---
kind: "range"
citation: "26 C.F.R. §§ 1.987-3–1.987-5"
title: "26"
from: "1.987-3"
to: "1.987-5"
count: 4
url: "https://uscodex.org/cfr/26/1.987-3..1.987-5"
---

# §1.987-3. Determination of section 987 taxable income or loss of an owner of a section 987 QBU.

- (a) **In general.** This section provides rules for determining the taxable income or loss of an owner of a [section 987](/cfr/26/987.md) QBU ([section 987](/cfr/26/987.md) taxable income or loss). [Paragraph (b)](#b) of this section provides rules for determining items of income, gain, deduction, and loss in the [section 987](/cfr/26/987.md) QBU's functional currency. [Paragraph (c)](#c) of this section provides rules for translating each item determined under [paragraph (b)](#b) of this section into the functional currency of the owner of the [section 987](/cfr/26/987.md) QBU. [Paragraph (d)](#d) of this section is reserved. [Paragraph (e)](#e) of this section provides examples illustrating the application of the rules of this section.
- (b) **Determination of each item of income, gain, deduction, or loss in the section 987 QBU's functional currency—**
  - (1) **In general.** The owner of a [section 987](/cfr/26/987.md) QBU must determine each item of income, gain, deduction, or loss attributable to the [section 987](/cfr/26/987.md) QBU in the [section 987](/cfr/26/987.md) QBU's functional currency under Federal income tax principles.
  - (2) **Translation of items of income, gain, deduction, or loss that are denominated in a nonfunctional currency.** Except as otherwise provided in [paragraph (b)(4)](#b-4) of this section, an item of income, gain, deduction, or loss (or the item's components and related items, such as gross receipts and amount realized) that is denominated in (or determined by reference to) a nonfunctional currency (including the functional currency of the owner) is translated into the [section 987](/cfr/26/987.md) QBU's functional currency at the spot rate on the date such item is properly taken into account. Paragraphs [(e)(1)](#e-1) and [(2)](#e-2) of this section (Examples 1 and 2) illustrate the application of this [paragraph (b)(2)](#b-2).
  - (3) [Reserved]
  - (4) **Section 988 transactions—**
    - (i) **In general.** [Section 988](/cfr/26/988.md) and the regulations under [section 988](/cfr/26/988.md) apply to [section 988](/cfr/26/988.md) transactions of a [section 987](/cfr/26/987.md) QBU. The determination of whether an asset or liability of a [section 987](/cfr/26/987.md) QBU is a [section 988](/cfr/26/988.md) transaction is determined by reference to the functional currency of the [section 987](/cfr/26/987.md) QBU. [Section 988](/cfr/26/988.md) gain or loss is determined in, and by reference to, the functional currency of the [section 987](/cfr/26/987.md) QBU. The amount of [section 988](/cfr/26/988.md) gain or loss determined under this [paragraph (b)(4)(i)](#b-4-i) is translated into the owner's functional currency under [paragraph (c)](#c) of this section.
    - (ii) **Section 988 mark-to-market election—**
      - (A) **In general.** A taxpayer may elect to apply the [section 988](/cfr/26/988.md) mark-to-market method of accounting described in this [paragraph (b)(4)(ii)](#b-4-ii) with respect to all [section 988](/cfr/26/988.md) transactions that are properly attributable to a [section 987](/cfr/26/987.md) QBU and that are not otherwise accounted for under a mark-to-market method of accounting under [section 475](/cfr/26/475.md) or [section 1256](/cfr/26/1256.md) (other than a [section 988](/cfr/26/988.md) transaction described in [paragraph (b)(4)(ii)(B)](#b-4-ii-B) of this section). Under the [section 988](/cfr/26/988.md) mark-to-market method of accounting, the timing of [section 988](/cfr/26/988.md) gain or loss on [section 988](/cfr/26/988.md) transactions described in the preceding sentence is determined under the principles of [section 1256](/cfr/26/1256.md). Only [section 988](/cfr/26/988.md) gain or loss is taken into account under the foreign currency mark-to-market method of accounting. Appropriate adjustments must be made to prevent the [section 988](/cfr/26/988.md) gain or loss from being taken into account again after it is recognized under this [paragraph (b)(4)(ii)](#b-4-ii). A [section 988](/cfr/26/988.md) transaction subject to the foreign currency mark-to-market method of accounting is not subject to the netting rule of [section 988(b)](/cfr/26/988.md?p=b) and [§ 1.988-2(b)(8)](/cfr/26/1.988-2.md?p=b-8) (under which exchange gain or loss is limited to overall gain or loss realized in a transaction) in taxable years before the taxable year in which [section 988](/cfr/26/988.md) gain or loss would be recognized with respect to the [section 988](/cfr/26/988.md) transaction but for this election.
      - (B) **Built-in loss transactions contributed to a section 987 QBU.** [Paragraph (b)(4)(ii)(A)](#b-4-ii-A) of this section does not apply to a [section 988](/cfr/26/988.md) transaction if—

        (1) The transaction was transferred to the [section 987](/cfr/26/987.md) QBU from its owner (or from another eligible QBU of the owner);

        (2) Immediately before the transfer, the transaction was a [section 988](/cfr/26/988.md) transaction in the hands of the owner (or other eligible QBU of the owner) and was not subject to a mark-to-market method of accounting;

        (3) If the owner (or other eligible QBU) had disposed of the [section 988](/cfr/26/988.md) transaction immediately before the transfer (and [§ 1.988-2(b)(8)](/cfr/26/1.988-2.md?p=b-8) did not apply), the owner would have recognized [section 988](/cfr/26/988.md) loss; and

        (4) [Section 988](/cfr/26/988.md) loss was not recognized in connection with the transfer under [§ 1.988-1(a)(10)](/cfr/26/1.988-1.md?p=a-10).

- (c) **Translation of items of income, gain, deduction, or loss of a section 987 QBU into the owner's functional currency—**
  - (1) **In general.** Except as otherwise provided in this section, the exchange rate to be used by an owner in translating an item of income, gain, deduction, or loss attributable to a [section 987](/cfr/26/987.md) QBU (or the item's components and related items, such as gross receipts, amount realized, basis, and cost of goods sold) into the owner's functional currency, if necessary, is the yearly average exchange rate for the taxable year.
  - (2) **Exceptions.** Except as otherwise provided in [paragraph (c)(2)(v)](#c-2-v) of this section, this [paragraph (c)(2)](#c-2) applies only to taxable years for which neither the annual recognition election nor the current rate election is in effect.
    - (i) **Recovery of basis with respect to historic assets.** Except as otherwise provided in this [paragraph (c)(2)](#c-2), the exchange rate to be used by the owner in translating any recovery of basis (whether through a sale or exchange; deemed sale or exchange; cost recovery deduction such as depreciation, depletion or amortization; or otherwise) with respect to a historic asset is the historic rate for the property to which such recovery of basis is attributable.
    - (ii) through (iii) [Reserved]
    - (iv) **Cost of goods sold computation—**
      - (A) **General rule—simplified inventory method.** Except as otherwise provided in [paragraph (c)(2)(iv)(B)](#c-2-iv-B) of this section, cost of goods sold (COGS) for a taxable year is translated into the functional currency of the owner at the yearly average exchange rate for the taxable year in which the sale of inventory occurs (or the COGS is otherwise taken into account in computing taxable income) and adjusted as provided in [paragraph (c)(3)](#c-3) of this section.
      - (B) **Election to use the historic inventory method.** In lieu of using the simplified inventory method described in [paragraph (c)(2)(iv)(A)](#c-2-iv-A) of this section, the owner of a [section 987](/cfr/26/987.md) QBU may elect under this [paragraph (c)(2)(iv)(B)](#c-2-iv-B) to translate inventoriable costs (including current-year inventoriable costs and costs that were capitalized into inventory in prior years) that are included in COGS at the historic rate for each such cost.
    - (v) **Translation of income to account for certain foreign income tax claimed as a credit.** The owner of a [section 987](/cfr/26/987.md) QBU claiming a credit under [section 901](/cfr/26/901.md) for foreign income taxes, other than foreign income taxes deemed paid under [section 960](/cfr/26/960.md), that are properly reflected on the books and records of the [section 987](/cfr/26/987.md) QBU (the creditable tax amount) must determine [section 987](/cfr/26/987.md) taxable income or loss attributable to the [section 987](/cfr/26/987.md) QBU by reducing the amount of [section 987](/cfr/26/987.md) taxable income or loss that otherwise would be determined under this section by an amount equal to the creditable tax amount, translated into U.S. dollars using the yearly average exchange rate for the taxable year in which the creditable tax is accrued, and by increasing the resulting amount by an amount equal to the creditable tax amount, translated using the same exchange rate that is used to translate the creditable taxes into U.S. dollars under [section 986(a)](/cfr/26/986.md?p=a). This [paragraph (c)(2)(v)](#c-2-v) applies whether or not a current rate election or an annual recognition election is in effect. See [paragraph (e)(14)](#e-14) of this section (Example 14) for an illustration of this rule.
  - (3) **Adjustments to COGS required under the simplified inventory method.** This [paragraph (c)(3)](#c-3) applies only to taxable years for which neither the annual recognition election nor the current rate election is in effect.
    - (i) **In general.** An owner of a [section 987](/cfr/26/987.md) QBU that uses the simplified inventory method described in [paragraph (c)(2)(iv)(A)](#c-2-iv-A) of this section must make the adjustment described in [paragraph (c)(3)(ii)](#c-3-ii) of this section. In addition, the owner must make the adjustment described in [paragraph (c)(3)(iii)](#c-3-iii) of this section with respect to any inventory for which the [section 987](/cfr/26/987.md) QBU does not use the LIFO inventory method and must make the adjustment described in [paragraph (c)(3)(iv)](#c-3-iv) of this section with respect to any inventory for which the [section 987](/cfr/26/987.md) QBU uses the LIFO inventory method. An owner of a [section 987](/cfr/26/987.md) QBU that uses the simplified inventory method must make all of the applicable adjustments described in [paragraphs (c)(3)(ii) through (iv)](#c-3-ii..c-3-iv) of this section with respect to the [section 987](/cfr/26/987.md) QBU even in taxable years in which the amount of COGS is zero.
    - (ii) **Adjustment for cost recovery deductions included in inventoriable costs—**
      - (A) **In general.** The translated COGS amount computed under [paragraph (c)(2)(iv)(A)](#c-2-iv-A) of this section is increased or decreased (as appropriate) by the amount described in [paragraph (c)(3)(ii)(B)](#c-3-ii-B) of this section. The adjustment is included as an adjustment to translated COGS computed under [paragraph (c)(2)(iv)(A)](#c-2-iv-A) of this section in full in the year to which the adjustment relates and is not allocated between COGS and ending inventory.
      - (B) **Amount of adjustment.** With respect to each cost recovery deduction attributable to a historic asset that is included in inventoriable costs for a taxable year, the adjustment is equal to—

        (1) The amount of the cost recovery deduction included in inventoriable costs, translated at the historic rate for the property to which the deduction is attributable; less

        (2) The amount of the cost recovery deduction included in inventoriable costs, translated at the yearly average exchange rate for the current taxable year.

    - (iii) **Adjustment for beginning inventory for non-LIFO inventory—**
      - (A) **In general.** In the case of non-LIFO inventory, the translated COGS amount computed under [paragraph (c)(2)(iv)(A)](#c-2-iv-A) of this section is increased or decreased (as appropriate) by the amount described in [paragraph (c)(3)(iii)(B)](#c-3-iii-B) of this section.
      - (B) **Amount of adjustment.** The adjustment is equal to—

        (1) The ending non-LIFO inventory included on the closing balance sheet for the preceding taxable year, translated at the exchange rate described in [paragraph (c)(3)(iii)(C)](#c-3-iii-C) of this section (which is generally the yearly average exchange rate for the preceding taxable year); less

        (2) The ending non-LIFO inventory included on the closing balance sheet for the preceding taxable year, translated at the yearly average exchange rate for the current taxable year.

      - (C) **Exchange rate—** (1) In general. Except as provided in paragraph (c)(3)(iii)(C)(2) of this section, the exchange rate used to translate non-LIFO inventory under paragraph (c)(3)(iii)(B)(1) of this section is the yearly average exchange rate for the preceding taxable year.

