Interest Rate Hedging Considerations for Corporate Taxpayers

Transcription

1 Interest Rate Hedging Considerations for Corporate Taxpayers Volume 6 Issue By William R. Pomierski William Pomierski describes the requirements for, as well as the expected tax consequences resulting from entering into, qualifying interest rate hedging transactions relating to current or anticipatory borrowings by a corporate taxpayer. It is imperative that these taxpayers know of potential tax character and timing mismatches before they enter into such transactions. Introduction Corporate taxpayers entering into interest rate hedging transactions relating to current or anticipated borrowings need dt to be aware are of potential tax character and timing i mismatches. m If interest rate hedging losses are treated das capital llosses, for example, they would not be deductible against ordinary ry business s profits. Timing mismatches are also possible in interest est rate hedging transactions. For example, an interest rate hedge that meets the definition of a section 1256 contract under Code Sec. 1256(g) could be subject to markto-market taxation, whereas the liability being hedged thereby would not be marked to market. 1 Hedging transactions that are intended to manage interest rate risk with respect to a taxpayer s U.S. dollar denominated borrowings may avoid potential tax character and timing mismatches by taking advantage of the hedging rules of Code Sec. 1221(a)(7), or under the hedge integration rules of Reg To qualify for the special tax rules that apply to qualifying hedging transactions, however, a number William R. Pomierski is a Partner in the international law firm of McDermott Will & Emery LLP, resident in its Chicago office. He is a former Editor-in-Chief of the JOURNAL OF TAXATION OF FINANCIAL PRODUCTS. of requirements must be satisfied. The balance of this article describes the requirements for, as well as the expected tax consequences resulting from entering into, qualifying interest rate hedging transactions relating to current or anticipatory borrowings by a corporate taxpayer. 3 Hedging Under Code Sec. 1221(a)(7) Code Sec. 1221(a)(7) assures ordinary gain or loss treatment for qualified hedging transactions by carving them out of capital asset treatment. A qualified hedging transaction is defined for purposes of Code Sec. 1221(a)(7) as a transaction that a taxpayer enters into in the normal course of its trade or business primarily to manage the risk of (1) price changes or currency fluctuations with respect to ordinary property that is held or to be held by the taxpayer, or (2) interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer. 4 It is worth noting that the ordinary income or loss assurances of Code Sec. 1221(a)(7) are relevant to the extent that gains or losses from an interest rate W.R. Pomierski JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 59

2 Interest Rate Hedging Considerations hedging transaction would, in the absence of Code Sec. 1221(a)(7), be considered capital gain or loss. For example, if a taxpayer hedges a current or anticipated borrowing by entering into a futures contract that is considered a section 1256 contract, gain and loss from such contract would, absent Code Sec. 1221(a)(7), be capital under Code Sec. 1256(a). Certain forms of interest rate hedging transactions, however, result in ordinary income or deductions in their own right. For example, if a taxpayer manages interest rate risk with respect to a borrowing by entering into an interest rate swap transaction that meets the definition of a notional principal contract under Reg , periodic and nonperiodic payments made or received with respect to such swap would be ordinary irrespective of Code Sec. 1221(a)(7). 5 Risk Management Reg (c)(4) states that whether a transaction manages a taxpayer s risk is determined based on all of the facts and circumstances surrounding the taxpayer s business and the transaction. A taxpayer s practices ces and procedures as reflected in its minutes or other business records are evidence of whether a hedging transaction manages risk. 6 Under the regulations, the general er test for risk management is a macro test that t is, does the transaction manage risk after considering the taxpayer s overall risk profile? This is often referred to as the enterprise risk reduction requirement. Notwithstanding this general rule, a hedging transaction that relates to a particular asset or liability generally is treated as managing overall risk if it is undertaken as part of a program reasonably expected to reduce the overall risk of the taxpayer s operations. 7 If a taxpayer borrows money and agrees to pay stated interest at a fixed (floating) rate, a risk management transaction whereby the taxpayer synthetically converts the interest rate to a floating (fixed) rate would qualify as a hedging transaction for purposes of Code Sec. 1221(a)(7). 8 Code Sec. 1221(a)(7) also extends to hedging of interest rate risk with respect to a contingent debt instrument governed by Reg For example, consider a debt instrument that provides for contingent interest payable at maturity based on the increase, if any, in the value of Under the regulations, the general test for risk management is a macro test that is, does the transaction manage risk after considering the taxpayer s overall risk profile? CCH. All Rights Reserved. a specified share of stock or an equity index. If the issuer hedges its risk relating to this contingent interest payment with a derivative (financial) instrument, the hedge should meet the definition of a hedge for purposes of Code Sec. 1221(a)(7). 9 Code Sec. 1221(a)(7) allows taxpayers to hedge an expected (or anticipatory) issuance of debt. By contrast, the integrated hedge rules of Reg , which are described below, are more restrictive in the case of anticipatory hedges. Finally, Reg makes it clear that a taxpayer may hedge all or part of its risk for all or part of the period over which the taxpayer is exposed to that risk. 10 For example, if a taxpayer issues a $100 million debt instrument that calls for the entire principal balance to be paid at maturity in 10 years, a notional principal contract with a notional principal amount of $40 million and a term of five years could, even though it hedges less than the entire principal amount for less than the entire period of the debt, qualify as a hedging transaction under Code Sec. 1221(a)(7). By contrast, the availability of the integrated hedge rules of Reg is limited in the case of partial hedging transactions. Consolidated Group Considerations As a general rule, a risk management transaction is a qualified hedging transaction under Code Sec. 1221(a)(7) only if the taxpayer manages its own risk. Managing the risk of a related taxpayer generally does not qualify as a hedge for purposes of Code Sec. 1221(a)(7). An exception is provided, however, in the case of taxpayers that are members of a U.S. consolidated federal income tax group. Under Reg (e)(1), all of the members of a U.S. consolidated group are generally treated as if they were divisions of a single corporation. This single-entity default rule effectively means that any member of a consolidated federal income tax group may hedge the risks of any other member of the group, and the hedge is eligible to be treated as a Code Sec. 1221(a)(7) hedge. 11 For example, if members of a U.S. consolidated group engage in their own borrowing transactions, a designated member of the group could enter into interest rate hedging transactions with third parties on behalf of members of the group that

