IRC 987 and Calculation of Earnings & Profits, Tax Pools – Canada PUC & Mexico

FROM PRINCIPLES TO PLANNING

IRC 987 and Calculation of Earnings & Profits, Tax Pools – Canada PUC & Mexico

FROM PRINCIPLES TO PLANNING

IRC 987, Earnings & Profits/Tax Pools, Canadian Paid-Up Capital, and Mexican CUFIN/CUCA

Joel Mitchell, Plante & Moran PLLCRandy Janiczek, Plante & Moran PLLC

Gerard Roddis, MNP LLPLuis Vazquez, Mazars Mexico

Concept of Earnings and ProfitsEarnings & Profits (“E&P”) measures the ability of a corporation to make distributions to its shareholdersExcept for purposes of determining the Accumulated Earnings Tax of § 531, for the most part, E&P does not affect the tax liability of corporations

Current and accumulated E&P may result in taxable income to the shareholder/recipient of

• Actual distributions under §§ 301and 316(a); or

• Deemed distributions from a controlled foreign corporation (“CFC”) under § 951 or 1248

IRC 987 and Calculation of Earnings & Profits, Tax Pools

Definition of E & PE&P is an economic measure of corporation’s ability to make distributions to shareholders; Conference Report on the Tax Reform Act of 1084, H.R. Rep. No. 98-861, at 835 (1984)

The term E&P is not defined in the Internal Revenue Code; instead, its meaning has been developed through case law, IRS rulings and Treasury Regulations


Definition of E & P (cont’d)In Luckman v. Comr. 418 F.2d 381, 383 (7th Cir. 1969), the court defined E&P:

“As used in federal taxation, (the concept of E&P) represents an attempt to separate those corporate distributions with respect to stock which represent returns of capital contributed by the stockholders from those distributions which represent gain derived from the initial investment by virtue of the conduct of the business. The crucial issue is whether a given transaction has a real effect upon the portion of the corporate net worth which is not representative of contributed capital and which results from the conduct of business”


Accounting Consistency RuleIn general, the method of accounting for federal taxable income is followed in computing E&P, Treas. Reg.§ 1.312-6(a)

For example, a corporation using the cash method of accounting for federal taxable income may not use the accrual method to determine E&P


Accounting Consistency Rule (cont’d)The Consistency Rule applies not only to the overall method of accounting, but to the accounting treatment of individual items

Examples include: deferring income for federal taxable income, use of the installment method, changes in method of accounting, and timing of inclusion of tax items in E&P


Calculating the E&P of a Foreign CorporationE&P of foreign corporations is determined under very similar rules, as those used for domestic corporations (§ 964)

The Three Steps for calculating E&P, per Treas. Reg. § 1.964-1(a)(1)1. Prepare a Profit and Loss Statement in CFC’s functional currency2. Make accounting adjustments necessary to P/L to conform with

U.S. GAAP3. Make additional adjustments to GAAP P/L to conform with U.S.

tax accounting


Mandatory US GAAP AdjustmentsTreas. Reg. § 1.964-1(b) contains the following adjustments that must be made to the foreign corporation’s financials, so that it conforms to GAAP principles:• Clear reflection of income (i.e. no allocation to an arbitrary reserve)• Use of historical cost for physical assets (i.e. no reflection of

appreciation or depreciation in value or in the relative value of the currency in which the cost was incurred)

• Valuation of assets and liabilities (i.e. an accounting adjustment must be made for inventory written down to below its market value, even if not required under foreign law)


Mandatory U.S. GAAP Adjustments (cont’d)Treas. Reg. § 1.964-1(b) contains the following adjustments that must be made to the foreign corporation’s financials, so that it conforms to GAAP principles• Equalization of income and expenses (i.e. percentage of completion

for long-term contracts is required for E&P)• Foreign currency (i.e., for transactions undertaken in currency other

than the functional currency of the corporation, translation must be made in a manner similar to U.S. rules for translating foreign currency into USD under § 988)


Basic Concepts of Tax Adjustments to E&PCertain items excluded from book (U.S. GAAP) income must be added back to determine E&P Similarly, certain items deducted for taxable income may not be deducted for E&PThe adjustments made to E&P of domestic corporations apply to foreign corporations with few notable exceptions § 952(c)(3):• LIFO inventory adjustments• Installment sales• Completed contract method of accounting


