As USCitizenAbroad pointed out in 2012 (and as Phil Hodgen more recently reminded us), the “Internal” Revenue Code penalises Americans in other countries who want to become homeowners:
Assuming a falling US dollar, there will be a phantom gain on the sale of the property where you are receiving money, but a phantom loss on the discharge of the mortgage where you are paying money. Assuming a rising US dollar, there will be a phantom loss on the sale of the property when receiving the money and a phantom gain on the discharge of the mortgage when you are paying the money.
US law does require you to pay tax on the “net” phantom capital gain but will not allow you a loss on the “net” phantom capital loss.
The main reason this occurs is the absurd tax law definition of “functional currency”: U.S. emigrants must pretend for tax purposes that they really earn & spend U.S. dollars and realise foreign currency gains & losses in every daily transaction in a foreign country, even if all their income, assets, and liabilities are in another currency. This requirement came into being in piecemeal fashion, scattered throughout various IRS revenue rulings, and was finally given Congressional endorsement and clarification by the Tax Reform Act of 1986. That Act explicitly exempted businesses from this inane requirement; they can pick a functional currency that actually makes sense. (Remember kids, corporations are people too, except when it’s more convenient for them not to be.)
In drawing up the 1986 Act, Congress examined the confused state of regulations & case law on foreign currency transactions, identified problems for both businesses and individuals, and fixed businesses’ problems while refusing to fix individuals’ problems. One new provision which Congress enacted to address multinational businesses’ issues — “integrated treatment” of hedging transactions, 26 USC § 988(d) — could also have fixed the mortgage “phantom gains” problem. However, Congress explicitly stated their intention that this new provision be “inapplicable to exchange gain or loss recognized by a U.S. individual resident abroad upon repayment of a foreign currency denominated mortgage on the individual’s principal residence”.
The same year, Congress also passed the Immigration and Nationality Act Amendments of 1986, which would drastically expand the number of cases of dual citizenship among the American diaspora. Guess who was the one Senator who was in the perfect position to be closely familiar with both bills and thus to understand their combined impact on the diaspora?
Table of contents
- Pre-reform cases & revenue rulings
- Congress makes (dys)functional currency rules
- And denies Section 988(d) benefits
- And treats foreign currency gain as ordinary income
- They know the rules are complicated & confusing
- 1996: tested in the courts
- Conclusion
Unless otherwise indicated in the text, all references to page numbers mean pages in S. Rept. 99-313, Part I, “Tax Reform Act of 1986: Report, together with Additional Views, to accompany H.R. 3838”.
Pre-reform cases & revenue rulings
Prior to 1986, the IRS & the courts created a mixed bag of not-exactly-consistent rules about what currency to use on tax returns and whether foreign currency loan gains could be offset against other types of losses.
The first rule for foreign currency transactions, established by Supreme Court Associate Justice Pierce Butler in Bowers v. Kerbaugh-Empire Co., 271 U.S. 170 (1926), said that a foreign currency gain on a transaction which otherwise lost money could not be regarded as “income”. In that case, Kerbaugh — a New York construction company — took out a German mark-denominated loan from Deutsche Bank a few years before World War I. Kerbaugh converted the marks to USD to conduct business in the U.S., but had far worse luck in construction than in currencies, and lost money. When the loans came due in 1921, they paid only US$113,688.23 to settle outstanding principal of M3,216,445 (US$764,650.81 at the 1913 exchange rate) plus interest.
The next major case, Helburn v. Commissioner of Internal Revenue, arose out of the sterling devaluation of 1949. Helburn — a Massachusetts corporation which dealt in sheepskins — had an agent in New Zealand borrow pounds (pre-devaluation) to buy sheepskins, and received GBP-denominated invoices. They paid off the invoices post-devaluation, but on their tax return reported the cost of the sheepskins at the pre-devaluation exchange rate (i.e. higher cost of goods sold, so lower taxable profit). The Tax Court held that the USD difference between the amounts borrowed & paid was taxable income. Helburn appealed, but to no avail: 214 F.2d 815 (1st Cir. 1954). Judge Calvert Magruder (an FDR appointee) chose to disregard Kerbaugh-Empire, because Helburn had not proven loss on the sheepskins in question. However, Magruder’s ruling did not mandate that the purchase of the sheepskins and the foreign currency loan & repayment must be treated as two separate transactions in which losses from one cannot offset gains in the other; Magruder simply noted that since Helburn themselves had chosen to treat these as two separate transactions, they couldn’t “have it both ways” by using the higher exchange rate to reduce the profit in the first transaction while also claiming that the second transaction did not result in taxable income.
