Euro Conversion

• International
• The Euro -- How And Why
• No Section 1001 Recognition
• Change in Functional Currency
• Requested Comments
• Conclusion

Edited by Sanford H. Goldberg, J.D., And Herbert H. Alpert, J.D.

Euro Conversion Temp. Regs. Take Favorable Approach on Gain Recognition

Despite the potential for finding taxable events in various milestones along the road to the conversion of legacy currencies to the euro, the Temporary Regulations generally allow for deferral. The reasonable approach taken by Treasury and IRS should calm the jitters of U.S. taxpayers that do business or invest in the euro-adopting countries of the European Union.

By Alan S. Lederman and Bobbe Hirsh

ALAN S. LEDERMAN, P.A., is a partner in the Miami office of the law firm of Broad & Cassel. BOBBE HIRSH is a partner in the law firm of Lord, Bissell & Brook, located in its Chicago office. Both are frequent contributors to The Journal and other professional publications.

One of the cornerstones of the European Union is the adoption of a single currency, the euro.¹ Temp. Regs. 1.1001-5T and 1.985-8T (TD 8776, 7/29/98; also Proposed Regulations, REG-110332-98, 7/29/98) provide guidance on the U.S. tax effects of the creation of the euro. Treasury's general allowance of deferral has alleviated the concerns of the many U.S. participants in the European Union economy. Under the Temporary Regulations, only a limited number of U.S. taxpayers will experience acceleration of gain due to the euro conversion. The Euro -- How And Why

On 1/1/99, 11 of the 15 members of the European Union² are scheduled to adopt the euro as their official currency and to transfer their foreign currency reserves to a newly created European Central Bank.³ On that date, the exchange rates of the 11 converting currencies ("legacy currencies") will become irrevocably fixed as to both the euro and each other.

Under European Union regulations, the euro introduction will proceed in stages. Under a three- to 31/2-year "no prohibition, no compulsion" regime, the legacy currencies will coexist in tandem with the euro from 1/1/99 through, depending on the country, some date between 1/1/02 and 6/30/02.⁴ During this period, the legacy currencies will be viewed as sub-units of the euro,⁵ and both the euro and the legacy currency will be able to be used interchangeably in the adopting countries. For example, companies will have the option to invoice in either a legacy currency or the euro.⁶

Nevertheless, the euro generally will be the currency used in wholesale, bookkeeping, and other noncash transactions, and many European stock exchanges will begin to conduct business in the euro commencing 1/1/99. New public debt issuances will be denominated in euros, as well as many pre-1999 public debt issuances, and euros automatically will be used to satisfy European Currency Unit (ECU) denominated obligations on a one-to-one basis, in the absence of a specific contractual provision stipulating otherwise. Euro bills and coins, however, will not enter into circulation until 2002. Thus, legacy currencies generally will continue to be used until then for retail transactions unless, for example, the consumer charges the purchase on a credit card issued by a credit card company using the euro. By 7/1/02, the process of converting to the euro will have been completed in all of the 11 adopting countries, and the legacy currencies will cease to be legal tender.

Despite the euro's not being legal tender until 1/1/99, the process of conversion began on 5/3/98 when the European Council fixed the 1/1/99 relative exchange rates (subject to the post-1998 rounding conventions) among the legacy currencies. The apparent rationale for this early fixing was to prevent a legacy currency country from depressing its relative exchange rate at or near the end of 1998 with a view to artificially improving its home companies' competitive position as compared to that of companies of other adopting members. The exchange rate of the legacy currencies to the euro cannot be fixed until 1/1/99, however, because European Council regulations require the euro to equal one ECU on that date, and the ECU can fluctuate independently of the legacy currencies until 1/1/99.⁷

The cost of euro conversion is estimated by some to far exceed the cost of the Year 2000 computer problem for affected businesses.⁸ One of the costs will be due to the elimination of official inter-legacy currency exchange rates during the transition period. Instead, conversion will require triangulation and the application of certain rounding conventions,⁹ necessitating the acquisition of complex new software to accommodate the dual currency system during the transition period.¹⁰ Simply modifying or replacing computer application software, keyboards, and fonts in order to accommodate the new euro symbol (similar to the letter C with two horizontal bars through its middle) will be a costly venture.

There are numerous other financial costs. Securities will not only have to be redenominated (i.e., converted from legacy currency into euros), but also renominalized (e.g., changed from a single bond with a face value of 10,000 denominated legacy currency into ten bonds with a face value of 1,000 euros each), with generally either a rounding up for the investor or a cash settlement for the difference. In some situations, the securities will have to be reconventioned for changing market conventions as well. In addition, interest rates' reference to the national -IBORs of certain adopting countries (e.g., France, Germany, the Netherlands, Ireland, and Belgium) are expected to be replaced soon by the EURIBOR.

Business costs are not limited to matters of financial, accounting, and information technology systems, but will be incurred in virtually every facet of running a business.¹¹ U.S. persons doing business with or investing in the European Union will incur many, if not all, of the same costs as European-based businesses and investors. The concern arose whether they could incur another cost not faced by their European Union competitors: the premature recognition of gain for U.S. tax purposes with respect to legacy-currency-denominated assets and investments. No Section 1001 Recogniton

Probably the single most important U.S. tax issue relating to the euro conversion was whether the mere conversion of a legacy-denominated financial instrument into a euro-denominated instrument would trigger the recognition of gain or loss under Section 1001.

