Conversion to the Euro

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8927] RIN 1545-AW34

TITLE: Conversion to the Euro

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations and removal of temporary regulations.

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 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
§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 §1.985-5. Treasury and the IRS believe that
the rules of §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, §1.985-8(d) provides
that the principles of §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 §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 * * * §1.985-1
[Amended]

Par. 2. In §1.985-1, paragraph (c)(6), in the last sentence,
the reference "§1.985-8T" is removed is removed and
"§1.985-8" is added in its place. §1.985-4 [Amended]

Par. 3. In §1.985-4, paragraph (a), in the last sentence, the
reference "§1.985-8T" is removed and "§1.985-8" is added
in its place.

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

(A) Under the rules set forth in §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 §1.989(a)-1(d)) in the euro; and

(C) The QBU is not required to use the dollar as its functional
currency under §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 §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
§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.
§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 §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 §1.988-2(b)(5). For this purpose, the
exchange rate used under §1.988-2(b)(5)(i) shall be the
guilder/euro conversion rate. The amount under §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 §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 §1.988-2(b)
(3). For this purpose, the exchange rate used under §1.988-2(b)
(3)(i) is the guilder/euro conversion rate and the exchange rate
used under §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 §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)(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 §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. §1.985-8T [Removed] Par.5. Section 1.985-8T is
removed. Par.6. Section 1.1001-5 is added to read as follows:
§1.1001-5 European Monetary Union (conversion to the euro).

(a) Conversion of currencies. For purposes of §1.1001-1(a), the
conversion to the euro of legacy currencies (as defined in
§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 §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 orobligations
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 §1.1001- 3(c).

(c) Effective date. This section applies to tax years ending
after July 29, 1998.
§1.1001-5T [Removed]
Par. 7. Section 1.1001-5T is removed.

Robert E. Wenzel
Deputy Commissioner of Internal Revenue.

Approved: 12/13/00

Jonathan Talisman
Acting Assistant Secretary of the Treasury.

SEARCH:

You can search the entire Tax Professionals section, or all of Uncle Fed's Tax*Board. For a more focused search, put your search word(s) in quotes.

2001 Regulations Main | IRS Regulations Main | Home