* * * * *

(g) * * *

(2) * * *

(ii)* * *(A) * * *

(1) Section 987 QBU. In the case of a section 987 QBU, the tax book value shall be determined by applying the rules of paragraphs (g)(2)(i) and (3) of this section to the beginning of year and end of year functional currency amount of assets. The beginning of year functional currency amount of assets shall be determined by reference to the functional currency amount of assets computed under §1.987-4(d)(1)(i)(B) and (e) on the last day of the preceding taxable year. The end of year functional currency amount of assets shall be determined by reference to the functional currency amount of assets computed under §1.987-4(d)(1)(i)(A) and (e) on the last day of the current taxable year. The beginning of year and end of year functional currency amount of assets, as so determined within each grouping must then be averaged as provided in paragraph (g)(2)(i) of this section.

* * * * *

(vi) Effective date. Generally, paragraph (g)(2)(ii)(A)(1) of this section shall apply to taxable years beginning one year after the first day of the first taxable year following the date of publication of a Treasury decision adopting this rule as a final regulation in the Federal Register. If a taxpayer makes an election under §1.987-11(b), then the effective date of paragraph (g)(2)(ii)(A)(1) of this section with respect to the taxpayer shall be consistent with such election.

* * * * *

Par. 3. Section 1.985-1 is amended as follows:

1. Paragraph (d)(2), second sentence; and paragraph (f), Example 9 and Example 10(i), ninth sentence are revised.

2. Paragraph (f), Example 11 is removed.

3. Paragraph (f), Example 12 is redesignated as Example 11.

4. Paragraph (g) is added.

The revisions and addition read as follows:

* * * * *

(d) * * *

(2) * * *The amount of income or loss or earnings and profits (or deficit in earnings and profits) of each QBU in its functional currency shall then be translated into the foreign corporation’s functional currency under the principles of section 987.

* * * * *

(f) Examples. * * *

Example (9). (i) The facts are the same as in Example (7). In addition, assume that in 1987 branch A has items of earnings of 100 FC and branch B has items of earnings of 100 LC as determined under section 987. S translates branch A’s and branch B’s items of earnings and profits into its functional currency under the principles of section 987.

Example (10). (i) * * * Assume that B’s items of income of 200 DCs when properly translated under the principles of section 987 is equal to 100LCs. * * *

* * * * *

(g) Effective date. Generally, the revisions to the second sentence of paragraph (d)(2), Example 9, and Example 10 shall apply to taxable years beginning one year after the first day of the first taxable year following the date of publication of a Treasury decision adopting this rule as a final regulation in the Federal Register. If a taxpayer makes an election under §1.987-11(b), then the effective date of these revisions with respect to the taxpayer shall be consistent with such election.

Par. 4. Section 1.985-5 is revised to read as follows:

(a) In general. This section applies in the case of a taxpayer, qualified business unit (QBU) or section 987 QBU as defined in §1.987-1(b)(2) changing from one functional currency (old functional currency) to another functional currency (new functional currency). A taxpayer, QBU, or section 987 QBU subject to the rules of this section shall make the adjustments set forth in the 3-step procedure described in paragraphs (b) through (e) of this section. Except as otherwise provided in this section, the adjustments shall be made on the last day of the taxable year ending before the year of change as defined in §1.481-1(a)(1). Gain or loss required to be recognized under paragraphs (b), (d)(2), (e)(2), and (e)(4)(iii) of this section is not subject to section 481 and, therefore, the full amount of the gain or loss must be included in income or earnings and profits on the last day of the taxable year ending before the year of change. Except as provided in §1.985-6, a QBU or section 987 QBU with a functional currency for its first taxable year beginning in 1987 that is different from the currency in which it had kept its books and records for United States accounting and tax accounting purposes for its prior taxable year shall apply the principles of this section for purposes of computing the relevant functional currency items, such as earnings and profits, basis of an asset, and amount of a liability, as of the first day of a taxpayer’s first taxable year beginning in 1987. However, a QBU that changes to the dollar pursuant to §1.985-1(b)(2) after 1987 shall apply §1.985-7.

(b) Step 1 Taking into account exchange gain or loss on certain section 988 transactions. The taxpayer, QBU or section 987 QBU shall recognize or otherwise take into account for all purposes of the Internal Revenue Code the amount of any unrealized exchange gain or loss attributable to a section 988 transaction (as defined in section 988(c)(1)(A), (B), and (C)) that, after applying section 988(d), is denominated in terms of or determined by reference to the new functional currency. The amount of such gain or loss shall be determined without regard to the limitations of section 988(b) (that is, whether any gain or loss would be realized on the transaction as a whole). The character and source of such gain or loss shall be determined under section 988.

(c) Step 2 Determining the new functional currency basis of property and the new functional currency amount of liabilities and any other relevant items. Except as otherwise provided in this section, the new functional currency adjusted basis of property and the new functional currency amount of liabilities and any other relevant items (for example, items described in section 988(c)(1)(B)(iii)) shall equal the product of the amount of the old functional currency adjusted basis or amount multiplied by the new functional currency/old functional currency spot exchange rate on the last day of the taxable year ending before the year of change (spot rate).

(d) Step 3A Additional adjustments that are necessary when a QBU or section 987 QBU changes functional currency —(1) QBU changing to a functional currency other than the owner’s functional currency—(i) Rule. If a QBU or section 987 QBU changes to a functional currency other than the owner’s functional currency, the owner and section 987 QBU shall make the adjustments set forth in either paragraph (d)(1)(ii) or (d)(1)(iii) of this section for purposes of section 987.

(ii) Where prior to the change the section 987 QBU and owner had different functional currencies. If the section 987 QBU and the owner had different functional currencies prior to the change, the owner and section 987 QBU shall make the following adjustments in the year of change.

(A) Determining the owner functional currency net value of the section 987 QBU under §1.987-4(d)(1)(i)(B)—(1) Historic items. For purposes of determining the owner functional currency net value of the section 987 QBU for the year of change under §1.987-4(d)(1)(i)(B), the owner or section 987 QBU shall first translate the section 987 historic items from the QBU’s old functional currency into its owner’s functional currency using the historic exchange rate as defined in §1.987-1(c)(3). The owner or section 987 QBU shall then translate the section 987 historic items as defined in §1.987-1(e) from the owner’s functional currency into the QBU’s new functional currency using the spot exchange rate between the section 987 QBU’s new functional currency and the owner’s functional currency on the last day of the taxable year ending before the year of change.

(2) Marked items. For purposes of determining the owner functional currency net value of the section 987 QBU for the year of change under §1.987-4(d)(1)(i)(B), the owner or section 987 QBU shall translate the section 987 QBU’s section 987 marked items as defined in §1.987-1(d) from the section 987 QBU’s old functional currency into the QBU’s new functional currency using the new functional currency/old functional currency spot exchange rate on the last day of the taxable year ending before the year of change.

(B) Net unrecognized section 987 gain or loss. No adjustment to the owner’s net unrecognized section 987 gain or loss is necessary.

(iii) Where prior to the change the QBU and the taxpayer had the same functional currency. If a QBU with the same functional currency of the taxpayer is changing to a new functional currency different from the taxpayer, and as a result of the change the taxpayer will be an owner of a section 987 QBU (see §1.987-1), the taxpayer and section 987 QBU shall become subject to section 987 for the year of change and subsequent years.

(2) Section 987 QBU changing to the owner’s functional currency. If a section 987 QBU changes its functional currency to its owner’s functional currency, the section 987 QBU shall be treated as if it terminated on the last day of the taxable year ending before the year of change. See §§1.987-5 and 1.987-8 for the effect of a termination.

(e) Step 3B Additional adjustments that are necessary when a taxpayer/owner changes functional currency (1) Corporations. The amount of a corporation’s new functional currency earnings and profits and the amount of its new functional currency paid-in capital shall equal the product of the old functional currency amounts of such items multiplied by the spot rate. The foreign income taxes and accumulated profits or deficits in accumulated profits of a foreign corporation that were maintained in foreign currency for purposes of section 902 and that are attributable to taxable years of the foreign corporation beginning before January 1, 1987, also shall be translated into the new functional currency at the spot rate.

(2) Collateral consequences to a United States shareholder of a corporation changing to the United States dollar as its functional currency. A United States shareholder (within the meaning of section 951(b) or section 953(c)(1)(A)) of a controlled foreign corporation (within the meaning of section 957 or section 953(c)(1)(B)) changing its functional currency to the dollar shall recognize foreign currency gain or loss computed under section 986(c) as if all previously taxed earnings and profits, if any, (including amounts attributable to pre-1987 taxable years that were translated from dollars into functional currency in the foreign corporation’s first post-1986 taxable year) were distributed immediately prior to the change. Such a shareholder shall also recognize gain or loss attributable to the corporation’s paid-in capital to the same extent, if any, that such gain or loss would be recognized under the regulations under section 367(b) if the corporation was liquidated completely.

(3) Taxpayers that are not corporations. [Reserved].

(4) Adjustments to a section 987 QBU’s balance sheet and net accumulated unrecognized section 987 gain or loss when an owner changes functional currency (i) Owner changing to a functional currency other than the section 987 QBU’s functional currency. If an owner changes to a functional currency that differs from the functional currency of its section 987 QBU, the owner shall make the following adjustments in the year of change.

(A) Determining the owner functional currency net value of the section 987 QBU under §1.987-4(d)(1)(i)(B)—(1) Historic items. For purposes of determining the owner functional currency net value of the section 987 QBU for the year of change under §1.987-4(d)(1)(i)(B), the owner shall first translate the QBU’s section 987 historic items into the owner’s old functional currency at the historic exchange rate as defined in §1.987-1(c)(3). The owner shall then translate the section 987 historic items into its new functional currency using the new functional currency/old functional currency spot rate on the last day of the taxable year ending before the year of change.

(2) Marked items. For purposes of determining the owner functional currency net value of the section 987 QBU for the year of change under §1.987-4(d)(1)(i)(B), the owner or section 987 QBU shall translate the QBU’s section 987 marked items from the owner’s old functional currency into the owner’s new functional currency using the new functional currency/old functional currency spot exchange rate on the last day of the taxable year ending before the year of change.

(B) Translation of net unrecognized section 987 gain or loss. The owner shall translate any net unrecognized section 987 gain or loss determined under §1.987-4 from its old functional currency into its new functional currency using the new functional currency/old functional currency spot exchange rate on the last day of the taxable year ending before the year of change.

(ii) Taxpayer with the same functional currency as its QBU changing to a different functional currency. If a taxpayer with the same functional currency as its QBU changes to a new functional currency and as a result of the change the taxpayer will be an owner of a section 987 QBU (see §1.987-1), the taxpayer and section 987 QBU shall become subject to section 987 for the year of change and subsequent years.

(iii) Owner changing to the same functional currency as the section 987 QBU. If an owner changes to the same functional currency as its section 987 QBU, such section 987 QBU shall be treated as if it terminated on last day of the taxable year ending before the year of change. See §§1.987-5 and 1.987-8 for the effect of a termination.

(f) Examples. The provisions of this section are illustrated by the following example:

Example. S, a calendar year foreign corporation, is wholly owned by domestic corporation P. The Commissioner granted permission to change S’s functional currency from the LC to the FC beginning January 1, 1993. The LC/FC exchange rate on December 31, 1992, is 1 LC/2 FC. The following shows how S must convert the items on its balance sheet from the LC to the FC.

(g) Effective date. Generally, this regulation shall apply to taxable years beginning one year after the first day of the first taxable year following the date of publication of a Treasury decision adopting this rule as a final regulation in the Federal Register. If a taxpayer makes an election under §1.987-11(b), then the effective date of this regulation with respect to the taxpayer shall be consistent with such election.

Par. 5. Sections 1.987-1 through 1.987-4 and §§1.987-6 through 1.987-11 are added and §1.987-5 is revised to read as follows:

(a) In general. These regulations provide rules for determining the taxable income or loss of a taxpayer with respect to a section 987 qualified business unit (section 987 QBU) as defined in paragraph (b)(2) of this section. Further, these regulations provide rules for determining the timing, amount, character and source of section 987 gain or loss recognized with respect to a section 987 QBU. This section addresses the scope of these regulations and provides certain definitions and special rules. Section 1.987-2 provides rules for attributing assets and liabilities and items of income, gain, deduction, and loss to an eligible QBU and a section 987 QBU. It also provides rules regarding transfers and the translation of items transferred to a section 987 QBU. Section 1.987-3 provides rules for determining and translating the section 987 taxable income or loss of a taxpayer with respect to a section 987 QBU. Section 1.987-4 provides rules for determining net unrecognized section 987 gain or loss. Section 1.987-5 provides rules regarding the recognition of section 987 gain or loss. Section 1.987-6 provides rules regarding the character and source of section 987 gain or loss. Section 1.987-7 provides rules with respect to partnerships and rules necessary to coordinate the provisions of section 987 with subchapter K. Section 1.987-8 provides rules regarding the termination of a section 987 QBU. Section 1.987-9 provides rules regarding the recordkeeping required under section 987. Section 1.987-10 provides transition rules. Section 1.987-11 provides the effective date of these regulations.

(b) Scope of section 987 and definitions—(1) Taxpayers subject to section 987—(i) In general. Except as provided in paragraphs (b)(1)(ii) and (iii) of this section, an individual or corporation is subject to section 987 if such person is an owner (as defined in paragraphs (b)(4) and (5) of this section) of an eligible QBU (as defined in paragraph (b)(3) of this section) that is a section 987 QBU (as defined in paragraph (b)(2) of this section). Such individual or corporation, and any section 987 QBU owned by such person, must comply with these regulations.

(ii) De minimis rule for certain indirectly owned section 987 QBUs. An individual or corporation that owns a section 987 QBU indirectly through a section 987 partnership may elect not to apply these regulations for purposes of taking into account the section 987 gain or loss of such section 987 QBU if the individual or corporation owns, directly or indirectly, less than five percent of either the total capital or the total profits interest in the section 987 partnership as determined on the date of acquisition of such interest or on the date such interest is increased or decreased. For purposes of this paragraph (b)(1)(ii), ownership of a capital or profits interest in a partnership shall be determined in accordance with the rules for constructive ownership of stock provided in section 267(c), other than section 267(c)(3). See §1.987-3 for purposes of determining the section 987 taxable income or loss attributable to such section 987 QBU.

(iii) Inapplicability to certain entities. These regulations do not apply to banks, insurance companies and similar financial entities (including, solely for purposes of section 987, leasing companies, finance coordination centers, regulated investment companies and real estate investment trusts). Further, these rules do not apply to trusts, estates and S corporations.

(2) Definition of a section 987 QBU—(i) In general. A section 987 QBU is an eligible QBU, as defined in paragraph (b)(3) of this section, that has a functional currency different from its owner. The functional currency of an eligible QBU shall be determined under §1.985-1, taking into account all of the QBU’s activities before the application of §1.987-7.

(ii) Section 987 QBU grouping election—(A) In general. Except as provided in paragraphs (b)(2)(ii)(B)(1) through (3) of this section, an owner may elect pursuant to paragraph (f) of this section to treat, solely for purposes of section 987, all section 987 QBUs with the same functional currency as a single section 987 QBU.

(B) Special grouping rules for section 987 QBUs owned indirectly through a partnership—(1) In general. An owner may elect to treat all section 987 QBUs with the same functional currency owned indirectly though a single section 987 partnership as a single section 987 QBU.

(2) Election not available to group section 987 QBUs owned indirectly through different partnerships. An owner cannot elect to treat multiple section 987 QBUs with the same functional currency as a single section 987 QBU if such QBUs are owned indirectly through different section 987 partnerships.

(3) Election not available to group section 987 QBUs owned directly and indirectly. An owner cannot elect to treat multiple section 987 QBUs with the same functional currency owned directly, and indirectly through a section 987 partnership, as a single section 987 QBU.

(3) Definition of an eligible QBU—(i) In general. The term eligible QBU means activities of an individual, corporation, partnership, or an entity disregarded as an entity separate from its owner for U.S. Federal income tax purposes (DE), if—

(A) The activities constitute a trade or business as defined in §1.989(a)-1(c);

(B) A separate set of books and records is maintained as defined in §1.989(a)-1(d) with respect to the activities, and assets and liabilities used in conducting such activities are reflected on such books and records under §1.987-2(b); and

(C) The activities are not subject to the Dollar Approximate Separate Transactions Method (DASTM) rules of §1.985-3.

(ii) Exclusion of DEs and certain QBUs. A DE itself is not an eligible QBU (even though a DE may have activities that qualify as an eligible QBU). In addition, an eligible QBU shall include a QBU defined in §1.989(a)-1(b) only if the requirements contained in paragraphs (b)(3)(i)(A) through (C) of this section are satisfied with respect to such QBU. Thus, for example, neither a corporation nor a partnership itself is an eligible QBU (even though a corporation and a partnership may have activities that qualify as an eligible QBU).

(4) Definition of the term “owner”. For purposes of section 987, only an individual or corporation may be an owner of an eligible QBU. An individual or corporation is an owner of an eligible QBU if—

(i) Direct ownership. The individual or corporation is the tax owner of the assets and liabilities of an eligible QBU as defined in paragraph (b)(3) of this section; or

(ii) Indirect ownership. In the case of an individual or corporation that is a partner in a partnership, the individual or corporation is allocated, under §1.987-7, all or a portion of the assets and liabilities of an eligible QBU of such partnership.

(5) Exception with respect to an eligible QBU or section 987 QBU of an owner. The term owner for section 987 purposes does not include an eligible QBU or a section 987 QBU of an owner. For example, a section 987 branch, as defined in paragraph (b)(6)(i) of this section is not an owner of another section 987 branch, regardless of its functional currency.

(6) Other definitions. Solely for purposes of section 987, the following definitions shall apply.

(i) Section 987 branch. A section 987 branch is an eligible QBU of an individual, partnership, DE, or corporation, all or a portion of which is a section 987 QBU. Assets and liabilities of an eligible QBU of a partnership that are allocated to a partner under §1.987-7 are considered to be a section 987 QBU of such partner, provided such partner has a functional currency different from that of such eligible QBU.

(ii) Section 987 partnership. A section 987 partnership is a partnership that has one or more section 987 branches.

(iii) Section 987 DE. A section 987 DE is a DE that has one or more section 987 branches.

(7) Examples. The following examples illustrate the principles of paragraph (b) of this section. Except as otherwise provided, the following facts are assumed for purposes of these examples. X is a domestic corporation, has the U.S. dollar as its functional currency, and uses the calendar year as its taxable year. Business A and Business B are eligible QBUs, maintain books and records that are separate from the books and records of the entity that owns such eligible QBUs, and have the euro and the Japanese yen, respectively, as their functional currencies. Finally, DE1 and DE2 are entities that are disregarded as entities separate from their owner for U.S. tax purposes, have no assets or liabilities, and conduct no activities.

