). However, this legislative history is not 
properly read as an explicit rejection of the net worth method in its 
entirety. Instead, it is more accurately viewed as a rejection of 
certain aspects of the law prevailing at that time. Importantly, the 
method provided in section 987 as enacted actually represents a blend 
of the separate methods, as it has aspects of both a net worth method 
and a profit and loss method. It also has at least one feature absent 
from each method--that is, section 987 includes the remittance 
recognition concept. Consistent with a profit and loss method, sections 
987(1) and (2) generally determine the items of income or loss of a QBU 
based on its profit and loss statement as determined in its functional 
currency. Such items are then translated into the taxpayer's

[[Page 52878]]

functional currency at the appropriate rate.\2\ Consistent with a net 
worth method, section 987(3) requires that exchange gain or loss be 
computed with respect to certain branch assets and liabilities (as 
prescribed by the Secretary). Unlike either method, section 987(3)(A) 
provides that exchange gain or loss is recognized upon a remittance.
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    \2\ Section 989(b)(4) provides that, ``except as provided in 
regulations,'' the appropriate exchange rate is the average exchange 
rate for the taxable year of the QBU.
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    The blending of features of both a profit and loss method and of a 
net worth method in section 987 is significant. Together with more 
specific principles identified in the legislative history, this 
blending of methods informs the Congressionally stated preference for 
the profit and loss method. The House Report states:

    A profit and loss method can be viewed as being more consistent 
with the functional currency concept than a net worth method. Under 
a profit and loss method, the functional currency is used as the 
measure of income or loss, so that earnings determined for U.S. tax 
purposes would bear a close relation to taxable income computed by 
the foreign jurisdiction. In contrast, a net worth method takes 
unrealized exchange gains and losses into account. Further, a profit 
and loss method minimizes the accounting procedures that otherwise 
would be required to make the item-by-item translations under a net 
worth method. Finally, in the case of a branch, the net worth method 
as applied under present law fails to characterize accurately items 
of income or loss that are subject to special U.S. tax rules. For 
example, although there are limitations on the deductibility of 
long-term capital losses, such a loss incurred by a branch would be 
given tax effect because it would be reflected as an adjustment to 
the balance sheet.

House Report at 469.
    The House and Senate reports are generally uniform in describing 
Congressional intent with regard to the computations required under 
section 987 as illustrated by the Senate Report.

    Under the bill, a taxpayer with a branch whose functional 
currency is a currency other than the U.S. dollar will be required 
to use the profit and loss method to compute branch income. Thus, 
the net worth method will no longer be an acceptable method of 
computing income or loss of a foreign branch for tax purposes, and 
only realized exchange gains and losses on branch capital will be 
reflected in taxable income.

    For each taxable year, the taxpayer will compute income or loss 
separately for each qualified business unit in the business unit's 
functional currency, converting this amount to U.S. dollars using 
the weighted average exchange rate for the taxable period over which 
the income or loss accrued. This amount will be included in income 
without reduction for remittances from the branch during the year. 
The committee anticipates that regulations will provide rules that 
will limit the deduction of branch losses to the taxpayer's dollar 
basis in the branch (that is, the original dollar investment plus 
subsequent capital contributions and unremitted earnings).

    A taxpayer will recognize exchange gain or loss on remittances 
(without regard to whether or when the remittances are converted to 
dollars), to the extent the value of the currency at the time of the 
remittance differs from the value when earned. Remittances of 
foreign branch earnings (and interbranch transfers involving 
branches with different functional currencies) after 1986 will be 
treated as paid pro rata out of post-1986 accumulated earnings of 
the branch. The committee anticipates that, for purposes of 
calculating exchange gain or loss on remittances, the value of the 
currency will be determined by translating the currency at the rate 
in effect on the date of remittance. Exchange gains and losses on 
such remittances will be deemed to be ordinary and domestic source.

    Senate Report (1986-3 CB Vol. 3, 470). Importantly, the Conference 
Report modifies the House and Senate reports by stating that a 
remittance by a QBU ``will trigger exchange gain or loss inherent in 
accumulated earnings or branch capital.'' Conference Report, 1986-3 CB 
Vol. 4, 675.

    From section 987 and the foregoing legislative history, several 
principles emerge:
    1. A branch profit and loss computation is required in order to 
properly characterize items of branch income or loss, which is taken 
into account in the year earned.
    2. Exchange gain or loss is recognized upon a remittance, in an 
amount prescribed by the Secretary.
    3. Both branch earnings and branch capital can give rise to 
exchange gain or loss under section 987.
    4. Regulations under section 987 should seek to minimize 
complexity regarding item-by-item translations.
    5. The currency gain or loss taken into account under section 
987 is only the economic gain or loss ``inherent in'' the assets and 
liabilities of a QBU.
2. Relationship Between Section 986(c) and 987
    Comments to the IRS and the Treasury Department have suggested that 
the computation under section 987 of exchange gain or loss for a branch 
is intended to operate in the same manner as the computation under 
section 986(c) of certain exchange gain or loss of a foreign 
corporation. In general, section 986(c) provides for the recognition of 
exchange gain or loss only with respect to distributions of previously 
taxed earnings and profits (as described in section 959 or 1293(c)). 
The Conference Report includes the following general statement about 
the translation rules:

    The same translation rule applies to the earnings and profits of 
a foreign corporation and the income or loss of a branch or other 
QBU. An entity that uses a nonfunctional currency to measure the 
results of operation is required to use a profit and loss method to 
translate income or loss into functional currency. * * * These 
translation rules apply without regard to the form of enterprise 
through which the taxpayer conducts business (e.g., sole 
proprietorship, partnership, or corporation) as long as such form of 
enterprise rises to the level of a QBU.

