The euro officially came into existence on January 1, 1999, replacing the national currencies of eleven EU member states and representing perhaps the most visible indication to date of European Monetary Union. The emergence of a pan-European capital market, with high liquidity and a rapidly expanding range of investment products, creates many new opportunities and challenges. Market participants are having to adjust rapidly to the ramifications of price transparency and increased competition.
Where the capital markets go, tax follows -- albeit a few paces behind. The changes being made in the capital markets to accommodate the switch into the euro raise the potential of taxes on "profits" that, economically, do not exist. This is because of the manner in which tax, in general, focuses on form rather than substance. The United Kingdom, in common with other jurisdictions, is trying to make the introduction of the single currency tax-neutral. In the UK, this has resulted in the December 1998 publication of the European Single Currency (Taxes) Regulations 1998, which deals with certain aspects of the switch to the euro. Other issues are to be dealt with through the application of existing law, as explained in various releases issued in 1998.
Debt Securities
Capital Markets
The advent of the single currency has triggered a number of changes in the eurobond markets. New issuance of government debt by europarticipants is now denominated in euro, rather than the national currency. This has led to rating agencies having to issue a range of sovereign credit ratings of EU governments, with ramifications on the raising of sovereign debt across the eurozone. Further, all eleven eurozone members have now redenominated some domestic currency government debt, changing the nominal amount of the debt from the national currency into euro.
Non-sovereign issuers are allowed to redenominate bonds, securitized debt and money market instruments unilaterally only where the relevant member state has redenominated its outstanding national debt pursuant to European regulations. A number of non-governmental issuers have been able to redenominate their existing national currency debt.
Where bonds have not been redenominated, interest and principal payments generally will be calculated in the national currency and converted to euro at the irrevocable conversion rates adopted by the EU Council, with rounding applied to each payment where necessary.
In addition to redenomination, most participating governments have changed the day-count convention for existing issues, where a day-count of 30/360 had previously applied, to bring consistency across old and new, eurodenominated issues. Member states have indicated that reconventioning of outstanding government bond issues will take place at various times over the transition period through December 31, 2001. Where reconventioning occurs other than on a coupon payment date it will affect accrued interest, with consequential adjustments in prevailing market prices for the relevant issue.
Redenomination may also lead to renominalization -- a change in the minimum nominal amount in which a bond can be held or traded to a round number. A number of participating member states have stated they will introduce minimum lot sizes for dealing purposes.
The combination of redenomination, renominalization and reconventioning may also lead to issuers making one-time payments to investors as a consequence of euroconversion. For example, ISDA has suggested that participants in the bond option markets may need to consider paying out rounding differences as a result of applying minimum lot sizes to a converted euro amount, subject to a de minimis threshold of 100.
Tax
For tax purposes, redenomination, renominalization and reconventioning are all brought together in a general concept of "euroconversion" in the UK tax regulations.
Investors. A euroconversion of a debt security will not be a recognition event for UK tax purposes. For corporate investors, non-recognition on euroconversion is assured by the manner in which existing rules work as such rules feed off the accounting treatment.
For non-corporates, Inland Revenue seems to accept that euroconversion will be regarded as a tax-free "conversion of securities" within existing law, so a "new" converted eurobond will be treated as if it is the same asset as the "old" bond for tax purposes. There are, however, specific rules to deal with euroconversion of discounted securities.
Non-recognition on euroconversion is, however, subject to one exception: any cash received on euroconversion of a bond must be brought into account for tax purposes.
Issuers. Where a UK company redenominates existing bonds, it will incur costs. The tax regulations ensure that such costs, where incurred as a result of a new issue in exchange for the existing securities, will be tax-deductible for the issuer.
However, these costs are deductible by a company only where they are incurred as a result of a euroconversion of its own securities. Where, for example, a group holding company incurs costs as a result of the redenomination of its investments (including shares in, or loans to, European subsidiaries), the deductibility of such costs is left to general principles.
Further, these provisions apply only where the costs relate to euroconversion effected by a "substitution" -- that is, an exchange of new eurosecurities for old. Where redenomination (with possible reconventioning, etc.) occurs without there being a new issue, then the issuer is subject to existing rules.
