Change from Dollar Approximate Separate Transactions
Method of Accounting to the Profit & Loss Method of
Accounting/Change from the Profit & Loss Method to Dastm

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8765] RIN: 1545-AL24;
1545-AS68

TITLE: CHANGE FROM DOLLAR APPROXIMATE SEPARATE TRANSACTIONS METHOD
OF ACCOUNTING (DASTM)TO THE PROFIT AND LOSS METHOD OF ACCOUNTING/
CHANGE FROM THE PROFIT AND LOSS METHOD TO DASTM

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final Regulations.

SUMMARY: This document contains final Income Tax Regulations
relating to adjustments required when a qualified business unit
(QBU) that used the profit and loss method of accounting (P&L) in a
post-1986 year begins to use the dollar approximate separate
transaction method of accounting (DASTM) and adjustments required
when a QBU that used DASTM begins using P&L. The regulations provide
rules for taxpayers to construct an opening dollar balance sheet for
the QBU and require income adjustments in certain cases.

DATES: These regulations are effective April 6, 1998.

FOR FURTHER INFORMATION CONTACT: Howard Wiener at (202) 622-3870
(not a toll-free number) of the office of Chief Counsel
(International) within the Office of Chief Counsel, Internal Revenue
Service, 1111 Constitution Avenue, N.W. Washington, DC 20224.

SUPPLEMENTARY INFORMATION:

Background

On January 5, 1993 and July 25, 1994, the IRS published proposed
amendments to �1.985-7 in the Federal Register at 58 FR
300(INTL-0045-92) and �1.985-1 in the Federal Register at 59 FR
37733 (INTL-0066-92), respectively. No public hearing was held and
few comments were received. After consideration of these comments,
the regulations are adopted as a Treasury Decision with
modifications as described below.

Explanation of Provisions

I. Proposed Rules for Changing From P&L to DASTM (�1.985-7)

1. The Proposed Regulations

The proposed regulations under �1.985-7 set forth transition rules
for QBUs changing from the profit and loss method of accounting
(P&L) to DASTM in tax years after 1987. Section 1.985- 6 provides
the translation rules for QBUs using DASTM in 1987.

Generally, when a QBU changes its functional currency, two basic
issues arise: (1) How should the QBU translate its balance sheet
accounts into the new functional currency in a way that preserves
any unrecognized currency gain or loss which accrued in the old
functional currency; and (2) whether income adjustments need to be
made to recognize any currency gain or loss which accrued in the old
functional currency that cannot be preserved.

Section 1.985-5 provides rules that generally apply when a QBU
changes its functional currency. Under �1.985-5 balance sheet
accounts are translated using the spot rate on the last day prior to
the taxable year of change. In addition, �1.985-5 generally requires
recognition of unrealized exchange gain or loss on instruments and
other accounts that were maintained in the functional currency to
which the QBU is changing.

The proposed regulations issued under �1.985-7 were issued in
response to taxpayer comments that �1.985-5 resulted in significant
distortions when a QBU either elected or was required to use DASTM.
Applying the spot rate on the last day prior to the year in which
the QBU begins to use DASTM (the "taxable year of change") to
translate fixed assets typically results in a significant loss of
basis in dollar terms and does not take into account certain income
and expense distortions that occur in the period immediately
preceding the taxable year of change.

In response to taxpayers' comments, the proposed regulations provide
for use of the translation rules provided under �1.985-3.

These rules generally translate fixed assets at the historical
exchange rate and other assets and liabilities at the current
exchange rate. To correct for distortions that would result from
applying historic exchange rates for fixed assets while applying the
current year's spot rate for other balance sheet accounts, the
proposed regulations provide for income adjustments in the case of a
controlled foreign corporation (CFC) and a branch that reflect
amounts that would have been included in income under DASTM.