Over the next several decades, the IRS made a few rulings demanding the use of the U.S. dollar for accounting purposes in various situations, though they hadn’t yet invented the term “functional currency”. First, Section 9 of Rev. Rul. 53-291 (1953-2 C.B. 42, 48), which laid out the rules for the Foreign Earned Income Exclusion, provided that:
The income reported on a Federal income tax return must be expressed in terms of United States dollars. Where income is actually or constructively received in foreign currency, the computation in terms of United States dollars must be based on the rate of exchange at the time of receipt by the citizen, or when credited to his account in the foreign country, even though not actually converted into United States currency at that time.
The following year, Rev. Rul 54-105 (1954-1 C.B. 12) primarily intended to clarify that gains from sale of personal property were not “earned income” for FEIE purposes, but also provided that “the cost and selling price of the property should be expressed in American currency at the rate of exchange prevailing as of the date of the purchase and the date of the sale, respectively”, i.e. phantom gains would be taxed).
Finally, Rev. Rul. 78-281 (1978-2 C.B. 204) created the headache-inducing rule that a taxpayer with a foreign-currency loan “will realize ordinary gain or loss on each annual payment to the bank equal to the difference, if any, between the original United States dollar value of that portion of the loan principal which is discharged and the United States dollar value of the F currency used to make the repayment on the date such payment is made”, i.e. every single monthly mortgage payment represents a separate foreign currency speculation transaction — except that, even with hundreds of such transactions, one every month over the lifetime of the loan, you’re not entitled to the tax treatment which the transactions of a true speculator would enjoy, thanks to America-Southeast Asia Co., 26 T.C. 198 (1956).
1986: Congress makes (dys)functional currency rules
Both Congress and the Reagan administration recognised the difficulties that the then-current rules caused, and proposed several fixes. First, they proposed to bring the concept of “functional currency” into the tax law. As the Senate Finance Committee explained (page 449):
The financial accounting concept of functional currency provides a reasonable basis for determining the amount and the timing of recognition of exchange gain or loss. The bill reflects the principle that income or loss should be measured in the currency of a taxpayer’s primary economic environment. Under this approach, the U.S. dollar will be the functional currency of most U.S. persons. The committee recognized, however, that there are circumstances in which it is appropriate to measure the results of a U.S. person’s foreign operation in a foreign currency so that a taxpayer is not required to recognize exchange gain or loss on currency that is not repatriated but is used to pay ordinary and necessary expenses.
Similarly, at page 456:
New section 985(a) generally requires all Federal income tax determinations to be made in a taxpayer’s functional currency. The functional currency approach presupposes a long-term commitment to a specific economic environment.
However, their proposal was that all U.S. citizens and resident aliens should be forced to use the U.S. dollar as their functional currency (and would thus have their ordinary integrated transactions, such as local-currency mortgages, be treated as a U.S. dollar loan combined with a separate series of fictional currency-conversion transactions); only businesses would be allowed to chose another functional currency. I guess that by “ordinary and necessary expenses”, Congress didn’t mean water, gas, and groceries for human beings who actually live abroad. They also decided to ignore the “long-term commitment to a specific economic environment” which is represented by taking a job paid solely in the currency of that economic environment, moving one’s family there and incurring all expenses of supporting them in that same currency, taking out a loan to buy a house there, and quite possibly naturalising there.
