Regs. § 1.985-0 Outline of regulations.
Regs. § 1.985-1 Functional currency.
Regs. § 1.985-2 Election to use the United States dollar as the functional currency of a QBU.
Regs. § 1.985-3 United States dollar approximate separate transactions method.
Regs. § 1.985-4 Method of Accounting.
Regs. § 1.985-5 Adjustments required upon change in functional currency.
This section lists the paragraphs contained in sections 1.985-1 through 1.985-6.
(a) Applicability and effective date
(b) Dollar functional currency
(c) Functional currency of a QBU that is not required to use the dollar
(d) Single functional currency for a foreign corporation
(e) Translation of nonfunctional currency transactions
(f) Examples
(a) Background and scope
(b) Eligible QBU
(c) Time and manner for dollar election
(d) Effect of dollar election
(a) Scope and effective date
(b) Statement of method
(c) Translation into United States dollars
(d) Computation of DASTM gain or loss
(e) Effect of DASTM gain or loss on gross income, taxable income, or earnings and profits
(a) Adoption or election
(b) Condition for changing functional currencies
(c) Relationship to certain other sections of the Code
(a) In general
(b) Step 1--Taking into account exchange gain or loss on certain section 988 transactions
(c) Step 2--Determining the new functional currency basis of property and the new functional currency amount of liabilities and any other relevant items
(d) Step 3A--Additional adjustments that are necessary when a branch changes functional currency
(e) Step 3B--Additional adjustments that are necessary when a taxpayer changes functional currency
(f) Examples
(a) In general
(b) Certain controlled foreign corporations
(c) All other foreign corporations
(d) Pre-l987 section 902 amounts
(e) Net worth branch
(f) Profit and loss branch
(a) Applicability and effective date
(1) Purpose and scope
These regulations provide guidance with respect to defining the functional currency of a taxpayer and each qualified business unit (QBU), as defined in section 989(a). Generally, a taxpayer and each QBU must make all determinations under subtitle A of the Code (relating to income taxes) in its respective functional currency. This section sets forth rules for determining when the functional currency is the United States dollar (dollar) or a currency other than the dollar. Section 1.985-2 provides an election to use the dollar as the functional currency for certain QBUs that absent the election would have a functional currency that is a hyperinflationary currency, and explains the effect of making the election. Section 1.985-3 sets forth the dollar approximate separate transactions method that certain QBUs must use to compute their income or loss or earnings and profits. Section 1.985-4 provides that the adoption of a functional currency is a method of accounting and sets forth conditions for a change in functional currency. Section 1.985-5 provides adjustments that are required to be made upon a change in functional currency. Finally, section 1.985-6 provides transition rules for a QBU that uses the dollar approximate separate transactions method for its first taxable year beginning after December 31, 1986.
(2) Effective date
These regulations apply to taxable years beginning after December 31, 1986. However, any taxpayer desiring to apply temporary Income Tax Regulations section 1.985-0T through section 1.985-4T in lieu of these regulations to all taxable years beginning after December 31, 1986, and on or before October 20, 1989 may (on a consistent basis) so choose. For the text of the temporary regulations, see 53 FR 20308 (1988).
(b) Dollar functional currency
(1) In general
The dollar shall be the functional currency of a taxpayer or QBU described in paragraph (b)(1)(i) through (v) of this section regardless of the currency used in keeping its books and records (as defined in section 1.989(a)-1(d)). The dollar shall be the functional currency of--
(i) A taxpayer that is not a QBU (e.g., an individual);
(ii) A QBU that conducts its activities primarily in dollars. A QBU conducts its activities primarily in dollars if the currency of the economic environment in which the QBU conducts its activities is primarily the dollar. The facts and circumstances test set forth in paragraph (c)(2) of this section shall apply in making this determination;
(iii) Except as otherwise provided by ruling or administrative pronouncement, a QBU that has the United States, or any possession or territory of the United States where the dollar is the standard currency, as its residence (as defined in section 988(a)(3)(B));
(iv) A QBU that does not keep books and records in the currency of any economic environment in which a significant part of its activities is conducted. Whether a QBU keeps such books and records is determined in accordance with paragraph (c)(3) of this section; or
(v) A QBU that produces income or loss that is, or is treated as, effectively connected with the conduct of a trade or business within the United States.
(2) QBUS operating in a hyperinflationary environment
(i) Taxable years beginning on or before August 24, 1994
For taxable years beginning on or before August 24, 1994, see section 1.985-2 with respect to a QBU that elects to use, or is otherwise required to use, the dollar as its functional currency.
(ii) Taxable years beginning after August 24, 1994
(A) In general
For taxable years beginning after August 24, 1994, except as otherwise provided in paragraph (b)(2)(ii)(B) of this section, any QBU that otherwise would be required to use a hyperinflationary currency as its functional currency must use the dollar as its functional currency and compute income or loss or earnings and profits under the rules of section 1.985-3.
(B) Exceptions
(1) Certain QBU branches
The functional currency of a QBU that otherwise would be required to use a hyperinflationary currency as its functional currency and that is a branch of a foreign corporation having a non-dollar functional currency that is not hyperinflationary shall be the functional currency of the foreign corporation. Such QBU's income or loss or earnings and profits shall be determined under section 1.985-3 by substituting the functional currency of the foreign corporation for the dollar.
(2) Corporation that is not a controlled foreign corporation
A foreign corporation (or its QBU branch) operating in a hyperinflationary environment is not required to use the dollar as its functional currency pursuant to paragraph (b)(2)(ii)(A) of this section if that foreign corporation is not a controlled foreign corporation as defined in section 957 or 953(c)(1)(B). However, a noncontrolled section 902 corporation, as defined in section 904(d)(2)(E), may elect to use the dollar (or, if appropriate, the currency specified in paragraph (b)(2)(ii)(B)(1) of this section) as its (or its QBU branch's) functional currency under the procedures set forth in section 1.985-2(c)(3).
(C) Change in functional currency
(1) In general
If a QBU is required to change its functional currency to the dollar under paragraph (b)(2)(ii)(A) of this section, or chooses or is required to change its functional currency to the dollar for any open taxable year (and all subsequent taxable years) under section 1.985-3(a)(2)(ii), the change is considered to be made with the consent of the Commissioner for purposes of section 1.985-4. A QBU changing functional currency must make adjustments described in section 1.985-7 if the year of change (as defined in section 1.481-1(a)(1)) begins after 1987, or the adjustments described in section 1.985-6 if the year of change begins in 1987. No adjustments under section 481 are required solely because of a change in functional currency described in this paragraph (b)(2)(ii)(C).
(2) Effective date
This paragraph (b)(2)(ii)(C) applies to taxable years beginning after April 6, 1998. However, a taxpayer may choose to apply this paragraph (b)(2)(ii)(C) to all open years after December 31, 1986, provided each person, and each QBU branch of a person, that is related (within the meaning of section 1.985-2(d)(3)) also applies to this paragraph (b)(2)(ii)(C).
(D) Hyperinfaltionary currency
For purposes of sections 985 through 989, the term hyperinflationary currency means the currency of a country in which there is cumulative inflation during the base period of at least 100 percent as determined by reference to the consumer price index of the country listed in the monthly issues of the "International Financial Statistics" or a successor publication of the International Monetary Fund. If a country's currency is not listed in the monthly issues of "International Financial Statistics," a QBU may use any other reasonable method consistently applied for determining the country's consumer price index. Base period means, with respect to any taxable year, the thirty-six calendar months immediately preceding the first day of the current calendar year. For this purpose, the cumulative inflation rate for the base period is based on compounded inflation rates. Thus, if for 1991, 1992, and 1993, a country's annual inflation rates are 29 percent, 25 percent, and 30 percent, respectively, the cumulative inflation rate for the three-year base period is 110 percent [((1.29 x 1.25 x 1.3) - 1.0 = 1.10) x 100 = 110%] and the currency of the country for the QBU's 1994 year is considered hyperinflationary. In making the determination whether a currency is hyperinflationary, the determination for purposes of United States generally accepted accounting principles may be used for income tax purposes provided the determination is based on criteria that is substantially similar to the rules previously set forth in this paragraph (b)(2)(ii)(D), the method of determination is applied consistently from year to year, and the same method is applied to all related persons as defined in section 1.985-3(e)(2)(vi).
(E) Change in functional currency when currency ceases to be hyperinflationary
(1) In general
A QBU that has been required to use the dollar as its functional currency under paragraph (b)(2) of this section, or has elected to use the dollar as its functional currency under paragraph (b)(2)(ii)(B)(2) of this section or section 1.985-2, must change its functional currency as of the first day of the first taxable year that follows three consecutive taxable years in which the currency of its economic environment, determined under paragraph (c)(2) of this section, is not a hyperinflationary currency. The functional currency of the QBU for such year shall be determined in accordance with paragraph (c) of this section. For purposes of section 1.985-4, the change is considered to be made with the consent of the Commissioner. See section 1.985-5 for adjustments that are required upon a change in functional currency.
