The Fundamentals of Foreign Currency Conversion Transactions

1. The Fundamentals of Foreign Currency Conversion Transactions John Golding President International Monetary Specialists

2. Basic Principles: Cash, Conversion and Delivery • What is cash? • The cash delivery market. • Cash denominated in FX it is treated as a commodity. • How do the foreign currency exchange markets work? • Point of conversion (POC). • Foreign currency exchange rates.

3. Point of Conversion: Gold Illustration The Point of Conversion (POC) Modifies the Value There is an economic cost at the point of conversion. POC Refinery + report

4. POC Report • The POC report provided after the gold refinery process is very detailed and describes all the other components of the gold ore that were extracted upon the conversion process. • Such other components have value! • There is no comparable report in the case of foreign currency conversions.

5. Common Cases Company A: US based parent company with foreign sales subsidiaries Company B: UK based parent company that is selling products in the US using a US based sales subsidiary Company C: US based company imports products from the UK into the US.

6. Example: Company A • Company A is a US corporation selling widgets worldwide. • Overseas sales are handled using foreign subsidiaries (e.g., in the UK). • Sales proceeds are denominated in the local subsidiary’s currency (GBP). • The subsidiary need to repatriate the money to its parent in USD. • Conversion from GBP to USD needs to be made to repatriate.

7. Example: Company B • Company B is a resident of the UK and is the business of producing and selling widgets. • The UK parent establishes a subsidiary in the US to sell the widgets in the US. • Sales proceeds are denominated in USD. • The subsidiary needs to repatriate the money to UK in GBP.

8. Example: Company C • US based company that is importing products from the UK into to the US. • The US company purchases the products from its subsidiary in the UK and needs to wire money denominated in GBP to the foreign subsidiary.

9. How Does Conversion Work? ₤ $ $ ₤ http://www.MonetarySpecialists.com

10. The Conversion Process • Vast majority of currency conversion transactions are conducted through banks. • The banks created their own primary market for conversion transactions. • When Company A, B and C need to convert GBP to USD or vice versa, they typically get exchange rates quotes from three different banks, and use the best quoted rate. • However, exchange rates are not the only cost involved in a foreign currency transaction.

11. Cost and Transparency • When the cash is being channeled through the various intermediaries at the bank, it is almost impossible to keep track on the various costs involved. • The ultimate client may not know how his or her money was channeled through the various divisions in the bank, until he or she receives the converted cash. • It presents a challenge for clients who are trying to account for gains and losses in a transaction. • According to the BIS, there is a daily GAP in currency trade

12. Contact Information John Golding President, IMS 888.990.9895 jgolding@monetaryspecialists.com

13. U.S. Tax Consequences of Foreign Currency Exchange Transactions Contact: Yoram Keinan  Shareholder  keinany@gtlaw.com  (212) 801-6826

14. Basic Principles • Foreign currency (FX) is treated as personal property for US tax purposes. • As such, disposition of FX is subject to the general realization principles. • Thus, when FX is acquired, its basis is the cost. • When the FX is disposed of, the resulting gain or loss equals the amount realized minus basis.

15. Functional Currency • Currency transactions with the taxpayer’s functional currency are generally not taxable events. For example, use of functional currency to purchase property denominated in functional currency does not result in FX gain or loss. • Thus, it is important to determine what is the taxpayer’s functional currency. • The taxpayer’s functional currency is determined by reference to either the taxpayer itself or the taxpayer’s identifiable separate business operation entitled “qualified business operation (“QBU”). • Each QBU of the taxpayer has its own functional currency.

16. Functional Currency (Cont.) • The USD is the functional currency of a US taxpayer, or of the taxpayer’s QBU, if its activities are mostly conducted in USD. • Any effectively connected income to a US trade or business of a foreign taxpayer is generally treated as a separate QBU with the USD as its functional currency. • Taxpayers can generally elect to treat the USD as their functional currency. • Functional currency is treated as a “method of accounting.”

17. Books and Records • A crucial factor in the functional currency determination is the books and records. • It is accepted that a QBU is deemed to maintain its books and records in the currency of the “economic environment” in which a significant part of its activities are conducted. • A QBU’s economic environment is determined under a facts and circumstances test.

