AICPA Comments on Revision of Proposed Section 987 ...



August 20, 2003

Mr. Jeffrey L. Dorfman

Branch Chief, Associate Chief Counsel (International)

Room 4562, CC:Intl:Br5

Internal Revenue Service

1111 Constitution Avenue

Washington DC 20224

Re: Comments on Revision of Proposed Section 987 Regulations

Dear Mr. Dorfman:

In Notice 2000-20, the Department of the Treasury and the Internal Revenue Service requested comments concerning certain issues that should be addressed in revised regulations under section 987. Although the Notice requested comments by June 19, 2000, revised regulations have not yet been issued.

In light of the importance of the matters addressed in the Notice, the American Institute of Certified Public Accountants offers the attached comments, addressing qualified business units (QBUs) that are branches, including disregarded entities. (Our comments do not address the section 987 consequences of partnerships, estates, or trusts.)

We suggest that the revised regulations provide that no exchange gain or loss is recognized on remittances of capital from a qualified business unit (QBU) and adopt the four-pool approach of reg. section 1.987-5 to determine whether transfers are remittances of earnings or capital. We suggest that the revised regulations also adopt an annual netting rule. We recommend that the revised regulations respect the legal form of ownership of QBUs in determining the section 987 consequences of any transfer of property between QBUs. The revised regulations should also provide that transfers between two QBUs with the same functional currency do not result in section 987 exchange gain or loss, regardless of how the QBUs are owned. Moreover, we recommend that the revised regulations should make no distinctions between the types of property distributed from a QBU. We have made other comments, as well.

We would be pleased to discuss our comments with you or a member of your staff. You may contact me at (202) 414-0705 or at robert.zarzar@us.; or Eileen Sherr, AICPA Technical Manager, at (202) 434-9256 or esherr@.

Sincerely,

Robert A. Zarzar

Chair, Tax Executive Committee

cc: The Honorable Pamela Olson, Assistant Secretary (Tax Policy), Department of the Treasury

Barbara Angus, International Tax Counsel, Department of the Treasury

Emily Parker., Acting Chief Counsel, Internal Revenue Service

Hal Hicks, Associate Chief Counsel (International), Internal Revenue Service

Steven Musher, Assistant Chief Counsel (International), Internal Revenue Service

Kenneth Christman, Assistant to the Branch Chief, Internal Revenue Service

AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on Revision of

Proposed Section 987 Regulations

Developed By:

International Tax Technical Resource Panel

Section 987 Task Force

Neil Feinstein, Chair

Alan L. Fischl, Member

John P. Kennedy, Member

Michael E. Steinsaltz, Member

Andrew M. Mattson, Chair, International Tax Technical Resource Panel

Eileen R. Sherr, AICPA Technical Manager

Approved By:

International Tax Technical Resource Panel

and

Tax Executive Committee

Submitted to

Department of the Treasury

and

Internal Revenue Service

August 20, 2003

AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on Revision of Proposed Section 987 Regulations

August 20, 2003

SUMMARY OF RECOMMENDATIONS

1. The revised regulations should provide that no exchange gain or loss is recognized on remittances of capital from a qualified business unit (QBU) and adopt the four-pool approach of reg. section 1.987-5 to determine whether transfers are remittances of earnings or capital.

2. The revised regulations should adopt an annual netting rule.

3. The revised regulations should respect the legal form of ownership of QBUs in determining the section 987 consequences of any transfer of property between QBUs. Thus, one QBU could be deemed to own another QBU. The revised regulations should also provide that transfers between two QBUs with the same functional currency do not result in section 987 exchange gain or loss, regardless of how the QBUs are owned.

4. As is the case under the proposed regulations,[1] the revised regulations should make no distinctions between the types of property distributed from a QBU.

5. The revised regulations should provide that transferring a QBU’s assets in any domestic-to-domestic section 351 transaction does not result in a branch termination, whether or not the transfer is between members of a consolidated group. The revised regulations should also eliminate the proposed regulations’ designation of certain other QBU asset transfers as branch terminations.

6. The revised regulations should include rules about the effect of sections 961 and 1293 on the equity and basis pools of a QBU holding stock in a controlled foreign corporation (CFC) or a qualified electing fund (QEF), and about the effect of sections 961 and 1293 on the basis of CFC or QEF stock in hands of the QBU.

COMMENTS

1. Treatment of Contributions and Distributions of Capital to or from a QBU under Section 987

The proposed regulations require a taxpayer to recognize exchange gain or loss upon receiving a remittance from a QBU by apportioning its basis in the QBU to each remittance and then recognizing exchange gain or loss based on difference between the value of the remittance and the basis apportioned to it. All unrealized exchange gain or loss with respect to a QBU is triggered upon a branch termination.