In the case of a CFC, the proposed regulations provide for a
shareholder level income adjustment to the extent subpart F income
realized during the period after 1986 until the taxable year of
change differs from subpart F income that would have been realized
if the CFC had used DASTM throughout this period. In the case of a
branch, the regulations provide that any difference between the
branch's local currency equity translated into dollars at the spot
exchange rate on the last day prior to the taxable year of change
and the taxpayer's dollar basis pool on that day is included in
income over three taxable years beginning with the taxable year of
change. For purposes of translating the balance sheet of
noncontrolled section 902 corporations, the proposed regulations
apply historic exchange rates for fixed assets. In such case, no
shareholder level income adjustments are required.

Recognizing the administrative burden of making income adjustments
for all post-1986 tax years in the case of a CFC, the preamble to
the proposed regulations requested comments regarding three
alternative transition rules as follows: (1) requiring shareholder
level adjustments for the three-year base period used to determine
the hyperinflationary status of the local currency, (in which case
the general rule of �1.985-5 would be applied in preparing the
balance sheet for the first year of the base period); (2) treating a
portion of retained earnings as subpart F income based on an average
historical rate of subpart F income to total earnings and profits,
and (3) using the spot rate on the last day prior to the taxable
year of change to translate balance sheet items with special rules
to allow historical exchange rates to translate fixed assets to the
extent of unrealized exchange loss on paid-in capital.

2. Reasons for change

The IRS is concerned that the approach of the proposed regulations
could create a significant administrative burden for shareholders of
CFCs. The administrative burden results from the requirement that
shareholders recompute subpart F income for all of the CFC's post
1986 taxable years. If the functional currency of a CFC becomes
hyperinflationary in a year that is significantly distant from the
CFC's first post-1986 taxable year, records supporting the required
recomputation may be unavailable.

Further, the required recomputation under the proposed regulations
is generally inconsistent with the policy of sections 986 and 987
that the income of branches with a functional currency different
than that of the taxpayer and the earnings and profits of foreign
corporations be computed under a profit and loss method, except in
the case of hyperinflation. See S. Rep. No. 99- 313, 99th Cong., 2d
Sess., 454 (1986). The recomputation under the proposed regulation
would put the CFC on DASTM for non-hyperinflationary years.
Accordingly, the rules in the proposed regulations have been
modified as described below.

II. Final Regulations for Changing From P&L to DASTM (�1.985-7)

1. General Rule

The approach employed in the final regulations has the general
effect of treating a QBU as if it had applied �1.985-5 on the last
day of the last taxable year prior to the base period for
determining whether a currency is hyperinflationary (transition
date) and had applied DASTM during the taxable years beginning after
the transition date until the taxable year of change (look-back
period). This approach addresses the problems of applying �1.985-5
in the taxable year of change for purposes of translating fixed
assets by applying the historical exchange rate to the extent fixed
assets were acquired during the look-back period.

Assets acquired prior to the look-back period are translated by
applying the spot rate on the transition date. This approach also
corrects distortions in income and expense (generally interest
income and expense) that occur during the look-back period.

The final regulations respond to taxpayers' comments and provide an
appropriate rule for translating the adjusted basis of fixed assets
into dollars by applying an exchange rate in effect prior to the
hyperinflationary period. Moreover, this method more accurately
reflects Congressional intent for QBUs to apply the profit and loss
method except in the case of hyperinflation. In addition, this
approach decreases the administrative burden of changing to DASTM.

2. Foreign Corporations

In the case of a foreign corporation which is either required or
elects to use DASTM, four basic corporate level adjustments are
required as follows. (1) The balance sheet is translated by treating
the corporation as if it had changed its functional currency to the
dollar for the first post-transition date taxable year and had
applied the rules of �1.985-5(c) on the transition date. Assets
acquired and liabilities incurred in the functional currency during
the look-back period are translated by applying the rules of
�1.985-3. (2) The unrealized gain or loss on dollar denominated
section 988 transactions as determined on the transition date are
treated as if recognized on that date (and actual gain or loss
recognized on dollar denominated section 988 transactions during the
look-back period is reversed). (3) The dollar value of the pre-1987
E&P of the corporation as stated on the transition date in the
functional currency is translated into U.S. dollars at the spot rate
in effect on the transition date.

