Par. 8. Section 1.987-16 is added to read as follows:
(a) Overview. This section provides rules relating to inbound nonrecognition transactions. Paragraph (b) of this section describes the scope of this section's application. Paragraphs (c) and (d) of this section provide rules for, respectively, computing and recognizing the amount of a transferor CFC's section 987 asset basis with respect to an inbound nonrecognition transaction. Paragraph (e) of this section provides a de minimis rule. Paragraph (f) of this section provides an example that illustrates the application of the rules of this section.
(b) Scope —(1) In general. This section applies if a domestic corporation (the domestic acquiring corporation ) acquires the assets of a CFC (the transferor CFC ) in either a liquidation described in section 332 or an asset acquisition described in section 368(a)(1) (an inbound nonrecognition transaction ), and the transferor CFC was subject to a CFC exemption election for any taxable year ending during the pre-transaction period described in paragraph (b)(2) of this section. For purposes of this section, references to the transferor CFC include any CFC that transferred its assets to the transferor CFC in a transaction described in section 381(a) during the pre-transaction period.
(2) Pre-transaction period. For purposes of this section, the pre-transaction period is the period beginning 72 months before the inbound nonrecognition transaction and ending on the date of the inbound nonrecognition transaction.
(c) Computation of section 987 asset basis —(1) Choice of methodology. A transferor CFC is required to compute the amount of its section 987 asset basis under either the lookback methodology described in paragraph (c)(2) of this section or the excess asset basis methodology described in paragraph (c)(3) of this section. The same methodology must be applied with respect to all inbound nonrecognition transactions entered into as part of the same plan or arrangement. The amount of section 987 asset basis computed under this paragraph (c) cannot be less than zero.
(2) Lookback methodology —(i) In general. If a taxpayer uses the methodology described in this paragraph (c)(2), a transferor CFC's section 987 asset basis is equal to the sum of the transferor CFC's annual unrecognized section 987 gain or loss determined under § 1.987-10(e)(3)(iii) (or, if applicable, under paragraph (c)(2)(iv) of this section) for each pre-transaction taxable year described in paragraph (c)(2)(ii) of this section with respect to each section 987 QBU described in paragraph (c)(2)(iii) of this section. Paragraph (c)(2)(v) of this section provides rules for computing a transferor CFC's section 987 asset basis with respect to an exempt partnership.
(ii) Pre-transaction taxable year. A pre-transaction taxable year is a taxable year ending during the pre-transaction period, if a CFC exemption election was in effect for the taxable year.
(iii) Section 987 QBUs. Annual unrecognized section 987 gain or loss must be computed with respect to each section 987 QBU (including each exempt partnership QBU) owned by the transferor CFC in a pre-transaction taxable year. Thus, for example, if the transferor CFC owned a section 987 QBU during a pre-transaction taxable year, and the section 987 QBU was terminated or the CFC exemption election was revoked before the inbound nonrecognition transaction occurred, annual unrecognized section 987 gain or loss must nevertheless be computed with respect to the section 987 QBU for the taxable years preceding the termination or revocation.
(iv) Annual unrecognized section 987 gain or loss with respect to an exempt partnership QBU. In the case of an exempt partnership QBU, annual unrecognized section 987 gain or loss for a taxable year is equal to the amount of gain or loss that the owner would have recognized under section 987(3) if the QBU was formed on the first day of the taxable year (or, if later, the date on which the QBU was actually formed) and terminated on the last day of the taxable year (or, if earlier, the date on which the QBU was actually terminated). This amount must be determined without regard to the CFC exemption election (and without regard to the rules of §§ 1.987-7(d) and 1.987-11 through 1.987-13) using a reasonable method that is applied consistently with respect to all partnerships in which the transferor CFC is a partner.
(v) Exempt partnerships —(A) In general. If the transferor CFC is a partner in an exempt partnership in a pre-transaction taxable year, the transferor CFC's section 987 asset basis must be determined by taking into account the transferor CFC's share of the exempt partnership's annual unrecognized section 987 gain or loss (determined under paragraph (c)(2)(iv) of this section) with respect to each section 987 QBU owned by the exempt partnership for each pre-transaction taxable year in which the partnership was an exempt partnership. This amount is translated, if necessary, into the transferor CFC's functional currency at the spot rate on the date of the inbound nonrecognition transaction.
(B) Transferor CFC's share of an exempt partnership's annual unrecognized section 987 gain or loss. The transferor CFC's share of an exempt partnership's annual unrecognized section 987 gain or loss with respect to a section 987 QBU for a taxable year is equal to the amount of section 987 gain or loss that would be included in the transferor CFC's distributive share of profits or losses with respect to the section 987 QBU for the taxable year if the exempt partnership recognized the annual unrecognized section 987 gain or loss in the taxable year. The principles of section 706(d) apply in making this determination.
