[Federal Register Volume 66, Number 8 (Thursday, January 11, 2001)]
[Rules and Regulations]
[Pages 2215-2218]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-252]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8927]
RIN 1545-AW34


Conversion to the Euro

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations and removal of temporary regulations.

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SUMMARY: This document contains final Income Tax Regulations relating 
to U.S. taxpayers operating, investing, or otherwise conducting 
business in the currencies of certain European countries that replace 
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.

DATES: Effective Date: These regulations are effective January 11, 
2001.
    Applicability Date: These regulations are applicable for tax years 
ending after July 29, 1998.

FOR FURTHER INFORMATION CONTACT: John W. Rogers III 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 the comments, and in order to provide immediate 
guidance, the Treasury and the IRS published in the Federal Register 
temporary regulations (63 FR 40366) and a notice of proposed rulemaking 
by cross-reference to the temporary regulations (63 FR 40383) on July 
29, 1998. No public hearing was held in conjunction with the notice of 
proposed rulemaking because no taxpayers requested to speak at the 
hearing.
    In the notice of proposed rulemaking, the Treasury and The IRS 
requested comments with respect to certain additional issues. Two 
comments were received in connection with the request for comments and 
are discussed in greater detail below.

Explanation of Provisions and Discussion of Comments

    The temporary regulations provide rules relating to U.S. taxpayers 
operating, investing, or otherwise conducting business in the 
currencies of countries that replace their national currencies (legacy 
currencies) with a single, multinational currency called the euro. 
Thus, a legacy currency would include former currencies of the eleven 
countries that adopted the euro in 1999 as well as the currency of a 
country after it adopts the euro at some later date. The temporary 
regulations generally provide guidance relating to the circumstances 
under which the euro conversion creates a realization event with 
respect to instruments and contracts denominated in a legacy currency, 
and the circumstances under which the euro conversion constitutes a 
change in functional currency for a qualified business unit (QBU or 
QBUs, as the case may be) whose functional currency is a legacy 
currency, and certain consequences thereof. The temporary regulations 
published in the Federal Register on July 29, 1998, are finalized 
substantially as proposed. See the preamble to the temporary 
regulations for an explanation of the provisions of those regulations.
    As noted above, two comments were received in connection with the 
publication of the temporary regulations and the notice of proposed 
rulemaking. One comment addressed the effect of the euro conversion to 
a corporation that has significant numbers of legacy currency 
transactions but has a non-legacy currency as its functional currency. 
For example, a corporation may have a non-legacy currency as its 
functional currency because its economic environment reflected more 
significant activities denominated in such currency (e.g., the U.S. 
dollar or the Swiss franc) relative to any single legacy currency. 
However, given the aggregation of the individual legacy currencies into 
the euro, the currency of the corporation's economic environment

[[Page 2216]]

in which a significant part of its activities are conducted is the 
euro. The commenter suggested that, in such circumstances, the 
corporation should be allowed to change its functional currency to the 
euro automatically.
    In response to the comment, the regulation provides a new rule in 
which a QBU that uses a non-legacy currency as its functional currency 
may change its functional currency to the euro provided that the euro 
is a currency of the economic environment in which a significant part 
of the QBU's activities are conducted, the QBU maintains its books and 
records in the euro after conversion, and the QBU is not required to 
use the dollar as its functional currency. The change is deemed to be 
made with the consent of the Commissioner if the change is made within 
the period set forth in Sec. 1.985-8(b)(2). A QBU changing its 
functional currency under this new rule is required to make the change 
in method of accounting adjustments under Sec. 1.985-5. Treasury and 
the IRS believe that the rules of Sec. 1.985-5 appropriately apply to 
this circumstance because the change in functional currency is not an 
involuntary change of the same nature as a QBU whose functional 
currency is a legacy currency.
    The second comment suggested that the temporary regulations do not 
provide clear guidance in the case where, prior to conversion, the 
functional currency of a taxpayer and one of its QBU branches is the 
same legacy currency, and either the taxpayer or its QBU branch 
converts to the euro as its functional currency in a taxable year prior 
to the conversion of the other. The comment noted that the temporary 
regulations presume that the taxpayer and its branch have a different 
functional currency, but do not address instances where they have the 
same functional currency. The comment recommended that the regulations 
provide rules that require calculation of section 987 gain or loss 
during the period in which the taxpayer and its branch have different 
functional currencies. The recommendation is not adopted because 
section 987 currency gain or loss should not arise when a taxpayer and 
its branch use the same legacy currency as their functional currencies 
even if each adopts the euro as its functional currency in different 
years.
    Finally, the notice of proposed rulemaking requested comments 
regarding the treatment of section 988 transactions that are held by 
euro functional currency QBUs and that are denominated in a currency 
that is replaced by the euro in the future. While no comments were 
received, Treasury and the IRS believe that rules relating to this 
issue should be clarified. Accordingly, Sec. 1.985-8(d) provides that 
the principles of Sec. 1.985-8(c)(3) apply in this context. Under this 
rule, legacy currency transactions generally continue to be treated as 
section 988 transactions and the principles of section 988 apply. 
Further, the principles provided in Sec. 1.985-8(c)(3)(iii) and (iv) 
continue to apply to currency and accounts payable and receivable, 
respectively.