And denies Section 988(d) benefits
Congress, in their great wisdom, recognised the difficulty that rigid functional currency rules could cause. Specifically, they understood that some taxpayers deemed to have the U.S. dollar as their functional currency nevertheless had legitimate reasons for borrowing money in a foreign currency as part of certain transactions, and Congress wanted to make sure that such “people” wouldn’t be subject to the unfair “separate transaction” treatment. At pages 464–465:
The bill authorizes the issuance of regulations that address the treatment of section 988 transactions that are part of a hedge. The committee included this regulatory authority to provide certainty of tax treatment for foreign currency hedging transactions that are fast becoming commonplace (such as fully hedged foreign currency borrowings) and to insure that such a transaction is taxed in accordance with its economic substance. A hedging transaction includes certain transactions entered into primarily to reduce the risk of (1) foreign currency exchange rate fluctuations with respect to property held or to be held by the taxpayer, or (2) foreign currency fluctuations with respect to borrowings or obligations of the taxpayer. The bill provides that a hedging transaction is to be identified by the taxpayer or the Secretary.
To the extent provided in regulations, if any section 988 transaction is part of a hedging transaction all positions in the hedging transaction are integrated and treated as a single transaction, or otherwise treated consistently (e.g., for purposes of characterizing the nature of income or the sourcing rules). The committee intends that these regulations address two different categories of hedging transactions.
The first category is a narrow class of fully hedged transactions that are in substance part of an integrated economic package through which the taxpayer (by simultaneously combining a bundle of financial rights and obligations) has assured itself of a cash flow that will not vary with movements in exchange rates. With respect to this category, the committee intends that such rights and obligations be integrated and treated as a single transaction with respect to that taxpayer … The second category of hedging transactions involves transacions that are not entered into as an integrated financial package but are designed to limit a taxpayer’s exposure in a particular currency (e.g., the acquisition of a foreign currency denominated liabilty to offset exposure with regard to a foreign currency denominated asset).
Now, if I were a legislative draughtsman, I wouldn’t try to fix the mortgage “phantom gains” problem through § 988(d) treatment. It makes far more sense to fix it by allowing taxpayers to use the currency in which they earn their wages as their functional currency (something which American Citizens Abroad has actually proposed to Congress). However, a fix through § 988(d) could have worked. It would accomplish the committee’s stated goals of providing integrated tax treatment for transactions which were designed to match foreign currency assets to foreign currency liabilities, and of “insur[ing] that such a transaction is taxed in accordance with its economic substance”. It wouldn’t have been anywhere near the worst kludge in Title 26.
But of course, Congress didn’t care about the economic substance of transactions engaged in by human people, only by paper people (page 468):
Section 988 applies to transactions entered into by an individual only to the extent that expenses attributable to such transactions would be deductible under section 162 (as a trade or business expense) or section 212 (as an expense of producing income, other than expenses incurred in connection with the determination, collection or refund of taxes). Thus, for example, section 988 is inapplicable to exchange gain or loss recognized by a U.S. individual resident abroad upon repayment of a foreign currency denominated mortgage on the individual’s principal residence. The principles of current law would continue to apply to such transactions.
Congress were not ignorant of the problems they were creating for “U.S. individual[s] resident abroad”; they were explicitly aware and refused to provide any amelioration.
And treats foreign currency gain as ordinary income
At page 452, the Senate Finance Committee discussed why they did not feel foreign currency gains should be treated as capital gains in most cases:
The committee did not adopt the interest equivalency approach in its entirety, but concluded that characterizing exchange gain or loss as ordinary income or loss for most purposes is a pragmatic solution to an issue about which tax scholars and practitioners hold disparate views. The committee bill authorizes the Secretary to treat exchange gain or loss as interest income or expense in appropriate circumstances (e.g., in the case of hedging transactions where a taxpayer’s expectations about future exchange rates are locked in).
