Final and proposed DASTM regulations.
On behalf of Tax Executives Institute, I am pleased to submit the following comments on the proposed regulations under section 985 of the Internal Revenue Code, relating to the computation and characterization of income and earnings and profits under the dollar approximate separate transactions method (DASTM). In addition, this letter addresses several issues raised by the final DASTM regulations issued on December 31, 1992, and July 21, 1994, and the proposed transition rules issued on December 31, 1992.
The Institute commends the Treasury and IRS for issuing the final DASTM regulations which represent a significant improvement over the 1991 and 1989 proposed regulations. By bringing the DASTM method into even closer conformity with U.S. generally accepted accounting principles (GAAP), the final regulations will not only more accurately reflect taxable income and earnings and profits, but also significantly ease the administrative burden on taxpayers. TEI believes, however, that the final regulations seriously underestimate the administrative burden imposed in calculating DASTM gain or loss. The rules are simply unadministrable. In addition, the Institute remains concerned about the mandatory nature of the use of DASTM - a concern that has been compounded by the mandatory reversion requirements imposed by the 1994 proposed regulations. Finally, the Institute urges the Treasury and IRS to issue the final [sections] 1.985-7 transition rules as soon as possible.(1)
1. Proposed Regulations:
Cessation of Hyperinflationary
A. Mandatory Reversion from DASTM. TEI strongly objects to the mandatory reversion from DASTM when the currency ceases to be hyperinflationary. Prop. Reg. [sections] 1.985-1(b)(2)(ii)(E) requires that a qualified business unit (QBU) that has elected or been required to use the dollar as its functional currency under DASTM 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 required movement in and out of DASTM imposes both harsh conversion rules and substantial administrative burdens on taxpayers.
Under the mandatory requirement, a three-year inflation rate of less than 100 percent can easily cause taxpayers operating in countries with highly volatile foreign currencies to bounce between hyperinflationary and non-hyperinflationary status. Consider, for example, the financial situation in Mexico - a leading trading partner of the United States - where the economy has suddenly become unstable. In addition, since 1986, at least four countries - Afghanistan, Nigeria, Paraguay, and Suriname - have flipped' in and out of hyperinflationary status.
Under Treas. Reg. [sections] 1.985-5, changing from DASTM requires the taxpayer to make adjustments to the QBU - s earnings and profits. When the QBU reverts from use of DASTM, its fixed assets will be translated under local currency spot rates.(2) Such an approach will distort the QBU's depreciation charges in relation to its operating income - a situation Congress wanted to avoid in providing for the DASTM election. See S. Rep. No. 99-841, 99th Cong., 2d Sess. 459 (1986). Eliminating the mandatory reversion will more closely effectuate congressional intent.(3)
Moreover, flipping in and out of DASTM entails substantial administrative burdens. For example, taxpayers could be repeatedly required to change a QBU's reporting systems. Indeed, the requirement could well force taxpayers to maintain two reporting systems in the interim non-hyperinflationary period. In addition, under Financial Accounting Standard No. 52 (which is the basis for the DASTM rules), a QBU could maintain the dollar as its functional currency, even though the local currency may no longer be hyperinflationary for purposes of Treas. Reg. [sections] 1.985-1(b)(2)(ii)(D). If the QBU is forced to "flip" back to reporting in the local currency solely for tax purposes, taxpayers will also be required to maintain separate tax and accounting systems.
The final regulations demonstrate a refreshing and commendable merger of tax and accounting principles. We recommend that this consistency be carried over for purposes of Prop. Reg. [sections] 1.985-1(b)(2)(ii)(E). The final regulations should provide that a QBU that has computed its earnings and profits under DASTM may continue to use the dollar as its functional currency, as long as it does so for U.S. GAAP purposes.(4) In addition, TEI recommends that the transition rules of Treas. Reg. [sections] 1.985-6 be used when a QBU is required to change its functional currency. The transition rules of Treas. Reg. [sections] 1.985-5 should be reserved for taxpayers that elect to change functional currency.