Basic Concepts of Tax Adjustments to E&P (cont’d)Depreciation under § 312(k)(4) for assets placed into service after 1986• Foreign Corporations with 20% or more U.S. source income, 312(k)

(4) requires the use of the alternative depreciation system for E&P purposes

• Foreign Corporations with less than 20% of U.S. source income and property outside of the U.S. must use the alternative depreciation system for all purposes

The alternative depreciation system generally requires• Property divided into classes• Straight line depreciation based on lives specified under the Code


Common E&P Adjustments Foreign CorporationsCommon adjustments made to E&P include the following 1) Taxes 2) Inventory reserve 3) Bad Debts reserve 4) Stock options


Impact of Distributions with Respect to Stock on E&P§ 312(a) provides in part, that distributions to shareholders with respect to their stock shall reduce E&P. The amount of reduction equals the sum of:• money• debt of the corporation, and• adjusted basis of property distributed during the year

The reduction cannot create a deficit in E&P


Ordering and Tracing Rules of Distributions§ 316(a) provides that a distribution made by a corporation to its shareholders is treated as a dividend to the extent of current and accumulated E&P§ 301(c) provides the order and character of corporate distributions

1. First distributions are characterized as dividends to the extent of E&P (as determined under § 316)

2. Once current and accumulated E&P have been exhausted, distributions shall reduce the adjusted basis of stock

3. Distributions in excess of basis shall be treated as capital gains


Example of §§ 301 and 316• Example: • Assume that P owns 100% of the stock of S. P has a $ 800 basis in the

shares of S. S has accumulated deficit of ($ 6,000) E&P at end of 2010• In May of 2011, S makes a distribution of $ 1,000. At the time of

distribution, S has no current year E&P• Due to a large sale, S ends up with $ 700 of current year E&P• Result: • The distribution is sourced for purposes of § 301 as follows:

• (a) $ 700 of the distribution constitutes a dividend, § 301(c)(1)• (b) $ 300 of the distribution represents basis recovery, §301(c)(2)


Nimble Dividend Rule• When a foreign corporation with an accumulated deficit in E&P,

distributes a dividend out of current E&P, that dividend is commonly known as nimble dividend. Since the foreign corporation does not have a positive pool of E&P, the shareholder is not allowed a § 902 credit

• Example: M, a domestic corporation, owns 100% of A, a foreign corporation. At Dec. 31, 2010, A has a deficit in post-1986 Undistributed Earnings of ($ 200). At Dec. 31, 2011, A earns $100 net of foreign taxes of $40. A distributes $ 50 to M during 2010

• Result: The $ 50 distribution is treated as a dividend per §316(a)(2). However, no foreign tax credit is allowed because of accumulated deficit pool of ($100), per § 902


Distributions by Controlled Foreign CorporationsThere are certain differences in the ordering rules of distributions between CFC’s and domestic corporations§ 959 alters the distribution rules to avoid earnings from being taxed twiceBasic idea behind § 959 is to allow a CFC’s distributions of previously taxed income (“PTI”) to be free of taxEarnings previously taxed under the Subpart F regime or § 956, are tax free when distributed to U.S. Shareholders


Ordering of Distributions Previously Taxed Earnings § 959Under § 959 three different baskets of E&P are maintained. CFC’s distributions to U.S. Shareholders are deemed to come out E&P in the following order

1. §959(c)(1) – earnings included in income because of Investments in U.S. Property – the § 956 amount

2. §959(c)(2) – earnings included in income because of Subpart F

3. §959(c)(3) – other earnings - those not previously included in income of U.S. Shareholder


Example of Ordering DistributionExample: A domestic corporation (D) owns all the stock of F, a CFC. F has accumulated E&P of 225, which includes 30 of previously taxed § 956 income and 25 of previously taxed Subpart F income. During the calendar year 2011 the following transactions occurred

(a) F makes a cash distribution of $ 100 to D. (b) There is an increase in Investment in U.S. Property of $ 10. (c) Subpart F income of $ 15 and other earnings of $ 30

Total current E&P = $ 55

Question: How much of the Distribution is taxable as a dividend?