        (2) Revocation of current rate election or taxable year beginning on the transition date. In the first taxable year in which a current rate election is revoked or otherwise ceases to be in effect (or in the taxable year beginning on the transition date), the exchange rate used to translate non-LIFO inventory under paragraph (c)(3)(iii)(B)(1) of this section is the spot rate applicable to the last day of the preceding taxable year.

    - (iv) **Adjustment for year of LIFO liquidation—**
      - (A) **In general.** In the case of inventory with respect to which a [section 987](/cfr/26/987.md) QBU uses the LIFO inventory method, the translated COGS amount computed under [paragraph (c)(2)(iv)(A)](#c-2-iv-A) of this section is increased or decreased (as appropriate) by the amount described in [paragraph (c)(3)(iv)(B)](#c-3-iv-B) of this section.
      - (B) **Amount of adjustment.** With respect to each LIFO layer liquidated in whole or in part during the taxable year, the adjustment is equal to:

        (1) The amount of the LIFO layer liquidated during the taxable year, translated at the historic rate that is used for translating the LIFO layer (which is generally the yearly average exchange rate for the year the LIFO layer arose); less

        (2) The amount of the LIFO layer liquidated during the taxable year, translated at the yearly average exchange rate for the taxable year.

- (d) [Reserved]
- (e) **Examples.** The following examples illustrate the application of this section. For purposes of the examples, U.S. Corp is a domestic corporation that uses the calendar year as its taxable year and has the U.S. dollar as its functional currency. Except as otherwise indicated, U.S. Corp is the owner of Business A, a [section 987](/cfr/26/987.md) QBU with the euro as its functional currency, and U.S. Corp elects under [paragraph (c)(2)(iv)(B)](#c-2-iv-B) of this section to use the historic inventory method with respect to Business A but does not make any other elections.
  - (1) **Example 1: Item of income denominated in nonfunctional currency.** Business A accrues £100 of income from the provision of services. Under [paragraph (b)(2)](#b-2) of this section, the £100 is translated into €90 at the spot rate on the date of accrual, without the use of a spot rate convention. In determining U.S. Corp's taxable income, the €90 of income is translated into dollars at the yearly average exchange rate under [paragraph (c)(1)](#c-1) of this section.
  - (2) **Example 2: Asset sold for nonfunctional currency.** Business A sells a historic asset consisting of non-inventory property for £100. Under [paragraph (b)(2)](#b-2) of this section, the £100 amount realized is translated into €85 at the spot rate on the sale date without the use of a spot rate convention. In determining U.S. Corp's taxable income, the €85 is translated into dollars at the yearly average exchange rate under [paragraph (c)(1)](#c-1) of this section. The euro basis of the property is translated into dollars at the historic rate under [paragraph (c)(2)(i)](#c-2-i) of this section.
  - (3) **Example 3: Historic inventory method—**
    - (i) **Facts.** Business A uses a first-in, first-out (FIFO) method of accounting for inventory. Business A sells 1,200 units of inventory in year 2 for €3 per unit. The yearly average exchange rate is €1 = $1.02 for year 1 and €1 = $1.05 for year 2.
    - (ii) **Analysis—**
      - (A) **Gross sales.** Business A's gross sales are translated under [paragraph (c)(1)](#c-1) of this section at the yearly average exchange rate for the year of the sale. Business A's dollar gross sales will be computed as follows:
      - (B) **Translated basis of inventory.** The purchase price for each inventory unit was €1.50. Under [§ 1.987-1(c)(3)(i)](/cfr/26/1.987-1.md?p=c-3-i) and [paragraph (c)(2)(iv)(B)](#c-2-iv-B) of this section, the basis of each item of inventory is translated into dollars at the yearly average exchange rate for the year the inventory was acquired.
      - (C) **COGS.** Because Business A uses a FIFO method for inventory, Business A is considered to have sold in year 2 the 100 units of opening inventory purchased in year 1 ($153.00), the 300 units purchased in January year 2 ($472.50), the 300 units purchased in April year 2 ($472.50), the 300 units purchased in July year 2 ($472.50), and 200 of the 300 units purchased in November year 2 ($315.00). Accordingly, Business A's translated dollar COGS for year 2 is $1,885.50. Business A's opening inventory for year 3 is 100 units of inventory with a translated dollar basis of $157.50.
      - (D) **Gross sales income.** Accordingly, for purposes of [section 987](/cfr/26/987.md), Business A has gross income in dollars of $1,894.50 ($3,780.00−$1,885.50) from the sale of inventory in year 2.
  - (4) **Example 4: Simplified inventory method—**
    - (i) **Facts.** The facts are the same as in [paragraph (e)(3)](#e-3) of this section (Example 3), except that U.S. Corp does not elect to use the historic inventory method with respect to Business A.
    - (ii) **Analysis.** Because U.S. Corp does not elect to use the historic inventory method, the simplified inventory method under [paragraph (c)(2)(iv)(A)](#c-2-iv-A) of this section applies.
      - (A) **Gross sales.** Business A's dollar gross sales will be computed as described in [paragraph (e)(3)(ii)(A)](#e-3-ii-A) of this section (Example 3). Therefore, Business A has gross sales of $3,780.
      - (B) **COGS.** Business A sold 1,200 units of inventory in year 2, and the purchase price for each unit was €1.50. The total purchase price for the inventory sold in year 2 was €1,800. Under the simplified inventory method provided in [paragraph (c)(2)(iv)(A)](#c-2-iv-A) of this section, COGS for a taxable year is translated into the functional currency of the owner at the yearly average exchange rate for the taxable year in which the sale of inventory occurs. Therefore, before making the adjustments required under [paragraph (c)(3)](#c-3) of this section, Business A's dollar COGS for year 2 is equal to $1,890 (the purchase price for the inventory sold in year 2 (€1,800), translated at the yearly average exchange rate of €1 = $1.05).
      - (C) **Adjustments required.** Because the simplified inventory method applies, Business A's COGS must be adjusted under [paragraph (c)(3)](#c-3) of this section. No adjustment is required under [paragraph (c)(3)(ii)](#c-3-ii) of this section because no cost recovery deduction attributable to a historic asset is included in inventoriable costs for year 2. However, an adjustment for beginning inventory is required under [paragraph (c)(3)(iii)(A)](#c-3-iii-A) of this section because Business A uses a FIFO method of accounting for inventory.
      - (D) **Adjustment for beginning inventory.** The adjustment required under [paragraph (c)(3)(iii)(A)](#c-3-iii-A) of this section is equal to: the ending non-LIFO inventory included on Business A's closing balance sheet for the preceding taxable year (€150), translated at the yearly average exchange rate for year 1 (€1 = $1.02), which is $153; less the ending non-LIFO inventory included on Business A's closing balance sheet for the preceding taxable year (€150), translated at the yearly average exchange rate for year 2 (€1 = $1.05), which is $157.50. Therefore, there is a negative adjustment to COGS of $4.50. Business A's COGS for year 2 is reduced from $1,890 to $1,885.50.
      - (E) **Gross sales income.** Accordingly, for purposes of [section 987](/cfr/26/987.md), Business A has gross income in dollars of $1,894.50 ($3,780.00−$1,885.50) from the sale of inventory in year 2.
  - (5) **Example 5: Depreciation expense that is not an inventoriable cost.** The facts are the same as in [paragraph (e)(3)](#e-3) of this section (Example 3) except that during year 2, Business A incurred €100 of depreciation expense with respect to a truck. No portion of the depreciation expense is an inventoriable cost. The truck was purchased on January 15, year 1. The yearly average exchange rate for year 1 was €1 = $1.02. Under [paragraph (c)(2)(i)](#c-2-i) of this section, the €100 of depreciation is translated into dollars at the historic rate. The historic rate is the yearly average exchange rate for year 1. Accordingly, U.S. Corp takes into account depreciation of $102 with respect to Business A in year 2.
  - (6) **Example 6: Translation of depreciation expense that is an inventoriable cost (historic inventory method).** The facts are the same as in [paragraph (e)(5)](#e-5) of this section (Example 5) except that the €100 of depreciation expense incurred during year 2 with respect to the truck is an inventoriable cost. As a result, the depreciation expense is capitalized into the 1,200 units of inventory purchased by Business A in year 2. Of those 1,200 units, 1,100 units are sold during the year, and 100 units become ending inventory. The portion of depreciation expense capitalized into inventory that is sold during year 2 is reflected in Business A's euro COGS and is translated at the €1 = $1.02 yearly average exchange rate for year 1, the year in which the truck was purchased. The portion of the depreciation expense capitalized into the 100 units of ending inventory is not taken into account in year 2 but rather, will be taken into account in the year the ending inventory is sold, translated at the €1 = $1.02 yearly average exchange rate for year 1.
  - (7) **Example 7: Sale of land.** Business A purchased raw land on October 16, year 1, for €8,000 and sold the land on November 1, year 2, for €10,000. The yearly average exchange rate was €1 = $1.02 for year 1 and €1 = $1.05 for year 2. Under [paragraph (c)(1)](#c-1) of this section, the amount realized is translated into dollars at the yearly average exchange rate for year 2 (€10,000 × $1.05 = $10,500). Under [paragraph (c)(2)(i)](#c-2-i) of this section, the basis is translated at the historic rate for year 1, which is the yearly average exchange rate under section [§ 1.987-1(c)(3)(i)](/cfr/26/1.987-1.md?p=c-3-i) (€8,000 × $1.02 = $8,160). Accordingly, the amount of gain reported by U.S. Corp on the sale of the land is $2,340 ($10,500−$8,160).
  - (8) **Example 8: Current rate election.** The facts are the same as in [paragraph (e)(7)](#e-7) of this section (Example 7), except that U.S. Corp makes a current rate election under [§ 1.987-1(d)(2)](/cfr/26/1.987-1.md?p=d-2). Under [paragraph (c)(2)](#c-2) of this section, the exceptions to [paragraph (c)(1)](#c-1) of this section generally do not apply in a taxable year for which an annual recognition election or a current rate election is in effect. As a result, all items of income, gain, deduction, and loss with respect to Business A are translated into U.S Corp's functional currency at the yearly average exchange rate under [paragraph (c)(1)](#c-1) of this section. Business A's gain on the sale of the land is determined in its functional currency and is equal to €2,000 (amount realized of €10,000 less basis of €8,000). This gain is translated at the yearly average exchange rate for year 2 of €1 = $1.05, and the amount of gain reported by U.S. Corp on the sale of the land is $2,100. The result would be the same if U.S. Corp made an annual recognition election under [§ 1.987-5(b)(2)](/cfr/26/1.987-5.md?p=b-2) (and did not make a current rate election).
  - (9) -(12) [Reserved]
  - (13) **Example 13: Section 988 transaction—**
    - (i) **Facts.** Business A receives and accrues $100 of income from the provision of services on January 1, 2021. Business A continues to hold the $100 as a U.S. dollar-denominated demand deposit at a bank on December 31, 2021. U.S. Corp has made a [section 988](/cfr/26/988.md) mark-to-market election under [paragraph (b)(4)(ii)](#b-4-ii) of this section. The euro-dollar spot rate without the use of a spot rate convention is €1 = $1 on January 1, 2021, and €1 = $2 on December 31, 2021, and the yearly average exchange rate for 2021 is €1 = $1.50.
    - (ii) **Analysis—**
      - (A) Under [paragraph (b)(2)](#b-2) of this section, the $100 earned by Business A is translated into €100 at the spot rate on January 1, 2021, as defined in [§ 1.987-1(c)(1)](/cfr/26/1.987-1.md?p=c-1) without the use of a spot rate convention. In determining U.S. Corp's taxable income, the €100 of services income is translated into $150 at the yearly average exchange rate for 2021, as provided in [paragraph (c)(1)](#c-1) of this section.
      - (B) Under [paragraph (b)(4)(i)](#b-4-i) of this section, [section 988](/cfr/26/988.md) gain or loss for Business A's [section 988](/cfr/26/988.md) transactions is determined in, and by reference to, the euro, the functional currency of Business A. Accordingly, [section 988](/cfr/26/988.md) gain or loss must be determined on Business A's holding of the $100 demand deposit in, and by reference to, the euro. Under [§ 1.988-2(a)(2)](/cfr/26/1.988-2.md?p=a-2), Business A is treated as having an amount realized of €50 when the $100 is marked to market at the end of 2021 under [paragraph (b)(4)(ii)](#b-4-ii) of this section. Marking the dollars to market gives rise to a [section 988](/cfr/26/988.md) loss of €50 (€50 amount realized, less Business A's €100 basis in the $100). In determining U.S. Corp's taxable income, that €50 loss is translated into a $75 loss at the yearly average exchange rate for 2021, as provided in [paragraph (c)(1)](#c-1) of this section.
  - (14) **Example 14: Payment of foreign income tax—**
    - (i) **Facts.** Business A earns €100 of revenue from the provision of services and incurs €30 of general expenses and €10 of depreciation expense during 2021. Except as otherwise provided, U.S. Corp uses the yearly average exchange rate described in [§ 1.987-1(c)(2)](/cfr/26/1.987-1.md?p=c-2) to translate items of income, gain, deduction, and loss of Business A. Business A is subject to income tax in Country X at a 25 percent rate. U.S. Corp claims a credit with respect to Business A's foreign income taxes and elects under [section 986(a)(1)(D)](/cfr/26/986.md?p=a-1-D) to translate the foreign income taxes at the spot rate on the date the taxes were paid. The yearly average exchange rate for 2021 is €1 = $1.50. The historic rate used to translate the depreciation expense is €1 = $1.00. The spot rate on the date that Business A paid its foreign income taxes was €1 = $1.60.
    - (ii) **Analysis.** Because U.S. Corp has elected to translate foreign income taxes at the spot rate on the date such taxes were paid rather than at the yearly average exchange rate, U.S. Corp must make the adjustments described in [paragraph (c)(2)(v)](#c-2-v) of this section. Accordingly, U.S. Corp determines its [section 987](/cfr/26/987.md) taxable income or loss by reducing the [section 987](/cfr/26/987.md) taxable income or loss that otherwise would be determined under this section by €15, translated into U.S. dollars at the yearly average exchange rate (€1 = $1.50), and increasing the resulting amount by €15, translated using the same exchange rate that is used to translate the creditable taxes into U.S. dollars under [section 986(a)](/cfr/26/986.md?p=a) (€1 = $1.60). Following these adjustments, Business A's [section 987](/cfr/26/987.md) taxable income for 2021 is $96.50, computed as follows:

# §1.987-3T. Determination of section 987 taxable income or loss of an owner of a section 987 QBU (temporary).

- (a) through (b)(2)(i) [Reserved] For further guidance, see [§ 1.987-3(a) through (b)(2)(i)](/cfr/26/1.987-3.md?p=a..b-2-i).
- (ii) **No translation of basis or amount realized with respect to a specified owner functional currency transaction treated as a historic asset.** If the acquisition of a historic asset gives rise to a specified owner functional currency transaction described in paragraph (b)(4)(ii) of this section, the basis of the historic asset, and any amount realized on a disposition of the historic asset, is not translated if the amount is denominated in the owner's functional currency.
  - (3) [Reserved] For further guidance, see [§ 1.987-3(b)(3)](/cfr/26/1.987-3.md?p=b-3).
  - (4) **Special rule for section 988 transactions—**
    - (i) **In general.** [Section 988](/cfr/26/988.md) and the regulations thereunder apply to [section 988](/cfr/26/988.md) transactions of a [section 987](/cfr/26/987.md) QBU. For this purpose, whether a transaction is a [section 988](/cfr/26/988.md) transaction is determined by reference to the functional currency of the [section 987](/cfr/26/987.md) QBU. (But see paragraph (b)(4)(ii) of this section, providing that specified owner functional currency transactions are not treated as [section 988](/cfr/26/988.md) transactions.) However, except as provided in paragraph (b)(4)(iii)(A) of this section, [section 988](/cfr/26/988.md) gain or loss is determined in, and by reference to, the functional currency of the owner of the [section 987](/cfr/26/987.md) QBU rather than the functional currency of the [section 987](/cfr/26/987.md) QBU. Accordingly, in determining [section 988](/cfr/26/988.md) gain or loss of a [section 987](/cfr/26/987.md) QBU with respect to a [section 988](/cfr/26/988.md) transaction of the [section 987](/cfr/26/987.md) QBU, the amounts required under [section 988](/cfr/26/988.md) and the regulations thereunder to be translated on the applicable booking date or payment date with respect to the [section 988](/cfr/26/988.md) transaction are translated into the owner's functional currency at the rate required under [section 988](/cfr/26/988.md) and the regulations thereunder.
    - (ii) **Specified owner functional currency transactions not treated as section 988 transactions.** Transactions of a [section 987](/cfr/26/987.md) QBU described in sections [988(c)(1)(B)(i)](/cfr/26/988.md?p=c-1-B-i), [988(c)(1)(B)(ii)](/cfr/26/988.md?p=c-1-B-ii), and [988(c)(1)(C)](/cfr/26/988.md?p=c-1-C) (including the acquisition of nonfunctional currency as described in [§ 1.988-1(a)(1)](/cfr/26/1.988-1.md?p=a-1)), other than transactions described in paragraph (b)(4)(iii)(A) of this section, that are denominated in (or determined by reference to) the owner's functional currency (specified owner functional currency transactions) are not treated as [section 988](/cfr/26/988.md) transactions. Thus, no currency gain or loss is recognized by a [section 987](/cfr/26/987.md) QBU under [section 988](/cfr/26/988.md) with respect to such transactions.
    - (iii) **Determination of section 988 gain or loss for qualified short-term section 988 transactions—**
      - (A) **Determination by reference to the section 987 QBU's functional currency for certain transactions subject to a mark-to-market method of accounting.** [Section 988](/cfr/26/988.md) gain or loss with respect to [section 988](/cfr/26/988.md) transactions described in paragraph (b)(4)(iii)(B) of this section that are accounted for under a mark-to-market method of accounting for Federal income tax purposes or under the foreign currency mark-to-market method of accounting described in paragraph (b)(4)(iii)(C) of this section, and any hedges entered into to manage risk with respect to such transactions within the meaning of [§ 1.1221-2(c)(4)](/cfr/26/1.1221-2.md?p=c-4) (related hedges), must be determined in, and by reference to, the functional currency of the [section 987](/cfr/26/987.md) QBU (rather than the functional currency of its owner).
      - (B) **Qualified short-term section 988 transaction.** A qualified short-term [section 988](/cfr/26/988.md) transaction is a [section 988](/cfr/26/988.md) transaction that occurs in the ordinary course of a [section 987](/cfr/26/987.md) QBU's business and has an original term of one year or less on the date the transaction is entered into by the [section 987](/cfr/26/987.md) QBU. The holding of currency that is nonfunctional currency (within the meaning of [section 988(c)(1)(C)(ii)](/cfr/26/988.md?p=c-1-C-ii)) to the [section 987](/cfr/26/987.md) QBU in the ordinary course of a [section 987](/cfr/26/987.md) QBU's trade or business also is treated as a qualified short-term [section 988](/cfr/26/988.md) transaction. Any transaction that is denominated in, or determined by reference to, a hyperinflationary currency, including the holding of hyperinflationary currency, is not considered a qualified short-term [section 988](/cfr/26/988.md) transaction. See §§ [1.988-2(b)(15)](/cfr/26/1.988-2.md?p=b-15), [1.988-2(d)(5)](/cfr/26/1.988-2.md?p=d-5), and [1.988-2(e)(7)](/cfr/26/1.988-2.md?p=e-7) for rules relating to transactions denominated in, or determined by reference to, a hyperinflationary currency.
      - (C) **Election to use a foreign currency mark-to-market method of accounting.** A taxpayer may elect under this paragraph (b)(4)(iii)(C) to apply the foreign currency mark-to-market method of accounting described in this paragraph for all qualified short-term [section 988](/cfr/26/988.md) transactions described in paragraph (b)(4)(iii)(B) of this section, and any related hedges, that are properly attributable to a [section 987](/cfr/26/987.md) QBU on or after the effective date of the election and that are not otherwise accounted for under a mark-to-market method of accounting under [section 475](/cfr/26/475.md) or [section 1256](/cfr/26/1256.md). Under the foreign currency mark-to-market method of accounting, the timing of [section 988](/cfr/26/988.md) gain or loss on [section 988](/cfr/26/988.md) transactions is determined under the principles of [section 1256(a)(1)](/cfr/26/1256.md?p=a-1). Thus, only [section 988](/cfr/26/988.md) gain or loss is taken into account under the foreign currency mark-to-market method of accounting. Appropriate adjustments must be made to prevent the [section 988](/cfr/26/988.md) gain or loss from being taken into account again under [section 988](/cfr/26/988.md) or another provision of the Code or regulations. A [section 988](/cfr/26/988.md) transaction subject to this election is not subject to the “netting rule” of [section 988(b)](/cfr/26/988.md?p=b) and [§ 1.988-2(b)(8)](/cfr/26/1.988-2.md?p=b-8), under which exchange gain or loss is limited to overall gain or loss realized in a transaction, in taxable years prior to the taxable year in which [section 988](/cfr/26/988.md) gain or loss would be recognized with respect to such [section 988](/cfr/26/988.md) transaction but for this election.
    - (iv) **Examples.** Examples 10 through 13 of [paragraph (e)](#e) of this section illustrate the application of this paragraph (b)(4).
- (c)
  - (1) through (c)(2)(i) [Reserved] For further guidance, see [§ 1.987-3(c)(1) through (c)(2)(i)](/cfr/26/1.987-3.md?p=c-1..c-2-i).
    - (ii) **Amount realized with respect to historic assets that are section 988 transactions.** If the acquisition of a historic asset gave rise to a [section 988](/cfr/26/988.md) transaction described in paragraph (b)(4)(i) of this section, then in computing the total gain or loss on a disposition of the historic asset (some or all of which total gain or loss may be [section 988](/cfr/26/988.md) gain or loss described in [section 988(b)](/cfr/26/988.md?p=b) and paragraph (b)(4)(i) of this section), the amount realized (determined, if necessary, under [§ 1.987-3(b)(2)(i)](/cfr/26/1.987-3.md?p=b-2-i)) is translated into the owner's functional currency using the spot rate on the date such item is properly taken into account, subject to the limitation under [§ 1.987-1T(c)(1)(ii)(B)](/cfr/26/1.987-1T.md?p=c-1-ii-B) regarding the use of a spot rate convention.
    - (iii) through (iv) [Reserved] For further guidance, see [§ 1.987-3(c)(2)(iii) through (iv)](/cfr/26/1.987-3.md?p=c-2-iii..c-2-iv).
    - (v) **Translation of income to account for certain foreign income tax claimed as a credit.** The owner of a [section 987](/cfr/26/987.md) QBU claiming a credit under [section 901](/cfr/26/901.md) for foreign income taxes, other than foreign income taxes deemed paid under [section 902](/cfr/26/902.md) or [section 960](/cfr/26/960.md), that are properly reflected on the books and records of the [section 987](/cfr/26/987.md) QBU (the creditable tax amount) must determine [section 987](/cfr/26/987.md) taxable income or loss attributable to the [section 987](/cfr/26/987.md) QBU by reducing the amount of [section 987](/cfr/26/987.md) taxable income or loss that otherwise would be determined under this section by an amount equal to the creditable tax amount, translated into U.S. dollars using the yearly average exchange rate for the taxable year in which the creditable tax is accrued, and by increasing the resulting amount by an amount equal to the creditable tax amount, translated using the same exchange rate that is used to translate the creditable taxes into U.S. dollars under [section 986(a)](/cfr/26/986.md?p=a). See Example 14 of [paragraph (e)](#e) of this section,, for an illustration of this rule.
- (d) **Election to translate all items at the yearly average exchange rate.** Notwithstanding [§ 1.987-3(c)](/cfr/26/1.987-3.md?p=c), a taxpayer that has made the annual deemed termination election described in [§ 1.987-8T(d)](/cfr/26/1.987-8T.md?p=d) may elect under this [paragraph (d)](#d) to translate all items of income, gain, deduction, and loss with respect to a [section 987](/cfr/26/987.md) QBU determined under [§ 1.987-3(b)](/cfr/26/1.987-3.md?p=b) in the functional currency of the [section 987](/cfr/26/987.md) QBU into the owner's functional currency, if necessary, at the yearly average exchange rate for the taxable year. Example 9 of [paragraph (e)](#e) of this section illustrates the application of this election.
- (e) **Example 1—** through Example 8 [Reserved] For further guidance, see [§ 1.987-3(e)](/cfr/26/1.987-3.md?p=e), Example 1 through Example 8.
- (f) **Effective/applicability date.** This section applies to taxable years beginning on or after one year after the first day of the first taxable year following December 7, 2016. Notwithstanding the preceding sentence, if a taxpayer makes an election under [§ 1.987-11(b)](/cfr/26/1.987-11.md?p=b), then this section applies to taxable years to which [§§ 1.987-1 through 1.987-10](/cfr/26/1.987-1..1.987-10.md) apply as a result of such election.
- (g) **Expiration date.** The applicability of this section expires on December 6, 2019.

