TAXATION OF FOREIGN EXCHANGE 

GAINS AND LOSSES* 

Jenny Bourne Wahl 

U.S. Treasury Department 

OTA Paper 57 October 1987 

OTA Papers and Briefs are circulated so that the preliminary findings of tax research 

conducted by staff members and others associated with the Office of Tax Analysis may reach a 

wider audience. The views expressed are those of the authors, and do not reflect Treasury 

policy, Comments are invited, but OTA Papers and Briefs should not be quoted without 

permission from the authors, Additional copies of this publication may be purchased from 

the National Technical Information Sentice, 5285 Port Royal Rd., Springfield, VA 22161. 

Phone: (703) 487-4660. 

Office of Tax Analysis 

U.S. Treasury Department, Room 4040 

Washington, D.C. 20220 

* This research benefited from comments and suggestions macle by the staff of the Office of 

Tax Analysis. I am also grateful to Edward Wahl. The views contained in the paper do not 

necessarily represent those of the Office of Tax Analysis or of the U.S. Treasury 

Department. 
Table of Contents 

Page 

I. INTRODUCTION 1 

11. EQUILIBRIUM UNDER NO TAXES 2 

111. OPTIMAL TAXATION 3 

IV. FEGL TAXATION CONSISTENT WITH THE RESTRICTIONS OF 

EXISTING U.S.TAX LAW 7 

V. U.S. LAW ON THE TAXATION OF FEGL 15 

VI, SUMMARY AND CONCLUSIONS 20 

APPENDIX 23 

FOOTNOTES 28 

BIBLIOGRAPHY 30 

List of Tables 

CUMULATIVE TAX PAID UNDER VARIOUS SOURCING RULES FOR 

UNANTICIPATED FEGL 10 

INCOME AND TAXES UNDER THE VARIOUS RULES 17 

TAX RULES 26 
TAXATION OF FOREIGN EXCHANGE GAINS AND LOSSES 

I. INTRODUCTION 

The Tax Reform Act of 1986 (TU)substantially changed the taxation of foreign exchange 

gains and losses (FEGL). The principal objective underlying the new tax law on FEGL is to 

encourage the recognition of income on an economic rather than a tax-induced basis. This 

paper evaluates the extent to which that objective is reached. It begins by developing an 

optimal tax rule for FEGL in a simplified world, from the standpoint of worldwide 

1 efficiency. The optimal rule is recast to conform with existing U.S. tax law on other 

types of gains and losses. The reformulated rule, which treats expected and unexpected FEGL 

differently, departs from optimal taxation, As a result, capital may be misallocated. 

Moreover, taxpayers with the same realized income may not pay the same taxes and the fisc 

may be whipsawed. The reformulated rule is then compared to the TRA legislation and to 

pre-TRA law. The TRA rule does not generally adopt optimal taxation, nor does it implement 

the bifurcated rule consistent with existing law, primarily for administrative reasons. 

TRA’s asymmetric treatment of branches and subsidiaries may be particularly distortive. The 

table at the end of the appendix summarizes the optimal tax rule, the reformulated rule, and 

the U.S. tax rules for FEGL before and after TRA. 

U. S. taxpayers experience FEGL because the dollar values of foreign-currency-denominated 

holdings fluctuate. These holdings could represent a direct foreign-currency transaction or 

a U.S. company’s interest in a foreign affiliate. Section I1 describes the no-tax 

equilibrium condition for taxpayers with multicurrency holdings. Section I11 develops an 

optimal tax rule for determining the timing and amount of FECL. Section IV refashions the 

optimal rule in light of established U.S. tax law. Emphasis is given to the policy of 

primary taxing power over domestic income, limitations on carryover rules, accrual taxation 

of certain gains and losses but realization-based taxation of other gains and losses. and 

tax deferral for foreign subsidiary earnings, Section V discusses U.S.law concerning FEGL 

taxation, and section VI summarizes the analysis. 
-- 

-2-

11. EQUILIBRIUM UNDER NO TAXES 

The following notation will be used throughout the paper: 

K,+~ = the expected inflation rate from time t to time t+ I, 

It+l = the one-period before-tax nominal interest rate at time t, 

rt+1 = the one-period expected before-tax real interest rate at time t, 

Tt+l = the tax rate, 

S, = the spot exchange rate at time t (dollarslforeign currency), 

St+, = the spot exchange rate for time t + 1 expected at time t. 

For the first four variables, those with an asterisk denote foreign variables, those without 

denote domestic variables. For example, IT^+^ is the expected foreign inflation rate from 

time t to time t + L. If rates are assumed to be constant over time, no subscript appears. 

In a no-tax world, three conditions are assumed to hold ex ante. Relative purchasing 

power parity (PPP) equates the expected rate of change in the exchange rate between two 

currencies to the difference between expected national inflation rates: 

The currencies of countries with inflation expected to exceed U.S. inflation are anticipated 

to depreciate against the dollar ("depreciating currencies"), and currencies of countries 

with inflation expected to be smaller than U.S. inflation are anticipated to appreciate 

against the dollar ("appreciating currencies"), Uncovered interest rate parity (U1P) 

equates the nominal interest rate differential between investments denominated in different 

currencies to the expected rate of change in the exchange rate between the currencies:2 

The Fisher (1930) equations equate the expected real retum on an investment to the 

difference between the nominal retum and the expected inflation rate. 

- lt+l - 't+l + %+l 

In a no-tax world a U.S.taxpayer can invest domestically or abroad, either directly or 

through an affiliate. By combining (1) and (2) and substituting (3a) and (3b). equation (4) 

results: 

Equilibrium condition (4)implies equality of expected real returns for similar investments 

denominated in different currencies, Therefore, worldwide efficiency is attained. 
-3-

Suppose income taxes are introduced. For simplicity, assume there is a single type of 

3 investment and a single representative corporate taxpayer. The taxpayer will acl.iust 

investments to equalize expected after-tax real returns. To fulfill the worldwide 

efficiency condition, taxes must be imposed so that the equilibrium expected before-tax real 

returns to investments denominated in different currencies are equal, Le., so (4)holds. 

111. OPTIMAL TAXATION 

A. Anticipated FEGL 

1. Nominal versus Real Income Taxation 

Both n and n* are likely to be nonzero; if n > n* the foreign currency is expected to 

appreciate against the dollar, and if n < n* the foreign currency is expected to depreciate 

against the dollar. To economize on notation without loss of generality, suppose that the 

U.S. has no expected inflation (K,+~= 0 for all n20). This implies that dollar and real 

income are the same. For this section, suppose also that only the U.S. imposes tax (TT+n= 0 

for all n20). Assuming nominal income is taxed at a constant rate of T, equation (2) is 

rewritten as: 

It+, ' (I-T) - iT+,(I-T) = ln(S,+, IS,).

Equilibrium is therefore represented by equation (4"): 

m

1 

rT+, - r,+, + -II~+~. (4") 1-T 

If taxes are imposed in this fashion, the equilibrium expected before-tax real return is 

greater for a depreciating-currency investment and less for an appreciating-currency investment than the equilibrium expected before-tax real return for a dollar investment. 

Therefore, equilibrium depreciating-currency investment will be less than optimal and 

appreciating-currency investment greater than optimal. This result is directly related to 

the taxation of nominal income, If only real income were taxed, equilibrium condition (4) 

would hold and capital would be efficiently allocated. 

2. Realization versus Accrual Taxation 

Equations (2") and (4")implicitly assume that expected FEGL are never recognized. For 

instance, if i* >i because R * >0, income from a depreciating-foreign-currency-denominated 

asset with a given original dollar basis appears to pay greater tax each period than income 

from a dollar asset with the same dollar basis. However, (2") and (4")omit the potential 

tax consequences at the end of the asset-holding period. 

Under U.S. tax law, the extreme case represented in the previous section is unlikely to 

occur. Rather, recognition of expected FEGL might be deferred until the close of a transaction or the liquidation of an affiliate, that is, until realization. If so, nominal 
-4-

income would be taxed in interim periods and efficiency condition (4)could be undermined, 

but (4*)would hold with equality only for infinitely lived f2reign operations. If expected 

FEGL were instead accrued for tax purposes, only real income would be taxed and efficiency 

condition (4)would hold, The following paragraphs derive equilibrium conditions for both 

infinitely and finite-lived foreign operations under accrual- and realization-based taxation 

of FEGL. 