(2) Effective Date
This paragraph (b)(2)(ii)(E) of this section applies to taxable years beginning after April 6, 1998.
(c) Functional currency of a QBU that is not required to use the dollar
(1) General rule
The functional currency of a QBU that is not required to use the dollar under paragraph (b) of this section shall be the currency of the economic environment in which a significant part of the QBU's activities is conducted, if the QBU keeps, or is presumed under paragraph (c)(3) of this section to keep, its books and records in such currency.
(2) Economic environment
For purposes of section 985 and the regulations thereunder, the economic environment in which a significant part of a QBU's activities is conducted shall be determined by taking into account all the facts and circumstances.
(i) Facts and circumstances
The facts and circumstances that are considered in determining the economic environment in which a significant part of a QBU's activities is conducted include, but are not limited to, the following:
(A) The currency of the country in which the QBU is a resident as determined under section 988(a)(3)(B);
(B) The currencies of the QBU's cash flows;
(C) The currencies in which the QBU generates revenues and incurs expenses;
(D) The currencies in which the QBU borrows and lends;
(E) The currencies of the QBU's sales markets;
(F) The currencies in which pricing and other financial decisions are made;
(G) The duration of the QBU's business operations; and
(H) The significance and/or volume of the QBU's independent activities.
(ii) Rate of inflation
The rate of inflation (regardless of how it is determined) shall not be a factor used to determine a QBU's economic environment.
(iii) Consistency
A taxpayer must consistently apply the facts and circumstances test set forth in this paragraph (c)(2) in evaluating the economic environment of its QBUs, e.g., its branches, that engage in the same or similar trades or businesses.
(3) Books and records presumption
A QBU shall be presumed to keep books and records in the currency of the economic environment in which a significant part of its activities are conducted. The presumption may be overcome only if the QBU can demonstrate to the satisfaction of the district director that a substantial nontax purpose exists for not keeping any books and records in such currency. A taxpayer may not use this presumption affirmatively in determining a QBU's functional currency.
(4) Multiple currencies
If a QBU has more than one currency that satisfies the requirements of paragraph (c)(1) of this section, the QBU may choose any such currency as its functional currency.
(5) Relationship of United States accounting principles
In making the functional currency determination under this paragraph (c), the currency of the QBU for purposes of United States generally accepted accounting principles (GAAP) will ordinarily be accepted as the functional currency of the QBU for income tax purposes, provided that the GAAP determination is based on facts and circumstances substantially similar to those set forth in paragraph (c)(2) of this section.
(6) Effect of changed circumstances
Regardless of any change in circumstances, a QBU may change its functional currency determined under this paragraph (c) only if the QBU complies with section 1.985-4 or the Commissioner's consent is considered to have been granted under section 1.985-2(d)(4) or section 1.985-3(a)(2)(ii). For special rules relating to the conversion to the euro, see section 1.985-8.
(d) Single functional currency for a foreign corporation
(1) General rule
This paragraph (d) applies to a foreign corporation that has two or more QBUs that do not have the same functional currency. The foreign corporation shall be treated as having a single functional currency for the corporation as a whole that is different from the functional currency of one or more of its QBUs. The determination of a foreign corporation's functional currency shall be made by first applying paragraph (d)(1)(i) and then paragraph (d)(l)(ii) of this section.
(i) Step 1
Each QBU of the foreign corporation determines its functional currency in accordance with the rules set forth in paragraphs (b) and (c) of this section and section 1.985-2.
(ii) Step 2
The foreign corporation determines its functional currency applying the principles of paragraphs (b) and (c) of this section to the corporation's activities as a whole. Thus, if a foreign corporation has two branches, the corporation shall determine its functional currency by applying the principles of paragraphs (b) and (c) of this section to the combined activities of the corporation and the branches. For purposes of this paragraph (d)(1), if a QBU of a foreign corporation has the dollar as its functional currency under paragraph (b)(2) of this section, the QBU's activities shall be considered dollar activities of the corporation.
(2) Translation of income or loss of QBUs having different functional currencies than the foreign corporation as a whole
Where the functional currency of a foreign corporation as a whole differs from the functional currency of one or more of its QBUs, each such QBU shall determine the amount of its income or loss or earnings and profits (or deficit in earnings and profits) in its functional currency under the principles of section 987 (relating to branch transactions). The amount of income or loss or earnings and profits (or deficit in earnings and profits) of each QBU in its functional currency shall then be translated into the foreign corporation's functional currency using the appropriate exchange rate as defined in section 989(b)(4) for purposes of determining the corporation's income or loss or earnings and profits (or deficit in earnings and profits).
(e) Translation of nonfunctional currency transactions
Except for a QBU using the dollar approximate separate transactions method described in section 1.985-3, see section 988 and the regulations thereunder for the treatment of nonfunctional currency transactions.
(f) Examples
The provisions of this section are illustrated by the following examples:
Example (1). P, a domestic corporation, operates exclusively through foreign branch X in Country A. X is a QBU within the meaning of section 989(a) and its residence is Country A as determined under section 988 (a)(3)(B). The currency of Country A is the LC. All of X's purchases, sales, and expenses are in the LC. The laws of A require X to keep books and records in the LC. It is determined that the LC is the currency of X under United States generally accepted accounting principles. This determination is based on facts and circumstances substantially similar to those set forth in paragraph (c)(2) of this section. Under these facts, while the functional currency of P is the dollar since its residence is the United States, the functional currency of X is the LC.
Example (2). P, a publicly-held domestic regulated investment company (as defined under section 851), operates exclusively through foreign branch B in Country R. B is a QBU within the meaning of section 989(a) and its residence is Country R as determined under section 988(a)(3)(B). The currency of Country R is the LC. B's principal activities consist of purchasing and selling stock and securities of Country R companies and securities issued by Country R. It is determined that the dollar is the currency of B under United States generally accepted accounting principles. This determination is not based on facts and circumstances substantially similar to those set forth in paragraph (c)(2) of this section. Under these facts, while the functional currency of P is the dollar since its residence is the United States, B may choose the LC as its functional currency because it has significant activities in the LC provided it keeps books and records in the LC. The fact that the dollar is the currency of B under generally accepted accounting principles is irrelevant for purposes of determining B's functional currency because the GAAP determination was not based on factors similar to those set forth in paragraph (c)(2) of this section.
Example (3). P, a domestic bank, operates through foreign branch X in Country R. X is a QBU within the meaning of section 989(a) and its residence is Country R as determined under section 988(a)(3)(B). The currency of Country R is the LC. The laws of R require X to keep books and records in the LC. The branch customarily loans dollars and LCs. In the case of its LC loans, X ordinarily fixes the terms of the loans by reference to a contemporary London Inter-Bank Offered Rate (LIBOR) on dollar deposits. For instance, the interest on the amount of the outstanding LC loan principal might equal LIBOR plus 2 percent and the amount of the outstanding LC loan principal would be adjusted to reflect changes in the dollar value of the LC. X is primarily funded with dollar-denominated funds borrowed from related and unrelated parties. X's only LC activities are paying local taxes, employee wages, and local expenses such as rent and electricity. Under these facts, X's activities are primarily conducted in dollars. Thus, although X keeps its books and records in LCs, X's functional currency is the dollar.
Example (4). S, a foreign corporation organized in Country U, is wholly-owned by P, a domestic corporation. The currency of Country U is the LC. S's sole function is acting as a financing vehicle for P and domestic corporations that are affiliated with P. All borrowing and lending transactions between S and P and its domestic affiliates are in dollars. Furthermore, primarily all of S's other borrowings are dollar-denominated or based on a dollar index. S's only LC activities are paying local taxes, employee wages, and local expenses such as rent and electricity. S keeps its books and records in the LC. Under these facts, S's activities are primarily conducted in dollars. Thus, although S keeps its books and records in LCs, S's functional currency is the dollar.
Example (5). D is a domestic corporation whose primary activity is the extraction of natural gas and oil through foreign branch X in Country Y. X is a QBU within the meaning of section 989(a) and its residence is Country Y as determined under section 988(a)(3)(B). The currency of Country Y is the LC. X bills a significant amount of its natural gas and oil sales in dollars and a significant amount in LCs. X also incurs significant LC and dollar expenses and liabilities. The laws of Country Y require X to keep its books and records in the LC. It is determined that the LC is the currency of X under United States generally accepted accounting principles. This determination is based on facts and circumstances substantially similar to those set forth in paragraph (c)(2) of this section. Absent other factors indicating that X primarily conducts its activities in the dollar, D could choose either the dollar or the LC as X's functional currency because X has significant activities in both the dollar and the LC, provided the books and records requirement is satisfied. If, instead, X's activities were determined to be primarily in the dollar, then X would have to use the dollar as its functional currency.