Example 1. (i) Facts. X owns Business A and the interests in DE1. DE1 maintains a separate set of books and records that are kept in British pounds. DE1 owns British pounds and 100% of the stock of a foreign corporation, FC. DE1 is liable on a pound-denominated obligation to a lender that was incurred to acquire the stock of FC. The FC stock, the pounds, and the liability incurred to acquire the FC stock are recorded on DE1’s separate books and records. DE1 has no other assets or liabilities and conducts no activities (other than holding the FC stock and servicing its liability).

(ii) Analysis. (A) Pursuant to paragraph (b)(4)(i) of this section, X is the direct owner of Business A because it is the tax owner of the assets and liabilities of such business. Because Business A is an eligible QBU with a functional currency that is different from the functional currency of its owner, X, Business A is a section 987 QBU, as defined in paragraph (b)(2) of this section. As a result, X and its section 987 QBU, Business A, are subject to section 987.

(B) Holding the stock of FC and pounds, and servicing a single liability, does not constitute a trade or business within the meaning of §1.989(a)-1(c). Because the activities of DE1 do not constitute a trade or business within the meaning of §1.989(a)-1(c), such activities are not an eligible QBU. In addition, pursuant to paragraph (b)(3)(ii) of this section, DE1 is not an eligible QBU. As a result, neither DE1 nor its activities qualify as a section 987 QBU of X. Therefore, neither the activities of DE1 nor DE1 are subject to section 987. For the foreign currency treatment of payments on DE1’s pound-denominated liability, see §§1.987-2(b)(4) and 1.988-1(a)(4).

Example 2. (i) Facts. X owns the interests in DE1. DE1 owns Business A and the interests in DE2. The only activities of DE1 are Business A activities and holding the interests in DE2. DE2 owns Business B and Business C. For purposes of this example, Business B does not maintain books and records that are separate from its owner, DE2. Instead, the activities of Business B are reflected on the books and records of DE2, which are maintained in Japanese yen. In addition, Business C has the U.S. dollar as its functional currency, maintains books and records that are separate from the books and records of DE2, and is an eligible QBU.

(ii) Analysis. (A) Pursuant to paragraph (b)(3)(ii) of this section, DE1 and DE2 are not eligible QBUs. Pursuant to paragraph (b)(3)(i) of this section, the Business B and Business C activities of DE2, and the Business A activities of DE1, are eligible QBUs. Moreover, pursuant to paragraph (b)(4) this section, DE1 is not the owner of the Business A, Business B, or Business C eligible QBUs, and DE2 is not the owner of the Business B or Business C eligible QBUs. Instead, pursuant to paragraph (b)(4)(i) of this section, X is the direct owner of the Business A, Business B, and Business C eligible QBUs.

(B) Because Business A and Business B are eligible QBUs with functional currencies that are different than the functional currency of X, Business A and Business B are section 987 QBUs as defined in paragraph (b)(2) of this section. Therefore, X, and these QBUs, are subject to section 987. Under paragraph (b)(6)(iii) of this section, DE1 and DE2 are section 987 DEs.

(C) The Business C eligible QBU has the same functional currency as X. Therefore, the Business C eligible QBU is not a section 987 QBU. As a result, X is not subject to section 987 with respect to its Business C eligible QBU.

Example 3. (i) Facts. X owns DE1. DE1 owns Business A and Business B. For purposes of this example, assume Business B has the euro as its functional currency.

(ii) Analysis. (A) Pursuant to paragraph (b)(3)(ii) of this section, DE1 is not an eligible QBU. Moreover, pursuant to paragraph (b)(4) of this section, DE1 is not the owner of the Business A or Business B eligible QBUs. Instead, pursuant to paragraph (b)(4)(i) of this section, X is the direct owner of the Business A and Business B eligible QBUs.

(B) Business A and Business B constitute two separate eligible QBUs with the euro as their respective functional currency. Accordingly, Business A and Business B are section 987 QBUs of X. X may elect to treat Business A and Business B as a single section 987 QBU pursuant to paragraph (b)(2)(ii)(A) of this section. If such election is made, pursuant to paragraph (b)(4)(i) of this section, X is the direct owner of the Business AB section 987 QBU that includes the activities of both the Business A section 987 QBU and the Business B section 987 QBU. In addition, pursuant to paragraph (b)(4) of this section, DE1 is not treated as the owner of the Business AB section 987 QBU. X, and its AB section 987 QBU, are subject to section 987. Under paragraph (b)(6)(iii) of this section, DE1 is a section 987 DE.

Example 4. (i) Facts. X is a partner in P, a partnership. FC, a controlled foreign corporation (as defined in section 957(a)) of X with the Japanese yen as its functional currency, is the only other partner in P. P owns DE1 and Business A. DE1 owns Business B.

(ii) Analysis. (A) Pursuant to paragraph (b)(3)(ii) of this section, P and DE1 are not eligible section 987 QBUs. Moreover, pursuant to paragraph (b)(4) of this section, neither P nor DE1 is the owner of the Business A eligible QBU or the Business B eligible QBU for section 987 purposes. Instead, pursuant to paragraph (b)(4)(ii) of this section, X and FC are indirect owners of the Business A eligible QBU and the Business B eligible QBU to the extent they are allocated assets and liabilities of such businesses under §1.987-7. Under paragraphs (b)(6)(ii) and (iii) of this section, respectively, P is a section 987 partnership and DE1 is a section 987 DE.

(B) Because Business A and Business B are eligible QBUs with a different functional currency than X, the portions of Business A and Business B allocated to X under §1.987-7 are section 987 QBUs of X. As a result, X and its section 987 QBUs are subject to section 987.

(C) Because the Business A eligible QBU has a different functional currency than FC, the portion of the Business A eligible QBU that is allocated to FC under §1.987-7 is a section 987 QBU, and FC and its section 987 QBU are subject to section 987. However, the Business B eligible QBU has the same functional currency as FC. Therefore, the portion of the Business B eligible QBU that is allocated to FC, under §1.987-7, is not a section 987 QBU. As a result, FC is not subject to section 987 with respect to its Business B eligible QBU.

Example 5. (i) Facts. X owns all of the interests in DE1. DE1 owns Business A. DE1 owns all of the interests in DE2. DE2 owns Business B. DE2 owns all of the interests in DE3, an entity disregarded as an entity separate from its owner. DE3 owns Business C, which is an eligible QBU with the Russian ruble as its functional currency.

(ii) Analysis. Pursuant to paragraph (b)(3)(ii) of this section, DE1, DE2 and DE3 are not eligible QBUs. Pursuant to paragraph (b)(3)(i) of this section, the Business A, Business B and Business C activities are eligible QBUs. Moreover, pursuant to paragraph (b)(4) of this section, X is the direct owner of the Business A, Business B and Business C eligible QBUs. Pursuant to paragraph (b)(5) of this section, an eligible QBU is not an owner of another eligible QBU. Accordingly, the Business A eligible QBU is not the owner of the Business B eligible QBU, and the Business B eligible QBU is not the owner of the Business C eligible QBU. Since the Business A, Business B, and Business C eligible QBUs each has a different functional currency than X, such eligible QBUs are section 987 QBUs of X. As a result, X and its section 987 QBUs are subject to section 987. Under paragraphs (b)(6)(iii) of this section, DE1, DE2 and DE3 are section 987 DEs.

(c) Exchange rates. Solely for purposes of section 987, the following definitions shall apply.

(1) Spot rate—(i) In general. Except as otherwise provided in this section, the spot rate means the rate determined under the principles of §1.988-1(d)(1), (2) and (4) on the relevant day.

(ii) Election to use a spot rate convention—(A) In general. In lieu of the spot rate determined in paragraph (c)(1)(i) of this section, an owner may elect under paragraph (f) of this section to use a spot rate convention that reasonably approximates the rate in paragraph (c)(1)(i) of this section. A spot rate convention may be determined with respect to a rate at the beginning of a reasonable period, the end of a reasonable period, an average of spot rates for a reasonable period, or by reference to spot and forward rates for a reasonable period. For example, in lieu of the spot rate determined in paragraph (c)(1)(i) of this section, the spot rate for all transactions during a monthly period can be determined pursuant to the following conventions: the spot rate at the beginning of the current month or at the end of the preceding month; the monthly average of daily spot rates for the current or preceding month; or an average of the beginning and ending spot rates for the current or preceding month. Similarly, in lieu of the spot rate determined in paragraph (c)(1)(i) of this section, the spot rate can be determined pursuant to an average of the spot rate and the 30-day forward rate on a day of the preceding month. Use of a spot rate convention that is consistent with the owner’s convention used for financial accounting purposes is presumed to reasonably approximate the rate in paragraph (c)(1)(i) of this section. The Commissioner can rebut this presumption if use of such a convention results in a significant distortion of income or loss under the facts and circumstances.

(B) Election does not apply with respect to section 988 transactions. The election to use a spot rate convention set forth in paragraph (c)(1)(ii)(A) of this section does not apply to section 988 transactions of a section 987 QBU.

(2) Yearly average exchange rate. Notwithstanding §1.989(b)-1, for purposes of section 987, the yearly average exchange rate is a rate determined by the owner that represents an average exchange rate for the taxable year (or, if the section 987 QBU is sold or terminated prior to the close of the taxable year, such portion of the taxable year) computed under any reasonable method. For example, an owner may determine the yearly average exchange rate based on a daily, monthly or quarterly averaging convention, whether weighted or unweighted, and may take into account forward rates for a period not to exceed three months. The method for determining the yearly average exchange rate must be consistently applied by the taxpayer.

(3) Historic exchange rate—(i) In general. Except as otherwise provided in these regulations, the historic exchange rate shall be—

(A) In the case of an asset that is transferred to a section 987 QBU, the spot rate as defined in paragraphs (c)(1)(i) and (ii) of this section on the day of transfer;

(B) In the case of an asset that is acquired by a section 987 QBU (other than by a transfer to a section 987 QBU described in paragraph (c)(3)(i)(A) of this section), the spot rate as defined in paragraphs (c)(1)(i) and (ii) of this section on the day the asset is acquired;

(C) In the case of a liability that is entered into by a section 987 QBU, the spot rate as defined in paragraphs (c)(1)(i) and (ii) of this section on the day the liability is entered into; and

(D) In the case of a liability that is transferred to a section 987 QBU, the spot rate as defined in paragraphs (c)(1)(i) and (ii) of this section on the day the liability is transferred.

(ii) Changed functional currency. In the case of a section 987 QBU that previously changed its functional currency, §1.985-5 shall be taken into account in determining the historic exchange rate for an item.

(d) Section 987 marked item. A section 987 marked item is an asset (section 987 marked asset) or liability (section 987 marked liability) that—

(1) Is reflected on the books and records of a section 987 QBU under §1.987-2(b);

(2) Would be a section 988 transaction if such item were held or entered into directly by the owner of the section 987 QBU; and

(3) Is not a section 988 transaction with respect to the section 987 QBU.

(e) Section 987 historic item—(1) In general. A section 987 historic item is an asset (section 987 historic asset) or liability (section 987 historic liability) that—

(i) Is reflected on the books and records of a section 987 QBU under §1.987-2(b); and

(ii) Is not a section 987 marked item as defined in paragraph (d) of this section.

(2) Example. The following example illustrates the application of paragraphs (d) and (e) of this section:

Example. X is a domestic corporation with the dollar as its functional currency. X owns all the interests in UK DE, a section 987 DE that owns a section 987 branch having the pound as its functional currency. Items reflected on the branch’s balance sheet include £100 of cash, $25 dollars of cash, a building with a basis of £1,000, a truck with a basis of £75, a computer with a basis of £10, a 60 day receivable for ¥15 and a note payable of £500. Under paragraph (d) of this section, the £100 of cash and the £500 note payable are section 987 marked items. The other items are section 987 historic items under this paragraph (e).

(f) Elections—(1) In general. Elections made under section 987 shall be treated as methods of accounting and, except as otherwise provided in this paragraph (f), are governed by the general rules concerning changes in methods of accounting.

(2) Persons making the election—(i) In general. Except as provided in paragraphs (f)(2)(ii) and (iii) of this section, elections regarding section 987 shall be made by the owner as defined in paragraph (b)(4) of this section.

(ii) Controlled foreign corporations. Where a section 987 QBU is held by a controlled foreign corporation, elections shall be made in accordance with §§1.952-2(c)(2)(iv) and 1.964-1(c) by its controlling U.S. shareholders.

(iii) Foreign corporations that are not controlled foreign corporations. Where a section 987 QBU is held by a foreign corporation that is not a controlled foreign corporation, elections shall be made in accordance with the principles of §1.964-1(c) by the majority domestic corporate shareholders.

(3) When elections must be made. An election under section 987 must be made with respect to a section 987 QBU for the first taxable year in which the election is relevant in determining the section 987 taxable income or loss, or section 987 gain or loss, of the section 987 QBU.

(4) Manner of making elections. Elections shall be made under section 987 by attaching a statement to the timely filed tax return of the owner, or other applicable person, for the first taxable year in which the owner intends the election to be effective. The statement must be dated and titled “Election(s) Under Section 987,” must indicate the regulation section that authorizes the election(s), and must clearly describe the election(s) being made. Each section 987 election must remain a part of the books and records of the taxpayer and be available to the IRS upon request.

(5) Consent of the Commissioner. Elections made in accordance with the rules of this paragraph (f) shall be considered made with the consent of the Commissioner.

(6) Failure to make election. If an owner is permitted to file an election pursuant to this paragraph (f), but fails to make such election in a timely manner, the owner shall be considered to have satisfied the timeliness requirement with respect to such election if the owner is able to demonstrate to the Area Director, Field Examination, Small Business/Self Employed or the Director, Field Operations, Large and Mid-Size Business (Director) having jurisdiction of the taxpayer’s return for the taxable year, that such failure was due to reasonable cause and not willful neglect. The previous sentence shall only apply if, once the owner becomes aware of the failure, the owner attaches the election, as well as a written statement setting forth the reasons for the failure to timely comply, to an amended income tax return that amends the return to which the election should have been attached under the rules of this paragraph (f). In determining whether the owner has reasonable cause, the Director shall consider whether the taxpayer acted reasonably and in good faith. Whether the taxpayer acted reasonably and in good faith will be determined after considering all the facts and circumstances. The Director shall notify the owner in writing within 120 days of the filing if it is determined that the failure to comply was not due to reasonable cause, or if additional time will be needed to make such determination. If the Director fails to notify the owner within 120 days of the filing, the owner shall be considered to have demonstrated to the Director that such failure was due to reasonable cause and not willful neglect.

(7) Revocation of election—(i) In general. Elections under section 987 cannot be revoked without the consent of the Commissioner. The Commissioner will consider allowing the revocation of an election if the taxpayer can demonstrate significantly changed circumstance or such other circumstances that in the judgment of the Commissioner clearly demonstrates a substantial non-tax business reason for revoking the election.

(ii) Exception in the case of certain acquisitions. [Reserved].

(a) Scope and general principles. Paragraph (b) of this section provides rules for attributing assets and liabilities, and items of income, gain, deduction, and loss, to an eligible QBU and a section 987 QBU. Assets and liabilities are attributed to an eligible QBU, all or a portion of which is a section 987 QBU for purposes of section 987. Items of income, gain, deduction, and loss are attributed to an eligible QBU all or a portion of which is a section 987 QBU for purposes of computing the section 987 taxable income of such section 987 QBU, and of the owner of such section 987 QBU. Paragraph (c) of this section defines a transfer for purposes of section 987. Paragraph (d) of this section provides translation rules for transfers to a section 987 QBU.

(b) Attribution of items to an eligible QBU—(1) General rules. Except as provided in paragraphs (b)(2) and (3) of this section, items are attributable to an eligible QBU to the extent they are reflected on the separate set of books and records, as defined in §1.989(a)-1(d), of the eligible QBU. For purposes of this section, the term “item” refers to assets and liabilities, and items of income, gain, deduction, and loss. Items that are attributed to an eligible QBU pursuant to this section must be adjusted to conform to U.S. tax principles as provided in §1.987-4(e). These attribution rules apply solely for purposes of section 987. For example, the allocation and apportionment of interest expense under section 864(e) is independent of the rules under section 987.

(2) Exceptions for non-portfolio stock, interests in partnerships, and certain acquisition indebtedness—(i) General rule. Except as provided in paragraph (b)(2)(ii) of this section, the following shall not be considered to be on the books and records of a an eligible QBU:

(A) Stock of a corporation (whether domestic or foreign).

(B) An interest in a partnership (whether domestic or foreign).

(C) A liability that was incurred to acquire the stock or an interest in a partnership described in paragraphs (b)(2)(i)(A) or (B) of this section, respectively.

(D) Income, gain, deduction, or loss arising from the items described in paragraphs (b)(2)(i)(A) through (C) of this section. For example, a section 951 inclusion with respect to stock of a foreign corporation that is described in paragraph (b)(2)(i)(A) of this section shall not be considered to be on the books and records of the eligible QBU.

(ii) Portfolio stock. Paragraph (b)(2)(i)(A) of this section shall not apply to stock of a corporation (whether domestic or foreign) reflected on the books and records, within the meaning of paragraph (b)(1) of this section, of an eligible QBU provided the owner of the eligible QBU owns less than 10 percent of the total voting power or value of all classes of stock of such corporation. For purposes of this paragraph (b)(2)(ii), section 318(a) shall be applied in determining ownership, except that in applying section 318(a)(2)(C), the phrase “10 percent” is used instead of the phrase “50 percent.”

(3) Adjustments to items reflected on the books and records—(i) General rule. If a principal purpose of recording (or failing to record) an item on the books and records of an eligible QBU is the avoidance of U.S. tax under section 987, the Commissioner may allocate any item between or among the eligible QBU, the owner of such eligible QBU, and any other persons, entities (including disregarded entities), or other QBUs within the meaning of §1.989(a)-1(b) (including eligible QBUs). A transaction may have such a principal purpose even though the tax avoidance purpose is outweighed by other purposes when taken together. For purposes of this paragraph (b)(3)(i), relevant factors for determining whether such U.S. tax avoidance is a principal purpose of recording (or failing to record) an item on the books and records of an eligible QBU shall include, but are not limited to, the factors set forth in paragraphs (b)(3)(ii) and (iii) of this section. The presence or absence of any factor, or of a particular number of factors, is not determinative. Moreover, the weight given to any factor (whether or not set forth in paragraphs (b)(3)(ii) and (iii) of this section) depends on the particular case.

(ii) Factors indicating no tax avoidance. For purposes of paragraph (b)(3)(i) of this section, relevant factors which may indicate that the recording (or failing to record) an item on the books and records of an eligible QBU does not have as a principal purpose the avoidance of U.S. tax under section 987 include the recording (or not recording) of an item:

(A) For a significant and bona fide business purpose.

(B) In a manner that is consistent with the economics of the underlying transaction.

(C) In accordance with generally accepted accounting principles (or similar comprehensive body of professional accounting standards).

