An entity located and taxed in a foreign jurisdiction that has the US dollar as its functional currency may have monetary assets and liabilities denominated in the local currency. When there is a difference between the local currency tax basis and the local currency US GAAP book basis, a temporary difference would be recognized in the financial statements. The local currency is typically the currency used to prepare the income tax return in the foreign jurisdiction. When the monetary item is denominated in local currency, changes in exchange rates do not have tax consequences in the foreign jurisdiction and do not create basis differences between the local currency financial statement carrying amounts and the local currency tax basis provided that for local tax purposes, local currency is the functional currency. While the effects of changes in the exchange rate would give rise to transaction gains or losses in the functional currency financial statements, the resulting change in the functional currency financial statement carrying amounts generally will not result in the recognition of either current or deferred taxes in the foreign jurisdiction.

However, such an entity may have monetary assets and liabilities that are denominated in currencies other than the local currency, such as US dollar denominated items. Gains or losses from such foreign currency transactions may be taxable either in the local country or in a foreign country based on the applicable tax law. If these gains and losses are included in taxable income in a period that differs from the period in which they are included in income for financial reporting purposes, a deferred tax liability or asset would need to be recorded consistent with ASC 830-20-05-3.

A common example is a foreign subsidiary’s intercompany payables denominated in US dollars. If the entity will be taxed on the difference between the original foreign currency asset or liability and the amount at which it is ultimately settled, there would be a temporary difference for the monetary asset or liability. That difference would be computed by comparing the book basis in the local currency (i.e., the carrying amount in US dollars in the financial statements translated into the local currency at the current exchange rate) with the tax basis in the local currency. After application of the applicable tax rate to the temporary difference, the deferred tax would be remeasured at the current exchange rate into US dollars for inclusion in the functional currency financial statements.

This process will cause a deferred tax asset or liability to be recognized as the exchange rate (between the foreign currency and local currency) changes. Accordingly, changes in the exchange rate between the US dollar and the local currency can give rise to a deferred tax, even though there is no pretax exchange rate gain or loss in the functional currency financial statements. In some jurisdictions, changes in the exchange rate would have current tax consequences, as illustrated in Example TX 13-2.

EXAMPLE TX 13-2
Foreign subsidiary with US dollar functional currency and unrealized foreign exchange gains/losses on intercompany loans

Company P is a multinational company domiciled in the US with a wholly-owned subsidiary (“Sub”) in Country B where the local currency is the euro. Company P prepares US GAAP consolidated financial statements in US dollars. Sub has concluded that its functional currency is also the US dollar, and, therefore, has decided to maintain its books and records in US dollars. Thus, Sub has no need to remeasure its assets, liabilities, revenues, and expenses from local currency to some other functional currency for financial reporting purposes. However, under the provisions of the tax law in Country B, Sub must file its tax return in local currency, the euro. Sub has a US dollar-denominated intercompany payable to Company P in the amount of $30 million.

The tax law of Country B recognizes gains and losses from foreign currency-denominated receivables and payables only upon settlement (i.e., unrealized gains and losses are not included in taxable income until the period in which the asset or liability settles and the gain or loss becomes realized). Since the intercompany loan is denominated in US dollars, there is no pre-tax accounting under ASC 830 for unrealized transaction gains/losses at each reporting date. However, for purposes of Sub’s tax filing in local currency, foreign exchange gains/losses will be reported on the tax return when the liability is settled.

Do the unrealized foreign exchange gains/losses result in a temporary difference under ASC 740?

Yes. The unrealized foreign exchange gains/losses that are not currently taxable will be taxable when the liability is settled. Therefore, unrealized foreign exchange gains/losses that arise upon remeasurement of the intercompany loan to local currency for tax reporting purposes should be treated as a temporary difference. 

An understanding of the applicable tax law in the relevant jurisdiction is important in determining the accounting for the income tax effects of such unrealized gains/losses. In this particular fact pattern, the tax law of Country B requires that such gains/losses be included in taxable income in the period in which the liability is settled. In some jurisdictions, however, the law instead would require taxation when the exchange gains/losses arise. In those circumstances, because the tax effects would be incurred and recognized as part of each period’s current tax provision, a temporary difference would not exist and a deferred tax asset/liability would not be required.