Example (6). S, a foreign corporation organized in Country U, is wholly-owned by P, a domestic corporation. The currency of U is the LC. S purchases the products it sells from related and unrelated parties, including P. These purchases are made in the LC. In addition, most of S's gross receipts are generated by transactions denominated in the LC. S attempts to determine its LC price for goods sold in such a manner as to obtain an LC equivalent of a certain dollar amount after reduction for all LC costs. However, local market conditions sometimes result in pricing adjustments. Thus, changes in the LC-dollar exchange rate from period to period generally result in corresponding changes in the LC price of S's products. S pays local taxes, employee wages, and other local expenses in the LC. It is determined that the dollar is the currency of S under United States generally accepted accounting principles. This determination is not based on facts and circumstances substantially similar to those set forth in paragraph (c)(2) of this section. Under these facts, S could choose either the dollar or the LC as its functional currency because S has significant activities in both the dollar and the LC, provided that the books and records requirement is satisfied.
Example (7). S, a foreign corporation organized in Country X, is wholly-owned by P, a domestic corporation. S conducts all of its operations through two branches. Branch A is located in Country F and branch B is located in Country G. S, A, and B are QBUs within the meaning of section 989(a). Branch A's and branch B's residences are Country F and Country G respectively as determined under section 988(a)(3)(B). The currency of Country F is the FC and the currency of Country G is the LC. The functional currencies of S, A, and B are determined in a two step procedure.
Step 1: The functional currency of branches A and B. Branch A and branch B both conduct all activities in their respective local currencies. The FC is the currency of branch A and the LC is the currency of branch B under United States generally accepted accounting principles. This determination is based on facts and circumstances substantially similar to those set forth in paragraph (c)(2) of this section. Under these facts, the functional currency of branch A is the FC and the functional currency of branch B is the LC.
Step 2: The functional currency of S. S's functional currency is determined by disregarding the fact that A and B are branches. When A's activities and B's activities are viewed as a whole, S determines that it only conducts significant activities in the LC. Therefore, S's functional currency is the LC. See Examples (9), (10), and (11) for how the earnings and profits of a foreign corporation, which has branches with different functional currencies, are determined.
Example (8). Assume the same facts as in Example (7), except that S does not exist and P conducts all of its operations through branch A and branch B. In this instance P's functional currency in Step 2 is the dollar, regardless of the fact that its branches' activities viewed as a whole are in the LC, because P is a taxpayer whose residence is the United States under section 988(a)(3)(B)(i). Therefore, while the functional currency of branch A is the FC and the functional currency of branch B is the LC, the functional currency of P is the dollar because its residence is the United States.
Example (9). The facts are the same as in Example (7). ln addition, assume that in 1987 branch A has earnings of 100 FC and branch B has earnings of 100 LC as determined under section 987. The weighted average exchange rate for the year is 1 FC/2 LC. Branch A's earnings are translated into 200 LC for purposes of computing S's earnings and profits in 1987. Thus, the total earnings and profits of S from branch A and branch B for 1987 is 300 LC.
Example (10).
(i) X, a foreign corporation organized in Country W, is wholly-owned by P, a domestic corporation. Both X and P are calendar year taxpayers that began business during 1987. X operates exclusively through two branches, A and B both of which are located outside of Country W. The functional currency of X and A is the LC, while the functional currency of B is the DC as determined under section 985 and section 1.985-1. The earnings of B must be computed under section 987, relating to branch transactions. In 1987, A earns 900 LCs of nonsubpart F income and B earns 200 DCs of nonsubpart F income. Under section 904(d)(2), A's income is financial service income and B's income is general limitation income. In order to determine X's earnings and profits, B's income must be translated into LCs (the functional currency of X). The weighted average exchange rate for 1987 is 1 LC/2 DC. Thus, in 1987 X's current earnings and profits (and its post-1986 undistributed earnings) are 1000 LCs consisting of 900 LCs of financial services income earned by A and 100 LCs (200 DC/2) of general limitation income earned by B. Neither A nor B makes any remittances during 1987.
(ii) In 1988, neither A nor B earns any income or generates any loss. On December 31, 1988, A remits 50 LCs directly to P. The remittance to P is considered to be remitted by A to X and then immediately distributed by X as a dividend. The 50 LC remittance does not result in an exchange gain or loss under section 987 to X because the functional currency of X and A is the LC. See section 987(3). Under section 904(d)(3)(D), the 50 LC dividend is treated as income in a separate category to the extent of the dividend's pro rata share of X's earnings and profits in each separate limitation category. Thus, 90 percent, or 45 LCs, is treated as financial services income, and 10 percent, or 5 LCs, is treated as general limitation income. After the dividend distribution, X has 950 LCs of accumulated earnings and profits (and post-1986 undistributed earnings) consisting of 855 LCs of financial service limitation income and 95 LCs of general limitation income.
Example (11). The facts are the same as in Example (10), except that A makes no remittance during 1988 but B remits 120 DCs to X on December 31, 1988, which X immediately converts into LCs, and X makes no dividend distribution during 1988. Assume that the appropriate exchange rate for the remittance is 1 LC/3 DCs. B's remittance triggers exchange loss to X. See section 987(3). Under section 987, the exchange loss on the remittance is 20 LCs calculated as follows: 40 LCs, which is the LC value of the 120 DC remittance (120 DCs/3), less 60 LCs, their LC basis (120 DCs/2). This loss is sourced and characterized under section 987 and regulations thereunder.
Example (12). F, a foreign corporation, has gain from the disposition of a United States real property interest (as defined in section 897(c)). The gain is taken into account as if F were engaged in a trade or business within the United States during the taxable year and as if such gain were effectively connected with such trade or business. F's disposition activity shall be treated as a separate QBU with a dollar functional currency because such activity produced income that is treated as effectively connected with a trade or business within the United States. Therefore, F must compute its gain from the disposition by giving the United States real property interest an historic dollar basis.
(a) Background and scope
(1) In general
This section permits an eligible QBU to elect to use the dollar as its functional currency for taxable years beginning on or before August 24, 1994. An election to use a dollar functional currency is not permitted for a QBU other than an eligible QBU. Paragraph (b) of this section defines an eligible QBU. Paragraph (c) of this section describes the time and manner for making the dollar election and paragraph (d) of this section describes the effect of making the election. For the definition of a QBU, see section 989(a). See section 1.985-1(b)(2)(ii) for rules requiring a QBU to use the dollar as its functional currency in taxable years beginning after August 24, 1994.
(2) Exception
Pursuant to section 1.985-1(b)(2)(ii)(B)(2), the rules of paragraph (c)(3) of this section shall apply with respect to the procedure required to be followed by a noncontrolled section 902 corporation as defined in section 904(d)(2)(E) to elect the dollar as its (or its QBU branch's) functional currency and the application of section 1.985-3.
(b) Eligible QBU
(1) In general
The term "eligible QBU" means a QBU that could have used a hyperinflationary currency as its functional currency absent the dollar election. See section 1.985-1 for how a QBU determines its functional currency absent the dollar election.
(2) Hyperinflationary currency
See section 1.985-1(b)(2)(ii)(D) for the definition of hyperinflationary currency.
(c) Time and manner for dollar election
(1) QBUs that are branches of United States persons
(i) Rule
If an eligible QBU is a branch of a United States person, the dollar election shall be made by attaching a completed Form 8819 to the United States person's timely filed (taking extensions into account) tax return for the first taxable year for which the election is to be effective.
(ii) Procedure prior to the issuance of Form 8819
In the absence of Form 8819, the election shall be made in accordance with section 1.985-2T(c)(1). Failure to file an amended return within the time period prescribed in section 1.985-2T(c)(1) shall not invalidate the dollar election if it is established to the satisfaction of the district director that reasonable cause existed for such failure. A subsequent election for 1988 will not prejudice the taxpayer with respect to such reasonable cause determination. Nevertheless, each United States person making an election under the section 1.985-2T(c)(1) must file a Form 8819 in the time and manner provided in the Form's instructions.
(2) Eligible QBUs that are controlled foreign corporations or branches of controlled foreign corporations
(i) Rule
If an eligible QBU is a controlled foreign corporation (as described in section 957), or a branch of a controlled foreign corporation, the election may be made either by the foreign corporation or by the controlling United States shareholders on behalf of the foreign corporation by--
(A) Filing a completed Form 8819 in the time and manner provided in the Form's instructions, and
(B) Providing the written notice required by paragraph (c)(2)(ii) of this section at the time and in the manner prescribed therein.
The term "controlling United States shareholders" means those United States shareholders (as defined in section 951(b)) who, in the aggregate, own (within the meaning of section 958(a)) greater than 50 percent of the total combined voting power of all classes of stock of the foreign corporation entitled to vote. If the foreign corporation is a controlled foreign corporation (as described in section 957) but the United States shareholders do not, in the aggregate, own the requisite voting power, the term "controlling United States shareholders" means all the United States shareholders (as defined in section 951(b)) who own (within the meaning of section 958(a)) stock of the controlled foreign corporation.
(ii) Notice
Prior to filing Form 8819, the controlling United States shareholders (or the foreign corporation, if the dollar election is made by the corporation) shall provide written notice that the dollar election will be made to all United States persons known to be shareholders who own (within the meaning of section 958(a)) stock of the foreign corporation. Such notice shall also include all information required in Form 8819.