Suppose nominal interest rates, the tax rate, and the inflation rate n* are constant, and 

n =O. The taxpayer is assumed to invest $1 initially when So = 1 and to reinvest all income 

into the business until period N, when the operation is liquidated. Equation (5) shows the 

expected after-tax real present value of domestic operations: 

JO 

If expected FEGL were recognized on an accrual basis, equation (6) would express the 

expected after-tax real present value of foreign operations: 

Equating (5) and (6) yields an equilibrium condition in which r=r*, showing that accrual 

taxation is efficient. 

If expected FEGL were recognized on a realization basis, (6) would be rewritten as: 

where the second term represents lump-sum taxation of FEGL at the termination of operationsi 

Intuitively, one would expect the second term in (7) to go to zero as N goes to infinity. 

Equating (5) and (7) as N goes to infinity therefore produces equilibrium condition (4"). 

If N is finite, however, equating (5) and (7) yields the following equilibrium condition: 

(i*(l-T)-K*)N 

e

-K(l-T)N -1-Te-K (1-T)N (e-X*N 

- 1) = e

I(1-T)N 

e

-r(l-T)N 

e - 1. (8)

Simplifying, 

(r*(l-T)-TK*)N + ~(1 r(l-T)N e - = e (9) 

The second term on the left-hand side is negative if n*<O and positive if n*>O. implying 

that: 

r* > r +-n*T as n* [ <,0. < 1-T 

Equation (10) simply says that operations in an appreciating-currency country would have 

to earn a larger real rate of retuin if FEG were taxed in the future than if they were never 

taxed. Conversely, depreciating-currency operations could earn a smaller real return if FEL 
-5-

reduced taxable income in the future rather than never reducing taxable income. However, r* 

would remain lower than r for appreciating-currency operations (and higher than r for 

depreciating-currency operations) as long as T>O and tax were applied to realized rather 

than accrued income. Therefore, efficiency condition (4) is violated under realizationbased taxation whether foreign-currency operations are perpetual or not. 

3, Transactions 

The preceding analysis can be applied to direct transactions. Borrowers and lenders can 

choose the currency in which a transaction is denominated. Interest rates, expected 

exchange rates, and taxes codetermine the equilibrium quantity of a given currency used for 

transactions, and UIP implies that expected FEGL are similar to interest income and expense. 

For example, expected foreign exchange gains (FEG) on the principal of an outstanding 

foreign-cun-ency-denominated loan compensate a lender for charging an interest rate lower 

than the rate on a similar dollar-denominated loan. 

Suppose a U.S. taxpayer can lend either a dollar or a unit of foreign currency for two 

years when S,=l. Let i=r=.15, T=S, and n*=;.05. The equilibrium expected after-tax 

present value of $1 equals $1, so the following holds : 

2 

s, e 

i(1-T)T 

e

-r(l-T)T dr = e.15(.5)2-.15(.5)2 -1 =o. 

If FEGL are accrued, the taxpayer is indifferent between lending dollars and lending 

foreign currency if the following holds: 

2 

s, e 

(i*-R*)(l-T)T

e

-K(l-T)T dr = e(i*+.O5)(.5)2-.15(.5)2 -1=o. 

The solution is i*=.lO, which implies that r*=,l5 and worldwide efficiency is attained. 

Because n*<O, i* is less than i, showing the compensating effect of expected FEG. 

If FEGL are taxed when realized, the taxpayer will be indifferent between dollar- and 

foreign-currency-denominated loans if the following holds: 

2 2 

s, e 

(i*(l-T)-n*)T 

e

-r(l-T)~ d?: - Te-r ( 1-T) 2 J, dr 

=e 

(i*(.5)+.05)2-.15(5)2 - I - .5e-.15(.5)2 (e(.05)2 - 1) = 0. 

The solution is i"r.0943. which implies that r*<r. Therefore. if stated interest is the 

basis for taxation and FEG are recognized when realized, worldwide efficiency will be 

violated and the equilibrium amount of lending in appreciating currencies (Le.. those for 

which IC*<<)by U.S.taxpayers will be greater than optimal. 

By the same token, if stated interest i* is the basis for tax deductions. equilibrium 

borrowing in depreciating currencies by U.S. taxpayers will be greater than optimal. 

Expected foreign exchange losses (FEL) on the borrowed principal should reduce the stated 
-6-

interest payments before a deduction is allowed if worldwide efficiency is to hold. If 

recognition of FEL is deferred until the close of a transaction, however, inflation is 

permitted to increase deductions in interim years. Because this enables borrowers to defer 

income recognition, they will therefore desire greater-than-optimal amounts of depreciatingcurrency loans. 

4. Affiliates 

The optimal tax rule for foreign-currency transactions can readily be extended to foreign 

affiliate investments. If a U.S. parent invests in a domestic affiliate, the discounted 

expected after-tax change in real net worth is: 

If the U.S. parent invests in a foreign affiliate, it has generally been allowed to use a 

net-worth or a profit-loss method of income recognition. Under the net-worth method, the 

affiliate's dollar net worth is calculated at the end of a period, and the increment over 

the last period's dollar net worth is taxed. Under the profit-loss method, annual profit 

(translated into dollars) is taxed but recognition of FEGL is deferred until affiliate 

investments (contributed capital and retained earnings) are repatriated to the parent. 

Suppose a U.S. company contributes $1 to a foreign affiliate when So = 1, assuming n*, i*. 

i, and T constant. Suppose the affiliate retains earnings and contributed capital until 

period N. If income earned through a foreign affiliate is taxed on ;he basis of increased 

net worth (net-worth method), FEGL are recognized on an accrual basis. Equation (12) shows 

the discounted expected after-tax change in real net worth under this method: 

If the income basis is instead the stated affiliate profit translated into dollars (profitloss method), FEGL are taxed upon realization. The discounted expected after-tax change in 

real net woith equals: 

(i*(l-T)-K*)T

e

-r(l-T)T d-c - Te-r(l-T)N J[ e-'*' d-c. 

Clearly, (tl) corresponds to (5), (12) to (6), and (13) to (7). Therefore. if the networth method is used for foreign affiliates, (11) and (12) should be equal at the margin so 

r=r* and worldwide efficiency is attained. If the profit-loss method applies. (I I) and (13) 

should be equal at the margin. As a result, (9) represents equilibrium so r*<r if n*<O and 

r*>r if rr*>O. The equilibrium before-tax real return expected for new investments will be 

smaller in appreciating-currency countries and greater in depreciating-currency countries 

than the before-tax real return expected for U.S. investments. Accordingly, investment will 

be greater than optimal in deflationary countries and smaller than optimal in inflationary 

countries if the profit-loss method is used. 
-7-

B. Unanticipated FEGL 

Accrual of unanticipated FEGL is irrelevant for efficiency, because economic decisions 

are based on expectations. However, unanticipated FEGL should be accrued under optimal 

taxation. Otherwise, neutrality among taxpayers with the same income may not be preserved, 

and the fisc will be whipsawed because taxpayers can choose the timing of income 

recognition. (See section 1V.B for more detail.) Therefore, taxable FEGL on a U.S. 

taxpayer’s investment, loan, or borrowing are calculated by using the realized exchange rate 

rather than the expected exchange rate under optimal taxation. Unanticipated FEGL equal the 

difference between actual and expected FEGL. 

IV. FEGL TAXATION CONSISTENT WITH THE RESTRICTIONS OF 

EXISTING U.S. TAX LAW 

Thus far, the optimal tax rule for FEGL has ignored existing law. Four areas of U.S. tax 

law have an important influence on the equilibrium conditions. First, the U.S. claims 

primary taxing power over U.S. income. Second, taxpayers must carry over net losses from a 

given period to offset income in earlier or later periods, carryovers do not accrue 

interest, and maximum carryover periods are limited. Third, anticipated gains and losses 

are accrued under original issue discount (OID) rules but other anticipated and most 

unanticipated gains and losses are recognized only when realized. Fourth, U.S.taxes are 

deferred on income earned through foreign subsidiaries until dividends are repatriated to 

8

the U.S. taxpayers. The first restriction is an income sourcing issue, discussed in 

section A. The latter three are income timing issues, discussed in section B. The 

following paragraphs show that, although the optimal rule can be reformulated to be 

consistent with existing law, the reformulated rule may violate the efficiency condition, 

lead to non-neutrality among taxpayers, and allow taxpayers to choose the timing of income 

recognition, thus giving rise to potential whipsaw of the fisc. 