(3) Excess asset basis methodology. If a taxpayer uses the excess asset basis methodology described in this paragraph (c)(3), a transferor CFC's section 987 asset basis with respect to an inbound nonrecognition transaction is equal to the amount of excess asset basis determined under § 1.367(b)-3(g)(2)(i) with respect to the transferor CFC. This amount is translated (if necessary) into the transferor CFC's functional currency at the spot rate on the date of the inbound nonrecognition transaction. Notwithstanding § 1.367(b)-3(g)(2)(i), for purposes of this paragraph (c)(3), excess asset basis is determined without regard to the application of paragraph (d) of this section.
(d) Recognition of section 987 gain equal to the amount of section 987 asset basis —(1) In general. Immediately before an inbound nonrecognition transaction, the transferor CFC is required to recognize section 987 gain equal to the amount of its section 987 asset basis.
(2) Source and character —(i) In general. The source and character of section 987 gain recognized under paragraph (d)(1) of this section are determined under the rules of § 1.987-6, subject to the modifications described in paragraph (d)(2)(ii) of this section. See § 1.987-6(b)(1)(vi).
(ii) Initial assignment is made by reference to all of the transferor CFC's assets. Notwithstanding § 1.987-6(b)(2)(i)(A), for purposes of the initial assignment, section 987 gain recognized under paragraph (d)(1) of this section is assigned to the statutory and residual groupings in the same proportions as the proportions in which the tax book value of the assets of the transferor CFC (other than stock described in § 1.987-2(b)(2)(i)(A)) are assigned to the groupings under the asset method in §§ 1.861-9(g) and 1.861-9T(g) in the taxable year of the initial assignment.
(e) De minimis rule —(1) In general. The rules of paragraphs (c) and (d) of this section do not apply to an inbound nonrecognition transaction if the transferor CFC's inside asset basis is less than $25 million. If multiple inbound nonrecognition transactions occur as part of the same plan or arrangement, all transferor CFCs' assets are aggregated for this purpose.
(2) Inside asset basis. In general, for purposes of paragraph (e)(1) of this section, a transferor CFC's inside asset basis is determined under § 1.367(b)-3(g)(2)(iv). However, the basis of stock of a corporation owned by the transferor CFC that is described in § 1.987-2(b)(2)(i)(A) is taken into account only to the extent of the transferor CFC's aggregate adjusted basis in assets (other than stock described in § 1.987-2(b)(2)(i)(A)) or the amount of the transferor CFC's functional currency that was exchanged for stock of the CFC (for example, in a transaction to which section 351 applies) during the pre-transaction period.
(f) Example: Computation of section 987 asset basis. The following example illustrates the rules of this section. For purposes of this example, except as otherwise indicated, no section 987 elections are in effect. This example is not intended to illustrate the appropriate determination of any QBU's functional currency.
(1) Facts —(i) In general. U.S. Corp is a domestic corporation that uses the calendar year as its taxable year and has the U.S. dollar as its functional currency. U.S. Corp owns 100 percent of the stock of CFC 1 (a controlled foreign corporation within the meaning of section 957(a)), which also uses the calendar year as its taxable year and has the U.S. dollar as its functional currency. CFC 1 forms Business A, a section 987 QBU with the euro as its functional currency, at the beginning of Year 1. At the beginning of Year 1, U.S. Corp's adjusted basis in the stock of CFC 1 is zero, and no assets or liabilities of CFC 1 are attributable to Business A. A CFC exemption election is in effect with respect to CFC 1 beginning in Year 1.
(ii) Exchange rates. The spot rate on December 31, Year 1, is €1 = $1.15. The yearly average exchange rate for Year 1 is €1 = $1.10. The spot rate on June 30, Year 2 is €1 = $1.25.
(iii) Year 1 income and activities. In Year 1, Business A earns income of €100x, which is subpart F income. Business A purchases Property X, a nondepreciable asset, for €100x. Under § 1.987-3(c), Business A's income of €100x is translated into CFC 1's functional currency at the yearly average exchange rate of €1 = $1.10. Therefore, CFC 1 has $110x of subpart F income (€100x × ($1.10/€1)). Under section 961(a), U.S. Corp's adjusted basis in the stock of CFC 1 is increased by $110x.
(iv) Liquidation of CFC 1. On June 30, Year 2, CFC 1 distributes Property X to U.S. Corp in a liquidation to which section 332 applies. Immediately before the liquidation, CFC 1 and Business A have no liabilities and no assets other than Property X. CFC1 has inside asset basis of at least $25 million.