    Conference Report, 1986-3 CB Vol. 4, 670. See Sec.  601.601(d)(2). 
The suggestion in comments is to apply this general principle such that 
section 987 would require the recognition of exchange gain or loss only 
with respect to branch earnings and not with respect to contributed 
capital.
    Despite the broad statements of principle quoted above, Congress 
provided more specific guidance regarding the treatment of branches in 
this regard. The Conference Report states that a remittance by a QBU 
``will trigger exchange gain or loss inherent in accumulated earnings 
or branch capital.'' Conference Report, 1986-3 CB Vol. 4, 675. See 
Sec.  601.601(d)(2). Similarly, despite the stated requirement that 
QBUs must use a notional profit and loss method to determine branch 
taxable income, the specific method actually provided in section 987 
and described in the legislative history represents a blend of a net 
worth method and a profit and loss method. Accordingly, the IRS and the 
Treasury Department believe that the more specific statements made by 
Congress regarding the treatment of branch exchange gain or loss 
reflect an intention that the methodologies of section 986(c) and 
section 987 not be identical.

D. The 1991 Proposed Regulations

    The 1991 proposed regulations provide generally that the net income 
of a QBU having a functional currency different than the taxpayer is 
determined annually. Such determination is based on the profit and loss 
appearing on the QBU's books and records, adjusted to conform to U.S. 
tax principles, and translated into the functional currency of the 
taxpayer using the weighted average exchange rate for the taxable year. 
The 1991 proposed regulations also provide for the recognition of 
exchange gain or loss upon a remittance from the QBU's equity pool. In 
general, the equity pool consists of the undistributed capital and 
earnings of the QBU, determined in the QBU's functional currency. The 
1991 proposed regulations also provide for a basis pool, which consists 
of the basis

[[Page 52879]]

of the capital and earnings in the equity pool, expressed in the 
functional currency of the taxpayer. The portion of the basis pool, 
expressed in the functional currency of the taxpayer, that is 
attributable to a remittance is generally determined according to the 
following formula:
[GRAPHIC] [TIFF OMITTED] TP07SE06.000

    Section 987 gain or loss is the difference between the value of the 
remittance from the QBU translated into the taxpayer's functional 
currency at the spot rate on the date the remittance is made, less the 
basis associated with the remittance as determined above. One important 
consequence of the equity pool paradigm is that all branch equity gives 
rise to exchange gain or loss, regardless of whether or not that equity 
is held in a form that actually exposes the QBU's owner to currency 
fluctuations (compare assets such as cash or indebtedness to assets 
such as equipment).
    Under the 1991 proposed regulations, a taxpayer must determine the 
source and character of section 987 gain or loss for all purposes of 
the Code, including sections 904(d), 907, and 954, by using the same 
method the taxpayer uses to allocate and apportion its interest expense 
under section 861, with certain modifications.

