Code of Federal Regulations (alpha)

CFR /  Title 26  /  Part 1  /  Sec. 1.988-6 Nonfunctional currency contingent payment debt instruments.

(a) In general--(1) Scope. This section determines the accrual of interest and the amount, timing, source, and character of any gain or loss on nonfunctional currency contingent payment debt instruments described in this paragraph (a)(1) and to which Sec. 1.1275-4(a) would otherwise apply if the debt instrument were denominated in the taxpayer's functional currency. Except as provided by the rules in this section, the rules in Sec. 1.1275-4 (relating to contingent payment debt instruments) apply to the following instruments--

(1) Scope. This section determines the accrual of interest and the amount, timing, source, and character of any gain or loss on nonfunctional currency contingent payment debt instruments described in this paragraph (a)(1) and to which Sec. 1.1275-4(a) would otherwise apply if the debt instrument were denominated in the taxpayer's functional currency. Except as provided by the rules in this section, the rules in Sec. 1.1275-4 (relating to contingent payment debt instruments) apply to the following instruments--

(i) A debt instrument described in Sec. 1.1275-4(b)(1) for which all payments of principal and interest are denominated in, or determined by reference to, a single nonfunctional currency and which has one or more non-currency related contingencies;

(ii) A debt instrument described in Sec. 1.1275-4(b)(1) for which payments of principal or interest are denominated in, or determined by reference to, more than one currency and which has no non-currency related contingencies;

(iii) A debt instrument described in Sec. 1.1275-4(b)(1) for which payments of principal or interest are denominated in, or determined by reference to, more than one currency and which has one or more non-currency related contingencies; and

(iv) A debt instrument otherwise described in paragraph (a)(1)(i), (ii) or (iii) of this section, except that the debt instrument is described in Sec. 1.1275- 4(c)(1) rather than Sec. 1.1275-4(b)(1) (e.g., the instrument is issued for non-publicly traded property).

(2) Exception for hyperinflationary currencies--(i) In general. Except as provided in paragraph (a)(2)(ii) of this section, this section shall not apply to an instrument described in paragraph (a)(1) of this section if any payment made under such instrument is determined by reference to a hyperinflationary currency, as defined in Sec. 1.985-1(b)(2)(ii)(D). In such case, the amount, timing, source and character of interest, principal, foreign currency gain or loss, and gain or loss relating to a non-currency contingency shall be determined under the method that reflects the instrument's economic substance.

(i) In general. Except as provided in paragraph (a)(2)(ii) of this section, this section shall not apply to an instrument described in paragraph (a)(1) of this section if any payment made under such instrument is determined by reference to a hyperinflationary currency, as defined in Sec. 1.985-1(b)(2)(ii)(D). In such case, the amount, timing, source and character of interest, principal, foreign currency gain or loss, and gain or loss relating to a non-currency contingency shall be determined under the method that reflects the instrument's economic substance.

(ii) Discretion as to method. If a taxpayer does not account for an instrument described in paragraph (a)(2)(i) of this section in a manner that reflects the instrument's economic substance, the Commissioner may apply the rules of this section to such an instrument or apply the principles of Sec. 1.988-2(b)(15), reasonably taking into account the contingent feature or features of the instrument.

(b) Instruments described in paragraph (a)(1)(i) of this section--(1) In general. Paragraph (b)(2) of this section provides rules for applying the noncontingent bond method (as set forth in Sec. 1.1275-4(b)) in the nonfunctional currency in which a debt instrument described in paragraph (a)(1)(i) of this section is denominated, or by reference to which its payments are determined (the denomination currency). Paragraph (b)(3) of this section describes how amounts determined in paragraph (b)(2) of this section shall be translated from the denomination currency of the instrument into the taxpayer's functional currency. Paragraph (b)(4) of this section describes how gain or loss (other than foreign currency gain or loss) shall be determined and characterized with respect to the instrument. Paragraph (b)(5) of this section describes how foreign currency gain or loss shall be determined with respect to accrued interest and principal on the instrument. Paragraph (b)(6) of this section provides rules for determining the source and character of any gain or loss with respect to the instrument. Paragraph (b)(7) of this section provides rules for subsequent holders of an instrument who purchase the instrument for an amount other than the adjusted issue price of the instrument. Paragraph (c) of this section provides examples of the application of paragraph (b) of this section. See paragraph (d) of this section for the determination of the denomination currency of an instrument described in paragraph (a)(1)(ii) or (iii) of this section. See paragraph (e) of this section for the treatment of an instrument described in paragraph (a)(1)(iv) of this section.

(1)(i) of this section--(1) In general. Paragraph (b)(2) of this section provides rules for applying the noncontingent bond method (as set forth in Sec. 1.1275-4(b)) in the nonfunctional currency in which a debt instrument described in paragraph (a)(1)(i) of this section is denominated, or by reference to which its payments are determined (the denomination currency). Paragraph (b)(3) of this section describes how amounts determined in paragraph (b)(2) of this section shall be translated from the denomination currency of the instrument into the taxpayer's functional currency. Paragraph (b)(4) of this section describes how gain or loss (other than foreign currency gain or loss) shall be determined and characterized with respect to the instrument. Paragraph (b)(5) of this section describes how foreign currency gain or loss shall be determined with respect to accrued interest and principal on the instrument. Paragraph (b)(6) of this section provides rules for determining the source and character of any gain or loss with respect to the instrument. Paragraph (b)(7) of this section provides rules for subsequent holders of an instrument who purchase the instrument for an amount other than the adjusted issue price of the instrument. Paragraph (c) of this section provides examples of the application of paragraph (b) of this section. See paragraph (d) of this section for the determination of the denomination currency of an instrument described in paragraph (a)(1)(ii) or (iii) of this section. See paragraph (e) of this section for the treatment of an instrument described in paragraph (a)(1)(iv) of this section.

(2) Application of noncontingent bond method--(i) Accrued interest. Interest accruals on an instrument described in paragraph (a)(1)(i) of this section are initially determined in the denomination currency of the instrument by applying the noncontingent bond method, set forth in Sec. 1.1275-4(b), to the instrument in its denomination currency. Accordingly, the comparable yield, projected payment schedule, and comparable fixed rate debt instrument, described in Sec. 1.1275-4(b)(4), are determined in the denomination currency. For purposes of applying the noncontingent bond method to instruments described in this paragraph, the applicable Federal rate described in Sec. 1.1275-4(b)(4)(i) shall be the rate described in Sec. 1.1274-4(d) with respect to the denomination currency.

(i) Accrued interest. Interest accruals on an instrument described in paragraph (a)(1)(i) of this section are initially determined in the denomination currency of the instrument by applying the noncontingent bond method, set forth in Sec. 1.1275-4(b), to the instrument in its denomination currency. Accordingly, the comparable yield, projected payment schedule, and comparable fixed rate debt instrument, described in Sec. 1.1275-4(b)(4), are determined in the denomination currency. For purposes of applying the noncontingent bond method to instruments described in this paragraph, the applicable Federal rate described in Sec. 1.1275-4(b)(4)(i) shall be the rate described in Sec. 1.1274-4(d) with respect to the denomination currency.

(ii) Net positive and negative adjustments. Positive and negative adjustments, and net positive and net negative adjustments, with respect to an instrument described in paragraph (a)(1)(i) of this section are determined by applying the rules of Sec. 1.1275-4(b)(6) (and Sec. 1.1275-4(b)(9)(i) and (ii), if applicable) in the denomination currency. Accordingly, a net positive adjustment is treated as additional interest (in the denomination currency) on the instrument. A net negative adjustment first reduces interest that otherwise would be accrued by the taxpayer during the current tax year in the denomination currency. If a net negative adjustment exceeds the interest that would otherwise be accrued by the taxpayer during the current tax year in the denomination currency, the excess is treated as ordinary loss (if the taxpayer is a holder of the instrument) or ordinary income (if the taxpayer is the issuer of the instrument). The amount treated as ordinary loss by a holder with respect to a net negative adjustment is limited, however, to the amount by which the holder's total interest inclusions on the debt instrument (determined in the denomination currency) exceed the total amount of the holder's net negative adjustments treated as ordinary loss on the debt instrument in prior taxable years (determined in the denomination currency). Similarly, the amount treated as ordinary income by an issuer with respect to a net negative adjustment is limited to the amount by which the issuer's total interest deductions on the debt instrument (determined in the denomination currency) exceed the total amount of the issuer's net negative adjustments treated as ordinary income on the debt instrument in prior taxable years (determined in the denomination currency). To the extent a net negative adjustment exceeds the current year's interest accrual and the amount treated as ordinary loss to a holder (or ordinary income to the issuer), the excess is treated as a negative adjustment carryforward, within the meaning of Sec. 1.1275-4(b)(6)(iii)(C), in the denomination currency.

(iii) Adjusted issue price. The adjusted issue price of an instrument described in paragraph (a)(1)(i) of this section is determined by applying the rules of Sec. 1.1275-4(b)(7) in the denomination currency. Accordingly, the adjusted issue price is equal to the debt instrument's issue price in the denomination currency, increased by the interest previously accrued on the debt instrument (determined without regard to any net positive or net negative adjustments on the instrument) and decreased by the amount of any noncontingent payment and the projected amount of any contingent payment previously made on the instrument. All adjustments to the adjusted issue price are calculated in the denomination currency.

(iv) Adjusted basis. The adjusted basis of an instrument described in paragraph (a)(1)(i) of this section is determined by applying the rules of Sec. 1.1275-4(b)(7) in the taxpayer's functional currency. In accordance with those rules, a holder's basis in the debt instrument is increased by the interest previously accrued on the debt instrument (translated into functional currency), without regard to any net positive or net negative adjustments on the instrument (except as provided in paragraph (b)(7) or (8) of this section, if applicable), and decreased by the amount of any noncontingent payment and the projected amount of any contingent payment previously made on the instrument to the holder (translated into functional currency). See paragraph (b)(3)(iii) of this section for translation rules.

(v) Amount realized. The amount realized by a holder and the repurchase price paid by the issuer on the scheduled or unscheduled retirement of a debt instrument described in paragraph (a)(1)(i) of this section are determined by applying the rules of Sec. 1.1275-4(b)(7) in the denomination currency. For example, with regard to a scheduled retirement at maturity, the holder is treated as receiving the projected amount of any contingent payment due at maturity, reduced by the amount of any negative adjustment carryforward. For purposes of translating the amount realized by the holder into functional currency, the rules of paragraph (b)(3)(iv) of this section shall apply.

(3) Treatment and translation of amounts determined under noncontingent bond method--(i) Accrued interest. The amount of accrued interest, determined under paragraph (b)(2)(i) of this section, is translated into the taxpayer's functional currency at the average exchange rate, as described in Sec. 1.988-2(b)(2)(iii)(A), or, at the taxpayer's election, at the appropriate spot rate, as described in Sec. 1.988-2(b)(2)(iii)(B).

(i) Accrued interest. The amount of accrued interest, determined under paragraph (b)(2)(i) of this section, is translated into the taxpayer's functional currency at the average exchange rate, as described in Sec. 1.988-2(b)(2)(iii)(A), or, at the taxpayer's election, at the appropriate spot rate, as described in Sec. 1.988-2(b)(2)(iii)(B).

(ii) Net positive and negative adjustments--(A) Net positive adjustments. A net positive adjustment, as referenced in paragraph (b)(2)(ii) of this section, is translated into the taxpayer's functional currency at the spot rate on the last day of the taxable year in which the adjustment is taken into account under Sec. 1.1275-4(b)(6), or, if earlier, the date the instrument is disposed of or otherwise terminated.

(A) Net positive adjustments. A net positive adjustment, as referenced in paragraph (b)(2)(ii) of this section, is translated into the taxpayer's functional currency at the spot rate on the last day of the taxable year in which the adjustment is taken into account under Sec. 1.1275-4(b)(6), or, if earlier, the date the instrument is disposed of or otherwise terminated.

(B) Net negative adjustments. A net negative adjustment is treated and, where necessary, is translated from the denomination currency into the taxpayer's functional currency under the following rules:

(1) The amount of a net negative adjustment determined in the denomination currency that reduces the current year's interest in that currency shall first reduce the current year's accrued but unpaid interest, and then shall reduce the current year's interest which was accrued and paid. No translation is required.