# §1.987-4. Determination of net unrecognized section 987 gain or loss of a section 987 QBU.

- (a) **In general.** The net unrecognized [section 987](/cfr/26/987.md) gain or loss of a [section 987](/cfr/26/987.md) QBU is determined by the owner annually as provided in [paragraph (b)](#b) of this section in the owner's functional currency. Only assets and liabilities attributable to the [section 987](/cfr/26/987.md) QBU are taken into account.
- (b) **Calculation of net unrecognized section 987 gain or loss.** Net unrecognized [section 987](/cfr/26/987.md) gain or loss of a [section 987](/cfr/26/987.md) QBU for a taxable year equals the sum of:
  - (1) The [section 987](/cfr/26/987.md) QBU's net accumulated unrecognized [section 987](/cfr/26/987.md) gain or loss for all prior taxable years as determined in [paragraph (c)](#c) of this section; and
  - (2) The [section 987](/cfr/26/987.md) QBU's unrecognized [section 987](/cfr/26/987.md) gain or loss for the current taxable year as determined in [paragraph (d)](#d) of this section and [§ 1.987-14](/cfr/26/1.987-14.md).
- (c) **Net accumulated unrecognized section 987 gain or loss for all prior taxable years—**
  - (1) **In general.** A [section 987](/cfr/26/987.md) QBU's net accumulated unrecognized [section 987](/cfr/26/987.md) gain or loss for all prior taxable years is the aggregate of the amounts determined under [paragraph (d)](#d) of this section for all prior taxable years to which this section applies, reduced by amounts recognized under [§ 1.987-5(a)](/cfr/26/1.987-5.md?p=a), amounts treated as deferred [section 987](/cfr/26/987.md) gain or loss, and amounts treated as suspended [section 987](/cfr/26/987.md) loss for all prior taxable years to which this section applies. Accordingly, net accumulated unrecognized [section 987](/cfr/26/987.md) gain or loss is not reduced under this [paragraph (c)(1)](#c-1) when deferred [section 987](/cfr/26/987.md) gain or loss is recognized (or suspended) under [§ 1.987-12](/cfr/26/1.987-12.md) or when suspended [section 987](/cfr/26/987.md) loss is recognized under [§ 1.987-11](/cfr/26/1.987-11.md) or [§ 1.987-13](/cfr/26/1.987-13.md).
  - (2) **Additional adjustments for certain taxable years beginning on or before December 31, 2024.** For any [section 987](/cfr/26/987.md) QBU in existence before the transition date, see § [1.987-10(e)(5)](/cfr/26/1.987-10.md?p=e-5) and [(f)(2)](/cfr/26/1.987-10.md?p=f-2) for additional adjustments to the [section 987](/cfr/26/987.md) QBU's net accumulated unrecognized [section 987](/cfr/26/987.md) gain or loss.
- (d) **Calculation of unrecognized section 987 gain or loss for a taxable year.** The unrecognized [section 987](/cfr/26/987.md) gain or loss of a [section 987](/cfr/26/987.md) QBU for a taxable year is generally determined under [paragraphs (d)(1) through (10)](#d-1..d-10) of this section. However, for taxable years in which a current rate election or an annual recognition election is in effect, the unrecognized [section 987](/cfr/26/987.md) gain or loss of a [section 987](/cfr/26/987.md) QBU for a taxable year is determined by applying only paragraphs [(d)(1) through (5)](#d-1..d-5) and [(10)](#d-10) of this section. See [§ 1.987-14](/cfr/26/1.987-14.md) for additional adjustments that must be made to the unrecognized [section 987](/cfr/26/987.md) gain or loss of a [section 987](/cfr/26/987.md) QBU for a taxable year in connection with a [section 987](/cfr/26/987.md) hedging transaction.
  - (1) **Step 1: Determine the change in the owner functional currency net value of the section 987 QBU for the taxable year—**
    - (i) **In general.** The change in the owner functional currency net value of the [section 987](/cfr/26/987.md) QBU for the taxable year equals—
      - (A) The owner functional currency net value of the [section 987](/cfr/26/987.md) QBU, determined in the functional currency of the owner under [paragraph (e)](#e) of this section, on the last day of the taxable year; less
      - (B) The owner functional currency net value of the [section 987](/cfr/26/987.md) QBU, determined in the functional currency of the owner under [paragraph (e)](#e) of this section, on the last day of the preceding taxable year.
    - (ii) **Year section 987 QBU is terminated.** If a [section 987](/cfr/26/987.md) QBU is terminated within the meaning of [§ 1.987-8](/cfr/26/1.987-8.md) during an owner's taxable year, the termination date is treated as the last day of the taxable year for purposes of this section.
    - (iii) **First taxable year of a section 987 QBU.** If the owner's taxable year is the first taxable year of a [section 987](/cfr/26/987.md) QBU, the owner functional currency net value of the [section 987](/cfr/26/987.md) QBU described in [paragraph (d)(1)(i)(B)](#d-1-i-B) of this section is zero.
    - (iv) **First year in which an election is in effect or ceases to be in effect.** Except as otherwise provided, the owner functional currency net value of the [section 987](/cfr/26/987.md) QBU described in [paragraph (d)(1)(i)(B)](#d-1-i-B) of this section is determined based on the elections that were (or were not) in effect on the last day of the preceding taxable year.
  - (2) **Step 2: Increase the amount determined in step 1 by the amount of assets transferred from the section 987 QBU to the owner—**
    - (i) **In general.** The amount determined in [paragraph (d)(1)](#d-1) of this section is increased by the total amount of assets transferred from the [section 987](/cfr/26/987.md) QBU to the owner during the taxable year translated into the functional currency of the owner as provided in [paragraph (d)(2)(ii)](#d-2-ii) of this section.
    - (ii) **Assets transferred from the section 987 QBU to the owner during the taxable year.** The total amount of assets transferred from the [section 987](/cfr/26/987.md) QBU to the owner for the taxable year translated into the functional currency of the owner equals the sum of:
      - (A) The amount of the functional currency of the [section 987](/cfr/26/987.md) QBU and the aggregate adjusted basis of all other marked assets, after taking into account [§ 1.988-1(a)(10)](/cfr/26/1.988-1.md?p=a-10), transferred to the owner during the taxable year determined in the functional currency of the [section 987](/cfr/26/987.md) QBU and translated into the functional currency of the owner at the spot rate applicable to the date of transfer; and
      - (B) The aggregate adjusted basis of all historic assets transferred to the owner during the taxable year determined in the functional currency of the [section 987](/cfr/26/987.md) QBU and translated into the functional currency of the owner at the historic rate for each such asset.
  - (3) **Step 3: Decrease the amount determined in steps 1 and 2 by the amount of assets transferred from the owner to the section 987 QBU—**
    - (i) **In general.** The aggregate amount determined in paragraphs [(d)(1)](#d-1) and [(2)](#d-2) of this section is decreased by the total amount of assets transferred from the owner to the [section 987](/cfr/26/987.md) QBU during the taxable year determined in the functional currency of the owner as provided in [paragraph (d)(3)(ii)](#d-3-ii) of this section.
    - (ii) **Assets transferred from the owner to the section 987 QBU during the taxable year.** The total amount of assets transferred from the owner to the [section 987](/cfr/26/987.md) QBU for the taxable year equals the sum of:
      - (A) The amount of functional currency of the owner transferred to the [section 987](/cfr/26/987.md) QBU during the taxable year; and
      - (B) The aggregate adjusted basis of all other assets, after taking into account [§ 1.988-1(a)(10)](/cfr/26/1.988-1.md?p=a-10), transferred to the [section 987](/cfr/26/987.md) QBU during the taxable year determined in the functional currency of the owner immediately before the transfer.
  - (4) **Step 4: Decrease the amount determined in steps 1 through 3 by the amount of liabilities transferred from the section 987 QBU to the owner—**
    - (i) **In general.** The aggregate amount determined in [paragraphs (d)(1) through (3)](#d-1..d-3) of this section is decreased by the total amount of liabilities transferred from the [section 987](/cfr/26/987.md) QBU to the owner during the taxable year translated into the functional currency of the owner as provided in [paragraph (d)(4)(ii)](#d-4-ii) of this section.
    - (ii) **Liabilities transferred from the section 987 QBU to the owner during the taxable year.** The total amount of liabilities transferred from the [section 987](/cfr/26/987.md) QBU to the owner for the taxable year equals the sum of:
      - (A) The amount of marked liabilities, after taking into account [§ 1.988-1(a)(10)](/cfr/26/1.988-1.md?p=a-10), transferred to the owner during the taxable year determined in the functional currency of the [section 987](/cfr/26/987.md) QBU and translated into the functional currency of the owner at the spot rate applicable to the date of transfer; and
      - (B) The amount of historic liabilities transferred to the owner during the taxable year determined in the functional currency of the [section 987](/cfr/26/987.md) QBU and translated into the functional currency of the owner at the historic rate for each such liability.
  - (5) **Step 5: Increase the amount determined in steps 1 through 4 by the amount of liabilities transferred from the owner to the section 987 QBU.** The aggregate amount determined in [paragraphs (d)(1) through (4)](#d-1..d-4) of this section is increased by the total amount of liabilities, after taking into account [§ 1.988-1(a)(10)](/cfr/26/1.988-1.md?p=a-10), transferred from the owner to the [section 987](/cfr/26/987.md) QBU during the taxable year determined in the functional currency of the owner immediately before the transfer.
  - (6) **Step 6: Decrease or increase the amount determined in steps 1 through 5 by the section 987 taxable income or loss, respectively, of the section 987 QBU for the taxable year.** The aggregate amount determined in [paragraphs (d)(1) through (5)](#d-1..d-5) of this section is decreased or increased by the [section 987](/cfr/26/987.md) taxable income or loss, respectively, computed under [§ 1.987-3](/cfr/26/1.987-3.md) for the taxable year.
  - (7) **Step 7: Increase the amount determined in steps 1 through 6 by certain expenses or losses that are not deductible in computing the section 987 taxable income or loss of the section 987 QBU for the taxable year.** The aggregate amount determined under [paragraphs (d)(1) through (6)](#d-1..d-6) of this section is increased by the amount of any expense or loss that reduces the basis of assets or increases the amount of liabilities attributable to the [section 987](/cfr/26/987.md) QBU for the taxable year but is not deductible in computing the [section 987](/cfr/26/987.md) QBU's taxable income or loss for the taxable year (such as business interest expense that is not deductible under [section 163(j)](/cfr/26/163.md?p=j)). Items of expense or loss described in the preceding sentence are translated into the functional currency of the owner using the exchange rate that would apply under [§ 1.987-3(c)](/cfr/26/1.987-3.md?p=c) if they were deductible in computing the [section 987](/cfr/26/987.md) QBU's taxable income or loss for the taxable year. However, any foreign income taxes incurred by the [section 987](/cfr/26/987.md) QBU with respect to which the owner claims a credit are translated at the same rate at which such taxes were translated under [section 986(a)](/cfr/26/986.md?p=a).
  - (8) **Step 8: Decrease the amount determined in steps 1 through 7 by the amount of certain income or gain that is not included in taxable income in computing the section 987 taxable income or loss of the section 987 QBU for the taxable year.** The aggregate amount determined under [paragraphs (d)(1) through (7)](#d-1..d-7) of this section is decreased by the amount of any income or gain that increases the basis of assets or reduces the amount of liabilities attributable to the [section 987](/cfr/26/987.md) QBU for the taxable year but is not included in taxable income in computing the [section 987](/cfr/26/987.md) QBU's taxable income or loss for the taxable year. Items of income or gain described in the preceding sentence are translated into the functional currency of the owner using the exchange rate that would apply under [§ 1.987-3(c)](/cfr/26/1.987-3.md?p=c) if they were included in taxable income in computing the [section 987](/cfr/26/987.md) QBU's taxable income or loss for the taxable year.
  - (9) **Step 9: Increase or decrease the amount determined in steps 1 through 8 by any income or gain, or any deduction or loss, respectively, that does not impact the adjusted balance sheet.** The aggregate amount determined under [paragraphs (d)(1) through (8)](#d-1..d-8) of this section is increased by any items of income or gain taken into account in [paragraph (d)(6)](#d-6) of this section (step 6) that do not increase the basis of assets or reduce the amount of liabilities attributable to the [section 987](/cfr/26/987.md) QBU for the taxable year, and decreased by any items of deduction or loss taken into account in [paragraph (d)(6)](#d-6) of this section (step 6) that do not reduce the basis of assets or increase the amount of liabilities attributable to the [section 987](/cfr/26/987.md) QBU for the taxable year. Items of income, gain, deduction, or loss described in the preceding sentence are translated into the functional currency of the owner using the exchange rate that applied under [§ 1.987-3(c)](/cfr/26/1.987-3.md?p=c) in computing the [section 987](/cfr/26/987.md) QBU's taxable income or loss for the taxable year.
  - (10) **Step 10: Decrease or increase the amount determined in steps 1 through 9 by any increase or decrease, respectively, to the section 987 QBU's net assets that is not previously taken into account under steps 2 through 9—**
    - (i) **In general.** Except as provided in [paragraph (d)(10)(iii)](#d-10-iii) of this section, the aggregate amount determined under [paragraphs (d)(1) through (9)](#d-1..d-9) of this section is—
      - (A) Decreased by the residual increase to net assets (as defined in [paragraph (d)(10)(ii)](#d-10-ii) of this section), translated into the owner's functional currency at the yearly average exchange rate for the taxable year; or
      - (B) Increased by the residual decrease to net assets (as defined in [paragraph (d)(10)(ii)](#d-10-ii) of this section), translated into the owner's functional currency at the yearly average exchange rate for the taxable year.
    - (ii) **Determining the residual increase or decrease to net assets—**
      - (A) **In general.** The residual increase to net assets is the positive amount, if any, that would be determined under [paragraphs (d)(1) through (9)](#d-1..d-9) of this section in the functional currency of the [section 987](/cfr/26/987.md) QBU if such amounts were determined in the functional currency of the [section 987](/cfr/26/987.md) QBU. The residual decrease to net assets is the negative amount, if any, that would be determined under [paragraphs (d)(1) through (9)](#d-1..d-9) of this section in the functional currency of the [section 987](/cfr/26/987.md) QBU if such amounts were determined in the functional currency of the [section 987](/cfr/26/987.md) QBU.
