The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments on the collection of information should be received by November 6, 2006. Comments are requested specifically concerning:

Whether the proposed collection of information is necessary for the proper performance of the functions of the Internal Revenue Service, including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed collection of information (see below);

How the quality, utility, and clarity of the information to be collected may be enhanced;

How the burden of complying with the proposed collection of information may be minimized, including through the application or automated collection techniques or other forms of information technology; and

Estimates of capital or start-up costs and costs of operation, maintenance, and purchase of service to provide information.

The collection of information in these proposed regulations is in §§1.987-1(b)(1)(ii), 1.987-1(b)(2)(ii), 1.987-1(c)(1)(ii), 1.987-1(f), 1.987-3(b)(1), 1.987-9, 1.987-10 and 1.987-11. Section 1.987-1(b)(1)(ii) allows a partner to make an election not to take section 987 gain or loss into account. Section 1.987-1(b)(2)(ii) allows a taxpayer to make an election to group certain QBUs with the same functional currency as a single QBU. Sections 1.987-1(c)(1)(ii) and -3(b)(1) allow a taxpayer to make an election to use a convention for exchange rates. Section 1.987-11(b) allows a taxpayer to elect to apply these regulations to taxable years beginning after the date of publication of a Treasury decision adopting this rule as a final regulation in the Federal Register. The preceding elections are to be made pursuant to §1.987-1(f) by attaching a statement to the taxpayer’s tax return describing the election to be made. Section 1.987-9 contains recordkeeping rules to establish a qualified business unit’s income and section 987 gain or loss. This collection of information is required to establish the qualified business unit’s income, gain, deduction or loss and assets and liabilities as well as exchange rates used for foreign currency translation purposes. Section 1.987-10 provides rules for transitioning to the method provided under the new proposed regulations for determining section 987 gain or loss and provides certain corresponding reporting rules. The collection of information contained in this regulation facilitates the identification of the prior method used by the taxpayer to determine section 987 gain or loss. The collections of information are mandatory. The likely respondents are taxpayers with foreign qualified business units.

Estimated total annual reporting burden: 12,000.

Estimated average annual burden hours per respondent: 12.

Estimated number of respondents: 1,000.

Estimated annual frequency of responses: annually.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

Books and records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

As part of the Tax Reform Act of 1986, Public Law 99-514, 100 Stat. 2085 (October 22, 1986), 1986-3 C.B. Vol.1, 1, see §601.601(d)(2), Congress enacted comprehensive reforms to the tax treatment of foreign currency transactions by adding new subpart J. Those reforms included, among other things, the introduction of the functional currency concept, which generally distinguishes taxpayers on the basis of the primary currency in which they keep their books and records and conduct their business. Reforms also included the addition of the qualified business unit (QBU) concept, which generally provides a basis for allowing a taxpayer with a separate unit that conducts business and keeps books and records in a currency other than the functional currency of the taxpayer to account for the results of operation of the separate unit in the unit’s own functional currency. Against that conceptual background, section 988 provides rules for the treatment of transactions in a currency other than the taxpayer’s functional currency. Section 986 generally provides rules for translating into U.S. dollars the earnings and profits and foreign taxes of a foreign corporation whose functional currency is not the U.S. dollar (dollar). Section 987, in turn, generally provides rules for determining and translating income and currency gain and loss with respect to operations of a branch whose functional currency is other than the functional currency of the taxpayer. As discussed below, an already complex area of law was made even more complicated when the entity classification rules under §301.7701-1 through 301.7701-3 (the “check the box” regulations) were promulgated in 1997.

On September 25, 1991, the IRS and the Treasury Department issued proposed regulations under section 987 (the 1991 proposed regulations). See 56 FR 48457. In light of subsequent IRS experience with taxpayer claims of large non-economic currency losses under section 987, the IRS and the Treasury Department issued Notice 2000-20, 2000-1 C.B. 851. See §601.601(d)(2). This notice expressed serious concern that the 1991 proposed regulations had not fully achieved the original goal of facilitating recognition of true economic foreign currency gain and loss under appropriate circumstances and requested comments on this issue and other matters.

This document withdraws the 1991 proposed regulations and provides new proposed regulations based on the “foreign exchange exposure pool” method. The IRS and the Treasury Department believe that this method more accurately reflects foreign currency gain and loss than the 1991 proposed regulations and does so in a manner consistent with statutory authority and legislative intent. These new proposed regulations are designed to prescribe more precisely foreign currency gain and loss that is economically realized, while minimizing or eliminating the realization of non-economic currency gain and loss.

The following background discussion describes section 987, its legislative history, the 1991 proposed regulations, Notice 2000-20, and the general approach that provides the basis for the foreign exchange exposure pool method.

Section 987 generally provides that in the case of a taxpayer having a QBU with a functional currency other than that of the taxpayer, the taxable income of the taxpayer with respect to the QBU is determined by computing the taxable income or loss of the QBU separately and translating such income or loss at the appropriate exchange rate. Section 987 further requires the taxpayer to make “proper adjustments” (as prescribed by the Secretary) for transfers of property between QBUs having different functional currencies including treating post-1986 remittances from each such unit as made on a pro rata basis out of post-1986 accumulated earnings; treating section 987 gain or loss as ordinary income or loss; and sourcing such gain or loss by reference to the source of the income giving rise to post-1986 accumulated earnings.

As described in the applicable legislative history,^[1] section 987 was enacted against a background of, and partly in reaction to, perceived shortcomings with prevailing law. The prevailing law at that time was fairly limited. It consisted primarily of two revenue rulings that provided alternative methods for calculating branch taxable income.

Rev. Rul. 75-106, 1975-1 C.B. 31, see §601.601(d)(2), provides for the use of a “net worth” method. Under this method, taxable income of a branch of a domestic corporation engaged in business in a foreign country is defined generally as the difference between the branch’s opening and closing net worth as reflected on the branch’s balance sheets for the taxable year. Under this method, the branch’s balance sheet is translated into U.S. dollars. In general, the values of current items (such as cash or cash flows denominated in foreign currency) are translated at the year-end exchange rate, and the values of historical items (such as equipment) are translated at the exchange rate for the period in which the item was acquired or incurred. The translation of an item at the year-end rate causes changes in the item’s value due to currency fluctuations to be taken into account annually, and the translation of an item at the historical rate generally precludes recognition of fluctuations in value due to changing exchange rates. In this way, the net worth method was able to identify items considered economically exposed to fluctuations in exchange rates. The total change in net worth identified by the net worth method is equal to the sum of the operating profit or loss of the branch and the exchange gain or loss on current items. However, the net worth method does not identify separate items of income and expense because it is based solely on a balance sheet comparison and does not use a profit and loss statement.