E. Concerns Regarding the 1991 Proposed Regulations; Notice 2000-20

    Effective January 1, 1997, the IRS and the Treasury Department 
issued the check the box regulations implementing new elective entity-
classification rules. These regulations made it possible for certain 
entities with a single owner to be treated for federal income tax 
purposes as an entity disregarded as separate from its owner (a 
disregarded entity or DE). As a result, businesses that had previously 
operated through subsidiaries could operate through structures treated 
for tax purposes as branches. The effect of the check the box 
regulations was a dramatic increase in the number of branches resulting 
from DE elections that are subject to section 987. This increase has 
greatly exacerbated the already existing problems of the 1991 proposed 
regulations, especially the ability of taxpayers to trigger non-
economic losses (and the corresponding trap for the unwary taxpayer 
with non-economic gains).
    As indicated above, the equity pool paradigm in the 1991 proposed 
regulations imputes currency gain or loss to all equity of a QBU 
whether or not the assets of the QBU are economically exposed to 
changes in the value of the functional currency of the QBU. The IRS has 
faced many cases in which taxpayers have claimed substantial non-
economic exchange losses largely on the basis of the 1991 proposed 
regulations. An example may be instructive. Assume that a domestic 
corporation (US Corp) with the dollar as its functional currency forms 
a foreign corporation in Country X and then elects under the check the 
box regulations to treat that corporation as a DE. The DE conducts 
mineral extraction and owns all the necessary equipment. The equipment 
owned by the DE was contributed by US Corp. The DE has no employees and 
contracts with a subsidiary of US Corp for the employees needed in the 
business of extraction. US Corp, as the entity's sole owner, claims 
that the DE is a QBU for purposes of section 987. The DE has minimal 
financial assets and conducts no activities other than mineral 
extraction. US Corp claims that the DE's functional currency is Country 
X currency. A decline in the value of Country X currency relative to 
the dollar does not produce any economic loss for US Corp because the 
assets of the DE are not financial assets subject to currency 
fluctuation. Nevertheless, US Corp claims under the 1991 proposed 
regulations that the equity of the DE, which consists almost 
exclusively of equipment, gives rise to a substantial non-economic 
exchange loss and that terminating the DE (for example, by another 
check the box election) triggers recognition of such loss. Taxpayers 
have claimed similar results under other fact patterns. The IRS and the 
Treasury Department have serious concerns about these types of 
transactions.
    Although the foregoing example concerns the claiming of non-
economic losses, the equity pool approach in the 1991 proposed 
regulations can also give rise to non-economic gains. Recently, the 
value of the US dollar has declined against many foreign currencies. It 
is likely that under these circumstances, taxpayers subject to section 
987 may have large non-economic gains built into the equity pool. The 
IRS and the Treasury Department believe that Congress did not intend 
for section 987 to generate non-economic foreign currency gains or 
losses.
    In light of the entity-classification rules and the potential for 
the equity pool paradigm to generate non-economic currency gains and 
losses, the IRS and the Treasury Department issued Notice 2000-20, 
2000-1 CB 851. See Sec.  601.601(d)(2). Among other things, the notice 
indicated that the IRS and the Treasury Department were concerned that 
the proposed regulations may not have achieved their original goal of 
recognizing economic exchange gains and losses under appropriate 
circumstances. The notice requested comments on this and other issues.
    Several comments were received in response to the notice and raised 
a number of important points. Two of those comments suggested replacing 
the equity pool paradigm in the 1991 proposed regulations with a 
paradigm that recognizes exchange gain or loss only on the earnings of 
a QBU and not its capital. As described above, the IRS and the Treasury 
Department believe that such an approach is inconsistent with 
Congressional intent as expressed in the legislative history to section 
987. An earnings-only approach also would fail to address the core 
problem of distinguishing between items that economically give rise to 
exchange gain and loss and those that do not. Additionally, an 
earnings-only approach would produce different results for QBUs with 
the same net assets, depending upon whether the net assets were funded 
with capital or earnings. Finally, an earnings-only approach fails to 
take into account any foreign currency exposure on capital and so could 
disadvantage banks and other financial institutions, much of whose 
QBUs' capital may be subject to such exposure.

F. The Foreign Exchange Exposure Pool Method

    The IRS and the Treasury Department believe that Congress did not 
intend

[[Page 52880]]

section 987 to permit the largely uninhibited recognition of non-
economic exchange gain or loss. The 1991 proposed regulations, together 
with the check the box regulations, have combined to permit taxpayers 
to trigger non-economic losses with relative ease. Accordingly, the 
1991 proposed regulations are withdrawn and are replaced with new 
proposed regulations that adopt the ``foreign exchange exposure pool 
method.'' In general, the foreign exchange exposure pool method 
provides that the income of a QBU that is subject to section 987 
(``section 987 QBU'') is determined by reference to the items of 
income, gain, deduction and loss booked to the QBU in its functional 
currency, adjusted to reflect US tax principles. With certain 
exceptions, items of income, gain, deduction and loss of a section 987 
QBU are translated into the functional currency of the QBU's owner at 
the average exchange rate for the year. However, the basis of historic 
assets and deductions for depreciation, depletion, and amortization of 
such assets are translated at the historic exchange rate. Translating 
these items at the historic exchange rate differs from the approach 
taken in the 1991 proposed regulations, which instead uses the average 
exchange rate. Although using the average exchange rate for translating 
such items might be simpler than using the historic exchange rate, it 
leads to the generation of non-economic foreign currency gains or 
losses described in this preamble.
    The foreign exchange exposure pool method uses a balance sheet 
approach to determine exchange gain or loss, which is then recognized 
upon a remittance. Use of a balance sheet approach allows taxpayers and 
the IRS to distinguish between those items whose value fluctuates with 
respect to changes in the functional currency of the owner and those 
which do not. Under this method, exchange gain or loss with respect to 
``marked items'' is identified annually but is pooled and deferred 
until a remittance is made. The IRS and the Treasury Department believe 
that section 988(c) identifies the items that should be treated as 
giving rise to exchange gain or loss for purposes of section 987. 
Accordingly, a marked item is generally defined as an asset or 
liability that would generate section 988 gain or loss if such asset or 
liability were held or entered into directly by the owner of the 
section 987 QBU.
    When a section 987 QBU makes a remittance, a portion of the pooled 
and deferred exchange gain or loss is recognized. In general, the 
amount taken into account is an amount equal to the product of the 
owner's portion of the section 987 QBU's net unrecognized exchange gain 
or loss, multiplied by the owner's remittance proportion. The owner's 
remittance proportion generally is equal to the quotient of the amount 
of the remittance, divided by the aggregate basis of the section 987 
QBU's gross assets (as reflected on its year-end balance sheet), 
without reduction for the remittance.
    The source and character of exchange gain or loss recognized under 
section 987 for all purposes of the Code, including sections 904(d), 
907 and 954, is determined by reference to the source and character of 
the income derived from the section 987 QBU's assets.
    The IRS and the Treasury Department believe that the foreign 
exchange exposure pool method is consistent with section 987 and 
legislative intent for several reasons. First, the foreign exchange 
exposure pool method uses a profit and loss statement to determine the 
items of income, gain, deduction and loss of a section 987 QBU in its 
functional currency. This allows proper characterization of items of 
income, gain, deduction and loss. Second, exchange gain or loss must be 
taken into account only with respect to items of branch capital and 
earnings whose value fluctuates with changes in exchange rates by 
reference to the owner's functional currency. This comports both with 
Congressional intent that taxpayers recognize exchange gain or loss 
(but only economic exchange gain or loss) inherent in branch capital 
and branch earnings and with authority granted under section 987(3) to 
identify appropriate translation rates. Third, exchange gain or loss is 
recognized under section 987 only upon a remittance. Finally, the 
foreign exchange exposure pool method is an appropriate interpretation 
of the ``blended'' approach of section 987--that is, it incorporates 
certain aspects of the profit and loss method and the net worth method.