      - (B) **Application of step 1 in the functional currency of the section 987 QBU if a current rate election is in effect.** In a taxable year in which a current rate election is in effect, for purposes of applying step 1 ([paragraph (d)(1)](#d-1) of this section) in the functional currency of the [section 987](/cfr/26/987.md) QBU, the change in the net value of the [section 987](/cfr/26/987.md) QBU is determined by reference to the QBU net value described in [paragraph (e)(2)(ii)](#e-2-ii) of this section.
      - (C) **Application of steps 3 and 5 in the functional currency of the section 987 QBU.** For purposes of applying steps 3 and 5 (paragraphs [(d)(3)](#d-3) and [(5)](#d-5) of this section) in the functional currency of the [section 987](/cfr/26/987.md) QBU, the amount of assets and liabilities transferred from an owner to a [section 987](/cfr/26/987.md) QBU is determined by translating the basis of the assets and the amount of the liabilities under [§ 1.987-2(d)](/cfr/26/1.987-2.md?p=d).
    - (iii) **Modifications for taxable years to which a current rate election or an annual recognition election applies.** For any taxable year to which a current rate election or an annual recognition election applies, paragraphs [(d)(10)(i)](#d-10-i) and [(ii)](#d-10-ii) of this section are applied by replacing “[paragraphs (d)(1) through (9)](#d-1..d-9) of this section” with “[paragraphs (d)(1) through (5)](#d-1..d-5) of this section.”
- (e) **Determination of the owner functional currency net value of a section 987 QBU—**
  - (1) **In general.** Except as provided in [paragraph (e)(2)](#e-2) of this section, the owner functional currency net value of a [section 987](/cfr/26/987.md) QBU on the last day of a taxable year is equal to the aggregate amount of functional currency and the adjusted basis of each other asset on the [section 987](/cfr/26/987.md) QBU's adjusted balance sheet on that day, less the aggregate amount of each liability on the [section 987](/cfr/26/987.md) QBU's adjusted balance sheet on that day, in each case translated into the owner's functional currency as provided in paragraphs [(e)(1)(i)](#e-1-i) and [(ii)](#e-1-ii) of this section.
    - (i) **Marked item.** A marked item is translated into the owner's functional currency at the spot rate applicable to the last day of the relevant taxable year.
    - (ii) **Historic item.** A historic item is translated into the owner's functional currency at the historic rate.
  - (2) **Current rate election—**
    - (i) **In general.** If a current rate election is in effect, the owner functional currency net value of a [section 987](/cfr/26/987.md) QBU on the last day of a taxable year is equal to the QBU net value described in [paragraph (e)(2)(ii)](#e-2-ii) of this section, translated into the owner's functional currency at the spot rate applicable to that day.
    - (ii) **QBU net value.** The QBU net value of a [section 987](/cfr/26/987.md) QBU on the last day of a taxable year is determined in the functional currency of the [section 987](/cfr/26/987.md) QBU and is equal to the aggregate amount of functional currency and the adjusted basis of each other asset that is attributable to the [section 987](/cfr/26/987.md) QBU on that day, less the aggregate amount of each liability that is attributable to the [section 987](/cfr/26/987.md) QBU on that day. The QBU net value of a [section 987](/cfr/26/987.md) QBU on the last day of a taxable year may be determined either by preparing an adjusted balance sheet or by following the steps described in [paragraph (e)(2)(iii)](#e-2-iii) of this section (provided that the calculation is made consistently for all years in which a current rate election is in effect). However, in the first taxable year in which a current rate election ceases to be in effect, the owner functional currency net value of the [section 987](/cfr/26/987.md) QBU for the preceding taxable year must be determined by preparing an adjusted balance sheet.
    - (iii) **Alternative calculation of QBU net value.** The QBU net value of a [section 987](/cfr/26/987.md) QBU on the last day of a taxable year can be computed using the following steps (each applied in the functional currency of the [section 987](/cfr/26/987.md) QBU). See [paragraph (g)(2)(iii)](#g-2-iii) of this section (Example 2) for an example illustrating this rule.
      - (A) **Step 1: Determine the QBU net value on the last day of the preceding taxable year.** Determine the QBU net value on the last day of the preceding taxable year under this [paragraph (e)(2)](#e-2). If the owner's taxable year is the first taxable year of a [section 987](/cfr/26/987.md) QBU, the QBU net value on the last day of the preceding taxable year is zero. In the first taxable year in which a current rate election is in effect (other than the taxable year beginning on the transition date or the first taxable year of a [section 987](/cfr/26/987.md) QBU), the QBU net value on the last day of the preceding taxable year is determined by preparing an adjusted balance sheet. In the taxable year beginning on the transition date (other than the first taxable year of a [section 987](/cfr/26/987.md) QBU), the QBU net value on the last day of the preceding taxable year may be determined either by preparing an adjusted balance sheet or by applying the steps described in this [paragraph (e)(2)(iii)](#e-2-iii) for each taxable year beginning with the first taxable year of the [section 987](/cfr/26/987.md) QBU.
      - (B) **Step 2: Adjust for transfers between the section 987 QBU and its owner.** The amount determined in [paragraph (e)(2)(iii)(A)](#e-2-iii-A) of this section is increased by the amount of each transfer described in paragraph [(d)(3)](#d-3) or [(4)](#d-4) of this section and decreased by the amount of each transfer described in paragraph [(d)(2)](#d-2) or [(5)](#d-5) of this section (in each case, after adjustment for gain or loss recognized under [§ 1.988-1(a)(10)](/cfr/26/1.988-1.md?p=a-10)). For this purpose, the amount of assets and liabilities transferred from an owner to a [section 987](/cfr/26/987.md) QBU is determined by translating the basis of the assets and the amount of the liabilities under [§ 1.987-2(d)(1)](/cfr/26/1.987-2.md?p=d-1).
      - (C) **Step 3: Adjust for income or loss of the section 987 QBU.** The amount determined in [paragraph (e)(2)(iii)(B)](#e-2-iii-B) of this section is increased by items of income and gain attributable to the [section 987](/cfr/26/987.md) QBU (including tax-exempt income described in [paragraph (d)(8)](#d-8) of this section) for the taxable year and reduced by items of deduction and loss attributable to the [section 987](/cfr/26/987.md) QBU (including non-deductible expenses described in [paragraph (d)(7)](#d-7) of this section) for the taxable year. However, no adjustment is made under the preceding sentence for any item of income, gain, deduction, or loss described in [paragraph (d)(9)](#d-9) of this section.
- (f) **Combinations and separations—**
  - (1) **Combinations.** The net accumulated unrecognized [section 987](/cfr/26/987.md) gain or loss of a combined QBU for a taxable year is equal to the sum of the combining QBUs' net accumulated unrecognized [section 987](/cfr/26/987.md) gain or loss. See [paragraph (f)(3)(i)](#f-3-i) of this section (Example 1) for an illustration of this rule.
  - (2) **Separations.** The net accumulated unrecognized [section 987](/cfr/26/987.md) gain or loss of a separated QBU for a taxable year is equal to the separating QBU's net accumulated unrecognized [section 987](/cfr/26/987.md) gain or loss multiplied by the separation fraction. For purposes of determining the owner functional currency net value and QBU net value of the separated QBUs on the last day of the taxable year preceding the taxable year of separation under paragraphs [(d)(1)(i)(B)](#d-1-i-B) and (e) of this section, the assets and liabilities attributable to the separating QBU on that day are deemed to be attributable to the separated QBUs on that day, and are apportioned between the separated QBUs in a reasonable manner that takes into account the assets and liabilities attributable to the separated QBUs immediately after the separation. See [paragraph (f)(3)(ii)](#f-3-ii) of this section (Example 2) for an illustration of this rule.
  - (3) **Examples.** The following examples illustrate the rules of paragraphs [(f)(1)](#f-1) and [(2)](#f-2) of this section. For purposes of these examples, assume that no [section 987](/cfr/26/987.md) elections are in effect.
    - (i) **Example 1: Combination of two section 987 QBUs that have the same owner—**
      - (A) **Facts.** DC1, a domestic corporation, owns Entity A, a DE. Entity A conducts a manufacturing business that constitutes a [section 987](/cfr/26/987.md) QBU (Manufacturing QBU) that has the euro as its functional currency. Manufacturing QBU has a net accumulated unrecognized [section 987](/cfr/26/987.md) loss of $100. DC1 also owns Entity B, a DE. Entity B conducts a sales business that constitutes a [section 987](/cfr/26/987.md) QBU (Sales QBU) that has the euro as its functional currency. Sales QBU has a net accumulated unrecognized [section 987](/cfr/26/987.md) gain of $110. During the taxable year, Entity A merges into Entity B under local law pursuant to which Entity A ceases to exist, Entity B survives, and Entity B acquires all the assets and liabilities of Entity A. As a result, the books and records of Manufacturing QBU and Sales QBU are combined into a new single set of books and records. The combined entity has the euro as its functional currency.
      - (B) **Analysis.** Pursuant to [§ 1.987-2(c)(9)(i)](/cfr/26/1.987-2.md?p=c-9-i), Manufacturing QBU and Sales QBU are combining QBUs, and their combination does not give rise to a transfer that is taken into account in determining the amount of a remittance (as defined in [§ 1.987-5(c)](/cfr/26/1.987-5.md?p=c)). For purposes of computing net unrecognized [section 987](/cfr/26/987.md) gain or loss under this section for the year of the combination, the combination is deemed to have occurred on the last day of the owner's prior taxable year, such that the owner functional currency net value of the combined [section 987](/cfr/26/987.md) QBU at the end of that taxable year described under [paragraph (d)(1)(i)(B)](#d-1-i-B) of this section takes into account items attributable to both Manufacturing QBU and Sales QBU at that time. Additionally, any transactions between Manufacturing QBU and Sales QBU occurring during the year of the merger will not result in transfers to or from a [section 987](/cfr/26/987.md) QBU. Pursuant to [paragraph (f)(1)](#f-1) of this section, the combined QBU will have a net accumulated unrecognized [section 987](/cfr/26/987.md) gain of $10 (the $100 loss from Manufacturing QBU plus the $110 gain from Sales QBU).
    - (ii) **Example 2: Separation of two section 987 QBUs that have the same owner—**
      - (A) **Facts.** DC1, a domestic corporation, owns Entity A, a DE. Entity A conducts a business in the Netherlands that constitutes a [section 987](/cfr/26/987.md) QBU (Dutch QBU) that has the euro as its functional currency. The business of Dutch QBU consists of manufacturing and selling bicycles and scooters and is recorded on a single set of books and records. On the last day of year 1, the adjusted basis of the gross assets of Dutch QBU is €1,000. In year 2, the net accumulated unrecognized [section 987](/cfr/26/987.md) loss of Dutch QBU from all prior taxable years is $200. During year 2, Entity A separates the bicycle and scooter business such that each business begins to have its own books and records and to meet the definition of a [section 987](/cfr/26/987.md) QBU under [§ 1.987-1(b)(3)](/cfr/26/1.987-1.md?p=b-3) (hereafter, “bicycle QBU” and “scooter QBU”). There are no transfers between DC1 and Dutch QBU before the separation. After the separation, the aggregate adjusted basis of bicycle QBU's assets is €600 and the aggregate adjusted basis of scooter QBU's assets is €400. Each [section 987](/cfr/26/987.md) QBU continues to have the euro as its functional currency.
      - (B) **Analysis.** Pursuant to [§ 1.987-2(c)(9)(iii)](/cfr/26/1.987-2.md?p=c-9-iii), bicycle QBU and scooter QBU are separated QBUs, and the separation of Dutch QBU, a separating QBU, does not give rise to a transfer taken into account in determining the amount of a remittance. For purposes of computing net unrecognized [section 987](/cfr/26/987.md) gain or loss under this section for year 2, the separation will be deemed to have occurred on the last day of the owner's prior taxable year, year 1. Pursuant to [paragraph (f)(2)](#f-2) of this section and [§ 1.987-1(h)](/cfr/26/1.987-1.md?p=h), bicycle QBU will have a separation fraction of €600/€1,000 and net accumulated unrecognized [section 987](/cfr/26/987.md) loss of $120 (€600/€1,000 × $200), and scooter QBU will have a separation fraction of €400/€1,000 and net accumulated unrecognized [section 987](/cfr/26/987.md) loss of $80 (€400/€1,000 × $200).
- (g) **Examples.** The following examples illustrate the provisions of this section. For purposes of the examples, U.S. Corp is a domestic corporation that uses the calendar year as its taxable year and has the dollar as its functional currency. Except as otherwise indicated, no [section 987](/cfr/26/987.md) elections are in effect. The examples are not intended to demonstrate when activities constitute a trade or business within the meaning of § [1.989(a)-1(b)(2)(ii)(A)](/cfr/26/1.989..1.md) and [(c)](/cfr/26/1.989.md?p=c) and therefore whether a [section 987](/cfr/26/987.md) QBU is considered to exist.
  - (1) **Example 1: Determination of net unrecognized section 987 gain or loss—**
    - (i) **Facts.** On July 1, year 1, U.S. Corp establishes Japan Branch, a [section 987](/cfr/26/987.md) QBU that has the yen as its functional currency, and U.S. Corp transfers to Japan Branch ¥100,000 with a basis of $1,000 and raw land with a basis of $500. On the same day, Japan Branch borrows ¥10,000 from a bank. In year 1, Japan Branch earns ¥12,000 for providing services and incurs ¥2,000 of related expenses. Japan Branch thus earns ¥10,000 of net income in year 1. The spot rate on July 1, year 1, is $1 = ¥100; the spot rate on December 31, year 1, is $1 = ¥120; and the average rate for the period of July 1, year 1, to December 31, year 1, is $1 = ¥110. Thus, the ¥12,000 of services revenue when translated under [§ 1.987-3(c)(1)](/cfr/26/1.987-3.md?p=c-1) at the yearly average exchange rate equals $109.09 (¥12,000 × ($1/¥110)) = $109.09). The ¥2,000 of expenses translated at the same yearly average exchange rate equals $18.18 (¥2,000 × ($1/¥110) = $18.18). Thus, Japan Branch's net income translated into dollars equals $90.91 ($109.09−$18.18 = $90.91).
    - (ii) **Analysis.** Under [paragraph (a)](#a) of this section, U.S. Corp must compute the net unrecognized [section 987](/cfr/26/987.md) gain or loss of Japan Branch for year 1. Because this is Japan Branch's first taxable year, the net unrecognized [section 987](/cfr/26/987.md) gain or loss (as defined under [paragraph (b)](#b) of this section) is equal to the branch's unrecognized [section 987](/cfr/26/987.md) gain or loss for year 1 as determined in [paragraph (d)](#d) of this section. The calculations under [paragraph (d)](#d) of this section are made as follows:
      - (A) **Step 1.** Under [paragraph (d)(1)](#d-1) of this section (step 1), U.S. Corp must determine the change in the owner functional currency net value (OFCNV) of Japan Branch for year 1 in dollars. The change in the OFCNV of Japan Branch for year 1 is equal to the OFCNV of Japan Branch determined in dollars on the last day of year 1, less the OFCNV of Japan Branch determined in dollars on the last day of the preceding taxable year.

