Title 26—Internal Revenue--Volume 1
PART 1—INCOME TAXES
§ 1.987-15   Applicability date.
(a) Applicability date of the section 987 regulations —(1) In general. Except as provided in this section, the section 987 regulations apply to taxable years beginning after December 31, 2024.
(2) Applicability date for a terminating QBU. The section 987 regulations apply to the owner of a terminating QBU immediately before the section 987 QBU terminates, but only with respect to the section 987 QBU, any successor deferral QBUs or successor suspended loss QBUs (in their capacity as such), and any net unrecognized section 987 gain or loss, deferred section 987 gain or loss, or suspended section 987 loss with respect thereto. See § 1.987-1(h) for the definition of a terminating QBU.
(b) Application of the section 987 regulations to taxable years beginning on or before December 31, 2024, and ending after November 9, 2023. A taxpayer (including a taxpayer that has applied the 2016 and 2019 section 987 regulations to a prior taxable year under paragraph (c) of this section) may choose to apply the section 987 regulations to a taxable year beginning on or before December 31, 2024, and ending after November 9, 2023, provided the taxpayer and each member of its consolidated group and section 987 electing group:
(1) Consistently apply the section 987 regulations in their entirety to the taxable year and all subsequent taxable years beginning on or before December 31, 2024; and
(2) Apply the section 987 regulations on their original timely filed (including extensions) returns for the first taxable year to which the taxpayer chooses to apply the section 987 regulations.
(c) Application of the 2016 and 2019 section 987 regulations —(1) In general. A taxpayer may choose to apply the 2016 and 2019 section 987 regulations to a taxable year beginning after December 7, 2016, and beginning on or before December 31, 2024, provided the taxpayer and each member of its consolidated group and section 987 electing group:
(i) First apply the 2016 and 2019 section 987 regulations to a taxable year ending before November 9, 2023;
(ii) Consistently apply the 2016 and 2019 section 987 regulations in their entirety to all section 987 QBUs (within the meaning of prior § 1.987-1(b)(2)) directly or indirectly owned (within the meaning of prior § 1.987-1(b)(4)) by the taxpayer and each member of its consolidated group and section 987 electing group on the transition date for that taxable year and all subsequent taxable years before the taxable year in which the taxpayer and each member of its consolidated group and section 987 electing group apply the section 987 regulations pursuant to paragraph (a) or (b) of this section; and
(iii) Either—
(A) First applied the 2016 and 2019 section 987 regulations on their returns filed before November 9, 2023; or
(B) First apply the 2016 and 2019 section 987 regulations on their returns filed on or after November 9, 2023 and apply § 1.987-10 in lieu of prior § 1.987-10.
(2) Application to section 987 QBUs not owned on the transition date. For any taxable year in which a taxpayer applies the 2016 and 2019 section 987 regulations pursuant to paragraph (c)(1) of this section, the taxpayer may choose to apply the 2016 and 2019 section 987 regulations to any section 987 QBU (within the meaning of prior § 1.987-1(b)(2)) that the taxpayer did not directly or indirectly own (within the meaning of prior § 1.987-1(b)(4)) on the transition date, provided the taxpayer applies the 2016 and 2019 section 987 regulations consistently to that QBU for that taxable year and all subsequent taxable years before the taxable year in which the taxpayer applies the section 987 regulations pursuant to paragraph (a) or (b) of this section and the taxpayer either—
(i) First applied the 2016 and 2019 section 987 regulations to the section 987 QBU on its return filed before November 9, 2023; or
(ii) First applies the 2016 and 2019 section 987 regulations to the section 987 QBU on its return filed on or after November 9, 2023, and applies § 1.987-10 in lieu of prior § 1.987-10.
(3) Modifications of defined terms for purposes of this paragraph (c). Solely for purposes of this paragraph (c)—
(i) Application of § 1.987-10 in lieu of prior § 1.987-10. For any taxpayer to which paragraph (c)(1)(iii)(B) or (c)(2)(ii) of this section applies, the term 2016 and 2019 section 987 regulations includes § 1.987-10 and not prior § 1.987-10.
(ii) Partnerships not included in section 987 electing group. The term section 987 electing group does not include foreign partnerships.
(iii) Transition date. The term transition date has the meaning provided in prior § 1.987-10.
(d) Prior § 1.987-12. For the applicability dates of prior § 1.987-12, see prior § 1.987-12(j). Prior § 1.987-12 applies through the end of the taxable year immediately preceding the first taxable year in which a taxpayer applies § 1.987-12 pursuant to paragraph (a) or (b) of this section.
§ 1.988-0   Taxation of gain or loss from a section 988 transaction; Table of Contents.
This section lists captioned paragraphs contained in §§ 1.988-1 through 1.988-6.
(a) Section 988 transaction.
(1) In general.
(2) Description of transactions.
(3) [Reserved]
(4) Treatment of assets and liabilities of a section 987 aggregate partnership or DE that are not attributed to an eligible QBU.
(5) [Reserved]
(6) Examples.
(7) Special rules for regulated futures contracts and non-equity options.
(8) Special rules for qualified funds.
(9) Exception for certain transactions entered into by an individual.
(10) Intra-taxpayer transactions.
(11) Authority of Commissioner to include or exclude transactions from section 988.
(b) Spot contract.
(c) Nonfunctional currency.
(d) Spot rate.
(1) In general.
(2) Consistency required in valuing transactions subject to section 988.
(3) Use of certain spot rate conventions for payables and receivables denominated in nonfunctional currency.
(4) Currency where an official government established rate differs from a free market rate.
(e) Exchange gain or loss.
(f) Hyperinflationary currency.
(g) Fair market value.
(h) Interaction with sections 1092 and 1256 in examples.
(i) Effective date.
(a) Disposition of nonfunctional currency.
(1) Recognition of exchange gain or loss.
(2) Computation of exchange gain or loss.
(b) Translation of interest income or expense and determination of exchange gain or loss with respect to debt instruments.
(1) Translation of interest income received with respect to a nonfunctional currency demand account.
(2) Translation of nonfunctional currency interest income or expense received or paid with respect to a debt instrument described in § 1.988-1(a)(1)(ii) and (2)(i).
(3) Exchange gain or loss recognized by the holder with respect to accrued interest income.
(4) Exchange gain or loss recognized by the obligor with respect to accrued interest expense.
(5) Exchange gain or loss recognized by the holder of a debt instrument with respect to principal.
(6) Exchange gain or loss recognized by the obligor of a debt instrument with respect to principal.
(7) Payment ordering rules.
(8) Limitation of exchange gain or loss on payment or disposition of a debt instrument.
(9) Examples.
(10) Treatment of bond premium.
(11) Market discount.
(12) Tax exempt bonds.
(13) Nonfunctional currency debt exchanged for stock of obligor.
(14) [Reserved]
(15) Debt instruments and deposits denominated in hyperinflationary currencies.
(16) [Reserved]
(17) Coordination with installment method under section 453.
(18) Interaction of section 988 and § 1.1275-2(g).
(c) Item of expense or gross income or receipts which is to be paid or received after the date accrued.
(1) In general.
(2) Determination of exchange gain or loss with respect to an item of gross income or receipts.
(3) Determination of exchange gain or loss with respect to an item of expense.
(4) Examples.
(d) Exchange gain or loss with respect to forward contracts, futures contracts and option contracts.
(1) Scope.
(2) Realization of exchange gain or loss.
(3) Recognition of exchange gain or loss.
(4) Determination of exchange gain or loss.
(5) Hyperinflationary contracts.
(e) Currency swaps and notional principal contracts.
(1) Notional principal contract denominated in a single nonfunctional currency.
(2) Special rules for currency swaps.
(3) Amortization of swap premium or discount in the case of off market swaps.
(4) Treatment of taxpayer disposing of a currency swap.
(5) Examples.
(6) Special effective date for rules regarding currency swaps.
(7) Special rules for currency swap contracts in hyperinflationary currencies.
(f) Substance over form.
(1) In general.
(2) Example.
(g) Effective date.
(h) Timing of income and deductions from notional principal contracts.
(i) [Reserved]
(a) In general.
(b) Election to characterize exchange gain or loss on certain identified forward contracts, futures contracts and option contracts as capital gain or loss.
(1) In general.
(2) Special rule for contracts that become part of a straddle after the election is made.
(3) Requirements for making the election.
(4) Verification.
(5) Independent verification.
(6) Effective date.
(c) Exchange gain or loss treated as interest.
(1) In general.
(2) Exchange loss realized by the holder on nonfunctional currency tax exempt bonds.
(d) Effective date.
(a) In general.
(b) Qualified business unit.
(1) In general.
(2) Proper reflection on the books of the taxpayer or qualified business unit.
(c) Effectively connected exchange gain or loss.
(d) Residence.
(1) In general.
(2) Exception.
(3) Partner in a partnership not engaged in a U.S. trade or business under section 864(b)(2).
(e) Special rule for certain related party loans.
(1) In general.
(2) United States person.
(3) Loans by related person.
(4) 10 percent owned foreign corporation.
(f) Exchange gain or loss treated as interest under § 1.988-3.
(g) Exchange gain or loss allocated in the same manner as interest under § 1.861-9T.
(h) Effective date.
(a) Integration of a nonfunctional currency debt instrument and a § 1.988-5(a) hedge.
(1) In general.
(2) Exception.
(3) Qualifying debt instrument.
(4) Section 1.988-5(a) hedge.
(5) Definition of integrated economic transaction.
(6) Special rules for legging in and legging out of integrated treatment.
(7) Transactions part of a straddle.
(8) Identification requirements.
(9) Taxation of qualified hedging transactions.
(10) Transition rules and effective dates.
(b) Hedged executory contracts.
(1) In general.
(2) Definitions.
(3) Identification rules.
(4) Effect of hedged executory contract.
(5) References to this paragraph (b).
(c) Hedges of period between trade date and settlement date on purchase or sale of publicly traded stock or security.
(d) [Reserved]
(e) Advance rulings regarding net hedging and anticipatory hedging systems.
(f) [Reserved]
(g) General effective date.
(a) In general.
(1) Scope.
(2) Exception for hyperinflationary currencies.
(b) Instruments described in paragraph (a)(1)(i) of this section.
(1) In general.
(2) Application of noncontingent bond method.
(3) Treatment and translation of amounts determined under noncontingent bond method.
(4) Determination of gain or loss not attributable to foreign currency.
(5) Determination of foreign currency gain or loss.
(6) Source of gain or loss.
(7) Basis different from adjusted issue price.
(8) Fixed but deferred contingent payments.
(c) Examples.
(d) Multicurrency debt instruments.
(1) In general.
(2) Determination of denomination currency.
(3) Issuer/holder consistency.
(4) Treatment of payments in currencies other than the denomination currency.
(e) Instruments issued for nonpublicly traded property.
(1) Applicability.
(2) Separation into components.
(3) Treatment of components consisting of one or more noncontingent payments in the same currency.
(4) Treatment of components consisting of contingent payments.
(5) Basis different from adjusted issue price.
(6) Treatment of holder on sale, exchange, or retirement.
(f) Rules for nonfunctional currency tax exempt obligations described in § 1.1275-4(d).
(g) Effective date.
§ 1.988-1   Certain definitions and special rules.
(a) Section 988 transaction —(1) In general. The term “section 988 transaction” means any of the following transactions—
(i) A disposition of nonfunctional currency as defined in paragraph (c) of this section;
(ii) Any transaction described in paragraph (a)(2) of this section if any amount which the taxpayer is entitled to receive or is required to pay by reason of such transaction is denominated in terms of a nonfunctional currency or is determined by reference to the value of one or more nonfunctional currencies.
(2) Description of transactions. The following transactions are described in this paragraph (a)(2).
(i) Debt instruments. Acquiring a debt instrument or becoming an obligor under a debt instrument. The term “debt instrument” means a bond, debenture, note, certificate or other evidence of indebtedness.
(ii) Payables, receivables, etc. Accruing, or otherwise taking into account, for purposes of subtitle A of the Internal Revenue Code, any item of expense or gross income or receipts which is to be paid or received after the date on which so accrued or taken into account. A payable relating to cost of goods sold, or a payable or receivable relating to a capital expenditure or receipt, is within the meaning of this paragraph (a)(2)(ii). Generally, a payable relating to foreign taxes (whether or not claimed as a credit under section 901) is within the meaning of this paragraph (a)(2)(ii). However, a payable of a domestic person relating to accrued foreign taxes of its qualified business unit (QBU branch) is not within the meaning of this paragraph (a)(2)(ii) if the QBU branch's functional currency is the U.S. dollar and the foreign taxes are claimed as a credit under section 901.
(iii) Forward contract, futures contract, option contract, or similar financial instrument. Except as otherwise provided in this paragraph (a)(2)(iii) and paragraph (a)(4)(i) of this section, entering into or acquiring any forward contract, futures contract, option, warrant, or similar financial instrument.
(A) Limitation for certain derivative instruments. A forward contract, futures contract, option, warrant, or similar financial instrument is within this paragraph (a)(2)(iii) only if the underlying property to which the instrument ultimately relates is a nonfunctional currency or is otherwise described in paragraph (a)(1)(ii) of this section. Thus, if the underlying property of an instrument is another financial instrument ( e.g., an option on a futures contract), then the underlying property to which such other instrument ( e.g., the futures contract) ultimately relates must be a nonfunctional currency. For example, a forward contract to purchase wheat denominated in a nonfunctional currency, an option to enter into a forward contract to purchase wheat denominated in a nonfunctional currency, or a warrant to purchase stock denominated in a nonfunctional currency is not described in this paragraph (a)(2)(iii). On the other hand, a forward contract to purchase a nonfunctional currency, an option to enter into a forward contract to purchase a nonfunctional currency, an option to purchase a bond denominated in or the payments of which are determined by reference to the value of a nonfunctional currency, or a warrant to purchase nonfunctional currency is described in this paragraph (a)(2)(iii).
(B) Nonfunctional currency notional principal contracts —( 1 ) In general. The term “similar financial instrument” includes a notional principal contract only if the payments required to be made or received under the contract are determined with reference to a nonfunctional currency.
