Understanding Section 988: Foreign Currency Transactions and Tax Implications

What Is Section 988?

Section 988 of the Internal Revenue Code governs the taxation of gains and losses from investments or transactions in foreign (nonfunctional) currencies. This provision is essential for determining how both individuals and corporations report capital gains or losses resulting from currency fluctuations.

Enacted after Dec. 31, 1986, Section 988 ensures that profits or losses arising from exchange movements are properly accounted for under U.S. tax law. Its application spans a range of real-world scenarios, from multinational corporations managing overseas income to individual investors trading foreign currencies, which this article explores in greater detail.

Understanding the Functionality of Section 988

Per rules of the Internal Revenue Code (IRC), gains or losses must be recognized at the time of sale or disposition of a foreign currency-denominated capital asset. In addition, most gains from foreign currency transactions are to be treated as ordinary income, whether earned by an individual or a corporation. Gains and losses not necessarily related to foreign exchange fluctuation from these transactions are typically viewed outside of any gain or loss due to exchange rate changes between the U.S. dollar and the foreign currency.

Section 988 transactions are nonfunctional currency transactions that generally give rise to functional currency gain or loss. (Note that a taxpayer’s functional currency is the US Dollar, except stated otherwise in the code and regulations). Section 988 regulation provides that the foreign currency element of a transaction must be computed and taken into account separately from the gain or loss on the underlying transaction. The gain or loss attributed to the foreign currency is treated as ordinary income. For instance, a debt holder can have a gain or loss on their underlying position if interest rates or the credit rating of the issuer of the debt instrument changes. Section 988 transactions involve foreign bonds, foreign currency expenses or receipts, and instruments like options, forward contracts, and futures in nonfunctional currency. If there is gain or loss on the underlying transaction, as well as offsetting foreign currency loss or gain, the two should be netted; only the excess foreign currency loss or gain, if any, should be reported separately under Section 988(a)(1)(A). 

Examples of Section 988 Transactions

For instance, if a U.S. bank issues a bond that is denominated in the euro, it is considered a 988 transaction. Foreign currency gain or loss on a 988 transaction is treated as ordinary income or loss unless an election is made to treat it as a capital gain or loss. For instance, if an investor makes an election before the transaction is entered into, they may be able to classify the gain or loss on a specific investment as a capital gain rather than ordinary income. This most often applies to forward contract transactions, options, and futures.

The Bottom Line

Section 988 governs the U.S. tax treatment of gains and losses from investments or transactions in foreign (nonfunctional) currencies, ensuring they're properly reported. Under this rule, most gains from foreign currency fluctuations are treated as ordinary income, rather than capital gains, which can significantly impact tax liabilities.

Section 988 applies to a wide range of financial instruments, including foreign bonds, options, forward contracts, and futures contracts denominated in foreign currencies.

Taxpayers generally must net any gains or losses from currency fluctuations against the underlying transaction before reporting. However, investors can elect to treat certain foreign currency gains or losses as capital gains or losses under specific conditions, a valuable option for strategic tax planning.