Section 1001(a) requires recognition of gain or loss on a sale or other disposition of property equal to the difference between the amount realized and the adjusted basis of the disposed property. When property is exchanged for other property that differs materially in kind or extent, Reg. 1.1001-1(a) treats the exchange as a taxable disposition of the property. Thus, when a debt instrument undergoes a "significant modification," Reg. 1.1001-3(b) deems there to be a constructive taxable exchange of the pre-modified debt instrument for the modified debt instrument.¹²

A broad scope of U.S. taxpayers, including those investing in mutual funds with investments in legacy currency securities, faced possible recognition of gain on the euro conversion date. Moreover, any gain or loss would not be limited to exchange gain; rather, the entire gain or loss, such as that attributable to changes in market rates, the credit-worthiness of the issuer, and the like, would be triggered. The possibility that constructive taxable exchange treatment could extend to any investment or obligation modified because of the conversion to the euro made the possible class of affected U.S. taxpayers quite large.

Taxpayers raised several arguments against gain recognition. Although Reg. 1.1001-3(c)(1)(i) generally views an alteration of a legal right or obligation under a debt instrument as a "modification," an alteration that occurs by operation of the terms of a debt instrument itself is excluded from the definition of a taxable modification.¹³ Some have argued that conversion to the euro can be analogized to an alteration that occurs by operation of the terms of the instrument, because many legacy currency denominated debt instruments are governed by the laws of the European Union, which provide that the contractual rights and obligations of the parties, unless otherwise specifically provided, are to be unchanged by reason of the restatement to the euro. Some U.S. states whose laws govern some legacy-currency-denominated instruments (notably New York, Illinois, and California) have similarly codified the European Union's continuity-of-contract legislation on the euro.¹⁴

Many suggested that even if the restatement to the euro were viewed as a modification--a distinct possibility since most pre-1999 debt instruments do not explicitly provide for the euro conversion--such a modification should not be viewed as "significant." Reg. 1.1001-3(e)(1) provides generally that a modification is significant "only if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant." Reg. 1.1001-3, as promulgated in 1996, arguably supported the position that the euro conversion was not an "economically significant" modification because it omitted the Proposed Regulations' characterization of a change of the currency for payment as per se "significant," leaving the determination to be made, according to the Preamble to the final Regulations, under the general significance rule.¹⁵ Thus, some argued that the euro conversion is not economically significant because the euro value of the instrument is identical to the legacy currency value and, by law, the legacy currency is merely a denomination of the euro with a value to the euro permanently fixed, just as a penny is permanently fixed as one-hundredth of a dollar.

A third argument raised for nonrecognition was that if any gain was to be triggered under Reg. 1.1001-3, it should be deferred by analogy to the involuntary conversion provisions of Section 1033.

The Treasury accepted the first argument. New Temp. Reg. 1.1001-5T generally eliminates the concern over immediate gain recognition due solely to conversion to the euro. Temp. Reg. 1.1001-5T(a) disposes of the issue for U.S. holders of legacy currency and accounts by providing that the conversion of a legacy currency to the euro is not an exchange of property for materially different property and, thus, is not a constructive exchange taxable under Reg. 1.1001-1(a). Accordingly, U.S. taxpayers with the U.S. dollar as their functional currency will not recognize gain or loss on conversion to the euro of their legacy currency bills, coins, and accounts. Similarly, gain or loss will not be recognized by a taxpayer with a legacy functional currency when its functional currency converts to the euro but, as discussed later, such a taxpayer will recognize exchange gain or loss under Temp. Reg. 1.985-8T(c)(3)(iii) on conversion of holdings of any of the other legacy currencies.

Temp. Reg. 1.1001-5T(b) deals with the issue of legacy-currency-denominated debt instruments. It allows nonrecognition when such instruments change to euro-denominated instruments solely as a result of the conversion to the euro by providing that such event is not a modification within the meaning of Reg. 1.1001-3(c). This Temporary Regulation has the collateral effect of protecting the tax benefits of legacy-currency-denominated "TEFRA D" bonds on conversion to the euro.¹⁶ It also extends protection to legacy-currency-denominated rights and obligations by providing that the euro conversion is not an event that is a taxable exchange under Reg. 1.1001-1(a).

Temp. Reg. 1.985-8T(a)(1) treats the ECU as a "legacy currency,"¹⁷ thereby extending the benefit of Temp. Reg. 1.1001-5T to conversions of ECU-denominated debt instruments, rights, and obligations. The Preamble to TD 8776 points out, however, that collateral agreements could cause conversion to be a taxable event. For example, if in connection with a change to the euro the interest yield on a floating rate bond denominated in a legacy currency general index is renegotiated to a EURIBOR index and the two yields differ by more than the greater of 25 basis points or 5% of the pre-modification yield, the renegotiation could be a taxable event under Reg. 1.1001-3(e)(2).

Many holders of legacy currency debt will recognize some gain or loss in connection with partial prepayment due to the euro conversion, but only to the extent realized. This recognition will arise from issuers' actions to avoid having oddly nominalized bonds when the denomination changes from legacy currency to euro. Some issuers intend to make a pro-rata prepayment of principal and accrued interest of a portion of the debt to allow the bond instruments to be reissued in a round face amount of whole euros. Reg. 1.1001-3(e)(2) indicates that such a pro rata prepayment will not constitute a constructive exchange as to the remaining portion of the debt, although the prepayment will be treated under Reg. 1.1275-2(f) as a payment of accrued interest, principal, and possibly OID on an allocable portion of the bond. Thus, the bondholder would recognize any market or exchange gain or loss with respect to the amount of the prepayment, while the issuer could have exchange gain or loss and discharge of indebtedness income or purchase premium.¹⁸ Change in Functional Currency

The tax issues arising from the conversion to the euro are more complex for certain taxpayers conducting business abroad through a branch or foreign subsidiary that has a "functional currency."

