Suppose your client decides to invest in the stock of a European company that is not traded in the United States. How would he report the transactions for tax purposes?
Suppose your client decides to invest in the stock of a European company that is not traded in the United States. How would he report the transactions for tax purposes?
Clients may come to you seeking advice on such matters, so let's take a look at a hypothetical series of transactions in connection with such a purchase and see what happens.
First, let's assume the client deposits $10,000 into his brokerage account on Jan. 2.
The next day, that sum is converted into 6,820 euros, at a rate of 1 euro = $1.4659. On Jan. 4, the client purchases approximately 682 shares of stock in Euro SA at 10 euros per share. The exchange rate in effect at the time of the purchase is 1 euro = $1.4726. When the purchase settles three days later, the exchange rate is 1 euros = $1.4748.
On Jan. 5, however, the client sells all his shares at 15 euros per share, resulting in a net gain of 5 euros per share (the exchange rate at the trade date is 1 euro = $1.37800 and the exchange rate at the settlement date of the sale three days later is 1 euro = $1.35740).
At the end of the year, the client cashes out of his brokerage account and converts his euro-denominated holdings back into dollars at the rate of 1 euro = $1.40520. The client asks for your advice on the tax treatment/reporting of these transactions during the year.
Solution: Taxpayers must express the amounts reported on a U.S. tax return in dollars. This means that if they received all or part of their income in foreign currency, they must translate the foreign currency into dollars. As such, in order for your client to report the gain from the sale of the various European stock transactions on his or her U.S. federal income tax return, he must convert the gain determined and reported in euros into dollars on the basis of the foreign exchange rates prevailing at the time the income is actually or constructively received.
Additionally, your client has a possible gain/loss because of the disposition of non-functional currency, which is the euro in this particular case. Internal Revenue Code Section 988 provides that a non-functional currency is treated as property other than money, having a basis (usually cost) in the functional currency, and gain or loss on the disposition is exchange gain or loss. When a non-functional currency is used to purchase property such as stock, the currency is deemed exchanged for functional currency (dollars) immediately before the purchase of the property, and the payment is deemed made in the functional currency.
Also, Regulations Section 1.988-2(a)(2)(iv)(A) provide that when a cash method taxpayer, which is the case of your client, receives non-functional currency on the purchase and/or sale of publicly traded stock, the amount realized is computed by translating the units of non-functional currency into functional currency at the spot rate on the settlement date, even though the realization events occurs on the trade date.
In this case, the client's transactions during the year are broken down into following transactions:
First, there is a deemed exchange of the units of non-functional currency (euros) for units of functional currency (dollars) at the spot rate on the date the European stock is settled. In computing your client's exchange gain on the disposition of the 6,820 euros, the realized foreign currency gain is $61 = [($1.47480 - $1.46590) x 6,820 euros.] The adjusted cost base of European company shares is $10,058 = (10 euros x 682 x $1.47480).
If we subtract the adjusted cost basis from the proceeds of the disposition (which is $13,886, or 15 euros x 682 x $1.35740, we are left with a taxable short-term capital gain of $3,828.
When the client converted the euros back to dollars at the end of the year, he also realized a foreign currency gain of $489 [($1.40520 - $1.35740) x the 10,230 euros, the proceeds from the disposition].
In summary, the taxpayer has three transactions that he should report on his tax return. First, there is a capital gain transaction (converted into dollars) to report on Schedule D from the sale of the European stock. Then there are the two foreign currency conversions that resulted in ordinary gains.