The committee considered whether unanticipated exchange gain or loss on a financial asset or liability should be characterized as capital gain or loss. This approach was not followed because it is difficult to distinguish anticipated exchange gain or loss from unanticipated exchange gain or loss. Anticipated gain or loss could be measured with reference to the premium or discount element in a forward contract had one been obtained; however, forward contracts are not available in all currencies and do not trade at all maturities. Even where anticipated gain or loss is determinable (e.g., were a taxpayer enters into a forward contract), the bill treats all such gain or loss as ordinary in nature to reduce discontinuities. The narrowing of the rate differential between ordinary income and capital gain for corporations and the elimination of the differential for individuals under the bill reduces the importance of capital gain characterization.
Two decades later, the Tax Increase Prevention and Reconciliation Act of 2005 would make the distinction very salient again by introducing a lower tax rate on capital gains than on ordinary income. At the same time, Chuck Grassley (R-IA) — who was on the Senate Finance Committee both in 1986 and in 2005 — also took the opportunity sneak in an obscure modification known as “stacking” for the calculation of tax rates on taxpayers taking the Foreign Earned Income Exclusion into the Tax Increase “Prevention” and Reconciliation Act.
In other words, the Tax Reform Act of 1986 was just one example in a long line of so-called “tax cuts” pushed by a Republican Congress & president which would turn out to contain massive tax hikes on emigrants. And nor was the treatment of foreign-currency mortgages the only case of Reagan putting burdens on U.S. Persons abroad in order to pay for tax goodies for the folks back home — PFIC taxation, which makes it unprofitable and even dangerous for emigrants to access ordinary financial planning tools in the countries where they actually live, was also a product of the Tax Reform Act of 1986.
They know the rules are complicated & confusing
Congress were and remain well aware that the tax laws which apply to the diaspora are incredibly complicated, and that every round of tax reform makes things even worse. Their response has never been to simplify the rules or provide safe harbours for emigrants, but to double-down on the harassment. As they said about their efforts to promote tax filing by fining people who applied for U.S. passports without providing their Social Security number (page 389):
The General Accounting Office has gathered evidence suggesting that the percentage of taxpayers who fail to file returns is substantially higher among Americans living abroad than it is among those resident in the United States. Such nonfilers may consist of two general types. First, there are the negligent nonfilers: those who assume that their residence overseas exempts them from U.S. tax, and those who think that they need not file if section 911 and/or foreign tax credits eliminate their U.S. tax liability. Second, there are fraudulent nonfilers, those who know their duty to pay U.S. tax but do not fulfill it. The committee believes that both of these cases present significant compliance problems that must be addressed.
With respect to the first case, the negligent nonfiler, the committee emphasizes that it is important that a return be filed even by those who believe their U.S. tax liability to be zero (as long as their gross income exceeds the return filing threshold). The Internal Revenue Service should have the opportunity to determine that taxpayers with significant gross income have properly applied the provisions relevant to the determination of their liability. Since the foreign tax credit is among the most difficult provisions of the Code, it is particularly important that the Service have an opportunity to review the application of those provisions by citizens and residents abroad.
Congress understood that even the “simpler” international paperwork like Form 1116 is difficult for ordinary human beings to fill out properly, let alone the Form 8621 that would arise out of their brand new PFIC rules. They knew that the vast majority of U.S. citizens abroad owe no tax. But instead of simplifying the rules for human beings, they created special rules for corporations while making the situation worse for human beings. Even when we owe no tax, they explicitly want us to file ever-increasing piles of useless paperwork with obscene fines for errors.
The same 99th Congress which passed the Tax Reform Act of 1986 also three weeks later passed the Immigration and Nationality Act Amendments of 1986 (Pub. L. 99-653), which drastically expanded the number of cases in which emigrants’ children would be deemed U.S. citizens (§§ 12 and 13), and also made it much harder to prove relinquishment of U.S. citizenship (§ 18). Brockers shouldn’t be too surprised to learn who was the one Senator in the 99th Congress who sat on both the Judiciary Committee (which oversees immigration-and-nationality-related bills) and the Finance Committee, and thus almost certainly knew that he was making many more people abroad into Americans while also making it much harder for them to have mortgages where they lived: Chuck Grassley.
