Tax accounting services: Foreign currency tax accounting Tax ... - PwC

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If they are part of the foreign entity's books those accounts must be converted ... If maintained in local currency, the books of the foreign subsidiary must be ...
Tax accounting services: Foreign currency tax accounting

October 2012

The globalization of commerce and capital markets has resulted in business, investment and capital formation transactions increasingly being conducted in different currencies throughout the world. Enterprises that report financial results in one currency may have branches or subsidiaries operating in different currency environments. Those businesses may, in turn, engage in transactions denominated in currencies different from the operating currency. Global economic conditions of the past few years have resulted in greater currency volatility and respective efforts by enterprises to manage multiple currency risks. The taxation of currency movements and transactions varies by jurisdiction, adding further complexity to the financial reporting process. Accordingly, it is more important than ever for multinational enterprises to understand, and continually assess, the income tax accounting for currency movements and transactions. This publication highlights key considerations in applying U.S. GAAP with respect to foreign currency income tax reporting. In order to explain tax accounting for foreign currency, it is important to understand the ―basics‖ and relevant areas of focus when applying Accounting Standards Codification (ASC) 830, Foreign Currency Matters. The publication begins there and proceeds to discuss the application of ASC 740, Accounting for Income Taxes, to foreign currency.

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Table of Contents Relevant Aspects of ASC 830

4

Summary of Key Terms

5

The Translation Process

6

Foreign Currency Transactions

12

Tax Accounting for the Translation Process

17

Change in Functional Currency

28

Currency-related Tax Disclosures

30

Notable Differences Between U.S. GAAP and IFRS

31

Acknowledgements

32

Contacts

33

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Relevant Aspects of ASC 830 ASC 830 provides standards of financial accounting for foreign currency transactions and translating foreign currency financial statements that are incorporated in the financial statements of an enterprise by consolidation, combination, or the equity method of accounting under U.S. GAAP. Under ASC 830, separate entities of an enterprise that operate in different economic and currency environments may prepare financial statements in the currency of their respective environments. These separate statements are consolidated by translating them into a ―single unit of measure‖ - the reporting currency of the enterprise. In effect, translation is the process of adjusting, through accounting entries, a set of books maintained in another currency to the reporting currency. For transactions in, or denominated in, a foreign currency, exchange rate movements will also generally result in accounting entries each reporting period. Subject to certain exceptions, gains and losses are recognized in the financial statements for monetary accounts denominated in a currency other than the respective functional currency.

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Summary of Key Terms Foreign entity

A business whose financial statements are prepared in a currency other than the reporting currency of the enterprise

Local currency

Currency of the country in which the foreign entity is located

Functional currency

Primary currency of the entity’s operations

Reporting currency

Currency reported in the consolidated financial statements or separate company financial statements

Foreign currency translation

Process of expressing, in the reporting currency, an entity’s financial position measured in a different currency

Foreign currency transactions

Transactions denominated in a currency other than the functional currency

Translation adjustments

Results of the process of translating functional currency to reporting currency

Transaction gains and losses

Results of changes in exchange rates between functional currency and other currency

Exchange rate

Rate to convert one unit of currency into another unit of currency

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The Translation Process One of the primary objectives of ASC 830 is to use a single reporting currency for financial statements. The reporting currency is the currency used in the consolidated financial statements or separate company financial statements. Accordingly, accounts that are maintained in a foreign currency are translated each reporting period into the enterprise's reporting currency. The translation process is primarily accomplished in the following three steps: 1.

The functional currency of the foreign entity is determined. The functional currency is the primary currency in which the foreign entity conducts its business. It is normally the currency of the economic environment in which cash is primarily generated and expended by the entity. The functional currency may be one among many currencies in which an entity transacts business. Judgment is applied to consider all relevant economic facts and circumstances in determining the functional currency. In many situations, the functional currency is the currency of the country in which the foreign entity is located. However, where a foreign entity is a direct extension of a business operating in the reporting currency, the reporting currency is likely to be the functional currency. For example, the functional currency may be the U.S. dollar for a sales branch of a U.S. parent. Similarly, businesses that deal in commodities or markets in which purchases and sales are U.S.-dollar-denominated may have U.S. dollar functional currency. The functional currency also serves as the basis for determining whether the foreign entity is engaging in foreign currency transactions that generate transaction gains or losses.

2.

All transactions in, or denominated in, a currency other than the functional currency are "remeasured" into the functional currency of the foreign entity using the current exchange rate for monetary accounts and historical exchange rates for nonmonetary accounts. Accordingly, for monetary accounts changes in the exchange rate between the initial recording and remeasurement date will give rise to foreign currency gain or loss. The purpose of remeasurement is to produce the same financial results as if the entity's records were initially maintained in the functional currency. In general, transaction gains and losses are recorded as part of income from continuing operations.

3.

The functional currency financial statements are translated into the reporting currency using the "current rate method" of translation. Under the current rate method of translation:

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Assets and liabilities are translated using the current exchange rate at the balance sheet date



Capital accounts (e.g., common and preferred shares) are translated at historical exchange rates (i.e., the exchange rates in effect when the transactions occurred)



Revenues and expenses are translated at the current or average of historical rates in effect when the income was earned

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Foreign income tax assets or liabilities, including foreign deferred taxes and liabilities for uncertain tax positions, are translated at current rates regardless of the foreign entity's functional currency. Additionally, so-called ―topside‖ and consolidating accounting entries should be evaluated to determine whether or not such accounts are part of the foreign entity’s books. If they are part of the foreign entity's books those accounts must be converted into the functional currency and then translated under the current rate method of translation. Such accounting entries, for example, may include acquisition accounting adjustments or unrecognized tax benefits relating to uncertain tax positions of the foreign operation. The result of the functional currency translation process is reported as cumulative translation adjustment (CTA), which is part of other comprehensive income (OCI). OCI is a component of shareholders' equity and represents gains and losses not recognized within the income statement. Thus, the overall translation process may be described as including in net income those currency exchange effects that impact cash flows (remeasurement) and including in equity (CTA) those that do not impact cash flows. Said differently, net income reflects exchange effects on individual assets and liabilities of a foreign operation, whereas, the functional currency translation (CTA) reflects the effects on the net investment in the operation. The following summarizes the typical overall process in the context of a U.S. parent consolidated reporting group:

Summary of Translation Process Currency in which Books are Maintained Local currency

Functional Currency Local currency

Translation Method Current rate method of translation of functional currency to U.S. dollars

Local currency

Third currency (i.e., a foreign currency other than the local currency)

Local currency

U.S. dollar

Remeasurement from local currency to functional currency (monetary/nonmonetary method) and Current rate method of translation of functional currency to U.S. dollars Remeasurement to U.S. dollars (monetary/nonmonetary method)

U.S. dollar

U.S. dollar

No translation required

Exchange Rates ASC 830 allows an enterprise to make a practical approximation of an average exchange rate to be used in translating revenues, expenses, gains, and losses. For example, an exchange rate that is weighted in proportion to the volume of sales occurring in each month may be an appropriate measure in foreign environments that have been experiencing wide currency fluctuations throughout the year. The technical requirement, however, is for translation at the exchange rate on the date each transaction is recognized. Nonrecurring transactions, including intangible asset impairments and long-lived asset transactions, should be translated at the actual prevailing rate on the transaction date. In all cases, facts and circumstances should support the determination of the rates used.