(2) The amount of a net negative adjustment treated as ordinary income or loss under Sec. 1.1275-4(b)(6)(iii)(B) first is attributable to accrued but unpaid interest accrued in prior taxable years. For this purpose, the net negative adjustment shall be treated as attributable to any unpaid interest accrued in the immediately preceding taxable year, and thereafter to unpaid interest accrued in each preceding taxable year. The amount of the net negative adjustment applied to accrued but unpaid interest is translated into functional currency at the same rate used, in each of the respective prior taxable years, to translate the accrued interest.

(3) Any amount of the net negative adjustment remaining after the application of paragraphs (b)(3)(ii)(B)(1) and (2) of this section is attributable to interest accrued and paid in prior taxable years. The amount of the net negative adjustment applied to such amounts is translated into functional currency at the spot rate on the date the debt instrument was issued or, if later, acquired.

(4) Any amount of the net negative adjustment remaining after application of paragraphs (b)(3)(ii)(B)(1), (2) and (3) of this section is a negative adjustment carryforward, within the meaning of Sec. 1.1275-4(b)(6)(iii)(C). A negative adjustment carryforward is carried forward in the denomination currency and is applied to reduce interest accruals in subsequent years. In the year in which the instrument is sold, exchanged or retired, any negative adjustment carryforward not applied to interest reduces the holder's amount realized on the instrument (in the denomination currency). An issuer of a debt instrument described in paragraph (a)(1)(i) of this section who takes into income a negative adjustment carryforward (that is not applied to interest) in the year the instrument is retired, as described in Sec. 1.1275-4(b)(6)(iii)(C), translates such income into functional currency at the spot rate on the date the instrument was issued.

(iii) Adjusted basis--(A) In general. Except as otherwise provided in this paragraph and paragraph (b)(7) or (8) of this section, a holder determines and maintains adjusted basis by translating the denomination currency amounts determined under Sec. 1.1275-4(b)(7)(iii) into functional currency as follows:

(1) The holder's initial basis in the instrument is determined by translating the amount paid by the holder to acquire the instrument (in the denomination currency) into functional currency at the spot rate on the date the instrument was issued or, if later, acquired.

(2) An increase in basis attributable to interest accrued on the instrument is translated at the rate applicable to such interest under paragraph (b)(3)(i) of this section.

(3) Any noncontingent payment and the projected amount of any contingent payments determined in the denomination currency that decrease the holder's basis in the instrument under Sec. 1.1275-4(b)(7)(iii) are translated as follows:

(i) The payment first is attributable to the most recently accrued interest to which prior amounts have not already been attributed. The payment is translated into functional currency at the rate at which the interest was accrued.

(ii) Any amount remaining after the application of paragraph (b)(3)(iii)(A)(3)(i) of this section is attributable to principal. Such amounts are translated into functional currency at the spot rate on the date the instrument was issued or, if later, acquired.

(B) Exception for interest reduced by a negative adjustment carryforward. Solely for purposes of this Sec. 1.988-6, any amounts of accrued interest income that are reduced as a result of a negative adjustment carryforward shall be treated as principal and translated at the spot rate on the date the instrument was issued or, if later, acquired.

(iv) Amount realized--(A) Instrument held to maturity--(1) In general. With respect to an instrument held to maturity, a holder translates the amount realized by separating such amount in the denomination currency into the component parts of interest and principal that make up adjusted basis prior to translation under paragraph (b)(3)(iii) of this section, and translating each of those component parts of the amount realized at the same rate used to translate the respective component parts of basis under paragraph (b)(3)(iii) of this section. The amount realized first shall be translated by reference to the component parts of basis consisting of accrued interest during the taxpayer's holding period as determined under paragraph (b)(3)(iii) of this section and ordering such amounts on a last in first out basis. Any remaining portion of the amount realized shall be translated by reference to the rate used to translate the component of basis consisting of principal as determined under paragraph (b)(3)(iii) of this section.

(2) Subsequent purchases at discount and fixed but deferred contingent payments. For purposes of this paragraph (b)(3)(iv) of this section, any amount which is required to be added to adjusted basis under paragraph (b)(7) or (8) of this section shall be treated as additional interest which was accrued on the date the amount was added to adjusted basis. To the extent included in amount realized, such amounts shall be translated into functional currency at the same rates at which they were translated for purposes of determining adjusted basis. See paragraphs (b)(7)(iv) and (b)(8) of this section for rules governing the rates at which the amounts are translated for purposes of determining adjusted basis.

(B) Sale, exchange, or unscheduled retirement--(1) Holder. In the case of a sale, exchange, or unscheduled retirement, application of the rule stated in paragraph (b)(3)(iv)(A) of this section shall be as follows. The holder's amount realized first shall be translated by reference to the principal component of basis as determined under paragraph (b)(3)(iii) of this section, and then to the component of basis consisting of accrued interest as determined under paragraph (b)(3)(iii) of this section and ordering such amounts on a first in first out basis. Any gain recognized by the holder (i.e., any excess of the sale price over the holder's basis, both expressed in the denomination currency) is translated into functional currency at the spot rate on the payment date.

(2) Issuer. In the case of an unscheduled retirement of the debt instrument, any excess of the adjusted issue price of the debt instrument over the amount paid by the issuer (expressed in denomination currency) shall first be attributable to accrued unpaid interest, to the extent the accrued unpaid interest had not been previously offset by a negative adjustment, on a last-in-first-out basis, and then to principal. The accrued unpaid interest shall be translated into functional currency at the rate at which the interest was accrued. The principal shall be translated at the spot rate on the date the debt instrument was issued.

(C) Effect of negative adjustment carryforward with respect to the issuer. Any amount of negative adjustment carryforward treated as ordinary income under Sec. 1.1275-4(b)(6)(iii)(C) shall be translated at the exchange rate on the day the debt instrument was issued.

(4) Determination of gain or loss not attributable to foreign currency. A holder of a debt instrument described in paragraph (a)(1)(i) of this section shall recognize gain or loss upon sale, exchange, or retirement of the instrument equal to the difference between the amount realized with respect to the instrument, translated into functional currency as described in paragraph (b)(3)(iv) of this section, and the adjusted basis in the instrument, determined and maintained in functional currency as described in paragraph (b)(3)(iii) of this section. The amount of any gain or loss so determined is characterized as provided in Sec. 1.1275-4(b)(8), and sourced as provided in paragraph (b)(6) of this section.

(5) Determination of foreign currency gain or loss--(i) In general. Other than in a taxable disposition of the debt instrument, foreign currency gain or loss is recognized with respect to a debt instrument described in paragraph (a)(1)(i) of this section only when payments are made or received. No foreign currency gain or loss is recognized with respect to a net positive or negative adjustment, as determined under paragraph (b)(2)(ii) of this section (except with respect to a positive adjustment described in paragraph (b)(8) of this section). As described in this paragraph (b)(5), foreign currency gain or loss is determined in accordance with the rules of Sec. 1.988-2(b).

(i) In general. Other than in a taxable disposition of the debt instrument, foreign currency gain or loss is recognized with respect to a debt instrument described in paragraph (a)(1)(i) of this section only when payments are made or received. No foreign currency gain or loss is recognized with respect to a net positive or negative adjustment, as determined under paragraph (b)(2)(ii) of this section (except with respect to a positive adjustment described in paragraph (b)(8) of this section). As described in this paragraph (b)(5), foreign currency gain or loss is determined in accordance with the rules of Sec. 1.988-2(b).

(ii) Foreign currency gain or loss attributable to accrued interest. The amount of foreign currency gain or loss recognized with respect to payments of interest previously accrued on the instrument is determined by translating the amount of interest paid or received into functional currency at the spot rate on the date of payment and subtracting from such amount the amount determined by translating the interest paid or received into functional currency at the rate at which such interest was accrued under the rules of paragraph (b)(3)(i) of this section. For purposes of this paragraph, the amount of any payment that is treated as accrued interest shall be reduced by the amount of any net negative adjustment treated as ordinary loss (to the holder) or ordinary income (to the issuer), as provided in paragraph (b)(2)(ii) of this section. For purposes of determining whether the payment consists of interest or principal, see the payment ordering rules in paragraph (b)(5)(iv) of this section.

(iii) Principal. The amount of foreign currency gain or loss recognized with respect to payment or receipt of principal is determined by translating the amount paid or received into functional currency at the spot rate on the date of payment or receipt and subtracting from such amount the amount determined by translating the principal into functional currency at the spot rate on the date the instrument was issued or, in case of the holder, if later, acquired. For purposes of determining whether the payment consists of interest or principal, see the payment ordering rules in paragraph (b)(5)(iv) of this section.

(iv) Payment ordering rules--(A) In general. Except as provided in paragraph (b)(5)(iv)(B) of this section, payments with respect to an instrument described in paragraph (a)(1)(i) of this section shall be treated as follows:

(1) A payment shall first be attributable to any net positive adjustment on the instrument that has not previously been taken into account.

(2) Any amount remaining after applying paragraph (b)(5)(iv)(A)(1) of this section shall be attributable to accrued but unpaid interest, remaining after reduction by any net negative adjustment, and shall be attributable to the most recent accrual period to the extent prior amounts have not already been attributed to such period.

(3) Any amount remaining after applying paragraphs (b)(5)(iv)(A)(1) and (2) of this section shall be attributable to principal. Any interest paid in the current year that is reduced by a net negative adjustment shall be considered a payment of principal for purposes of determining foreign currency gain or loss.

(B) Special rule for sale or exchange or unscheduled retirement. Payments made or received upon a sale or exchange or unscheduled retirement shall first be applied against the principal of the debt instrument (or in the case of a subsequent purchaser, the purchase price of the instrument in denomination currency) and then against accrued unpaid interest (in the case of a holder, accrued while the holder held the instrument).

(C) Subsequent purchaser that has a positive adjustment allocated to a daily portion of interest. A positive adjustment that is allocated to a daily portion of interest pursuant to paragraph (b)(7)(iv) of this section shall be treated as interest for purposes of applying the payment ordering rule of this paragraph (b)(5)(iv).

(6) Source of gain or loss. The source of foreign currency gain or loss recognized with respect to an instrument described in paragraph (a)(1)(i) of this section shall be determined pursuant to Sec. 1.988-4. Consistent with the rules of Sec. 1.1275-4(b)(8), all gain (other than foreign currency gain) on an instrument described in paragraph (a)(1)(i) of this section is treated as interest income for all purposes. The source of an ordinary loss (other than foreign currency loss) with respect to an instrument described in paragraph (a)(1)(i) of this section shall be determined pursuant to Sec. 1.1275-4(b)(9)(iv). The source of a capital loss with respect to an instrument described in paragraph (a)(1)(i) of this section shall be determined pursuant to Sec. 1.865-1(b)(2).

(7) Basis different from adjusted issue price--(i) In general. The rules of Sec. 1.1275-4(b)(9)(i), except as set forth in this paragraph (b)(7), shall apply to an instrument described in paragraph (a)(1)(i) of this section purchased by a subsequent holder for more or less than the instrument's adjusted issue price.

(i) In general. The rules of Sec. 1.1275-4(b)(9)(i), except as set forth in this paragraph (b)(7), shall apply to an instrument described in paragraph (a)(1)(i) of this section purchased by a subsequent holder for more or less than the instrument's adjusted issue price.

(ii) Determination of basis. If an instrument described in paragraph (a)(1)(i) of this section is purchased by a subsequent holder, the subsequent holder's initial basis in the instrument shall equal the amount paid by the holder to acquire the instrument, translated into functional currency at the spot rate on the date of acquisition.

(iii) Purchase price greater than adjusted issue price. If the purchase price of the instrument (determined in the denomination currency) exceeds the adjusted issue price of the instrument, the holder shall, consistent with the rules of Sec. 1.1275-4(b)(9)(i)(B), reasonably allocate such excess to the daily portions of interest accrued on the instrument or to a projected payment on the instrument. To the extent attributable to interest, the excess shall be reasonably allocated over the remaining term of the instrument to the daily portions of interest accrued and shall be a negative adjustment on the dates the daily portions accrue. On the date of such adjustment, the holder's adjusted basis in the instrument is reduced by the amount treated as a negative adjustment under this paragraph (b)(7)(iii), translated into functional currency at the rate used to translate the interest which is offset by the negative adjustment. To the extent related to a projected payment, such excess shall be treated as a negative adjustment on the date the payment is made. On the date of such adjustment, the holder's adjusted basis in the instrument is reduced by the amount treated as a negative adjustment under this paragraph (b)(7)(iii), translated into functional currency at the spot rate on the date the instrument was acquired.

