For Tax Professionals  
T.D. 8860 January 13, 2000

Treatment of Income & Expense From Certain Hyperinflationary,
Nonfunctional Currency Transactions &
Certain Notional Principal Contracts

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8860] RIN 1545-AP78

TITLE: Treatment of Income and Expense From Certain
Hyperinflationary, Nonfunctional Currency Transactions and Certain
Notional Principal Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations regarding the
treatment of income and deductions arising from certain foreign
currency transactions denominated in hyperinflationary currencies
and coordinates section 988 with the section 446 regulations
pertaining to significant nonperiodic payments. These regulations
are intended to prevent distortions in computing income and
deductions of taxpayers who enter into certain transactions in
hyperinflationary currencies, and nonfunctional currency, notional
principal contracts with significant nonperiodic payments.

DATES: These regulations are effective February 14, 2000.

FOR FURTHER INFORMATION CONTACT: Roger M. Brown at (202) 622-3830
(not a toll-free number) of the Office of the Associate Chief
Counsel (International) within the Office of the Chief Counsel, Room
4554, 1111 Constitution Avenue, NW., Washington, DC. 20224.

SUPPLEMENTARY INFORMATION:

Background

On March 17, 1992, proposed regulations were published in the
Federal Register at 57 FR 9217 (INTL-15-91). The IRS received two
written comments on the proposed regulations, which are discussed
below. No public hearing was held and no requests to speak were
received.

Having considered the comments, the IRS and Treasury Department
adopt the proposed regulations, as modified by this Treasury
decision.

Explanation of Provisions

I. Hyperinflationary Instruments

A. Proposed Regulations

The proposed regulations under 1.988-2(b)(15) generally provided
that currency gain or loss on debt instruments and demand deposits
entered into or acquired when the currency in which the item was
denominated was hyperinflationary must be realized annually under a
mark-to-market methodology. For purposes of determining the
character and source (or allocation) of such currency gain or loss,
the gain or loss was generally treated as an increase in, or a
reduction of, interest income or expense.

The proposed 1.988-2(b)(15) regulations excluded instruments
described in section 988(a)(3)(C) (relating to non-dollar, related-
party loans where the rate of interest is at least 10 percentage
points higher than the Federal mid-term rate) from these rules.
Proposed regulations 1.988-2(d)(5) and (e)(7) generally provided
that currency gain or loss realized with respect to section 988
forward contracts, futures contracts, option contracts and similar
items (such as currency swap contracts) entered into or acquired
when the currency in which such an item is denominated was
hyperinflationary was recognized annually under a mark-to-market
methodology.

B. Discussion of Comments and Final Regulations

1. Comments and the Treasury and IRS's responses

One of the comments responding to the proposed regulations
criticized the exclusion of loans described in section 988(a)(3)(C)
from the rules of proposed regulation 1.988-2(b)(15).

The comment noted that it was inappropriate to treat related-party
loans differently from loans between unrelated parties in this
context.

Proposed regulation 1.988-2(b)(15) excluded loans subject to
section 988(a)(3)(C) from the mark-to-market rule of the proposed
regulations because the loans were already subject to mark-to-market
treatment under section 988(a)(3)(C), which was enacted to prevent
manipulation of the section 904(a) foreign tax credit limitation
through related party loans with artificially high interest rates.
See H. Conf. Rep. No. 841, 99 Cong., 2d Sess. 668 (1986). However,
due to th interest income's U.S. source treatment under section
988(a)(3)(C)(ii), mark-to-market treatment under section 988(a)(3)
(C), rather than 1.988-2(b)(15), would be, in most cases, more
unfavorable to taxpayers.

Since the rules of proposed regulation 1.988-2(b)(15) were
consistent with the approach of section 988(a)(3)(C) and prevented
manipulation of the type Congress addressed in that section, the IRS
and Treasury agree that transactions described in section 988(a)(3)
(C) should not be excluded from the mark-to-market rule of the final
regulations. The IRS and Treasury also have concluded that to the
extent a debt instrument is subject to the rules of 1.988-2(b)(15),
the application of section 988(a)(3)(C)'s resourcing rule is not
necessary. The final regulations reflect these changes.

The other comment identified the need for coordinating the mark-to-
market regime for hyperinflationary instruments under proposed
regulation 1.988-2(b)(15), and the mark-to-market election under
proposed regulation 1.988-5(f) for all section 988 transactions.
The final regulations do not include a rule coordinating these two
mark-to-market regimes because the mark-to-market election for all
section 988 transactions is still in proposed form. Accordingly, the
IRS and Treasury have decided that consideration of the proper
coordination is most appropriate when the regulations relating to
the general mark-to-market election for all section 988 transactions
are finalized.