(4) The dollar value of the post-1986 E&P is computed by translating
the post-1986 E&P as stated on the transition date in the functional
currency at the spot rate on such date and adding to it the E&P for
the years during the look-back period as computed under DASTM.

In the case of a CFC, there are three shareholder level adjustments
as follows: (1) The U.S. shareholders must take into income exchange
gain or loss on the deemed recognition of the section 988
transactions as determined at the corporate level to the extent such
gain or loss is subpart F income. (2) The U.S.
shareholders must recognize foreign currency gain or loss as
computed under section 986(c) as if all previously taxed earnings
and profits were distributed on the transition date (however, any
actual 986(c) gain or loss recognized during the look-back period is
reversed). (3) The subpart F income of the CFC is recomputed during
the look-back period under DASTM and compared to the subpart F
income as computed under the P&L method. The difference (positive or
negative) is taken into account in the taxable year of change and
spread over four years. Similar rules apply to United States persons
who have made an election under section 1295 to treat a passive
foreign investment company as a qualified electing fund. In the case
of other foreign corporations, no shareholder level income
adjustments are necessary.

4. Branches

In accord with the general approach articulated above, the
regulations treat a branch changing to DASTM as applying the
principles of �1.985-5 on the transition date. Thus, the balance
sheet is translated by treating the branch as if it had changed its
functional currency to the dollar for the first post-transition date
taxable year and had applied the rules of �1.985- 5(c) on the
transition date. Unrealized gain or loss on dollar denominated
section 988 transactions as stated on the transition date are
treated as if recognized on that date (and any actual gain or loss
realized with respect to section 988 transactions during the look-
back period is reversed). Further, the regulations require that the
taxpayer recognize gain or loss attributable to the branch's equity
pool (as stated on the transition date) under the principles of
section 987, computed as if the branch terminated on the transition
date. Such gain or loss is reduced by any section 987 gain and
increased by any section 987 loss that was recognized by the
taxpayer with respect to remittances during the look-back period.
Finally, branch income shall be determined under �1.985-3 for each
look-back year and compared to the amount that was taken into
account for each year. The sum of the difference (positive or
negative) is taken into account in the taxable year of change and
spread over four years.

III. Rules for Changing from DASTM to P&L (�1.985-1)

Under the proposed regulation, a QBU that has been required or had
elected to use DASTM must change functional currency to the currency
of its economic environment in a year in which the currency is no
longer hyperinflationary pursuant to the three-year test under
�1.985-1(b). These rules provide that when a taxpayer changes from
DASTM to the P&L method of accounting, �1.985-5 shall apply for
purposes of translating a QBU's balance sheet and for making certain
income adjustments. Because these rules generally do not create
distortions and are administrable, the final regulations adopt these
regulations as proposed.

IV. Other Changes

Various conforming changes have been made to ��1.985-1 and 1.985-5
to account for the addition of �1.985-7. In addition, the definition
of hyperinflation has been liberalized to provide that for purposes
of determining whether a currency is hyperinflationary for income
tax purposes, United States generally accepted accounting principles
will be accepted provided that the determination is based on
criteria that is substantially similar to the general rules provided
in the regulations, the method of determination is applied
consistently from year to year, and the same method is applied to
all related persons.

Special Analysis

It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It also has been determined
that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these regulations, and because the
notice of proposed rulemaking preceding the regulations was issued
prior to March 29, 1996, the Regulatory Flexibility Act (5 U.S.C.
chapter 6) does not apply. Accordingly, a regulatory flexibility
analysis is not required. Pursuant to section 7805(f) of the Code,
the notice of proposed rulemaking preceding these regulations was
submitted to the Small Business Administration for comment on its
impact on small business.

Drafting Information

The principal author of these regulations is Howard A. Wiener of the
Office of the Associate Chief Counsel (International).

