Currency and International Financial Centers

World Currency blog postGenerally

The normal assumption in domestic business transactions is the expectation that there will not be a movement in terms of a currency’s accelerating or declining value during the interim of a financial transaction. In an international transaction there is an expectation the currency will have volatility. The use of financial instruments has as its purpose, a prudence of assurance that delivery of currency on a contract date certain will enable the sale or purchase of goods to be unaffected by a fluctuation. To accommodate the necessity in the international market place to hedge international transactional risks, a business enterprise often utilizes an offshore corporate conduit to carryout the financial management of this function.

Financial instruments frequently are companion to a business transaction and utilized to manage the market risk inherent in the currency fluctuations of the floating exchange system. A purchase or sale of goods in conjunction with transnational agreements is in many instances a secondary transaction that poses a risk by virtue of a financial instrument being tied to the transaction. Where a purchase of merchandise requires payment in a currency other than the vendee, financial instruments insure against currency fluctuations. The purchase of such financial instruments is incidental to the transaction and can result in gain or loss of the actual financial instrument utilized to manage the risk.

One party to a transaction may anticipate a currency to accelerate in value and purchase a currency contract reflecting that expectation. Contrarily, a counter party may sell a currency contract anticipating a currency will decline in value. The gain or loss occasioned by that type of underlying companion transaction is deemed to be a separate transaction pertaining to the characterization, timing, and source.

Taxation Principles of Currency

The characterization issues of gain or loss occurring upon the sale or exchange of foreign currency raise issues similar to those in the domestic setting. A taxpayer formulates a transaction sequence to avail himself or itself of capital gains treatment if the transaction is anticipated to result in realized gain. On the other hand, where a transaction results in a loss, the taxpayer normally desires that it be cast as ordinary income. These underlying transactions that involve foreign currency hedging to manage currency fluctuation during the course of a contractual agreement have resulted in taxpayers and the government having inconsistent views of the appropriate characterization resulting from gain or loss.

The disposition of foreign currency or foreign currency positions trigger a realization of gain, the character of which is not necessarily set in stone. Foreign currency dispositions in which gains realized as integrally related to a business are treated as ordinary income. The Supreme Court has subsequently stated that although in accordance with Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955) futures were not capital assets and received ordinary income characterization, they must be limited to hedging transactions that are an integral part of a business inventory purchase system. The court’s interpretation has had contrasting views.

Where a taxpayer is a debtor in the repayment of a foreign currency denominated loan, the circuits are divided. In the case of National Standard Company v. Commissioner, 749 F.2d 369 (6th Cir. 1984) authority was established for the proposition that a repayment of debt is not a sale or exchange. Where an exchange loss occurs, the taxpayer may take the position that the transaction is ordinary income because of the lack of a sale or exchange requisite to a capital gains characterization. The Service, however, has taken a contrary view in its General Counsel Memorandum. Its view is that a sale or exchange occurs on repayment of a loan in this transactional circumstance.

The characterization of gain or loss to a creditor revolves around the question of whether a debt instrument is deemed a capital asset when held by a creditor. Where a loan of foreign currency has been repaid to the creditor, taxpayer, repayment results in a gain or loss realized by virtue of the currency’s increase or decrease in value. The increase or decreased is occasioned by the daily fluctuation or currency values. The Code provides that amounts received by the holder of any debt instrument on retirement of the debt shall be considered as amounts received as an exchange. The character of gain is determined by the characterization of the asset in the hands of a creditor. A capital asset would result in capital gain or loss, and a non-capital asset result in ordinary gain or loss. In practice, the objective is to understand the conceptual differences and strive to maintain a consistent characterization theory to prevent costly government intervention and disputes.

The second aspect of tax treatment of currency transactions is the timing of gain or loss. As a general rule, gain or loss for a non-dealer is realized at the time that a transaction is closed by virtue of a sale or other disposition of foreign currency or a position. A dealer in foreign currency, on the other hand, computes gain or loss by the use of his cost basis or the market value at year-end. The so called Section 1256 Contracts are treated as a disposition on the last day of the taxable year. Gain and loss is recognized at that time. This is the defined marked to market treatment. Recognition of loss from closing a position in a straddle is taken into account to the extent that any such amount exceeds the unrecognized gain as to one or more offsetting positions.