Under Reg. 1.989(a)-1(b), a qualified business unit or QBU is a trade or business for which a separate set of books and records is maintained. The currency of the economic environment in which a significant part of the activities of the QBU are conducted and that is used by the QBU in keeping its books and records is the QBU's functional currency.¹⁹ A corporation is always treated as a QBU, while a branch or partnership²⁰ is treated as a QBU of its sole owner or each of its partners only if the branch or partnership satisfies the trade or business and books and records tests. Thus, for example, a controlled foreign corporation (CFC) incorporated in an adopting country is a QBU, as is a partnership it forms or a branch it operates in another adopting country, if the trade or business and books and records test are met by the partnership or branch.

The euro conversion causes difficult tax issues to arise only where a U.S. taxpayer has a legacy functional currency QBU (1) with assets or liabilities on 12/31/98 denominated in another legacy currency ("legacy nonfunctional currency") or (2) which in turn has a branch that uses another legacy currency as its functional currency. Both situations could be present, as shown in the example below.

The first circumstance would occur when a legacy functional currency QBU has entered into a "Section 988 transaction" denominated in a legacy nonfunctional currency, and such transaction is open on 12/31/98.²¹ Such Section 988 transactions would include holding nonfunctional currency, acquiring or becoming the obligor on a nonfunctional-currency-denominated debt instrument, holding receivables or payables on which the associated accrued income or expense has been recognized, and entering into or acquiring a forward, futures, or option contract or similar financial instrument.²²

In the second circumstance--a legacy functional currency QBU has a branch that uses another of the legacy currencies as its functional currency--Prop. Reg. 1.987-2(c) requires such a QBU to maintain a floating legacy functional currency "equity pool" account for its branch, to reflect its capital investment in the branch, computed using historical exchange rates.²³

Example: At the end of 1998 an Irish CFC with an Irish punt functional currency could have Section 988 transactions from holding Italian lira bank deposits and accounts receivable and being indebted under a German mark loan and could also maintain an equity pool for a branch in Portugal with an escudo functional currency.

Legacy functional currency QBUs will experience neither additional exchange gain or loss after the close of 1998 with respect to their legacy nonfunctional currency transactions that remain open on 12/31/98 nor any further exchange rate adjustments after 1998 with respect to their branch functional currency equity pool for legacy currency branches. Such QBUs, however, will have unrealized exchange gain or loss on nonfunctional legacy currency holdings, nonfunctional legacy currency open Section 988 transactions, and nonfunctional legacy currency branch equity pools on 12/31/98.

The issue was raised as to whether Reg. 1.985-5 would be applied to the euro conversion to cause recognition of this pre-1999 unrealized exchange gain or loss.²⁴ That Regulation generally provides that a QBU which changes its functional currency must recognize in the tax year preceding the year of change the unrealized gain or loss on open Section 988 transactions that are denominated in or determined by reference to the new functional currency. Further, if a taxpayer and its branch use different functional currencies and either the taxpayer changes its functional currency to that of the branch, or the branch changes its functional currency to that of the taxpayer, the taxpayer must recognize exchange gain or loss on the branch's equity pool in the tax year preceding the year of change.

Thus, in the example above, the issue would be whether, in the year preceding the year the Irish CFC changed its functional currency from the punt to the euro, the Irish CFC would immediately recognize the pre-1999 punt-lira exchange gain or loss with respect to its lira-denominated bank deposits and accounts receivable, the pre-1999 punt-mark exchange gain or loss with respect to its mark-denominated loan, and the pre-1999 punt-escudo exchange gain or loss with respect to its Portuguese branch equity pool.

In addition to the issue of whether Reg. 1.985-5 should be applied to the adoption of the euro to cause recognition of the unrealized gain, the issue also arose as to when a legacy currency QBU should be viewed as changing its functional currency to the euro: the 1/1/99 introduction of the euro; the year the QBU changes its books to the euro; or the year in which the euro completely replaces the legacy currency (2001 or 2002).

Not all U.S. taxpayers with legacy functional currency QBUs faced the potential of acceleration of U.S. tax due to the euro conversion. If, for example, the pre-1999 nonfunctional legacy currency Section 988 transaction would be marked-to-market on 12/31/98 under Section 1256 (concerning certain foreign currency contracts) or under Section 475 (concerning portfolios of securities dealers), the pre-1999 unrealized gain or loss would be recognized on 12/31/98 regardless of the resolution of the issues posed by conversion to the euro.²⁵ Even were a CFC to have to recognize exchange gain from the euro conversion, certain exceptions from Subpart F income treatment potentially could apply to permit the U.S. parent to continue to defer U.S. taxation of the gain, such as the Reg. 1.954-2(g)(2)(ii) exception for exchange gain that relates to assets acquired in the ordinary course of business.