Specifically, under the proposed regulations, a taxpayer is required to maintain two pools for each QBU: an equity pool and a basis pool. The equity pool represents the tax basis in the equity of the QBU in the functional currency of the QBU. The basis pool represents the tax basis in the equity of the QBU in the functional currency of the taxpayer. The equity pool and basis pool generally consists of the property transferred to the QBU by the taxpayer and the earnings of the QBU less distributions from the QBU to the taxpayer and losses of the QBU.

The taxpayer recognizes exchange gain on loss on a remittance from a QBU equal to the difference between the amount of the remittance translated into the functional currency of the taxpayer at the spot rate on the date of the remittance and the basis pool apportioned to the remittance. The basis pool apportioned to a remittance is determined in accordance with the following formula:

Remittance from the QBU in the QBU’s functional currency / equity pool x basis pool.

A remittance is a transfer from a QBU to the extent of the equity pool. A transfer is the net amount of property that, on any day, either is distributed from a QBU to the taxpayer (or to any other QBU of the taxpayer) or is contributed to the QBU by the taxpayer (or by any other QBU of the taxpayer). The amount of property is generally determined by reference to its basis immediately before the transfer.

Under the proposed regulations, a taxpayer recognizes exchange gain or loss on remittances of both earnings and capital. Moreover, because earnings and capital are included in the same set of pools, each remittance is, in effect, made proportionately out of earnings and capital.

Notice 2000-20 states that Treasury and the Service are reevaluating the treatment of contributions of capital to and distributions of capital from a QBU. The Notice suggests that an approach different from that in the proposed regulations might be to compute exchange gain or loss only on remittances of earnings, rather than taking remittances of capital into account. The Notice recognizes that such an approach would align the principles of section 987 more closely with the principles of section 986.

The AICPA agrees that the revised regulations should compute exchange gain or loss only on remittances of earnings for the reason given in the Notice. Section 987 was enacted as part of The Tax Reform Act of 1986. The act adopted comprehensive rules concerning branches and foreign subsidiaries. One of the general themes of these rules was to minimize the disparate treatment of branches and foreign subsidiaries.[2] A taxpayer does not recognize exchange gain or loss upon receiving distributions from a foreign corporation except as provided under section 986. Under that section, the taxpayer recognizes exchange gain or loss only upon receiving distributions of previously taxed earnings and profits described in section 959 and section 1293(c).[3] The AICPA believes that a taxpayer should similarly recognize exchange gain or loss only upon receiving remittances of earnings from a QBU.

The AICPA recognizes that the legislative history to section 987 contemplates that remittances of capital could trigger exchange gain or loss under section 987.[4] However, the AICPA points out that, consistent with the general theme of The Tax Reform Act of 1986, this legislative history also contemplates that branches and foreign subsidiaries should be treated the same to the extent possible.[5]

The AICPA recognizes that it is not possible to bring the treatment of remittances from QBUs and distributions from foreign subsidiaries into perfect alignment. Nevertheless, the AICPA believes that the proposed regulations create a significant, unwarranted disparity between branches and foreign subsidiaries in contravention of the general theme of The Tax Reform Act of 1986.

As is mentioned in the Notice, the proposed regulations may also significantly distort the tax consequences of transactions involving branch capital. For example, assume that A uses the dollar as its functional currency. A transfers a capital asset with a basis and fair market value of $100 to a QBU that uses the pound as its functional currency. At the time of the transfer, the spot rate is $1.00 = £1.00. The QBU has no other property or income. A’s equity pool after the transfer is £100 and its basis pool is $100. The QBU later transfers the property to A when the spot rate is $2.00 = £1.00 and the property is still worth $100. Under the proposed regulations, A would recognize a $100 exchange gain upon receiving the remittance ((£100 x $2.00) - $100) even though the value of the property was unaffected by exchange rates. A would have a $200 basis in the property and would recognize a $100 capital loss on a later sale of the property assuming the value of the property did not change.[6] The proposed regulations artificially create exchange gain and loss in such circumstances. The AICPA believes that this result is inappropriate. The AICPA understands that the distortion illustrated by this example would occur with respect to many types of typically held business assets.[7]

