Sec. 1.985-8 Special rules applicable to the European Monetary Union (conversion to euro).

(A) That begins on or after the day that the euro is substituted for that legacy currency (in accordance with the Treaty on European Union); and

(B) In which the QBU begins to maintain its books and records (as described in section 1.989(a)-1(d)) in the euro.

(A) Under the rules set forth in section 1.985-1(c) , the euro is the currency of the economic environment in which a significant part of the QBU's activities are conducted;

(B) After conversion, the QBU maintains its books and records (as described in section 1.989(a)-1(d)) in the euro; and

(C) The QBU is not required to use the dollar as its functional currency under section 1.985-1(b).

Example 1. X, a calendar year QBU on the cash method of accounting, uses the deutschmark as its functional currency. X is not described in section 1281(b). On July 1, 1998, X converts 10,000 deutschmarks(DM) into Dutch guilders(fl) at the spot rate of fl1 = DM1 and loans the 10,000 guilders to Y (an unrelated party) for one year at a rate of 10% with principal and interest to be paid on June 30, 1999. On January 1, 1999, X changes its functional currency to the euro pursuant to this section. Assume that the euro/deutschmark conversion rate is set by the European Council at [euro]1= DM2. Assume further that the euro/guilder conversion rate is set at [euro]1 = fl2.25. Accordingly, under the terms of the note, on June 30, 1999, X will receive [euro]4444.44 (fl10,000/2.25) of principal and [euro]444.44 (fl1,000/2.25) of interest. Pursuant to this paragraph (c)(3), X will realize an exchange loss on the principal computed under the principles of section 1.988-2(b)(5) . For this purpose, the exchange rate used under section 1.988-2(b)(5) (i) shall be the guilder/euro conversion rate. The amount under section 1.988-2(b)(5) (ii) is determined by translating the fl10,000 at the guilder/deutschmark spot rate on July 1, 1998, and translating that deutschmark amount into euros at the deutschmark/euro conversion rate. Thus, X will compute an exchange loss for 1999 of [euro]555.56 determined as follows: [[euro]4444.44 (fl10,000/2.25) - [euro]5000 ((fl10,000/1)/2) = -[euro]555.56]. Pursuant to this paragraph (c)(3), the character and source of the loss are determined pursuant to section 988 and regulations thereunder. Because X uses the cash method of accounting for the interest on this debt instrument, X does not realize exchange gain or loss on the receipt of that interest.

Example 2.

(i) X, a calendar year QBU on the accrual method of accounting, uses the deutschmark as its functional currency. On February 1, 1998, X converts 12,000 deutschmarks into Dutch guilders at the spot rate of fl1 = DM1 and loans the 12,000 guilders to Y (an unrelated party) for one year at a rate of 10% with principal and interest to be paid on January 31, 1999. In addition, assume the average rate (deutschmark/guilder) for the period from February 1, 1998, through December 31, 1998 is fl1.07 = DM1. Pursuant to section 1.988-2(b)(2)(ii)(C), X will accrue eleven months of interest on the note and recognize interest income of DM1028.04 (fl1100/1.07) in the 1998 taxable year.

(ii) On January 1, 1999, the euro will replace the deutschmark as the national currency of Germany pursuant to the Treaty on European Union signed February 7, 1992. Assume that on January 1, 1999, X changes its functional currency to the euro pursuant to this section. Assume that the euro/deutschmark conversion rate is set by the European Council at [euro]1 = DM2. Assume further that the euro/guilder conversion rate is set at [euro]1 = fl2.25. In 1999, X will accrue one month of interest equal to [euro]44.44 (fl100/2.25). On January 31, 1999, pursuant to the note, X will receive interest denominated in euros of [euro]533.33 (fl1200/2.25). Pursuant to this paragraph (c)(3), X will realize an exchange loss in the 1999 taxable year with respect to accrued interest computed under the principles of section 1.988-2(b)(3). For this purpose, the exchange rate used under section 1.988-2(b)(3)(i) is the guilder/euro conversion rate and the exchange rate used under section 1.988-2(b)(3)(ii) is the deutschmark/euro conversion rate. Thus, with respect to the interest accrued in 1998, X will realize exchange loss of [euro]25.13 under section 1.988-2(b)(3) as follows: [[euro]488.89 (fl1100/2.25)- [euro]514.02 (DM1028.04/2) = -[euro]25.13]. With respect to the one month of interest accrued in 1999, X will realize no exchange gain or loss since the exchange rate when the interest accrued and the spot rate on the payment date are the same.

(iii) X will realize exchange loss of [euro]666.67 on repayment of the loan principal computed in the same manner as in Example 1 [[euro]5333.33 (fl12,000/2.25)-[euro]6000 fl12,000/1)/2)]. The losses with respect to accrued interest and principal are characterized and sourced under the rules of section 988.

(A) In general.

A QBU may elect to realize or otherwise take into account for all purposes of the Internal Revenue Code the amount of any unrealized exchange gain or loss attributable to a legacy currency denominated item described in section 988(c)(1)(B)(ii) as if the item were terminated on the last day of the taxable year ending prior to the year of change.

(B) Time and manner of election.

With respect to a QBU that makes an election described in paragraph (c)(3)(iv)(A) of this section, an affected taxpayer (as described in paragraph (b)(5) of this section) shall attach a statement to its tax return for the taxable year ending immediately prior to the year of change which includes the following: "TAXPAYER CERTIFIES THAT A QBU OF THE TAXPAYER HAS ELECTED TO REALIZE CURRENCY GAIN OR LOSS ON LEGACY CURRENCY DENOMINATED ACCOUNTS RECEIVABLE AND PAYABLE UPON CHANGE OF FUNCTIONAL CURRENCY TO THE EURO." A QBU making the election must do so for all legacy currency denominated items described in section 988(c)(1)(B)(ii).