Nevertheless, a sufficient number of U.S.-based multinational corporations were affected, resulting in several responses to the Service's request for comment letters in Ann. 98-18, 1998-10 IRB 44. Not unexpectedly, the comments uniformly requested that the euro conversion be tax neutral for U.S. taxpayers by allowing continuing deferral of the unrealized pre-1999 exchange gains. The comments frequently noted that the change to the euro, unlike the normally voluntary changes in functional currency described in Reg. 1.985-5, was an involuntary change that had some features of a redenomination of an existing currency (e.g., a change from 100 "old" units to one "new" unit), a change generally not thought to be within the scope of Reg. 1.985-5(a).

Approach of the Temp. Regs.

The Temporary Regulations adopt different approaches that depend on the origin of the unrealized exchange gain or loss. With respect to holdings of nonfunctional currency (including bank deposits), Temp. Reg. 1.985-8T(c)(3)(iii) rejects the comments received by the Service and triggers the recognition of the unrealized exchange gain or loss on the last day of the tax year preceding the year of the adoption of the euro. While this rule would seem unduly harsh, the Preamble to TD 8776 rationalizes that cash accounts are generally turned over rapidly and the administrative burdens in tracking exchange gains and losses outweigh the benefit of deferral. On the other hand, this acceleration may be detrimental to some U.S. multinationals with large cash balances that have built up over time. Acceleration of tax also creates the risk that if the euro disintegrates and the legacy currencies are restored, an otherwise avoidable tax cost will have been incurred.

In contrast, Temp. Reg. 1.985-8T generally responds favorably to the request for deferral on open pre-1999 Section 988 transactions other than nonfunctional currency holdings. Most important, open pre-1999 Section 988 transactions denominated in nonfunctional legacy currencies are generally treated as a Section 988 transaction after the conversion to the euro, and the principles of Section 988 continue to apply irrespective of the year in which the QBU changes to the euro. As a consequence, pre-1999 exchange gain on nonfunctional-legacy-currency-denominated Section 988 transactions generally are deferred until settlement.

In addition, the Section 988 characterization of gain and loss controls rather than the Reg. 1.985-5 rules. Thus, for example, if a QBU sells a nonfunctional currency capital asset, such as a bond, at a price that reflects both an exchange gain and a market loss, it will be allowed to use the capital loss from the decline in market value to offset the ordinary gain due to currency exchange fluctuation. In contrast, Reg. 1.985-5 does not allow unrealized exchange gain or loss recognized on a change in functional currency to be offset by the unrealized market gain or loss.

Temp. Reg. 1.985-8T(c)(3)(iv) allows a QBU to accelerate recognition of the pre-1999 exchange gain or loss on accounts receivable and accounts payable to the year preceding the adoption of the euro as a functional currency. Since the 5/3/98 fixing of the 1/1/99 inter-legacy exchange rates by the European Commission moderates fluctuations in such rates during the period from the fixing through 12/31/98, the magnitude of the potential exchange gain or loss is probably not large. The tax effect of the election normally would be limited to a one-year acceleration of exchange gain or loss because pre-1999 accounts receivable and accounts payable typically will be collected or paid during the first tax year ending in 1999. Such an election would be useful if, because of software constraints, it were impractical to track the pre-1999 exchange gain or loss associated with nonfunctional currency accounts receivable or accounts payable until their collection or payment.

Temp. Reg. 1.985-8T(b) also provides that a legacy functional currency QBU can continue to use the legacy currency as its functional currency up to the last tax year beginning on or before the first day such legacy currency is no longer valid legal tender. Nevertheless, a QBU must change its functional currency to the euro if it begins to maintain its books and records in the euro before that last year. Calendar-year QBUs, for example, will change from their 1998 legacy functional currency to the euro in either 1999, 2000, 2001, or possibly 2002 (if the legacy currency country decides to exercise its option to extend the legality of its currency until mid-2002), depending on the year that the QBU changes its books and records to the euro. The determination of when the QBU begins to maintain its books and records in the euro can create some controversy, since some QBUs will, as a practical matter, maintain dual euro and legacy currency books and records from 1999 through to perhaps mid-2002.

In addition, Temp. Reg. 1.985-8T(b) provides that a QBU changing its functional currency from a legacy currency to the euro need not obtain IRS consent, otherwise generally required by Reg. 1.985-4 for a change in functional currency, but a statement regarding the change to euro functional currency must be filed with certain U.S. taxpayers' returns. Temp. Reg. 1.985-8T(b)(1) prohibits a QBU with an initial tax year beginning after 12/31/98 from adopting any of the legacy currencies as its functional currency.

If a branch changes its functional currency from a legacy currency to the euro in a year when the taxpayer has already adopted the euro as its functional currency, or if a taxpayer changes its functional currency from a legacy currency to the euro in a year when the branch has already adopted the euro as its functional currency, Temp. Reg. 1.985-8T(c)(4) generally requires recognition of gain and loss. Instead of being included in full in the year preceding the change, however--as Reg. 1.985-5 normally would require--the gain or loss is taken into account ratably over four tax years, beginning with the tax year of the change to the euro.²⁶ The Preamble to TD 8776 states that permitting longer deferral would provide additional administrative burdens and opportunities for abuse that outweigh the benefit of further deferral. On the other hand, consistent with Reg. 1.985-5, if a branch changes its functional currency to the euro during a year in which the taxpayer's functional currency is not the euro, or if a taxpayer changes from a legacy currency to the euro and the branch's functional currency is not the euro, no gain or loss is recognized.

