Conversion of certain European currencies to a single currency.

On May 5, 1998, Tax Executives Institute submitted the following comments to the Internal Revenue Service on the U.S. tax implications of converting the currencies of certain European countries to a single European currency ("the euro"). The comments were prepared under the aegis of the International Tax Committee whose chair is Joseph S. Tann, Jr. of Ameritech Corporation. Other individuals participating in the development of the submission were Joseph E. Bernot of NCR Corporation and Lora Wilkinson of Citibank.

On February 20, 1998, the Internal Revenue Service issued Announcement 98-18, soliciting comments on the issues presented by the planned conversion of certain European currencies ("legacy currencies") to a single European currency (the "euro"). The Announcement was printed in the March 9, 1998, issue of the Internal Revenue Bulletin (1998-10 I.R.B. 1).

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our 5,000 members represent nearly 2,800 of the leading corporations in the United States and Canada. TEl represents a cross-section of the business community, and is dedicated to developing and implementing sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and one with which taxpayers can comply in a cost-efficient manner.

TEI's members are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax laws relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by Announcement 98-18, relating to the conversion to the euro.

In general, TEI believes that U.S. economic and foreign policy interests warrant coordinated U.S. support for this conversion. The euro conversion will not only affect companies located in Europe, but because of the global nature of trading, the conversion affects any company that does business, borrows money, or has investments in Europe. We appreciate the Government's reaching out to taxpayers for comments on this vital issue.

TEI submits that following the euro conversion, U.S. multinational corporations should be in the same tax position that they were in before the conversion. We understand that the Treasury Department and IRS are seriously considering ways in which to keep the conversion process tax neutral for U.S. taxpayers. See Euro Conversion Should Be Tax Neutral, But IRS Official Says Issue Is Complicated, BNA Daily Tax Rep. No. 84 at G-3 (May 1, 1998) (Remarks of Howard Wiener). We commend the Treasury Department and the IRS for moving in this direction and strongly urge that they exercise their administrative and regulatory authority -- and, if necessary, seek legislation -- to accomplish the following:

* Ensure that the conversion to the euro is a tax-neutral event for U.S. tax purposes;

* Avoid double taxation; and

* Maintain the deductibility of transition costs.

Conversion to the Euro

On February 7, 1992, the European Union (EU) signed the Maastricht Treaty, which created the Economic and Monetary Union (EMU) to begin the creation of one market with unrestricted and unencumbered trade and commerce across borders in the European economic zone. At the beginning of 1999, most of the European economy will begin operating with a single currency. By 2002, the euro will replace many of the legacy currencies. On May 2, 1998, the Council of the European Union designated 11 of the EU's 15 members to participate in the first phase of the euro conversion.(1)(*) The Council will soon announce the bilateral exchange rates between legacy currencies converting to the euro on January 1, 1999.(2) A new European Central Bank will set monetary policy, including money supply and short-term interest rates, while national governments will retain their existing authority to set taxing and spending policies, public debt levels, and interest rates on government debt.

On January 1, 1999, the euro will become a currency and the euro-to-legacy-currency exchange rates will become fixed. In addition, legacy currencies will become "currency units," or denominations of the euro. During the three-year transition phase, the euro generally will be used for transactions such as intergovernmental payments, issuance of government debt, transactions between central and commercial banks, and transactions in the interbank market. Belgium, France, and Germany have announced that they will redenominate existing government debt in euros as of January 1, 1999. During the transition period, businesses may elect whether -- and to what extent -- to use the euro. On January 1, 2002, euro notes will be issued and, by July 1, 2002, legacy currencies will be withdrawn from circulation.

The move to the euro is extremely important to the U.S. economy and U.S. multinational corporations. Collectively, the EU is this country's second largest trading partner. According to Treasury Department data, in 1996 total U.S.-related merchandise trade with the EU exceeded $270 billion. Moreover, more than half- or about $400 billion -- of U.S. foreign direct investments are in Europe.(3)

Although the economic aspects of the conversion are hardly free from doubt, the introduction of the euro is expected to reinforce European Commission directives aimed at increasing cross-border competition. The cost of preparing for the conversion, however, is also significant and requires systems changes that, for certain industries, are parallel in scope and rival in magnitude the costs associated with addressing the Year 2000 problem.

TEI believes that nations outside the EU should treat the euro conversion as a tax-neutral event. Hence, no taxpayer should be required to pay additional taxes solely because of the currency conversion. We are pleased that IRS representatives have expressed a willingness to consider a tax-neutral conversion process. Deferral of both gains and losses would not necessarily be a taxpayer-favorable or unfavorable event because treating the conversion to the euro as a recognition event for U.S. income tax purposes would allow taxpayers to recognize foreign exchange losses as well as gains. In other words, the overall revenue effect of requiring recognition is unclear. If the change is not tax neutral, the primary effect might well be to grant "windfall" losses to one group of taxpayers while taxing paper gains to another.

