New DASTM regulations may create phantom taxable profits in hyperinflationary economies.

Estimating the U.S. income tax effects of controlled foreign corporations (CFCs) to U.S. shareholders based on the unadjusted local currency books of the foreign corporation has always been a risky business. New rules first affecting calendar-year taxpayers in 1995 make the likelihood of estimation errors far more likely, and the U.S. tax consequences of estimation errors more severe. These rules affect how a foreign subsidiary operating in a hyperinflationary environment may have to determine its earnings and profits (E&P) in U.S. dollars using the "dollar approximate separate transactions method" (DASTM).

U.S. entities are taking advantage of increasing equity investment opportunities arising in the expanding economies of Eastern Europe, Latin America and Asia. With the rapid growth of some of these economies come high levels of inflation. Hyperinflation occurs when there has been cumulative inflation of at least 100% over a 36-month period. The financial accounting rules under SFAS 52 conclude that the U.S. dollar should be the functional currency in a hyperinflationary environment.

Unlike SFAS 52, the original functional currency regulations under Sec. 985 did not automatically impose the U.S. dollar as the functional currency on a corporation operating in a hyperinflationary economy unless the corporation conducted its activities primarily in U.S. dollars; the corporation was resident in a location using the U.S. dollar as the standard currency; the corporation did not maintain books and records in the currency of any significant environment in which a significant part of its activities were conducted; or the corporation produced U.S. effectively connected income or loss. However, Regs. Sec. 1.985-1(b)(2)(ii) now requires the U.S. dollar to be the functional currency of CFCs otherwise required to use a hyperinflationary currency as its functional currency, effective for tax years beginning after Aug. 24, 1994. In addition, the CFC must follow the DASTM rules of Regs. Sec. 1.985-3 to determine its gross income, taxable income or loss, or E&P.

U.S. Taxpayer-Controlled Foreign Subsidiary DASTM Workpapers (fiscal year

ending 12/31/94)

                                          12/31/94
                                    Using DASTM method
  Income statement             LC         Rate          USD
Sales                     1,000,000,000     Avg.    $33,675,000
Cost of goods sold
 Beginning inventory        (55,000,000)  0.0500     (2,750,000)
 Purchases                 (950,000,000)    Avg.    (33,475,500)
 Ending inventory            55,000,000   0.0230      1,265,000
 Net cost of goods sold    (950,000,000)            (34,960,500)
Depreciation--1993           (2,500,000)  0.0700       (175,000)
Depreciation--1994           (2,500,000)  0.0500       (125,000)
Other expenses              (97,000,000)    Avg.     (3,619,500)
Interest income               2,000,000     Avg.         75,000
DASTM gain/(loss)                                     7,800,000
Net income                  (50,000,000)            $ 2,670,000
                                          12/31/94
                                    Using current method
  Income statement             LC         Rate(*)       USD
Sales                     1,000,000,000    0.038    $38,000,000
Cost of goods sold
 Beginning inventory        (55,000,000)   0.038     (2,090,000)
 Purchases                 (950,000,000)   0.038    (36,100,000)
 Ending inventory            55,000,000    0.038      2,090,000
 Net cost of goods sold    (950,000,000)            (36,100,000)
Depreciation--1993           (2,500,000)   0.038        (95,000)
Depreciation--1994           (2,500,000)   0.038        (95,000)
Other expenses              (97,000,000)   0.038     (3,686,000)
Interest income               2,000,000    0.038         76,000
DASTM gain/(loss)                                           N/A
Net income                  (50,000,000)           $ (1,900,000)

(*)Rate based on average sales, purchases and other expenses for selected accounts.

Very broadly speaking, the DASTM rules are reminiscent of the temporal method rules of SFAS 8 (replaced in the early 1980s by SFAS 52). The general process of translation, outlined at Regs. Sec. 1.985-3(b), and fleshed out in Regs. Sec. 1.985-3(c) and (d), involves preparation of a local currency balance sheet reflecting U.S. E&P adjustments; translation of assets and liabilities at various rates, depending on when the asset or liability came into existence and whether it is "monetary"; translation of income statement items relating to assets at the rates used to translate the corresponding assets on the balance sheet; translation of other income statement items, depending on when they were earned or incurred; translation of dividends or other net worth adjustments at the rate in effect on the date of payment or occurrence; and plugging any unreconciled difference in net worth to the income statement as a DASTM gain or loss. The DASTM gain or loss is then allocated to various classes of gross income earned by the foreign corporation under the rules of Regs. Sec. 1.985-3(e). This allocation process potentially affects the current taxation of gross income in the hands of U.S. shareholders.

Entities operating in a highly inflationary environment try to place themselves in a net monetary liability position. The "economic" value of liabilities denominated in inflated currency is decreasing faster than the "economic" value of assets denominated in the same inflated currency. The intended result is a net economic gain (or at least avoiding a net economic loss). The effect of the DASTM rules is to increase gross income, taxable income or loss, or E&P by this economic gain.

Consider the income statement above for a foreign subsidiary that sells only to customers located in the country of incorporation. Had the controlled foreign subsidiary used the local currency as its functional currency for 1994, there would have been a deficit in E&P. However, use of the U.S. dollar as the functional currency results in positive E&P of $2.67 million, thanks to a DASTM gain of $7.8 million.

Using the local currency as the functional currency would have resulted in no potential subpart F income taxable to U.S. shareholders. The only potential subpart F gross income would have been the LC 2 million of interest income; however, net subpart F income would have been negative after the allocation of expenses.

Using the U.S. dollar as the functional currency, however, results in positive E&P. Since there is a negative gross margin on sales, a taxpayer electing the special small qualified business unit (QBU) DASTM allocation under Regs. Sec. 1.985-3(e)(2) for purposes of simplicity is forced to allocate all DASTM gain to interest income, the only class of gross income earned by the subsidiary. The result is that all $2.67 million of E&P would be considered interest income. All E&P therefore becomes immediately taxable to U.S. shareholders as subpart F income, with no foreign taxes available to offset the U.S. income tax liability.

A U.S. taxpayer with CFCs in this situation is well-advised to follow the complete DASTM nine-step procedure outlined in Regs. Sec. 1.985-3(e)(3), painful and tedious as it may be. Application of this procedure to the example subsidiary would permit the allocation of at least some of the DASTM gain to E&P other than interest income, potentially reducing the current subpart F income inclusion required of U.S. shareholders. U.S. corporate shareholders should also be aware that Sec. 6655(e)(4) treats subpart F income as earned throughout the U.S. shareholders' year for corporate estimated payment purposes.

U.S. shareholders with CFCs using the local currency as the functional currency are required to follow the procedures outlined in Regs. Sec. 1.985-5 for adjustments required on a change in functional currency. Effects to the foreign subsidiary include the deemed realization of certain foreign currency gains and losses and the revaluation of assets and liabilities in the new functional currency, using the spot rate in effect on the first day of the change year. Effects to the U.S. shareholders include recognition of foreign currency gain or loss as if a deemed distribution of all E&P took place immediately prior to the change, including foreign currency gain or loss attributable to paid-in capital, as computed under the Sec. 367(b) regulations for an inbound liquidation.

The new DASTM rules for 1995 calendar years should be considered in ongoing tax planning for controlled subsidiaries in hyperinflationary countries, because of the deemed taxable events occurring as a result of a potential change in functional currency to the U.S. dollar, and because of the potential for U.S. shareholders to be taxed currently on phantom subpart F income when local currency books and records may show a cumulative or current financial loss.

From Bill Major, CPA, Peoria, Ill.