Chapter 9 — Foreign Currency Matters
Chapter 9 — Foreign Currency Matters
9.1 Overview
The primary objective of ASC 830, which provides guidance on foreign
currency matters, is for reporting entities to present their consolidated financial
statements as though they are the financial statements of a single entity. Therefore, if
a reporting entity operates in more than one currency environment, it must translate the
financial results of those operations into a single currency (referred to as the
reporting currency). However, this process should not affect the financial results and
relationships that were created in the economic environment of those operations.
In accordance with the primary objective of ASC 830, a reporting entity must use a
“functional currency approach” in which all transactions are first measured in the
currency of the primary economic environment in which the reporting entity operates
(i.e., the functional currency) and then translated into the reporting currency.
In preparing consolidated financial statements as though they are the financial
statements of a single entity, an entity has essentially three currencies to consider:
- Local currency (abbreviated in examples below as "LC" in references to specific currency amounts) — Generally the currency of the country in which the entity operates, it is also the currency in which the financial statements are maintained for local reporting purposes and is commonly, but not always, the currency in which an entity files its tax returns.
- Functional currency (abbreviated in examples below as "FC" in references to specific currency amounts) — The ASC master glossary states that “[a]n entity’s functional currency is the currency of the primary economic environment in which the entity operates; normally, that is the currency of the environment in which an entity primarily generates and expends cash” from its activities. It is also commonly, but not necessarily, the local currency.
- Reporting currency (abbreviated in examples below as "RC" in references to specific currency amounts) — This is the currency in which the financial statements of the reporting group are prepared for consolidated financial reporting purposes.
Local currency amounts are remeasured into functional currency,
and functional currency amounts are translated into the reporting currency in
accordance with the guidance in ASC 830, as discussed in more detail below.
See Deloitte’s Roadmap Foreign Currency Matters for more information.
ASC 830-740
05-1 Topic
740 addresses the majority of differences between the financial
reporting (or book) basis and tax basis of assets and
liabilities (basis differences).
05-2 This
Subtopic addresses the accounting for specific types of basis
differences for entities operating in foreign countries. The
accounting addressed in this Subtopic is limited to the deferred
tax accounting for changes in tax or financial reporting bases
due to their restatement under the requirements of tax laws or
generally accepted accounting principles (GAAP) in the United
States. These changes arise from tax or financial reporting
basis changes caused by any of the following:
- Changes in an entity’s functional currency
- Price-level related changes
- A foreign entity’s functional currency being different from its local currency.
This Subtopic addresses whether these changes, which can affect
the amount of basis differences, result in recognition of
changes to deferred tax assets or liabilities.
Overall Guidance
15-1 This
Subtopic follows the same Scope and Scope Exceptions as outlined
in the Overall Subtopic, see Section 830-10-15, with specific
qualifications noted below.
Entities
15-2 The
guidance in this Subtopic applies to all entities operating in
foreign countries.
Transactions
15-3 The
guidance in this Subtopic applies to certain specified deferred
tax accounting matters, specifically to the income tax
consequences of changes to tax or financial reporting bases from
their restatements caused by:
- Changes in an entity’s functional currency
- Price-level related changes
- A foreign entity’s functional currency being different from its local currency.
Remeasurement Changes Causing Deferred Tax Recognition
25-1 This
Section addresses basis differences that result from
remeasurement of assets and liabilities due to changes in
functional currency and price levels. These remeasurement
changes will often affect the amount of temporary differences
for which deferred taxes are recognized.
Functional Currency Related Changes
25-2 Subtopic 830-10 requires that a
change in functional currency from the reporting currency to the
local currency when an economy ceases to be considered highly
inflationary shall be accounted for by establishing new
functional currency bases for nonmonetary items. Those bases are
computed by translating the historical reporting currency
amounts of nonmonetary items into the local currency at current
exchange rates.
25-3 As a
result of applying those requirements, the functional currency
bases generally will exceed the local currency tax bases of
nonmonetary items. The differences between the new functional
currency bases and the tax bases represent temporary differences
under Subtopic 740-10, for which deferred taxes shall be
recognized. Paragraph 830-740-45-2 addresses the presentation of
the effect of recognizing these deferred taxes.
Price-Level Related Changes
25-4
Entities located in countries with highly inflationary economies
may prepare financial statements restated for general
price-level changes in accordance with generally accepted
accounting principles (GAAP) in the United States. The tax bases
of assets and liabilities of those entities are often restated
for the effects of inflation.
25-5 When
preparing financial statements restated for general price-level
changes using end-of-current-year purchasing power units,
temporary differences are determined based on the difference
between the indexed tax basis amount of the asset or liability
and the related price-level restated amount reported in the
financial statements. Example 1 (see paragraph 830-740-55-1)
illustrates the application of this guidance.
Inside Basis Differences
Within Foreign Subsidiaries That Meet the Indefinite
Reversal Criterion
25-6
Temporary differences within an entity’s foreign subsidiaries
are referred to as inside basis differences. Differences between
the tax basis and the financial reporting basis of an investment
in a foreign subsidiary are referred to as outside basis
differences.
25-7
Inside basis differences of a foreign subsidiary of a U.S.
parent where the local currency is the functional currency may
result from foreign laws that provide for the occasional
restatement of fixed assets for tax purposes to compensate for
the effects of inflation. The amount that offsets the increase
in the tax basis of fixed assets is sometimes described as a
credit to revaluation surplus, which some view as a component of
equity for tax purposes. That amount becomes taxable in certain
situations, such as in the event of a liquidation of the foreign
subsidiary or if the earnings associated with the revaluation
surplus are distributed. In this situation, it is assumed that
no mechanisms are available under the tax law to avoid eventual
treatment of the revaluation surplus as taxable income. The
indefinite reversal criteria of Subtopic 740-30 shall not be
applied to inside basis differences of a foreign subsidiary, as
indicated in paragraph 740-30-25-17, and a deferred tax
liability shall be provided on the amount of the revaluation
surplus.
25-8
Paragraph 740-10-25-24 indicates that some temporary differences
are deferred taxable income and have balances only on the income
tax balance sheet. Therefore, these differences cannot be
identified with a particular asset or liability for financial
reporting purposes. Because the inside basis difference related
to the revaluation surplus results in taxable amounts in future
years based on the provisions of the foreign tax law, it
qualifies as a temporary difference even though it may be
characterized as a component of equity for tax purposes.
Subtopic 740-30 clearly limits the indefinite reversal criterion
to the temporary differences described in paragraph
740-10-25-3(a) and shall not be applied to analogous types of
temporary differences.
Remeasurement Changes Not Resulting in Deferred Tax
Recognition
25-9 Some
remeasurement-caused changes in basis differences do not result
in recognition of deferred taxes.
25-10 As
indicated in paragraph 740-10-25-3(f), recognition is prohibited
for a deferred tax liability or asset for differences related to
assets and liabilities that, under the requirements of Subtopic
830-10, are remeasured from the local currency into the
functional currency using historical exchange rates and that
result from changes in exchange rates or indexing for tax
purposes.
25-11
Paragraph 830-10-45-16 provides additional guidance on
accounting for the eventual recognition of indexing related
deferred tax benefits after an entity’s functional currency
changes from the foreign currency to the reporting currency
because the foreign economy becomes highly inflationary.
Foreign Financial Statements Restated for General Price Level
Changes
30-1 In
foreign financial statements that are restated for general
price-level changes, the deferred tax expense or benefit shall
be calculated as the difference between the following two
measures:
- Deferred tax assets and liabilities reported at the end of the current year, determined in accordance with paragraph 830-740-25-5
- Deferred tax assets and liabilities reported at the end of the prior year, remeasured to units of current general purchasing power at the end of the current year.
30-2 The
remeasurement of deferred tax assets and liabilities at the end
of the prior year is reported together with the remeasurement of
all other assets and liabilities as a restatement of beginning
equity.
30-3
Example 1 (see paragraph 830-740-55-1) illustrates the
application of this guidance.
45-1 As
indicated in paragraph 830-20-45-3, when the reporting currency
(not the foreign currency) is the functional currency,
remeasurement of an entity’s deferred foreign tax liability or
asset after a change in the exchange rate will result in a
transaction gain or loss that is recognized currently in
determining net income. Paragraph 830-20-45-1 requires
disclosure of the aggregate transaction gain or loss included in
determining net income but does not specify how to display that
transaction gain or loss or its components for financial
reporting. Accordingly, a transaction gain or loss that results
from remeasuring a deferred foreign tax liability or asset may
be included in the reported amount of deferred tax benefit or
expense if that presentation is considered to be more useful. If
reported in that manner, that transaction gain or loss is still
included in the aggregate transaction gain or loss for the
period to be disclosed as required by that paragraph.
45-2 The
deferred taxes associated with the temporary differences that
arise from a change in functional currency discussed in
paragraph 830-740-25-3 when an economy ceases to be considered
highly inflationary shall be presented as an adjustment to the
cumulative translation adjustments component of shareholders’
equity and therefore shall be recognized in other comprehensive
income.
Related Implementation Guidance and Illustrations
9.2 Remeasurement
An entity’s functional currency is determined by considering each of the economic factors
in ASC 830-10-55. After considering these factors, management may determine that an
entity’s functional currency is the currency of the jurisdiction in which the entity
operates (i.e., the local currency). Management may also conclude, on the basis of the
facts and circumstances, that the functional currency is that of another jurisdiction
(e.g., a U.K. subsidiary of a U.S. parent might have a local currency of pounds
sterling, a functional currency of euros, and a reporting currency of U.S. dollars).
Each balance sheet and income statement account must be measured in an entity’s
functional currency for financial reporting purposes. Therefore, if an asset or
liability or transaction is denominated in a currency other than the functional currency
(e.g., local currency), it must be remeasured from that currency into the functional
currency. In addition, if an entity’s books and records are not maintained in the
functional currency, the entity must remeasure each balance sheet and income statement
account into the functional currency. Therefore, an entity’s book basis in an asset or
liability is also established in its functional currency.
ASC 830 provides the following guidance on the rate to be used in
remeasuring local currency balance sheet and income statement amounts:
Description
|
Exchange Rate
|
---|---|
Monetary assets and liabilities
|
Current exchange rate
|
Nonmonetary assets and liabilities
|
Historical exchange rate
|
Revenue and expense items
|
Weighted-average or historical exchange rate
|
Remeasurement of various balance sheet and income statement items by
using different exchange rates will generally cause the balance sheet to not balance;
unlike the translation adjustment, the adjustment required to bring the balance sheet
into balance is usually recorded through the income statement as a remeasurement gain or
loss, or often referred to as a transaction gain or loss.
Regardless of an entity’s functional currency for financial reporting
purposes, its tax return is generally prepared in the local currency. Therefore, an
entity’s tax basis in an asset or liability is also typically established in the local
currency. As a result, the remeasurement gains and losses noted above generally never
enter into the tax computation in the local jurisdiction and, hence, represent a
permanent difference, as discussed in more detail below.
Example 9-1
Remeasurement — Monetary
Entity S is a foreign subsidiary of Entity X.
The functional currency (FC) of S is the euro, which is not the
local currency (LC). Assume the following:
- On January 1, 20X1, S obtains a 500,000 LC loan from a third party (i.e., monetary liability) when the exchange rate is 1 LC to 1 FC.
- Entity S’s tax basis in the loan is 500,000 LC on January 1, 20X1.
- On December 31, 20X1, the exchange rate is 1 LC to 2 FC.
- For simplicity, assume that the liability balance has not changed.
On December 31, 20X1, S remeasures the liability
from its local-currency-denominated value of 500,000 LC to 1
million FC. The remeasured value results in an unrealized pretax
remeasurement loss of 500,000 FC for financial reporting
purposes. However, there is no change in book/tax basis
difference since the amount required to settle the liability
(500,000 LC = 1 million FC ÷ 2) and the tax basis (500,000 LC)
has not changed. Therefore, although the fluctuations in the
exchange rate resulted in a pretax loss for financial reporting
purposes, S would not record any deferred taxes (i.e.,
remeasurement loss represents a permanent item since it is not
deductible for income tax reporting purposes).
Connecting the Dots
Because the tax return is generally prepared in the local currency (and taxable
income therefore is determined in the local currency), an entity must also
calculate the temporary differences in the local currency to determine the
amount that will ultimately result in an increase or decrease to taxes payable
in future years.
The inherent assumption in ASC 740 regarding the accounting for
temporary differences is that assets will be recovered and liabilities will be settled
at their respective book basis, which is determined in the entity’s functional currency.
Therefore, if the functional currency is different from the local currency, changes in
the exchange rate will also change the amount of local currency revenues necessary to
recover or settle the book basis of an asset or liability; however, the local currency
tax basis will not have changed. In addition, because temporary differences (i.e., the
deductible/taxable difference between the book basis and tax basis) must be determined
in the local currency, fluctuations in exchanges will affect the book basis of an asset
or liability when calculated in the local currency.
The income tax accounting for nonmonetary and monetary assets and
liabilities is discussed in further detail in the next sections.
9.2.1 Nonmonetary Assets and Liabilities
When the functional currency is not the local currency, an entity is
required to remeasure, for financial reporting purposes, nonmonetary assets and
liabilities (e.g., PP&E) from the local currency into the functional currency by
using the historical exchange rate (i.e., the exchange rate that was in effect when
the transaction was executed). By using the historical exchange rate to remeasure
nonmonetary assets and liabilities, the entity achieves the same result it would
have achieved had it entered into the related transactions in its functional
currency. Therefore, fluctuations in exchange rates will neither increase nor
decrease the carrying amount of nonmonetary assets and liabilities (and will not
give rise to remeasurement gains and losses for financial reporting purposes).
Under ASC 740, it is assumed that assets will be recovered and liabilities will be
settled at their respective financial reporting carrying amounts. Therefore, if the
exchange rate changes after a nonmonetary asset or liability is acquired or
incurred, respectively, the amount of local currency needed to recover the asset or
settle the liability will also change. However, the tax basis of the asset or
liability will not change because it would have been established when the asset was
acquired or the liability was incurred (in the local currency). Therefore, changes
in the exchange rate result in a difference between the amount of local currency
needed to recover the functional-currency-denominated carrying value and the local
currency tax basis.
ASC 740-10-25-3(f) prohibits “recognition of a deferred tax liability or asset for
differences related to assets and liabilities that, under Subtopic 830-10, are
remeasured from the local currency into the functional currency using historical
exchange rates and that result from changes in exchange rates or indexing for tax
purposes.” In other words, deferred taxes are not recorded for basis differences
related to nonmonetary assets and liabilities that result from changes in exchange
rates.
Although this basis difference technically meets the definition of a temporary
difference under ASC 740, the FASB concluded that accounting for it as a temporary
difference would result in the recognition of deferred taxes on exchange gains and
losses that are not recognized in the income statement under ASC 830. For this
reason, the FASB decided to prohibit recognition of the deferred tax consequences
for those differences.
However, entities are still required to record deferred taxes for
differences between the local currency tax basis and the local currency book basis
that do not arise from changes in exchange rates or indexing for tax purposes (e.g.,
when a nonmonetary asset is depreciated over different periods or at different rates
for book and tax purposes). The deferred taxes for these types of basis differences
are determined in the local currency and then remeasured into the functional
currency at the spot rate. See Example 9-3 for
an illustration of this concept.
Example 9-2
Temporary Differences Not Recognized Under ASC 740
Entity S is a foreign subsidiary of Entity P. The FC of S is
USD, which is not the LC. Assume the following:
- On January 1, 20X1, S purchases a piece of equipment for 500,000 LC when the exchange rate is 1 USD to 1.25 LC (i.e., FC book basis is 400,000 USD).
- The equipment is depreciable on a straight-line basis over 10 years for both financial reporting and tax purposes.