A. Source of Income or Expense 

1. The Foreign Tax Credit 

The U.S.taxes the worldwide income of U.S.taxpayers but peimits a credit for foreign 

income taxes imposed on foreign-source taxable income. The amount of taxable income by 

source is computed by first determining the sources of gross income items, then allocating 

expenses to domestic- and foreign-source income. The taxpayer is generally granted a 

foreign tax credit only up to the point where the average foreign tax rate on foreign-source 

income equals the U.S. tax rateag This ”foreign tax credit limitation” equals 

(foreign-source taxable income) 

x pre-credit U.S.tax liability 

(worldwide taxable income) on worldwide income.10 

The limitation ensures that the foreign tax credit offsets U.S.tax on foreign-source income 
-8-

only. If the average foreign tax rate were higher than the U.S. rate and the U.S.had no 

limitation. a taxpayer could reduce U.S. tax on domestic-source income. 

Thus far, foreign taxes have been assumed to be zero. Under the credit system, the total 

tax rate on domestic-source income is T and the total tax rate on foreign-source income is 

the greater of T or T*, abstracting from carryovers. As long as T>T*, the analysis in 

previous sections could apply and worldwide efficient capital allocation could be achieved 

if anticipated FEGL were accrued. 

If the U.S. reserves primary taxing power over U.S.-source income, however, U.S. 

taxpayers will not want to allocate capital efficiently if the average foreign tax rate 

always exceeds the U.S. rate. (If the average foreign rate fluctuated above and below the 

U.S. rate, the taxpayer would have some leeway because foreign tax credits can be carried 

back two years and forward five.) Given this constraint, the source of income and expense 

items can clearly be important. If the foreign tax rate exceeds the U.S. rate, the U.S. 

taxpayer is said to have "excess foreign tax credits." Example one of the appendix shows 

cases in which the taxpayer has foreign tax credits exactly offsetting U.S. taxes, has 

excess foreign tax credits, and has a shortage of foreign tax credits. Given worldwide 

income and foreign taxes, if the taxpayer could transform $1 of domestic-source income into 

foreign-source income (thus increasing the foreign tax credit limitation), it could reduce 

net U.S. tax liability by T. The same result follows if the taxpayer could transform $I of 

foreign-allocated expense into $1 of domestic-allocated expense. The source rules for FEGL 

must therefore be carefully written so taxpayers are not induced to reallocate investments 

for tax reasons. 

2. Source of FEGL 

a. Anticipated FEGL 

For purposes of this analysis, existing interest source rules are assumed to be correct. 

Interest income received from foreigners is generally foreign-source; interest expense is 

11 allocated ratably to foreign and domestic sources on an asset basis. Because anticipated 

FEGL are the same as interest, the reformulated rule nets them against stated interest 

income or expense and sources the net amount according to interest-sourcing rules. If 

anticipated FEGL were sourced differently than interest, the taxpayer might favor certain 

currencies for transactions and investments. For instance, if anticipated FEGL were 

domestic-source and the taxpayer had excess foreign tax credits, it might be induced to lend 

depreciating currencies (rather than dollars) to foreigners in order to keep its foreign tax 

credit limitation artificially high. Because the lender expects FEL, it would charge a 

higher interest rate on the depreciating-currency loan than on a dollar loan. The inflated 

interest income would be foreign-source while the FEL would be an expense allocated to 

domestic sources. Therefore, the foreign tax credit limitation would be artificially high 

and more foreign taxes could be credited than if anticipated FEL were first netted against 

interest income. 

For foreign-currency-denominated transactions. the expected net yield will be positive. 

so lenders will expect net interest income (i*-n*) and their anticipated FEGL would be 

foreign-source under the reformulated rule. Borrowers of foreign currency will expect net 
-9-

interest expense (i*-E*), so their anticipated FEGL would be allocated to foreign and 

domestic sources. Foreign affiliate investments will presumably produce expected income so 

anticipated FEGL would be foreign-source in this case. 

b. Unanticipated FEGL 

Unanticipated FEGL are not like interest and therefore require different sourcing rules. 

Under UIP, unanticipated FEGL are random and should average out over time. Assuming that 

taxpayers have unlimited carryovers of foreign tax credits and net operating losses (NOLs). 

unanticipated FEGL could be sourced as all foreign or all domestic, as long as unanticipated 

gains and losses were treated symmetrically. If unanticipated FEGL were instead treated as 

interest, the taxpayer could use up excess foreign tax credits generated by non-FEGL 

foreign-source income and lower U.S. tax on U.S.-source income, which would defeat the 

purpose of the foreign tax credit limitation. 

The following example clarifies this. Suppose domestic assets equal foreign assets so 

interest expense is allocated equally to foreign and domestic sources. Suppose an 

excess-credit taxpayer has unanticipatedlyEG of $20 on a loan in year one and unanticipated 

FEL of $20 on a borrowing in year two. The table below shows that, if unanticipated FEGL 

were either foreign- or domestic-source, the taxpayer would pay the same cumulative tax as 

if no unanticipated FEGL occurred. However, if unanticipated FEGL were sourced as interest, 

cumulative tax would be lower. 

Either domestic or foreign sourcing of all unanticipated FEGL would be acceptable if the 

value of carryovers were preserved and carryover periods were unlimited. A second-best 

solution would permit taxpayers to use the more generous domestic-based rules. (Domestic 

sourcing is also consistent with sourcing rules for other types of gains and losses under 26 

USC 865.) If a taxpayer had large FEL in a given year that were sourced as foreign, it 

could generate excess foreign tax credits. The taxpayer would be likely to have compensatory FEG in another year, but the gain could occur outside of the carryover period and the 

excess foreign tax credits would expire. In theory, domestic sourcing could cause a similar 

problem if FEL were large enough to force worldwide income to be negative. However, most 

U.S. taxpayers have more U.S. than foreign income against which to balance a FEL. Also, NOL 

carryover rules are more generous than foreign tax credit rules, with carrybacks of three 

years and carryforwards of fifteen years for NOLs and carrybacks of two years and 

carryforwards of five years for foreign tax credits. Under domestic sourcing. therefore. 

U.S. taxpayers would be less likely to be in a loss-carryover position and would have a 

longer carryover period should a loss occur. 

B. Timing of Recognition of FEGL 

1. Anticipated versus Unanticipated FEGL 

The calculation of anticipated FEGL on foreign-currency-denominated transactions is 

closely related to the calculation of original issue discount (OlD), a procedure which 

determines interest income on dollar-denominated debt instruments sold at below-par prices 

(e.g., zero-coupon bonds), An 01D transaction analogous to the lending example of section 
Y 

09 09

P P 

c! ? i d

W W 

09 

00

c! 

P Ic! T 3 3 

W I09 09 

P I-d

9 T 

00 3 

W I9 T 

00 3 

W I­*$ Y 

3 

-0 

SC 

a 

.3 

4

.. 

2 g 5 

a Z 
-11-

III.A.3 is the purchase of a two-year dollar bond with a face value of $e-'* (rt*<O), an 

issue price of $I, and a stated interest rate of i*. The 01D rules in the U.S. tax code 

accrue the implicit gain on the principal, assigning a taxable yield of i*-n*. (See Garlock 

1987.) 

Although the OID rules tax anticipated gains and losses on dollar-denominated debt 

instruments on an accrual basis, other anticipated and unanticipated gains and losses on 

dollar-denominated assets and liabilities are not usually taxed until the property is sold 

or exchanged. The prime example of realization-based taxation is the treatment of capital 

gains. Economists generally agree that capital gains should be taxed on an accrual basis 

(see, for example, Musgrave and Musgrave 1984). Because capital gains are not accrued, 

however, accrual of unanticipated FEGL would treat dollar-denominated and foreign-currencydenominated assets and liabilities asymmetrically and could distort economic incentives, 

The arguments for recognition upon realization are generally based on administrability , 

fairness, and stability objectives, among others. Accrual-based taxation may require 

frequent and complex calculations by the taxpayer. Moreover, carryover periods are limited. 

so an accrued unanticipated loss might expire before it could offset an unanticipated gain. 

With progressive tax rates, even if unanticipated FEGL offset over time the FEG might be 

taxed at a rate different than the rate at which the FEL is deducted. in addition, accrual 

of unanticipated gains and losses could cause large swings in tax bills and in the fisc. 

One can demonstrate this result by consideiing the tax treatment of a foreign affiliate. 

recalling that the alternatives are the net-worth method (which requires accrual) and the 

profit-loss method (which does not). Example two of the appendix shows that, even though 

total (undiscounted) U.S. tax liability is the same over time for both methods, the 

net-worth method causes great variability in annual U.S.taxes. 

