Editor: Michael Dell, CPA
Gains & Losses
On Sept. 6, 2012, the IRS published final and temporary regulations (T.D. 9598) and proposed regulations (REG-138489-09) under Sec. 988(d) addressing certain integrated transactions that involve a foreign currency denominated debt instrument and multiple associated hedging transactions. The regulations provide that if a taxpayer has identified multiple hedges as being part of a qualified hedging transaction (which is referred to as “legging into” integrated treatment), and the taxpayer has terminated at least one but fewer than all of the hedges (which is referred to as “legging out” of a transaction), the taxpayer must treat the remaining hedges as having been sold for fair market value on the date of disposition of the terminated hedge. (The final and proposed regulations contain only a cross-reference to the temporary regulations.)
The temporary regulations apply to leg-outs that occur on or after Sept. 6, 2012. Under Regs. Sec. 1.988-5(a)(6)(ii), leg-outs mean that a taxpayer disposes of all or a part of the qualifying debt instrument or hedge before the maturity of the qualified hedging transaction or changes a material term of the qualifying debt instrument or hedge. This results in “legging out” of integrated treatment.
Sec. 988 and its regulations generally provide that foreign currency gain or loss with respect to a “Sec. 988 transaction” is (1) recognized at the time established by the recognition provisions of the Code that apply to the sale or other disposition of property; (2) characterized as ordinary gain or loss; and (3) sourced based on the residence of the holder. The definition of a Sec. 988 transaction includes acquiring or becoming the obligor under a nonfunctional currency–denominated debt instrument and entering into or acquiring any nonfunctional currency–denominated forward contract, futures contract, option, or similar instrument. Under these general rules, a taxpayer who hedges foreign currency exposure arising from issuing or holding a debt instrument would have to separately account for the hedge and the hedged item and could face mismatches in character, source, and timing of income (of which the last is likely to be the most significant).
To provide certainty of tax treatment for foreign currency hedging transactions that were fast becoming commonplace (such as fully hedged foreign currency borrowings) and to ensure that those transactions were taxed in accordance with their economic substance, Congress, when it enacted Sec. 988(d), authorized regulations that would provide for the integration of any Sec. 988 transaction that was part of a “988 hedging transaction.”
Regs. Sec. 1.988-5 provides integration treatment for a properly identified “qualified hedging transaction,” which is defined as a qualifying debt instrument and a Regs. Sec. 1.988-5(a) hedge. A qualifying debt instrument is defined as any debt instrument, regardless of whether payments under the instrument are denominated in, or determined by reference to, a nonfunctional currency, but it does not include accounts payable, accounts receivable, or similar items of expense or income.
A Regs. Sec. 1.988-5(a) hedge is defined as a spot contract, futures contract, forward contract, option contract, notional principal contract, currency swap contract, a similar financial instrument, or series or combination thereof, that when integrated with a qualifying debt instrument, permits the calculation of a yield to maturity in the currency in which the synthetic debt instrument is denominated. The effect of the integration is to create a synthetic debt instrument, and, under the regulations, neither the qualifying debt instrument nor the hedge is subject to the straddle rules for the period the transactions are integrated.
Special rules apply when a taxpayer terminates the qualifying debt instrument or Regs. Sec. 1.988-5(a) hedge (a legging-out). When a taxpayer disposes of (or changes a material term of) the hedge, the qualifying debt instrument is treated as sold for its fair market value (FMV) on the date of disposition of the hedge (the leg-out date), and any gain or loss on the qualifying debt instrument from the date of identification to the leg-out date is recognized on the leg-out date.
The IRS and Treasury have indicated that because the regulations do not explicitly address legging-out transactions involving multiple Regs. Sec. 1.988-5(a) hedges, some taxpayers who were in a loss position for a nonfunctional currency debt instrument that was hedged with multiple derivative instruments interpreted the regulations as allowing them to recognize the loss on the debt instrument without recognizing the amount of the corresponding gain on any associated hedges that were not actually terminated at that time. This interpretation gave those taxpayers the opportunity to recognize a net tax loss without a corresponding economic loss by terminating one but not all of the derivatives (presumably the one with the smallest or no gain) and recognizing the entire loss on the debt.
The preamble to the final and temporary regulations states that the IRS believes such a result is inappropriate because the claimed loss is largely offset by unrealized gain on the remaining component(s) of the hedging transaction. The straddle rules do not prevent the recognition of the loss on the debt, however, because the legging-out regulations specifically provide that the loss is recognized at the time of the legging-out.
The Temporary Regulations
The temporary regulations prevent a perceived timing mismatch and tax the transaction in accordance with its economic substance by providing that the legging-out rules apply to all the positions making up the qualifying hedging transaction and by expanding (or clarifying) the application of the legging-out rules. Since the IRS was concerned with current perceived abuses, the temporary regulations are immediately effective.
The temporary regulations add a new subparagraph, Temp. Regs. Sec. 1.988-5T(a)(6)(ii)(C), which provides that if a hedge has more than one component “and at least one but not all of the components” are disposed of or otherwise terminated (or if part of any component of the hedge is terminated), then the date the component (or part of it) is disposed of or terminated is considered the leg-out date, and the qualifying debt instrument is treated as sold for its FMV on that date. Additionally, Temp. Regs. Sec. 1.988-5T(a)(6)(ii)(C) states that “all of the remaining components (or parts thereof) that have not been disposed of or otherwise terminated shall be treated as sold for their fair market value on the leg-out date, and any gain or loss from the identification date to the leg-out date is realized and recognized on the leg-out date” (emphasis added).
The temporary regulations also indicate that a partial termination of a qualifying debt instrument will trigger the legging-out rules. Temp. Regs. Sec. 1.988-5T(a)(6)(ii)(D) states that, “[i]f the qualifying debt instrument is disposed of or otherwise terminated in whole or in part , the date of such disposition or termination shall be considered the leg-out date” (emphasis added), and the hedge (including all components making up the hedge in their entirety) is treated as sold for its FMV on the leg-out date, and gain or loss is realized and recognized accordingly.
The regulations appear to be a reasonable way to eliminate what may have been perceived as a small loophole in the legging-out provisions of the integration regulations. They should not deter taxpayers’ continued use of the integration rules, including the legging-out provisions, for their intended purpose of providing certainty in the tax treatment of many foreign currency hedging transactions.
The regulations may, however, have inadvertently cast some doubt on another legging-out question that relates to hedged convertible debt instruments. If a portion of the debt issue is retired early, and a proportionate part of the hedge is terminated, there should not be a legging-out for the remaining portion of the debt and the hedge. Instead, the partial termination should be viewed as a pro rata prepayment of a portion of the synthetic debt instrument. The new regulations do not directly affect this question because they do not address whether a transaction is a legging-out, only what happens to derivative positions once it has been determined that there has been a legging-out. Nevertheless, practitioners may seek to clarify this point on behalf of clients who have integrated convertible debt instruments.
Michael Dell is a partner with Ernst & Young LLP in Washington, D.C.
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