( 2 ) Definition of notional principal contract. The term “notional principal contract” means a contract ( e.g., a swap, cap, floor or collar) that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts. For this purpose, a “notional principal contract” shall only include an instrument where the underlying property to which the instrument ultimately relates is money ( e.g., functional currency), nonfunctional currency, or property the value of which is determined by reference to an interest rate. Thus, the term “notional principal contract” includes a currency swap as defined in § 1.988-2(e)(2)(ii), but does not include a swap referenced to a commodity or equity index.
(C) Effective date with respect to certain contracts. This paragraph (a)(2)(iii) does not apply to any forward contract, futures contract, option, warrant, or similar financial instrument entered into or acquired on or before October 21, 1988, if such instrument would have been marked to market under section 1256 if held on the last day of the taxable year.
(3) [Reserved] For further guidance, see § 1.988-1T(a)(3).
(4)-(5) {Reserved]
(6) Examples. The following examples illustrate the application of paragraph (a) of this section. The examples assume that X is a U.S. corporation on an accrual method with the calendar year as its taxable year. Because X is a U.S. corporation the U.S. dollar is its functional currency under section 985. The examples also assume that section 988(d) does not apply.
(7) Special rules for regulated futures contracts and non-equity options —(i) In general. Except as provided in paragraph (a)(7)(ii) of this section, paragraph (a)(2)(iii) of this section shall not apply to any regulated futures contract or non-equity option which would be marked to market under section 1256 if held on the last day of the taxable year.
(ii) Election to have paragraph (a)(2)(iii) of this section apply. Notwithstanding paragraph (a)(7)(i) of this section, a taxpayer may elect to have paragraph (a)(2)(iii) of this section apply to regulated futures contracts and non-equity options as provided in paragraphs (a)(7)(iii) and (iv) of this section.
(iii) Procedure for making the election. A taxpayer shall make the election provided in paragraph (a)(7)(ii) of this section by sending to the Internal Revenue Service Center, Examination Branch, Stop Number 92, Kansas City, MO 64999 a statement titled “Election to Treat Regulated Futures Contracts and Non-Equity Options as Section 988 Transactions Under Section 988 (c)(1)(D)(ii)” that contains the following:
(A) The taxpayer's name, address, and taxpayer identification number;
(B) The date the notice is mailed or otherwise delivered to the Internal Revenue Service Center;
(C) A statement that the taxpayer (including all members of such person's affiliated group as defined in section 1504 or in the case of an individual all persons filing a joint return with such individual) elects to have section 988(c)(1)(D)(i) and § 1.988-1(a)(7)(i) not apply;
(D) The date of the beginning of the taxable year for which the election is being made;
(E) If the election is filed after the first day of the taxable year, a statement regarding whether the taxpayer has previously held a contract described in section 988(c)(1)(D)(i) or § 1.988-1(a)(7)(i) during such taxable year, and if so, the first date during the taxable year on which such contract was held; and
(F) The signature of the person making the election (in the case of individuals filing a joint return, the signature of all persons filing such return).
(iv) Time for making the election —(A) In general. Unless the requirements for making a late election described in paragraph (a)(7)(iv)(B) of this section are satisfied, an election under section 988 (c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section for any taxable year shall be made on or before the first day of the taxable year or, if later, on or before the first day during such taxable year on which the taxpayer holds a contract described in section 988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section. The election under section 988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section shall apply to contracts entered into or acquired after October 21, 1988, and held on or after the effective date of the election. The election shall be effective as of the beginning of the taxable year and shall be binding with respect to all succeeding taxable years unless revoked with the prior consent of the Commissioner. In determining whether to grant revocation of the election, recapture of the tax benefit derived from the election in previous taxable years will be considered.
(B) Late elections. A taxpayer may make an election under section 988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section within 30 days after the time prescribed in the first sentence of paragraph (a)(7)(iv)(A) of this section. Such a late election shall be effective as of the beginning of the taxable year; however, any losses recognized during the taxable year with respect to contracts described in section 988(c)(1)(D)(ii) or paragraph (a)(7)(ii) of this section which were entered into or acquired after October 21, 1988, and held on or before the date on which the late election is mailed or otherwise delivered to the Internal Revenue Service Center shall not be treated as derived from a section 988 transaction. A late election must comply with the procedures set forth in paragraph (a)(7)(iii) of this section.
(v) Transition rule. An election made prior to September 21, 1989 which satisfied the requirements of Notice 88-124, 1988-51 I.R.B. 6, shall be deemed to satisfy the requirements of paragraphs (a)(7)(iii) and (iv) of this section.
(vi) General effective date provision. This paragraph (a)(7) shall apply with respect to futures contracts and options entered into or acquired after October 21, 1988.
(8) Special rules for qualified funds —(i) Definition of qualified fund. The term “qualified fund” means any partnership if—
(A) At all times during the taxable year (and during each preceding taxable year to which an election under section 988(c)(1)(E)(iii)(V) applied) such partnership has at least 20 partners and no single partner owns more than 20 percent of the interests in the capital or profits of the partnership;
(B) The principa1 activity of such partnership for such taxable year (and each such preceding taxable year) consists of buying and selling options, futures, or forwards with respect to commodities;
(C) At least 90 percent of the gross income of the partnership for the taxable year (and each such preceding year) consists of income or gains described in subparagraph (A), (B), or (G) of section 7704(d)(1) or gain from the sale or disposition of capital assets held for the production of interest or dividends;
(D) No more than a de minimis amount of the gross income of the partnership for the taxable year (and each such preceding taxable year) was derived from buying and selling commodities; and
(E) An election under section 988 (c)(1)(E)(iii)(V) as provided in paragraph (a)(8)(iv) of this section applies to the taxable year.
(ii) Special rules relating to paragraph (a)(8)(i)(A) of this section —(A) Certain general partners. The interest of a general partner in the partnership shall not be treated as failing to meet the 20 percent ownership requirement of paragraph (a)(8)(i)(A) of this section for any taxable year of the partnership if, for the taxable year of the partner in which such partnership's taxable year ends, such partner (and each corporation filing a consolidated return with such partner) had no ordinary income or loss from a section 988 transaction (other than income from the partnership) which is exchange gain or loss (as the case may be).
(B) Treatment of incentive compensation. For purposes of paragraph (a)(8)(i)(A) of this section, any income allocable to a general partner as incentive compensation based on profits rather than capital shall not be taken into account in determining such partner's interest in the profits of the partnership.
(C) Treatment of tax exempt partners. The interest of a partner in the partnership shall not be treated as failing to meet the 20 percent ownership requirements of paragraph (a)(5)(8)(A) of this section if none of the income of such partner from such partnership is subject to tax under chapter 1 of subtitle A of the Internal Revenue Code (whether directly or through one or more pass-through entities).
(D) Look-through rule. In determining whether the 20 percent ownership requirement of paragraph (a)(8)(i)(A) of this section is met with respect to any partnership, any interest in such partnership held by another partnership shall be treated as held proportionately by the partners in such other partnership.
(iii) Other special rules —(A) Related persons. Interests in the partnership held by persons related to each other (within the meaning of section 267(b) or 707(b)) shall be treated as held by one person.
(B) Predecessors. Reference to any partnership shall include a reference to any predecessor thereof.
(C) Treatment of certain debt instruments. Solely for purposes of paragraph (a)(8)(i)(D) of this section, any debt instrument which is described in both paragraphs (a)(1)(ii) and (2)(i) of this section shall be treated as a commodity.
(iv) Procedure for making the election provided in section 988(c)(1)(E)(iii)(V). A partnership shall make the election provided in section 988(c)(1)(E)(iii)(V) by sending to the Internal Revenue Service Center, Examination Branch, Stop Number 92, Kansas City, MO 64999 a statement titled “QUALIFIED FUND ELECTION UNDER SECTION 988(c)(1)(E)(iii)(V)” that contains the following:
(A) The partnership's name, address, and taxpayer identification number;
(B) The name, address and taxpayer identification number of the general partner making the election on behalf of the partnership;
(C) The date the notice is mailed or otherwise delivered to the Internal Revenue Service Center;
(D) A brief description of the activity of the partnership;
(E) A statement that the partnership is making the election provided in section 988(c)(1)(E)(iii)(V);
(F) The date of the beginning of the taxable year for which the election is being made;
(G) If the election is filed after the first day of the taxable year, then a statement regarding whether the partnership previously held an instrument referred to in section 988(c)(1)(E)(i) during such taxable year and, if so, the first date during the taxable year on which such contract was held; and
(H) The signature of the general partner making the election.
(v) Time for making the election. The election under section 988(c)(1)(E)(iii)(V) for any taxable year shall be made on or before the first day of the taxable year or, if later, on or before the first day during such year on which the partnership holds an instrument described in section 988(c)(1)(E)(i). The election under section 988(c)(1)(E)(iii)(V) shall apply to the taxable year for which made and all succeeding taxable years. Such election may only be revoked with the consent of the Commissioner. In determining whether to grant revocation of the election, recapture by the partners of the tax benefit derived from the election in previous taxable years will be considered.
(vi) Operative rules applicable to qualified funds —(A) In general. In the case of a qualified fund, any bank forward contract or any foreign currency futures contract traded on a foreign exchange which is not otherwise a section 1256 contract shall be treated as a section 1256 contract for purposes of section 1256.
(B) Gains and losses treated as short-term. In the case of any instrument treated as a section 1256 contract under paragraph (a)(8)(vi)(A) of this section, subparagraph (A) of section 1256(a)(3) shall be applied by substituting “100 percent” for “40 percent” (and subparagraph (B) of such section shall not apply).
(vii) Transition rule. An election made prior to September 21, 1989, which satisfied the requirements of Notice 88-124, 1988-51 I.R.B. 6, shall be deemed to satisfy the requirements of § 1.988-1(a)(8)(iv) and (v).
(viii) General effective date rules —(A) The requirements of subclause (IV) of section 988(c)(1)(E)(iii) shall not apply to contracts entered into or acquired on or before October 21, 1988.
(B) In the case of any partner in an existing partnership, the 20 percent ownership requirements of subclause (I) of section 988(c)(1)(E)(iii) shall be treated as met during any period during which such partner does not own a percentage interest in the capital or profits of such partnership greater than 33 1/3 percent (or, if lower, the lowest such percentage interest of such partner during any period after October 21, 1988, during which such partnership is in existence). For purposes of the preceding sentence, the term “existing partnership” means any partnership if—
( 1 ) Such partnership was in existence on October 21, 1988, and principally engaged on such date in buying and selling options, futures, or forwards with respect to commodities; or
( 2 ) A registration statement was filed with respect to such partnership with the Securities and Exchange Commission on or before such date and such registration statement indicated that the principal activity of such partnership will consist of buying and selling instruments referred to in paragraph (a)(8)(viii)(B)( 1 ) of this section.
(9) Exception for certain transactions entered into by an individual —(i) In general. A transaction entered into by an individual which otherwise qualifies as a section 988 transaction shall be considered a section 988 transaction only to the extent expenses properly allocable to such transaction meet the requirements of section 162 or 212 (other than the part of section 212 dealing with expenses incurred in connection with taxes).
(ii) Examples. The following examples illustrate the application of paragraph (a)(9) of this section.
(10) Intra-taxpayer transactions —(i) In general. Except as provided in paragraph (a)(10)(ii) of this section, disregarded transactions between or among the taxpayer and/or qualified business units of that taxpayer (“intra-taxpayer transactions”) are not section 988 transactions. See section 987 and the regulations thereunder.
(ii) Certain intra-taxpayer transfers of section 988 transactions that result in the recognition of section 988 gain or loss —(A) In general. Exchange gain or loss with respect to nonfunctional currency or any item described in paragraph (a)(2) of this section entered into with another taxpayer shall be realized upon a transfer (as defined under § 1.987-2(c)) of such currency or item from an owner to a section 987 QBU or from a section 987 QBU to an owner if as a result of such transfer—
( 1 ) The currency or item loses its character as nonfunctional currency or as an item described in paragraph (a)(2) of this section; or
( 2 ) The source of the exchange gain or loss could be altered absent the application of paragraph (a)(10)(ii)(B) of this section.
(B) Computation of exchange gain or loss. Exchange gain or loss described in section (a)(10)(ii)(A) of this section shall be computed in accordance with § 1.988-2 (without regard to § 1.988-2(b)(8)) as if the nonfunctional currency or item described in paragraph (a)(2) of this section had been sold or otherwise transferred at fair market value between unrelated taxpayers. For purposes of the preceding sentence, a taxpayer must use a translation rate that is consistent with the translation conventions of the section 987 QBU to or from which, as the case may be, the item is being transferred. In the case of a gain or loss incurred in a transaction described in this paragraph (a)(10)(ii) that does not have a significant business purpose, the Commissioner may defer such gain or loss.
(iii) Example. The following example illustrates the provisions of this paragraph (a)(10).
(B) If instead Y transfers the $25 to Z, exchange gain is not realized because the $25 is nonfunctional currency with respect to Z and if Z were to immediately convert the $25 into LCs, the gain would be foreign source. For purposes of determining whether the transfer is a remittance resulting in additional gain or loss, see section 987 and the regulations thereunder.
(11) Authority to include or exclude transactions from section 988 —(i) In general. The Commissioner may recharacterize a transaction (or series of transactions) in whole or in part as a section 988 transaction if the effect of such transaction (or series of transactions) is to avoid section 988. In addition, the Commissioner may exclude a transaction (or series of transactions) which in form is a section 988 transaction from the provisions of section 988 if the substance of the transaction (or series of transactions) indicates that it is not properly considered a section 988 transaction.
(ii) Example. The following example illustrates the provisions of this paragraph (a)(11).
(b) Spot contract. A spot contract is a contract to buy or sell nonfunctional currency on or before two business days following the date of the execution of the contract. See § 1.988-2 (d)(1)(ii) for operative rules regarding spot contracts.
(c) Nonfunctional currency. The term “nonfunctional currency” means with respect to a taxpayer or a qualified business unit (as defined in section 989 (a)) a currency (including the European Currency Unit) other than the taxpayer's or the qualified business unit's functional currency as defined in section 985 and the regulations thereunder. For rules relating to nonrecognition of exchange gain or loss with respect to certain dispositions of nonfunctional currency, see § 1.988-2 (a)(1)(iii).
