PRIA Logo™
Title 26, Internal Revenue CodeRelease 119-110

§986 Determination of Foreign Taxes and Foreign Corporation’s Earnings and Profits

Title 26 › Subtitle A — Income Taxes › CHAPTER 1 — NORMAL TAXES AND SURTAXES › Subchapter N — Tax Based on Income From Sources Within or Without the United States › PART III — INCOME FROM SOURCES WITHOUT THE UNITED STATES › Subpart J — Foreign Currency Transactions › § 986

Last updated Sep 22, 2026|Official source

Summary

When you claim a foreign tax credit and you use accrual accounting, you must convert foreign income taxes and any adjustments into U.S. dollars using the average exchange rate for the taxable year those taxes relate to. That average-rate rule does not apply if the tax is paid more than 2 years after the end of that taxable year, paid before the taxable year starts, or if the tax liability is in an inflationary currency (Treasury will define those). You can choose not to use the average rate for taxes denominated in a currency other than your functional currency; that choice applies to the year you make it and future years unless Treasury allows you to revoke it. Regulated investment companies that use accrual accounting must instead convert taxes using the exchange rate on the date the income accrues. If the average-rate rule or the RIC rule does not apply, translate taxes at the exchange rate when you pay them. Translate adjustments at the rate when the adjustment is paid, except refunds or credits use the rate from the original payment. Treasury may allow using an average rate for the payment period. “Foreign income taxes” here means income, war-profits, or excess-profits taxes paid or accrued to a foreign country or to a U.S. possession. A foreign corporation’s earnings and profits are figured in its own functional currency. When a U.S. person gets those earnings (or they are treated as received), convert them to dollars using the right exchange rate. If previously taxed earnings are later distributed, any gain or loss from exchange rate changes between the deemed and actual distribution must be reported as ordinary income or loss from the same source as the original inclusion. Treasury will issue rules for multi-tiered foreign corporation distributions.

Full Legal Text

Title 26, §986

Internal Revenue Code, Source: USLM XML via OLRC

(a)Foreign income taxes
(1)Translation of accrued taxes
(A)In general
For purposes of determining the amount of the foreign tax credit, in the case of a taxpayer who takes foreign income taxes into account when accrued, the amount of any foreign income taxes (and any adjustment thereto) shall be translated into dollars by using the average exchange rate for the taxable year to which such taxes relate.
(B)Exception for certain taxes
Subparagraph (A) shall not apply to any foreign income taxes—
(i)paid after the date 2 years after the close of the taxable year to which such taxes relate, or
(ii)paid before the beginning of the taxable year to which such taxes relate.
(C)Exception for inflationary currencies
Subparagraph (A) shall not apply to any foreign income taxes the liability for which is denominated in any inflationary currency (as determined under regulations).
(D)Elective exception for taxes paid other than in functional currency
(i)In general
At the election of the taxpayer, subparagraph (A) shall not apply to any foreign income taxes the liability for which is denominated in any currency other than in the taxpayer’s functional currency.
(ii)Application to qualified business units
An election under this subparagraph may apply to foreign income taxes attributable to a qualified business unit in accordance with regulations prescribed by the Secretary.
(iii)Election
Any such election shall apply to the taxable year for which made and all subsequent taxable years unless revoked with the consent of the Secretary.
(E)Special rule for regulated investment companies
In the case of a regulated investment company which takes into account income on an accrual basis, subparagraphs (A) through (D) shall not apply and foreign income taxes paid or accrued with respect to such income shall be translated into dollars using the exchange rate as of the date the income accrues.
(F)Cross reference
For adjustments where tax is not paid within 2 years, see section 905(c).
(2)Translation of taxes to which paragraph (1) does not apply
For purposes of determining the amount of the foreign tax credit, in the case of any foreign income taxes to which subparagraph (A) or (E) of paragraph (1) does not apply—
(A)such taxes shall be translated into dollars using the exchange rates as of the time such taxes were paid to the foreign country or possession of the United States, and
(B)any adjustment to the amount of such taxes shall be translated into dollars using—
(i)except as provided in clause (ii), the exchange rate as of the time when such adjustment is paid to the foreign country or possession, or
(ii)in the case of any refund or credit of foreign income taxes, using the exchange rate as of the time of the original payment of such foreign income taxes.
(3)Authority to permit use of average rates
To the extent prescribed in regulations, the average exchange rate for the period (specified in such regulations) during which the taxes or adjustment is paid may be used instead of the exchange rate as of the time of such payment.
(4)Foreign income taxes
For purposes of this subsection, the term “foreign income taxes” means any income, war profits, or excess profits taxes paid or accrued to any foreign country or to any possession of the United States.
(b)Earnings and profits and distributions
For purposes of determining the tax under this subtitle—
(1)of any shareholder of any foreign corporation, the earnings and profits of such corporation shall be determined in the corporation’s functional currency, and
(2)in the case of any United States person, the earnings and profits determined under paragraph (1) (when distributed, deemed distributed, or otherwise taken into account under this subtitle) shall (if necessary) be translated into dollars using the appropriate exchange rate.
(c)Previously taxed earnings and profits
(1)In general
Foreign currency gain or loss with respect to distributions of previously taxed earnings and profits (as described in section 959 or 1293(c)) attributable to movements in exchange rates between the times of deemed and actual distribution shall be recognized and treated as ordinary income or loss from the same source as the associated income inclusion.
(2)Distributions through tiers
The Secretary shall prescribe regulations with respect to the treatment of distributions of previously taxed earnings and profits through tiers of foreign corporations.