(iv) Purchase price less than adjusted issue price. If the purchase price of the instrument (determined in the denomination currency) is less than the adjusted issue price of the instrument, the holder shall, consistent with the rules of Sec. 1.1275-4(b)(9)(i)(C), reasonably allocate the difference to the daily portions of interest accrued on the instrument or to a projected payment on the instrument. To the extent attributable to interest, the difference shall be reasonably allocated over the remaining term of the instrument to the daily portions of interest accrued and shall be a positive adjustment on the dates the daily portions accrue. On the date of such adjustment, the holder's adjusted basis in the instrument is increased by the amount treated as a positive adjustment under this paragraph (b)(7)(iv), translated into functional currency at the rate used to translate the interest to which it relates. For purposes of determining adjusted basis under paragraph (b)(3)(iii) of this section, such increase in adjusted basis shall be treated as an additional accrual of interest during the period to which the positive adjustment relates. To the extent related to a projected payment, such difference shall be treated as a positive adjustment on the date the payment is made. On the date of such adjustment, the holder's adjusted basis in the instrument is increased by the amount treated as a positive adjustment under this paragraph (b)(7)(iv), translated into functional currency at the spot rate on the date the adjustment is taken into account. For purposes of determining the amount realized on the instrument in functional currency under paragraph (b)(3)(iv) of this section, amounts attributable to the excess of the adjusted issue price of the instrument over the purchase price of the instrument shall be translated into functional currency at the same rate at which the corresponding adjustments are taken into account under this paragraph (b)(7)(iv) for purposes of determining the adjusted basis of the instrument.

(8) Fixed but deferred contingent payments. In the case of an instrument with a contingent payment that becomes fixed as to amount before the payment is due, the rules of Sec. 1.1275-4(b)(9)(ii) shall be applied in the denomination currency of the instrument. For this purpose, foreign currency gain or loss shall be recognized on the date payment is made or received with respect to the instrument under the principles of paragraph (b)(5) of this section. Any increase or decrease in basis required under Sec. 1.1275-4(b)(9)(ii)(D) shall be taken into account at the same exchange rate as the corresponding net positive or negative adjustment is taken into account.

(c) Examples. The provisions of paragraph (b) of this section may be illustrated by the following examples. In each example, assume that the instrument described is a debt instrument for federal income tax purposes. No inference is intended, however, as to whether the instrument is a debt instrument for federal income tax purposes. The examples are as follows:

(i) Facts. On December 31, 2004, Z, a calendar year U.S. resident taxpayer whose functional currency is the U.S. dollar, purchases from a foreign corporation, at original issue, a zero-coupon debt instrument with a non-currency contingency for 1000. All payments of principal and interest with respect to the instrument are denominated in, or determined by reference to, a single nonfunctional currency (the British pound). The debt instrument would be subject to Sec. 1.1275-4(b) if it were denominated in dollars. The debt instrument's comparable yield, determined in British pounds under paragraph (b)(2)(i) of this section and Sec. 1.1275-4(b), is 10 percent, compounded annually, and the projected payment schedule, as constructed under the rules of Sec. 1.1275-4(b), provides for a single payment of 1210 on December 31, 2006 (consisting of a noncontingent payment of 975 and a projected payment of 235). The debt instrument is a capital asset in the hands of Z. Z does not elect to use the spot-rate convention described in Sec. 1.988-2(b)(2)(iii)(B). The payment actually made on December 31, 2006, is 1300. The relevant pound/dollar spot rates over the term of the instrument are as follows: ------------------------------------------------------------------------

Date Spot rate (pounds to dollars)------------------------------------------------------------------------Dec. 31, 2004....................... 1.00 = $1.00Dec. 31, 2005....................... 1.00 = $1.10Dec. 31, 2006....................... 1.00 = $1.20------------------------------------------------------------------------ ------------------------------------------------------------------------

Accrual period Average rate (pounds to dollars)------------------------------------------------------------------------2005................................ 1.00 = $1.052006................................ 1.00 = $1.15------------------------------------------------------------------------

(ii) Treatment in 2005--(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z accrues 100 of interest on the debt instrument for 2005 (issue price of 1000 x 10 percent). Under paragraph (b)(3)(i) of this section, Z translates the 100 at the average exchange rate for the accrual period ($1.05 x 100 = $105). Accordingly, Z has interest income in 2005 of $105.

(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z accrues 100 of interest on the debt instrument for 2005 (issue price of 1000 x 10 percent). Under paragraph (b)(3)(i) of this section, Z translates the 100 at the average exchange rate for the accrual period ($1.05 x 100 = $105). Accordingly, Z has interest income in 2005 of $105.

(B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii) and (iv) of this section, the adjusted issue price of the debt instrument determined in pounds and Z's adjusted basis in dollars in the debt instrument are increased by the interest accrued in 2005. Thus, on January 1, 2006, the adjusted issue price of the debt instrument is 1100. For purposes of determining Z's dollar basis in the debt instrument, the $1000 basis ($1.00 x 1000 original cost basis) is increased by the 100 of accrued interest, translated at the rate at which interest was accrued for 2005. See paragraph (b)(3)(iii) of this section. Accordingly, Z's adjusted basis in the debt instrument as of January 1, 2006, is $1105.

(iii) Treatment in 2006--(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z accrues 110 of interest on the debt instrument for 2006 (adjusted issue price of 1100 x 10 percent). Under paragraph (b)(3)(i) of this section, Z translates the 110 at the average exchange rate for the accrual period ($1.15 x 110 = $126.50). Accordingly, Z has interest income in 2006 of $126.50.

(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z accrues 110 of interest on the debt instrument for 2006 (adjusted issue price of 1100 x 10 percent). Under paragraph (b)(3)(i) of this section, Z translates the 110 at the average exchange rate for the accrual period ($1.15 x 110 = $126.50). Accordingly, Z has interest income in 2006 of $126.50.

(B) Effect of net positive adjustment. The payment actually made on December 31, 2006, is 1300, rather than the projected 1210. Under paragraph (b)(2)(ii) of this section, Z has a net positive adjustment of 90 on December 31, 2006, attributable to the difference between the amount of the actual payment and the amount of the projected payment. Under paragraph (b)(3)(ii)(A) of this section, the 90 net positive adjustment is treated as additional interest income and is translated into dollars at the spot rate on the last day of the year ($1.20 x 90 = $108). Accordingly, Z has a net positive adjustment of $108 resulting in a total interest inclusion for 2006 of $234.50 ($126.50 + $108 = $234.50).

(C) Adjusted issue price and basis. Based on the projected payment schedule, the adjusted issue price of the debt instrument immediately before the payment at maturity is 1210 (1100 plus 110 of accrued interest for 2006). Z's adjusted basis in dollars, based only on the noncontingent payment and the projected amount of the contingent payment to be received, is $1231.50 ($1105 plus $126.50 of accrued interest for 2006).

(D) Amount realized. Even though Z receives 1300 at maturity, for purposes of determining the amount realized, Z is treated under paragraph (b)(2)(v) of this section as receiving the projected amount of the contingent payment on December 31, 2006. Therefore, Z is treated as receiving 1210 on December 31, 2006. Under paragraph (b)(3)(iv) of this section, Z translates its amount realized into dollars and computes its gain or loss on the instrument (other than foreign currency gain or loss) by breaking the amount realized into its component parts. Accordingly, 100 of the 1210 (representing the interest accrued in 2005) is translated at the rate at which it was accrued (1 = $1.05), resulting in an amount realized of $105; 110 of the 1210 (representing the interest accrued in 2006) is translated into dollars at the rate at which it was accrued (1 = $1.15), resulting in an amount realized of $126.50; and 1000 of the 1210 (representing a return of principal) is translated into dollars at the spot rate on the date the instrument was purchased (1 = $1), resulting in an amount realized of $1000. Z's total amount realized is $1231.50, the same as its basis, and Z recognizes no gain or loss (before consideration of foreign currency gain or loss) on retirement of the instrument.

(E) Foreign currency gain or loss. Under paragraph (b)(5) of this section Z recognizes foreign currency gain under section 988 on the instrument with respect to the consideration actually received at maturity (except for the net positive adjustment), 1210. The amount of recognized foreign currency gain is determined based on the difference between the spot rate on the date the instrument matures and the rates at which the principal and interest were taken into account. With respect to the portion of the payment attributable to interest accrued in 2005, the foreign currency gain is $15 [100 x ($1.20-$1.05)]. With respect to interest accrued in 2006, the foreign currency gain equals $5.50 [110 x ($1.20-$1.15)]. With respect to principal, the foreign currency gain is $200 [1000 x ($1.20-$1.00)]. Thus, Z recognizes a total foreign currency gain on December 31, 2006, of $220.50.

(F) Source. Z has interest income of $105 in 2005, interest income of $234.50 in 2006 (attributable to 110 of accrued interest and the 90 net positive adjustment), and a foreign currency gain of $220.50 in 2006. Under paragraph (b)(6) of this section and section 862(a)(1), the interest income is sourced by reference to the residence of the payor and is therefore from sources without the United States. Under paragraph (b)(6) of this section and Sec. 1.988-4, Z's foreign currency gain of $220.50 is sourced by reference to Z's residence and is therefore from sources within the United States.

(i) Facts. Assume the same facts as in Example 1, except that Z receives 975 at maturity instead of 1300.

(ii) Treatment in 2005. The treatment of the debt instrument in 2005 is the same as in Example 1. Thus, Z has interest income in 2005 of $105. On January 1, 2006, the adjusted issue price of the debt instrument is 1100, and Z's adjusted basis in the instrument is $1105.

(iii) Treatment in 2006--(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section and based on the comparable yield, Z's accrued interest for 2006 is 110 (adjusted issue price of 1100 x 10 percent). Under paragraph (b)(3)(i) of this section, the 110 of accrued interest is translated at the average exchange rate for the accrual period ($1.15 x 110 = $126.50).

(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section and based on the comparable yield, Z's accrued interest for 2006 is 110 (adjusted issue price of 1100 x 10 percent). Under paragraph (b)(3)(i) of this section, the 110 of accrued interest is translated at the average exchange rate for the accrual period ($1.15 x 110 = $126.50).

(B) Effect of net negative adjustment. The payment actually made on December 31, 2006, is 975, rather than the projected 1210. Under paragraph (b)(2)(ii) of this section, Z has a net negative adjustment of 235 on December 31, 2006, attributable to the difference between the amount of the actual payment and the amount of the projected payment. Z's accrued interest income of 110 in 2006 is reduced to zero by the net negative adjustment. Under paragraph (b)(3)(ii)(B)(1) of this section the net negative adjustment which reduces the current year's interest is not translated into functional currency. Under paragraph (b)(2)(ii) of this section, Z treats the remaining 125 net negative adjustment as an ordinary loss to the extent of the 100 previously accrued interest in 2005. This 100 ordinary loss is attributable to interest accrued but not paid in the preceding year. Therefore, under paragraph (b)(3)(ii)(B)(2) of this section, Z translates the loss into dollars at the average rate for such year (1 = $1.05). Accordingly, Z has an ordinary loss of $105 in 2006. The remaining 25 of net negative adjustment is a negative adjustment carryforward under paragraph (b)(2)(ii) of this section.

(C) Adjusted issue price and basis. Based on the projected payment schedule, the adjusted issue price of the debt instrument immediately before the payment at maturity is 1210 (1100 plus 110 of accrued interest for 2006). Z's adjusted basis in dollars, based only on the noncontingent payments and the projected amount of the contingent payments to be received, is $1231.50 ($1105 plus $126.50 of accrued interest for 2006).

(D) Amount realized. Even though Z receives 975 at maturity, for purposes of determining the amount realized, Z is treated under paragraph (b)(2)(v) of this section as receiving the projected amount of the contingent payment on December 31, 2006, reduced by the amount of Z's negative adjustment carryforward of 25. Therefore, Z is treated as receiving 1185 (1210-25) on December 31, 2006. Under paragraph (b)(3)(iv) of this section, Z translates its amount realized into dollars and computes its gain or loss on the instrument (other than foreign currency gain or loss) by breaking the amount realized into its component parts. Accordingly, 100 of the 1185 (representing the interest accrued in 2005) is translated at the rate at which it was accrued (1 = $1.05), resulting in an amount realized of $105; 110 of the 1185 (representing the interest accrued in 2006) is translated into dollars at the rate at which it was accrued (1 = $1.15), resulting in an amount realized of $126.50; and 975 of the 1185 (representing a return of principal) is translated into dollars at the spot rate on the date the instrument was purchased (1 = $1), resulting in an amount realized of $975. Z's amount realized is $1206.50 ($105 + $126.50 + $975 = $1206.50), and Z recognizes a capital loss (before consideration of foreign currency gain or loss) of $25 on retirement of the instrument ($1206.50-$1231.50 = -$25).