The AICPA is also of the view that no distinction should be drawn between monetary and nonmonetary assets.[8] The AICPA notes that reg. section 1.988-1(a)(10) addresses intra-taxpayer transfers of monetary assets. Under that regulation, a QBU is required to recognize exchange gain or loss upon transferring nonfunctional currency and monetary assets subject to section 988 (Section 988 Assets) where the item loses its character as nonfunctional currency or as a Section 988 Asset or where the source of the exchange gain or loss would be altered in the absence of the application of the regulation. The AICPA is of the view that reg. section 1.988-1(a)(10) adequately addresses transfers of monetary assets.[9]

The AICPA believes that the revised regulations should adopt the four-pool approach of reg. section 1.987-5 to determine whether transfers are remittances of earnings or capital. Under that regulation, a taxpayer is required to maintain two sets of pools to determine section 987 exchange gain or loss on remittances made during taxable years beginning after December 31, 1986 and before October 25, 1991: (1) equity and basis pools for income; and (2) equity and basis pools for capital. Remittances are treated as first made from the equity pool for earnings and then from the equity pool for capital.[10] This approach would serve to align the treatment of corporate distributions and branch remittances more closely. The AICPA would expect a four-pool approach to be just as administrable as a two-pool approach; a four-pool approach should require only minor changes to existing software.

If the revised regulations, as suggested, do not require the recognition of exchange gain or loss on remittances of capital, the revised regulations will need to assign a basis to the remitted property in the functional currency of the taxpayer. The Notice states that Treasury and the Service are considering whether it might be appropriate to maintain a historic dollar basis in certain tangible assets for purposes of adjusting the equity and basis pools in lieu of calculating exchange gain or loss. The AICPA believes that maintaining historic dollar bases would not be administrable. The AICPA understands that taxpayers typically maintain only a single set of books for each QBU in the functional currency of the QBU. The AICPA believes that maintaining historic dollar basis amounts for particular assets would place an undue burden on taxpayers, especially in the case of depreciable and amortizable assets. The AICPA believes that the revised regulations should assign a portion of the basis pool for capital to capital remittances under the principles of reg. section 1.987-5; that is, assign the same portion of the basis pool to the remitted capital as the portion of the equity pool for capital that is remitted.[11]

The AICPA strongly believes that if the revised regulations do provide for the recognition of exchange gain or loss on remittances of capital, the revised regulations should still adopt the four-pool approach. The proposed regulations impose a significant penalty on branches that remit their earnings that is not imposed on similarly situated foreign subsidiaries.[12] For example, assume that A uses the dollar as its functional currency. A organizes foreign subsidiary S and QBU B on January 1, 2002, contributing $100 to each. S and B each use the pound as its functional currency. The spot rate on that date is $1.00 = £1.00. During 2002, S and B each earn £100. The income in S is subpart F income. The average exchange rate for 2002 is $1.20 = £1.00; therefore, A includes $120 in income from S and $120 in income from B. On December 31, 2002, S distributes £100 and B remits £100 to A. The spot rate on that date is $1.20 = £1.00. A will recognize no exchange gain or loss under section 986. However, because the proposed regulations treat remittances as, in effect, having been made proportionately out of earnings and capital, A would recognize a $10 exchange gain under section 987.[13]

The proposed regulations as they relate to the determination of exchange gains and losses on remittances are generally effective for taxable years beginning after the date that is thirty days after the date the proposed regulations are published as final regulations. The proposed regulations provide that in the meantime, a taxpayer must use some reasonable method to determine exchange gain and loss that is consistent with the principles of the proposed regulations.

The AICPA understands that there is widespread noncompliance with the requirement of the proposed regulations requiring the recognition of exchange gains and losses on remittances. The AICPA notes the following concerning taxpayer noncompliance. First, the proposed regulations are not binding on taxpayers, and section 987(3) may not be self-executing at least to the extent contemplated by the proposed regulations. Section 987(3) provides for proper adjustments to be made with respect to transfers of property between QBUs that use different functional currencies “as prescribed by the Secretary.” Regulation sections 1.987-5 and 1.989(c)-1 prescribe rules concerning the determination of exchange gains and losses on remittances, but those regulations apply only to taxpayers with branches in existence before January 1, 1987. Moreover, as is discussed above, the proposed regulations do not provide appropriate results in many cases.

The AICPA believes that the revised regulations will need to provide transitional rules that take into account the fact that taxpayers may have been justified in not following the principles of the proposed regulations. The revised regulations could adopt a fresh-start approach similar to the one set forth in reg. section 1.987-5. Specifically, the revised regulations could provide that the opening amount of the pools should be computed as follows:

Equity pool for capital. The opening amount of the equity pool for capital would equal the bases of the assets of the QBU less the amount of the liabilities of the QBU in the functional currency of the QBU as of the end of the taxable year immediately preceding the effective date.