(D) In a manner that is consistent with the treatment of similar items from year to year.

(E) In accordance with accepted conditions or practices in the particular trade or business of the eligible QBU.

(F) In a manner that is consistent with an explanation of existing internal accounting policies that is evidenced by documentation contemporaneous with the timely filing of a return for the taxable year.

(G) As a result of a transaction between legal entities (that is, the transfer of an asset, or the assumption of a liability), even if such transaction is not regarded for Federal tax purposes (that is, a transaction between a DE and its owner).

(iii) Factors indicating tax avoidance. For purposes of paragraph (b)(3)(i) of this section, relevant factors which may indicate that a principal purpose of recording (or failing to record) an item on the books and records of an eligible QBU is the avoidance of U.S. tax under section 987 are—

(A) The presence or absence of an item on the books and records that is disregarded as transitory due to a circular flow of cash or other property;

(B) The presence or absence of an item on the books and records that is the result of one or more transactions that do not have economic substance;

(C) The presence or absence of an item on the books and records that results in the taxpayer (or person related to the taxpayer as defined in section 267(b) or 707(b)) having offsetting positions in the functional currency of a section 987 QBU; and

(D) The absence of any or all of the factors listed in paragraphs (b)(3)(ii)(A) through (E) of this section.

(4) Assets and liabilities of a partnership or DE that are not attributed to an eligible QBU. Neither a partnership nor a DE is an eligible QBU and, thus, cannot be a section 987 QBU. See §1.987-1(b)(2) and (3). As a result, a partnership or DE may own assets and liabilities that are not attributed to an eligible QBU (or a section 987 QBU) as provided under this paragraph (b) and, therefore, are not subject to section 987. For the foreign currency treatment of such assets or liabilities, see §1.988-1(a)(4).

(c) Transfers to and from section 987 QBUs—(1) In general. The following rules apply for purposes of determining whether there is a transfer of an asset or a liability from the owner to a section 987 QBU, or from such section 987 QBU to the owner. These rules apply solely for purposes of section 987.

(2) Disregarded transactions—(i) General rule. Solely for purposes of section 987, an asset or liability shall be treated as transferred to a section 987 QBU if, as a result of a disregarded transaction, such asset or liability is reflected on the books and records of the section 987 QBU within the meaning of paragraph (b) of this section. Similarly, an asset or liability shall be treated as transferred from a section 987 QBU if, as a result of a disregarded transaction, such asset or liability is not reflected on the books and records of the section 987 QBU within the meaning of paragraph (b) of this section.

(ii) Definition of a disregarded transaction. For purposes of this section, the term disregarded transaction means a transaction that is not regarded for U.S. Federal tax purposes. For purposes of this paragraph (c), a disregarded transaction shall be treated as including the recording of an asset or liability on one set of books and records, if the recording is the result of such asset or liability being removed from another set of books and records of the same person or entity (including a DE or partnership).

(iii) Items derived from disregarded transactions ignored. For purposes of section 987, disregarded transactions shall not give rise to items of income, gain, deduction, or loss that must be taken into account in determining section 987 taxable income or loss under §1.987-3.

(3) Transfers of assets to and from indirectly owned section 987 QBUs—(i) Contributions to partnerships. Solely for purposes of section 987, an asset shall be treated as transferred to an indirectly owned section 987 QBU if, and to the extent, the asset is contributed to the section 987 partnership that carries on the section 987 QBU provided that immediately following such contribution, the asset is reflected on the books and records of the section 987 QBU within the meaning of paragraph (b) of this section. For purposes of this paragraph (c)(3)(i), deemed contributions under section 752 shall be disregarded.

(ii) Distributions from partnerships. Solely for purposes of section 987, an asset shall be treated as transferred from an indirectly owned section 987 QBU if, and to the extent, the section 987 partnership that carries on the section 987 QBU distributes the asset to a partner provided that, immediately prior to such distribution, the asset was reflected on the books and records of such section 987 QBU within the meaning of paragraph (b) of this section. For purposes of this paragraph (c)(3)(ii), deemed distributions under section 752 shall be disregarded.

(4) Transfers of liabilities to and from indirectly owned section 987 QBUs—(i) Assumptions of partner liabilities. Solely for purposes of section 987, a liability shall be treated as transferred to an indirectly owned section 987 QBU if, and to the extent, the section 987 partnership assumes such liability, provided that immediately following such assumption, the liability is reflected on the books and records of the section 987 QBU within the meaning of paragraph (b) of this section.

(ii) Assumptions of partnership liabilities. Solely for purposes of section 987, a liability shall be treated as transferred from an indirectly owned section 987 QBU if, and to the extent, the owner assumes such liability of the section 987 partnership provided that immediately prior to such assumption, the liability was reflected on the books and records of the section 987 QBU within the meaning of paragraph (b) of this section.

(5) Acquisitions and dispositions of interests in DEs and partnerships. Solely for purposes of section 987, an asset or liability shall be treated as transferred to a section 987 QBU if, as a result of an acquisition (including by contribution) or disposition of an interest in a section 987 partnership or section 987 DE, such asset or liability is reflected on the books and records of the section 987 QBU. Similarly, an asset or liability shall be treated as transferred from a section 987 QBU if, as a result of an acquisition or disposition of an interest in a section 987 partnership or section 987 DE, the asset or liability is not reflected on the books and records of the section 987 QBU.

(6) Changes in form of ownership. For purposes of this paragraph (c), mere changes in form of ownership of an eligible QBU shall not result in a transfer to or from a section 987 QBU. Instead, the determination of whether a transfer has occurred in such case shall be made under paragraph (c)(5) of this section. For example, a transaction with respect to an eligible QBU that causes a direct owner of the eligible QBU to become an indirect owner of such eligible QBU, shall not, except to the extent provided in paragraph (c)(5) of this section, result in a transfer to or from a section 987 QBU. See for example, Rev. Rul. 99-5, 1999-1 C.B. 434, Rev. Rul. 99-6, 1999-1 C.B. 432, see §601.601(d)(2) of this chapter, and section 708 and the applicable regulations.

(7) Application of general tax law principles. General tax law principles, including the circular cash flow, step-transaction, and substance-over-form doctrines, apply for purposes of determining whether there is a transfer of an asset or liability under this paragraph (c).

(8) Interaction with §1.988-1(a)(10). See §1.988-1(a)(10) for rules regarding the treatment of an intra-taxpayer transfer of a section 988 transaction.

(9) Examples. The following examples illustrate the principles of this paragraph (c). For purposes of these examples, it is assumed that X and Y are domestic corporations, have the dollar as their functional currency, and use the calendar year as their taxable year. It is also assumed that Business A and Business B are eligible QBUs, maintain books and records that are separate from the books and records of the entity that owns such eligible QBUs, and have the euro and the yen, respectively, as their functional currencies. Finally, it is assumed that DE1 and DE2 are entities that are disregarded as entities separate from their owner for U.S. tax purposes. For purposes of determining whether any of the transfers in these examples result in remittances, see §1.987-5.

Example 1. Transfer to a directly owned section 987 QBU. (i) Facts. X owns 100 percent of the interests in DE1. DE1 owns Business A. X owns €100 that are not reflected on the books and records of Business A. Business A is in need of additional capital and, as a result, X loans the €100 to DE1 (to be used in Business A) in exchange for a note.

(ii) Analysis. (A) The loan from X to DE1 is not regarded for U.S. federal tax purposes and therefore is a disregarded transaction. As a result, the Business A note held by X, and the liability of DE1 under the note, are not taken into account under this section. However, the €100 of cash that was loaned from X to DE1 (and used in Business A) pursuant to the note must be taken into account under this paragraph (c).

(B) The loan of €100 from X to DE1 is a disregarded transaction and, as a result of such disregarded transaction, the €100 is reflected on the books and records of Business A. Therefore, there has been a transfer of €100 from X to Business A. See §1.988-1(a)(10)(ii) for the application of section 988 to X as a result of the loan.

Example 2. Transfer to a directly owned section 987 QBU. (i) Facts. X owns Business A and Business B. X owns equipment that is used in Business A and is reflected on the books and records of Business A. Because Business A has excess manufacturing capacity and X intends to expand the manufacturing capacity of Business B, the equipment formerly used in Business A discontinues being used in Business A and begins being used in Business B. As a result of such equipment being used by Business B, the equipment is removed from the books and records of Business A, and is recorded on the books and records of Business B.

(ii) Analysis. As a result of Business B using the equipment formerly used by Business A, the equipment ceases to be reflected on the books and records of Business A, and becomes reflected on the books and records of Business B. As a result, such entries constitute a disregarded transaction. Therefore, there has been a transfer of the equipment from the Business A section 987 QBU to X, and a transfer by X of such equipment to the Business B section 987 QBU.

Example 3. Intercompany sale of property between two section 987 QBUs. (i) Facts. X owns DE1 and DE2. DE1 and DE2 own Business A and Business B, respectively. DE1 owns equipment that is used in Business A and is reflected on the books and records of Business A. For business reasons, DE1 sells a portion of the equipment used in Business A to DE2 for cash. The cash used by DE2 to acquire the equipment was generated by Business B and was reflected on Business B’s books and records. Following the sale, the cash and equipment will be used in Business A and Business B, respectively. As a result of such sale, the equipment is removed from the books and records of Business A, and is recorded on the books and records of Business B. Similarly, as a result of the sale, the cash is removed from the books and records of Business B, and is recorded on the books and records of Business A.

(ii) Analysis. (A) The sale of equipment between DE1 and DE2 is not regarded for Federal tax purposes and therefore is a disregarded transaction. As a result, such sale is not taken into account under this section and does not give rise to an item of income, gain, deduction or loss pursuant to paragraph (c)(2)(iii) of this section. However, the cash and equipment exchanged by DE1 and DE2 in connection with the sale must be taken into account under this paragraph (c).

(B) The sale of the equipment is a disregarded transaction and, as a result of such disregarded transaction, the equipment ceases to be reflected on the books and records of Business A, and becomes reflected on the books and records of Business B. Therefore, there has been a transfer of the equipment from DE1’s Business A section 987 QBU owned by X to X, and a subsequent transfer of such equipment from X to DE2’s Business B section 987 QBU, owned by X.

(C) As a result of the sale of equipment (that is, the disregarded transaction), the cash proceeds cease to be reflected on the books and records of Business B, and become reflected on the books and records of Business A. Therefore, there has been a transfer of the cash from DE2’s Business B section 987 QBU owned by X to X, and a subsequent transfer of such cash from X to DE1’s Business A section 987 QBU, owned by X.

Example 4. Transactions between directly and indirectly owned section 987 QBUs. (i) Facts. X owns 50% of the interest in P, a partnership. Y owns the other 50% interest in P. P owns 100% of the interests in DE1 and DE2. DE1 owns Business A and DE2 owns Business B. X and Y each have a 50% allocable share of the assets and liabilities of Business A and Business B, as determined under §1.987-7, that constitute section 987 QBUs. In connection with Business A, DE1 licenses intangible property to both DE2 and X. X enters into the license agreement in a transaction other than in its capacity as a partner of P and, therefore, the license is considered as occurring between P and one who is not a partner within the meaning of section 707(a). DE2 uses the intangible property in Business B. Pursuant to the license agreement, X and DE2 pay a €30 and €50 royalty, respectively, to DE1.

(ii) Analysis. (A) The license from DE2 to DE1 is not regarded for U.S. tax purposes and, as a result, royalty payments under the license are disregarded transactions. Thus, neither the payment nor the receipt of the royalty pursuant to the license agreement gives rise to an item of income, gain, deduction or loss pursuant to paragraph (c)(2)(iii) of this section. However, the €50 of cash that is paid from DE2 to DE1 pursuant to the license agreement must be taken into account under this paragraph (c).

(B) As a result of the royalty payment from DE2 to DE1, €50 ceases being reflected on the books and records of Business B, and becomes reflected on the books and records of Business A. Accordingly, there has been a transfer of €25 from the Business B section 987 QBUs of X and Y, to X and Y, respectively. Similarly, there has been a transfer of €25 from X and Y to their respective Business A section 987 QBUs.

(C) The €30 royalty payment from X to DE1 is not a disregarded transaction because it is regarded for U.S. Federal tax purposes. As a result, it gives rise to an item of income and deduction that must be taken into account in computing taxable income or loss of Business A pursuant to §1.987-3. In addition, the payment does not give rise to a transfer as defined in this paragraph (c).

Example 5. Acquisition of an interest in a partnership. (i) Facts. X owns 50% of the interest in P, a partnership. Y owns the other 50% interest in P. P owns Business A. X and Y each have a 50% allocable share of the assets and liabilities of Business A as determined under §1.987-7, that constitute section 987 QBUs. On December 31, year 1, Z, a domestic corporation with the dollar as its functional currency, contributes cash to P in exchange for a 20% interest in P. The cash Z contributes to P is not used in Business A and is not reflected on Business A’s books and records (but is instead reflected on P’s books and records). Immediately after Z’s contribution of cash to P, Z has a 20% allocable share of the assets and liabilities of Business A as determined under §1.987-7. In addition, immediately following such contribution X and Y each own a 40% interest in P and have a 40% allocable share of the assets and liabilities of Business A, as determined under §1.987-7, that constitute section 987 QBUs.

(ii) Analysis. (A) As a result of Z’s acquisition of an interest in P, a section 987 partnership, 10% of the assets and liabilities of Business A ceased being reflected on the books and records of both X’s and Y’s section 987 QBUs. As a result, such amounts are treated as if they are transferred from such section 987 QBUs to X and Y.

(B) As a result of Z’s acquisition of the interest in P, a section 987 partnership, Z was allocated 20% of the assets and liabilities of Business A. Because Z and Business A have different functional currencies, Z’s portion of the Business A assets and liabilities constitutes a section 987 QBU. Moreover, 20% of the assets and liabilities of Business A are reflected on the books and records of Z’s section 987 QBU as a result of Z’s acquisition of the interest in P. Therefore, 20% of the assets and liabilities of Business A are treated as transferred from Z to Z’s section 987 QBU.

Example 6. Conversion of a DE to a partnership through a sale of an interest. (i) Facts. X owns 100% of the interests in DE1. DE1 owns Business A. On December 31, year 1, Y acquires 50% of the DE1 interests from X for cash. Immediately after such acquisition, Y has a 50% allocable share of the assets and liabilities of Business A as determined under §1.987-7.

(ii) Analysis. (A) For Federal tax purposes DE1 is converted to a partnership when Y purchases the 50% interest in DE1. Y’s purchase of 50% of X’s interest in DE1 is treated as the purchase of 50% of Business A, which is treated as held directly by X for Federal tax purposes. Immediately after the deemed purchase of 50% of Business A, X and Y are treated as contributing their respective interests in Business A to a partnership. See Rev. Rul. 99-5 (situation 1), (1999-1 C.B. 434). See §601.601(d)(2) of this chapter. For purposes of this paragraph (c), these deemed transactions are not taken into account.

(B) As a result of Y’s acquisition of 50% of X’s interest in DE1, a section 987 DE, 50% of the assets and liabilities of Business A ceased being reflected on the books and records of X’s section 987 QBU. As a result, such amounts are treated as if they are transferred from X’s section 987 QBU to X.

(C) As a result of Y’s acquisition of 50% of the interest in DE1, a section 987 DE, Y was allocated 50% of the assets and liabilities of Business A. Because Y and Business A have different functional currencies, Y’s portion of the Business A assets and liabilities constitutes a section 987 QBU. Moreover, 50% of the assets and liabilities of Business A are reflected on the books and records of Y’s section 987 QBU as a result of Y’s acquisition of the 50% interest in DE1. Therefore, 50% of the assets and liabilities of Business A are treated as transferred by Y to Y’s section 987 QBU.

Example 7. Conversion of a DE to a partnership through a contribution. (i) Facts. X owns 100% of the interests in DE1. DE1 owns Business A. On December 31, year 1, Y contributes property to DE1 in exchange for an interest in DE1. The property transferred by Y to DE1 is used in Business A and is reflected on the books and records of Business A. Immediately after such contribution, X and Y each have a 50% allocable share of the assets and liabilities of Business A as determined under §1.987-7.

(ii) Analysis. (A) For Federal tax purposes DE1 is converted to a partnership when Y contributes property to DE1 in exchange for a 50% interest in DE1. Y’s contribution is treated as a contribution to a partnership in exchange for an ownership interest in the partnership. X is treated as contributing all of Business A to the partnership in exchange for a partnership interest. See Rev. Rul. 99-5 (situation 2), (1999-1 C.B. 434). See §601.601(d)(2) of this chapter. For purposes of this paragraph (c), these deemed transactions are not taken into account.

(B) As a result of Y’s acquisition of a 50% interest in DE1, 50% of the assets and liabilities of Business A ceased being reflected on the books and records of X’s section 987 QBU, and 50% of the assets contributed by Y to DE1 are reflected on the books and records of such section 987 QBU. As a result, 50% of the Business A assets are treated as if they are transferred from X’s section 987 QBU to X. Further, 50% of the assets contributed by Y to DE1 are treated as if they are transferred by X to X’s section 987 QBU.

(C) Because Y and Business A have different functional currencies, Y’s portion of the Business A assets and liabilities (including the property contributed by Y that is used in Business A) constitutes a section 987 QBU. As a result of Y’s acquisition of a 50% interest in DE1, 50% of the assets and liabilities of Business A are reflected on the books and records of Y’s section 987 QBU and, therefore, are treated as if they are transferred by Y to such section 987 QBU.

Example 8. Termination of a partnership under section 708(b). (i) Facts. X owns 60% of the interest in P, a partnership. Y owns the other 40% interest in P. P owns Business A. X and Y have a 60% and 40% allocable share of the assets and liabilities of Business A, respectively, as determined under §1.987-7, that constitute section 987 QBUs. On December 31, year 1, X sells a 50% interest in P to Y. After such sale, X and Y own 10% and 90%, respectively, in P. In addition, after such sale, X and Y have a 10% and 90% allocable share of the assets and liabilities of Business A, respectively, as determined under §1.987-7.

(ii) Analysis. (A) X’s sale of 50% of the interests in P to Y causes P to terminate pursuant to section 708(b). As a result of such termination, P is treated as if it contributes all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership; and, immediately thereafter, P distributes 10% and 90% of the interests in the new partnership to X and Y, respectively, in liquidation of P. See §1.708-1(b)(4). For purposes of this paragraph (c), these deemed transactions are not taken into account.

(B) As a result of Y’s acquisition of a 50% interest in P from X, 50% of the assets and liabilities of Business A ceased being reflected on the books and records of X’s section 987 QBU and become reflected on the books and records of Y’s section 987 QBU. As a result, 50% of the Business A assets are treated as if they are transferred from X’s section 987 QBU to X. Further, 50% of the Business A assets are treated as if they are transferred by Y to Y’s section 987 QBU.