(E) Foreign currency gain or loss. Z recognizes foreign currency gain with respect to the consideration actually received at maturity, 975. Under paragraph (b)(5)(ii) of this section, no foreign currency gain or loss is recognized with respect to unpaid accrued interest reduced to zero by the net negative adjustment resulting in 2006. In addition, no foreign currency gain or loss is recognized with respect to unpaid accrued interest from 2005, also reduced to zero by the ordinary loss. Accordingly, Z recognizes foreign currency gain with respect to principal only. Thus, Z recognizes a total foreign currency gain on December 31, 2006, of $195 [975 x ($1.20-$1.00)].

(F) Source. In 2006, Z has an ordinary loss of $105, a capital loss of $25, and a foreign currency gain of $195. Under paragraph (b)(6) of this section and Sec. 1.1275-4(b)(9)(iv), the $105 ordinary loss generally reduces Z's foreign source passive income under section 904(d) and the regulations thereunder. Under paragraph (b)(6) of this section and Sec. 1.865-1(b)(2), the $25 capital loss is sourced by reference to how interest income on the instrument would have been sourced. Therefore, the $25 capital loss generally reduces Z's foreign source passive income under section 904(d) and the regulations thereunder. Under paragraph (b)(6) of this section and Sec. 1.988-4, Z's foreign currency gain of $195 is sourced by reference to Z's residence and is therefore from sources within the United States.

(i) Facts. On December 31, 2004, Z, a calendar year U.S. resident taxpayer whose functional currency is the U.S. dollar, purchases from a foreign corporation, at original issue, a two-year debt instrument with a non-currency contingency for 1000. All payments of principal and interest with respect to the instrument are denominated in, or determined by reference to, a single nonfunctional currency (the British pound). The debt instrument would be subject to Sec. 1.1275-4(b) if it were denominated in dollars. The debt instrument's comparable yield, determined in British pounds under Secs. 1.988-2(b)(2) and 1.1275-4(b), is 10 percent, compounded semiannually. The debt instrument provides for semiannual interest payments of 30 payable each June 30, and December 31, and a contingent payment at maturity on December 31, 2006, which is projected to equal 1086.20 (consisting of a noncontingent payment of 980 and a projected payment of 106.20) in addition to the interest payable at maturity. The debt instrument is a capital asset in the hands of Z. Z does not elect to use the spot-rate convention described in Sec. 1.988-2(b)(2)(iii)(B). The payment actually made on December 31, 2006, is 981.00. The relevant pound/dollar spot rates over the term of the instrument are as follows: ------------------------------------------------------------------------

Date Spot rate (pounds to dollars)------------------------------------------------------------------------Dec. 31, 2004....................... 1.00 = $1.00June 30, 2005....................... 1.00 = $1.20Dec. 31, 2005....................... 1.00 = $1.40June 30, 2006....................... 1.00 = $1.60Dec. 31, 2006....................... 1.00 = $1.80------------------------------------------------------------------------ ------------------------------------------------------------------------

Accrual period Average rate (pounds to dollars)------------------------------------------------------------------------Jan.-June 2005...................... 1.00 = $1.10July-Dec. 2005...................... 1.00 = $1.30Jan.-June 2006...................... 1.00 = $1.50July-Dec. 2006...................... 1.00 = $1.70------------------------------------------------------------------------

(ii) Treatment in 2005--(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z accrues 50 of interest on the debt instrument for the January-June accrual period (issue price of 1000 x 10 percent/2). Under paragraph (b)(3)(i) of this section, Z translates the 50 at the average exchange rate for the accrual period ($1.10 x 50 = $55.00). Similarly, Z accrues 51 of interest in the July-December accrual period [(1000 + 50-30) x 10 percent/2], which is translated at the average exchange rate for the accrual period ($1.30 x 51 = $66.30). Accordingly, Z accrues $121.30 of interest income in 2005.

(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z accrues 50 of interest on the debt instrument for the January-June accrual period (issue price of 1000 x 10 percent/2). Under paragraph (b)(3)(i) of this section, Z translates the 50 at the average exchange rate for the accrual period ($1.10 x 50 = $55.00). Similarly, Z accrues 51 of interest in the July-December accrual period [(1000 + 50-30) x 10 percent/2], which is translated at the average exchange rate for the accrual period ($1.30 x 51 = $66.30). Accordingly, Z accrues $121.30 of interest income in 2005.

(B) Adjusted issue price and basis--(1) January-June accrual period. Under paragraphs (b)(2)(iii) and (iv) of this section, the adjusted issue price of the debt instrument determined in pounds and Z's adjusted basis in dollars in the debt instrument are increased by the interest accrued, and decreased by the interest payment made, in the January-June accrual period. Thus, on July 1, 2005, the adjusted issue price of the debt instrument is 1020 (1000 + 50 - 30 = 1020). For purposes of determining Z's dollar basis in the debt instrument, the $1000 basis is increased by the 50 of accrued interest, translated, under paragraph (b)(3)(iii) of this section, at the rate at which interest was accrued for the January-June accrual period ($1.10 x 50 = $55). The resulting amount is reduced by the 30 payment of interest made during the accrual period, translated, under paragraph (b)(3)(iii) of this section and Sec. 1.988-2(b)(7), at the rate applicable to accrued interest ($1.10 x 30 = $33). Accordingly, Z's adjusted basis as of July 1, 2005, is $1022 ($1000 + $55 - $33).

(2) July-December accrual period. Under paragraphs (b)(2)(iii) and (iv) of this section, the adjusted issue price of the debt instrument determined in pounds and Z's adjusted basis in dollars in the debt instrument are increased by the interest accrued, and decreased by the interest payment made, in the July-December accrual period. Thus, on January 1, 2006, the adjusted issue price of the instrument is 1041 (1020 + 51 - 30 = 1041). For purposes of determining Z's dollar basis in the debt instrument, the $1022 basis is increased by the 51 of accrued interest, translated, under paragraph (b)(3)(iii) of this section, at the rate at which interest was accrued for the July-December accrual period ($1.30 x 51 = $66.30). The resulting amount is reduced by the 30 payment of interest made during the accrual period, translated, under paragraph (b)(3)(iii) of this section and Sec. 1.988-2(b)(7), at the rate applicable to accrued interest ($1.30 x 30 = $39). Accordingly, Z's adjusted basis as of January 1, 2006, is $1049.30 ($1022 + $66.30 - $39).

(C) Foreign currency gain or loss. Z will recognize foreign currency gain on the receipt of each 30 payment of interest actually received during 2005. The amount of foreign currency gain in each case is determined, under paragraph (b)(5)(ii) of this section, by reference to the difference between the spot rate on the date the 30 payment was made and the average exchange rate for the accrual period during which the interest accrued. Accordingly, Z recognizes $3 of foreign currency gain on the January-June interest payment [30 x ($1.20 - $1.10)], and $3 of foreign currency gain on the July-December interest payment [30 x ($1.40 - $1.30)]. Z recognizes in 2005 a total of $6 of foreign currency gain.

(D) Source. Z has interest income of $121.30 and a foreign currency gain of $6. Under paragraph (b)(6) of this section and section 862(a)(1), the interest income is sourced by reference to the residence of the payor and is therefore from sources without the United States. Under paragraph (b)(6) of this section and Sec. 1.988-4, Z's foreign currency gain of $6 is sourced by reference to Z's residence and is therefore from sources within the United States.

(iii) Treatment in 2006--(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z's accrued interest for the January-June accrual period is 52.05 (adjusted issue price of 1041 x 10 percent/2). Under paragraph (b)(3)(i) of this section, Z translates the 52.05 at the average exchange rate for the accrual period ($1.50 x 52.05 = $78.08). Similarly, Z accrues 53.15 of interest in the July-December accrual period [(1041 + 52.05-30) x 10 percent/2], which is translated at the average exchange rate for the accrual period ($1.70 x 53.15 = $90.35). Accordingly, Z accrues 105.20, or $168.43, of interest income in 2006.

(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z's accrued interest for the January-June accrual period is 52.05 (adjusted issue price of 1041 x 10 percent/2). Under paragraph (b)(3)(i) of this section, Z translates the 52.05 at the average exchange rate for the accrual period ($1.50 x 52.05 = $78.08). Similarly, Z accrues 53.15 of interest in the July-December accrual period [(1041 + 52.05-30) x 10 percent/2], which is translated at the average exchange rate for the accrual period ($1.70 x 53.15 = $90.35). Accordingly, Z accrues 105.20, or $168.43, of interest income in 2006.

(B) Effect of net negative adjustment. The payment actually made on December 31, 2006, is 981.00, rather than the projected 1086.20. Under paragraph (b)(2)(ii)(B) of this section, Z has a net negative adjustment of 105.20 on December 31, 2006, attributable to the difference between the amount of the actual payment and the amount of the projected payment. Z's accrued interest income of 105.20 in 2006 is reduced to zero by the net negative adjustment. Elimination of the 2006 accrued interest fully utilizes the net negative adjustment.

(C) Adjusted issue price and basis--(1) January-June accrual period. Under paragraphs (b)(2)(iii) and (iv) of this section, the adjusted issue price of the debt instrument determined in pounds and Z's adjusted basis in dollars in the debt instrument are increased by the interest accrued, and decreased by the interest payment made, in the January-June accrual period. Thus, on July 1, 2006, the adjusted issue price of the debt instrument is 1063.05 (1041 + 52.05 - 30 = 1063.05). For purposes of determining Z's dollar basis in the debt instrument, the $1049.30 adjusted basis is increased by the 52.05 of accrued interest, translated, under paragraph (b)(3)(iii) of this section, at the rate at which interest was accrued for the January-June accrual period ($1.50 x 52.05 = $78.08). The resulting amount is reduced by the 30 payment of interest made during the accrual period, translated, under paragraph (b)(3)(iii) of this section and Sec. 1.988-2(b)(7), at the rate applicable to accrued interest ($1.50 x 30 = $45). Accordingly, Z's adjusted basis as of July 1, 2006, is $1082.38 ($1049.30 + $78.08 - $45).

(2) July-December accrual period. Under paragraphs (b)(2)(iii) and (iv) of this section, the adjusted issue price of the debt instrument determined in pounds and Z's adjusted basis in dollars in the debt instrument are increased by the interest accrued, and decreased by the interest payment made, in the July-December accrual period. Thus, immediately before maturity on December 31, 2006, the adjusted issue price of the instrument is 1086.20 (1063.05 + 53.15 - 30 = 1086.20). For purposes of determining Z's dollar basis in the debt instrument, the $1082.38 adjusted basis is increased by the 53.15 of accrued interest, translated, under paragraph (b)(3)(iii) of this section, at the rate at which interest was accrued for the July-December accrual period ($1.70 x 53.15 = $90.36). The resulting amount is reduced by the 30 payment of interest made during the accrual period, translated, under paragraph (b)(3)(iii) of this section and Sec. 1.988-2(b)(7), at the rate applicable to accrued interest ($1.70 x 30 = $51). Accordingly, Z's adjusted basis on December 31, 2006, immediately prior to maturity is $1121.74 ($1082.38 + $90.36 - $51).

(D) Amount realized. Even though Z receives 981.00 at maturity, for purposes of determining the amount realized, Z is treated under paragraph (b)(2)(v) of this section as receiving the projected amount of the contingent payment on December 31, 2006. Therefore, Z is treated as receiving 1086.20 on December 31, 2006. Under paragraph (b)(3)(iv) of this section, Z translates its amount realized into dollars and computes its gain or loss on the instrument (other than foreign currency gain or loss) by breaking the amount realized into its component parts. Accordingly, 20 of the 1086.20 (representing the interest accrued in the January-June 2005 accrual period, less 30 interest paid) is translated into dollars at the rate at which it was accrued (1 = $1.10), resulting in an amount realized of $22; 21 of the 1086.20 (representing the interest accrued in the July-December 2005 accrual period, less 30 interest paid) is translated into dollars at the rate at which it was accrued (1 = $1.30), resulting in an amount realized of $27.30; 22.05 of the 1086.20 (representing the interest accrued in the January-June 2006 accrual period, less 30 interest paid) is translated into dollars at the rate at which it was accrued (1 = $1.50), resulting in an amount realized of $33.08; 23.15 of the 1086.20 (representing the interest accrued in the July 1-December 31, 2006 accrual period, less the 30 interest payment) is translated into dollars at the rate at which it was accrued (1 = $1.70), resulting in an amount realized of $39.36; and 1000 (representing principal) is translated into dollars at the spot rate on the date the instrument was purchased (1 = $1), resulting in an amount realized of $1000. Accordingly, Z's total amount realized is $1121.74 ($22 + $27.30 + $33.08 + $39.36 + $1000), the same as its basis, and Z recognizes no gain or loss (before consideration of foreign currency gain or loss) on retirement of the instrument.

