Generally, a taxpayer and each of its qualified business units (QBUs) must make all determinations under subtitle A of the Internal Revenue Code in its respective functional currency. See §1.985-1(a)(1). For taxable years beginning after August 24, 1994, a U.S. corporation’s QBU that would otherwise be required to use a hyperinflationary currency as its functional currency generally must use the dollar as its functional currency and must compute income or loss under the DASTM method of accounting described in §1.985-3. See §1.985-1(b)(2)(ii). Section 1.985-3(d)(3) contains a rule for translating into dollars dividends, certain transfers, and returns of capital from the QBU to its home office or parent corporation. On March 8, 2005, Notice 2005-27, 2005-13 I.R.B. 795, (see §601.601(d)(2) of this chapter), announced the intention to amend §1.985-3(d)(3) regarding the proper exchange rate for determining DASTM gain or loss when translating certain current and historical assets upon a transfer from a QBU to its home office or parent corporation, as the case may be.

Under the DASTM method of accounting, a QBU’s income or loss for a taxable year is computed in U.S. dollars and adjusted to account for its DASTM gain or loss. See §1.985-3(b). A QBU’s DASTM gain or loss for a taxable year is determined under §1.985-3(d) by first computing the QBU’s change in net worth from the prior year and then making specified adjustments. The QBU’s change in net worth is computed by comparing the year-end balance sheets for the current and preceding taxable years. See §1.985-3(d)(1)(i). Special rules provide that some balance-sheet items are translated at the exchange rate for the translation period in which the cost of the item was incurred and so do not give rise to DASTM gain or loss from year to year (“historical items”). See §1.985-3(d)(5). Other items are translated at the exchange rate for the last translation period for the taxable year and therefore do give rise to DASTM gain or loss (“current items”). See §1.985-3(d)(5).

The classification of an item as historical or current generally reflects the extent to which the item’s dollar value changes with fluctuations in exchange rates. For example, the dollar value of a financial asset, such as a unit of hyperinflationary local currency, necessarily changes with fluctuations in exchange rates. Accordingly, a financial asset generally is a current item. See §1.985-3(d)(5)(iv). By contrast, the value of a nonfinancial asset generally does not change with fluctuations in exchange rates. Accordingly, a nonfinancial asset generally is an historical item. See §1.985-3(d)(5)(v).

The computed change in the QBU’s net worth is then adjusted to reflect transactions that increase or decrease the QBU’s net worth without affecting the QBU’s income or loss. For example, an asset transferred from a QBU branch to its home office decreases the QBU’s net worth but does not affect the QBU’s income or loss and so must be added back to the QBU’s net worth for purposes of computing DASTM gain or loss. See §1.985-3(d)(3).

The DASTM method of accounting provides that adjustments described in the preceding paragraphs generally shall be translated into dollars at the exchange rate on the date the amount is paid. See §1.985-3(d)(3). This rule ensures that the QBU branch properly takes into account a current item’s change in value due to currency fluctuations while the item was in the QBU branch. However, applying this translation rule to historical items could potentially lead to distortions in the calculation of DASTM gain or loss. Because the value of historical items generally does not change with fluctuations in exchange rates, translating adjustments relating to historical items at the exchange rate on the date of distribution or transfer would inappropriately give rise to DASTM gain or loss.

The potentially anomalous results that may arise due to the application of the existing translation rule in §1.985-3(d)(3) can be prevented by modifying the rule to ensure that only the assets whose dollar value changes with fluctuations in exchange rates will give rise to DASTM gain or loss upon a transfer from a QBU to its home office. Accordingly, this proposed regulation amends §1.985-3(d)(3) in accordance with Notice 2005-27 as follows. The proposed regulation provides that if the item giving rise to the adjustment is a current asset which would be translated under §1.985-3(d)(5) at the exchange rate for the last translation period of the taxable year if it were on the QBU’s year-end balance sheet, the item will be translated at the exchange rate on the date the item is transferred. However, if the item giving rise to the adjustment is a historical asset which would be translated under §1.985-3(d)(5) at the exchange rate for the translation period in which the cost of the item was incurred if it were on the QBU’s year-end balance sheet, the item will be translated at the same historical rate.

Consistent with Notice 2005-27, this regulation is proposed to be effective for any transfer, dividend, or distribution that is a return of capital that is made after March 8, 2005, and that gives rise to an adjustment under §1.985-3(d)(3).

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because these regulations do not impose a collection of information on small entities, the provisions of the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply. Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying. A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for a public hearing will be published in the Federal Register.

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.985-3 is amended by revising paragraph (d)(3) to read as follows: