Section 986 Rules for Foreign Currency Gains and Losses

U.S. tax law provides a detailed framework for converting foreign currency amounts into U.S. dollars, a necessary step for reporting income and calculating taxes for U.S. persons with foreign interests. These rules, primarily found in Section 986 of the Internal Revenue Code, establish specific methods for handling the financial results of foreign corporations and their distributions to U.S. shareholders. The regulations ensure that income, expenses, and credits are reported consistently and that fluctuations in currency exchange rates are accounted for in a prescribed manner.

Translating Foreign Income Taxes

For a U.S. shareholder to claim a foreign tax credit, the foreign income taxes paid or accrued by a foreign corporation must first be translated into U.S. dollars. The governing principle for taxpayers on the accrual method is to use the average exchange rate for the taxable year to which the foreign income taxes relate. This approach smooths out short-term volatility in currency markets by applying a single, year-long average rate. This translated amount is what becomes eligible for the U.S. shareholder’s foreign tax credit calculation on forms such as Form 1116 or 1118.

There are specific exceptions to this rule. If the foreign taxes are paid more than 24 months after the close of the taxable year they relate to, or before that taxable year begins, the taxpayer must use the exchange rate on the date of payment. This same payment-date rate applies if the taxes are denominated in an inflationary currency, as defined by Treasury regulations.

Consider a foreign corporation that accrued 100,000 units of foreign currency in income taxes for a specific taxable year. If the average exchange rate for that year was 1 unit of foreign currency to $1.20, the translated tax amount would be $120,000. This is the figure the U.S. shareholder would use for foreign tax credit purposes. If the taxes were instead paid more than two years later when the exchange rate was $1.10, the translated amount would be $110,000.

Determining Gain or Loss on PTEP Distributions

Previously Taxed Earnings and Profits (PTEP) are a foreign corporation’s earnings already included in a U.S. shareholder’s income before the cash is distributed. When these earnings are paid out, a foreign currency gain or loss must be calculated based on the change in the exchange rate between when the income was first recognized and when it is distributed. The calculation compares the distribution amount translated at the historical exchange rate from the date of income inclusion against the same distribution translated at the spot exchange rate on the date it is made.

This resulting gain or loss is characterized as ordinary income or loss. Its source is treated as the same as the associated income that created the PTEP, ensuring consistent tax treatment from inclusion to distribution.

For example, assume a U.S. shareholder included €10,000 of a foreign subsidiary’s income, creating PTEP. At the time of inclusion, the exchange rate was €1 to $1.15, making the PTEP account value $11,500. Two years later, the subsidiary distributes the €10,000. On the distribution date, the spot exchange rate is €1 to $1.25. The distributed amount is now worth $12,500, and the shareholder must recognize a $1,000 foreign currency gain, which is treated as ordinary income.

Treatment of Non-PTEP Distributions

Distributions from a foreign corporation not classified as PTEP are treated as dividends to the extent of the corporation’s earnings and profits. The dividend amount is translated into U.S. dollars using the spot exchange rate on the date it is included in the shareholder’s income. For a non-PTEP dividend, only this spot rate matters, as it reflects that the shareholder is receiving new income whose value is determined at the moment of receipt.

To illustrate, suppose a foreign corporation pays a dividend of 50,000 in its local currency, and this distribution is not from PTEP. On the date of distribution, the spot exchange rate is 1 unit of local currency to $0.75. The U.S. shareholder would include $37,500 in their gross income as a dividend.