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Example 1: Translation when the Local Currency is the Functional Currency The current rate method of translation must be used if the local currency is the functional currency (FC) and the books and records are maintained in that currency. In this example the U.S. dollar (USD) is assumed to be the reporting currency and the local currency (LC) of the subsidiary is its functional currency. The exchange rates are assumed to be as follows: –

Historical and average exchange rate (for all prior years' transactions) is FC 1 = $0.30



Year-end exchange rate (FX) for the current year is FC1 =$0.50



Weighted average exchange rate for the year is FC1 = $0.40

Current Rate Method of Translation LC

FX

USD

Cash

235,000

0.5

117,500

Net plant

490,000

0.5

245,000

725,000 Common stock

350,000

Retained earnings

375,000

Translation adjustments

-

362,500 0.3

105,000 121,550

See Below

725,000

135,950 362,500

Gross profit

125,000

0.4

50,000

Depreciation

(34,500)

0.4

(13,800)

Net income

90,500

Retained earnings, beginning-of-year

284,500

Retained earnings, end-of-year

36,200 0.3

375,000

85,330 121,550

Analysis of Cumulative Translation Adjustment LC Net assets, beginning-of-year Net income for the year

FX

USD

634,500

(0.5 - 0.3) = 0.2

126,900

90,500

(0.5 - 0.4) = 0.1

9,050 135,950

Beginning exchange rate (0.3) Average exchange rate for current year (0.4) Exchange rate for current year (0.5)

Since this example assumes that the historical and average rate for all prior years' transactions did not fluctuate, there is no opening balance in the CTA account.

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Example 2: Translation when the U.S. Dollar is the Functional Currency If maintained in local currency, the books of the foreign subsidiary must be remeasured into U.S. dollars using the current exchange rate for monetary accounts and historical exchange rates for nonmonetary accounts. In this example, the U.S. dollar is assumed to be both the functional currency of the subsidiary and the reporting currency. The exchange rates are the same as in Example 1. Additionally, assume the foreign subsidiary reflected beginning-of-year balances in local currency of: Cash Net plant

110,000 524,500 634,500

Remeasurement LC

FX

USD

Cash

235,000

0.5

117,500

Net plant

490,000

0.3

147,000

725,000 Common stock

350,000

Retained earnings

375,000

264,500 0.3

105,000 159,500

725,000

264,500

Gross profit

125,000

0.4

50,000

Depreciation

(34,500)

0.3

(10,350)

Foreign exchange gain

-

Net income

90,500

Retained earnings, beginning-of-year

284,500

Retained earnings, end-of-year

See below

34,500 74,150

0.3

375,000

85,350 159,500

Analysis of Foreign Exchange Gain LC

FX

USD

Effect of change in the exchange rate during the year on net monetary assets at the beginning of the year Cash

110,000

(0.5 - 0.3) = 0.2

125,000

(0.5 - 0.4) = 0.1

22,000

Effect of translating the change in net monetary assets at the weighted average exchange rate for the year instead of at the year-end exchange rate Increase in cash

12,500 34,500

Beginning exchange rate (0.3) Average exchange rate for current year (0.4) Exchange rate for current year (0.5)

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Goodwill Goodwill arising from the acquisition of a business whose functional currency is the local currency should be presumed to have a functional currency value based on the exchange rate at the date of acquisition. Goodwill should be subsequently translated at the current rate, whether the amount arises in consolidation or has been recorded ("pushed down") in the acquired company's books. The effect of translation is recorded in CTA. The same principles would apply in translating tax basis goodwill.

Equity Method Investments An investor's investment in an entity with a functional currency different from that of the investor and accounted for under the equity method can produce a CTA account after translation. The investor's accounting for the investment follows a process similar to the translation of the accounts of a consolidated subsidiary. In addition, if the investee records changes in its CTA account (in OCI), the investor should record a proportionate change in its investment and CTA accounts. Similarly, the investor's earnings would take into account hypothetical acquisition accounting adjustments, including applicable translation adjustments arising from the acquisition of the investment. Other consolidation principles are also applied to determine equity method income, including the elimination of profits and losses from certain transactions between the investor and investee.

Noncontrolling Interests A noncontrolling interest (NCI) account should be translated at historical rates, as if it were an equity account. A proportionate share of the CTA account should be allocated to the NCI account in the consolidated financial statements.

CTA Impacts of Disposal Events ASC 830-30-40-1 provides that the CTA account not be taken into income until "sale or upon complete or substantially complete liquidation of an investment in a foreign entity." The phrase ―substantially complete liquidation" implies that a very significant portion, perhaps 90% or more, of the investment will be liquidated. Accordingly, the following generally would not represent a substantially complete liquidation: 1.

Payment of periodic dividends to the parent out of the foreign entity’s net income

2.

Payment of liquidating dividends in amounts less than a very significant portion of the underlying assets

3.

Changing the nature of an intercompany advance from permanent (i.e., similar to capital) to debt intended to be settled in the foreseeable future

The accounting guidance in ASC 810, Consolidation, applies to the sale of an ownership interest in a consolidated foreign entity. Under that guidance, when a parent's sale of a portion of its ownership interest in a subsidiary results in a loss of control of the subsidiary, the parent deconsolidates the subsidiary. Any retained noncontrolling investment is recorded at its fair value and a gain or loss is recognized on the disposal of the subsidiary. Upon deconsolidation, the entire CTA balance that relates to such subsidiary should be recognized as part of the gain or loss on the sale. Determining if and when the CTA account should be released to income for enterprises having a multi-tiered legal entity structure requires judgment based upon the facts and circumstances. Typically, the sale of a "legal entity" within a multi-tiered organization does not result in the release of the CTA account when the substance of the transaction is that of a partial liquidation of the foreign entity business. The CTA account would not be released, for example, when a first-tier foreign subsidiary sells or liquidates a second-tier subsidiary yet maintains similar operations with the same functional currency as the disposed subsidiary.

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To illustrate: Fact Pattern Company A has a wholly-owned foreign subsidiary and sells a 30% ownership interest in the subsidiary. Company A maintains control over the subsidiary.

Company A has a wholly-owned foreign subsidiary and sells a 60% ownership interest in the subsidiary. Company A loses control of the subsidiary. Company A has an equity method investment in a foreign entity and sells a portion of its ownership interest. Company A maintains significant influence over the investee and continues to apply the equity method of accounting for the investment. Company A owns 55% of a foreign subsidiary. The subsidiary issues additional shares to an outside third party which results in Company A losing control of the subsidiary.

Impact on CTA The CTA would not be released because Company A did not lose control of the subsidiary. The sale of a noncontrolling interest is an equity transaction. A proportionate share of the CTA balance that relates to the subsidiary is reallocated between NCI and AOCI of the parent company. The full amount of CTA would be recognized in measuring the gain or loss on the deconsolidation unless the deconsolidated subsidiary was part of a larger foreign entity.

Relevant Guidance ASC 810-10-45-23 through 45-24

A pro rata portion of the CTA would be recognized in measuring the gain or loss on the sale unless the equity investment was part of a larger foreign entity.

ASC 830-30-40-2

The full amount of CTA would be recognized in measuring the gain or loss on the deconsolidation unless the deconsolidated subsidiary was part of a larger foreign entity.

ASC 810-10-40-5

ASC 810-10-40-5

Example 3: Conversion of a Controlled Foreign Corporation to a Foreign Branch Company A is a U.S. company with U.S. dollar functional currency. Subsidiary B is a foreign subsidiary of Company A with Euro functional currency that conducts sales activities in Germany. Company A liquidates its investment in Subsidiary B by transferring Subsidiary B's net assets to a U.S. subsidiary (Subsidiary C) whose functional currency is the U.S. dollar. Subsidiary C continues to operate the former Subsidiary B business as a branch. As a result of this transaction, the CTA related to the net assets in Subsidiary B should not be recognized in income, as those net assets have not been liquidated outside of the consolidated group and the related operations in Germany have not ceased. The CTA should remain unchanged at the time of the transfer, as the functional currency of the entity now holding those assets is the U.S. dollar. (In prospective years, foreign currency gains and losses will be treated under the branch principles - refer to page 19).

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Foreign Currency Transactions Foreign currency transactions are transactions in, or denominated in, a currency other than an entity's functional currency. The accounting for foreign currency transactions and balances under ASC 830 is generally as follows: 1.

At the date the transaction is recognized, the income and balance sheet accounts arising from the transaction should be measured and recorded in the functional currency of the reporting entity by using the exchange rate in effect on that date. The use of a weighted average exchange rate is acceptable as a reasonable approximation.