Example: Applying the rules of Temp. Reg. 1.985-8T to the preceding example concerning the Irish CFC, if the CFC changed to the euro in 1999, it:

• Would recognize the pre-1999 exchange gain on its lira-denominated bank deposits in 1998.
• Could either elect to recognize the pre-1999 exchange gain on its lira-denominated accounts receivable in 1998 or defer this gain until the date of collection.
• Would generally defer the pre-1999 punt-mark exchange gain or loss with respect to its mark-denominated loan until the year it repaid the loan.
• Would defer the pre-1999 punt-escudo exchange gain or loss with respect to its Portuguese branch equity pool until the branch similarly adopted the euro as its functional currency, at which time the gain or loss would be included in its income ratably over four years.

Temp. Reg. 1.985-8T(c)(2) requires that a euro basis in assets and liabilities be established by multiplying the legacy functional currency adjusted basis or amount of liabilities by the applicable 1/1/99 euro-to-legacy functional currency exchange rate. Temp. Reg. 1.985-8T(c)(6) similarly requires a corporation's euro currency E&P and its euro paid-in capital to equal the product of the legacy currency amounts multiplied by the applicable conversion rate. It also requires that the pre-1987 foreign income taxes and accumulated profits or deficits maintained in a foreign currency for purposes of the Section 902 foreign tax credit (FTC) be translated into the euro at the applicable exchange rate.

Double tax potential. The principal means for avoiding double taxation on international operations is the FTC. Treasury's enlightened approach in the Temporary Regulations of providing nonrecognition of unrealized exchange gains and losses from the conversion to the euro under Reg. 1.1001-1(a) and deferral of such unrealized gains or losses on Section 988 transactions (other than nonfunctional currency and deposits) is consistent with the approaches being taken by Revenue Canada, U.K.'s Inland Revenue, and the tax authorities of most of the euro adopting countries.²⁷ When the U.S. rules for the recognition of income are consistent with those of the foreign countries in which a U.S.-based multinational operates, the FTC typically will work well to alleviate double taxation.

Where the Temporary Regulations' approach differs from that being taken by foreign taxing authorities, however, the potential for double taxation can arise. Temp. Reg. 1.985-8T's rules--triggering the recognition of pre-1999 exchange gain on nonfunctional foreign currency in the year preceding adoption of the euro as functional currency, requiring the inclusion of gain or loss with respect to the branch equity pool over four years, and permitting an election to accelerate exchange gain or loss on accounts receivable and accounts payable to the year prior to the adoption of the euro as a functional currency--typically will not be followed in other foreign jurisdictions, although it is possible that some other countries (such as Belgium) may not be as lenient as Temp. Reg. 1.985-8T in deferring exchange gains beyond 1998. Therefore, as acknowledged in the Preamble to TD 8776, there can be mismatching in the operation of the FTC.

The problem caused by such mismatching is not one merely of the timing of relief (this is an endemic problem dealt with by the carryback and carryforward of credits), but rather, due to the mechanics of how income and taxes are assigned for purposes of the Section 904(d) separate limitations, of whether any relief will be obtained. Reg. 1.904-6(a)(1)(iv) provides that where income is recognized for foreign tax purposes in a year different from that in which it is recognized for U.S. purposes, the FTC carryover attributable to the income is assigned to the category of income to which it would have been assigned had it been recognized for U.S. tax purposes in the year it was recognized for foreign tax purposes. Under Sections 954(c)(1)(D) and 904(d)(2)(A)(i), foreign exchange gains that do not directly relate to the needs of a CFC's business is generally passive. Where a high rate of tax is imposed on such income, however, Section 904(d)(2)(A)(iii)(III) treats the gain as general limitation income. Depending on the amount, source, and foreign taxability of the taxpayer's other passive income²⁸ recognized for U.S. tax purposes in the year in which the exchange gains are recognized for foreign income tax purposes as compared with the amount, source, and foreign taxability of the taxpayer's other passive income in the year in which the exchange gains are recognized for U.S. income tax purposes, it is possible that the foreign taxes on the gains and the gains themselves could be assigned to different separate limitation categories, leading to double taxation of the gains. Requested Comments

In connection with issuing the rules on the euro conversion as Temporary and Proposed Regulations, Treasury and IRS asked for comments on five issues.

Application of Sections 1092 and 1259. The first issue is how the Section 1259 rules on constructive sales treatment for appreciated financial positions and the Section 1092 straddle rules should be applied to the euro conversion, with separate comments requested for periods before 5/3/98, between 5/3/98 and 12/31/98, and post-1998. The conversion to the euro has increased the possibility that taxpayers who entered into financial transactions (such as various borrowings and investments) in different legacy currencies, possibly at different national -IBOR rates, could be found subject to the Section 1092 straddle rules²⁹ or have Section 1259 constructive sales³⁰ when those financial positions all become denominated in the euro, possibly at EURIBOR rates. For example, a U.S. corporation with a Belgian branch that borrowed in Belgian francs and a Spanish branch that made a loan of a similar amount in Spanish pesetas arguably could find itself subject to the straddle rules due to the post-1998 franc-peseta exchange rates being fixed by the European Union on 5/3/98.

Interaction with Section 905. The second issue is how the rules of Section 905 for redeterminations of foreign tax liabilities should operate in the context of the euro conversion. For example, a U.S. taxpayer may pay foreign income tax in a legacy currency before 1999, claim an FTC for the tax paid, and later receive a refund in euros of a portion of that tax. Section 905(c) requires that the pre-1999 U.S. income tax be redetermined to reflect a reduction in the FTC by the amount of the refund. Section 986(a)(2)(B)(ii) requires conversion of the foreign tax refund at the U.S. dollar exchange rate on the date of original payment of the tax. Because the euro did not exist on the pre-1999 date of payment, it is literally impossible to apply this rule.³¹ One approach could be to express the euro refund in terms of legacy currency, using the exchange rates fixed on 1/1/99, and then determine the U.S. dollar value of the amount of legacy currency on the date the refunded tax was originally paid.

