Proposed DASTM regulations.
On July 16, 1991, the Internal Revenue Service issued proposed regulations under sections 904, 954, and 985 of the Internal Revenue Code, providing rules for the computation and characterization of income and earnings and profits under the dollar approximate separate transactions method (DASTM) of accounting for qualified business units (QBUs) operating in countries affected by hyperinflationary conditions. The proposed regulations (INTL-29-91) were published in the Federal Register on July 17, 1991 (56 Fed. Reg. 32525) and in the Internal Revenue Cumulative Bulletin (1991-2 C.B. 1062).(1) A public hearing on the proposed regulations was held on September 13, 1991.
Tax Executives Institute (TEI) is the principal association of corporate tax executives in North America. Our approximately 4,800 members are employed by more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike.
As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is consistent with sound tax policy, one that taxpayers can comply with, and one in which the Internal Revenue Service can effectively perform its examination function. Many TEI members work for multinational enterprises with active business operations in countries affected by hyperinflationary economic conditions on which the DASTM rules have a substantial impact. Thus, TEI brings an important, balanced, and informed perspective to bear on the proposed regulations.
The Institute commends the IRS for publishing the proposed DASTM regulations in response to taxpayer criticism of the existing regulations. As the preamble to the proposed regulations recognizes, an election under the existing regulations would have frequently resulted in significant distortions in the timing of income or loss and in the foreign tax credit limitation categories into which DASTM pin or loss may fall. Consequently, many taxpayers have been unwilling to make the DASTM election.
In TEI's view, the proposed regulations adequately address the principal issues impeding taxpayers from electing DASTM for operations in hyperinflationary economies. Generally, the methodology of the proposed regulations will properly reflect taxable income and earnings and profits for the years to which they apply. Moreover, the drafter's decision to conform DASTM to U.S. generally accepted accounting principles (GAAP) will significantly ease the administrative burden on taxpayers.
The importance of finalizing the proposed changes cannot be overemphasized. The proposed regulations permit taxpayers to apply the revised DASTM method to all open, post-1986 Tax Reform Act taxable years. Given the substantive flaws in the current regulations, this "election back" will provide relief to taxpayers that have not made the DASTM election. Absent the prompt issuance of final regulations, however, the opportunity to make a retroactive election for all open years may be lost because post-1986 taxable years are closing (or, indeed, may already have closed) for many taxpayers. Moreover, failure to quickly promulgate final regulations may lead to significant problems arising from application of the transition rules; in effect, taxpayers may be denied the opportunity to use the transition rules of Temp. Reg. [section] 1.985-6T and will be compelled instead to use the less favorable rules of Temp. Reg. [section] 1.985-5T. TEI urges IRS to issue final regulations as soon as possible.
In addition to these general comments, TEI has specific comments, set forth more fully below, to improve the operation of the regulations. In summary, TEI recommends that:
* In order to conform DASTM
more closely to GAAP, the
regulations should expressly
permit taxpayers to use
period-end translation rates
for purposes of the various
* The regulations should clarify
that gross income should
be calculated after adjustment
for DASTM gain or
loss for all purposes of the
* The regulations should provide
that DASTM gain or loss
on non-interest bearing liabilities
is to be traced to the
category of income to which
the liability is related.
* The regulations, which generally
allocate DASTM pin
as contra interest expense,
should take into account the
exceptions to fungibility contained
in Temp. Reg. [section] 1.861-10T
(relating to non-recourse
debt and integrated
* The regulations should provide
a simplified version of
the eight-step DASTM calculation
for taxpayers that
earn income principally in
one foreign tax credit limitation
category or have de
minimis amounts of separate
limitation passive income.
* The regulations should expand
the scope of relief for
taxpayers that are adversely
affected by the transition
to the new DASTM regime.
* Finally, the mandatory application
of DASTM should
be reconsidered on the
grounds that it violates principles
of sound tax administration
and statutory construction.
At a minimum,
an adjustment resulting
from the imposition of
DASTM should be spread
prospectively under principles
similar to those employed
under section 481.
1. Year-End Rate.
The proposed regulations prescribe a translation method for calculating DASTM gain and loss similar in most respects to that used for U.S. GAAP purposes. The use of GAAP translation methods eliminates the timing distortions caused by the translation method in the current regulations by more closely matching the timing of recognition of DASTM gain or loss to the recognition of income or expense for a QBU's income statement. By more closely conforming DASTM to the GAAP translation method, the DASTM compliance burden is reduced because taxpayers will be able to rely on financial statements already prepared for reporting purposes.