Withholding. The main thrust of the tax changes is to treat redenomination as a non-event. However, in the case of treaty claims for reduced or zero withholding on payments of interest by a UK borrower, the Inland Revenue has stated that redenomination of a debt into euro is a "material change" in the terms of the debt, of which the borrower must notify Inland Revenue for any existing treaty claim to remain valid.
Although this should not affect the euromarkets (most UK issuers rely on the "quoted eurobond" exemption from withholding), this is something that should be borne in mind for any syndicated loans or "private" deals involving a UK debtor, including loans made by a US parent to a UK subsidiary.
Equity Securities
Capital Markets
A rapid consolidation and rationalization in eurozone equity markets has accompanied the introduction of the euro.
The most important change has perhaps been the conversion of quoted prices for stocks from national currencies to the euro (shares are traded by number and value at prevailing quoted prices, in contrast to bonds, which are traded in nominal amounts and priced as a percentage of par).
The London Stock Exchange is now quoting prices for eurozone equities in euro and has stipulated the criteria on which it would switch pricing of a UK domestic equity from sterling to euro. However, it does not anticipate a high level of demand for the latter prior to a decision by the UK government to join the single currency.
The UK government has proposed that a UK company will be entitled to redenominate its share capital into euro simply through a resolution of the board of directors providing that references in any document to share capital denominated in sterling are to be construed as references to the equivalent in euro. This power could be exercised at any time following UK entry into EMU during the UK eurotransition period. However, the board resolution would be subject to a veto by shareholders.
There has not yet been any proposal to require a company that redenominates its share capital to issue redenominated share certificates.
Tax
The UK government has not yet directed its attention to tax aspects of UK euroequity concerns. Instead, the Inland Revenue is applying a "wait-and-see" approach: waiting to see if companies redenominate and, if so, how redenomination is achieved, before considering any tax changes.
Derivatives
Capital Markets
The impact of the euro on OTC derivative instruments has been the subject of a great deal of preparation by ISDA and market participants -- not least because of the inherent bilateral and private contractual nature of such transactions. The adoption of the euro has had a number of effects on derivatives, which industry bodies, especially ISDA, have sought to anticipate through adoption of market standard protocols. The main goal has been to achieve continuity by ensuring the switch to the euro did not result in termination of transactions.
In relation to EU participants, EU regulations provide that contracts will not be frustrated because of euro-related changes. However, as these regulations affect intra-EU contracts only, ISDA and other bodies have introduced protocols which are designed to provide for continuity as a bilateral contractual matter. The protocols can be adopted by both EU and non-EU participants.
While the substitution of the euro for participating national currencies did not automatically alter the denomination of OTC derivatives contracts, parties to such contracts needed to ensure that essential pricing or other reference sources to be adopted following the advent of the single currency were clarified for any affected OTC contracts. ISDA's EMU Protocol recognizes that the introduction of the euro could result in the disappearance of deposit rates in the national currencies of participating member states used as determinant rates in OTC derivatives contracts. The Protocol therefore provides for a series of fallback rate sources by reference to the originally designated rate source.
In relation to payment obligations, the majority of OTC derivatives stipulating payment in a participant national currency will continue to require payment in that currency during the transition period, unless the parties agree otherwise.
However, in order to enforce "legal equivalence" of the euro to participating national currencies, ensuring the euro and its "non-decimal subdivisions" are fully interchangeable, EU regulations confer on debtors a unilateral right to make payments in either the euro or the relevant national currency, provided that the payment is denominated in the euro or the national currency of the member state in which the account of the payee is situated.
For example, a company can make a settlement payment on French franc denominated obligations in either euro or francs (with conversion being effected at the irrevocable conversion rates) where payment is to be credited to an account of a payee in France. However, if the payment is to be made to an account located in Madrid, then this provision would not apply -- settlement would have to be in francs.
Under the applicable EU regulations, swap contracts constitute "legal instruments" and so are subject to the same rules that apply to debt for purposes of substituting the euro for the participant national currencies. Swap transactions involving the currencies of two participating member states have therefore been effectively transformed into an obligation of one party to make a series of net payments to its counterparty.