To conform with existing U.S. tax rules on timing of recognition, the optimal tax rule 

needs to be reformulated. The OID rules provide a precedent for taxing anticipated FEGL on 

an accrual basis. However, capital gains rules point to realization-based taxation of 

unanticipated FEGL. 

The problems inherent in a recognition-upon-realization rule are potential lack of 

neutrality among taxpayers and whipsawing. Two taxpayers with the same income, one having 

anticipated gains and the other having unanticipated gains, will pay different taxes. The 

taxpayer's discretion over the timing of recognition of unanticipated gains and losses can 

also lead to whipsawing of the fisc. Stiglitz (1981) showed the whipsawing problem for 

capital gains, and a similar argument can be made for FEGL. Suppose unanticipated FEGL are 

sourced as foreign. if a taxpayer had unanticipated FEG on an assets (either from a direct 

transaction or held through affiliates) and also had excess foreign tax credits on other 

foreign-source income, it could recognize the FEG by selling the asset. Because FEG are not 

taxed abroad, foreign taxes would not change. However, the foreign tax credit limitation 

would increase, enabling the taxpayer to use up excess foreign tax credits against the 

untaxed FEG. If excess foreign tax credits counterbalanced pre-credit U.S. tax liability on 

the FEG, the taxpayer could recognize the FEG free of tax. It could then purchase a similar 

set of assets to replace the sold asset. (Wash sale rules could prevent purchase of a 

single similar asset .) Conversely, suppose FEGL are sourced domestically. A taxpayer could 

recognize unanticipated FEL and lower U.S. tax on US.-source income. It could then 

purchase a replacement set of assets, 
-12-

2. Deferral of Taxation on Income Earned Through Foreign Subsidiaries 

Although branch earnings are included annually in the consolidated income of the branch’s 

U.S. parent, subsidiary earnings are generally included only when distributed as dividends. 

The reasoning that has been used is that a branch is a part of the U.S. parent and therefore 

should be taxed like the parent, but a subsidiary is a sovereign entity and its earnings 

generally should not bear U.S. tax until in the hands of a U.S.taxpayer. When dividends 

are repatriated, a U.S. parent is entitled to an indirect or ”deemed-paid” credit for 

foreign income taxes paid by the foreign subsidiary. The credit is based on the percentage 

of total profits repatriated and the parent’s percentage of ownership. Although Hartman 

(1985) has shown that deferral is irrelevant for existing investment, it is important for 

new investment if foreign tax rates differ from U.S. tax rates. (Also see Newlon 1986.) 

a. Dollar-Based Foreign Subsidiaries’ 

Deferral for a dollar-based foreign subsidiary leads to an equilibrium before-tax return 

abroad that is lower than the retum in a no-tax regime if the foreign tax rate is lower 

than the U.S. rate and dividends are not repatriated every year. For example, if a wholly 

owned subsidiary repatriated contributed capital of $1 and all after-foreign-tax income at 

the end of its second year of operation, U.S. tax and the net repatriation amount would be 

calculated as follows (assuming the taxpayer has a shortage of foreign tax credits):14 

Net income inclusion 

Gross-up for foreign taxes 

Gross income inclusion 

Pre-credit U.S. tax 

Foreign tax credit 

Net U.S. tax 

Net repatriation amount 

(after-tax income and 

contributed capital) 

(l-T*)[2i* +i*2(1-T*)] 

T*[2i* +i*2(1-T*)] 

2i* +i*2(l-T*) 

T12i* +i**( l-T*)] 

T*[2i* +i*2(1-T*)] 

(T-T*)[2i* (1-T*)] 

[l + i*(l-T)]’ + (T-T*)i*2(1-T). 

Assuming that repatriation of earnings and contributed capital always occurs after two 

15 periods, r* is given by the following equilibrium equation. The second term reflects the 

effect of deferral. 

[l + r(1-T)f = [I + r*(l-T)]’ + r*2(T-T*)(1-T) (15) 

Clearly, r*>r as T*>T and r*<r as T*<T. Therefore. deferral favors prospective dollar 

investment in low-tax countries in the form of subsidiaries and in high-tax countries in the 

form of branches. 
-13-

b. Foreign-Currency-Based Foreign Subsidiaries 

The optimal timing rule would accrue all FEGL on subsidiary investments. and the 

reformulated timing rule would accrue anticipated FEGL and recognize unanticipated FEGL when 

the U.S. parent realizes them. Deferral of U.S. tax on foreign subsidiary eamings makes 

both rules impossible to fulfill. At best, anticipated FEGL on investments remaining in the 

subsidiary, plus all FEGL not previously recognized on repatriated dividends, could be 

recognized at the time of dividend repatriation. As in the case of dollar investments, 

low-tax countries would be favored for prospective foreign-currency-denominated subsidiary 

investments under this scheme. 

Practically speaking, deferral makes direct recognition of anticipated FEGL on 

unrepatriated subsidiary investments difficult. Deferral implies that only net dividends, 

translated at the exchange rate on the date of distribution, may be included as net income 

to the U.S.parent. Net dividends are, however, grossed up by foreign taxes to obtain the 

gross income inclusion. Anticipated FEGL on unrepatriated investments could therefore be 

recognized indirectly by adjusting the gross-up for foreign taxes, as shown in the following 

paragraphs. 

(1) Current Translation of Foreign Taxes 

If taxes are translated at the exchange rate in effect on the date of repatriation 

("current translation"), only FEGL on repatriated dividends are recognized. Suppose foreign 

subsidiaries repatriate all eamings (but not contributed capital) at the end of the second 

year of operation. The following example shows that current translation of foreign taxes 

leads to no U.S. tax if T=T* and So =I. 

Year 1 

Gross income i* 

Foreign taxes T*i* 

After-tax income (1-T*)i* 

Net income inclusion ($) 

Gross-up for foreign tax ($) 

Gross income inclusion ($) 

Pre-credit U.S.tax ($) 

Foreign tax credit ($) 

Net U.S. tax ($) 

After-tax repatriation (Yat) 

Year 2 Total 

i*[l +i*( 1-T*)J i*[2 +i*( 1-T*)] 

T*i*[ 1 +i*( 1-T*)J T*i*[2 +i*( l-T*)] 

(1-T*)i*[1 +i*( 1-T*)] 11 +i*(l-T*)]' - 1 

(l-T*)[2i* +i*2 (I -T*)]S2 

T*[2i* (l-T*)]S2 

(l-T)[2i* +i*2(l-T*)]S, 
-14-

In this example, net income to the U.S. parent is the current value of net subsidiary 

income. FEGL on subsidiary income is explicitly recognized because each foreign currency 

unit of net income was worth $1 in year one and $S1 in year two but is included in income at 

$S2 . FEGL on contributed capital, however, remains unrecognized until the capital is 

repatriated. The current translation method therefore closely resembles the profit-loss 

method for branches. Accordingly, investment in countries with expected deflation would be 

greater than investment under worldwide efficiency, and investment in countries with 

expected inflation would be lesser, that is, r*>r as K*>O and r*<r as n*>O (assuming the 

taxpayer has a shortage of credits). 

(2) Historical Translation of Foreign Taxes 

Suppose net dividends and net earnings are translated at the exchange rate in effect at 

the time of repatriation, but foreign taxes are translated at the exchange rate in effect at 

the time taxes were paid ("historical translation"). In the example above, the gross-up for 

foreign tax and the foreign tax credit would therefore equal T*i*S, +T*i*[ 1+i*( l-T*)]S2. 

Historical translation of foreign taxes increases the effective expected foreign tax rate T' 

above the statutory rate for depreciating-currency countries (where S, >S2) and decreases it 

below the statutory rate for appreciating-currency countries (where S, <S2). Equation (16) 

shows the relationship for the two-year repatriation example: 

i*T*( I-T*)(S, - S,) T' =T* +( i*[T*(S, + S2)+ S2(l-T*)(i*+ 2)] 

For a given investment in a subsidiary, equation (17) shows that dollar income after all 

taxes would be greater for investments in depreciating-currency countries under historical 

translation than under current translation of foreign taxes. The reverse would be true for 

investments in appreciating-currency countries. 