B. Base Period for Determination of Non-Hyperinflationary Status. An ambiguity exists under Prop. Reg. [sections] 1.985-1(b)(2)(ii)(E) concerning the matching of the base period used for determination of hyperinflationary status. We believe that the regulations should be clarified to show which years constitute the base period. We suggest the addition of the following example:
S is a controlled foreign corporation operating in an economic environment previously determined to be hyperinflationary. In 1987, S elects the U.S. dollar as its functional currency. In 1997, S reevaluates its economic environment, as follows:
Taxable Base Cumulative Year Period Inflation
1995 1992, 1993, 1994 95% 1996 1993, 1994, 1995 40% 1997 1994, 1995, 1996 15%
Pursuant to [Prop. Reg.] [sections] 1.985-1(b)(2)(ii)(E) (as currently drafted), S must change its functional currency from the U.S. dollar to its local currency as of January 1, 1998.
2. Transition Rules
TEI is concerned that the final transition rules have not been promulgated under [sections] 1.985-7, relating to the adjustments required in connection with a change to DASTM. The proposed regulations were issued in 1991 and would apply to QBUs that begin using DASTM in any post-1986 year. The 1991 proposed regulations would effectively permit taxpayers that begin using DASTM in a year other than their first post-1986 year to obtain the benefits of the favorable transition rules provided in Treas. Reg. [sections] 1.986-6 - i.e., use of historical translation rates to determine the opening U.S. dollar balance sheets - rather than the harsher spot-rate translation rules of Treas. Reg. [sections] 1.985-5. The proposed regulations would be effective for tax years beginning 30 days after promulgation of final regulations and may be retroactively applied to all open taxable years.
Taxpayers are understandably reluctant to make an election when they do not know the full consequences of that election - consequences that cannot be known until final regulations are issued. Absent the prompt issuance of final regulations, the opportunity to make a retroactive election for all open years may be lost because post-1986 taxable years are closing (or, indeed, may have already closed) for many taxpayers. Section 985 grants the IRS and Treasury broad authority to structure the DASTM election. See I.R.C. [sections] 985(b)(3) (permitting the use of DASTM "[t]o the extent provided in regulations"). Taxpayers should not be disadvantaged by the government's delay in developing the regulations. Therefore, Prop. Reg. [sections] 1.985-7 should be made final as soon as possible.
3. Final Regulations
TEI continues to have concerns about the operation of the final DASTM regulations. Although the final rules are a great improvement over the 1989 (and, in some cases, the 1991) proposed regulations, we disagree with several aspects of the final rules. We would be pleased to work with Treasury and IRS personnel to resolve these lingering issues.
A. Related-Person Interest. The final regulations provide a nine-step formula for allocating DASTM gain or loss. Under Treas. Reg. [sections] 1.985-3(e)(3)(vii)(A) [Step 71, DASTM gain on interest-bearing liabilities generally reduces interest expense generated by such liabilities before that expense is allocated under the section 861 regulations. Under Treas. Reg. [sections] 1.985-3(e)(3)(vii)(B), DASTM gain or loss from interest-bearing liabilities that generate related-person interest shall be allocated in the same manner as the related-person interest under section 954(b)(5) and Treas. Reg. [sections] 1.904-5(c)(2).(5)
TEI believes that the Treasury and IRS greatly underestimate the administrative complexity imposed by the interaction of the rules relating to: (i) the allocation of DASTM gain or loss based on the apportionment of interest expense, (ii) the related-person interest expense direct allocation rules of section 954(c)(3), and (iii) the de minimis rules of section 954(b)(3). The regulations essentially require a taxpayer, first, to compute the DASTM loss on assets and apply that loss to the income from specific assets and, then, to compute the DASTM gain on liabilities and apply that gain in the same manner as the look-through interest expense. This creates a circular calculation, however, since the look-through rules under Treas. Reg. [sections] 1.904-5 are generally applied after the calculation of the DASTM gain on liabilities. To our knowledge, there is no commercially available tax compliance software to perform these calculations; they must be done manually (or by an in-house program).
