United States Tax Alert - 10 September 2012
IRS guidance addresses “legging out” of “qualified hedging transactions” under §988(d)
By G. Garner Prillaman, Jr., Jackie N. Tran and Maruti R. Narayan
On 5 September 2012, the U.S. Internal Revenue Service (IRS) issued temporary1 and proposed regulations2 (the “Temporary Regulations”) under Internal Revenue Code §988(d) that amend certain aspects of the “legging out” rules of Treas. Reg. §1.988-5(a)(6)(ii) applicable to nonfunctional currency denominated debt and one or more related hedging transactions treated as a qualified hedging transaction under Treas. Reg. §1.988-5(a). The changes, which apply where the taxpayer has identified multiple hedges as being part of the qualified hedging transaction, are intended to discourage taxpayers from taking positions that the IRS and Treasury believe to be inappropriate under the current rules for “legging out.”
By way of background, Treas. Reg. §1.988-5(a) permits taxpayers to integrate a qualifying debt instrument3 with a Treas. Reg. §1.988-5(a) hedge4 to constitute a “qualified hedging transaction,” provided the hedging transaction completely eliminates the currency exposure5 and certain other requirements are met.6 If so treated, the qualified hedging transaction is treated as a synthetic debt instrument denominated in the taxpayer’s functional currency, and no foreign exchange gain or loss is recognized by the taxpayer on the qualifying debt instrument or the Treas. Reg. §1.988-5(a) hedge for the period that it is a part of a qualified hedging transaction.7
Treas. Reg. §1.988-5(a)(6)(ii) of the current final regulations provides special rules for “legging out” of integrated treatment. In this regard, the term “legging out” is defined to mean the taxpayer disposes of or otherwise terminates all or a part of the qualifying debt instrument or hedge prior to the maturity of the qualified hedging transaction. Under Treas. Reg. §1.988-5(a)(6)(ii)(B), if legging out results from the disposition or other termination of the hedge, the taxpayer is treated as selling the related debt instrument for fair market value on the leg out date, and any gain or loss with respect to the instrument is treated as recognized.
Substantial uncertainty exists under the current final regulations where the hedge comprising the qualified hedging transaction consists of multiple, separate hedging transactions. As mentioned above, the term “hedge” is defined by the final regulations to include all hedging transactions entered into and identified by the taxpayer as part of the qualified hedging transaction, and thus it seems clear that the termination of any individual hedging transactions comprising the hedge would constitute a “leg-out” under the final regulations. However, in describing the consequences resulting from a leg-out, the final regulations state only that the debt instrument is treated as sold for fair market value, and do not explicitly address the consequences to the remaining hedging transactions that have not been terminated.
The Preamble8 to the Temporary Regulations provides that the IRS has become aware of some taxpayers in a loss position with respect to an integrated debt instrument involving multiple hedging transactions who have interpreted the legging-out rules of Treas. Reg. §1.988-5(a)(6)(ii)(B) to permit the recognition of the loss on the debt instrument without recognition of the related gains on the hedging transactions that remain outstanding. In this regard, the Preamble provides as follows:
For example, a taxpayer may fully hedge a fixed rate nonfunctional currency denominated debt instrument that it has issued with two swaps--a nonfunctional currency/dollar currency swap and a fixed for floating dollar interest rate swap. The effect of matching the currency swap with the foreign currency denominated debt is to create synthetic fixed rate U.S. dollar debt while the effect of the interest rate swap is to simultaneously transform the synthetic fixed rate U.S. dollar debt into synthetic floating rate U.S. dollar debt. Thus, assuming that the rules of §1.988-5(a) are otherwise satisfied, the taxpayer will have effectively converted the fixed rate foreign currency denominated debt instrument into a synthetic floating rate U.S. dollar denominated debt instrument.
As the U.S. dollar declines in value relative to the foreign currency in which the debt instrument is denominated, the taxpayer disposes of the interest rate swap while keeping the currency swap in existence. The taxpayer takes the position that the disposition of the interest rate swap allows it to treat the debt instrument as having been terminated on the date of disposition and claims a loss on the debt instrument without taking into account the offsetting gain on the remaining component of the hedge. Thus, the taxpayer claims the transaction generates a net loss. The IRS and the Treasury Department believe that these results are inappropriate under the legging-out rules since the claimed loss is largely offset by unrealized gain on the remaining component of the hedging transaction. Therefore, the IRS and the Treasury Department are issuing these regulations to clarify the rules regarding the consequences of legging-out of qualified hedging transactions that consist of multiple components [emphasis added].