2. Other changes to the final regulations

(a) Source and Character of Gain or Loss

The proposed regulations provided that any exchange gain or loss
realized upon marking to market a debt instrument or a demand
deposit under proposed regulation 1.988-2(b)(15)(i) was to be
directly allocable to the interest income or interest expense from
the debt instrument or deposit. Accordingly, the gain or loss
reduced or increased the amount of interest income or interest
expense paid or accrued during that year with respect to that
instrument or deposit.

Additionally, if realized exchange gain exceeded interest expense of
an issuer, or realized exchange loss exceeded interest income of a
holder or depositor, the character and source of such excess amount
were to be determined under the general rules of 1.988-3 and
1.988-4.

The assumption underlying this proposed treatment was that in
hyperinflationary conditions, high nominal interest rates perform
two functions: compensate lenders for currency loss attributable to
the repayment of the principal with a devalued currency, and account
for borrowers' currency gain on the repayment of the principal with
a devalued currency. In instances, however, where hyperinflationary
conditions are subsiding and a lender would actually have currency
gain on principal repayment (and the borrower would have currency
loss on principal repayment), these assumptions are no longer
appropriate. For example, if a lender has currency gain on the
marking to market (for currency fluctuations only) of the principal
of a debt instrument, high nominal interest rates would not be
compensating the lender for the decline in the value of the
principal as there would be a gain on the principal.

Accordingly, the final regulations retain the source and character
rule of the proposed regulations (direct allocation of the exchange
gain or loss against interest expense or income, respectively) when
hyperinflationary conditions result in exchange loss to lenders or
exchange gain to borrowers on the principal amount of a debt
instrument or deposit. However, where a lender has exchange gain or
a borrower has exchange loss on the debt instrument -- which may
occur as hyperinflationary conditions subside -- the final
regulations clarify that the exchange gain or loss is not allocated
against interest expense or income. Rather, the exchange gain or
loss is treated under the normal currency character and source rules
of 1.988-3 and 1.988-4. Thus, for example, 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.

(b) Synthetic, Non-hyperinflationary Currency Debt Instruments

The final regulations also make clear that when a debt instrument
has interest and principal payments that are to be made by reference
to a non-hyperinflationary currency or item (commonly known as
interest and principal protection features), the instrument is not
marked to market under the final section 988 regulations. This is
because the instrument is, in substance, a synthetic non-
hyperinflationary instrument and does not experience the distortions
associated with a hyperinflationary instrument.

(c) Treatment of Hyperinflationary Contracts Proposed regulation
1.988-2(d)(5) generally provided that currency gain or loss on
derivative contracts described in 1.988-1(a)(2)(iii) and
denominated in a currency that was hyperinflationary at the time the
contract was entered into was to be realized annually under a mark-
to-market methodology. This proposed regulation was issued prior to
promulgation of the 1.446-4 regulations (published in the Federal
Register on July 18, 1994) which requires that, to clearly reflect
income, the timing of income, deduction, gain or loss on a hedge
must match the timing of income, deduction, gain or loss on the item
being hedged. The final regulations modify proposed regulation
1.988-2(d)(5) by providing that 1.446-4, to the extent applicable,
will take precedence over proposed regulation 1.988-2(d)(5). This
is because the IRS and Treasury believe that a clearer reflection of
income is present where the income and deductions arising from an
item hedged under 1.446-4 is matched with the income and deductions
arising from the hedge. See 1.446-4(b).

(d) Demand and Time Deposits

The proposed regulations applied the mark-to-market rules to demand
deposits denominated in a currency that was hyperinflationary at the
time the deposit was entered into. Under the final regulations, the
mark-to-market rules apply to demand and time deposits that provide
for payments denominated in or by reference to a currency which is
hyperinflationary at the time the taxpayer enters into or otherwise
acquires the deposit, or whose interest rate reflects
hyperinflationary conditions in a country. Similar clarifications
have been made with respect to the definitions of hyperinflationary
debt instruments and currency swap contracts.

