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.

1. 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...