New Considerations in Taxation of Foreign Exchange Transactions After the 2017 Act

Foreign exchange gain or loss is a feature of most cross-border business activity and has tax implications under two different sets of rules governing foreign currency transactions (§ 988) and foreign currency translation (§§ 986 and 987). By ushering in a system of worldwide taxation under the global intangible low-taxed income (GILTI) rules, the 2017 Tax Act has made foreign exchange tax impacts to controlled foreign corporations (CFCs) more immediate to many taxpayers than was previously the case under the deferral regime.

This article reviews selected issues and new considerations in applying the foreign exchange transaction rules for § 988 transactions after the 2017 act, particularly at the CFC level. In addition, this reviews a helpful set of proposed regulations issued concurrently with the tax reform that address many of the complexities and technical problems in currency transactions at the CFC level and provide a new election for mark-to-market accounting for § 988 transactions.

Treatment of FX Transactions – A Brief Review

Section 988 provides a comprehensive set of rules for certain transactions denominated in a “nonfunctional,” or foreign, currency. Specifically, Section 988 applies to:

  • Acquisitions and dispositions of units of nonfunctional currency,
  • Accounts payable and receivable,
  • Debt instruments, and
  • Entry into foreign currency derivative contracts, such as forward contracts, swaps, and other financial products used for hedging the foreign currency exposure arising in a taxpayer’s business.1

Section 988 generally operates on a realization-based system, rather than the mark-to-market system used for certain financial accounting purposes. However, proposed regulations discussed below would allow taxpayers to elect mark-to-market treatment for tax purposes. It is unclear when the proposed regulations will be finalized, but taxpayers can immediately begin to rely on the proposed regulations if that would be helpful to their position.

At the U.S. taxpayer level, Section 988 gain or loss is generally treated as ordinary income and sourced to the residence of the taxpayer.2 At the CFC level, the character of § 988 gain or loss is subject to a more complex analysis. Generally, the excess of a CFC’s § 988 gains over its § 988 losses is included in a category of passive foreign personal holding company income (FPHC) under § 954(c)(1)(D) that is immediately taxable to the U.S. taxpayer.

However, certain exceptions to subpart F income treatment are available. First, under a so-called “business needs” exception, § 988 gains and losses are excluded from subpart F income to the extent they arise from a transaction entered into in the ordinary course of business of the CFC, where the transaction itself neither gives rise to, nor is it reasonably expected to give rise to, any subpart F income of another type.3 Second, the regulations also except from subpart F income treatment § 988 gains and losses from certain “bona fide hedging transactions” where the exposure hedged satisfies the business needs exception.4 Among other requirements, a bona fide hedging transaction must be identified for tax purposes on a same-day basis. Third, FX gain or loss with respect to interest-bearing liabilities is allocated between categories of subpart F income and other income based on the manner in which the CFC allocates and apportions interest expense under § 1.861-9.5

In addition to the basic rules above, the subpart F regulations allow taxpayers to make certain elections with respect to § 988 gains and losses of CFCs. Under Treas. Reg. § 1.954-2(g)(3), a taxpayer that generates § 988 gain or loss from transactions entered into in the ordinary course of business that generate subpart F income of some other type may elect to characterize the FX gain or loss as arising in that other category. For example, this election could apply to recharacterize FX gain or loss of a CFC from trade receivables that arise from transactions generating foreign base company sales income or services income. Lastly, CFCs may also make a so-called “full inclusion” election under Treas. Reg. § 1.954-2(g)(4) and treat all Section 988 gains and losses as FPHC income. This election alleviates the burden of identifying business needs transactions and non-business needs transactions, but at the cost of including all FX gains and losses in subpart F income.

Relevance of Characterizing Section 988 Transactions in a GILTI Environment

Under old law, the application of subpart F rules to currency transactions was important given the difference between deferred earnings (no U.S. tax unless and until repatriated) and subpart F income taxed at 35% (subject to foreign tax credits). Thus, fitting within the subpart F income exceptions and avoiding mismatched treatment of currency hedging transactions was necessary to avoid negative rate arbitrage of up to 35%.6

How does the enactment of tax reform affect these incentives? Under the new laws, the same potential for negative tax arbitrage still exists, though with lower stakes, given the difference between subpart F currency income taxed at 21% and tested income / GILTI taxed at 10.5%. For example, if a taxpayer fails to properly structure or identify a bona fide hedging transaction (see Reg. § 1.954-2(a)(4)), the gain on the hedge may be subpart F income, while the economically offsetting loss reduces tested income or produces a tested loss.