F’s E&P for § 959

Total ( c ) (1) ( c ) (2) ( c ) (3)

E&P 12/31/10 225 30 25 170

2011 Current E&P

55 10 15 30

Balance before-Distribution

280 40 40 200

-Cash distributed

(100) (40) (40) (20)

-E&P 12/31/11 180 0 0 180

Example of Ordering Distribution (cont’d)


Example of Ordering Distribution (cont’d)Answer:• Portion of cash distribution treated as dividends = $ 20

(the § 959(c)(3) component)


E&P and Tax Pools The E&P and Foreign Taxes are calculated annually, and accumulated into separate pools

E&P pools are maintained in the foreign corporation’s functional currency and translated into U.S dollar at the appropriate rate under § 989(b)

Foreign Taxes are translated into U.S. dollar at the average currency exchange rate for the year to which they relate under § 986 (a)(1)


E&P “Appropriate Exchange Rate” § 989(b)• E&P is translated into US dollar at the “appropriate exchange rate.”

This is necessary when a taxable event occurs (i.e. inclusion of earnings in the gross income of U.S. Shareholder)

1.Distributions of earnings – dividends – E&P is translated at the spot rate on the date of distribution, § 989(b)(1)

2.Deemed dividend arising from sale /disposition of stock - § 1248 transaction- E&P is translated at the spot rate on the date of income inclusion, § 989(b)(2)

3.Subpart F inclusions – E&P is translated at the average exchange rate for the year, § 989(b)(3)

4.Investments in U.S. Property - § 956 Amount- E&P is translated at the average exchange rate for the year, § 989(b)(4)


E&P of a CFC must be categorized into baskets, pools, and layers, and characterized by source• E&P pools are subdivided into baskets according to the type of

income from which it is derived (i.e. Subpart F, general category, passive income, etc.), § 902(c)

• The identification of E&P by categories is required to determine the following among others

1. Foreign tax credit basket classification of the dividend 2. U.S. or foreign source of the dividend 3. Taxability of actual distributions as dividends 4. Amount of exchange gain or losses on distributions of PTI 5. Subpart F and investments of U.S. property


E&P and Tax Pools: Example Example: Assume the following facts

E&P in Local Taxes in Taxes Currency Local Currency in USD 2009 LC 300 LC 300 $ 250 2010 LC 200 LC 200 $ 100 LC 500 LC 500 $ 350

The CFC pays a dividend of LC 250 to its U.S. parent in 2010. The taxes deemed paid are $ 175 (LC 250/LC500 X $ 350). After the dividend, the pool of E&P and taxes is reduced by the payment of LC 250 and by the $ 175 of taxes.

E&P Taxes Pools of E&P before payment LC 500 $ 350 Dividend LC (250) $ (175) Undistributed E&P and Taxes LC 250 $ 175


Reorganizations and Similar Transfers §381(c) Carryover Tax AttributesGenerally, in an acquisitive type reorganization under § 368, the acquiring corporation succeeds to certain tax attributes of the acquired corporation, per § 381(c)

One of the tax attributes that the acquiring corporation succeeds to is the E&P (or deficit) of the acquired corporation,§ 381(c)(2)


Reorganizations and Similar Transfers §381(c) Carryover Tax Attributes (cont.)At the date of reorganization, if both the acquiring and acquired corporations have accumulated E&P (positive earnings), these are simply blended into one account

At the date of reorganization, if the acquired corporation has a deficit, and the acquiring has E&P, the two accounts (pools) cannot be blended into one account. The deficit in the acquired corporation can only offset future earnings (post-acquisition earnings) of the acquiring corporation; this is commonly known as, the Hovering Deficit rule, per § 381(c)(2)(B)


E&P Considerations for Various Transactions:Stock Sale - §1248Related Party Redemption - §304Check the Box Election - §332Spinoff - §355


History

• Prior to 1972, a return to shareholders from a corporation treated similar to the U.S. system – first out of “E&P” and treated as a dividend

• Post-1971, corporations may make a tax-free distribution of the corporate paid-up capital (“PUC”) even where “E&P” exists

• The Income Tax Act, Canada permits payments to shareholders as a reduction of capital up to the PUC of the shares

Canadian Paid-Up Capital

Definitions

• PUC is defined in the context of a class of shares by the applicable corporate jurisdiction and corporate law