Nonlegacy currency conversions. The third issue is whether a QBU whose functional currency was not a legacy currency, but whose functional currency should properly be the euro after the conversion, should be deemed to have automatically changed its functional currency. In other words, should the automatic change in functional currency provided for in Temp. Reg. 1.985-8T(b)(2) for changes to the euro from a legacy currency be extended to a nonlegacy currency QBU properly converting to the euro?

For example, Reg. 1.985-1(d)(1) states that a foreign corporation with branches in several countries determines its functional currencies by taking into account the combined activities of itself and all its branches. This branch aggregation rule would logically lead many CFCs with branch operations in at least several of the 11 adopting countries to find themselves with the euro as their functional currency, even if their functional currency before the conversion were properly not a legacy currency. Reg. 1.985-4(a) currently requires a nonlegacy functional currency QBU to obtain permission of the Service before changing its functional currency.

Future euro conversions. The fourth issue is whether additional guidance should be provided with respect to QBUs with functional currencies that adopt the euro in the future. Additionally, comments are requested concerning Section 988 transactions of a QBU using the euro as a functional currency that are denominated in a currency that later adopts the euro.

If, for example, the U.K. converts to the euro on 1/1/03, the question would arise as to whether QBUs using the euro as their functional currency with open British-pound-denominated Section 988 transactions on 12/31/02 (1) can defer their pre-2003 unrealized euro-pound exchange gains or losses on open Section 988 transactions until the transaction is terminated, by analogy to Temp. Reg. 1.985-8T(c)(3), (2) should recognize those gains in 2002 or over a four-year period, by analogy to Reg. 1.985-5, or (3) should be subject to some other approach. One would think that the date of adoption of the euro should not affect the taxation of the transaction.

Integrated Section 988(d) hedging transactions. Finally, is guidance required to address Section 988(d) hedging transactions? The Preamble to TD 8776 notes that it is intended that Temp. Reg. 1.985-8T be applied on an integrated basis and that if a QBU subsequently closes one position of a Section 988(d) integrated hedging transaction after the euro conversion, Section 988 should be applied to the remaining open euro-denominated position.

Example: A U.S. corporation's German subsidiary with a mark functional currency makes a French-franc-denominated loan before 1999 and, to hedge its exposure to depreciation in the franc relative to the mark, it simultaneously enters into a forward contract to sell the French francs as received on the loan for German marks at a fixed exchange rate. Reg. 1.988-5(a) would treat the loan and nonfunctional currency hedge, if properly designated, as a single mark-denominated loan. After the German subsidiary's functional currency changed to the euro, the French franc (eventually euro) forward contract arguably would no longer qualify as a nonfunctional currency hedge for purposes of Reg. 1.988-5(a). Under the Preamble and Temp. Reg. 1.985-8T(c)(3)(i), the pre-1999 French franc-German mark exchange gain or loss apparently should be deferred until the corresponding loan payments are received. If, however, the German subsidiary either sells the loan or closes out the forward contract prior to maturity, the gain or loss on the remaining position would apparently be triggered under Reg. 1.988-5(a)(6)(ii). Conclusion

The euro conversion presents novel tax issues that are appropriately settled by reference to tax policy rather than narrow, technical analyses of authorities dealing with abusive transactions. Rather than trying to squeeze additional U.S. tax revenue from a European political decision, the Service's adherence to sound tax policy exhibited by Temp. Regs. 1.1001-5T and 1.985-8T is commendable. By neither imposing onerous tax liabilities on taxpayers prior to the realization of income with which to pay the tax nor allowing windfall tax savings to taxpayers on transactions that are still open, Treasury and IRS have taken a big step toward tax equity and tax fairness.

¹Treaty on European Union signed 2/7/92 (31 I.L.M. 247) (entered into force 11/1/93); "Joint Communique of 3 May," 1998 European Commission Official Journal C 1998 160 (5/27/98). See the European Commission's website at http://www.europa.eu.int. See also Gruson, "The Introduction of the Euro and Its Implications for Obligations Denominated in Currencies Replaced by the Euro," 21 Fordham Int'l L.J. 65 (1997).

²Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Denmark, Sweden, and the U.K. declined to participate, ostensibly for reasons of national sovereignty. Greece failed to meet required economic targets, but hopes to participate in the future. The European Union plans to expand its membership, in which event the newer members may adopt the euro, as may the four current members not presently participating.

³The European Central Bank will govern the new currency and is empowered to implement certain central monetary policies, such as those involving short-term interest rates, the money supply, and foreign exchange rates with the currencies of the non-euro-adopting countries.

⁴While no legacy currency will be acceptable legal tender after 6/30/02, member countries have the option of reducing or eliminating the final six-month currency transition period.

⁵This is designed to deter speculation that the euro will fail. For example, during the 1999-2002 transition period, speculators otherwise might buy perceived strong legacy currencies and incur liabilities in perceived weak legacy currencies. Because the legacy currencies will be treated as mere denominations of the euro, legacy currency exchange rates will be fixed relative to the euro. Thus, if the euro fails, it appears that legacy currencies will be settled at the 1/1/99 official conversion rates, preventing this strategy from succeeding. See van Overbeeke, "No Profit For EMU Speculators," available through ING website, http://euro.ing.nl.

