Conversion to the Euro

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8776]

RIN 1545-AW34

Conversion to the Euro

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains temporary Income Tax Regulations

relating to U.S. taxpayers operating, investing or otherwise conducting

business in the currencies of certain European countries that are

replacing their national currencies with a single, multinational

currency called the euro. These regulations provide rules relating to

adjustments required for qualified business units operating in such

currencies and rules relating to the tax effect of holding such

currencies or financial instruments or contracts denominated in such

currencies. The text of these temporary regulations also serves as the

text of proposed regulations published elsewhere in this issue of the

Federal Register.

DATES: These regulations are effective July 29, 1998.

FOR FURTHER INFORMATION CONTACT: Howard Wiener of the Office of

Associate Chief Counsel (International), (202) 622-3870, regarding the

change in functional currency rules and Thomas Preston of the Office of

Assistant Chief Counsel (Financial Institutions and Products), (202)

622-3930, regarding section 1001 (not toll free calls).

SUPPLEMENTARY INFORMATION:

Background

On March 9, 1998, the IRS issued Announcement 98-18 (1998-9 IRB 44)

requesting comments relating to the tax issues for U.S. taxpayers

operating, investing or otherwise conducting business in a currency

that is converting to the euro. Numerous comments were received. After

consideration of these comments, these regulations are adopted as a

temporary Treasury decision to provide immediate guidance to taxpayers.

Explanation of Provisions

I. Background

The Treaty on European Union signed February 7, 1992, (31 I.L.M.

247) (entered into force November 1, 1993), sets forth a plan to

replace the national currencies of participating members (legacy

currencies) that meet certain economic criteria with a single European

currency (euro). Pursuant to directives of the European Council, the

process of converting the legacy currencies into the euro will take

place in three phases.

On January 1, 1999, the currency of participating member states of

the European Union shall be the euro. At that time, the euro will be

substituted for the currency of each state at a conversion rate

established pursuant to the Treaty on European Union. Thereafter, the

bills and coins of each of the legacy currencies will remain in

circulation but will cease to have independent value apart from the

euro. On January 1, 2002, euro bills and coins will be introduced into

circulation. From January 1, 1999, until June 30, 2002 (transition

period), the legacy currencies will remain in circulation as subunits

of the euro. The transition period is referred to as the ``no

prohibition, no compulsion'' period because during this time amounts

may generally be denominated in the legacy currencies and/or the euro

at the option of individuals and businesses. Finally, by July 1, 2002,

the legacy currencies will no longer be accepted as legal tender.

On May 3, 1998, the European Union announced the eleven countries

that would initially participate in the conversion and the expected

rates at which the respective currencies would convert to the euro. The

eleven countries are Austria, Belgium, Finland, France, Germany,

Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain. Four

current members of the European Union (Denmark, Greece, Sweden, and the

United Kingdom) will not participate in the initial conversion to the

euro. These countries, along with other countries that later join the

European Union, however, may convert their currencies to the euro at

some future time.

II. Temporary Regulations

1. In General

These temporary regulations provide guidance regarding certain of

the federal income tax consequences arising from the introduction of

the euro. Consistent with comments received from taxpayers, the

regulations generally minimize the tax consequences that arise by

reason of the euro conversion. In a limited number of circumstances,

however, the Treasury and IRS determined that considerations, such as

administrative feasibility, made a different result more appropriate.

The regulations provide guidance with respect to two issues: (i)

the circumstances under which the euro conversion creates a realization

event with respect to instruments and contracts denominated in a legacy

currency, and (ii) the circumstances under which the euro conversion

constitutes a change in functional currency for a qualified business

unit (QBU) whose functional currency is a legacy currency, and certain

consequences thereof.

2. Realization

The temporary regulations provide that the conversion of legacy

currencies to the euro does not result in a realization event under

section 1001. This rule is broadly applicable to all situations where

the rights and obligations of a taxpayer are altered solely by reason

of the euro conversion. Thus, conversion to the euro of legacy

[[Page 40367]]

currency held by a taxpayer and conversion of legacy currency

denominated contractual relationships, financial instruments, and other

claims or obligations are not realization events solely as a result of

the conversion. In addition, as a result of this rule, exchange gains

and losses on section 988 transactions denominated in a legacy currency

will not be taken into account until a subsequent realization event

with respect to the underlying instrument. For example, when the Dutch

guilder is converted into the euro, a U.S. dollar functional currency

taxpayer will not recognize either market gain or loss or exchange gain

or loss on a fixed interest rate Dutch guilder debt instrument.

Other aspects of the euro conversion may result in taxable events.

For example, if an unscheduled fractional principal payment is made on

a debt instrument in order to facilitate a rounding convention, this

payment is accounted for under the rules governing payments on debt

instruments (such as Secs. 1.446-2 and 1.1275-2) and under section 988

(in the case of a section 988 transaction). Other changes may or may

not constitute realization events depending on the terms of the

changes. For example, accrual periods, holiday conventions or indices

on a floating rate instrument may be altered. Whether these changes are

realization events must be determined under existing law. See, e.g.,

Sec. 1.1001-3.

Limitations that under otherwise applicable principles prevent or

defer the recognition of realized gains and losses continue to apply.

Thus, for example, recognition of losses between related parties under

section 267 and Sec. 1.988-1(a)(10) remain subject to the limitations

set forth in those sections.

3. Change in Functional Currency

The regulations provide that QBUs with a legacy functional currency

will be deemed to have automatically changed their functional currency

to the euro at the beginning of the year they are required to make such

change. Because of the significant administrative burdens that will be

imposed on QBUs when they are required to change their internal systems

to accommodate the introduction of the euro, the regulations provide

that a QBU that currently uses a legacy functional currency is deemed

to automatically change its functional currency to the euro in the year

the QBU changes its books and records to the euro. That change,

however, must be made no later than the last taxable year beginning on

or before the first day such legacy currency is no longer valid legal

tender.

The euro conversion implicates the policy concerns underlying

Sec. 1.985-5, namely, the preservation of built-in exchange gains and

losses arising from the fact that positions that had once been

denominated in a nonfunctional currency will now be made or received in

a QBU's functional currency.

In the context of the euro conversion, two items are of particular

concern in properly accounting for exchange gains and losses: (1)

section 988 transactions denominated in a legacy currency other than

the QBU's legacy functional currency, and (2) unremitted earnings of a

branch with a legacy functional currency different from the home

office's legacy functional currency. In both these instances, positions

that had previously been accounted for in a nonfunctional currency

(against which exchange gains and loses would be computed) will, after

the conversion, be accounted for in euros (against which exchange gains

and losses would not be computed when a QBU's functional currency is

also the euro).

Rather than requiring immediate recognition, as would be required

under Sec. 1.985-5, the temporary regulations provide special rules for

the euro conversion. These rules provide that for affected section 988

transactions (other than transactions in or holdings of nonfunctional

currency cash), exchange gains and losses that would have been

recognized immediately if the Sec. 1.985-5 change in functional

currency rules applied will be deferred until otherwise realized. This

is accomplished by providing that section 988 transactions continue to

be treated as nonfunctional currency transactions under the principles

of section 988 even though the remaining payments on the asset or

liability will be made in the QBU's new functional currency (i.e., the

euro).

In response to comments by taxpayers, an election is provided for

QBUs to realize exchange gain or loss on accounts receivable and

payable immediately prior to the year of change. A QBU making this

election must realize exchange gains and losses on all of its accounts

receivable and payable that are legacy currency denominated section 988

transactions. The election responds to the administrative burdens

associated with tracking exchange gains and losses on large quantities

of accounts receivable and payable. Taxpayers not making the election

will continue to treat these positions as section 988 transactions

under the general rule described above.

