12 05 2020

U.S. IRS Releases Practice Units on Foreign Currency Gain or Loss, Exchange Rates, Accounting Method Changes, and Foreign Earned Income Exclusion Adjustments

The U.S. IRS has released practice units on IRC 986(c) Gain or Loss Prior to Tax Cuts and Jobs Act of 2017, Official Versus Free Market Exchange Rate, IRC 481(a) Adjustments for IRC 263A Accounting Method Changes, and Foreign Earned Income Exclusion Adjustment

The overviews of each unit are provided as follows:

Multinational businesses that file federal income tax returns in the United States must report any income subject to U.S. federal income tax in U.S. dollars. However, when these businesses operate in different countries, these businesses must adhere to the laws and regulations of each country. Therefore, multinational businesses structure their worldwide operations to operate legally and efficiently for both global accounting and tax purposes. For U.S. tax purposes, these businesses usually structure their international business operations under entities such as foreign disregarded entities (FDEs), foreign partnerships (FPs), and controlled foreign corporations (CFCs). Foreign currency gain or loss on the distribution of previously taxed income (PTI) by a CFC to the U.S. shareholder will be the focus of this Practice Unit.

IRC 957(a) states that a foreign corporation is a CFC if more than 50 percent of its stock is held by U.S. shareholders at any time during the year. When a foreign corporation meets the definition of a CFC, the U.S. shareholders must include certain income earned by the CFC as well as distributions made by the CFC to the U.S. shareholder in its U.S. federal taxable income. CFC income that must be included by |P U.S. shareholders in U.S. federal taxable income includes earnings invested in U.S. property under IRC 956 and subpart F Income under IRC 952 (collectively, section 951 inclusions) and the new global intangible low-taxed income (GILTI) under section 951A. (Additionally, see section 965 for the treatment of deferred foreign income as subpart F.)

Potential for double taxation exists when a dividend is received from a CFC by a U.S. shareholder when the shareholder (or a prior U.S shareholder) has already recognized income in their U.S. federal income tax return on the earnings and profits of the CFC from which the dividend was distributed. To avoid this double taxation, IRC 959 allows for an exclusion from U.S. federal income tax for any distribution of previously taxed income by a CFC to its U.S. shareholder.

IRC 986(c) generally applies to these types of distributions. Since the originating deemed distribution under, for example, section 951 is earned and maintained as PTI in the CFC's functional currency, the distribution of PTI by the CFC must be translated to the U.S. dollar for U.S. federal income tax purposes at the spot rate on the date of actual distribution. If the exchange rate on the date of the actual distribution differs from the exchange rate utilized for the inclusion of the deemed distribution under section 951, 951A or 965, an exchange gain or loss under IRC 986(c) will result. Under section 986(c), a foreign currency gain or loss with respect to distributions of PTI (as described in section 959 or 1293(c)) attributable to movements in exchange rates between the times of the deemed and actual distributions is recognized and treated as ordinary income or loss from the same source as the associated income inclusion.

This Practice Unit supersedes the previously published Practice Unit with the same title published on December 20, 2016. It was updated to include Argentina as a hyperinflationary economy.

Multinational businesses that file federal income tax returns in the United States must report any income subject to U.S. federal income tax in U.S. dollars. However, when these businesses operate in different countries, they must adhere to the laws and regulations of each country. Therefore, multinational businesses structure their worldwide operations to operate legally and efficiently for both global accounting and tax purposes.

One challenge of reporting total income subject to U.S. federal income tax is computing income earned in non-U.S. locations. Often the books and records of some business enterprises are recorded in multiple currencies and locations. The U.S. federal income tax system for U.S. owned Multinational Enterprises is based on worldwide income in U.S. dollars, so it is necessary to translate amounts that are measured or denominated in different currencies into U.S. dollars. To do so, an appropriate exchange rate must be used to translate the foreign currency amounts. The "appropriate exchange rate" is based on the transaction to be reported on the U.S. federal income tax return. Generally, an item that is recognized as a taxable event at a specific point in time is translated at the foreign currency exchange rate applicable at that specific point in time (e.g., a dividend), also known as the spot rate. However, if the item has occurred over a period of time, it is generally translated at a weighted average foreign currency exchange rate applicable to the period of time.

In general, an accounting method is a set of rules used to determine when and how a taxpayer takes income and expenses into account for federal income tax purposes. A method of accounting must involve timing. If an accounting practice for an item does not permanently affect the taxpayer's lifetime taxable income, but does or could change the year in which taxable income is reported (or in which deductions are claimed), the accounting practice for the item involves timing and is therefore considered a method of accounting.

A Service-imposed change in accounting method (CAM) requires specific written notification to the taxpayer. If the Service does not provide written notice to the taxpayer that it is treating an accounting method issue as a CAM, then the taxpayer's accounting method has not been changed. It is important to properly identify change in accounting method issues and properly compute the IRC 481(a) adjustment. A change to the tax treatment of IRC 263A costs, methods, allocations, etc. may be a CAM.

If multiple change in accounting methods occur in the same year, then method change procedures generally deem the IRC 263A CAM to occur before any other CAM for that tax year. However, there are some changes that do not follow this general rule. See Treas. Reg. 1.263A-7(b).

First, if there is a change to a taxpayer's overall method of accounting, such as from the cash receipts and disbursements method to the accrual method, in the same tax year a change to the method of accounting for costs subject to IRC 263A, the change to the accrual method must occur before the change to the method of accounting for IRC 263A costs. Second, if there are changes to a taxpayer's method of accounting for depreciation in the same year a change to the method of accounting for IRC 263A costs and any portion of the depreciation is subject to IRC 263A, the change in the method for depreciation must occur before the IRC 263A method change.

In addition, there are a few other exceptions to this general rule. Certain LIFO changes made in the same year as changes to a method of accounting for IRC 263A costs are not required to follow this rule. For example, if there is a change to terminate the use of LIFO method or a change from using the specific goods LIFO method to using the dollar value LIFO inventory method in the same year a change to the method of accounting for IRC 263A costs, the changes to the LIFO method may occur before the IRC 263A changes.

The purpose of the foreign tax credit (FTC) is to relieve taxpayers of a double tax burden when their foreign source income is taxed by the foreign country and also by the United States. Taxpayers with foreign source earned income may be able to claim the foreign earned income exclusion (FEIE) on a portion of their foreign earnings. However, taxpayers are not allowed to claim a credit for taxes paid on earned income that is excluded under the FEIE. See IRC 911(d)(6).

Taxpayers that exclude all of their foreign earned income cannot take a credit for any taxes paid or accrued on that income. However, taxpayers that only exclude a portion of their foreign earned income, cannot take a credit for any part of the foreign taxes allocable to the excluded amount.

The focus of this unit is to determine the amount of foreign taxes allocable to excluded income, which will reduce the foreign taxes eligible for the FTC, and will apply when:

1. Taxpayers report foreign earned income, either wages or salaries on Form 1040 or Form 1040-SR, or as independent contractors on Schedule C or Schedule C-EZ, and

2. Taxpayers exclude a portion of their foreign earned income on Form 2555, and

3. Taxpayers claim a foreign tax credit on Form 1116 if the general category income box is checked.

Click the following link for the International Practice Units page on the IRS website.