U.S. Tax Issues Posed by the Euro Conversion

Existing U.S. tax rules raise significant questions concerning the tax treatment of the replacement of legacy currencies with the euro. Similar issues have also arisen in a number of European nations; many are taking steps to ensure that conversion to the euro is a tax-neutral event, usually by adopting rules that defer otherwise-applicable recognition of exchange gain.(4)

Announcement 98-18 solicits comments regarding the following two issues:

(1) Whether a qualified business unit (QBU) that uses a legacy currency as its functional currency will have changed its functional currency when its legacy currency is converted to the euro and the implications of that change; and

(2) Whether the conversion of a legacy currency to the euro creates a realization event with respect to a financial instrument denominated in a legacy currency and the appropriate time to recognize, any resulting gain or loss.

To the consideration of these issues, the following issues should also be addressed:

(3) Whether the allocation of any foreign exchange gain to the passive-income basket for foreign tax purposes potentially creates instances of double taxation; and

(4) Whether U.S. taxpayers will be permitted to expense the conversion costs incurred to implement the conversion to the euro.

As previously stated, TEI submits that conversion to the euro should be a tax-neutral event for U.S. tax purposes without regard to whether (i) the converting legacy currency is the taxpayer's "functional currency" for purposes of section 985 of the Code, or (ii) the conversion affects the taxpayer's cash, cash equivalents, or financial instruments. We recognize, however, that significant issues exist concerning whether the conversion technically constitutes a change in functional currency under section 985 or otherwise constitutes a realization event under section 1001. The paradigmatic case is a European branch or subsidiary of a U.S. taxpayer (a QBU) that currently uses one converting legacy currency as its functional currency but also engages in business transactions in other converting legacy currencies (i.e., non-functional legacy currencies). If conversion to the euro constitutes a change in functional currency, the QBU will recognize exchange gain or loss attributable to all nonfunctional legacy currency transactions under Treas. Reg. [sections] 1.985-5(b). Even if the conversion is not considered a change in functional currency, the conversion may arguably give rise to a realization event under section 1001. See Treas. Reg. [subsections] 1.988-2(a)(1) and 1.1001-3. These issues are discussed below.

A. Change in Functional Currency. Section 985 of the Code requires that a taxpayer segregate its operations into qualified business units (QBUs) such as foreign branches or subsidiaries. The functional currency of a QBU is the currency of the "economic environment" in which the unit conducts significant business. The section 985 rules do not define what a currency is, but rather focus on the selection of a functional currency and the change from one functional currency to another.

When a QBU changes its functional currency, it must take into account foreign exchange gain or loss with respect to its section 988 transactions denominated in the new functional currency under the principles of Treas. Reg. [sections] 1.985-5(b). Section 988 transactions are transactions in debt instruments, financial contracts, and accounts receivable or payable that are not denominated in the QBU's functional currency. For example, if an Italian subsidiary using the lira as its functional currency makes a loan denominated in French francs and later elects to change its functional currency to the French franc, the Italian subsidiary will recognize exchange gain or loss on the loan at the time of the election.

If conversion to the euro were treated as a change in functional currency, section 985 would require recognition of foreign exchange gain or loss on financial assets and liabilities denominated in nonfunctional legacy currencies. See Treas. Reg. [sections] 1.985-5(b).(5) In other words, section 985 treats the conversion as a deemed realization event with respect to exchange gains or losses inherent in such assets and liabilities, regardless of the application of section 1001. Furthermore, this realization event is deemed to occur in the tax year preceding the year of conversion. Thus, for calendar-year foreign branches and subsidiaries, exchange gain or loss will be recognized in 1998, if conversion constitutes a change in functional currency in 1999.

B. Realization Event. Even if conversion to the euro is not considered a change in functional currency, the conversion may still give rise to a realization event under section 1001.(6) If the conversion is so treated, U.S. taxpayers will recognize not only their foreign exchange gains or losses under section 988,(7) but also income or loss with respect to the asset.(8) For example, upon conversion to the euro, a U.S. corporation that holds a bond denominated in a nonfunctional legacy currency may, on conversion of that legacy currency to the euro, be required to recognize both (1) exchange gain or loss on the bond and (2) any other gain or loss on the bond.

An exception to this treatment may apply to certain debt instruments issued in anticipation of conversion to the euro. Treas. Reg. [sections] 1.1001-3 generally provides that a change in the terms of a debt instrument that is made in accordance with the instrument's terms is not a "modification" resulting in a deemed disposition of the instrument. Therefore, nonfunctional legacy currency debt instruments that specifically anticipate conversion to the euro should not be treated as modified by that conversion.

For other, nonfunctional legacy currency debt instruments, the change of currency may constitute a significant modification and, thus, a realization event under section 1001. Proposed regulations issued under section 1001 in 1992 originally suggested that a change of currency denomination will always be considered a significant modification. Prop. Reg. [sections] 1.1001-3(e)(4)(ii)(D), 1992-2 C.B. 683,687. The final regulations deleted this language, however, because the IRS determined that some currency changes may be economically insignificant while others may not be. T.D. 8675, 1996-2 C.B. 60, 63.(9) The treatment of instruments other than straight debt instruments may be even murkier.(10)

In the case of U.S. domestic corporations and overseas branches and subsidiaries holding financial assets and liabilities denominated in nonfunctional legacy currencies converting to the euro, Treasury could simply take the position under Treas. Reg. [sections] 1001-3(c) that the change of currency is made in accordance with the terms of the instrument and thus is not a modification for purposes of section 1001. This interpretation is in harmony with EU law and the laws of several States (e.g., New York, California, and Illinois) that provide for continuity of contract despite conversion to the euro. It is also consistent with the policy underlying such laws that seeks to avoid the serious market disruption that would occur were EMU permitted to interfere with the anticipated results, tax or otherwise, of existing contractual obligations.

For taxpayers holding cash or cash equivalents in nonfunctional legacy currencies, conversion to the euro would likely constitute a realization event under the general principles of section 1001.(11) See Treas. Reg. [sections] 1.988-2(a)(1)(i) (applying the recognition rules to section 988 transactions). The like-kind exchange rules of section 1031 do not apply to such exchanges. Treas. Reg. [sections] 1.9882(a)(1)(ii).

This effect may be mitigated to the extent that the taxpayer has hedged its nonfunctional currency financial assets and liabilities. Under most circumstances, the realization event would seemingly apply simultaneously to both the hedge and the hedged item. Consider the following example:

The functional currency of a

Netherlands subsidiary of a

U.S. company ("Subsidiary")

is the Dutch guilder. The

subsidiary enters into a

transaction on February 1,

1998, with a French customer,

giving rise to a 500,000

French franc account receivable.(12)

The receivable is to be

paid on February 1, 1999.

Upon entering into the

transaction, the Subsidiary

has foreign currency exposure.

To reduce its currency

risk and to lock in its profit

margin, the Subsidiary enters

into a forward contract

selling 500,000 francs for

100,000 guilders (i.e., at an

exchange rate of 5.0 francs

to i guilder). The forward

contract will mature on February

1, 1999. The taxpayer

properly identifies the forward

contract as a hedge of

the receivable.

On January 1, 1999, the euro

member internal exchange

rate is established at 4.90

francs to i guilder; 9.8 francs

to 1 euro; and 2.0 guilders to

I euro. Assume the conversion

to the euro on January

1, 1999, is a realization

event. The Subsidiary's

French franc receivable of

500,000 is worth 102,040

guilders; it therefore will recognize

a 2,040 guilder (or

1.020 euro) gain. With respect

to the forward contract,

the Subsidiary will be viewed

as delivering 500,000 francs

(worth 102,040 guilders) on

January 1, 1999, in exchange

for 100,000 guilders; the

Subsidiary will therefore recognize

a 2,040 guilder (or

1,020 euro) loss on its hedge.

The net foreign currency

exchange gain or loss is zero.

The Subsidiary's basis in the

receivable and the forward

contract (to the extent the

Subsidiary does not close it

out) will be restated

accordingly.(13) Hence, under these

circumstances, an effective

hedge may be able to minimize

potentially negative tax

consequences from conversion

to the euro.(14)

Approaches to Achieve Tax Neutrality

There are several approaches that the Treasury Department and IRS could take to achieve tax neutrality within the current provisions of the Internal Revenue Code: (1) treatment of the conversion as a redenomination; (2) treatment of the change as an involuntary conversion; or (3) an intermediate approach, using functional currency concepts but requiring deferral of gains and losses. TEI believes that the third approach -- which treats the conversion as a change in functional currency but permits deferral of the recognition of gains and losses -- may accord best with current statutory and equitable principles. These three approaches are discussed below.

A. Redenomination Approach. The euro could be treated as a replacement currency for each legacy currency. Under this approach, the euro is viewed as a redenomination of each of those currencies rather than a change in functional currency. Under U.S. tax principles, redenominations generally are not treated either as realization events under section 1001 or a change in functional currency within the meaning of section 985.(15)

Concededly, the euro conversion does not fit neatly within the redenomination criteria. Normally, a redenomination revolves a change in a single currency, as for example with the recent conversion of 1,000 Russian rubles into one "new ruble." In addition, because the euro will replace as many as 11 legacy currencies, the redenomination approach requires the Treasury and IRS to adopt basis translation rules to ensure that exchange gains and losses on financial assets and liabilities held on January 1, 1999, remain "built-in" (i.e., that gains and losses in each nonfunctional legacy currency are preserved after that currency is replaced by the euro).(16) Additional rules may also be necessary where the nature or character of other gains and losses to which the assets and liabilities may give rise differ from those of the exchange gains and losses.