(d) Spot rate —(1) In general. Except as otherwise provided in this paragraph, the term “spot rate” means a rate demonstrated to the satisfaction of the District Director or the Assistant Commissioner (International) to reflect a fair market rate of exchange available to the public for currency under a spot contract in a free market and involving representative amounts. In the absence of such a demonstration, the District Director or the Assistant Commissioner (International), in his or her sole discretion, shall determine the spot rate from a source of exchange rate information reflecting actual transactions conducted in a free market. For example, the taxpayer or the District Director or the Assistant Commissioner (International) may determine the spot rate by reference to exchange rates published in the pertinent monthly issue of “International Financial Statistics” or a successor publication of the International Monetary Fund; exchange rates published by the Board of Governors of the Federal Reserve System pursuant to 31 U.S.C. section 5151; exchange rates published in newspapers, financial journals or other daily financial news sources; or exchange rates quoted by electronic financial news services.
(2) Consistency required in valuing transactions subject to section 988. If the use of inconsistent sources of spot rate quotations results in the distortion of income, the District Director or the Assistant Commissioner (International) may determine the appropriate spot rate.
(3) Use of certain spot rate conventions for payables and receivables denominated in nonfunctional currency. If consistent with the taxpayer's financial accounting, a taxpayer may utilize a spot rate convention determined at intervals of one quarter year or less for purposes of computing exchange gain or loss with respect to payables and receivables denominated in a nonfunctional currency that are incurred in the ordinary course of business with respect to the acquisition or sale of goods or the obtaining or performance of services. For example, if consistent with the taxpayer's financial accounting, a taxpayer may accrue all payables and receivables incurred during the month of January at the spot rate on December 31 or January 31 (or at an average of any spot rates occurring between these two dates) and record the payment or receipt of amounts in satisfaction of such payables and receivables consistent with such convention. The use of a spot rate convention cannot be changed without the consent of the Commissioner.
(4) Currency where an official government established rate differs from a free market rate —(i) In general. If a currency has an official government established rate that differs from a free market rate, the spot rate shall be the rate which most clearly reflects the taxpayer's income. Generally, this shall be the free market rate.
(ii) Examples. The following examples illustrate the application of this paragraph (d)(4).
(i) X purchases LC100 for $60 in L on the secondary market when the official exchange rate is S1 = LC1;
(ii) X transfers the LC100 to Y;
(iii) Y purchases $100 for LC100; and
(iv) Y transfers $65 ($100 less an L tax withheld of $35 on the transfer) to the home office of X.
(e) Exchange gain or loss. The term “exchange gain or loss” means the amount of gain or loss realized as determined in § 1.988-2 with respect to a section 988 transaction. Except as otherwise provided in these regulations ( e.g., § 1.98B-5), the amount of exchange gain or loss from a section 988 transaction shall be separately computed for each section 988 transaction, and such amount shall not be integrated with gain or loss recognized on another transaction (whether or not such transaction is economically related to the section 988 transaction). See § 1.988-2 (b)(8) for a special rule with respect to debt instruments.
(f) Hyperinflationary currency —(1) Definition —(i) General rule. For purposes of section 988, a hyperinflationary currency means a currency described in § 1.985-1(b)(2)(ii)(D). Unless otherwise provided, the currency in any example used in §§ 1.988-1 through 1.988-5 is not a hyperinflationary currency.
(ii) Special rules for determining base period. In determining whether a currency is hyperinflationary under § 1.985-1(b)(2)(ii)(D) for purposes of this paragraph (f), the following rules will apply:
(A) The base period means the thirty-six calendar month period ending on the last day of the taxpayer's (or qualified business unit's) current taxable year. Thus, for example, if for 1996, 1997, and 1998, a country's annual inflation rates are 6 percent, 11 percent, and 90 percent, respectively, the cumulative inflation rate for the three-year base period is 124% [((1.06 × 1.11 × 1.90) − 1.0 = 1.24) × 100 = 124%]. Accordingly, assuming the QBU has a calendar year as its taxable year, the currency of the country is hyperinflationary for the 1998 taxable year. This change in the § 1.985-1(b)(2)(ii)(D) base period shall not apply to any section 988 transaction of an entity described in section 851 (regulated investment company (RIC)) or section 856 (real estate investment trust (REIT)). The Service may, by notice, provide that the foregoing change in the § 1.985-1(b)(2)(ii)(D) base period does not apply to any section 988 transaction of an entity with distribution requirements similar to a RIC or REIT.
(B) The last sentence of § 1.985-1(b)(2)(ii)(D) shall not apply to alter the base period for purposes of this paragraph (f) in determining whether a currency is hyperinflationary for purposes of section 988. Accordingly, generally accepted accounting principles may not apply to alter the base period for purposes of this paragraph (f).
(2) Effective date. Paragraph (f)(1) of this section shall apply to transactions entered into after February 14, 2000.
(g) Fair market value. The fair market value of an item shall, where relevant, reflect an appropriate premium or discount for the time value of money ( e.g., the fair market value of a forward contract to buy or sell nonfunctional currency shall reflect the present value of the difference between the units of nonfunctional currency times the market forward rate at the time of valuation and the units of nonfunctional currency times the forward rate set forth in the contract). However, if consistent with the taxpayer's method of financial accounting (and consistently applied from year to year), the preceding sentence shall not apply to a financial instrument that matures within one year from the date of issuance or acquisition. Unless otherwise provided, the fair market value given in any example used in §§ 1.988-1 through 1.988-5 is deemed to reflect appropriately the time value of money. If the use of inconsistent sources of forward or other market rate quotations results in the distortion of income, the District Director or the Assistant Commissioner (International) may determine the appropriate rate.
(h) Interaction with sections 1092 and 1256. Unless otherwise provided, it is assumed for purposes of §§ 1.988-1 through 1.988-5 that any contract used in any example is not a section 1256 contract and is not part of a straddle as defined in section 1092. No inference is intended regarding the application of section 1092 or 1256 unless expressly stated.
(i) Applicability date —(1) In general. Except as otherwise provided in this section, this section applies to taxable years beginning after December 31, 1986. Thus, except as otherwise provided in this section, any payments made or received with respect to a section 988 transaction in taxable years beginning after December 31, 1986, are subject to this section.
(2) Paragraph (a)(10)(ii). Generally, paragraph (a)(10)(ii) of this section applies to taxable years beginning after December 31, 2024. However, if pursuant to § 1.987-15(b), a taxpayer chooses to apply §§ 1.987-1 through 1.987-15 to a taxable year before the first taxable year described in § 1.987-15(a)(1), then paragraph (a)(10)(ii) of this section applies to that taxable year. See § 1.988-1(i), as contained in 26 CFR in part 1 in effect on April 1, 2024, for a prior applicability date for paragraph (a)(10)(ii) of this section.
§ 1.988-1T   Certain definitions and special rules (temporary).
(a)(1) through (a)(2) [Reserved] For further guidance, see § 1.988-1(a)(1) through (2).
(3) Specified owner functional currency transactions of a section 987 QBU not treated as section 988 transactions. Specified owner functional currency transactions, as defined in § 1.987-3T(b)(4)(ii), held by a section 987 QBU are not treated as section 988 transactions. Thus, no currency gain or loss shall be recognized by a section 987 QBU under section 988 with respect to such transactions.
(4) through (i) [Reserved] For further guidance, see § 1.988-1(a)(4) through (i).
(j) Effective/applicability date. This section applies to taxable years beginning on or after one year after the first day of the first taxable year following December 7, 2016. Notwithstanding the preceding sentence, if a taxpayer makes an election under § 1.987-11(b), then this section applies to taxable years to which §§ 1.987-1 through 1.987-10 apply as a result of such election.
(k) Expiration date. The applicability of this section expires on December 6, 2019.
§ 1.988-2   Recognition and computation of exchange gain or loss.
(a) Disposition of nonfunctional currency —(1) Recognition of exchange gain or loss —(i) In general. Except as otherwise provided in this section, § 1.988-1(a)(7)(ii), and § 1.988-5, the recognition of exchange gain or loss upon the sale or other disposition of nonfunctional currency shall be governed by the recognition provisions of the Internal Revenue Code which apply to the sale or disposition of property ( e.g., section 1001 or, to the extent provided in regulations, section 1092). The disposition of nonfunctional currency in settlement of a forward contract, futures contract, option contract, or similar financial instrument is considered to be a sale or disposition of the nonfunctional currency for purposes of the preceding sentence.
(ii) Clarification of section 1031. An amount of one nonfunctional currency is not “property of like kind” with respect to an amount of a different nonfunctional currency.
(iii) Coordination with section 988(c)(1)(C)(ii). No exchange gain or loss is recognized with respect to the following transactions—
(A) An exchange of units of nonfunctional currency for different units of the same nonfunctional currency;
(B) The deposit of nonfunctional currency in a demand or time deposit or similar instrument (including a certificate of deposit) issued by a bank or other financial institution if such instrument is denominated in such currency;
(C) The withdrawal of nonfunctional currency from a demand or time deposit or similar instrument issued by a bank or other financial institution if such instrument is denominated in such currency;
(D) The receipt of nonfunctional currency from a bank or other financial institution from which the taxpayer purchased a certificate of deposit or similar instrument denominated in such currency by reason of the maturing or other termination of such instrument; and
(E) The transfer of nonfunctional currency from a demand or time deposit or similar instrument issued by a bank or other financial institution to another demand or time deposit or similar instrument denominated in the same nonfunctional currency issued by a bank or other financial institution.
(iv) Example. The following example illustrates the provisions of paragraph (a)(1)(iii) of this section.
(2) Computation of gain or loss —(i) In general. Exchange gain realized from the sale or other disposition of nonfunctional currency shall be the excess of the amount realized over the adjusted basis of such currency, and exchange loss realized shall be the excess of the adjusted basis of such currency over the amount realized.
(ii) Amount realized —(A) In general. The amount realized from the disposition of nonfunctional currency shall be determined under section 1001(b). A taxpayer that uses a spot rate convention under § 1.988-1(d)(3) to determine exchange gain or loss with respect to a payable shall determine the amount realized upon the disposition of nonfunctional currency paid in satisfaction of the payable in a manner consistent with such convention.
(B) Exchange of nonfunctional currency for property. For purpose of paragraph (a)(2) of this section, the exchange of nonfunctional currency for property (other than nonfunctional currency) shall be treated as—
( 1 ) An exchange of the units of nonfunctional currency for units of functional currency at the spot rate on the date of the exchange, and
( 2 ) The purchase or sale of the property for such units of functional currency.
(C) Example. The following example illustrates the provisions of paragraph (a)(2)(ii)(B) of this section.
(iii) Adjusted basis —(A) In general. Except as provided in paragraphs (a)(2)(iii)(B) and (C) of this section, the adjusted basis of nonfunctional currency is determined under the applicable provisions of the Internal Revenue Code ( e.g., sections 1011 through 1023). A taxpayer that uses a spot rate convention under § 1.988-1 (d)(3) to determine exchange gain or loss with respect to a receivable shall determine the basis of nonfunctional currency received in satisfaction of such receivable in a manner consistent with such convention.
(B) Determination of the basis of nonfunctional currency withdrawn from an account with a bank or other financial institution —( 1 ) In general. The basis of nonfunctional currency withdrawn from an account with a bank or other financial institution shall be determined under any reasonable method that is consistently applied from year to year by the taxpayer to all accounts denominated in a nonfunctional currency. For example, a taxpayer may use a first in first out method, a last in first out method, a pro rata method (as illustrated in the example below), or any other reasonable method that is consistently applied. However, a method that consistently results in units of nonfunctional currency with the highest basis being withdrawn first shall not be considered reasonable.
( 2 ) Example. The following example illustrates the provisions of this paragraph (a)(2)(iii)(B).
(C) Basis in refunded foreign income tax. See § 1.986(a)-1(e) for rules relating to the determination of basis in refunded foreign income tax denominated in nonfunctional currency.
(iv) Purchase and sale of stock or securities traded on an established securities market by cash basis taxpayer—
(A) Amount realized. If stock or securities traded on an established securities market are sold by a cash basis taxpayer for nonfunctional currency, the amount realized with respect to the stock or securities (as determined on the trade date) shall be computed by translating the units of nonfunctional currency received into functional currency at the spot rate on the settlement date of the sale. This rule applies notwithstanding that the stock or securities are treated as disposed of on a date other than the settlement date under another section of the Code. See section 453(k).
(B) Basis. If stock or securities traded on an established securities market are purchased by a cash basis taxpayer for nonfunctional currency, the basis of the stock or securities shall be determined by translating the units of nonfunctional currency paid into functional currency at the spot rate on the settlement date of the purchase.
(C) Example. The following example illustrates the provisions of this paragraph (a)(2)(iv).
(v) Purchase and sale of stock or securities traded on an established securities market by accrual basis taxpayer. For taxable years beginning after March 17, 1992, an accrual basis taxpayer may elect to apply the rules of paragraph (a)(2)(iv) of this section. The election shall be made by filing a statement with the taxpayer's first return in which the election is effective clearly indicating that the election has been made. A method so elected must be applied consistently from year to year and cannot be changed without the consent of the Commissioner.
(b) Translation of interest income or expense and determination of exchange gain or loss with respect to debt instruments —(1) Translation of interest income received with respect to a nonfunctional currency demand account. Interest income received with respect to a demand account with a bank or other financial institution which is denominated in (or the payments of which are determined by reference to) a nonfunctional currency shall be translated into functional currency at the spot rate on the date received or accrued or pursuant to any reasonable spot rate convention consistently applied by the taxpayer to all taxable years and to all accounts denominated in nonfunctional currency in the same financial institution. For example, a taxpayer may translate interest income received with respect to a demand account on the last day of each month of the taxable year, on the last day of each quarter of the taxable year, on the last day of each half of the taxable year, or on the last day of the taxable year. No exchange gain or loss is realized upon the receipt or accrual of interest income with respect to a demand account subject to this paragraph (b)(1).