(iii) Reasonable cause exception
Failure of the controlling United States shareholders (or the foreign corporation, if the dollar election is made by the corporation) to timely file Form 8819 or provide written notice to a United States person required to be notified by paragraph (c)(2)(ii) of this section shall not invalidate the dollar election, if it is established to the satisfaction of the district director that reasonable cause existed for such failure.
(iv) Procedure prior to the issuance of Form 8819
In the absence of Form 8819, an eligible QBU described in paragraph (c)(2)(i) of this section shall make the dollar election in accordance with section 1.985-2T(c)(2). Nevertheless, the person or persons that made such election must file a Form 8819 in the time and manner provided in the Form's instructions.
(3) Eligible QBUs that are noncontrolled foreign corporations or branches of noncontrolled foreign corporations
(i) Rule
If an eligible QBU is a noncontrolled foreign corporation (a foreign corporation not described in section 957), or a branch of a noncontrolled foreign corporation, the dollar election must be made by the corporation or the majority domestic corporate shareholders on behalf of the corporation by applying the rules provided in paragraph (c)(2) (i) (A) and (B), (ii), (iii), and (iv) of this section substituting "majority domestic corporate shareholders" for "controlling United States shareholders" wherever it appears therein. The term "majority domestic corporate shareholders" means those domestic corporate shareholders (as described in section 902(a)) who, in the aggregate, own (within the meaning of section 958(a)) greater than 50 percent of the total combined voting stock of all classes of stock of the noncontrolled foreign corporation entitled to vote that is owned (within the meaning of section 958(a)) by all the domestic corporate shareholders.
(ii) Procedure prior to the issuance of Form 8819
In the absence of Form 8819, an eligible QBU described in paragraph (c)(3)(i) of this section shall make the dollar election in accordance with section 1.985-2T(c)(3). Nevertheless, the person or persons that made such election must file a Form 8819 in the time and manner provided in the Form's instructions.
(4) Others
Any other person making a dollar election under this section shall elect by filing Form 8819 and fulfilling any other notice requirements that may be required by the Commissioner.
(d) Effect of dollar election
(1) General rule
If a dollar election is made (or considered made under paragraph (d)(3) of this section) by or on behalf of an eligible QBU, the QBU shall be deemed to have the dollar as its functional currency. Each United States person that owns (within the meaning of section 958(a)) stock of a foreign corporation which has the dollar as its functional currency under section 1.985-2 must make all of its federal income tax calculations with respect to the foreign corporation using the dollar as the corporation's functional currency (regardless of when ownership was acquired or whether the United States person received the written notice required by paragraph (c)(2)(i)(B) of this section).
(2) Computation
(i) In general
Except as provided in paragraph (d)(2)(ii) of this section, any eligible QBU that pursuant to this section 1.985-2 has a dollar functional currency must compute income or loss or earnings and profits (or deficit in earnings and profits) in dollars using the dollar approximate separate transactions method described in section 1.985-3.
(ii) Alternative method
An eligible QBU that has a dollar functional currency pursuant to this section 1.985-2 may use a method other than the dollar approximate separate transactions method described in section 1.985-3 only if the QBU demonstrates to the satisfaction of the Commissioner that it can properly employ such method. Generally, the QBU must show that it could compute foreign currency gain or loss under the principles of section 988 with respect to each of its section 988 transactions. If subsequently the QBU can no longer demonstrate to the satisfaction of the district director that it can properly employ such an alternative method, then the QBU will be deemed to have changed its method of accounting to the dollar approximate separate transactions method described in section 1.985-3. This change in accounting will be treated as having been made with the consent of the Commissioner. No adjustments under either section 1.985-5T (or any succeeding final regulation) or section 481(a) shall be required solely because of the change. Rather the QBU shall begin accounting for its operations under section 1.985-3 based on its dollar books and records as of the time of the change.
(3) Conformity
(i) General rule
If a dollar election is made under this section 1.985-2 for an eligible QBU ("electing QBU"), then the dollar shall be the functional currency of any related person (regardless of when such person became related to the electing QBU) that is an eligible QBU, or any branch of any such related person that is an eligible QBU. For purposes of the preceding sentence, the term "related person" means any person with a relationship defined in section 267 (b) to the electing QBU (or to the United States or foreign person of which the electing QBU is a part). In determining whether two or more corporations are members of the same controlled group under section 267(b)(3), a person is considered to own stock owned directly by such person, stock owned with the application of section 1563(e)(1), and stock owned with the application of section 267(c).
(ii) Branches of United States and foreign persons
If a dollar election is made for a QBU branch of any person, each eligible QBU branch of such person shall have the dollar as its functional currency.
(4) Required adjustments
If an eligible QBU's functional currency changes due to a dollar election, or due to the conformity requirements of paragraph (d)(3) of this section, such change shall be deemed for purposes of section 1.9B5-4 to be consented to by the Commissioner. No adjustments under section 481(a) shall be required solely because of the change. However, the QBU must make those adjustments required by section 1.985-5T (or any succeeding final regulation).
(5) Taxable year conformity required
Generally, the adjustments required by paragraph (d)(4) of this section shall be made for a related person's taxable year--
(i) That includes the date in which the electing QBU made the dollar election if the person was related to such electing QBU at any time during the QBU's taxable year that includes such date, or
(ii) During which the person first becomes related to any electing QBU, in all other cases.
For purposes of this paragraph (d)(5), the date in which the electing QBU makes the dollar election shall be the last day of the electing QBU's taxable year. The district director may permit the related party to make such adjustments beginning one taxable year later if, in the district director's sole judgment, reasonable cause exists for the related party not being able to make the required adjustments for the earlier year.
(6) Availability of election
A dollar election may be made by or on behalf of a QBU, or considered made under the conformity rule of paragraph (d)(3), in any year in which the QBU is an eligible QBU. If a dollar election is not made by or on behalf of a QBU for its first taxable year beginning after December 31, 1986 in which it is an eligible QBU, then any dollar election made by or on behalf of the QBU, or considered made under the conformity rules of paragraph (d)(3) of this section, that results in a change in the QBU's functional currency shall be treated as having been made with the consent of the Commissioner. In such a case, however, the taxpayer must make those adjustments required by section 1.985-5T (or any succeeding final regulation).
(7) Effect of changed circumstances
Regardless of any change in circumstances (e.g., a currency ceases to qualify as hyperinflationary), a QBU whose functional currency is the dollar under this section may change its functional currency only if the QBU complies with section 1.985-4.
(8) Examples
The provisions of this section are illustrated by the following examples.
Example (1). X is a calendar year domestic corporation that in 1987 establishes a branch, A, in Country Z. A's functional currency under section 985(b) (1) and (2) and section 1.985-1 is the "h", the currency of Country Z. The cumulative inflation in Country Z exceeds 100 percent for the thirty-six months prior to January 1987, as measured by the consumer price index of Country Z listed in the monthly issues of the "International Financial Statistics". Accordingly, A is an eligible QBU in 1987 because the h is a hyperinflationary currency. Thus, X may elect the dollar as the functional currency of A for 1987.
Example (2). The facts are the same as in Example (1). X does not elect the dollar as the functional currency of A for 1987. Rather, X elects the dollar as the functional currency of A for l991, a year A is an eligible QBU. The election constitutes a change in A's functional currency that is made with the consent of the Commissioner. However, A must make the adjustments required under section 1.985-5T (or any succeeding final regulation).
Example (3). X is a domestic corporation that establishes A, an eligible QBU branch. X is wholly owned by domestic corporation Y. Y has an eligible QBU branch, B. Both X and Y are calendar year taxpayers. X makes a dollar election for A in 1987. Thus, A is an electing QBU. X and Y are related persons as defined in section 267(b) (i.e., Y has a relationship under section 267(b)(3) to X, the corporation of which A is a part). Therefore, the dollar election by X for A in 1987 results in B, the eligible QBU branch of Y, also having the dollar as its functional currency for 1987.
Example (4). The facts are the same as in Example (3), except that Y does not have an eligible QBU branch but owns all the stock of C, a calendar year controlled foreign corporation, which is not itself an eligible QBU but which has an eligible QBU branch, D. X and C are related persons as defined in section 267(b) (i.e., C has a relationship under section 267(b)(3) to X, the corporation of which A is a part). Therefore, the dollar election by X for A in 1987 results in D, the eligible QBU branch of C, also having the dollar as its functional currency for 1987.
Example (5). X, whose taxable year ends September 30, is an eligible QBU that does not use the dollar as its functional currency. X is wholly-owned by domestic corporation W. On January 1, 1989, X acquires all the stock of Y, an unrelated eligible QBU that made the dollar election under section 1.985-2. Y is a calendar year taxpayer. After the stock purchase, X and Y are related persons as defined in section 267(b). Under section 1.985-2(d) (3) and (5), the dollar shall be the functional currency of X, any person related to X, and any branch of such related person that is an eligible QBU beginning with the taxable year that includes December 31, 1989. Thus, X must change to the dollar for its taxable year beginning October 1, 1988. However, the district director may allow X to change to the dollar for its taxable year beginning October 1, 1989, provided reasonable cause exists. Those QBUs changing to the dollar as their functional currency as the result of the conformity requirements must make the adjustments required under section 1.985-5T (or any succeeding final regulation).