Example 9. Transfer of section 987 QBU to a partnership. (i) Facts. X owns Business A. On December 31, year 1, X and Y form P, a partnership. X transfers Business A to P in exchange for a 50% interest in P. Y transfers property to P in exchange for the other 50% interest in P. The property Y transfers to P is not used in Business A and is not reflected on the books and records of Business A (but is instead reflected on the books and records of P). After the formation of P, Business A continues to be an eligible QBU. In addition, after the formation of P, X and Y each have a 50% allocable share of the assets and liabilities of Business A, respectively, as determined under §1.987-7.

(ii) Analysis. As a result of X contributing Business A to P, 50% of the assets and liabilities of Business A ceased being reflected on the books and records of X’s section 987 QBU, and became reflected on the books and records of Y’s section 987 QBU. As a result, 50% of the Business A assets are treated as if they are transferred from X’s section 987 QBU to X. Further, 50% of the Business A assets are treated as if they are transferred from Y to Y’s section 987 QBU.

Example 10. Contribution of assets to a corporation. (i) Facts. X owns Business A. On December 31, year 1, X forms Z, a domestic corporation. X and Z do not file a consolidated tax return. X contributes 50% of its Business A assets and liabilities to Z in exchange for 100% of the stock of Z. The Z stock is recorded on the books and records of Business A. After the contribution, X continues to operate Business A, and Business A continues to maintain separate books and records from X.

(ii) Analysis. Even though the Z stock is recorded on the books and records of Business A, it is not reflected on the books and records for purposes of section 987 pursuant to paragraph (b)(2) of this section. As a result, there has been a transfer of 50% of the assets and liabilities of Business A to X, and a subsequent transfer of such assets and liabilities to Z. The answer would be the same even if X and Z filed a consolidated return.

Example 11. Transfers pursuant to general tax principles. (i) Facts. X owns 100 percent of the stock of Y. Y owns 100 percent of the interests in DE1. DE1 owns Business A. X owns €100. Because Business A is in need of additional capital, X transfers the €100 to Y as a contribution to capital and, as a result of such transfer, Business A records €100 on its separate books and records. Y did not record the €100 on its separate books and records.

(ii) Analysis. As a result of the contribution of €100 from X to Y, the €100 is reflected on the books and records of Business A. Pursuant to paragraph (c)(7) of this section, the €100 is treated as if it was transferred first from X to Y. Therefore, the €100 recorded on the books and records of Business A is treated as a transfer from Y to Business A, even though there was no transaction between Y and Business A. See also §1.988-1(a)(10)(ii) for the application of section 988 to Y as a result of the transaction.

Example 12. Circular transfers. (i) Facts. X owns Business A. On December 30, year 1, Business A purports to transfer €100 to X. On January 2, year 2, X purports to transfer €50 to Business A. On January 4, year 2, X purports to transfer another €50 to Business A. As of the end of year 1, X has an unrecognized section 987 loss with respect to Business A, such that a remittance, if respected, would result in recognition of a foreign currency loss under section 987.

(ii) Analysis. Because the transfers by Business A are offset by a transfer from X that occurred in close temporal proximity, pursuant to paragraph (c) of this section the IRS will scrutinize the transaction and may disregard the purported transfers to and from Business A for purposes of section 987.

Example 13. Transfers without economic substance. (i) Facts. X owns Business A and Business B. On January 1, year 1, Business A purports to transfer €100 to X. On January 4, year 1, X purports to transfer €100 to Business B. The account in which Business B deposited the €100 is used to pay the operating expenses and other costs of Business A. As of the end of year 1, X has an unrecognized section 987 loss with respect to Business A, such that a remittance, if respected, would result in recognition of a foreign currency loss under section 987.

(ii) Analysis. Because Business A continues to have use of the transferred property, pursuant to paragraph (c) of this section, the IRS will scrutinize the transaction and may disregard the €100 purported transfer from Business A to X for purposes of section 987.

Example 14. Offsetting positions in section 987 QBUs. (i) Facts. X owns Business A and Business B. Business A and Business B each has the euro as its functional currency. X has not made a grouping election under §1.987-1(b)(2)(ii). On January 1, year 1, X borrowed €1,000 from a third party lender, recorded the liability with respect to the borrowing on the books and records of Business A, and recorded the €1,000 of borrowed cash on the books and records of Business B. On December 31, year 2, when Business A has $100 of net unrecognized section 987 loss and Business B has $100 of net unrecognized section 987 gain resulting from the change in exchange rates with respect to the liability and the €1,000 cash, X terminates the Business A section 987 QBU.

(ii) Analysis. Because Business A and Business B have offsetting positions in the euro, the IRS will scrutinize the transaction to determine if a principal purpose of recording the euro-denominated liability and the borrowed euros on the books and records of Business A and Business B, respectively, was the avoidance of tax under section 987. If such a principal purpose is present, the Commissioner may reallocate the items (that is, the euros and the euro-denominated liability) between Business A, Business B, and X, to reflect the economic substance of the transaction.

Example 15. Offsetting positions with respect to a section 987 QBU and a section 988 transaction. (i) Facts. X owns DE1, and DE1 owns Business A. On January 1, year 1, X borrows €1,000 from a third party lender and records the liability with respect to the borrowing on its books and records. X contributes the €1,000 loan proceeds to DE1 and the €1,000 are reflected on the books and records of Business A. On December 31, year 2, when Business A has $100 of net unrecognized section 987 loss resulting from the €1,000 cash received from the borrowing, and the euro-denominated borrowing, if repaid, would result in $100 of gain under section 988, X terminates the Business A section 987 QBU.

(ii) Analysis. Because X and Business A have offsetting positions in euro, the Internal Revenue Service will scrutinize the transaction to determine whether a principal purpose of recording the borrowed euros on the books and records of Business A, or not recording the corresponding euro-denominated liability on the books and records of Business A, was the avoidance of tax under section 987. If such a principal purpose is present, the Commissioner may reallocate the items (that is, the euros and the euro-denominated liability) between Business A and X to reflect the economic substance of the transaction.

(d) Translation of items transferred to a section 987 QBU—(1) In general—(i) Assets. Except as otherwise provided in this section, the adjusted basis of an asset transferred to a section 987 QBU shall be translated into the section 987 QBU’s functional currency at the spot rate as defined in §1.987-1(c)(1)(i) and (ii) on the day of transfer. If the asset transferred is denominated in (or determined by reference to) the functional currency of the section 987 QBU (for example, cash or note denominated in the functional currency of the section 987 QBU), no translation is required.

(ii) Liabilities. Except as otherwise provided in this section, a liability of the owner that is transferred to a section 987 QBU, shall be translated into the section 987 QBU’s functional currency at the spot rate (as defined in §1.987-1(c)(1)(i) and (ii)) on the day of transfer. If the liability transferred is denominated in (or determined by reference to) the functional currency of the section 987 QBU, no translation is required.

(2) Items denominated in the owner’s functional currency. Transactions described in section 988(c)(1)(i) and (ii) and section 988(c)(1)(C) that are denominated in (or determined by reference to) the owner’s functional currency and that are attributable to a section 987 QBU under paragraph (b) of this section, shall not be translated and shall be carried on the balance sheet described in §1.987-4(e) in the owner’s functional currency.

(a) Determination of the section 987 taxable income or loss of an owner of a section 987 QBU. Except as otherwise provided in this section, the section 987 taxable income or loss of an owner with respect to a section 987 QBU shall be determined in accordance with paragraphs (a)(1) and (a)(2) of this section.

(1) In general—(i) Determination of each item of income, gain, deduction or loss in the section 987 QBU’s functional currency. Except as otherwise provided in this section, the section 987 QBU shall determine each item of income, gain, deduction or loss attributable to such QBU under §1.987-2(b) in its functional currency under U.S. tax principles.

(ii) Translation of items into the owner’s functional currency. The owner shall translate each item determined under this paragraph (a)(1) into its functional currency as provided in paragraph (b) of this section.

(2) Determination in the case of a section 987 QBU owned indirectly through a partnership—(i) In general. Except as otherwise provided in this paragraph (a)(2), the taxable income or loss of a section 987 partnership, and the distributive share of any owner that is a partner in such partnership, shall be determined in accordance with the provisions of subchapter K of this chapter.

(ii) Determination of each item of income, gain, deduction or loss in the eligible QBU’s functional currency. Except as otherwise provided in this section, the section 987 partnership shall determine each item of income, gain, deduction or loss reflected on the books and records of each of its eligible QBUs under §1.987-2(b) in the functional currency of each such QBU.

(iii) Allocation of items of income, gain, deduction or loss of an eligible QBU. The section 987 partnership shall allocate the items of income, gain, deduction or loss of each eligible QBU among its partners in accordance with each partner’s distributive share of such income, gain, deduction, or loss as determined under subchapter K of this chapter.

(iv) Translation of items into the owner’s functional currency. To the extent such items are reflected on the books and records of a section 987 QBU of a partner to whom they are allocated, the partner shall adjust the items to conform to U.S. tax principles and translate the items into the partner’s functional currency as provided in paragraph (b) of this section.

(b) Exchange rates to be used in translating items of income, gain, deduction or loss of a section 987 QBU into the owner’s functional currency—(1) In general. Except as otherwise provided in this section, the exchange rate to be used by an owner in translating an item of income, gain, deduction, or loss of a section 987 QBU as determined in §1.987-2(b) into the owner’s functional currency shall be the yearly average exchange rate as defined in §1.987-1(c)(2) for the taxable year. Alternatively, the owner may elect under §1.987-1(f) to use the spot rate as defined in §1.987-1(c)(1)(i) and (ii) for the day each item is properly taken into account.

(2) Exceptions—(i) Depreciation, depletion, and amortization deductions. The exchange rate to be used by the owner in translating deductions allowable with respect to section 987 historic assets (as defined in §1.987-1(e)) for depreciation, depletion, and amortization under the pertinent provisions of the Code shall be the historic exchange rate as determined under §1.987-1(c)(3) for the property to which such deductions are attributable.

(ii) Gain or loss from the sale of property. In the case of gain or loss recognized on a sale or other disposition of property that is reflected on the books and records of a section 987 QBU during the taxable year, the following exchange rates shall apply with respect to such sale or other disposition:

(A) Amount realized—(1) In general. Except as otherwise provided in paragraph (b)(2)(ii)(A)(2), the exchange rate to be used in translating the amount realized of such property shall be the rate provided in paragraph (b)(1) of this section for the taxable year.

(2) Certain section 987 marked assets. In the case of a section 987 marked asset (other than cash) that was held on the first day of the taxable year, the exchange rate to be used in translating the amount realized shall be the rate used for such asset in determining the owner functional currency net value of the section 987 QBU under §1.987-4(d)(1)(i)(B) for the preceding taxable year. However, in the case of a section 987 marked asset (other than cash) transferred to the section 987 QBU or acquired by the section 987 QBU during the taxable year, the exchange rate to be used in translating the amount realized shall be the spot rate, as defined in §1.987-1(c)(1)(i) and (ii), for the day transferred or acquired.

(B) Adjusted basis—(1) In general. Except as otherwise provided in paragraph (b)(2)(ii)(B)(2), the exchange rate to be used in translating the adjusted basis of such property shall be the historic exchange rate as determined under §1.987-1(c)(3) for such asset.

(2) Certain section 987 marked assets. In the case of a section 987 marked asset (other than cash) that was held on the first day of the taxable year, the exchange rate to be used in translating its adjusted basis shall be the rate used for such asset in determining the owner functional currency net value of the section 987 QBU under §1.987-4(d)(1)(i)(B) for the preceding taxable year. However, in the case of a section 987 marked asset (other than cash) transferred to the section 987 QBU or acquired by the section 987 QBU during the taxable year, the exchange rate to be used in translating the adjusted basis of such asset shall be the spot rate, as defined in §1.987-1(c)(1)(i) and (ii), for the day transferred or acquired.

(3) Gain or loss on the sale, exchange or other disposition of an interest in a section 987 partnership. For purposes of determining the adjusted basis of a partner’s interest in a section 987 partnership and computing gain or loss recognized on the sale, exchange or other disposition of such interest, see §1.987-7.

(c) Items of income, gain, deduction or loss that are denominated in the functional currency of the owner. An item of income, gain, deduction or loss attributable to a section 987 QBU under §1.987-2(b) that is denominated in (or determined by reference to) the owner’s functional currency shall not be translated and shall be taken into account by the section 987 QBU under U.S. tax principles in the owner’s functional currency.

(d) Items of income, gain, deduction or loss that are denominated in a nonfunctional currency (other than the functional currency of the owner). An item of income, gain, deduction or loss attributable to a section 987 QBU under §1.987-2(b) that is denominated in (or determined by reference to) a nonfunctional currency (other than the owner’s functional currency) shall be translated into the section 987 QBU’s functional currency at the spot rate as defined in §1.987-1(c)(1)(i) and (ii) on the day such item is properly taken into account.

(e) Section 988 transactions—(1) In general. Except as provided in paragraph (e)(2) of this section, section 988 shall apply to the section 988 transactions attributable to a section 987 QBU under §1.987-2(b), and the timing of any gain or loss shall be determined under the applicable provisions of the Internal Revenue Code. Such transactions are section 987 historic items as defined in §1.987-1(e).

(2) Certain transactions denominated in (or determined by reference to) the owner’s functional currency are not section 988 transactions. Transactions described in section 988(c)(1)(A)(i) and (ii) and section 988(c)(1)(C) that are denominated in (or determined by reference to) the owner’s functional currency and that are attributable to a section 987 QBU under §1.987-2(b) shall not be treated as section 988 transactions to such QBU. Thus, no currency gain or loss shall be recognized by a section 987 QBU under section 988 with respect to such items.

(f) Examples. The following examples illustrate the application of this section:

Example 1. (i) U.S. Corp is a domestic corporation with the dollar as its functional currency. U.S. Corp owns French DE, a section 987 DE that has a section 987 branch with the euro as its functional currency. For purposes of paragraph (b)(1) of this section, U.S. Corp uses the yearly average exchange rate under §1.987-1(c)(2) to translate items of income, gain, deduction or loss where such rate is appropriate. U.S. Corp also properly elects to use a spot rate convention under §1.987-1(c)(1)(ii) where the spot rate is otherwise required. Under this convention, items booked during a particular month are translated at the average of the spot rates on the first and last day of the preceding month (the “convention rate”). Accordingly, gross sales income is translated at the yearly average exchange rate and under paragraph (b)(2)(ii)(B) of this section the basis of assets acquired during a month is translated into dollars at the convention rate. Assume that the yearly average exchange rate for 2009 is €1 = $1.05. For the taxable year 2009, French DE sells 1,200 units of inventory for a sales price of €3 per unit. Assume that the purchase price for each inventory unit is €1.50. Thus, French DE’s dollar gross sales will be computed as follows:

(ii) French DE uses a first in first out method of accounting for inventory (FIFO). Thus, for 2009, French DE is considered to have sold the 100 units of opening inventory ($150), the 300 units purchased in January ($450), the 300 units purchased in April ($459), the 300 units purchased in July ($477) and 200 of the 300 units purchased in November ($324). Thus, French DE’s cost of goods sold is $1,860. French DE’s opening inventory for 2010 is 100 units of inventory with a dollar basis of $162.

(iii) Accordingly, for purposes of section 987 French DE has gross income in dollars of $1,920 ($3,780 - $1,860).

Example 2. (i) The facts are the same as in Example 1 except that for purposes of paragraph (b)(1) of this section, U.S. Corp properly elects to use a spot rate convention under §1.987-1(c)(1)(ii) to translate items of income, gain, deduction or loss where such rate is appropriate. Thus, French DE’s dollar gross sales will be computed as follows:

(ii) As in Example 1, French DE’s cost of goods sold is $1,860.

(iii) Accordingly, for purposes of section 987 French DE has gross income in dollars of $1,923 ($3,783 - $1,860).

Example 3. The facts are the same as in Example 1 except that French DE sold raw land on November 1, 2009 for €10,000. The yearly average rate for 2009 was €1=$1.05. The land was purchased on October 16, 2007 for €8,000 when the convention rate was €1=$1.00. Under paragraph (a)(1) of this section, French DE will determine the amount realized and basis in euros. Under paragraph (a)(1)(ii) of this section, the amount realized is translated into dollars at the yearly average exchange rate for 2009 as provided in paragraph (b)(2)(ii)(A) of this section (€10,000 x $1.05 = $10,500) and the basis at the convention rate for 2007 as provided in paragraph (b)(2)(ii)(B) of this section and §1.987-1(c)(3) (€8,000 x $1 = $8,000). Accordingly, the amount of gain reported by U.S. Corp on the sale of the land is $2,500 ($10,500 - $8,000).

Example 4. The facts are the same as in Example 3 except that U.S. Corp properly elects under paragraph (b)(1) of this section to use the spot rate to translate items of income, gain, deduction or loss. Accordingly, the amount realized will be translated at the convention rate on the day of sale. Assume that the convention rate for November 2009 is €1=$1.08. Under these facts, the amount realized is $10,800 (€10,000 x $1.08) and the basis on the day of purchase $8,000 (€8,000 x $1.00). The amount of gain reported by U.S. Corp on the sale of the land is $2,800 ($10,800 - $8,000).

Example 5.The facts are the same as in Example 1 except that on September 15, 2009, French DE provides services to an unrelated customer and receives a cash payment of €2,000 on that day. Under paragraph (b)(1) of this section, U.S. Corp translates the €2,000 item of income into dollars at the yearly average exchange rate of €1= $1.05. Accordingly, U.S. Corp will report income of $2,100 from providing services.

Example 6. The facts are the same as in Example 5 except that U.S. Corp properly elects under paragraph (b)(1) of this section to use the spot rate to translate items of income, gain, deduction or loss. Assume that the convention rate for September 2009 is €1=$1.06. Under these facts, U.S. Corp translates the €2,000 item of income into dollars at the convention rate of €1=$1.06. Accordingly, U.S. Corp will report income of $2,120 from providing services.

Example 7. The facts are the same as in Example 1 except that on March 31, 2009, French DE incurs €500 of rental expense, €300 of salary expense and €100 of utilities expense. Under paragraph (b)(1) of this section, U.S. Corp translates these items of expense at the yearly average exchange rate of €1=$1.05. Accordingly the expenses are translated as follows: rental expense of $525, salary expense of $315 and utilities expense of $105.

Example 8. The facts are the same as in Example 7 except that U.S. Corp properly elects under paragraph (b)(1) of this section to use the spot rate to translate items of income and expense. Assume that the convention rate for March 2009 is €1=$1.03. Under these facts, U.S. Corp translates the €500 of rental expense, €300 of salary expense and €100 of utilities expense at the convention rate of €1=$1.03. Accordingly, the expenses are translated as follows: rental expense of $515, salary expense of $309 and utilities expense of $103.