Explanation of Provisions

A. Section 1.987 1 Scope, Definitions and Special Rules

1. Scope in General
    The proposed regulations provide rules for determining the section 
987 taxable income or loss of a taxpayer with respect to a section 987 
QBU as well as the timing, amount, character, and source of section 987 
gain or loss recognized with respect to such QBU. The proposed 
regulations do not apply to banks, insurance companies, and similar 
financial entities (including, solely for this purpose, leasing 
companies, finance coordination centers, regulated investment 
companies, and real estate investment trusts). The IRS and the Treasury 
Department plan to apply the foreign exchange exposure pool method 
adopted in the proposed regulations to such entities in subsequent 
guidance but believe it is appropriate to request comments regarding 
how the rules of the proposed regulations need to be precisely tailored 
to address issues unique to financial entities. Financial entities are 
urged to make necessary comments to help tailor the planned extension 
of the foreign exchange exposure pool method to such entities.
    Specifically, in the context of banks, the IRS and the Treasury 
Department request comments on whether special rules are needed for the 
global dealing of currencies and securities. Comments are also 
requested on the relationship of sections 987 and 988 for banks. 
Finally, comments are requested on whether the use of exchange rate 
conventions is appropriate for banks and finance entities and, if so, 
how such conventions should be determined. In the context of insurance 
companies, the IRS and the Treasury Department request comments on the 
proper treatment of insurance reserves, surplus, and investment assets 
held by the separate trades or business of an insurance company. In 
particular, comments are requested on the proper treatment of stock 
held in separate accounts of a section 987 QBU of a life insurance 
company and the related insurance reserves established for those 
separate accounts. In the context of leasing companies, comments are 
requested regarding the treatment of stock in other leasing companies 
recorded on the books and records of a section 987 QBU and how the 
rules of sections 986 and 987 can be reconciled if stock is treated as 
a ``marked asset'' in this setting. Until regulations are issued 
applying the foreign exchange exposure pool method to financial 
entities, such entities must comply with section 987 under a reasonable 
method, consistently applied. For this purpose, reasonable methods 
include using the method described in the 1991 proposed regulations and 
a method that imputes section 987 gain or loss to earnings but not 
capital.
    The proposed regulations also do not apply to trusts, estates and S 
corporations. The IRS and the Treasury Department plan to apply the 
foreign exchange exposure pool method adopted in the proposed 
regulations to such entities but believe it is appropriate to request 
comments

[[Page 52881]]