Exchange gains and losses on transactions in, or holdings of,

nonfunctional currency cash are recognized immediately because cash

accounts are generally turned over rapidly and the administrative

burdens in tracking exchange gains and losses outweigh the benefits of

deferral.

The regulations also provide special rules for taking into account

exchange gain or loss when the taxpayer and a branch of the taxpayer

change their functional currencies to the euro. The rules provide that

exchange gains and losses on unremitted earnings of affected branches

be recognized ratably over a four-year period beginning in the year of

change. Some commentators recommended that the principles of section

987 continue to be applied after the conversion. As in the case with

cash, however, the Treasury and IRS believe that the administrative

burdens for taxpayers and the government as well as the potential for

abuse, outweigh the benefit of extended deferral.

These temporary regulations also provide rules for the proper

translation of a QBU's balance sheet accounts in a manner that

preserves any accrued but unrecognized currency gain or loss. These

rules are consistent with the existing Sec. 1.985-5, change in

functional currency rules.

III. Other Issues

Finally, these regulations do not address certain issues that

taxpayers have commented upon that are not unique to the euro

conversion. In particular, these regulations do not address the

deductibility of costs associated with the euro conversion and foreign

tax credit mismatches that can occur as a result of tax accounting

differences between the United States and other countries.

Special Analysis

It has been determined that this Treasury decision is not a

significant regulatory action as defined in Executive Order 12866.

Therefore, a regulatory assessment is not required. It has also been

determined that section 553(b) of the Administrative Procedures Act (5

U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter

6) do not apply to these regulations, and therefore, a Regulatory

Flexibility Analysis is not required. Pursuant to section 7805(f) of

the Internal Revenue Code, these temporary regulations will be

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on their impact on small business.

Drafting Information: The principal authors of these regulations

are Howard A. Wiener of the Office of the Associate Chief Counsel

(International) and Thomas Preston of the Office of Associate Chief

Counsel (Domestic).

[[Page 40368]]

Other personnel from the IRS and Treasury Department also participated

in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in

part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. In Sec. 1.985-1, paragraph (c)(6) is amended by adding a

sentence at the end to read as follows:

Sec. 1.985-1 Functional currency.

* * * * *

(c) * * *

(6) * * * For special rules relating to the conversion to the euro,

see Sec. 1.985-8T.

* * * * *

Sec. 1.985-4 [Amended]

Par. 3. In Sec. 1.985-4, the last sentence of paragraph (a) is

amended by removing the reference ``Sec. 1.985-2'' and adding

``Sec. 1.985-2 or 1.985-8T'' in its place.

Par. 4. Section 1.985-8T is added to read as follows:

Sec. 1.985-8T Special rules applicable to the European Monetary Union

(conversion to the euro) (temporary).

(a) Definitions--(1) Legacy currency. A legacy currency is the

national currency of a participating member state of the European Union

used prior to the substitution of the euro for the national currency of

that state in accordance with the Treaty on European Union signed

February 7, 1992. The term legacy currency shall also include the

European Currency Unit.

(2) Conversion rate. The conversion rate is the rate at which the

euro is substituted for a legacy currency.

(b) Operative rules--(1) Initial adoption. A QBU (as defined in

Sec. 1.989(a)-1(b)) whose first taxable year begins after the euro has

been substituted for a legacy currency may not adopt that legacy

currency as its functional currency.

(2) QBU with a legacy functional currency--(i) Required change. A

QBU with a legacy currency as its functional currency is required to

change its functional currency to the euro beginning the first day of

the first taxable year:

(A) That begins on or after the day that the euro is substituted

for that legacy currency (in accordance with the Treaty on European

Union); and

(B) In which the QBU begins to maintain its books and records (as

described in Sec. 1.989(a)-1(d)) in the euro.

(ii) Notwithstanding paragraph (b)(2)(i) of this section, a QBU

with a legacy currency as its functional currency is required to change

its functional currency to the euro no later than the last taxable year

beginning on or before the first day such legacy currency is no longer

valid legal tender.

