Transitional rules for converting currencies to the Euro.

On Jan. 1, 1999, 11 European Union (EU) countries converted their currencies (legacy currencies) to the euro. Companies conducting business in the legacy currencies generally will have three years to make the conversion to the euro; by July 1, 2002, the legacy currencies will be replaced entirely by the euro. The IRS has issued temporary regulations that provide transitional rules for existing businesses using legacy functional currencies that must convert to the euro (Temp. Regs. Sec. 1.985-8T(a)(1)). The primary purpose of the regulations is to provide transitional rules for the conversion, and thus should have no effect beyond the transition period. In addition, the regulations do not create new substantive tax rules. This may give taxpayers a significant amount of flexibility in applying the transition rules.

EU Members Converting to the Euro after Jan. 1, 1999

Four EU member countries (Denmark, Greece, Sweden and the U.K.) are not participating in the initial round of conversion to the euro. The U.K. tentatively has stated that it will adopt the euro as its national currency in 2005. The question arises as to whether the temporary regulations will apply to post-Jan. 1, 1999 conversions. The regulations were promulgated to address issues relating to the initial euro conversion and, thus, may not apply when companies resident in other EU-member countries adopt the euro as their currency in later years. The regulations, however, do not provide a specific date by which conversion must be completed, and thus may be broad enough to apply to later conversions. If the regulations do not apply to these later conversions, such conversions may be viewed as realization events.

Parallel Books and Records

Many European qualified business units (QBUs) may be unable to completely convert their accounting systems to accept the euro before 2002 and, thus, may be required to keep two sets of books during the transition period. The euro books may be a secondary set of accounts that is less complete than the legacy currency books (e.g., to comply with certain tax or regulatory reporting requirements before 2002). A QBU will not be treated as having adopted the euro as its functional currency unless it maintains all its books and records in the euro (Temp. Regs. Sec. 1.985-8T(b)(2)(B) and Regs. Sec. 1.989(a)-1(d)). Thus, depending on a client's circumstances, maintaining a temporary euro set of books for a QBU may or may not mean that it has adopted the euro as its functional currency.

Time When New QBU Is Established

The formation of a new QBU typically is a readily identifiable event. A QBU is any separate and clearly identified unit of a trade or business of a taxpayer that maintains separate books and records (Sec. 989(a)). Under Temp. Regs. Sec. 1.985-8T(b)(1), a QBU formed after 1998 cannot adopt a legacy currency as its functional currency; it must adopt the euro as its functional currency from its inception. This means that the transition period provided in the regulations for converting to the euro will not apply, nor presumably will the rules deferring currency gain or loss realization on conversion to the euro. Before undertaking any acquisitions or business restructuring of European operations during the transition period (1999-2001), a U.S. multinational must consider whether (1) a new QBU will be created and, if so, whether and when it will be required to adopt the euro as its functional currency and (2) the transaction could be structured differently to provide a better result in terms of functional currency elections.

Although there generally should be no issue as to when a QBU was formed, under certain circumstances, whether a new QBU has been formed for purposes of the euro functional currency requirement may depend on how a transaction is structured (e.g., as the formation of a new business, expansion of an existing business, purchase of assets or stock of an existing business or reorganization). Under Regs. Sec. 1.989(a)-1, the determination of whether a new QBU has been formed is made based on all of the facts and circumstances. Because the new regulations do not change existing substantive rules, a great deal of flexibility remains to structure a business expansion or reorganization in a manner that may produce the desired result (i.e., a new QBU that must adopt the euro as its functional currency or a continuation of an existing QBU that can continue to use its legacy functional currency until 2002).

Currency Gain or Loss Realization on Legacy Currency Cash

Temp. Regs. Sec. 1.985-8T generally provides that conversion to the euro is not a realization event. An exception applies, however, for legacy nonfunctional currency cash. Any built-in currency gain or loss on legacy nonfunctional currency cash must be recognized on conversion of the legacy currency to the euro. The preamble to the regulations states that exchange gains or losses on nonfunctional currency cash are required to be recognized as of the end of the year before conversion. This may have a significant effect on companies (such as banks) that are required to maintain substantial amounts of cash on hand. One way to avoid current gain recognition would be to acquire an instrument that would not meet the definition of "nonfunctional currency" under Sec. 988(c)(1)(C)(ii) (e.g., a bond) before converting the QBU's functional currency to the euro.

Conversion to the Euro Deemed to Occur at Beginning of Tax Year

If a QBU converts its books and records to the euro at any me during a tax year beginning after Jan. 1, 1999, it will be deemed to have changed its functional currency as of the first day of the tax year (Temp. Regs. Sec. 1.985-8T(b)(2)(i)). As noted, with certain exceptions, conversion to the euro generally is not a taxable event. If a QBU changes its functional currency late in the year and after its U.S. parent has filed its corporate tax return for the prior year, an amended return may be required to be filed to reflect currency gain or loss required to be realized as of the end of the tax year prior to conversion. Because when a QBU converts to the euro generally is within the U.S. parent's control, the U.S. parent may affect such timing to avoid filing amended returns.

Sec. 988 Netting Rule

Although it is not an issue specific to the conversion to the euro, clients should be aware of the potential effect of the Sec. 988(b)(1) and (2) netting rule on deferred Sec. 988 exchange gains or losses. Sec. 988 applies to a transaction redenominated in the euro. Under the netting rule, exchange gains or losses on a Sec. 988 transaction are realized only to the extent of total gains or losses on the transaction. For example, assume a QBU has a fixed-rate note denominated in a legacy currency converted to the euro. The built-in Sec. 988 gain on the note is not recognized currently, but must be tracked and recognized on the occurrence of a later realization event. If interest rates increase after the QBU converts to the euro and it suffers an overall economic loss on the note, no exchange gain or loss will be recognized; the built-in gain simply disappears. Similarly, post-conversion events may cause a built-in loss to disappear. Under the appropriate circumstances, consideration should be given to triggering built-in exchange losses before converting a QBU's functional currency to the euro to prevent them from potentially disappearing. Triggering built-in gains also may avoid the burden of tracking Sec. 988 transactions after conversion.

Straddle Transactions

Conversion of positions in legacy currencies to the euro may inadvertently create a straddle transaction to which the loss deferral rules of Sec. 1092 apply. Sec. 1092 defers the recognition of loss on a position in personal property to the extent that a taxpayer has unrealized gain on an offsetting position. For this purpose, personal property means any personal property actively traded, including an obligor's interest in a nonfunctional currency-denominated debt obligation or security. The Sec. 1092 straddle rules generally produce harsh results for taxpayers. Commentators have argued that straddles inadvertently created as the result of conversion to the euro should not be subject to these rules. The regulations, however, do not carve out any exceptions.

FROM ANGELA YU, MBA, CPA, AND CAREN SHEIN, J.D., MLT, WASHINGTON, DC