Foreign Currency Translations and Transactions

Currency translation issues:

Foreign branches and subsidiaries keep their books and records in the currency of host country.

Parent companies in USA are required to compute their taxable income and foreign tax credits in U.S dollars.

Following  items must be translated in U.S dollars for tax purposes:

• Taxable income or loss.
• Foreign income taxes paid.
• Remittances from foreign branch.
• Dividends and subpart F inclusions from foreign corporations.
• Foreign income taxes deemed paid by a domestic shareholder of a foreign corporation.

Transactional issues also arise when domestic corporations engage in transactions with customers in foreign countries. Issues can occur due to fluctuating currency rates.

Foreign  currency translations:

Foreign currency translation rules are based on concept of qualified business unit and functional currency.

Qualified  Business unit:

• Any separate and clearly identified unit of a trade or business can qualify as qualified business unit. It must maintain separate books and records.
• A branch of a corporation can qualify as a separate unit if it is a separate business unit of trade and maintains its books separately.
• It is not necessary that the trade or business carried by the branch is of a different type than the parent corporation.
• A corporation is automatically a QBU.
• An individual is not a QBU.
• Activities of an individual conducted as an employee do not constitute a QBU.
• If a sole proprietor satisfies a separate trade or business and maintains separate books and records, he may qualify as QBU.
• Partnerships, trusts and estates automatically qualify as QBU.

Functional  Currency:

• QBUs can compute its taxable income or its profits in its functional currency.
• The adoption of a functional currency is treated as a method of accounting.
• A functional currency used in the year of adoption must be used for all subsequent taxable years unless permission to change is guaranteed by IRS.
• If a foreign branch is a QBU and has a functional currency other than the U.S dollar, the taxable income or loss of the branch is computed in its functional currency and then translated into U.S dollar using yearly average exchange rate.

Foreign  corporation’s dividends distribution rules

Dividend:

• If foreign corporation pays a dividend in a foreign currency, the U.S taxpayer must translate this income in U.S dollars using the spot rate for the date on which dividends are included in taxpayer’s income.
• Foreign withholding taxes:
• Accrual basis taxpayers translate foreign withholding taxes into U.S dollars using the average exchange rate.

Deemed  paid foreign tax credit:

• Accrual basis taxpayers translate corporation’s post – 1986 foreign income taxes into U.S dollars using the average exchange rate.
• Post – 1986 undistributed earnings are not translated into U.S dollars but are maintained in foreign corporation’s functional currency.

Subpart  F inclusion:

Rules  for computing the U.S tax of a U.S shareholder’s subpart F inclusion from a  controlled foreign corporation are as follows:

Subpart  F inclusion:

An inclusion of subpart F income in translated into U.S dollars using the average exchange rate for the CFC’s taxable year. Inclusion for investments in the U.S property are computed using the spot rate for the last day of the CFC’s taxable year.

Deemed  paid foreign tax credit:

For purpose of computing the deemed paid credit, the CFC’s subpart F inclusion and post – 1986 undistributed earnings and profits are not translated into U.S dollars, but are instead maintained in the CFC’s functional currency.

Accrual basis taxpayers generally translate a CFC’s post – 1986 foreign income taxes into U.S dollars using the average exchange rate for the tax year to which the tax relates.

For tracing actual dividend distribution to previously taxed income, the taxpayer measures the CFC’s earnings in its functional currency. Later, when receiving a distribution of previously taxed income, the U.S shareholder must recognize a foreign currency gain or loss equal to the difference between:

• The U.S dollar value of the distribution as determined using the spot rate for the date of distribution and
• The U.S shareholder’s basis in the distribution as determined by the U.S dollar amount at which the taxpayer previously included the earnings in U.S taxable income.

Passive  foreign investment company inclusion:

A U.S person translates his or her pro rata share of the undistributed earnings and profits of a qualified electing fund into U.S dollars using the average exchange rate for the QEF’s taxable year.

A U.S person who receives a distribution of a QEF’s previously taxed income must recognize a foreign currency gain or loss equal to the difference between:

• The U.S dollar value of the actual distribution as determined using the spot rate for the date of distribution and
• The taxpayer’s basis in the distribution as determined by the U.S dollar amount at which the taxpayer previously included the earnings in U.S taxable income.

Foreign income taxes:

Accrual basis taxpayers translate foreign income taxes into U.S dollars using the average exchange rate for the tax year to which the taxes relate.

Cash basis taxpayers translate foreign income taxes into U.S dollars using spot rates.

References:

Practical Guide to US Taxation of International transactions 9^th Edition

Robert J. Misey Jr.

Michael S. Schadewald

Publishers: Wolter Kluwer, CCH Incorporated.