(E) Foreign currency gain or loss. Z recognizes foreign currency gain with respect to each 30 payment actually received during 2006. These payments, however, are treated as payments of principal for this purpose because all 2006 accrued interest is reduced to zero by the net negative adjustment. See paragraph (b)(5)(iv)(A)(3) of this section. The amount of foreign currency gain in each case is determined, under paragraph (b)(5)(iii) of this section, by reference to the difference between the spot rate on the date the 30 payment is made and the spot rate on the date the debt instrument was issued. Accordingly, Z recognizes $18 of foreign currency gain on the January-June 2006 interest payment [30 x ($1.60 - $1.00)], and $24 of foreign currency gain on the July-December 2006 interest payment [30 x ($1.80 - $1.00)]. Z separately recognizes foreign currency gain with respect to the consideration actually received at maturity, 981.00. The amount of such gain is determined based on the difference between the spot rate on the date the instrument matures and the rates at which the principal and interest were taken into account. With respect to the portion of the payment attributable to interest accrued in January-June 2005 (other than the 30 payments), the foreign currency gain is $14 [20 x ($1.80 - $1.10)]. With respect to the portion of the payment attributable to interest accrued in July-December 2005 (other than the 30 payments), the foreign currency gain is $10.50 [21 x ($1.80 - $1.30)]. With respect to the portion of the payment attributable to interest accrued in 2006 (other than the 30 payments), no foreign currency gain or loss is recognized under paragraph (b)(5)(ii) of this section because such interest was reduced to zero by the net negative adjustment. With respect to the portion of the payment attributable to principal, the foreign currency gain is $752 [940 x ($1.80 - $1.00)]. Thus, Z recognizes a foreign currency gain of $42 on receipt of the two 30 payments in 2006, and $776.50 ($14 + $10.50 + $752) on receipt of the payment at maturity, for a total 2006 foreign currency gain of $818.50.

(F) Source. Under paragraph (b)(6) of this section and Sec. 1.988-4, Z's foreign currency gain of $818.50 is sourced by reference to Z's residence and is therefore from sources within the United States.

(i) Facts. On July 1, 2005, Z, a calendar year U.S. resident taxpayer whose functional currency is the U.S. dollar, purchases a debt instrument with a non-currency contingency for 1405. All payments of principal and interest with respect to the instrument are denominated in, or determined by reference to, a single nonfunctional currency (the British pound). The debt instrument would be subject to Sec. 1.1275-4(b) if it were denominated in dollars. The debt instrument was originally issued by a foreign corporation on December 31, 2003, for an issue price of 1000, and matures on December 31, 2006. The debt instrument's comparable yield, determined in British pounds under Secs. 1.988-2(b)(2) and 1.1275-4(b), is 10.25 percent, compounded semiannually, and the projected payment schedule for the debt instrument (determined as of the issue date under the rules of Sec. 1.1275-4(b)) provides for a single payment at maturity of 1349.70 (consisting of a noncontingent payment of 1000 and a projected payment of 349.70). At the time of the purchase, the adjusted issue price of the debt instrument is 1161.76, assuming semiannual accrual periods ending on June 30 and December 31 of each year. The increase in the value of the debt instrument over its adjusted issue price is due to an increase in the expected amount of the contingent payment. The debt instrument is a capital asset in the hands of Z. Z does not elect to use the spot-rate convention described in Sec. 1.988-2(b)(2)(iii)(B). The payment actually made on December 31, 2006, is 1400. The relevant pound/dollar spot rates over the term of the instrument are as follows: ------------------------------------------------------------------------

Date Spot rate (pounds to dollars)------------------------------------------------------------------------July 1, 2005........................ 1.00 = $1.00Dec. 31, 2006....................... 1.00 = $2.00------------------------------------------------------------------------ ------------------------------------------------------------------------

Accrual period Average rate (pounds to dollars)------------------------------------------------------------------------July 1-Dec. 31, 2005................ 1.00 = $1.50Jan. 1-June 30, 2006................ 1.00 = $1.50July 1-Dec. 31, 2006................ 1.00 = $1.50------------------------------------------------------------------------

(ii) Initial basis. Under paragraph (b)(7)(ii) of this section, Z's initial basis in the debt instrument is $1405, Z's purchase price of 1405, translated into functional currency at the spot rate on the date the debt instrument was purchased (1 = $1).

(iii) Allocation of purchase price differential. Z purchased the debt instrument for 1405 when its adjusted issue price was 1161.76. Under paragraph (b)(7)(iii) of this section, Z allocates the 243.24 excess of purchase price over adjusted issue price to the contingent payment at maturity. This allocation is reasonable because the excess is due to an increase in the expected amount of the contingent payment and not, for example, to a decrease in prevailing interest rates.

(iv) Treatment in 2005--(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z accrues 59.54 of interest on the debt instrument for the July-December 2005 accrual period (issue price of 1161.76 x 10.25 percent/2). Under paragraph (b)(3)(i) of this section, Z translates the 59.54 of interest at the average exchange rate for the accrual period ($1.50 x 59.54 = $89.31). Accordingly, Z has interest income in 2005 of $89.31.

(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z accrues 59.54 of interest on the debt instrument for the July-December 2005 accrual period (issue price of 1161.76 x 10.25 percent/2). Under paragraph (b)(3)(i) of this section, Z translates the 59.54 of interest at the average exchange rate for the accrual period ($1.50 x 59.54 = $89.31). Accordingly, Z has interest income in 2005 of $89.31.

(B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii) and (iv) of this section, the adjusted issue price of the debt instrument determined in pounds and Z's adjusted basis in dollars in the debt instrument are increased by the interest accrued in July-December 2005. Thus, on January 1, 2006, the adjusted issue price of the debt instrument is 1221.30 (1161.76 + 59.54). For purposes of determining Z's dollar basis in the debt instrument on January 1, 2006, the $1405 basis is increased by the 59.54 of accrued interest, translated at the rate at which interest was accrued for the July-December 2005 accrual period. Paragraph (b)(3)(iii) of this section. Accordingly, Z's adjusted basis in the instrument, as of January 1, 2006, is $1494.31 [$1405 + (59.54 x $1.50)].

(v) Treatment in 2006--(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z accrues 62.59 of interest on the debt instrument for the January-June 2006 accrual period (issue price of 1221.30 x 10.25 percent/2). Under paragraph (b)(3)(i) of this section, Z translates the 62.59 of accrued interest at the average exchange rate for the accrual period ($1.50 x 62.59 = $93.89). Similarly, Z accrues 65.80 of interest in the July-December 2006 accrual period [(1221.30 + 62.59) x 10.25 percent/2], which is translated at the average exchange rate for the accrual period ($1.50 x 65.80 = $98.70). Accordingly, Z accrues 128.39, or $192.59, of interest income in 2006.

(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z accrues 62.59 of interest on the debt instrument for the January-June 2006 accrual period (issue price of 1221.30 x 10.25 percent/2). Under paragraph (b)(3)(i) of this section, Z translates the 62.59 of accrued interest at the average exchange rate for the accrual period ($1.50 x 62.59 = $93.89). Similarly, Z accrues 65.80 of interest in the July-December 2006 accrual period [(1221.30 + 62.59) x 10.25 percent/2], which is translated at the average exchange rate for the accrual period ($1.50 x 65.80 = $98.70). Accordingly, Z accrues 128.39, or $192.59, of interest income in 2006.

(B) Effect of positive and negative adjustments--(1) Offset of positive adjustment. The payment actually made on December 31, 2006, is 1400, rather than the projected 1349.70. Under paragraph (b)(2)(ii) of this section, Z has a positive adjustment of 50.30 on December 31, 2006, attributable to the difference between the amount of the actual payment and the amount of the projected payment. Under paragraph (b)(7)(iii) of this section, however, Z also has a negative adjustment of 243.24, attributable to the excess of Z's purchase price for the debt instrument over its adjusted issue price. Accordingly, Z will have a net negative adjustment of 192.94 (50.30-243.24 = 192.94) for 2006.

(2) Offset of accrued interest. Z's accrued interest income of 128.39 in 2006 is reduced to zero by the net negative adjustment. The net negative adjustment which reduces the current year's interest is not translated into functional currency. Under paragraph (b)(2)(ii) of this section, Z treats the remaining 64.55 net negative adjustment as an ordinary loss to the extent of the 59.54 previously accrued interest in 2005. This 59.54 ordinary loss is attributable to interest accrued but not paid in the preceding year. Therefore, under paragraph (b)(3)(ii)(B)(2) of this section, Z translates the loss into dollars at the average rate for such year (1 = $1.50). Accordingly, Z has an ordinary loss of $89.31 in 2006. The remaining 5.01 of net negative adjustment is a negative adjustment carryforward under paragraph (b)(2)(ii) of this section.

(C) Adjusted issue price and basis--(1) January-June accrual period. Under paragraph (b)(2)(iii) of this section, the adjusted issue price of the debt instrument on July 1, 2006, is 1283.89 (1221.30 + 62.59 = 1283.89). Under paragraphs (b)(2)(iv) and (b)(3)(iii) of this section, Z's adjusted basis as of July 1, 2006, is $1588.20 ($1494.31 + $93.89).

(2) July-December accrual period. Based on the projected payment schedule, the adjusted issue price of the debt instrument immediately before the payment at maturity is 1349.70 (1283.89 + 65.80 accrued interest for July-December). Z's adjusted basis in dollars, based only on the noncontingent payments and the projected amount of the contingent payments to be received, is $1686.90 ($1588.20 plus $98.70 of accrued interest for July-December).

(3) Adjustment to basis upon contingent payment. Under paragraph (b)(7)(iii) of this section, Z's adjusted basis in the debt instrument is reduced at maturity by 243.24, the excess of Z's purchase price for the debt instrument over its adjusted issue price. For this purpose, the adjustment is translated into functional currency at the spot rate on the date the instrument was acquired (1 = $1). Accordingly, Z's adjusted basis in the debt instrument at maturity is $1443.66 ($1686.90-$243.24).

(D) Amount realized. Even though Z receives 1400 at maturity, for purposes of determining the amount realized, Z is treated under paragraph (b)(2)(v) of this section as receiving the projected amount of the contingent payment on December 31, 2006, reduced by the amount of Z's negative adjustment carryforward of 5.01. Therefore, Z is treated as receiving 1344.69 (1349.70-5.01) on December 31, 2006. Under paragraph (b)(3)(iv) of this section, Z translates its amount realized into dollars and computes its gain or loss on the instrument (other than foreign currency gain or loss) by breaking the amount realized into its component parts. Accordingly, 59.54 of the 1344.69 (representing the interest accrued in 2005) is translated at the rate at which it was accrued (1 = $1.50), resulting in an amount realized of $89.31; 62.59 of the 1344.69 (representing the interest accrued in January-June 2006) is translated into dollars at the rate at which it was accrued (1 = $1.50), resulting in an amount realized of $93.89; 65.80 of the 1344.69 (representing the interest accrued in July-December 2006) is translated into dollars at the rate at which it was accrued (1 = $1.50), resulting in an amount realized of $98.70; and 1156.76 of the 1344.69 (representing a return of principal) is translated into dollars at the spot rate on the date the instrument was purchased (1 = $1), resulting in an amount realized of $1156.76. Z's amount realized is $1438.66 ($89.31 + $93.89 + $98.70 + $1156.76), and Z recognizes a capital loss (before consideration of foreign currency gain or loss) of $5 on retirement of the instrument ($1438.66 - $1443.66 = -$5).

(E) Foreign currency gain or loss. Z recognizes foreign currency gain under section 988 on the instrument with respect to the entire consideration actually received at maturity, 1400. While foreign currency gain or loss ordinarily would not have arisen with respect to 50.30 of the 1400, which was initially treated as a positive adjustment in 2006, the larger negative adjustment in 2006 reduced this positive adjustment to zero. Accordingly, foreign currency gain or loss is recognized with respect to the entire 1400. Under paragraph (b)(5)(ii) of this section, however, no foreign currency gain or loss is recognized with respect to unpaid accrued interest reduced to zero by the net negative adjustment resulting in 2006, and no foreign currency gain or loss is recognized with respect to unpaid accrued interest from 2005, also reduced to zero by the ordinary loss. Therefore, the entire 1400 is treated as a return of principal for the purpose of determining foreign currency gain or loss, and Z recognizes a total foreign currency gain on December 31, 2001, of $1400 [1400 x ($2.00-$1.00)].