18. QBU • “any separate and clearly identified unit of a trade or business of a taxpayer” if such unit “maintains separate books and records.” • An individual may have a qualified business unit (QBU) that has a non-dollar functional currency. • However, an activity that does not generate deductible expenses does not qualify as a QBU.

19. QBU (Cont.) • Corporations, partnerships, trusts and branches may be considered QBUs. • Certain activities of the above entities may qualify as a separate QBU if such activities (1) constitute a trade or business and (2) separate books ad records are kept for such activities. • The activities or an individual, as an employee, are generally not considered a separate QBU.

20. Economic Environment Factors • The currency of the country in which the QBU is a resident. • The currencies of the QBU's cash flows. • The currencies in which the QBU generates revenues and incurs expenses. • The currencies in which the QBU borrows and lends.

21. Economic Environment Factors (Cont.) • The currencies of the QBU's sales markets. • The currencies in which pricing and other financial decisions are made. • The duration of the QBU's business operations. • The significance and/or volume of the QBU's independent activities.

22. Section 988 • Section 988 and regulations thereunder provide guidance as to the timing, character and source of gains and losses from FX transactions that are subject to it.

23. Section 988: Timing • Section 988 requires gain or loss from the overall transaction as a threshold matter. • The second step is to bifurcate the overall gain or loss between gain or loss attributable to changes in the exchange rates and gain or loss attributed to the underlying transaction. • The “spot” rate is used to determine the extent of the FX gain or loss • If there is gain or loss on the underlying transaction, and an offsetting FX gain or loss, the two are netted and only the excess is recognized.

24. Section 988: Character • As a general rule, FX gain or loss is ordinary • Upon a taxpayer’s election, FX gains or losses from certain FX denominated contracts, including forwards, futures and options can be treated as capital. • Some FX gains and losses in connection with FX denominated debt instrument are characterized as interest.

25. Section 988: Source • In general, the source of FX gains and losses is determined by reference to the taxpayer’s residence or the residence of the taxpayer’s QBU. • Exceptions: • FX gains/losses in connection with trade or business • Certain high yield related party FX denominated loans • FX gains/losses characterized as interest • Integrated FX debt and a hedge.

26. Disposition of FX • A mere decline in the FX’s value does not result in taxable event, unless the FX was held in connection with a trade or business and becomes valueless during the year. • If a taxpayer disposes of functional currency, there are no taxable consequences. • Sale and other disposition of nonfunctional currency will give rise to FX gain or loss, computed under the general principles of section 1001.

27. Exchange of FX for other Currency • Exchange of functional currency with functional currency does not give rise to FX gain or loss. • Exchange of units of nonfunctional currency with different units of same nonfunctional currency is not taxable event. • Exchange of one nonfunctional currency with another nonfunctional currency (e.g., Euro to Yen) is taxable event. • Exchange of nonfunctional currency with functional currency is taxable event.

28. Exchange of FX for Property • Treated as a two step transaction: • exchange of nonfunctional currency to functional currency at the spot rate. • Purchase of the property for functional currency.

29. Example • G is a U.S. corporation with the U.S. dollar as its functional currency. • On January 1, 1989, G enters into a contract to purchase a paper manufacturing machine for 10,000,000 British pounds for delivery on January 1, 1991. • On January 1, 1991, when G exchanges the BP 10,000,000 (which G purchased for $ 12,000,000) for the machine, the fair market value of the machine is BP17,000,000. • On January 1, 1991, the spot exchange rate is BP1 = $ 1.50.

30. Example (Cont.) • The transaction is treated as an exchange of BP 10,000,000 for $ 15,000,000 and the purchase of the machine for $ 15,000,000. • Accordingly, in computing G's exchange gain of $ 3,000,000 on the disposition of the BP 10,000,000, the amount realized is $ 15,000,000. • G's basis in the machine is $ 15,000,000. • No gain is recognized on the bargain purchase of the machine.

31. Contact Information Yoram Keinan Shareholder, Tax Greenberg Traurig LLP 200 Park Avenue, New York, NY 10166 212.801.6826 keinany@gtlaw.com