Rev. Rul. 75-107, 1975-1 C.B. 32, see §601.601(d)(2), provides for the use of a “profit and loss” method. Under this method, the branch computes taxable income by translating the local currency profit and loss statement (adjusted for U.S. tax principles) into dollars. Any portion of the profit and loss remitted to the home office during the year is translated at the exchange rate on the date of the remittance, and the remainder is translated at the year-end exchange rate. No exchange gain or loss is recognized on a remittance.

The net worth method of Rev. Rul. 75-106 and the profit and loss method of Rev. Rul. 75-107 each suffered from infirmities. The net worth method resulted in the realization of foreign currency gain and loss that was not consistent with the general realization principles of the Code; it also failed to accurately characterize items of income, gain, deduction or loss of the branch. The profit and loss method, in turn, did not take into account foreign currency gain and loss inherent in the assets and liabilities on the balance sheet as part of such method. Both methods failed to account for foreign currency gain or loss in the event of a remittance.

The legislative history states that under section 987, a taxpayer with a QBU whose functional currency is other than the functional currency of the taxpayer will be required to use a profit and loss method, rather than the net worth method (as this method was understood at the time). House Report (1986-3 C.B. Vol. 2, 479); Senate Report (1986-3 C.B. Vol. 3, 470); and Conference Report (1986-3 C.B. Vol. 4, 675). See §601.601(d)(2). However, this legislative history is not properly read as an explicit rejection of the net worth method in its entirety. Instead, it is more accurately viewed as a rejection of certain aspects of the law prevailing at that time. Importantly, the method provided in section 987 as enacted actually represents a blend of the separate methods, as it has aspects of both a net worth method and a profit and loss method. It also has at least one feature absent from each method—that is, section 987 includes the remittance recognition concept. Consistent with a profit and loss method, sections 987(1) and (2) generally determine the items of income or loss of a QBU based on its profit and loss statement as determined in its functional currency. Such items are then translated into the taxpayer’s functional currency at the appropriate rate.^[2] Consistent with a net worth method, section 987(3) requires that exchange gain or loss be computed with respect to certain branch assets and liabilities (as prescribed by the Secretary). Unlike either method, section 987(3)(A) provides that exchange gain or loss is recognized upon a remittance.

The blending of features of both a profit and loss method and of a net worth method in section 987 is significant. Together with more specific principles identified in the legislative history, this blending of methods informs the Congressionally stated preference for the profit and loss method. The House Report states:

House Report at 469.

The House and Senate reports are generally uniform in describing Congressional intent with regard to the computations required under section 987 as illustrated by the Senate Report.

Senate Report (1986-3 C.B. Vol. 3, 470). Importantly, the Conference Report modifies the House and Senate reports by stating that a remittance by a QBU “will trigger exchange gain or loss inherent in accumulated earnings or branch capital.” Conference Report, 1986-3 C.B. Vol. 4, 675.

From section 987 and the foregoing legislative history, several principles emerge:

Comments to the IRS and the Treasury Department have suggested that the computation under section 987 of exchange gain or loss for a branch is intended to operate in the same manner as the computation under section 986(c) of certain exchange gain or loss of a foreign corporation. In general, section 986(c) provides for the recognition of exchange gain or loss only with respect to distributions of previously taxed earnings and profits (as described in section 959 or 1293(c)). The Conference Report includes the following general statement about the translation rules:

Conference Report, 1986-3 C.B. Vol. 4, 670. See §601.601(d)(2). The suggestion in comments is to apply this general principle such that section 987 would require the recognition of exchange gain or loss only with respect to branch earnings and not with respect to contributed capital.

Despite the broad statements of principle quoted above, Congress provided more specific guidance regarding the treatment of branches in this regard. The Conference Report states that a remittance by a QBU “will trigger exchange gain or loss inherent in accumulated earnings or branch capital.” Conference Report, 1986-3 C.B. Vol. 4, 675. See §601.601(d)(2). Similarly, despite the stated requirement that QBUs must use a notional profit and loss method to determine branch taxable income, the specific method actually provided in section 987 and described in the legislative history represents a blend of a net worth method and a profit and loss method. Accordingly, the IRS and the Treasury Department believe that the more specific statements made by Congress regarding the treatment of branch exchange gain or loss reflect an intention that the methodologies of section 986(c) and section 987 not be identical.

The 1991 proposed regulations provide generally that the net income of a QBU having a functional currency different than the taxpayer is determined annually. Such determination is based on the profit and loss appearing on the QBU’s books and records, adjusted to conform to U.S. tax principles, and translated into the functional currency of the taxpayer using the weighted average exchange rate for the taxable year. The 1991 proposed regulations also provide for the recognition of exchange gain or loss upon a remittance from the QBU’s equity pool. In general, the equity pool consists of the undistributed capital and earnings of the QBU, determined in the QBU’s functional currency. The 1991 proposed regulations also provide for a basis pool, which consists of the basis of the capital and earnings in the equity pool, expressed in the functional currency of the taxpayer. The portion of the basis pool, expressed in the functional currency of the taxpayer, that is attributable to a remittance is generally determined according to the following formula:

Section 987 gain or loss is the difference between the value of the remittance from the QBU translated into the taxpayer’s functional currency at the spot rate on the date the remittance is made, less the basis associated with the remittance as determined above. One important consequence of the equity pool paradigm is that all branch equity gives rise to exchange gain or loss, regardless of whether or not that equity is held in a form that actually exposes the QBU’s owner to currency fluctuations (compare assets such as cash or indebtedness to assets such as equipment).

Under the 1991 proposed regulations, a taxpayer must determine the source and character of section 987 gain or loss for all purposes of the Code, including sections 904(d), 907, and 954, by using the same method the taxpayer uses to allocate and apportion its interest expense under section 861, with certain modifications.

