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Interest income that is received with respect to a demand account with a bank or other financial institution and that is denominated in (or whose payments are determined by reference to) a nonfunctional currency is translated into functional currency at the spot rate on the date received or accrued or pursuant to any reasonable spot rate convention consistently applied by the taxpayer to all taxable years and to all accounts denominated in nonfunctional currency in the same financial institution. For example, the taxpayer may translate interest received with respect to a nonfunctional currency demand account on the last day of each month of the taxable year, on the last day of each quarter of the taxable year, on the last day of each half of the taxable year, or on the last day of the taxable year. No exchange gain or loss is recognized on the receipt or accrual of the interest income.

Translated interest income or expense on Section 988 debt instruments when all payments are denominated in, or determined with reference to, a single nonfunctional currency is determined in units of nonfunctional currency and translated into functional currency at either the spot rate at the time of payment if accrual was not required or, if accrued, at the average rate (simple average of the spot rates) for the interest accrual period. For taxable years beginning after March 17, 1992, a taxpayer may elect to translate interest income and expense at the spot rate on the last day of the accrual period.

The holder of a debt instrument will realize gain or loss with respect to the accrued interest income on the date the accrued interest is received, or the instrument is disposed of. The amount of exchange gain or loss realized with respect to accrued interest income is determined for each accrual period by subtracting, from the translated units of nonfunctional currency interest income received with respect to the accrual period, the amount computed by translating the units of nonfunctional currency interest income accrued with respect to the income received at the average exchange rate for the accrual period.

The obligor under a debt instrument will realize exchange gain or loss with respect to accrued interest expense on the date such accrued interest expense is paid or the obligation to make payments is transferred or extinguished (including a deemed disposition that results from a material change in terms of the instrument). The amount of exchange gain or loss realized with respect to accrued interest expense is determined for each accrual period using the following procedure: (a) translating the units of nonfunctional currency interest expense accrued at the average rate (or other rate specified) and (b) subtracting from that amount the amount computed by translating the units of nonfunctional currency interest paid (or, if the obligation to make payments is extinguished or transferred, the units accrued) with respect to such accrual period into functional currency at the spot rate (a) on the date payment is made or (b) the obligation is transferred or extinguished (or deemed extinguished).

The holder of a debt instrument will realize exchange gain or loss with respect to the principal amount of such instrument on the date principal is received from the obligor or the instrument is disposed of (including a deemed disposition that results from a material change in terms of the instrument). For purposes of computing exchange gain or loss, the principal amount of a debt instrument is the holder’s purchase price in units of nonfunctional currency. If, however, the holder acquired the instrument in a transaction in which exchange gain or loss was realized but not recognized by the transferor, the nonfunctional currency principal amount of the instrument with respect to the holder shall be the same as that of the transferor. The amount of exchange gain or loss so realized by the holder with respect to principal is determined by translating the units of nonfunctional currency principal at the spot rate on the date payment is received or the instrument is disposed of (or deemed disposed of) and subtracting from that amount the amount computed by translating the units of nonfunctional currency principal at the spot rate on the date the holder, or a transferor from whom the nonfunctional principal amount is carried over, acquired the instrument or is deemed to acquire the instrument.

An obligor under a debt instrument will realize an exchange gain or loss with respect to the principal amount on the date on which principal is paid or the obligation to make payments is extinguished or transferred. The principal amount of a debt instrument is the amount received by the obligor for the debt instrument in units of nonfunctional currency. If the obligation was acquired in a nontaxable exchange, the nonfunctional currency principal amount of the instrument for the obligor will be the same as that of the transferor. If exchange gain or loss realized is required to be recognized, the amount of gain or loss realized by the obligor is determined by subtracting, from the translated (at the spot rate) units of nonfunctional currency principal on the date the obligor became obligor, the amount computed by translating the units of nonfunctional currency principal at the spot rate on the date payment is made or the obligation is extinguished or transferred.