(iii) Consent of Commissioner. A change made pursuant to paragraph

(b)(2)(i) of this section shall be deemed to be made with the consent

of the Commissioner for purposes of Sec. 1.985-4. A QBU changing its

functional currency to the euro pursuant to this paragraph (b)(2) must

make adjustments as provided in paragraph (c) of this section.

(3) Statement to file upon change. With respect to a QBU that

changes its functional currency to the euro under paragraph (b)(2) of

this section, an affected taxpayer shall attach to its return for the

taxable year of change a statement that includes the following:

``TAXPAYER CERTIFIES THAT A QBU OF THE TAXPAYER HAS CHANGED ITS

FUNCTIONAL CURRENCY TO THE EURO PURSUANT TO TREAS. REG. Sec. 1.985-

8T.'' For purposes of this paragraph (b)(3), an affected taxpayer shall

be in the case where the QBU is: a QBU of an individual U.S. resident

(as a result of the activities of such individual), the individual; a

QBU branch of a U.S. corporation, the corporation; a controlled foreign

corporation (as described in section 957)(or QBU branch thereof), each

United States shareholder (as described in section 951(b)); a

partnership, each partner separately; a noncontrolled section 902

corporation (as described in section 904(d)(2)(E)) (or branch thereof),

each domestic shareholder as described in Sec. 1.902-1(a)(1); or a

trust or estate, the fiduciary of such trust or estate.

(c) Adjustments required--(1) In general. A QBU that changes its

functional currency to the euro pursuant to paragraph (b) of this

section must make the adjustments described in paragraphs (c)(2)

through (5) of this section. Section 1.985-5 shall not apply.

(2) Determining the euro basis of property and the euro amount of

liabilities and other relevant items. The euro basis in property and

the euro amount of liabilities and other relevant items shall equal the

product of the legacy functional currency adjusted basis or amount of

liabilities multiplied by the applicable conversion rate.

(3) Taking into account exchange gain or loss on legacy currency

section 988 transactions--(i) In general. Except as provided in

paragraphs (c)(3) (iii) and (iv) of this section, a legacy currency

denominated section 988 transaction (determined after applying section

988(d)) outstanding on the last day of the taxable year immediately

prior to the year of change shall continue to be treated as a section

988 transaction after the change and the principles of section 988

shall apply.

(ii) Examples. The application of this paragraph (c)(3) may be

illustrated by the following examples:

Example 1. X, a calendar year QBU on the cash method of

accounting, uses the deutschmark as its functional currency. X is

not described in section 1281(b). On July 1, 1998, X converts 10,000

deutschmarks(DM) into Dutch guilders(fl) at the spot rate of fl1 =

DM1 and loans the 10,000 guilders to Y (an unrelated party) for one

year at a rate of 10% with principal and interest to be paid on June

30, 1999. On January 1, 1999, X changes its functional currency to

the euro pursuant to this section. The euro/deutschmark conversion

rate is set by the European Council at =1= DM2. The euro/guilder

conversion rate is set at =1 = fl2.25. Accordingly, under the terms

of the note, on June 30, 1999, X will receive =4444.44 (f110,000/

2.25) of principal and =444.44 (fl1,000/2.25) of interest. Pursuant

to this paragraph (c)(3), X will realize an exchange loss on the

principal computed under the principles of Sec. 1.988-2(b)(5). For

this purpose, the exchange rate used under Sec. 1.988-2(b)(5)(i)

shall be the guilder/euro conversion rate. The amount under

Sec. 1.988-2(b)(5)(ii) is determined by translating the fl10,000 at

the guilder/deutschmark spot rate on July 1, 1998, and translating

that deutschmark amount into euros at the deutschmark/euro

conversion rate. Thus, X will compute an exchange loss for 1999 of

=555.56 determined as follows: [=4444.44 (fl10,000/2.25)-=5000

((fl10,000/1)/2) =-=555.56]. Pursuant to this paragraph (c)(3), the

character and source of the loss are determined pursuant to section

988 and regulations thereunder. Because X uses the cash method of

accounting for the interest on this debt instrument, X does not

realize exchange gain or loss on the receipt of that interest.

