Foreign Currency Translation Part II

Temporary Differences (when the U.S. Dollar is the Functional Currency)

Under Statement 52, the functional currency is the currency of the primary economic environment in which the foreign subsidiary operates. Although the local currency is the functional currency for many foreign operations, some subsidiaries' functional currency is the U.S. dollar because those operations are primarily an extension of the U.S. parent. Also, if the cumulative three-year inflation rate in the foreign country is approximately 100 percent or more, the U.S. dollar is assumed to be the functional currency.

When a foreign entity uses the U.S. dollar as its functional currency, assets such as inventory, land, and depreciable assets are remeasured into dollars at historical exchange rates.

When exchange rates change, the amount of foreign currency revenues needed to recover the U.S. dollar cost of those assets also changes-but the foreign currency tax basis of those assets does not change. (In certain countries, particularly those with hyperi inflationary economies, however, the tax bases of such assets may be revalued in line with inflation as discussed later in this Section.) Following changes in exchange rates, there will be differences between (a) the amount of foreign currency needed to recover the U.S. dollar cost of those assets and (b) the foreign currency tax bases of those assets. Those differences are referred to as «Statement 52 differences.»

Statement 96 required deferred taxes be provided on those differences because such differences would be taxable or deductible for foreign tax purposes when the reported amounts of the related assets were recovered. During deliberations preceding the issuance of Statement 109, the FASB acknowledged that technically those differences meet the definition of a temporary difference. However, the FASB concluded that the substance of this accounting would be to recognize deferred taxes on exchange gains and losses that are not recognized under Statement 52. As a result, the FASB decided to resolve the conflict between the requirements of Statements 96 and 52 by prohibiting recognition of deferred taxes due to exchange rate changes.

The decision to prohibit recognition of deferred taxes for such differences represents a major change from Statement 96. In this regard, the FASB concluded that a change in exchange rates is not an event that should give rise to recognition of a deferred tax asset or liability-notwithstanding the temporary difference that theoretically results. The FASB believes this decision will reduce complexity by eliminating cross-currency (U.S. dollar cost versus foreign tax basis) computations of deferred taxes for those differences.

It is important to note that while there are no deferred taxes relating to Statement 52 differences, deferred taxes must be provided for differences between the foreign currency financial reporting amount and the foreign currency tax bases of assets and liabilities. A comparison of deferred tax calculations under Statements 109 and 96 follows.

Example. Assume that a foreign operation of a U.S. parent purchased fixed assets in 1991 costing FC1,000 when the exchange rate was FC1 = $1. Beginning in 1992, the assets are amortized on a 5 year straight-line basis for tax purposes and on a 10 year straight-line basis for financial reporting purposes. The foreign tax rate is 50% and the exchange rate at December 31, 1992 is FC1 = $0.80. The U.S. dollar is the functional currency. For simplicity, U.S. deferred tax consequences are ignored. Deferred taxes at December 31, 1992 would be computed in accordance with Statement 109 as follows:

Difference between the foreign currency book and tax basis of fixed assets

Under Statement 109, deferred taxes are provided for temporary differences between the foreign currency book and tax basis of assets and liabilities. In this example, the original cost of the assets is FC1,000 and book accumulated depreciation would be FC100 at December 31, 1992, assuming straight-line depreciation over a 10-year life. Accumulated depreciation for tax purposes is 20% of the tax basis, or FC200. The FC100 resulting taxable temporary difference is multiplied times the 50% foreign tax rate to arrive at the deferred foreign tax liability of FC50, which equals $40 when remeasured in U.S. dollars.

In contrast, deferred taxes at December 31, 1992 under Statement 96 would have been computed as follows:

* U.S. dollar historical cost amount divided by the $0.80 year end exchange rate.

The $90 difference ($130 under Statement 96 – $40 under Statement 109) between the deferred tax liability calculations in the example above represents the tax effect (50% foreign tax rate) of exchange rate changes on the foreign currency (FC1,125 – FC900 = FC225) that do not give rise to a deferred tax liability under Statement 109. In other words, the tax effect on the changes in the foreign currency amounts caused by exchange rate changes and by using the U.S. dollar as the functional currency (FC 225 x 50% x.80=$90) are not provided for under Statement 109 but were recorded under Statement 96.

This example illustrates the significance of the change in regard to exchange rate fluctuations in the calculation of deferred taxes comparing Statements 109 and 96 when the U.S. dollar is the functional currency. In applying Statement 96, several companies had found that volatile exchange rate movements could produce significant deferred tax effects-especially in highly-inflationary economies. In response to concerns about the meaningfulness of such an approach, the FASB decided to prohibit recognition of deferred taxes for those differences.