2. At each balance sheet date, recorded balances that are denominated in a currency other than the functional currency of the reporting entity should be adjusted to reflect the current exchange rate. 3. Exchange gains and losses on foreign currency transactions are included in income, except for gains and losses attributable to the following: –

Foreign currency transactions that effectively hedge an investment in a foreign entity; for example, a foreign exchange contract or receivables/payables denominated in a foreign currency (refer to page 20)



Intercompany transactions that are of a long-term investment nature; for example, intercompany transactions for which settlement is not planned or anticipated in the foreseeable future (refer to page 16)



Hedging instruments in qualifying foreign currency cash flow hedges

Remeasuring Foreign Currency Transactions Subsidiaries with a functional currency different from the reporting currency may have monetary assets and liabilities denominated in the reporting currency. When these items are remeasured to the subsidiary's functional currency, a gain or loss is recognized in the income statement as a result of exchange rate fluctuation. The translation of the subsidiary's financial statements into the reporting currency does not reverse this income statement gain or loss, but generates an offsetting gain or loss that is reflected in the CTA account.

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Example 4: Remeasuring Foreign Subsidiary U.S. Dollar Sales On October 31, 20X2, a foreign subsidiary whose local currency is its functional currency, sells goods to its U.S. parent for $55,000 payable on January 1, 20X3. The receivable is recorded in U.S. dollars, which is the reporting currency. The foreign subsidiary's U.S. dollar sales throughout the year are such that use of an average exchange rate for the year is appropriate. The exchange rates are assumed to be as follows: –

Exchange rate on October 31, 20X2 is FC 1 = $0.40



Exchange rate on December 31, 20X2 is FC 1 = $0.50



Average exchange rate for the year ended December 31, 20X2 is FC 1 = $0.30

The foreign subsidiary will record a receivable and a sale of FC 137,500 (U.S. $55,000/0.40). On December 31, 20X2, the receivable will be translated into FC 110,000 (U.S. 55,000/.50) resulting in an unrealized loss of FC 27,500 (FC 137,500 less FC 110,000). The unrealized loss will be included in the foreign subsidiary's functional currency income statement, which will then be included in the consolidated income statement after translation into U.S. dollars. Remeasuring Foreign Currency Transactions LC

FX

USD

Receivable (U.S.-dollar-denominated)

137,500

0.4

55,000

Retained earnings

137,500

October 31, 20X2

55,000

December 31, 20X2 Receivable (U.S.-dollar-denominated)

110,000

Retained earnings

137,500

(Loss) on U.S. dollar receivable (Income statement)

(27,500)

0.5

55,000

55,000 0.3

CTA (Balance sheet)

(8,250) 8,250

110,000

55,000

Note that consolidated equity does not change as a result of the exchange rate accounting. However, the exchange loss in functional currency carries through to the U.S. dollar consolidated income statement with an offsetting amount (translation gain) credited to CTA.

Debt Denominated in Other Than Functional Currency When a company issues debt denominated in other than its functional currency, the debt should initially be translated to its functional currency at the exchange rate in effect at the issuance date and remeasured at each reporting date based on the current exchange rate. Debt premium, discount, and debt issuance costs are considered part of the carrying value of the debt. Therefore, any resulting unamortized debt premium or discount and debt issuance costs should be reported in the balance sheet at the current exchange rate, with changes in rates reflected in the income statement as a foreign exchange transaction gain or loss in the manner consistent with the debt.

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ASC 830 does not specifically address the rate at which amortization of debt issuance discount or premium should be reported in the income statement. Because amortization economically occurs throughout the period, it may be appropriate to record amortization for a period using the weighted average exchange rate for that period.

Example 5: Issuance of U.S. Dollar Debt by Foreign Subsidiary On January 1, 20X1, a foreign entity issues $100,000 (U.S. dollar) debt in the form of 4.5% per annum fixed interest rate bonds. The bonds mature on December 31, 20X5 and the market interest rate on the date of issuance for the bonds is 4% per annum. The bond proceeds were $102,050. As a result, the entity will pay $4,500 of annual interest each December 31 and amortize bond premium of $2,050 over the life of the bond. The local currency is the functional currency and the U.S. dollar is the reporting currency. The exchange rates are assumed to be as follows: – – – –

Exchange rate on January 1, 20X1 is FC 1 = $0.40 Exchange rate on December 31, 20X1 is FC 1 = $0.50 Weighted average exchange rate for the year ended December 31, 20X1 is FC 1 = $0.45 Assume the only transaction during the year was for the annual interest accrual: Dr. Interest Expense $4,090 Dr. Premium on Bonds Payable $410 Cr. Cash $4,500 Debt Denominated in Other Than Functional Currency LC

FX

USD

255,125

0.4

102,050

250,000

0.4

100,000

5,125

0.4

2,050

CTA

January 1, 20X1 Cash

Bonds Payable Premium on Bonds Payable Total Liabilities

255,125

102,050

December 31, 20X1 Cash

246,125

0.5

123,063

Effect of change in the exchange rate on local currency cash Bonds Payable (U.S.-dollar-denominated) Premium on Bonds Payable (U.S.-dollardenominated) Total Liabilities Retained earnings

25,513 200,000

0.5

100,000

3,280

0.5

1,640

203,280 42,845

101,640 0.45

CTA (Balance sheet)

2,143 42,845

Income Statement and CTA Effects Amortization of Premium Interest Expense Gain on Bonds Gain on Premium Gain on Accrued Interest

21,423

LC

FX

USD

CTA

911

0.45

410

(10,000)

0.45

(4,500)

(450)

50,000

0.45

22,500

(22,500)

934

0.45

420

(420)

1,000

0.45

42,845

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19,280

450

19,280

2,143

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Intercompany Transactions ASC 830 provides special rules for certain foreign currency transactions arising from intercompany activity. Intercompany transactions are a consideration in the determination of an entity's functional currency. The elimination of intra-entity profits that are attributable to sales or other transfers between entities that are consolidated, combined, or under the equity method is based on the exchange rates in effect on the dates of the sales or transfers. Facts and circumstances may support the use of an average rate as a reasonable approximation. Intercompany dividends payable in a foreign currency that are recorded when declared should be translated using the exchange rate in effect on the date of declaration. The current rate would be used in translating the payable or receivable at the balance sheet date and in recording the remittance. Exchange gains or losses would be avoided if dividends were remitted upon declaration.

Example 6: Intercompany Profit Elimination The exchange rates are assumed to be as follows: –

Exchange rate on the transfer date FC 1 = $1 USD



Exchange rate on the balance sheet date FC 1 = $1.25 USD

Intercompany Profit Elimination Transfer Date

Intercompany transfer price Parent cost Parent profit component Inventory after profit elimination

Balance Sheet Date

LC

USD

LC

USD

120

120

120

150

100

100

20

20

100

130

The consolidated balance sheet will include inventories carried at $130 USD (transfer price of $150 USD less intercompany profit elimination of $20 USD). The $30 USD increase in the inventory carrying value will be included in CTA.

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Long-Term Advances In general, currency gains and losses relating to intercompany transactions are included in consolidated earnings in the year such transactions occur. However, intercompany financing transactions of a long-term investment nature may be treated as the equivalent of equity transactions which would not be reported in earnings. That would be the case, for example, if a U.S. parent asserts that settlement of a loan made to a foreign subsidiary is not planned or anticipated in the foreseeable future. Gains or losses on translation of such transactions are included in CTA in consolidation. Management's intention used in determining whether a loan is of a long-term investment nature under U.S. GAAP should be consistent with management's intentions used in determining the appropriate tax return treatment. If for accounting purposes management asserts that the debt will be renewed at maturity and, therefore, is of a longterm investment nature, that assertion must be considered in assessing the relevant tax law treatment of the transaction. At the time management changes its intention with respect to a loan of a long-term investment nature and decides to repay the loan in the foreseeable future, the loan is no longer viewed as a capital contribution. The amount of any exchange gains or losses included in CTA (applicable to the period for which settlement was not planned or anticipated) should remain in CTA. However, foreign exchange transaction gains and losses in subsequent periods are recorded in the income statement.