regarding how the rules of the proposed regulations should be applied 
to such entities. The IRS and the Treasury Department request comments 
regarding whether principles similar to those applied to partnerships 
should apply to these entities.
2. Taxpayers Subject to Section 987 and Related Definitions
    The IRS and the Treasury Department believe that section 987 should 
only apply where an individual or corporation (whether foreign or 
domestic) has activities that constitute a trade or business under 
Sec.  1.989(a)-1(c) and the trade or business has a functional currency 
different from the individual or corporation. In such cases, the 
individual or corporation will be subject to the rules of the proposed 
regulations if the individual or corporation is the owner of a section 
987 QBU. A section 987 QBU is defined in Sec.  1.987-1(b)(2) as an 
eligible QBU that has a functional currency different from its owner.
    An eligible QBU is defined in Sec.  1.987-1(b)(3) of the proposed 
regulations. Generally, an eligible QBU is an activity of an 
individual, corporation, partnership or DE that is a trade or business 
as defined in Sec.  1.989(a)-1(c); maintains separate books and records 
as defined in Sec.  1.989(a)-1(d) and assets and liabilities used in 
conducting such activities are reflected on such books and records; and 
the activities are not subject to the dollar approximate separate 
transaction (DASTM) rules of Sec.  1.985-3. A corporation is not an 
eligible QBU. An individual is not a QBU under Sec.  1.989(a)-
1(b)(2)(i) and therefore cannot be an eligible QBU. In addition, and as 
discussed in this preamble, neither a partnership nor a DE is an 
eligible QBU.
    In the case of ownership other than through a partnership (that is, 
direct ownership), the individual or corporation is treated as the 
owner of an eligible QBU if the individual or corporation is the tax 
owner of the assets and liabilities of the eligible QBU. For purposes 
of determining direct ownership, an individual or corporation will be 
treated as a direct owner of the assets and liabilities of an eligible 
QBU if it owns a DE that holds an eligible QBU. In such case, because 
the DE is not recognized as a separate entity, it cannot be a QBU under 
section 989 and, therefore, is not treated as an eligible QBU under the 
proposed regulations. However, the activities of the DE, which are 
treated for purposes of the Code as carried on directly by its owner, 
can qualify as an eligible QBU of the DE's owner.
    With respect to partnerships, the IRS and the Treasury Department 
recognize that issues often arise as to whether the international tax 
provisions of the Code operate on an aggregate or an entity basis. The 
legislative history of subchapter K of chapter 1 of the Code provides 
that, for purposes of interpreting Code provisions outside of that 
subchapter, a partnership may be treated as either an entity separate 
from its partners or an aggregate of its partners, depending on which 
characterization is more appropriate to carry out the purpose of the 
particular section under consideration. H.R. Conf. Rep. No. 2543, 83rd 
Cong. 2d. Sess. 59 (1954).
    In the case of section 987, the calculations under the foreign 
exchange exposure pool method would differ dramatically based on 
whether an aggregate or an entity approach is adopted. For example, if 
the foreign exchange exposure pool method is applied at the entity 
level, the partnership will make the method's calculations by reference 
to the partnership's functional currency. Under this approach, any 
foreign currency gain or loss will be an item of the partnership and 
will be allocated among the partners in accordance with the partnership 
agreement, to the extent such allocation is consistent with the 
provisions of subchapter K. If, in the alternative, the foreign 
exchange exposure pool method is applied under an aggregate approach, 
each partner will make its own foreign exchange exposure pool 
calculations by reference to the partner's functional currency and such 
amounts will not be subject to separate allocation under subchapter K.
    The IRS and the Treasury Department believe that, on balance, an 
aggregate approach is more appropriate for section 987 purposes. 
Applying the foreign exchange exposure pool method directly at the 
partner level will more appropriately preserve the correct amounts of 
exchange gain or loss. In addition, such approach will measure the 
foreign currency exposure by reference to the functional currencies of 
the persons who generally bear the economic risk from such exposure. As 
a result, the proposed regulations provide that for purposes of 
applying the foreign exchange exposure pool method each individual or 
corporation that is a partner in a partnership will be considered to 
own indirectly an eligible QBU consisting of a portion of the assets 
and liabilities of the partnership allocated to it under Sec.  1.987-7. 
If such eligible QBU has a different functional currency from the 
partner and therefore is a section 987 QBU, the foreign exchange 
exposure pool method is applied with respect to those assets and 
liabilities. In addition, the proposed regulations provide rules for 
converting the items of section 987 taxable income or loss of a section 
987 QBU into the functional currency of the partner (when necessary), 
and rules coordinating this aggregate approach with other provisions of 
subchapter K.
    Section 1.987-1(b)(2)(ii) allows an owner to elect to treat certain 
section 987 QBUs with the same functional currency as a single section 
987 QBU. The purpose of this rule is to simplify section 987 
calculations by reducing the number of interbranch transactions that 
would be considered as ``transfers'' of assets and liabilities. This 
election applies only to certain section 987 QBUs of the owner. The IRS 
and the Treasury Department request comments regarding whether such 
election should be available to treat section 987 QBUs of owners that 
are members of a consolidated group as a single section 987 QBU and how 
this should be technically effectuated.
    Section 1.987-1(b)(5) provides that the term ``owner'' for section 
987 purposes does not include an eligible QBU or section 987 QBU of an 
owner. Under this rule, a tiered ownership structure of eligible QBUs 
and/or section 987 QBUs will not be respected as distinct tiers of QBUs 
for purposes of section 987. Rather, tiers of eligible and/or section 
987 QBUs will be treated as a ``flat'' structure, with each QBU in the 
tier considered as owned directly by the ultimate non-QBU owner. For 
example, if a domestic corporation is the holder of the interests in a 
section 987 DE (section 987 DE1) and that DE owns the interests in 
another section 987 DE (section 987 DE2) for purposes other than U.S. 
tax law, the structure will not be treated as a tier of QBUs for 
purposes of section 987. Rather, the domestic corporation will be 
considered the direct holder of the interests in the section 987 
branches of section 987 DE1 and DE2. This flat structure, which is 
consistent with the general approach taken in the proposed dual 
consolidated loss regulations (70 FR 29868-29907), is expected to be 
easier to administer for both taxpayers and the IRS and to provide more 
appropriate results under the section 987 rules.
3. De Minimis Rule for Certain Indirectly Owned Section 987 QBUs
    The IRS and the Treasury Department recognize that it may be 
administratively burdensome for taxpayers to apply certain aspects of 
the proposed regulations to section 987 QBUs indirectly owned through