(2) Translation of nonfunctional currency interest income or expense received or paid with respect to a debt instrument described in § 1.988-1(a)(1)(ii) and (2)(i) —(i) Scope —(A) In general. Paragraph (b) of this section only applies to debt instruments described in § 1.988-1(a)(1)(ii) and (2)(i) where all payments are denominated in, or determined with reference to, a single nonfunctional currency. Except as provided in paragraph (b)(2)(i)(B) of this section, this paragraph (b) shall not apply to contingent payment debt instruments.
(B) Nonfunctional currency contingent payment debt instruments —( 1 ) Operative rules. See § 1.988-6 for rules applicable to contingent payment debt instruments for which one or more payments are denominated in, or determined by reference to, a nonfunctional currency.
( 2 ) Certain instruments are not contingent payment debt instruments. For purposes of sections 163(e) and 1271 through 1275 and the regulations thereunder, a debt instrument does not provide for contingent payments merely because the instrument is denominated in, or all payments of which are determined with reference to, a single nonfunctional currency. See § 1.988-6 for the treatment of nonfunctional currency contingent payment debt instruments.
(ii) Determination and translation of interest income or expense —(A) In general. Interest income or expense on a debt instrument described in paragraph (b)(2)(i) of this section (including original issue discount determined in accordance with sections 1271 through 1275 and 163(e) as adjusted for acquisition premium under section 1272(a)(7), and acquisition discount determined in accordance with sections 1281 through 1283) shall be determined in units of nonfunctional currency and translated into functional currency as provided in paragraphs (b)(2)(ii)(B) and (C) of this section. For purposes of sections 483, 1273(b)(5) and 1274, the nonfunctional currency in which an instrument is denominated (or by reference to which payments are determined) shall be considered money.
(B) Translation of interest income or expense that is not required to be accrued prior to receipt or payment. With respect to an instrument described in paragraph (b)(2)(i) of this section, interest income or expense received or paid that is not required to be accrued by the taxpayer prior to receipt or payment shall be translated at the spot rate on the date of receipt or payment. No exchange gain or loss is realized with respect to the receipt or payment of such interest income or expense (other than the exchange gain or loss that might be realized under paragraph (a) of this section upon the disposition of the nonfunctional currency so received or paid).
(C) Translation of interest income or expense that is required to be accrued prior to receipt or payment. With respect to an instrument described in paragraph (b)(2)(i) of this section, interest income or expense that is required to be accrued prior to receipt or payment ( e.g. , under section 1272, 1281 or 163(e) or because the taxpayer uses an accrual method of accounting) shall be translated at the average rate (or other rate specified in paragraph (b)(2)(iii)(B) of this section) for the interest accrual period or, with respect to an interest accrual period that spans two taxable years, at the average rate (or other rate specified in paragraph (b)(2)(iii)(B) of this section) for the partial period within the taxable year. See paragraphs (b)(3) and (4) of this section for the determination of exchange gain or loss on the receipt or payment of accrued interest income or expense.
(iii) Determination of average rate or other accrual convention —(A) In general. For purposes of this paragraph (b), the average rate for an accrual period (or partial period) shall be a simple average of the spot exchange rates for each business day of such period or other average exchange rate for the period reasonably derived and consistently applied by the taxpayer.
(B) Election to use spot accrual convention. For taxable years beginning after March 17, 1992, a taxpayer may elect to translate interest income and expense at the spot rate on the last day of the interest accrual period (and in the case of a partial accrual period, the spot rate on the last day of the taxable year). If the last day of the interest accrual period is within five business days of the date of receipt or payment, the taxpayer may translate interest income or expense at the spot rate on the date of receipt or payment. The election shall be made by filing a statement with the taxpayer's first return in which the election is effective clearly indicating that the election has been made. A method so elected must be applied consistently to all debt instruments from year to year and cannot be changed without the consent of the Commissioner.
(3) Exchange gain or loss recognized by the holder with respect to accrued interest income. The holder of a debt instrument described in paragraph (b)(2)(i) of this section shall realize exchange gain or loss with respect to accrued interest income on the date such accrued interest income is received or the instrument is disposed of (including a deemed disposition under section 1001 that results from a material change in terms of the instrument). Except as otherwise provided in this paragraph (b) ( e.g. , paragraph (b)(8) of this section), exchange gain or loss realized with respect to accrued interest income shall be recognized in accordance with the applicable recognition provisions of the Internal Revenue Code. The amount of exchange gain or loss so realized with respect to accrued interest income is determined for each accrual period by—
(i) Translating the units of nonfunctional currency interest income received with respect to such accrual period (as determined under the ordering rules of paragraph (b)(7) of this section) into functional currency at the spot rate on the date the interest income is received or the instrument is disposed of (or deemed disposed of), and
(ii) Subtracting from such amount the amount computed by translating the units of nonfunctional currency interest income accrued with respect to such income received at the average rate (or other rate specified in paragraph (b)(2)(iii)(B) of this section) for the accrual period.
(4) Exchange gain or loss recognized by the obligor with respect to accrued interest expense. The obligor under a debt instrument described in paragraph (b)(2)(i) of this section shall realize exchange gain or loss with respect to accrued interest expense on the date such accrued interest expense is paid or the obligation to make payments is transferred or extinguished (including a deemed disposition under section 1001 that results from a material change in terms of the instrument). Except as otherwise provided in this paragraph (b) ( e.g., paragraph (b)(8) of this section), exchange gain or loss realized with respect to accrued interest expense shall be recognized in accordance with the applicable recognition provisions of the Internal Revenue Code. The amount of exchange gain or loss so realized with respect to accrued interest expense is determined for each accrual period by—
(i) Translating the units of nonfunctional currency interest expense accrued with respect to the amount of interest paid into functional currency at the average rate (or other rate specified in paragraph (b)(2)(iii)(B) of this section) for such accrual period; and
(ii) Subtracting from such amount the amount computed by translating the units of nonfunctional currency interest paid (or, if the obligation to make payments is extinguished or transferred, the units accrued) with respect to such accrual period (as determined under the ordering rules in paragraph (b)(7) of this section) into functional currency at the spot rate on the date payment is made or the obligation is transferred or extinguished (or deemed extinguished).
(5) Exchange gain or loss recognized by the holder of a debt instrument with respect to principal. The holder of a debt instrument described in paragraph (b)(2)(i) of this section shall realize exchange gain or loss with respect to the principal amount of such instrument on the date principal (determined under the ordering rules of paragraph (b)(7) of this section) is received from the obligor or the instrument is disposed of (including a deemed disposition under section 1001 that results from a material change in terms of the instrument). For purposes of computing exchange gain or loss, the principal amount of a debt instrument is the holder's purchase price in units of nonfunctional currency. See paragraph (b)(10) of this section for rules regarding the amortization of that part of the principal amount that represents bond premium and the computation of exchange gain or loss thereon. If, however, the holder acquired the instrument in a transaction in which exchange gain or loss was realized but not recognized by the transferor, the nonfunctional currency principal amount of the instrument with respect to the holder shall be the same as that of the transferor. Except as otherwise provided in this paragraph (b) ( e.g., paragraph (b)(8) of this section), exchange gain or loss realized with respect to such principal amount shall be recognized in accordance with the applicable recognition provisions of the Internal Revenue Code. The amount of exchange gain or loss so realized by the holder with respect to principal is determined by—
(i) Translating the units of nonfunctional currency principal at the spot rate on the date payment is received or the instrument is disposed of (or deemed disposed of); and
(ii) Subtracting from such amount the amount computed by translating the units of nonfunctional currency principal at the spot rate on the date the holder (or a transferor from whom the nonfunctional principal amount is carried over) acquired the instrument (is deemed to acquire the instrument).
(6) Exchange gain or loss recognized by the obligor of a debt instrument with respect to principal. The obligor under a debt instrument described in paragraph (b)(2)(i) of this section shall realize exchange gain or loss with respect to the principal amount of such instrument on the date principal (determined under the ordering rules of paragraph (b)(7) of this section) is paid or the obligation to make payments is transferred or extinguished (including a deemed disposition under section 1001 that results from a material change in terms of the instrument). For purposes of computing exchange gain or loss, the principal amount of a debt instrument is the amount received by the obligor for the debt instrument in units of nonfunctional currency. See paragraph (b)(10) of this section for rules regarding the amortization of that part of the principal amount that represents bond premium and the computation of exchange gain or loss thereon. If, however, the obligor became the obligor in a transaction in which exchange gain or loss was realized but not recognized by the transferor, the nonfunctional currency principal amount of the instrument with respect to such obligor shall be the same as that of the transferor. Except as otherwise provided in this paragraph (b) ( e.g., paragraph (b)(8) of this section), exchange gain or loss realized with respect to such principal shall be recognized in accordance with the applicable recognition provisions of the Internal Revenue Code. The amount of exchange gain or loss so realized by the obligor is determined by—
(i) Translating the units of nonfunctional currency principal at the spot rate on the date the obligor (or a transferor from whom the principal amount is carried over) became the obligor (or is deemed to have become the obligor); and
(ii) Subtracting from such amount the amount computed by translating the units of nonfunctional currency principal at the spot rate on the date payment is made or the obligation is transferred or extinguished (or deemed extinguished).
(7) Payment ordering rules —(i) Debt instruments subject to the rules of sections 163(e), or 1271 through 1288. In the case of a debt instrument described in paragraph (b)(2)(i) of this section that is subject to the rules of sections 163(e), or 1272 through 1288, units of nonfunctional currency (or an amount determined with reference to nonfunctional currency) received or paid with respect to such debt instrument shall be treated first as a receipt or payment of periodic interest under the principles of section 1273 and the regulations thereunder, second as a receipt or payment of original issue discount to the extent accrued as of the date of the receipt or payment, and finally as a receipt or payment of principal. Units of nonfunctional currency (or an amount determined with reference to nonfunctional currency) treated as a receipt or payment of original issue discount under the preceding sentence are attributed to the earliest accrual period in which original issue discount has accrued and to which prior receipts or payments have not been attributed. No portion thereof shall be treated as prepaid interest. These rules are illustrated by Example 10 of paragraph (b)(9) of this section.
(ii) Other debt instruments. In the case of a debt instrument described in paragraph (b)(2)(i) of this section that is not subject to the rules of section 163(e) or 1272 through 1288, whether units of nonfunctional currency (or an amount determined with reference to nonfunctional currency) received or paid with respect to such debt instrument are treated as interest or principal shall be determined under section 163 or other applicable section of the Code.
(8) Limitation of exchange gain or loss on payment or disposition of a debt instrument. When a debt instrument described in paragraph (b)(2)(i) of this section is paid or disposed of, or when the obligation to make payments thereunder is satisfied by another person, or extinguished or assumed by another person, exchange gain or loss is computed with respect to both principal and any accrued interest (including original issue discount), as provided in paragraph (b)(3) through (7) of this section. However, pursuant to section 988(b)(1) and (2), the sum of any exchange gain or loss with respect to the principal and interest of any such debt instrument shall be realized only to the extent of the total gain or loss realized on the transaction. The gain or loss realized shall be recognized in accordance with the general principles of the Code. See Examples 3, 4 and 6 of paragraph (b)(9) of this section.
(9) Examples. The preceding provisions are illustrated in the following examples. The examples assume that any transaction involving an individual is a section 988 transaction.
(iii) Under paragraph (b)(5) of this section, X will realize exchange gain upon repayment of the £10,000 principal amount determined by translating the £10,000 at the spot rate on the date it is received (£10,000 × $1.45 = $14,500) and subtracting from such amount, the amount determined by translating the £10,000 at the spot rate on the date the loan was made (£10,000 × $1.30 = $13,000). Accordingly, X will realize an exchange gain of $1,500 on the repayment of the loan on December 31, 1994.
(ii) If the exchange rate on December 31, 1994, were £1 = $1.25, rather than £1 = $1.45, X would compute exchange loss under paragraph (b)(8) of this section, on the £10,000 originally booked. The exchange loss would be $500 [(£10,000 × $1.25)−(£10,000 × $1.30) = ($500)]. X's total loss on the disposition would be $3,000 [(£8,000 × $1.25)-(£10,000 × $1.30) = ($3,000)]. Thus, X would realize $500 of exchange loss and a $2,500 market loss on the disposition.
1 Pounds to dollars.
(iii) Under paragraph (b)(6) of this section, X will realize exchange loss on December 31, 1990, upon repayment of the £10,000 principal amount determined by translating the £10,000 received at the spot rate on January 1, 1989 (£10,000 × $1.50 = $15,000) and subtracting from such amount, the amount determined by translating the £10,000 paid at the spot rate on December 31, 1990 (£10,000 × $1.70 = $17,000). Thus, under paragraph (b)(6) of this section, X has an exchange loss with respect to the £10,000 principal of $2,000. Further, under paragraph (a)(2) of this section, X will realize an exchange gain upon disposition of the £10,000 on December 31, 1990. Under paragraph (a)(2) of this section, X will subtract his adjusted basis in the £10,000 ($16,000) from the amount realized upon the disposition of the £10,000 (£10,000 × $1.70 = $17,000) resulting in a gain of $1,000. Accordingly, X's combined exchange gain and loss realized on December 31, 1990, with respect to the repayment of the £10,000 is a $1,000 exchange loss.
(ii) Under paragraph (b)(2)(ii)(A) of this section, X will determine its interest income in Canadian dollars. Accordingly, under section 1272, X must take into account original issue discount in the amount of C$8.26 on December 31, 1989, and C$9.10 on December 31, 1990. Pursuant to paragraph (b)(2)(ii)(C) of this section, X will translate these amounts into U.S. dollars at the average exchange rate for the relevant accrual period. Thus, the amount of interest income taken into account in 1989 is U.S.$6.28 (C$8.26 × U.S.$.76) and in 1990 is U.S.$7.37 (C$9.10 × U.S.$.81). Pursuant to paragraph (b)(3)(ii) of this section, X will realize exchange gain or loss with respect to the accrued interest determined for each accrual period by translating the Canadian dollars received with respect to such accrual period into U.S. dollars at the spot rate on the date the interest is received and subtracting from that amount the amount accrued in U.S. dollars. Thus, the amount of exchange gain realized on December 31, 1990, is U.S.$.58 (U.S.$.49 from 1989 + U.S.$.09 from 1990). Pursuant to paragraph (b)(5) of this section, X shall realize exchange gain or loss with respect to the principal (C$82.64) on December 31, 1990, computed by translating the C$82.64 at the spot rate on December 31, 1990 (U.S.$67.76) and subtracting the C$82.64 translated at the spot rate on January 1, 1989 (U.S.$59.50) for an exchange gain of U.S.$8.26. Thus, X's combined exchange gain is U.S.$8.84 (U.S.$.49 + U.S.$.09 + U.S.$8.26).