Other personnel from the IRS and Treasury Department also
participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements Adoption of
Amendments to the Regulations Accordingly, 26 CFR part 1 is amended
as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in
part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.985-1 is amended by:

1. Revising paragraph (b)(2)(ii)(C).

2. Adding a sentence to the end of paragraph (b)(2)(ii)(D).

3. Adding paragraph (b)(2)(ii)(E).

The additions and revision reads as follows:

�1.985-1. Functional currency.

* * * * *

(b) * * *

(2) * * *

(ii) * * *

(C) Change in functional currency. If a QBU is required to change
its functional currency to the dollar under paragraph (b)(2)(ii)(A)
of this section, or chooses or is required to change its functional
currency to the dollar for any open taxable year (and all subsequent
taxable years) under �1.985-3(a)(2)(ii), the change is considered to
be made with the consent of the Commissioner for purposes of
�1.985-4. A QBU changing functional currency must make adjustments
described in �1.985-7 if the year of change (as defined in
�1.481-1(a)(1)) begins after 1987, or the adjustments described in
�1.985-6 if the year of change begins in 1987. No adjustments under
section 481 are required solely because of a change in functional
currency described in this paragraph (b)(2)(ii)(C).

(D) * * * In making the determination whether a currency is
hyperinflationary, the determination for purposes of United States
generally accepted accounting principles may be used for income tax
purposes provided the determination is based on criteria that is
substantially similar to the rules previously set forth in this
paragraph (b)(2)(ii)(D), the method of determination is applied
consistently from year to year, and the same method is applied to
all related persons as defined in �1.985-3(e)(2)(vi).

(E) Change in functional currency when currency ceases to be
hyperinflationary-(1) In general. A QBU that has been required to
use the dollar as its functional currency under paragraph (b)(2) of
this section, or has elected to use the dollar as its functional
currency under paragraph (b)(2)(ii)(B)(2) of this section or
�1.985-2, must change its functional currency as of the first day of
the first taxable year that follows three consecutive taxable years
in which the currency of its economic environment, determined under
paragraph (c)(2) of this section, is not a hyperinflationary
currency. The functional currency of the QBU for such year shall be
determined in accordance with paragraph (c) of this section. For
purposes of �1.985-4, the change is considered to be made with the
consent of the Commissioner. See �1.985-5 for adjustments that are
required upon a change in functional currency.

(2) Effective Date. This paragraph (b)(2)(ii)(E) of this section
applies to taxable years beginning after April 6, 1998.

Par. 3. Section 1.985-5(a) is amended by adding the following
sentence to the end of the paragraph:

�1.985-5 Adjustments required upon change in functional currency.

(a) * * *

However, a QBU that changes to the dollar pursuant to �1.985- 1(b)
(2) after 1987 shall apply �1.985-7.

* * * * *

Par. 4. Section 1.985-7 is added as follows:

1.985-7 Adjustments required in connection with a change to DASTM.

(a) In general. If a QBU begins to use the dollar approximate
separate transactions method of accounting set forth in �1.985-3
(DASTM) in a taxable year beginning after April 6, 1998, adjustments
shall be made as provided by this section. For the rules with
respect to foreign corporations, see paragraph (b) of this section.
For the rules with respect to adjustments to the income of United
States shareholders of controlled foreign corporations, see
paragraph (c) of this section. For the rules with respect to
adjustments relating to QBU branches, see paragraph (d) of this
section. For the effective date of this section, see paragraph (e).
For purposes of applying this section, the look-back period shall be
the period beginning with the first taxable year after the
transition date and ending on the last day prior to the taxable year
of change. The term transition date means the later of the last day
of the last taxable year ending before the base period as defined in
�1.985-1(b)(2)(ii)(D) or the last day of the taxable year in which
the QBU last applied DASTM. The taxable year of change shall mean
the taxable year of change as defined in �1.481-1(a)(1). The
application of this paragraph may be illustrated by the following
examples:

Example 1. A calendar year QBU that has not previously used DASTM
operates in a country in which the functional currency of the
country is hyperinflationary as defined under �1.985- 1(b)(2)(ii)(D)
for the QBU's 1999 tax year. The look-back period is the period from
January 1, 1996 through December 31, 1998, the transition date is
December 31, 1995, and the taxable year of change is the taxable
year beginning January 1, 1999.