Y',t = [2i*(l-T*)+i**(l-T*)ZIS, + i*T*[(S, +S2)(1-T*) - 2S2(l-T*)] (17) 

Historical translation of foreign taxes would therefore encourage investment in inflationary 

countries and discourage investment in deflationary countries relative to investments under 

current translation (assuming the taxpayer has a shortage of foreign tax credits). 

Accordingly, historical translation appears comparable to a net-worth method for subsidiaries, because it may indirectly recognize anticipated FEGL on unrepatriated investments. 

However, it is not a perfect extension because of deferral. Unlike the net-worth and 

profit-loss methods for branches, current and historical translation of foreign taxes will 

not necessarily yield the same total taxes over the time a subsidiary is established to the 

time it is liquidated. 

There are three problems with the tax treatment of foreign subsidiaries. First. deferral 

of recognition of unanticipated FEGL allows the taxpayer discretion over timing, so the fisc 

can be whipsawed no matter which method of translating foreign taxes is used. Second, even 
-15-

though historical translation attempts to accrue income, deferral of recognition of 

anticipated FEGL until the first dividend repatriation after a capital contrihrrtion can 

cause an inefficient capital allocation. Third, historical translation may peimi t the 

taxpayer to generate artificial gains and losses on subsidiary investments. Suppose a U.S. 

taxpayer has a shortage of foreign tax credits. The taxpayer may choose to repatriate 

income from a given country because unanticipated exchange rate movements in the time 

between income is eamed and the time it is repatriated have caused the effective foreign 

tax rate on that income to exceed the U.S.rate. If the taxpayer instead has excess foreign 

tax credits, it can repatriate from a country with an effective tax rate lower than the U.S. 

rate. Example three of the appendix shows that the taxpayer can generate an artificial loss 

or gain on the original investment abroad, even though at the time of repatriation the 

original investment has not changed in value, Therefore, historical translation of foreign 

taxes creates marginal tax incentives for repatriation where no economic incentive exists. 

V. U.S.LAW ON THE TAXATION OF FEGL 

A. General Tax Rule 

1. Timing of Recognition of FEGL 

U.S. tax law follows the optimal timing rule for certain foreign currency transactions 

denominated in the currencies of major trading partners. However, neither pre-TRA law nor 

TRA adopted the optimal rule of accruing FEGL, or the reformulated rule taxing anticipated 

FEGL annually and unanticipated FEGL upon realization, for other transactions or for 

affiliates. 

Pre-TRA law taxed all FEGL accrued on foreign currency contracts (such as forwards. 

futures, and options) denominated in yen, pounds sterling. Deutsche marks, guilders, Swiss 

francs, French francs, Canadian dollars, or the ECU. This rule remains intact in present 

law. (See 26 USC 1256.) However, before TRA, taxfmyers could recognize FEL on other 

transactions currently but defer recognition of FEG. Similarly, taxpayers could use 

either a net-worth or a profit-loss method to translate branch profit:’ and couldl;ranslate 

foreign taxes paid by subsidiaries at either current or historical exchange rates. Each 

of these rules not only allowed whipsawing of the fisc but also reduced the possibility of 

attaining worldwide efficiency. 

The President’s Tax Proposals (1985) advocated the reformulated timing rule of accrual 

taxation for anticipated FEGL and realization-based taxation for unanticipated FEGL on 

transactions. However, Congress implemented taxation upon realization for all FEGL from 

transactions other than foreign-currency contracts and from branches. This was done for 

administrative reasons. Although anticipated FEGL from short-term transactions could be 

reasonably well-determined by using forward exchange rates as proxies for expected future 

spot exchange rates, forward rates are not readily available for the long term. This makes 

estimation of expected future spot rates and anticipated FEGL for long-term transactions and 

affiliate investments difficult. A logical extension of the non-accrual system implemented 

for transactions and branch investments is current translation of foreign taxes attributable 

to repatriated subsidiary dividends. However, the new tax law is inconsistent because it 
-16-

requires historical translation of foreign taxes for subsidiary eamings, which resembles an 

accrual system. 

2. Source of FEGL 

The reformulated rules call for interest-based sourcing of anticipated FEGL and either 

domestic or foreign sourcing of unanticipated FEGL. Although these rules are fulfilled in 

present tax law for foreign affiliates (and also were for subsidiaries before TRA), they are 

not (and generally were not before TRA) for foreign-currency-denominated transactions. 

Before TRA, taxpayers could arrange to have all FEG from transactions be foreign-source 

(by passing title to the foreign currency abroad), and to have FEL allocated on the basis of 

the income generated by the foreign currency (domestic or foreign).19 Because income 

generated by foreign-currency transactions is generally foreign-source, both FEG and FEL 

were likely to have been foreign-source. FEGL on subsidiary investments were sourced as 

foreign, although the source of FEGL on branch investments was not explicitly established. 

In contrast with pre-TRA law, TRA sources all FEGL from transactions domestically. 

However, TRA sources all FEGL on foreign affiliate investments as foreign. 

3. Effects of TRA Timing and Source Rules 

To the extent currencies can be identified as appreciating or depreciating against the 

dollar and nominal changes in income enter the tax calculation, TRA rules can distort 

economic choices for transactions and branch investments because some FEGL are accrued and 

some are not, and because sourcing rules for anticipated FEGL on transactions are 

inconsistent with interest-sourcing rules. The manner of distortion depends on the 

taxpayer’s foreign tax credit position. 

For example, suppose a U.S. taxpayer has $X of dollar-denominated foreign-source income 

and $Y of dollar-denominated domestic-source income. It lends one unit of foreign currency. 

The following table shows the total tax it would expect to pay under the reformulated rule 

and under the TRA rules for So = 1 and R*, i*, i, and T constant. 

Suppose the taxpayer is in equilibrium under the reformulated rule. The TRA rules would 

induce a change in equilibrium behavior. If the taxpayer has excess foreign tax credits. 

the TRA rules for a given amount of lending would allow it to pay lower taxes if n*>O. To 

be in the same equilibrium tax credit position, the taxpayer would be willing either to 

increase lending of depreciating currencies (thus lowering the real retum below r for these 

currencies) or to lend to foreign countries with higher tax rates than T*, or both. 

Furthermore, because the taxpayer could recognize FEL (and thus lower taxable income) 

earlier under accrual, it would prefer to acquire more of certain types of foreign currency 

contracts. For instance, it could buy depreciating foreign currency forward. If the 

taxpayer instead has a shortage of foreign tax credits. under the TRA rules it could shift 

tax payment of (-n*T) from year one to year two for transactions in which FEGL are not 

accrued. Given a certain amount of lending, it would pay a lower discounted value of taxes 

for these transactions if K*<O. The taxpayer would therefore be willing to increase lending 

of appreciating currencies. 
+ 8

0 

P m

eG P

GI 

w m

-.-u

4, 57 

u 

Y 

n 

0% 

.. 

7 

* 
-1 8-

These results follow for two reasons. In the excess-credits case, the important factor 

in the TRA rules is domestic sourcing of FEL from lending depreciating currencies. which 

would increase the foreign tax credit limitation above the reformulated-rule level. 

Domestic sourcing would permit the taxpayer to lower its overall tax bill for a given amount 

of lending, In the shortage-of-credits case, sourcing would make no difference but the 

deferral of recognition of FEG from lending appreciating currencies would permit the 

taxpayer to lower the discounted value of its overall tax bill. 

More complicated cases could be constructed. For instance, a taxpayer could have an 

excess of credits under the reformulated rule but a shortage of credits under the TRA rule 

for non-accrued transactions if n*>O. For a given loan, it would pay lower tax under the 

TRA rule because the tax rate on foreign source income would be lower in both periods (T<T*) 

and the tax base in period two would be lower (Y+X+i* < Y+X+(l-n*)(i*-n*)-n*). It would 

therefore be willing to make more loans in inflationary currencies or to lend in higher-tax 

foreign countries. 

Similar incentives exist for borrowings and investments in foreign branches under the TRA 

rules. For borrowings, non-accrual is key. Borrowing in depreciating currencies would

lower taxes for a given amount of borrowing relative to the reformulated rule, no matter 

what the foreign tax credit position the borrower has, Interest payments would be 

artificially high in the periods before a transaction is closed, and only part of the 

expense would be allocated to foreign sources. If a borrower has excess foreign tax 

credits, it could inflate the foreign tax credit limitation in interim periods and lower 

U.S. taxes and therefore total taxes. At the close of the transaction, the result is that 

domestic income and therefore total taxes would be lower under the TRA rules for non-accrued 

transactions. If the borrower has a shortage of credits, worldwide income would be lower 

under TRA rules in interim periods. Cumulative taxes would be higher but deferred income 

recognition would make the present value of taxes over the entire period lower. 

