September 4, 2024

Proposed regulations reduce flexibility of foreign currency mark-to-market election

Robert Chase II, Aaron Payne, Jonathan Sambur, Theodore Smith, Brian Tschosik

Eversheds Sutherland (US) LLP

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Eversheds Sutherland (US) LLP

I. Introduction

On August 19, 2024, the Internal Revenue Service (IRS) and the Department of the Treasury (Treasury) issued proposed regulations (Proposed Regulations) making changes to previously proposed regulations published in December of 2017 (2017 Proposed Regulations) that allowed elective mark-to-market treatment for foreign currency gains and losses. Specifically, the Proposed Regulations eliminate the ability to make a Section 988 MTM Election (defined below) with the benefit of hindsight and prevent the revocation of such an election except with the consent of the Commissioner. Additionally, the Proposed Regulations include technical changes related to the time for filing statements to make and revoke subpart F foreign currency elections under Treas. Reg. § 1.954-2(g)(3) and (4).

II. Foreign Currency Mark-to-Market Election

A. Background

Under the 2017 Proposed Regulations, a taxpayer, including a controlled foreign corporation (CFC), would have been able to elect to use a mark-to-market method of accounting for section 988 (i.e., foreign currency) gain or loss with respect to certain section 988 transactions (Section 988 MTM Election). Further, based on permitted reliance on the 2017 Proposed Regulations, taxpayers were able to make such elections while the 2017 Proposed Regulations were pending. A taxpayer could make a Section 988 MTM Election by filing a statement that clearly indicated that the election had been made with its timely-filed original federal income tax return for the taxable year for which the election is made. Controlling US shareholders of a CFC could make a Section 988 MTM Election on behalf of the CFC by filing a statement that clearly indicated that the election had been made with their timely-filed, original Federal income tax returns for the “taxable year of the US shareholders ending with or within the taxable year of the CFC for which the election is made.”

The 2017 Proposed Regulations further provided that a taxpayer could revoke an initial Section 988 MTM Election at any time. If the election had been revoked, a new Section 988 MTM Election could not be made until the sixth taxable year following the year in which the previous election was revoked. Further, a subsequent election could not be revoked until the sixth taxable year following the year in which the subsequent election was made. A taxpayer would revoke the election by filing a statement that clearly indicates that the election has been revoked with its original or amended federal income tax return for the taxable year for which the election is revoked.

B. Changes in Proposed Regulations

Treasury and the IRS expressed concern that the 2017 Proposed Regulations “provided an excessive amount of flexibility” by permitting taxpayers to make a Section 988 MTM Election with the benefit of hindsight and then, also with the benefit of hindsight, revoke the election at any time. Under the Proposed Regulations, a Section 988 MTM Election generally must be made by the original due date (i.e., without extension) for the taxpayer’s return for the taxable year immediately preceding the year for which the election is made, with special rules for new taxpayers or controlling US shareholders making the election on behalf of a CFC. Thus, a Section 988 MTM Election now may generally only be made no later than April 15 (or, if the taxpayer has a fiscal year, the 15th day of the fourth month) of the taxable year to which it relates, and thus without certainty as to whether the election will ultimately result in a gain or loss for the initial year to which it applies.

Additionally, rather than being allowed to revoke the election at any time, the Proposed Regulations would require the consent of the Commissioner to revoke a Section 988 MTM Election, regardless of whether the election was an initial election or subsequent election. The changes to the election and revocation procedures are intended to align the procedures with those under section 475(e) or (f), which allow mark-to-market elections for dealers in commodities and traders in securities and commodities.

The Proposed Regulations withdraw the corresponding portions of the 2017 Proposed Regulations, and taxpayers may no longer rely on the Proposed 2017 Regulations, though they may rely on the Proposed Regulations pending finalization. Thus, Section 988 MTM Elections that taxpayers had already made pursuant to the 2017 Proposed Regulations will be respected, but cannot be withdrawn without the consent of the Commissioner. In addition, calendar year taxpayers that had not yet filed their 2023 returns prior to the issuance of the Proposed Regulations are now unable to make a Section 988 MTM Election for either 2023 or 2024, and fiscal year taxpayers face similar limitations, except that they may make a Section 988 MTM Election for their current taxable year if the due date (without extensions) of the return for the prior taxable year has not already passed.

