26 C.F.R. §§ 1.987-1–1.987-10

(1) Step 1. The change in the OFCNV of Japan Branch for year 10 is equal to the OFCNV of Japan Branch determined in dollars on the last day of year 10, less the OFCNV of Japan Branch determined in dollars on the last day of year 9. Therefore, the change in OFCNV is equal to $6.41 ($1,339.74—$1,333.33).

(2) Steps 2 through 5 (no adjustment). No adjustment is made under paragraphs (d)(2) through (5) of this section (steps 2 through 5) because no assets or liabilities were transferred by U.S. Corp to Japan Branch or by Japan Branch to U.S. Corp during the taxable year.

(3) Step 6. Under paragraph (d)(6) of this section (step 6), the amount determined in previous steps is decreased by the section 987 taxable income of Japan Branch of $80.00, from $6.41 to negative $73.59.

(4) Steps 7 through 10 (no adjustment). No adjustment is made under paragraphs (d)(7) through (10) of this section (steps 7 through 10) because all of Japan Branch's items of income or deduction for the taxable year impact the basis of Japan Branch's assets or the amount of its liabilities and are taken into account in computing taxable income. In addition, Japan Branch does not have a residual increase or decrease to net assets (because the change in net value of ¥10,000 is equal to the amount of Japan Branch's net income in year 10). Accordingly, the unrecognized section 987 loss of Japan Branch for year 10 is negative $73.59.

(2) Coordination with § 1.954-2(g). The rules of § 1.954-2(g)(2), (3) and (4) apply without regard to any section 987 gain treated as gain from section 988 transactions, or loss allocated and apportioned to such gain, by reason of an election under paragraph (b)(2)(i)(C)(1) of this section.

(2) For purposes of the GILTI high-tax exclusion, section 987 gain or loss is not attributable to any tested unit. In the case of a controlled foreign corporation, the initial assignment of section 987 gain or loss is made as though the section 987 gain or loss was not attributable to any tested unit for purposes of applying § 1.951A-2(c)(7) (GILTI high-tax exclusion). See paragraph (b)(2)(iii) of this section (applying the GILTI high-tax exclusion by treating all section 987 gain or loss in the same tentative tested income group as composing a single tentative tested income item).

(B) Treatment of P as a section 987 QBU. P is a partnership described in paragraph (c)(1)(ii) of this section because DC1 and DC2 each treat their interest in P as a section 987 QBU. Under paragraph (d)(1)(ii)(B) of this section, if DC1 and DC2 are related within the meaning of section 267(b) or section 707(b), the loss suspension rule in paragraph (d)(1)(ii) of this section applies to suspend DC1's and DC2's recognition of section 987 loss with respect to their interest in P. However, if DC1 and DC2 are unrelated, the loss suspension rule in paragraph (d)(1)(ii) of this section does not apply.

(1) Deemed termination amount. Under paragraph (e)(2)(i)(A) of this section, the deemed termination amount is the amount of section 987 gain or loss that would have been recognized by DC under the eligible pretransition method if Branch terminated and transferred all its assets and liabilities to DC (the land with a basis of €100) on December 31, year 3. Under DC's eligible pretransition method, DC would have recognized section 987 gain of $35, determined by subtracting the remaining basis pool of $105 from the amount of the remittance of $140 (€100 translated at the spot rate on December 31, year 3, of €1 = $1.40). Therefore, the deemed termination amount is $35.

(2) Owner functional currency net value adjustment. On December 31, year 3, Branch had no liabilities and only one asset: land with a basis of €100. Under paragraph (e)(2)(i)(B) of this section, the owner functional currency net value adjustment is equal to the basis of the land, translated into U.S. dollars at the transition exchange rate, reduced by the basis of the land, translated into U.S. dollars at the pretransition translation rate. Under paragraph (d)(3)(i) of this section, the transition exchange rate is the spot rate applicable to December 31, year 3. Under paragraph (e)(2)(i)(C) of this section, the pretransition translation rate is the rate that would be used under DC's eligible pretransition method to determine the basis of the land in the hands of DC if Branch transferred the land to DC on December 31, year 3. Under DC's eligible pretransition method, if Branch transferred the land to DC, DC's basis in the land would be equal to Branch's basis (€100) translated at the spot rate on the date of the remittance. Therefore, the pretransition translation rate on December 31, year 3, is equal to the spot rate on December 31, year 3. Consequently, the owner functional currency net value adjustment is zero.

(1) Remittance out of earnings. For purposes of determining section 987 gain or loss recognized on the remittance, Branch's earnings equity pool was equal to €50, and its earnings basis pool was equal to $60, as shown in the table below. Because Branch remitted 100% of the earnings equity pool (€50), the entire earnings basis pool, or $60, was attributable to the remittance. The value of the remittance was $67.50 (€50 translated at the spot rate on June 30, year 3, of €1 = $1.35). Therefore, in year 3, DC recognized section 987 gain of $7.50, equal to the difference between the value of the remittance ($67.50) and the portion of the basis pool attributable to the remittance ($60). As a result of the remittance, the earnings equity pool and the earnings basis pool were each reduced to zero. In the hands of DC, the €50 distributed out of earnings had a basis of $67.50 (€50 translated at the spot rate on June 30, year 3, of €1 = $1.35).