Example 2. (i) X, a calendar year QBU on the accrual method of

accounting, uses the deutschmark as its functional currency.

On February 1, 1998, X converts 12,000 deutschmarks into Dutch

guilders at the spot rate of fl1 = DM1 and loans the 12,000 guilders

to Y (an unrelated party) for one year at a rate of 10% with

principal and interest to be paid on January 31, 1999. In addition,

assume the average rate (deutschmark/guilder) for the period from

February 1, 1998, through December 31, 1998 is fl1.07 = DM1.

Pursuant to Sec. 1.988-2(b)(2)(ii)(C), X will accrue eleven months

of interest on the note

[[Page 40369]]

and recognize interest income of DM1028.04 (fl1100/1.07) in the 1998

taxable year.

(ii) On January 1, 1999, the euro will replace the deutschmark

as the national currency of Germany pursuant to the Treaty on

European Union signed February 7, 1992. Assume that on January 1,

1999, X changes its functional currency to the euro pursuant to this

section. The euro/deutschmark conversion rate is set by the European

Council at =1 = DM2. The euro/guilder conversion rate is set at =1 =

fl2.25. In 1999, X will accrue one month of interest equal to =44.44

(fl100/2.25). On January 31, 1999, pursuant to the note, X will

receive interest denominated in euros of =533.33 (fl1200/2.25).

Pursuant to this paragraph (c)(3), X will realize an exchange loss

in the 1999 taxable year with respect to accrued interest computed

under the principles of Sec. 1.988-2(b)(3). For this purpose, the

exchange rate used under Sec. 1.988-2(b)(3)(i) is the guilder/euro

conversion rate and the exchange rate used under Sec. 1.988-

2(b)(3)(ii) is the deutschmark/euro conversion rate. Thus, with

respect to the interest accrued in 1998, X will realize exchange

loss of =25.13 under Sec. 1.988-2(b)(3) as follows: [=488.89

(fl1100/2.25)-=514.02 (DM1028.04/2) = -=25.13]. With respect to the

one month of interest accrued in 1999, X will realize no exchange

gain or loss since the exchange rate when the interest accrued and

the spot rate on the payment date are the same.

(iii) X will realize exchange loss of =666.67 on repayment of

the loan principal computed in the same manner as in Example 1

[=5333.33 (fl12,000/2.25)-=6000 fl12,000/1)/2)]. The losses with

respect to accrued interest and principal are characterized and

sourced under the rules of section 988.

(iii) Special rule for legacy nonfunctional currency. The QBU shall

realize or otherwise take into account for all purposes of the Internal

Revenue Code the amount of any unrealized exchange gain or loss

attributable to nonfunctional currency (as described in section

988(c)(1)(C)(ii)) that is denominated in a legacy currency as if the

currency were disposed of on the last day of the taxable year

immediately prior to the year of change. The character and source of

the gain or loss are determined under section 988.

(iv) Legacy currency denominated accounts receivable and payable--

(A) In general. A QBU may elect to realize or otherwise take into

account for all purposes of the Internal Revenue Code the amount of any

unrealized exchange gain or loss attributable to a legacy currency

denominated item described in section 988(c)(1)(B)(ii) as if the item

were terminated on the last day of the taxable year ending prior to the

year of change.

(B) Time and manner of election. With respect to a QBU that makes

an election described in paragraph (c)(3)(iv)(A) of this section, an

affected taxpayer (as described in paragraph (b)(3) of this section)

shall attach a statement to its tax return for the taxable year of

change which includes the following: ``TAXPAYER CERTIFIES THAT A QBU OF

THE TAXPAYER HAS ELECTED TO REALIZE CURRENCY GAIN OR LOSS ON LEGACY

CURRENCY DENOMINATED ACCOUNTS RECEIVABLE AND PAYABLE UPON CHANGE OF

FUNCTIONAL CURRENCY TO THE EURO.'' A QBU making the election must do so

for all legacy currency denominated items described in section

988(c)(1)(B)(ii).

