(b) Transactions. For transactions in other than the functional currency, a disposi-
tion of foreign currency results in the recognition of gain or loss. The foreign ex-
change gain or loss is accounted for separately from any gain or loss attributable to
the underlying transaction, except in the case of certain integrated financial transac-
tions. This is known as the “dual transaction theory.” As an example, let us assume
that a U.S. exporter sells its products for a designated amount of foreign currency
units. It determines the selling price at the translation rate on the day of the sale.
When it collects its payment, the foreign currency exchange rate on the date of pay-
ment and the date the account receivable were set up are different. There is a foreign
currency gain or loss.
Gain or loss is generally not recognized until there is a closed and completed
transaction, such as the collection of an account receivable. The foreign currency
gain or loss is generally ordinary income or loss (U.S. or foreign source).
The IRS has issued regulations providing for the integration of certain financial
transactions, such as where a taxpayer borrows or lends foreign currency and enters
into a hedging transaction in the same day on which the underlying foreign currency
transaction is entered into. By this means, any foreign exchange gain or loss on the un-
derlying loan is offset by gain or loss on the hedging contract. By integrating the two,
the hedge gain or loss becomes an addition or reduction of interest income or expense.
Generally, foreign currency gains or losses are allocated between U.S. and foreign
sources by reference to the residence of the taxpayer or qualified business unit on
whose books the asset or liability is reflected. Accordingly, for a U.S. corporation, the
gain or loss would come from the United States. A special rule applies to certain re-
lated party loans that have to be marked to market annually. On foreign currency
loans that bear interest at a rate at least 10 percentage points higher than the applica-
ble rate for midterm federal obligations at the time the loan is made and that are made
by U.S. persons or a related foreign person to a 10% owned foreign corporation, any
interest income is treated as U.S.-source income to the extent of any loss on the loan
caused by the marking to market. In addition, to determining foreign exchange gain
or loss on foreign currency transactions, such as loans and purchase and sale of
goods, foreign currency translation losses have to be accounted for.
(c) Translations
(i) Branch. If a U.S. taxpayer conducts its activities in a foreign country through a
branch, it has to translate the branch results into U.S. dollars. Except for hyperinfla-
tionary economies, the branch’s taxable profits are first determined on the basis of its
functional currency. The functional currency is then converted into U.S. dollars using
the weighted average exchange rate for the taxable period. Any repatriations to the
United States are translated at the rate in effect at the time of the repatriation. For-
eign income taxes are translated at the rate in effect at the time the tax is paid and
then added to the foreign taxable income or “grossed-up.” The foreign taxes can then
be claimed as a credit, as described in section 30.4. On remittances, any exchange
gain or loss is recognized to the extent that the value of the foreign currency differs
from its value when earned.
(ii) Subsidiary. Actual and deemed dividends related to the sale of a foreign sub-
sidiary are translated at the exchange rate on the date the dividend is included in in-
30.6 FOREIGN CURRENCY ISSUES 30 • 17