In addition, because the euro will replace more than one legacy currency, the redenomination approach implicitly treats individual legacy currencies as being the same currency. The pooling of currency risk and responsibilities (e.g., through the establishment of the European Central Bank) likely means that the euro will carry a different interest rate and a different risk exposure than any single legacy currency.

Nevertheless, the redenomination approach provides a simple means of achieving U.S. tax neutrality with respect to the euro conversion. It also preserves the approach of the existing rules that a change of functional currency is normally elective rather than involuntary. Moreover, the redenomination approach provides flexibility if certain nations drop out of the process or if the euro fails. If this were to occur during the transition period, a country leaving the process would undoubtedly return to its original, still-circulating national currency. The redenomination approach makes it easier for U.S. taxpayers to "unwind" these conversions, while minimizing any U.S. tax anomalies that might result from treating the "unwinding" as a second change in functional currency.

B. Involuntary Conversion Approach. Even if the conversion of legacy currencies to the euro were to constitute a realization event under section 1001, TEI believes that the conversion should nonetheless be treated as a nonrecognition event because of its unique and involuntary nature.

Congress has long recognized that taxing gains resulting from involuntary conversions is inequitable.(17) Today, section 1033 generally defers gains realized upon (i) the involuntary conversion of property (or the threat thereof); (ii) the theft, seizure, requisition, or condemnation of property (or the threat thereof); (iii) the sale of property pursuant to federal reclamation laws, (iv) the destruction of livestock by disease or drought; and (v) certain sales mandated by the Federal Communications Commission.(18) Similarly, section 1081 allows the deferral of gains realized upon certain sales of securities mandated by the Securities and Exchange Commission.(19) In each case, any gain is preserved by adjusting the basis of the property received in the conversion.

Because conversion to the euro is involuntary, taxing exchange gains is inequitable.(20) Thus, recognition should be deferred until ultimate disposition of the underlying asset or liability, regardless of whether the asset or liability (i) continues unchanged beyond 2001, (ii) is amended to provide for payment in euro, (iii) is amended to provide for a change of currency and interest rate, or (iv) is actually replaced with a new euro item for the same amount and term.

TEI believes that the Treasury and IRS have sufficient authority under the general rule of section 1033(a) to issue guidance clarifying that conversion to the euro constitutes an involuntary conversion of legacy currencies that is entitled to nonrecognition treatment. Alternatively, the Treasury and IRS could call on Congress to enact a specific relief provision akin to the one provided to facilitate the FCC's microwave relocation policy. See I.R.C. [sections] 1033(j).

Concededly, an involuntary conversion approach -- resulting in deferral of gains, but not losses -- reaches an outcome that may be favorable to some taxpayers. The European union will result, however, in a substantial portion of U.S. overseas investment becoming part of an economic and political experiment of unprecedented proportions. The benefits of the economic union for business, at least in the short term, seem minor compared with the costs and risks associated with the endeavor. Deferral of gain on legacy currency-denominated property may thus not be as discomforting a concept as it might first appear.

C. The Intermediate Approach -- Treatment of the Conversion as Unique. TEI believes that conversion to the euro should not be treated as a normal change in functional currency, even though, upon factual analysis, conversion to the euro more closely resembles a change of functional currency than a redenomination. Indeed, since conversion to the euro encompasses features of both approaches and fits squarely within neither, it may be appropriate to adopt an intermediate approach uniquely suited to the conversion. Treatment of the conversion in this manner permits Treasury to act within the scope of its authority in deferring recognition of both gains and losses on conversion to the euro. Moreover, it avoids the potential for whipsaw, i.e., taxpayers deferring gains while recognizing losses. TEI believes that Treasury has broad authority under section 985 to adopt special rules to defer exchange gain or loss that would otherwise be recognized on conversion to the euro.(21)

Change in Functional Currency Approaches

Another approach is to treat the euro conversion as a change in functional currency, but permit taxpayers to elect -- on a worldwide basis -- deferral of euro-related gains and losses. Because taxpayers are required to make the election for all of their QBUs, the opportunity for adverse selection -- the taxpayer's ability to "cherry-pick" -- will be minimized. Such a requirement thus diminishes any whipsaw inherent in the election for the Treasury.

For taxpayers electing deferral, TEI urges the Treasury and IRS to consider two exceptions: one for nonfunctional currency cash and cash equivalents and one for nonfunctional currency accounts receivable and payable. Because transactions involving these short-term items may be voluminous and the administrative tracking of such items extremely complex, taxpayers may prefer to recognize gain or loss immediately.