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Tax Accounting for the Translation Process The taxation of foreign currency movements varies depending on the transaction and the tax laws of the relevant jurisdictions. Local currency is typically the income tax return currency. Obligations and assets denominated in another currency may be taxed either when realized (i.e., when the obligation or asset is settled) or on an unrealized basis (i.e., as the foreign currency moves against the local currency). Translation gains or losses are usually not subject to tax, although currency movements can affect the local currency amounts that can be distributed by a foreign subsidiary. ASC 740 generally requires deferred taxes to be provided on temporary differences between the book carrying values and the tax bases of assets and liabilities. That general principle is considered in determining the appropriate tax accounting for temporary differences relating to foreign currency translation and transactions.

Translation Adjustments on Outside Basis Differences Translation adjustments for foreign subsidiaries typically create a portion of the "outside basis" temporary difference related to the parent’s investment in the subsidiary. Generally, the CTA reflects the gains and losses associated with the translation of a foreign subsidiary’s books from its functional currency into the reporting currency. If the foreign entity's earnings are considered indefinitely reinvested, deferred taxes are not provided on either the earnings or translation adjustments. Disclosure of the outside basis difference must be considered for the financial statement footnotes along with an estimate of the unrecorded tax liability or a statement indicating that an estimate is not practicable. In some cases, deferred taxes may not be provided on unremitted earnings because it is expected that their repatriation will result in no additional home country tax because of foreign tax credits. In those circumstances, it may be necessary to record deferred taxes on translation adjustments if there are not sufficient foreign tax credits to absorb the tax attributable to those adjustments. If the outside basis difference is not indefinitely reinvested, deferred taxes are recorded for the tax estimated to be incurred upon repatriation of the outside basis difference, including the portion attributable to the CTA account. When determining whether to record taxes on translation adjustments, as well as how the tax would be estimated, consideration should be given to the following: 1.

The need for recording taxes on translation adjustments is determined on an operation-by-operation basis. As such, it may be appropriate to tax-effect translation adjustments of only certain foreign operations. While the need is determined on an operation-by-operation basis, circumstances may indicate that operations be aggregated by tax jurisdiction for tax-planning and measurement purposes. Even though all local currency net assets (represented by total capital and retained earnings) affect the CTA, the measurement of the tax should be directly related to the portion of equity that is expected to be remitted. For example, if a return of capital is not expected but all retained earnings will be remitted, it may be appropriate to record taxes only on the portion of the CTA related to retained earnings.

2.

It is necessary to consider whether the translation adjustments will result in ordinary or capital gain or loss since different tax rates may apply, along with consideration of uncertainties relating to expected tax positions in accordance with ASC 740-10. Further, potential utilization of foreign tax credits and applicable foreign withholding taxes need to be considered in determining the measurement of deferred taxes on the outside basis temporary difference.

3.

Under U.S. income tax law the taxation of distributions and other repatriation events depends upon the earnings and profits (E&P) of the subsidiary. Earnings and profits are measured in local currency until they are reflected on the U.S. taxpayer’s return as the result of a taxable event such as a dividend. For example, for

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a U.S. parent the U.S. dollar equivalent of the subsidiary's E&P will determine how much of a remittance will be taxed as a dividend for U.S. tax purposes. The amount of E&P expressed in U.S. dollars will therefore change as foreign currency moves against the U.S. dollar, in turn affecting the amount of the dividend that would be recognized for U.S. tax return purposes. As a result, exchange rate movements may affect the amount of deferred tax that needs to be recognized on the outside basis difference. 4.

When outside tax basis exceeds book basis in a foreign subsidiary, a deferred tax asset with respect to that temporary difference is recognized only when it is apparent that the difference will reverse in the foreseeable future. Realization of a benefit may, for example, occur when there is a planned disposal of the subsidiary. This would typically be the date at which the investment is classified as "held for sale" (or would be classified if the investment were to be considered a business component). The determination of foreseeable future requires judgment and, in practice, has generally been considered to mean within the next year. The generation of future subsidiary profits, however, would not provide a basis for recognizing a deferred tax asset on the outside basis difference. Deferred tax assets would also be assessed for realizability; that is, to determine whether they require a valuation allowance.

U.S. Subpart F Income If a U.S. corporation conducts business through a foreign subsidiary that has not elected to be taxed as a disregarded entity or partnership, there is normally no U.S. taxation unless earnings are distributed to the U.S. parent. This difference in the timing of income recognition for book and tax purposes contributes to the outside basis difference described above. The exceptions to this general tax law deferral are contained within subpart F of the Internal Revenue Code (IRC). Under the subpart F provisions, certain types of income are currently taxable to the extent of the foreign subsidiary's current earnings and profits (current E&P). Subpart F income, when taxable, is treated as a deemed dividend and re-contribution to the foreign subsidiary. This results in an increase in the U.S. parent’s tax basis in the foreign subsidiary. Foreign entities subject to subpart F may produce U.S. tax consequences (to the U.S. parent) which arise upon the reversal of temporary differences that represent subpart F income. Foreign temporary differences, both deductible and taxable, that will impact subpart F income (and thus U.S. taxes) when they reverse may give rise to U.S. deferred taxes. These foreign temporary differences are also translated every period and give rise to a corresponding change in the U.S. deferred taxes, which effectively reflect the foreign deferred taxes. Similar accounting consequences can occur when subpart F income is realized by the foreign subsidiary, but deferred for U.S. tax purposes because the subsidiary has no current E&P. Income that has been subjected to subpart F and reported on a tax return is commonly referred to as previously taxed income (PTI). PTI can generally be repatriated without further taxation other than potential withholding taxes and any tax consequences applicable to foreign currency gains or losses. Deferred taxes may not be provided on the unrealized foreign currency gains or losses associated with PTI if the company has the ability and intends to indefinitely reinvest the amounts that correspond to PTI. Similar considerations apply with respect to U.S. deferred taxes recorded on subpart F income that has been realized, but not yet subject to U.S. tax because of the absence of current E&P.

Intraperiod Tax Allocation to CTA ASC 740 provides rules for allocating the total tax expense (or benefit) for the year among the various financial statement components, including components of net income and OCI. These "intraperiod allocation" rules require allocation to the CTA account for both current and deferred taxes on transaction gains and losses recorded in the CTA account and for deferred taxes on translation adjustments. With respect to deferred taxes provided by a parent or investor on an outside basis difference, the method of allocating deferred taxes between continuing operations and other items must be considered. Although several alternatives exist, one illustrative method of allocation is set forth below. For simplicity of discussion, the illustration assumes that (1) the only sources of change in the outside basis difference during the year are

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continuing operations and translation adjustments for the year, and (2) no remittance or other recovery of the parent’s investment has occurred during the year. 1.

Compute the total deferred tax provision for the year. This would be the difference between (a) the required year-end deferred taxes at enacted tax rates and current exchange rates, utilizing available credits and taxplanning alternatives, and (b) the beginning-of-year deferred taxes.

2.

Compute the charge to continuing operations. This consists of the following components: –

The deferred taxes related to the current year’s continuing operations at average translation rates for the year



The change in the deferred taxes resulting from changes in tax rates, tax-planning actions, and the portion of a change in the valuation allowance that results from a change in judgment about the realizability of the related deferred tax asset in future years. Note that in the absence of a basis for allocation, it may be appropriate to pro-rate the effects of changes in tax-planning actions between continuing operations and the CTA account.

3. The differential (1 less 2 above) represents (in the absence of any other items except continuing operations) the charge (or credit) to the CTA account, which should include the following components: –

The capital gain or loss effect of revaluation of contributed capital



The effect of exchange rate changes on beginning-of-year deferred taxes provided on unremitted earnings



The effect of exchange rate changes on the deferred tax liability provided on current year continuing operations (2 above) at year-end exchange rates



The effects of changes in the valuation allowance and changes in tax-planning actions that are not appropriately allocated to continuing operations

This computation will require appropriate consideration of foreign withholding taxes and limitations on utilization of foreign tax credits. Subsequent adjustments to deferred taxes originally charged or credited to CTA are not always allocated to CTA, but instead may be reported in continuing operations. Depending upon the accounting policy, adjustments due to changes in uncertain tax positions may be recorded either in CTA or as part of income tax from continuing operations. When subsequent adjustments to deferred taxes are not recorded in CTA, tax effects lodged therein will not necessarily equal the respective deferred taxes recognized in the balance sheet for the temporary differences related to the gains or losses in CTA. Recognition of those tax effects in net income would generally occur upon a disposal event that requires the CTA account to be recognized in income.