Basis pool for capital. The opening amount of the basis pool for capital would equal (a) the amount of all the earnings of the QBU that were reported on the taxpayer’s income tax returns for taxable years beginning before the effective date and the bases of the assets transferred to the QBU by the taxpayer in the functional currency of the taxpayer during that period less (b) the amount of all the losses of the QBU reported on the taxpayer’s income tax returns for such years and the bases of the assets transferred to the taxpayer by the QBU in the functional currency of the taxpayer during that period. The basis of an asset that would be taken into account for this purpose would depend on whether or not the taxpayer followed the principles of the proposed regulations. If for example, the taxpayer recognized exchange gain or loss upon receiving an asset, the basis apportioned to the asset from the basis pool would be subtracted from the basis pool under the revised regulations. If the taxpayer did not recognize exchange gain or loss, the basis of the asset claimed by taxpayer would be subtracted. Proper account would need to be taken for liabilities.[14]

The opening amount of the equity pool and basis pool for earnings would be zero.[15]

2. Use of an Annual Netting Rule

As is noted above, the proposed regulations define a transfer as the net amount of property that on any day either is distributed from a QBU to the taxpayer (or to any other QBU of the taxpayer) or is contributed to the QBU by the taxpayer (or by any other QBU of the taxpayer). The amount of property is generally determined by reference to its basis immediately before the transfer. The proposed regulations recharacterize transactions between a taxpayer and a QBU under the “interbranch doctrine” as transfers to and from the QBU.[16] Thus, for example, the proposed regulations treat a cash sale by a QBU of property to the taxpayer as a transfer of the profit on the sale by the taxpayer to the QBU. As a further example, the proposed regulations treat a loan by one QBU of a taxpayer to another QBU of the taxpayer as a remittance by the first QBU to the taxpayer followed by a contribution by the taxpayer to the second QBU.[17] The Notice indicates that Treasury and the Service are considering an annual netting rule both to decrease the administrative burden of determining transfers and to prevent manipulation. Treasury and the Service have requested comments concerning the netting rule.

The AICPA recommends that the revised regulations abandon the daily netting rule for the following reasons. First, a daily netting rule may result in distortions because of the “interbranch doctrine.” Thus, if a taxpayer sold a machine with a $75 basis to QBU A for cash of $100 and sold a machine with a $75 basis to QBU B for $100 on 30-day terms, the section 987 consequences of the two transactions would be significantly different. QBU A would be treated as having made a $25 remittance. However, because the payment obligation of QBU B would be ignored under the interbranch doctrine, QBU B would be treated as having made a $100 remittance. The purpose of section 987 is to permit appropriate adjustments to be made, including the recognition of exchange gain and loss, when property is withdrawn from a nonfunctional currency economic environment of a taxpayer. Economically, the amount of property withdrawn from a nonfunctional currency economic environment of the taxpayer as a result of the sale to QBU A is the same as the amount withdrawn as a result of the sale to QBU B.

Second, a daily netting rule would be administratively very burdensome for many taxpayers. Indeed, the AICPA understands that many taxpayers cannot capture the information needed to comply with the daily netting rule from their information reporting systems. The AICPA also understands that the administrative burden of complying with a daily netting rule is compounded by the proliferation of disregarded entities. For example, many taxpayers use disregarded entities as buy-sell distributors and make numerous sales to those entities. The AICPA understands that complying with a daily netting rule would impose a very significant administrative burden on these types of operations.

The AICPA strongly recommends that the revised regulations adopt an annual netting rule. An annual netting rule will minimize the distortion illustrated in the above example.[18] Moreover, it should significantly reduce cost and expense of complying with section 987.[19]

Treasury and the Service have specifically requested comments as to whether the daily netting rule would be susceptible to manipulation and whether it is conceptually consistent with the regime applied to CFCs under section 986. The AICPA believes that manipulation of the daily netting rule (or an annual netting rule for that matter) can be adequately dealt with under an anti-abuse rule.[20] The AICPA recognizes that neither the daily netting rule nor an annual netting rule would be consistent with the regime applied to CFCs under section 986. Distributions and contributions by CFCs are not netted. Nevertheless, the AICPA believes that this inconsistency is warranted because ordinary business transactions between shareholders and corporations are not recast as contributions and distributions.