Effective January 1, 1997, the IRS and the Treasury Department issued the check the box regulations implementing new elective entity-classification rules. These regulations made it possible for certain entities with a single owner to be treated for federal income tax purposes as an entity disregarded as separate from its owner (a disregarded entity or DE). As a result, businesses that had previously operated through subsidiaries could operate through structures treated for tax purposes as branches. The effect of the check the box regulations was a dramatic increase in the number of branches resulting from DE elections that are subject to section 987. This increase has greatly exacerbated the already existing problems of the 1991 proposed regulations, especially the ability of taxpayers to trigger non-economic losses (and the corresponding trap for the unwary taxpayer with non-economic gains).

As indicated above, the equity pool paradigm in the 1991 proposed regulations imputes currency gain or loss to all equity of a QBU whether or not the assets of the QBU are economically exposed to changes in the value of the functional currency of the QBU. The IRS has faced many cases in which taxpayers have claimed substantial non-economic exchange losses largely on the basis of the 1991 proposed regulations. An example may be instructive. Assume that a domestic corporation (US Corp) with the dollar as its functional currency forms a foreign corporation in Country X and then elects under the check the box regulations to treat that corporation as a DE. The DE conducts mineral extraction and owns all the necessary equipment. The equipment owned by the DE was contributed by US Corp. The DE has no employees and contracts with a subsidiary of US Corp for the employees needed in the business of extraction. US Corp, as the entity’s sole owner, claims that the DE is a QBU for purposes of section 987. The DE has minimal financial assets and conducts no activities other than mineral extraction. US Corp claims that the DE’s functional currency is Country X currency. A decline in the value of Country X currency relative to the dollar does not produce any economic loss for US Corp because the assets of the DE are not financial assets subject to currency fluctuation. Nevertheless, US Corp claims under the 1991 proposed regulations that the equity of the DE, which consists almost exclusively of equipment, gives rise to a substantial non-economic exchange loss and that terminating the DE (for example, by another check the box election) triggers recognition of such loss. Taxpayers have claimed similar results under other fact patterns. The IRS and the Treasury Department have serious concerns about these types of transactions.

Although the foregoing example concerns the claiming of non-economic losses, the equity pool approach in the 1991 proposed regulations can also give rise to non-economic gains. Recently, the value of the U.S. dollar has declined against many foreign currencies. It is likely that under these circumstances, taxpayers subject to section 987 may have large non-economic gains built into the equity pool. The IRS and the Treasury Department believe that Congress did not intend for section 987 to generate non-economic foreign currency gains or losses.

In light of the entity-classification rules and the potential for the equity pool paradigm to generate non-economic currency gains and losses, the IRS and the Treasury Department issued Notice 2000-20, 2000-1 C.B. 851. See §601.601(d)(2). Among other things, the notice indicated that the IRS and the Treasury Department were concerned that the proposed regulations may not have achieved their original goal of recognizing economic exchange gains and losses under appropriate circumstances. The notice requested comments on this and other issues.

Several comments were received in response to the notice and raised a number of important points. Two of those comments suggested replacing the equity pool paradigm in the 1991 proposed regulations with a paradigm that recognizes exchange gain or loss only on the earnings of a QBU and not its capital. As described above, the IRS and the Treasury Department believe that such an approach is inconsistent with Congressional intent as expressed in the legislative history to section 987. An earnings-only approach also would fail to address the core problem of distinguishing between items that economically give rise to exchange gain and loss and those that do not. Additionally, an earnings-only approach would produce different results for QBUs with the same net assets, depending upon whether the net assets were funded with capital or earnings. Finally, an earnings-only approach fails to take into account any foreign currency exposure on capital and so could disadvantage banks and other financial institutions, much of whose QBUs’ capital may be subject to such exposure.

The IRS and the Treasury Department believe that Congress did not intend section 987 to permit the largely uninhibited recognition of non-economic exchange gain or loss. The 1991 proposed regulations, together with the check the box regulations, have combined to permit taxpayers to trigger non-economic losses with relative ease. Accordingly, the 1991 proposed regulations are withdrawn and are replaced with new proposed regulations that adopt the “foreign exchange exposure pool method.” In general, the foreign exchange exposure pool method provides that the income of a QBU that is subject to section 987 (“section 987 QBU”) is determined by reference to the items of income, gain, deduction and loss booked to the QBU in its functional currency, adjusted to reflect U.S. tax principles. With certain exceptions, items of income, gain, deduction and loss of a section 987 QBU are translated into the functional currency of the QBU’s owner at the average exchange rate for the year. However, the basis of historic assets and deductions for depreciation, depletion, and amortization of such assets are translated at the historic exchange rate. Translating these items at the historic exchange rate differs from the approach taken in the 1991 proposed regulations, which instead uses the average exchange rate. Although using the average exchange rate for translating such items might be simpler than using the historic exchange rate, it leads to the generation of non-economic foreign currency gains or losses described in this preamble.

The foreign exchange exposure pool method uses a balance sheet approach to determine exchange gain or loss, which is then recognized upon a remittance. Use of a balance sheet approach allows taxpayers and the IRS to distinguish between those items whose value fluctuates with respect to changes in the functional currency of the owner and those which do not. Under this method, exchange gain or loss with respect to “marked items” is identified annually but is pooled and deferred until a remittance is made. The IRS and the Treasury Department believe that section 988(c) identifies the items that should be treated as giving rise to exchange gain or loss for purposes of section 987. Accordingly, a marked item is generally defined as an asset or liability that would generate section 988 gain or loss if such asset or liability were held or entered into directly by the owner the section 987 QBU.

When a section 987 QBU makes a remittance, a portion of the pooled and deferred exchange gain or loss is recognized. In general, the amount taken into account is an amount equal to the product of the owner’s portion of the section 987 QBU’s net unrecognized exchange gain or loss, multiplied by the owner’s remittance proportion. The owner’s remittance proportion generally is equal to the quotient of the amount of the remittance, divided by the aggregate basis of the section 987 QBU’s gross assets (as reflected on its year-end balance sheet), without reduction for the remittance.