1996: tested in the courts
In response to Congress’ intentions, the IRS produced Rev. Rul. 90-79, which stated:
Since the [foreign currency] increased in value against the dollar between the time A’s
liability was fixed (at the time of the borrowing) and the time A repaid the loan, the amount of dollars required to retire the debt exceeded the dollar value of the amount originally borrowed. Therefore, A realized a loss on the loan repayment. The amount of the loss is $4,474. (The dollar value of 85,000 [units of foreign currency] borrowed: $85,000, less the dollar value of 85,000 [units of foreign currency] used to repay the loan $89,474).Section 165(a) of the Code provides generally that a deduction shall be allowed for losses sustained during a taxable year and not compensated for by insurance or otherwise. Section 165(c) limits the loss deduction for individuals to losses incurred in a trade or business, losses incurred in any transaction entered into for profit, and casualty losses. Thus, an individual is not allowed to deduct all realized losses. See Billman v. Commissioner, 73 T.C. 139 (1979), where the Tax Court denied an individual a loss resulting from the devaluation of a foreign currency.
A’s loss was not incurred in an activity or as the result of an event described in section 165(c) of the Code. Therefore A may not deduct the $4,474 realized loss. Similarly, if A had realized a loss on the sale of the personal residence and a gain on the repayment of the mortgage, A could not deduct the loss.
I really don’t see how Billman is on point here: it does not support the contention that a loss due to devaluation of a foreign currency is not a loss in a transaction entered into for profit. It only held that an unrealised foreign currency loss is not a casualty loss: Mr. & Mrs. Billman were still holding onto the huge pile of worthless South Vietnamese piastres on which they were trying to claim a tax loss. And the judges in the case couldn’t even agree why not.
Nevertheless, in Quijano v. United States, the courts have given their seal of approval to Rev. Rul. 90-79. The plaintiffs had bought a house in London, and sold it four years later for a profit in GBP. Over the period they owned the house, the GBP also appreciated against the USD. They first paid tax on both the house’s appreciation & the GBP appreciation, but then tried to amend their tax return to include only the house’s appreciation as income. When that was denied, they sued in the District Court of Maine for a refund (76 AFTR 2d 95-7739), but were not successful. On appeal, Conrad Cyr (a Reagan appointee), Bailey Aldrich (an Eisenhower appointee), and Nancy Gertner (U.S. District Judge for the District of Massachusetts, a Clinton appointee) upheld the lower court’s ruling: 93 F.3d 26 (1st Cir. 1996), pointing out that, in enacting the Tax Reform Act of 1986, Congress had specifically intended to screw the diaspora by denying them tax benefits given to businesses:
Under I.R.C. § 985(b)(1), use of a functional currency other than the U.S. dollar is restricted to qualified business units (“QBU”s). The functional currency of a QBU that is not required to use the dollar is “the currency of the economic environment in which a significant part of such unit’s activities are conducted and which is used by such unit in keeping its books and records.” 26 U.S.C. § 985(b)(1)(B). Although appellants correctly assert that their residence was purchased “for a pound-denominated value” while they were “living and working in a pound-denominated economy,” under I.R.C. § 989(a) a QBU must be a “separate and clearly identified unit of trade or business of a taxpayer which maintains separate books and records.” 26 U.S.C. § 989(a). And since appellants concede that the purchase and sale of their residence was not carried out by a QBU, the district court properly rejected their plea to treat the pound as their functional currency.
As The New York Times noted, the Quijano family’s situation was extremely common among American emigrants in the United Kingdom in those days:
The difficulty and stress would have been much higher for American homeowners in Britain in 1992 when the pound made its forced and disastrous exit from the European exchange-rate mechanism, the system intended to try to keep currencies aligned before the euro was adopted. Sterling plunged against the dollar, and at the same time the British economy and property prices were sinking.
“It could be a train wreck if you have a ’90s-style crash and you have to move back to the States,” Stidham said. An expat could be left with a big real loss on the house and no tax relief, a whopping taxable paper gain on the mortgage and perhaps no job to come home to.
The NYT suggested a solution, but it was not very encouraging nor practical, and would be available only to those with the time or money to handle even more compliance costs:
Another possibility is forming a personal corporation, which then buys the home. This may allow for gains and losses to be netted off when the home is sold and the mortgage is repaid.