To redress this problem, DASTM gain or loss of the related payor and recipient generated by the related-person liability should be sourced based on gross income per separate limitation category after application of Treas. Reg. [sections] 1.985-3(e)(3)(i) through (vii)(A). Then, interest expense under Temp. Reg. [sections] 1.861-9T may be allocated and the look-through rules of Treas. Reg. [sections] 1.904-5 may be applied. TEI strongly urges that the calculation of Step 7 in the allocation formula be clarified in this manner.(6)
B. Integrated Financial Transactions. Treas. Reg. [sections] 1.985-3(e)(3)(vii)(A) provides that currency gains or losses from liabilities shall be allocated in a fashion similar to interest expense, but without regard to the exceptions to fungibility contained in Temp. Reg. [sections] 1.861-10T. To the extent that a transaction falls within an exception under the section 861 regulations, all elements of the transaction should be treated similarly. The Institute therefore recommends that the fungibility exclusion for integrated financial transactions be included in Treas. Reg. [sections] 1.985-3(e)(3)(vii)(A).(7)
C. Netting of DASTM Gain with Interest Expense. Treas. Reg. [sections] 1.985-3(e)(3)(vii)(A) [Step 7] provides for the adjustment of dollar income and expense by DASTM gain or loss from interest-bearing liabilities. It is unclear, however, whether the taxpayer may net the gain against the interest expense. If not, the regulations will produce another circular calculation. To clarify this issue, TEI recommends inclusion of the following example:
S is a controlled foreign corporation that has elected DASTM. Pursuant to Treas. Reg. [sections] 1.985-3(e)(3)(vi) [Step 6], S has identified local currency liabilities with unrelated parties that bear interest expense in the amount of $100,000 and DASTM gain in the amount of $120,000. By application of Treas. Reg. [sections] 1.985-3(e)(3)(vii)(A) [Step 7], S must reduce the apportionable interest expense generated by the identified liabilities by the DASTM gain generated by the same identified liabilities. Therefore, S reduces its gross income and DASTM gain by $100,000. After the reduction, S has excess DASTM gain generated by the identified liabilities of $20,000. Similarly, S reduces the apportionable interest expense generated by the identified liabilities by $100,000. After the reduction, S has eliminated all apportionable interest expense generated by the identified liabilities. Finally, the excess $20,000 DASTM gain generated by the identified liabilities is sourced in a manner consistent with Temp. Reg. [sections] 1.861-9T or its successor.
D. Interaction with Section 902. Treas. Reg. [sections] 1.985-6(d)(2) provides rules for the carryforward of deficits in accumulated profits from pre-1987 taxable years to post-1986 taxable years. The regulations provide that, for purposes of section 902 and 960, the post-1986 undistributed earnings of a foreign corporation that is subject to DASTM shall be reduced by the dollar amount of the corporation's deficit in accumulated profits, if any, determined under section 902 that was accumulated at the end of the corporation's last taxable year beginning before January 1, 1987. The regulations fail to provide, however, for any section 481 adjustment to earnings and profits (E&P) in respect of the post-1986 pool, and this omission creates a problem in respect of the recent proposed section 902 regulations.
The proposed section 902 regulations specify that the sum of the post-1986 undistributed E&P and the pre-1987 accumulated profits must equal the foreign corporation's E&P. For taxpayers using DASTM that did not compute pre-1987 E&P for Subpart F purposes, the pre-1987 pool and the post-1986 pool (computed under DASTM) will never equal the total accumulated E&P unless a section 481 adjustment is made. Hence, the tax balance sheet will not balance.(8)
Section 985(b)(4) clearly states that a change in functional currency is treated as a change in method of accounting under section 481. The Secretary is thus given authority to establish the appropriate section 481 adjustment. We recommend that the Secretary exercise this authority and provide for an adjustment consistent with section 481 principles.