Example (6). The facts are the same as in Example (5), except that before X purchased the Y stock, X made the dollar election under section 1.985-2 but Y did not use the dollar as its functional currency. Under section 1.985-2(d) (3) and (5) the dollar shall be the functional currency of Y, any person related to Y, and any branch of such related person that is an eligible QBU beginning with the taxable year that includes September 30, 1989. Thus, Y must change to the dollar for its taxable year beginning January 1, 1989. However the district director may allow Y to change to the dollar for its taxable year beginning January 1, 1990, provided reasonable cause exists. Those QBUs changing to the dollar as their functional currency as the result of the conformity requirements must make the adjustments required under section 1.985-5T (or any succeeding final regulation).
(a) Scope and effective date
(1) Scope
This section describes the United States dollar (dollar) approximate separate transactions method of accounting (DASTM). For all purposes of subtitle A, this method of accounting must be used to compute the gross income, taxable income or loss, or earnings and profits (or deficit in earnings and profits) of a QBU (as defined in section 989(a)) that has the dollar as its functional currency pursuant to section 1.985-1(b)(2).
(2) Effective date
(i) In general
This section is effective for taxable years beginning after August 24, 1994.
(ii) DASTM Prior-year election
A taxpayer may elect to apply this section to any open taxable year beginning after December 31, 1986 (whether or not DASTM has been previously elected for some or all of those years). In order to make this election, the taxpayer must apply section 1.985-3 to that year and all subsequent years. In addition, each person that is related (within the meaning of section 1.985-3(e)(2)(vi)) to the taxpayer on the last day of any taxable year for which the election is effective and that would have been eligible to elect DASTM must also apply these rules to that year and all subsequent years. A taxpayer that has not previously elected to apply DASTM to its prior taxable years may make the DASTM election for the pertinent years by filing amended returns and complying with the applicable election procedures of section 1.985-2. Form 8819 shall be attached to the return for the first year for which the election is to be effective. A taxpayer that has elected DASTM for prior taxable years and applied the rules under section 1.985-3 (as contained in the April 1, 1994 edition of 26 CFR part 1 (1.908 to 1.1000)) may amend its returns to apply the rules of this section 1.985-3. In either case, the DASTM election for prior taxable years shall be deemed to be made with the consent of the Commissioner.
(b) Statement of method
Under DASTM, income or loss or earnings and profits (or a deficit in earnings and profits) of a QBU for its taxable year shall be determined in dollars by --
(1) Preparing an income or loss statement from the QBU's books and records (within the meaning of section 1.989(a)-1(d)) as recorded in the QBU's hyperinflationary currency (as defined in section 1.985- 1(b)(2)(ii)(D));
(2) Making the adjustments necessary to conform such statement to United States generally accepted accounting principles and tax accounting principles (including reversing monetary correction adjustments required by local accounting principles);
(3) Translating the amounts of hyperinflationary currency as shown on such adjusted statement into dollars in accordance with paragraph (c) of this section; and
(4) Adjusting the resulting dollar income or loss or earnings and profits (or deficit in earnings and profits) and, where necessary, particular items of gross income, deductible expense or other amounts, in accordance with paragraph (e) of this section to reflect the amount of DASTM gain or loss as determined under paragraph (d) of this section.
(c) Translation into United States dollars
(1) In general
Except as otherwise provided in this paragraph (c), the amounts shown on the income or loss statement, as adjusted under paragraph (b)(2) of this section, shall be translated into dollars at the exchange rate (as defined in paragraph (c)(6) of this section) for the translation period (as defined in paragraph (c)(7) of this section) to which they relate. However, if the QBU previously changed its functional currency to the dollar, and the rules of section 1.985-5 (or, if applicable, section 1.985-5T, as contained in the April 1, 1993 edition of 26 CFR part 1 (1.908 to 1.1000)) applied in translating its balance sheet amounts into dollars, then the spot exchange rate applied under those rules shall be used to translate any amount that would otherwise be translated at a rate determined by reference to a translation period prior to the change in functional currency. For example, depreciation with respect to an asset acquired while the QBU had a nondollar functional currency shall be translated into dollars at the spot rate on the last day of the taxable year before the year of change to a dollar functional currency, rather than at the rate for the period in which the asset was acquired.
(2) Cost of goods sold
The dollar value of cost of goods sold shall equal the sum of the dollar values of beginning inventory and purchases less the dollar value of closing inventory as these amounts are determined under paragraph (c)(3) of this section.
(3) Beginning inventory, purchases, and closing inventory
(i) Beginning inventory
Amounts representing beginning inventory shall be translated so as to obtain the same amount of dollars which represented such items in the closing inventory balance for the preceding taxable year.
(ii) Purchases
Amounts representing items purchased or otherwise first included in inventory during the taxable year shall be translated at the exchange rate for the translation period in which the cost of such items was incurred.
(iii) Closing inventory
(A) In general
Amounts representing items included in the closing inventory balance shall be translated at the exchange rate for the translation period in which the cost of such items was incurred. However, if amounts representing items included in the closing inventory balance are either valued at market or written down to market value, they shall be translated at the exchange rate existing on the last day of the taxable year. For purposes of determining lower of cost or market, items of inventory included in the closing inventory balance shall be translated into dollars at the exchange rate for the translation period in which the cost of such items was incurred and compared with market as determined in the QBU's hyperinflationary currency translated into dollars at the exchange rate existing on the last day of the taxable year.
(B) Determination of translation period
The method used to determine the translation period of amounts representing items of closing inventory for purposes of paragraph (c)(3)(iii)(A) of this section may be based upon reasonable approximations and averages, including rates of turnover, provided that the method is used consistently from year to year.
(4) Depreciation, depletion, and amortization
Amounts representing allowances for depreciation, depletion, or amortization shall be translated at the exchange rate for the translation period in which the cost of the underlying asset was incurred, except as provided in paragraph (c)(1) of this section.
(5) Prepaid expenses or income
Amounts representing expense or income paid or received in a prior taxable year shall be translated at the exchange rate for the translation period during which they were paid or received.
(6) Exchange rate
The exchange rate for a translation period may be determined under any reasonable method, provided that the method is consistently applied to all translation periods and conforms to the taxpayer's method of financial accounting. Reasonable methods include the average of beginning and ending exchange rates for the translation period and the spot rate on the last day of the translation period. Once chosen, a method for determining an exchange rate can be changed only with the consent of the district director.
(7) Translation period
(i) In general
Except as provided in paragraphs (c)(3)(iii)(B) and (c)(7)(ii) of this section, a translation period shall be each month within a QBU's taxable year.
(ii) Exception
A taxpayer may divide its taxable year into translation periods of equal length (with not more than one short period annually) that are less than one month. Once such a translation period is established, it may not be changed without the consent of the district director.
(8) Dollar transactions
(i) In general
Except as provided in paragraph (c)(8)(ii) of this section, no DASTM gain or loss is realized with respect to dollar transactions since the dollar is the functional currency of the QBU. Thus, the amount of any payment or receipt of dollars shall be reflected in the income or loss statement by the amount of such dollars. Also, the income or loss attributable to any transaction in which the amount that a QBU is entitled to receive (or is required to pay) by reason of such transaction is denominated in terms of the dollar, or is determined by reference to the value of the dollar, must be computed transaction by transaction. For example, if a foreign corporation lends 20 LC when 20 LC = $20 and is entitled to receive the LC equivalent of $20 at maturity plus a market rate of interest in dollars (or its LC equivalent), the loan is a dollar transaction. Similarly, this paragraph applies to any transaction that is determined to be a dollar transaction under section 988.
(ii) Non-dollar functional currency
If pursuant to section 1.985-1(b)(2)(ii)(B)(1), a QBU is required to use a functional currency other than the dollar, then that currency shall be substituted for the dollar in applying paragraph (c)(8)(i) of this section.
(9) Third currency transactions
A taxpayer may use any reasonable method of accounting for transactions described in section 988(c)(1)(B) and (C) that are denominated in, or determined by reference to, a currency other than the QBU's hyperinflationary currency or the dollar (third currency transactions) so long as such method is consistent with its method of financial accounting.
(10) Examples
The provisions of this paragraph (c) are illustrated by the following examples:
Example 1. S is an accrual basis QBU that is required to use the dollar as its functional currency for its first taxable year beginning in 1994. S's hyperinflationary currency is the "h." During 1994, S accrues 100 dollars attributable to dollar-denominated sales. Because this is a dollar transaction under paragraph (c)(8) of this section, S's income or loss for 1994 shall reflect the 100 dollars (not the hyperinflationary value of such dollars when accrued).