The source and character of exchange gain or loss recognized under section 987 for all purposes of the Code, including sections 904(d), 907 and 954, is determined by reference to the source and character of the income derived from the section 987 QBU’s assets.

The IRS and the Treasury Department believe that the foreign exchange exposure pool method is consistent with section 987 and legislative intent for several reasons. First, the foreign exchange exposure pool method uses a profit and loss statement to determine the items of income, gain, deduction and loss of a section 987 QBU in its functional currency. This allows proper characterization of items of income, gain, deduction and loss. Second, exchange gain or loss must be taken into account only with respect to items of branch capital and earnings whose value fluctuates with changes in exchange rates by reference to the owner’s functional currency. This comports both with Congressional intent that taxpayers recognize exchange gain or loss (but only economic exchange gain or loss) inherent in branch capital and branch earnings and with authority granted under section 987(3) to identify appropriate translation rates. Third, exchange gain or loss is recognized under section 987 only upon a remittance. Finally, the foreign exchange exposure pool method is an appropriate interpretation of the “blended” approach of section 987—that is, it incorporates certain aspects of the profit and loss method and the net worth method.

The proposed regulations provide rules for determining the section 987 taxable income or loss of a taxpayer with respect to a section 987 QBU as well as the timing, amount, character, and source of section 987 gain or loss recognized with respect to such QBU. The proposed regulations do not apply to banks, insurance companies, and similar financial entities (including, solely for this purpose, leasing companies, finance coordination centers, regulated investment companies, and real estate investment trusts). The IRS and the Treasury Department plan to apply the foreign exchange exposure pool method adopted in the proposed regulations to such entities in subsequent guidance but believe it is appropriate to request comments regarding how the rules of the proposed regulations need to be precisely tailored to address issues unique to financial entities. Financial entities are urged to make necessary comments to help tailor the planned extension of the foreign exchange exposure pool method to such entities.

Specifically, in the context of banks, the IRS and the Treasury Department request comments on whether special rules are needed for the global dealing of currencies and securities. Comments are also requested on the relationship of sections 987 and 988 for banks. Finally, comments are requested on whether the use of exchange rate conventions is appropriate for banks and finance entities and, if so, how such conventions should be determined. In the context of insurance companies, the IRS and the Treasury Department request comments on the proper treatment of insurance reserves, surplus, and investment assets held by the separate trades or business of an insurance company. In particular, comments are requested on the proper treatment of stock held in separate accounts of a section 987 QBU of a life insurance company and the related insurance reserves established for those separate accounts. In the context of leasing companies, comments are requested regarding the treatment of stock in other leasing companies recorded on the books and records of a section 987 QBU and how the rules of sections 986 and 987 can be reconciled if stock is treated as a “marked asset” in this setting. Until regulations are issued applying the foreign exchange exposure pool method to financial entities, such entities must comply with section 987 under a reasonable method, consistently applied. For this purpose, reasonable methods include using the method described in the 1991 proposed regulations and a method that imputes section 987 gain or loss to earnings but not capital.

The proposed regulations also do not apply to trusts, estates and S corporations. The IRS and the Treasury Department plan to apply the foreign exchange exposure pool method adopted in the proposed regulations to such entities but believe it is appropriate to request comments regarding how the rules of the proposed regulations should be applied to such entities. The IRS and the Treasury Department request comments regarding whether principles similar to those applied to partnerships should apply to these entities.

The IRS and the Treasury Department believe that section 987 should only apply where an individual or corporation (whether foreign or domestic) has activities that constitute a trade or business under §1.989(a)-1(c) and the trade or business has a functional currency different from the individual or corporation. In such cases, the individual or corporation will be subject to the rules of the proposed regulations if the individual or corporation is the owner of a section 987 QBU. A section 987 QBU is defined in §1.987-1(b)(2) as an eligible QBU that has a functional currency different from its owner.

An eligible QBU is defined in §1.987-1(b)(3) of the proposed regulations. Generally, an eligible QBU is an activity of an individual, corporation, partnership or DE that is a trade or business as defined in §1.989(a)-1(c); maintains separate books and records as defined in §1.989(a)-1(d) and assets and liabilities used in conducting such activities are reflected on such books and records; and the activities are not subject to the dollar approximate separate transaction (DASTM) rules of §1.985-3. A corporation is not an eligible QBU. An individual is not a QBU under §1.989(a)-1(b)(2)(i) and therefore cannot be an eligible QBU. In addition, and as discussed in this preamble, neither a partnership nor a DE is an eligible QBU.

In the case of ownership other than through a partnership (that is, direct ownership), the individual or corporation is treated as the owner of an eligible QBU if the individual or corporation is the tax owner of the assets and liabilities of the eligible QBU. For purposes of determining direct ownership, an individual or corporation will be treated as a direct owner of the assets and liabilities of an eligible QBU if it owns a DE that holds an eligible QBU. In such case, because the DE is not recognized as a separate entity, it cannot be a QBU under section 989 and, therefore, is not treated as an eligible QBU under the proposed regulations. However, the activities of the DE, which are treated for purposes of the Code as carried on directly by its owner, can qualify as an eligible QBU of the DE’s owner.

With respect to partnerships, the IRS and the Treasury Department recognize that issues often arise as to whether the international tax provisions of the Code operate on an aggregate or an entity basis. The legislative history of subchapter K of chapter 1 of the Code provides that, for purposes of interpreting Code provisions outside of that subchapter, a partnership may be treated as either an entity separate from its partners or an aggregate of its partners, depending on which characterization is more appropriate to carry out the purpose of the particular section under consideration. H.R. Conf. Rep. No. 2543, 83rd Cong. 2d. Sess. 59 (1954).

In the case of section 987, the calculations under the foreign exchange exposure pool method would differ dramatically based on whether an aggregate or an entity approach is adopted. For example, if the foreign exchange exposure pool method is applied at the entity level, the partnership will make the method’s calculations by reference to the partnership’s functional currency. Under this approach, any foreign currency gain or loss will be an item of the partnership and will be allocated among the partners in accordance with the partnership agreement, to the extent such allocation is consistent with the provisions of subchapter K. If, in the alternative, the foreign exchange exposure pool method is applied under an aggregate approach, each partner will make its own foreign exchange exposure pool calculations by reference to the partner’s functional currency and such amounts will not be subject to separate allocation under subchapter K.