• The corporate jurisdiction will likely use “stated capital” which is a legal term

• PUC is a tax term based on legal capital

• PUC is a corporate reference, and is averaged across a class of shares


Basics

• Shareholders control their adjusted cost base (“ACB”), but do not control PUC – usually differences between the two

• Mr. A subscribes for one common share for $1 - PUC and his ACB are $1

• Mr. A sells his common share to Mr. B for $10 - PUC is still $1, but Mr. B’s ACB in the common share is $10


Application

• PUC is relevant to many corporate/shareholder transactions, including acquisitions, wind-ups, amalgamations, share redemptions, capital reductions

• Since PUC may be returned tax-free to shareholders, specific avoidance provisions apply

• These provisions are directed primarily at limiting artificial increases in PUC


Planning #1 - acquisition


USCo

CanTarget

CanVendor

Canada

USA

• USCo intends on acquiring CanTarget for $10M

• Existing CanTarget PUC is $1M

• CanTarget owns valuable Canadian real property



USCo

CanTarget

CanVendor

Canada

USA

• USCo acquires shares of CanTarget

• USCo has an ACB of $10M in CanTarget shares

• CanTarget’s PUC is still $1M

• USCo may extract $1M tax-free from CanTarget

• Can we do better?



USCo

CanTarget

CanVendor

Canada

USA

• USCo incorporates CanAcqCo and subscribes for $10M in shares

• CanAcqCo PUC is $10M

• CanAcqCo acquires CanTarget from CanVendor for $10M

• CanAcqCo and CanTarget amalgamate to form AmalCo

CanAcqCo



USCo

CanTarget

Canada

USA

• AmalCo’s PUC is $10M

• AmalCo may distribute $10M of its after-tax profits or property to USCo tax-free

• Amalco may “bump” to $10M the ACB of its non-depreciable property

CanAcqCo

Planning #2 – ULC repatriation


USCo

CanULC

Canada

USA

• USCo owns 100% of CanULC

• CanULC wishes to repatriate $10M of earnings to USCo

• Article IV(7)(b) of the Treaty applies and USCo not afforded treaty benefits – 25% Canadian withholding tax

• Can we use the Canadian PUC rules to our advantage?



USCo

CanULC

Canada

USA

• CanULC authorizes a $10M increase in its stated capital

• PUC is increased by $10M

• The Act treats an increase in PUC as a deemed dividend

• A “nothing” for U.S. federal income tax purposes

• Canadian withholding tax applies at 5% because the same Canadian and U.S. income tax treatment applies whether or not CanULC is a hybrid entity

PUC increase



USCo

CanULC

Canada

USA

• CanULC authorizes a $10M reduction in its PUC

• CanULC distributes $10M to USCo as a PUC reduction – no Canadian or U.S. income tax effect

• $10M of CanULC’s earning have been repatriated to USCo at a 5% Canadian withholding tax rate

PUC decrease

• Net Tax Profit of the Year• The Net Tax Profit of the year (UFIN) will be determined as follow:

• Net Tax result • (-) Income tax paid• (-) Employee profit sharing • (-) Non-deductible expenses • (=) Net tax profit of the year (UFIN)

• If resulting number is negative, it will be reduced from the CUFIN balance

Mexico – Calculation of Earnings and Profits

Dividends distribution

• Corporate requirements:• Financial statements must be approved by shareholders• Must exist profits in the financial statements

• Tax implications:• If shareholder is a Mexican company and dividends < CUFIN, no income tax will be

triggered and the income received will not be considered as taxable income by the receiving company

• If dividends > CUFIN, the balance will pay income tax. Tax will be calculated by grossing up this balance multiplying it by 1.4286, the result will be multiplied by tax rate (30%) – income tax determined will be paid by the Mexican entity

• Income tax paid by the Mexican entity could be credited against its annual income tax and the following tow years, also against advance payments


Dividends distribution

• If shareholder is a US entity and dividends < CUFIN, tax free dividends (no need to analyze USA – Mexico Tax Treaty)

• If shareholder is a Mexican individual, the dividend received will be taxable on his Mexican annual income tax return. The individual will be able to credit the income tax paid by the legal entity that distributed the dividends


Capital Contributions Account - CUCA

• Capital Contribution Account (CUCA) should be determined as follows:

• Balance of CUCA last year• (+) Capital contribution (effectively paid)• (+) Net premium of shares subscription• (-) Capital reductions• (=) Capital contribution account

• Reinvestments or capitalization of profits or any other item that is part of the legal entity´s shareholders equity should not be consider for the CUCA calculation

• Liabilities could be capitalized and should be considered as capital contributions


Capital Reimbursement:

• Entity must determine a tax profit, if applicable, considering two procedures:

• Section I – Levied shareholders reimbursement

• Section II – Levied profit distributed by the entity


Capital Reimbursement (CR)

CR < CUCA

Equity account < CUCA

No tax triggered

The difference is considered as

profit distributedSection I

Profit < CUFIN = no tax triggered

Profit > CUFIN

Difference is considered as profit,

not exceeding the amount of the

reimbursement

Yes

Yes

No

No

Section I

Section II

Profit x 1.4286 x 30% = income tax Section I

and Section II

Profit Section II> CUFIN

Profit Section II < CUFIN = no tax

triggered

Such Profit less Profit Section I = Profit Section II


Section 987 - Agenda• Overview• §987 Taxable Income or Loss• §987 Gain or Loss

IRC 987

Section 987 - BackgroundDefinitions• QBU – Qualified business unit (Prop. Reg. §1.987-1(b))

• Eligible QBU is (1) a trade or business activity (2) with separate books and records, (3) assets and liabilities of the trade or business are reflected on those books and records, and (4) the activities do not operate in hyperinflationary environment.

• Does not require a legal entity• §987 QBU – “eligible QBU […] that has a functional currency different from

its owner” • Remittance (Prop. Reg. §1.987-5(c))

• Total amounts, in the owner’s functional currency, transferred from §987 QBU to the owner in excess of total amounts transferred from the owner to its §987 QBU

IRC 987

Section 987 - Background• §987 provides rules for determining (1) taxable income or loss and

(2) §987 gain or loss of a taxpayer owning a §987 QBU.• (1) Taxable income is income or loss of the QBU translated into

the owner’s functional currency • Average exchange rate (1991 regulations)• Historical vs. Average approach (2006 regulations)

• (2) The §987 gain or loss results from appreciation or depreciation in the value of the QBU’s capital and earnings, based on changes in the value of the QBU’s currency relative to the owner’s functional currency.

• §987 gain or loss is recognized when the taxpayer makes “remittances” from QBU to its owner

IRC 987

Section 987 - Background• In 1991, proposed 987 regulations were issued providing for the

determination of taxable income or loss at the average exchange rate, plus §987 gain or loss based on the recovery of equity and basis pools as remittances are made.

• The evolution of check-the-box (CTB) regulations subjected more taxpayers to §987.

• Concern by IRS and Treasury Department that the 1991 proposed regulations permit the recognition of “non-economic §987 losses” because they determine §987 gain or loss with respect to all assets and liabilities, including nonfinancial assets.• Remittances are not limited to “dividend” type distributions

(Prop Reg. 1.987-5(c)(1))

IRC 987

Section 987 - Background• For Years after 2004, Form 8858 requires 987 reporting• On September 7, 2006, new proposed regulations were

issued (the 2006 proposed regulations). The 1991 proposed regulations were withdrawn.

• The 2006 regulations, addressing the concerns of the 1991 proposed regulations, generally determine §987 gain or loss with respect to only financial items.• Method for determining taxable income or loss also changed.

IRC 987

Section 987 - Background• Proposed to be effective for taxable years beginning one year

after the first day of the first taxable year following the adoption of regulations as final (so if finalized in 2012, then for calendar year taxpayers, will be effective on January 1, 2014). Taxpayers can elect to apply one year earlier.

• Pending finalization of the regulations, positions consistent with the 2006 proposed regulations are reasonable interpretation of §987.

IRC 987

Section 987 – Taxable Income or Loss• 1991 Regulations - “Profit and Loss Method”

• Compute QBU after-tax income in functional currency• Conform income to US E&P or Taxable Income basis• Convert amount to US Dollars (or other functional

currency of tax owner) at average exchange rate for the taxable period

IRC 987

Section 987 – Taxable Income or Loss• 2006 Regulations - Item by item computation:

• Taxable income or loss is determined on an item by item basis.