Example 2. (i) S is an accrual basis QBU that is required to use the dollar as its functional currency for its first taxable year beginning in 1994. S's hyperinflationary currency is the "h." During 1994, S's sales amounted to 240,000,000h, its currently deductible expenses were 26,000,000h, and its total inventory purchases amounted to 100,000,000h. During January and February of 1994, S purchased depreciable assets for 80,000,000h and was allowed depreciation of 4,000,000h. At the end of 1994, S's closing inventory was 23,000,000h. No election to use a translation period other than the month is made, S had no transactions described in paragraph (c)(8) or (c)(9) of this section, and S's closing inventory was computed on the first-in, first-out inventory method. S's adjusted income or loss statement for 1994 is translated into dollars as follows:
Hyperinflationary Exchange United States
Currency Rate Dollars
_________________ ________ _____________
Sales
(Jan-Feb) 10,000,000h 20:1 /1/ $ 500,000
(Mar-Apr) 20,000,000 21:1 952,381
(May-Jun) 50,000,000 22:1 2,272,727
(July) 50,000,000 23:1 2,173,913
(August) 20,000,000 26:1 769,231
(Sept.) 20,000,000 28:1 714,286
(Oct.) 20,000,000 29:1 689,655
(Nov.) 20,000,000 30:1 666,667
(Dec.) 30,000,000 31:1 967,742
___________ __________
Total 240,000,000h $9,706,602
Cost of Goods
Sold:
Opening
Inventory -0- -0-
Purchases:
(Jan-Feb) 15,000,000h 20:1 $ 750,000
(Mar-Apr) 10,000,000 21:1 476,190
(May-June) 30,000,000 22:1 1,363,636
(July) 20,000,000 23:1 869,565
(August) 10,000,000 26:1 384,615
(Sept.) 5,000,000 28:1 178,571
(Oct.) 5,000,000 29:1 172,414
(Nov.) 2,500,000 30:1 83,333
(Dec.) 2,500,000 31:1 80,645
Less
Closing
Inventory (23,000,000) /2/ (822,655)
____________ _________
77,000,000h $3,536,314
____________ ___________
FOOTNOTES TO TABLE
/1/ Where multiple months are indicated, the exchange rate
applies for all months.
/2/ See paragraph (ii) of this Example.
END OF FOOTNOTES TO TABLE
(ii) Since S uses the first-in, first-out inventory method, the closing inventory is assumed to consist of purchases made during the most recent translation period as follows:
United
Hyperinfla- Exchange States
tionary Currency Rate Dollars
________________ ________ _______
December 2,500,000h 31:1 $ 80,645
November 2,500,000 30:1 83,333
October 5,000,000 29:1 172,414
September 5,000,000 28:1 178,571
August 8,000,000 26:1 307,692
__________ ________
Total 23,000,000h $822,655
=========== ========
Non-Capital-
ized Expenses:
(Jan-Feb) 4,000,000h 20:1 $ 200,000
(Mar-Apr) 2,500,000 21:1 119,048
(May-June) 2,500,000 22:1 113,636
(July) 2,000,000 23:1 86,957
(August) 3,000,000 26:1 115,385
(Sept.) 3,000,000 28:1 107,143
(Oct.) 2,000,000 29:1 68,966
(Nov.) 3,000,000 30:1 100,000
(Dec.) 4,000,000 31:1 129,032
___________ __________
Total 26,000,000h $1,040,167
Depreciation 4,000,000h 20:1 $ 200,000
Total Cost
& Expenses 107,000,000h $4,776,481
____________ __________
Operating
Profit 133,000,000h $4,930,121
============ ==========
(d) Computation of DASTM gain or loss
(1) Rule
DASTM gain or loss of a QBU equals--
(i) The net worth of the QBU (as determined under paragraph (d)(2) of this section) at the end of the taxable year minus the net worth of the QBU at the end of the preceding taxable year; plus
(ii) The dollar amount of the items described in paragraph (d)(3) of this section and minus the dollar amount of the items described in paragraph (d)(4) of this section; minus
(iii) The amount of dollar income or earnings and profits (or plus the amount of any dollar loss or deficit in earnings and profits) as determined for the taxable year pursuant to paragraphs (b)(1) through (b)(3) of this section.
(2) Net worth
Net worth of a QBU at the end of any taxable year equals the aggregate dollar amount representing assets on the QBU's balance sheet at the end of the taxable year less the aggregate dollar amount representing liabilities on the balance sheet. Notwithstanding any other provision in this paragraph (d)(2), the district director may adjust the amount of any asset or liability if a purpose for acquiring (or disposing of) the asset or incurring (or discharging) the liability is to manipulate the composition of the balance sheet for any period during the taxable year in order to avoid tax. The taxpayer shall determine net worth by --
(i) Preparing a balance sheet as of the end of the taxable year from the QBU's books and records (within the meaning of section 1.989(a)-1(d)) as recorded in the QBU's hyperinflationary currency;
(ii) Making adjustments necessary to conform such balance sheet to United States generally accepted accounting principles and tax accounting principles (including reversing monetary correction adjustments required by local accounting principles); and
(iii) Translating the asset and liability amounts shown on the balance sheet into United States dollars in accordance with paragraph (d)(5) of this section.
(3) Positive adjustments
The items described in this paragraph (d)(3) are dividend distributions for the taxable year and any items that decrease net worth for the taxable year but that generally do not affect income or loss or earnings and profits (or a deficit in earnings and profits). Such items include a transfer to the home office of a QBU branch and a return of capital. Except as otherwise provided by ruling or administrative pronouncement, the amount of a transfer to the home office of a QBU branch, a dividend, or a distribution that is a return of capital shall be translated into dollars at the exchange rate on the date the amount is paid.
(4) Negative adjustments
The items described in this paragraph (d)(4) are items that increase net worth for the taxable year but that generally do not affect income or loss or earnings and profits (or a deficit in earnings and profits). Such items include a capital contribution or a transfer from a home office to a QBU branch. Except as otherwise provided by ruling or administrative pronouncement, if the contribution or transfer is not in dollars, the amount of a capital contribution or transfer shall be translated into dollars at the exchange rate on the date made.
(5) Translation of balance sheet
Asset and liability amounts shown on the balance sheet in hyperinflationary currency (adjusted pursuant to paragraph (d)(2)(ii) of this section) shall be translated into dollars as provided in this paragraph (d)(5). However, if the QBU previously changed its functional currency to the dollar and the rules of section 1.985-5 (or, if applicable, section 1.985-5T, as contained in the April 1, 1993 edition of 26 CFR part 1 (1.908 to 1.1000)) applied in translating its balance sheet amounts into dollars, then the spot exchange rate applied under those rules shall be used to translate any amount that would otherwise be translated at a rate determined by reference to a translation period prior to the change in functional currency. For example, the basis of real property acquired while the QBU had a nondollar functional currency shall be translated into dollars at the spot rate on the last day of the taxable year before the year of change to a dollar functional currency, rather than at the rate for the period in which the cost was incurred.
(i) Closing inventory
Amounts representing items of inventory included in the closing inventory balance shall be translated in accordance with paragraph (c)(3)(iii) of this section.
(ii) Bad debt reserves
Amounts representing bad debt reserves shall be translated at the exchange rate for the last translation period for the taxable year.
(iii) Prepaid income or expense
Amounts representing expenses or income paid or received in a prior taxable year shall be translated in accordance with paragraph (c)(5) of this section.
(iv) Hyperinflationary currency
Amounts of the hyperinflationary currency and hyperinflationary demand deposit balances shall be translated at the exchange rate for the last translation period of the taxable year.
(v) Certain assets
(A) In general
Amounts representing plant, real property, equipment, goodwill, and patents and other intangibles shall be translated at the exchange rate for the translation period in which the cost of the asset was incurred.
(B) Adjustment to certain assets
Amounts representing depreciation, depletion, and amortization reserves shall be translated in accordance with paragraph (c)(4) of this section.
(vi) Hyperinflationary debt obligations
Except as provided in paragraph (d)(5)(vii) of this section, amounts representing a hyperinflationary debt obligation (including accounts receivable and payable) shall be translated at the exchange rate for the last translation period for the taxable year.
(vii) Accrued foreign income taxes
Amounts representing an accrued but unpaid foreign income tax shall be translated at the exchange rate on the last day of the last translation period of the taxable year of accrual.
(viii) Certain hyperinflationary financial instruments
Amounts representing any item described in section 988(c)(1)(B)(iii) (relating to forward contracts, futures contracts, options, or similar financial instruments) denominated in or determined by reference to the hyperinflationary currency shall be translated at the exchange rate for the last translation period for the taxable year.
(ix) Other assets and liabilities
Amounts representing assets and liabilities, other than those described in paragraphs (d)(5)(i) through (viii) of this section, shall be translated at the exchange rate for the translation period in which the cost of the asset or the amount of the liability was incurred.
(6) Dollar transactions
Notwithstanding any other provisions of this paragraph (d), where the amount representing an item shown on the balance sheet reflects a dollar transaction (described in paragraph (c)(8) of this section), the transaction shall be taken into account in accordance with that paragraph.
