SECTION 2. BACKGROUND

Generally, a taxpayer and each QBU must make all determinations under subtitle A of the Code in its respective functional currency. Treas. Reg. § 1.985–1(a)(1). For taxable years beginning after August 24, 1994, a U.S. corporation’s QBU that would otherwise be required to use a hyperinflationary currency as its functional currency generally must use the dollar as its functional currency and must compute income or loss under the DASTM method of accounting described in § 1.985–3. See Treas. Reg. § 1.985–1(b)(2)(ii).

Under the DASTM method of accounting, a QBU’s income or loss for a taxable year is computed in U.S. dollars and adjusted to account for its DASTM gain or loss. See Treas. Reg. § 1.985–3(b). A QBU’s DASTM gain or loss for a taxable year is determined under Treas. Reg. § 1.985–3(d) by first computing the QBU’s change in net worth from the prior year and then making specified adjustments. The QBU’s change in net worth is computed by comparing the year-end balance sheets for the current and preceding taxable years. See Treas. Reg. § 1.985–3(d)(1)(i). Special rules provide that some balance-sheet items are translated at the exchange rate for the translation period in which the cost of the item was incurred and so do not give rise to DASTM gain or loss from year to year (“historical items”). See Treas. Reg. § 1.985–3(d)(5). Other items are translated at the exchange rate for the last transla

tion period for the taxable year and therefore do give rise to DASTM gain or loss (“current items”). See id . The classification of an item as historical or current generally reflects the extent to which the item’s dollar value changes with fluctuations in exchange rates. For example, the value of a financial asset, such as a unit of hyperinflationary local currency, necessarily changes with fluctuations in exchange rates. Accordingly, a financial asset generally is a current item. See Treas. Reg. § 1.985–3(d)(5)(iv). By contrast, the value of a nonfinancial asset generally does not change with fluctuations in exchange rates. Accordingly, a nonfinancial asset generally is an historical item. See Treas. Reg. § 1.985–3(d)(5)(v). In a hyperinflationary environment, currency exposure with respect to a financial asset typically is expected to give rise to loss.

The computed change in the QBU’s net worth is then adjusted to reflect transactions that increase or decrease the QBU’s net worth without affecting the QBU’s income or loss. For example, an asset transferred from a QBU branch to its home office decreases the QBU’s net worth but does not affect the QBU’s income or loss and so must be added back to the QBU’s net worth for purposes of computing DASTM gain or loss. See Treas. Reg. § 1.985–3(d)(3).

A rule is required for translating the amount of any such adjustment into dollars. The DASTM method of accounting provides that adjustments generally shall be translated into dollars at the exchange rate on the date the amount is paid. Treas. Reg. § 1.985–3(d)(3). This rule ensures that the QBU branch properly takes into account a current item’s change in value due to currency fluctuations while the item was in the QBU branch. However, because historical items do not give rise to DASTM gain or loss, applying the existing translation rule to an adjustment relating to an historical item would inappropriately give rise to DASTM gain or loss.