3. Abusive transactions

The Treasury and the IRS are concerned about the use of
hyperinflationary currencies in transactions motivated by tax
considerations. Because the direction of exchange rates is
relatively predictable in hyperinflation economies, some taxpayers
have attempted to use such currencies in transactions lacking
economic substance. See, e.g., Agro Science Co. v. Commissioner,
T.C. Memo. 1989-687, aff'd, 927 F.2d 213 (5 Cir.), cert. denied, 502
U.S. 907 (1991). However, th section 988 may be applied by the IRS
in a manner that reflects the proper timing, source, and character
of income, gain, loss, or expense arising from a transaction whose
form is not in accordance with its economic substance. 1.988-1(a)
(11) and 1.988-2(f); Agro Science Co. v. Commissioner, supra.
Accordingly, the rules contained in this Treasury decision will be
applied within the framework of these general economic substance
principles.

II. Significant Non-periodic Payments and Currency Swaps The
proposed regulations coordinated section 988 with the section 446
regulations pertaining to significant nonperiodic payments. The
final regulations maintain this coordination and clarify that
exchange gain or loss may be realized on the principal and interest
components of a significant nonperiodic payment.

III. Proposed Change to Base Period in Notice of Proposed Rulemaking
Elsewhere in this issue of the Federal Register, the IRS and
Treasury are publishing a notice of proposed rulemaking that
proposes to change the period during which inflation rates are
measured in the determination of whether a currency is
hyperinflationary for purposes of section 988 (base period). The
effect of this change to 1.988-1(f) (defining hyperinflationary
currency for purposes of section 988) is to take into account
current year, hyperinflationary conditions, rather than determining
whether a currency is hyperinflationary based on the three years
prior to the current year. The proposed change relates only to
section 988 and not to the dollar approximate separate transactions
method of 1.985-3 (DASTM). However, other sections, such as
1.267(f)-1(e) (relating to application of the loss disallowance
rule of section 267(a)(1) as applied to related party, nonfunctional
currency loans), which make reference to the section 988 definition
of hyperinflation will be affected.

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It has also been
determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C.
chapter 6) do not apply to these regulations, and, therefore, a
Regulatory Flexibility Analysis is not required. Pursuant to section
7805(f) of the Internal Revenue Code, the notice of proposed
rulemaking preceding these regulations was submitted to the Small
Business Administration for comment on its impact on small
businesses.

Drafting Information

The principal author of these regulations is Roger M. Brown of the
Office of the Associate Chief Counsel (International). However,
other personnel from the IRS and Treasury Department also
participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of the Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read, in
part, as follows: Authority: 26 U.S.C. 7805 ***

Par. 2. Section 1.988-0 in the Table of Contents is amended by:

1. The entry for 1.988-2(b)(14)-(15) is removed.

2. An entry for 1.988-2(b)(14) is added.

3. An entry for 1.988-2(b)(15) is added.

4. The entry for 1.988-2(d)(5) is revised.

5. The entry for 1.988-2(e)(7) is revised.

The revisions and additions read as follows: 1.988-0 Taxation of
gain or loss from a section 988 transaction; Table of Contents.

* * * * *

1.988-2 Recognition and computation of exchange gain or loss.

* * * * *

(b) ***

(14) [Reserved]

(15) Debt instruments and deposits denominated in hyperinflationary
currencies.

* * * * *

(d) ***

(5) Hyperinflationary contracts.

(e) ***

(7) Special rules for currency swap contracts in hyperinflationary
currencies.

* * * * *

Par. 3. Section 1.988-2 is amended by:

1. Adding paragraphs (b)(14) and (b)(15).

2. Adding paragraph (d)(5).

3. Adding paragraph (e)(3)(iv).

4. Adding paragraph (e)(7).

The additions read as follows: 1.988-2 Recognition and computation
of exchange gain or loss.

* * * * *

(b) ***

(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: Example. When the Turkish lira (TL) is a
hyperinflationary currency, A, a U.S. corporation with the U.S.
dollar as its functional currency, makes a 5 year, 100,000 TL-
denominated loan to B, an unrelated corporation, at a 10% interest
rate when 1,000 TL equals $1. Under the terms of the debt
instrument, B must pay interest annually to A in amount of Turkish
lira that is equal to $100. Also under the terms of the debt
instrument, B must pay A upon maturity of the debt instrument an
amount of Turkish lira that is equal to $1,000. Although the
principal and interest are payable in a hyperinflationary currency,
the debt instrument is a synthetic dollar debt instrument and is not
subject to paragraph (b)(15)(i) of this section.

(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.

* * * * *

(d) * * *

(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) ***

(3) ***

(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.

* * * * *

(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. Paragraph
(e)(7) applies to transactions entered into after February 14, 2000.

Robert E. Wenzel
Deputy Commissioner of Internal Revenue
Approved: 12-13-99
Jonathan Talisman
Acting Assistant Secretary of the Treasury


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