If conversion to the euro is treated as a change in functional currency, that change could be deemed to take place on any of several different dates, including introduction of the euro on January 1, 1999, and at the end of the transition phase on December 31, 2001.

A. Dual-Currency Approach. The EU Council takes the position that a single currency will be created on January 1, 1999. Legacy currencies will, however, have currency features during the transition period and be "currencies" in a colloquial sense. There will be no euro cash or coin during the transition period. Thus, it may be appropriate to treat the conversion process as a "dual-currency" system during the three-year transition period. Under this approach, no change in functional currency or realization event is deemed to occur until the end of the transition period.

In support of the dual-currency concept, an analogy could be made between the legacy currencies during the transition period and the ECU, which -- though it is not a currency of any country -- is treated as a currency for U.S. tax purposes. See Treas. Reg. [sections] 1.988-1(c). A dual-currency approach could prove propitious if the conversion process does not proceed as planned. A country leaving the conversion process during the transition period would probably return to its legacy currency; the dual-currency approach (like the redenomination approach) would ensure that a taxpayer that had not yet elected to change its functional currency to the euro is not treated as making two changes in functional currency. One drawback to this approach, however, is that taxpayers must track different legacy and euro currency transactions as section 988 transactions, despite the improbability of any exchange gain or loss arising from such transactions.

B. Involuntary Hedge Approach. Alternatively, the conversion of legacy currencies to the euro might be treated as if U.S. taxpayers had effectively "hedged" their exposure to legacy currencies with related investments in euro-denominated assets. Under certain conditions, a taxpayer may integrate a debt instrument denominated in a foreign currency and a related hedge that fixes the taxpayer's currency exposure. See I.R.C. 988(d); Treas. Reg. [sections] 1.988-5. For example, if a taxpayer borrows French francs and purchases forward contracts to hedge its exposure to the French franc, the taxpayer may integrate the loan and the forward contracts. The taxpayer then treats the loan and the hedge as a synthetic debt instrument denominated in the currency used to purchase the forward contracts. This currency need not be the taxpayer's functional currency. See Treas. Reg. [sections] 1.988-5(a). Thus, a U.S. corporation may redenominate a French franc borrowing into an Italian lira synthetic borrowing by purchasing forward contracts with Italian lira that hedge the taxpayer's exposure to the French franc.

A taxpayer may "leg in" to achieve integrated treatment, i.e., the taxpayer may hedge its exposure after having entered into the loan transaction. When the taxpayer legs in integrated treatment, the taxpayer realizes an exchange gain or loss. Treas. Reg. [sections] 1.988-5(a)(6)(i). The taxpayer does not, however, recognize this gain or loss. Instead, the taxpayer must defer the gain or loss until the debt instrument matures or is otherwise disposed of Id.

Other Transition Issues

Section 985(b)(4) states that "[a]ny change in functional currency shall be treated as a change in the taxpayer's method of accounting for purposes of section 481." Treas. Reg. [sections] 1.985-4(a) adds that "[t]he adoption of, or the election to use, a functional currency shall be treated as a method of accounting." Thus, the resolution of some transition issues may turn on whether the conversion is a change in functional currency.

Special rules should permit taxpayers to convert their U.S. tax books to the euro during the transition period in order to ensure that they coincide with conversion of their local statutory or tax books and, presumably, their U.S. GAAP books as well. This will allow U.S. taxpayers with many European branches and subsidiaries to distribute the workload of the conversion over a period of several years. Consent requirements should be waived in order to ease the administrative burden. In addition, redenomination of shares of stock may take the form of a tax-free reorganization, invoking notice requirements under sections 367 and 368, which should be waived.

If the conversion is treated as a change in functional currency (and therefore a change in method of accounting), taxpayers should be permitted to elect under section 481 either to spread any unavoidable inclusions in income over a four-year period(22) or to include the entire adjustment in income in the year in which the change of accounting method occurs.(23) Such treatment is proper in light of Congress's intent that section 481 be available to mitigate any "especially heavy tax burden" that might arise from the bunching of income upon a change of accounting method. See S. Rep. No. 1622, 83d Cong., 2d Sess. (1954). Accord S. Rep. No. 1983, 85th Cong., 2d Sess. (1958). Such relief is appropriate because, unlike the typical change of functional currency, conversion to the euro is essentially involuntary and does not arise from any errors or affirmative choices by taxpayers.

Avoiding Double Taxation

Under existing rules, net foreign exchange gain generally falls into the passive-income basket for foreign tax credit purposes.(24) This income is subject to the high-tax kickout provisions of section 904(d)(2)(A)(iii)(III). Treas. Reg. [sections] 1.904-6(a)(1)(iv)provides that where income is recognized for U.S. tax purposes in one year and for foreign tax purposes in another year, the foreign tax credits on such income will be assigned to the category of income to which they would have been assigned had the income been recognized for U.S. purposes in the same year as it was recognized for foreign tax purposes.

