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Out of the Ordinary: Capital Gain/Loss from the
Foreign currency gain or loss
realized by a holder on foreign currency-denominated debt generally is thought
to be ordinary in character. However, when a holder disposes of such an
instrument, the entire gain or loss realized on the transaction is not
necessarily related to exchange-rate fluctuation. Sec. 988 and its regulations
acknowledge this principle by providing that the foreign currency element of a
transaction must be computed and taken into account separately from gain or
loss on the underlying transaction. Taxpayers and practitioners need to
remember that both ordinary and capital character may result from the disposition
of a foreign currency-denominated debt instrument.
Computing Overall and Foreign Currency Gain or
Loss
Sec. 988(a)(1)(A) generally provides that a
taxpayer’s foreign currency gain or loss
attributable to a Sec. 988 transaction is computed separately and
treated as ordinary income or loss. A “Sec. 988 transaction” includes the
acquisition of a debt instrument denominated in terms of a nonfunctional
currency; see Sec. 988(c)(1)(A) and (B). The term
“foreign currency gain or loss” refers to any gain (or loss) from a Sec. 988
transaction to the extent it
does not exceed the gain (or loss) realized by reason of changes
in exchange rates on or after the booking date and before the payment date.
Stated differently, if there is gain or loss on the underlying transaction, as
well as offsetting foreign currency loss or gain, the two should be netted;
only the excess foreign currency loss or gain (if any) should be reported
separately under Sec. 988(a)(1)(A). Regs. Sec. 1.988-2(b) describes the mechanics of computing gain or loss on the underlying transaction (i.e., market gain or loss) and that on movements in the value of the foreign currency (i.e., exchange gain or loss), as well as the process by which the two are netted. A holder of a foreign currency-denominated debt instrument may have exchange gain or loss as to the principal amount when the instrument is paid or disposed of, computed as the principal amount in nonfunctional currency units, translated into functional currency at the spot rate on the date payment is received or the instrument is disposed of, less the nonfunctional currency principal amount translated at the spot rate for the date the taxpayer acquired the instrument; see Regs. Sec. 1.988-2(b)(5). In computing exchange gain or loss, the “principal amount” of a debt instrument refers to the amount received by the holder in nonfunctional currency units; see Regs. Sec. 1.988-2(b)(6). A holder also can have gain or loss on the underlying transaction if interest rates or the credit of the issuer of the debt instrument shifts.
Examples These
rules can be illustrated by a series of examples that assume that the taxpayer
(T) is a nondealer calendar-year corporation on the
accrual method, with a U.S. dollar functional currency.
TP
has a $50 overall economic gain at the time of disposition—the principal amount
at the spot rate for date of sale (€1,000 × $0.75) less the principal amount at
the spot rate for date of purchase (€1,000 × $0.70). The $50 overall economic
gain is entirely attributable to exchange gain; thus, it is ordinary gain. Regs. Sec. 1.988-2(b)(8)
provides that a holder’s exchange gain or loss on the payment or disposition of
a foreign currency-denominated debt instrument, including gain or loss as to
both principal and interest, may not exceed the holder’s total economic gain or
loss on the payment or disposition (the “netting rule”). In other words, while
a holder’s exchange gain or loss must be computed on the entire principal
amount, it must then be compared to the overall economic gain or loss realized
on the disposition to determine if the netting rule applies. If the economic
gain or loss exceeds the ceiling, it is bifurcated between exchange and other
gain or loss.
Under
the general rules, T’s exchange gain is $50. However, the overall economic gain
on the sale is $12.50—the amount realized on the sale (€950 × $0.75, or
$712.50) less the bond’s adjusted basis (€1,000 × $0.70, or $700). Under the
netting rule, T’s exchange gain is limited to $12.50; see Regs.
Sec. 1.988-2(b)(9), Example (4). The $12.50 exchange gain is ordinary gain.
Under
the general rules, T’s exchange loss is $50. However, the sale results in an
overall $15 economic gain—the amount realized on the sale (€1,100 × $0.65, or
$715) less the bond’s adjusted basis (€1,000 × $0.70, or $700). Under the
netting rule, T’s exchange loss is realized only to the extent of the total
loss on the sale. Here, T realizes a $15 overall economic gain; thus, T will
realize no exchange loss and a $15 market gain (capital gain); see Regs. Sec. 1.988-2(b)(9), Example (5)(i).
Under
the general rules, T’s exchange loss is $50 ((€1,000 × $0.70) less the
principal amount at the spot rate for date of purchase (€1,000 × $0.65)).
However, the overall economic loss on the sale is $82.50—the amount realized
(€950 × $0.65, or $617.50) less the bond’s adjusted basis (€1,000 × $0.70, or
$700). Thus, under the netting rule, T’s $82.50 overall economic loss consists
of $50 ordinary exchange loss and a $32.50 market loss, which is capital in
character; see Regs. Sec. 1.988-2(b)(9),
Example (5)(ii).
Observations There
are several implications of the often-ignored netting rule under Regs. Sec. 1.988-2(b)(8). First,
portfolio investors (e.g., hedge funds) may need to bifurcate
their overall economic gain or loss into its separate exchange and market
components. The result of such character bifurcation may be beneficial or
detrimental, depending on the results and profile of the individual investor.
Second, although the examples illustrated above relate solely to long positions
in foreign currency-denominated debt instruments, the same principles appear
equally applicable to short sales of such instruments. To the extent the market
gain or loss resulting from a short sale exceeds the netting rule,
it should be subject to the Sec. 1233 rules. Finally, to the extent a taxpayer
(e.g., a nondealer financial institution) holds a
foreign currency-denominated debt instrument to which Prop. Regs. Sec. 1.1221-1(e)(1) applies, the netting rule raises the issue of whether
such taxpayer can have a qualified Regs. Sec. 1.1221-2 hedging transaction as to such instrument. To
avoid this issue, it might be advisable instead to identify such a hedge as a
hedge of the value of the foreign currency to be received on payment of the
debt instrument. In that case, gain or loss on a disposition of such currency
would be entirely ordinary in character.
From Wei-Chin (Michael) Mou, J.D., LL.M., and Brian Ciszczon,
CPA, LL.M., |