TEI believes that the burden can be further reduced and compliance improved by conforming the regulations even more closely to a GAAP standard. Specifically, the regulations should expressly permit cash, debt obligations, and certain financial instruments to be translated at the period-end exchange rate (i.e., the current spot rate at the balance sheet date). As proposed, the regulations would require taxpayers to translate these items at the exchange rate for the last translation period for the taxable year.(2) Unless taxpayers specifically elect to specify a translation period of less than one month (as permitted under Prop. Reg. [section] 1.985-3(c)(7)(ii)), the translation rate for monetary assets and liabilities will presumably be the average rate for the period. Prop. Reg. [section] 1.985-3(c)(6) permits taxpayers sufficient latitude in selecting an exchange rate convention to closely conform financial and tax accounting, while the consistency requirement adequately safeguards the fisc. TEI recommends that the regulations expressly permit the translation of monetary assets and liabilities at the period-end exchange rate.
2. Classification of DASTM Gain or Loss as Gross Income.
The effect of many Code sections affecting QBUs in hyperinflationary economies depends upon the definition of gross income -- including, among others, section 954(b)(3)(B) (the full inclusion rule), section 954(b)(5) (related party interest), section 6501(e) (the extended statute of limitations based on substantial omissions of gross income), and section 1296 (containing the rules on passive foreign investment companies). The regulations should thus clarify that gross income is calculated after adjustment for DASTM gain or loss for all purposes of the Internal Revenue Code.
3. Allocation of DASTM Gain on Liabilities to Categories of Income.
Under Prop. Reg. [section] 1.985-3(e)(7), DASTM gain attributable to the translation of all liabilities is allocated and apportioned generally in the same manner as interest expense -- i.e., on a modified gross income or gross asset basis. This approach may produce severe distortions of a QBU's income or loss through the allocation of translation exchange pin to categories of income (for purposes of the various section 904(d) foreign tax credit limitations) that do not generate such gains.
The distortions caused by the proposed regulations can be illustrated by the following example. Suppose a product is worth 100 units of local currency at current prices at a time when the local currency exchange rate is 100 units per U.S. dollar. The vendor, however, contemplates devaluation of the currency in the hyperinflationary environment and charges 105 local currency units. Thus, the vendor anticipates a 2-1/2 percent monthly inflation rate, an expected payment cycle of 60 days, and an exchange rate of 105 local currency units per U.S. dollar at the date of payment. Under the proposed regulations, a taxpayer's purchase would be booked at $1.05 and interest expense would be reduced by the subsequent exchange gain of 5 [cents].
TEI believes that the 5 [cents] exchange gain should be treated as an offset to cost of goods sold, rather than an offset to interest expense. By associating the DASTM gain and loss on non-interest bearing payables with related inflationary costs, interest bearing and non-interest bearing liabilities will be treated consistently. In both cases, gains attributable to inflation will be treated as an offset to directly related expenses. This approach would also be consistent with the allocation of DASTM pin or loss on financial assets to income from such assets.
TEI believes that it is illogical to have one rule for accounts receivable -- direct allocation -- and a different rule for accounts payable -- apportionment (like interest expense.) Furthermore, TEI believes that the DASTM methodology should be expanded to reflect the economic results of hyperinflation. We thus recommend that Steps Two and Three of Prop. Reg. [section] 1.985-3(e) be modified to permit the identification and characterization of all assets and liabilities translated at other than historical rates.(3) Step Seven of the DASTM calculation should be revised so that pin [or loss] on noninterest bearing liabilities would first be allocated to the limitation category to which the liability relates (e.g., the overall limitation category for trade accounts payable). Then, the DASTM pin [or loss] on interest-bearing liabilities would be allocated in one of two ways. The first approach would be to permit the direct allocation of the DASTM gain [or loss] to the category of income to which the liability relates. Alternatively, the DASTM gain could be allocated based on the gross income (after the preceding DASTM allocations) within each category.(4) The second approach, while simpler, is similar to the approach in the current regulations and, thus, suffers from the defect of producing noneconomic results. Taxpayers should, perhaps, be given the opportunity to select an approach, with the selection being treated as an accounting method.
4. Exceptions to Fungibility.
Step Seven of Prop. Reg. [section] 1.985-3(e)(7) provides that currency gain or loss from liabilities shall be allocated in a fashion similar to interest expense, but without regard to the exceptions to fungibility contained in Temp. Reg. [section] 1.861-10T. To the extent a transaction qualifies for an exception to fungibility under Temp. Reg. [section] 1.861-10T, TEI believes that all elements of the transaction should be treated similarly. Since DASTM loss on assets is traced directly to income from the asset, DASTM gain on liabilities should be traced directly to interest expense associated with liabilities that have already been identified pursuant to Temp. Reg. [section] 1.861-10T.(5)
5. Simplified Method.
Although the proposed DASTM calculation is generally beneficial to taxpayers, TEI believes its complexity is generally warranted only in cases where the QBU has income or expense in multiple section 904 categories. Taxpayers with only general limitation income may prefer to avoid the multiple calculations required by Prop. Reg. [section] 1.985-3(e) and simply determine beginning and ending net worth under Prop. Reg. [section] 1.985-3(d). Further, many QBUs will have only small amounts of passive income. TEI believes a simplified alternative to the eight-step method is warranted in either situation.