Another advantage is that the home may be exempted from inheritance tax should the de facto owner die because the home is legally owned by the corporation. What the expat owns is shares in the company, and if these are kept outside the country where he was based before his demise, there should be no tax due. Laws that apply in certain countries, mainly in continental Europe, requiring an estate to be divided among various relatives, regardless of the wishes of the deceased, may also be skirted.
But there are costs involved in setting up and maintaining a company. Perhaps more important, while a gain on the sale of a personal residence may escape tax liability, that is not the case when a corporation owns a home. It isn’t personal then; it’s strictly business.
Conclusion
Emigrants who still love the United States, and genuinely believe that their country will eventually do the right thing and just has a few more bad alternatives to exhaust, try to comfort themselves with wishful thinking: “The tax code may be out of control, but this will all be solved if we vote Roosevelt Truman Kennedy Nixon Ford Reagan Clinton Bush Obama out of office so the Other Party can return our country to its golden age of liberty!”
Unfortunately, Congress did not create citizenship-based taxation in a fit of absent-mindedness. None of the anti-emigrant laws of the past six decades were piled on “accidentally” or “innocently” in an effort to target Homeland tax evaders. Homelanders are suspicious of the diaspora, and Congresscritters very well know we exist and are happy to respond to the popular desire to punish us. They are extremely frustrated that the Section 901 foreign tax credit protects us and that the demands of treaties prevent them from unilaterally repealing it. That’s why they keep passing laws which are explicitly designed to create fictional “taxable income” on which no FTCs will be available, and to require absurd amounts of record-keeping and form-filing against which they can impose obscene fines for non-compliance.
Hey look! The IRS has new regulations for “people” who want to use multiple functional currencies!
https://www.federalregister.gov/documents/2016/12/08/2016-28377/recognition-and-deferral-of-section-987-gain-or-loss
https://www.federalregister.gov/documents/2016/12/08/2016-28381/income-and-currency-gain-or-loss-with-respect-to-a-section-987-qbu
Isn’t it great being a “person”?
I’m completely mystified by the latest from Brian Dooley.
https://blog.intltaxcounselors.com/section-988-and-currency-devaluation-from-the-britain-to-australia/
He cites Kerbaugh-Empire and then Cottage Savings Ass’n v. Commissioner, 499 U.S. 554 (1991)
https://en.wikipedia.org/wiki/Cottage_Savings_Ass'n_v._Commissioner
He also refers to an earlier post where he stated, regarding Rev. Rul. 90-79:
https://blog.intltaxcounselors.com/international-tax-cpa-research-foreign-accountant/where-to-report-foreign-currency-gain-where-to-report-a-section-9388-transaction-bowers-v-kerbaugh-empire-company-currency-exhanges-and-section-988/
Anyone else groks this?
Brian Dooley again implying he knows how to use Kerbaugh-Empire to beat the phantom gains problem.
https://blog.intltaxcounselors.com/tax-planning-for-expats-and-aliens-with-foreign-homes/
Not much detail. Maybe he’s holding his cards close to his vest deliberately because it’s about a current client. Wonder if we’ll see this in Tax Court.
And, somewhat off topic, on the general concept of the IRS claiming “precedent” from cases that don’t support their position at all (like their use of Billman mentioned in the main post), an interesting TaxProf Blog post:
http://taxprof.typepad.com/taxprof_blog/2017/10/lesson-from-tax-court-when-precedent-is-a-game-of-telephone.html
The above-mentioned Section 987 qualified business unit functional currency regulations have been repealed
http://taxprof.typepad.com/taxprof_blog/2017/10/treasury-rolls-back-eight-tax-regulations.html
This was part of the Trump regulatory review (which ended up doing jack squat for US Persons abroad)
http://isaacbrocksociety.ca/2017/05/05/fatca-reciprocity-watch-form-5472/
Companies continue to be in a far better position than actual flesh-and-blood people with regard to functional currencies