The IRS and the Treasury Department believe that, on balance, an aggregate approach is more appropriate for section 987 purposes. Applying the foreign exchange exposure pool method directly at the partner level will more appropriately preserve the correct amounts of exchange gain or loss. In addition, such approach will measure the foreign currency exposure by reference to the functional currencies of the persons who generally bear the economic risk from such exposure. As a result, the proposed regulations provide that for purposes of applying the foreign exchange exposure pool method each individual or corporation that is a partner in a partnership will be considered to own indirectly an eligible QBU consisting of a portion of the assets and liabilities of the partnership allocated to it under §1.987-7. If such eligible QBU has a different functional currency from the partner and therefore is a section 987 QBU, the foreign exchange exposure pool method is applied with respect to those assets and liabilities. In addition, the proposed regulations provide rules for converting the items of section 987 taxable income or loss of a section 987 QBU into the functional currency of the partner (when necessary), and rules coordinating this aggregate approach with other provisions of subchapter K.

Section 1.987-1(b)(2)(ii) allows an owner to elect to treat certain section 987 QBUs with the same functional currency as a single section 987 QBU. The purpose of this rule is to simplify section 987 calculations by reducing the number of interbranch transactions that would be considered as “transfers” of assets and liabilities. This election applies only to certain section 987 QBUs of the owner. The IRS and the Treasury Department request comments regarding whether such election should be available to treat section 987 QBUs of owners that are members of a consolidated group as a single section 987 QBU and how this should be technically effectuated.

Section 1.987-1(b)(5) provides that the term “owner” for section 987 purposes does not include an eligible QBU or section 987 QBU of an owner. Under this rule, a tiered ownership structure of eligible QBUs and/or section 987 QBUs will not be respected as distinct tiers of QBUs for purposes of section 987. Rather, tiers of eligible and/or section 987 QBUs will be treated as a “flat” structure, with each QBU in the tier considered as owned directly by the ultimate non-QBU owner. For example, if a domestic corporation is the holder of the interests in a section 987 DE (section 987 DE1) and that DE owns the interests in another section 987 DE (section 987 DE2) for purposes other than U.S. tax law, the structure will not be treated as a tier of QBUs for purposes of section 987. Rather, the domestic corporation will be considered the direct holder of the interests in the section 987 branches of section 987 DE1 and DE2. This flat structure, which is consistent with the general approach taken in the proposed dual consolidated loss regulations (REG-102144-04, 2005-25 I.R.B. 1297 [70 FR 29868-29907]), is expected to be easier to administer for both taxpayers and the IRS and to provide more appropriate results under the section 987 rules.

The IRS and the Treasury Department recognize that it may be administratively burdensome for taxpayers to apply certain aspects of the proposed regulations to section 987 QBUs indirectly owned through relatively small interests in partnerships. As a result, the proposed regulations provide a de minimis election for certain indirectly owned section 987 QBUs. Under this rule, an individual or corporation that owns a section 987 QBU indirectly through a partnership may elect not to take into account the section 987 gain or loss of such section 987 QBU, provided such individual or corporation owns, directly or indirectly, less than five percent of the section 987 partnership. Constructive ownership rules apply for purposes of determining whether the less than five percent ownership threshold is satisfied.

This de minimis exception only applies to recognition of section 987 gain or loss with respect to a section 987 QBU. Thus, owners of section 987 QBUs that qualify under the de minimis exception must comply with all other aspects of the proposed regulations, including the requirement to take into account the section 987 taxable income or loss with respect to such section 987 QBUs.

An individual or corporation that qualifies for the election (that is, because they owned less than five percent of a section 987 partnership) subsequently may fail to qualify as a result of an increase in their interest in a section 987 partnership. In such a case, taxpayers must begin taking into account the section 987 gain or loss with respect to section 987 QBUs owned through such partnerships. Similarly, taxpayers that were required to take into account section 987 gain or loss with respect to an indirectly owned section 987 QBU may reduce their ownership such that they become eligible for the de minimis exception and, as a result, may elect to no longer take into account section 987 gain or loss. The IRS and the Treasury Department recognize that transition issues will arise when interests in section 987 partnerships change such that individuals or corporations no longer qualify (or are able to qualify) for the de minimis exception. The IRS and the Treasury Department are considering such transition rules and request comments as to their application.

Section 1.987-1(c)(1)(i) defines the spot rate as the rate determined under the principles of §1.988-1(d)(1), (2) and (4) on the relevant day. Section 1.987-1(c)(1)(ii) allows taxpayers to elect to use spot rate conventions that reasonably approximate the spot rate on a particular day. It is anticipated that taxpayers will be able to conform the spot rate convention for section 987 to the spot rate conventions used under FAS 52 for financial accounting purposes. This is intended to simplify the calculations required under section 987.

In a similar attempt to simplify calculations, §1.987-1(c)(2) defines the yearly average exchange rate as an average exchange rate for the taxable year computed under any reasonable method that is consistently applied.

Finally, §1.987-1(c)(3) defines the historic exchange rate by reference to the spot rate on the day that assets are transferred to (or acquired by) the section 987 QBU, or on the day that liabilities are assumed (or entered into) by the section 987 QBU. The reference to the spot rate as defined in §1.987-1(c)(1)(i) and (ii) allows taxpayers to elect to use spot rate conventions for these purposes.

The definitions of a section 987 marked item and a section 987 historic item are central to the foreign exchange exposure pool method. When taken into account in the context of the calculation of net unrecognized section 987 gain or loss under §1.987-4, the definitions distinguish those items that generate section 987 gain or loss from those that do not. The IRS and the Treasury Department believe that section 988 identifies those items properly treated as giving rise to exchange gain or loss for purposes of section 987. Thus, a marked item as defined in §1.987-1(d) is an asset or liability reflected on the books and records of the section 987 QBU that both (1) would generate section 988 gain or loss if held or entered into directly by the owner of the section 987 QBU and (2) is not a section 988 transaction to the section 987 QBU. It is important to exclude section 988 transactions of a section 987 QBU because section 988 already requires the section 987 QBU to recognize gain or loss from such transactions. Thus, treating such transactions as marked items for purposes of section 987 would result in double counting. Marked items give rise to exchange gain or loss under section 987. Historic items, which are defined in §1.987-1(e) as items other than marked items, do not give rise to exchange gain or loss under section 987.