Example 2. A QBU that has not previously used DASTM with a taxable
year ending June 30, operates in a country in which the functional
currency of the country is hyperinflationary for the QBU's tax year
beginning July 1, 1999 as defined under �1.985- 1(b)(2)(ii)(D)(where
the base period is the thirty-six calendar months immediately
preceding the first day of the current calendar year 1999). The
look-back period is the period from July 1, 1995 through June 30,
1999, the transition date is June 30, 1995, and the taxable year of
change is the taxable year beginning July 1, 1999.

(b) Adjustments to foreign corporations--(1) In general. In the case
of a foreign corporation, the corporation shall make the adjustments
set forth in paragraphs (b)(2) through (4) of this section. The
adjustments shall be made on the first day of the taxable year of
change.

(2) Treatment of certain section 988 transactions--(i) Exchange gain
or loss from section 988 transactions unrealized as of the
transition date. A foreign corporation shall adjust earnings and
profits by the amount of any unrealized exchange gain or loss that
was attributable to a section 988 transaction (as defined in
sections 988(c)(1)(A), (B), and (C)) that was denominated in terms
of (or determined by reference to) the dollar and was held by the
corporation on the transition date. Such gain or loss shall be
computed as if recognized on the transition date and shall be
reduced by any gain and increased by any loss recognized by the
corporation with respect to such transaction during the look-back
period. The amount of such gain or loss shall be determined without
regard to the limitations of section 988(b) (i.e., whether any gain
or loss would be realized on the transaction as a whole). The
character and source of such gain or loss shall be determined under
section 988. Proper adjustments shall be made to account for gain or
loss taken into account by reason of this paragraph (b)(2). See
�1.985-5(f) Example 1, footnote 1.

(ii) Treatment of a section 988 transaction entered into and
terminated during the look-back period. A foreign corporation shall
reduce earnings and profits by the amount of any gain, and increase
earnings and profits by the amount of any loss, that was recognized
with respect to any dollar denominated section 988 transactions
entered into and terminated during the look-back period.

(3) Opening balance sheet. The opening balance sheet of a foreign
corporation for the taxable year of change shall be determined as if
the corporation had changed its functional currency to the dollar by
applying � 1.985-5(c) on the transition date and had translated its
assets and liabilities under �1.985-3 during the look-back period.

(4) Earnings and profits adjustments--(i) Pre-1987 accumulated
profits. The foreign income taxes and accumulated profits or
deficits in accumulated profits of a foreign corporation that are
attributable to taxable years beginning before January 1, 1987, as
stated on the transition date, and that were maintained for purposes
of section 902 in the old functional currency, shall be translated
into dollars at the spot rate in effect on the transition date. The
applicable accumulated profits shall be reduced on a last-in, first-
out basis by the aggregate dollar amount (translated from functional
currency in accordance with the rules of section 989(b))
attributable to earnings and profits that were distributed (or
treated as distributed) during the look-back period to the extent
such amounts distributed exceed the earnings and profits calculated
under (b)(4)(ii) or (b)(4)(iii), as applicable. See �1.902-1(b)(2)
(ii). Once translated into dollars, these pre-1987 taxes and
accumulated profits or deficits in accumulated profits shall (absent
a change in functional currency) remain in dollars for all federal
income tax purposes.

(ii) Post-1986 undistributed earnings of a CFC. In the case of a
controlled foreign corporation (within the meaning of section 957 or
section 953(c)(1)(B))(CFC) or a foreign corporation subject to the
rules of �1.904-6(a)(2), the corporation's post-1986 undistributed
earnings in each separate category as defined in �1.904-5(a)(1) as
of the first day of the taxable year of change (and prior to
adjustment under paragraph (c)(1) of this section) shall equal the
sum of--

(A) The corporation's post-1986 undistributed earnings and profits
(or deficit in earnings and profits) in each separate category as
defined in �1.904-5(a)(1) as stated on the transition date
translated into dollars at the spot rate in effect on the transition
date; and

(B) The sum of the earnings and profits (or deficit in earnings and
profits) in each separate category determined under �1.985-3 for
each post-transition date taxable year prior to the taxable year of
change.