3. Transfers Between QBUs

The proposed regulations treat a transfer of property between two QBU branches of a taxpayer as a remittance by the first QBU to the taxpayer followed by a contribution by the taxpayer to the second QBU. This rule applies even where the two QBUs have the same functional currency.[21] The rule may also apply even where the second QBU owns the first QBU. The Notice indicates that Treasury and the Service have requested comments concerning whether such a transfer should be treated in this manner.

The AICPA recommends that the revised regulations provide that the legal form of ownership of a taxpayer’s QBUs be respected in determining the section 987 consequences of any transfer of property between the QBUs. Thus, if a taxpayer A owns QBU B, which in turn owns QBU C, B, not A, should be treated as receiving remittances made by C. The section 987 consequences of this approach would more closely reflect the economic consequences of transfers between branches. Moreover, the AICPA is not aware of any abuse concerning section 987 resulting from the stacked ownership of QBUs. Thus, the AICPA believes that reconstructing transactions as would be required by the proposed regulations would cause additional, unnecessary complexities.[22]

The AICPA also recommends that the revised regulations provide that a transfer between two QBUs with the same functional currency not result in section 987 exchange gain or loss, regardless of how the QBUs are owned. As is noted above, the purpose of section 987 is to require appropriate adjustments be made when property is withdrawn from a nonfunctional currency economic environment of a taxpayer. Transfers within the same nonfunctional currency environment should not trigger section 987 exchange gain or loss.[23]

4. Types of Property the Distribution of Which Can Constitute a Transfer

Treasury and the Service have requested comments concerning whether distributions of property normally transferred in the ordinary course of business between a taxpayer and a QBU (“Ordinary Business Property”), such as inventory, should be distinguished from distributions of property more in the nature of a repatriation of earning or capital (“Other Property”). Evidently, Treasury and the Service are contemplating that section 987 gain or loss would not be recognized on the distribution of Ordinary Business Property.

The AICPA believes that the revised regulations should make no distinctions between the types of property distributed from a QBU for the following reasons. First, distributions of Ordinary Business Property can be as much in the nature of repatriation of earnings or capital as distributions of other property. Second, many of the problems presented by distributions of Ordinary Business Property would be obviated by an annual netting rule. Moreover, the AICPA would expect that implementing such a distinction would be difficult in practice.

In any event, the AICPA would expect that in most cases such a rule would be of little benefit to taxpayers. The AICPA would expect that a distributed item of Ordinary Business Property would be assigned a portion of the basis pool for the QBU. Consequently, the property would take with it a share of the taxpayer’s unrealized exchange gain or loss in the QBU. Because Ordinary Business Property would typically turn over frequently, the unrealized exchange gain or loss would be deferred for only a short time.

5. Section 351 Transaction and Related Issues

The proposed regulations provide that an outbound section 351 transfer of the assets of a QBU results in a branch termination and reserves on whether other section 351 transactions should be treated as branch terminations. The Notice indicates the Treasury and the Service have requested comments whether other section 351 transactions should be treated as branch terminations.

The AICPA strongly believes that the revised regulations should provide that a transfer of assets of a QBU in any domestic-to-domestic section 351 transaction, whether or not between members of a consolidated group, does not result in a branch termination. The AICPA can see no reason for such a transfer to result in section 987 gain or loss inasmuch as the unrealized exchange gain or loss in the QBU would be fully preserved in the hands a domestic transferee.

The AICPA is also of the view that other transfers of assets of a QBU designated in the proposed regulations as branch terminations should not be branch terminations. The proposed regulations provide that a transfer of assets of a QBU in an outbound section 351 transaction or reorganization results in a branch termination. The proposed regulations also provide that a transfer of assets of a QBU in an inbound tax-free liquidation or reorganization results in a branch termination. On the other hand, the proposed regulations provide that an asset transfer in a foreign-to-foreign liquidation or reorganization does not result in a branch termination unless the functional currency of the transferee is the same as the functional currency of the QBU.

The AICPA can see no meaningful distinction between these transactions. A foreign-to-foreign liquidation or reorganizations does not result in a branch termination evidently because the unrealized exchange gain or loss in the QBU would be preserved in the hands of the transferee. The unrealized exchange gain or loss in a QBU could also be preserved in the case of an outbound section 351 transaction or reorganization where the functional currency of the transferee is not the same as the functional currency of the QBU. Therefore, the AICPA is of the view that the revised regulations should provide that an asset transfer in an outbound section 351 transaction or reorganization or in an inbound tax-free liquidation or reorganization does not result in a branch termination unless the functional currency of the transferee is the same as the functional currency of the branch.