• Deductions allowable with respect to “historic” assets must use historical exchange rate

• Depreciable/amortizable assets• Effectively fixes US Dollar depreciation on date of

acquisition of asset• Inventory?

• Income items and “non-historic” deductions translated at average exchange rate for taxable period

IRC 987

Section 987 – Taxable Income or Loss – Example A• US Corporation is the owner of German GmbH, an entity that has

made an election to be disregarded as separate from its owner.• Under §987(1) & (2), US must determine its taxable income or loss

with respect to German DE’s trade or business activities.

US

GermanyDE

US dollarfunctional currency

Eurofunctional currency

IRC 987

Section 987 – Taxable Income or Loss – Example A• On January 1, 2007, German DE purchased equipment for

€600 and inventory for €800.• On December 31, 2007, German DE sells the inventory for

€1000.

US

GermanyDE

(10-year straight-linerecovery for equipment)

2007 Results for Germany

Sales €1000COGS €800Depreciation €60Net income €140

Exchange rate on 1/1/2007$1 to €1Average exchange rate for 2007$1.10 to €1

IRC 987

Section 987 – Taxable Income or Loss – Example A• Results under 1991 proposed regulations = $154 taxable

income.• Taxable income determined at the average exchange rate =

$1.10 to €1.

US

GermanyDE

Taxable income = €140 * 1.1 = $154

2007 Results for Germany DE

Sales €1000COGS €800Depreciation €60Net income €140

IRC 987

Section 987 – Taxable Income or Loss – Example A• Results under 2006 proposed regulations = $240 taxable

income.• Taxable income determined on an item by item basis.• Difference over 1991 regulations is $86.

US

GermanyDE

Amount realized = avg. fx rateAdjusted basis = historic fx rateDepreciation = historic fx rate

2007 Results for Germany DE

Sales €1000 = $1100COGS €800 = $800Depreciation €60 = $60

Taxable income = $240

Exchange rate at the time the equipment was purchased $1 to €1

Average exchange rate for 2007$1.10 to €1

IRC 987

Section 987 – Currency Gain or Loss• Due to changing exchange rates, amounts transferred

to QBU owner likely will be converted into owner’s functional currency at rate other than what was used to recognize taxable income

• Difference is generally the gain or loss under §987• 1991 Regs (basis and equity pool approach) vs. 2006

Regs (foreign exchange exposure pool approach)• Character = Ordinary• Source – determined with reference to QBU assets

IRC 987

Section 987 – Currency Gain or Loss – Summary of 1991 Regs• Taxpayer is required to report “§987 gain or loss” on remittance of cash or

property from the QBU to the U.S.• §987 gain or loss is calculated as the functional currency amount of the

remittance (translated into dollars at the spot rate), less the pro rata amount of the dollar basis pool allocated to the distribution

• The pro rata portion of the basis pool allocated to the distribution was determined as follows:

• The equity pool represents the branch’s net equity (kept in QBU functional currency)

• The basis pool represents the taxpayer’s basis in the branch (kept in tax owners functional currency)

IRC 987

Section 987 – Currency Gain or Loss – Summary of 2006 Regs• Step 1 is to determine the change in value of the §987 QBU’s balance sheet from the

prior year to the current year, measured in the owner’s functional currency.• Beginning and ending balance sheets compared carrying Historic Assets at historic

exchange rates and Marked Assets at year-end spot rates.• US tax basis must be used• Marked Asset – any item that would give rise to a §988 transaction• Historic Asset – any item that is not a Marked Asset• Net Equity amounts are compared

• Generally, three components are reflected in the change:• Taxable income or loss of the §987 QBU;• Transfers of assets or liabilities to and from the QBU; and• Changes in the value of the §987 QBU’s Marked Items.

IRC 987

Section 987 – Currency Gain or Loss – Summary of 2006 Regs• In order to isolate the change in value due to currency movements in the Marked Items, the other

changes must be reversed out:• Steps 2&3: Transfer of assets to/from the §987 QBU• Steps 4&5: Transfer of liabilities to/from the §987 QBU• Steps 6&7: Income/loss of the §987 QBU.

• The result of the 7 steps is to calculate the unrecognized §987 gain or loss for the year, which is then added to any prior year(s) cumulative balance.

