The Fundamentals
of Foreign Currency Conversion Transactions
John Golding
President
International Monetary
Specialists
- What
is cash?
- The
cash delivery market.
- Cash
denominated in FX it is treated as a commodity.
- How
do the foreign currency exchange markets work?
- Point
of conversion (POC).
- Foreign
currency exchange rates.
Basic
Principles: Cash, Conversion and Delivery
Point
of Conversion: Gold Illustration
The Point
of Conversion (POC) Modifies the Value
POC
Refinery
report
+
There is an economic cost
at the point of conversion.
POC
Report
- The POC report provided
after the gold refinery process is very detailed and describes all the
other components of the gold ore that were extracted upon the conversion
process.
- Such other components have
value!
- There is no comparable report
in the case of foreign currency conversions.
Common
Cases
- Company A: US based
parent company with foreign sales subsidiaries
- Company B: UK based
parent company that is selling products in the US using a US based sales
subsidiary
- Company C:
US based company imports products from the UK into the US.
Example:
Company A
- Company A is a
US corporation selling widgets worldwide.
- Overseas sales
are handled using foreign subsidiaries (e.g., in the UK).
- Sales proceeds
are denominated in the local subsidiary’s currency (GBP).
- The subsidiary
need to repatriate the money to its parent in USD.
- Conversion from
GBP to USD needs to be made to repatriate.
Example:
Company B
- Company B is a
resident of the UK and is the business of producing and selling widgets.
- The UK parent
establishes a subsidiary in the US to sell the widgets in the US.
- Sales proceeds
are denominated in USD.
- The subsidiary
needs to repatriate the money to UK in GBP.
Example:
Company C
- US based company
that is importing products from the UK into to the US.
- The US company
purchases the products from its subsidiary in the UK and needs to wire
money denominated in GBP to the foreign subsidiary.
http://www.MonetarySpecialists.com
How
Does Conversion Work?
The
Conversion Process
- Vast majority
of currency conversion transactions are conducted through banks.
- The banks created
their own primary market for conversion transactions.
- When Company A,
B and C need to convert GBP to USD or vice versa, they typically get
exchange rates quotes from three different banks, and use the best quoted
rate.
- However, exchange
rates are not the only cost involved in a foreign currency transaction.
Cost
and Transparency
- When the cash
is being channeled through the various intermediaries at the bank, it
is almost impossible to keep track on the various costs involved.
- The ultimate client
may not know how his or her money was channeled through the various
divisions in the bank, until he or she receives the converted cash.
- It presents a
challenge for clients who are trying to account for gains and losses
in a transaction.
- According to the
BIS, there is a daily GAP in currency trade
Contact
Information
John Golding
President, IMS
888.990.9895
jgolding@monetaryspecialists.com
GREENBERG TRAURIG, LLP
ATTORNEYS AT LAW WWW.GTLAW.COM
©2009. All rights reserved.
U.S. Tax Consequences
of Foreign Currency Exchange Transactions
Contact:
Yoram Keinan Shareholder keinany@gtlaw.com (212) 801-6826
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Basic Principles
- Foreign currency
(FX) is treated as personal property for US tax purposes.
- As such, disposition
of FX is subject to the general realization principles.
- Thus, when FX is
acquired, its basis is the cost.
- When the FX is
disposed of, the resulting gain or loss equals the amount realized minus
basis.
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Functional
Currency
- Currency transactions
with the taxpayer’s functional currency are generally
not taxable events. For example, use of functional currency to purchase
property denominated in functional currency does not result in FX gain
or loss.
- Thus, it is important
to determine what is the taxpayer’s functional currency.
- The taxpayer’s
functional currency is determined by reference to either the taxpayer
itself or the taxpayer’s identifiable separate business operation
entitled “qualified business operation (“QBU”).
- Each QBU of the
taxpayer has its own functional currency.
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Functional
Currency (Cont.)
- The USD is the
functional currency of a US taxpayer, or of the taxpayer’s
QBU, if its activities are mostly conducted in USD.
- Any effectively
connected income to a US trade or business of a foreign taxpayer is
generally treated as a separate QBU with the USD as its functional currency.
- Taxpayers can generally
elect to treat the USD as their functional currency.
- Functional currency
is treated as a “method of accounting.”
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Books and Records
- A crucial factor
in the functional currency determination is the books and records.
- It is accepted
that a QBU is deemed to maintain its books and records in the currency
of the “economic environment”
in which a significant part of its activities are conducted.
