[Federal Register Volume 63, Number 145 (Wednesday, July 29, 1998)]
[Rules and Regulations]
[Pages 40366-40369]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-20023]
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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]
BILLING CODE 4830-01-U