The proposed regulations also provide that a QBU of a foreign corporation terminates upon an asset transfer in a foreign-to-foreign reorganization where a United States shareholder is required to include in income a section 1248 amount under section 367(b). The proposed regulations further provide that a QBU of a foreign corporation terminates upon a sale or exchange by a United States person of 10 percent or more of the stock in the foreign corporation during a twelve-month period in a transaction described in section 1248. The purpose of section 1248 is to ensure that a United States shareholder in a foreign corporation is taxed at ordinary rates on its share of the earnings and profits of the foreign corporation. The section 367(b) regulations are a backstop to section 1248. Because section 1248 does not require gain recognition at the corporate level, the AICPA believes that requiring a foreign corporation to recognize exchange gain or loss in a section 367(b) or section 1248 transaction is inappropriate. Therefore, the AICPA recommends that these provisions be omitted in the revised regulations.[24]

6. Other Issues - Treatment of PTA

The proposed regulations provide that income described in section 951(a) and section 1293(a)(1) is not included on a QBU’s profit and loss statement. The proposed regulations also provide that the equity pool is increased by the previously tax amounts (“PTA”) under those sections received by the QBU,[25] and that the basis pool is increased by the PTA received by the QBU translated into the taxpayer’s functional currency at the spot rate on the date the PTA is received. The proposed regulations, in effect, treat the taxpayer has having received the PTA directly and then as having contributed the PTA to the QBU.

Under section 961(a) and section 1293(d), a shareholder in a CFC or a QEF increases the basis of its shares in the CFC or QEF by the amount of the PTA. The proposed regulations provide no rules concerning the effect of section 961(a) or section 1293(d) on the equity pool or basis pool of a QBU holding stock in a CFC or QEF or the effect of those sections on the basis of stock of a CFC or QEF in the hands of the QBU.

The revised regulations could provide that income described in section 951(a) and section 1293(a)(1) is included in the income of the QBU, and that PTA received by the QBU has no effect on the equity pool or basis pool (except where such amounts are actually distributed by the QBU to the taxpayer). Under this suggestion, a QBU will be able to maintain the basis of its CFC and QEF stock, including basis adjustments under section 961(a) and section 1293(d), in its functional currency.

For example, assume that A uses the dollar as its functional currency. A owns QBU B, which uses the pound as its functional currency. A also owns all of the stock of CFC C, which uses the euro as its functional currency. A has no basis in its C stock. On January 1, 2002, A transfers its C stock to B. During 2002, C earns €100 of subpart F income. B has no other income during the year and has no assets other than the C stock. The average euro-pound exchange rate for 2002 is €1.00 = £1.00. The average pound-dollar exchange rate for 2002 is £1.00 = $1.00.

Under the proposal, B would have £100 of income, the €100 of subpart F income translated at the average euro-pound exchange rate. A would have $100 of income from B, £100 translated at the average pound-dollar exchange rate for the year. A would have an equity pool of £100 and a basis pool of $100 with respect to B. B would have a basis in its stock of C of £100.

On December 31, 2003, B sells the stock of C for £200 and distributes the £200 to A. B has no other income during the year. On December 31, 2003, the spot pound-dollar rate is £1.00 = $2.00. The average pound-dollar rate during the year is £1.00 = $1.50.

B would recognize a £100 (£200 - £100) gain on the sale of its stock of C. A would have $150 of income from B, the £100 gain translated at the average pound-dollar exchange rate A would have an equity pool of £200 (£100 + £100) and a basis pool of $250 ($100 + $150) with respect to B immediately before the distribution. A would recognize $150 of exchange gain under section 987 on the distribution of the £200 ((£200 x 2) - $250).

As to character, A would have $400 of total income – $250 of ordinary income ($100 of subpart F income and $150 of exchange gain) and $150 of capital gain.

As an alternative, the revised regulations could adopt the rules of the proposed regulations with the following modification. The QBU would not increase the basis of its CFC or QEF stock under section 951(a) or section 1293(a)(1). Rather, the taxpayer would maintain a special basis account separate from the branch to reflect the basis increases under the foregoing section.

Assume the facts in the above example. Under this proposal, B would recognize £200 (£200 - £0) gain on the sale of its C stock. A would have $300 of income from B, the £200 gain translated at the average pound-dollar exchange rate. A would reduce that income by the $100 of special basis. A would have an equity pool of £200 and a basis pool of $300 with respect to B. (Under the proposed regulations, A would not increase its equity pool or basis pool for the 2002 subpart F income from C.) A would recognize $100 of exchange gain under section 987 on the distribution of the £200 ((£200 x 2) - $300).