Foreign Branch Currency Gains and Losses Section 987 of the Internal Revenue Code addresses the taxation of foreign currency translation gains or losses arising from branches and certain other entities that operate in a currency other than the currency of their owner. Section 987 applies, for example, to a Euro functional currency branch owned by a U.S. company or to a Sterling branch owned by a Euro subsidiary of a U.S. company. Similar to the approach set forth in ASC 830, the existing section 987 regulations require taxpayers to translate income statement items at the average rate for the year. Under Treasury regulations proposed in 2006 the determination of applicable exchange rates is more complex. The 2006 regulations do not allow branch income to

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be calculated in its own functional currency and then translated into the owner's currency. Rather, the proposed regulations require that separate items of income, gain, deduction, and loss be translated into the owner's currency at various specified exchange rates. This approach makes the quantification of deferred taxes arising from translation process much more complex and can create permanent differences between book and taxable income. The approaches used to calculate translation gains and losses for book and U.S. federal tax purposes under the existing regulations typically produce the same amount of translation adjustments over the life cycle of a branch. Differences between book and tax currency translation gains or losses are largely of a timing nature because translation adjustments are taxed only upon remittance from the branch to its parent or (owner). Accordingly, prior to remittance, an owner would typically have a temporary difference attributable to the translation adjustments of the branch. Adoption of the approach set forth in the proposed regulations could, in contrast, result in a permanent difference because of the mandated use of specified exchange rates for tax purposes. Because branch income is directly taxable to the owner, both U.S. and local country deferred taxes are generally provided with respect to the temporary differences of the branch. However, depending on the owner's accounting policy, the owner may or may not record deferred taxes in the U.S. on the unrealized foreign currency translation gains or losses of the branch. (The branch will never record deferred taxes on these amounts as their reversal will not be subject to tax in the local jurisdiction). One acceptable policy holds that there is technically no outside basis for a branch and, therefore, an indefinite reinvestment assertion is not available. Thus, an owner would record deferred taxes related to the unremitted branch CTA. In a year in which a remittance is made, the owner would record a current tax expense or benefit included in its U.S. taxable income and an offsetting deferred tax benefit or expense to reflect the reversal of the temporary difference. A second acceptable policy allows for the application of an indefinite reinvestment assertion when facts and circumstances permit. Under this view, because taxation of the CTA occurs only upon remittance of cash from a branch, the accounting is based upon whether the owner has the ability to control the timing of taxation. If the owner has the ability and intention to postpone remittance, an indefinite reinvestment assertion can be applied to the CTA of a branch such that deferred taxes would be recorded only when a remittance is expected. When after applying this policy a remittance is subsequently expected, the resulting tax provision would be recorded in earnings attributable to continuing operations. Only the portion of the tax provision related to the current year change in CTA would be allocated to OCI.

Taxation of Foreign Currency Transactions Gains and losses from foreign currency transactions will generally be taxable (or deductible) either in the U.S. or in a foreign country. In the U.S., IRC Section 988 provides the general income tax rules for determining the timing, character (ordinary or capital), and source for foreign currency transactions denominated in, or determined by reference to, a non-functional currency. The types of transactions covered include: 1.

The acquisition or disposition of a non-functional currency

2. The acquisition of a debt instrument or becoming the obligor under a debt instrument 3. The accrual of any item of receipt or expense that is to be paid or received after the accrual date 4. Entering into or acquiring any forward contract, futures contract, option, or similar financial instrument

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The amount of a section 988 foreign currency gain or loss generally reflects the change in spot exchange rates between the "booking date" and the settlement date. The spot rate of a foreign currency generally is the quoted price for immediate settlement (payment and delivery). The booking date generally is the date a transaction is entered into or the date of origination. To the extent there is a difference in the timing of recognition of gain or loss for book and tax purposes, deferred tax accounting will apply. In general, a foreign currency gain or loss is treated as ordinary income for U.S. federal tax purposes. Special rules apply to transactions dealing with forward contracts, futures contracts, options, or similar financial instruments. A taxpayer may generally elect to treat a foreign currency gain or loss attributable to such transactions as capital if the underlying contract is a capital asset. A capital loss carryforward deferred tax asset created by a foreign currency loss would need to be assessed for realizability. Conversely, a deferred tax liability that reflects a future capital gain can provide a source of income to support the realizability of other capital loss deferred tax assets. The section 988 non-functional currency rules also apply to the calculation of E&P for foreign subsidiaries. Accordingly, the calculation of E&P would reflect the application of section 988 to transactions entered into by a foreign subsidiary. In turn, this may have an impact on the amount of deferred tax that is recognized or estimated for the outside basis difference in the subsidiary.

Hedging an Investment in a Foreign Subsidiary A parent company may enter into a transaction that qualifies as a hedge of its net investment in a foreign subsidiary. Because the net investment in a foreign subsidiary is in effect a position in the functional currency of that subsidiary, such a hedge might take the form of a foreign exchange forward contract. Another way that companies may hedge their net investment in a subsidiary is to take out a loan denominated in the foreign currency. Any gains or losses associated with this hedge are recognized in the CTA account. Consistent with the treatment of gains and losses associated with the hedging transaction, the tax effects of temporary differences created by the hedging transaction generally are credited or charged to CTA. If the indefinite reinvestment assertion applies to the foreign earnings, the parent would generally not provide deferred taxes related to CTA. However, unlike indefinitely reinvested earnings, these hedges are typically owned by the group parent and thus will be subject to tax in the parent’s tax return. Thus, the parent should provide for the tax effects of any temporary differences resulting from the hedging transaction because the associated tax consequences do not meet the indefinite reinvestment criteria. In such situations, a deferred tax asset or liability would be recognized on any gains or losses associated with the hedge, with corresponding entries in CTA. A resulting deferred tax asset would be assessed for realizability, particularly giving consideration to whether the hedge would give rise to a capital loss. Upon settlement of the hedge, the deferred taxes would be reclassified from OCI to income from continuing operations although the gain or loss remains in CTA. The net tax effects of the hedge would remain in CTA until the investment in the foreign entity was sold or, completely or substantially, liquidated. At that time, the remaining net tax effects of the hedge within CTA would be reversed and a corresponding tax expense or benefit would be recorded in continuing operations.

Hedging a Deferred Tax Balance An entity may have a foreign subsidiary that hedges the foreign currency risks associated with a deferred tax asset or liability. If the functional currency of the entity is the reporting currency, gains and losses from the remeasurement of the deferred tax asset or liability are recorded in the income statement and gains or losses from the hedging instrument designated as a fair value hedge of foreign currency should also be recorded in the income statement. The hedging gains or losses should be netted with the foreign currency gains or losses and reported on the same line within the income statement.

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Entities Whose Functional Currency is the Reporting Currency

Nonmonetary Assets and Liabilities The recognition of deferred taxes that are implicit in the balance sheet is based on the assumption that assets will be recovered and liabilities will be settled at their book carrying amounts. When a foreign operation uses the reporting currency (U.S. dollar for most U.S. multinationals) as its functional currency, the carrying amounts of nonmonetary assets and liabilities (e.g., fixed assets, inventory and deferred income) are based on reporting currency amounts that are derived by using historical exchange rates. That is, the rate of exchange between the foreign currency and the reporting currency at the time the asset or liability was recorded. The foreign tax basis of the asset generally would have been initially established when the asset was acquired and would have equalled the amount of foreign currency paid to acquire the asset. This is generally the same foreign currency amount which is translated at the exchange rate in effect when the asset was acquired (i.e., the historical rate) to arrive at the reporting currency carrying amount before depreciation. The foreign tax basis may also be subject to indexing under the foreign tax law. As a result, for any nonmonetary asset, the temporary difference for foreign tax purposes typically includes the following three components: 1.

The difference between the foreign tax basis before any adjustment for indexing and the carrying amount on the foreign currency books (i.e., after adjustment to U.S. GAAP and before remeasurement into the reporting currency)

2.