[[Page 52882]]

relatively small interests in partnerships. As a result, the proposed 
regulations provide a de minimis election for certain indirectly owned 
section 987 QBUs. Under this rule, an individual or corporation that 
owns a section 987 QBU indirectly through a partnership may elect not 
to take into account the section 987 gain or loss of such section 987 
QBU, provided such individual or corporation owns, directly or 
indirectly, less than five percent of the section 987 partnership. 
Constructive ownership rules apply for purposes of determining whether 
the less than five percent ownership threshold is satisfied.
    This de minimis exception only applies to recognition of section 
987 gain or loss with respect to a section 987 QBU. Thus, owners of 
section 987 QBUs that qualify under the de minimis exception must 
comply with all other aspects of the proposed regulations, including 
the requirement to take into account the section 987 taxable income or 
loss with respect to such section 987 QBUs.
    An individual or corporation that qualifies for the election (that 
is, because they owned less than five percent of a section 987 
partnership) subsequently may fail to qualify as a result of an 
increase in their interest in a section 987 partnership. In such a 
case, taxpayers must begin taking into account the section 987 gain or 
loss with respect to section 987 QBUs owned through such partnerships. 
Similarly, taxpayers that were required to take into account section 
987 gain or loss with respect to an indirectly owned section 987 QBU 
may reduce their ownership such that they become eligible for the de 
minimis exception and, as a result, may elect to no longer take into 
account section 987 gain or loss. The IRS and the Treasury Department 
recognize that transition issues will arise when interests in section 
987 partnerships change such that individuals or corporations no longer 
qualify (or are able to qualify) for the de minimis exception. The IRS 
and the Treasury Department are considering such transition rules and 
request comments as to their application.
4. Exchange Rates
    Section 1.987-1(c)(1)(i) defines the spot rate as the rate 
determined under the principles of Sec.  1.988-1(d)(1), (2) and (4) on 
the relevant day. Section 1.987-1(c)(1)(ii) allows taxpayers to elect 
to use spot rate conventions that reasonably approximate the spot rate 
on a particular day. It is anticipated that taxpayers will be able to 
conform the spot rate convention for section 987 to the spot rate 
conventions used under FAS 52 for financial accounting purposes. This 
is intended to simplify the calculations required under section 987.
    In a similar attempt to simplify calculations, Sec.  1.987-1(c)(2) 
defines the yearly average exchange rate as an average exchange rate 
for the taxable year computed under any reasonable method that is 
consistently applied.
    Finally, Sec.  1.987-1(c)(3) defines the historic exchange rate by 
reference to the spot rate on the day that assets are transferred to 
(or acquired by) the section 987 QBU, or on the day that liabilities 
are assumed (or entered into) by the section 987 QBU. The reference to 
the spot rate as defined in Sec.  1.987-1(c)(1)(i) and (ii) allows 
taxpayers to elect to use spot rate conventions for these purposes.
5. Definitions of a Section 987 Marked Item and a Section 987 Historic 
Item
    The definitions of a section 987 marked item and a section 987 
historic item are central to the foreign exchange exposure pool method. 
When taken into account in the context of the calculation of net 
unrecognized section 987 gain or loss under Sec.  1.987-4, the 
definitions distinguish those items that generate section 987 gain or 
loss from those that do not. The IRS and the Treasury Department 
believe that section 988 identifies those items properly treated as 
giving rise to exchange gain or loss for purposes of section 987. Thus, 
a marked item as defined in Sec.  1.987-1(d) is an asset or liability 
reflected on the books and records of the section 987 QBU that both (1) 
Would generate section 988 gain or loss if held or entered into 
directly by the owner of the section 987 QBU and (2) is not a section 
988 transaction to the section 987 QBU. It is important to exclude 
section 988 transactions of a section 987 QBU because section 988 
already requires the section 987 QBU to recognize gain or loss from 
such transactions. Thus, treating such transactions as marked items for 
purposes of section 987 would result in double counting. Marked items 
give rise to exchange gain or loss under section 987. Historic items, 
which are defined in Sec.  1.987-1(e) as items other than marked items, 
do not give rise to exchange gain or loss under section 987.
6. Elections Under Section 987
    Section 1.987-1(f) provides rules for making elections under 
section 987. In general, the elections made under section 987 must be 
made by the owner of the section 987 QBU. The elections must be made 
with respect to a section 987 QBU for the first taxable year in which 
the election is relevant, and must be made by attaching a statement to 
a timely filed tax return for such taxable year. Elections under 
section 987 are treated as methods of accounting and are governed by 
the general rules regarding changes in methods of accounting.
    The IRS and the Treasury Department believe that a reasonable cause 
standard should be applied to determine whether taxpayers that fail to 
make a timely election are eligible for an extension of time to file 
elections pursuant to Sec.  1.987-1(f) of the proposed regulations. As 
a result, extensions of time under Sec. Sec.  301.9100-1 through 
301.9100-3 will not be granted for filings under the proposed 
regulations. See Sec.  301.9100-1(d).
    Under the reasonable cause standard, if an owner that is permitted 
to file an election under the proposed regulations fails to make such a 
filing in a timely manner, the owner is considered to have satisfied 
the timeliness requirement with respect to such filing if it 
demonstrates, to the satisfaction of the Area Director, Field 
Examination, Small Business/Self Employed or the Director, Field 
Operations, Large and Mid-Size Business (Director) having jurisdiction 
of the taxpayer's return for the taxable year, that such failure was 
due to reasonable cause and not willful neglect. Once the owner becomes 
aware of the failure, the owner must demonstrate reasonable cause and 
must satisfy the filing requirement by attaching the election to an 
amended tax return (that amends the tax return to which the election 
should have been attached). A written statement must be included that 
explains the reasons for the failure to comply.
    In determining whether the taxpayer has reasonable cause, the 
Director shall consider whether the taxpayer acted reasonably and in 
good faith. Whether the taxpayer acted reasonably and in good faith 
will be determined after considering all the facts and circumstances. 
The Director shall notify the person in writing within 120 days of the 
filing if it is determined that the failure to comply was not due to 
reasonable cause or if additional time will be needed to make such 
determination. If the Director fails to notify the owner within 120 
days of the filing, the owner shall be considered to have demonstrated 
to the Director that such failure was due to reasonable cause and not 
willful neglect.
    The proposed regulations provide that elections under section 987 
cannot be revoked without the consent of the Commissioner. In addition, 
the proposed regulations provide that the