In addition, there are new foreign tax credit limitations and new restrictions on the use of losses that may heighten the stakes further. For one thing, given the reduced rate of tax on GILTI of 10.5%, together with apportionment of expenses to GILTI, many taxpayers find themselves in an excess credit position in the GILTI basket, so that additional tested income from a currency transaction does not result in any additional U.S. tax. By contrast, subpart F income in the passive basket for currency gains may have no foreign taxes.

Additionally, at the CFC level, losses are now more difficult for taxpayers to utilize across baskets. While the earnings and profits (E&P) limitation of §952(c) remains in the Code, it is now much more circumscribed by the GILTI rule that provides that tested losses cannot be used to reduce subpart F income inclusions.7 Thus, a loss in tested income category from a currency transaction, cannot reduce a subpart F inclusion even under the §952(c) limitation of Subpart F income inclusions to current E&P. Conversely, a subpart F currency loss may be trapped in a category without positive subpart F income to be offset by the loss, as Subpart F losses cannot offset tested income.8 Without proper planning, currency losses at the CFC level may not produce tax benefits for the taxpayer.

Lastly, in the new annual foreign tax credit system, a currency loss may give rise to a loss in one of the CFC’s net income categories under the new § 960 regulations. An income category that is negative for a year cannot produce any deemed paid foreign tax credits to the U.S. shareholder, even if foreign taxes are located in that category.9 With the repeal of pooling, any taxes that are not deemed paid on a current basis are trapped in the CFC permanently. Given the realization system, a large currency loss may be triggered when a loan receivable or payable is satisfied. If this is large enough, it might swamp the CFC’s tested income and preclude the foreign tax credits on that year’s operating income from being claimed.

Potential Help in the 2017 Proposed Regulations

Concurrently with the passage of tax reform, the IRS and Treasury issued proposed revisions to the subpart F currency rules that clear out a number of the technical problems under the old regulations (REG-119514-15, Dec. 19, 2017). Since December 2017 was the busiest month in many corporate tax professionals’ careers, these proposed regulations went unnoticed. However, they contain several helpful provisions relating to FX transactions that may merit review, particularly given that the proposed regulations may be adopted by taxpayers at their election, by applying them consistently to all transactions entered into after December 19, 2017 in all taxable years between 2017 and the enactment of the final regulations.10

Mark-to-Market Election for § 988 Transactions

The most significant part of the proposed regulations is an election of mark-to-market accounting for FX transactions under Prop. Reg. § 1.988-7. Previously, mark-to-market accounting for tax purposes was limited only to certain exchange-traded contracts (§ 1256) or specialized taxpayers acting as dealers in foreign currency (§ 475). The new proposed regulations would make mark-to-market accounting available on an elective basis across the board, using the principles applicable to § 1256 contracts.

This new rule, Prop. Reg. § 1.988-7, could be elected on a CFC-by-CFC basis.11 Once the mark-to-market election is made, the taxpayer is free to revoke it at any time without IRS consent. However, once the election is revoked, the taxpayer could not re-elect it for five years without IRS consent.12 Among potential other benefits of mark-to-market treatment, it might even out recognition of FX gain or loss and avoid some of the issues noted above in the case of trapped losses or one-time spikes and dips in a CFC’s income. It also could produce administrative benefits of not needing to track § 988 gains and losses on a separate realization system. The impact of transitioning to this rule needs to be carefully examined, since the election year would presumably result in a deemed sale of the electing taxpayer’s position, causing the accumulated gains and losses to be taken into account.

In addition to the new mark-to-market election, the proposed regulations also would resolve a number of technical problems in the existing regulations that lead to unnecessary issues:

Elimination of the Cliff Effect on the Business-Needs Exception. The subpart F exception for business-needs transactions contains a limitation where, even with a transaction in the ordinary course of business, the business-needs exception is available only if the transaction does not give rise to, nor is it expected to give rise to, subpart F income. Thus, even a relatively small amount of subpart F income would disqualify the CFC from the business-needs exception.