E. De Minimis Rule. TEI commends the Treasury and IRS for including a de minimis exception for small QBUs with an adjusted basis in assets of less than $10 million. We suggest, however, that the simplified method for allocating DASTM gain or loss should be modified. QBUs with only general limitation income or small amounts of passive income should also be excepted from use of the more complex, multiple calculation formula.
In certain countries, special lines of business are required to be organized in separate legal entities under local law. For example, Brazilian law requires that insurance operations be organized in separate, distinct legal entities; Italian law similarly requires the separation of financing and commercial enterprises. In addition, taxpayers may be required to establish separate legal entities because of the presence of a minority interest shareholder or partner. To avoid penalizing taxpayers with multiple QBUs in the same hyperinflationary country, TEI recommends that the $10 million threshold of Treas. Reg. [sections] 1.985-3(e)(2)(i) be applied on a separate-entity asset basis rather than a related group-asset basis.(9)
F. Mandatory Use of DASTM. TEI continues to object to the mandatory application of DASTM as unauthorized, unjustified, and unfair.(10) The mandatory "flipping" in and out of DASTM (coupled with the use of the spot rate under Treas. Reg. [sections] 1.985-5) will eventually cause all companies to lose their historic dollar basis - in direct contravention of section 985's purpose of maintaining the U.S. dollar historical basis.
Consider, for example, the situation in Brazil. On a historical basis, the Brazilian currency is a hyperinflationary currency within the definition of Treas. Reg. [sections] 1.985-1(b)(2)(ii)(D). Under an economic plan adopted on July 1, 1994, however, the rate of inflation has decreased to single digits for the last six months of 1994. It appears likely that Brazil will have a rate of inflation in 1995 and subsequent years that is less than 100 percent on a three-year average basis. Hence, for taxable years beginning after August 24, 1994, Brazilian QBUs that have not previously adopted DASTM will be required to adopt the dollar as their functional currency. Taking into account the three-year requirement in Prop. Reg. [sections] 1.985-1(b)(2)(E), these QBUs must keep the dollar as a functional currency through the year 2001, even if Brazil maintains its non-hyperinflationary status throughout the post-1994 years. This result does not make sense. We urge Treasury and the IRS to reconsider their resolution of this issue.
Tax Executives Institute appreciates this opportunity to present our views on the final and proposed section 985 regulations relating to the computation and characterization of income and earnings and profits under DASTM. If you have any questions, please do not hesitate to call Philip J. Bergquist, chair of TEI's International Tax Committee, at (408) 974-1531 or Mary L. Fahey of the Institute's professional staff at (202) 638-5601.
1 Final (T.D. 8556) and proposed (INTL-66-92) regulations relating to the calculation of DASTM gain and loss were published in the August 29, 1994, issue of the Internal Revenue Bulletin (1994-35 I.R.B. 6, 52) and the July 22, 1994, issue of the Federal Register (59 F.R. 37669, 37733). The final regulations replace, in part, proposed regulations issued on July 17, 1991. In addition, the final (T.D. 8464) and proposed (INTL-45-92) regulations relating to the transition rules were published in 1993-1 C.B. 171, 853, and in the January 5, 1993, issue of the Federal Register (58 F.R. 231, 300). (2) Treas. Reg. [sections] 1.985-5(b)(2) requires that the basis of assets be translated at the exchange rate in effect at the time of the change in functional currency. In its July 2, 1992, comments on the 1991 proposed regulations, TEI objected to this harsh transition rule in cases where taxpayers are required to change their functional currency. This problem is exacerbated where a QBU operates in an economic environment that flips in and out of hyperinflationary status. (3) Even if the use of DASTM remains mandatory (see comment 3.F), TEI believes the mandatory reversion from DASTM conflicts with the statute. The last sentence of section 985(b)(3) provides that "[a]ny such [DASTM] election shall apply to the taxable year for which made and all subsequent taxable years unless revoked with the consent of the Secretary." The italicized language suggests that the reversion can only be initiated by the taxpayer. Rather than mandating a return to the local currency, then, the regulations should provide for the automatic consent of the Secretary to a taxpayer's request for a reversion after three years