Section 988 of the Internal Revenue Code Treatment of Certain Foreign Currency Transactions taxes certain transactions defined as ‘Section 988 transactions’.
The general rule is that the disposition of any non-functional currency will be treated as a section 988 transaction.
However, there are exceptions to the general rule, particularly with respect to individuals holding foreign-currency-denominated financial assets and liabilities.
What is a section 988 transaction?
Firstly, let’s define what constitutes a ‘section 988 transaction.
The term “section 988 transaction” means any transaction, described in subparagraph (B), if:
the amount which the taxpayer is entitled to receive (or is required to pay) by reason of such transaction is –
(i) denominated in terms of a non-functional currency, or
(ii) determined by reference to the value of 1 or more non-functional currencies.
(B) For purposes of subparagraph (A), the following transactions are described in this subparagraph:
(i) The acquisition of a debt instrument or becoming the obligor under a debt instrument.
(ii) Accruing (or otherwise taking into account) for purposes of this subtitle any item of expense or gross income or receipts which is to be paid or received after the date on which so accrued or taken into account.
(iii) Entering into or acquiring any forward contract, futures contract, option, or similar financial instrument.
The term ‘non-functional currency’ includes:
a) coin or currency, and;
b) non-functional currency denominated demand or time deposits or similar instruments issued by a bank or other financial institution.
For US citizens and resident aliens, their functional currency is the US dollar. Accordingly, all other currencies can be classified as ‘non-functional currency’.
The effect of this section is that a foreign currency gain or loss, arising at the time of disposition of an asset or liability in a currency other than the US dollar, is recognized by the taxpayer, either as ordinary income or ordinary loss.
However, in some cases, a taxpayer can make an election to treat a foreign currency gain or loss as a capital gain or loss – provided an election to do so is made by the close of the day on which the transaction is entered into.
This rule applies to forward contracts, futures contracts and options.
An exemption from classification as a section 988 transaction exists for individual taxpayers dealing in personal non-functional currency transactions.
Provided the expenses attributable to the financial instrument do not meet the provisions of either of the following sections:
a) 162 – Trade or Business expenses, or;
b) 212 – Expenses for the production of income, expenses attributable in generating ordinary income,
then there should be no section 988 transaction and no requirement to recognize foreign currency gains and losses.
As stated in the Regulation 1.988-1 – Certain definitions and special rules:
‘A transaction entered into by an individual which otherwise qualifies as a section 988 transaction shall be considered a section 988 transaction only to the extent expenses properly allocable to such transaction meet the requirements of section 162 or 212 (other than the part of section 212 dealing with expenses incurred in connection with taxes)’.
Here are two examples from the regulations which set out the application of the exemption available for individuals under section 988:
X is a U.S. citizen who therefore has the U.S. dollar as his functional currency. On January 1, 1990, Jack enters into a spot contract to purchase 10,000 British pounds (£) for $15,000 for delivery on January 3, 1990. Immediately upon delivery, X acquires at original issue a pound-denominated bond with an issue price of £10,000. The bond matures on January 3, 1993, pays interest in pounds at a rate of 10% compounded semi-annually, and has no original issue discount. Assume that all expenses properly allocable to these transactions would meet the requirements of section 212. Under § 1.988-2(d)(1)(ii), entering into the spot contract on January 1, 1990, is not a section 988 transaction.
The acquisition of the pounds on January 3, 1990, under the spot contract, is a section 988 transaction for purposes of establishing X’s basis in the pounds. The disposition of the pounds and the acquisition of the bond by X are section 988 transactions. These transactions are not excluded from the definition of a section 988 transaction under paragraph (a)(9) of this section because expenses properly allocable to such transactions meet the requirements of section 212.
X is a U.S. citizen who therefore has the U.S. dollar as his functional currency. In preparation for X’s vacation, X purchases 1,000 British pounds (£) from a bank on June 1, 1989. During the period of X’s vacation in the United Kingdom beginning June 10, 1989, and ending June 20, 1989, X spends £500 for hotel rooms, £300 for food and £200 for miscellaneous vacation expenses. The expenses properly allocable to such dispositions do not meet the requirements of section 162 or 212. Thus, the disposition of the pounds by X on his vacation is not a Section 988 transaction.
Section 988 applies to non-functional currency liabilities, as well as assets.
Here is another illustrative example from the regulations, which assumes that the transaction is a section 988 transaction.
(i) X is an individual on the cash method of accounting with the dollar as his functional currency. On January 1, 1992, X converts $13,000 to 10,000 British pounds (£) at the spot rate of £1 = $1.30 and loans the £10,000 to Y for 3 years.
The terms of the loan provide that Y will make interest payments of £1,000 on December 31 of 1992, 1993, and 1994, and will repay X’s £10,000 principal on December 31, 1994.
Assume the spot rates for the pertinent dates are as follows:
Spot rate (pounds to dollars)
Jan. 1, 1992
£1 = $1.30
Dec. 31, 1992
£1 = $1.35
Dec. 31, 1993
£1 = $1.40
Dec. 31, 1994
£1 = $1.45
(ii) Under paragraph (b)(2)(ii)(B) of this section, X will trans1ate the £1,000 interest payments at the spot rate on the date received. Accordingly, X will have interest income of $1,350 in 1992, $1,400 in 1993, and $1,450 in 1994. Because X is a cash basis taxpayer, X does not realize exchange gain or loss on the receipt of interest income.
(iii) Under paragraph (b)(5) of this section, X will realize exchange gain upon repayment of the £10,000 principal amount determined by translating the £10,000 at the spot rate on the date it is received (£10,000 × $1.45 = $14,500) and subtracting from such amount, the amount determined by translating the £10,000 at the spot rate on the date the loan was made (£10,000 × $1.30 = $13,000). Accordingly, X will realize an exchange gain of $1,500 on the repayment of the loan on December 31, 1994.
The exposure of US citizens and resident aliens to US taxation on the disposition of foreign-currency denominated financial assets and liabilities ultimately depends on whether the asset or liability which has been disposed of, can be classified as ‘personal’ under section 988, or not. This will depend on whether there are expenses properly allocable to the asset or liability as a trade or business expense, or an expense for the production of income.
This article provides general information, current at the time of publication. The information contained in this article does not constitute advice and should not be relied upon as such. Professional advice should be sought prior to actions being taken based on the information contained in this article.
NZ US Tax Specialists Ltd disclaims all responsibility and liability (including, without limitation, for any direct or indirect consequential costs, loss or damage or loss of profits) arising from anything done or omitted to be done by any party in reliance, whether wholly or partially, on any of the information. Any party that relies on the information does so at its own risk.