• §987 gain or loss is then determined by multiplying the unrecognized gain or loss by the “remittance proportion”

Remittance

• Remittance Proportion = Adjusted Basis of QBU Gross Assets + Remittance

IRC 987

Section 987 – Currency Gain or Loss – Example B• US Corporation is the owner of GmbH, an entity that has

made an election to be disregarded as separate from its owner.

• Under §987(3), US must determine its §987 gain or loss with respect to German DE’s trade or business activities.

US

GermanyDE

US dollarfunctional currency

Eurofunctional currency

IRC 987

Section 987 – Currency Gain or Loss – Example B• On December 31, 2006, US contributes $100 to Germany DE, which

purchases real estate.

• During 2007, Germany DE earns €50 of taxable income and holds that €50.

• During 2008, Germany DE earns no income, but makes a €50 remittance on December 31, 2008.

US

GermanyDE

Exchange rate on 12/31/2006$1 to €1

Average exchange rate in 2007$1.20 to €1

Spot exchange rate on 12/31/2007$1.40 to €1

Spot exchange rate on 12/31/2008$1.40 to €1

IRC 987

Section 987 – Currency Gain or Loss – Example B• 12/31/08 - §987 gain or loss under 1991 proposed

regulations = $17.

US

GermanyDE

Amount realized = $70 (€50 remittance * 1.4 spot fx rate) Basis pool recovery = $53 ($160 * €50/ €150) Gain = $17 ($70 – $53)

Equity Pool

Cash contribution = €100Earnings = €50Total earnings = €150Remittance = €50

Basis Pool

Cash contributions = $100Earnings = $60(at avg fx rate = $1.2 to €1)Total = $160

IRC 987

Section 987 – Currency Gain or Loss – Example B• 2006 regs – Determine year end owner functional currency

net values.

US

GermanyDE



Spot exchange rate on 12/31/2007/2008$1.40 to €1

2006 balance sheet

Determination of 12/31/06 ValuesReal estate €100 $100 (historic) *Total Balance Sheet $100

Less contributions (100) Adjusted Total $0

* Determined in functional currency at which contributed

IRC 987

Section 987 – Currency Gain or Loss – Example B• 2006 regs – Determine year end owner functional currency

net values.

US

GermanyDE




2007 balance sheet

Determination of 12/31/07 Values1. Real estate €100 $100 (historic)2. Euro €50 $70 (marked)Total Balance Sheet $17012/31/06 Amount $100Change in Equity $70

Less Earnings €50 ($60) *Adjusted Total $10

2007/2006 difference $10

* Reduced at average exchange rate.

IRC 987

Section 987 – Currency Gain or Loss – Example B• 2006 regs –Determine year end owner functional currency net

values.

US

GermanyDE




2008 balance sheet

Determination of 12/31/08 ValuesReal estate €100 $100 (historic) Total Balance Sheet $100

Add remittance €50 $70* Adjusted Total $170

2007/2008 difference $0Prior differences $10Cumulative differences $10

* Remittance added back at spot rate.

IRC 987

Section 987 – Currency Gain or Loss – Example B• 2008 – Determine gain under §987

US

GermanyDE




Determination of §987 Gain or Loss

Unrecognized§987 gain $10

Remittance €50*1.4 $70Total adjusted assets $170 41%

§987 gain equals $4.10

Gain Under 1991 Regulations was $17

IRC 987

Section 987 – Key Takeaways• §987 Gain or loss applies to all QBU’s/branches with functional currency

other than that of owner• Remittances can be triggered from many types of transfers

• Loan repayment, interest, dividends, management fees, etc.• Netting rules apply

• 1991 regulations – daily netting• 2006 regulations – annual netting

• §987 Gain or loss directly impacts taxable income• Calculation not “optional”• Historical Calculation – must be done every year

• Regulations are not final – many hybrid approaches exist

IRC 987

Questions?

Contact Information

Joel Mitchell, Plante Moran PLLC [email protected]

Randy Janiczek, Plante Moran PLLC [email protected]

Gerard Rodis, MNP LLP [email protected]

Luis [email protected]

mailto:[email protected]




Documents

IRC 987 and Calculation of Earnings & Profits, Tax Pools – Canada PUC & Mexico