(7) Third currency transactions
A taxpayer may use any reasonable method of accounting for transactions described in section 988(c)(1)(B) and (C) that are denominated in, or determined by reference to, a currency other than the QBU's hyperinflationary currency or the dollar (third currency transactions), so long as such method is consistent with its method of financial accounting.
(8) Character
The amount of DASTM gain or loss determined under paragraph (d)(1) of this section shall be ordinary income or loss.
(9) Example
The provisions of this paragraph (d) are illustrated by the following example:
Example. (i) S, an accrual method calendar year foreign corporation, uses DASTM. S's hyperinflationary currency is the "h." S's net worth at December 31, 1993 was $3,246,495. For 1994, S's operating profit is 81,340,000h, or $2,038,200. S made a 5,000,000h distribution in April and again in December of 1994. S's translation period is the month. None of S's assets or liabilities reflect a dollar or third currency transaction described in paragraph (c)(8) or (c)(9) of this section, respectively. The exchange rate for each month in 1994 is as follows:
January 32h:$1
Feb.-Mar. 33:1
April-May 34:1
June 35:1
July 36:1
Aug.-Sept. 37:1
Oct. 38:1
Nov. 39:1
Dec. 40:1
(ii) At the end of 1994, S's assets and liabilities, as adjusted and translated pursuant to paragraphs (d)(2) and (d)(5) of this section, are as follows:
Hyperin- Exchange U.S.
flationary Rate Dollar
__________ ________ ______
Hyperinflationary cash on hand 40,000h 40:1 $ 1,000
Checking account 400,000 40:1 10,000
Accounts Receivable -- 30 Day
Accounts 20,000,000 40:1 /1/ 500,000
60 Day Accounts 25,000,000 40:1 625,000
Inventory 65,000,000 /2/ 2,500,000
Fixed assets -- Property 90,000,000 27:1 3,333,333
Plant 190,000,000 /3/ 6,785,714
Accumulated Depreciation (600,000) /3/ (21,428)
Equipment 10,000,000 /4/ 340,000
Accumulated Depreciation (400,000) /4/ (13,333)
Common Stock -- Stock A 500,000 34:1 14,706
Stock B 400,000 26:1 15,385
Preferred Stock 1,000,000 32:1 31,250
C.D.s 5,000,000 40:1 125,000
Total Assets 406,340,000 14,246,627
Accounts Payable 35,000,000 40:1 875,000
Long-term liabilities:
Liability A 150,000,000 40:1 3,750,000
Liability B 80,000,000 40:1 2,000,000
Liability C 30,000,000 40:1 750,000
Total Liabilities 295,000,000h $ 7,375,000
_____________________________________________________________________
FOOTNOTES TO TABLE
/1/ S ages its accounts receivable and groups them into two
categories -- those outstanding for 30 days and those outstanding for
60 days.
/2/ Translated the same as closing inventory under paragraph
(c)(3)(iii).
/3/ The cost of S's plant was incurred in several translation
periods. Therefore, the dollar cost and dollar depreciation reflect
several translation rates.
/4/ S has a variety of equipment. Therefore, S's dollar basis
represents the sum of the hyperinflationary cost of each, translated
according to the exchange rate for the translation period incurred.
END OF FOOTNOTES TO TABLE
(iii) The DASTM gain of S for 1994 is computed as follows:
Net worth -- 1994 $6,871,627
Less -- Net worth -- 1993 $3,246,495
Plus -- 1994 Dividends -- April $ 149,254
December 126,582 /1/ 275,836
Less Operating Profit -- 1994 2,038,200
DASTM Gain $1,862,768
==========
_____________________________________________________________________
FOOTNOTE TO TABLE
/1/ The exchange rates on the date of the April and December
dividends were 33.5h:$1 and 39.5h:$1, respectively.
END OF FOOTNOTE TO TABLE
(iv) Thus, total profit = $2,038,200 + $1,862,768 = $3,900,968
(e) Effect of DASTM gain or loss on gross income, taxable income, or earnings and profits
(1) In general
For all purposes of subtitle A, the amount of DASTM gain or loss of a QBU determined under paragraph (d) of this section is taken into account by the QBU for purposes of determining the amount of its gross income, taxable income or loss, earnings and profits (or deficit in earnings and profits), and, where necessary, particular items of income, expense or other amounts. DASTM gain or loss is allocated under one of two methods. Certain small QBUs may elect the small QBU DASTM allocation described in paragraph (e)(2) of this section. All other QBUs must use the 9-step procedure described in paragraph (e)(3) of this section.
(2) Small QBU DASTM allocation
(i) Election threshold
A taxpayer may elect to use the small QBU DASTM allocation described in paragraph (e)(2)(iv) of this section with respect to a QBU that has an adjusted basis in assets (translated as provided in paragraph (d)(5) of this section) of $10 million or less at the end of any taxable year. In calculating the $10 million threshold, a QBU shall be treated as owning all of the assets of each related QBU (as defined in paragraph (e)(2)(vi) of this section) having its residence (as defined in section 988(a)(3)(B)) in the QBU's country of residence (related same-country QBU). For this purpose, appropriate adjustment shall be made to eliminate the double counting of assets created in transactions between related QBUs resident in the same country. For example, assume QBU-1, resident in country X, sells inventory to related QBU-2, also resident in country X, in exchange for an account receivable. For purposes of determining the assets of QBU-1 under this paragraph (e)(2)(i), the taxpayer shall take into account either the inventory shown on the books of QBU-2 or QBU-1's receivable from QBU-2 (but not both).
(ii) Consent to election
The election of the small QBU DASTM allocation or subsequent application of the rules of paragraph (e)(3) of this section due to an increase in the adjusted basis of the QBU's assets shall be deemed to have been made with the consent of the Commissioner. Once the election under paragraph (e)(2)(iii) of this section is made, it shall apply for all years in which the adjusted basis of the assets of the QBU (and any related same-country QBU) is $10 million or less, unless revoked with the Commissioner's consent. If the adjusted basis of the assets of the QBU (and any related same- country QBU) exceeds $10 million at the end of any taxable year, the rules of paragraph (e)(3) of this section shall apply to that QBU (and any related same-country QBU) for such year and each subsequent year unless such QBU again qualifies, and applies for and obtains the Commissioner's consent, to use the small QBU DASTM allocation. However, if a QBU acquires assets with a principal purpose of avoiding the application of paragraph (e)(2)(iv) of this section, the Commissioner may disregard the acquisition of such assets.
(iii) Manner of making election
(A) QBUs that are branches of United States persons
For the first year in which this election is effective, in the case of a QBU branch of a United States person, a statement shall be attached to the United States person's timely filed Federal income tax return (taking extensions into account). The statement shall identify the QBU (or QBUs) for which the election is being made by describing its business and its country of residence, state the adjusted basis of the assets of the QBU (and any related same-country QBUs) to which the election applies, and include a statement that the election is being made pursuant to section 1.985-3(e)(2).
(B) Other QBUs
In the case of a QBU other than one described in paragraph (e)(2)(iii)(A) of this section, an election must be made in the manner prescribed in section 1.964-1. The statement filed with the Internal Revenue Service as required under section 1.964-1 must include the information required under paragraph (e)(2)(iii)(A) of this section.
(iv) Effect of election
If a taxpayer elects under this paragraph (e)(2) to use the small QBU DASTM allocation, DASTM gain or loss, as determined under paragraph (d) of this section, of a small QBU shall be allocated ratably to all items of the QBU's gross income (determined prior to adjustment for DASTM gain or loss). Therefore, for purposes of the foreign tax credit, DASTM gain or loss shall be allocated on the basis of the relative amounts of gross income in each separate category as defined in section 1.904-5(a)(1). In the case of a controlled foreign corporation (within the meaning of section 957 or 953(c)(1)(B)), for purposes of section 952, DASTM gain or loss shall be allocated to subpart F income in a separate category in the same ratio that the gross subpart F income in that category for the taxable year bears to its total gross income in that category for the taxable year.
(v) Conformity
If a person (or a QBU of such person) makes an election under this paragraph (e)(2) to use the small QBU DASTM allocation, then each QBU of any related person (as defined in paragraph (e)(2)(vi) of this section) that satisfies the threshold requirement of paragraph (e)(2)(i) of this section (after application of the aggregation rule of paragraph (e)(2)(i) of this section) shall be deemed to have made the election.
(vi) Related person
The term related person means any person with a relationship to the QBU (or to the United States or foreign person of which the electing QBU is a part) that is defined in section 267(b) or section 707(b).
(3) DASTM 9-Step procedure
(i) Step 1 -- Prepare balance sheets
The taxpayer shall prepare an opening and a closing balance sheet for the QBU for each balance sheet period during the taxable year. The balance sheet period is the most frequent period for which balance sheet data are reasonably available (but in no event less frequently than quarterly). The balance sheet period may not be changed without the consent of the district director. The balance sheets must be prepared under the principles of paragraph (d)(2) of this section.
