What Is a Section 986(c) Gain or Loss?

International business operations introduce complexity to a company’s finances, particularly concerning fluctuating foreign currency values. When a U.S. entity has ownership in a foreign corporation, the profits earned abroad are in a different currency. The movement in exchange rates between the U.S. dollar and foreign currencies creates the potential for gains or losses that are separate from the underlying business operations and have tax consequences when money is moved across borders.

The Internal Revenue Code (IRC) provides a framework for these situations. Section 986(c) establishes the rules for recognizing foreign currency gains or losses that arise from certain distributions received from foreign corporations. This provision ensures that the economic effect of currency fluctuations is captured for U.S. tax purposes. Understanding this section helps manage the tax position of any U.S. enterprise with international subsidiaries.

Defining a Section 986(c) Gain or Loss

A Section 986(c) gain or loss is a foreign currency gain or loss that a U.S. shareholder recognizes upon receiving a distribution from a foreign corporation. This gain or loss is not related to the operational profitability of the foreign entity but is tied directly to the change in currency exchange rates over time. It arises when the distribution consists of Previously Taxed Earnings and Profits (PTEP).

PTEP represents the income of a foreign subsidiary that has already been included in the U.S. shareholder’s taxable income in a prior year, even though the cash had not yet been distributed. This occurs under provisions like Subpart F inclusions, the Global Intangible Low-Taxed Income (GILTI) regime, or the transition tax under Section 965. Because the U.S. shareholder has already paid tax on these earnings, the subsequent cash distribution is not taxed again.

The gain or loss is generated by the timing difference between the U.S. dollar value of the foreign earnings when they were originally included in income, versus the U.S. dollar value when the cash is actually distributed. If the foreign currency has strengthened against the dollar in the interim, the shareholder receives more U.S. dollars than originally recorded, resulting in a gain. Conversely, if the currency has weakened, it leads to a loss.

Triggering Events and Scope

Section 986(c) applies following specific events, primarily a distribution from a foreign corporation to a U.S. shareholder. This rule comes into play only when the distribution is classified as being paid out of the foreign corporation’s PTEP accounts. An actual distribution of cash or property must occur for these rules to apply in most cases.

To understand the scope, a “foreign corporation” is any corporation not organized under the laws of the United States. A “U.S. shareholder” is a U.S. person who owns 10% or more of the total combined voting power or value of the foreign corporation’s stock. The rules apply to these specific shareholders who have previously had income inclusions from the foreign entity.

While an actual distribution is the most common trigger, other corporate events can also require recognition of a Section 986(c) gain or loss. For instance, certain reorganizations or dispositions of the foreign corporation’s stock might be treated as a deemed distribution of PTEP. Proposed regulations issued in late 2024 provide comprehensive guidance on how these rules apply.

These proposed regulations also clarify that distributions of PTEP from one foreign corporation to another within a tiered structure may not trigger a gain or loss for the ultimate U.S. shareholder. This allows for the internal restructuring of foreign operations without immediate U.S. tax consequences related to currency fluctuations.

Calculation of the Gain or Loss

The calculation of a Section 986(c) gain or loss compares the value of a distribution at two different points in time. The formula is the U.S. dollar value of the distribution on its date, minus the U.S. dollar basis of the distributed PTEP.

The first part of the calculation is the U.S. dollar value of the distribution. This is found by taking the amount of foreign currency distributed and translating it into U.S. dollars using the spot exchange rate on the date of the distribution. The spot rate is the prevailing market exchange rate, and taxpayers must use a consistent source for determining this rate.

The second part of the formula is determining the U.S. dollar basis of the PTEP being distributed. This basis is the U.S. dollar amount that the shareholder originally included in their taxable income when the earnings were first generated by the foreign corporation. This requires careful record-keeping because a foreign corporation may accumulate PTEP over many years at different exchange rates.

This leads to the concept of tracking PTEP by year and category. A U.S. shareholder must track its PTEP in separate accounts, each with its own U.S. dollar basis reflecting the historical exchange rate from the year the income was earned. When a distribution is made, tax rules dictate the order in which these PTEP accounts are deemed to be distributed.

To illustrate, assume a U.S. corporation owns a German subsidiary. In Year 1, the subsidiary earns income that results in a €100,000 PTEP inclusion for the U.S. parent, translated at an average exchange rate of $1.10 per euro, establishing a U.S. dollar basis of $110,000. In Year 3, the subsidiary distributes the €100,000 to its parent. On the distribution date, the spot exchange rate is $1.15 per euro. The U.S. dollar value of the distribution is €100,000 multiplied by $1.15, which equals $115,000. The Section 986(c) gain is calculated as $115,000 (current value) minus $110,000 (historical basis), resulting in a $5,000 foreign currency gain.

Tax Treatment and Reporting

Any gain or loss recognized under this section is treated as ordinary income or ordinary loss. It is not treated as a capital gain or loss. This ordinary treatment reflects the view that currency fluctuations are a regular risk of doing business internationally.

The source of the income or loss is another consideration, as it affects the calculation of the U.S. foreign tax credit. A Section 986(c) gain or loss is sourced based on the residence of the taxpayer recognizing it. For a U.S. shareholder, this means the gain or loss is treated as U.S. source income, which cannot be offset by foreign tax credits.

The calculated gain or loss must be included on the U.S. shareholder’s annual income tax return. For a corporate shareholder, this would be reported on Form 1120, U.S. Corporation Income Tax Return, and included with other ordinary income or losses.

Taxpayers are required to maintain detailed records to support their calculation. These records are often managed through schedules associated with Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. This form and its schedules are used to report a U.S. shareholder’s interest in a foreign corporation and track attributes like the PTEP accounts and their corresponding U.S. dollar basis.