For investments in foreign branches, non-accrual under the TRA rules is the only 

important factor. Presumably, i*-n * >O for investments (unless the tax distortion is 

extreme), so foreign allocation of FEGL under the TRA rules essentially parallels the 

reformulated sourcing rule, which nets interest income and anticipated FEGL and sources the 

net amount as foreign, Therefore, for taxpayers in an excess-credit position in all 

periods, the --ex ante investment decision would not be affected even under TRA’s profit-loss 

method. For those with a shortage of credits, the TRA rule would favor investment in 

appreciating-currency countries because recognition of anticipated FEG would be deferred. 

(If deferral of anticipated FEGL caused the foreign tax credit position to alternate between 

an excess and a shortage, the investment decision might also be affected.) 

Several factors mitigate the distortive effect of the TRA rules on transactions and 

branch investments. First, it is widely accepted (Dombusch 1978, 1980; Mussa 1979; Frenkel 

1981, 1982) that predicted changes in exchange rates account for a very small proportion of 

actual changes, at least for non-hyperinflationary currencies. This unpredictability makes 

it difficult for a taxpayer to identify currencies as appreciating or depreciating. 

especially over the long run. Hyperinflationary currencies are more predictable and TRA 

provides a special rule for transactions denominated in these currencies. Second. 

businesses that conduct foreign-currency operations maintain that they hedge their assets 

and liabilities, particularly long-term ones. As the next section points out, FEGL from 
-19-

hedging transactions are recognized currently because they are fully anticipated. Finally, 

at least for branch investments, non-accrual will not generally be responsible for 

inefficiency. The U.S. tax rate is now below that of most of her major trading partners. 

meaning that the majority of U.S. companies will have excess foreign tax credits. 

Therefore, the general constraint that the U.S. limits foreign tax credits to U.S. tax on 

foreign-source income rather than non-accrual of anticipated FEGL, will be the principal 2 0' 

cause of inefficiency. 

The TRA treatment of foreign subsidiaries may prove to be highly distortive, however. 

Although historical translation of foreign taxes is an attempt to accrue anticipated FEGL, 

deferral makes it impossible to do so perfectly. Historical translation also offers 

marginal tax incentives where no economic incentives exist. Finally, the asymmetric treatment of branches (which are taxed on a realization basis) and subsidiaries (which are taxed 

on a quasi-accrual basis) could skew organizational choices. 

B. Exceptions to the General Tax Rule 

The TRA rules for timing and sourcing are rationalized by the assumptions that 

administrative costs of separating unanticipated and anticipated FEGL are prohibitively 

large and that unanticipated FEGL are relatively more important than anticipated FEGL. In 

at least two cases, the reverse is true. First, if a taxpayer can hedge against currency 

fluctuations, its unanticipated FEGL are nil. Second, if a taxpayer lends a hypeiinflationary currency, anticipated FEL are likely to be very large and could easily be larger 

than unanticipated FEGL.*l 

TRA recognized these two cases and prescribed special rules that reinstate interest-based 

treatment for FEGL. Under IRS Notice 87-1 1 (1987), hedging transactions are integrated and 

treated as a single transaction. The timing, source, and character of FEGL are the same as 

2 2 in the analogous single transaction. The lending example in section III.A.3 provides a 

case in point. The taxpayer can lock in its expected FEG from lending foreign currency 

(abstracting from transactions costs) by hedging, perhaps through a forward sale of the 

foreign-currency interest and principal payments. An OID-type rule is applied under TRA and 

the foreign-source net yield is i*-n*, where -n* represents the locked-in FEG. 

An anti-abuse rule in TRA annually accrues FEL on loans denominated in a hyperinflationary currency (as under the optimal tax rule) if the loans are made to increase the 

foreign tax credit limitation artificially and she1ter other foreign-source income. 

Interest income is recharacterized as domestic-source to the extent of the FEL on the loan. 

This source rule differs from the reformulated rule. Under the reformulated rule. 

anticipated FEL offset interest income and are therefore foreign-source. Unanticipated FEGL 

could be either domestic- or foreign-source. The anti-abuse rule effectively offsets 

interest income by all realized FEGL up to the point where net interest income would be 

zero. This rule isthe same as the reformulated rule only if there are no unanticipated 

FEGL, and it is harsher for a taxpayer with excess foreign tax credits and unanticipated 

FEL. 
-- 

-20-

C. Character and Amount of FEGL 

Before TRA, the character of FEGL was important because ordinary and capital income were 

taxed at different rates. FEGL were characterized as ordinary income if the foreign 

currency was used as a part of the taxpayer’s trade or business. If not, taxpayers could 

appeal to IRS rules that FEG were capital gains, but to court decisions that FEL were 

23 ordinary losses. 

Because TRA removed the disparity in tax rates, the question of character is a relatively 

minor one. (For those interested in the exhaustive review of this topic, however, see 

O’Neill and Lee 1986.) In determining the amount of FEGL on long-term transactions, 

however, characterization issues are important if both FEGL and other gains or losses are 

realized. FEGL are generally characterized as ordinary income or loss by TRA, but other 

gains and losses on long-term transactions are capital. Suppose a taxpayer has FEG on a 

long-term bond that are perfectly offset by a capital loss. The bond yields no economic 

gain or loss. Because capital losses are allowed only against capital gains for 

corporations (individuals may take up to $3000 of capital loss against ordinary income), it 

seems that a corporate taxpayer would have to pay tax on the FEG. However, TRA imposes SL 

constraint that the amount of FEGL cannot be larger in absolute value than the total gain or 

loss realized on the transaction. In the example, both the FEG and the capital loss would 

be set to zero, resulting in no tax despite the limitation on capital losses. 

VI. SUMMARY AND CONCLUSIONS 

This paper develops an optimal rule for the taxation of foreign-currency-denominated 

income eamed through transactions and foreign affiliates from the standpoint of worldwide 

efficiency. The optimal rule, which would implement accrual taxation, is based on the 

assumptions of ex ante purchasing power parity, uncovered interest rate parity, and the 

Fisher relation equating expected real retums to nominal retums minus expected inflation. 

The optimal rule is reformulated in light of existing U.S. tax law. Four areas are 

considered: accrual of certain anticipated gains and losses but general recognition of 

unanticipated gains and losses only upon realization, limited carryover periods. deferral of 

U.S. tax on income received through foreign subsidiaries, and the U.S.’s primary taxing 

power over U.S.income. 

The first two considerations point toward accrual of anticipated FEGL but recognition of 

unanticipated FEGL only upon realization. As with capital gains, this treatment may permit 

whipsawing of the fisc and lead to non-neutrality among taxpayers. The third consideration 

makes direct recognition of anticipated FEGL from subsidiary investments on an accrual basis 

impossible. An indirect method is proposed which translates net dividends at the exchange 

rate in effect at the time of repatriation, but which translates foreign taxes attributable 

to the earnings producing the dividends at the exchange rate in effect when the taxes were 

paid. However, deferral of U.S. taxes on subsidiary earnings permits whipsawing. and 

”historical translation” of foreign taxes allows the taxpayer to generate ai-tificial gains 

and losses. 

The last consideration, the U.S.‘s unwillingness to allow foreign taxes to offset U.S. 

tax on U.S.income, brings forth the issue of sourcing of income and expense items. Under 
-21-

the reformulated rule, anticipated FEGL (which closely resemble interest income or expense 

under UIP) would be sourced as interest income or expense for purposes of the U.S.’s foreign 

tax credit. Unanticipated FEGL (which occur randomly under UIP) would be sourced as all 

foreign or all domestic. Domestic sourcing would be consistent with the rules for sourcing 

of other types of gains and losses. Because the U.S. will not credit foreign taxes 

exceeding the pre-credit U.S.tax on foreign-source income, worldwide efficiency may be 

unattainable if the foreign tax rate is greater than the U.S. tax rate solely because of the 

foreign tax credit limitation. 

U.S. tax law implements the optimal timing rule for certain transactions in major foreign 

currencies. It does not, however, adopt either the optimal or the reformulated timing rule 

for other transactions or for branches, nor does it apply the reformulated sourcing rule for 

transactions. Before the Tax Reform Act of 1986 (TU), taxpayers had to accrue FEGL on 

major-foreign-currency contracts such as forwards, futures, and options, but could choose 

any method of recognition they desired for other foreign-currency operations. Rather than 

interest-based sourcing for anticipated FEGL, all FEGL were generally foreign-source. 