- The foreign tax basis and book basis in the asset is 500,000 LC (the amount paid to acquire the asset). Therefore, no temporary difference exists at the time of purchase.
- The exchange rate on December 31, 20X1, is 1 USD to 1.5 LC.
- The tax rate in S’s jurisdiction is 30 percent.
In this example, if S were to sell the
equipment for its functional currency book basis of $360,000
($400,000 historical cost less $40,000 of accumulated
depreciation) as of December 31, 20X1, S would not recognize
any book gain or loss in its functional currency financial
statements. However, S would realize a taxable gain of
90,000 LC in its local tax return, as illustrated in the
following table:
The difference between the local-currency-denominated
hypothetical sale proceeds and the tax basis meets the
definition of a temporary difference. However, because ASC
740-10-25-3(f) prohibits the recognition of deferred taxes
associated with differences related to nonmonetary assets
and liabilities that are caused by changes in the exchange
rate, S should not record deferred taxes for the 90,000 LC
basis difference.
In this example, there are no other differences between the
local currency book basis and the local currency tax basis
of the equipment that would give rise to deferred taxes.
Example 9-3
Temporary Differences Recognized Under ASC 740
Assume the same facts as in the example
above, except:
- The equipment is depreciated over five years for tax purposes.
- The weighted-average exchange rate during 20X1 is 1 USD to 1.35 LC.
As of December 31, 20X1, Entity S measures
the deferred taxes related to the equipment, as illustrated
in the following table (all amounts are in local
currency):
As indicated above, S recognizes a DTL of
15,000 LC (30% of 50,000 LC) as of December 31, 20X1,
related to the equipment for the difference between the
local currency book basis and local currency tax basis
caused by the difference in depreciation methods. The DTL is
then remeasured into the functional currency at the
reporting-date spot rate. In addition, S recognizes a
deferred tax expense of 15,000 LC in 20X1 as a result of the
increase in the DTL, which is then remeasured into the
functional currency at the weighted-average exchange rate in
effect during 20X1. The difference between these two amounts
results in a foreign currency transaction gain during 20X1,
as illustrated in the following table:
In accordance with ASC 830-740-45-1, S may
present the transaction gain as a deferred tax benefit (as
opposed to a transaction gain above the line) if that
presentation is considered more useful. If the transaction
gain is reported in that manner, it would still be included
in the aggregate transaction gain or loss for the period to
be disclosed as required by ASC 830-20-45-1.
9.2.2 Indexing of the Tax Basis
In addition to fluctuations in the exchange rate, basis differences may arise for
nonmonetary assets and liabilities as a result of indexing that is permitted or
required under the local tax law. Specifically, certain countries (especially those
with economies that are considered highly inflationary) may permit or require
taxpayers to adjust the tax basis of an asset or liability to take into account the
effects of inflation. The inflation-adjusted tax basis of an asset or liability
would be used to determine the future taxable or deductible amounts.
ASC 740-10-25-3(f) prohibits the recognition of a DTL or DTA for tax
consequences of “differences related to assets and liabilities that, under Subtopic
830-10, are remeasured from the local currency into the functional currency using
historical exchange rates and that result from changes in exchange rates or indexing for tax purposes” (emphasis added).
As discussed in Section 9.2, under ASC 830, assets and liabilities are remeasured
when the local currency and the functional currency are not the same. The exception
in ASC 740-10-25-3(f) applies only with respect to nonmonetary assets and
liabilities when the parent remeasures the foreign entity’s financial statements
from the local currency into the functional currency (i.e., by using historical
exchange rates). DTAs and DTLs are considered to be monetary assets and
liabilities,1 and therefore, the prohibition in ASC 740-10-25-3(f) would not apply to the
indexation of NOL carryforwards, if permitted. If the foreign entity’s local
currency is the functional currency (i.e., subject to translation rather than
remeasurement), the guidance in ASC 740-10-25-3(f) does not apply. The foreign
entity would recognize the deferred tax effects of any indexing, and the parent
would then translate the resulting deferred taxes into the reporting currency. The
example below illustrates this concept.
Example 9-4
Assume that Entity X reports under U.S. GAAP
in USD and has operations in a foreign country in which the
local currency is the functional currency. Under the foreign
jurisdiction’s tax law, the tax basis of depreciable assets
increases in accordance with a particular index. That
increase is 10 percent at the end of 20X1, and X is
therefore able to deduct additional depreciation in current
and future years. Further, at the end of 20X1, the basis of
depreciable assets is 1,000 FC units for financial reporting
purposes and 1,100 FC units for tax purposes after indexing
is taken into account. In addition, the foreign tax rate is
50 percent, and the current exchange rate between the
foreign currency and the USD is 2 FC to $1.
Entity X would establish a DTA related to the indexation of
the tax basis. The DTA is measured in accordance with
foreign tax law and is determined on the basis of the
deductible temporary difference between the financial
reporting basis of the asset (1,000 FC) and the indexed tax
basis (1,100 FC). Thus, at the end of 20X1, X would record a
DTA of 50 FC ([1,100–1,000] × 50%) in the foreign currency
books of record. That DTA would be translated as $25 (50 FC
× 0.5) on the basis of the current exchange rate.
Note that in accordance with ASC 740-10-25-3(f), if the
functional currency is different from the local currency,
the DTA related to the indexed tax basis would not be
recognized.
9.2.3 Monetary Assets and Liabilities When the Reporting Currency Is the Functional Currency
As stated above, the exception in ASC 740-10-25-3(f) does not apply to assets and
liabilities that are remeasured by using current exchange rates (referred to as
“monetary assets and liabilities”). However, when a foreign entity’s functional
currency is different from the local currency (e.g., the functional currency is the
reporting currency of its parent), the foreign entity’s deferred tax accounting for
monetary assets and liabilities depends on whether the asset or liability is
denominated in the local currency or the reporting currency.
9.2.3.1 Local-Currency-Denominated Monetary Assets and Liabilities
When a monetary asset or liability is denominated in an entity’s local currency,
it must be remeasured into the entity’s functional currency each period by using
the current exchange rate for financial reporting purposes. Therefore, when the
reporting currency is the functional currency, monetary assets and liabilities
denominated in the local currency must be remeasured into the reporting currency
at the then-current exchange rate. Fluctuations in the exchange rate between the
local currency and the reporting currency will result in (1) changes in the
financial-reporting carrying value of the monetary asset or liability and (2)
transaction gains and losses for financial reporting purposes.
However, although a pretax gain or loss is recognized for
financial reporting purposes, there will be no current or deferred tax expense
or benefit. This is because the exchange rate fluctuations will not result in
taxable income or loss when the asset is recovered or the liability is settled
since the local currency is used to determine taxable income (i.e., those gains
and losses exist only when the asset or liability is measured in the functional
currency). Further, these exchange rate fluctuations do not contribute to any
difference between the book and tax basis of the asset or liability when the
book basis is measured in the local currency. Therefore, there are no current or
deferred tax consequences related to the transaction gains and losses. Thus,
such gains or losses will be permanent items that affect the ETR (i.e., pretax
income or loss with no related tax expense or benefit).
Example 9-5
Local-Currency-Denominated Debt
Entity A, a foreign entity located in
Canada, has a U.S. parent that uses the USD as its
reporting currency. In accordance with ASC 830, A
determines that its functional currency is the reporting
currency of its parent (USD) and not the local currency,
the Canadian dollar (CAD). Entity A’s currency for
income tax reporting purposes is the CAD. On September
30, 20X5, A obtains a loan for CAD 100 million from its
U.S. parent when the exchange rate is USD 1 to CAD 1.25.
The exchange rate on December 31, 20X5, is USD 1 to CAD
1.33.
On September 30, 20X5, the date of the borrowing, A
records the loan at its USD-equivalent value of USD 80
million (CAD 100 million ÷ 1.25). Entity A’s tax basis
in the borrowing is the initial amount borrowed of CAD
100 million (i.e., the tax basis is the
local-currency-denominated amount).