Example 9. The facts are the same as in Example 1 except that during 2009, French DE incurred €100 of depreciation expense with respect to a truck. The truck was purchased on January 15, 2008, when the convention rate was €1=$1.02.Under paragraph (b)(2)(i) of this section, the €100 of depreciation is translated into dollars at the historic exchange rate. Since U.S. Corp has properly elected to use a spot rate convention, depreciation will be translated in accordance with the convention. Accordingly, U.S. Corp translates the €100 of depreciation to equal $102.

Example 10. (i) The facts are the same as in Example 1 except that on January 12, 2009, French DE performed services for a U.K. person and received £10,000 in compensation. The exchange rate on January 12, 2009, was £1=€1.25. Under paragraph (d) of this section, French DE will translate such income into euros at the spot rate on January 12, 2009. Accordingly, French DE will take into account €12,500 of income from services in 2009. Under paragraph (b)(1) of this section, U.S. Corp translates the €12,500 item of income into dollars at the yearly average euro to dollar exchange rate. Assume that such exchange rate is €1=$1.10. Accordingly, U.S. Corp translates the €12,500 income from services to equal $13,750.

(ii) On October 16, 2009, French DE disposes of the £10,000 for €10,000. Under section 988(c)(1)(C), the disposition is a section 988 transaction. Under §1.988-2(a)(2), French DE will realize a loss of €2,500 (€10,000 amount realized less €12,500 basis). Under paragraph (b)(1) of this section, U.S. Corp translates the €2,500 loss into dollars at the yearly average euro to dollar exchange rate. Assume that such exchange rate is €1=$1.05. Accordingly, U.S. Corp translates the €2,500 section 988 loss to equal $2,625.

(a) In general. The net unrecognized section 987 gain or loss of a section 987 QBU shall be determined by the owner annually as provided in paragraph (b) of this section in the owner’s functional currency. Only assets and liabilities reflected on the books and records of the section 987 QBU under §1.987-2(b) shall be taken into account.

(b) Calculation of net unrecognized section 987 gain or loss of a section 987 QBU. Net unrecognized section 987 gain or loss of a section 987 QBU for a taxable year shall equal the sum of—

(1) The section 987 QBU’s net accumulated unrecognized section 987 gain or loss for all prior taxable years to which these regulations apply as determined in paragraph (c) of this section; and

(2) The section 987 QBU’s unrecognized section 987 gain or loss for the current taxable year as determined in paragraph (d) of this section.

(c) Net accumulated unrecognized section 987 gain or loss for all prior taxable years.A section 987 QBU’s net accumulated unrecognized section 987 gain or loss for all prior taxable years is the aggregate of the amounts determined under paragraph (d) of this section for all prior years to which these regulations apply, reduced by the amounts taken into account under §1.987-5 upon a remittance for all such prior taxable years. This amount shall include amounts appropriately considered as net unrecognized exchange gain or loss under the transition rules of §1.987-10.

(d) Calculation of unrecognized section 987 gain or loss of a section 987 QBU for a taxable year. The unrecognized section 987 gain or loss of a section 987 QBU for a taxable year shall be determined under paragraphs (d)(1) through (7) of this section as follows:

(1) Step 1: Determine the change in the owner functional currency net value of the section 987 QBU for the taxable year—(i) In general. The change in the owner functional currency net value of the section 987 QBU for the taxable year shall equal—

(A) The owner functional currency net value of the section 987 QBU, determined in the functional currency of the owner under paragraph (e) of this section, on the last day of the current taxable year; less

(B) The owner functional currency net value of the section 987 QBU, determined in the functional currency of the owner under paragraph (e) of this section on the last day of the preceding taxable year. This amount shall be zero in the case of the QBU’s first taxable year.

(ii) Year section 987 QBU is terminated. If a section 987 QBU is terminated under the rules of §1.987-8 during an owner’s taxable year, the owner functional currency net value of the section 987 QBU as provided in paragraph (d)(1)(i)(A) of this section shall be determined on the day the section 987 QBU is terminated.

(2) Step 2: Increase the aggregate amount determined in step 1 by the assets transferred from the section 987 QBU to its owner—(i) In general. The aggregate amount determined in paragraph (d)(1) of this section shall be increased by the total amount of assets described in paragraph (d)(2)(ii) of this section transferred from the section 987 QBU to the owner during the taxable year translated into the owner’s functional currency as provided in paragraph (d)(2)(iii) of this section.

(ii) Assets transferred from the section 987 QBU to the owner during the taxable year. The assets transferred from the section 987 QBU to the owner for the taxable year shall equal the aggregate of—

(A) The amount of the section 987 QBU’s functional currency and the adjusted basis of any section 987 marked asset (as defined in §1.987-1(d)) transferred from the section 987 QBU to the owner during the taxable year determined in the functional currency of the section 987 QBU and translated into the owner’s functional currency as provided in paragraph (d)(2)(iii)(A) of this section; and

(B) The adjusted basis of any section 987 historic asset (as defined in §1.987-1(e)) transferred to the owner during the taxable year determined in the functional currency of the section 987 QBU and translated into the owner’s functional currency as provided in paragraph (d)(2)(iii)(B) of this section. Such amount shall be adjusted to take into account the proper translation of depreciation, depletion and amortization as provided in §1.987-3(b)(2)(i).

(iii) Translation of amounts transferred from the section 987 QBU to the owner. In the case of a transfer from the section 987 QBU to an owner of any asset the following exchange rates shall be used:

(A) In the case of an amount described in paragraph (d)(2)(ii)(A) of this section, the spot exchange rate, as defined in §1.987-1(c)(1), on the day of transfer.

(B) In the case of a transfer of a section 987 historic asset, the historic exchange rate for such asset as defined in §1.987-1(c)(3).

(3) Step 3: Decrease the aggregate amount determined in steps 1 and 2 by the owner’s transfers to the section 987 QBU—(i) In general. The aggregate amount determined in paragraphs (d)(1) and (d)(2) of this section shall be decreased by the total amount of assets transferred from the owner to the section 987 QBU during the taxable year determined in the functional currency of the owner as provided in paragraph (d)(3)(ii) of this section.

(ii) Total of all amounts transferred from the owner to the section 987 QBU during the taxable year. The total amount of assets transferred from the owner to the section 987 QBU for the taxable year shall equal the aggregate of—

(A) The total amount of functional currency of the owner transferred to the section 987 QBU during the taxable year; and

(B) The adjusted basis, determined in the functional currency of the owner, of any asset transferred to the section 987 QBU during the taxable year (after taking into account §1.988-1(a)(10)).

(4) Step 4: Decrease the aggregate amount determined in steps 1 through 3 by the amount of liabilities transferred from the section 987 QBU to the owner. The aggregate amount determined in paragraphs (d)(1) through (d)(3) of this section shall be decreased by the aggregate amount of liabilities transferred from the section 987 QBU to the owner. The amount of such liabilities shall be translated into the functional currency of the owner at the spot exchange rate, as defined in §1.987-1(c)(1), on the day of transfer.

(5) Step 5: Increase the aggregate amount determined in steps 1 through 4 by amount of liabilities transferred from the owner to the section 987 QBU. The aggregate amount determined in paragraphs (d)(1) through (d)(4) of this section shall be increased by the aggregate amount of liabilities transferred by the owner to the section 987 QBU. The amount of such liabilities shall be translated into the functional currency of the owner, if required, at the spot exchange rate, as defined in §1.987-1(c)(1)(i) and (ii), on the day of transfer.

(6) Step 6: Increase the aggregate amount determined in steps 1 through 5 by the section 987 taxable loss of the section 987 QBU for the taxable year. In the case of a section 987 taxable loss of the section 987 QBU computed under §1.987-3 for the taxable year, the aggregate amount determined in paragraphs (d)(1) through (d)(5) of this section shall be increased by such section 987 taxable loss.

(7) Step 7: Decrease the aggregate amount determined in steps 1 through 5 by the section 987 taxable income of the section 987 QBU for the taxable year. In the case of section 987 taxable income of the section 987 QBU computed under §1.987-3 for the taxable year, the aggregate amount determined in paragraphs (d)(1) through (d)(5) of this section shall be decreased by such section 987 taxable income.

(e) Determination of the owner functional currency net value of a section 987 QBU—(1) In general. The owner functional currency net value of a section 987 QBU on the last day of a taxable year shall equal the aggregate amount of the QBU’s functional currency and the basis of each asset on the section 987 QBU’s balance sheet on that day, less the aggregate amount of each liability on the section 987 QBU’s balance sheet on that day translated, if necessary, into the owner’s functional currency as provided in paragraph (e)(2) of this section. Such amount shall be determined as follows:

(i) The owner, or section 987 QBU on behalf of the owner, shall prepare a balance sheet for the relevant date from the section 987 QBU’s books and records (within the meaning of §1.989(a)-1(d)) as recorded in the section 987 QBU’s functional currency showing all assets and liabilities reflected on such books and records as provided in §1.987-2(b). Assets and liabilities denominated in the functional currency of the owner shall be reflected on the balance sheet in the owner’s functional currency.

(ii) The owner, or section 987 QBU on behalf of the owner, shall make adjustments necessary to conform the items reflected on the balance sheet described in paragraph (e)(1)(i) of this section to United States generally accepted accounting principles and tax accounting principles.

(iii) The owner, or section 987 QBU on behalf of the owner, shall translate the asset and liability amounts on the adjusted balance sheet described in paragraph (e)(1)(ii) of this section into the functional currency of the owner in accordance with paragraph (e)(2) of this section. Assets and liabilities denominated in the functional currency of the owner are not translated.

(2) Translation of balance sheet items into the owner’s functional currency. The amount of the section 987 QBU’s functional currency, the basis of an asset, or the amount of a liability (other than an asset or liability reflected on the balance sheet in the functional currency of the owner) shall be translated as follows:

(i) Section 987 marked item. A section 987 marked item as defined in §1.987-1(d) shall be translated into the owner’s functional currency at the spot exchange rate as defined in §1.987-1(c)(1)(i) and (ii) on the last day of the taxable year.

(ii) Section 987 historic item. A section 987 historic item as defined in §1.987-1(e) shall be translated into the owner’s functional currency at the historic exchange rate as defined in §1.987-1(c)(3).

(f) Examples. The provisions of this section are illustrated by the following examples. Unless otherwise indicated, all items are assumed to be reflected on the books and records, within the meaning of §1.987-2(b), of the relevant section 987 QBU.

Example 1. (i) U.S. Corp is a calendar year domestic corporation with the dollar as its functional currency. On July 1, 2009, U.S. Corp establishes Japan Branch that has the yen as its functional currency. Japan Branch is a section 987 QBU of U.S. Corp. U.S. Corp properly elects to use a spot rate convention under §1.987-1(c)(1)(ii) with respect to Japan Branch. Under this convention, the spot rate for any transaction occurring during a month is the spot rate on the first day of the month. U.S. Corp also elects under §1.987-3(b)(1) to use this convention to translate items of income, gain, deduction, or loss into dollars. On July 1, 2009, when $1 = ¥100 (or ¥1 = $0.01), U.S. Corp transfers $1,000 to Japan Branch and raw land with a basis of $500. Japan Branch immediately purchases ¥100,000 with the $1,000. On the same day, Japan Branch borrows ¥10,000. Assume that for the taxable year 2009, Japan Branch earns ¥2,000 per month (total of ¥12,000 for the six month period from July 1, 2009, through December 31, 2009) for providing services and incurs ¥333.33 per month (total of ¥2,000 when rounded for the six month period from July 1, 2009, through December 31, 2009) of related expenses. Assume that all items of income earned and expenses incurred by Japan Branch during 2009 are received and paid, respectively, in yen. Further, assume that the ¥12,000 of income when properly translated under the monthly convention equals $109.08 and that the ¥2,000 of related expenses equal $18.18. Thus, Japan Branch’s income translated into dollars equals $90.90. Assume that the spot exchange rate on the December 1, 2009, is $1=¥120 (¥1= $0.00833).

(ii) Under paragraph (a) of this section, U.S. Corp must compute the net unrecognized section 987 gain or loss of Japan Branch for 2009. Since this is Japan Branch’s first taxable year, the net unrecognized section 987 gain or loss as defined under paragraph (b) of this section is the branch’s unrecognized section 987 gain or loss for 2009 as determined in paragraph (d) of this section. The calculation under paragraph (d) of this section is made as follows:

(iii) Step 1. Under paragraph (d) of this section, U.S. Corp must determine the change in the owner functional currency net value of Japan Branch for the year 2009 in dollars. The change in the owner functional currency net value of Japan Branch for 2009 is equal to the owner functional currency net value of Japan Branch determined in dollars on the last day of 2009, less the owner functional currency net value of Japan Branch determined in dollars on the last day of the preceding taxable year.

(A) The owner functional currency net value of Japan Branch determined in dollars on the last day of the current taxable year is determined under paragraph (e) of this section. Such amount is the aggregate of the basis of each asset on Japan Branch’s balance sheet on December 31, 2009, less the aggregate of the amount of each liability on the Japan Branch’s balance sheet on that day, translated into dollars as provided in paragraph (e)(2) of this section.

(B) For this purpose, Japan Branch will show the following assets and liabilities on its balance sheet for December 31, 2009:

(1) Cash of ¥120,000 [($1,000 transferred and immediately converted to ¥100,000) + ¥10,000 borrowed + ¥12,000 income from services - ¥2,000 of expenses].

(2) Raw land with a basis of ¥50,000.

(3) Liabilities of ¥10,000.

(C) Under paragraph (e)(2) of this section, U.S. Corp will translate these items as follows. The cash of ¥120,000 is a section 987 marked asset and the ¥10,000 liability is a section 987 marked liability as defined in §1.987-1(d). These items are translated into dollars on December 31, 2009, using the spot rate on December 1, 2009 of ¥1=$0.00833. The raw land is a section 987 historic asset as defined in §1.987-1(e) and is translated into the dollars at the convention rate for the day of transfer (¥1= $0.01). Thus, the owner functional currency net value of Japan Branch on December 31, 2009, in dollars is $1,416.60 determined as follows:

(D) Under paragraph (d)(1) of this section, the change in owner functional currency net value of Japan Branch for 2009 is equal to the owner functional currency net value of the branch determined in dollars on December 31, 2009 ($1,416.30) less the owner functional currency net value of the branch determined in dollars on the last day of the preceding taxable year. Since this is the first taxable year of Japan Branch, the owner functional currency net value of Japan Branch determined in dollars on the last day of the preceding taxable year is zero under paragraph (d)(1)(i)(B) of this section. Accordingly, the change in owner functional currency net value of Japan Branch for 2009 is $1,416.30.

(iv) Step 2. Under paragraph (d)(2) of this section, the aggregate amount determined in paragraph (d)(1) of this section (step 1) is increased by the total amount of assets described in paragraph (d)(2)(ii) of this section transferred from the section 987 QBU to the owner during the taxable year translated into the owner’s functional currency as provided in paragraph (d)(2)(iii) of this section. Since no such amounts were transferred under these facts, there is no change in the $1,416.30 determined in step 1.

(v) Step 3. Under paragraph (d)(3) of this section, the aggregate amount determined in paragraphs (d)(1) and (2) of this section (steps 1 - 2) is decreased by the total amount of assets transferred from the owner to the section 987 QBU during the taxable year as determined in paragraph (d)(3)(ii) of this section in dollars. On July 1, 2009, U.S. Corp transferred to Japan Branch $1,000 (which Japan Branch immediately converted into ¥100,000) and raw land with a basis of $500 (equal to ¥50,000 on the day of transfer). Thus, the step 2 amount of $1,416.30 is reduced by $1,500.00 to equal ($83.70).

(vi) Steps 4, 5 and 6. Since no liabilities were transferred by U.S. Corp to Japan Branch or vice versa, the amount determined after applying paragraphs (d)(1) through (d)(5) of this section is ($83.70). Further, paragraph (d)(6) of this section does not apply since Japan Branch does not have a section 987 taxable loss.

(vii) Step 7. Under paragraph (d)(7) of this section, the aggregate amount determined after applying paragraphs (d)(1) through (d)(5) of this section (steps 1-5) is decreased by the section 987 taxable income of Japan Branch of $90.90. Accordingly, the unrecognized section 987 loss of Japan Branch for 2009 is $174.60 (-$83.70 - $90.90).

Example 2. (i) U.S. Corp, a calendar year domestic corporation with the dollar as its functional currency, operates in the United Kingdom through UK Branch. UK Branch has the pound as its functional currency and is a section 987 QBU. U.S. Corp properly elects to use a spot rate convention under §1.987-1(c)(1)(ii). Under this convention, the spot rate for any transaction occurring during a month is the average of the pound spot rate and the 30-day forward rate for pounds on the next-to-last Thursday of the preceding month. Pursuant to §1.987-3(b)(1), U.S. Corp uses the yearly average exchange rate as defined in §1.987-1(c)(2) to translate items of income, gain, deduction, or loss into dollars for the taxable year, where appropriate. The yearly average exchange rate for 2009 was £1 = $1.05. The closing balance sheet of UK Branch for the prior year (2008) reflected the following assets and liabilities. With respect to assets, UK Branch held—

(A) Cash of £100;

(B) Plant purchased in May 2007 with an adjusted basis of £1000;

(C) A machine purchased in May 2007 with an adjusted basis of £200;

(D) Inventory of 100 units manufactured in December 2008 with a basis of £100;

(E) Portfolio stock (as defined in §1.987-2(b)(2)(ii)) in ABC Corporation purchased in September 2008 with a basis of £158; and

(F) $50 acquired in 2008 (and held in a non-interest bearing account).

With respect to liabilities, UK Branch has £50 of long-term debt entered into in 2007 with F Bank, an unrelated bank. The plant, machine, inventory, stock and dollars are section 987 historic assets as defined in §1.987-1(e). The cash of £100 and long-term debt are section 987 marked items as defined under §1.987-1(d). Assume the U.S. Corp translated UK Branch’s 2008 closing balance sheet as follows:

(ii) UK Branch uses the first in first out method of accounting for inventory. In 2009, UK Branch sold 100 units of inventory for a total of £300 and purchased another 100 units of inventory in December 2009 for £100. Assume that the dollar basis of the inventory purchased in December 2009 when translated at the December 2009 monthly convention rate is $110; that depreciation with respect to the plant is £33 and for the machine £40^[4]; and that UK Branch incurred £30 of business expenses during 2009. Assume all items of income earned and expenses incurred during 2009 are received and paid, respectively, in pounds. The yearly average exchange rate for 2009 is £1 = $1.05. Under §1.987-3, UK Branch’s section 987 taxable income or loss is determined as follows:

(iii) Assume that in December 2009, UK Branch transferred $20 and £30 to U.S. Corp and that U.S. Corp transferred a computer with a basis of $10 to UK Branch. The convention exchange rate for December 2009 is £1 = $1.10. Finally, assume that U.S. Corp’s net accumulated unrecognized section 987 gain or loss for all prior taxable years as determined in paragraph (c) of this section is $30.