Section 1.987-1(f) provides rules for making elections under section 987. In general, the elections made under section 987 must be made by the owner of the section 987 QBU. The elections must be made with respect to a section 987 QBU for the first taxable year in which the election is relevant, and must be made by attaching a statement to a timely filed tax return for such taxable year. Elections under section 987 are treated as methods of accounting and are governed by the general rules regarding changes in methods of accounting.

The IRS and the Treasury Department believe that a reasonable cause standard should be applied to determine whether taxpayers that fail to make a timely election are eligible for an extension of time to file elections pursuant to §1.987-1(f) of the proposed regulations. As a result, extensions of time under §§301.9100-1 through 301.9100-3 will not be granted for filings under the proposed regulations. See §301.9100-1(d).

Under the reasonable cause standard, if an owner that is permitted to file an election under the proposed regulations fails to make such a filing in a timely manner, the owner is considered to have satisfied the timeliness requirement with respect to such filing if it demonstrates, to the satisfaction of the Area Director, Field Examination, Small Business/Self Employed or the Director, Field Operations, Large and Mid-Size Business (Director) having jurisdiction of the taxpayer’s return for the taxable year, that such failure was due to reasonable cause and not willful neglect. Once the owner becomes aware of the failure, the owner must demonstrate reasonable cause and must satisfy the filing requirement by attaching the election to an amended tax return (that amends the tax return to which the election should have been attached). A written statement must be included that explains the reasons for the failure to comply.

In determining whether the taxpayer has reasonable cause, the Director shall consider whether the taxpayer acted reasonably and in good faith. Whether the taxpayer acted reasonably and in good faith will be determined after considering all the facts and circumstances. The Director shall notify the person in writing within 120 days of the filing if it is determined that the failure to comply was not due to reasonable cause or if additional time will be needed to make such determination. If the Director fails to notify the owner within 120 days of the filing, the owner shall be considered to have demonstrated to the Director that such failure was due to reasonable cause and not willful neglect.

The proposed regulations provide that elections under section 987 cannot be revoked without the consent of the Commissioner. In addition, the proposed regulations provide that the Commissioner will consider allowing revocation of such an election if the taxpayer demonstrates significantly changed circumstances, or other circumstances that demonstrate a substantial non-tax business reason for such revocation. Finally, the IRS and the Treasury Department are considering an exception to the general revocation rule where a section 987 QBU is acquired in certain transactions that do not result in the termination of such QBU. Comments are requested as to whether such an exception is warranted and, if so, the appropriate scope of such an exception.

A section 987 QBU is not itself a taxpayer and does not have its own taxable income. Items of income, gain, deduction and loss must nonetheless be attributed to such section 987 QBU for purposes of determining the owner’s taxable income. The items of income, gain, deduction and loss attributed to a section 987 QBU are generally determined in the functional currency of the section 987 QBU and then translated into the functional currency of the owner. The aggregate translated amount is the section 987 taxable income or loss of the section 987 QBU. Thus, attribution rules are necessary to determine which items of income, gain, deduction and loss are attributed to the section 987 QBU.

Under section 987(3), assets and liabilities must be attributed to a section 987 QBU in order to determine the amount of section 987 gain or loss of such QBU. In some cases, a section 987 QBU of a taxpayer will not be held through an entity separate from the taxpayer that can legally own assets and incur liabilities. In addition, not all the assets and liabilities of an entity that is separate from the taxpayer may be attributable to a section 987 QBU for purposes of section 987. Moreover, assets and liabilities may constitute a section 987 QBU of a taxpayer even when such assets and liabilities are owned or incurred by separate legal entities. As a result, assets and liabilities of the taxpayer (or of entities owned by the taxpayer that are not themselves taxpayers) must be attributed to the section 987 QBU.

Neither section 987 nor the underlying legislative history provides explicit rules for attributing a taxpayer’s items of income, gain, deduction, or loss to a section 987 QBU to determine the QBU’s section 987 taxable income or loss. Similarly, no explicit rules are provided in the statute or legislative history for attributing a taxpayer’s assets or liabilities to a section 987 QBU to determine the section 987 gain or loss of such QBU.

Other provisions of the Code provide various methods for attributing or allocating a taxpayer’s assets and liabilities, or items of income, gain, deduction and loss (items) for particular purposes. These provisions provide complex rules for making such determinations and, in many cases, require a detailed analysis of various factors and relationships involving income, assets, and activities of the taxpayer. For example, section 864(c) and the regulations thereunder provide rules for determining the income, gain, deduction, or loss of a nonresident alien individual or foreign corporation which are treated as effectively connected with the conduct of a trade or business within the United States. Other examples are §§1.882-5, 1.861-8 and 1.861-9T through 1.861-13T. These regulations provide rules for the allocation and apportionment of expenses, losses, and other deductions of a taxpayer. Finally, section 884(c)(2) and §1.884-1(d) and (e) provide rules for determining U.S. assets and U.S. liabilities of a foreign corporation for purposes of the branch profits tax. As discussed below, the IRS and the Treasury Department do not believe these complex methodologies are appropriate for purposes of section 987.

The IRS and the Treasury Department believe that items should be attributed to an eligible QBU (and, if all or a portion of such eligible QBU has a different functional currency than its owner, to a section 987 QBU of such owner) to the extent they are reflected on the books and records of the eligible QBU (books and records method). The IRS and the Treasury Department believe that using a books and records method for attributing items under section 987 is consistent with other provisions of the Code involving foreign currency transactions. For example, it is consistent with the requirement under section 989(a) that a QBU maintain books and records separate from the taxpayer. It is also consistent with the requirement under section 985(b)(1) that, in order to have a functional currency other than the dollar, a QBU must keep its books and records in such currency. Moreover, the IRS and the Treasury Department believe the books and records method is administrable for both taxpayers and the Commissioner. This is the case because the books and records method should be consistent with the taxpayer’s accounting treatment of the items and, unlike the methods discussed above, it does not require a complex and factually intensive analysis of the circumstances and activities of the eligible QBU.