The difference created by changes in tax basis, if any, resulting from indexing provisions of the foreign tax law

3.

The difference arising in remeasurement (i.e., the difference between the historical-rate and current-rate translations of the reporting currency carrying amount)

An exception in ASC 740 to the general recognition of deferred taxes precludes the recording of deferred taxes for the second and third components when the functional currency is the reporting currency. Accordingly, they are not recognized when the functional currency and reporting currency are the same. Pre-tax income effects created by these assets and liabilities are conceptually the same as they would be if they were acquired in reporting currency. Thus, for fixed assets, when the reporting currency is the functional currency, deferred taxes should be computed in the foreign currency by comparing the historical book and tax bases in the foreign currency after the respective depreciation, but before any indexing for book or tax purposes. The foreign currency deferred tax is then remeasured into the reporting currency using the current exchange rate consistent with the requirement that all deferred taxes are translated at the current rate. Any additional tax depreciation on the current tax return that results from indexing will reduce the current tax provision and will be a permanent difference as there is no corresponding amount in pre-tax income.

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Example 7: Foreign Subsidiary with U.S. Dollar Functional Currency Fixed Asset Temporary Difference A parent that reports in U.S. dollars has a foreign subsidiary with U.S. dollar functional currency. The subsidiary purchased an item of plant and equipment for FC 5,000 at the start of year 1, when the exchange rate was FC5 to $1. The asset is depreciated on the straight-line basis over ten years for financial reporting purposes and over five years for tax purposes. The foreign tax law does not include indexing. The exchange rate increases to FC7 to $1 in year 3. In this example, deferred taxes should only be provided on the difference between the FC tax basis and the FC equivalent of the U.S. dollar book basis (i.e., the FC carrying amount under U.S. GAAP before remeasurement) translated at the historical exchange rate. Deferred taxes should not be provided on the remaining difference that is attributable to changes in the exchange rate since the time of the asset’s acquisition (i.e., the difference between the current exchange rate and the historical exchange rate at the date of acquisition). The calculation is illustrated below: Foreign currency Tax basis

Book Basis Before Remeasurement

USD book basis

Cost

FC5,000

FC5,000

$1,000

Accumulated depreciation Asset basis

(1,000) FC4,000

(500) FC4,500

(100) $ 900

Temporary difference

FC 500

Recognized under ASC 740

FC 500

U.S. dollar book basis translated into the foreign currency

Year 1 FX: FC5 = $1

FC4,500

Year 2 FX: FC5 = $1 Cost

FC5,000

FC5,000

$1,000

Accumulated Depreciation Asset basis

(2,000) FC3,000

(1,000) FC4,000

(200) $ 800

Temporary difference

FC1,000

Recognized under ASC

FC1,000

FC5,000

FC5,000

$1,000

(3,000)

(1,500)

(300)

Asset basis

FC2,000

FC3,500

$ 700

Temporary difference

FC2,900

Recognized under ASC 740

FC1,500

FC4,000

740 Year 3 FX: FC7 = $1 Cost Accumulated depreciation

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The temporary difference recognized under ASC 740 would be tax-effected at the applicable foreign tax rate and remeasured into the functional currency at the current exchange rate. In year 3 above, there is a total temporary difference of FC 2,900. This is the difference between the tax basis of the asset and the future foreign currency depreciation, at the current exchange rate, which is needed to recover the functional currency book basis. The temporary difference has arisen from two sources: –

The difference between U.S. GAAP depreciation in the foreign currency before remeasurement and tax depreciation. This element, which is a temporary difference of FC 1,500, is recognized under ASC 740.

The change in the exchange rate that changes the foreign currency equivalent of the functional currency book basis, using the current exchange rate. In this example, it increases the temporary difference by FC 1,400, (FC 4,900 vs. FC 3,500). This element is not recognized in the financial statements under U.S. GAAP.

Monetary Assets and Liabilities An entity located and taxed in a foreign jurisdiction, and having the reporting currency (or a third currency) as its functional currency, may have monetary assets and liabilities (e.g., cash, receivables, payables) denominated in the local currency. The local currency is typically the currency used to prepare income tax returns. While the effects of changes in the exchange rate would give rise to transaction gains or losses in the functional currency financial statements, the resulting change in the functional currency financial statement carrying amounts generally will not result in the recognition of either current or deferred taxes in the foreign jurisdiction. Where the monetary item is denominated in the local currency, changes in foreign exchange rates do not have tax consequences in the foreign jurisdiction and do not create basis differences between the local currency financial statement carrying amounts and the local currency tax basis. However, such an entity would usually have monetary assets and liabilities that are denominated in currencies other than the local currency. Gains and losses from foreign currency transactions may be taxable either in the local country or in a foreign country. If these gains and losses are included in taxable income in a period that differs from the period in which they are included in income for financial reporting purposes, a deferred tax liability or asset would need to be recorded. An example would be a foreign subsidiary’s intercompany payables denominated in the parent’s reporting currency. If the entity will be taxed on the difference between the original foreign currency asset or liability and the amount for which it will be ultimately settled, there would be a temporary difference for the monetary asset or liability. That difference would be computed by comparing the book basis in the local currency—e.g., the carrying amount in U.S. dollars in the remeasured financial statements translated at the current exchange rate—with the tax basis in the local currency. After application of the applicable tax rate to the temporary difference, the deferred tax would be translated at the current exchange rate into U.S. dollars for inclusion in the remeasured financial statements. A deferred tax asset would need to be assessed for realizability. This process will cause a deferred tax asset or liability to be recognized as the exchange rate changes. When the monetary asset or liability is denominated in U.S. dollars and the U.S. dollar is the reporting currency, changes in the exchange rate between the U.S. dollar and the foreign currency will give rise to a deferred tax effect, even though there is no pre-tax exchange-rate gain or loss in the remeasured financial statements. Foreign withholding taxes related to the reversal of outside basis differences are technically a liability of the parent and therefore the parent’s foreign currency transactions. As a result, to the extent foreign withholding taxes are being provided on the outside basis difference in a foreign subsidiary the related transaction gains and losses caused by changes in exchange rates should be recognized in the income statement. This may also be the case with respect to interest payments on intercompany loans. These transaction gains and losses can be recognized in either pre-tax income or as part of the income tax provision. Once made, this classification decision should be consistently applied to all foreign withholding tax transaction gains and losses.

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Example 8: U.S. Dollar Functional Currency Subsidiary Unrealized Foreign Exchange Gains/Losses Company P is a multinational company domiciled in the U.S. with a wholly-owned subsidiary (Sub) in Country B. Both the reporting currency (RC) and the functional currency of Sub is the U.S. dollar. Since Sub maintains its books in USD, there is no remeasurement from local currency into USD for financial statement purposes. Sub files its Country B tax return in local currency. Sub has a USD-denominated intercompany payable to P in the amount of $30 million. In addition, Sub has a customer receivable denominated in LC 10 million. The tax law of Country B requires that Sub’s unrealized foreign exchange gains or losses be included in both statutory income and taxable income in the period in which they arise. It is determined that this law applies with respect to both the intercompany loan and receivable. Since the intercompany loan is denominated in USD, there is no pre-tax accounting for unrealized translation gains or losses at each reporting date. For purposes of Sub’s tax filing in LC, unrealized exchange gains or losses are reported on the tax return as they occur. With respect to the receivable, Sub will recognize a transaction gain or loss in pre-tax income with no effect for local tax purposes. In this fact pattern, the unrealized gains or losses on the intercompany loan that are currently taxable will not reverse either on a future tax return or when the liability is settled. Therefore, such gains or losses that arise upon translation of the intercompany loan to local currency for tax reporting purposes should not be treated as a temporary difference. Rather, the effects on taxable income should be accounted for in the periods in which they arise. This treatment will impact the effective tax rate of the entity because there is no pre-tax gain or loss associated with the intercompany loan. Such tax effects should generally be included within income tax expense in continuing operations. To the extent the tax effects resulting from unrealized exchange gains or losses are significant, additional explanation may be provided with the tax rate reconciliation in the financial statements. It should be noted that a deferred tax liability or asset will be recorded if the taxing jurisdiction taxes such gains and losses only at the time they are realized. With respect to the receivable that is denominated in local currency, a transaction gain or loss will be recognized in the income statement as a result of the remeasurement process. However, this gain or loss has no current or future consequences for local income tax purposes. As a result, the effective tax rate will be impacted because a transaction gain or loss will be included in the consolidated income statement with no corresponding impact on income tax expense. Consideration should be given to disclosure of this effect in connection with the tax rate reconciliation in the financial statements.

