Tax Quarry

International tax rules can get very complicated, especially if a person - individual or corporation- is carrying on a business in a foreign country and is a resident of a country that levies taxes on worldwide income, such as the United States for example.  In this situation, local reporting rules, regulations and standards, as well as the US reporting requirements must be considered when filing a return.   In addition, reporting obligations for any person falling into this category is further complicated when dealing with different currencies. 

There are a number of provisions in the Internal Revenue Code (“the Code”) that govern foreign currency transactions and appropriate conversion methods.  In general, the rules provide that:

(a)    Federal tax determinations must be made in a taxpayer’s “functional currency”.  A taxpayers functional currency can be represented by US Dollars or the currency used for substantial business operations;

(b)   Separately identifiable business operations, otherwise known as Qualified Business Units (“QBU”), must determine their taxable income in their functional currency.  These QBUs must use the profit and loss method of accounting;

(c)    Gains and losses from currency translation are recognized when income is remitted from a branch or distributed from a foreign corporation;

(d)   Exchange gain or loss is taken into account when an activity that was conducted in a foreign currency is closed; AND

(e)   A separate transaction method of accounting should be used for operations not conducted in the businesses functional currency

Where a QBU is engaged in a particular activity in a country with a foreign currency that is different from the US dollar special rules apply.  An eligible QBU is defined as a corporation, partnership or disregarded entity separate from its owner if:

(i)                  Its activities constitute a trade or business:  A facts and circumstances test is applied to determine what functional currency should be used for the business.  Among the factors that are considered are whether (i) the specific unified group of activities constitute an independent enterprise carried on for profit; (ii) the activities are part of a single unit that will be deductible under section 162 or section 212 of the Code; and (iii) the activities ordinarily include every operation that forms a part of, or are a step in, an enterprise’s income generating process, such as collecting income and paying taxes

(ii)                It maintains a separate set of books and records for its activities and assets:  This includes books of original entry and ledger accounts, both general and subsidiary, or similar records

(iii)               It does not use DASTM to account for its foreign currency transactions

 Once a QBU has been identified, it is important for a taxpayer to determine whether it is an owner of the QBU.  In addition to the construction ownership rules that may apply, a corporation is likely to be treated as the owner of a QBU if it meets the following conditions: 

(a)    It is the tax owner of the assets and liabilities of the eligible QBU. 

(b)   It is a QBU that is held anywhere in a chain of DEs

(c)    It is a QBU held by a partnership in which the owner is a partner

You should take note of a few additional points about QBUs.  First, one QBU cannot be treated as the owner of another QBU.  Also, an owner can elect to treat all section 987 QBUs with the same functional currency as a single QBU.  And, the profit and loss method of section 987 treats only the portion of gain or loss measured in foreign currency as immediately realized. 

Marsha Henry ©
June 5, 2012