For the reasons described above, the proposed regulations adopt a books and records method for allocating items to an eligible QBU. The proposed regulations provide that, subject to certain exceptions, items are attributable to an eligible QBU to the extent they are reflected on the separate set of books and records of such eligible QBU, as defined in §1.989(a)-1(d). The proposed regulations make clear that these rules apply solely for purposes of section 987. Thus, for example, the attribution rules contained in the proposed regulations do not apply for purposes of allocating and apportioning interest expense under section 864(e).

As discussed above, the IRS and the Treasury Department believe that the assets and liabilities reflected on the books and records of an eligible QBU are a reasonable approximation of the assets and liabilities that are used in the trade or business of the eligible QBU and, therefore, should be taken into account for purposes of section 987. However, the IRS and the Treasury Department believe that certain assets and liabilities should not be attributed to an eligible QBU, even if such assets and liabilities are reflected on the books and records of such QBU. The IRS and the Treasury Department believe that non-portfolio stock and interests in partnerships (and liabilities to acquire such assets), even if reflected on the books and records of the eligible QBU, should not be attributed to such QBU for purposes of section 987. This is consistent with the principle stated above that a section 987 QBU cannot be an owner of another section 987 QBU. Excluding non-portfolio stock is also consistent with the principle that non-portfolio stock cannot be used in, or held for the use in, the conduct of a trade or business in the United States. See §1.864-4(c)(2)(iii).

As a result, the proposed regulations provide that stock of a corporation (whether domestic or foreign) and an interest in a partnership (whether domestic or foreign) are not considered to be on the books and records of an eligible QBU. The proposed regulations provide an exception, however, for portfolio stock where the owner of the eligible QBU owns (directly or constructively) less than ten percent of the total voting power or value of the stock of such corporation. The proposed regulations also provide that indebtedness incurred to acquire stock or a partnership interest that is not treated as being reflected on the books and records of an eligible QBU should similarly be excluded from the books and records. Finally, the proposed regulations provide that items of income, gain, deduction and loss arising from ownership of stock, a partnership interest, or related acquisition indebtedness that is excluded from the general books and records rule, shall similarly not be treated as being on the books and records of the eligible QBU.

Section 988(a)(3) provides that the source of gain or loss recognized under section 988(a)(1) is determined by reference to the residence of the taxpayer or the QBU of the taxpayer on whose books the asset, liability, or item of income or expense is properly reflected. Section 1.988-4(b)(2) provides that, in general, the determination of whether an asset, liability, or item of income or expense is properly reflected on the books of a QBU is a question of fact. The regulations under section 988 further provide that such items are presumed not to be properly reflected on the books and records for this purpose if inconsistent booking practices are employed with respect to the same or similar items. Finally, the regulations provide that if such items are not properly reflected on the books of the QBU, the Commissioner may allocate the item between or among the taxpayer and its QBUs to properly reflect the source (or realization) of exchange gain or loss.

The IRS and the Treasury Department believe that rules for determining whether items are properly reflected on the books of a QBU for purposes of sourcing section 988 gain or loss should be consistent with the rules for attributing items to an eligible QBU under section 987. As a result, the proposed regulations modify the sourcing rules in the section 988 regulations to provide that the principles of §1.987-2(b) apply in determining whether an asset, liability, or item of income or expense is properly reflected on the books of a QBU.

Section 988 applies to certain transactions described in section 988(c) if the transaction is denominated (or determined by reference to) a currency that is not the functional currency of the taxpayer or QBU of the taxpayer. Thus, in order to determine if a transaction is subject to section 988, it must be determined whether a transaction is attributable to the taxpayer or a QBU of the taxpayer.

Under the current section 989 regulations, a partnership is a QBU even if it does not have activities that constitute a trade or business (“per se QBU”). As a result, a partnership may have a functional currency different than its partners and section 988 is applied at the partnership level with respect to section 988 transactions properly attributable to the partnership. These regulations propose to amend section 989 to provide that a partnership is no longer a per se QBU of its partners, but instead the activities of such partnership may be treated as a QBU.

As discussed above, the IRS and the Treasury Department will generally apply either an entity or an aggregate approach with respect to partnerships depending on which approach more appropriately carries out the purpose of the particular Code section under consideration. Following the amendments made by the proposed regulations, and because only certain activities of a partnership (and not the partnership itself) can qualify as a section 987 QBU, the IRS and the Treasury Department believe that it is appropriate, in cases where an asset or liability of a partnership is not reflected on the books and records of an eligible QBU of the partnership, to determine whether section 988 applies by reference to the functional currencies of the partners. The IRS and the Treasury Department believe that this rule will have limited application and will apply, for example, where the only activity of a partnership is the incurrence of a liability used to acquire stock that is held by the partnership. The proposed regulations provide examples illustrating the application of this rule.

As discussed above, the proposed regulations provide that a DE itself is not an eligible QBU and, instead, certain activities of the DE will be treated as an eligible QBU of the owner to the extent a separate set of books and records with respect to such activities are maintained. Thus, an issue similar to that discussed above with respect to partnerships will arise where the DE is the local law owner of certain assets or the local law obligor on certain liabilities, which are not reflected on the books and records of an eligible QBU held by the DE. The proposed regulations provide that the determination of whether section 988 (rather than section 987) applies with respect to transactions involving assets and liabilities of a DE that are not attributable to an eligible QBU is determined by reference to the functional currency of the owner of such DE.

Section 987(3) provides, in part, that taxable income of a taxpayer shall be determined by making proper adjustments (as prescribed by the Secretary) for transfers of property between qualified business units of the taxpayer having different functional currencies. Similarly, the legislative history to section 987 refers to contributions to, and remittances from, QBUs. See, H.R. Conf. Rep. No. 841, 99th Cong. 2d. Sess. II 673-76 (1986). However, neither the statute nor the legislative history defines the terms “transfer,” “contribution,” or “remittance.”

