Can Sec. 267(f) Defer a Debtor’s Currency Loss?

Sec. 267(f) generally defers a loss on a sale or exchange of property between members of a controlled group until and unless certain timing conventions (akin to those applicable to consolidated group intercompany transactions) are met or the property leaves the group; see Sec. 267(f) and Regs. Sec. 1.267(f)-1. Sec. 267(f)(3)(C) and Regs. Sec. 1.267(f)-1(e) provide an exception for a holder of a debt instrument denominated in foreign currency, but do not address a debtor issuing a nonfunctional, currency-denominated instrument.

Cases

In Fairbanks, 306 US 436 (1939), the Supreme Court stated that an issuer’s “payment and discharge of a bond is neither a sale nor exchange within the commonly accepted meaning of the words,” even though Congress had provided for exchange treatment to the holder. Subsequently, in National-Standard Co., 80 TC 551 (1983), aff’d, 749 F2d 369 (6th Cir. 1984), satisfying a debt instrument denominated in a foreign currency was held not to be a “sale or exchange” in determining the character of the debtor’s currency loss. The Sixth Circuit largely rested its decision on Fairbanks, despite the fact that nonfunctional currency was used to discharge the obligation. Around the same time, the Tax Court held that a borrower could deduct its foreign-currency loss arising from the redenomination of a loan obligation, because it was a closed and completed transaction (American Air Filter Co., 81 TC 709 (1983)).

Legislative Developments

Current Sec. 267(f) was added by the Deficit Reduction Act of 1984 (DRA ’84). The legislative history does not mention any intent to change the debtor’s treatment. Arguably, prior to the DRA ’84, the enactment of Sec. 1234A, Gains or losses from certain terminations, reversed National-Standard, by causing gain or loss from terminating a foreign-currency obligation to be treated as from the sale of a capital asset; DRA ’84, Section 102(e)(9), added a sentence to that provision, making Sec. 1234A inapplicable to the retirement of a debt instrument.

The Tax Reform Act of 1986 (TRA ’86) added to the Code subpart J (foreign currency transactions) and Sec. 1271 (providing exchange treatment to the holder of a debt instrument on retirement). The legislative history of the TRA ’86 refers to National-Standard several times, because the case relates to a separate transaction principle and the character of currency losses; see the General Explanation of the Tax Reform Act of 1986, p. 1068–1080. However, the decision to provide authority for regulations to treat currency gains or losses as ordinary was described as a “pragmatic decision” that did not necessarily reflect any intent to cause sale or exchange treatment. Further, Congress recognized Sec. 267(f)’s treatment of the holder and instructed the IRS to review this particular exception in light of the enactment of subpart J. There was no mention of whether the debtor was (or should be) subject to Sec. 267(f).

IRS Guidance

In 1992, the IRS issued proposed regulations which, if finalized, would retroactively provide the discretion to defer a loss attributable to the disposition or termination of a debt between related parties, if it was effectively replaced with debt denominated in a different currency; see Prop. Regs. Sec. 1.988-2(b)(14)(i). The proposed regulations are reserved on how to treat debt-for-debt “exchanges” in the same nonfunctional currency, and include an example that assumes that a borrower would both realize and recognize a currency loss on the redenomination of a foreign-currency borrowing in the absence of the regulations; see Prop. Regs. Sec. 1.988-2(b)(14)(ii) and (iii). Thus, the proposed regulations appear to evidence a belief within the IRS that Sec. 267(f) would not apply to the borrower. They have been pending for the last 13 years without further action.

The IRS issued two Field Service Advice Memoranda (FSAs) concluding that Sec. 267(f) would not apply. In an unnumbered FSA (1996 WL 33321230), the IRS concluded that Sec. 267(f) did not apply to the redenomination of a U.S. borrower’s related-party debt from Deutschmarks (DM) into U.S. dollars, for two reasons. First, citing National-Standard, the IRS noted the “threshold issue” of whether there was a sale or exchange from the debtor’s perspective. Next, it noted that even if the loss was attributable to a property exchange, the transaction should be viewed as a repayment of the DM by the borrower, a sale of the DM by the lender for dollars and a re-lending of the dollars to the borrower. The deemed sale of the DM by the lender then caused the DM to “leave the group,” thereby triggering the loss.

In another unnumbered FSA (1997 WL 33314922), the IRS incorrectly applied the exception from Sec. 267(f) to the borrower, although, by its terms, it applies only to the holder. Both FSAs appear to relate to years before the proposed regulations’ effective date.

Finally, in 1996, Treasury issued Regs. Sec. 1.1001-3(b), providing that a “significant modification” of a debt instrument constitutes an “exchange.” It is debatable whether these regulations give rise to an exchange to a debtor for Sec. 267(f) purposes as well; compare Fairbanks with Neal, 516 US 284 (1996).

Observation

It appears that Sec. 267(f) does not apply to a debtor’s foreign-currency loss on a related-party borrowing and that the IRS has consistently shared this view. Nevertheless, it would be helpful if this issue were addressed explicitly in public guidance.

From Michael Harper, J.D., LL.M., Washington, DC