Comments are requested on all aspects of the rules for making and revoking a Section 988 MTM Election, including the related terms and conditions, such as whether an automatic change in method of accounting should be permitted in certain circumstances, whether a taxpayer should be required to establish a substantial business reason for the change, the extent to which the terms and conditions should incorporate or deviate from those that apply to mark-to-market elections under section 475, and whether related parties should be required to apply a Section 988 MTM Election in a consistent manner.

Eversheds Sutherland Observation: The purpose of this change to the Section 988 MTM Election is to restrict the ability of taxpayers to selectively recognize foreign currency losses, including with the benefit of hindsight. However, it also inhibits taxpayers’ ability to make a Section 988 MTM Election to adopt mark-to-market treatment for reasons unrelated to achieving a tax benefit, such as conforming tax to accounting treatment in order to simplify compliance or avoiding the need to apply complex straddle or hedging transaction rules. Taxpayers may not always know early in a taxable year what business developments later in the year (such as engaging in new types of transactions, or increasing the level of business activity, denominated in a non-functional currency) will make a Section 988 MTM Election desirable (for reasons other than triggering a foreign currency loss). As a result, the more restrictive timing rules in the Proposed Regulations will subject many taxpayers to compliance burdens they could have avoided under the 2017 Proposed Regulations.

In addition, the elimination, without a transition period, of taxpayers’ ability to revoke a Section 988 MTM Election absent consent may be viewed by some as unfair to taxpayers who made Section 988 MTM Elections in a prior year, with the understanding that such elections could be unilaterally revoked in the future if mark-to-market treatment proved unfavorable. While it is reasonable for Treasury and the IRS to conclude, in retrospect, that the flexibility provided by the 2017 Proposed Regulations was overly generous, this immediately effective change in the rules arguably reneges on the terms of the election offered by the 2017 Proposed Regulations, in a manner that disadvantaged taxpayers may be inclined to challenge. It is hoped that final regulations (or other interim guidance) will include a transition rule that allows taxpayers that previously made a Section 988 MTM Election an opportunity to unilaterally revoke such election if they prefer not to be required to continue to apply a mark-to-market method of accounting indefinitely.

The preamble to the Proposed Regulations discusses generally conforming the requirements for Section 988 MTM elections to those that apply to mark-to-market elections under section 475, which suggests that ultimately an automatic change in method of accounting may be available once a Section 988 MTM Election has been in place for at least five years, but until guidance providing an automatic method change is issued, taxpayers that want to revoke a Section 988 MTM Election have no recourse other than to request consent through a non-automatic change in method of accounting.

III. Treas. Reg. §1.954-2(g) Elections

As noted above, the Proposed Regulations also include changes intended to clarify the procedure by which Treas. Reg. § 1.954-2(g)(3) and (4) elections are made or revoked by a controlling US shareholder. These elections are available to either change the category of foreign currency gain or loss that is recognized and treated as subpart F income or to treat all foreign currency gain or loss recognized as subpart F income, respectively. Under the existing final regulations, controlling US shareholders make either of the Treas. Reg. § 1.954-2(g) elections on behalf of the CFC by filing a statement with their original income tax return for the taxable year of the US shareholders ending “with or within the taxable year of the [CFC] for which the election is made.” Additionally, under the 2017 Proposed Regulations, a CFC’s controlling US shareholders would be permitted to revoke an initial election under Treas. Reg. § 1.954-2(g) at any time by filing a statement with their return for their taxable years ending, similarly, “with or within the taxable year of the [CFC] for which the election is revoked.”

The Proposed Regulations would conform the description of the return to which a statement (to either make or revoke an election) is required to be attached to the language that is typically used in connection with elections related to CFCs, such that a US shareholder may make or revoke an election filing a statement with the tax return for its tax year “in which or with which” the relevant tax year of the CFC ends. In addition, the Proposed Regulations would provide that Treas. Reg. § 1.954-2(g) elections may not be revoked until the sixth taxable year following the year in which the election was made.

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