As to character, A would have $400 of total income – $200 of ordinary income ($100 of subpart F income and $100 of exchange gain) and $200 of capital gain.

The AICPA believes that the first proposal for dealing with PTA is preferable because it would be consistent with the legal ownership of the CFC or QEF stock, would give rise to tax consequences that more consistent with the treatment under section 987 of the any other assets held by the QBU, and would be easier to administer.

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[1] The reference to “proposed regulations” in these comments refers to prop. reg. sections 1.987-1, 1.987-2, and 1.987-3, 56 Fed. Reg. 48457 (Sept. 25, 1991).

[2] See, e.g., S. Rep. No. 99-313 at 455 (pooling approach of section 987 was adopted to minimize disparate treatment of branches and subsidiaries).

[3] Proposed reg. section 1.367(b)-3, 56 Fed. Reg.41993 (Aug. 26, 1991) (the 1991 proposed regulations), required a taxpayer to recognize exchange gain or loss with respect to the capital of a foreign corporation on certain inbound transactions. This rule would have generally aligned the treatment of tax-free inbound transactions, such as section 332 corporate liquidations, to the treatment of branch terminations under the proposed regulations. In light of the complexities presented by the proposed rule, the rule was not included in the final regulations.

[4] See, e.g., H.R. Conf. Rep. No. 99-841 at II-675 (1986). The AIPCA is of the view that neither section 987 nor its legislative history requires the recognition of exchange gain and loss on a remittance of capital.

[5] For example, the Senate Report provides,

In the case of a branch, because the profit and loss method would not translate balance sheet gains and losses, some mechanism for recognizing gains and losses inherent in functional currency or other property remitted to the home office must be provided. A similar issue arises in the case of controlled foreign corporations.

S. Rep. No. 99-313 at 455 (1985) (emphasis added). The italicized language suggests that the treatment of branch remittances and corporate distributions should be the same.

[6] If a foreign subsidiary transferred the property to a shareholder in the same circumstances, the shareholder would recognize no exchange gain or loss. If the shareholder received the property as an ordinary distribution, it would have a basis in the property of $100 – its fair market value under section 301(d). If the shareholder received the property in a section 332 liquidation, it may have a basis in the property equal to the basis in the property in the hands of the foreign subsidiary translated at the spot rate on the date of the distribution or $200. The 1991 proposed regulations addressed this basis step-up by requiring the shareholder to recognize exchange gain or loss with respect to the capital of the foreign subsidiary. The preamble to T.D. 8862 (January 24, 2000) indicates that Treasury and the Service are still considering this matter. The AICPA questions whether the recognition of exchange gain or loss in this situation is appropriate; conceptually, an adjustment to the basis of the distributed property would give rise to an economically more appropriate result.

[7] The AICPA recognizes that distortions will also occur upon remittances of earnings. The AICPA believes, however, that remittances of capital will in most cases lead to greater distortions. In any event, the distortions from remittances of earnings are a necessary by-product of aligning section 987 with section 986. The AICPA sees no good reason to extend the problem to remittances of capital.

[8] The proposed regulations make no distinction between the types of property distributed from a QBU.

[9] It may be necessary for the revised regulations to require the recognition of exchange gain or loss on a remittance of functional currency of the taxpayer. In such case, the taxpayer could not receive its functional currency with built-in gain or loss.

[10] Reg. section 1.987-5 does not address accumulated deficits. The AICPA is of the view that accumulated deficits should reduce the equity pool for capital and that subsequent earnings would increase the equity pool for capital until the accumulated deficit in the equity pool for capital is eliminated. The AICPA is also of the view that no “nimble dividend” rule should apply. The nimble dividend rule was adopted to allow corporations with accumulated deficits to avoid personal holding company tax. A nimble dividend rule is obviously not needed in the context of section 987. Moreover, the adoption of such a rule would add needless complexities to the section 987 calculations.

[11] The AICPA recognizes that where a taxpayer contributes an asset to a QBU and then receives that asset back from the QBU, the asset may be assigned a basis different from its basis before the contribution under the suggested approach. The AICPA believes that any abuse of this rule can be adequately dealt with under general tax anti-abuse principles.