(2) Distribution out of capital. The basis of the €50 distributed out of capital was equal to the portion of the capital basis pool attributable to the distribution. For this purpose, the capital equity pool was equal to €150, and the capital basis pool was equal to $150, as shown in the table below. Because Branch distributed 33% of the capital equity pool, or €50, 33% of the capital basis pool, or $50, was attributable to the distribution. In the hands of DC, the €50 distributed out of capital had a basis of $50. As a result of the capital distribution, the capital equity pool was reduced to €100 and the capital basis pool was reduced to $100.

(3) Section 988 gain recognized. On June 30, year 3, DC exchanged €100 with an aggregate basis of $117.50 (equal to the sum of the $67.50 basis of the remittance out of earnings and the $50 basis of the distribution out of capital) for $135. Therefore, DC recognized $17.50 of gain under section 988.

(1) DC's total amount of income under its pretransition method. Under DC's pretransition method, DC recognized $7.50 of section 987 gain and $17.50 of section 988 gain in year 3. In addition, on December 31, year 3, DC had $40 of embedded gain in its capital equity and basis pools (equal to the difference between its capital equity pool of €100, translated at the spot rate on December 31, year 3, of €1 = $1.40, and its capital basis pool of $100) which will be taken into account in the future (when Branch distributes property out of capital and the property is sold). DC also recognized $60 of earnings with respect to Branch ($28.75 in year 2 and $31.25 in year 3). Thus, DC's total income (recognized and unrecognized) with respect to Branch is $125.

(2) DC's total amount of income under an earnings and capital method. If DC had instead applied an earnings and capital method, as described in paragraph (l)(1)(i)(C) of this section (Example 1), DC would have recognized section 987 gain of $30 in year 3 and would not have recognized section 988 gain in year 3, as explained in paragraph (l)(1)(i)(D) of this section. On December 31, year 3, DC would have unrecognized section 987 gain in its equity and basis pools of $35 (see paragraph (l)(1)(ii)(B)(1) of this section (Example 1)). DC would also have recognized $60 of earnings with respect to Branch ($28.75 in year 2 and $31.25 in year 3). Thus, DC's total income (recognized and unrecognized) with respect to Branch is $125.

(1) Deemed termination amount. Under paragraph (e)(2)(i)(A) of this section, the deemed termination amount is the amount of section 987 gain or loss that would have been recognized by DC under the eligible pretransition method if Branch terminated and transferred all of its assets and liabilities to DC on December 31, year 3. Under DC's eligible pretransition method, if Branch had transferred all of its assets and liabilities to DC, this would have been treated as a distribution out of capital. Under its eligible pretransition method, DC would not have recognized section 987 gain or loss on a distribution out of capital. Therefore, the deemed termination amount is zero.

(2) Owner functional currency net value adjustment. On December 31, year 3, Branch had no liabilities and only one asset: land with a basis of €100. Under paragraph (e)(2)(i)(B) of this section, the owner functional currency net value adjustment is equal to the basis of Branch's land, translated into U.S. dollars at the transition exchange rate, reduced by the basis of Branch's land, translated into U.S. dollars at the pretransition translation rate on December 31, year 3. Under paragraph (e)(2)(i)(C) of this section, the pretransition translation rate is the rate that would be used under the eligible pretransition method to determine the basis of the land in the hands of DC if Branch transferred the land to DC. Under DC's eligible pretransition method, DC's basis in assets distributed from Branch is equal to the portion of the capital basis pool attributable to the distribution. If Branch transferred the land with a basis of €100 to DC on December 31, year 3, its remaining capital basis pool of $100 would be attributable to the distribution, and the land would have a basis of $100 in the hands of DC. Because the land had a basis of €100 in the hands of Branch, and would have a basis of $100 in the hands of DC if it were distributed on December 31, year 3, the pretransition translation rate is €1 = $1. Under paragraph (d)(3)(i) of this section, because a current rate election is in effect for year 4, the transition exchange rate is the spot rate applicable to December 31, year 3. The €100 basis of Branch's land, translated at the spot rate on December 31, year 3 of €1 = $1.40 is equal to $140. The €100 basis of Branch's land, translated at the pretransition translation rate on December 31, year 3 of €1 = $1 is equal to $100. Therefore, the owner functional currency net value adjustment is equal to $40 ($140−$100).

(1) Transition exchange rate. DC applied an earnings only method described in paragraph (e)(4)(ii) of this section before the transition date. Under paragraph (d)(3)(ii) of this section, because a current rate election is not in effect for year 4, the transition exchange rate for Branch's land is equal to the pretransition translation rate. As explained in paragraph (l)(2)(ii)(B)(2) of this section (Example 2), the pretransition translation rate is €1 = $1.