As noted above, section 987 QBUs can be divisions of an owner that have no legal distinction separate from their owner. Section 987 QBUs can also be owned indirectly through partnerships, where they have legal distinction separate from their owners. Moreover, as a result of the entity classification regulations, a section 987 QBU held through a DE can have legal distinction separate from its owner, even though the section 987 QBU is treated as a division of the owner for federal income tax purposes. As a result, assets and liabilities can be transferred between an owner and a section 987 QBU in a manner that has legal significance (that is, a distribution from a section 987 partnership), or in a manner that has no legal significance because the transfers are simply between divisions of the same legal entity (that is, a transfer involving divisions of a taxpayer that is reflected through accounting entries).

The definition of a transfer under the proposed regulations includes transactions that are regarded for both legal and tax purposes, and transactions that are regarded for legal purposes, but disregarded as transactions for tax purposes (“disregarded transactions”). For this purpose, the term disregarded transaction is treated as including the recording of an asset or liability on one set of books and records, if the recording is the result of such asset or liability being removed from another set of books and records of the same person or entity (including a DE or partnership).

The proposed regulations provide that an asset or liability is treated as transferred to or from a section 987 QBU if, as a result of a disregarded transaction, such asset or liability is reflected, or is not reflected, respectively, on the books and records of the section 987 QBU. For example, if an owner of a section 987 DE loans cash to the section 987 QBU held by the section 987 DE, the loan is disregarded for Federal income tax purposes. However, as a result of such disregarded transaction, the loaned cash is reflected on the books and records of the section 987 QBU and, therefore, is treated as transferred to such section 987 QBU.

The proposed regulations also provide that transfers to and from section 987 QBUs include certain contributions of assets to, or distributions of assets from, a section 987 partnership. For example, an asset contributed by a partner to a section 987 partnership is treated as transferred to an indirectly owned section 987 QBU of the partner if the asset is reflected on the section 987 QBU’s books and records following such contribution. The proposed regulations provide similar rules for assumptions of liabilities between a section 987 partnership and its partners.

The proposed regulations also provide that transfers to or from a section 987 QBU may occur as a result of certain acquisitions (including by contribution) and dispositions of interests in DEs and partnerships. For example, if a partner in a section 987 partnership sells a portion of its interest in such partnership, the sale results in a transfer from the partner’s indirectly owned section 987 QBU to the extent assets and liabilities are not reflected on the books and records of such QBU as a result of such sale.

The owner of a section 987 QBU can change its form of ownership in all or a portion of such section 987 QBU. Such changes in form of ownership often occur in a manner that does not affect the operation of the eligible QBU (or its status as an eligible QBU), but rather only changes the owner’s interest in its section 987 QBU. For example, a direct owner of a section 987 QBU that is owned through a section 987 DE can change to being an indirect owner of all or a portion of such section 987 QBU, if the interests in the section 987 DE are transferred to a partnership.

Changes in form of ownership of a section 987 QBU can occur through actual or deemed transactions involving the section 987 QBU itself, or actual or deemed transactions involving interests in a section 987 DE or section 987 partnership that owns such QBU. For example, certain conversions of DEs to partnerships, or partnerships to DEs, result in deemed transactions pursuant to Rev. Ruls. 99-5, 1999-1 C.B. 434, and 99-6, 1999-1 C.B. 432. See §601.601(d)(2). Deemed transactions with respect to partnerships also occur pursuant to section 708(b) and the regulations thereunder.

The IRS and the Treasury Department believe that changes in form of ownership should result in a transfer only to the extent such change affects the assets and liabilities attributable to the section 987 QBU of the owner. As a result, the proposed regulations provide that a mere change in form of ownership of a section 987 QBU does not result in a transfer to or from the section 987 QBU. Instead, the proposed regulations provide that the determination of whether a transfer has occurred in such cases should be made under the general transfer rules, discussed above. Moreover, the proposed regulations clarify that deemed transactions (for example, pursuant to Rev. Ruls. 99-5 and 99-6) shall not be taken into account for purposes of determining whether there is a transfer.

The proposed regulations clarify that general tax law principles, including the circular cash flow, step-transaction, and substance-over-form doctrines apply for purposes of determining whether there is a transfer of an asset or liability to or from a QBU. For example, if a shareholder of a corporation that directly owns a section 987 QBU transfers property to the corporation and the property is recorded on the books and records of the corporation’s section 987 QBU, the shareholder is first treated as transferring the property to the corporation, and then the corporation is treated as transferring the property to the section 987 QBU in a disregarded transaction.

As noted above, a section 987 QBU of a taxpayer may not be an entity separate from the taxpayer that can legally own assets and incur liabilities. As a result, recording (or failing to record) an asset or liability on the books and records may, other than for purposes of section 987, have little significance for tax or legal purposes. In addition, transfers between section 987 QBUs of the same owner that are divisions of the same legal entity may have no legal significance and are accomplished only through journal entries on the books and records of such section 987 QBUs. As a result, the IRS and the Treasury Department are concerned that, in certain circumstances, transfers to or from a section 987 QBU may be structured solely to achieve advantages under section 987, especially given that such transfers may have little or no significance from a legal or business perspective.

In Notice 2000-20, the IRS and the Treasury Department expressed similar concerns in connection with taxpayers taking positions that certain contributions and distributions triggered foreign currency losses prematurely with respect to transactions that were undertaken for tax purposes, but lacked meaningful non-tax economic consequences. The notice provided that the IRS and the Treasury Department believe that circular cash flows and similar transactions lacking economic substance will not result in recognition of foreign currency losses under general tax principles because such transactions are not properly treated as transfers or remittances under section 987.

The IRS and the Treasury Department continue to be concerned about transactions that are undertaken for tax purposes and lack meaningful non-tax economic consequences. As a result, the proposed regulations provide the Commissioner the ability to allocate assets and liabilities, and items of income, gain, deduction and loss, where a principal purpose of recording (or failing to record) an item on the books and records of an eligible QBU (including an eligible QBU owned indirectly through a partnership) is the avoidance of U.S. tax under section 987. The proposed regulations also provide various factors that indicate whether recording (or failing to record) an item on books and records has as a principal purpose the avoidance of U.S. tax under section 987. For example, factors indicating that such tax avoidance was not a principal purpose of recording (or not recording) an item include doing so for a substantial and bona fide business purpose, or in a manner that is consistent with the economics o