(iv) The unrecognized section 987 gain or loss of UK Branch for 2009 is determined as follows:

(A) Step 1: Determine the change in owner functional currency net value of UK Branch. Under paragraph (d)(1) of this section, the change in owner functional currency net value for the taxable year must be determined. This amount is equal to the owner functional currency net value of UK Branch determined under paragraph (e) of this section on the last day of 2009, less the owner functional currency net value of UK Branch determined on the last day of 2008. The owner functional currency net value of UK Branch on December 31, 2009, and the change in owner functional currency net value is determined as follows:

(B) Step 2: Increase the aggregate amount described in step 1 by each owner’s share of assets transferred by the section 987 QBU to its owners. Under paragraph (d)(2) of this section, the aggregate amount determined in step 1 must be increased by the total amount of assets described in paragraph (d)(2)(ii) of this section transferred from UK Branch to U.S. Corp during the taxable year, translated into U.S. Corp’s functional currency as provided in paragraph (d)(2)(iii) of this section. The amount of assets transferred from UK Branch to U.S. Corp during 2009 is determined as follows:

(C) Step 3: Decrease the aggregate amount described in steps 1 and 2 by the owner’s transfers to the section 987 QBU. Under paragraph (d)(3) of this section, the aggregate amount determined in steps 1 and 2 must be decreased by the total amount of all assets transferred from U.S. Corp to UK Branch during the taxable year as determined in paragraph (d)(3)(ii) of this section. The amount of assets transferred from U.S. Corp to UK Branch is determined as follows:

(D) Step 4: Decrease the aggregate amount determined in steps 1 through 3 by the amount of liabilities transferred by the section 987 QBU to the owner. Under paragraph (d)(4) of this section, the aggregate amount determined in steps 1 through 3 must be decreased by the aggregate amount of liabilities transferred by UK Branch to U.S. Corp. Under these facts, such amount is $0.

(E) Step 5: Increase the aggregate amount determined in steps 1 through 4 by the amount of liabilities transferred by the owner to the section 987 QBU. Under paragraph (d)(5) of this section, the aggregate amount determined in steps 1 through 4 must be increased by the aggregate amount of liabilities transferred by U.S. Corp to UK Branch. Under these facts, such amount is $0.

(F) Step 6: Increase the aggregate amount determined in steps 1 through 5 by the section 987 taxable loss of the section 987 QBU for the taxable year. Under paragraph (d)(6) of this section, the aggregate amount determined in steps 1 through 5 must be increased by the section 987 taxable loss of UK Branch. Since UK Branch had no such taxable loss in 2009, paragraph (d)(6) of this section does not apply.

(G) Step 7: Decrease the aggregate amount determined in steps 1 through 5 by the section 987 taxable income of the section 987 QBU for the taxable year. Under paragraph (d)(7) of this section, the aggregate amount determined in steps 1 through 5 must be decreased by the section 987 taxable income of UK Branch. The amount of UK Branch’s taxable income, as determined above, is $117.80.

(v) Summary. Taking steps 1 through 7 into account, the amount of U.S. Corp’s unrecognized section 987 gain or loss with respect to UK Branch in 2009 is computed as follows:

Thus, U.S. Corp’s unrecognized section 987 gain in 2009 with respect to UK Branch is $18.50. As of the end of 2009, before taking into account the recognition of any section 987 gain or loss under §1.987-5, U.S. Corp’s net unrecognized section 987 gain is $48.50 (i.e., $30 accumulated from prior years, plus $18.50 in 2009).

(a) Recognition of section 987 gain or loss by the owner of a section 987 QBU. The taxable income of an owner of a section 987 QBU shall include the owner’s section 987 gain or loss recognized with respect to the section 987 QBU for the taxable year. For any taxable year, the owner’s section 987 gain or loss recognized with respect to a section 987 QBU shall be equal to—

(1) The owner’s net unrecognized section 987 gain or loss of the section 987 QBU determined under §1.987-4 on the last day of such taxable year (or, if earlier, on the day the section 987 QBU is terminated under §1.987-8); multiplied by

(2) The owner’s remittance proportion for the taxable year, as determined under paragraph (b) of this section.

(b) Remittance proportion. The owner’s remittance proportion with respect to a section 987 QBU for a taxable year is the quotient, equal to—

(1) The remittance, as determined under paragraph (c) of this section, to the owner from the section 987 QBU for such taxable year; divided by

(2) The total adjusted basis of the gross assets of the section 987 QBU as of the end of the taxable year (or, if terminated prior to the end of such taxable year under §1.987-8, the day of termination) that are reflected on its year-end balance sheet (or, if terminated prior to the end of such taxable year under §1.987-8, the balance sheet on the day terminated), translated into the owner’s functional currency as provided in §1.987-4(e)(2) and increased by the amount of the remittance.

(c) Remittance—(1) Definition. A remittance shall be determined in the owner’s functional currency and shall equal the excess, if any, of—

(i) The total of all amounts transferred from the section 987 QBU to the owner during the taxable year, as determined in paragraph (d) of this section; over

(ii) The total of all amounts transferred from the owner to the section 987 QBU during the taxable year, as determined in paragraph (e) of this section.

(2) Day when a remittance is determined. An owner’s remittance from a section 987 QBU shall be determined on the last day of the owner’s taxable year (or, if earlier, on the day the section 987 QBU is terminated under §1.987-8).

(3) Termination. A termination of a section 987 QBU as determined under §1.987-8 is treated as a remittance of all the gross assets of the section 987 QBU to the owner on the date of such termination. See §1.987-8(d). Accordingly, the remittance proportion in the case of a termination is 1.

(d) Total of all amounts transferred from the section 987 QBU to the owner for the taxable year. For purposes of paragraph (c)(1)(i) of this section, the total of all amounts transferred from the section 987 QBU to the owner for the taxable year shall be determined in the owner’s functional currency under §1.987-4(d)(2) with reference to the adjusted basis of the assets transferred. Solely for this purpose, the amount of liabilities transferred from the owner to the section 987 QBU determined under §1.987-4(d)(5) shall be treated as a transfer of assets from the section 987 QBU to the owner in an amount equal to the amount of such liabilities.

(e) Total of all amounts transferred from the owner to the section 987 QBU for the taxable year. For purposes of paragraph (c)(1)(ii) of this section, the total of all amounts transferred from the owner to the section 987 QBU for the taxable year shall be determined in the owner’s functional currency under §1.987-4(d)(3) with reference to the adjusted basis of the assets transferred. Solely for this purpose, the amount of liabilities transferred from the section 987 QBU to the owner determined under §1.987-4(d)(4) shall be treated as a transfer of assets from the owner to the section 987 QBU in an amount equal to the amount of such liabilities.

(f) Determination of owner’s adjusted basis in transferred assets—(1) In general. The owner’s adjusted basis in an asset received in a transfer from the section 987 QBU (whether or not such transfer is made in connection with a remittance as defined in paragraphs (c) of this section) shall be determined under the rules prescribed in paragraphs (f)(2) through (f)(4) of this section.

(2) Section 987 marked asset. The basis of a section 987 marked asset shall be determined in the owner’s functional currency and shall be the same as the amount determined under §1.987-4(d)(2)(ii)(A).

(3) Section 987 historic asset. The basis of a section 987 historic asset shall be determined in the owner’s functional currency and shall be the same as the amount determined under §1.987-4(d)(2)(ii)(B).

(4) Partner’s adjusted basis in distributed assets. See also section 732 and §1.987-7 for purposes of determining an owner’s adjusted basis of an asset distributed from a section 987 QBU owned indirectly through a section 987 partnership.

(g) Examples. The following examples illustrate the calculation of section 987 gain or loss under this section:

Example 1. (i) U.S. Corp, a calendar year domestic corporation with the dollar as its functional currency, operates in the U.K. through U.K. DE, an entity disregarded as an entity separate from its owner under §§301.7701-1 through 301.7701-3 of this chapter. U.K. DE has a section 987 branch (U.K. section 987 branch) with the pound as its functional currency. During year 2, the following transfers took place between U.S. Corp and U.K. section 987 branch. On January 5, year 2, U.S. Corp transferred to U.K. section 987 branch $300 (which the branch used during the year to purchase services). On March 5, year 2, U.K. section 987 branch transferred a machine to U.S. Corp. Assume that the pound adjusted basis of the machine when properly translated into dollars under §§1.987-4(d)(2)(ii)(B) and paragraph (d) of this section is $500. On November 1, year 2, U.K. section 987 branch transferred pound cash to U.S. Corp. Assume that the dollar amount of the pounds when properly translated under §1.987-4(d)(2)(ii)(A) and paragraph (d) of this section is $2,300. On December 7, year 2, U.S Corp transferred a truck to U.K. section 987 branch with an adjusted basis of $2,000.

(ii) Assume that at the end of year 2, U.K. section 987 branch holds assets, properly translated into the owner’s functional currency pursuant to §1.987-4(e)(2), consisting of a computer with a pound adjusted basis equivalent to $500, a truck with a pound adjusted basis equivalent to $2,000, and pound cash equivalent to $2,850. In addition, assume that U.K. section 987 branch has a pound liability entered into in year 1 with Bank A. The liability, when translated into the owner functional currency pursuant to §1.987-4(e)(2), is equivalent to $200. All such assets and liabilities are reflected on the books and records of U.K. section 987 branch. Assume that the net unrecognized section 987 gain for U.K. section 987 branch as determined under §1.987-4 as of the last day of year 2 is $80.

(iii) U.S. Corp’s section 987 gain with respect to U.K. section 987 branch is determined as follows:

(A) Computation of amount of remittance. Under paragraphs (c)(1) and (2) of this section, U.S. Corp must determine the amount of the remittance for year 2 in the owner’s functional currency (dollars) on the last day of year 2. The amount of the remittance for year 2 is $500, determined as follows:

(B) Computation of branch gross assets plus remittance. Under paragraph (b)(2) of this section, U.K. section 987 branch must determine the total basis of its gross assets that are reflected on its year-end balance sheet translated into the owner’s functional currency, and must increase this amount by the amount of the remittance.

(C) Computation of remittance proportion. Under paragraph (b) of this section, U.K. section 987 branch must compute the remittance proportion as follows:

(D) Computation of section 987 gain or loss. The amount of U.S. Corp’s section 987 gain or loss that must be recognized with respect to U.K. section 987 branch is determined under paragraph (a) of this section.

Example 2. U.S. Corp, a calendar year domestic corporation with the dollar as its functional currency, operates in the U.K. through U.K. DE, an entity disregarded as an entity separate from its owner. U.K. DE has a section 987 branch (U.K. section 987 branch) with the pound as its functional currency. During year 2, the following transfers took place between U.S. Corp and U.K. section 987 branch. On March 1, year 2, U.S. Corp transferred to U.K. section 987 branch a computer with a basis of $100. On November 1, year 2, U.K. section 987 branch transferred pounds to U.S. Corp. Assume that the dollar amount of the pounds when properly translated under §1.987-4(d)(2)(ii)(A) and paragraph (d) of this section is $300. On the same day, U.K. section 987 branch transferred $20 to U.S. Corp.

(ii) Assume that at the end of year 2, U.K. section 987 branch holds assets translated (as necessary) into the owner functional currency pursuant to §1.987-4(e)(2) consisting of a plant with a pound adjusted basis equivalent $1,000, pound cash equivalent to $100, a machine with a pound adjusted basis equivalent to $200, portfolio stock (within the meaning of §1.987-2(b)(2)(ii)) in ABC Corporation with a pound adjusted basis equivalent to $150, inventory of 100 units with an aggregate pound adjusted basis equivalent to $100 and a computer with a pound adjusted basis equivalent to $100. In addition, assume that U.K. section 987 branch has a pound liability that it entered into with Bank A in year 1. When properly translated into dollars pursuant to §1.987-4(e)(2) the principal amount of the liability is equal to $500. All such assets and liabilities are reflected on the books and records of U.K. section 987 branch. Assume that the net unrecognized 987 gain for U.K. section 987 branch as determined under §1.987-4 as of the last day of year 2 is $100.

(iii) U.S. Corp’s section 987 gain with respect to U.K. section 987 branch is determined as follows:

(A) Computation of amount of remittance. Under paragraphs (c)(1) and (2) of this section, U.S. Corp must determine the amount of the remittance for year 2 in the owner’s functional currency on the last day of year 2. The amount of the remittance for year 2 is $220 determined as follows:

(B) Computation of branch gross assets plus remittance. Under paragraph (b)(2) of this section, U.K. section 987 branch must determine the total basis of its gross assets as are reflected on its year-end balance sheet translated into dollars and must increase this amount by the amount of the remittance.

(C) Computation of remittance proportion. Under paragraph (b) of this section, UK section 987 branch must compute the remittance proportion as follows.

(D) Computation of section 987 gain or loss. The amount of U.S. Corp’s section 987 gain or loss that must be recognized with respect to U.K. section 987 branch is determined under paragraph (a) of this section.

(a) Ordinary income or loss. Section 987 gain or loss is ordinary income or loss for Federal income tax purposes.

(b) Source and character of section 987 gain or loss—(1) In general. Except as otherwise provided in this section, the owner of a section 987 QBU must determine the source and character of section 987 gain or loss in the year of a remittance under the rules of this paragraph (b) for all purposes of the Internal Revenue Code, including sections 904(d), 907 and 954.

(2) Method required to characterize and source section 987 gain or loss. The owner must use the asset method set forth in §1.861-9T(g) to characterize and source section 987 gain or loss. The modified gross income method described in §1.861-9T(j) cannot be used.

(3) Method required to characterize and source section 987 gain or loss with respect to regulated investment companies and real estate investment trusts. [Reserved].

(c) Example. The following example illustrates the application of this section.

Example. CFC is a controlled foreign corporation as defined in section 957 with the Swiss franc (Sf) as its functional currency. CFC holds all the interest in a section 987 DE as defined in §1.987-1(b)(6)(iii) that has a section 987 branch with significant operations in Germany (German Branch). German Branch has the euro as its functional currency. For the year 2009, CFC recognizes section 987 gain of Sf10,000 under §§1.987-4 and 1.987-5. Applying the rules of this section, German Branch has total average assets of Sf1,000,000 which generate income as follows: Sf750,000 of assets that generate foreign source general limitation income under section 904(d)(1)(I), none of which is subpart F income under section 952; and Sf250,000 of assets that generate foreign source passive income under section 904(d)(1)(B), all of which is subpart F income. Under paragraph (b) of this section, Sf7,500 (Sf750,000/Sf1,000,000 x Sf10,000) of the section 987 gain will be treated as foreign source general limitation income which is not subpart F income and Sf2,500 (Sf250,000/Sf1,000,000 x Sf10,000) will be treated as foreign source passive income which is subpart F income. All of the section 987 gain is treated as ordinary income.

(a) In general. In the case of an owner that is a partner in a section 987 partnership, this section provides rules for determining the owner’s share of assets and liabilities of a section 987 QBU owned indirectly, as described in §1.987-1(b)(4)(ii), through a section 987 partnership. In addition, this section provides rules coordinating these regulations with subchapter K of chapter 1 of the Internal Revenue Code.

(b) Assets and liabilities of an eligible QBU or a section 987 QBU held indirectly through a partnership. A partner’s share of the assets and liabilities reflected under §1.987-2(b) on the books and records of an eligible QBU or a section 987 QBU owned indirectly through a partnership shall be determined in a manner that is consistent with the manner in which the partners have agreed to share the economic benefits and burdens (if any), corresponding to the assets and liabilities, taking into account the rules and principles of sections 701 through 761, and the applicable regulations, including section 704(b) and §1.701-2.

(c) Coordination with subchapter K (1) Partner’s adjusted basis in its partnership interest (i) In general. Except as provided in this paragraph, a partner’s adjusted basis in its section 987 partnership interest shall be maintained in the functional currency of that partner and shall not be adjusted as a result of any fluctuations in the value of the partner’s functional currency and the functional currency of any section 987 QBU owned indirectly through the section 987 partnership.

(ii) Adjustments for section 987 taxable income or loss and section 987 gain or loss—(A) Section 987 taxable income or loss. A partner’s share of the items of income, gain, deduction or loss taken into account in calculating section 987 taxable income or loss of a section 987 QBU, determined under §1.987-3, held indirectly through a section 987 partnership shall be treated as income or loss of the section 987 partnership through which the partner indirectly owns the interest. As a result, the partner’s allocable share of the items of income, gain, deduction or loss taken into account in calculating section 987 taxable income or loss of the section 987 QBU shall be taken into account, following conversion into the partner’s functional currency, in determining the appropriate adjustments to the partner’s adjusted basis in its partnership interest under section 705.

(B) Section 987 gain or loss. Solely for purposes of determining the appropriate adjustments to a partner’s adjusted basis in its interest in a section 987 partnership under section 705, an individual or corporation that owns a section 987 QBU indirectly through a section 987 partnership shall treat any section 987 gain or loss of such section 987 QBU as gain or loss of the section 987 partnership. Any adjustments to the adjusted basis of a partner’s interest in such section 987 partnership required under this paragraph (c)(1)(ii)(B) of this section shall occur prior to determining the effect under the Internal Revenue Code of any sale, exchange, distribution or other event.

(iii) Adjustments for contributions and distributions. For purposes of making adjustments to the partner’s adjusted basis in its interest in a section 987 partnership, as a result of any contributions or distributions (including deemed contributions and distributions under section 752) between the section 987 partnership and the owner of a section 987 QBU owned indirectly through the partnership, such amounts will be taken into account in the owner’s functional currency.

(iv) Determination of deemed distributions and contributions under section 752—(A) Increase in partner’s liabilities. For purposes of determining the amount of any increase in a partner’s share of the liabilities of the partnership, or any increase in the partner’s individual liabilities by reason of the assumption by such partner of a liability of the partnership, which are reflected on the books and records of a section 987 QBU owned indirectly through such partnership and which are denominated in a functional currency different from the partner’s, the amount of such liabilities shall be translated into the functional currency of the partner using the spot rate (as defined in §1.987-1(c)(1)(i) and (ii)) on the date of such increase.

(B) Decrease in partner’s liabilities. For purposes of determining the amount of any decrease in a partner’s share of the liabilities of the partnership which were reflected on the books and records of a section 987 QBU owned indirectly through such partnership and which are denominated in a functional currency different from the partner’s functional currency, the amount of such liabilities shall be translated into the functional currency of the partner using the historic rate (as defined in §1.987-1(c)(3)) for the date on which such liabilities increased the partner’s adjusted basis in its partnership interest under section 752.

(2) Special rule for determining gain or loss on the sale, exchange or other disposition of an interest in a section 987 partnership. For purposes of determining the amount realized by a partner in a section 987 partnership on the sale, exchange, or other disposition of that partner’s interest in such partnership, the amount of liabilities reflected on the books and records of a section 987 QBU (in a functional currency different from such partner) from which that partner is relieved as a result of such disposition, and which are included in the amount realized pursuant to section 752(d), shall be translated into the partner’s functional currency using the historic exchange rate (as determined under §1.987-1(c)(3)) for the date on which such liabilities increased the partner’s adjusted basis in its partnership interest under section 752.

