The OECD Observer: Tax and the Euro

The OECD Observer
January 1999, No. 215

Tax and the Euro
By John Neighbour

The long-standing project to create a single currency for the EU has become a reality for 11 of its 15 member states. Although individuals will be relatively unaffected until the coins and notes of their domestic currencies are replaced by a common denomination in 2002, the effect on businesses and tax administrations will be immediate.

The process of considering the tax implications of economic and monetary union (EMU) has already been underway for some time. From 1 January 1999 the euro has to be used for a variety of paper transactions, including intergovernmental payments, issuance of government debt and transactions in the inter-bank market. Of more relevance for taxation, many businesses will take up the option of using the euro for issuing bonds, pricing goods and services, general invoicing and accounting from that date. Accordingly, many businesses will be conducting a significant part of their business in the euro long before the introduction of the notes and coins.

The emergence of the euro and the disappearance of domestic currencies in the euro area—so-called Euroland—raises important conversion issues, and not just for participating countries. There are longer term economic questions to be addressed as well.

Conversion to the Euro

Any country whose residents have active interests in the EMU area will have to consider how to cope with the euro for a variety of tax purposes. Even if taxpayers have no business operations in the euro area, they may still be affected if they hold taxable assets denominated in one of the 11 disappearing currencies. The most immediate issue is how to deal with the consequences of any conversion into the euro of taxable assets and liabilities previously denominated in one of the EMU currencies. This will occur from 1 January 1999 for the businesses who opt to account in euros at the earliest opportunity and for everyone else by 30 June 2002.

There are three broad possible approaches to coping with conversion, which the following example may help to illustrate. Consider an individual in the United Kingdom who owns a FF100,000 bond in a French company. The bond was bought when the French franc /sterling exchange rate was FF10: £1 and so was worth £10,000. At 31 December 1998 the French franc /sterling exchange rate is, say, FF9.52: £1 and so the bond is worth £10,500, i.e. there is a foreign exchange gain of £500. On 1 January 1999 the French company re-denominates the bonds in euros. Owing to interest rate movements, the market value of the bond at 31 December 1998 has increased to FF105,000.

Now, the first approach is that the conversion of the French franc bond to a euro denominated bond should be treated as an event for tax purposes and so give rise to an immediate gain or loss (‘immediate recognition’). In our example the taxpayer would be treated as if he or she had sold the old bond and bought a new one at the conversion date and so would be taxed on the foreign exchange gain of £500. Potentially, the person could also be taxed on the gain of FF5,000 arising from the increase in market value of the bond.

The second approach also involves the recognition of the conversion for tax purposes but instead spreads the recognition of any gains or losses over a number of years (‘spreading’). In the example, the foreign exchange gain of £500 could be spread over five years and only £100 taxed each year.

The third approach is to ignore the conversion for tax purposes (‘deferral’). In our example, no exchange gains or losses would be triggered until the person sold the re-denominated bond.

The decision whether to opt for immediate recognition, spreading or deferral, will depend on a number of policy considerations, in particular the general view on the treatment of exchange gains and losses and the government’s wider approach to the euro. There are no obviously right or wrong solutions, nor any real precedents. Even among the 11 countries going into EMU, there is no uniform view. A majority of participants have gone for some form of the deferral option. However, other countries have gone for immediate recognition or have not proposed to change existing tax systems which are based on that option for some types of monetary assets, such as trade debt.

The different treatment adopted by the countries of the euro zone creates the possibility of businesses being taxed more than once on their true profits (‘double taxation’) or of being taxed on less than their true profits by exploiting those differences in tax treatment (‘tax arbitrage’). One example of possible tax arbitrage would be for a taxpayer to arrange to have exchange losses on conversion to the euro in countries where they will be recognised immediately, while the expectation is that exchange gains on conversion will arise in countries opting for deferral. The taxpayer will get an immediate tax deduction for conversion losses, while he will not have to pay tax on conversion gains until some time later.

Some Longer-term Effects

The big policy question is whether it is possible to have a single currency without having a common tax policy that goes beyond the 1997 Stability and Growth Pact (box, p. 5). Perhaps a tighter co-ordination of tax rates and systems than currently exists would be useful. Interestingly, the budgetary discipline needed for the introduction of the euro has already promoted some higher degree of fiscal co-ordination among the EU member states. Examples include the publication of the Code of Conduct for Business Taxation (aimed at counteracting harmful tax competition) and the proposed Directive on the effective taxation of savings by individuals.

The advent of the euro has already led to a wave of mergers, take-overs and business reorganisations, which can be expected to continue apace. This will indirectly have a number of tax effects, for example, making transfer pricing issues more common as previously independent firms are taken over by larger European-wide multinationals. More generally, the volume of cross-border transactions of all kinds can be expected to increase within the euro area because of the elimination of foreign exchange risk and the creation of a truly single market. The abolition of currency risk in the euro zone should increase cross-border investment and lead to more diversification of investment in terms of the types of assets and countries chosen.

There are also likely to be major changes in the nature and types of financial products, operation of financial markets and exchanges and in the behaviour of investors, pension funds and intermediaries. Such changes are likely to lead to the creation of much wider and deeper European capital and financial markets, thereby reducing the cost of borrowing as well as providing increased investment opportunities.

However, in the absence of any move to co-ordinate the tax rules in the euro area, the authorities will still pay considerable attention to their domestic boundaries, even if those boundaries become less important to businesses. This dichotomy between the tax and business dynamics may lead to more pressure to co-ordinate the tax systems in Euroland. This pressure may well increase if recent adverse global events, such as the spread of the Asian financial crisis, threaten to knock the euro off course or affect some parts of the euro zone considerably more than others (an asymmetric shock). For example, any further collapse of the Russian economic system would have a much greater effect on the eastern members of Euroland than on its southern members. At a minimum, the authorities may have to review their existing tax policies to maximise the benefits of the changes brought about by the euro. Issues will also arise on how tax policies formulated in the euro zone will affect other OECD countries. Whatever happens, the move to the euro is likely to make the next few years very interesting indeed for tax policy-makers everywhere.