Continuity of contract will apply to all such cross-currency intra-EU swap contracts pursuant to the EU regulations. ISDA's EMU Protocol provides for continuity as a matter of bilateral contractual provision for such contracts and so can be adopted by both EU and non-EU counterparties. In practice, however, a number of market counterparties have opted to close out such contracts because the primary purpose for such contracts, such as currency exchange risk, has been lost.
Parties to derivative transactions on equities originally quoted in participant national currencies now need to consider exercise mechanics. In particular, it may be necessary to provide for conversion of the relevant exercise price and any cash settlement amount, as well as a change in the pricing methodology, to reflect any redenomination into euro. ISDA has recommended that parties confer on the calculation agent discretion to make any necessary conversions to pricing (whether of the exercise price into euro or the share price back into a national currency) on the exercise date.
LIFFE has already converted individual on-exchange equity options to euro where the underlying stock has transferred to trading in euro.
Tax
For UK tax purposes, specific regulations have been adopted. These ensure that, if the parties agree to continue a derivative transaction where the impact of the euro on the relevant contract (e.g., a change in rates or the loss of currency risk if both currencies switch to the euro) could lead to rescission/termination of the derivative, or where the transaction continues as a matter of law notwithstanding different terms as a result of the switch to euro, the tax rules will respect this continuance and so recognition of profit/loss is deferred.
Therefore, the switch to the euro should not have immediate tax consequences for UK counterparties. However, if the parties opt to let euroconversion terminate the transaction, normal tax consequences will follow.
Repos
Capital Markets
Perhaps the market which has had to deal with the most complex issues arising from the advent of the single currency is the repo market. Repo transactions also fall within EU legislation designed to ensure continuity of contract.
ISMA has adopted a similar approach to ISDA by expressly providing for continuity of contract in its Annex of Additional Terms and Conditions relating to European Economic and Monetary Union, published in June 1998.
Paragraph 4 of the ISMA Annex provides that for the purposes of the standard market agreement, securities redenominated from a national currency into euro will be "equivalent" to the securities originally delivered, even where renominalization and reconventioning have occurred. This is necessary given that the standard agreement requires delivery on a repurchase date of equivalent securities in the same nominal value as the securities that were the subject of the first leg of the repo transaction.
Tax
For UK tax purposes, repos are subject to detailed provisions. For the provisions to apply, a repo must require redelivery of "similar securities." Redenomination and reconventioning of a bond can clearly affect its "similarity" as so defined. As mentioned above, this is recognized by the ISMA Annex as a contractual matter. The tax regulations are designed to achieve a similar result for UK tax purposes by ensuring that repos do not fall outside the relevant tax rules purely because the repo'd securities euroconvert prior to redelivery, whether pursuant to an exchange for new securities or otherwise. In such circumstances, the new euro securities are to be treated as "similar" to the original securities.
The Inland Revenue has also introduced rules to deal with any capital payments made on euroconversion by the relevant issuer (that is, their tax treatment if "passed on" to the seller by the buyer). The broad effect of the rules is to treat the seller as if it had received payment directly from the issuer.
The regulations also ensure that the availability of UK stamp duty and stamp duty reserve tax reliefs to repos is not prejudiced by euroconversion.
Conclusion
All persons affected by the adoption of the single currency have attempted to make the transition as smooth as possible. Although much attention has been focused on the political issues, the capital markets have placed their emphasis at the micro level -- on the documentary and regulatory details. Industry bodies -- such as ISDA and ISMA -- have put considerable effort into making the process of euroconversion appear a "non-event," with UK tax authorities recognizing the need to follow suit. The intention underlying all documentary and legislative changes has been to provide for continuity. This seems to have been achieved -- although, with the euro only a few months old, the success of this effort is still being tested. *
- Securitization/Asset Finance Update
- This Update is published periodically by the Capital Markets Department of Cadwalader, Wickersham & Taft. © 1999 Cadwalader, Wickersham & Taft. All rights reserved. Quotation with attribution is permitted. The newsletter provides general information and should not be used or taken as legal advice for specific situations, which depend on the evaluation of precise factual circumstances. For further information on the articles contained in this Update, or matters related to Cadwalader, Wickersham & Taft's practice, please contact a member of the Firm.