        (1) The OFCNV of Japan Branch on December 31, year 1 is determined under [paragraph (e)](#e) of this section as the sum of the basis of each asset on Japan Branch's adjusted balance sheet on December 31, year 1, less the sum of each liability on Japan Branch's adjusted balance sheet on that date, translated into dollars as provided in paragraphs [(e)(1)(i)](#e-1-i) and [(ii)](#e-1-ii) of this section.

        (2) For this purpose, Japan Branch will show the following assets and liabilities on its adjusted balance sheet for December 31, year 1: cash of ¥120,000; raw land with a basis of ¥55,000 ($500 translated under [§ 1.987-2(d)(2)](/cfr/26/1.987-2.md?p=d-2) at the historic rate of $1 = ¥110); and liabilities of ¥10,000.

        (3) Under paragraphs [(e)(1)(i)](#e-1-i) and [(ii)](#e-1-ii) of this section, U.S. Corp will translate these items as follows. The ¥120,000 is a marked asset and the ¥10,000 liability is a marked liability. These items are translated into dollars on December 31, year 1, using the spot rate on December 31, year 1, of $1 = ¥120. The raw land is a historic asset and is translated into dollars under [paragraph (e)(1)(ii)](#e-1-ii) of this section at the historic rate, which under [§ 1.987-1(c)(3)(i)(A)](/cfr/26/1.987-1.md?p=c-3-i-A) is the yearly average exchange rate of $1 = ¥110 applicable to the year the land was transferred to the QBU.

        (4) The OFCNV of Japan Branch on December 31, year 1, in dollars is $1,416.67. The determination of the OFCNV of Japan Branch on December 31, year 1, is shown below in dollars together with the corresponding amounts in yen.

        (5) Under [paragraph (d)(1)](#d-1) of this section, the change in OFCNV of Japan Branch for year 1 is equal to the OFCNV of the branch determined in dollars on December 31, year 1, (which is $1,416.67) less the OFCNV of the branch determined in dollars on the last day of the preceding taxable year. Because this is the first taxable year of Japan Branch, the OFCNV of Japan Branch determined in dollars on the last day of the preceding taxable year is zero under [paragraph (d)(1)(iii)](#d-1-iii) of this section. Accordingly, the change in OFCNV of Japan Branch for year 1 is $1,416.67.

      - (B) **Step 2 (no adjustment).** No adjustment is made under [paragraph (d)(2)](#d-2) of this section (step 2) because no assets were transferred by Japan Branch to U.S. Corp during the taxable year.
      - (C) **Step 3.** On July 1, year 1, U.S. Corp transferred to Japan Branch ¥100,000 with a basis of $1,000.00 and raw land with a basis of $500.00 (equal to ¥55,000, translated under [§ 1.987-2(d)(2)](/cfr/26/1.987-2.md?p=d-2) at the historic rate of $1 = ¥110). The total amount of assets transferred from U.S. Corp to Japan Branch in dollars is $1,500, and the total amount of the transfer in yen is ¥155,000. Therefore, under [paragraph (d)(3)](#d-3) of this section (step 3), the amount determined in previous steps is reduced by $1,500.00, from $1,416.67 to negative $83.33.
      - (D) **Steps 4 and 5 (no adjustment).** No adjustment is made under paragraphs [(d)(4)](#d-4) and [(5)](#d-5) of this section (steps 4 and 5) because no liabilities were transferred by U.S. Corp to Japan Branch or by Japan Branch to U.S. Corp during the taxable year.
      - (E) **Step 6.** Under [paragraph (d)(6)](#d-6) of this section (step 6), the amount determined in previous steps is decreased by the [section 987](/cfr/26/987.md) taxable income of Japan Branch of $90.91, from negative $83.33 to negative $174.24.
      - (F) **Steps 7 through 9 (no adjustment).** No adjustment is made under [paragraphs (d)(7) through (9)](#d-7..d-9) of this section (steps 7 through 9) 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.
      - (G) **Step 10 (no adjustment)—** (1) Calculation of residual increase or decrease to net assets. Under [paragraph (d)(10)(ii)](#d-10-ii) of this section, the residual increase (or decrease) to net assets is the positive (or negative) amount, if any, that would be determined under [paragraphs (d)(1) through (9)](#d-1..d-9) of this section (steps 1 through 9) in the functional currency of the [section 987](/cfr/26/987.md) QBU if such amounts were determined in the functional currency of the [section 987](/cfr/26/987.md) QBU. In year 1, the relevant steps that must be applied in the functional currency of Japan Branch (the yen) are paragraphs [(d)(1)](#d-1), [(3)](#d-3), and [(6)](#d-6) of this section (steps 1, 3, and 6). For purposes of applying [paragraph (d)(1)](#d-1) of this section (step 1) in yen, the change in the net value of Japan Branch is ¥165,000. See paragraph (g)(1)(ii)(A)(4) of this section. For purposes of applying [paragraph (d)(3)](#d-3) of this section (step 3) in yen, the amount of assets transferred from U.S. Corp to Japan Branch is ¥155,000. See [paragraph (g)(1)(ii)(C)](#g-1-ii-C) of this section. For purposes of applying [paragraph (d)(6)](#d-6) of this section (step 6) in yen, Japan Branch earned ¥10,000 of net income in year 1. The application of these steps results in no residual increase or decrease to the adjusted balance sheet, as shown below:

        (2) No residual increase or decrease to the adjusted balance sheet. As explained in paragraph (g)(1)(ii)(G)(1) of this section, there is no residual increase or decrease to the adjusted balance sheet of Japan Branch in year 1. Therefore, no adjustment is made under [paragraph (d)(10)](#d-10) of this section (step 10). Accordingly, the unrecognized [section 987](/cfr/26/987.md) loss of Japan Branch for year 1 is $174.24.

  - (2) **Example 2: Determination of net unrecognized section 987 gain or loss if a current rate election is in effect—**
    - (i) **Facts.** The facts are the same as in [paragraph (g)(1)](#g-1) of this section (Example 1), except that U.S. Corp makes a current rate election under [§ 1.987-1(d)(2)](/cfr/26/1.987-1.md?p=d-2) for year 1.
    - (ii) **Analysis.** Because a current rate election is in effect for year 1, the unrecognized [section 987](/cfr/26/987.md) gain or loss for year 1 is determined by applying only paragraphs [(d)(1) through (5)](#d-1..d-5) and [(10)](#d-10) of this section (steps 1 through 5 and step 10). The calculations under [paragraph (d)](#d) of this section are made as follows:
      - (A) **Step 1.** The change in the OFCNV of Japan Branch for year 1 is equal to the OFCNV of Japan Branch determined in dollars on the last day of year 1, less the OFCNV of Japan Branch determined in dollars on the last day of the preceding taxable year.

