Imagine you are an American taxpayer living overseas. Like so many other Americans you are facing financial hardships wrought by COVID-19. You have a car loan you cannot pay and mounting credit card debt. Like an angel from above, your creditors agree to forever forgive some of the amounts you otherwise owe them. You cannot believe your good fortune and feel as if you are in heaven…. That is, until the taxman comes calling. Suddenly, instead of feeling richer, you realize you are a lot poorer because you owe Uncle Sam tax dollars on income you never put in your pocket. Here’s the scoop….
“Fake” Income When Debt is Forgiven
My earlier blog post explained how generally, under the US tax laws, if a taxpayer is in default with a creditor and the parties reach an agreement such that the taxpayer can resolve the debt for less money than was originally owed, the amount that is “forgiven” is treated as “income” from the cancellation of indebtedness. As discussed in the earlier blog post, there is a temporary tax break for debt associated with the personal home, but not to any other kind of debt.
This is very unfortunate because the economic fallout from COVID-19 has led to the loss of jobs and the concomitant inability to make payments on loans and credit cards. Some creditors are extending a helping hand and forgiving some of the debt otherwise owed. Unfortunately, no tax break exists for these other types of debt forgiveness and the forgiveness results in “phantom” or “fake” income to the US taxpayer.
Here is a simple example of the concept and how taxable income can arise even if an individual is in dire financial straits: Assume a taxpayer owed US$7,000 on a credit card, but due to COVID-19 the taxpayer loses his job and is not able to pay the full amount due. Assume the creditor agrees to settle the debt for US$4,000 instead. According to Uncle Sam, this taxpayer will now have US$3,000 of taxable income – the amount of debt his creditor cancelled. Here is Uncle Sam’s way of thinking: the taxpayer is US$3,000 “richer” because he gets to keep a sum of money, that he was otherwise legally obligated to pay. Under the US tax laws, Section 61(a) of the Internal Revenue Code defines gross income as “all income from whatever source derived…” So, the cancellation of the debt results in gross income for tax purposes.
For the US person abroad, the tax hit can be even more harsh due to various tax law rulings and the provisions of Internal Revenue Code Section 988 which deal with foreign currency gains and losses. There may be income from the discharge of indebtedness and income from the foreign currency exchanges that are deemed to occur with the loan forgiveness assuming the loan is denominated in a foreign currency. Some detail about Section 988 is in my earlier blog post, but for those who have not read the post, below follows a brief overview.
Internal Revenue Code Section 988
IRC Section 988 is a highly complex provision. Understanding some basic principles will help. First, under the US tax rules, foreign currency is not viewed as “money”; it is viewed as personal property. The reader should think of foreign currency as any other asset such as company stocks, jewelry or cars. The second helpful point to remember is that in the case of US individuals, a so-called “nonfunctional” currency is any currency other than the US dollar. This remains the case even if the taxpayer is living abroad and using a “foreign” currency on a daily basis to meet daily needs.
Section 988 provides that any foreign currency gain or loss attributable to a “Section 988 transaction” is computed separately from the underlying transaction. Gain from a section 988 transaction is treated as ordinary income (i.e., there is no capital gain treatment) and loss is treated as an ordinary (not capital) loss. In general, Section 988 transactions include any disposition of any “nonfunctional currency” or becoming the obligor under a debt instrument when the amount that the taxpayer is required to pay is denominated in terms of a nonfunctional currency. Thus, when the debt is denominated in foreign currency, the provisions of Section 988 can apply and can possibly result in foreign currency gain on the income that was forgiven. So, while the individual may be desperate for cash in real life, he is treated as having taxable income as far as the taxman is concerned.
“Personal Transactions” Excluded
Certain types of transactions are excluded from application of section 988. Among them is an exception embodied in IRC Sec 988(e)(2)(B) for certain “personal transactions”. A personal transaction is generally any transaction other than a transaction which is a trade or business expense or an expense incurred in a ‘for profit’ activity. This exception applies only to gains, and only if the gains do not exceed US $200.
Unfortunately, the tax law is very confusing on this exception and issues related to it. There is scant statutory guidance applicable to the individual taxpayer with foreign currency transactions that are of a personal nature (as opposed to having a business or investment nature). Most personal transactions of individuals involving foreign currency are governed by the laws established before the enactment of Section 988. When dealing with personal transactions of an individual, gain realized on the disposition of a “nonfunctional currency” by an individual in a personal transaction is not recognized (i.e., it is essentially ignored for US tax purposes) if the gain which would otherwise be recognized on the transaction does not exceed US$200. When the gain exceeds US$200, however, the tax laws will result in a consequence to the taxpayer and it appears to me as well as to other commentators, that the transaction is governed by the laws established before enactment of IRC section 988. This prior law however is very confusing!