(d) Examples. The purpose of the following examples is to illustrate the application of section 987 to partnerships and their partners. The examples are not meant to be a comprehensive interpretation of the step-by-step computations involved in computing net unrecognized section 987 gain or loss. Thus, for the sake of simplicity, the examples only calculate section 987 gain or loss by reference to certain identified assets and liabilities, rather than by all the assets and liabilities of the section 987 QBU (as is required under these regulations). See §1.987-4 and the examples therein for step-by-step computations for determining the unrecognized section 987 gain or loss of the owner of a section 987 QBU.

Example 1. Computation of an owner’s net unrecognized section 987 gain or loss. (i) Facts. PRS is a partnership which owns QBUx, an eligible QBU, operating in the United Kingdom. QBUx has the pound as its functional currency determined under §1.985-1 taking into account all of QBUx’s activities before application of this section. PRS has two equal partners that are domestic corporations, A and B, each with the U.S. dollar as its functional currency. The portions of QBUx allocated to A and B under paragraph (b) of this section are section 987 QBUs of A and B because under §1.987-1(b)(2), such portions are allocated from an eligible QBU with a different functional currency than A and B, respectively. Assume that PRS has no items of section 987 taxable income or loss for 2007. On January 1, 2007, A and B each contribute $50 to PRS. PRS immediately converts the $100 into £100. The £100 is reflected, in accordance with §1.987-2(b), on the books and records of QBUx. On January 1, 2007, the spot rate is $1 = £1. On December 31, 2007, the spot rate is $1.50 = £1. Pursuant to §1.987-3(b)(1), A and B use the yearly average exchange rate, as defined in §1.987-1(c)(2), to translate items of income, gain, deduction, or loss into dollars for the taxable year. Assume the yearly average exchange rate is $1.25 = £1 ($1 = £.80). Under the PRS partnership agreement, A and B each have an equal interest in all items of partnership income and loss.

(ii) Calculation of net unrecognized section 987 gain or loss. Under paragraph (b) of this section, A and B are each allocated £50 from eligible QBUx. This amount is reflected on the balance sheet of the section 987 QBU of A and B, respectively, for purposes of determining the unrecognized section 987 gain or loss under §1.987-4. Pursuant to §1.987-4(d), the net unrecognized section 987 gain of A’s section 987 QBU and B’s section 987 QBU is $25.

Example 2. Computation of owner’s net unrecognized section 987 gain or loss. (i) Facts. The facts are the same as Example 1, except that in addition to the £100 contributed by A and B, PRS incurred a £50 recourse liability from an unrelated third party on January 1, 2007. The liability and the £50 are both reflected on the books and records of QBUx under §1.987-2(b). Under section 752, and the regulations thereunder, A and B bear the economic risk of loss with respect to the £50 recourse debt equally.

(ii) Calculation of net unrecognized section 987 gain or loss. Under paragraph (b) of this section, A and B are each allocated £75 from QBUx. In addition, under paragraph (b) of this section, A and B are each allocated £25 of the liability of QBUx because the economic burden of such liability, taking into account sections 701 through 761 of the Code, is borne equally by A and B. Under §1.987-4(d), A and B each have net unrecognized section 987 gain of $25.

(iii) Determination of partner’s adjusted basis in PRS. Pursuant to paragraph (c)(1)(i) of this section and section 985(a), A and B must determine the adjusted basis in their PRS partnership interests in U.S. dollars. Under sections 722, 752(a) and paragraph (c)(1)(iv)(A) of this section, the adjusted bases in such interests are increased by the U.S. dollar amount of a deemed contribution determined using the spot rate for the date on which such liability was incurred. Therefore, A and B will increase the adjusted basis in their PRS partnership interests by $25.

Example 3. Computation of owner’s net unrecognized section 987 gain or loss. (i) Facts. The facts are the same as Example 2, except as follows: On January 1, 2007, instead of incurring a £50 recourse liability, PRS incurred a £50 nonrecourse liability from an unrelated third party, which was secured by and used to purchase non-depreciable real property located in the United Kingdom. Under the partnership agreement, A and B agree to share all items of partnership income and loss equally, except that A guaranteed the nonrecourse liability and, in addition, the partnership agreement provides that A will be allocated any gain from the sale or exchange of the non-depreciable property. Further, the partnership agreement provides that in the event the partnership liquidates prior to satisfying the liability, the non-depreciable property shall be distributed to A.

(ii) Calculation of net unrecognized section 987 gain or loss. Under paragraph (b) of this section, A and B are each allocated £50 from eligible QBUx. In addition, because A bears the economic burden of the nonrecourse liability incurred by PRS and the economic benefits of the non-depreciable property securing such liability, both of which are reflected on the books and records of QBUx under §1.987-2(b), A is allocated, for purposes of applying §1.987-4(d), both the £50 liability and the non-depreciable property with an adjusted tax basis of £50. Under §1.987-4(d), A’s net unrecognized section 987 gain is $0, and B’s net unrecognized section 987 gain is $25.

(iii) Determination of partner’s adjusted basis in PRS. Pursuant to paragraph (c)(1)(i) of this section and section 985(a), A and B must determine the adjusted bases in their PRS partnership interests in U.S. dollars. Under sections 722, 752(a) and paragraph (c)(1)(iv) of this section, A’s adjusted basis is increased by the U.S. dollar amount of the deemed contribution determined using the spot rate for the date on which such liability was incurred. Therefore, A will increase the adjusted basis in its PRS partnership interest by $50.

Example 4. Computation of owner’s share of items of section 987 taxable income. (i) Facts. The facts are the same as in Example 1, except that during 2007 PRS earns £50 which are reflected on the books and records of QBUx. In accordance with the partnership agreement, the £50 are allocated equally between A and B.

(ii) Calculation of section 987 taxable income or loss. Under §1.987-3, A and B’s allocable share of the taxable income of QBUx, as determined by PRS, and adjusted to conform to U.S. tax principles, is £25 each. Under §1.987-3, A and B must convert their allocable share of the £25 into U.S. dollars using the yearly average exchange rate for the year, in accordance with §1.987-1(c)(2). As a result, A and B each take into account as their respective distributive share of PRS income $31.25. Under paragraph (c)(1)(ii)(A) of this section, section 985(a) and section 705, such amounts, as reflected in U.S. dollars, will be taken into account in determining any adjustments to the adjusted bases of A’s and B’s partnership interests. In addition, such amounts will be taken into account in calculating, under §1.987-4, the unrecognized section 987 gain or loss of the section 987 QBUs of A and B.

Example 5. Computation of owner’s share of items of section 987 taxable income. (i) Facts. The facts are the same as in Example 4, except A and B agree to allocate the £50 of income to A. Assume for purposes of this example that such allocation has substantial economic effect as provided under section 704(b).

(ii) Calculation of section 987 taxable income or loss. Under §1.987-3, A and B’s allocable share of the taxable income of QBUx, as determined by PRS, and adjusted to conform to U.S. tax principles, is £50 and £0, respectively. Under §1.987-3, A and B must convert their allocable share into U.S. dollars using the yearly average exchange rate for the year, in accordance with §1.987-1(c)(2). As a result, A and B must each take into account as their respective distributive share of PRS income $62.50 and $0, respectively. Under paragraph (c)(1)(ii)(A) of this section, section 985(a) and section 705, such amounts, as reflected in U.S. dollars, will be taken into account in determining any adjustments to the adjusted bases of A’s and B’s respective partnership interests. In addition, such amounts will be taken into account in calculating, under §1.987-4, the unrecognized section 987 gain or loss of the section 987 QBUs of A and B.

Example 6. Election by de minimis partner to not take into account section 987 gain or loss. (i) Facts. The facts are the same as in Example 1, except assume that A owns, directly or indirectly, less than 5% of the total capital and profits interest in PRS and, as a result, is eligible to elect, under §1.987-1(b)(1)(ii) not to apply the provisions of the regulations under section 987 for purposes of taking into account the section 987 gain or loss of A’s section 987 QBU. Assume further that A makes such election. On January 1, 2008, A sells its interest to an unrelated third party, C, for $75.

(ii) Determination of partner’s adjusted basis in PRS. Pursuant to paragraph (c)(1)(i) of this section and section 985(a), A must determine the adjusted basis of its PRS partnership interest in U.S. dollars. A’s basis in PRS is $50, the amount of its contribution to PRS.

(iii) Sale of partnership interest by A. Under section 1001, A’s amount realized on the sale of the partnership interest to C is $75. A’s adjusted basis of its PRS partnership interest is $50, the amount of A’s contribution to PRS, unadjusted by the fluctuations between the pound and the U.S. dollar. A’s gain on the sale of the partnership interest is $25.

(a) Scope. This section provides rules regarding the termination of a section 987 QBU. Paragraph (b) of this section provides general rules for determining when a termination occurs. Paragraph (c) of this section provides exceptions to the general termination rules for certain transactions described in section 381(a). Paragraph (d) of this section provides certain effects of terminations. Paragraph (e) of this section contains examples that illustrate the principles of this section.

(b) In general. Except as provided in paragraph (c) of this section, a section 987 QBU terminates when—

(1) Its activities cease, such that it no longer meets the definition of an eligible QBU as defined in §1.987-1(b)(3);

(2) Substantially all (within the meaning of section 368(a)(1)(C)) of the section 987 QBU’s assets are transferred from such section 987 QBU to its owner, as provided under §1.987-2(c). For purposes of this paragraph (b)(2), the amount of assets transferred from the section 987 QBU to its owner as a result of a transaction (for example, a contribution of property to a DE or a partnership) as provided under §1.987-2(c) shall be reduced by assets that are transferred from the owner to such section 987 QBU, as provided under §1.987-2(c), pursuant to the same transaction;

(3) A foreign corporation that is a controlled foreign corporation (as defined in section 957) that is the owner of a section 987 QBU ceases to be a controlled foreign corporation; or

(4) The owner of such section 987 QBU ceases to exist (including in connection with a transaction described in section 381(a)).

(c) Transactions described in section 381(a)—(1) Liquidations. A termination does not occur when the owner of a section 987 QBU ceases to exist in a liquidation described in section 332, except in the following cases:

(i) The distributor is a domestic corporation and the distributee is a foreign corporation.

(ii) The distributor is a foreign corporation and the distributee is a domestic corporation.

(iii) The distributor and the distributee are both foreign corporations and the functional currency of the distributee is the same as the functional currency of the distributor’s section 987 QBU.

(2) Reorganizations. A termination does not occur when the owner of the section 987 QBU ceases to exist in a reorganization described in section 381(a)(2), except in the following cases:

(i) The transferor is a domestic corporation and the acquiring corporation is a foreign corporation.

(ii) The transferor is a foreign corporation and the acquiring corporation is a domestic corporation.

(iii) The transferor is a controlled foreign corporation immediately before the transfer and the acquiring corporation is a foreign corporation that is not a controlled foreign corporation immediately after the transfer.

(iv) The transferor and the acquiring corporation are foreign corporations and the functional currency of the acquiring corporation is the same as the functional currency of the transferor’s section 987 QBU.

(d) Effect of terminations. A termination of a section 987 QBU as determined in this section is treated as a remittance of all the gross assets of the section 987 QBU to its owner. As a result, any net unrecognized section 987 gain or loss of the section 987 QBU is recognized. See §1.987-5. For purposes of the preceding sentence, the amount of net unrecognized section 987 gain or loss is determined as of the date of termination by closing the books and records of the section 987 QBU on that date.

(e) Examples. The following examples illustrate the principles of this section:

Example 1. Cessation of operations. (i) Facts. DC, a domestic corporation, has a sales office in Country X (Country X Branch) that is a section 987 QBU. DC closes its Country X Branch.

(ii) Analysis. The cessation of the activities of the Country X Branch causes a termination of the section 987 QBU under paragraph (b)(1) of this section.

Example 2. Incorporation of section 987 QBU. (i) Facts. DC, a domestic corporation, has a branch in Country X (Country X Branch) that is a section 987 QBU. DC transfers all the assets and liabilities of Country X Branch to DS, a domestic corporation, in exchange for stock of DS in a transaction qualifying under section 351.

(ii) Analysis. Country X Branch terminates pursuant to paragraph (b)(1) of this section because the Country X Branch ceases to be an eligible QBU of DC.

Example 3. Cessation of controlled foreign corporation status. (i) Facts. DC, a domestic corporation, owns all of the stock of FC, a controlled foreign corporation as defined in section 957. FC has a section 987 QBU. FA, a foreign corporation owned solely by foreign persons, purchases all of the FC stock. FC will not constitute a controlled foreign corporation after the transaction.

(ii) Analysis. Because FC ceases to qualify as a controlled foreign corporation after the sale of the FC stock, FC’s section 987 QBU terminates pursuant to paragraph (b)(3) of this section.

Example 4. Section 332 liquidation. (i) Facts. DC, a domestic corporation, operates in Country X through FC, a wholly-owned foreign corporation organized under the laws of Country X. FC also has a branch in Country Y (Country Y Branch) that is a section 987 QBU. Pursuant to a liquidation described in section 332, FC transfers all of its assets and liabilities to DC.

(ii) Analysis. FC’s liquidation is a termination as provided in paragraph (b)(4) of this section because FC ceases to exist. The exception for certain section 332 liquidations provided under paragraph (c)(1) of this section does not apply because DC is a domestic corporation and FC is a foreign corporation. See paragraph (c)(1)(ii) of this section.

Example 5. Transfers to and from section 987 QBU pursuant to the same transaction. (i) Facts. DC1, a domestic corporation, owns Entity A, a DE. Entity A conducts a business in Country X and that business is an eligible QBU and a section 987 QBU (Country X QBU) of DC1. DC2, a domestic corporation, contributes property to Entity A in exchange for a 95% interest in Entity A. The property DC2 contributes to Entity A is used in the business conducted by the Country X QBU and is reflected on its books and records as provided under §1.987-2(b). Moreover, Entity A is converted to a partnership as a result of the contribution. See Rev. Rul. 99-5 (situation 2), (1999-1 C.B. 434). See §601.601(d)(2) of this chapter. Also, as a result of the contribution, and pursuant to §1.987-2(c)(5), 95% of the assets and liabilities on the books and records of DC1’s section 987 QBU are deemed to be transferred from such QBU to DC1, and DC1 is deemed to transfer to such QBU 5% of the property, as determined under §1.987-7, contributed by DC2 to Entity A.

(ii) Analysis. As a result of the contribution of property from DC2 to Entity A, assets were transferred from DC1’s section 987 QBU to DC1. Similarly, assets were transferred from DC1 to its section 987 QBU as a result of the contribution. Accordingly, for purposes of determining whether substantially all the assets of Country X QBU were transferred from DC1’s section 987 QBU as provided under paragraph (b)(2) of this section, the assets transferred from DC1’s section 987 QBU to DC1 under §1.987-2(c) are reduced by the amount of assets transferred from DC1 to such section 987 QBU pursuant to the contribution.

(a) In general. A taxpayer that is an owner of a section 987 QBU shall keep such reasonable records as are sufficient to establish the QBU’s section 987 taxable income or loss and section 987 gain or loss. See section 987 and section 6001 and the applicable regulations.

(b) Supplemental information. An owner’s obligation to maintain records under section 6001 and paragraph (a) of this section is not satisfied unless the following information is maintained in such records:

(1) The amount of the items of income, gain, deduction or loss attributed to each section 987 QBU of the owner in the functional currency of the section 987 QBU.

(2) The amount of assets and liabilities attributed to each section 987 QBU of the owner in the functional currency of the QBU.

(3) The exchange rates used to translate items of income, gain, deduction or loss of each section 987 QBU into the owner’s functional currency. If a spot rate convention is used, the manner in which such convention is determined.

(4) The exchange rates used to translate the assets and liabilities of each section 987 QBU into the owner’s functional currency. If a spot rate convention is used, the manner in which such convention is determined.

(5) The amount of the items of income, gain, deduction or loss attributed to each section 987 QBU of the owner translated into the functional currency of the owner.

(6) The amount of assets and liabilities attributed to each section 987 QBU of the owner translated into the functional currency of the owner.

(7) The amount of assets and liabilities transferred by the owner to a section 987 QBU determined in the functional currency of the owner.

(8) The amount of assets and liabilities transferred by the section 987 QBU to the owner determined in the functional currency of the owner.

(9) The amount of the unrecognized section 987 gain or loss for the taxable year.

(10) The amount of the net unrecognized section 987 gain or loss at the close of the taxable year.

(11) If a remittance is made, the average tax book value of assets as determined under §1.861-9T(g).

(12) The transition information required to be determined under §1.987-10(c)(2)(v).

(c) Retention of records. The records required by this section must be kept at all times available for inspection by the Internal Revenue Service, and shall be retained so long as the contents thereof may become material in the administration of the Internal Revenue Code.

(a) Scope—(1) In general. These transition rules shall apply to any taxpayer that is an owner of a section 987 QBU pursuant to §1.987-1(b)(4) on the transition date (as defined in paragraph (b) of this section). A taxpayer to whom this section applies must transition from the method previously used by such taxpayer to comply with section 987 (the “prior section 987 method”) to the method prescribed by these regulations pursuant to the rules set forth in paragraph (c) of this section.

(2) Limitation where the prior method was unreasonable. Notwithstanding paragraph (a)(1) of this section, if the prior section 987 method was unreasonable (including the case where the taxpayer failed to make the determinations required under section 987 for any open taxable year), then the taxpayer must apply the rules of paragraph (c)(4) of this section (and cannot apply the rules of paragraph (c)(3) of this section) to transition to the method prescribed by these regulations.

(b) Transition date. The transition date is the first day of the first taxable year to which these regulations apply to a taxpayer.

(c) Transition methods and corresponding rules—(1) In general. Except as provided in paragraph (a)(2) of this section, a taxpayer must transition from its prior method to the method prescribed by these regulations under the “deferral transition method” of paragraph (c)(3) of this section or the “fresh start transition method” of paragraph (c)(4) of this section. If a taxpayer fails to comply with the rules of this section, the Area Director, Field Examination, Small Business/Self Employed or the Director, Field Operations, Large and Mid-Size Business having jurisdiction of the taxpayer’s return for the taxable year shall determine the appropriate transition method.

(2) Conformity rules. The taxpayer (including all members that file a consolidated return that includes that taxpayer), and any controlled foreign corporation as defined in section 957 in which the taxpayer owns more than 50 percent of the voting power or stock (as determined in section 957(a)), must consistently apply the same transition method for each qualified business unit subject to section 987 owned on the transition date.