⁶It is expected that larger companies will use euros immediately (Philips Electronics and Siemens have announced that they will adopt the euro on 1/1/99), with small retail cash businesses likely being the last to convert. See Hofland and Janowski, "The European Monetary Union is Causing Massive Headaches for Europe's Businesses" (September 1997), available through Byte Magazine website, http://www.byte.com.

⁷The ECU is not a currency in the traditional sense, but rather a weighted average of the currencies of the European Union's 12 original members (the current members except for Finland, Sweden, and Austria). The value of the ECU is therefore determined by including in its average the value of the British pound, the Danish krone, and the Greek drachma, none of which will convert to the euro on 1/1/99, and not including in its average the Austrian schilling and the Finnish markka, since those adopting countries were not original members of the European Union. Thus, the value of the legacy currencies to the ECU will continue to fluctuate until 1/1/99, with the consequence that their value relative to a euro cannot be fixed until that date.

⁸See, e.g., Xenakis, "Much Ado About the Euro," CFO (April 1998), available through http://www.cfonet.com.

⁹Triangulation requires converting the first legacy currency to the euro in accordance with the official exchange rate for that legacy currency and then converting the euro to the second legacy currency using the official exchange rate for the second legacy currency. The exchange rate will be quoted to six significant figures, with converted amounts rounded to the nearest tenth of a eurocent and then converted to the second legacy currency rounded to the nearest cent.

¹⁰In Rev. Proc. 97-50, 1997-45 IRB 8, the Service held that self-developed software relating to solving the year 2000 problem could be expensed immediately, whereas purchased software had to be capitalized and amortized over the shorter of its useful life or five years. This capitalization requirement for purchased software has been criticized by some commentators on the theory that the cost of purchased year 2000 software should be analogized to a currently deductible repair. See, e.g., Kahn, "Deducting Year 2000 Costs," 98 TNT 119-66. The costs of modifying software to conform to the euro introduction seem sufficiently analogous to the year 2000 problem to qualify for the treatment set forth in Rev. Proc. 97-50. Nevertheless, the treatment of euro conversion costs was explicitly left open by the Preamble to TD 8776, 7/29/98, presumably because conversion costs are under the jurisdiction of a domestic review group, not the international group responsible for these Temporary Regulations. Further, IRS officials responsible for domestic issues have stated that no guidance will be issued on the deductibility of euro conversion costs, which, according to these officials, will be determined through a facts and circumstances test. See "ABA Tax Section Meeting: Words of Warning on Hybrid Transactions," 98 TNT 148-5; "IRS Will Not Issue Rules Addressing Deductibility of Euro Conversion Expenses," BNA Daily Tax Report, 8/3/98, page G-2.

The five-year amortization requirement of Rev. Proc. 97-50 for purchased software contrasts with the general three-year depreciable life assigned by Section 167(f)(1). For example, purchased software that is useful only during the three- to 31/₂-year transition period should, even if not viewed as a repair, be depreciable over no longer than that period. Some comment letters to the Service requested that the depreciable life of certain equipment, such as vending machines that cannot be economically modified to accept euro coins, should be permitted to be redetermined to no later than the end of the transition period. Unfortunately, in Miller, TCM 1989-66, the Tax Court noted that Section 168 does not incorporate any provision reducing useful life by projected obsolescence.

¹¹For example, marketing decisions will have to be made on whether to price items in round euros or round legacy currencies during the transition period, and with a single reference currency, it will be more difficult to charge different prices for the same product in different countries, requiring businesses to adopt new pricing strategies. SEC Staff Legal Bulletin No. 6 (7/22/98) notes that publicly traded companies should disclose on their SEC-required reports material issues concerning conversion costs, price transparency, and U.S. and foreign tax liabilities triggered by the euro conversion.

¹²"Modification" and "significant" are defined in Regs. 1.1001-3(c) and (e), respectively. For a discussion of constructive exchanges, see Lipton, "The Section 1001 Debt Modifications Regulations: Problems and Opportunities," 85 JTAX 216 (October 1996); Wolf and Malvey, "IRS Proposes Debt Modification Rules in Response to Cottage Savings," 78 JTAX 140 (March 1993).

¹³Reg. 1.1001-3(c)(1)(ii).

¹⁴See ILCS Ann. , ch. 815; N.Y. Gen. Obl. L. sections 5-1601 to 5-1604; Cal. Civil Code section 1663. See also pending Michigan H.B. 5835 ("Euro Conversion Act") and Pennsylvania H.B. 2193 ("European Union Currency Equivalency Law"). In other states, the "continuity of contract" result might be reached by case law. See Gruson, supra note 1; Lenihan, "The Legal Implications of the European Monetary Union Under U.S. and New York Law," at http://www.euro.fee.be/Library/BE/BEC03A2102a.htm. The efficacy of the New York and Illinois statutes has been questioned. See "Countdown to the Euro," 18 J. Business Strategy 3 (November/December 1997).

¹⁵The Preamble to TD 8675, 6/25/96, noted: "The [1992] Proposed Regulations provide[d] that a modification is significant if it ... changes the currency in which payment under the debt instrument is made. The Treasury and the IRS determined that [under the 1992 Proposed Regulations] certain changes involving economically insignificant adjustments would be characterized as significant.... Accordingly, the final regulations do not provide any bright line rules so that the significance of any change in the method under which the payments are calculated is made under the general significance rule."

