Foreign currency losses attributable to loans.

The Service's position had been that foreign currency losses between related parties resulted from the sale or exchange of a capital asset and thus were not allowable under the related-party loss rules (Sec. 267). Therefore, the disallowance of these losses had been an IRS audit target. However, it appears that this position no longer applies.

If a related-party loan is denominated in a foreign currency and an exchange loss attributable to principal repayments is sustained, there is substantial authority that the loss is currently deductible as an ordinary loss. However, if the debt is replaced by another related-party debt denominated in a different foreign currency, the loss is deferred until the new debt is retired.

Background

On Dec. 12, 1984, in National-Standard Co., 749 F2d 369, aff'g 80 TC 551 (1983), the Sixth Circuit held that foreign currency exchange losses attributable to principal repayments were ordinary losses. In that decision, the loan was between a corporation and an unrelated bank. A transaction resulting in a capital loss must involve a "sale or exchange" of a "capital asset." The court concluded that the discharge of the debt was not a "sale or exchange," because the company received nothing in the transaction other than the discharge of its debt. Since there was no "sale or exchange," the court did not decide if the foreign currency was a capital asset in the taxpayer's hands.

In GCM 39294, the Service has taken a position contrary to the Tax Court's National-Standard decision. This memorandum stated that foreign currency is a capital asset and a debt repayment is a sale or exchange of the foreign currency. Therefore, according to the IRS, foreign currency exchange losses attributable to principal repayments were capital losses.

As capital losses, foreign currency loss deductions are subject to the Sec. 1211 limitations. They also are subject to the Sec. 267 related-party loss restrictions.

However, under Sec. 988 (enacted in 1986), certain foreign currency losses are treated as ordinary losses. For instance, if a loan between unrelated parties, such as a corporation and a bank, is denominated in a foreign currency and an exchange loss is sustained on principal repayment, the loss is treated as an ordinary loss and is currently deductible in full.

On the other hand, if there is a similar loan between related parties and a foreign currency exchange loss is sustained on principal repayment, is the loss's current deduction precluded by the Sec. 267 related-party loss restrictions? It appears that a foreign currency loss between related parties should be subject to Sec. 988 and, therefore, should be treated as an ordinary loss. Further, the loss should be deductible currently - unless the debt is replaced with another debt denominated in a different foreign currency.

The application of the Sec. 267 rules to debt repayment is awkward, at best. It appears the the Service continues to follow GCM 39294. Accordingly, under Sec. 267(a) and (f), certain related-party losses generally are deferred, but not denied, until the property is "transferred outside the group." Presumably, the property (the foreign currency) is transferred outside the group when the debt is extinguished. The practical effect is that, on principal repayment, the debt leaves the group and Sec. 267 neither defers nor denies the loss. However, Regs. Sec. 1.988-2(b)(16)(ii), coordinating with Sec. 267, has reserved the treatment of a debtor for future determination.

If a loss arises from the repayment before maturity of a debt denominated in a foreign currency, the loss may be deferred if the IRS determines that the debt has been replaced with some other debt denominated in a different currency ("replacement debt") entered into with the same or another related person (Prop. Regs. Sec. 1.988-2(b)(14)(i)). Presumably, the reason for this proposed rule is that the foreign currency has not left the controlled group.

The loss deferral may not exceed the earlier of the date that the replacement debt is terminated in a transaction in which gain or loss is recognized or the maturity date of the replacement debt, as long as the debt is not replaced with debt of a related person in a different currency. It appears that the final regulation should follow this proposed regulation.

The same rules apply to foreign currency exchange losses sustained on the payment of foreign denominated accrued interest owed to related parties; see Sec. 988(c)(1)(B)(ii).

The treatment of related-party creditors is discussed in the Tax Reform Act of 1986's "Blue Book":

Section 267(f)(3)(C) authorizes the Secretary to prescribe regulations excepting certain foreign currency losses from the loss disallowance and loss deferral rules of section 267(a)(1) and section 267(f)(2), respectively. The statutory authorization relates to a loss sustained by a corporate lender on repayment of a foreign currency denominated loan by a affiliated corporation. Pursuant to this regulatory authority, the Secretary has issued temporary regulation sec. 1.26(f)-1T(h).

The Act contemplates that the Secretary will review these temporary regulations with a view towards conforming the regulatory exception to the provisions of the Act. For example, the application of the temporary regulation is limited to a loan that is |payable or denominated solely in a foreign currency;' consistent with the statutory definition of a section 988 transaction, the regulatory rule should take account of a loan where the principal is determined by reference to the value of a nonfunctional currency. Further, the Secretary will determine the appropriateness of applying the 267 regulatory exception to every case currently covered there-under. In light of the section 989(c)(5) regulatory authority to provide for the appropriate treatment of related-party transactions, for example, the Secretary should determine the extent to which the scope of the section 267 regulatory exception should be limited. Any section 267 exceptions that survive this review should be narrowly drawn.

In turn, Regs. Sec. 1.267(f)-1(h) reads as follows:

Treatment of a creditor with respect to a loan in nonfunctional currency. Section 267(a)(1) and (f)(2) shall not apply to an exchange loss realized with respect to a loan of nonfunctional currency if -

(1) The loss is realized by a member with respect to nonfunctional currency loaned to another member;

(2) The loan is described in [section]1.988-1(a)(2)(i);

(3) The loan is not in a hyperinflationary currency as defined in [section]1.988-1(f); and

(4) The transaction does not have as a significant purpose the avoidance of federal income tax.