[12] Under the proposed regulations, section 987 exchange gains and losses on remittances of capital would generally be foreign source income and loss. The proposed regulations require a taxpayer to use the same method it uses to allocate and apportion its interest expense under section 861 to determine source. The AICPA questions whether the proposed regulations assign an appropriate source to section 987 exchange gains and losses on remittances of capital. Section 987 exchange gains and losses on remittances are not typically taken into account in determining income subject to foreign tax. Consequently, treating section 987 exchange gains and losses on remittances of capital as foreign source would, in many cases, distort the foreign tax credit limitation

[13] A would recognize no exchange gain or loss under section 986 because the amount of the distribution from S translated into dollars at the spot rate on December 31, 2002 or $120, equals the dollar amount of the subpart F inclusion. A would have an equity pool of £200 and a basis pool of $220 in B under the proposed regulations. Because the remittance would represent 50 percent of the equity pool, 50 percent of the basis pool or $110 would be assigned to the remittance. A would recognize section 987 exchange gain under the proposed regulations equal to the amount of the remittance translated into dollars at the spot rate on December 31, 2002 or $120 less the basis assigned to the remittance or $110.

[14] A taxpayer may have a negative opening basis pool for capital under this method because the taxpayer had previously claimed a spot-rate basis in assets received from the QBU without recognizing exchange gain or loss under the section 987. The AICPA recommends that a taxpayer with a negative opening basis pool be required to recapture that negative basis under the rules applicable to negative basis pools in the proposed regulations.

[15] The transitional rules could provide an election to compute the opening equity pools and basis pools for capital and earnings by reconstructing the pools by treating each remittance as having been made proportionally out of earnings and capital. The basis pools would be reduced for a remittance depending on whether or not the taxpayer recognized exchange gain or loss on the remittance. The computation of the pools will need to be coordinated with reg. section 1.987-5 in the case of QBUs subject to those rules. The transitional rules could also provide an election to apply the revised regulations retroactively to the beginning of the taxpayer’s first open year.

[16] The interbranch doctrine provides that a transaction between a taxpayer and a branch is essentially a transaction between the taxpayer and itself, and thus the transaction cannot be given cognizance for tax purposes.

[17] Proposed reg. section 1.987-2(b)(2) and (d)(3), Exs. (1) and (4).

[18] The AICPA recognizes that distortions will still occur under an annual netting rule as a result of sales requiring payment in the next year. Moreover, distortions will occur as a result of all remittances, in effect, being translated at a single rate. The revised regulations could eliminate the first distortion by treating year-end amounts owing between a taxpayer and a QBU from ordinary business transactions as having been paid at year-end for purposes of section 987.

[19] The AICPA envisions that an annual netting rule would be implemented in practice by comparing the beginning and ending net equity of the QBU in a manner similar to the calculation of the dividend equivalent amount under section 884. The section 987 calculation should create no greater administrative burdens than does the section 884 calculation. Indeed, the section 987 calculation may be less burdensome inasmuch as it will not require an allocation of liabilities as is required under reg. section 1.882-5. The AICPA envisions that any net remittance or contribution would be translated at the average rate for the year.

[20] An anti-abuse rules could provide that a remittance will be ignored where (a) an offsetting contribution to the QBU is made within a specified period before or after the remittance and (b) the principal purpose of the remittance is to generate exchange gain or loss. Manipulation will be less likely under annual netting rule. Nevertheless, an anti-abuse rule may still be needed under an annual netting rule to address transitory, tax motivated year-end remittances.

[21] See Proposed reg. section 1.987-2(b)(2) and (d)(3), Ex. (4).

[22] The AICPA recognizes that in some circumstances treating all QBUs as owned directly by a taxpayer will cause fewer complexities. For example, assume a taxpayer owns a chain of six QBUs each with a different functional currency. If QBU six makes a distribution down the chain to the taxpayer, only one set of pools would be affected. However, deemed-direct ownership causes more complexities in other circumstances. For example, if QBU five made a contribution to QBU six, the transaction would be recharacterized as a distribution by QBU six to the taxpayer followed by a contribution by the taxpayer to QBU five. The AIPCA believes that the pools should track the book accounts as closely as possible. The AICPA is concerned that over time, the pools under the deemed-direct ownership model would deviate substantially from the book accounts thus requiring numerous adjustments to the book accounts in determining the pools.

[23] Where the transferee QBU does not own the transferor QBU, appropriate adjustments to the equity and basis pools of the transferor and transferee QBUs would need to be made.

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h½>5?\need to be coordinated with the overall foreign loss rules of section 904(f) and the branch loss recapture rules of section 367(a). In addition, the section 987 rules concerning remittances and branch terminations will need to be coordinated with the dual consolidated loss rules of reg. section 1.1503-2.

[25] Where the CFC’s functional currency is different from the QBU’s functional currency, the PTA presumably is translated into the QBU’s functional currency at the spot rate on the date the PTA is received.

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