Acquisition debt uses the partners' functional currency for Section 988 calculations

Plain-English summary

A foreign corporation used a disregarded acquisition entity to borrow in several currencies and buy a corporate group. It later contributed that entity to a partnership whose separate business used a different functional currency. The IRS examination team attributed the acquisition debt to the partnership and calculated foreign-currency gains under IRC § 988 using the partnership's currency. The National Office concluded instead that the debt belonged on the books of the partnership's partners because it financed stock acquisitions unrelated to the partnership's asset-management business. The partners' functional currency therefore governs the Section 988 gain or loss on the loan principal and interest payments for the years at issue. The conclusion also aligned with proposed Section 987 regulations that excluded stock-acquisition debt from an eligible qualified business unit's books.

Ruling snapshot

• Question: Which functional currency applies when calculating Section 988 gain or loss on the acquisition-loan payments?
• Outcome: Advice given, use the partners' functional currency rather than the partnership's currency
• Key authorities: IRC §§ 985, 987, 988, 989(a); former Treas. Reg. §§ 1.988-4(b), 1.989(a)-1; proposed Treas. Reg. §§ 1.987-2, 1.988-1

Full text (IRS public release)

                           INTERNAL REVENUE SERVICE
                 NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                          September 25, 2018

                                                   Third Party Communication: None
                                                   Date of Communication: Not Applicable
Number:                  201902030
Release Date:            1/11/2019
Index (UIL) No.:         985.00-00, 987.00-00, 988.00-00, 989.01-00
CASE-MIS No.:            TAM-111960-18

Chief, Appeals Office
IRS Appeals

        Taxpayer's Name:                          ----------------------------------------------------------
        Taxpayer's Address:                       -----------------------------------
                                                   ------------------------------
        Taxpayer's Identification No              -----------------------
                                                   --------------------------
        Year(s) Involved:                         ----------------
        Date of Conference:                       --------------------------


LEGEND:

Currency A=----------------------
Currency B=-------------
Year 1=----------------------------
Year 2=-------------------------
Year 3=-------------------------
Date 1= ---------------------------
Country A= -------------------
Country B = -----------------------
Taxpayer=------------------------------------
Corp A Group=---------------------------
Seller=---------------------
Property=----------
Brand Name= --------------------------
Corp B=------------------------------------------------------------
X=------------
Corp C=------------------------------
Y=------------

Entity=-----------------------
Date 2=--------------------------
Date 3=--------------------------
Date 4=--------------------------
Amount 1= ----------------
Amount 2= ------------------------------------
Amount 3= ------------------------------------
Amount 4= ------------------------------------
Amount 5= ----------------
Amount 6= ----------------
Currency C=-----------------------------
Currency D=---------------------------------
Amount 7= -----------------
Amount 8= -----------------
Amount 9= ----------------
Date 5=---------------
Partnership=-------------------------------------------------
Country C=-------------
Corp D= -------------------------------------
Corp E= ----------------------------------------
Date 6= ------------------------
Asset= -------------------------------
Year 4= -------
Year 5= -------
Amount 10= -------------------
Amount 11= -------------------
Amount 12= -------------------
Amount 13= ------------------
Amount 14= ------------------
Amount 15= ------------------

ISSUE(S):

       Whether Currency A or Currency B is the correct functional currency to calculate
any foreign currency exchange gain or loss under section 988 of the Internal Revenue
Code (the “Code”) with respect to payments of principal and interest made on loans
during the taxable years that ended on Year 1, Year 2, and Year 3.

CONCLUSION(S):

       Currency A is the proper functional currency to use to calculate foreign currency
exchange gain or loss under section 988 with respect to payments of principal and
interest made on loans during the taxable years that ended on Year 1, Year 2, and Year
3.

FACTS:

      Taxpayer is a Country A corporation. On Date 1, Taxpayer entered into an
agreement with Seller, a Country B publicly traded company, to buy the Corp A group.
The Corp A group owned and operated Property internationally that used the Brand
Name. Under the sale agreement, Taxpayer would acquire Corp B, which owned
approximately X% of Corp C (the parent company of the Corp A group’s Country A
consolidated group). Additionally, the agreement provided that Taxpayer would directly
acquire the remaining interest of Y% in Corp C from Seller.