¹⁶TEFRA D bonds are foreign-targeted bearer obligations issued by U.S. companies that are designed to permit the issuer a deduction for interest under Section 163(f)(2)(B) and the foreign holder an exemption for portfolio interest under Section 871(h)(2)(A) or 881(c)(2)(A). A Reg. 1.1001-3 significant modification of such an obligation will trigger a Reg. 1.1001-1(a) constructive exchange, generally causing the loss of the interest deduction and portfolio interest exemption. Reg. 1.163-5(c)(2)(i)(C).

¹⁷This is consistent with Reg. 1.988-1(c), which treats the ECU as a "currency."

¹⁸See the Preamble to TD 8517, 1/27/94; Conlon, Butch, and Connors, "IRS Clarifies OID Rules for Variable Rate Debt and Accounting Method Changes," 81 JTAX 20 (July 1994); Wolf and Malvey, supra note 12; Philip Morris Inc., 71 F.3d 1040, 76 AFTR2d 95-8002 (CA-2 1995), fn. 6 (gain on nonfunctional currency debt repaid with depreciated foreign currency is governed by Section 988).

¹⁹Reg. 1.985-1.

²⁰Including an LLC that is treated under Reg. 301.7701-3(b) as a branch or sole proprietorship if it has a single owner or as a partnership if it has more than one owner.

²¹See Wilson and Nassau, "New Foreign Currency Regulations Provide Guidance Under Section 988," 72 JTAX 96 (February 1990).

²²See Reg. 1.988-1(a).

²³See Williamson and Law, "Computing Foreign Currency Gains and Losses on Branch Transactions," 78 JTAX 172 (March 1993).

²⁴See, e.g., National Foreign Trade Council, Inc., "Implications of European Economic and Monetary Union," 98 TNT 75-51; Johnsen, "U.S. Tax Issues Raised by Conversion to the Euro," 98 TNT 93-85; Cope and Donahoo, "Will European Monetary Convergence Be a Taxable Event? Some Thoughts on the Conversion to the Euro," 26 BNA Tax Mgm't Int'l J. 526 (10/10/97).

²⁵See Rosenthal, "Applying The Mark-To-Market Rules: New Problems, New Issues Cause Growing Pains," 88 JTAX 207 (April 1998).

²⁶A four-year spread was apparently selected by analogy to the four-year spread applicable to Service-approved, taxpayer-initiated changes of accounting method provided by Rev. Proc. 97-27, 1997-1 CB 680, section 5.02(5), certain automatically approved, taxpayer-initiated changes of accounting method provided by Rev. Proc. 97-37, 1997-33 IRB 18, section 5.04(1), and a QBU branch that changes to the DASTM method of accounting provided by Reg. 1.985-7(c)(1). See generally Conjura, "Changing an Accounting Method Now Easier But Barriers Remain for Taxpayers Under Examination," 87 JTAX 5 (July 1997).

²⁷See Inland Revenue Press Release 110/98 (7/29/98), available through http://www.worldserver.pipex.com/coi; "Revenue Canada Says No Realization of Foreign Exchange Gain or Loss," 98 TNI 51-6. For a discussion of the approach taken by the various European Union countries, see, e.g., KPMG Peat Marwick, "Overview of the Tax and Accounting Implications of the Euro," available at http://www.kpmg.com; "EU Committee Urges IRS to Treat Euro Conversion as Tax Neutral Event," 98 TNT 93-40. See also National Foreign Trade Council, supra note 24 (Belgium plans to tax pre-1999 unrealized exchange gains upon introduction of the euro).

²⁸See Regs. 1.904-6(a)(1)(iv) and 1.904-4(c); Prop. Regs. 1.904-4(c)(3)(iii) and (iv).

²⁹See Weinrib, Driscoll, and Connors, "Final and Proposed Regulations Expand Available Foreign Currency Hedging Opportunities," 77 JTAX 110 (August 1992), pointing out that "the straddle rules apply to unintended straddles, even if the offsetting positions are entered into by certain related parties and different members of the same U.S. consolidated group." Cf. Ltr. Rul. 9640023 (foreign currency forward contracts and stock in nonpublicly traded foreign subsidiaries are not offsetting positions for purposes of Section 1092).

³⁰See Paul, "Constructive Sales Under New Section 1259," 97 TNT 178-63, fn. 9 (concluding that foreign currencies themselves are not within the scope of Section 1259 because they are not "stock, debt instrument or partnership interest[s]" described in Section 1259(b)(1)). See generally Willens, "TRA '97 Closes Loopholes for Tax Deferral and Conversions of Gains Into Dividend Income," 87 JTAX 197 (October 1997).

³¹See Fisher and Picciano, "The Euro Is Coming: U.S. Companies May Be Caught Short By Complex Tax Issues," 9 J. Int'l Tax'n 12 (March 1998) (noting that the use of the 1/1/99 fixed rates would take into account the post-payment, pre-1999, U.S. dollar-legacy currency fluctuation, in contradiction to Section 986(a)(1)'s failure to take into account post-payment currency fluctuations). See generally Hirschfeld, "International Taxation After 1997 Tax Reform: Major Simplification at a Minor Cost," 87 JTAX 365 (December 1997). Similar issues arise with respect to accrued foreign taxes that are settled at a different dollar value.