(F) Source. Z has an ordinary loss of $89.31, a capital loss of $5, and a foreign currency gain of $1400. Under paragraph (b)(6) of this section and Sec. 1.1275-4(b)(9)(iv), the $89.31 ordinary loss generally reduces Z's foreign source passive income under section 904(d) and the regulations thereunder. Under paragraph (b)(6) of this section and Sec. 1.865-1(b)(2), the $5 capital loss is sourced by reference to how interest income on the instrument would have been sourced. Therefore, the $5 capital loss generally reduces Z's foreign source passive income under section 904(d) and the regulations thereunder. Under paragraph (b)(6) of this section and Sec. 1.988-4, Z's foreign currency gain of $1400 is sourced by reference to Z's residence and is therefore from sources within the United States.

(i) Facts. On December 31, 2003, Z, a calendar year U.S. resident taxpayer whose functional currency is the U.S. dollar, purchases at original issue a debt instrument with non-currency contingencies for 1000. All payments of principal and interest with respect to the instrument are denominated in, or determined by reference to, a single nonfunctional currency (the British pound). The debt instrument would be subject to Sec. 1.1275-4(b) if it were denominated in dollars. The debt instrument's comparable yield, determined in British poundsunder Secs. 1.988-2(b)(2) and 1.1275-4(b), is 10 percent, compounded annually, and the projected payment schedule for the debt instrument provides for payments of 310 on December 31, 2005 (consisting of a noncontingent payment of 50 and a projected amount of 260) and 990 on December 31, 2006 (consisting of a noncontingent payment of 940 and a projected amount of 50). The debt instrument is a capital asset in the hands of Z. Z does not elect to use the spot-rate convention described in Sec. 1.988-2(b)(2)(iii)(B). The payment actually made on December 31, 2005, is 50. On December 30, 2006, Z sells the debt instrument for 940. The relevant pound/dollar spot rates over the term of the instrument are as follows: ------------------------------------------------------------------------

Date Spot rate (pounds to dollars)------------------------------------------------------------------------Dec. 31, 2003....................... 1.00 = $1.00Dec. 31, 2005....................... 1.00 = $2.00Dec. 30, 2006....................... 1.00 = $2.00------------------------------------------------------------------------ ------------------------------------------------------------------------

Accrual period Average rate (pounds to dollars)------------------------------------------------------------------------Jan. 1-Dec. 31, 2004................ 1.00 = $2.00Jan. 1-Dec. 31, 2005................ 1.00 = $2.00Jan. 1-Dec. 31, 2006................ 1.00 = $2.00------------------------------------------------------------------------

(ii) Treatment in 2004--(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z accrues 100 of interest on the debt instrument for 2004 (issue price of 1000 x 10 percent). Under paragraph (b)(3)(i) of this section, Z translates the 100 at the average exchange rate for the accrual period ($2.00 x 100 = $200). Accordingly, Z has interest income in 2004 of $200.

(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z accrues 100 of interest on the debt instrument for 2004 (issue price of 1000 x 10 percent). Under paragraph (b)(3)(i) of this section, Z translates the 100 at the average exchange rate for the accrual period ($2.00 x 100 = $200). Accordingly, Z has interest income in 2004 of $200.

(B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii) and (iv) of this section, the adjusted issue price of the debt instrument determined in pounds and Z's adjusted basis in dollars in the debt instrument are increased by the interest accrued in 2004. Thus, on January 1, 2005, the adjusted issue price of the debt instrument is 1100. For purposes of determining Z's dollar basis in the debt instrument, the $1000 basis ($1.00 x 1000 original cost basis) is increased by the 100 of accrued interest, translated at the rate at which interest was accrued for 2004. See paragraph (b)(3)(iii) of this section. Accordingly, Z's adjusted basis in the debt instrument as of January 1, 2005, is $1200 ($1000 + $200).

(iii) Treatment in 2005--(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z's accrued interest for 2005 is 110 (adjusted issue price of 1100 x 10 percent). Under paragraph (b)(3)(i) of this section, the 110 of accrued interest is translated at the average exchange rate for the accrual period ($2.00 x 110 = $220).

(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z's accrued interest for 2005 is 110 (adjusted issue price of 1100 x 10 percent). Under paragraph (b)(3)(i) of this section, the 110 of accrued interest is translated at the average exchange rate for the accrual period ($2.00 x 110 = $220).

(B) Effect of net negative adjustment. The payment actually made on December 31, 2005, is 50, rather than the projected 310. Under paragraph (b)(2)(ii) of this section, Z has a net negative adjustment of 260 on December 31, 2005, attributable to the difference between the amount of the actual payment and the amount of the projected payment. Z's accrued interest income of 110 in 2005 is reduced to zero by the net negative adjustment. Under paragraph (b)(3)(ii)(B)(1) of this section, the net negative adjustment which reduces the current year's interest is not translated into functional currency. Under paragraph (b)(2)(ii) of this section, Z treats the remaining 150 net negative adjustment as an ordinary loss to the extent of the 100 previously accrued interest in 2004. This 100 ordinary loss is attributable to interest accrued but not paid in the preceding year. Therefore, under paragraph (b)(3)(ii)(B)(2) of this section, Z translates the loss into dollars at the average rate for such year (1 = $2.00). Accordingly, Z has an ordinary loss of $200 in 2005. The remaining 50 of net negative adjustment is a negative adjustment carryforward under paragraph (b)(2)(ii) of this section.

(C) Adjusted issue price and basis. Based on the projected payment schedule, the adjusted issue price of the debt instrument on January 1, 2006 is 900, i.e., the adjusted issue price of the debt instrument on January 1, 2005 (1100), increased by the interest accrued in 2005 (110), and decreased by the projected amount of the December 31, 2005, payment (310). See paragraph (b)(2)(iii) of this section. Z's adjusted basis on January 1, 2006 is Z's adjusted basis on January 1, 2005 ($1200), increased by the functional currency amount of interest accrued in 2005 ($220), and decreased by the amount of the payments made in 2005, based solely on the projected payment schedule, (310). The amount of the projected payment is first attributable to the interest accrued in 2005 (110), and then to the interest accrued in 2004 (100), and the remaining amount to principal (100). The interest component of the projected payment is translated into functional currency at the rates at which it was accrued, and the principal component of the projected payment is translated into functional currency at the spot rate on the date the instrument was issued. See paragraph (b)(3)(iii) of this section. Accordingly, Z's adjusted basis in the debt instrument, following the increase of adjusted basis for interest accrued in 2005 ($1200 + $220 = $1420), is decreased by $520 ($220 + $200 + $100 = $520). Z's adjusted basis on January 1, 2006 is therefore, $900.

(D) Foreign currency gain or loss. Z will recognize foreign currency gain on the receipt of the 50 payment actually received on December 31, 2005. Based on paragraph (b)(5)(iv) of this section, the 50 payment is attributable to principal since the accrued unpaid interest was completely eliminated by the net negative adjustment. The amount of foreign currency gain is determined, under paragraph (b)(5)(iii) of this section, by reference to the difference between the spot rate on the date the 50 payment was made and the spot rate on the date the debt instrument was issued. Accordingly, Z recognizes $50 of foreign currency gain on the 50 payment. [($2.00--$1.00) x 50 =$50]. Under paragraph (b)(6) of this section and Sec. 1.988-4, Z's foreign currency gain of $50 is sourced by reference to Z's residence and is therefore from sources within the United States.

(iv) Treatment in 2006--(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z accrues 90 of interest on the debt instrument for 2006 (adjusted issue price of 900 x 10 percent). Under paragraph (b)(3)(i) of this section, Z translates the 90 at the average exchange rate for the accrual period ($2.00 x 90 = $180). Accordingly, prior to taking into account the 2005 negative adjustment carryforward, Z has interest income in 2006 of $180.

(A) Determination of accrued interest. Under paragraph (b)(2)(i) of this section, and based on the comparable yield, Z accrues 90 of interest on the debt instrument for 2006 (adjusted issue price of 900 x 10 percent). Under paragraph (b)(3)(i) of this section, Z translates the 90 at the average exchange rate for the accrual period ($2.00 x 90 = $180). Accordingly, prior to taking into account the 2005 negative adjustment carryforward, Z has interest income in 2006 of $180.

(B) Effect of net negative adjustment. The 50 negative adjustment carryforward from 2005 is a negative adjustment for 2006. Since there are no other positive or negative adjustments, there is a 50 negative adjustment in 2006 which reduces Z's accrued interest income by 50. Accordingly, after giving effect to the 50 negative adjustment carryforward, Z will accrue $80 of interest income. [(90-50) x $2.00 = $80]

(C) Adjusted issue price. Under paragraph (b)(2)(iii) of this section, the adjusted issue price of the debt instrument determined in pounds is increased by the interest accrued in 2006 (prior to taking into account the negative adjustment carryforward). Thus, on December 30, 2006, the adjusted issue price of the debt instrument is 990.

(D) Adjusted basis. For purposes of determining Z's dollar basis in the debt instrument, Z's $900 adjusted basis on January 1, 2006, is increased by the accrued interest, translated at the rate at which interest was accrued for 2006. See paragraph (b)(3)(iii)(A) of this section. Note, however, that under paragraph (b)(3)(iii)(B) of this section the amount of accrued interest which is reduced as a result of the negative adjustment carryforward, i.e., 50, is treated for purposes of this section as principal, and is translated at the spot rate on the date the instrument was issued, i.e., 1.00 =$1.00. Accordingly, Z's adjusted basis in the debt instrument as of December 30, 2006, is $1030 ($900 + $50 + $80).

(E) Amount realized. Z's amount realized in denomination currency is 940, i.e., the amount of pounds Z received on the sale of the debt instrument. Under paragraph (b)(3)(iv)(B)(1) of this section, Z's amount realized is first translated by reference to the principal component of basis (including the amount which is treated as principal under paragraph (b)(3)(iii)(B) of this section) and then the remaining amount realized, if any, is translated by reference to the accrued unpaid interest component of adjusted basis. Thus, 900 of Z's amount realized is translated by reference to the principal component of adjusted basis. The remaining 40 of Z's amount realized is treated as principal under paragraph (b)(3)(iii)(B) of this section, and is also translated by reference to the principal component of adjusted basis. Accordingly, Z's amount realized in functional currency is $940. (No part of Z's amount realized is attributable to the interest accrued on the debt instrument.) Z realizes a loss of $90 on the sale of the debt instrument ($1030 basis-$940 amount realized). Under paragraph (b)(4) of this section and Sec. 1.1275-4(b)(8), $80 of the loss is characterized as ordinary loss, and the remaining $10 of loss is characterized as capital loss. Under Secs. 1.988-6(b)(6) and 1.1275-4(b)(9)(iv) the $80 ordinary loss is treated as a deduction that is definitely related to the interest income accrued on the debt instrument. Similarly, under Secs. 1.988-6(b)(6) and 1.865-1(b)(2) the $10 capital loss is also allocated to the interest income from the debt instrument.

(F) Foreign currency gain or loss. Z recognizes foreign currency gain with respect to the 940 he received on the sale of the debt instrument. Under paragraph (b)(5)(iv) of this section, the Z received is attributable to principal (and the amount which is treated as principal under paragraph (b)(3)(iii)(B) of this section). Thus, Z recognizes foreign currency gain on December 31, 2006, of $940. [($2.00-$1.00) x 940]. Under paragraph (b)(6) of this section and Sec. 1.988-4, Z's foreign currency gain of $940 is sourced by reference to Z's residence and is therefore from sources within the United States.

(d) Multicurrency debt instruments--(1) In general. Except as provided in this paragraph (d), a multicurrency debt instrument described in paragraph (a)(1)(ii) or (iii) of this section shall be treated as an instrument described in paragraph (a)(1)(i) of this section and shall be accounted for under the rules of paragraph (b) of this section. Because payments on an instrument described in paragraph (a)(1)(ii) or (iii) of this section are denominated in, or determined by reference to, more than one currency, the issuer and holder or holders of the instrument are required to determine the denomination currency of the instrument under paragraph (d)(2) of this section before applying the rules of paragraph (b) of this section.

