IRS proposes elective Section 987 exemption for CFCs

Key elements

The CFC exemption election

Under the proposed regulations, a taxpayer may elect to limit the application of Section 987(3) with respect to its CFCs. In a taxable year to which the election applies, an electing CFC (an “exempt CFC”) generally does not compute or recognize a Section 987 gain or loss, and the rules of Section 1.987-4 through 1.987-6 and Section 1.987-11 through 1.987-14 generally do not apply to it.

The determination of Section 987 taxable income or loss under Section 1.987-3 continues to apply, and the regulations deem a current rate election to be in effect for each exempt CFC, so that historic exchange rates do not need to be tracked. QBU income is translated at the yearly average exchange rate, and transfers between a QBU and its owner are translated at the spot rate.

Certain partnerships and their QBUs also can qualify for exempt treatment, generally where at least 80% of the capital or profits interests are owned, directly or indirectly, by exempt CFCs in the same controlled group.

The election is a Section 987 election within the meaning of Section 1.987-1(g) and is made by the authorized person for the relevant Section 987 electing group. The election generally must be made on a timely filed return, although special transition rules permit the election to be made on an amended return in certain cases for taxable years beginning before 2027. The election generally cannot be revoked without the consent of the IRS commissioner, which may be obtained through a private letter ruling.

Consistency requirements

The Section 987 election consistency rules apply to the CFC exemption election, subject to two modifications. Under the general rule, a Section 987 election must be made consistently for all members of a Section 987 electing group, which includes each CFC in which the relevant U.S. shareholder owns, within the meaning of Section 958(a), more than 50% of the stock by vote or value. A CFC that joins an electing group is deemed to make or revoke elections as necessary to conform.

The two modifications broaden the group that must conform. First, all domestic corporations that are affiliated generally must make consistent CFC exemption elections with respect to their majority-owned CFCs. This requires consistency between certain related but non-consolidated corporations, including separate consolidated groups that are commonly owned by a foreign parent, and corporations that would be members of the same consolidated group but for the interposition of a partnership.

Second, a U.S. person is treated as owning CFC stock that it holds indirectly through a domestic partnership, as the domestic partnership is treated in the same manner as a foreign partnership in applying Section 958(a).

The proposed regulations also include anti-avoidance rules that can treat the election as made, or disregard a purported revocation, where a related-party transaction is undertaken with a principal purpose of avoiding the consistency requirements or triggering a deemed revocation.

Pre-election Section 987 gain or loss

A taxpayer that makes the election generally must compute their pre-election Section 987 gain or loss and may not elect out of doing so. Treasury and the IRS declined to permit an election to eliminate these amounts, reasoning that a “fresh start” approach would expose the government to whipsaw, because taxpayers with a pre-election gain could eliminate it while taxpayers with a pre-election loss could preserve and amortize it. A pre-election Section 987 gain or loss is generally recognized ratably over 120 months beginning with the first month of the first taxable year in which the election applies.

A de minimis exception generally applies to QBUs with average assets of less than $50 million during the three taxable years preceding the first election year, based on the total assets reported on Schedule F of Form 8858, allowing these taxpayers to treat a pre-election Section 987 gain or loss as zero.

Inbound nonrecognition transactions

Special rules are intended to require recognition of a Section 987 gain when excess asset basis is imported into the U.S. in certain transactions. The rules generally apply when a domestic corporation acquires the assets of a transferor CFC in an inbound nonrecognition transaction — generally a Section 332 liquidation or a Section 368 reorganization — and the transferor CFC was subject to a CFC exemption election for any taxable year ending during the 72-month period preceding the transaction. Thus, the rule may apply even if the election is no longer in effect when the inbound transaction occurs.

A de minimis exception applies if the transferor CFC’s aggregate tax basis in its assets is less than $25 million, in which case the Section 987 gain calculation and recognition are not required.

The amount of the gain generally equals the CFC’s “Section 987 asset basis,” which represents the increase in the basis of the transferred assets attributable to appreciation in the QBU’s functional currency. Only gain, and not loss, is recognized, consistent with the longstanding treatment of inbound nonrecognition transactions under Section 367(b). Importantly, the Section 987 gain is recognized immediately before, rather than as part of, the inbound transaction. As a result, the gain does not increase the domestic acquiring corporation’s basis in the acquired assets.

The proposed regulations provide two methods for computing the Section 987 asset basis:

• A lookback method based on annual unrecognized Section 987 gain or loss computed under the simplified method of Section 1.987-10(e)(3) for taxable years ending during the 72-month period in which the election was in effect
• A method based on the transferor CFC’s excess asset basis determined under Section 1.367(b)-3

Applicability dates

The proposed regulations generally are proposed to apply to taxable years ending on or after the date the final regulations are filed with the Federal Register. Proposed Section 1.987-16 applies to transactions completed within taxable years of the domestic acquiring corporation ending on or after that finalization date. The pre-transition amortization rule in proposed Section 1.987-10(e)(5)(ii) applies to taxable years beginning after Dec. 31, 2024, and ending on or after Nov. 25, 2025.

Taxpayers may rely on the proposed regulations for a taxable year beginning after Dec. 31, 2024, and ending before the finalization date, provided that the taxpayer and all members of its consolidated group and Section 987 electing group consistently follow the proposed regulations for that year and all subsequent taxable years ending before finalization.

Special election procedures apply during the transition period. For taxable years beginning after Dec. 31, 2024, and ending on or before Dec. 31, 2026, the election generally is made on an original, timely filed return. An election for a taxable year beginning in 2025 may instead be made on an amended return filed by Oct. 15, 2027.

For a taxable year ending in 2027, the election statement generally must be filed with the IRS by Oct. 15, 2027, with a copy attached to the return. For later taxable years, the general rule requires the statement to be filed on or before the first day of the election year. A separate exception permits the election to be made on the original, timely filed return for the first taxable year in which the election becomes relevant.

Next steps

Taxpayers that own CFCs with Section 987 QBUs should identify their Section 987 electing groups, quantify pre-election (pre-transition) gain or loss pools, model the affected CFCs' Section 987 profiles, and evaluate the potential impact of any contemplated transactions involving those CFCs. Calendar-year taxpayers considering the election for 2025 through 2027 should make it on either an original or amended return filed no later than Oct. 15, 2027.