The third element of currency gain or loss analysis is the source, which determines where the transaction is taxable. Gain, profits, and income derived from the purchase and sale of personal property are treated as derived entirely from the country in which the property is sold. Gross income from sources within the United States includes gain, profits, and income derived from the purchase of personal property without the United States and the sales income generated there from within the United States.

Analyzing Character, Timing, and Source

Analyzing a transaction dealing with character, timing, and source of the gain or loss generated raises accounting issues. Accounting methods utilized to calculate income tax have raised issues of consistency in the determination of gain or loss. The Tax Reform Act of 1986 sought to codify rulings and provide clarification of those issue by new legislation.

As a general rule, the determination of the tax liability is to be calculated in the taxpayer’s respective functional currency. The United States dollar is the functional currency with respect to the following taxpayers. Naturally the individual taxpayer is one of those taxpayers, but also any activity wherever conducted and regardless of its frequency that produces income or loss that is treated as effectively connected with the conduct of a trade or business with the United States is another.

A third such taxpayer, but not inclusive, is a qualified unit that has the United States as its residence, or a possession of where the dollar is the standard currency. In this regard it also includes a qualified business unit that does not maintain books or records in the currency of any economic environment in which a significant part of its activities are conducted. A qualified business unit is defined as any separate and clearly identified unit of a trade or business of a taxpayer provided that separate books and records are maintained.

A qualified business unit is not required to use the United States dollar as its functional currency for purposes of income tax calculations. It is permissible to utilize another currency if that other currency is one in which the qualified has its activities conducted and maintains its books and records in accordance with the other currency. The other currency must be that which is considered as the currency of economic environment in which a significant part of the business is conducted. The determinative factors deeming a location’s functional currency are the cash flow of the currency, the currency in which the qualified business until generates revenues and incurs expenses, and the currency of the sales market. There are additional influences, but those are the essential determining points.

The treatment of exchange gains or loss from transactions denominated in a currency other than the taxpayer’s functional currency is characterized as a Section 988 Transaction. The effect of gain or loss of a Section 988 Transaction is determined by the calculation of the character, timing, and source. In the most general terms, the timing of gain or loss is dependent on whether a Section 988 Transaction is categorized as a Section 1256 Contract, a mixed straddle variety of Section 1092 of the Code, or a closed transaction.

The making or receiving of the delivery of currency with respect to a forward contract, futures contract, options contract, or other similar financial instrument is a taxable event. The character of the gain or loss of a Section 988 contract is computed separately and treated as ordinary income or loss. A taxpayer may elect to treat as a capital gain or loss any foreign currency gain or loss attributable to a forward contract, a futures contract, or an option deemed a capital asset in the hands of the taxpayer. It cannot be deemed to be part of a straddle to receive this election treatment. Additionally, the taxpayer is required to elect this treatment and must identify the transaction before the close of the day on which the transaction is entered into.

The source of exchange gain or loss is generally determined by reference to a taxpayer’s residence or the qualified business unit on whose books the asset, liability, or item of income or expense is reflected. Residence for the individual and corporation for this purpose is the country in which the taxpayer’s tax home is located. A corporation that is a United States person has its residency determined by having a residence in a country other than that of the United States. A qualified business unit has a residence for this purpose of source of income rule as the principal place at which the business is located.

In accordance with Circular 230 Disclosure

William Richards is a Sole Practitioner in Orlando, Florida, USA 32626. Attorney at Law, Legal Advisor. 1978 – Present

PUBLICATIONS: International Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2012, 378 pages. The Handbook of Offshore Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2004, 266 pages; Offshore Financial Centers and Tax Havens, Archives of Tulane Law Library, Tulane Law School, Tulane University, New Orleans, Louisiana, Copyright, 1996, 512 Pages.

Subscribe to TaxConnections Blog

Enter your email address to subscribe to this blog and receive notifications of new posts by email.