In the case of a taxpayer with income in only one category, the regulations should provide that use of the eight-step procedure is unnecessary. In the case of a taxpayer with a de minimis amount of passive income, the regulations should permit tracing of exchange loss on financial assets to income from such financial assets without requiring the taxpayer to go through the full eight-step procedure.
6. Transition Rules.
Temp. Reg. [section] 1.986-6T sets forth transition rules for QBUs that elect DASTM under Treas. Reg. [section] 1.985-2 for the first taxable year following the effective date of the Tax Reform Act of 1986 (the 1986 Act). Taxpayers that elect to change functional currency in a year subsequent to the first taxable year following the effective date of the 1986 Act are subject to the rules contained in Temp. Reg. [section] 1.985-5T.
A. Translation of Assets and Liabilities
Temp. Reg. [section] 1.985-6T provides rules for QBUs that elect the dollar method for their first taxable year following the 1986 Act. Under these rules, the taxpayer's liabilities and assets are translated at the historical rate for the date the asset was acquired or the liability incurred. Thus, no exchange gain or loss will be recognized when the assets are collected or the liabilities are paid. Further, the calculation of depreciation expense for periods subsequent to the date of change will be based on the historical dollar-value acquisition cost of the assets. Similarly, taxpayers that elected DASTM pursuant to the temporary and proposed regulations as they existed prior to September 19, 1989, were afforded the same historical exchange rate treatment.(6)
Temp. Reg. [section] 1.985-5T provides general rules that apply when a QBU voluntarily changes its functional currency. These rules also apply to QBUs that elect to use the dollar beginning in years subsequent to the first post-1986 Act taxable year. Under Temp. Reg. [section] 1.985-5T(b)(2), the basis of assets is translated at the exchange rate in effect at the time of the change in functional currency. Under these rules, QBUs will translate inventory at the spot rate on the last day of the taxable year before the change. As a result, cost of goods sold will be lower and, thus, taxable income will be inflated when items of inventory are subsequently sold. Furthermore, depreciation expense for fixed assets will not reflect their historical dollar cost; rather, such expense will be calculated on the dollar value of the asset based on the spot rate at the end of the taxable year preceding the change to the dollar. Thus, QBUs that do not elect DASTM in the first post-1986 Act taxable year will experience the disappearing plant' problem measured by the difference in the value of local currency against the dollar between the date fixed assets were acquired and the date of the dollar election.
TEI opposes the application of harsh transition rules to taxpayers that do not make the dollar election in the initial post-1986 Act taxable year. The transition rules contained in Temp. Reg. [section] 1.985-6T implement congressional intent regarding the use of DASTM by taxpayers operating in hyperinflationary environments, particularly with respect to the "disappearing plant' issue. Thus, the less favorable rules in Prop. Reg. [section] 1.985-5T should not be imposed on taxpayers simply because they did not avail themselves of the dollar election for earlier taxable years.
The application of more generous transition rules to QBUs that were not required to use DASTM until a year subsequent to 1987 would be particularly appropriate. QBUs operating in countries that did not develop hyperinflationary economies until after the first post-1986 Act taxable year should also be able to use the more favorable rules of Temp. Reg. [section] 1.985-6T. (During the past five years, there have been nine additions to the list of countries with hyperinflationary currencies; ten additional countries verge on becoming hyperinflationary within the next year.) TEI submits that it is inequitable not to apply the more favorable transition rules of Temp. Reg. [section] 1.985-6T to taxpayers compelled to apply DASTM under the conformity rule of Treas. Reg. [section] 1.985-2(d)(3).
In addition, TEI believes that the transition rules of Temp. Reg. [section] 1.985-6T should be applied in other circumstances including. (1) QBUs that elected DASTM in reliance on the temporary and proposed regulations for tax years ending before September 19, 1989, and (2) QBUs that have had post-1986 taxable years close and are unable to retroactively elect DASTM for their first post-1986 taxable years. Taxpayers that have had post-1986 taxable years close or that made DASTM elections under the temporary and proposed regulations -- which provide a result similar to Temp. Reg. [section] 1.985-6T -- should not be burdened with either a harsher transition rule (under Temp. Reg. [section] 1.985-5T) or making changes as a result of a previous voluntary DASTM election.
