Currency risk occurs throughout cross-border business activity, and as a result, currency hedging is a common practice among multinational businesses. If a company’s currency risk entails hedges of more than trade payables and receivables, and a significant amount of the risk being hedged is located offshore in one or more controlled foreign corporations (CFCs), there are significant tax issues to be considered in the application of Subpart F’s currency rules to common hedging activity.
While the tax issues with a CFC hedging currency risk are not new, they present complex questions that are frequently overlooked by taxpayers. Without proper focus, a taxpayer engaged in hedging currency risk at its CFC can be at risk of paying U.S. tax on significantly more than its economic income from the transaction. This may occur because the subpart F rules, as discussed below, generally tax gains from hedging contracts as currently taxable subpart F income, while losses may be deferred and produce no tax benefit. As a result, an improperly structured hedge or hedge that the taxpayer has failed to contemporaneously identify for tax purpose may give rise to a transaction that converts deferred foreign earnings into currently taxable subpart F income.
To flesh out these issues, this article will consider three common fact patterns. Each fact pattern will involve a CFC that uses the U.S. dollar as its functional currency and enters a forward contract with a bank to hedge its exposure to the euro. First, CFC will borrow in euros from another affiliated CFC. Second, CFC will lend in euros to an affiliated CFC. Third, CFC will hedge its "net investment" in a euro functional currency subsidiary. The subsidiary in this third fact pattern may either be classified as a CFC or a disregarded entity (DRE) of CFC for U.S. tax purposes.
In each case, the article considers and applies the subpart F "business needs exception" and rules for bona fide hedging transactions, as well as offering some potential planning suggestions by way of conclusion.
This article is reprinted with the publisher’s permission from the International Tax Journal a bi-monthly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher’s permission is prohibited.