(3) Deferral transition method—(i) In general. Pursuant to the deferral transition method prescribed by this paragraph (c)(3), section 987 gain or loss must be determined on the transition date under the taxpayer’s prior section 987 method as if all qualified business units of the taxpayer subject to section 987 (taking into account the conformity rules of paragraph (c)(2) of this section) terminated on the last day of the taxable year preceding the transition date. This deemed termination applies solely for purposes of this section. Any section 987 gain or loss determined with respect to a section 987 QBU under the preceding sentence shall not be recognized on the transition date but shall be considered as net unrecognized section 987 gain or loss of the section 987 QBU in the first taxable year for which these regulations are effective (in addition to any net unrecognized section 987 gain or loss otherwise determined for such taxable year). Recognition of net unrecognized section 987 gain or loss determined under the preceding sentence is governed by §1.987-5 for periods after the transition date. The owner of a qualified business unit that is deemed to terminate under these rules is treated as having transferred all of the assets and liabilities attributable to such qualified business unit to a new section 987 QBU on the transition date.

(ii) Translation rates used to determine the amount of assets and liabilities transferred from the owner to the section 987 QBU for the section 987 QBU’s first taxable year beginning on the transition date. The exchange rates used to determine the amount of assets and liabilities transferred from the owner to the section 987 QBU on the transition date (for example, for purposes of making calculations under §1.987-4) under the deferral transition method in this paragraph (c)(3) shall be determined with reference to the historic exchange rates on the day the assets were acquired or liabilities entered into by the qualified business unit deemed terminated, adjusted to take into account any gain or loss determined under paragraph (c)(3)(i) of this section. See Examples 1 and 2 of paragraph (d) of this section.

(4) Fresh start transition method—(i) In general. Pursuant to the fresh start transition method prescribed by this paragraph (c)(4), on the transition date all qualified business units of the taxpayer subject to section 987 (taking into account the conformity rules of paragraph (c)(2) of this section) are deemed terminated on the last day of the taxable year preceding the transition date. This deemed termination applies solely for purposes of this section. No section 987 gain or loss is determined or recognized on such deemed termination. The owner of a qualified business unit that is deemed to terminate under this method is treated as having transferred all of the assets and liabilities attributable to such qualified business unit to a section 987 QBU on the transition date.

(ii) Translation rates used to determine the amount of assets and liabilities transferred from the owner to the section 987 QBU for the section 987 QBU’s first taxable year on the transition date. The exchange rates used to determine the amount of assets and liabilities transferred from the owner to the section 987 QBU on the transition date (for example, for purposes of making calculations under §1.987-4) under the fresh start transition method of this paragraph (c)(4) shall be determined with reference to the historic exchange rates on the day the assets were acquired or liabilities entered into by the qualified business unit deemed terminated. See Example 3 of paragraph (d) of this section.

(5) Double counting prohibited. The transition method used by the taxpayer cannot result in taking into account section 987 gain or loss with respect to an asset or liability attributable to a period prior to the transition date more than once.

(6) Reporting. The taxpayer must attach a statement to its return for the first taxable year beginning on the transition date providing the following information:

(i) A description of each qualified business unit to which these rules apply, the qualified business unit’s owner and its principal place of business, and a description of the prior method used by the taxpayer to determine section 987 gain or loss with respect to such qualified business unit.

(ii) The transition method used by the taxpayer under paragraph (c) of this section for each qualified business unit.

(iii) If the taxpayer uses the deferral transition method prescribed in paragraph (c)(3) of this section with respect to a qualified business unit, an explanation of the method used to determine section 987 gain or loss.

(iv) If the taxpayer uses the deferral transition method prescribed in paragraph (c)(3) of this section with respect to a qualified business unit, the amount treated as net unrecognized section 987 gain or loss under paragraph (c)(3)(i) of this section.

(v) The method used by the taxpayer for determining the exchange rates used to translate the basis of assets and the amount of liabilities of a section 987 QBU into the functional currency of the owner on the transition date as provided in paragraphs (c)(3)(ii) and (c)(4)(ii) of this section for purposes of applying these regulations.

(d) Examples. The principles of this section are illustrated by the following examples:

Example 1. Deferral transition method. (i) US Corp is a domestic corporation with the dollar as its functional currency. US Corp owns UK Branch, a branch with the pound as its functional currency. UK Branch was formed on January 1, 2006. US Corp uses the method prescribed in the 1991 proposed section 987 regulations to determine the section 987 gain or loss of UK Branch. US Corp contributed £6,000 to UK Branch on January 1, 2006. On the same day, UK Branch bought a truck for £4,000 and a computer for £1,000. Assume that the spot rate on January 1, 2006, is £1 = $1. UK Branch had profits determined under §1.987-1(b)(1)(i) through (iii) of the 1991 proposed section 987 regulations of £250 in each taxable year of 2006, 2007, 2008, and 2009. Assume that the average exchange rates used to translate UK Branch’s profits under the 1991 proposed section 987 regulations were as follows: 2006—£1 = $1.10; 2007—£1 = $1.20; 2008—£1 = $1.30; 2009—£1 = $1.40. UK Branch makes no remittances to US Corp in any year. On January 1, 2010, UK Branch transitions to the method provided in §§1.987-1 through 1.987-11 of these regulations pursuant to paragraph (a) of this section. US Corp chooses to use the deferral transition method of paragraph (c)(3) of this section in transitioning from its prior section 987 method (the method set forth in the 1991 proposed section 987 regulations) to the method prescribed in the §§1.987-1 through 1.987-11 of these regulations. The spot rate on December 31, 2009, is £1=$2.

(ii) Pursuant to paragraph (c)(3) of this section, US Corp must determine UK Branch’s section 987 gain or loss on January 1, 2010, using its prior section 987 method (the method prescribed under the 1991 proposed section 987 regulations), as if UK Branch terminated on December 31, 2009. On December 31, 2009, UK Branch has an equity pool of £7,000 and a basis pool of $7,250 determined under the 1991 proposed section 987 regulations based on the following amounts:

(iii) Under paragraph (c)(3)(i) of this section, US Corp does not recognize the $6,750 of section 987 gain determined on the transition date. Instead, the $6,750 will be treated as net unrecognized section 987 gain of UK Branch for 2010 and subsequent years (in addition to any net unrecognized section 987 gain or loss otherwise determined at the close of 2010 and subsequent years). Recognition of net unrecognized section 987 gain or loss is governed by §1.987-5.

(iv) Pursuant to paragraph (c)(3)(ii) of this section, when computing the exchange rates used to determine the amount of assets and liabilities transferred from US Corp to UK Branch on the transition date, US Corp must adjust the historic exchange rates attributable to such assets to take into account UK Branch’s section 987 gain determined under paragraph (c)(3) of this section. Under these facts, where all of UK Branch’s assets are considered to generate deferred section 987 gain, US Corp takes into account this section 987 gain by translating the assets deemed contributed by US Corp to UK Branch on the transition date using the same spot rate it used to determine UK Branch’s section 987 gain on the deemed termination date of December 31, 2009. Accordingly, on January 1, 2010, US Corp translates the assets deemed contributed (cash is segregated for ease of illustration) to UK Branch as follows:

Example 2. Deferral transition method. (i) The facts are the same as in Example 1 except that US Corp and UK Branch use an “earnings only” approach to determine section 987 gain or loss prior to the transition date. Under this approach, US Corp maintains a basis and equity pool for UK Branch’s earnings and a separate basis and equity pool for UK Branch’s capital. Section 987 gain or loss is only recognized on remittances of earnings (but not with respect to capital) under principles similar to those of the 1991 proposed section 987 regulations. Remittances are first considered as distributed from the earnings equity pool and then from the capital equity pool. For purposes of this example, this method is assumed to be a reasonable section 987 method and does not violate §1.987-10(a)(2).

(ii) Using principles similar to those set forth in §1.987-2 of the 1991 proposed section 987 regulations, the earnings equity pool of UK Branch is £1,000 (£250 earned in each taxable year of 2006, 2007, 2008 and 2009) and the corresponding earnings basis pool is $1,250 ($275 in 2006, $300 in 2007, $325 in 2008 and $350 in 2009). The capital equity pool is £6,000 and the corresponding capital basis pool is $6,000 (contributed cash of £6,000 translated to equal $6,000—which US Corp can trace to contributed cash remaining of £1,000 with a translated basis equal to $1,000; a truck of £4,000 with a translated basis equal to $4,000; and a computer of £1,000 with a translated basis equal to $1,000).

(iii) Pursuant to paragraph (c)(3)(i) of this section, US Corp must determine UK Branch’s section 987 gain or loss on January 1, 2010, using its prior section 987 method (the “earnings only” method), as if UK Branch terminated on December 31, 2009. Using principles similar to §1.987-3(h) of the 1991 proposed section 987 regulations with respect to the earnings equity and basis pool, US Corp would determine $750 of section 987 gain as follows:

(iv) Under paragraph (c)(3)(i) of this section, US Corp does not recognize the $750 of section 987 gain determined on the transition date. Instead, the $750 will be treated as net unrecognized section 987 gain of UK Branch for 2010 and subsequent years (in addition to any net unrecognized section 987 gain or loss otherwise determined at the close of 2010 and subsequent years). Recognition of net unrecognized section 987 gain or loss is governed by §1.987-5.

(v) Pursuant to paragraph (c)(3)(ii) of this section, when computing the exchange rates used to determine the amount of assets and liabilities transferred from US Corp to UK Branch on the transition date, US Corp must adjust the historic exchange rates attributable to such assets to take into account UK Branch’s section 987 gain determined under paragraph (c)(3) of this section. Under these facts, US Corp may reasonably take into account UK Branch’s section 987 gain by translating those UK Branch’s assets that generated such gain using the same spot rate it used to determine UK Branch’s section 987 gain on the termination date of December 31, 2009 and by determining the translation rate of other assets by reference to the traced basis of such assets. Accordingly, on January 1, 2010, US Corp translates the deemed contributions to UK Branch as follows:

(vi) If UK Branch was not able to trace historic dollar basis as set forth in paragraph (v) of this Example 2, when translating the assets deemed contributed to UK Branch on January 1, 2010, under paragraph (c)(3)(ii) of this section, US Corp would be required to use exchange rates that take into account a reasonable allocation of the aggregate historic basis and the $750 of deferred section 987 gain to the UK Branch assets.

Example 3. Fresh start transition method. (i) The facts are the same as in Example 1, except that US Corp chooses to use the fresh start transition method of paragraph (c)(4) of this section in transitioning from the 1991 proposed regulations to the method prescribed in the current regulations. Pursuant to paragraph (c)(4)(i) of this section, UK Branch is deemed to terminate on December 31, 2009. However, no section 987 gain or loss will be determined or recognized. On January 1, 2010, when translating the assets deemed contributed to UK Branch, US Corp will use the historic exchange rates existing on the date the assets were acquired by UK Branch pursuant to paragraph (c)(4)(ii) of this section. Accordingly, US Corp translates the assets deemed contributed (cash is segregated for ease of illustration) to UK Branch as follows:

(ii) If UK Branch was not able to trace historic dollar basis as set forth in paragraph (i) of this Example 3, when translating the assets deemed contributed to UK Branch on January 1, 2010, under paragraph (c)(3)(ii) of this section, US Corp would be required to use exchange rates that take into account a reasonable allocation of the aggregate historic basis of the UK Branch assets.

(a) In general. Except as otherwise provided in this section, these regulations shall apply to taxable years beginning one year after the first day of the first taxable year following the date of publication of a Treasury decision adopting this rule as a final regulation in the Federal Register.

(b) Election to apply these regulations to taxable years beginning after the date of publication of a Treasury decision adopting this rule as a final regulation in the Federal Register. A taxpayer may elect to apply these regulations to taxable years beginning after the date of publication of a Treasury decision adopting this rule as a final regulation in the Federal Register. Such election shall be binding on all members that file a consolidated return with the taxpayer and any controlled foreign corporation, as defined in section 957, in which the taxpayer owns more than 50 percent of the voting power or stock (as determined in section 957(a)). An election made under this paragraph shall be made in accordance with §1.987-1(f).

Par. 6. Section 1.988-1 is amended by:

1. Adding paragraphs (a)(3) and (a)(4).

2. Revising paragraph (a)(10)(ii).

3. Adding two sentences to the end of paragraph (i).

The additions and revision read as follows:

* * * * *

(a) * * *

(3) Certain transactions of a section 987 QBU denominated in the functional currency of the owner are not treated as section 988 transactions. Transactions described in §1.987-3(e)(2) (regarding certain transactions that are denominated in the functional currency of the owner of a section 987 QBU) are not treated as section 988 transactions to a section 987 QBU. Thus, no currency gain or loss shall be recognized by a section 987 QBU under section 988 with respect to such items.

(4) Treatment of assets and liabilities of a partnership or DE that are not attributed to an eligible QBU—(i) Scope. This paragraph (a)(4) applies to assets and liabilities of a partnership, or of an entity disregarded as an entity separate from its owner for U.S. Federal income tax purposes (DE), that are not attributable to an eligible QBU (within the meaning of §1.987-1(b)(3)) as provided under §1.987-2(b).

(ii) Partnerships. For purposes of applying section 988 and the applicable regulations to transactions involving the assets and liabilities described in paragraph (a)(4)(i) of this section that are held by a partnership, the owners of the partnership (within the meaning of §1.987-1(b)(4)) shall be treated as owning their share of such assets and liabilities. Section 1.987-7(b) shall apply for purposes of determining an owner’s share of such assets or liabilities.

(iii) Disregarded entities. For purposes of applying section 988 and the applicable regulations to transactions involving the assets and liabilities described in paragraph (a)(4)(i) of this section that are held by a DE, the owner of the DE (within the meaning of §1.987-1(b)(4)) shall be treated as owning all of such assets and liabilities.

(iv) Example. The following example illustrates the application of paragraph (a)(4) of this section:

Example. Liability held through a partnership. (i) Facts. P, a foreign partnership, has two equal partners, X and Y. X is a domestic corporation with the dollar as its functional currency. Y is a foreign corporation that has the yen as its functional currency. On January 1, year 1, P borrowed yen and issued a note to the lender that obligated P to pay interest and repay principal to the lender in yen. Also on January 1, year 1, P used the yen it borrowed from the lender to acquire 100% of the stock of F, a foreign corporation, from an unrelated person. P also holds an eligible section 987 QBU (within the meaning of §1.987-1(b)(3)) that has the yen as its functional currency. P maintains one set of books and records. The assets and liabilities of the eligible QBU are reflected on the P books and records as provided under §1.987-2(b). The F stock held by P, and the yen liability incurred to acquire the F stock, are also recorded on the books and records of P, but are not reflected on such books and records for purposes of section 987 pursuant to §1.987-2(b)(2)(i)(A) and (C), respectively.

(ii) Analysis. X’s portion of the assets and liabilities of the eligible QBU owned by P is a section 987 QBU. Y’s portion of the assets and liabilities of the eligible QBU owned by P is not a section 987 QBU because Y and the eligible QBU have the same functional currency. Because the F stock and yen-denominated liability incurred to acquire such stock are not reflected on the books and records of the eligible QBU, they are not subject to section 987. In addition, because the F stock and the yen-denominated liability incurred to acquire such stock are held by P (but not attributable to P’s eligible QBU), X and Y are treated as owning their share of such stock and liability, determined under §1.987-7(b), for purposes of applying section 988. As a result, P’s becoming the obligor under the portion of the yen-denominated note that is treated as being an obligation of X is a section 988 transaction pursuant to paragraphs (a)(1)(ii), (a)(2)(ii) and (a)(3) of this section. Similarly, the disposition of yen on payments of interest and principal on the liability, to the extent such yen are treated as owned by X, are section 988 transactions under paragraphs (a)(1)(i) and (a)(3) of this section. P’s becoming the obligor under Y’s portion of the yen-denominated note, and Y’s portion of the yen disposed of in connection with payments on such note, are not section 988 transactions because Y has the yen as its functional currency.

(5) [Reserved].

* * * * *

(10) * * *

(ii) Certain transfers. (A) Exchange gain or loss with respect to nonfunctional currency or any item described in paragraph (a)(2) of this section entered into with another taxpayer shall be realized upon a transfer (as defined under §1.987-2(c)) of such currency or item from an owner to a section 987 QBU or from a section 987 QBU to the owner where as a result of such transfers the currency or other such item—

(i) Loses its character as nonfunctional currency or an item described in paragraph (a)(2) of this section; or

(ii) Where the source of the exchange gain or loss could be altered absent the application of this paragraph (a)(10)(ii).

(B) Such exchange gain or loss shall be computed in accordance with §1.988-2 (without regard to §1.988-2(b)(8) as if the nonfunctional currency or item described in paragraph (a)(2) of this section had been sold or otherwise transferred at fair market value between unrelated taxpayers. For purposes of the preceding sentence, a taxpayer must use a translation rate that is consistent with the translation conventions of the section 987 QBU to which or from which, as the case may be, the item is being transferred. In the case of a gain or loss incurred in a transaction described in this paragraph (a)(10)(ii) that does not have a significant business purpose, the Commissioner, may defer such gain or loss.

* * * * *

(i) * * * Generally, the revisions to paragraphs (a)(3), (a)(4), (a)(5), and (a)(10)(ii) of this section shall apply to taxable years beginning one year after the first day of the first taxable year following the date of publication of a Treasury decision adopting this rule as a final regulation in the Federal Register. If a taxpayer makes an election under §1.987-11(b), then the effective date of the revisions to paragraphs (a)(3), (a)(4), and (a)(10)(ii) of this section with respect to the taxpayer shall be consistent with such election.

Par. 7. Section 1.988-4 is amended by revising paragraph (b)(2) to read as follows:

* * * * *

(b) * * *

(2) Proper reflection on the books of the taxpayer or qualified business unit—(i) In general. For purposes of paragraph (b)(1) of this section, the principles of §1.987-2(b) shall apply in determining whether an asset, liability, or item of income or expense is reflected on the books of a qualified business unit.

(ii) Effective date. Generally, paragraph (b)(2)(i) of this section shall apply to taxable years beginning one year after the first day of the first taxable year following the date of publication of a Treasury decision adopting this rule as a final regulation in the Federal Register. If a taxpayer makes an election under §1.987-11(b), then the effective date of paragraph (b)(2)(i) with respect to the taxpayer shall be consistent with such election.

* * * * *

Par. 8. Section 1.989(a)-1 is amended as follows:

1. The last sentence of paragraph (b)(2)(i) is revised.

2. Paragraph (b)(4) is added.

The revision and addition reads as follows:

(b) * * *

(2) * * *

(i) Persons— * * * A trust or estate is a QBU of the beneficiary.

* * * * *

(4) Effective date. Generally, the revisions to paragraph (b)(2)(i) of this section shall apply to taxable years beginning one year after the first day of the first taxable year following the date of publication of a Treasury decision adopting this rule as a final regulation in the Federal Register. If a taxpayer makes an election under §1.987-11(b), then the effective date of the revisions to paragraph (b)(2)(i) of this section with respect to the taxpayer shall be consistent with such election.

* * * * *

Par. 9. Section 1.989(c)-1 is removed.