(iii) Assume instead that on January 1, 1990, X sells the note for C$86.95, which it immediately converts to U.S. dollars. X's exchange gain is computed under paragraph (b)(8) of this section with reference to the nonfunctional currency denominated principal amount (C$82.64) and the nonfunctional currency denominated accrued original issue discount (C$8.26). X will compute an exchange gain of U.S.$6.61 with respect to the issue price [(C$82.64 × U.S.$.80)−(C$82.64 × U.S.$.72)] and an exchange gain of U.S.$.33 with respect to the accrued original issue discount [(C$8.26 × U.S.$.80)− (C$8.26 × U.S.$ .76)]. Accordingly, prior to the application of paragraph (b)(8) of this section, X's total exchange gain is U.S.$6.94 (U.S.$6.61 + U.S.$.33), and X's market loss is U.S.$3.16 [(C$90.90−C$86.95) × U.S.$.80]. Pursuant to paragraph (b)(8) of this section, however, X's market loss on the note of U.S.$3.16 is netted against X's exchange gain of U.S.$6.94, resulting in a realized exchange gain of U.S.$3.78 and no market loss.
(ii) Y's exchange gain is computed under paragraph (b)(3) of this section with respect to accrued interest income and paragraph (b)(5) of this section with respect to the nonfunctional currency principal amount. Under paragraph (b)(3) of this section, Y will realize exchange gain or loss for each accrual period computed by translating the units of nonfunctional currency interest income received with respect to such accrual period at the spot rate on the day received and subtracting the amounts of interest income accrued for such period. Thus, Y will realize $.49 of exchange gain with respect to original issue discount accrued in 1989 [(C$8.26 × U.S.$.82)−(C$8.26 × U.S.$.76) = U.S. $.49] and $.09 of exchange gain with respect to original issue discount accrued in 1990 [(C$9.10 × U.S.$.82)−(C$9.10 × U.S.$.81) = $.09].
(iii) Pursuant to paragraph (b)(5) of this section, the nonfunctional currency principal amount of the M bond in the hands of Y is C$82.64, the amount carried over from X, the transferor. Y's exchange gain with respect to the nonfunctional currency principal amount is $8.26 [(C$82.64 × U.S.$.82)− (C$82.64 × U.S.$.72) = U.S. $8.26]. Accordingly, Y's combined exchange gain is U.S. $8.84 ($.49 + $.09 + $8.26). Because the amount realized in Canadian dollars equals the adjusted issue price (C$100) on retirement of the M note, there is no market loss, and the netting rule of paragraph (b)(8) of this section does not limit realization of the exchange gain.
1 Pounds to dollars.
(iii) Under paragraph (b)(5) of this section, X will realize exchange gain upon repayment of the £100 principal amount determined by translating the £100 at the spot rate on the date it is received (£100 × $1.61 = $161.00) and subtracting from such amount, the amount determined by translating the £100 at the spot rate on the date the loan was made (£100 × $1.50 = $150.00). Accordingly, X will realize an exchange gain of $11 on the repayment of the loan on January 31, 1993.
Table 1
Table 2
(iii) Because C is an accrual basis taxpayer, C will translate the interest income at the average rate for the annual accrual period pursuant to paragraph (b)(2)(ii)(C) of this section. Thus, C's interest income is $13.50 (£10.00 × $1.35) in 1989, and $7.60 (£5.24 × $1.45) in 1990. C will realize exchange gain or loss upon receipt of accrued interest computed in accordance with paragraph (b)(3) of this section. Thus, C will realize exchange gain in the amount of $.50 [(£10.00 × $1.40)−$13.50] in 1989, and $.26 [(£5.24 × $1.50)−$7.60] in 1990.
(iv) In addition, C will realize exchange gain or loss upon the receipt of principal each year computed under paragraph (b)(5) of this section. Thus, C will realize exchange gain in the amount of $4.76 [(£47.62 × $1.40)−(£47.62 × $1.30)] in 1989, and $10.48 [(£52.38 × $1.50)−(£52.38 × $1.30)] in 1990.
(10) Treatment of bond premium —(i) In general. Amortizable bond premium on a bond described in paragraph (b)(2)(i) of this section shall be computed in the units of nonfunctional currency in which the bond is denominated (or in which the payments are determined). Amortizable bond premium properly taken into account under section 171 or § 1.61-12 (or the successor provision thereof) shall reduce interest income or expense in units of nonfunctional currency. Exchange gain or loss is realized with respect to bond premium described in the preceding sentence by treating the portion of premium amortized with respect to any period as a return of principal. With respect to a holder that does not elect to amortize bond premium under section 171, the amount of bond premium will constitute a market loss when the bond matures. See paragraph (b)(8) of this section. The principles set forth in this paragraph (b)(10) shall apply to determine the treatment of acquisition premium described in section 1272(a)(7).
(ii) Example. The following example illustrates the provisions of this paragraph (b)(10).
(11) Market discount —(i) In general. Market discount as defined in section 1278(a)(2) shall be determined in units of nonfunctional currency in which the market discount bond is denominated (or in which the payments are determined). Accrued market discount (other than market discount currently included in income pursuant to section 1278(b)) shall be translated into functional currency at the spot rate on the date the market discount bond is disposed of. No part of such accrued market discount is treated as exchange gain or loss. Accrued market discount currently includible in income pursuant to section 1278(b) shall be translated into functional currency at the average exchange rate for the accrual period. Exchange gain or loss with respect to accrued market discount currently includible in income under section 1278(b) shall be determined in accordance with paragraph (b)(3) of this section relating to accrued interest income.
(ii) Example. The following example illustrates the provisions of this paragraph (b)(11).
(B) Pursuant to paragraph (b)(11) of this section, X computes market discount in units of nonfunctional currency. Thus, the market discount as defined under section 1278(a)(2) is £3,470. Accrued market discount (other than market discount currently included in income pursuant to section 1278(b)) is translated at the spot rate on the date the market discount bond is disposed of. Accordingly, X will translate the accrued market discount of £3,470 at the spot rate on December 31, 1991 (£3,470 × $1.50 = $5,205). No exchange gain or loss is realized with respect to the £3,470 of accrued market discount. See paragraphs (b)(3) and (5) of this section for the realization and recognition of exchange gain or loss with respect to accrued interest and principal.
(12) Tax exempt bonds. See § 1.988-3(c)(2), which characterizes exchange loss realized with respect to a nonfunctional currency tax exempt bond as a reduction of interest income.
(13) Nonfunctional currency debt exchanged for stock of obligor —(i) In general. Notwithstanding any other section of the Code other than section 267, 1091 or 1092, exchange gain or loss shall be realized and recognized by the holder and the obligor in accordance with the rules of paragraphs (b)(3) through (7) of this section with respect to the principal and accrued interest of a debt instrument described in paragraph (b)(2)(i) of this section that is acquired by the obligor in exchange for its stock, provided however, that such gain or loss shall be recognized only to the extent of the total gain or loss on the exchange (regardless of whether such gain or loss would otherwise be recognized). This rule shall apply whether the debt instrument is converted into stock according to its terms or exchanged pursuant to a separate agreement between the obligor and the holder. A debt instrument that is acquired by the obligor from a shareholder as a contribution to capital shall be treated for purposes of this section as exchanged for stock, whether or not additional stock is issued.
(ii) Coordination with section 108. Section 988 and this section shall apply before section 108. Exchange gain realized by the obligor on an exchange described in paragraph (b)(13)(i) of this section shall not be treated as discharge of indebtedness income, but shall be considered to reduce the amount of the liability for purposes of computing the obligor's income on the exchange under section 108(e)(4), section 108(e)(6) or section 108(e)(10).
(iii) Effective date. This paragraph (b)(13) shall be effective for exchanges of debt for stock effected after September 21, 1989.
(iv) Examples. The following examples illustrate the operation of this paragraph (b)(13). In each such example, assume that sections 267, 1091 and 1092 do not apply.
(ii) Pursuant to paragraph (b)(13) of this section, X will realize and recognize exchange gain with respect to the issue price (£100,000) of the bond on January 1, 1994, when the bond is converted to stock. X will compute exchange gain pursuant to paragraph (b)(5) of this section by translating the issue price at the spot rate on the conversion date (£100.000 × $1.50 = $150,000) and subtracting from such amount the issue price translated at the spot rate on the date X acquired the bond (£100,000 × $1.30 = $130,000). Thus, X will realize and recognize $20,000 of exchange gain. X's basis in the 20 shares of Y common stock is $150,000 ($130,000 substituted basis + $20,000 recognized gain).
(ii) Under section 108(e)(6), on the acquisition of its indebtedness from X as a contribution to capital Y is treated as having satisfied the debt with an amount of money equal to X's adjusted basis in the debt (£100). For purposes of section 108(e)(6), X's adjusted basis is translated into United States dollars at the spot rate on the date Y acquires the debt (£1 = $.50). Therefore, Y is treated as having satisfied the debt for $50. Pursuant to paragraph (b)(13) of this section, for purposes of section 108 the amount of the indebtedness is considered to be reduced by the exchange gain from $100 to $50. Accordingly, Y recognizes $50 of exchange gain and no discharge of indebtedness income on the extinguishment of its debt to X.
(iii) If X were a United States taxpayer with a dollar functional currency and a $100 basis in Y's obligation. X would realize and recognize an exchange loss of $50 under paragraph (b)(5) of this section on the contribution of the debt to Y. The recognized loss would reduce X's adjusted basis in the debt from $100 to $50, so that for purposes of applying section 108(e)(6) Y is treated as having satisfied the debt for $50. Accordingly, under these facts as well Y would recognize $50 of exchange gain and no discharge of indebtedness income.
(a) The spot rate on January 1, 1990, is £1 = $1.00,
(b) The spot rate on January 1, 1994, is £1 = $.50,
(c) Interest rates on equivalent bonds have increased so that as of January 1, 1994, the value of Y's bond has declined to £90,000, and
(d) The 20 shares of Y common stock have a market value of £90,000 as of January 1, 1994.
(ii) Pursuant to paragraph (b)(13) of this section, X will realize and recognize exchange loss with respect to the issue price (£100,000) of the bond on January 1, 1994, when the bond is exchanged for stock. X will compute exchange loss pursuant to paragraph (b)(5) of this section by translating the issue price at the spot rate on the exchange date (£100,000 × $.50 = $50,000) and subtracting from such amount the issue price translated at the spot rate on the date X acquired the bond (£100,000 × $1.00 = $100,000). Thus, X will compute $50,000 of exchange loss, all of which will be realized and recognized because it does not exceed the total $55,000 realized loss on the exchange ($45,000 worth of stock received less $100,000 basis in the exchanged bond).
(iii) Pursuant to paragraph (b)(13) of this section, Y will realize and recognize exchange gain with respect to the issue price, computed under paragraph (b)(6) of this section by translating the issue price at the spot rate on the date Y became the obligor (£100,000 × $1.00 = $100,000) and subtracting from such amount the issue price translated at the spot rate on the exchange date (£100,000 × $.50 = $50,000). Thus, Y will realize and recognize $50,000 of exchange gain. Under section 108(e)(10), on the transfer of stock to X in satisfaction of its indebtedness Y is treated as having satisfied the indebtedness with an amount of money equal to the fair market value of the stock (£90,000 × $.50 = $45,000). Pursuant to paragraph (b)(13) of this section, for purposes of section 108 the amount of the indebtedness is considered to be reduced by the recognized exchange gain from $100,000 to $50,000. Accordingly, Y recognizes an additional $5,000 of discharge of indebtedness income on the exchange.
(ii) Pursuant to paragraphs (b)(13) and (b)(6) of this section, Y will compute $50,000 of exchange gain with respect to the issue price. See Example 3. Under section 108(e)(10), Y is treated as having satisfied the $100,000 indebtedness with an amount of money equal to the fair market value of the stock (£112,500 × $.50 = $56,250), resulting in a total gain on the exchange of $43,750. Accordingly, under paragraph (b)(13) of this section Y's realized (and recognized) exchange gain on the exchange is limited to $43,750. Also pursuant to paragraph (b)(13) of this section, for purposes of section 108 the amount of the indebtedness is considered to be reduced by the recognized exchange gain from $100,000 to $56,250. Accordingly, Y recognizes no discharge of indebtedness income on the exchange.
(14) [Reserved]
(15) Debt instruments and deposits denominated in hyperinflationary currencies —(i) In general. If a taxpayer issues, acquires, or otherwise enters into or holds a hyperinflationary debt instrument (as defined in paragraph (b)(15)(vi)(A) of this section) or a hyperinflationary deposit (as defined in paragraph (b)(15)(vi)(B) of this section) on which interest is paid or accrued that is denominated in (or determined by reference to) a nonfunctional currency of the taxpayer, then the taxpayer shall realize exchange gain or loss with respect to such instrument or deposit for its taxable year determined by reference to the change in exchange rates between—
(A) The later of the first day of the taxable year, or the date the instrument was entered into (or an amount deposited); and
(B) The earlier of the last day of the taxable year, or the date the instrument (or deposit) is disposed of or otherwise terminated.
(ii) Only exchange gain or loss is realized. No gain or loss is realized under paragraph (b)(15)(i) by reason of factors other than movement in exchange rates, such as the creditworthiness of the debtor.
(iii) Special rule for synthetic, non-hyperinflationary currency debt instruments —(A) General rule. Paragraph (b)(15)(i) does not apply to a debt instrument that has interest and principal payments that are to be made by reference to a currency or item that does not reflect hyperinflationary conditions in a country (within the meaning of § 1.988-1(f)).