        (1) For this purpose, Japan Branch will show the same assets and liabilities on its adjusted balance sheet for December 31, year 1 as are described in paragraph (g)(1)(ii)(A)(2) of this section (Example 1), but the land is treated as a marked asset as a result of the current rate election. The adjusted balance sheet reflects cash of ¥120,000, raw land with a basis of ¥50,000 ($500 translated under [§ 1.987-2(d)(1)](/cfr/26/1.987-2.md?p=d-1) at the July 1, year 1 spot rate of $1 = ¥100), and liabilities of ¥10,000.

        (2) Under [paragraph (e)(2)(ii)](#e-2-ii) of this section, because a current rate election is in effect, the OFCNV of Japan Branch at the end of year 1 is equal to the QBU net value, translated into U.S. dollars at the applicable spot rate on the last day of the taxable year. The QBU net value of Japan Branch at the end of year 1 is ¥160,000, as shown below. The OFCNV of Japan Branch is $1,333.33, which is equal to the QBU net value of ¥160,000, translated at the applicable spot rate on December 31, year 1 of $1 = ¥120.

        (3) Under [paragraph (d)(1)](#d-1) of this section, the change in OFCNV of Japan Branch for year 1 is equal to the OFCNV of the branch determined in dollars on December 31, year 1, (which is $1,333.33) less the OFCNV of the branch determined in dollars on the last day of the preceding taxable year. Because this is the first taxable year of Japan Branch, the OFCNV of Japan Branch determined in dollars on the last day of the preceding taxable year is zero under [paragraph (d)(1)(iii)](#d-1-iii) of this section. Accordingly, the change in OFCNV of Japan Branch for year 1 is $1,333.33.

      - (B) **Step 2 (no adjustment).** No adjustment is made under [paragraph (d)(2)](#d-2) of this section (step 2) because no assets were transferred by Japan Branch to U.S. Corp during the taxable year.
      - (C) **Step 3.** On July 1, year 1, U.S. Corp transferred to Japan Branch ¥100,000 with a basis of $1,000.00 and raw land with a basis of $500.00 (equal to ¥50,000, translated under [§ 1.987-2(d)(1)](/cfr/26/1.987-2.md?p=d-1) at the spot rate on July 31, year 1 of $1 = ¥100). The total amount of assets transferred in dollars is $1,500.00, and the amount of assets transferred in yen is ¥150,000. Therefore, under [paragraph (d)(3)](#d-3) of this section (step 3), the amount determined in previous steps is reduced by $1,500, from $1,333.33 to negative $166.67.
      - (D) **Steps 4 and 5 (no adjustment—** ). No adjustment is made under paragraphs [(d)(4)](#d-4) and [(5)](#d-5) of this section (steps 4 and 5) because no liabilities were transferred by U.S. Corp to Japan Branch or by Japan Branch to U.S. Corp during the taxable year.
      - (E) **Steps 6 through 9 do not apply.** Under [paragraph (d)](#d) of this section, [paragraphs (d)(6) through (9)](#d-6..d-9) of this section (steps 6 through 9) do not apply because a current rate election is in effect.
      - (F) **Step 10—** (1) Application of relevant steps in Japan Branch's functional currency. Under [paragraph (d)(10)(iii)](#d-10-iii) of this section, because a current rate election is in effect, the residual increase or decrease to net assets is determined by applying [paragraphs (d)(1) through (5)](#d-1..d-5) of this section (steps 1 through 5) in the functional currency of the [section 987](/cfr/26/987.md) QBU. The relevant steps that must be applied under [paragraph (d)(10)](#d-10) of this section in the functional currency of Japan Branch are paragraphs [(d)(1)](#d-1) and [(3)](#d-3) of this section (steps 1 and 3). Under [paragraph (d)(10)(ii)(B)](#d-10-ii-B) of this section, step 1 is applied by reference to Japan Branch's QBU net value. See paragraphs [(g)(2)(ii)(A)](#g-2-ii-A) and [(C)](#g-2-ii-C) of this section for amounts determined in yen. The residual increase to net assets is determined as follows:

        (2) Residual increase or decrease to net assets. As explained in paragraph (g)(2)(ii)(F)(1) of this section, the residual increase to Japan Branch's net assets in year 1 is ¥10,000. This amount, translated at the yearly average exchange rate of $1 = ¥110, equals $90.91. Therefore, the amount determined in previous steps is reduced by $90.91, from negative $166.67 to negative $257.58. Accordingly, the unrecognized [section 987](/cfr/26/987.md) loss of Japan Branch for year 1 is $257.58.

    - (iii) **Alternative computation of QBU net value.** Alternatively, for purposes of applying steps 1 and 10 (paragraphs [(d)(1)](#d-1) and [(10)](#d-10) of this section), U.S. Corp can determine QBU net value using the following steps under [paragraph (e)(2)(iii)](#e-2-iii) of this section.
      - (A) **Step 1: Determine QBU net value at the end of the preceding taxable year.** Because year 1 is the first taxable year in which Japan Branch exists, the QBU net value at the end of the preceding taxable year is zero.
      - (B) **Step 2: Adjust for transfers between the section 987 QBU and its owner.** During year 1, U.S. Corp transferred assets to Japan Branch with an aggregate basis of ¥150,000, as described in [paragraph (g)(2)(ii)(C)](#g-2-ii-C) of this section. Therefore, the amount determined in step 1 is increased from zero to ¥150,000.
      - (C) **Step 3: Adjust for income or loss of the section 987 QBU.** During year 1, Japan Branch earned ¥10,000 of net income. Therefore, the amount determined in step 2 is increased from ¥150,000 to ¥160,000.
      - (D) **QBU net value.** Japan Branch's QBU net value at the end of the preceding taxable year is zero. This amount is increased by the transfer from U.S. Corp of ¥150,000 and by Japan Branch's taxable income of ¥10,000. Japan Branch did not have any tax-exempt income or non-deductible expenses in year 1. Accordingly, Japan Branch's QBU net value at the end of year 1 is ¥160,000.
  - (3) **Example 3: Determination of net unrecognized section 987 gain or loss when a current rate election is revoked—**
    - (i) **Facts—**
      - (A) **Background.** The facts in year 1 are the same as in [paragraph (g)(2)](#g-2) of this section (Example 2). In year 9, a current rate election remains in effect, U.S. Corp has net unrecognized [section 987](/cfr/26/987.md) loss of $1,000 with respect to Japan Branch, and Japan Branch does not make a remittance. On December 31, year 9, the adjusted balance sheet of Japan Branch shows the following assets and liabilities: cash of ¥120,000; raw land with a basis of ¥50,000; and liabilities of ¥10,000. Effective for year 10, U.S. Corp revokes the current rate election.
      - (B) **Operations in year 10.** In year 10, Japan Branch earns ¥12,000 for providing services and incurs ¥2,000 of related expenses. Japan Branch thus earns ¥10,000 of net income in year 10. On December 31, year 10, the adjusted balance sheet of Japan Branch shows the following assets and liabilities: cash of ¥130,000; raw land with a basis of ¥50,000; and liabilities of ¥10,000. Assume that the spot rate on December 31, year 9, is $1 = ¥120; the spot rate on December 31, year 10, is $1 = ¥130; and the yearly average exchange rate for year 10 is $1 = ¥125. Thus, the ¥12,000 of services revenue when properly translated under [§ 1.987-3(c)(1)](/cfr/26/1.987-3.md?p=c-1) at the yearly average exchange rate equals $96.00 (¥12,000 × ($1/¥125)) = $96.00). The ¥2,000 of expenses translated at the same yearly average exchange rate equals $16.00 (¥2,000 × ($1/¥125) = $16.00). Thus, Japan Branch's net income translated into dollars equals $80. There are no transfers of assets or liabilities between U.S. Corp and Japan Branch in year 10.
    - (ii) **Analysis—**
      - (A) **Determination of OFCNV for year 9.** Under [paragraph (d)(1)(iv)](#d-1-iv) of this section, the OFCNV of a [section 987](/cfr/26/987.md) QBU on the last day of the preceding taxable year is determined based on the elections that were (or were not) in effect on the last day of that taxable year. In year 9, a current rate election was in effect. Therefore, in determining the OFCNV of Japan Branch for year 9, all assets and liabilities of Japan Branch (including the land) are treated as marked items. Under [paragraph (e)(2)(ii)](#e-2-ii) of this section, because a current rate election was in effect for year 9, the OFCNV of Japan Branch at the end of year 9 is equal to the QBU net value, translated into U.S. dollars at the applicable spot rate on the last day of the taxable year. The QBU net value of Japan Branch at the end of year 9 is ¥160,000, as shown below. The OFCNV of Japan Branch is $1,333.33, which is equal to the QBU net value of ¥160,000, translated at the applicable spot rate on December 31, year 9 of $1 = ¥120.
      - (B) **Determination of OFCNV for year 10.** In year 10, a current rate election is not in effect. Therefore, in determining the OFCNV of Japan Branch for year 10, the land owned by Japan Branch is treated as a historic item. Under [§ 1.987-1(c)(3)(i)(E)](/cfr/26/1.987-1.md?p=c-3-i-E), the historic rate applicable to historic items that were attributable to Japan Branch on the last day of the last taxable year in which a current rate election was in effect (December 31, year 9) generally is equal to the spot rate applicable to that day. Therefore, the historic rate applicable to the land is the spot rate on December 31, year 9. The OFCNV of Japan Branch for year 10 is $1,339.74, determined under [paragraph (e)](#e) of this section as follows (together with the corresponding amounts in yen):
      - (C) **Determination of unrecognized section 987 gain or loss for year 10.** The unrecognized [section 987](/cfr/26/987.md) gain or loss of Japan Branch for year 10 is determined under [paragraph (d)](#d) of this section as follows:

        (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)](#d-2..d-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)](#d-6) of this section (step 6), the amount determined in previous steps is decreased by the [section 987](/cfr/26/987.md) 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)](#d-7..d-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](/cfr/26/987.md) loss of Japan Branch for year 10 is negative $73.59.

      - (D) **Determination of net unrecognized section 987 gain or loss.** In year 10, Japan Branch has net accumulated [section 987](/cfr/26/987.md) loss of $1,000. Because U.S. Corp revoked the current rate election for year 10, the net accumulated [section 987](/cfr/26/987.md) loss of $1,000 becomes suspended [section 987](/cfr/26/987.md) loss under [§ 1.987-11(d)(2)](/cfr/26/1.987-11.md?p=d-2) and Japan Branch's net accumulated [section 987](/cfr/26/987.md) loss is reduced to zero. Therefore, in year 10, Japan Branch's net unrecognized [section 987](/cfr/26/987.md) loss is equal to $73.59, its unrecognized [section 987](/cfr/26/987.md) loss for year 10.