Legislative History

Notes & Related Subsidiaries

Editorial Notes

Amendments

2004—Subsec. (a)(1)(D). Pub. L. 108–357, § 408(a), added subpar. (D). Former subpar. (D) redesignated (E). Subsec. (a)(1)(E). Pub. L. 108–357, § 408(b)(1), added subpar. (E). Former subpar. (E) redesignated (F). Pub. L. 108–357, § 408(a), redesignated subpar. (D) as (E). Subsec. (a)(1)(F). Pub. L. 108–357, § 408(b)(1), redesignated subpar. (E) as (F). Subsec. (a)(2). Pub. L. 108–357, § 408(b)(2), inserted “or (E)” after “subparagraph (A)” in introductory provisions. 1997—Subsec. (a). Pub. L. 105–34, § 1102(a)(1), amended subsec. (a) generally. Prior to amendment, subsec. (a) read as follows: “(a) Foreign Taxes.— “(1) In general.—For purposes of determining the amount of the foreign tax credit— “(A) any foreign income taxes shall be translated into dollars using the exchange rates as of the time such taxes were paid to the foreign country or possession of the United States, and “(B) any adjustment to the amount of foreign income taxes shall be translated into dollars using— “(i) except as provided in clause (ii), the exchange rate as of the time when such adjustment is paid to the foreign country or possession, or “(ii) in the case of any refund or credit of foreign income taxes, using the exchange rate as of the time of original payment of such foreign income taxes. “(2) Foreign income taxes.—For purposes of paragraph (1), ‘foreign income taxes’ means any income, war profits, or excess profits taxes paid to any foreign country or to any possession of the United States.” Subsec. (a)(3), (4). Pub. L. 105–34, § 1102(b)(1), added par. (3) and redesignated former par. (3) as (4). 1988—Pub. L. 100–647 substituted “foreign taxes and foreign corporation’s earnings and profits” for “foreign corporation’s earnings and profits and foreign taxes” in heading, and revised and restructured the provisions of subsecs. (a) and (b).

Statutory Notes and Related Subsidiaries

Effective Date

of 2004 Amendment Pub. L. 108–357, title IV, § 408(c), Oct. 22, 2004, 118 Stat. 1500, provided that: “The

Amendments

made by this section [amending this section] shall apply to taxable years beginning after December 31, 2004.”

Effective Date

of 1997 Amendment Pub. L. 105–34, title XI, § 1102(c)(1), Aug. 5, 1997, 111 Stat. 966, provided that: “The

Amendments

made by subsections (a)(1) and (b) [amending this section and section 989 of this title] shall apply to taxes paid or accrued in taxable years beginning after December 31, 1997.”

Effective Date

of 1988 AmendmentAmendment by Pub. L. 100–647 effective, except as otherwise provided, as if included in the provision of the Tax Reform Act of 1986, Pub. L. 99–514, to which such amendment relates, see section 1019(a) of Pub. L. 100–647, set out as a note under section 1 of this title.

Effective Date

Section applicable to taxable years beginning after Dec. 31, 1986, with certain exceptions and qualifications, see section 1261(e) of Pub. L. 99–514, set out as a note under section 985 of this title.

Reference

Citations & Metadata

Citation

26 U.S.C. § 986

Title 26, Internal Revenue Code

Last Updated

Sep 22, 2026

Release point: 119-110