What Is Section 988?
Section 988 is a tax regulation governing capital losses or gains on investments held in a foreign currency. A Section 988 transaction relates to Section 988(c)(1) of the Internal Revenue Code, which went into effect after Dec. 31, 1986.
How Section 988 Works
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 include the acquisition of foreign bonds (which have their interest and principal in a domestically "nonfunctional" currency), accrued expenses or receipts in a foreign currency, options, forward contracts, futures contracts, or similar instruments denominated in any 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).
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.