# §1.987-5. Recognition of section 987 gain or loss.

- (a) **Recognition of section 987 gain or loss by the owner of a section 987 QBU.** The taxable income of an owner of a [section 987](/cfr/26/987.md) QBU includes the owner's [section 987](/cfr/26/987.md) gain or loss recognized with respect to the [section 987](/cfr/26/987.md) QBU for the taxable year. Except as otherwise provided in the [section 987](/cfr/26/987.md) regulations (including [§ 1.987-11(c)](/cfr/26/1.987-11.md?p=c), § [1.987-12(b)](/cfr/26/1.987-12.md?p=b) or [(e)](/cfr/26/1.987-12.md?p=e), or § [1.987-13(h)](/cfr/26/1.987-13.md?p=h) or [(k)](/cfr/26/1.987-13.md?p=k)), for any taxable year the owner's [section 987](/cfr/26/987.md) gain or loss recognized with respect to a [section 987](/cfr/26/987.md) QBU is equal to:
  - (1) The owner's net unrecognized [section 987](/cfr/26/987.md) gain or loss with respect to the [section 987](/cfr/26/987.md) QBU determined under [§ 1.987-4](/cfr/26/1.987-4.md) on the last day of such taxable year (or, if earlier, on the day the [section 987](/cfr/26/987.md) QBU is terminated under [§ 1.987-8](/cfr/26/1.987-8.md)); multiplied by
  - (2) The owner's remittance proportion for the taxable year, as determined under [paragraph (b)](#b) of this section.
- (b) **Remittance proportion—**
  - (1) **In general.** Except as provided in [paragraph (b)(2)](#b-2) of this section, the owner's remittance proportion with respect to a [section 987](/cfr/26/987.md) QBU for a taxable year is equal to:
    - (i) The amount of the remittance, as determined under [paragraph (c)](#c) of this section, to the owner from the [section 987](/cfr/26/987.md) QBU for such taxable year; divided by
    - (ii) **The sum of—**
      - (A) The aggregate adjusted basis of the gross assets that are attributable to the [section 987](/cfr/26/987.md) QBU as of the end of the taxable year, determined in the functional currency of the [section 987](/cfr/26/987.md) QBU; and
      - (B) **The amount of the remittance, as determined under paragraph (c) of this section.**
  - (2) **Annual recognition election.** A taxpayer may elect to recognize its net unrecognized [section 987](/cfr/26/987.md) gain or loss with respect to the [section 987](/cfr/26/987.md) QBU on an annual basis (annual recognition election). For any taxable year in which the annual recognition election is in effect, the owner's remittance proportion with respect to a [section 987](/cfr/26/987.md) QBU is one. See [paragraph (g)](#g) of this section for an example illustrating this rule. Additionally, for any taxable year of an original deferral QBU owner in which an annual recognition election is in effect, the remittance proportion with respect to any successor deferral QBU is one.
- (c) **Remittance—**
  - (1) **Definition.** A remittance is determined in the [section 987](/cfr/26/987.md) QBU's functional currency and equals the excess, if any, of:
    - (i) The aggregate of all amounts transferred from the [section 987](/cfr/26/987.md) QBU to the owner during the taxable year, as determined in [paragraph (d)](#d) of this section; over
    - (ii) The aggregate of all amounts transferred from the owner to the [section 987](/cfr/26/987.md) QBU during the taxable year, as determined in [paragraph (e)](#e) of this section.
  - (2) **Alternative calculation.** The amount of a remittance described in [paragraph (c)(1)](#c-1) of this section may alternatively be determined under the following steps (each applied in the functional currency of the [section 987](/cfr/26/987.md) QBU). If the amount determined under this [paragraph (c)(2)](#c-2) is negative, the amount of the remittance is zero.
    - (i) **Step 1: Determine the change in QBU net value.** The change in QBU net value is equal to the QBU net value on the date provided in [paragraph (c)(3)](#c-3) of this section, less the QBU net value on the last day of the preceding taxable year. In the first taxable year in which the [section 987](/cfr/26/987.md) QBU exists, the QBU net value on the last day of the preceding taxable year is zero.
    - (ii) **Step 2: Adjust the amount determined in step 1 for income or loss of the section 987 QBU.** The amount determined in [paragraph (c)(2)(i)](#c-2-i) of this section is reduced (including below zero) by items of income and gain attributable to the [section 987](/cfr/26/987.md) QBU (including tax-exempt income described in [§ 1.987-4(d)(8)](/cfr/26/1.987-4.md?p=d-8)) for the taxable year and increased by items of deduction and loss attributable to the [section 987](/cfr/26/987.md) QBU (including non-deductible expenses described in [§ 1.987-4(d)(7)](/cfr/26/1.987-4.md?p=d-7)) for the taxable year. However, no adjustment is made under the preceding sentence for any item of income, gain, deduction, or loss described in [§ 1.987-4(d)(9)](/cfr/26/1.987-4.md?p=d-9) (items that do not impact the adjusted balance sheet).
    - (iii) **Step 3: Multiply the amount determined in step 2 by negative one.** The amount of a remittance is equal to the amount determined in [paragraph (c)(2)(ii)](#c-2-ii) of this section multiplied by negative one.
  - (3) **Day when a remittance is determined.** An owner's remittance from a [section 987](/cfr/26/987.md) QBU for a taxable year is determined on the last day of the taxable year (or, if earlier, on the day of the taxable year when the [section 987](/cfr/26/987.md) QBU is terminated under [§ 1.987-8](/cfr/26/1.987-8.md)).
  - (4) **Termination.** A termination of a [section 987](/cfr/26/987.md) QBU as determined under [§ 1.987-8](/cfr/26/1.987-8.md) is treated as a remittance of all the gross assets of the [section 987](/cfr/26/987.md) QBU to the owner on the date of such termination. See [§ 1.987-8(e)](/cfr/26/1.987-8.md?p=e). Accordingly, for purposes of [paragraph (b)](#b) of this section, the remittance proportion in the case of a termination is one.
- (d) **Aggregate of all amounts transferred from the section 987 QBU to the owner for the taxable year.** For purposes of [paragraph (c)(1)(i)](#c-1-i) of this section, the aggregate of all amounts transferred from the [section 987](/cfr/26/987.md) QBU to the owner for the taxable year is the aggregate amount of functional currency and the aggregate adjusted basis of the other assets transferred (after taking into account [§ 1.988-1(a)(10)](/cfr/26/1.988-1.md?p=a-10)), determined in the [section 987](/cfr/26/987.md) QBU's functional currency. Solely for this purpose, the amount of liabilities transferred from the owner to the [section 987](/cfr/26/987.md) QBU (determined in the [section 987](/cfr/26/987.md) QBU's functional currency under [§ 1.987-2(d)](/cfr/26/1.987-2.md?p=d) after taking into account [§ 1.988-1(a)(10)](/cfr/26/1.988-1.md?p=a-10)) is treated as a transfer of assets from the [section 987](/cfr/26/987.md) QBU to the owner with an adjusted basis equal to the amount of such liabilities.
- (e) **Aggregate of all amounts transferred from the owner to the section 987 QBU for the taxable year.** For purposes of [paragraph (c)(1)(ii)](#c-1-ii) of this section, the aggregate of all amounts transferred from the owner to the [section 987](/cfr/26/987.md) QBU for the taxable year is the aggregate amount of functional currency and the aggregate adjusted basis of the assets transferred (determined in the [section 987](/cfr/26/987.md) QBU's functional currency under [§ 1.987-2(d)](/cfr/26/1.987-2.md?p=d) after taking into account [§ 1.988-1(a)(10)](/cfr/26/1.988-1.md?p=a-10)). Solely for this purpose, the amount of liabilities transferred from the [section 987](/cfr/26/987.md) QBU to the owner (determined in the [section 987](/cfr/26/987.md) QBU's functional currency after taking into account [§ 1.988-1(a)(10)](/cfr/26/1.988-1.md?p=a-10)) is treated as a transfer of assets from the owner to the [section 987](/cfr/26/987.md) QBU with an adjusted basis equal to the amount of such liabilities.
- (f) **Determination of owner's adjusted basis in transferred assets and amount of transferred liabilities—**
  - (1) **In general.** The owner's adjusted basis in an asset or the amount of a liability received in a transfer from a [section 987](/cfr/26/987.md) QBU (whether or not such transfer is made in connection with a remittance) is determined in the owner's functional currency under the rules prescribed in paragraphs [(f)(2)](#f-2) and [(3)](#f-3) of this section.
  - (2) **Marked items.** The basis of a marked asset or amount of a marked liability is the amount determined by translating the [section 987](/cfr/26/987.md) QBU's functional currency basis of the asset or amount of the liability, after taking into account [§ 1.988-1(a)(10)](/cfr/26/1.988-1.md?p=a-10), into the owner's functional currency at the spot rate applicable to the date of transfer.
  - (3) **Historic items.** The basis of a historic asset or amount of a historic liability is the amount determined by translating the [section 987](/cfr/26/987.md) QBU's functional currency basis of the asset or amount of the liability into the owner's functional currency at the historic rate for the asset or liability.
- (g) **Example—Calculation of section 987 gain or loss recognized.** The following example illustrates the calculation of [section 987](/cfr/26/987.md) gain or loss under this section. For purposes of this example, except as otherwise indicated, assume that no [section 987](/cfr/26/987.md) elections are in effect. Depreciation is ignored for purposes of this example.
  - (1) **Facts—**
    - (i) **In general.** U.S. Corp, a domestic corporation with the dollar as its functional currency, operates in the United Kingdom through Business A, a [section 987](/cfr/26/987.md) QBU with the pound as its functional currency. The net unrecognized [section 987](/cfr/26/987.md) gain for Business A as determined under [§ 1.987-4](/cfr/26/1.987-4.md) as of the last day of year 2 is $80.
    - (ii) **Year 1 balance sheet.** At the end of year 1, the following assets are attributable to Business A: cash of £3,350; a computer with an adjusted basis of £500; and a machine with an adjusted basis of £500. Thus, the aggregate basis of Business A's assets is £4,350. Business A has no liabilities.
    - (iii) **Transfers and income in year 2.** During year 2, Business A earned income of £1,500. In addition, the following transfers took place between U.S. Corp and Business A in year 2. On January 5, year 2, U.S. Corp transferred to Business A £300 (acquired by U.S. Corp immediately before the transfer). On March 5, year 2, Business A transferred a machine (with an adjusted basis of £500) to U.S. Corp. On November 1, year 2, Business A transferred £2,300 to U.S. Corp. On December 7, year 2, U.S. Corp transferred a truck to Business A. The adjusted basis of the truck, when properly translated into pounds under [§ 1.987-2(d)](/cfr/26/1.987-2.md?p=d), is £2,000.
    - (iv) **Year 2 balance sheet.** At the end of year 2, the following assets are attributable to Business A: cash of £2,850, a computer with a pound adjusted basis of £500, and a truck with a pound adjusted basis of £2,000. Thus, the aggregate basis of Business A's assets is £5,350. Business A has no liabilities.
  - (2) **Analysis.** U.S. Corp's [section 987](/cfr/26/987.md) gain with respect to Business A is determined as follows:
    - (i) **Computation of amount of remittance.** Under paragraphs [(c)(1)](#c-1) and [(2)](#c-2) of this section, U.S. Corp must determine the amount of the remittance for year 2 in the QBU's functional currency (pounds) on the last day of year 2. The amount of the remittance for year 2 is £500, determined as follows:
    - (ii) **Alternative computation of remittance amount.** Under [paragraph (c)(2)](#c-2) of this section, U.S. Corp can compute the amount of the remittance for year 2 using the following steps.
      - (A) **Step 1: Change in QBU net value.** The change in Business A's QBU net value is equal to £1,000 (£5,350—£4,350).
      - (B) **Step 2: Adjustment for income or loss.** The amount determined in step 1 (£1,000) is reduced by Business A's income for year 2 of £1,500, to negative £500.
      - (C) **Step 3: Multiply by negative one.** The amount determined in step 2 (negative £500) is multiplied by negative one. The remittance for year 2 is equal to £500.
    - (iii) **Computation of section 987 QBU gross assets plus remittance.** Under [paragraph (b)(1)(ii)](#b-1-ii) of this section, Business A must determine the aggregate basis of its gross assets and must increase this amount by the amount of the remittance.
    - (iv) **Computation of remittance proportion.** Under [paragraph (b)](#b) of this section, Business A must compute the remittance proportion by dividing the £500 remittance amount by the £5,850 sum of the aggregate basis of Business A's gross assets and the amount of the remittance. The resulting remittance proportion is 0.085.
    - (v) **Computation of section 987 gain or loss.** The amount of U.S. Corp's [section 987](/cfr/26/987.md) gain or loss that is recognized with respect to Business A is determined under [paragraph (a)](#a) of this section by multiplying the 0.085 remittance proportion by the $80 of net unrecognized [section 987](/cfr/26/987.md) gain. U.S. Corp's resulting recognized [section 987](/cfr/26/987.md) gain for year 2 is $6.80.
  - (3) **Annual recognition election.** If an annual recognition election under [paragraph (b)(2)](#b-2) of this section were in effect for year 2, U.S. Corp's remittance proportion would be one. Accordingly, U.S. Corp would recognize all $80 of the net unrecognized [section 987](/cfr/26/987.md) gain with respect to Business A.