On December 31, 20X5, A remeasures the
liability from its local-currency-denominated value of
CAD 100 million into USD by using the exchange rate in
effect on that date. The remeasured value of USD 75
million (CAD 100 million ÷ 1.33) results in an
unrealized pretax transaction gain of USD 5 million for
financial reporting purposes, which is the difference
between the financial statement carrying value (in USD)
on September 30, 20X5, and that on December 31,
20X5.
However, on December 31, 20X5, there is no unrealized
gain for tax purposes because there is no difference
between the amount required to settle the liability (CAD
100 million) and the tax basis of the liability (CAD 100
million). Since taxable income is determined by using
CAD and the loan is denominated in CAD, the balance is
unchanged from its original tax basis of CAD 100 million
and there is no unrealized gain for tax corresponding to
the gain for financial reporting. Therefore, although
the fluctuation in the exchange rate resulted in a
pretax gain for financial reporting purposes, A would
not record any deferred taxes.
Observation
As discussed above, A will have pretax gain or loss on a
separate-company basis but will not have any
corresponding tax expense or benefit. On a consolidated
basis, because the loan is denominated in CAD, there
will be an equal and offsetting pretax gain or loss for
the U.S. parent. So, on a consolidated basis, there will
be no net pretax gain or loss. While such a pretax gain
or loss will not have any tax effects for A (since A’s
tax return is filed in CAD), there will be a tax effect
related to the U.S. parent’s pretax amount since the
parent uses USD in filing its tax return. The U.S.
parent will have a deferred tax effect related to the
CAD-denominated loan since the USD amount required to
settle the loan fluctuates from the tax basis of the
liability (the USD equivalent of the CAD 100 million
when the loan is entered into). In summary, there will
be no pretax gain or loss on a consolidated basis (there
are equal and offsetting pretax amounts) and no Canadian
tax effect for A; however, there will be a tax effect
for the U.S. parent, which will affect the ETR.
9.2.3.2 Reporting-Currency-Denominated Monetary Assets and Liabilities
Unlike the local-currency-denominated monetary assets and liabilities discussed
above, monetary assets or liabilities denominated in an entity’s reporting
currency do not need to be remeasured for financial reporting purposes since
they are already denominated in the functional currency. Therefore, in such
cases, currency fluctuations do not give rise to pretax transaction gains or
losses for financial reporting purposes.
However, fluctuations in the exchange rates will create a difference between the
book and tax basis of the asset or liability when the local-currency equivalent
of the reporting-currency book basis is compared with the local-currency tax
basis. Therefore, although no pretax gain or loss is recognized for financial
reporting purposes, current or deferred taxes may be required. Whether a current
or deferred tax is required in this situation depends on whether the entity will
be taxed on a realized or unrealized basis, as explained below:
- Realized basis (or “settlement approach”) — The gain or loss is included in taxable income only on the date the asset is recovered or the liability is settled. The amount of gain or loss is calculated by comparing the initial tax basis of the asset or liability with its tax basis when the asset or liability is recovered or settled, respectively. The initial tax basis of the asset or liability is generally the local-currency equivalent of the reporting-currency carrying value, determined by using the spot rate on the transaction date. The tax basis of the asset or liability upon settlement is generally the local-currency equivalent of the reporting-currency carrying value, determined by using the spot rate on the settlement/recovery date.
- Unrealized basis (or “mark-to-spot approach”) — The unrealized gain or loss is included in taxable income each year. The amount of unrealized gain or loss is calculated by comparing the initial tax basis of the asset or liability with its tax basis at the end of each year. The initial tax basis is determined in the same manner as the initial tax basis determined under the settlement approach described above. The tax basis of the asset or liability at the end of each year is generally the local-currency equivalent of the reporting-currency carrying value, determined by using the spot rate in effect at the end of the year.
If a foreign entity is taxed under the settlement approach, it
is necessary to calculate a temporary difference and related DTL or DTA as of
the end of each reporting period. The amount of deferred taxes required is equal
to the difference between the initial tax basis of the asset or liability (in
local currency) and the local-currency equivalent of the financial-statement
carrying value, determined by using the exchange rate in effect at the end of
the year and multiplied by the enacted tax rate expected to apply.
Conversely, for jurisdictions that tax unrealized foreign exchange gains or
losses under the mark-to-spot approach, there will generally be no temporary
difference since the entire unrealized amount will be included in taxable income
as it arises and a corresponding current tax expense or benefit will be
recognized.
Because any tax expense or benefit (whether current or deferred) will not have a
corresponding pretax book amount, the related tax expense or benefit will
generally affect the ETR that should be appropriately disclosed in the footnotes
to the financial statements.
Example 9-6
Reporting-Currency-Denominated Debt
Assume the same facts as in Example
9-5, except that the loan is for 100
million denominated in USD, instead of CAD, and Entity
A’s tax rate is 30 percent.
On September 30, 20X5, the date of the borrowing, A
records the loan at its USD-equivalent value of USD 100
million. Entity A’s initial tax basis in the loan is CAD
125 million, the local-currency equivalent of the amount
borrowed, which is calculated by using the exchange rate
in effect on the date of the borrowing (USD 100 million
× 1.25).
On December 31, 20X5, the financial-reporting carrying
value of the loan is still USD 100 million since the
loan is denominated in the functional currency. However,
the local-currency-equivalent value of the loan has
changed to CAD 133 million as a result of the
fluctuation in the exchange rate. Therefore, the change
in the exchange rate has created an unrealized tax loss
of CAD 8 million (equal to the difference between the
book and tax basis of the loan when converted into the
local currency).
If A is taxed under the settlement
approach, it would record a DTA of CAD 2.4 million,
which is equal to the tax effect of the difference
between the tax basis of the loan and the
local-currency-equivalent value on December 31, 20X5, or
(CAD 125 million – CAD 133 million) × 30%. The DTA would
be recognized at the average exchange rate (to determine
the amount to recognize as an income tax benefit) and
would then be remeasured at the exchange rate in effect
on December 31, 20X5; any difference between the two
amounts would be included in the income statement. Under
ASC 830-740-45-1, A may present the transaction gain or
loss that results from remeasuring the DTA as deferred
tax expense or benefit (as opposed to foreign-currency
transaction gain or loss) if such presentation is
considered more useful. If reported in that manner, that
transaction gain or loss is still included in the
aggregate transaction gain or loss for the period, which
is disclosed in accordance with ASC 830-20-45-1.
Conversely, if A is taxed under the mark-to-spot
approach, it would recognize a taxable loss of CAD 8
million and should record a CAD 2.4 million reduction in
current tax payable and a CAD 2.4 million income tax
benefit.
Observation
In this example, there will be no pretax
income for either A or the U.S. parent, nor will there
be such income in consolidation (since A, the U.S.
parent, and the consolidated financial statements use
USD). Further, the U.S. parent in this example (unlike
the U.S. parent in Example 9-5) will have no tax effect
since the loan is denominated in USD and the U.S. parent
files its tax return in USD. However, A will have a tax
effect (either current or deferred, depending on
Canadian tax law) related to the loan, since it files
its tax return in CAD but the loan is denominated in
USD.
In summary, in both examples, there is
no consolidated pretax gain or loss. (In Example 9-5, there are
equal and offsetting pretax amounts; in this example,
because the loan is denominated in USD, there is no
pretax gain or loss in either A or the U.S. parent.) In
each example, there is a tax effect in the consolidated
financial statements (and that tax effect affects the
ETR, since there is a tax effect with no corresponding
pretax amount; however, see Section 9.7 for a
possible exception). In Example 9-5, the loan is denominated in
CAD so the tax effect is in the U.S. parent; in this
example, the loan is denominated in USD so the tax
effect is in A.
Footnotes
1
Paragraph 54 of FASB Statement 52 (not codified).