(B) Example. Paragraph (b)(15)(iii)(A) is illustrated by the following example:
(iv) Source and character of gain or loss —(A) General rule for hyperinflationary conditions. The rules of this paragraph (b)(15)(iv)(A) shall apply to any taxpayer that is either an issuer of (or obligor under) a hyperinflationary debt instrument or deposit and has currency gain on such debt instrument or deposit, or a holder of a hyperinflationary debt instrument or deposit and has currency loss on such debt instrument or deposit. For purposes of subtitle A of the Internal Revenue Code, any exchange gain or loss realized under paragraph (b)(15)(i) of this section is directly allocable to the interest expense or interest income, respectively, from the debt instrument or deposit (computed under this paragraph (b)), and therefore reduces or increases the amount of interest income or interest expense paid or accrued during that year with respect to that instrument or deposit. With respect to a debt instrument or deposit during a taxable year, to the extent exchange gain realized under paragraph (b)(15)(i) of this section exceeds interest expense of an issuer, or exchange loss realized under paragraph (b)(15)(i) of this section exceeds interest income of a holder or depositor, the character and source of such excess amount shall be determined under §§ 1.988-3 and 1.988-4.
(B) Special rule for subsiding hyperinflationary conditions. If the taxpayer is an issuer of (or obligor under) a hyperinflationary debt instrument or deposit and has currency loss, or if the taxpayer is a holder of a hyperinflationary debt instrument or deposit and has currency gain, then for purposes of subtitle A of the Internal Revenue Code, the character and source of the currency gain or loss is determined under §§ 1.988-3 and 1.988-4. Thus, if an issuer has both interest expense and currency loss, the currency loss is sourced and characterized under section 988, and does not affect the determination of interest expense.
(v) Adjustment to principal or basis. Any exchange gain or loss realized under paragraph (b)(15)(i) of this section is an adjustment to the functional currency principal amount of the issuer, functional currency basis of the holder, or the functional currency amount of the deposit. This adjusted amount or basis is used in making subsequent computations of exchange gain or loss, computing the basis of assets for purposes of allocating interest under §§ 1.861-9T through 1.861-12T and 1.882-5, or making other determinations that may be relevant for computing taxable income or loss.
(vi) Definitions —(A) Hyperinflationary debt instrument. A hyperinflationary debt instrument is a debt instrument that provides for—
( 1 ) Payments denominated in or determined by reference to a currency that is hyperinflationary (as defined in § 1.988-1(f)) at the time the taxpayer enters into or otherwise acquires the debt instrument; or
( 2 ) Payments denominated in or determined by reference to a currency that is hyperinflationary (as defined in § 1.988-1(f)) during the taxable year, and the terms of the instrument provide for the adjustment of principal or interest payments in a manner that reflects hyperinflation. For example, a debt instrument providing for a variable interest rate based on local conditions and generally responding to changes in the local consumer price index will reflect hyperinflation.
(B) Hyperinflationary deposit. A hyperinflationary deposit is a demand or time deposit or similar instrument issued by a bank or other financial institution that provides for—
( 1 ) Payments denominated in or determined by reference to a currency that is hyperinflationary (as defined in § 1.988-1(f)) at the time the taxpayer enters into or otherwise acquires the deposit; or
( 2 ) Payments denominated in or determined by reference to a currency that is hyperinflationary (as defined in § 1.988-1(f)) during the taxable year, and the terms of the deposit provide for the adjustment of the deposit amount or interest payments in a manner that reflects hyperinflation.
(vii) Interaction with other provisions —(A) Interest allocation rules. In determining the amount of interest expense, this paragraph (b)(15) applies before §§ 1.861-9T through 1.861-12T, and 1.882-5.
(B) DASTM. With respect to a qualified business unit that uses the United States dollar approximate separate transactions method of accounting described in § 1.985-3, paragraph (b)(15)(i) of this section does not apply.
(C) Interaction with section 988(a)(3)(C). Section 988(a)(3)(C) does not apply to a debt instrument subject to the rules of paragraph (b)(15)(i) of this section.
(D) Hedging rules. To the extent § 1.446-4 or 1.988-5 apply, the rules of paragraph (b)(15)(i) of this section will not apply. This paragraph (b)(15)(vii)(D) does not apply if the application of § 1.988-5 results in hyperinflationary debt instrument or deposit described in paragraph (b)(15)(vi)(A) or (B) of this section.
(viii) Effective date. This paragraph (b)(15) applies to transactions entered into after February 14, 2000.
(16) [Reserved] For further guidance, see § 1.988-2T(b)(16).
(17) Coordination with installment method under section 453. [Reserved]
(18) Interaction of section 988 and § 1.1275-2(g) —(i) In general. If a principal purpose of structuring a debt instrument subject to section 988 and any related hedges is to achieve a result that is unreasonable in light of the purposes of section 163(e), section 988, sections 1271 through 1275, or any related section of the Internal Revenue Code, the Commissioner can apply or depart from the regulations under the applicable sections as necessary or appropriate to achieve a reasonable result. For example, if this paragraph (b)(18) applies to a multicurrency debt instrument and a hedge or hedges, the Commissioner can wholly or partially integrate transactions or treat portions of the debt instrument as separate instruments where appropriate. See also § 1.1275-2(g).
(ii) Unreasonable result. Whether a result is unreasonable is determined based on all the facts and circumstances. In making this determination, a significant fact is whether the treatment of the debt instrument is expected to have a substantial effect on the issuer's or a holder's U.S. tax liability. Another significant fact is whether the result is obtainable without the application of § 1.988-6 and any related provisions ( e.g. , if the debt instrument and the contingency were entered into separately). A result will not be considered unreasonable, however, in the absence of an expected substantial effect on the present value of a taxpayer's tax liability.
(iii) Effective date. This paragraph (b)(18) shall apply to debt instruments issued on or after October 29, 2004.
(c) Item of expense or gross income or receipts which is to be paid or received after the date accrued —(1) In general. Except as provided in § 1.988-5, exchange gain or loss with respect to an item described in § 1.988-1(a)(1)(ii) and (2)(ii) (other than accrued interest income or expense subject to paragraph (b) of this section) shall be realized on the date payment is made or received. Except as provided in the succeeding sentence, such exchange gain or loss shall be recognized in accordance with the applicable recognition provisions of the Internal Revenue Code. If the taxpayer's right to receive income, or obligation to pay an expense, is transferred or modified in a transaction in which gain or loss would otherwise be recognized, exchange gain or loss shall be realized and recognized only to the extent of the total gain or loss on the transaction.
(2) Determination of exchange gain or loss with respect to an item of gross income or receipts. Exchange gain or loss realized on an item of gross income or receipts described in paragraph (c)(1) of this section shall be determined by multiplying the units of nonfunctional currency received by the spot rate on the payment date, and subtracting from such amount the amount determined by multiplying the units of nonfunctional currency received by the spot rate on the booking date. The term “spot rate on the payment date” means the spot rate determined under § 1.988-1(d) on the date payment is received or otherwise taken into account. Pursuant to § 1.988-1(d)(3), a taxpayer may use a spot rate convention for purposes of determining the spot rate on the payment date. The term “spot rate on the booking date” means the spot rate determined under § 1.988-1(d) on the date the item of gross income or receipts is accrued or otherwise taken into account. Pursuant to § 1.988-1(d)(3), a taxpayer may use a spot rate convention for purposes of determining the spot rate on the booking date.
(3) Determination of exchange gain or loss with respect to an item of expense. Exchange gain or loss realized on an item of expense described in paragraph (c)(1) of this section shall be determined by multiplying the units of nonfunctional currency paid by the spot rate on the booking date and subtracting from such amount the amount determined by multiplying the units of nonfunctional currency paid by the spot rate on the payment date. The term “spot rate on the booking date” means the spot rate determined under § 1.988-1(d) on the date the item of expense is accrued or otherwise taken into account. Pursuant to § 1.988-1(d)(3), a taxpayer may use a spot rate convention for purposes of determining the spot rate on the booking date. The term “spot rate on the payment date” means the spot rate determined under § 1.988-1(d) on the date payment is made or otherwise taken into account. Pursuant to § 1.988-1(d)(3), a taxpayer may use a spot rate convention for purposes of determining the spot rate on the date.
(4) Examples. The following examples illustrate the application of paragraph (c) of this section.
(d) Exchange gain or loss with respect to forward contracts, futures contracts and option contracts —(1) Scope —(i) In general. This paragraph (d) applies to forward contracts, futures contracts and option contracts described in § 1.988-1(a)(1)(ii) and (2)(iii). For rules applicable to currency swaps and notional principal contracts described in § 1.988-1(a) (1)(ii) and (2)(iii), see paragraph (e) of this section.
(ii) Treatment of spot contracts. Solely for purposes of this paragraph (d), a spot contract as defined in § 1.988-1(b) to buy or sell nonfunctional currency is not considered a forward contract or similar transaction described in § 1.988-1(a)(2)(iii) unless such spot contract is disposed of (or otherwise terminated) prior to making or taking delivery of the currency. For example, if a taxpayer with the dollar as its functional currency enters into a spot contract to purchase British pounds, and takes delivery of such pounds under the contract, the delivery of the pounds is not a realization event under section 988(c)(5) and paragraph (e)(4)(ii) of this section because the contract is not considered a forward contract or similar transaction described in § 1.988-1(a)(2)(iii). However, if the taxpayer sells or otherwise terminates the contract before taking delivery of the pounds, exchange gain or loss shall be realized and recognized in accordance with paragraphs (d)(2) and (3) of this section.
(2) Realization of exchange gain or loss —(i) In general. Except as provided in § 1.988-5, exchange gain or loss on a contract described in § 1.988-2(d)(1) shall be realized in accordance with the applicable realization section of the Internal Revenue Code ( e.g. , sections 1001, 1092, and 1256). See also section 988(c)(5). For purposes of determining the timing of the realization of exchange gain or loss, sections 1092 and 1256 shall take precedence over section 988(c)(5).
(ii) Realization by offset —(A) In general. Except as provided in paragraphs (d)(2)(ii)(B) and (C) of this section, exchange gain or loss with respect to a transaction described in § 1.988-1(a)(1)(ii) and (2)(iii) shall not be realized solely because such transaction is offset by another transaction (or transactions).
(B) Exception where economic benefit is derived. If a transaction described in § 1.988-1(a)(1)(ii) and (2)(iii) is offset by another transaction or transactions, exchange gain shall be realized to the extent the taxpayer derives, by pledge or otherwise, an economic benefit ( e.g. , cash, property or the proceeds from a borrowing) from any gain inherent in such offsetting positions. Proper adjustment shall be made in the amount of any gain or loss subsequently realized for gain taken into account by reason of the preceding sentence. This paragraph (d)(2)(ii)(B) shall apply to transactions creating an offset after September 21, 1989.
(C) Certain contracts traded on an exchange. If a transaction described in § 1.988-1(a)(1)(ii) and (2)(iii) is traded on an exchange and it is the general practice of the exchange to terminate offsetting contracts, entering into an offsetting contract shall be considered a termination of the contract being offset.
(iii) Clarification of section 988(c)(5). If the delivery date of a contract subject to section 988(c)(5) and paragraph (d)(4)(ii) of this section is different than the date the contract expires, then for purposes of determining the date exchange gain or loss is realized, the term delivery date shall mean expiration date.
(iv) Examples. The following examples illustrate the rules of this paragraph (d)(1) and (2).
(v) Extension of the maturity date of certain contracts. An extension of time for making or taking delivery under a contract described in paragraph (d)(1) of this section ( e.g., a historical rate rollover as defined in § 1.988-5(b)(2)(iii)(C)) shall be considered a sale or exchange of the contract for its fair market value on the date of the extension and the establishment of a new contract on such date. If, under the terms of the extension, the time value of any gain or loss recognized pursuant to the preceding sentence adjusts the price of the currency to be bought or sold under the new contract, the amount attributable to such time value shall be treated as interest income or expense for all purposes of the Code. However, the preceding sentence shall not apply and the amount attributable to the time value of any gain or loss recognized shall be treated as exchange gain or loss if the period beginning on the first date the contract is rolled over and ending on the date payment is ultimately made or received with respect to such contract does not exceed 183 days.
(3) Recognition of exchange gain or loss. Except as provided in § 1.988-5 (relating to section 988 hedging transactions), exchange gain or loss realized with respect to a contract described in paragraph (d)(1) of this section shall be recognized in accordance with the applicable recognition provisions of the Internal Revenue Code. For example, a loss realized with respect to a contract described in paragraph (d)(1) of this section which is part of a straddle shall be recognized in accordance with the provisions of section 1092 to the extent such section is applicable.
(4) Determination of exchange gain or loss —(i) In general. Exchange gain or loss with respect to a contract described in § 1.988-2(d)(1) shall be determined by subtracting the amount paid (or deemed paid), if any, for or with respect to the contract (including any amount paid upon termination of the contract) from the amount received (or deemed received), if any, for or with respect to the contract (including any amount received upon termination of the contract). Any gain or loss determined according to the preceding sentence shall be treated as exchange gain or loss.
(ii) Special rules where taxpayer makes or takes delivery. If the taxpayer makes or takes delivery in connection with a contract described in paragraph (d)(1) of this section, any gain or loss shall be realized and recognized in the same manner as if the taxpayer sold the contract (or paid another person to assume the contract) on the date on which he took or made delivery for its fair market value on such date. See paragraph (d)(2)(iii) of this section regarding the definition of the term “delivery date.” This paragraph (d)(4)(ii) shall not apply in any case in which the taxpayer makes or takes delivery before June 11, 1987.
(iii) Examples. The following examples illustrate the application of paragraph (d)(4) of this section.
(5) Hyperinflationary contracts —(i) In general. If a taxpayer acquires or otherwise enters into a hyperinflationary contract (as defined in paragraph (d)(5)(ii) of this section) that has payments to be made or received that are denominated in (or determined by reference to) a nonfunctional currency of the taxpayer, then the taxpayer shall realize exchange gain or loss with respect to such contract for its taxable year determined by reference to the change in exchange rates between—
(A) The later of the first day of the taxable year, or the date the contract was acquired or entered into; and
(B) The earlier of the last day of the taxable year, or the date the contract is disposed of or otherwise terminated.
