What Are the Final Section 987 Regulations?

The U.S. tax system requires American taxpayers to translate the results of their foreign business activities into U.S. dollars for reporting on a U.S. tax return. The framework for this translation is complex, involving rules to account for currency exchange rate fluctuations that can create gains or losses. For unincorporated foreign operations, known as branches, rules under Internal Revenue Code Section 987 provide the methodology for this currency translation.

In December 2024, the U.S. Department of the Treasury and the IRS released new final regulations that establish a standardized approach for determining the timing, character, and source of these foreign currency gains and losses. These regulations are generally effective for taxable years beginning after December 31, 2024.

Determining Applicability of the Regulations

The Section 987 regulations apply to U.S. persons, including individuals, corporations, and partnerships, that own a qualified business unit (QBU). A QBU is a separate and clearly identified unit of a taxpayer’s trade or business that maintains its own books and records, such as a manufacturing plant in Mexico or a sales office in Japan. To be a QBU, the operation must be a complete trade or business with its own assets, liabilities, and activities that generate revenue and expenses.

The concept of “functional currency” is central to determining if Section 987 is applicable. Functional currency is the currency of the primary economic environment in which the QBU operates, meaning the currency it uses to generate revenue and incur expenses. For example, a French branch of a U.S. company that conducts all its business in euros would have the euro as its functional currency.

The condition for the Section 987 regulations to apply is a mismatch between the functional currency of the QBU and its U.S. owner. Since a U.S. taxpayer’s functional currency is the U.S. dollar, the rules are engaged whenever that taxpayer owns a QBU whose functional currency is anything other than the U.S. dollar.

The Core Calculation Framework

The final regulations under Section 987 establish a balance sheet approach to calculate foreign currency gains and losses. This method, known as the Foreign Exchange Exposure Pool (FEEP) method, tracks the annual change in the net value of the qualified business unit (QBU) due to currency fluctuations. The framework classifies balance sheet items into two categories: marked items and historic items.

Marked items are assets and liabilities whose value is directly tied to the QBU’s functional currency. This category includes cash, bank deposits, accounts receivable, and accounts payable. These items are translated into U.S. dollars using the year-end spot exchange rate, reflecting their current value at the close of the tax year.

Historic items are assets and liabilities whose U.S. dollar basis is fixed at the time they are acquired. This category includes long-term assets like machinery, buildings, and intangible property, as well as long-term liabilities. These items are translated into U.S. dollars using the historical exchange rate from the date the asset was purchased or the liability was incurred.

The regulations lay out a multi-step process to determine the net unrecognized Section 987 gain or loss for the year. This involves translating the QBU’s balance sheet into the owner’s functional currency at the start and end of the year and adjusting for profit or loss and property transfers. The result is the total unrecognized gain or loss for the year, which is added to a cumulative pool of previously unrecognized gains and losses.

As part of adopting these new rules, taxpayers must follow specific transition rules. This involves calculating a “pretransition gain or loss” as of the day before the transition date, which for most calendar-year taxpayers is December 31, 2024. This calculation establishes the opening balance of the cumulative unrecognized Section 987 gain or loss pool.

Recognizing and Characterizing Gain or Loss

The gain or loss calculated each year under the Section 987 framework is not immediately taxable. This pooling mechanism defers the tax impact until a triggering event causes a portion of the accumulated gain or loss to be recognized. The rules also apply retroactively to QBUs that terminated on or after November 9, 2023.

The primary event that triggers the recognition of this pooled gain or loss is a “remittance,” which is any transfer of property from the qualified business unit (QBU) to its U.S. owner. For instance, if a German branch with a euro functional currency transfers cash to the U.S. parent company’s dollar-denominated account, that transfer is a remittance.

The amount of gain or loss that must be recognized is proportional to the size of the remittance. The calculation involves a formula that compares the U.S. dollar value of the remittance to the total U.S. dollar value of the QBU’s gross assets. This ratio is then multiplied by the total accumulated pool of unrecognized Section 987 gains or losses to determine the amount of gain or loss the taxpayer must report.

A recognized Section 987 gain or loss is treated as ordinary income or loss. The source of the income or loss is determined by the residence of the taxpayer. For a U.S.-based owner, this means the recognized gain or loss is treated as U.S. source income or loss.

Available Tax Elections

The final Section 987 regulations provide taxpayers with several elections that can alter the default calculation and reporting methods. One option is the annual election to recognize all Section 987 gains and losses in the current year. This approach eliminates the need to track the pool of unrecognized gains and losses and the complexities of remittance calculations.

Another choice is the current rate election, which allows the taxpayer to translate all items on the QBU’s balance sheet, including historic items, at the year-end spot exchange rate. This simplifies the process by removing the need to track historic exchange rates. However, taxpayers who make this election are subject to loss suspension rules, which can prevent the immediate deduction of a Section 987 loss.

The regulations also permit an election to group multiple QBUs that use the same functional currency. If a U.S. parent company has several branches in different countries that all operate in euros, it can elect to treat them as a single QBU for Section 987 purposes. This consolidation simplifies the calculation by requiring only one set of gain or loss computations for the entire group.

Compliance and Reporting Requirements

Taxpayers must report their Section 987 calculations to the IRS on Schedule Q (Form 8858), “Information Return of U.S. Persons With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs).” This schedule is an integral part of Form 8858 and serves as the official record of a taxpayer’s Section 987 activity for the year.

On Schedule Q, the taxpayer must disclose the net unrecognized Section 987 gain or loss for the current tax year and the total accumulated balance of all unrecognized gains and losses from prior years. Taxpayers must also report any remittances from the QBU to the U.S. owner and show the calculation of the recognized gain or loss.

The final recognized gain or loss figure from Schedule Q is carried to the taxpayer’s main income tax return, such as Form 1120 for corporations, and included in the calculation of total taxable income. The schedule must be attached to Form 8858, which is filed with the taxpayer’s annual income tax return.