Before enactment of section 988, the courts had very few cases involving income from the discharge of indebtedness when the debt was denominated in a foreign currency. Foreign currency was treated as property and, the courts sometimes considered gains or losses from sales of foreign currency as ordinary rather than capital, if the courts adopted what was known as the “Corn Products Doctrine” or if they found an absence of the “sale or exchange” required for capital treatment. On the other hand, sometimes capital gain resulted in such transactions. In all events, gain or loss from currency exchange was treated separately from any gain or loss on the underlying transaction.
With the enactment of Code Section 988, gains and losses from foreign currency transactions are classified as ordinary income or loss. However remember there is the carve out for “personal transactions”, leaving some confusion as to the application of prior law. Readers with greater interest in this messy area can look to Frewing, Scott, “Foreign Currency Gains and Income from Discharge of Indebtedness: Philip Morris, Inc. v. Commissioner”, The Tax Lawyer Vol. 49, No. 2 (Winter 1996), pp. 491-503.
Example: The American Abroad
Let’s take an example of how the US tax law might work for a typical expatriate. Assume a US taxpayer living in Switzerland buys a car there for 60,000 Swiss francs (CHF) when the exchange rate was $1.20 to CHF1; USD cost $50,000. (For those who, like me, struggle with numerical concepts it will help to understand this in the following way – In order to buy 1 Swiss franc, you had to pay US$0.833 [CHF1/US$ 1.20].) Assume the taxpayer finances the car purchase with a personal loan from a finance company for CHF30,000, also converted at US$1.20 to CHF1 (US$25,000). Let us assume that no principal was repaid, and the car was later repossessed due to the buyer’s default in payments, and sold at auction for CHF10,000 when the exchange rate was $0.90 to CHF1 (US$11,111; in order to buy 1 Swiss franc, you had to pay US$1.11[CHF1/US$0.90].) ). Assume further that at the same exchange rate, the lender forgave the CHF20,000 shortfall (US$22,222).
What is the US tax impact to the American abroad? (HINT: it is confusing and it is not good).
In this example there are various separate tax transactions to be examined:
- First, with respect to the sale at auction, the taxpayer has a capital loss on the forced sale of the car, but because this is a personal asset, the tax law prohibits the taxpayer from claiming this loss on his tax return.
- Second, with respect to the amount that is repaid on the loan, it is possible that the taxpayer may be considered to have a foreign currency loss of US$2,778. Recall that the creditor was repaid through a sale of the car at auction, where it sold for CHF10,000 (the USD value of which at that time was US$ 11,111). The USD value of CHF 10,000 at the time the loan was made, however, was only US$ 8,333. So the debtor-taxpayer had to use US$11,111 to repay the creditor on an amount that at the time of borrowing had a value of only US$8,333. If this is treated as a capital loss, it could be used to offset capital gains, but it is possible in this instance that the loss will be completely denied as a “personal loss”. See e.g., Rul. 90-79, 1990-2 C.B. 187 (nicely discussed by Andrew Mitchell here).
- Third, this US taxpayer abroad has forgiveness of indebtedness income. Since this is a personal transaction, Section 988 should not apply and I think we look at the USD value of the shortfall. This would be in the amount of US$22,222 (the USD amount of shortfall of CHF20,000 what would otherwise be owed by the taxpayer to the creditor). This income may be taxed at ordinary income rates (current maximum 37%).
- Fourth, there is something more, but this generates confusion. It appears to me that the taxpayer will have a foreign currency gain of US$5,554 with respect to the CHF20,000 forgiven. At the time of the debt forgiveness, CHF 20,000 had a USD value of US$22,222; at the time the loan was originally made CHF 20,000 had a USD value of US$16,668 resulting in foreign currency gain to the taxpayer of US$5,554. This might be treated as a capital gain. On the other hand if treated as forgiven debt rather than as foreign currency gain, it can be treated as ordinary income.
The example illustrates how the US taxpayer abroad faces complexity and unexpected tax consequences on the most simple transaction, a transaction that we will be seeing far more frequently as collateral damage resulting from the notorious COVID-19. Here, the taxpayer has a loss on the car that he cannot claim on his tax return, yet, with respect to the repossession and subsequent sale of the car, the Internal Revenue Service may determine that he has a foreign currency gain and income from the discharge of indebtedness. The taxpayer has no car and furthermore, he has no cash in hand as a result of the transaction, so any deemed income is “fake” income to the taxpayer. Real income to the taxpayer = US$ 0; cost for tax compliance to figure all this out = $$$$$.
Ignorance is Bliss?
Many tax return preparers are simply not aware of the tax rules when it comes to properly reporting foreign currency exchange gains and losses. This can lead to serious problems with the tax return, especially if there are currency gains that are significant. The tax principles at play have been around for a long time, but many tax practitioners are simply unaware of the rules or how they can impact the American abroad since such individuals deal with what the tax law treats as “foreign currency”, all the time. There needs to be some kind of carve-out for the American abroad for whom this “foreign” currency is really NOT “foreign” at all, but merely a part of everyday life in the country of residence. Until that happens, the hapless American overseas will have expensive and burdensome tax compliance duties and in many cases will have to pay real tax dollars on fake income.
Posted December 17, 2020
Virginia - US TAX TALK 