If you are receiving returns on investments or payments from an employer in a currency other than US dollars, there are particular steps to take in order to make sure you are reporting it correctly to the IRS.
First, you must always report the income and expenses on a U.S. tax return in U.S. dollars by converting the foreign currency amounts. How the IRS wants you to do that conversion depends on your “functional currency.”
Functional currency is a concept borrowed from the accounting world. The functional currency of a business is the currency that account for most of its earned and expended cash.
Foreign Functional Currency
Businesses that operate primarily or completely in foreign countries, and maintain their books in the local currency, would generally use that currency as their functional currency. For example, a business based and operating mostly in Japan would have the Yen as its functional currency. If that company had an obligation to file a U.S. tax return, because it’s owned by a U.S.-based company, IRS guidelines state that all income tax determinations should be made in the local currency and then the final result should be translated into U.S. dollars using an average exchange rate for the year.
U.S. Dollar Functional Currency
Individuals with an obligation to file a U.S. tax return must usually consider the U.S. dollar their functional currency, even if their income and business-related expenses are entirely in a foreign currency. An American employee or independent contractor being paid in Yen by the Japanese business in the previous example must translate all income received (and Japanese taxes paid) into U.S. dollars as it is received or accrued. The same holds true for any related business expenses, or other income or expense amounts that have an impact the tax return.
Whether you’re doing the conversion to U.S. dollars after operating with a foreign currency or the U.S. dollar as your functional currency, you need to do the exchange conversions using a rate that the IRS will find acceptable. We recommend that contact the U.S. embassy or consulate where you are doing business or working to inquire about exchange rates, or from a major bank. The following web resources might be sufficient when it comes to determining exchange rates:
US Department of Treasury’s Bureau of Fiscal Services Reporting of Exchange Rates: http://www.fiscal.treasury.gov/fsreports/rpt/treasRptRateExch/treasRptRateExch_home.htm
OANDA Currency Converter: http://www.oanda.com/currency/converter/