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. PwC Page 2 of 34
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 PwC Page 3 of 34
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. PwC Page 4 of 34
Summary of Key Terms Foreign entity Local currency Functional currency Reporting currency Foreign currency translation Foreign currency transactions Translation adjustments Transaction gains and losses Exchange rate A business whose financial statements are prepared in a currency other than the reporting currency of the enterprise Currency of the country in which the foreign entity is located Primary currency of the entity s operations Currency reported in the consolidated financial statements or separate company financial statements Process of expressing, in the reporting currency, an entity s financial position measured in a different currency Transactions denominated in a currency other than the functional currency Results of the process of translating functional currency to reporting currency Results of changes in exchange rates between functional currency and other currency Rate to convert one unit of currency into another unit of currency PwC Page 5 of 34
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: 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 PwC Page 6 of 34
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 Functional Currency Translation Method Local currency Local currency 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) Remeasurement from local currency to functional currency (monetary/nonmonetary method) and Current rate method of translation of functional currency to U.S. dollars Local currency U.S. dollar 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. PwC Page 7 of 34
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 0.5 245,000 725,000 362,500 Common stock 350,000 0.3 105,000 Retained earnings 375,000 121,550 Translation adjustments - See Below 135,950 725,000 362,500 Gross profit 125,000 0.4 50,000 Depreciation (34,500) 0.4 (13,800) Net income 90,500 36,200 Retained earnings, beginning-of-year 284,500 0.3 85,330 Retained earnings, end-of-year 375,000 121,550 Analysis of Cumulative Translation Adjustment LC FX USD Net assets, beginning-of-year 634,500 (0.5-0.3) = 0.2 126,900 Net income for the year 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. PwC Page 8 of 34
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 110,000 Net plant 524,500 634,500 Remeasurement LC FX USD Cash 235,000 0.5 117,500 Net plant 490,000 0.3 147,000 725,000 264,500 Common stock 350,000 0.3 105,000 Retained earnings 375,000 159,500 725,000 264,500 Gross profit 125,000 0.4 50,000 Depreciation (34,500) 0.3 (10,350) Foreign exchange gain - See below 34,500 Net income 90,500 74,150 Retained earnings, beginning-of-year 284,500 0.3 85,350 Retained earnings, end-of-year 375,000 159,500 Analysis of Foreign Exchange Gain Effect of change in the exchange rate during the year on net monetary assets at the beginning of the year LC FX USD Cash 110,000 (0.5-0.3) = 0.2 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 Beginning exchange rate (0.3) Average exchange rate for current year (0.4) Exchange rate for current year (0.5) Increase in cash 125,000 (0.5-0.4) = 0.1 12,500 34,500 PwC Page 9 of 34
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. PwC Page 10 of 34
To illustrate: Fact Pattern Impact on CTA Relevant Guidance Company A has a wholly-owned foreign subsidiary and sells a 30% ownership interest in the subsidiary. Company A maintains control over the subsidiary. 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. ASC 810-10-45-23 through 45-24 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. 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. 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. 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 830-30-40-2 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). PwC Page 11 of 34
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. PwC Page 12 of 34
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 October 31, 20X2 Receivable (U.S.-dollar-denominated) 137,500 0.4 55,000 Retained earnings 137,500 55,000 December 31, 20X2 Receivable (U.S.-dollar-denominated) 110,000 0.5 55,000 Retained earnings 137,500 55,000 (Loss) on U.S. dollar receivable (Income statement) (27,500) 0.3 (8,250) CTA (Balance sheet) 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. PwC Page 13 of 34
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 CTA January 1, 20X1 Cash 255,125 0.4 102,050 Bonds Payable 250,000 0.4 100,000 Premium on Bonds Payable 5,125 0.4 2,050 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) 200,000 0.5 100,000 Premium on Bonds Payable (U.S.-dollardenominated) 3,280 0.5 1,640 Total Liabilities 203,280 101,640 25,513 Retained earnings 42,845 0.45 19,280 CTA (Balance sheet) 2,143 42,845 21,423 Income Statement and CTA Effects LC FX USD CTA Amortization of Premium 911 0.45 410 Interest Expense (10,000) 0.45 (4,500) (450) Gain on Bonds 50,000 0.45 22,500 (22,500) Gain on Premium 934 0.45 420 (420) Gain on Accrued Interest 1,000 0.45 450 42,845 19,280 2,143 PwC Page 14 of 34
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 Balance Sheet Date LC USD LC USD Intercompany transfer price 120 120 120 150 Parent cost 100 100 Parent profit component 20 20 Inventory after profit elimination 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. PwC Page 15 of 34
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. PwC Page 16 of 34
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 PwC Page 17 of 34
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 PwC Page 18 of 34
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 PwC Page 19 of 34
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 PwC Page 20 of 34
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. PwC Page 21 of 34
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. PwC Page 22 of 34