3 Volume 6 Issue would still qualify under Code Sec. 1221(a)(7). Note, however, that because consolidated group members are treated as divisions of a single corporation for this purpose, a risk management transaction between members of a consolidated group will not be treated as a qualified hedging transaction for purposes of Code Sec. 1221(a)(7). 12 This is because of the fact that in an intercompany transaction, the risk being hedged does not leave the group unless and until one of the members shifts the risk outside of the group by entering into a transaction with a third party (in which case the third-party transaction would be eligible to be treated as a qualified hedging transaction). Notwithstanding the single-entity default rule, a consolidated group may elect to treat each member of the group as a separate taxpayer for purposes of Code Sec. 1221(a)(7). 13 This separate-entity election is made by filing an appropriate statement on a timely filed federal income tax return for the first taxable year for which the election is to apply. 14 Once made, a separate-entity election may only be revoked with the consent of the IRS. If a separate entity election is made, a risk management transaction will be eligible to be treated as a Code Sec. 1221(a)(7) hedging transaction only if the risk being hedged is the taxpayer s own risk. Special rules are provided for intercompany hedging transactions entered into among members of a consolidated group that has made a separate entity ty election. 15 Identification Requirements Code Sec. 1221(a)(7) 21 (7) states that a hedging (risk management) transaction must be clearly identified before the close of the day on which it was acquired, originated or entered into, or at such other time as the Treasury may determine by regulations. 16 There are two components to the identification requirement. First, Reg (f)(1) provides that a taxpayer must identify the hedging transaction meaning the futures contract, option, forward, swap or similar transaction that manages risk on the same day that the hedging transaction is entered into. In addition to identifying the hedging (risk management) transaction, the asset, ordinary obligation or borrowing being hedged thereby (the hedged item ) must also be identified. 17 The hedged item must be identified substantially contemporaneously with the hedging transaction, but in no event more than 35 days later. 18 The only exception to the requirement that the hedged item be specifically identified is in the context of aggregate or macro hedging activities, where the adoption of an aggregate tax hedge policy replaces the requirement of specifically identifying each hedged item. 19 Method of Hedge Identification Reg (f)(4) provides limited guidance regarding the manner in which the hedge identification requirements can be met. The regulations require that the hedge identification be made on, and retained as part of, the taxpayer s books and records. To qualify, an identification must be clear and unambiguous. The regulations also indicate that identification of a hedging transaction for financial accounting or regulatory purposes will not satisfy this requirement unless the taxpayer s books and records indicate that the identification is also being made for tax purposes. Note that hedge identifications under Code Sec. 1221(a)(7) need not be filed with the IRS, but are simply retained as part of the taxpayer s books and records. Reg (f)(4)(iv) provides that a taxpayer may either separately make each identification or, so long as the identification is unambiguous, may establish a system pursuant to which the identification is indicated either by the type of transaction or by the manner in which the transaction is consummated or recorded. The hedging regulations offer three examples of permissible forms of identification: (1) hedge accounts, (2) a designation in the taxpayer s books and records and (3) stamped trade records. 20 In addition to identifying the hedging (risk management) transaction, the regulations also provide for identification of the hedged item (e.g., the liability being hedged). With respect to hedges of existing debt, the taxpayer should specify the issue and, if the hedge is for less than the full issue price or the full term of the debt, the amount of the issue price and the term covered by the hedge. 21 If a taxpayer hedges anticipatory debt, 22 the identification should include all of the following information: Expected maturity or maturities of the debt Total expected issue price of the issue Expected interest provisions If the hedge is for less than the entire expected amount of the issue price of the debt or the full term of the debt, a taxpayer must identify the amount being hedged and/or the term being hedged, as appropriate. The identification of anticipatory debt may indicate a range of dates, terms and amounts instead of specific dates, terms and amounts. JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 61

4 Interest Rate Hedging Considerations If a taxpayer enters into infrequent interest rate hedging transactions, a common practice is to identify both the hedging (risk management) transaction and the debt being hedged thereby pursuant to a same-day identification form/memorandum that describes (1) the terms of the hedging transaction (including the type of risk management transaction (e.g., futures contract, option, swap contract), the name of the taxpayer s counterparty in the case of an over-the-counter transaction or the exchange on which the risk management transaction is traded in the case of an exchange-traded position, the notional amount or number of contracts, maturity date, cash flows, etc.) and (2) the terms of the borrowing (such as the principal amount, interest rate, payment dates and maturity). If, however, a taxpayer enters into numerous interest rate hedging transactions or enters into hedging transactions on an aggregate (or macro) basis such that the hedging transactions cannot be associated with any particular borrowing, another form of hedge identification may be required. Misidentification n Issues Code Sec. 1221(b)(2)(B) authorizes the Treasury Secretary to prescribe regulations to properly characterize any income, gain, expense or loss s arising from a transaction that is either er a qualified hedging transaction that is not identified as such, or that is not a qualified hedging transaction but is identified as a hedge. Reg (g) includes two separate provisions for misidentified hedging transactions. 23 First, in the case of nonqualifying transactions that are identified as Code Sec. 1221(a)(7) hedging transactions, the regulations state that the identification is binding with respect to any gain resulting from the transaction (meaning that gain will be ordinary), whereas losses from the particular transaction will be characterized under the general rules for the type of transaction. 24 Note that there is an inadvertent error exception that may be applicable in certain cases to avoid this character mismatch potential. 25 A second misidentification provision potentially applies to transactions that meet the definition of a qualified hedging transaction, but are not identified as such. In such cases, the regulations provide that, [T]he regulations include an antiabuse rule for transactions that meet the definition of a qualified hedging transaction, but are not identified as such CCH. All Rights Reserved. as a general rule, both gains and losses from such transactions are to be determined without regard to Code Sec. 1221(a)(7), meaning that the character of gains and losses would be determined under the general rules for the particular type of transaction. The regulations then set out two exceptions to this characterization rule. The first exception is referred to as the inadvertent error exception. 