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The guidance for recognizing deferred taxes related to assets and liabilities of a foreign entity whose functional currency is the US dollar (rather than the local currency) depends on the nature of the individual foreign assets and liabilities as either monetary or nonmonetary. The guidance in TX 13.5.1 and TX 13.5.2 assumes that the functional currency of the foreign entity and its parent (as well as its parent’s reporting currency) is the US dollar. However, the same principles would apply in any circumstance in which a “foreign” subsidiary’s functional currency is the same as the ultimate parent’s functional and reporting currency.

13.5.1 Deferred taxes on foreign nonmonetary assets and liabilities

Deferred taxes are recognized under ASC 740 based on the assumption that assets will be recovered and liabilities will be settled at their carrying amounts. When a foreign operation has a US dollar functional currency, the carrying amounts of nonmonetary assets and liabilities (e.g., fixed assets, inventory) should be based on US dollar amounts that are derived using historical exchange rates (assuming the foreign entity maintains its books in a currency other than the functional currency).
The foreign tax basis of the asset would have been initially established when the asset was acquired and would have equaled the amount of foreign currency paid to acquire the asset. To be recorded in the US dollar functional currency, the amount would have been remeasured at the exchange rate in effect when the asset was acquired (i.e., the historical rate). The foreign tax basis, especially in hyperinflationary countries, may also be subject to indexing under the foreign tax law. As a result, for any nonmonetary asset, the temporary difference for financial statement purposes includes the following three components:
  1. The difference between the foreign tax basis, before any adjustment for indexing, and the US GAAP carrying amount on the local currency books (before remeasurement into US dollars)
  2. The difference created by changes in tax basis, if any, resulting from indexing provisions of the foreign tax law
  3. The difference arising in remeasurement (i.e., the difference between nonmonetary assets remeasured at the historical rate for financial statement purposes and the tax basis at the current rate)
Under ASC 740-10-25-3(f), an exception to the general recognition of deferred taxes precludes recognition of deferred taxes for the second and third components.

Excerpt from ASC 740-10-25-3(f)

A prohibition on recognition of a deferred tax liability or asset for differences related to assets and liabilities that, under Subtopic 830-10, are remeasured from the local currency into the functional currency using historical exchange rates and that result from changes in exchange rates or indexing for tax purposes. See Subtopic 830-740 for guidance on foreign currency related income taxes matters

Thus, for fixed assets, when the US dollar is the functional currency, deferred taxes should be computed in the local currency by comparing the historical book and tax bases in the local currency after the respective depreciation, but before any indexing for book or tax purposes. The local currency deferred tax is then remeasured into US dollars using the current exchange rate with the resulting remeasurement impact recorded to the income statement. Any additional tax depreciation on the current period return that results from indexing will reduce the current tax provision and the foreign effective tax rate as there is no corresponding amount in pre-tax book income.
In many instances, net operating loss carryforwards in these jurisdictions are also indexed for inflation. The impact of indexing the NOLs should be recognized in the financial statements and the tax loss reported on the tax return should be used to calculate the NOL upon which a deferred tax asset is reported. Because ASC 830-10-45-18 does not regard deferred tax assets and liabilities as items that must be remeasured using historical exchange rates, we believe the prohibition in ASC 740-10-25-3(f) does not apply. In jurisdictions employing indexation for tax purposes, a foreign entity’s tax return will use indexed tax bases for nonmonetary assets to calculate tax deductions that may increase the NOL upon which a deferred tax asset is reported. We do not believe that it is practicable to determine the portion of prior tax losses that are attributable to indexing nonmonetary assets. Thus, the entire amount of the indexed foreign currency NOLs should be recognized as a deferred tax asset and remeasured using current exchange rates. Such deferred tax assets should then be evaluated for realization as required by ASC 740.
Example TX 13-1 illustrates the deferred tax accounting for nonmonetary assets.
EXAMPLE TX 13-1
Foreign subsidiary with US dollar functional currency
A foreign subsidiary with a US dollar functional currency purchased manufacturing equipment for 5,000 euro at the start of 20X1, when the euro-US dollar exchange rate was 5 to 1. The asset is depreciated on a straight-line basis over ten years for financial reporting purposes and over five years for tax purposes. The applicable foreign tax law does not include indexing. The exchange rate increases to 7 to 1 in 20X3.
What portion of the temporary difference gives rise to deferred taxes?
Analysis
Deferred taxes should only be provided on the difference between the euro tax basis and the euro equivalent of the US dollar book basis, both remeasured at the current exchange rate. Consistent with ASC 740-10-25-3(f), deferred taxes should not be provided on the remaining difference that is attributable to changes in the exchange rate since the time of the asset’s acquisition (i.e., the difference between the current exchange rate and the historical exchange rate at the date of the asset’s acquisition). The temporary differences and the portion of the temporary difference that gives rise to deferred taxes are calculated as follows:
Foreign currency
Tax basis
Book basis before remeasurement
US dollar book basis
US dollar book basis in local currency (at current rate)
Year 2
Exchange rate: €5 = $1 (no change in 20X1 or 20X2)
Cost
€5,000
€5,000
$1,000
Accumulated depreciation
(2,000)
(1,000)
(200)
Tax/book basis
€3,000
€4,000
$800
€4,000
Temporary difference
€1,000
Recognized under ASC 740
€1,000
Year 3
Exchange rate: €7 = $1
Cost
€5,000
€5,000
$1,000
Accumulated depreciation
(3,000)
(1,500)
(300)
Tax/book basis
€2,000
€3,500
$700
€4,900
Temporary difference
€2,900
Recognized under ASC 740
€1,500
The temporary differences recognized under ASC 740 would be measured at the applicable foreign tax rate and remeasured into the functional currency (US dollar) at the current exchange rate.
In 20X3, there is a total temporary difference of €2,900. This is the difference between the tax basis of the asset and the future foreign currency revenues at the current exchange rate needed to recover the functional currency book basis. The temporary difference of €2,900 has arisen from two sources:
  • The difference between US GAAP book depreciation in the foreign currency before remeasurement and tax depreciation. This element, which is a temporary difference of €1,500, is recognized under ASC 740. After applying the foreign tax rate to this temporary difference, the local currency deferred tax liability would be remeasured at the current exchange rate into US dollars for inclusion in the functional currency financial statements.
  • The change in the exchange rate that changes the foreign currency equivalent of the functional currency book basis, using the current exchange rate. In this example, it increases the temporary difference by €1,400, (€4,900 vs. €3,500). This element is not recognized in the financial statements under the exception of ASC 740-10-25-3(f).

13.5.2 Deferred taxes on foreign monetary assets and liabilities

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.
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 remeasured 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?
Analysis
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.
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