- A QBU’s
economic environment is determined under a facts and circumstances test.
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QBU
- “any
separate and clearly identified unit of a trade or business of a taxpayer”
if such unit “maintains separate books and records.”
- An individual may
have a qualified business unit (QBU) that has a non-dollar functional
currency.
- However, an activity
that does not generate deductible expenses does not qualify as a QBU.
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QBU (Cont.)
- Corporations, partnerships,
trusts and branches may be considered QBUs.
- Certain activities
of the above entities may qualify as a separate QBU if such activities
(1) constitute a trade or business and (2) separate books ad records
are kept for such activities.
- The activities
or an individual, as an employee, are generally not considered a separate
QBU.
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Economic Environment
Factors
- The currency of
the country in which the QBU is a resident.
- The currencies
of the QBU's cash flows.
- The currencies
in which the QBU generates revenues and incurs expenses.
- The currencies
in which the QBU borrows and lends.
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Economic Environment
Factors (Cont.)
- The currencies
of the QBU's sales markets.
- The currencies
in which pricing and other financial decisions are made.
- The duration of
the QBU's business operations.
- The significance
and/or volume of the QBU's independent activities.
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Section 988
- Section 988 and
regulations thereunder provide guidance as to the
timing, character and
source of gains and losses from FX transactions that are subject
to it.
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Section 988:
Timing
- Section 988 requires
gain or loss from the overall transaction as a threshold matter.
- The second step
is to bifurcate the overall gain or loss between gain or loss attributable
to changes in the exchange rates and gain or loss attributed to the
underlying transaction.
- The “spot”
rate is used to determine the extent of the FX gain or loss
- If there is gain
or loss on the underlying transaction, and an offsetting FX gain or
loss, the two are netted and only the excess is recognized.
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Section 988:
Character
- As a general rule,
FX gain or loss is ordinary
- Upon a taxpayer’s
election, FX gains or losses from certain FX denominated contracts,
including forwards, futures and options can be treated as capital.
- Some FX gains and
losses in connection with FX denominated debt instrument are characterized
as interest.
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Section 988:
Source
- In general, the
source of FX gains and losses is determined by reference to the taxpayer’s
residence or the residence of the taxpayer’s QBU.
- Exceptions:
- FX gains/losses
in connection with trade or business
- Certain high yield
related party FX denominated loans
- FX gains/losses characterized
as interest
- Integrated FX debt
and a hedge.
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Disposition
of FX
- A mere decline
in the FX’s value does not result in taxable
event, unless the FX was held in connection with a trade or business
and becomes valueless during the year.
- If a taxpayer disposes
of functional currency, there are no taxable consequences.
- Sale and other
disposition of nonfunctional currency will give rise to FX gain or loss,
computed under the general principles of section 1001.
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Exchange of
FX for other Currency
- Exchange of functional
currency with functional currency does not give rise to FX gain or loss.
- Exchange of units
of nonfunctional currency with different units of same nonfunctional
currency is not taxable event.
- Exchange of one
nonfunctional currency with another nonfunctional currency (e.g., Euro
to Yen) is taxable event.
- Exchange of nonfunctional
currency with functional currency is taxable event.
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Exchange of
FX for Property
- Treated as a two
step transaction:
- exchange of nonfunctional
currency to functional currency at the spot rate.
- Purchase of the property
for functional currency.
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Example
- G is a U.S. corporation
with the U.S. dollar as its functional currency.
- On January 1, 1989,
G enters into a contract to purchase a paper manufacturing machine for
10,000,000 British pounds for delivery on January 1, 1991.
- On January 1, 1991,
when G exchanges the BP 10,000,000 (which G purchased for $ 12,000,000)
for the machine, the fair market value of the machine is BP17,000,000.
- On January 1, 1991,
the spot exchange rate is BP1 = $ 1.50.
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Example (Cont.)
- The transaction
is treated as an exchange of BP 10,000,000 for $ 15,000,000 and the
purchase of the machine for $ 15,000,000.
- Accordingly, in
computing G's exchange gain of $ 3,000,000 on the disposition of the
BP 10,000,000, the amount realized is $ 15,000,000.
- G's basis in the
machine is $ 15,000,000.
- No gain is recognized
on the bargain purchase of the machine.
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Contact Information
Yoram Keinan
Shareholder, Tax
Greenberg Traurig
LLP
200 Park Avenue,
New York, NY 10166
212.801.6826
keinany@gtlaw.com