9.3 Price-Level-Adjusted Financial Statements
Entities located in countries with highly inflationary economies may prepare financial
statements restated for general price-level changes in accordance with U.S. GAAP. The
tax bases of those entities’ assets and liabilities are often restated for the effects
of inflation.
When a foreign entity prepares domestic price-level-adjusted financial statements in
accordance with U.S. GAAP, the recognition exception in ASC 740-10-25-3(f) does not
apply. ASC 830-740-25-5 concludes that “[w]hen preparing financial statements restated
for general price-level changes using end-of-current-year purchasing power units,
temporary differences [under ASC 740] are determined based on the difference between the
indexed tax basis amount of the asset or liability and the related price-level restated
amount reported in the financial statements.”
In addition, ASC 830-740-30-1 concludes that the deferred tax expense or
benefit should be calculated as the difference between (1) “[d]eferred tax assets and
liabilities reported at the end of the current year, determined in accordance with
paragraph 830-740-25-5,” and (2) “[d]eferred tax assets and liabilities reported at the
end of the prior year, remeasured to units of current general purchasing power at the
end of the current year.” Further, ASC 830-740-30-2 states that the “remeasurement of
deferred tax assets and liabilities at the end of the prior year is reported together
with the remeasurement of all other assets and liabilities as a restatement of beginning
equity.”
The graphic below illustrates the calculation of deferred tax expense or
benefit.
9.4 Cumulative Translation Account Overview
Under ASC 830-30, all financial statement elements must be translated from the functional
currency to the reporting currency by using a current exchange rate, which ASC
830-30-45-4 defines as “the rate as of the end of the period covered by the financial
statements or as of the dates of recognition in those statements in the case of
revenues, expenses, gains, and losses.” For practical reasons, ASC 830 permits the use
of weighted-average exchange rates or other methods that provide a reasonable
approximation of the rates in effect on the date of recognition.
The following is a summary of the exchange rates used in the translation process:
9.4.1 Recognition of Deferred Taxes for Temporary Differences Related to the CTA
As stated above, under foreign currency guidance in ASC 830, assets,
liabilities, revenues, expenses, gains, and losses of a foreign subsidiary whose
functional currency is the local currency are translated from that foreign currency
into the reporting currency by using current exchange rates. Translation adjustments
recognized as part of this process are not included in the determination of net
income but are reported as a separate component of shareholders’ equity (the CTA).
After a change in exchange rates, the translation process often creates basis
differences in amounts equal to the parent entity’s translation adjustment because
it changes the parent’s financial reporting amount of the investment in the foreign
entity but the parent’s tax basis in that entity generally does not change.
A DTA or DTL may be required when an entity recognizes translation
adjustments as a result of an exchange rate change if the parent entity is accruing
income taxes on its outside basis difference in a particular investment (note that a
CTA can be recorded on both the capital and undistributed earnings of the
investment, as illustrated in the example below). However, ASC 830-30-45-21 states,
in part, that if “deferred taxes are not provided for unremitted earnings of a
subsidiary, in those instances, deferred taxes shall not be provided on translation
adjustments.” In other words, if all or a portion of the earnings are not
indefinitely reinvested and the related temporary differences will reverse within
the foreseeable future (i.e., the earnings will be repatriated to the parent),
translation adjustments associated with such unremitted earnings will affect the
deferred taxes to be recorded. Conversely, if the earnings are indefinitely
reinvested and the requirements in ASC 740-30 for not recording deferred taxes on
unremitted earnings of a subsidiary have been met, deferred taxes on the translation
adjustments are similarly not recorded.
Example 9-7
Assume that Entity X, a calendar-year U.S. entity whose
reporting currency is USD, has a majority-owned subsidiary,
S, located in the United Kingdom, and that S’s functional
currency is the British pound. In addition, assume that as
of December 31, 20X1, S’s net assets subject to translation
under ASC 830 are 1,100 British pounds, the exchange rate
between USD and the British pound is 1 to 1, X’s tax basis
in S’s common stock is $1,000, and S had $100 in unremitted
earnings for 20X1. Further assume that, in a manner
consistent with ASC 830-10-55-10 and 55-11, the calculation
of $100 in unremitted earnings was based on “an
appropriately weighted average exchange rate for the
period,” which was also 1 to 1.
Moreover, assume that on December 31, 20X2, S’s common stock
subject to translation is unchanged at 1,000 British pounds,
S’s undistributed earnings for 20X2 are 200 British pounds
(the total undistributed earnings as of December 31, 20X2,
are 300 British pounds), and the weighted-average exchange
rate during the year between USD and the British pound
remained at 1 to 1. As of December 31, 20X2, however, the
exchange rate is 2 to 1. Thus, X’s investment in S is
translated at $2,600, and the CTA account reflects a $1,300
pretax gain. Entity X has the intent and ability to
indefinitely reinvest undistributed earnings of S (inclusive
of the CTA). Thus, in accordance with ASC 740-10-25-3(a)(1),
no DTL is recognized on the portion of the outside basis
difference related to the undistributed earnings of S
(inclusive of the CTA). Further, in accordance with ASC
830-30-45-21, no deferred taxes are provided on the
translation adjustments related to the common stock.
However, if X does not have the intent and
ability to indefinitely reinvest S’s earnings (although X
believes that its original investment in S is considered
indefinite under ASC 740-30), a DTL should be recorded for
the portion of the outside basis difference related to
unremitted earnings, including the $300 translation
adjustment on the earnings (on the basis of a weighted
average of exchange rates for the period). However, X would
not have to record a DTL for the $1,000 of CTA related to
the 1,000 British pounds of common stock if the initial
investment is indefinitely reinvested.
Note that after the enactment date of the
2017 Act, undistributed earnings may not give rise to a
taxable outside basis difference because such earnings
are/were immediately includable in an entity’s U.S. taxable
income (whether as a result of (1) the entity’s deemed
repatriation tax (see IRC Section 965) or (2) deemed
repatriation as a GILTI inclusion or Subpart F inclusion in
the year earned) or are eligible for the IRC Section 245A
dividends received deduction when the entity is measuring
the U.S. DTL. However, there may still be a future tax
impact related to foreign currency fluctuations (see IRC
Section 986(c)); therefore, if X is not indefinitely
reinvested in S, the $1,300 gain recognized in CTA may
represent a taxable temporary difference.
When a DTL or DTA related to a parent entity’s cumulative foreign
currency translation adjustments is recognized, the tax consequences of foreign
currency exchange translations are generally, in accordance with the intraperiod
allocation rules, reported as a component of the CTA account in accordance with ASC
740-20-45-11(b).
See Chapter 6 for a detailed discussion of intraperiod allocation.
9.5 Hedge of a Net Investment in a Foreign Subsidiary
Entities sometimes enter into transactions to hedge their net investment
in a foreign subsidiary (e.g., through the use of a forward contract). Under the
derivatives and hedging guidance in ASC 815, such a transaction would be designated as a
hedge of the foreign currency exposure of a net investment in a foreign operation. Gains
and losses included in the assessment of hedge effectiveness are credited or charged
directly to OCI through the CTA in accordance with ASC 815-35-35-1.
If such a hedging transaction creates a temporary difference but the
parent does not provide for deferred taxes related to translation adjustments, the
deferred taxes should nonetheless be recognized for the temporary difference created by
the hedging transaction. The tax consequences of hedging gains or losses that are
attributable to assets and liabilities of a foreign subsidiary or foreign corporate
joint venture are not indefinitely postponed, as contemplated in ASC 740-10-25-3(a)(1),
because the tax consequences are generally recognized upon settlement (e.g., settlement
at the end of a contract period or repayment of a loan). Therefore, usually a DTL or DTA
will result from hedging gains and losses, irrespective of whether a parent entity’s
investment in a foreign subsidiary or foreign corporate joint venture is considered
indefinite. In accordance with the intraperiod allocation rules, specifically ASC
740-20-45-11(b), the tax consequences of establishing a DTA or DTL on an asset or
liability related to a hedging transaction is typically reported as a component of
CTA.