of non-hyperinflationary status. (4) At a minimum, any mandatory change from DASTM should be limited to situations where the inflation rate drops to an unusually low rate (say, equal to or lower than the U.S. rate of inflation). (5) Under Treas. Reg. [sections] 1.1904-5(c)(2), related-person interest expense is first applied to, and reduces, passive foreign personal holding company income (FPHCI). Any remaining related-person interest expense is then allocated under Temp. Reg. [sections] 1.861-9T(f)(3), on either the asset method or the modified gross income method. The DASTM gain is to be allocated in computing adjusted gross income before the allocation of the related-person interest expense. Because of this ordering - and because the allocation of the related-person interest expense is dependent upon the absolute amount of passive FPHC adjusted gross income after allocation of the DASTM gain - it is unclear how a taxpayer should interpret the words "in the same manner." A taxpayer cannot apply a DASTM gain to reduce passive FPHCI to zero; the gain increases such income. An amount of DASTM gain equal to the passive FPHC adjusted gross income could be allocated to that basket, but there is no particular rationale for doing so. Nor is it clear how DASTM gain, if required by Step 7, would affect the allocation of related-person interest income inclusion by the payee. (6) An alternative to the circular calculation problem is to reduce the DASTM gain or loss, and the interest income/expense of the related recipients and payor in a manner similar to Treas. Reg. [sections] 1.985-3(e)(vii)(a). (7) The operational problems with the DASTM rules stem, in part, from the narrow definition of an integrated financial transaction in the section 861 regulations, which pay precious little attention to the manner in which multinational corporations manage financial assets and liabilities in a hyperinflationary environment. A typical integrated financial transaction in a hyperinflationary economy will involve rollovers of the financial asset and therefore will not qualify for integrated treatment. As a result, a mismatching of the interest/investment income, interest expense, and DASTM gain or loss will occur under Treas. Reg. [sections] 1.985-3(e)(vii)(A). The first two legs' of the transaction - the interest/investment income and the DASTM loss on the financial asset - will be passive Subpart F income. The second two "legs" - the interest expense and the DASTM gain or loss on the liability - will be apportioned under Temp. Reg. [sections] 1.861-9T. TEI recommends that (i) integrated financial transaction rules be incorporated into DASTM and (ii) the integrated financial transaction rules be expanded to encompass certain transactions (e.g., asset rollovers) common in hyperinflationary economies. (8) We recognize that, prior to the Tax Reform Act of 1986, section 902 accumulated profits did not equal E&P profits under section 964, but the only difference was timing. Upon a complete liquidation the two would be equal. We suggest that section 985 was enacted to bring these two provisions into conformity. (9) This exception could be structured as a safe harbor by permitting either: (i) grandfathering of CFCs established before the publication of the final regulations under section 985; (ii) exceptions for situations where local (foreign) law requires use of multiple entities; or (iii) the presence of a minority interest shareholder. (10) We recognize that section 989(c) of the Code grants the Secretary broad authority to prescribe such regulations "as may be necessary or appropriate to carry out the purposes of this subpart ... " This language contrasts with section 985(b)(3) which provides for an election of the DASTM method by the taxpayer. Since the two provisions were adopted at the same time, under standard statutory rules of construction the more specific language of section 985(b)(3) providing for the DASTM election is controlling. See, e.g., United States v. Chase, 135 U.S. 255, 260 (1890) ("Where there is, in the same statute, a particular enactment, and also a general one, which, in its most comprehensive sense, would include what is embraced in the former, the particular enactment must be operative, and the general enactment must be taken to affect only such cases within its general language as are not within the provisions of the particular enactment."). See also Essenfeld v. Commissioner, 37 T.C. 117, 123 (1961), aff'd, 311 F.2d 208 (2d Cir. 1962).
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|Title Annotation:||Tax Executives Institute International Tax Committee; dollar approximate separate transactions method|
|Date:||Mar 1, 1995|
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