Foreign Deferred Taxes When the Reporting Currency is the Functional Currency The total deferred tax expense or benefit for the year generally equals the change between the beginning-of-year and end-of-year balances of deferred tax accounts (i.e., assets, liabilities, and valuation allowance) on the balance sheet. In certain circumstances, however, the change in deferred tax balances is reflected in other asset and liability accounts. For example, changes in the deferred tax balances resulting from foreign currency exchange rate changes may not be classified as a tax expense or benefit. When the U.S. dollar is the functional currency of a foreign subsidiary, revaluations of foreign deferred tax balances are reported as transaction gains and losses or, if considered more useful, as deferred tax benefit or expense. When the foreign currency is the functional currency, revaluations of foreign deferred tax balances are included in CTA.

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Deferred Taxes on Intercompany Loans with Foreign Subsidiaries As noted in the discussion of Long-Term Advances, parent entities often have intercompany loans with their foreign subsidiaries that are of a long-term-investment nature such that settlement is not planned or anticipated in the foreseeable future. These loans may be denominated in the functional currency of the parent or the functional currency of the subsidiary. Because of the difference between the functional currencies and the denomination of the loan, foreign currency translation adjustments arise. The same considerations can apply to loans between other members of a consolidated reporting group. As a result, consideration must be given to whether deferred taxes should be recorded on these translation adjustments.

Example 9: Foreign Currency Gains and Losses Relating to Intercompany Loans Company X is a U.S. multinational corporation and has several outstanding intercompany loans with one of its wholly-owned foreign subsidiaries, Subsidiary Y. The functional currency of Subsidiary Y is the local currency. Company X has asserted that the loans are of a long-term investment nature and Company X meets the indefinite reinvestment criteria for its investment in Subsidiary Y. Therefore, foreign currency gains and losses with respect to the loans are reported in OCI. The intercompany loans can be divided into the following two categories: –

Loans denominated in the functional currency of Company X (the parent) for which Subsidiary Y bears the FX risk



Loans denominated in the functional currency of Subsidiary Y for which the parent bears the FX risk

Loans denominated in the functional currency of Subsidiary Y The intercompany loans and the related foreign currency gains and losses on the loans denominated in the functional currency of Subsidiary Y are not included in income. Instead, they are viewed as a part of Company X’s net investment in Subsidiary Y (i.e., outside basis difference). The tax effects should be evaluated under the principles of the indefinite reinvestment criteria. Accordingly, a deferred tax liability should be recorded for a book-over-tax outside basis difference unless an assertion of indefinite reinvestment is made.

Loans denominated in the functional currency of the parent The foreign currency gains and losses on intercompany loans denominated in the functional currency of Company X create a difference between the book basis and tax basis of the intercompany payable or receivable on Subsidiary Y’s books (i.e., an inside basis temporary difference). Deferred taxes should generally be provided on these types of temporary differences, and the tax benefit or expense should generally be recorded in OCI. However, if the parent is asserting indefinite reinvestment of its outside basis difference in Subsidiary Y, it may be appropriate to extend the principles of the indefinite reinvestment exception to the temporary differences related to the intercompany loans. This latter approach would only be appropriate if the ultimate taxation of the foreign currency effects of a loan only occur upon repayment and if settlement is not planned or anticipated in the foreseeable future. In cases where indefinite reinvestment is asserted, a second assessment must also be performed with respect to the intercompany loans to determine whether a deferred tax liability should be provided. If events other than a cash remittance or repatriation event could cause that portion of the temporary difference to become taxable, Company X would need to consider whether the taxable event can, in fact, be deferred indefinitely. For example, if a significant modification to the terms of the loan would cause a taxable event, if Company X is unwilling or unable to assert that such an event can be deferred indefinitely, a deferred tax liability should be established. The related tax expense would be recorded in OCI. A deferred tax asset for an excess of tax-over-book outside basis difference would be recorded only when it is apparent that it will be realized in the foreseeable future.

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Foreign Currency Interplay with Other Areas of ASC 740 The accounting for foreign currency can have an impact on other income tax accounting judgments and estimates. For example, CTA is part of OCI and, therefore, represents a potential source of income or loss of an entity. Accordingly, the amount of CTA can affect the assessment of the realizability of an entity's deferred tax assets. Recent foreign exchange losses could contribute to negative evidence in assessing the realizability of deferred tax assets. Conversely, a positive CTA balance may be considered a source of future taxable income if not indefinitely reinvested or there is a history of remittances. It is important to ensure that the judgments and estimates applied in various affected areas of reporting are not inconsistent. Another example would be the effects of translation of foreign deferred taxes on a U.S. parent's deferred taxes relating to the foreign operation. In the context of a U.S. parent that records deferred taxes on the temporary differences of a foreign branch including currency translation, exchange movements may impact the measurement of the U.S. deferred taxes. Similar consequences can arise with respect to translation effects on foreign deferred taxes of a subsidiary whose temporary differences will result in U.S. subpart F income or other circumstances in which the consequences are not indefinitely deferred.

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Change in Functional Currency Once a functional currency is determined a subsequent change, though unusual, may be made based upon changes in economic facts and circumstances. Such a change might be driven by changes in the currency environment or by business changes such as an operational evolution of a dependent branch into a more autonomous business. A change in functional currency is not a change in accounting principle that requires retrospective application to prior periods. Generally, the effects of the change, including the income tax accounting effects, will be recorded in the period of change. Once the functional currency is changed, financial statement translation and remeasurement of foreign currency transactions will be based on the entity's new functional currency. ASC 830 prescribes specific treatment for a change in functional currency to, or from, the reporting currency. If a change is made to the reporting currency, translation adjustments for prior periods are not removed from equity and the translated amounts for nonmonetary assets at the end of the prior period become the accounting bases of those assets in the period of the change and thereafter. If a change is made from the reporting currency to another currency, the adjustment attributable to current-rate translation of nonmonetary assets as of the date of the change is reported in CTA. The accounting bases of those assets are adjusted, as if they had always been measured in that manner. The former reporting currency values will be translated to the new currency at the then current exchange rates. Thus, differences from remeasurement of nonmonetary items and from tax indexing become part of the temporary differences between the new functional currency book and tax bases. A different rule applies, however, if the functional currency changes from the reporting currency to the local currency because the economy ceases to be considered highly inflationary. There has been speculation as to how the sovereign debt crisis in Europe will unfold and eventually be resolved. One possible scenario is that one or more Eurozone countries will exit the Euro and issue a new local currency. If that were to occur, Euro functional currency businesses operating in the country would need to evaluate whether the new local currency should be designated as the functional currency. Management would consider all of the relevant factors when considering whether a change is warranted, which could be well after the country changes its currency. The tax accounting for a change in functional currency to, or from, the reporting currency are the same regardless of the reason for the change. The U.S. federal income tax law concept of functional currency is rooted in the financial accounting concept; the regulations under IRC Section 985 allow functional currency to be determined in accordance with financial accounting in certain circumstances. Nonetheless, the timing of the recognition of the effects of a change can differ for book and tax purposes. For U.S. federal tax purposes a change in functional currency is a change in accounting method. The resulting adjustments are computed as of the last day of the taxable year prior to the year of change. Depending upon the circumstances, tax adjustments may include recognition of exchange gains or losses and effects on the tax basis of assets and liabilities. Such adjustments may have direct tax consequences, for example, for branch operations, whereas for foreign subsidiaries, the effects may only arise through E&P adjustments.