To address the perceived abuse, the Temporary Regulations provide that if a qualified hedging transaction consists of more than one hedging instrument (each referred to as a “component” of the hedge), and at least one but not all of the components of the hedge, or part of any component, has been disposed of or otherwise terminated (whether a hedge consists of a single or multiple components), all the remaining components that have not been disposed of or otherwise terminated (as well as the debt) will be treated as sold for their fair market value on the “leg-out date” of the terminated hedge.
In addition, the Temporary Regulations add a new subsection (F) to the leg-out rules, which replace the rules of current Treas. Reg. §1.988-5(a)(6)(ii)(E). Under the old rule, if a taxpayer legs out of a qualified hedging transaction and recognizes a gain on the terminated instrument, and it enters into a second transaction to hedge at least 50% of the remaining currency flows with respect to the qualifying debt instrument, the legging out rules are generally inapplicable, and the taxpayer will recognize currently only the gain on the positions actually terminated. The new rule, in addition to covering the situation addressed by the old rule, also addresses the situation in which a hedge has multiple components and the remaining components, supplemented by any newly-acquired hedging transactions, hedge at least 50% of the remaining currency flows with respect to the qualifying debt instrument. In that latter situation, as a result of the amendment, the taxpayer will recognize currently only the gain on the positions actually terminated. The Temporary Regulations provide an example illustrating the effect of the new rule.
Finally, we note that new Temp. Treas. Reg. § 1.988-5T(a)(6)(ii)(D), which deals with the situation in which only a portion of the debt instrument is disposed of or otherwise terminated, does not specifically address how the remaining portion of the debt should be treated. Thus, for example, if the taxpayer enters into a qualifying debt instrument that by its terms allows for prepayment, but hedges the debt to its scheduled maturity date, the Temporary Regulations, like the current final regulations, do not explicitly provide for the recognition of the gain or loss on the portion of the debt that remains outstanding.
The Temporary Regulations apply to leg-outs that occur on or after 6 September 2012. The Preamble states that, in appropriate cases, the IRS may challenge the claimed results in the case of transactions occurring prior to the applicability date of the Temporary Regulations.
1 77 Fed. Reg. 54808 (6 September 2012).
2 77 Fed. Reg. 54862 (6 September 2012). The text of the temporary regulations also serves as the text of the proposed regulations.
3 The term “qualifying debt instrument” is defined in Treas. Reg. §1.988-5(a)(3) as a debt instrument described in Treas. Reg. §1.988-1(a)(2)(i), regardless of whether denominated in, or determined by reference to, nonfunctional currency (including dual currency debt instruments, multi-currency debt instruments and contingent payment debt instruments). Note that a qualifying debt instrument does not include accounts payable, accounts receivable or similar items of expense or income.
4 The term “section 1.988-5(a) hedge” is defined in Treas. Reg. §1.988-5(a)(4)(i) as a “spot contract, futures contract, forward contract, option contract, notional principal contract, currency swap contract, similar financial instrument, or series or combination thereof, that, when integrated with a qualifying debt instrument permits the calculation of a yield to maturity (under the principles of section 1272) in the currency in which the synthetic debt instrument is denominated (as determined under [1.988-5](a)(9)(ii)(A) of this section).”
5 The final regulations also allow a taxpayer to treat a portion of its debt as a qualified hedging transaction provided all principal and interest payments under the debt instrument are hedged in the same proportion.
6 Most importantly, a taxpayer must identify the hedge on or before the date the financial instrument(s) constituting the hedge is entered into by providing the information listed in Treas. Reg. §1.988-5(a)(8)(i)(A)-(E) for each qualified hedging transaction. See Treas. Reg. §1.988-5(a)(5) for the additional requirements that must be satisfied to qualify for integrated hedging treatment.
7 The regulations also allow a taxpayer to integrate a foreign currency denominated debt and a hedging transaction to create a nonfunctional currency denominated synthetic debt instrument, provided the debt is fully hedged such that a yield-to-maturity in the currency in which the synthetic debt is denominated (i.e. the currency in which the taxpayer is obligated to make payments under the hedge in the case of a borrowing, or is entitled to receive payments under the hedge in the case of a lending) can be calculated.
8 T.D. 9598 (6 September 2012).