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) does not apply to these regulations, and because the 
final rule does not impose a collection of information on small 
entities, the provisions of the Regulatory Flexibility Act do not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, these 
regulations were 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 final regulations are John W. Rogers 
III of the Office of the Associate Chief Counsel (International) and 
Thomas Preston of the Office of Associate Chief Counsel (Financial 
Institutions and Products). 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 record keeping 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 * * *


Sec. 1.985-1  [Amended]

    Par. 2. In Sec. 1.985-1, paragraph (c)(6), in the last sentence, 
the reference ``Sec. 1.985-8T'' is removed and ``Sec. 1.985-8'' is 
added in its place.


Sec. 1.985-4  [Amended]

    Par. 3. In Sec. 1.985-4, paragraph (a), in the last sentence, the 
reference ``Sec. 1.985-8T'' is removed and ``Sec. 1.985-8'' is added in 
its place.
    Par. 4. Section 1.985-8 is added to read as follows:


Sec. 1.985-8  Special rules applicable to the European Monetary Union 
(conversion to euro).

    (a) Definitions--(1) Legacy currency. A legacy currency is the 
former currency of a Member State of the European Community which is 
substituted for the euro in accordance with the Treaty establishing the 
European Community 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 a legacy currency 
as its functional currency.
    (2) QBU with a legacy currency as its 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.
    (3) QBU with a non-legacy currency as its functional currency --(i) 
In general. A QBU with a non-legacy currency as its functional currency 
may change its functional currency to the euro pursuant to this 
Sec. 1.985-8 if--
    (A) Under the rules set forth in Sec. 1.985-1(c), the euro is the 
currency of the economic environment in which a significant part of the 
QBU's activities are conducted;
    (B) After conversion, the QBU maintains its books and records (as 
described in Sec. 1.989(a)-1(d)) in the euro; and

[[Page 2217]]

    (C) The QBU is not required to use the dollar as its functional 
currency under Sec. 1.985-1(b).
    (ii) Time period for change. A QBU with a non-legacy currency as 
its functional currency may change its functional currency to the euro 
under this section only if it does so within the period set forth in 
paragraph (b)(2) of this section as if the functional currency of the 
QBU was a legacy currency.
    (4) Consent of Commissioner. A change made pursuant to paragraph 
(b) 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 paragraph (b)(2) of this 
section must make adjustments as provided in paragraph (c) of this 
section. A QBU changing its functional currency to the euro pursuant to 
paragraph (b)(3) must make adjustments as provided in Sec. 1.985-5.
    (5) Statement to file upon change. With respect to a QBU that 
changes its functional currency to the euro under paragraph (b) 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. 1.985-8.'' 
For purposes of this paragraph (b)(5), 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 when a QBU changes its functional currency 
from a legacy currency to the euro pursuant to paragraph (b)(2) of this 
section--(1) In general. A QBU that changes its functional currency 
from a legacy currency to the euro pursuant to paragraph (b)(2) 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. Assume that the euro/deutschmark 
conversion rate is set by the European Council at =1= DM2. Assume 
further that 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 (fl10,000/2.25) 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 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. Assume that the euro/deutschmark conversion rate is set by 
the European Council at =1 = DM2. Assume further that 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

[[Page 2218]]

election described in paragraph (c)(3)(iv)(A) of this section, an 
affected taxpayer (as described in paragraph (b)(5) of this section) 
shall attach a statement to its tax return for the taxable year ending 
immediately prior to the 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) Treatment of legacy currency section 988 transactions with 
respect to a QBU that has the euro as its functional currency--(1) In 
general. This Sec. 1.985-8(d) applies to a QBU that has the euro as its 
functional currency and that holds a section 988 transaction 
denominated in, or determined by reference to, a currency that is 
substituted by the euro. For example, this paragraph (d) will apply to 
a German QBU with the euro as its functional currency if the QBU is 
holding Country X currency or other section 988 transactions 
denominated in such currency on the day in the year 2005 when the euro 
is substituted for the Country X currency.
    (2) Principles of paragraph (c)(3) of this section shall apply. 
With respect to a QBU described in paragraph (d) of this section, the 
principles of paragraph (c)(3) of this section shall apply. For 
example, if a German QBU with the euro as its functional currency is 
holding a Country X currency denominated debt instrument on the day in 
the year 2005 when the euro is substituted for the Country X currency, 
the instrument shall continue to be treated as a section 988 
transaction pursuant to the principles of paragraph (c)(3)(i) of this 
section. However, if such QBU holds Country X currency, the QBU shall 
take into account any unrealized exchange gain or loss pursuant to the 
principles of paragraph (c)(3)(iii) of this section as if the currency 
was disposed of on the day prior to the day the euro is substituted for 
the Country X currency. Similarly, if the QBU makes an election under 
the principles of paragraph (c)(3)(iv) of this section, the QBU shall 
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 day prior to the day the euro is 
substituted for the Country X currency.
    (e) Effective date. This section applies to tax years ending after 
July 29, 1998.


Sec. 1.985-8T  [Removed]

    Par. 5. Section 1.985-8T is removed.
    Par. 6. Section 1.1001-5 is added to read as follows:


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

    (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-
8(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.


Sec. 1.1001-5T  [Removed]

    Par. 7. Section 1.1001-5T is removed.

    Approved: December 13, 2000.
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 01-252 Filed 1-10-01; 8:45 am]
BILLING CODE 4830-01-P