(2) Analysis —(i) Termination of Business A QBU. Under § 1.987-8(b)(4) and (c)(1)(ii), the Business A QBU terminates as a result of the liquidation of CFC 1. Therefore, under § 1.987-8(e), Business A is deemed to transfer Property X to CFC 1 immediately before the termination, on June 30, Year 2. As a result, immediately before the liquidation, CFC 1's basis in Property X is $125x (equal to Business A's basis of €100x, translated at the June 30, Year 2, spot rate of €1 = $1.25). See § 1.987-5(f)(2).
(ii) Computation of section 987 asset basis —(A) In general. CFC 1 was subject to a CFC exemption election during the pre-transaction period described in paragraph (b)(2) of this section. Thus, under paragraph (d) of this section, CFC 1 is required to recognize section 987 gain immediately before the liquidation in an amount equal to its section 987 asset basis. Under paragraph (c) of this section, CFC 1 may compute the amount of section 987 asset basis using either the lookback methodology or the excess asset basis methodology.
(B) Lookback methodology —( 1 ) In general. Under the lookback methodology provided in paragraph (c)(2) of this section, CFC 1's section 987 asset basis is equal to the sum of its annual unrecognized section 987 gain or loss with respect to Business A determined under § 1.987-10(e)(3)(iii) for each pre-transaction taxable year. For each taxable year, CFC 1's annual unrecognized section 987 gain or loss with respect to Business A is calculated by applying only Steps 1 and 10 of the ten-step determination under § 1.987-4(d). CFC 1's pre-transaction taxable years are the full taxable year beginning January 1, Year 1, and the short taxable year beginning January 1, Year 2, and ending June 30, Year 2. As explained in paragraph (f)(2)(ii)(B)( 2 ) of this section, CFC 1 has annual unrecognized section 987 gain of $5x in Year 1, and CFC 1 has annual unrecognized section 987 gain of $10x in Year 2. Thus, under the lookback methodology, CFC 1's section 987 asset basis equals $15x ($5x + $10x), and CFC 1 recognizes $15x of section 987 gain under paragraph (d)(1) of this section.
( 2 ) Annual unrecognized section 987 gain or loss —( i ) Year 1. For Year 1, CFC 1's annual unrecognized section 987 gain equals $5. The change in owner functional currency net value (Step 1) equals $115x (€100x × ($1.15/€1)−0). Step 10 reduces this amount by the residual increase to net assets determined in Business A's functional currency (the €100x basis in Property X), translated into CFC 1's functional currency at the yearly average exchange rate (€1 = $1.10). Thus, the reduction in Step 10 equals $110x, and CFC 1 has annual unrecognized gain of $5x ($115x−$110x).
( ii ) Year 2. For short Year 2, CFC 1's annual unrecognized section 987 gain equals $10x. This is equal to the amount determined in Step 1. The Step 1 amount is $10x, equal to the difference in Business A's €100x balance sheet translated into CFC 1's functional currency at the spot rate on the last day of Year 2 (€1 = $1.25) and the spot rate on the last day of Year 1 (€1 = $1.15). The Step 10 amount for Year 2 is zero because there is no residual increase or decrease to Business A's net assets as determined in Business A's functional currency; throughout Year 2, Business A had net assets of €100x.
(C) Excess asset basis methodology. Under the excess asset basis methodology provided in paragraph (c)(3) of this section, CFC 1's section 987 asset basis is equal to the amount of excess asset basis determined under § 1.367(b)-3(g)(2)(i). Under § 1.367(b)-3(g)(2)(i) (applied without regard to paragraph (d) of this section), the excess asset basis is equal to CFC 1's inside asset basis (determined in the hands of U.S. Corp immediately after the liquidation of CFC 1) minus the sum of CFC 1's earnings and profits (excluding previously taxed earnings and profits); U.S. Corp's aggregate basis in the stock of CFC 1 immediately before the liquidation of CFC 1; and the aggregate amount of any liabilities assumed by U.S. Corp as a result of the liquidation of CFC 1. CFC 1's inside asset basis equals $125x, as explained in paragraph (f)(2)(iii) of this section. CFC 1 has no earnings and profits (other than previously taxed earnings and profits), and no liabilities. U.S. Corp's aggregate basis in the stock of CFC 1 is $110x. Accordingly, the excess asset basis with respect to CFC 1 is $15x ($125x minus $110x). Thus, under the excess asset basis methodology, CFC 1's section 987 asset basis equals $15x, and CFC 1 recognizes $15x of section 987 gain under paragraph (d)(1) of this section.
(iii) Liquidation of CFC 1. For purposes of section 334(b), section 987 gain recognized under paragraph (d) of this section is not treated as gain recognized with respect to property distributed by CFC 1 in the liquidation, because the gain is recognized immediately before the liquidation. Therefore, under section 334(b), U.S. Corp receives Property X with a basis of $125x.