9.8 Changes in U.S. Deferred Income Taxes Related to a Foreign Branch CTA
As discussed in Section 3.3.6.3, a branch is subject to taxation in two countries;
therefore, it will generally have in-country temporary differences and U.S. temporary
differences. Further, because a foreign branch of a U.S. parent operates in a foreign
country, its functional currency as determined under ASC 830 may be, and often is,
different from the U.S. parent’s functional currency. For example, the branch’s
functional currency may be the local currency, while the U.S. parent’s functional
currency is USD. When the U.S. parent uses the 1991 proposed regulations under IRC
Section 987,8 the branch’s taxable income or loss is calculated in the branch’s functional
currency and then translated into USD by using the average exchange rate for the taxable
year. Because the U.S. tax bases of the branch’s assets and liabilities are maintained
in the branch’s functional currency, the U.S. temporary differences and DTAs and DTLs
related to such assets and liabilities must be calculated in the functional currency;
then, the appropriate exchange rate must be used to translate the DTAs and DTLs into
USD. Therefore, exchange rate changes will cause the financial reporting carrying value
of the U.S. parent’s DTAs or DTLs related to the U.S. temporary differences to
fluctuate.
When exchange rate fluctuations cause fluctuations in the carrying value of DTAs or DTLs
related to U.S. temporary differences, each of the following views is acceptable for
recording the offsetting entry:
- View A — The offsetting adjustment should be recognized in the CTA account. The exchange rate fluctuation’s effect on the carrying value of the assets, including the change in the DTA or DTL, would be captured in CTA as part of the translation of the investment in the branch. Therefore, the foreign currency exchange rate effect on the DTA or DTL would be part of the tax effect of such translation adjustment, which should be recorded in CTA in accordance with ASC 740-20-45-11(b) and ASC 830-20-45-5.
- View B — The offsetting adjustment should be recognized in the U.S. parent’s income statement. Although the branch is considered a foreign entity under ASC 830, the DTAs or DTLs related to the U.S. temporary differences represent assets and liabilities of the parent entity rather than those of the branch being translated. Accordingly, the DTAs or DTLs represent the U.S. parent’s assets or liabilities that are denominated in a currency other than its functional currency. Exchange rate fluctuations will increase or decrease the amount of the parent’s functional currency cash flows upon recovery or settlement of the DTA or DTL; therefore, in accordance with ASC 830-20-35-1, such fluctuations would be reported as foreign currency transaction gains or losses in the determination of net income. Alternatively, under ASC 830-740-45-1, the U.S. parent may classify the transaction gain or loss in deferred tax benefit or expense rather than in pretax income if that presentation is considered more useful.
The selected method should be applied consistently to all DTAs and DTLs related to U.S.
temporary differences denominated in a foreign currency.
Example 9-10
Assume that a U.S. parent company (Parent Co.) establishes a
branch (Branch Co.) in the United Kingdom. In accordance with
ASC 830, management determines that the functional currency of
Parent Co. is USD, and that of Branch Co. is the British pound.
Parent Co. is subject to tax in the United States at 21 percent,
and Branch Co. is subject to tax in the United Kingdom at 20
percent. In addition, the taxes paid by Branch Co. in the United
Kingdom are fully creditable in the United States without
limitation, and Parent Co. intends to elect to claim FTCs in the
year in which the foreign temporary difference reverses.
Assume the following:
- In 20X6, Branch Co. had pretax book income of £200,000.
- For U.S. and U.K. income tax reporting purposes, Branch Co. has a taxable temporary difference of £100,000 because of accelerated depreciation.
- Branch Co. had no other U.K. or U.S. temporary differences.
- The exchange rates in effect during 20X6 were as follows:
- January 1 £1 = $1.5
- December 31 £1 = $1.2
- Weighted average £1 = $1.3
Parent Co. uses the 1991 proposed regulations to determine its
IRC Section 987 gain/loss.
Parent Co. calculates the currency adjustment for the DTAs and
DTLs associated with the U.S. temporary differences as
follows:
To record the currency adjustment of $100, Parent Co. would make
the following journal entries:
Journal Entry 1: Views A and B
Journal Entry 2: View A
Journal Entry 2: View B
Footnotes
8
On December 7, 2016, the IRS and the U.S. Treasury issued new
final and temporary regulations under IRC Section 987 (the “2016 Regulations”)
with a prospective effective date. The IRS subsequently issued additional
guidance that further deferred the prospective effective date of the regulations
and withdrew a portion of the temporary regulations. For reporting periods
including and after the issuance of the 2016 Regulations, entities will
generally need to adjust their computation of deferred taxes related to IRC
Section 987. In November 2023, the IRS and the U.S. Treasury released proposed
regulations under IRC Section 987 and related rules that would (1) retain the
basic approach in the final regulations issued in 2016 and 2019 and (2) add
various significant elections.