Rules Target Abuse of “Legging Out” of Foreign Currency Hedges

The IRS issued final regulations aimed at preventing taxpayers in certain Sec. 988 qualified hedging transactions from recognizing a loss upon termination of one leg of the transaction without taking into account corresponding gain in the other (T.D. 9736).

The final regulations also clarify the tax treatment of such terminations. They adopt without substantial change temporary regulations issued in September 2012 (T.D. 9598).

Sec. 988 prescribes the tax treatment of certain foreign currency transactions, and the existing regulations define a qualified hedging transaction as an integrated economic transaction consisting of a qualifying debt instrument and a Regs. Sec. 1.988-5(a) hedge (as defined in Regs. Secs. 1.988-5(a)(3) and (a)(4), respectively). A qualified hedging transaction permits taxpayers to recognize no exchange gain or loss during the period that it remains a qualified hedging transaction. The qualifying debt instrument and the Regs. Sec. 1.988-5(a) hedge together form a “synthetic debt instrument” that is subject to the original issue discount provisions of Secs. 1272 through 1288 and 163(e) and subject to rules contained in Regs. Sec. 1.988-5(a)(9)(ii).

A Regs. Sec. 1.988-5(a) hedge is defined as any of several types of financial contracts, such as spot, futures, forward, option, notional principal, and currency swap contracts, or similar financial instruments, or a series or combination of them that, when integrated with a qualifying debt instrument, permits a calculation of a yield to maturity in the currency in which the synthetic debt instrument is denominated.

Disposing of, or changing the material terms of, all or part of either the qualifying debt instrument or hedge before the maturity of the former is referred to as “legging out” of their integration. If the hedge is disposed of, the qualifying debt instrument is treated as sold for its fair market value (FMV) on the date of disposition of the hedge, with any resulting gain or loss recognized on that date. Generally, under this deemed-disposition rule, gain or loss on the qualifying debt instrument will be offset by gain or loss on the hedge.

Before adoption of the temporary (now final) rules, the IRS and Treasury were concerned that some taxpayers had taken the position that they could recognize a loss on a qualifying debt instrument without recognizing corresponding gain on a hedging transaction with multiple financial instruments, by selectively disposing of less than all the positions.

Consequently, under final Regs. Sec. 1.988-5(a)(6)(ii), if a taxpayer has identified multiple hedges as part of a qualified hedging transaction and the taxpayer has terminated at least one or a portion of them but less than all of the hedges, the taxpayer must treat the remaining hedges as having been sold for their FMV on the date of disposition of the terminated hedge.

The final regulations apply to leg-outs occurring on or after Sept. 6, 2012, the date the temporary regulations were issued.

—Paul Bonner (pbonner@aicpa.org) is a TTA senior editor.