For U.S. taxpayers with excess foreign tax credits, this may result in double taxation. For example, assume that Belgium treats the conversion of non-Belgian legacy currencies to the euro as a realization and recognition event as of December 31, 1998, but the United States does not. If a Belgian subsidiary of a U.S. taxpayer has unrealized foreign exchange gain on a French franc loan, for Belgian tax purposes conversion to the euro triggers recognition of that exchange gain in 1998. For U.S. tax purposes, the exchange gain is passive and the Belgian tax credits are assigned to the passive basket as if the income had been recognized for U.S. purposes in 1998. If there is little or no income in the subsidiary's passive basket for 1998 and a large amount of tax credits, the high-tax kickout rule for passive income operates to transfer the tax credits to the general limitation category (which may or may not be used). When the exchange gain is recognized for U.S. tax purposes in a later year (upon the economic disposition of the loan), the Belgian subsidiary has a large amount of income in its passive basket and no associated tax credits to offset the income. The exchange gain may be taxed twice--once in Belgium and once in the United States.

As part of its guidance relating to conversion to the euro, the Treasury Department should adopt rules to prevent double taxation from occurring in this situation. To eliminate the problem, income could be accelerated or foreign tax credits could be deferred, at the option of the taxpayer.

Conversion-Related Costs Should Be Deductible

U.S. corporations have borne and will continue to bear enormous costs in preparing for the conversion to the euro. These costs consist primarily of reprogramming computer systems for the currency change, but also include consultancy fees and other associated costs. TEI believes that such conversion costs should be currently deductible. The Supreme Court's INDOPCO decision and subsequent administrative guidance provide a sufficient basis for permitting U.S. companies to deduct costs incurred to convert to the euro.

In INDOPCO, the Supreme Court held that certain professional fees paid by a corporation to facilitate a friendly acquisition of a target company were capital expenditures because they created significant long-term benefits. In the wake of the INDOPCO decision, the "future-benefit" test has been used to determine the deductibility of expenses.

Under the existing cases and rulings, costs incurred by taxpayers to adapt their systems for the conversion to the euro should be deductible. The costs incurred do not create any future benefit but rather merely restore taxpayers' systems to their current, pre-conversion capacities. In fact, these required software changes generally require taxpayers to reallocate resources away from systems improvements.

In Rev. Proc. 97-50, 1997-45 I.R.B. 8, the IRS permitted taxpayers to deduct analogous computer software restructuring costs. That revenue procedure dealt with so-called year 2000 costs incurred by a taxpayer in its trade or business to restructure computer software to recognize dates beginning in the year 2000. The IRS held that these costs fall within the purview of the rules delineated in Rev. Proc. 69-71, 1969-2 C.B. 303, which permits taxpayers to deduct expenses incurred to develop computer software.

Taxpayers' costs of converting to the euro are similar to year 2000 costs. In both cases, taxpayers are required to adapt their systems in order to continue doing business and the costs of making these necessary changes do not provide a future benefit. Thus, the costs of developing computer software to make the required conversion to the euro should also be deductible.

Summary

For the reasons described above, TEI recommends that the Treasury and IRS take the following actions in response to the implementation of the conversion to the euro:

* Issue guidance that the conversion to the euro is a tax-neutral event under sections 985 and 1001 of the Code.

* Issue guidance that addresses the matching of foreign tax credits to income to prevent any double taxation occurring as a result of the conversion to the euro.

* Clarify that costs incurred by U.S. taxpayers in the conversion are immediately deductible.

The Treasury Department and IRS should issue this guidance as soon as possible to ensure that U.S. taxpayers may conduct business in Europe with certainty regarding the U.S. tax consequences of the euro conversion.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on Announcement 98-18. If you have any questions, please do not hesitate to call Joseph S. Tann, Jr., chair of TEI's International Tax Committee, at [phone], or Mary L. Fahey of the Institute's professional staff at [phone].

Notes

(1) The participants are: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. The United Kingdom, Denmark, and Sweden have deferred joining the conversion. Greece does not qualify to join.

(2) Euro-legacy currency exchange rates will become effective January 1, 1999, depending upon the ECU-legacy currency exchange rates on December 31, 1998. One cure will equal one ECU. (The ECU is a weighted basket currency derived from the currencies of the 12 original EU member states.)

(3) Testimony of Lawrence H. Summers, U.S. Deputy Secretary of the Treasury, before the Senate Budget Committee (Oct. 21, 1997), available in Lexis (News Library).

(4) See the Appendix for a summary of the tax rules under consideration by some participating countries.

(5) Consider a foreign branch and a foreign subsidiary that use two different legacy currencies as their functional currencies. In this case, conversion to the cure will trigger recognition of exchange gain or loss on the branch's equity pool. See Treas. Reg. [sections] 1.985-5(d)(2). For example, a German subsidiary with a deutsche mark functional currency that has a French branch with a French franc functional currency will have to recognize exchange gain or loss on the branch's equity pool upon the conversion of both currencies to the cure.