B. Full Recognition of Exchange Gain of Loss Under Temp. Reg. [section] 1.985-5T
Temp. Reg. [section] 1.985-5T requires that all the exchange pin or loss inherent in a QBU branch of a U.S. taxpayer or controlled foreign corporation under sections 987 and 986(c), respectively, must be recognized immediately upon a change in functional currency pursuant to use of the dollar and DASTM. TEI believes the immediate recognition of such exchange gain or loss, which is attributable to dramatic exchange movements over a period of years, is improper because of the significant distortion that arises from the inclusion and because the approach overrides the recognition triggering principles of sections 987 and 986(c). This distortion presents a clear case for spreading the adjustment over several years, analogous to the manner in which adjustments are taken into account under section 481. Indeed, a change in functional currency is considered a change of accounting method under section 985(b)(4). Accordingly, TEI submits that any section 987 or section 986(c) exchange gain or loss recognized pursuant to Temp. Reg. [section] 1.985-5T should be spread over a period of years similar to the spread available under section 481 for other accounting method changes.
7. Mandatory Use of the Dollar and DASTM.
Section 985(b)(3) of the Code provides in part "To the extent provided in regulations, the taxpayer may elect to use the dollar as the functional currency for any qualified business unit . . . ." Notwithstanding the discretion the statutory provision seemingly grants (that "the taxpayer may elect"), Prop. Reg. [section] 1.985-1(b)(7) requires QBUs operating in hyperinflationary environments to use the dollar as their functional currency. The presence in the proposed regulations of a provision mandating the use of the dollar and DASTM is controversial, particularly since it represents a departure from the existing regulations that fully implemented a statutorily authorized election to use the dollar.
TEI recommends that the imposition of a mandatory rule be reconsidered. At a minimum, TEI believes it would be extraordinarily inappropriate to mandate recognition of the taxpayer's entire adjustment under Temp. Reg. [section] 1.985-5T in one year because such an approach distorts taxable income and represents a dramatic policy reversal. Accordingly, TEI submits that the effect of Prop. Reg. [section] 1.985-1(b)(7) should be tempered by spreading any such adjustment over several years under principles similar to those employed under section 481.
TEI is pleased to have the opportunity to present its views on the subject of the proposed DASTM regulations. These comments were prepared under the aegis of TEI's International Committee whose chair is Raymond G. Rossi. If you have any questions concerning these comments, please call either Mr. Rossi of Intel Corporation at (408) 765-1193, or Jeffery P. Rasmussen of the Institute's professional tax staff at (202) 638-5601. (1) For simplicity's sake, the proposed regulations are referred to as "the proposed regulations" and specific provision8 are cited as "Prop. Reg. [section]". The current regulations will be referred to as such and specific provisions are cited as "Treas. Reg. [section]." Specific provisions of temporary regulations are cited as "Temp. Reg. [section]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Cumulative Bulletin. (2) As a period translation rate, the focus is on the income statement (or current period taxable income.) (3) Steps Two and Seven should also be modified to allocate DASTM gains and losses directly to assets and liabilities that are part of an integrated financial transaction. See TEI's following comment. (4) An allocation based on interest expense as required in the proposed regulations may be theoretically correct; however, the interaction of this method with the de minimis rule of section 954(b)(3) and with the related party payment rules of section 954(c)(3) produces circular calculations that are exceedingly complex. (5) The proposed regulations, in general, capture the economic results of operating in a hyperinflationary environment. The narrow definition of an integrated financial transaction under the section 861 regulations, however, ignores the manner in which multinational enterprises manage financial assets and liabilities under such conditions. Specifically, Temp. Reg. [section] 1.861-10T disqualifies rollover investments from qualifying for integration with a directly related borrowing. In byperinflationary environments, however, rollovers of investments with shorter-term maturities than the related liability are not only common, but constitute prudent financial management. Absent integrated financial transaction treatment, DASTM, revised as we suggest, produces the following results: (1) The income from the investment is Subpart F passive income; (2) DASTM loss on the investment is allocated directly to reduce the passive, Subpart F income; (3) DASTM gain on the liability is allocated as Subpart F income; and (4) Interest expense of the obligation is not directly allocated to reduce the Subpart F income. Thus, only three out of the four legs would be joined. TEI would be willing to work with IRS to make the appropriate changes to the integrated financial transactions rule. (6) See T. D. 8208.
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|Title Annotation:||dollar approximate separate transactions method of accounting|
|Date:||Jul 1, 1992|
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