9.6 Changes in an Entity’s Functional Currency
An entity may determine that it needs to change its functional currency as a result of
significant changes in economic facts and circumstances. For example, changes in
functional currency may result from one-time transactions, such as a merger or
acquisition, or from a longer-term shift in an entity’s operations.
In addition, when the economy in the country in which a foreign entity
operates becomes highly inflationary,2 the entity must change its functional currency to its immediate parent’s reporting
currency (e.g., USD). Likewise, when the economy in the country in which a foreign
entity operates ceases to be highly inflationary, the entity should discontinue using
its immediate parent’s reporting currency as its functional currency, provided that the
entity’s facts and circumstances have not changed in such a way that its functional
currency should now be the same as the reporting currency used for highly inflationary
accounting (e.g., analysis of the economic indicators described in ASC 830-10 results in
the determination that the entity’s functional currency should be that of its parent
regardless of the inflationary status of its local economy).
Regardless of the reason, ASC 830 requires entities to account for the effects of a
change in the functional currency by remeasuring the carrying value of their assets and
liabilities into the new functional currency. ASC 830-740 addresses the accounting for
the income tax effects related to a change in the functional currency, which differs
depending on whether the functional currency changed to or from the reporting
currency.
9.6.1 Changes From the Local Currency to the Reporting Currency
When the reporting currency is the functional currency, ASC
830-10-45-18 requires that historical exchange rates be used to remeasure
nonmonetary assets and liabilities from the local currency into the reporting
currency, and therefore the exception in ASC 740-10-25-3(f), as discussed in
Section 9.2.1, applies.
ASC 830-10-45-10 states, in part, that “[i]f the functional currency
changes from a foreign currency to the reporting currency, translation adjustments
for prior periods shall not be removed from equity and the translated amounts for
nonmonetary assets at the end of the prior period become the accounting basis for
those assets in the period of the change and subsequent periods.”
In this case, because the pretax carrying amounts of the
subsidiary’s assets and liabilities do not change when the functional currency
changes, temporary differences also do not change. Therefore, the subsidiary’s DTAs
and DTLs should not be adjusted on the date on which the functional currency changes
from local currency to the reporting currency.
However, the guidance in ASC 740-10-25-3(f) would be applied prospectively from the
date of the change. Therefore, after the functional currency is changed to the
reporting currency, the exception applies and, while the local-currency-equivalent
amount of the financial reporting carrying value (for use in determining the
temporary difference) is measured by using the spot rate as of the subsequent
reporting date, deferred tax on the temporary difference associated with the change
in exchange rates is not recognized.
In addition, an entity would continue to recognize deferred taxes
for (1) differences related to the effects of exchange rate changes associated with
reporting-currency-denominated (or any other nonlocal-currency-denominated) monetary assets and liabilities and (2) other differences
between the local-currency financial reporting carrying value and local-currency tax
basis of nonmonetary assets (e.g., differences arising when
a nonmonetary asset is depreciated over different periods for book and tax
purposes), excluding the effects of indexing. As discussed in Section 9.2.2, certain
countries (especially those that are considered highly inflationary) permit the tax
basis of assets to be indexed. ASC 830-10-45-16 states, in part:
[D]eferred tax benefits attributable to any such indexing that occurs after the
change in functional currency to the reporting currency shall be recognized when
realized on the tax return and not before. Deferred tax benefits that were
recognized for indexing before the change in functional currency to the
reporting currency are eliminated when the related indexed amounts shall be
realized as deductions for tax purposes.
Therefore, deferred tax effects (either a lesser DTL or a DTA) that
were recognized as a result of indexing before the change in functional currency to
the reporting currency are not derecognized. Rather, such effects reverse over time
as those benefits are realized on the tax return (i.e., previously recognized DTAs
should not be reversed when the functional currency is changed to the reporting
currency). Going forward, in accordance with ASC 740-10-25-3(f), no new DTAs should
be recognized for the effects of indexing that occur after the change in the
functional currency.
Because the effects of indexing are ignored for deferred tax accounting purposes when
the reporting currency is the functional currency, the current-year tax depreciation
of indexation not recognized under ASC 740 (i.e., any indexation after the reporting
currency became the functional currency) will result in a current-period tax benefit
and a favorable permanent difference. Therefore, the excess tax depreciation
(because of unrecognized indexing) will result in a lower ETR in the year in which
it is realized on the entity’s tax return. The prohibition in ASC 740-10-25-3(f)
causes the timing of recognition of the tax benefit related to indexing to shift
from the period in which the indexing occurs to the period in which the additional
tax basis is depreciated or amortized (even when the resulting deduction increases
an NOL carryforward).
Example 9-8
Entity A, a foreign entity, uses the LC as its functional
currency. Entity A’s parent is a U.S. entity that uses USD
as its reporting currency. On January 1, 20X5, A acquires a
piece of equipment for 1 million LC. The equipment is
depreciated on a straight-line basis over four years for
both book and tax purposes. The tax laws of the foreign
country in which A operates allow for a 15 percent increase
in the tax basis at the end of each year (i.e., the
depreciable tax basis includes the additional tax basis from
indexation), which is depreciated over the remaining tax
life of the equipment. Assume that A’s tax rate is 40
percent.
Entity A’s deferred taxes on the temporary difference
associated with the equipment are calculated as follows (all
amounts are in local currency):
Assume that on January 1, 20X6, the country
in which A operates becomes highly inflationary (or that A
otherwise determines that its functional currency has
changed to the reporting currency). The exchange rate on
January 1, 20X6, is 1 USD to 5 LC, the average exchange rate
for 20X6 is 1 USD to 12.5 LC, and the exchange rate on
December 31, 20X6, is 1 USD to 20 LC. Under ASC 830, A’s
functional currency would change to the reporting currency
of its parent (USD) in the period in which A determines that
the jurisdiction is highly inflationary (or otherwise
determines that its functional currency should be the
reporting currency). The USD-translated amount for the
equipment at the end of the prior period (December 31, 20X5)
becomes the accounting basis in the current period and in
subsequent periods. The following table illustrates the tax
effects when A changes its functional currency from the
local currency to the reporting currency (all amounts are in
local currency):
On December 31, 20X6, A would recognize a
DTA of 30,000 LC (temporary difference of 75,000 LC × 40%
tax rate). The change in the local currency DTA from the
beginning of the year to the end of the year would be
recognized at the average exchange rate (to determine the
amount to recognize as an income tax expense) (45,000 LC −
30,000 LC = 15,000 LC ÷ 12.5 = $1,200), and the end-of-year
local currency DTA would then be converted at the exchange
rate in effect on December 31, 20X6; any difference between
the change in the USD beginning-of-the-year DTA ($9,000 =
45,000 LC ÷ 5) and the USD end-of-year DTA ($1,500 = 30,000
LC ÷ 20) and the amount recognized as an income tax expense
($1,200) would be included in the income statement, which is
calculated as ($9,000 – $1,500) – $1,200 = $6,300. Under ASC
830-740-45-1, A may present the transaction gain or loss
that results from remeasuring the DTA (i.e., $6,300) as
deferred tax expense or benefit (rather than as a
transaction gain or loss) if such presentation is considered
more useful. If reported in that manner, the transaction
gain or loss would still be included in the aggregate
transaction gain or loss for the period, which would be
disclosed in accordance with ASC 830-20-45-1.
Because A’s functional currency changed to USD (i.e., the
reporting currency of its parent) in 20X6, it would not
recognize any deferred taxes related to the additional
indexing that occurred in 20X6 since that adjustment was
made after the functional currency changed. Further, A would
not immediately reverse the DTA that it previously recorded
in connection with the 20X5 indexing adjustments before its
functional currency changed. Rather, the DTA would be
reversed over time as those benefits (in the form of
increased tax depreciation expense) are realized on A’s tax
return. In 20X6, A claimed 37,500 LC more tax depreciation
than book depreciation. Because this additional depreciation
was realized on the return, A reverses the DTA by the
corresponding, tax-effected amount (37,500 LC × 40% =
15,000).
