n-05-27.pdf

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Part III - Administrative, Procedural, and Miscellaneous

Section 985- Functional Currency

26 CFR 1-985-3(d): United States dollar approximate separate transactions method

Notice 2005-27

SECTION 1. PURPOSE

This Notice provides guidance with respect to, and announces the intention to
amend, Treas. Reg. §1.985-3(d) regarding the proper exchange rate for determining
dollar approximate separate transactions method (“DASTM”) gain or loss when
translating current and historical assets upon a transfer from a qualified business unit (a
“QBU”) to its U.S. home office.
SECTION 2. BACKGROUND

Generally, a taxpayer and each QBU must make all determinations under subtitle
A of the Code in its respective functional currency. Treas. Reg. §1.985-1(a)(1). For
taxable years beginning after August 24, 1994, a U.S. corporation’s QBU that would
otherwise be required to use a hyperinflationary currency as its functional currency
generally must use the dollar as its functional currency and must compute income or
loss under the DASTM method of accounting described in §1.985-3. See Treas. Reg.
§1.985-1(b)(2)(ii).

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Under the DASTM method of accounting, a QBU’s income or loss for a taxable
year is computed in U.S. dollars and adjusted to account for its DASTM gain or loss.
See Treas. Reg. §1.985-3(b). A QBU’s DASTM gain or loss for a taxable year is
determined under Treas. Reg. §1.985-3(d) by first computing the QBU’s change in net
worth from the prior year and then making specified adjustments. The QBU’s change in
net worth is computed by comparing the year-end balance sheets for the current and
preceding taxable years. See Treas. Reg. §1.985-3(d)(1)(i). Special rules provide that
some balance-sheet items are translated at the exchange rate for the translation period
in which the cost of the item was incurred and so do not give rise to DASTM gain or loss
from year to year (“historical items”). See Treas. Reg. §1.985-3(d)(5). Other items are
translated at the exchange rate for the last translation period for the taxable year and
therefore do give rise to DASTM gain or loss (“current items”). See id. The
classification of an item as historical or current generally reflects the extent to which the
item’s dollar value changes with fluctuations in exchange rates. For example, the value
of a financial asset, such as a unit of hyperinflationary local currency, necessarily
changes with fluctuations in exchange rates. Accordingly, a financial asset generally is
a current item. See Treas. Reg. §1.985-3(d)(5)(iv). By contrast, the value of a
nonfinancial asset generally does not change with fluctuations in exchange rates.
Accordingly, a nonfinancial asset generally is an historical item. See Treas. Reg.
§1.985-3(d)(5)(v). In a hyperinflationary environment, currency exposure with respect to
a financial asset typically is expected to give rise to loss.

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The computed change in the QBU’s net worth is then adjusted to reflect
transactions that increase or decrease the QBU’s net worth without affecting the QBU’s
income or loss. For example, an asset transferred from a QBU branch to its home
office decreases the QBU’s net worth but does not affect the QBU’s income or loss and
so must be added back to the QBU’s net worth for purposes of computing DASTM gain
or loss. See Treas. Reg. §1.985-3(d)(3).
A rule is required for translating the amount of any such adjustment into dollars.
The DASTM method of accounting provides that adjustments generally shall be
translated into dollars at the exchange rate on the date the amount is paid. Treas. Reg.
§1.985-3(d)(3). This rule ensures that the QBU branch properly takes into account a
current item’s change in value due to currency fluctuations while the item was in the
QBU branch. However, because historical items do not give rise to DASTM gain or
loss, applying the existing translation rule to an adjustment relating to an historical item
would inappropriately give rise to DASTM gain or loss.
SECTION 3. GUIDANCE

In view of the potentially anomalous results that may arise due to the application
of the existing translation regulation in Treas. Reg. §1.985-3(d)(3), the Treasury
Department and the Internal Revenue Service intend to amend that regulation to require
as follows. If the item giving rise to the adjustment would be translated under Treas.
Reg. §1.985-3(d)(5) at the exchange rate for the last translation period of the year if it
were on the QBU’s year-end balance sheet, for purposes of Treas. Reg. §1.985-3(d)(3)
such item shall be translated at the exchange rate on the date the item is transferred. If

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the item giving rise to the adjustment would be translated under Treas. Reg. §1.985-
3(d)(5) at the exchange rate for the translation period in which the cost of the item was
incurred if it were on the QBU’s year-end balance sheet, for purposes of Treas. Reg.
§1.985-3(d)(3) such item shall be translated at the same historical rate.
SECTION 4. EXAMPLE

The following example illustrates the guidance provided in Section 3 of this
notice. C is a U.S. corporation with a foreign branch, B, that constitutes a QBU within
the meaning of section 989. C’s functional currency is the U.S. dollar. Under Treas.
Reg. §1.985-1(b)(2)(ii)(A), B must also use the U.S. dollar as its functional currency
which would otherwise be a nondollar local currency that is hyperinflationary within the
meaning of Treas. Reg. §1.985-1(b)(2)(ii)(D). On January 1, 2003, B purchases a
parcel of undeveloped real property with units of local currency. On March 21, 2005, B
transfers to C 100 units of B’s local currency and the parcel of undeveloped real
property.
Because B is a QBU whose functional currency otherwise would be a
hyperinflationary currency, B must compute its income or loss in U.S. dollars using the
DASTM method of accounting. Because the transfers from B to C affect B’s balance
sheet but do not affect its income, B must adjust its year-end balance sheet in
accordance with the requirements of Treas. Reg. §1.985-3(d)(3). If the 100 units of
hyperinflationary currency had remained on B’s year-end balance sheet, then that
currency would have been translated at the exchange rate for the last translation period
of the taxable year, as required by Treas. Reg. §1.985-3(d)(5)(iv). If the real property

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had remained on B’s year-end balance sheet, then B’s basis in that property would have
been translated at the exchange rate for the period in which the cost was incurred, as
required by Treas. Reg. §1.985-3(d)(5)(v).
In accordance with Section 3 of this notice, for purposes of the adjustments
under Treas. Reg. §1.985-3(d) B must translate the 100 units of hyperinflationary local
currency transferred to C on March 21, 2005 using the exchange rate on that date and
must translate the basis of the real property transferred to C on March 21, 2005 using
the exchange rate for the period in which the cost of the property was incurred.
SECTION 5. EFFECTIVE DATE

The amendments to the regulation described in this notice will be effective for
any transfer
, dividend, or distribution that is a return of capital that is made after March
8, 2005 and that gives rise to an adjustment under §1.985-3(d)(3).
SECTION 6. COMMENTS

Written comments on the issues addressed in this notice may be submitted to the
Office of Associate Chief Counsel (International), Attention: Sheila Ramaswamy (Notice
2005-27), room 4566, CC:INTL:Br5, Internal Revenue Service, 1111 Constitution
Avenue, NW, Washington, DC 20224. Alternatively, taxpayers may submit comments
electronically to Notice 2005-27. Comments@irscounsel.treas.gov
. Comments will be
available for inspection and copying. Treasury and the IRS request comments by June
6, 2005.
The principal author of this notice is Sheila Ramaswamy of the Office of
Associate Chief Counsel (International). For further information regarding this notice

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contact Sheila Ramaswamy at (202) 622-3870 (not a toll-free call).