(ii) Definition of hyperinflationary contract. A hyperinflationary contract is a contract described in paragraph (d)(1) of this section that provides for payments denominated in or determined by reference to a currency that is hyperinflationary (as defined in § 1.988-1(f)) at the time the taxpayer acquires or otherwise enters into the contract.
(iii) Interaction with other provisions —(A) DASTM. With respect to a qualified business unit that uses the United States dollar approximate separate transactions method of accounting described in § 1.985-3, this paragraph (d)(5) does not apply.
(B) Hedging rules. To the extent § 1.446-4 or 1.988-5 apply, this paragraph (d)(5) does not apply.
(C) Adjustment for subsequent transactions. Proper adjustments must be made in the amount of any gain or loss subsequently realized for gain or loss taken into account by reason of this paragraph (d)(5).
(iv) Effective date. This paragraph (d) (5) is applicable to transactions acquired or otherwise entered into after February 14, 2000.
(e) Currency swaps and other notional principal contracts —(1) In general. Except as provided in paragraph (e)(2) of this section or in § 1.988-5, the timing of income, deduction and loss with respect to a notional principal contract that is a section 988 transaction shall be governed by section 446 and the regulations thereunder. Such income, deduction and loss is characterized as exchange gain or loss (except as provided in another section of the Internal Revenue Code (or regulations thereunder), § 1.988-5, or in paragraph (f) of this section).
(2) Special rules for currency swaps —(i) In general. Except as provided in paragraph (e)(2)(iii)(B) of this section, the provisions of this paragraph (e)(2) shall apply solely for purposes of determining the realization, recognition and amount of exchange gain or loss with respect to a currency swap contract, and not for purposes of determining the source of such gain or loss, or characterizing such gain or loss as interest. Except as provided in § 1.988-3(c), any income or loss realized with respect to a currency swap contract shall be characterized as exchange gain or loss (and not as interest income or expense). Any exchange gain or loss realized in accordance with this paragraph (e)(2) shall be recognized unless otherwise provided in an applicable section of the Code. For purposes of this paragraph (e)(2), a currency swap contract is a contract defined in paragraph (e)(2)(ii) of this section. With respect to a contract which requires the payment of swap principal prior to maturity of such contract, see paragraph (f) of this section. For purposes of this paragraph (e), the rules of paragraph (d)(2)(ii) of this section (regarding realization by offset) apply. See Example 2 of paragraph (d)(2)(iv) of this section.
(ii) Definition of currency swap contract —(A) In general. A currency swap contract is a contract involving different currencies between two or more parties to—
( 1 ) Exchange periodic interim payments, as defined in paragraph (e)(2)(ii)(C) of this section, on or prior to maturity of the contract; and
( 2 ) Exchange the swap principal amount upon maturity of the contract.
(B) Swap principal amount. The swap principal amount is an amount of two different currencies which, under the terms of the currency swap contract, is used to determine the periodic interim payments in each currency and which is exchanged upon maturity of the contract. If such amount is not clearly set forth in the contract, the Commissioner may determine the swap principal amount.
(C) Exchange of periodic interim payments. An exchange of periodic interim payments is an exchange of one or more payments in one currency specified by the contract for one or more payments in a different currency specified by the contract where the payments in each currency are computed by reference to an interest index applied to the swap principal amount. A currency swap contract must clearly indicate the periodic interim payments, or the interest index used to compute the periodic interim payments, in each currency.
(iii) Timing and computation of periodic interim payments —(A) In general. Except as provided in paragraph (e)(2)(iii)(B) of this section and § 1.988-5, the timing and computation of the periodic interim payments provided in a currency swap agreement shall be determined by treating—
( 1 ) Payments made under the swap as payments made pursuant to a hypothetical borrowing that is denominated in the currency in which payments are required to be made (or are determined with reference to) under the swap, and
( 2 ) Payments received under the swap as payments received pursuant to a hypothetical loan that is denominated in the currency in which payments are received (or are determined with reference to) under the swap.
(B) Effect of prepayment for purposes of section 956. For purposes of section 956, the Commissioner may treat any prepayment of a currency swap as a loan.
(iv) Timing and determination of exchange gain or loss with respect to the swap principal amount. Exchange gain or loss with respect to the swap principal amount shall be realized on the day the units of swap principal in each currency are exchanged. (See paragraph (e)(2)(ii)(A)( 2 ) of this section which requires that the entire swap principal amount be exchanged upon maturity of the contract.) Such gain or loss shall be determined on the date of the exchange by subtracting the value (on such date) of the units of swap principal paid from the value of the units of swap principal received. This paragraph (e)(2)(iv) does not apply to an equal exchange of the swap principal amount at the commencement of the agreement at a market exchange rate.
(v) Anti-abuse rules —(A) Method of accounting does not clearly reflect income. If the taxpayer's method of accounting for income, expense, gain or loss attributable to a currency swap does not clearly reflect income, or if the present value of the payments to be made is not equivalent to that of the payments to be received (including the swap premium or discount, as defined in paragraph (e)(3)(ii) of this section) on the day the taxpayer enters into or acquires the contract, the Commissioner may apply principles analogous to those of section 1274 or such other rules as the Commissioner deems appropriate to clearly reflect income. For example, in order to clearly reflect income the Commissioner may determine the hypothetical issue price, the hypothetical stated redemption price at maturity, and the amounts required to be taken into account within a taxable year. Further, if the present value of the payments to be made is not equivalent to that of the payments to be received (including the swap premium or discount, as defined in paragraph (e)(3)(ii) of this section) on the day the taxpayer enters into or acquires the contract, the Commissioner may integrate the swap with another transaction (or transactions) in order to clearly reflect income.
(B) Terms must be clearly stated. If the currency swap contract does not clearly set forth the swap principal amount in each currency, and the periodic interim payments in each currency (or the interest index used to compute the periodic interim payments in each currency), the Commissioner may defer any income, deduction, gain or loss with respect to such contract until termination of the contract.
(3) Amortization of swap premium or discount in the case of off-market currency swaps —(i) In general. An “off-market currency swap” is a currency swap contract under which the present value of the payments to be made is not equal to that of the payments to be received on the day the taxpayer enters into or acquires the contract (absent the swap premium or discount, as defined in paragraph (e)(3)(ii) of this section). Generally, such present values may not be equal if the swap exchange rate (as defined in paragraph (e)(3)(iii) of this section) is not the spot rate, or the interest indices used to compute the periodic interim payments do not reflect current values, on the day the taxpayer enters into or acquires the currency swap.
(ii) Treatment of taxpayer entering into or acquiring an off-market currency swap. If a taxpayer that enters into or acquires a currency swap makes a payment (that is, the taxpayer pays a premium, “swap premium,” to enter into or acquire the currency swap) or receives a payment (that is, the taxpayer enters into or acquires the currency swap at a discount, “swap discount”) in order to make the present value of the amounts to be paid equal the amounts to be received, such payment shall be amortized in a manner which places the taxpayer in the same position it would have been in had the taxpayer entered into a currency swap contract under which the present value of the amounts to be paid equal the amounts to be received (absent any swap premium or discount). Thus, swap premium or discount shall be amortized as follows—
(A) The amount of swap premium or discount that is attributable to the difference between the swap exchange rate (as defined in paragraph (e)(3)(iii) of this section) and the spot rate on the date the contract is entered into or acquired shall be taken into account as income or expense on the date the swap principal amounts are taken into account; and
(B) The amount of swap premium or discount attributable to the difference in values of the periodic interim payments shall be amortized in a manner consistent with the principles of economic accrual. Cf., section 171.
(iii) Definition of swap exchange rate. The swap exchange rate is the single exchange rate set forth in the contract at which the swap principal amounts are determined. If the swap exchange rate is not clearly set forth in the contract, the Commissioner may determine such rate.
(iv) Coordination with § 1.446-3(g)(4) regarding swaps with significant nonperiodic payments. The rules of § 1.446-3(g)(4) apply to any currency swap with a significant nonperiodic payment. Section 1.446-3(g)(4) applies before this paragraph (e)(3). Thus, if § 1.446-3(g)(4) applies, currency gain or loss may be realized on the loan. This paragraph (e)(3)(iv) applies to transactions entered into after February 14, 2000.
(4) Treatment of taxpayer disposing of a currency swap. Any gain or loss realized on the disposition or the termination of a currency swap is exchange gain or loss.
(5) Examples. The following examples illustrate the application of this paragraph (e).
(1) the principal amount is $150 and 100 British pounds (£) (the equivalent of $150 on the effective date of the contract assuming a spot rate of £1 = $1.50 on January 1, 1989);
(2) C will make payments equal to 10% of the dollar principal amount on December 31, 1989, and December 31, 1990;
(3) J will make payments equal to 12% of the pound principal amount on December 31, 1989, and December 31, 1990; and
(4) on December 31, 1990, C will pay to J the $150 principal amount and J will pay to C the £100 principal amount.
(ii) Under paragraph (e)(2)(iii) of this section, on December 31, 1989, X will realize an exchange loss of $6 (the sum of $10 of loss by reason of the $10 periodic interim payment paid to Y and $4.00 of gain, the value of Sf10 on December 31, 1989, from the receipt of Sf10 on such date).
(iii) On January 1, 1990, X transfers its rights and obligations under the swap contract to Z, an unrelated corporation. Z has the dollar as its functional currency, is on the accrual method of accounting, and has the calendar year as its taxable year. On January 1, 1990, the exchange rate is $1 = Sf2.50. The relevant dollar interest rate is 8% compounded annually and the relevant Swiss franc interest rate is 5% compounded annually. Because of the movement in exchange and interest rates, the agreement between X and Z to transfer the currency swap requires X to pay Z $23.56 (the swap discount as determined under paragraph (e)(3) of this section).
(iv) Pursuant to paragraph (e)(4) of this section, X may deduct the loss of $23.56 in 1990. The loss is characterized under § 1.988-3 and sourced under § 1.988-4.
(v) Pursuant to paragraph (e)(3)(ii) of this section, Z is required to amortize the $23.56 received as follows. The amount of the $23.56 payment that is attributable to movements in exchange rates ($20) is taken into account on December 31, 1991, the date the swap principal amounts are exchanged, under paragraph (e)(3)(ii)(A) of this section. This amount is the present value (discounted at 10%, the rate under the currency swap contract used to compute the dollar periodic interim payments) of the financial asset required to compensate Z for the loss in value of the hypothetical Swiss franc loan resulting from movements in exchange rates between January 1, 1989, and January 1, 1990. This amount is determined by assuming that interest rates did not change from the date the swap originally was entered into (January 1, 1989), but that the exchange rate is $1 = Sf2.50. Under this assumption, a taxpayer undertaking the obligation to pay dollars under the currency swap on January 1, 1990, would only agree to pay $8 for Sf10 on December 31, 1990, and $88 for Sf210 on December 31, 1991, because the exchange rates have moved from $1 = Sf2 to $1 = Sf2.50. Thus, Z requires $2 on December 31, 1990, and $22 on December 31, 1991, to compensate for the amount of dollar payments Z is required to make in exchange for the Swiss francs received on December 31, 1990 and 1991. The present value of $2 on December 31, 1990, and $22 on December 31, 1991, discounted at the rate for U.S. dollar payments of 10% is $20 ($1.82 + $18.18). This amount is discounted at the rate for U.S. dollar payments (i.e., at the historic rate) because the amount of the $23.56 payment received by Z that is attributable to movements in interest rates is computed and amortized separately as provided in the following paragraph.
(vi) Pursuant to paragraph (e)(3)(ii)(B) of this section, Z is required to amortize the portion of the $23.56 payment attributable to movements in interest rates under principles of economic accrual over the term of the currency swap agreement. The amount of the $23.56 payment that is attributable to movements in interest rates (assuming that exchange rates have not changed) is the present value ($3.56) of the excess ($2.00 in 1990 and $2.00 in 1991) of the periodic interim payments Z is required to pay under the currency swap agreement ($10 in 1990 and $10 in 1991) over the amount Z would be required to pay if the currency swap agreement reflected current interest rates on the day Z acquired the swap contract ($8 in 1990 and $8 in 1991) discounted at the appropriate dollar interest rate on January 1, 1990. Thus, under principles of economic accrual (e.g., see section 171 of the Code), Z will include in income $1.72 on December 31, 1990, the amount that, when added to the interest ($.28) on the $3.56 computed at the 8% rate on the date Z acquired the currency swap contract, will equal the $2.00 needed to compensate Z for the movement in interest rates between January 1, 1989, and January 1, 1990. Z also will include in income $1.85 on December 31, 1991, the amount that, when added to the interest ($.15) on the $1.85 (the remaining balance of the $3.56 payment) computed at the 8% rate on the date Z acquired the currency swap contract, will equal the $2.00 needed to compensate Z for the movement in interest rates between January 1, 1990, and January 1, 1991. This amount is computed assuming exchange rates have not changed because the amount attributable to movements in exchange rates is computed and amortized separately under the preceding paragraph.
(6) Special effective date for rules regarding currency swaps. Paragraph (e)(3) of this section regarding amortization of swap premium or discount in the case of off-market currency swaps shall be effective for transactions entered into after September 21, 1989, unless such swap premium or discount was paid or received pursuant to a binding contract with an unrelated party that was entered into prior to such date. For transactions entered into prior to this date, see Notice 89-21, 1989-8 I.R.B. 23.
(7) Special rules for currency swap contracts in hyperinflationary currencies —(i) In general. If a taxpayer enters into a hyperinflationary currency swap (as defined in paragraph (e)(7)(iv) of this section), then the taxpayer realizes exchange gain or loss for its taxable year with respect to such instrument determined by reference to the change in exchange rates between—
(A) The later of the first day of the taxable year, or the date the instrument was entered into (by the taxpayer); and
(B) The earlier of the last day of the taxable year, or the date the instrument is disposed of or otherwise terminated.
(ii) Adjustment to principal or basis. Proper adjustments are made in the amount of any gain or loss subsequently realized for gain or loss taken into account by reason of this paragraph (e)(7).