(6) This is unlikely to be a widespread problem. TEI recommends that Treasury accord taxpayers the option either to elect, to recognize such gains or losses immediately or to defer recognition until disposition of the pool. The latter alternative would probably involve the creation of a cure-denominated pool. For example, a French branch of a German subsidiary has an equity pool of FF600 with a basis of DM300 at January 1, 1999. The equity pool is converted to cure 100 (FF6:euro 1) and the basis in the pool to cure 150 (DM2:euro 1). On remittance by the branch of cure 50, the German subsidiary recognizes cure 25 of section 987 loss. Alternatively, on termination of the branch, the German subsidiary recognizes cure 50 of section 987 loss. In both cases, recognition of section 987 gain or loss is preserved until the time it would have been recognized had conversion to the cure not occurred.

(6) Section 1001(a) defines gain on a "sale or other disposition of property" as the excess of the amount realized in the disposition over the property's adjusted basis. In general, a sale or other disposition occurs when the taxpayer disposes of property for cash or other property "differing materially either in kind or in extent." Treas. Reg. [sections] 1.1001-1(a).

(7) See American Air Filter Co. v. Commissioner, 81 T.C. 709 (1983) (when a taxpayer borrowed nonfunctional currency and thereafter converted the loan to a functional currency, the conversion fixed the foreign exchange loss under section 1001). Arguably, the case should be limited to its facts, which involved a significant modification of the debt instrument because currency exchange risk was eliminated. Redenomination from one nonfunctional currency to another could also be treated as a significant modification because of the change in currency risk.

(8) Realization issues also arise in respect of U.S. expatriates working in the EU. Under most -- if not all -- tax equalization programs sponsored by U.S. employers, the tax cost of a taxable conversion will increase the U.S. employers' cost and render foreign nationals more attractive hires for positions now occupied by U.S. expatriates.

(9) The proposed section 988 regulations (issued in 1992) provide an exception to disposition treatment for related- party transactions. Prop. Reg. [sections] 1.988-2(b)(14), 1992-1 C.B. 1202, 1205. The proposed regulation apparently applies, however, only to exchange gain or loss. With respect to non-exchange loss inherent in a related-party debt instrument, section 267 may apply to defer the loss. Section 267 does not apply to gains.

(10) Under the section 1001 regulations, debt instruments include bonds, notes, mortgages, debentures, and certificates, as well as demand deposits and accounts receivable and payable. Although the regulations also provide rules governing modification of notional principal contracts (e.g., currency and interest rate swaps, caps, floors, and collars), they do not address whether a change of currency should be considered a modification of such contracts.

Treas. Reg. [sections] 1.1001-3 does not address other financial instruments such as forward contracts, futures contracts, options, and warrants. As an analytical matter, however, such contracts should be affected by conversion to the cure in a manner similar to debt instruments.

(11) This is also a likely scenario for U.S. expatriates working in the EU. In this event, the U.S. employer's cost will increase to reflect its tax equalization agreement and, as a result, the U.S. employer will be at a competitive disadvantage vis-a-vis its EU trading partners.

(12) The receivable is not a "qualifying debt instrument" within the meaning of Treas. Reg. [sections] 1.988-5(a)(3).

(13) An issue arises, however, if the hedge is a section 988(d) hedging transaction treated as an integrated transaction under Treas. Reg. [sections] 1.988-5(a). Conversion to the cure could cause the transaction to fail to qualify as a section 988 transaction because, for example, the qualifying debt instrument that is hedged is no longer in nonfunctional currency and the hedge no longer reduces risk. Section 988 does not address this situation. If the conversion were viewed as causing the taxpayer to "leg out" of the hedging transaction within the meaning of Treas Reg. [sections] 1.988-5(a)(6)(ii), -- although there may be no net foreign currency exchange gain or loss -- gain or loss on the underlying debt instrument resulting from factors other than movements in exchange rates may be triggered under Treas. Reg. [sections] 1.988-5(a)(6)(ii)(B).

(14) Additionally, conversion to the cure may create inadvertent straddles subject to section 1092 because conversion could result in taxpayers holding offsetting positions in personal property. We believe these inadvertent straddles should be exempted from such treatment.

(15) Sec Charles Cope & Carol Dunahoo, Will European Monetary Convergence Be a Taxable Event? Some Thoughts on the Conversion to the Euro, 26 Tax Management Int'l J. 526, 528 (Oct. 10, 1997).

(16) Assume a German subsidiary makes a loan of FF6,000,000 to a French subsidiary when FF5 equals DM3. The German subsidiary places the receivable on its books with a basis equal to DM3,600,000. Assume that at the time of con version to the cure, FF6 equals DM2 and cure 1.