In addition, when determining the
local-currency-equivalent amount of the USD carrying value
of the equipment (for use in measuring the temporary
difference related to the equipment), A must use the
exchange rate in effect at the time the functional currency
changed (i.e., the historical exchange rate).3 The fact that the presumed recovery of the equipment
for its USD carrying amount implies a different
local-currency-equivalent amount (i.e., 500,000 LC ÷ 5 =
$100,000 × 20 = 2 million LC ) as the exchange rate
fluctuates is not considered because the equipment is
remeasured from the local currency into the functional
currency by using historical exchange rates (which is the
exception in ASC 740-10-25-3(f)).
Further assume that throughout 20X7, the country in which A
operates continues to be highly inflationary and that its
functional currency therefore continues to be the reporting
currency. The following table illustrates A’s tax effects in
20X7 (all amounts are in local currency):
In 20X7, A realizes total tax depreciation
of 330,625 LC on its tax return (the total of the first and
second columns in the table above). However, of the total
tax depreciation realized, 43,125 LC is related to the
effects of the indexing that occurred in 20X6.4 Because the indexing occurred after the functional
currency changed to the reporting currency, the excess
depreciation realized in 20X7 has no impact on the DTA.
Because this amount is realized on the entity’s return, it
creates a permanent difference in 20X7, which would lower
A’s ETR and current payable (provided that A reported
taxable income).
The remainder of the tax depreciation realized in 20X7
(287,500 LC) is related to the tax basis that existed before
the functional currency changed to the reporting currency.
The amount is the same as the amount calculated in 20X6 and
would remain the same in 20X8 (the last year of the asset’s
useful life for tax purposes). Because this amount is 37,500
LC higher than the depreciation expense realized for book
purposes, A reverses the DTA by the corresponding,
tax-effected amount (37,500 LC × 40% = 15,000). The
remaining temporary difference of 37,500 LC at the end of
20X7 would be reversed in 20X8.
Lastly, A does not recognize a DTA for the additional
indexing that occurred at the end of 20X7 since that
adjustment occurred after the functional currency was
changed.
9.6.2 Change in the Functional Currency When an Economy Ceases to Be Considered Highly Inflationary
As discussed above, when an entity has a foreign subsidiary operating in an economy
that is considered highly inflationary under ASC 830, the reporting currency will be
used as the subsidiary’s functional currency to measure foreign nonmonetary assets
and liabilities, such as inventory, land, and depreciable assets. If the rate of
inflation for the local currency significantly declines, the economy will no longer
be considered highly inflationary and the entity will need to account for the change
in its subsidiary’s functional currency from the reporting currency to the local
currency.
Deferred taxes should be recognized when the new local currency
accounting bases are established for the foreign nonmonetary assets and liabilities.
ASC 830-740-25-3 concludes that any resulting difference between the new functional
currency basis and the tax basis is a temporary difference for which intraperiod tax
allocation is required under ASC 740. Since the functional currency book basis
generally will exceed the local currency tax basis in this situation, a DTL will be
recognized at the time the change occurs. In addition, under ASC 830-740-45-2, the
deferred tax expense associated with the taxable temporary difference that arises
should be reflected as an adjustment to the cumulative translation component of OCI
rather than as a charge to income. The example below illustrates this concept.
Example 9-9
A foreign subsidiary of a U.S. entity
operating in a highly inflationary economy purchases
equipment with a 10-year useful life for 100,000 LC on
January 1, 20X1. The asset is depreciated over 10 years for
both book and tax purposes. The exchange rate on the
purchase date is 10 LC to $1, so USD-equivalent cost was
$10,000. On December 31, 20X5, the equipment has a net book
value on the subsidiary’s local books of 50,000 LC (the
original cost of 100,000 LC less accumulated depreciation of
50,000 LC) and the current exchange rate is 75 LC to 1 USD.
In the U.S. parent’s consolidated financial statements,
annual depreciation expense of $1,000 has been reported for
each of the last five years, and on December 31, 20X5, a
$5,000 amount is reported for the equipment (foreign
currency basis measured at the historical exchange rate
between USD and the foreign currency on the date of
purchase).
At the beginning of 20X6, the economy in
which the subsidiary operates ceases to be considered highly
inflationary. Accordingly, assuming the functional currency
and local currency are now the same, the foreign subsidiary
would establish a new functional currency accounting basis
for the equipment as of January 1, 20X6, by translating the
reporting currency amount of $5,000 into the functional
currency at the current exchange rate of 75 LC to 1 USD. The
new functional currency accounting basis on the date of
change would be 375,000 LC (5,000 × 75).5
A DTL, as measured under the tax laws of the
foreign jurisdiction, is recorded in the subsidiary’s local
books on January 1, 20X6. This measurement is based on the
temporary difference between the new reporting basis of the
asset of 375,000 LC and its underlying tax basis, 50,000 LC,
on that date. Thus, if a tax rate of 50 percent in the
foreign jurisdiction is assumed, a DTL of 162,500 LC
(325,000 LC × 50%) would be recorded on the local books of
record. That DTL would then be translated at the current
exchange rate between USD and the local currency and
reported as $2,167 (i.e., 162,500 LC ÷ 75) in the
consolidated financial statements with a corresponding
charge to the cumulative translation account. The foreign
subsidiary would compare the functional currency book basis
with the tax basis prospectively to determine the temporary
difference and change in the DTL recognized.
Footnotes
2
The CAQ’s International Practices Task Force (IPTF) has
developed a framework for compiling inflation data to help registrants determine
whether a particular country has met the definition in ASC 830 of highly
inflationary. The IPTF periodically issues discussion documents on this topic.
3
With respect to assets held at the
time the functional currency is changed to the
reporting currency, the “historical exchange rate”
means the rate in effect on the date of change in
the functional currency. With respect to assets
acquired after the change in functional currency,
the “historical exchange rate” means the rate used
to remeasure the local-currency cost of the asset
into the reporting-currency amount (generally, the
rate in effect when the asset was acquired).
4
The amount of depreciation expense
related specifically to the 20X6 indexing is
calculated by dividing the amount of tax basis
created as a result of the indexing (86,250 LC) by
the number of years remaining on the asset’s useful
life for tax purposes at the time the basis
increased (two years). This amount can also be
calculated by comparing the amounts of tax
depreciation expense before and after the change in
functional currency.
5
Note that the redetermination of the
new functional currency occurs only in the year in
which the economy ceases to be highly
inflationary.
9.7 Long-Term Intra-Entity Loans to Foreign Subsidiaries
In accordance with ASC 830-20-35-4, intra-entity loans to foreign
subsidiaries that are of a long-term-investment nature and whose repayment is not
foreseeable are treated as part of the overall net investment in the foreign subsidiary.
If either the parent or the subsidiary has a different functional currency than the
currency in which the loan is denominated, it will have foreign currency exposure for
financial reporting purposes related to fluctuations in the exchange rate. In a manner
consistent with the loan’s “part of the net investment” characterization, ASC
830-20-35-3(b) requires that any loan-related pretax foreign exchange gain or loss that
would have been classified as a foreign currency transaction gain or loss in the income
statement be recognized in the CTA account within OCI.
If the loan is denominated in the subsidiary’s functional currency, any gain or loss
related to fluctuations in the exchange rate will reside with the parent. If the loan is
denominated in the parent’s functional currency, any gain or loss related to
fluctuations in the exchange rate will reside with the foreign subsidiary. In either
case, as noted above, the gain or loss is recognized as part of the CTA account within
OCI rather than as a foreign exchange gain or loss in the period in which the gain or
loss arises.
Because the loan is characterized as part of the overall net investment,
questions can arise regarding the recognition of deferred taxes. The next sections
discuss in further detail the income tax accounting for a loan that is of a long-term
investment nature.