[[Page 52883]]

Commissioner will consider allowing revocation of such an election if 
the taxpayer demonstrates significantly changed circumstances, or other 
circumstances that demonstrate a substantial non-tax business reason 
for such revocation. Finally, the IRS and the Treasury Department are 
considering an exception to the general revocation rule where a section 
987 QBU is acquired in certain transactions that do not result in the 
termination of such QBU. Comments are requested as to whether such an 
exception is warranted and, if so, the appropriate scope of such an 
exception.

B. Section 1.987-2 Attribution of Items to an Eligible QBU; the 
Definition of a Transfer, and Related Rules

1. Attribution of Items to an Eligible QBU
i. Overview
    A section 987 QBU is not itself a taxpayer and does not have its 
own taxable income. Items of income, gain, deduction and loss must 
nonetheless be attributed to such section 987 QBU for purposes of 
determining the owner's taxable income. The items of income, gain, 
deduction and loss attributed to a section 987 QBU are generally 
determined in the functional currency of the section 987 QBU and then 
translated into the functional currency of the owner. The aggregate 
translated amount is the section 987 taxable income or loss of the 
section 987 QBU. Thus, attribution rules are necessary to determine 
which items of income, gain, deduction and loss are attributed to the 
section 987 QBU.
    Under section 987(3), assets and liabilities must be attributed to 
a section 987 QBU in order to determine the amount of section 987 gain 
or loss of such QBU. In some cases, a section 987 QBU of a taxpayer 
will not be held through an entity separate from the taxpayer that can 
legally own assets and incur liabilities. In addition, not all the 
assets and liabilities of an entity that is separate from the taxpayer 
may be attributable to a section 987 QBU for purposes of section 987. 
Moreover, assets and liabilities may constitute a section 987 QBU of a 
taxpayer even when such assets and liabilities are owned or incurred by 
separate legal entities. As a result, assets and liabilities of the 
taxpayer (or of entities owned by the taxpayer that are not themselves 
taxpayers) must be attributed to the section 987 QBU.
    Neither section 987 nor the underlying legislative history provides 
explicit rules for attributing a taxpayer's items of income, gain, 
deduction, or loss to a section 987 QBU to determine the QBU's section 
987 taxable income or loss. Similarly, no explicit rules are provided 
in the statute or legislative history for attributing a taxpayer's 
assets or liabilities to a section 987 QBU to determine the section 987 
gain or loss of such QBU.
    Other provisions of the Code provide various methods for 
attributing or allocating a taxpayer's assets and liabilities, or items 
of income, gain, deduction and loss (items) for particular purposes. 
These provisions provide complex rules for making such determinations 
and, in many cases, require a detailed analysis of various factors and 
relationships involving income, assets, and activities of the taxpayer. 
For example, section 864(c) and the regulations thereunder provide 
rules for determining the income, gain, deduction, or loss of a 
nonresident alien individual or foreign corporation which are treated 
as effectively connected with the conduct of a trade or business within 
the United States. Other examples are Sec. Sec.  1.882-5, 1.861-8 and 
1.861-9T through 1.861-13T. These regulations provide rules for the 
allocation and apportionment of expenses, losses, and other deductions 
of a taxpayer. Finally, section 884(c)(2) and Sec.  1.884-1(d) and (e) 
provide rules for determining U.S. assets and U.S. liabilities of a 
foreign corporation for purposes of the branch profits tax. As 
discussed below, the IRS and the Treasury Department do not believe 
these complex methodologies are appropriate for purposes of section 
987.
ii. Books and Records Method--General Rule
    The IRS and the Treasury Department believe that items should be 
attributed to an eligible QBU (and, if all or a portion of such 
eligible QBU has a different functional currency than its owner, to a 
section 987 QBU of such owner) to the extent they are reflected on the 
books and records of the eligible QBU (books and records method). The 
IRS and the Treasury Department believe that using a books and records 
method for attributing items under section 987 is consistent with other 
provisions of the Code involving foreign currency transactions. For 
example, it is consistent with the requirement under section 989(a) 
that a QBU maintain books and records separate from the taxpayer. It is 
also consistent with the requirement under section 985(b)(1) that, in 
order to have a functional currency other than the dollar, a QBU must 
keep its books and records in such currency. Moreover, the IRS and the 
Treasury Department believe the books and records method is 
administrable for both taxpayers and the Commissioner. This is the case 
because the books and records method should be consistent with the 
taxpayer's accounting treatment of the items and, unlike the methods 
discussed above, it does not require a complex and factually intensive 
analysis of the circumstances and activities of the eligible QBU.
    For the reasons described above, the proposed regulations adopt a 
books and records method for allocating items to an eligible QBU. The 
proposed regulations provide that, subject to certain exceptions, items 
are attributable to an eligible QBU to the extent they are reflected on 
the separate set of books and records of such eligible QBU, as defined 
in Sec.  1.989(a)-1(d). The proposed regulations make clear that these 
rules apply solely for purposes of section 987. Thus, for example, the 
attribution rules contained in the proposed regulations do not apply 
for purposes of allocating and apportioning interest expense under 
section 864(e).
iii. Exception for Non-Portfolio Stock, Interests in Partnerships and 
Certain Acquisition Indebtedness
    As discussed above, the IRS and the Treasury Department believe 
that the assets and liabilities reflected on the books and records of 
an eligible QBU are a reasonable approximation of the assets and 
liabilities that are used in the trade or business of the eligible QBU 
and, therefore, should be taken into account for purposes of section 
987. However, the IRS and the Treasury Department believe that certain 
assets and liabilities should not be attributed to an eligible QBU, 
even if such assets and liabilities are reflected on the books and 
records of such QBU. The IRS and the Treasury Department believe that 
non-portfolio stock and interests in partnerships (and liabilities to 
acquire such assets), even if reflected on the books and records of the 
eligible QBU, should not be attributed to such QBU for purposes of 
section 987. This is consistent with the principle stated above that a 
section 987 QBU cannot be an owner of another section 987 QBU. 
Excluding non-portfolio stock is also consistent with the principle 
that non-portfolio stock cannot be used in, or held for the use in, the 
conduct of a trade or business in the United States. See Sec.  1.864-
4(c)(2)(iii).
    As a result, the proposed regulations provide that stock of a 
corporation (whether domestic or foreign) and an interest in a 
partnership (whether domestic or foreign) are not considered to be on 
the books and records of an eligible QBU. The proposed regulations