Therefore, the allocation of capital was inefficient and there was a potential for 

whipsawing. TRA introduced new legislation on the taxation of FEGL that eliminates choices 

of method but continues to permit inefficient capital allocation and some types of 

whipsawing. FEGL from certain major-foreign-currency transactions are accrued as under 

prior law, but FEGL from most foreign-currency transactions and from foreign branch 

investments are recognized when realized. FEGL from subsidiary investments are partially 

recognized on an accrual basis, although deferral makes pure accrual difficult. Rather than 

interest-based sourcing for anticipated FEGL and domestic sourcing for unanticipated FEGL on 

transactions, TRA sources all FEGL from transactions domestically. 

The TRA rules can distort economic incentives for U.S. taxpayers. Lenders with excess 

foreign tax credits may be induced to lend more in depreciating currencies and to buy more 

depreciating-currency forward contracts, while those with a shortage of credits have an 

incentive to lend more in appreciating currencies than optimal. Borrowers may be induced to 

borrow more in depreciating currencies. Branch investments in appreciating-currency 

countries may be greater than optimal for investors with a shortage of foreign tax credits 

but will be unaffected for investors with excess foreign tax credits. These potential 

consequences are mitigated by the unpredictability of exchange rates, the exceptions to the 

non-accrual rule for certain transactions, and (for branches only) the predominance of 

investors with excess foreign tax credits. Two exceptions, for hedging transactions and 

loans in hyperinflationary currencies, reinstate the optimal rule of accrual-based taxation 

and interest-based sourcing because FEGL are largely anticipated in these cases. 

The TRA rules for unhedged transactions, hyperinflationary loans. and branches may be 

justified because the cost of administering an accrual-based system for these might exceed 

the loss from a realization-based system. In the case of subsidiaries. however. there are 

special problems. Although administrability arguments swayed Congress to choose 

realization-based taxation for transactions and branches. a quasi-accrual system was 

instituted for subsidiaries. As a result, taxpayers may be able to recognize artificial 

gains or losses. Moreover, the asymmetry in tax treatment of branches and subsidiaries 

could affect a U.S.company’s choice of organizational form for foreign affiliates. 
-- 

-- 

-22-

The analysis in the paper is based on simplifying assumptions: that purchasing power 

parity (PPP), uncovered interest parity (UIP), and the Fisher equations hold ex ante: that 

the U.S. taxpayer determines the rate of return everywhere; that all assets are taxed in the 

same fashion, and that all taxpayers bear a uniform rate of tax in the U.S. and abroad. Not 

everyone supports the assumptions of ex ante PPP and UIP. Additionally, foreign investors 

help determine rates of return, assets bear different effective tax rates, and the marginal 

taxpayer may bear effective tax rates larger or smaller than statutory rates. An extension 

of the analysis could consider these issues in formulating more general rules for the 

optimal taxation of FEGL. 
-23-

APPENDIX 

A. Examples 

1. Foreign Tax Credit Calculation 

The following example outlines three cases. In the first, U.S. tax liability on 

foreign-source income is exactly offset by foreign taxes. In the second, more foreign tax 

is paid on foreign-source income than the U.S.tax that would have been paid on the same 

income. In the third, less foreign tax is paid than would have been paid in the U.S. and a 

residual U.S.tax liability is incurred. 

Exact Offset Excess Credits Shortage of Credits 

Country

US A B 

Countq 

us A B 

Country 

us A B 

Taxable income $100 $100 $100 $100 $100 $100 $100 $100 $100 

Home-country tax 34 51 17 34 51 34 34 51 0 

After-home-tax income $66 $49 $83 $66 $49 $66 $66 $49 $100 

Worldwide income $300 $300 $300 

Pre-credit U.S.tax 102 102 102 

Foreign tax credit $68 $68 $5 1 

= Min(Taxes paid, $68 $85 $5 1 

limitation) 68 68 68 

Net U.S.tax $34 $34 $5 1 

Total taxes $102 $119 $102 

Average foreign 

tax rate 34 % 42.5 % 25.5 % 

2. Fluctuations in Tax Liability under the Net Worth Method if FEGL are 

Unanticipated 

The following example shows that, for the same dollar branch investment and the same 

time of establishment and liquidation, the net worth and profit-loss methods yield the same 

U.S. total tax (aside from timing) if all FEGL are unanticipated. However. annual U.S. tax 

liability varies substantially under the net worth method. 
--- --- 

-24-

Net Worth 

Initial investment 1 oox 

Initial exchange rate $l/lx 

Year 1 Year 2 Year 3 

Expected spot rate $l/lx $I/lx $l/lx 

Actual spot rate $.5/1x $1.5/1x $l/lx 

Gross income 10.00~ 10.66~ 1 I .36x 

Foreign tax 3.40~ 3.62~ 3.86~ 

Net income 6.60~ 7.04~ 7.50~ 

Net worth $53.30 $170.46 $12 1.14 

Net income -$46.70 $1 17.16 -$49.32 

Gross-up $1.70 $5.43 $3.86 

Gross income -$45.00 $122.59 -$45.46 

Pre-credit tax -$15.30 $41.68 -$15.39 

Net U.S. tax -$17.00 $36.25 -$19.25 

Liquidation amount $121.41 

(contributed capital and 

previously taxed income) 

Cumulative U.S. taxes paid $0.00 

Profit-Loss 

1oox 

$I/lx 

Year 1 Year 2 Year 3 

$I/lx $I/lx $I/lx 

$.5/1x $1.5/1x $l/lx 

10.66~ 11.36~ 1 1.36~ 

3.40~ 3.62~ 3.86~ 

6.60~ 7.04~ 7.50~ 

$3.30 $10.56 $7.50 

$1.70 $5.43 $3.86 

$5.00 $15.99 $I 1.36 

$1.70 $5.43 $3.86 

$0.00 $0.00 $0.00 

$121.41 

$0.00 

3. Distortive Effects of Historical Translation of Foreign Taxes When FEGL Are 

Unanticipated 

Suppose a U.S. parent has subsidiaries in foreign countries X and Y with corporate tax 

rates equal to the U.S. rate. Current exchange rates are $l/lx and $111~and are not 

expected to change, so that expected returns are the same in both countries. Suppose. 

however, exchange rates move unexpectedly during the period before dividends are repatriated 

but return to initial rates in the year of repatriation. The following example shows that. 

under historical translation of foreign taxes, the taxpayer has an incentive to repatriate 

from X if it has a shortage of foreign tax credits on other income (because it can generate 

an artificial loss on its investment) and from Y if it has excess foreign tax credits on 

other income (because it can generate an artificial gain on its investment). Under current 

translation of foreign taxes, no such incentives exist. 
--- --- 

-25-

Historical Translation of Foreign Taxes 

Gross income 

Foreign tax 

After-tax income 

Actual spot rate 

Net dividend 

Gross-up 

Gross dividend 

Pre-credit U.S. tax 

Foreign tax credit 

Net U.S.tax 

Effective foreign tax rate 

Gross income 

Foreign tax 

After-tax income 

Actual spot rate 

Net dividend 

Gross-up 

Gross dividend 

Pre-credit U.S.tax 

Foreign tax credit 

Net U.S. tax 

Effective foreign tax rate 

B. Table 

Country X Country Y 

Year 1 Year 2 Year3 Year 1 Year 2 Year 3 

10.00~ 10.66~ 11.36~ 10.00~ 10.66~ 1I .36y 

3.40~ 3.62~ 3.86~ 3.40~ 3.62~ 3.86~ 

6.60~ 7.04~ 7.50~ 6.60~ 7.04~ 7.50~ 

$.5/1x $131~ $I/lx $1.5/ly $.5/ly $I/ly 

$21.14 $21. I4 

$10.99 $10.77 

$32.13 $31.91 

$10.92 $10.85 

$10.99 $10.77 

-$0.07 $0.08 

34.2% 33.8% 

Current Translation of Foreign Taxes 

Country X Country Y 

Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 

10.00~ 10.66~ 11.36~ 1O.OOy 10.66~ 1 I .36y 

3.40~ 3.62~ 3.86~ 3.40~ 3.62~ 3.86~ 

6.60~ 7.04~ 7.50~ 6.60~ 7.04~ 7.50~ 

$.5/1x $1.5/1x $I/lx $1.5/ly $.5/ly $I/ly 

$2 I. 14 $21.14 

$10.88 $10.88 

$32.02 $32.02 

$10.88 $10.88 

$10.88 $10.88 

$0* 00 $0.00 

34.0% 34.0% 

The following table summarizes the tax rules discussed in the paper. 
VI 

0

5 

Q)
LL 

0 

E 

."Mc

YI 

-a *-

8 v 

v1 

a 

E 

Y3 x 

c 3 

.-

M 

b

E 

8 a 0 

E, 

VI 

0 

3 2u
-28-

FOOTNOTES 

1

Worldwide efficiency equates after-tax returns to different investments, Domestic efficiency 

instead equates before-domestic-tax domestic returns to after-foreign-tax foreign returns, because the 

return to a country is the sum of after-domestic-tax returns and domestic taxes. While a single 

country is better off using the domestic efficiency criterion if all other countries subscribe to 

worldwide efficiency, all countries together using a criterion of worldwide efficiency is optimal 

under an income tax system, See Musgrave and Musgrave (1984), pp. 76 1-4. 