(1) In general. Except as provided in this paragraph (d), a multicurrency debt instrument described in paragraph (a)(1)(ii) or (iii) of this section shall be treated as an instrument described in paragraph (a)(1)(i) of this section and shall be accounted for under the rules of paragraph (b) of this section. Because payments on an instrument described in paragraph (a)(1)(ii) or (iii) of this section are denominated in, or determined by reference to, more than one currency, the issuer and holder or holders of the instrument are required to determine the denomination currency of the instrument under paragraph (d)(2) of this section before applying the rules of paragraph (b) of this section.

(2) Determination of denomination currency--(i) In general. The denomination currency of an instrument described in paragraph (a)(1)(ii) or (iii) of this section shall be the predominant currency of the instrument. Except as otherwise provided in paragraph (d)(2)(ii) of this section, the predominant currency of the instrument shall be the currency with the greatest value determined by comparing the functional currency value of the noncontingent and projected payments denominated in, or determined by reference to, each currency on the issue date, discounted to present value (in each relevant currency), and translated (if necessary) into functional currency at the spot rate on the issue date. For this purpose, the applicable discount rate may be determined using any method, consistently applied, that reasonably reflects the instrument's economic substance. If a taxpayer does not determine a discount rate using such a method, the Commissioner may choose a method for determining the discount rate that does reflect the instrument's economic substance. The predominant currency is determined as of the issue date and does not change based on subsequent events (e.g., changes in value of one or more currencies).

(i) In general. The denomination currency of an instrument described in paragraph (a)(1)(ii) or (iii) of this section shall be the predominant currency of the instrument. Except as otherwise provided in paragraph (d)(2)(ii) of this section, the predominant currency of the instrument shall be the currency with the greatest value determined by comparing the functional currency value of the noncontingent and projected payments denominated in, or determined by reference to, each currency on the issue date, discounted to present value (in each relevant currency), and translated (if necessary) into functional currency at the spot rate on the issue date. For this purpose, the applicable discount rate may be determined using any method, consistently applied, that reasonably reflects the instrument's economic substance. If a taxpayer does not determine a discount rate using such a method, the Commissioner may choose a method for determining the discount rate that does reflect the instrument's economic substance. The predominant currency is determined as of the issue date and does not change based on subsequent events (e.g., changes in value of one or more currencies).

(ii) Difference in discount rate of greater than 10 percentage points. This Sec. 1.988-6(d)(2)(ii) applies if no currency has a value determined under paragraph (d)(2)(i) of this section that is greater than 50% of the total value of all payments. In such a case, if the difference between the discount rate in the denomination currency otherwise determined under (d)(2)(i) of this section and the discount rate determined under paragraph (d)(2)(i) of this section with respect to any other currency in which payments are made (or determined by reference to) pursuant to the instrument is greater than 10 percentage points, then the Commissioner may determine the predominant currency under any reasonable method.

(3) Issuer/holder consistency. The issuer determines the denomination currency under the rules of paragraph (d)(2) of this section and provides this information to the holders of the instrument in a manner consistent with the issuer disclosure rules of Sec. 1.1275-2(e). If the issuer does not determine the denomination currency of the instrument, or if the issuer's determination is unreasonable, the holder of the instrument must determine the denomination currency under the rules of paragraph (d)(2) of this section. A holder that determines the denomination currency itself must explicitly disclose this fact on a statement attached to the holder's timely filed federal income tax return for the taxable year that includes the acquisition date of the instrument.

(4) Treatment of payments in currencies other than the denomination currency. For purposes of applying the rules of paragraph (b) of this section to debt instruments described in paragraph (a)(1)(ii) or (iii) of this section, payments not denominated in (or determined by reference to) the denomination currency shall be treated as non-currency-related contingent payments. Accordingly, if the denomination currency of the instrument is determined to be the taxpayer's functional currency, the instrument shall be accounted for under Sec. 1.1275-4(b) rather than under this section.

(e) Instruments issued for nonpublicly traded property--(1) Applicability. This paragraph (e) applies to debt instruments issued for nonpublicly traded property that would be described in paragraph (a)(1)(i), (ii), or (iii) of this section, but for the fact that such instruments are described in Sec. 1.1275-4(c)(1) rather than Sec. 1.1275-4(b)(1). For example, this paragraph (e) generally applies to a contingent payment debt instrument denominated in a nonfunctional currency that is issued for non-publicly traded property. Generally the rules of Sec. 1.1275-4(c) apply except as set forth by the rules of this paragraph (e).

(1) Applicability. This paragraph (e) applies to debt instruments issued for nonpublicly traded property that would be described in paragraph (a)(1)(i), (ii), or (iii) of this section, but for the fact that such instruments are described in Sec. 1.1275-4(c)(1) rather than Sec. 1.1275-4(b)(1). For example, this paragraph (e) generally applies to a contingent payment debt instrument denominated in a nonfunctional currency that is issued for non-publicly traded property. Generally the rules of Sec. 1.1275-4(c) apply except as set forth by the rules of this paragraph (e).

(2) Separation into components. An instrument described in this paragraph (e) is not accounted for using the noncontingent bond method of Sec. 1.1275-4(b) and paragraph (b) of this section. Rather, the instrument is separated into its component payments. Each noncontingent payment or group of noncontingent payments which is denominated in a single currency shall be considered a single component treated as a separate debt instrument denominated in the currency of the payment or group of payments. Each contingent payment shall be treated separately as provided in paragraph (e)(4) of this section.

(3) Treatment of components consisting of one or more noncontingent payments in the same currency. The issue price of each component treated as a separate debt instrument which consists of one or more noncontingent payments is the sum of the present values of the noncontingent payments contained in the separate instrument. The present value of any noncontingent payment shall be determined under Sec. 1.1274-2(c)(2), and the test rate shall be determined under Sec. 1.1274-4 with respect to the currency in which each separate instrument is considered denominated. No interest payments on the separate debt instrument are qualified stated interest payments (within the meaning of Sec. 1.1273-1(c)) and the de minimis rules of section 1273(a)(3) and Sec. 1.1273-1(d) do not apply to the separate debt instrument. Interest income or expense is translated, and exchange gain or loss is recognized on the separate debt instrument as provided in Sec. 1.988-2(b)(2), if the instrument is denominated in a nonfunctional currency.

(4) Treatment of components consisting of contingent payments--(i) General rule. A component consisting of a contingent payment shall generally be treated in the manner provided in Sec. 1.1275-4(c)(4). However, except as provided in paragraph (e)(4)(ii) of this section, the test rate shall be determined by reference to the U.S. dollar unless the dollar does not reasonably reflect the economic substance of the contingent component. In such case, the test rate shall be determined by reference to the currency which most reasonably reflects the economic substance of the contingent component. Any amount received in nonfunctional currency from a component consisting of a contingent payment shall be translated into functional currency at the spot rate on the date of receipt. Except in the case when the payment becomes fixed more than six months before the payment is due, no foreign currency gain or loss shall be recognized on a contingent payment component.

(i) General rule. A component consisting of a contingent payment shall generally be treated in the manner provided in Sec. 1.1275-4(c)(4). However, except as provided in paragraph (e)(4)(ii) of this section, the test rate shall be determined by reference to the U.S. dollar unless the dollar does not reasonably reflect the economic substance of the contingent component. In such case, the test rate shall be determined by reference to the currency which most reasonably reflects the economic substance of the contingent component. Any amount received in nonfunctional currency from a component consisting of a contingent payment shall be translated into functional currency at the spot rate on the date of receipt. Except in the case when the payment becomes fixed more than six months before the payment is due, no foreign currency gain or loss shall be recognized on a contingent payment component.

(ii) Certain delayed contingent payments--(A) Separate debt instrument relating to the fixed component. The rules of Sec. 1.1275-4(c)(4)(iii) shall apply to a contingent component the payment of which becomes fixed more than 6 months before the payment is due. For this purpose, the denomination currency of the separate debt instrument relating to the fixed payment shall be the currency in which payment is to be made and the test rate for such separate debt instrument shall be determined in the currency of that instrument. If the separate debt instrument relating to the fixed payment is denominated in nonfunctional currency, the rules of Sec. 1.988-2(b)(2) shall apply to that instrument for the period beginning on the date the payment is fixed and ending on the payment date.

(A) Separate debt instrument relating to the fixed component. The rules of Sec. 1.1275-4(c)(4)(iii) shall apply to a contingent component the payment of which becomes fixed more than 6 months before the payment is due. For this purpose, the denomination currency of the separate debt instrument relating to the fixed payment shall be the currency in which payment is to be made and the test rate for such separate debt instrument shall be determined in the currency of that instrument. If the separate debt instrument relating to the fixed payment is denominated in nonfunctional currency, the rules of Sec. 1.988-2(b)(2) shall apply to that instrument for the period beginning on the date the payment is fixed and ending on the payment date.

(B) Contingent component. With respect to the contingent component, the issue price considered to have been paid by the issuer to the holder under Sec. 1.1275-4(c)(4)(iii)(A) shall be translated, if necessary, into the functional currency of the issuer or holder at the spot rate on the date the payment becomes fixed.

(5) Basis different from adjusted issue price. The rules of Sec. 1.1275-4(c)(5) shall apply to an instrument subject to this paragraph (e).

(6) Treatment of a holder on sale, exchange, or retirement. The rules of Sec. 1.1275-4(c)(6) shall apply to an instrument subject to this paragraph (e).

(f) Rules for nonfunctional currency tax exempt obligations described in Sec. 1.1275-4(d)--(1) In general. Except as provided in paragraph (f)(2) of this section, section 1.988-6 shall not apply to a debt instrument the interest on which is excluded from gross income under section 103(a).

(1) In general. Except as provided in paragraph (f)(2) of this section, section 1.988-6 shall not apply to a debt instrument the interest on which is excluded from gross income under section 103(a).

(2) Operative rules. [Reserved].

(g) Effective date. This section shall apply to debt instruments issued on or after October 29, 2004. [T.D. 9157, 69 FR 52819, Aug. 30, 2004] Sec. 1.989(a)-1 Definition of a qualified business unit.

(a) Applicability--(1) In general. This section provides rules relating to the definition of the term ``qualified business unit'' (QBU) within the meaning of section 989.

(1) In general. This section provides rules relating to the definition of the term ``qualified business unit'' (QBU) within the meaning of section 989.

(2) Effective date. These rules shall apply to taxable years beginning after December 31, 1986. However, any person may apply on a consistent basis Sec. 1.989(a)-1T (c) of the Temporary Income Tax Regulations in lieu of Sec. 1.989(a)-1 (c) to all taxable years beginning after December 31, 1986, and on or before February 5, 1990. For the text of the temporary regulation, see 53 FR 20612 (June 8, 1988).

(b) Definition of a qualified business unit--(1) In general. A QBU is any separate and clearly identified unit of a trade or business of a taxpayer provided that separate books and records are maintained.

(1) In general. A QBU is any separate and clearly identified unit of a trade or business of a taxpayer provided that separate books and records are maintained.

(2) Application of the QBU definition--(i) Persons. A corporation is QBU. An individual is not a QBU. A partnership, trust, or estate is a QBU of a partner or beneficiary.

(i) Persons. A corporation is QBU. An individual is not a QBU. A partnership, trust, or estate is a QBU of a partner or beneficiary.

(ii) Activities. Activities of a corporation, partnership, trust, estate, or individual qualify as a QBU if--

(A) The activities constitute a trade or business; and

(B) A separate set of books and records is maintained with respect to the activities.

(3) Special rule. Any activity (wherever conducted and regardless of its frequency) that produces income or loss that is, or is treated as, effectively connected with the conduct of a trade or business within the United States shall be treated as a separate QBU, provided the books and records requirement of paragraph (d)(2) of this section is satisfied.

(c) Trade or business. The determination as to whether activities constitute a trade or business is ultimately dependent upon an examination of all the facts and circumstances. Generally, a trade or business for purposes of section 989(a) is a specific unified group of activities that constitutes (or could constitute) an independent economic enterprise carried on for profit, the expenses related to which are deductible under section 162 or 212 (other than that part of section 212 dealing with expenses incurred in connection with taxes). To constitute a trade or business, a group of activities must ordinarily include every operation which forms a part of, or a step in, a process by which an enterprise may earn income or profit. Such group of activities must ordinarily include the collection of income and the payment of expenses. It is not necessary that the activities carried out by a QBU constitute a different trade or business from those carried out by other QBUs of the taxpayer. A vertical, functional, or geographic division of the same trade or business may be a trade or business for this purpose provided that the activities otherwise qualify as trade or business under this paragraph (c). However, activities that are merely ancillary to a trade or business will not constitute a trade or business under this paragraph (c). Activities of an individual as an employee are not considered by themselves to constitute a trade or business under this paragraph (c).

