What Is the Section 987 7-Step Calculation Method?

Section 987 of the U.S. Internal Revenue Code provides a framework for U.S. taxpayers to address the tax implications of foreign currency fluctuations within their foreign business operations. When a U.S. entity operates a business in another country, the foreign operation uses the local currency for its transactions. Section 987 establishes the method for translating the financial results of that operation from its local currency into U.S. dollars.

This translation is necessary to determine the taxable income or loss from the foreign operation that must be reported on a U.S. tax return. The purpose of these rules is to calculate gains or losses that arise from changes in the exchange rate. These currency gains and losses are distinct from the underlying business profits or losses and require a specific calculation under U.S. tax law.

Determining Applicability of Section 987

The rules of Section 987 apply to a U.S. taxpayer that owns a foreign operation known as a Qualified Business Unit, or QBU. A taxpayer is a U.S. individual, a domestic corporation, or a partnership required to file a U.S. income tax return. The regulations are triggered when this taxpayer has a direct ownership interest in a business unit that meets the QBU criteria.

A QBU is a separate and clearly identified unit of a taxpayer’s trade or business that maintains its own set of books and records. This can take the form of a foreign branch or a disregarded entity, such as a single-member foreign LLC. The requirement is that the unit constitutes a genuine business activity and that its financial activities are tracked independently from its U.S. owner. Simply holding foreign stock or passive assets is not enough to create a QBU.

The final element that brings an operation under Section 987 is a difference in functional currencies. A functional currency is the primary currency of the economic environment in which an entity operates. If a QBU’s functional currency is the Japanese Yen and its U.S. owner’s functional currency is the U.S. dollar, the mismatch subjects the owner to the Section 987 calculation requirements.

Information Required for Calculation

Before undertaking the Section 987 calculation, a taxpayer must gather specific financial data from the QBU. This information includes:

• The QBU’s balance sheet, prepared in its functional currency, for both the beginning and the end of the tax year, detailing all assets and liabilities.
• A complete profit and loss statement for the QBU in its functional currency, which is used to determine the QBU’s net income or loss for the year.
• A detailed log of all transfers of money or property, known as remittances, between the owner and the QBU, recording the date and amount in both currencies.
• A set of specific exchange rates, including the yearly average rate, the spot rate on the date of each remittance, and the spot rate on the last day of the tax year.

The Section 987 Calculation Method

The calculation of a Section 987 gain or loss follows a multi-step process designed to isolate foreign currency effects, known as the foreign exchange exposure pool (FEEP) method. The process begins by determining the QBU’s net worth at the start and end of the year. The taxpayer translates the QBU’s balance sheets into U.S. dollars, and the change in this translated net worth between the beginning and end of the year is the starting point.

This initial amount is then adjusted for any transfers between the owner and the QBU. The value of any property or currency remitted from the QBU back to the owner during the year is added to the change in net worth. Conversely, the value of any capital contributions made by the owner to the QBU is subtracted, which removes the impact of capital flows.

The next step involves adjusting for the QBU’s business operations. The QBU’s taxable income or loss for the year, as calculated from its profit and loss statement and translated at the yearly average exchange rate, is factored in. A profit is subtracted from the running total, while a loss is added to neutralize the business’s operational performance.

The final figure resulting from this series of calculations represents the net unrecognized Section 987 gain or loss for the year, which is pooled with unrecognized gains or losses from prior years. A portion of this cumulative pool is then recognized as taxable income or loss based on the amount of remittances made from the QBU during the year. The recognized gain or loss is the amount the taxpayer must report.

Reporting and Deferral Elections

The Section 987 gain or loss recognized for the tax year is characterized as ordinary income or loss. This means it is not treated as a capital gain or loss and is combined with the taxpayer’s other ordinary income. This amount is reported on Form 8858, “Information Return of U.S. Persons With Respect to Foreign Disregarded Entities and Foreign Branches,” filed with the taxpayer’s annual income tax return.

New final regulations issued in late 2024 are generally effective for tax years beginning after December 31, 2024. These regulations formalize the FEEP method and provide transition rules for taxpayers moving from their prior methods, which may have been used in years before 2025 when rules were more flexible.

The rules also contain various elections, including an option to defer the recognition of certain gains or losses. This deferral is particularly relevant in the context of related-party transactions and can provide flexibility in managing the timing of tax consequences.