9.7.1 Deferred Tax Considerations When Intra-Entity Loans That Are of a Long-Term-Investment Nature Are Denominated in the Subsidiary’s Functional Currency
When a loan that is of a long-term-investment nature is denominated
in the subsidiary’s functional currency and the parent will have an exchange-related
gain or loss, the parent should not automatically apply the exception to the
recognition of a DTL under ASC 740-30-25-18 (related to a taxable basis difference
in a foreign subsidiary whose reversal is not foreseeable) or the exception to the
recognition of a DTA under ASC 740-30-25-9 (related to a deductible temporary
difference in any subsidiary that is not expected to reverse in the
foreseeable future). Rather, an entity must consider applicable tax law and, if the
taxable or deductible temporary difference related to the loan is expected to
reverse in the foreseeable future, the entity should generally recognize deferred
taxes (i.e., either a DTL or a DTA), setting aside “unit of account” considerations
(see additional discussion in the next section).
For example, when the loan has a fixed term but it is asserted that repayment is not
foreseeable, a representation is being made that the loan either will be extended
when it would otherwise mature or will be contributed to the equity of the
subsidiary. If either of those actions will result in the recognition of an
unrealized foreign-exchange-related gain or loss for tax purposes, an entity should
generally recognize a DTL or DTA (setting aside “unit of account” considerations).
In other words, since both the loan’s maturity date and the date on which the
related temporary difference will reverse are known, it appears that the related
temporary difference (whether taxable or deductible) will reverse in the foreseeable
future. Since the temporary difference is certain to reverse on a known date, the
exceptions that might apply when the reversal of the temporary difference is not
foreseeable should not be applied.
9.7.1.1 Unit of Account
The fact that the loan is considered under ASC 830 as part of the overall net
investment in the foreign subsidiary raises an interesting question about the
identification of the appropriate “unit of account.” For example, if the U.S.
parent has a foreign-exchange-related gain or loss (the loan is denominated in
the functional currency of the subsidiary) and there is a taxable temporary
difference related to the loan but a deductible temporary difference related to
the parent’s investment in the subsidiary’s shares (as a result of losses in the
subsidiary), the overall basis difference (viewed as a single unit of account)
might net to a deductible temporary difference (i.e., the subsidiary’s losses
exceed the loan-related exchange gain). The reverse can also occur, in which
case a taxable temporary difference related to the shares and a deductible
temporary difference related to the loan would net to an overall taxable
temporary difference for the single unit of account.
We believe that, in such instances, an entity should establish
an accounting policy to address the “opposite direction” circumstances described
above. One acceptable alternative would be for the entity to consider the loan
and share temporary differences as distinct units of account, allowing a
deferred tax to be recognized for the loan-related temporary difference
irrespective of the overall temporary difference. According to this alternative,
two distinct assets are recognized as existing under the tax law (the loan and
the shares), each with its own separate and distinct basis difference. The other
acceptable alternative would be to consider the overall temporary difference as
a single unit of account for which deferred tax would be recognized for the
loan-related temporary difference only if it is (1) in the same direction as the
overall temporary difference and (2) limited to the greater of the overall
temporary difference or the loan-related temporary difference. According to this
alternative, the loan is considered part of the net investment in the subsidiary
under ASC 830 (i.e., there is only one investment balance for book purposes).6
Note that the “unit of account” question primarily arises when the temporary
difference related to the loan is in the opposite direction of the overall
temporary difference (including the loan). This question can also arise when the
loan-related temporary difference exceeds the overall temporary difference
(including the loan). When the temporary difference related to the loan and the
overall temporary difference are in the same direction and the overall
temporary difference exceeds the loan-related amount, the DTL or DTA would be
recognized under either accounting policy.
In accordance with the intraperiod allocation rules, specifically ASC
740-20-45-11(b), deferred income tax expense or benefit related to an unrealized
exchange gain or loss with respect to the loan would generally be allocated to
the CTA account within OCI.
9.7.2 Deferred Tax Considerations When Intra-Entity Loans That Are of a Long-Term-Investment Nature Are Denominated in the Parent’s Functional Currency
When a loan is denominated in the parent’s currency, the treatment
of the loan as part of the overall net investment might raise the question of
whether the loan should be treated as equity. Also, a question might arise regarding
whether the subsidiary should consider any of the exceptions that might apply to a
parent’s investment in a foreign subsidiary (generally, ASC 740-30-25-17 prohibits
the recognition of deferred taxes when it is not foreseeable that the related
taxable or deductible temporary difference will reverse).
When an intra-entity loan that is of a long-term-investment nature is denominated in
the parent’s functional currency, the foreign subsidiary should generally record
deferred taxes related to the pretax foreign exchange gain or loss unless the
foreign subsidiary’s jurisdiction will not tax the foreign exchange gain or loss at
any point in time. In such cases, the foreign subsidiary should neither analogize to
ASC 740-30-25-17 or ASC 740-30-25-9 nor consider the loan a component of its equity
that is therefore not subject to evaluation as a temporary difference.
It would not be appropriate for the foreign subsidiary to apply the exceptions in ASC
740-30-25-17 and ASC 740-30-25-9 because those exceptions apply to a parent’s
outside basis difference in an investment in a foreign subsidiary (i.e., the
exceptions apply to the parent as the “investor” in a foreign subsidiary and are not
relevant to the foreign subsidiary “investee”).
In addition, although an intra-entity loan that is of a long-term-investment nature
is treated as part of the parent’s net investment in the foreign subsidiary in the
accounting for foreign currency fluctuations, it is still a loan, albeit one that
has an indefinite duration. While an intra-entity loan that is of a
long-term-investment nature might ultimately be contributed to the equity of the
foreign subsidiary, in the intervening periods, an intra-entity loan that is of a
long-term-investment nature is reflected in the books of the parent and subsidiary
as an intra-entity receivable and payable (subject to the assessment of any
uncertain tax positions). Therefore, the foreign subsidiary should not treat the
liability as a component of its equity.
Accordingly, the temporary difference related to the foreign subsidiary’s liability
will need to be determined as of each reporting date by comparing the tax basis,
which is generally equal to the original amount borrowed (in terms of the local
currency that is used to measure taxable income), with the book basis in the
liability, which is equal to the amount required to repay the loan (again,
determined in terms of the local currency and the exchange rate as of the reporting
date). The difference, which represents a transaction gain or loss for tax purposes,
will generally be included in the local tax return on either a realized basis or an
unrealized basis as discussed in Section
9.2.3.
Because the actual mechanics may vary by jurisdiction (i.e., some
jurisdictions might limit the deductibility of losses but require that all gains be
taxed), an entity must consider the actual local tax law related to whether the
foreign currency transaction gain or loss is taxable or deductible as well as the
timing of recognition of any gain or loss.
Since it is not foreseeable that the loan will be repaid, it is expected that the
loan would be extended upon its scheduled maturity or contributed to equity. If
those events are not considered taxable transactions in the foreign subsidiary’s
jurisdiction, it would be appropriate to apply the exception in ASC 740-10-25-30,
which states that basis differences that do “not result in taxable or deductible
amounts in future years when the related asset or liability for financial reporting
is recovered or settled . . . may not be temporary differences for which a deferred
tax liability or asset is recognized” (e.g., corporate-owned life insurance that can
be recovered tax free upon the death of the insured in accordance with the intent of
the policy owner).
While the preceding discussion focuses on a foreign subsidiary (i.e., a foreign
corporation that is controlled and consolidated by the parent), the same potential
for tax consequences would apply to loans made to a disregarded entity (i.e., an
entity that is treated as a branch of the parent) or to loans between brother-sister
entities. However, in the case of a loan made to a disregarded entity, the parent
should also consider the FTC consequences of any current or deferred tax recognized
by the foreign subsidiary.
A U.S. parent should also be aware that any gain or loss recognized by a foreign
subsidiary might be treated as Subpart F income under the IRC.
Footnotes
6
Companies that have elected a policy to view the note
and shares as one unit of account may still be able to disaggregate the
outside basis difference into the underlying components. See Section 3.4.12A
for further discussion of disaggregation.
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 987,7 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:
Footnotes
7
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.