(d) Separate books and records--(1) General rule. Except as provided in paragraph (d)(2) of this section, a separate set of books and records shall include books of original entry and ledger accounts, both general and subsidiary, or similar records. For example, in the case of a taxpayer using the cash receipts and disbursements method of accounting, the books of original entry include a cash receipts and disbursements journal where each receipt and each disbursement is recorded. Similarly, in the case of a taxpayer using an accrual method of accounting, the books of original entry include a journal to record sales (accounts receivable) and a journal to record expenses incurred (accounts payable). In general, a journal represents a chronological account of all transactions entered into by an entity for an accounting period. A ledger account, on the other hand, chronicles the impact during an accounting period of the specific transactions recorded in the journal for that period upon the various items shown on the entity's balance sheet (i.e., assets, liabilities, and capital accounts) and income statement (i.e., revenues and expenses).

(1) General rule. Except as provided in paragraph (d)(2) of this section, a separate set of books and records shall include books of original entry and ledger accounts, both general and subsidiary, or similar records. For example, in the case of a taxpayer using the cash receipts and disbursements method of accounting, the books of original entry include a cash receipts and disbursements journal where each receipt and each disbursement is recorded. Similarly, in the case of a taxpayer using an accrual method of accounting, the books of original entry include a journal to record sales (accounts receivable) and a journal to record expenses incurred (accounts payable). In general, a journal represents a chronological account of all transactions entered into by an entity for an accounting period. A ledger account, on the other hand, chronicles the impact during an accounting period of the specific transactions recorded in the journal for that period upon the various items shown on the entity's balance sheet (i.e., assets, liabilities, and capital accounts) and income statement (i.e., revenues and expenses).

(2) Special rule. For purposes of paragraph (b)(3) of this section, books and records include books and records used to determine income or loss that is, or is treated as, effectively connected with the conduct of a trade or business within the United States.

(e) Examples. The provisions of this section may be illustrated by the following examples:

Example 1. Corporation X is a domestic corporation. Corporation X manufactures widgets in the U.S. for export. Corporation X sells widgets in the United Kingdom through a branch office in London. The London office has its own employees and solicits and processes orders. Corporation X maintains in the U.S. a separate set of books and records for all transactions conducted by the London office. Corporation X is a QBU under paragraph (b)(2)(i) of this section because of its corporate status. The London branch office is a QBU under paragraph (b)(2)(ii) of this section because (1) the sale of widgets is a trade or business as defined in paragraph (c) of this section; and (2) a complete and separate set of books and records (as described in paragraph (d) of this section) is maintained with respect to its sales operations.

Example 2. A domestic corporation incorporates a wholly-owned subsidiary in Switzerland. The domestic corporation is a manufacturer that markets its product abroad primarily through the Swiss subsidiary. To facilitate sales of the parent's product in Europe, the Swiss subsidiary has branch offices in France and West Germany that are responsible for all marketing operations in those countries. Each branch has its own employees, solicits and processes orders, and maintains a separate set of books and records. The domestic corporation and the Swiss subsidiary are both QBUs under paragraph (b)(2)(i) of this section because of their corporate status. The French and West German branches are QBUs of the Swiss subsidiary. They satisfy paragraph (b)(2)(ii) because each constitutes a trade or business (as defined in paragraph (c) of this section) and because separate sets of books and records (as described in paragraph (d) of this section) of their respective operations is maintained. Each branch is considered to have a trade or business although each is a geographical division of the same trade or business.

Example 3. W is a domestic corporation that manufactures product X in the United States for sale worldwide. All of W's sales functions are conducted exclusively in the United States. W employs individual Q to work in France. Q's sole function is to act as a courier to deliver sales documents to customers in France. With respect to Q's activities in France, a separate set of books and records as described in paragraph (d) is maintained. Under paragraph (c) of this section, Q's activities in France do not constitute a QBU since they are merely ancillary to W's manufacturing and selling business. Q is not considered to have a QBU because an individual's activities as an employee are not considered to constitute a trade or business of the individual under paragraph (c).

Example 4. The facts are the same as in example (3) except that the courier function is the sole activity of a wholly-owned French subsidiary of W. Under paragraph (b)(2)(i) of this section, the French subsidiary is considered to be a QBU.

Example 5. A corporation incorporated in the Netherlands is a subsidiary of a domestic corporation and a holding company for the stock of one or more subsidiaries incorporated in other countries. The Dutch corporation's activities are limited to paying its directors and its administrative expenses, receiving capital contributions from its United States parent corporation, contributing capital to its subsidiaries, receiving dividend distributions from its subsidiaries, and distributing dividends to its domestic parent corporation. Under paragraph (b)(2)(i) of this section, the Netherlands corporation is considered to be a QBU.

Example 6. Taxpayer A, an individual resident of the United States, is engaged in a trade or business wholly unrelated to any type of investment activity. A also maintains a portfolio of foreign currency-denominated investments through a foreign broker. The broker is responsible for all activities necessary to the management of A's investments and maintains books and records as described in paragraph (d) of this section, with respect to all investment activities of A. A's investment activities qualify as a QBU under paragraph (b)(2)(ii) of this section to the extent the activities engaged in by A generate expenses that are deductible under section 212 (other than that part of section 212 dealing with expenses incurred in connection with taxes).

Example 7. Taxpayer A, an individual resident of the United States, is the sole shareholder of foreign corporation (FC) whose activities are limited to trading in stocks and securities. FC is a QBU under paragraph (b)(2)(i) of this section.

Example 8. Taxpayer A, an individual resident of the United States, markets and sells in Spain and in the United States various products produced by other United States manufacturers. A has an office and employs a salesman to manage A's activities in Spain, maintains a separate set of books and records with respect to his activities in Spain, and is engaged in a trade or business as defined in paragraph (c) of this section. Therefore, under paragraph (b)(2)(ii) of this section, the activities of A in Spain are considered to be a QBU.

Example 9. Foreign corporation FX is incorporated in Mexico and is wholly owned by a domestic corporation. The domestic corporation elects to treat FX as a domestic corporation under section 1504(d). FX operates entirely in Mexico and maintains a separate set of books and records with respect to its activities in Mexico. FX is a QBU under paragraph (b)(2)(i) of this section. The activities of FX in Mexico also constitute a QBU under paragraph (b)(2)(ii) of this section.

Example 10. F, a foreign corporation, computes a gain of $100 from the disposition of a United States real property interest (as defined in section 897(c)). The gain is taken into account as if F were engaged in a trade or business in the United States and as if such gain were effectively connected with such trade or business. F is a QBU under paragraph (b)(2)(i) of this section because of its corporate status. F's disposition activity constitutes a separate QBU under paragraph (b)(3) of this section. [T.D. 8279, 55 FR 284, Jan. 4, 1990] Sec. 1.989(b)-1 Definition of weighted average exchange rate.

For purposes of section 989(b)(3) and (4), the term ``weighted average exchange rate'' means the simple average of the daily exchange rates (determined by reference to a qualified source of exchange rates described in Sec. 1.988-1(d)(1)), excluding weekends, holidays and any other nonbusiness days for the taxable year. [T.D. 8263, 54 FR 38664, Sept. 20, 1989. Redesignated by T.D. 8367, 56 FR 48437, Sept. 25, 1991; 57 FR 6060, Feb. 18, 1992; T.D. 9452, 74 FR 27890, June 11, 2009] Sec. 1.989(c)-1 Transition rules for certain branches of United Statespersons using a net worth method of accounting for taxable yearsbeginning before January 1, 1987.

(a) Applicability--(1) In general. This section applies to qualified business units (QBU) branches of United States persons, whose functional currency (as defined in section 985 of the Code and regulations issued thereunder) is other than the United States dollar (dollar) and that used a net worth method of accounting for their last taxable year beginning before January 1, 1987. Generally, a net worth method of accounting is any method of accounting under which the taxpayer calculates the taxable income of a QBU branch based on the net change in the dollar value of the QBU branch's equity over the course of a taxable year, taking into account any remittance made during the year. QBU branch equity is the excess of QBU branch assets over QBU branch liabilities. For all taxable years beginning after December 31, 1986, such QBU branches must use the profit and loss method of accounting as described in section 987, except to the extent otherwise provided in regulations under section 985 or any other provision of the Code.

(1) In general. This section applies to qualified business units (QBU) branches of United States persons, whose functional currency (as defined in section 985 of the Code and regulations issued thereunder) is other than the United States dollar (dollar) and that used a net worth method of accounting for their last taxable year beginning before January 1, 1987. Generally, a net worth method of accounting is any method of accounting under which the taxpayer calculates the taxable income of a QBU branch based on the net change in the dollar value of the QBU branch's equity over the course of a taxable year, taking into account any remittance made during the year. QBU branch equity is the excess of QBU branch assets over QBU branch liabilities. For all taxable years beginning after December 31, 1986, such QBU branches must use the profit and loss method of accounting as described in section 987, except to the extent otherwise provided in regulations under section 985 or any other provision of the Code.

(2) Insolvent QBU branches. A taxpayer may apply the principles of this section to a QBU branch that used a net worth method of accounting for its last taxable year beginning before January 1, 1987, whose $E pool (as defined in paragraph (d)(3)(i) of this section) is negative. For taxable years beginning on or after October 25, 1991, the principles of this section shall apply to insolvent QBU branches.

(b) General rules. For the general rules, see Sec. 1.987-5(b).

(c) Determining the pool(s) from which a remittance is made. To determine from which pool(s) a remittance is made, see Sec. 1.987-5(c).

(d) Calculation of section 987 gain or loss--(1) In general. See Sec. 1.987-5(d)(1) for rules to make this calculation.

(1) In general. See Sec. 1.987-5(d)(1) for rules to make this calculation.

(2) Step 1--Calculate the amount of the functional currency pools. For calculation of the amount of the functional currency pools, see Sec. 1.987-5(d)(2).

(3) Step 2--Calculate the dollar basis pools--(i) Dollar basis of the EQ pool--(A) Beginning dollar basis. The beginning dollar basis of the EQ pool (hereinafter referred to as the $E pool) equals the final net worth of the QBU branch. Final net worth of the QBU branch equals the QBU branch's equity value (assets less liabilities) measured in dollars at the end of the taxpayer's last taxable year beginning before January 1, 1987, determined on the basis of the QBU branch's books and records as adjusted according to United States tax principles.

(i) Dollar basis of the EQ pool--(A) Beginning dollar basis. The beginning dollar basis of the EQ pool (hereinafter referred to as the $E pool) equals the final net worth of the QBU branch. Final net worth of the QBU branch equals the QBU branch's equity value (assets less liabilities) measured in dollars at the end of the taxpayer's last taxable year beginning before January 1, 1987, determined on the basis of the QBU branch's books and records as adjusted according to United States tax principles.

(A) Beginning dollar basis. The beginning dollar basis of the EQ pool (hereinafter referred to as the $E pool) equals the final net worth of the QBU branch. Final net worth of the QBU branch equals the QBU branch's equity value (assets less liabilities) measured in dollars at the end of the taxpayer's last taxable year beginning before January 1, 1987, determined on the basis of the QBU branch's books and records as adjusted according to United States tax principles.

(B) Adjusting the $E pool. For adjustments to be made to the $E pool, see Sec. 1.987-5(d)(3)(i)(B).

(ii) Dollar basis of the post-86 profits pool. To calculate the dollar basis of the post-86 profits pool, see Sec. 1.987-5(d)(3)(ii).

(iii) Dollar basis of the equity pool. To calculate the dollar basis of the equity pool, see Sec. 1.987-5(d)(3)(iii).

(4) Step 3--Calculation of the dollar basis of a remittance. To calculate the dollar basis of the EQ remitted, see Sec. 1.987-5(d)(4).

(5) Step 4--Calculation of the section 987 gain or loss on a remittance. To calculate 987 gain or loss determined on a remittance, see Sec. 1.987-5(d)(5).

(e) Functional currency adjusted basis of QBU branch assets acquired in taxable years beginning before January 1, 1987. To determine the functional currency adjusted basis of QBU branch assets acquired in taxable years beginning before January 1, 1987, see Sec. 1.987-5(e).

(f) Functional currency amount of QBU branch liabilities acquired in taxable years beginning before January 1, 1987. To determine the functional currency amount of QBU branch liabilities acquired in taxable years beginning before January 1, 1987, see Sec. 1.987-5(f). [T.D. 8367, 56 FR 48437, Sept. 25, 1991]

Domestic International Sales Corporations