       Taxpayer formed a new wholly-owned subsidiary, Entity, on Date 2 to serve as a
financing and acquisition vehicle. Taxpayer made an election to treat Entity as a
disregarded entity for U.S. Federal income tax purposes effective as of Date 3.

        On Date 4, Taxpayer paid to Seller a purchase price of Amount 1 for the stock of
Corp B and a direct interest in Corp C. Taxpayer financed the cash portion of the
purchase price of Amount 2 with cash of Amount 3 and bank debt financing of Amount

4. Of the Amount 4, Entity borrowed the Currency A equivalent of Amount 5, consisting
of a term loan of approximately Amount 6 with Currency B, Currency C, and Currency D
tranches, a term loan denominated in Currency A of Amount 7, and a revolving line of
credit primarily denominated in Currency A of approximately Amount 8. Taxpayer
borrowed the remaining Amount 9 of acquisition debt in Currency A from the same
revolving line of credit.

        After the Corp A group acquisition, Entity held stock in Corp B and Corp C,
received distributions from subsidiaries acquired in the Corp A group acquisition,
incurred and serviced debt incurred to carry out the Corp A group acquisition, and
participated in a single hedging transaction with Corp C.

       In Date 5, subsequent to the acquisition of the Corp A group, Taxpayer
contributed the stock of Entity to Partnership, a Country C entity that is treated as a
partnership for U.S. Federal income tax purposes. Partnership was equally owned by
Corp D and Corp E, two subsidiaries of Taxpayer. Corp E was wholly owned by Corp
D. Corp D and Corp E had Currency A as their functional currencies.

      On Date 6, Corp E converted from a corporation to a U.S. limited liability
company (“LLC”). The conversion caused Corp E to be treated as a disregarded entity
of Corp D for U.S. Federal income tax purposes. The conversion of Corp E to a LLC
caused Partnership to become a single member entity disregarded for U.S. Federal
income tax purposes. Due to the conversion, Entity was treated as a disregarded entity
owned by Corp D for U.S. tax purposes.

        Partnership’s sole operating asset was a management agreement for Asset in
Country C, and its activities related solely to management of Asset. Prior to Year 4, all
of its assets, liabilities, income, and expenses were directly related to those activities. It

also held the equity interest in Entity. The functional currency of Partnership for U.S.
GAAP and U.S Federal income tax purposes was Currency B. Partnership and Entity
each maintained separate books of original entry and ledger accounts. Entity’s assets
and liabilities were not recorded on Partnership’s books. Additionally, Partnership
maintained its foreign exchange exposure pools under the methodology prescribed in
2006 Prop. Treas. Reg. §1.987-4 (REG-208270-86, 71 FR 52876). No portion of
Partnership’s pool of unrecognized section 987 gain or loss was ever triggered by a
remittance.

       During the tax year that ended on Year 1, and tax periods that ended on Year 2
and Year 3, Entity made principal and interest payments on the various loans.
Taxpayer used Currency A as the functional currency to calculate the section 988
foreign currency gain or loss on those payments. Taxpayer calculated net foreign
exchange losses with respect to Currency B, Currency C, and Currency D, resulting
from the payment of principal and interest with respect to the Corp A group acquisition
financing in Year 4 and Year 5. However, as a result of a hedging agreement between
Entity and Corp C, Corp C reported deductions of Amount 10 and Amount 11 on its
Schedule M-3 for tax year ended Year 1 and tax period ended Year 2, respectively, due
to the operation of this agreement. Taxpayer reported a deduction of Amount 12 on its
Schedule M-3 for the tax period ended Year 3 due to the operation of the agreement.

       Exam determined that Entity’s assets and liabilities should be attributed to
Partnership rather than to Corp D and Corp E for purposes of calculating any section
988 foreign currency gain or loss. Therefore, Exam determined that any section 988
foreign currency gain or loss should be computed using Currency B, which was the
functional currency of Partnership. The proposed adjustments by Exam were
determined using Currency B, resulting in foreign currency gain with respect to the loan
payments in the amounts of Amount 13, Amount 14, and Amount 15 for tax year ended
Year 1 and tax periods ended Year 2, and Year 3, respectively.