Such amount shall be reduced by the aggregate dollar amount
(translated from functional currency in accordance with the rules of
section 989(b)) attributable to earnings and profits that were
distributed (or treated as distributed) during the look-back period
out of post-1986 earnings and profits in such separate category. For
purposes of applying this paragraph (b)(4)(ii)(B), the opening
balance sheet for calculating earnings and profits under �1.985-3
for the first post-transition year shall be translated into dollars
pursuant to �1.985-5(c).

(iii) Post-1986 undistributed earnings of other foreign
corporations. In the case of a foreign corporation that is not a CFC
or subject to the rules of �1.904-6(a)(2), the corporation's
post-1986 undistributed earnings shall equal the sum of--

(A) The corporation's post-1986 undistributed earnings (or deficit)
on the transition date translated into dollars at the spot rate in
effect on the transition date; and

(B) The sum of the earnings and profits (or deficit in earnings and
profits) determined under �1.985-3 for each post-transition date
taxable year (or such later year determined under section 902(c)(3)
(A)) prior to the taxable year of change.

Such amount shall be reduced by the aggregate dollar amount
(translated from functional currency in accordance with the rules of
section 989(b)) that was distributed (or treated as distributed)
during the look-back period out of post-1986 earnings and profits.
For purposes of applying this paragraph (b)(4)(iii)(B), the opening
balance sheet for calculating earnings and profits under �1.985-3
for the first post-transition year shall be translated into dollars
pursuant to �1.985-5(c).

(c) United States shareholders of controlled foreign
corporations--(1) In general. A United States shareholder (within
the meaning of section 951(b) or section 953(c)(1)(B)) of a CFC that
changes to DASTM shall make the adjustments set forth in paragraphs
(c)(2) through (5) of this section on the first day of the taxable
year of change. Adjustments under this section shall be taken into
account by the shareholder (or such shareholder's successor in
interest) ratably over four taxable years beginning with the taxable
year of change. Similar rules shall apply in determining adjustments
to income of United States persons who have made an election under
section 1295 to treat a passive foreign investment company as a
qualified electing fund.

(2) Treatment under subpart F of income recognized on section 988
transactions. The character of amounts taken into account under
paragraph (b)(2) of this section for purposes of sections 951
through 964, shall be determined on the transition date and to the
extent characterized as subpart F income shall be taken into account
in accordance with the rules of paragraph (c)(1) of this section.
Such amounts shall retain their character for all federal income tax
purposes (including sections 902, 959, 960, 961, 1248, and 6038).

(3) Recognition of foreign currency gain or loss on previously taxed
earnings and profits on the transition date.

Gain or loss is recognized under section 986(c) as if all previously
taxed earnings and profits as determined on the transition date, if
any, were distributed on such date. Such gain or loss shall be
reduced by any foreign currency gain and increased by any foreign
currency loss that was recognized under section 986(c) with respect
to distributions of previously taxed earnings and profits during the
look-back period. Such amount shall be characterized in accordance
with section 986(c) and taken into account in accordance with the
rules of paragraph (c)(1) of this section.

(4) Subpart F income adjustment. Subpart F income in a separate
category shall be determined under �1.985-3 for each look-back year.
For this purpose, the opening DASTM balance sheet shall be
determined under �1.985-5. The sum of the difference (positive or
negative) between the amount computed pursuant to �1.985-3 and
amount that was included in income for each year shall be taken into
account in the taxable year of change pursuant to paragraph (c)(1)
of this section. Such amounts shall retain their character for all
federal income tax purposes (including sections 902, 959, 960, 961,
1248, and 6038). For rules applicable if an adjustment under this
section results in a loss for the taxable year in a separate
category, see section 904(f) and the regulations thereunder. The
amount of previously taxed earnings and profits as determined under
section 959(c)(2) shall be adjusted (positively or negatively) by
the amount taken into account under this paragraph (c)(4) as of the
first day of the taxable year of change.