The new proposed regulations would amend this rule to provide for pro rata subpart F and non-subpart F treatment of foreign exchange gain or loss with respect to transactions in the ordinary course of business. For example, if CFC-1 makes a non-functional currency loan to CFC-2 in the normal course of CFC-1’s trade or business,13 and 10% of the interest is treated as subpart F income under the look-through rule, then only 10% of CFC-1’s FX gain or loss would be treated as subpart F currency gain.14 Similar pro rata treatment is also provided for currency gain or loss from hedging transactions.15

Hedges of Interest-Bearing Liabilities. The proposed regulations would also provide matching treatment of FX gain or loss on interest-bearing liabilities and related hedges. Under the current regulations, FX gain or loss on an interest-bearing liability is allocated between the CFC’s categories of income in the same manner as the CFC allocates and apportions interest expense under § 861.16 A bona fide hedging transaction, by contrast, produces currency gain or loss that is entirely excluded from subpart F income. In the case of a CFC with a mix of subpart F income and non-subpart F income, this creates an undesirable mismatch between the subpart F treatment of the currency hedge and the nonfunctional currency borrowing.

The proposed regulations would resolve this issue by providing that a bona fide hedge of an interest-bearing liability produces FX gain or loss that is characterized in the same manner as FX gain or loss on the underlying borrowing. The proposed regulations also would allow a CFC to acquire a debt receivable as a means of hedging FX exposure on a borrowing.17

Exception for Certain Net Investment Hedges of QBUs. The proposed regulations also would allow CFCs to exempt from subpart F treatment certain hedging transactions with respect to their net investment in a § 987 qualified business unit (QBU). This addresses, again, an ambiguity in how to apply the currency rules to hedging transactions. The exception is available for a transaction that is executed by the CFC and is treated on the taxpayer’s financial statements as a net investment hedge with respect to its ownership in the QBU. Where this rule applies, the CFC treats FX gain or loss on the hedging transaction as subpart F income or non-subpart F income in the same manner as a remittance from the QBU would be characterized under the § 987 rules.

While this exception is helpful, it is not a panacea. With tax reform, the portion that qualifies for a subpart F income exception will still be treated as giving rise to tested income. In addition, the exception seems to be limited to transactions that are treated on the financial statements as net investment hedges, which may not be the case where the taxpayer hedges a disregarded payable or receivable as a cash flow hedge for financial accounting purposes.


Currency transactions, like many areas of international tax, are significantly impacted by the new quasi-worldwide tax system introduced by GILTI. While the lower rates would seem to reduce the stakes, the immediate inclusion of CFCs’ results in the U.S. shareholders’ income makes it important to get currency transactions right, especially given that the annual system creates more traps for taxpayers.

1 See § 988(c)(1); Treas. Reg. § 1.988-1(a)(1).

2 §§ 988(a)(1) and 988(a)(3).

3 Treas. Reg. § 1.954-2(g)(2)(ii)(B)(1).

4 Treas. Reg. §§ 1.954-2(a)(4)(ii) and 1.954-2(g)(2)(ii)(B)(2).

5 Treas. Reg. § 1.954-2(g)(2)(iii).

6 For more discussion of these potential mismatches and how they might arise, see

7 See § 951A(c)(2)(B)(ii).

8 A subpart F loss is allocated to a separate category from net tested income, and there does not appear to be any provision that allows this loss to be allocated across to reduce the CFC’s tested income. See Treas. Reg. § 1.951A-2(c). For a general discussion on the new rules for use of losses in computing subpart F income and tested income, see the prior article linked here:

9 See Treas. Reg. § 1.960-2(c)(5).

10 See Prop. Reg. § 1.954-2(i)(2)(C). Note that, in a correction to the proposed regulations issued on December 27, 2017, the preamble was amended to note that no inference was intended to apply currently for certain positions taken on the application of § 475 to certain Treasury centers.

11 See Prop. Reg. § 1.988-7(c).

12 See Prop. Reg. § 1.988-7(d). Once revoked for a taxpayer, the election could not be re-adopted for five years without IRS consent.

13 Obtaining the business needs exception for a loan receivable would also require the CFC to show that the loan was a transaction entered into in the ordinary course of CFC-1’s trade or business. The proposed regulations do not explicitly address this issue; however, the ratio test introduced by the proposed regulations would seem to be most relevant to a loan receivable. At the same time, it is helpful that the § 163(j) proposed regulations treat all interest income of a C corporation as “business interest income.” See Prop. Reg. § 1.163(j)-4(b)(1).

14 See Prop. Reg. § 1.954-2(g)(2)(ii)(C)(1).

15 FX gain or loss with respect to property that does not give rise to income (or hedge of such exposure) do not qualify for the business needs exception. See id.

16 Reg. § 1.954-2(g)(2)(iii).

17 See Prop. Reg. § 1.954-2(a)(4)(ii)(A). For § 1221 purposes, by contrast, the acquisition of a debt instrument is specifically deemed not to be a hedging transaction because it is not used primarily to manage or reduce risk. See Reg. § 1.1221-2(d)(5)(ii), Example 1.


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