The loan receivable -- denominated as FF6,000,000 and carried on the German subs(diary's books at DM3,600,000 -- is now worth 1,000,000 cure. The equivalent value in deutsche marks is DM2,000,000. As a result of the weakening of the French franc vis-a-vis the deutsche mark, the receivable has a built-in economic loss in functional currency of DM1,600,000 or 800,000 cure. The German subsidiary could be required to recognize the built- in loss upon conversion to the cure, with the result that the basis for the receivable going forward is 1,000,000 cure. Alternatively, if the German subsidiary simply restates its basis in the receivable using the conversion factor for deutsche marks into cure, the receivable would have a basis of 1,800,000 cure (DM3,600,000 a 2). When the receivable is later collected and FF6,000,000 --- or the equivalent of 1,000,000 cure -- are received by the German subsidiary, a loss of 800,000 cure results.

Although both the French franc and the deutsche mark have been converted to the cure, the built-in lass potential is preserved. In a tax-neutral fashion, the tax consequences have been deferred until the receivable is collected.

(17) For example, in 1921, Congress enacted a provision deferring gains resulting from requisitions of ships during World War I. See Revenue Act of 1921, [subsections] 214(a)(12) and 234(a)(14). Similarly, in 1939, Congress enacted a provision deferring gains resulting from "involuntary conversions." See I.R.C. [sections] 112(f)(1939 Code).

(18) Section 1033, like its predecessors, was enacted as "a relief measure designed to prevent inequitable incidents of taxation" and, therefore, must be construed liberally to effectuate its purpose. Gaynor News Co. v. Commissioner, 22 T.C. 1172, 1177 (1954). See also Cusack v. Commissioner, 48 T.C. 156, 163 11967); John Richard Corp. v. Commissioner, 46 T.C. 41, 44 (1966).

(19) In enacting section 1081(a), Congress recognized that "recognition of gain or loss should.. be postponed until a voluntary realization occurs." S. Rep. No. 75-1567, reprinted in 1939-1 C.B. 779,785.

(20) A similar deferral approach has been adopted or proposed by several countries participating in the cure conversion. Sec Appendix.

(21) See also I.R.C. [sections] 989(c) ("The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this subpart...").

(22) See I.R.C. [sections] 481(a). See also Rev. Proc. 97-27, 1997-21. I.R.B. 10, [sections] 5.02(3) (outlining procedures for requesting the IRS's consent to a change in method of accounting and providing for a four-year spread of adjustments); Rev. Proc. 97-37, 1997-33 I.R.B. 18, [sections] 5.04(1) (outlining procedures governing certain changes in accounting method to which the IRS will grant automatic consent and providing for a four-year spread of adjustments).

(23) Cf. Rev. Proc. 97-27, supra, at [sections] 7.03(1) (providing such treatment for certain de minimis section 481 (a) adjustments); Rev. Proc. 97-37, supra, at [sections] 5.04(3) (providing similar treatment of de minimis adjustments in automatic consent eases).

(24) I.R.C. [subsections] 954(c)(1)(D) and 904(d)(2)(A)(1).

RELATED ARTICLE: Euro Conversion: Country-by-Country Summary

The European Commission has issued a practical guide to introduction of the euro, calling on countries to adopt rules specifying how conversion to the euro's to be treated for local tax purposes as soon as possible. See Practical Aspects of the Introduction of the Euro (11503/97), [sections] 3.1. Below is a brief summary of the participating countries' proposed treatment of conversion to the euro (as of February 1998). Like the United States, these countries must determine whether their taxpayers will recognize exchange gain or loss on certain instruments denominated in non-functional currencies.

Country             Proposed Tax Treatment

Germany             Defer exchange gain until
                    disposition of an asset or liability
                    through use of a special reserve

Austria             Similar to Germany

Luxembourg          Generally, conversion to the euro
                    will not override the normal practice
                    of deferring gains until disposition
                    of the underlying asset or liability

The Netherlands     Permit deferral of gains that would
                    other,vise be triggered by
                    conversion to the euro

Spain               Expected to defer exchange gain

Belgium             Expected to require recognition of
                    exchange gains and losses for tax
                    purposes immediately upon
                    introduction of the euro

Finland             Accelerate recognition of
                    exchange gain if current
                    legislation is not changed

France              Now generally requires recognition

                    of both realized and unrealized
                    exchange gains and losses for tax
                    purposes under normal rules,
                    so acceleration of recognition
                    is not an issue

Ireland             Gains on capital items deferred

Italy               Unclear

Portugal            Unclear

Country             Legislation Adopted?

Germany             Yes

Austria             Expected May

Luxembourg          N/A

The Netherlands     No, but official position
                      has been announced

Spain               No

Belgium             No

Finland             No

France              N/A

Ireland             Expected

Italy               No

Portugal            No