2 Note that these assumptions are controversial. Although Roll (1979) and Frenkel (1981) support% 

-ante PPP, Cumby and Obstfeld (1984) do not. Moreover, although Frenkel (1981) and Levich (1978) 

genzrally endorse UIP, others do not. (See Cumby and Obstfeld 1984 for a review.) 

This allows me to make the standard assumption that a firm maximizes the expected net present 

value of an income stream, discounting by its real after-tax rate of return. 

4 Recall that TI -0 so dollar income equals real income. If K is not zero, optimal taxation would 

also require taxation of only real income from dollar operations. Because nominal dollar income is 

taxed in the U.S., R* would continue to represent FEGL relative to the dollar but would equal the 

difference between foreign and U.S. inflation in equations (6) and following. Accrual of anticipated 

FEGL would make the taxation of dollar and foreign-currency-denominated operations symmetric if TI is 

not zero and nominal dollar income is taxed, but the choice between pecuniary and non-pecuniary 

activities could be distorted. 

5 In a strict mathematical sense, this is true only if -(n*+r(l-T))<O. That is, the expected rate 

of deflation abroad cannot exceed the real after-tax return to domestic operations. 6 In the previous section, the taxpayer was assumed to reinvest earned after-tax income into the 

given operation. For direct transactions, this corresponds to incremental lending of principal by the 

tax a er. ':yThe method described abstracts from branch remittances. Provided all FEGL are anticipated, the 

net worth method would evaluate net worth before remittances to obtain the income inclusion, and 

remittances would come back without tax and without foreign tax credits. 

8 Only dividends from active income are being discussed. Passive income is treated as if it were 

distributed to U.S. shareholders as it is earned, similarly to branch income. See 26 USC 951-964. 

9 Some countries (such as the U.K.) attempt to tax each item of foreign-source income separately. 

Therefore, if the taxpayer had flO of foreign-source income taxed at 70 percent abroad and f10 taxed 

at 0 percent abroad, under the U.K. tax rate of 35 percent it would have excess foreign tax credits of 

f3.5 on the former and pay U.K. tax of f3.5 on the latter. Under an overall limitation, it would pay 

no U.K. tax and have no excess credits. The U.S. has an overall limitation for many types of income 

but segregates certain highly taxed income and certain lightly taxed income into separate "baskets" so 

that the taxpayer cannot average these types of income before calculating U.S. tax liability. 10The fraction cannot exceed one, If a taxpayer has domestic losses, it can take a foreign tax 

credit only up to the tentative U.S. tax liability on worldwide income. If for example worldwide 

income were zero in a given year, the foreign tax credit limitation would be zero and the taxpayer 

could not credit any foreign taxes that year. 11The principle underlying allocation of interest expense is fungibility of funds. A corporation 

financing the building of a plant in Britain could borrow from U.S. or British banks. Moreover. bank 

funds used to finance a British plant could have been borrowed so that the corporation could internally fund the building of a plant in Peru. Therefore, the attribution of the interest expense to 

forei n or domestic sources is not based on the location of borrowing. 1 8Problems with interest-based sourcing of unanticipated FEGL would arise if. for instance. 

unanticipated FEG on a borrowing exceeded the stated interest payments. Net interest expense would 

then be negative and it is unclear whether interest-based sourcing of unanticipated FEGL would call 

the net amount interest income or would allocate a negative amount to foreign and domestic soitrces. 
-29-

13I have assumed that an investment in a given country is denominated in the currency of that country. Under present U.S. law, each business unit of a U.S. taxpayer is required to keep its records in 

terms of its functional currency, or the currency in which it conducts the bulk of its business. This 

concept was introduced in the Statement of Financial Accounting Standards No. 52: Foreign Currency 

Translation (1980) and was borrowed by the Treasury Department Discussion Draft on Taxing Foreign 

Exchange Gains and Losses (1980). Therefore, a Japanese branch may be required to keep records in 

terms of dollars instead of yen if most of its transactions are in dollars. This does not change the 

thrust of the analysis. 14 In this section, I use $e approximation e'-(] +q) for q small, so interest earned over a period 

is iven as i* rather than el -1.

55 I am assuming a given pattern of dividend repatriation and liquidation. These patterns will of 

course be endogenous. 16Both precedents were established in the U.S.Court of Appeals for the Sixth Circuit. The court 

allowed current recognition ofFEL in National-Standard Co. v. Commissioner, 80T.C. 551 (1983), aff'd 

749 F.2nd 369 (6th Cir. 1984). However, inKentucky & IndianaTerminal Railroad Co. v. U.S. 330F.2d 

520 (6th Cir. 1969), FEG was ruled to be income from the discharge of indebtedness. Under 26 USC 108 

and 1017, such income is not recognized currently. 1 7The net worth method as it was applied also caused problems. Long-term assets and liabilities 

were translated at historic exchange rates, in accordance with generally accepted accouiiting 

principles. Therefore, if a foreign branch in a depreciating-currency country had short-term assets 

exceeding short-term liabilities and long-term liabilities exceeding long-term assets, the calculated 

change in dollar net worth would have been greater in absolute value than the actual change. If the 

opposite were true, the calculated change would have been less in absolute value than the actual 

chan e. 1BCurrent translation was prescribed in Bon Ami Co. v. Commissioner, 39 B.T.A. 825 (1939), and historical translation in H.H. Robertson & Co., 59 T.C. 53 (1972), and American Metal Co., 21 F.2d. 134, 

14iJ2d. Cir. 1955). 

These rules evolved from a somewhat strained interpretation of rules on property disposition. 

See2i6 CFR 1.861-7 and 1.861-8(e)(7). 

There is one way that sourcing causes problems with affiliates. FEGL from transactions conducted 

by an affiliate affect the total amount available for distribution to the parent. However, no FEGL 

arise for the parent directly. U.S. parents may attempt to conduct transactions that yield FEG 

through foreign branches and ones that yield FEL through domestic offices in order to increase their 

forei n tax credit limitation and lower U.S. tax liability. 2 8Not only are anticipated FEGL likely to outweigh unanticipated FEGL for these transactions, the 

risk of currency fluctuation could easily be eliminated by having a wholly owned foreign subsidiary 

borrow in the same currency. The lender has doniestic-source FEL on the loan. However, the hedge is 

not integrated under the hedging rules because the subsidiary and its parent are separate taxpayers, 

so the FEG the subsidiary receives are not recognized by the parent as long as they are not 

repatriated. Although economic loss matches economic gain, the loss is recognized currently while 

recognition of the gain is deferred. Moreover, the gain will generally be characterized as 

foreign-source income, which will increase the foreign tax credit limitation in the year of 

reco nition.

2 9Offsetting balance-sheet items, or "balance-sheet hedges, " are prevalent among financial 

institutions and have not yet been addressed by regulation. 23Before TU, FEGL were ordinary income if foreign currency was used in business under -1 

Products Refining Company v. Commissioner, 350 U.S. 46 (1958). Otherwise. the IRS held that FEGL 

were capital income (Rev. Rul. 78-396. 1978-2 C.B. 114; Rev. Rul. 78-281, 1978-2 C.B. 204: G.C.M. 

39294, June 15, 1984) while the courts held that FEL were ordinary income (Natioiial-Standard. supra.). 

IRS Notice 87-68 (1987) has suspended all revenue rulings that rely on or apply the "Corn Products 

Doctrine." 
-30-

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