(ii) Step 2 -- Identify certain assets and liabilities
The taxpayer shall identify each item on the balance sheet that is described in section 988(c)(1)(B) or (C) and that would have been translated under paragraph (d)(5) of this section into dollars at the exchange rate for the last translation period for the taxable year (or the exchange rate on the last day of the last translation period of the taxable year in the case of an accrued foreign income tax liability).
(iii) Step 3 -- Characterize the assets
The taxpayer shall characterize and group the assets identified in paragraph (e)(3)(ii) of this section (Step 2) according to the source and the type of income that they generate, have generated, or may reasonably be expected to generate by applying the principles of section 1.861- 9T(g)(3) or its successor regulation (relating to characterization of assets for purposes of interest expense allocation). If a purpose for a taxpayer's business practices is to manipulate asset characterization or groupings, the district director may allocate or apportion DASTM gain or loss attributable to the assets. Thus, if a taxpayer that previously did not separately state interest on accounts receivable begins to impose an interest charge and a purpose for the change was to manipulate tax characterizations or groupings, then the district director may require that none of the DASTM gain or loss attributable to those receivables be allocated or apportioned to interest income.
(iv) Step 4 -- Determine DASTM gain or loss attributable to certain assets
(A) General rule
The taxpayer shall determine the dollar amount of DASTM gain or loss attributable to assets in each group identified in paragraph (e)(3)(iii) of this section (Step 3) as follows:
[(bb + eb) / 2] x [er - br]
where
bb = the hyperinflationary currency adjusted basis of the
assets in the group at the beginning of the balance sheet
period.
eb = the hyperinflationary currency adjusted basis of the
assets in the group at the end of the balance sheet period.
er = one dollar divided by the number of hyperinflationary
currency units that equal one dollar at the end of the
balance sheet period.
br = one dollar divided by the number of hyperinflationary
currency units that equal one dollar at the beginning
of the balance sheet period.
(B) Weighting to prevent distortion
If averaging the adjusted basis of assets in a group at the beginning and end of a balance sheet period results in an allocation of DASTM gain or loss that does not clearly reflect income, as might be the case in the event of a purchase or disposition of an asset that is not in the normal course of business, the taxpayer must use a weighting method that reflects the time the assets are held by the QBU during the translation period.
(C) Example
The provisions of this paragraph (e)(3)(iv) are illustrated by the following example:
Example. S is a foreign corporation that operates in the hyperinflationary currency "h" and computes its income or loss or earnings and profits under DASTM. S's adjusted basis in a group of assets described in section 988(c)(1)(B) or (C) that generate general limitation foreign source income (as characterized under paragraph (e)(3)(iii) of this section) at the beginning of the balance sheet period is 750,000h. S's basis in such assets at the end of the balance sheet period is 1,250,000h. The exchange rate at the beginning of the balance sheet period is $1 = 200h. The exchange rate at the end of the balance sheet period is $1 = 500h. The DASTM loss attributable to the assets described above is $3,000, determined as follows:
[(750,000h + 1,250,000h) / 2] x [($1 / 500h) - ($1 / 200h)] = ($3000)
(v) Step 5 -- Adjust dollar gross income by DASTM gain or loss from assets
The taxpayer shall adjust the dollar amount of the QBU's gross income (computed under paragraphs (b)(1) through (b)(3) of this section) generated by each group of assets characterized in paragraph (e)(3)(iii) of this section (Step 3) by the amount of DASTM gain or loss attributable to those assets computed under paragraph (e)(3)(iv) of this section (Step 4). Thus, if a group of assets, such as accounts receivable, generates both a category of income described in section 904(d)(1)(I) (relating to general limitation income) that is not foreign base company income as defined in section 954 and a DASTM loss under paragraph (e)(3)(iv) of this section (Step 4), the amount of the DASTM loss would reduce the amount of the QBU's gross income in that category. Similarly, if a group of assets, such as short-term bank deposits, generates both foreign personal holding company income that is passive income (described in sections 954(c)(1)(A) and 904(d)(1)(A)) and a DASTM loss under paragraph (e)(3)(iv) of this section (Step 4), the amount of the DASTM loss would reduce the amount of the QBU's foreign personal holding company income and passive income. See section 904(f) and the regulations thereunder in the case where that section would apply and DASTM loss attributable to a group of assets exceeds the income generated by such assets.
(vi) Step 6 -- Determine DASTM gain or loss attributable to liabilities
(A) General rule
The taxpayer shall determine the dollar amount of DASTM gain or loss attributable to liabilities identified in paragraph (e)(3)(ii) of this section (Step 2), and described in paragraph (e)(3)(vi)(B) of this section as follows:
[(bl + el) / 2] x [br - er]
where
bl = the hyperinflationary currency amount of liabilities at the
beginning of the balance sheet period.
el = the hyperinflationary currency amount of liabilities at the
end of the balance sheet translation period.
br = one dollar divided by the number of hyperinflationary
currency units that equal one dollar at the beginning of
the balance sheet period.
er = one dollar divided by the number of hyperinflationary
currency units that equal one dollar at the end of the
balance sheet period.
(B) Separate calculation
The calculation shall be made separately for interest-bearing liabilities described in paragraph (e)(3)(vii) of this section (Step 7) and for each of the classes of non-interest-bearing liabilities described in paragraph (e)(3)(viii) of this section (Step 8).
(C) Weighting to prevent distortion
Where a distortion would result from averaging the amount of liabilities at the beginning and end of a balance sheet period, as might be the case where a taxpayer incurs or retires a substantial liability, the taxpayer must use a different method that more clearly reflects the average amount of liabilities weighted to reflect the time the liability was outstanding during the balance sheet period.
(vii) Step 7 -- Adjust dollar income and expense by DASTM gain or loss from interest-bearing liabilities
(A) In general
The taxpayer shall apply the amount of DASTM gain on interest-bearing liabilities computed under paragraph (e)(3)(vi) of this section (Step 6) to reduce interest expense generated by such liabilities (e.g., prior to the application of section 1.861-9T or its successor regulation). To the extent DASTM gain on such liabilities exceeds interest expense, it shall be sourced or otherwise classified in the same manner that interest expense is allocated and apportioned under section 1.861-9T or its successor regulation. The amount of DASTM loss on interest-bearing liabilities computed under paragraph (e)(3)(vi) of this section (Step 6) shall be allocated and apportioned in the same manner that interest expense is allocated and apportioned under section 1.861-9T or its successor regulation (without regard to the exceptions to fungibility in section 1.861-10T or its successor regulation). For purposes of this section, an interest-bearing liability is a liability that requires payment of periodic interest (whether fixed or variable), has original issue discount, or would have interest imputed under subtitle A.
(B) Allocation of DASTM gain or loss from interest-bearing liabilities that generate related person interest expense
DASTM gain or loss from interest-bearing liabilities that generate related person interest expense (as provided in section 954(b)(5)) shall be allocated for purposes of subtitle A (including sections 904 and 952) in the same manner that the related person interest expense of that debt is required to be allocated under the rules of section 954(b)(5) and section 1.904-5(c)(2).
(C) Modified gross income method
In applying the modified gross income method described in section 1.861-9T(j) or its successor regulation, gross income shall be adjusted for any DASTM gain or loss from assets as provided in paragraph (e)(3)(v) of this section (Step 5) and any DASTM gain or loss with respect to short-term, non- interest-bearing trade payables as provided in paragraph (e)(3)(viii)(A) of this section.
(viii) Step 8 -- Adjust dollar income and expense by DASTM gain or loss from non-interest bearing liabilities
(A) Short-term, non-interest-bearing trade payables
The taxpayer shall allocate DASTM gain or loss on short-term non-interest-bearing trade payables for purposes of subtitle A (including sections 904 and 952) to the same category or type of gross income as the cost or expense to which the trade payable relates. For this purpose, a short-term, non- interest-bearing trade payable is a non-interest-bearing liability with a term of 183 days or less that is incurred to purchase property or services to be used by the obligor in an active trade or business.
(B) Excise tax payables
The taxpayer shall allocate DASTM gain or loss on excise tax payables for purposes of subtitle A (including sections 904 and 952) to the same category or type of gross income as would be derived from the activity to which the excise tax relates.
(C) Other non-interest-bearing liabilities
(1) In general
Except as provided in paragraphs (e)(3)(viii)(A), (e)(3)(viii)(B), and (e)(3)(viii)(C)(2) of this section, DASTM gain or loss on non- interest-bearing liabilities shall be allocated under paragraph (e)(3)(ix) of this section (Step 9).
(2) Tracing of substantial distortion of income
DASTM gains and losses on liabilities described in paragraph (e)(3)(viii)(C)(1) of this section may be attributed to the same section 904(d) separate category or subpart F category as the transaction to which the liability relates if the taxpayer demonstrates to the satisfaction of the district director, or it is determined by the district director, that application of paragraph (e)(3)(viii)(C)(1) of this section results in a substantial distortion of income.