[[Page 52884]]

provide an exception, however, for portfolio stock where the owner of 
the eligible QBU owns (directly or constructively) less than ten 
percent of the total voting power or value of the stock of such 
corporation. The proposed regulations also provide that indebtedness 
incurred to acquire stock or a partnership interest that is not treated 
as being reflected on the books and records of an eligible QBU should 
similarly be excluded from the books and records. Finally, the proposed 
regulations provide that items of income, gain, deduction and loss 
arising from ownership of stock, a partnership interest, or related 
acquisition indebtedness that is excluded from the general books and 
records rule, shall similarly not be treated as being on the books and 
records of the eligible QBU.
iv. Coordination With Source Rules Under Section 988
    Section 988(a)(3) provides that the source of gain or loss 
recognized under section 988(a)(1) is 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. 
Section 1.988-4(b)(2) provides that, in general, the determination of 
whether an asset, liability, or item of income or expense is properly 
reflected on the books of a QBU is a question of fact. The regulations 
under section 988 further provide that such items are presumed not to 
be properly reflected on the books and records for this purpose if 
inconsistent booking practices are employed with respect to the same or 
similar items. Finally, the regulations provide that if such items are 
not properly reflected on the books of the QBU, the Commissioner may 
allocate the item between or among the taxpayer and its QBUs to 
properly reflect the source (or realization) of exchange gain or loss.
    The IRS and the Treasury Department believe that rules for 
determining whether items are properly reflected on the books of a QBU 
for purposes of sourcing section 988 gain or loss should be consistent 
with the rules for attributing items to an eligible QBU under section 
987. As a result, the proposed regulations modify the sourcing rules in 
the section 988 regulations to provide that the principles of Sec.  
1.987-2(b) apply in determining whether an asset, liability, or item of 
income or expense is properly reflected on the books of a QBU.
2. Certain Assets and Liabilities of Partnerships and DEs Not 
Attributable to an Eligible QBU
    Section 988 applies to certain transactions described in section 
988(c) if the transaction is denominated (or determined by reference 
to) a currency that is not the functional currency of the taxpayer or 
QBU of the taxpayer. Thus, in order to determine if a transaction is 
subject to section 988, it must be determined whether a transaction is 
attributable to the taxpayer or a QBU of the taxpayer.
    Under the current section 989 regulations, a partnership is a QBU 
even if it does not have activities that constitute a trade or business 
(``per se QBU''). As a result, a partnership may have a functional 
currency different than its partners and section 988 is applied at the 
partnership level with respect to section 988 transactions properly 
attributable to the partnership. These regulations propose to amend 
section 989 to provide that a partnership is no longer a per se QBU of 
its partners, but instead the activities of such partnership may be 
treated as a QBU.
    As discussed above, the IRS and the Treasury Department will 
generally apply either an entity or an aggregate approach with respect 
to partnerships depending on which approach more appropriately carries 
out the purpose of the particular Code section under consideration. 
Following the amendments made by the proposed regulations, and because 
only certain activities of a partnership (and not the partnership 
itself) can qualify as a section 987 QBU, the IRS and the Treasury 
Department believe that it is appropriate, in cases where an asset or 
liability of a partn