LAW AND ANALYSIS:

       Section 988(b)(1) of the Code provides that the term “foreign currency gain”
means any gain from a section 988 transaction to the extent the gain does not exceed
gain realized by reason of changes in exchange rates on or after the booking date and
before the payment date.

       Section 988(b)(2) of the Code provides that the term “foreign currency loss”
means any loss from a section 988 transaction to the extent the loss does not exceed
the loss realized by reason of changes in exchange rates on or after the booking date
and before the payment date.

       Section 988(c)(1)(A) of the Code defines the term “section 988 transaction” as
any transaction described in section 988(c)(1)(B) if the amount which the taxpayer is
required to receive or pay by reason of the transaction is denominated in terms of a

nonfunctional currency or is determined by reference to the value of one or more
nonfunctional currencies. The acquisition of a debt instrument or becoming an obligor
under a debt instrument are transactions included under section 988(c)(1)(B).

        Section 985(b) of the Code defines the term “functional currency” as the dollar or
in the case of a qualified business unit (“QBU”), the currency of the economic
environment in which a significant part of the QBU’s activities are conducted and which
is used by the QBU in keeping its books and records.

        Under section 989(a) of the Code, the term QBU means any separate and clearly
identified unit of a trade or business of a taxpayer that maintains separate books and
records.

     Former Treas. Reg. §1.989(a)-1 (TD 8279, 55 FR 283-01, effective prior to
December 7, 2016) provided, in part, that a partnership is a QBU of a partner.

         Section 987 of the Code provides that in the case of a taxpayer having one or
more QBUs with a functional currency other than the dollar, the taxable income of the
taxpayer is determined by computing the taxable income or loss of the QBU separately
in its functional currency and translating the 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 QBU 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 the gain or loss by reference to the source
of the income giving rise to post-1986 accumulated earnings.

       On September 6, 2006, the Treasury Department and the IRS published a notice
of proposed rulemaking (REG-208270-86, 71 FR 52876) that proposed new regulations
under section 987 (the 2006 proposed section 987 regulations) and withdrew proposed
regulations under section 987 published on September 25, 1991 (INTL-965-86, 56 FR
48457) (the 1991 proposed regulations). Final regulations under section 987 were
published on December 8, 2017 (TD 9794).

     Former Treas. Reg. §1.988-4(b) (TD 8400, 57 FR 9172-01, effective prior to
December 7, 2016) provided in part:

       (b) Qualified business unit. (1) In general. The source of exchange gain or loss
      shall be determined by reference to the residence of the qualified business unit of
      the taxpayer on whose books the asset, liability, or item of income or expense
      giving rise to such gain or loss is properly reflected.
      (2) Proper reflection on the books of the taxpayer or qualified business unit. (i) In
      general. Whether an asset, liability, or item of income is properly reflected on the
      books of a qualified business unit is a question of fact.

      (ii) Presumption if booking practices are inconsistent. It shall be presumed that
      an asset, liability, or item of income or expense is not properly reflected on the
      books of the qualified business unit if the taxpayer and its qualified business unit
      employ inconsistent booking practices with respect to the same or similar assets,
      liabilities, or items of income or expense. If not properly reflected on the books,
      the Commissioner may allocate any asset, liability, or item of income or expense
      between or among the taxpayer and its qualified business units to properly reflect
      the source (or realization) of exchange gain or loss.

        Prop. Reg. §1.987-2 of the 2006 proposed section 987 regulations provided rules
for attributing items to a section 987 QBU. This section provided in part:

      (b) Attribution of items to an eligible QBU--(1) General rules. Except as provided
      in paragraphs (b)(2) and (3) of this section, items are attributable to an eligible
      QBU to the extent they are reflected on the separate set of books and records,
      as defined in §1.989(a)-1(d), of the eligible QBU. For purposes of this section,
      the term “item” refers to assets and liabilities, and items of income, gain,
      deduction, and loss. Items that are attributed to an eligible QBU pursuant to this
      section must be adjusted to conform to U.S. tax principles as provided in §1.987-
      4(e). These attribution rules apply solely for purposes of section 987. For
      example, the allocation and apportionment of interest expense under section
      864(e) is independent of the rules under section 987.
      (2) Exceptions for non-portfolio stock, interests in partnerships, and certain
      acquisition indebtedness--(i) General rule. Except as provided in paragraph
      (b)(2)(ii) of this section, the following shall not be considered to be on the books
      and records of a an eligible QBU:
      (A) Stock of a corporation (whether domestic or foreign).
      (B) An interest in a partnership (whether domestic or foreign).
      (C) A liability that was incurred to acquire the stock or an interest in a partnership
      described in paragraphs (b)(2)(i)(A) or (B) of this section, respectively.
      (D) Income, gain, deduction, or loss arising from the items described in
      paragraphs (b)(2)(i)(A) through (C) of this section. For example, a section 951
      inclusion with respect to stock of a foreign corporation that is described in
      paragraph (b)(2)(i)(A) of this section shall not be considered to be on the books
      and records of the eligible QBU.
      (ii) Portfolio stock. Paragraph (b)(2)(i)(A) of this section shall not apply to stock
      of a corporation (whether domestic or foreign) reflected on the books and
      records, within the meaning of paragraph (b)(1) of this section, of an eligible QBU
      provided the owner of the eligible QBU owns less than 10 percent of the total
      voting power or value of all classes of stock of such corporation. For purposes of
      this paragraph (b)(2)(ii), section 318(a) shall be applied in determining
      ownership, except that in applying section 318(a)(2)(C), the phrase “10 percent”
      is used instead of the phrase “50 percent.”

          Prop. Reg. §1.988-1(a)(4)(ii) of the 2006 proposed section 987 regulations
provided that in the case of partnership assets and liabilities that are not attributable to
an eligible QBU, the owners of the partnership are treated as owning their share of the
partnership’s assets and liabilities. Similarly, Prop. Reg. §1.988-1(a)(4)(iii) of the 2006
proposed section 987 regulations provided that in the case of assets and liabilities
owned by a disregarded entity that are not attributable to an eligible QBU, the owner of
the disregarded entity is treated as owning all of the disregarded entity’s assets and
liabilities.

        In this particular case, whether Currency A or Currency B is the correct functional
currency to calculate any section 988 gain or loss with respect to the payments of
principal and interest made on the loans depends upon whether the debt is properly
attributed to the books of the Partnership or the books of the partners of the
Partnership. If the loans are properly reflected upon Partnership’s books, section 988
gain or loss must be computed with respect to Currency B. However, if the loans are
properly reflected upon the partners’ books, section 988 gain or loss must be computed
with respect to Currency A, which is the functional currency of both Corp D and Corp E.

        The versions of Treas. Reg. §1.989(a)-1 and Treas. Reg. §1.988-4(b) that were
in effect prior to their modification in TD 9794 are applicable to the years at issue.
Under former Treas. Reg. §1.989(a)-1, Partnership was a per se QBU of its partners
because of its status as a partnership. Under former Treas. Reg. §1.988-4(b), whether
an asset, liability, or item of income was properly reflected on the books of a QBU was a
question of fact. Partnership’s trade or business consisted of managing Asset in
Country B. The loans were used to finance the purchase of stock in Corp B and Corp
C; therefore, the Corp B stock, Corp C stock, and the associated acquisition debt were
not used in the conduct of the trade or business of Partnership. Under the facts of this
case, it is not appropriate to attribute the stock and acquisition debt to the books of
Partnership.

       Under the facts presented, we conclude that the loans, which were used to
finance the acquisition of the Corp A group, are properly reflected on the books of
Partnership’s partners, Corp D and Corp E, rather than on the books of Partnership.
This conclusion is also consistent with 2006 Prop. Reg. §1.987-2(b)(2)(i)(C)1. Under
Prop. Reg. §1.987-2(b)(2)(i)(C), the loans would not be attributed to Partnership
because they were liabilities incurred to acquire stock. Under these particular facts, the
debt is properly reflected on the books of Corp D and Corp E; therefore, foreign
currency gain or loss on the debt is properly computed using Currency A as the
functional currency.



1
    The principles of this rule were finalized in TD 9794 (§1.987-2(b)(2)(iii)).

CAVEAT(S):

      A copy of this technical advice memorandum is to be given to the taxpayer(s).
Section 6110(k) (3) of the Code provides that it may not be used or cited as precedent.