Part I
Section 988. --Treatment of
Certain Foreign Currency Transactions
26 CFR 1.988-1:
Certain definitions and special rules.
(Also § 1.988-2.)
Rev. Rul. 2008-1
ISSUE
What is the characterization for U.S. federal tax
purposes of an instrument (described further below) that is issued and redeemed
for U.S. dollars, but that provides an economic return that is determined by
reference to the euro and market interest rates in respect of the euro?
FACTS
Assume that on January 1, 2007, the spot rate of
exchange of U.S. dollars for euros was $1 =
€0.75. On January 1, 2007, Holder
delivered $100 to Issuer in exchange for the Issuer’s obligation (the
“Instrument”) to deliver to Holder, on January 1, 2010, the U.S. dollar
equivalent of an amount of euros (the “U.S. Dollar Equivalent Amount”). The U.S. Dollar Equivalent Amount is
determinable on January 1, 2010, and is the sum of the following amounts
translated into U.S. dollars at the spot rate on January 1, 2010: (i)
€75, and (ii) an amount of euros calculated by reference to a compound stated
rate of return applied to €75 from January 1, 2007, until January 1,
2010. The compound stated rate of
return is the excess of a rate based on euro interest rates over a rate labeled
as a “fee” for the benefit of the Issuer.
(The U.S. Dollar Equivalent Amount to be paid by Issuer to Holder on
January 1, 2010, may also be determined by reference to a mathematical formula
that generates the same substantive effect as the methodology described
above.)
Holder and Issuer expect that Issuer will pay the
U.S. Dollar Equivalent Amount on January 1, 2010. The legal remedies provided in the Instrument are not materially
different than legal remedies associated with instruments that are debt for
federal tax purposes.
The U.S. dollar is the functional currency of Holder.
There is a significant possibility that the U.S.
Dollar Equivalent Amount payable by Issuer to Holder on January 1, 2010,
may be significantly less than $100.
ANALYSIS
An instrument that requires payments to be made in a
foreign currency (that is, nonfunctional currency) can be debt for U.S. federal
income tax purposes. See, e.g.,
section 988(c)(1)(B)(i) of the Internal Revenue Code. Thus, although nonfunctional currency is considered to be
“property” for U.S. federal tax purposes (see, e.g., Philip Morris
Inc. v. Commissioner, 71 F.3d 1040 (2d Cir. 1995), aff’g
104 T.C. 61 (1995); National-Standard Company v. Commissioner, 749 F.2d
369 (6th Cir. 1984), aff’g 80 T.C. 551 (1983)), it is treated
like money for purposes of determining the amount and timing of interest that
accrues on debt. See
§1.988-2(b)(2) of the Income Tax Regulations; S. Rep. No. 313, 99th
Cong., 2d Sess., 1986-3 (Vol. 3) C.B. 461-463 (1986). Section 988 and regulations thereunder also provide that the
acquisition of a debt instrument or becoming the obligor under a debt
instrument is a section 988 transaction if the amount that a taxpayer is
entitled to receive or is required to pay is determined by reference to the
value of a nonfunctional currency. See,
e.g., section 988(c)(1); §§ 1.988-1(a)(1) (flush language),
1.988-2(b)(2)(i)(B)(2). These
provisions indicate that a financial instrument all the payments of which are
determined by reference to a single currency can be debt, notwithstanding the
fact that (i) all actual payments due under the instrument are made in a
different payment currency, and (ii) the amount of the different payment
currency that the issuer pays at maturity may be less than the amount of the
different payment currency that was initially advanced. Indeed, section 988 was adopted, in
part, to negate suggestions “that U.S. tax consequences can be manipulated by
arranging to repay a foreign-currency denominated loan in U.S. dollars
equivalent in value at repayment to the foreign currency borrowed.” S. Rep. No. 313, 99th
Cong., 2d Sess., 1986-3 (Vol. 3) C.B. 451 (1986). See also H.R. Rep. No. 426, 99th Cong. 1st
Sess. 1986-3 (Vol. 2) C.B. 466 (1985) and General Explanation of the Tax Reform Act of
1986, 100th Cong., 1st Sess., 1087 (1987).
The Instrument, in form, resembles a U.S. dollar
denominated derivative contract in which the Holder prepays its obligations
under the contract, and is entitled to receive a return based exclusively on
the value of property at maturity. (See
Notice 2008-2, 2008-2 I.R.B., dated January 14, 2008, requesting comments with
respect to these types of derivative contracts.) However, the U.S. Dollar Equivalent Amount that is payable at
maturity by the Issuer under the terms of the Instrument is determined
exclusively by reference to (i) the U.S. dollar value of the euros at issuance
and at maturity, and (ii) market interest rates in respect of the euro. At inception (on January 1, 2007), the
Holder delivers the U.S. dollar equivalent of €75, and at
maturity (on January 1, 2010) the
Issuer is required to pay the U.S. dollar equivalent of €75, plus the U.S. dollar value at maturity
of a return based on euro interest rates.
The fact that intervening currency fluctuations may cause the amount of
U.S. dollars that Holder receives at maturity (on January 1, 2010) to be less
than the amount of U.S. dollars that the Holder paid for the Instrument (on
January 1, 2007) does not affect the characterization of the Instrument as
debt, which is based on an analysis of payments with respect to the euro. The Issuer’s translation of U.S. dollars
into euros (on January 1, 2007) and euros into U.S. dollars (on January 1,
2010) is not relevant to the Instrument’s characterization.
HOLDING
For U.S. federal tax purposes, the Instrument is
euro-denominated indebtedness of Issuer.
This result is not affected if the Instrument is (i) privately offered,
(ii) publicly offered, or (iii) traded on an exchange.
DRAFTING INFORMATION
The principal authors of this revenue ruling are John
W. Rogers III of the Office of the Associate Chief Counsel (Financial
Institutions & Products) and Margaret Harris of the Office of Associate
Chief Counsel (International). For
further information regarding this revenue ruling contact Mr. Rogers at (202)
622-3950 or Ms. Harris at 202-622-3870 (not toll-free calls).