(4) Adjustments when a branch changes its functional currency to

the euro--(i) Branch changing from a legacy currency to the euro in a

taxable year during which taxpayer's functional currency is other than

the euro. If a branch changes its functional currency from a legacy

currency to the euro for a taxable year during which the taxpayer's

functional currency is other than the euro, the branch's euro equity

pool shall equal the product of the legacy currency amount of the

equity pool multiplied by the applicable conversion rate. No adjustment

to the basis pool is required.

(ii) Branch changing from a legacy currency to the euro in a

taxable year during which taxpayer's functional currency is the euro.

If a branch changes its functional currency from a legacy currency to

the euro for a taxable year during which the taxpayer's functional

currency is the euro, the taxpayer shall realize gain or loss

attributable to the branch's equity pool under the principles of

section 987, computed as if the branch terminated on the last day prior

to the year of change. Adjustments under this paragraph (c)(4)(ii)

shall be taken into account by the taxpayer ratably over four taxable

years beginning with the taxable year of change.

(5) Adjustments to a branch's accounts when a taxpayer changes to

the euro--(i) Taxpayer changing from a legacy currency to the euro in a

taxable year during which a branch's functional currency is other than

the euro. If a taxpayer changes its functional currency to the euro for

a taxable year during which the functional currency of a branch of the

taxpayer is other than the euro, the basis pool shall equal the product

of the legacy currency amount of the basis pool multiplied by the

applicable conversion rate. No adjustment to the equity pool is

required.

(ii) Taxpayer changing from a legacy currency to the euro in a

taxable year during which a branch's functional currency is the euro.

If a taxpayer changes its functional currency from a legacy currency to

the euro for a taxable year during which the functional currency of a

branch of the taxpayer is the euro, the taxpayer shall take into

account gain or loss as determined under paragraph (c)(4)(ii) of this

section.

(6) Additional adjustments that are necessary when a corporation

changes its functional currency to the euro. The amount of a

corporation's euro currency earnings and profits and the amount of its

euro paid-in capital shall equal the product of the legacy currency

amounts of these items multiplied by the applicable conversion rate.

The foreign income taxes and accumulated profits or deficits in

accumulated profits of a foreign corporation that were maintained in

foreign currency for purposes of section 902 and that are attributable

to taxable years of the foreign corporation beginning before January 1,

1987, also shall be translated into the euro at the conversion rate.

(d) Effective date. This section applies to tax years ending after

July 29, 1998.

Par. 5. Section 1.1001-5T is added to read as follows:

Sec. 1.1001-5T European Monetary Union (conversion to the

euro)(temporary).

(a) Conversion of currencies. For purposes of Sec. 1.1001-1(a), the

conversion to the euro of legacy currencies (as defined in Sec. 1.985-

8T(a)(1)) is not the exchange of property for other property differing

materially in kind or extent.

(b) Effect of currency conversion on other rights and obligations.

For purposes of Sec. 1.1001-1(a), if, solely as the result of the

conversion of legacy currencies to the euro, rights or obligations

denominated in a legacy currency become rights or obligations

denominated in the euro, that event is not the exchange of property for

other property differing materially in kind or extent. Thus, for

example, when a debt instrument that requires payments of amounts

denominated in a legacy currency becomes a debt instrument requiring

payments of euros, that alteration is not a modification within the

meaning of Sec. 1.1001-3(c).

(c) Effective date. This section applies to tax years ending after

July 29, 1998.

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

Approved: July 17, 1998.

Donald C. Lubick,

Assistant Secretary of the Treasury.

[FR Doc. 98-20023 Filed 7-28-98; 8:45 am]

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