(5) Foreign tax credit. A United States shareholder of a CFC shall
compute an amount of foreign taxes deemed paid under section 960
with respect to any positive adjustments determined under paragraph
(c) of this section. The amount of foreign tax deemed paid shall be
computed with reference to the full amount of the adjustment and to
the post-1986 undistributed earnings determined under paragraph (b)
(4)(i) and (ii) of this section and the post-1986 foreign income
taxes of the CFC on the first day of the taxable year of change
(i.e., without taking into account earnings and taxes for the
taxable year of change.) For purposes of section 960, the associated
taxes in each separate category shall be allocated pro rata among,
and deemed paid in, the shareholder's taxable years in which the
income is taken into account. (No adjustment to foreign taxes deemed
paid in prior years is required solely by reason of a negative
adjustment to income under paragraph (c)(1) of this section.)

(d) QBU branches --(1) In general. In the case of a QBU branch, the
taxpayer shall make the adjustments set forth in paragraphs (d)(2)
through (d)(4) of this section. Adjustments under this section shall
be taken into account by the taxpayer ratably over four taxable
years beginning with the taxable year of change.

(2) Treatment of certain section 988 transactions--(i) Exchange gain
or loss from section 988 transactions unrealized as of the
transition date. A QBU branch shall adjust income by the amount of
any unrealized exchange gain or loss that was attributable to a
section 988 transaction (as defined in sections 988(c)(1)(A), (B),
and (C)) that was denominated in terms of (or determined by
reference to) the dollar and was held by the QBU branch on the
transition date. Such gain or loss shall be computed as if
recognized on the transition date and shall be reduced by any gain
and increased by any loss recognized by the QBU branch with respect
to such transaction during the look-back period. The amount of such
gain or loss shall be determined without regard to the limitations
of section 988(b) (i.e., whether any gain or loss would be realized
on the transaction as a whole). The character and source of such
gain or loss shall be determined under section 988. Proper
adjustments shall be made to account for gain or loss taken into
account by reason of this paragraph (d)(2). See �1.985-5(f) Example
1, footnote 1.

(ii) Treatment of a section 988 transaction entered into and
terminated during the look-back period. A QBU branch shall reduce
income by the amount of any gain, and increase income by the amount
of any loss, that was recognized with respect to any dollar
denominated section 988 transactions entered into and terminated
during the look-back period.

(3) Deemed termination income adjustment. The taxpayer shall realize
gain or loss attributable to the QBU branch's equity pool (as stated
on the transition date) under the principles of section 987,
computed as if the branch terminated on the transition date.

Such amount shall be reduced by section 987 gain and increased by
section 987 loss that was recognized by such taxpayer with respect
to remittances during the look-back period.

(4) Branch income adjustment. Branch income in a separate category
shall be determined under �1.985-3 for each look-back year.

For this purpose, the opening DASTM balance sheet shall be
determined under �1.985-5. The sum of the difference (positive or
negative) between the amount computed pursuant to �1.985-3 and
amount taken into account for each year shall be taken into account
in the taxable year of change pursuant to paragraph (d)(1) of this
section. Such amounts shall retain their character for all federal
income tax purposes.

(5) Opening balance sheet. The opening balance sheet of a QBU branch
for the taxable year of change shall be determined as if the branch
had changed its functional currency to the dollar by applying �
1.985-5(c) on the transition date and had translated its assets and
liabilities under �1.985-3 during the look-back period.

(e) Effective date. This section is effective for taxable years
beginning after April 6, 1998. However, a taxpayer may choose to
apply this section to all open taxable years beginning after
December 31, 1986, provided each person, and each QBU branch of a
person, that is related (within the meaning of �1.985-2(d)(3)) to
the taxpayer also applies this section rules.

Michael P. Dolan
Deputy Commissioner of Internal Revenue
Approved: February 11, 1998
Donald C. Lubick
Assistant Secretary of the Treasury

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