26 Under Reg (g)(2)(ii), if a taxpayer does not identify a qualified hedging transaction, the taxpayer may but is not required to 27 treat gain or loss from the transaction as ordinary income or loss if each of the following requirements are satisfied: (1) The transaction qualifies as a hedging transaction within the meaning of Code 1221(b)(2). (2) The failure to identify the transaction was due to inadvertent error. (3) All of the taxpayer s qualified hedging transactions in all open years are being treated on either original or, if necessary, amended returns as qualified hedging transactions. Unfortunately, there is limited guidance regarding the meaning of inadvertent error. 28 Finally, the regulations include an anti-abuse rule for transactions that meet the definition of a qualified hedging transaction, but are not identified as such. Under rthis anti-abuse rule, the regulations authorize the IRS to treat gains from such transactions as ordinary. 29 The anti-abuse rule applies, however, only if the taxpayer has no reasonable grounds for treating the transaction as other than a hedging transaction. The reasonableness of the taxpayer s failure to identify a transaction is to be determined by taking into account not only the requirements of Reg (b), but also the taxpayer s treatment of the transaction for other purposes, as well as by taking into account the taxpayer s identification of similar transactions as hedging transactions. Hedge Timing Considerations If a taxpayer enters into a qualified hedging transaction within the meaning of Code Sec. 1221(b)(2), regardless of whether the transaction is identified as such, the timing of any gains and losses from the hedge must be accounted for under Reg Note that the hedge timing rules of Reg

5 Volume 6 Issue only apply to the hedging (risk management) transaction; the hedge timing rules do not, however, affect the timing of income, deduction, gain or loss with respect to the hedged item. Accordingly, in the case of a hedging transaction relating to a borrowing, the hedge timing rules do not alter the tax accrual principles that apply to determine the timing of the issuer s interest deductions with respect to the debt instrument itself. General Matching Requirement No particular hedge timing method is prescribed under Reg Instead, the hedge timing rules simply require that hedge gains and losses be accounted for under a method that clearly matches the timing of income, deductions, gains, or losses attributable to the item being hedged. As a general rule, the hedge timing provisions of Reg trump the timing rules that would otherwise apply to the risk management (hedging) transaction. Special timing rules are provided for hedges of debt instruments. 30 Under Reg (e)(4), gain or loss from transactions that hedge a debt instrument must be accounted for by reference to the terms of the debt instrument and the period or periods to which the hedge applies. This regulation further provides that hedges sof debt instruments that provide for fixed or floating rates of interest are generally accounted for using constant nt yield principles, which effectively require ea taxpayer to take hedging gains or losses into account over the same periods in which they would be taken into account co as if the hedging ggains or losses were to adjust the yield of the debt instrument. In the case of hedges of anticipatory borrowings, the constant yield principles of Reg (e)(4) require taxpayers to take gains and losses from hedges of anticipatory borrowings that are consummated into account as if the hedge adjusted the issue price of the debt instrument. Under Reg (e)(8), gains and losses from hedges of anticipatory borrowings that are not consummated, however, are generally taken into account when realized. 31 A taxpayer consummates an anticipatory borrowing when it issues either the anticipated debt or a different but similar transaction for which the hedge serves to reasonably reduce risk. Under special rules for hedges involving notional principal contracts, the rules of Reg will generally continue to govern the timing of income and deductions with respect to a notional principal contract that qualifies as a hedging transaction unless the application of those rules would not otherwise result in the matching needed to satisfy the clear reflection requirement of Reg For example, if a notional principal contract hedges a debt instrument, the method of accounting for periodic payments described in Reg (e) and the methods of accounting for nonperiodic payments described in Reg (f)(2)(iii) and (v) generally satisfy the clear reflection requirement of the hedge timing regulations. The methods described in Reg (f)(2)(ii) and (iv), however, generally do not clearly reflect the taxpayer s income in that situation. Identification The hedge timing rules of Reg automatically apply to any risk management transaction that meets the definition of a qualified hedging transaction set out in Code Sec. 1221(b)(2). In other words, application of the hedge timing rules is not dependent on identification of the transaction as a hedging transaction under Code Sec. 1221(a)(7). 33 Reg , however, includes its own identification requirements. Specifically, a taxpayer s books and records are to include a description of the accounting method used for each type of hedging transaction. This description must be sufficient to show how the clear reflection requirement of Reg is being satisfied. In addition, a taxpayer s books and records should contain additional information sufficient to verify that the taxpayer s hedge method of accounting co is being used for the particular transaction nor rtransactions. This identification is to be made on or before the date the hedging transaction is entered into, and is made on, and retained as part of, the taxpayer s books and records. 34 If a taxpayer does not timely identify its hedge method of tax accounting, the IRS may be more likely to challenge the taxpayer s hedge accounting method. Legging in A taxpayer legs in to a hedging transaction in situations where the risk management transaction and the hedged item are not entered into on the same day. For example, if a taxpayer issues a debt instrument and subsequently enters into an interest rate hedging transaction intended to manage interest rate risk with respect to the borrowing, the taxpayer would be viewed as having legged in at the time the risk management transaction is entered into. Under Reg , no special timing rules are provided for a legging-in transaction where the taxpayer incurs JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 63

6 Interest Rate Hedging Considerations a borrowing and subsequently engages in a related hedging transaction. 35 The absence of a legging-in rule under those circumstances is consistent with the notion that Reg does not alter the timing of income, deduction, etc., with respect to the hedged item itself (e.g., the liability being hedged). Legging out Once a hedging transaction is established, a taxpayer may leg out of the hedge by disposing of or terminating either the liability being hedged, the hedging (risk management) transaction itself, or both. The hedge timing rules set out two separate legging-out provisions. First, if the taxpayer disposes of or terminates the liability being hedged, but does not dispose of or terminate the related hedging (risk management) transaction, Reg (e)(6) requires that the taxpayer match the unrealized (built-in) gain or loss on the hedging transaction to the gain or loss on the hedged item (liability) being disposed of. To meet this requirement, Reg provides that the taxpayer may mark the hedging transaction to market on the date it disposes of or terminates the liability being hedged. 36 After the legging-out transaction, the hedging transaction would no longer be governed by Reg unless it is recycled to serve as a hedge with respect ec to another hedged item. 37 Second, a taxpayer may engage in a legging-out transaction by terminating the hedging (risk management) transaction n without disposing in of or terminating ng the liability being hedged. Inthat case, the ehedge timing rules do not require that the taxpayer take any income, deduction, gain or loss into account with respect to the liability being hedged. Instead, the taxpayer is required to account for any gain or loss resulting from the disposition (termination) of the hedging transaction in a manner that matches such gain or loss to the income, gain, loss or deductions to be realized in the future with respect to the liability being hedged. In LTR , the IRS considered whether a taxpayer s payments to terminate a hedging agreement could be deducted in the year paid. 38 In its analysis of Reg (b), the IRS stated that, under certain circumstances, taking gains and losses from hedging transactions into account in the period in which they are realized may clearly reflect income. As explained in LTR , such an accounting result would clearly reflect income if the hedge and the hedged item are disposed of in the same taxable year. In this ruling, the taxpayer terminated its interest rate hedge agreement and its lender financing agreement (borrowing) in the same tax year. Thus, the IRS concluded that the taxpayer s termination of the hedging transaction should be taken into account in the same tax year as the termination of the hedged borrowing. In LTR , the IRS addressed the application of the hedge timing rules of Reg to an anticipatory hedge with respect to a borrowing. 39 Specifically, the taxpayer planned to issue fixed-rate debt. To protect itself from an increase in interest rates, and to lock-in its interest rate obligation on the anticipated borrowing, the taxpayer entered into a Treasury lock agreement. A Treasury lock agreement is essentially a forward rate agreement that provides that if the interest rate on Treasury notes upon the maturity of the rate lock agreement is greater than a threshold amount, the taxpayer will receive money from the counterparty. If rates decrease, on the other hand, the taxpayer will pay money to the counterparty. The taxpayer s rate-lock agreement was to mature at or around the time that the related borrowing was to be incurred by the taxpayer. The IRS concluded that under Reg (e)(4), the taxpayer was required to account for income or loss from the anticipatory debt hedge in a manner that treats such gain (or loss) as if it decreased (or increased) the issue price of the debt instrument. As a result, the gain or loss from the hedge was to be spread out over the term of the debt instrument. In FSA , 93 the IRS disallowed a taxpayer s attempt to take hedging losses into account before the taxpayer realized gains or losses from the hedged item. 40 In this ruling, the taxpayer was in the business of leasing equipment to end-users. As part of its business operations, the taxpayer pooled its leases and sold securities that were collateralized by the pool of leases. The profitability of these transactions depended on the market rate of interest when the taxpayer offered these securities to the public. Prior to the issuance of the collateralized securities, the taxpayer entered into hedging transactions intended to lock-in an interest rate. The IRS disallowed the taxpayer s attempt to deduct losses from these hedging transactions in the year realized because the IRS believed that such accounting treatment would violate the clear reflection of income standard of Reg (b). The IRS concluded that the taxpayer s hedging gains or losses must be accounted for by reference to the terms of the debt instrument and the period to CCH. All Rights Reserved.

7 Volume 6 Issue which the hedge relates, meaning the hedge losses were to be deferred and matched to the income or deductions on the collateralized securities. Finally, Rev. Rul deals with the application of the hedge timing rules of Reg (e) to a legging-out transaction involving an early termination of an interest rate swap. 41 In Rev. Rul , the taxpayer issued a debt instrument with a 10- year term that provided for interest to be paid annually at a fixed rate. Contemporaneously with the issuance of the debt instrument, the taxpayer entered into an interest rate swap (the Swap ) with a five-year term that converted the fixed rate payments under the debt instrument into floating rate payments. The taxpayer then terminated the Swap on the last day of Year 2. According to Rev. Rul , prior to its termination on the last day of Year 2, the Swap would have continued to hedge interest payments on the debt instrument during Year 3 through Year 5, and the taxpayer generally would have been required to take into account the remaining income, deduction, gain or loss on the Swap over the period from Year 3 through Year 5. Since any termination payment made or received by ythe taxpayer upon termination of the Swap represented the present value of the extinguished e rights and obligations under the eswap for ryear 3 through hyear 5, the IRS ruled that the taxpayer should amortize the gain or loss resulting from terminating the Swap over the period from Year 3 through Year Unfortunately, gains from financial products that alter the effective cost of a borrowing are not automatically treated as an offset (reduction) to interest expense for foreign tax credit calculation purposes. Coordination with Temporary Reg T For foreign tax credit calculation purposes, in determining how to allocate or apportion interest expense between U.S. source and foreign source income, a taxpayer must first determine whether a given item of income or expense is interest. Temporary Reg T automatically treats certain losses from financial products that alter the effective cost of borrowing as an item of interest expense for purposes of the apportionment and allocation rules. This includes losses from swaps, options, forwards, caps, collars, and similar financial instruments. 43 Unfortunately, gains from financial products that alter the effective cost of a borrowing are not automatically treated as an offset (reduction) to interest expense for foreign tax credit calculation purposes. Temporary Reg T(b)(6)(iv)(B) allows taxpayers to use gains from such financial products to reduce total interest expense, but only if the financial products are properly identified as hedges. In order to take advantage of this rule for gains from interest rate hedges, Temporary Reg T(b)(6)(iv)(C) provides that taxpayers must identify a financial product as a hedge on the same day as it enters into the hedging transaction. Taxpayers have up to 120 days to identify anticipatory debt hedges. 44 A taxpayer can satisfy the rules of Temporary Reg T(b)(6)(iv)(C) by meeting the debt hedge identification requirements of Reg Coordination with Straddle Rules of Code Sec Although a taxpayer s own debt instrument is generally not viewed as a position in personal property that is potentially considered part of a tax straddle under Code Sec. 1092, the IRS has recently taken the position that, in limited circumstances, a taxpayer s own debt may be considered part of a tax straddle. 45 Even if a taxpayer s own debt is not considered part of fa tax straddle, a risk management (hedging) transaction entered into with the intent of managing interest rate risk on a borrowing could potentially be matched up with some other offsetting position of the taxpayer and therefore be considered part of a tax straddle. Fortunately, an exception to the application of the straddle rules is provided in the case of hedging transactions that meet the definition of a hedge under Code Sec. 1221(b)(2). Code Sec. 1092(e) provides a hedge exception to the application of the straddle rules. Code Sec. 1092(e) provides simply that the straddle rules will not apply in the case of any hedging transaction as defined in Code Sec. 1256(e). Code Sec. 1256(e), in turn, defines a hedging transaction as any transaction that meets the definition in Code Sec. 1221(b)(2)(A), if before the close of the day on which such transaction was entered into (or at such earlier time as the Secretary may prescribe by regulations), the taxpayer clearly identifies the transaction as being a hedging JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 65

8 Interest Rate Hedging Considerations transaction. This means that a hedging transaction that satisfies the Code Sec. 1221(b)(2) definition of a hedge, and is identified in a manner that satisfies the requirements of Reg (f), is exempt from the straddle rules of Code Sec Note further that the regulations issued under Code Sec. 1256(e) provide that a hedging transaction that is identified under Code Sec. 1221(a)(7) is automatically treated as an identification for purposes of Code 1256(e) and Reg (e) The straddle exemption provided for qualified hedging transactions under Code Sec. 1256(e) is twofold. First, the hedging transaction and the hedged item (borrowing) are not considered straddles with respect to each other. Second, neither the risk management (hedging) transaction nor the hedged item can be considered part of a tax straddle with respect to any other potentially offsetting positions of the taxpayer. Integrated Hedge Treatment Under Reg As described above, the hedging rules of Code Sec. 1221(a)(7) and Reg generally provide for matching of the tax character and timing of income, gains, deductions, and losses from a qualified hedging transaction ac to the character and timing of the income, gains, deductions ductio or losses resulting from the liability ity being hedged thereby. Although Code Sec. 1221(a)(7) and Reg provide for consistent treatment of the hedging transaction act and the liability being hedged thereby, eb the income, gains, deductions and losses from the hedging transaction would need to be reported separately from the liability being hedged. By contrast, Reg (a) provides for tax integration of a qualifying debt instrument and a hedge or combination of hedges that meet the requirements of that regulation. The integration rules of Reg trump other federal income tax rules that would otherwise govern the tax character and timing consequences of each individual component of the hedge. In other words, if a qualifying debt instrument and a qualifying hedge are integrated under Reg , during the period of integration the taxpayer ignores the separate existence of the hedging transaction and accounts for the qualifying debt instrument on a synthetic basis, meaning that the debt instrument is treated for all tax purposes as the combination of the debt instrument being hedged in combination with the hedging transaction itself. Qualifying Transactions Reg provides for integration of a qualifying debt instrument (a QDI ) and a qualifying hedging transaction (hereinafter a section hedge ). The regulation defines a QDI to include all debt instruments subject to three enumerated exceptions. 47 This can include QDI s issued by a taxpayer, as well as QDI s held as an asset by the taxpayer. 48 A section hedge is broadly defined to include any financial instrument such as spot, forward, or futures contracts, options, swaps, debt instruments or combinations thereof 49 that, when combined with the QDI, will permit the calculation of a yield to maturity or would qualify as a variable debt instrument under Reg In order to qualify as a section hedge, the resulting synthetic debt instrument must have the same term to maturity as the remaining term of the QDI. 50 By contrast, Code Sec. 1221(a)(7) simply requires that the hedging transaction manage the taxpayer s risk. As such, Reg requires a high degree of correlation between the terms of the hedging transaction and the terms of the QDI being hedged thereby. A transaction is eligible for integrated treatment under Reg only if the QDI is issued or acquired by the taxpayer on or before, or substantially contemporaneously with, the date of the first payment on the hedging transaction. 51 Unlike Code. Sec. 1221(a)(7), this means that anticipatory hedging is limited under Reg As stated ted above, under Reg , a QDI cannot be hedged for less than its entire remaining term. However, an instrument that hedges only a portion of the principal amount of a QDI can qualify for integration under Reg as long as the proportional hedge is for the entire remaining term of the QDI. 52 By contrast, Code Sec. 1221(a)(7) and Reg make it clear that a taxpayer may hedge all or part of its risk with respect to a borrowing for all or any portion of the period that it is subjected to such risk. 53 Requirements In addition to the basic rules described above, a taxpayer may take advantage of Reg only if the following requirements are met: There must be same-day identification under Reg (e). The parties to the hedge are not related, or, if they are related, the party proposing the hedge uses a mark-to-market method of accounting for the CCH. All Rights Reserved.

9 Volume 6 Issue hedge and all similar or related transactions. The same taxpayer enters into both the hedge and the QDI. If the taxpayer is a foreign person engaged in a U.S. trade or business, all items of income and expense (other than interest expense subject to Reg ) are effectively connected with the U.S. trade or business for the period of the QDI had Reg not applied. Neither the hedge or the QDI nor any other debt instrument that is part of the same issue as the QDI was part of an integrated transaction with respect to the taxpayer or otherwise legged out of in the 30 days preceding the issue date of the QDI. The taxpayer issues the QDI on or before the date on which the taxpayer makes or receives the first payment on the section hedge. 54 Neither the hedge nor the QDI may have previously been a part of a Code Sec straddle. Note that the third requirement, which is that the same taxpayer must enter into both the hedge and the QDI, effectively precludes Reg integrated hedge treatment in situations where one member of a consolidated group directly hedges a QDI of another member of the group. The related-party hedging rule set out above also makes it difficult to qualify for integrated treatment if the issuer of a QDI enters into a hedge with a related taxpayer. Identification ion To integrate a section hedge e with a QDI under Reg , a taxpayer must identify ify the resulting synthetic debt instrument by entering the required information in its books and records on or before the day that it enters into the section hedge. Method of Hedge Identification No particular form of identification is required under Reg However, the identification should indicate that it is being made for purposes of Reg , and should include the following information: The issue date of the QDI and the date that the hedge was entered into A description of the QDI and the section hedge A summary of the cash flows and accruals that result from integration of the QDI and the section hedge 55 Note that hedge identifications under Reg need not be filed with the IRS, but are simply retained as part of the taxpayer s books and records. The common practice is for taxpayers to identify both the QDI and the qualifying section hedging transaction pursuant to a same-day identification form/memorandum that satisfies the requirements of Reg Misidentification Issues Unlike Code Sec. 1221(a)(7), Reg does not include misidentification rules. Reg (c)(2), however, provides that the IRS may, in limited circumstances, integrate a QDI and a section hedge where the taxpayer has not elected to do so. 56 The circumstances under which integration may be imposed by the IRS include (1) a failure by a taxpayer to identify an otherwise qualifying transaction, (2) a related party entering into a section hedge and the taxpayer holding a QDI, (3) a taxpayer holding a QDI and entering into a hedge with a related party, or (4) a taxpayer legging out of an integrated transaction and entering into a new section hedge within 30 days with respect to the same QDI or another QDI that is part of the same issue. The IRS may deem a taxpayer to have made an integration election under Reg , however, only if (1) the QDI is subject to the rules of Reg (relating to contingent payment debt instruments), or (2) the QDI is subject to the rules of Reg (relating to variable rate debt instruments) and the QDI pays interest at an objective rate. Consolidated Group Considerations As noted above, one of the requirements for integrated treatment under Reg is that the same taxpayer must enter into both the section hedge and the QDI. This limitation denies integrated treatment under Reg in a situation where one member of a consolidated group enters into a hedge with respect to a QDI held or entered into by another member of the group. As a result, Reg is more restrictive than the rules under Code Sec. 1221(a)(7), which generally allows members of a consolidated group to hedge the risks of other members. Consequences of Integration Under Reg If an integration election is made with respect to a QDI and a qualifying section hedge, the result is that the QDI and the hedge are generally treated as a single transaction by the taxpayer for all JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 67

10 Interest Rate Hedging Considerations federal income tax purposes during the period that the transaction qualifies as an integrated transaction. This means that while a QDI and a qualifying hedge are part of an integrated transaction, neither the QDI nor the hedge will be subject to the rules that would otherwise apply on a separate basis, including but not limited to, the straddle rules of Code Sec Note, however, that an issuer s election to integrate a QDI and a qualifying hedging transaction has no impact on holders of the QDI. During the period of integrated treatment, the resulting synthetic debt instrument is subject to the general rules for debt instruments under Code Sec. 163(e) and Code Sec through The terms of the resulting synthetic debt instrument, such as the issue date, issue price, etc., are determined under Reg (f)(2) through (13). Legging in A taxpayer may leg in to a Reg hedge with respect ectto to an outstanding QDI, which means that the taxpayer can enter into the hedge at any time after the date on which h the QDI is issued. In order to leg in, a taxpayer aye must ensure that all of the integration requirements described above met. 58 ed are The synthetic tic instrument would become eligible ib e for Reg treatment from and after the leg-in date. The taxpayer would account for the separate debt instrument under applicable interest and original issue discount rules prior to the leg-in date, and would account for the resulting synthetic debt instrument under the integration rules of Reg thereafter. No income, deduction, gain or loss is generally recognized with respect to the QDI upon a legging-in transaction. 59 Legging out A taxpayer may also leg out of a Reg hedge by disposing of one or both of the components of the hedging transaction. A legging-out will also occur if any of the integration requirements of Reg are no longer met. Immediately before legging out, a taxpayer is treated as having disposed of the synthetic debt instrument for its fair market value, and is required to take into account any gain or loss resulting from the deemed disposition. In the context By reason of the integrated treatment resulting from Reg , the taxpayer s interest expense from a QDI that is part of a qualifying section hedge would be determined on a synthetic basis CCH. All Rights Reserved. of a legging-out transaction relating to a QDI that is a liability of the taxpayer, the transaction may result in the taxpayer being able to take an interest expense deduction as if the synthetic debt instrument were retired at a premium. 60 If the taxpayer retains the QDI after legging out of integrated treatment, it must make appropriate adjustments to the QDI to reflect any differences between the fair market value and issue price of the debt instrument. Any losses or deductions arising from legging out are disallowed if a taxpayer legs out of a Reg hedge within 30 days of legging in to the transaction. The legging-out rules of Reg should be contrasted to the legging-out provisions of Reg , as it relates to a Code Sec. 1221(a)(7) hedging transaction. As described above, the legging-out rules of Reg are one-sided, meaning that if a taxpayer legs out of a Code Sec. 1221(a)(7) hedge by terminating or disposing of the risk management transaction itself, the legging-out will have no impact on the debt instrument being hedged thereby. Coordination with Temporary Reg T By reason of the integrated treatment resulting from Reg , the taxpayer s interest expense from a QDI that is part of a qualifying section hedge would be determined on a synthetic basis. As such, during the period a section hedge is integrated with a QDI, no separate gains or losses from financial products that alter the effective cost of borrowing would arise for purposes of the rules under Temporary Reg T. Coordination with Straddle Rules of Code Sec As noted above, during the period that a QDI and a qualifying hedge are part of an integrated transaction under Reg , the QDI and the related section hedge cannot be considered offsetting positions with respect to each other for purposes of the straddle rules of Code Sec However, in contrast to the consequences resulting from a qualified hedging transaction under Code Sec. 1221(a)(7) and Code Sec. 1256(e), the resulting synthetic debt

11 Volume 6 Issue instrument could potentially be part of a straddle under Code Sec to the extent the synthetic debt instrument is considered an offsetting position with respect to another position of the taxpayer. Comparison If a taxpayer borrows money and agrees to pay interest at a fixed (floating) rate, a risk management transaction whereby the taxpayer synthetically converts the interest rate to a floating (fixed) rate may qualify under the integration rules of Reg , as well as under the hedging rules of Code Sec. 1221(a)(7). If an interest rate hedging transaction hedges the entire remaining life of a debt instrument and both the hedge and the debt instrument remain in place through their originally scheduled maturity dates, there may be little practical difference between the integrated transaction rules of Reg , and the coordinated hedge character and timing rules of Code Sec. 1221(a)(7)/Reg In each case, the net effect should be a matching of the character and timing of income, gain, deduction and loss resulting from the hedge to the interest expense deduction on the debt instrument being hedged thereby. In fact, the differences between the two approaches may be limited dto slight timing differences and the manner in which h the transactions s are reported. 61 If integrated treatment t is adopted, no separate gain orloss is reported with respect to the hedging transaction itself, and the interest es expense ense deduc- du tion resulting from thesynthetic t debt instrument n must be determined and reported as a single item. By contrast, in a Code Sec. 1221(a)(7) hedging situation, the timing and amount of interest expense deductions with respect to the debt being hedged remains unchanged, and the income or loss with respect to the hedging transaction is separately reported. As a result, separate reporting of the hedge gain or loss under Code Sec. 1221(a)(7)/ Reg may necessitate a separate hedge identification for foreign tax credit purposes under Temporary Reg T. Although the consequences under Reg and Code Sec. 1221(a)(7) may be similar, the requirements for integrated treatment under Reg are, as described above, potentially more difficult to satisfy than the definition of a hedging transaction under Code Sec. 1221(a)(7). In particular, integrated treatment under Reg requires a higher degree of correlation between the combined cash flows of the QDI and the offsetting hedging transaction than would be required under the risk management standard of Code Sec. 1221(a)(7). Other differences between these hedging provisions exist. For example, Code Sec. 1221(a)(7) allows taxpayers to hedge an expected (or anticipatory) issuance of debt. By contrast, the integrated hedge rules of Reg are more restrictive in the case of anticipatory hedges. Further, Reg makes it clear that a taxpayer may hedge all or part of its risk for all or part of the period over which the taxpayer is exposed to that risk. 62 By contrast, the integration rules of Reg are more restrictive in the case of partial hedging transactions. Further, identification of a hedging transaction under Code Sec. 1221(a)(7) results in the hedging transaction and the hedged item being exempt from application of the straddle rules, both relative to each other and relative to other positions of the taxpayer. By contrast, in the case of an integrated hedging transaction under Reg , although the QDI and the section hedge will not subject to the straddle rules relative to each other, the resulting synthetic instrument could be subject to application of the straddle rules in relation to other offsetting positions of the taxpayer. Finally, differences between the results under Reg versus Code Sec. 1221(a)(7)/Reg may arise in the context of a leggingout transaction. As described above, if a taxpayer legs out of a synthetic debt instrument under Reg , 1 but retains the QDI being hedged, the taxpayer would be treated as having sold or disposed of the synthetic debt instrument immediately prior to the legging-out transaction. By contrast, if a taxpayer legs out of a Code Sec. 1221(a)(7) hedge by disposing of the hedging transaction and retaining the debt instrument being hedged, no gain or loss would be taken into account with respect to the debt instrument upon the leggingout transaction, and any resulting gain or loss on the termination of the hedge would generally be deferred and taken into account over the remaining term of the debt instrument. Since it is impossible to predict whether and to what extent a legging-out transaction may occur in the future, it is difficult to judge whether the legging out rules of Reg would provide an advantage or a disadvantage, relative to Code Sec. 1221(a)(7)/Reg , depending on which side of the transaction is retained and which is terminated early. JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 69

12 Interest Rate Hedging Considerations 1 All references to the Code are to the Internal Revenue Code of 1986, as amended. 2 This article assumes that the taxpayer issues debt in its functional currency. A detailed discussion of the issues associated with hedging of nonfunctional currency denominated debt under Code Sec. 988(d) and Reg (a) is beyond the scope of this article. 3 This article does not address the special tax issues that arise in the case of taxpayers that are dealers in securities for federal income tax purposes. 4 Code Sec. 1221(a)(7); Reg (b). Code Sec. 1221(a)(7) is effective for hedging transactions entered into after December 17, Except as otherwise specifically noted, all references to Reg are to the regulations that were finalized in 2002 under Code Sec. 1221(a)(7). The 2002 version of Reg is effective for hedging transactions entered into on or after March 20, See Proposed Reg (2004) and Proposed Reg (q) (2004). 6 Reg (c)(4). 7 Reg (d)(1)(ii)(A). 8 See Reg (d)(2) ( [a] transaction that economically converts an interest rate from a fixed rate to a floating rate or that converts an interest rate from a floating rate toafi fixed rate manages risk ). Under the 1994 version of Reg , the regulations also made it clear that a hedge of a borrowing owin met the definition of a qualified hedging transaction without tregard dto the use of the proceeds of the borrowing. See Reg (c)(6) (1994). 9 See Reg (d)(5)(i), 21 ) however, providing that except as otherwise determined by published guidance or private letter ruling, the purchase or sale of a debt instrument, an equity security or an annuity contract is not a hedging transaction even if the transaction limits or reduces the taxpayer s risk with respect to ordinary property, borrowings or ordinary obligations. This provision reflects the IRS s view that certain traditional investment positions generally may not serve as tax hedging transactions for purposes of Code Sec. 1221(a)(7). 10 Reg (d)(1). 11 This exception does not extend to related entities that are outside of the consolidated federal income tax group even if such related entities are 100 percent owned by members of a group. For example, if two subsidiaries that are part of a consolidated federal income tax group are each 50-percent members of a state law limited liability company that is treated as a partnership for federal income tax purposes, a direct ENDNOTES hedge of the risks of the limited liability company by either such member would not qualify under Code Sec. 1221(a)(7). 12 Reg (e)(1). However, the transaction would be recognized by both members as an actual transaction, subject to the consistency requirements of Reg Note that the separate entity election is effective solely for purposes of determining hedge status under Code Sec. 1221(a)(7). 14 See Reg (e)(2). 15 See Reg (e)(2)(ii). An intercompany transaction is a hedging transaction with respect to a member of a consolidated group if and only if it meets the following requirements: (1) the position of the member in the intercompany transaction would qualify as a hedging transaction with respect to the member if the member had entered into the transaction with an unrelated party, and (2) the position of the other member (the marking member) in the transaction is marked to market under the marking member s method of accounting. If an intercompany hedging transaction meets the above requirements, the character and timing rules of Reg will not apply to the income, deduction, gain or loss from the intercompany hedging transaction and, subject to the identification requirements, the marking member s gain or loss from the transaction is ordinary. 16 It should be noted that an identification that satisfies the requirements of Reg (f) is treated as an identification for purposes of Code Sec. 1256(e) and Reg (e)-1. An identification of a transaction as a hedge for purposes of Code Sec. 1256(e) avoids the potential application of the straddle rules of Code Sec. 1092, as well as the mark-to-market rules for section 1256 contracts that are entered into as part of a qualifying hedging transaction. 17 The only exception to the requirement that the hedged item be identified is in the context of aggregate or macro hedging activities, where an aggregate tax hedge policy replaces the requirement of identifying the hedged item. See Reg (f)(3)(iv). 18 Reg (f)(2). 19 See Reg (f)(3)(iv). If a transaction hedges aggregate risk, by definition the taxpayer is unable to identify the ordinary asset or borrowing/ordinary obligation being hedged with sufficient detail to satisfy the requirements of the regulations. In that case, the identification requirements for the hedged item(s) or risk(s) can be met by placing in the taxpayer s books and records a description of the hedging program and by establishing a system under which individual transactions are identified as being entered into pursuant to the hedging program. This program is commonly referred to as an aggregate hedge policy statement. 20 Reg (f)(4)(iv). 21 Reg (f)(3)(iii)(A). 22 Reg (f)(3)(iii)(B). 23 See Note 4, above, relating to the effective date of Reg (g). 24 Reg (g)(1). 25 Reg (g)(1)(ii) 26 Reg (g)(2)(ii). 27 See TAM (Dec. 17, 2004). ( Where a failure to identify a hedging transaction is inadvertent and certain specified requirements have been satisfied, a taxpayer may, but is not required, to treat gain or loss from a hedging transaction as ordinary income or loss under section (a)(1) and (2). (Emphasis added.)) 28 Limited guidance is found in letter rulings relating to Code Sec. 1221(a)(7), but none of these rulings includes a specific conclusion by the IRS as to the availability of the inadvertent error exception. See, e.g., LTR (Oct. 24, 1996); and LTR (Sept. 25, 2000). See also LTR (Sept. 26, 2000) and LTR (Sept. 25, 2000), which are nearly identical except for the fact that LTR deals with tax years governed by the 1994 hedging regulations. 29 Reg (g)(2). 30 To the extent an integration election is made under Reg , the hedge timing rules of Reg will not apply. 31 Reg (e)(8). 32 Reg (e)(5). 33 The IRS has confirmed in Rev. Rul , IRB , 1245, that, for purposes of the hedge timing rules under Reg , the definition of a hedging transaction under Reg (b) is not modified by Reg (g)(2), dealing with income mischaracterization. 34 Reg (d)(1) and (2). 35 If, however, a taxpayer legs in to a hedging transaction by first entering into the hedging transaction and then incurring a borrowing, such a transaction would be covered by the anticipatory hedging rules of Reg (e)(4). 36 Reg (e)(6). 37 Even though a hedging transaction is no longer governed by the hedge timing rules of Reg following a legging-out transaction, the hedging (risk management) transaction should still be governed by the tax character provisions of Code Sec. 1221(a)(7) and Reg CCH. All Rights Reserved.

13 Volume 6 Issue LTR (Sept. 24, 1999). 39 LTR (Oct. 24, 1996). 40 FSA (May 4, 1999). 41 Rev. Rul , IRB , Rev. Rul also provides an alternative example in which the Swap is terminated at the end of Year 2, and that the debt instrument being hedged is then terminated at the end of Year 4. The ruling concludes that, upon the termination of the debt instrument at the end of Year 4, any remaining unamortized gain or loss with respect to the early termination of the Swap has to be taken into account at the time the debt is extinguished. 43 Temporary Reg T(b)(6)(i). 44 Temporary Reg T(b)(6)(iv)(C). 45 See, e.g., TAM (Oct. 14, 2005); TAM (July 29, 2005); and TAM (October 6, 2004). In each of these TAMs, the IRS concluded that debt instruments issued by the taxpayers were positions in personal property subject to the straddle rules of Code Sec. 1092, thereby resulting in capitalization of interest deductions with respect to such debt instruments under Code Sec. 263(g). See also Proposed Reg (g)-3(c)(3), issued on January 18, See Reg (e) Reg (b)(1). The enumerated ENDNOTES exceptions are (1) Code Sec. 1275(a)(3) tax exempt obligations, (2) Code Sec. 1272(a)(6) instruments (such as mortgages held by REMICs), and (3) certain contingent debt instruments issued for nonpublicly traded property. 48 Although either of Reg or Code Sec. 1221(a)(7) potentially applied to hedging transactions relating to a taxpayer s own debt, Reg may have broader application in the case of a taxpayer that hedges a debt instrument that it owns as an asset in light of the fact that integration treatment under Reg is not contingent on the debt instrument qualifying as an ordinary asset in the taxpayer s hands. By contrast, a taxpayer intending to hedge a debt instrument held as an asset would be eligible to utilize Code Sec. 1221(a)(7) only if the debt instrument is an ordinary asset in the taxpayer s hands. 49 Stock is not a financial instrument for purposes of Reg (b)(3). 50 Reg (b)(2)(i). 51 See Reg (c)(1)(vi). 52 For example, if a taxpayer entered into a $1 million borrowing for a term of 10 years, the taxpayer would not be permitted to elect integrated treatment under Reg for a hedge with a term of less than 10 years. However, the taxpayer could enter into a hedge with respect to $500,000 of the $1 million amount of the liability provided that such hedge was for the full 10-year term of the debt instrument. 53 See Reg (d)(7)(i). 54 This provision effectively limits a taxpayer s ability to engage in anticipatory hedging under Reg However, the QDI may be entered into substantially contemporaneously with the hedge if it is acquired or issued after the date of first payment on section hedge. 55 Reg (e). 56 Reg (c)(2). See, e.g., Rev. Rul , CB 744, pursuant to which the IRS deemed integration of two offsetting bull-bear bonds. 57 Reg (f)(1). 58 Reg (d)(1). 59 Reg (d)(1). Special rules are provided for abusive legging-in transactions. 60 See Reg There may be slight differences in timing resulting from the application of the OID principles under Code Secs through 1275 as applied to the resulting synthetic debt instrument under a section hedge, in contrast to the application of the hedge timing rules of Reg Reg (d)(1). This article is reprinted with the publisher s permission from the JOURNAL OF FINANCIAL PLANNING, a quarterly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher s permission is prohibited. To subscribe to the JOURNAL OF FINANCIAL PLANNING or other CCH Journals please call or visit All views expressed in the articles and columns are those of the author and not necessarily those of CCH. JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 71