Highly Inflationary Economies

Switching to a Highly Inflationary Economy U.S. GAAP considers an economy to be highly inflationary when cumulative three-year inflation exceeds 100%. A currency in a highly inflationary economy is not considered stable enough to serve as a functional currency. As a result, ASC 830 requires that the financial statements of a foreign entity in a highly inflationary economy be remeasured as if the functional currency were the reporting currency. This generally has the effect of discontinuing the recording of currency translation adjustments in OCI and instead recording gains and losses on monetary assets and liabilities in earnings. Translation adjustments from prior periods are not removed from

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equity and the translated amounts for nonmonetary assets at the end of the prior period become the accounting bases of those assets upon transition. If the entity operating in the highly inflationary economy is a subsidiary of a foreign entity with a functional currency other than the reporting currency of the ultimate parent, the requirement that the financial statements of the entity be remeasured into the reporting currency should be implemented on an entity-by-entity basis. That is, the subsidiary should be remeasured into the reporting currency (which is likely the functional currency) of the immediate parent. Although the foreign currency translation guidance refers only to nonmonetary assets, the accounting basis of monetary assets and liabilities should be the translated amounts at the end of the prior period as well. In addition, when remeasuring the books of the foreign entity into the reporting currency, the historical rate should be the rate used for translation in the period immediately prior to transition to highly inflationary status. When the functional currency is the reporting currency, there is no recognition of deferred tax benefits that result from indexing, for tax purposes, assets and liabilities when the assets and liabilities are ones which remeasured into the reporting currency using historical exchange rates. Thus, deferred tax benefits attributable to indexing that occurs after the change in functional currency to the reporting currency are recognized only when realized on the tax return. Deferred tax benefits that were recognized for indexing before the change in functional currency to the reporting currency are eliminated when the related indexed amounts are realized as deductions for tax purposes. Prospectively, deferred tax assets should not be recorded for future indexation. Many multinational companies were faced with the applying these complex rules when Venezuela was determined to be a highly inflationary economy as of November 30, 2009. In many instances, net operating loss carryforwards (NOLs) in these jurisdictions are also indexed for inflation. There is no explicit guidance as to whether the tax benefit resulting from the indexation of existing NOLs should be recorded or precluded from recognition. In jurisdictions employing indexation for tax purposes, a foreign entity’s tax return will use indexed tax bases for nonmonetary assets to calculate tax deductions that may increase NOLs for which a deferred tax asset is reported. Because ASC 830 no longer regards deferred tax assets and liabilities as items that must be translated using historical exchange rates, the prohibition in ASC 740 on recognition of deferred tax benefits does not apply. The impact of indexing the NOLs should be recognized in the financial statements and the tax loss reported on the tax return should be used to calculate the deferred tax asset. Thus, the entire amount of the indexed foreign currency NOLs should be recognized as a deferred tax asset and translated using current exchange rates. Such deferred tax assets would need to be assessed for realizability.

Economies That Are No Longer Highly Inflationary When an economy is no longer highly inflationary and as a result the local currency is reinstated as the functional currency, existing balances in the reporting currency for all assets, liabilities and equity are translated at the current exchange rate at the date of change. The translated amounts become the new functional currency bases going forward. The effects of future exchange rate movements are reflected through the overall translation process. The CTA account, however, is not adjusted for the period during which the economy was highly inflationary.

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Currency-related Tax Disclosures The amount of income tax expense or benefit allocated to each component of OCI must be disclosed either on the face of the statements in which those components are displayed or in the notes to the financial statements. This includes the amount of income taxes allocated to translation adjustments. There are several forms of acceptable presentation. Certain disclosures are required for deferred tax balance sheet accounts. For example, disclosures are required with respect to outside basis differences that are considered indefinitely reinvested. The information to be disclosed includes either the amount of unrecognized deferred tax liability if determining that amount is practicable, or a statement that the determination is not practicable. A similar disclosure is required for intercompany financing arrangements that are considered to be of a long-term investment nature. Disclosure should be considered for all temporary differences for which deferred taxes have not been provided and the types of events which would cause such differences to become taxable. Within these disclosures, it may be appropriate to include information describing the extent to which the tax effects of currency translation have not been recognized. Disclosure related to foreign currency translation or transactions may be appropriate in connection with the footnote effective tax rate reconciliation. Classification, presentation and other accounting policy decisions relating to the tax effects of foreign currency translation or transactions may be disclosed. When the U.S. dollar is the functional currency of a foreign subsidiary, revaluations of foreign deferred tax balances are reported as transaction gains and losses or, if considered more useful, as deferred tax benefit or expense. If reported as deferred tax benefit or expense, those transaction gains and losses are still included in the aggregate transaction gain or loss disclosed for the period. There are also prescriptive disclosures required by ASC 740 with respect to uncertain tax positions, including an annual tabular reconciliation of unrecognized tax benefits for public companies. This would include unrecognized tax benefits due to uncertainties with respect to tax return positions relating to foreign currency transactions. In addition, the effects of currency translation on the line items within the tabular reconciliation may be presented either as a separate line item or included in the amount presented in each line item. Disclosure may include reference to the manner of presentation.

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Notable Differences Between U.S. GAAP and IFRS Income tax accounting principles under International Financial Reporting Standards (IFRS) are primarily set forth in International Accounting Standard No. 12, Income Taxes (IAS 12). The income tax accounting frameworks of IAS 12 and ASC 740 are both balance sheet liability models and share many fundamental principles. There are, however, some potentially significant differences in their application to foreign currency matters. Under IAS 12, deferred taxes are recognized for the difference between the carrying amount (which is determined using the historical exchange rate) and the tax basis (which is determined using the exchange rate on the balance sheet date). This differs from U.S. GAAP under which deferred taxes are not recognized for foreign currency movements on nonmonetary assets and liabilities that are remeasured from local currency to the functional currency at historical exchange rates. Intraperiod tax allocation also represents a frequently encountered area of difference. Under IAS 12, income tax expense or benefit generally follows the related pre-tax classification regardless of the period in which each is recorded. This is often described as ―backwards tracing‖. Although simple conceptually, this principle can be difficult to apply in practice. For example, it may require an analysis of how much of a temporary difference was actually recognized in the income statement and how much was recognized in equity should a change in facts require that deferred tax be recognized or derecognized relative to the temporary difference. Thus, if an entity changes its judgment regarding indefinite reinvestment, it may need to isolate the portion of the outside basis difference which relates to CTA. Under U.S. GAAP, which does not allow backwards tracing, changes in income tax expense that occur after the pre-tax item is recognized are generally reported as part of income from continuing operations. Thus, the tax effects of a change in judgment about indefinite reinvestment would generally be reported in continuing operations with only those effects related to current-year translation recorded in CTA.

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Acknowledgements This publication draws upon PwC's published guidance, particularly the Guide to Accounting for Income Taxes (2012), which should be considered by those seeking a more in-depth technical discussion or PwC's views with regard to particular topics. The primary authors gratefully acknowledge their numerous colleagues whose contributions enhanced the quality of this publication. Special appreciation is devoted to Julian Buck, PwC Partner, whose retirement will have occurred upon completion of this publication. Julian's experience, insight and unique enthusiasm for the subject matter were instrumental to the delivery of this publication.

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Contacts PwC is committed to helping companies navigate today’s tax accounting issues. Our national and global network of specialized tax accounting resources can help you tackle a wide range of tax accounting needs. With that in mind, please visit www.pwc.com/us/tas to view our comprehensive library of tax accounting thought leadership, webcasts, and tools addressing the business and technical issues related to tax accounting. For more information, please reach out to your local PwC partner or one of the following PwC professionals: Edward Abahoonie Partner, US Tax Accounting Services Technical Leader Phone: 973.236.4448 Email: [email protected] Ken Kuykendall Partner, Global & US Tax Accounting Services Leader Phone: 312.298.2546 Email: [email protected] Douglas Berg Managing Director, Global & US Tax Accounting Services Phone: 313.394.6217 Email: [email protected] Amanda Flanagan Tax Director Phone: 213.356.6022 Email: [email protected]

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This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state or local tax penalties. Solicitation © 2012 PricewaterhouseCoopers LLP. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.