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13.6 Tax accounting—change in functional currency
Publication date: 31 Mar 2023
us Income taxes guide
The US federal income tax law concept of functional currency is rooted in the financial accounting concept. IRC Section 985 allows functional currency for US tax purposes to be determined in accordance with financial accounting in certain circumstances. Nonetheless, the timing of the recognition of the effects of a change can differ for book and tax purposes. For US federal tax purposes, a change in functional currency is a change in accounting method. The resulting adjustments generally are computed as of the last day of the taxable year prior to the year of change. However, there are certain circumstances where a change in functional currency occurs during the taxable year and the resulting adjustments are made the day before the effective day of the change. Depending on the circumstances, tax adjustments may include recognition of exchange gains or losses and the effects on the tax basis of assets and liabilities. Such adjustments may have direct tax consequences (e.g., branch operations) or the effects may only arise through E&P adjustments (e.g., foreign subsidiaries).
Refer to FX 3.3 for guidance on the financial statement accounting for a change in functional currency.
13.6.1 Tax accounting—highly inflationary economies
A currency in a highly inflationary economy is not considered stable enough to serve as a functional currency. As a result, ASC 830 requires that a foreign entity in a highly inflationary economy change its functional currency to the reporting currency. Generally, we believe the reporting currency is the functional currency of the entity’s immediate parent (see FX 6.3). This may have the effect of discontinuing the recording of CTA and instead recording gains and losses on monetary assets and liabilities in earnings. Translation adjustments from prior periods are not removed from equity and the translated amount for nonmonetary assets at the end of the prior period become the accounting bases of those assets upon transition.
When the functional currency is the reporting currency, ASC 740-10-25-3(f) prohibits recognition of deferred tax effects that result from indexing, for tax purposes, assets and liabilities that are remeasured into the reporting currency using historical exchange rates. Deferred tax effects that were recognized for indexing before the change in functional currency to the reporting currency are eliminated when the related indexed amounts are realized as deductions for tax purposes. Prospectively, deferred tax assets should not be recorded for future indexation consistent with the prohibition in ASC 740-10-25-3(f). Thus, tax effects attributable to any such indexing that occurs after the change in functional currency to the reporting currency are recognized when realized on the tax return.
13.6.2 Tax accounting—economy no longer highly inflationary
When an economy is no longer highly inflationary and, as a result, the local currency is reinstated as the functional currency, existing balances in the reporting currency are translated at the current exchange rate at the date of change. The translated amounts become the new functional currency bases going forward. The effects of future exchange rate movements are reflected through the overall consolidation process.
When the reporting currency is the functional currency, ASC 740 does not permit the recording of deferred taxes for the portions of the temporary differences that result from the remeasurement of nonmonetary items and from tax indexing. However, once ASC 830-10-45-15 has been applied, these portions become part of the temporary differences between the new functional currency book bases of nonmonetary items and their tax bases adjusted for any indexing. The temporary differences for nonmonetary items are not changed, but the ASC 740 exception for portions of the differences no longer applies. As such, there is likely to be an effect on deferred taxes even though there is no effect of the change in functional currency on the consolidated carrying amount of nonmonetary items. ASC 830-740-45-2 requires that deferred taxes associated with the temporary differences that arise from a change in functional currency when an economy ceases to be considered highly inflationary are reflected in CTA.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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