(iii) Interaction with DASTM. With respect to a qualified business unit that uses the United States dollar approximate separate transactions method of accounting described in § 1.985-3, this paragraph (e)(7) does not apply.
(iv) Definition of hyperinflationary currency swap contract. A hyperinflationary currency swap contract is a currency swap contract that provides for—
(A) Payments denominated in or determined by reference to a currency that is hyperinflationary (as defined in § 1.988-1(f)) at the time the taxpayer enters into or otherwise acquires the currency swap; or
(B) Payments that are adjusted to take into account the fact that the currency is hyperinflationary (as defined in § 1.988-1(f)) during the current taxable year. A currency swap contract that provides for periodic payments determined by reference to a variable interest rate based on local conditions and generally responding to changes in the local consumer price index is an example of this latter type of currency swap contract.
(v) Special effective date for nonfunctional hyperinflationary currency swap contracts. This paragraph (e)(7) applies to transactions entered into after February 14, 2000.
(f) Substance over form —(1) In general. If the substance of a transaction described in § 1.988-1(a)(1) differs from its form, the timing, source, and character of gains or losses with respect to such transaction may be recharacterized by the Commissioner in accordance with its substance. For example, if a taxpayer enters into a transaction that it designates a “currency swap contract” that requires the prepayment of all payments to be made or to be received (but not both), the Commissioner may recharacterize the contract as a loan. In applying the substance over form principle, separate transactions may be integrated where appropriate. See also § 1.861-9T(b)(1).
(2) Example. The following example illustrates the provisions of this paragraph (f).
(g) Effective date. Except as otherwise provided in this section, this section shall be effective for taxable years beginning after December 31, 1986. Thus, except as otherwise provided in this section, any payments made or received with respect to a section 988 transaction in taxable years beginning after December 31, 1986, are subject to this section.
(h) Timing of income and deductions from notional principal contracts. Except as otherwise provided (e.g., in § 1.988-5 or § 1.446-3(g)), income or loss from a notional principal contract described in § 1.988-1(a)(2)(iii)(B) (other than a currency swap) is exchange gain or loss. For the rules governing the timing of income and deductions with respect to notional principal contracts, see § 1.446-3. See paragraph (e)(2) of this section with respect to currency swaps.
(i) [Reserved] For further guidance, see § 1.988-2T(i).
§ 1.988-2T   Recognition and computation of exchange gain or loss (temporary).
(a) through (b)(15) [Reserved] For further guidance, see § 1.988-2(a) through (b)(15).
(16) Deferral of loss on certain related-party debt instruments —(i) Treatment of creditor. For rules applicable to a corporation included in a controlled group that is a creditor under a debt instrument see § 1.267(f)-1(e).
(ii) Treatment of debtor —(A) In general. Exchange loss realized under § 1.988-2(b)(4) or (b)(6) is deferred if—
( 1 ) The loss is realized by a debtor with respect to a loan from a person that has a relationship to the debtor described in section 267(b) or section 707(b); and
( 2 ) The transaction resulting in the realization of exchange loss has as a principal purpose the avoidance of Federal income tax.
(B) Recognition of deferred loss. Any exchange loss that is deferred under paragraph (b)(16)(ii)(A) of this section is deferred until the end of the term of the loan, determined immediately prior to the transaction.
(17) through (h) [Reserved] For further guidance, see § 1.988-2(b)(17) through (h).
(i) Special rules for section 988 transactions of a section 987 QBU. For rules regarding section 988 transactions of a section 987 QBU, see § 1.987-3T(b)(4) for section 987 QBUs in general and § 1.987-1T(b)(6) for dollar QBUs.
(j) Effective/applicability date. Paragraph (b)(16) of this section applies to any exchange loss realized on or after December 7, 2016. Paragraph (i) of this section applies to taxable years beginning on or after one year after the first day of the first taxable year following December 7, 2016. Notwithstanding the preceding sentence, if a taxpayer makes an election under § 1.987-11(b), then paragraph (i) of this section applies to taxable years to which §§ 1.987-1 through 1.987-10 apply as a result of such election.
(k) Expiration date. The applicability of this section expires on December 6, 2019.
§ 1.988-3   Character of exchange gain or loss.
(a) In general. The character of exchange gain or loss recognized on a section 988 transaction is governed by section 988 and this section. Except as otherwise provided in section 988(c)(1)(E), section 1092, § 1.988-5 and this section, exchange gain or loss realized with respect to a section 988 transaction (including a section 1256 contract that is also a section 988 transaction) shall be characterized as ordinary gain or loss. Accordingly, unless a valid election is made under paragraph (b) of this section, any section providing special rules for capital gain or loss treatment, such as sections 1233, 1234, 1234A, 1236 and 1256(f)(3), shall not apply.
(b) Election to characterize exchange gain or loss on certain identified forward contracts, futures contracts and option contracts as capital gain or loss —(1) In general. Except as provided in paragraph (b)(2) of this section, a taxpayer may elect, subject to the requirements of paragraph (b)(3) of this section, to treat any gain or loss recognized on a contract described in § 1.988-2(d)(1) as capital gain or loss, but only if the contract—
(i) Is a capital asset in the hands of the taxpayer;
(ii) Is not part of a straddle within the meaning of section 1092(c) (without regard to subsections (c)(4) or (e)); and
(iii) Is not a regulated futures contract or nonequity option with respect to which an election under section 988(c)(1)(D)(ii) is in effect.
(2) Special rule for contracts that become part of a straddle after an election is made. If a contract which is the subject of an election under paragraph (b)(1) of this section becomes part of a straddle within the meaning of section 1092(c) (without regard to subsections (c)(4) or (e)) after the date of the election, the election shall be invalid with respect to gains from such contract and the Commissioner, in his sole discretion, may invalidate the election with respect to losses.
(3) Requirements for making the election. A taxpayer elects to treat gain or loss on a transaction described in paragraph (b)(1) of this section as capital gain or loss by clearly identifying such transaction on its books and records on the date the transaction is entered into. No specific language or account is necessary for identifying a transaction referred to in the preceding sentence. However, the method of identification must be consistently applied and must clearly identify the pertinent transaction as subject to the section 988(a)(1)(B) election. The Commissioner, in his sole discretion, may invalidate any purported election that does not comply with the preceding sentence.
(4) Verification. A taxpayer that has made an election under § 1.988-3(b)(3) must attach to his income tax return a statement which sets forth the following:
(i) A description and the date of each election made by the taxpayer during the taxpayer's taxable year;
(ii) A statement that each election made during the taxable year was made before the close of the date the transaction was entered into;
(iii) A description of any contract for which an election was in effect and the date such contract expired or was otherwise sold or exchanged during the taxable year;
(iv) A statement that the contract was never part of a straddle as defined in section 1092; and
(v) A statement that all transactions subject to the election are included on the statement attached to the taxpayer's income tax return.
(5) Independent verification —(i) Effect of independent verification. If the taxpayer receives independent verification of the election in paragraph (b)(3) of this section, the taxpayer shall be presumed to have satisfied the requirements of paragraphs (b)(3) and (4) of this section. A contract that is a part of a straddle as defined in section 1092 may not be independently verified and shall be subject to the rules of paragraph (b)(2) of this section.
(ii) Requirements for independent verification. A taxpayer receives independent verification of the election in paragraph (b)(3) of this section if—
(A) The taxpayer establishes a separate account(s) with an unrelated broker(s) or dealer(s) through which all transactions to be independently verified pursuant to this paragraph (b)(5) are conducted and reported.
(B) Only transactions entered into on or after the date the taxpayer establishes such account may be recorded in the account.
(C) Transactions subject to the election of paragraph (b)(3) of this section are entered into such account on the date such transactions are entered into.
(D) The broker or dealer provides the taxpayer a statement detailing the transactions conducted through such account and includes on such statement the following: “Each transaction identified in this account is subject to the election set forth in section 988(a)(1)(B).”
(iii) Special effective date for independent verification. The rules of this paragraph (b)(5) shall be effective for transactions entered into after March 17, 1992.
(6) Effective date. Except as otherwise provided, this paragraph (b) is effective for taxable years beginning on or after September 21, 1989. For prior taxable years, any reasonable contemporaneous election meeting the requirements of section 988(a)(1)(B) shall satisfy this paragraph (b).
(c) Exchange gain or loss treated as interest —(1) In general. Except as provided in this paragraph (c)(1), exchange gain or loss realized on a section 988 transaction shall not be treated as interest income or expense. Exchange gain or loss realized on a section 988 transaction shall be treated as interest income or expense as provided in paragraph (c)(2) of this section with regard to tax exempt bonds, § 1.988-2(e)(2)(ii)(B), § 1.988-5, and in administrative pronouncements. See § 1.861-9T(b), providing rules for the allocation of certain items of exchange gain or loss in the same manner as interest expense.
(2) Exchange loss realized by the holder on nonfunctional currency tax exempt bonds. Exchange loss realized by the holder of a debt instrument the interest on which is excluded from gross income under section 103(a) or any similar provision of law shall be treated as an offset to and reduce total interest income received or accrued with respect to such instrument. Therefore, to the extent of total interest income, no exchange loss shall be recognized. This paragraph (c)(2) shall be effective with respect to debt instruments acquired on or after June 24, 1987.
(d) Effective date. Except as otherwise provided in this section, this section shall be effective for taxable years beginning after December 31, 1986. Thus, except as otherwise provided in this section, any payments made or received with respect to a section 988 transaction in taxable years beginning after December 31, 1986, are subject to this section. Thus, for example, a payment made prior to January 1, 1987, under a forward contract that results in the deferral of a loss under section 1092 to a taxable year beginning after December 31, 1986, is not characterized as an ordinary loss by virtue of paragraph (a) of this section because payment was made prior to January 1, 1987.
§ 1.988-4   Source of gain or loss realized on a section 988 transaction.
(a) In general. Except as otherwise provided in § 1.988-5 and this section, the source of exchange gain or loss shall be determined by reference to the residence of the taxpayer. This rule applies even if the taxpayer has made an election under § 1.988-3(b) to characterize exchange gain or loss as capital gain or loss. This section takes precedence over section 865.
(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. For purposes of paragraph (b)(1) of this section, the principles of § 1.987-2(b) apply in determining whether an asset, liability, or item of income, gain, deduction, or loss is reflected on the books and records of a qualified business unit.
(ii) Applicability date. Generally, paragraph (b)(2)(i) of this section applies to taxable years beginning after December 31, 2024. However, if pursuant to § 1.987-15(b), a taxpayer chooses to apply §§ 1.987-1 through 1.987-15 to a taxable year before the first taxable year described in § 1.987-15(a)(1), then paragraph (b)(2)(i) of this section applies to that taxable year.
(c) Effectively connected exchange gain or loss. Notwithstanding paragraphs (a) and (b) of this section, exchange gain or loss that under principles similar to those set forth in § 1.864-4(c) arises from the conduct of a United States trade or business shall be sourced in the United States and such gain or loss shall be treated as effectively connected to the conduct of a United States trade or business for purposes of sections 871(b) and 882 (a)(1).
(d) Residence —(1) In general. Except as otherwise provided in this paragraph (d), for purposes of sections 985 through 989, the residence of any person shall be—
(i) In the case of an individual, the country in which such individual's tax home (as defined in section 911(d)(3)) is located;
(ii) In the case of a corporation, partnership, trust or estate which is a United States person (as defined in section 7701(a)(30)), the United States; and
(iii) In the case of a corporation, partnership, trust or estate which is not a United States person, a country other than the United States.
(2) Exception. In the case of a qualified business unit of any taxpayer (including an individual), the residence of such unit shall be the country in which the principal place of business of such qualified business unit is located.
(3) Partner in a partnership not engaged in a U.S. trade or business under section 864(b)(2). The determination of residence shall be made at the partner level (without regard to whether the partnership is a qualified business unit of the partners) in the case of partners in a partnership that are not engaged in a U.S. trade or business by reason of section 864(b)(2).
(e) Special rule for certain related party loans —(1) In general. In the case of a loan by a United States person or a related person to a 10 percent owned foreign corporation, or a corporation that meets the 80 percent foreign business requirements test of section 861(c)(1), other than a corporation subject to § 1.861-11T(e)(2)(i), which is denominated in, or determined by reference to, a currency other than the U.S. dollar and bears interest at a rate at least 10 percentage points higher than the Federal mid-term rate (as determined under section 1274(d)) at the time such loan is entered into, the following rules shall apply—
(i) For purposes of section 904 only, such loan shall be marked to market annually on the earlier of the last business day of the United States person's (or related person's) taxable year or the date the loan matures; and
(ii) Any interest income earned with respect to such loan for the taxable year shall be treated as income from sources within the United States to the extent of any notional loss attributable to such loan under paragraph (d)(1)(i) of this section.
(2) United States person. For purposes of this paragraph (e), the term “United States person” means a person described in section 7701(a)(30).
(3) Loans by related foreign persons —(i) In general. [Reserved]
(ii) Definition of related person. For purposes of this paragraph (e), the term “related person” has the meaning given such term by section 954(d)(3) except that such section shall be applied by substituting “United States person” for “controlled foreign corporation” each place such term appears.
(4) 10 percent owned foreign corporation. For purposes of this paragraph (e), the term “10 percent owned foreign corporation” means any foreign corporation in which the United States person owns directly or indirectly (within the meaning of section 318(a)) at least 10 percent of the voting stock.
(f) Exchange gain or loss treated as interest under § 1.988-3. Notwithstanding the provisions of this section, any gain or loss realized on a section 988 transaction that is treated as interest income or expense under § 1.988-3(c)(1) shall be sourced or allocated and apportioned pursuant to section 861(a)(1), 862(a)(1), or 864(e) as the case may be.
(g) Exchange gain or loss allocated in the same manner as interest under § 1.861-9T. The allocation and apportionment of exchange gain or loss under § 1.861-9T shall not affect the source of exchange gain or loss for purposes of sections 871(a), 881, 1441, 1442 and 6049.
(h) Effective date. This section shall be effective for taxable years beginning after December 31, 1986. Thus, any payments made or received with respect to a section 988 transaction in taxable years beginning after December 31, 1986, are subject to this section.