[Federal Register Volume 77, Number 173 (Thursday, September 6, 2012)]
[Rules and Regulations]
[Pages 54808-54811]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-21986]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 9598]
RIN 1545-BK98
Integrated Hedging Transactions of Qualifying Debt
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Temporary and final regulations.
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SUMMARY: This document contains temporary regulations that address
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, and
the taxpayer has terminated at least one but less than all of the
hedges (including a portion of one or more of the hedges), 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 text of
the temporary regulations also serves as the text of the proposed
regulations set forth in the notice of proposed rulemaking on this
subject in the Proposed Rules section in this issue of the Federal
Register.
DATES: Effective Date. These regulations are effective on September 6,
2012.
Applicability Date. These regulations apply to leg-outs within the
meaning of Sec. 1.988-5(a)(6)(ii) which occur on or after September 6,
2012.
FOR FURTHER INFORMATION CONTACT: Sheila Ramaswamy, at (202) 622-3870
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
Section 1.988-5 provides detailed rules that permit the integration
of a qualifying debt instrument with a Sec. 1.988-5(a) hedge. The
effect of integration under the regulations is to create a synthetic
debt instrument. Generally, if a taxpayer enters into a qualified
hedging transaction and meets the requirements of the regulations, no
exchange gain or loss is recognized on the debt instrument or the hedge
for the period that it is part of a qualified hedging transaction
(provided that the synthetic debt instrument is not denominated in a
nonfunctional currency). See Sec. 1.988-5(a)(9). A qualified hedging
transaction is an integrated economic transaction
[[Page 54809]]
consisting of a qualifying debt instrument and a Sec. 1.988-5(a)
hedge. See Sec. 1.988-5(a)(1). A qualifying debt instrument is any
debt instrument described in Sec. 1.988-1(a)(2)(i) regardless of its
denominated currency. See Sec. 1.988-5(a)(3). A Sec. 1.988-5(a) hedge
is a spot contract, futures contract, forward contract, option
contract, notional principal contract, currency swap contract, or
similar financial instrument, or series or combinations of such
instruments, 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. See Sec. 1.988-5(a)(4).
Under Sec. 1.988-5(a)(6)(ii), a taxpayer that disposes of all or a
part of the qualifying debt instrument or hedge prior to the maturity
of the qualified hedging transaction, or that changes a material term
of the qualifying debt instrument or hedge, is viewed as ``legging
out'' of integrated treatment. One of the consequences of legging out
is that if the hedge is disposed of, the qualifying debt instrument is
treated as sold for its fair market value on the date of disposition of
the hedge (leg-out date). See Sec. 1.988-5(a)(6)(ii)(B). 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 intended
result of this deemed disposition rule is that the gain or loss on the
qualifying debt instrument will generally be offset by the gain or loss
on the hedge.
The Internal Revenue Service (IRS) and the Department of the
Treasury (Treasury Department) have become aware that some taxpayers
who are in a loss position with respect to a qualifying debt instrument
that is part of a qualified hedging transaction are interpreting the
legging-out rules of Sec. 1.988-5(a)(6)(ii)(B) to permit the
recognition of the loss on the debt instrument without recognition of
all of the corresponding gain on the hedging component of the
transaction. Taxpayers claim to achieve this result by hedging
nonfunctional currency debt instruments with multiple financial
instruments and selectively disposing of less than all of these
positions. Taxpayers take the position that Sec. 1.988-5(a)(6)(ii)(B)
triggers the entire loss in the qualifying debt instrument but not the
gain in the remaining components of the hedging side of the integrated
transaction.
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 Sec. 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. No inference
is intended regarding the merits of the position taken by the taxpayer
with respect to the transaction described above (or comparable
positions taken by taxpayers with respect to similar transactions) in
the case of transactions occurring prior to the applicability date of
these regulations, and in appropriate cases the IRS may challenge the
claimed results.
Explanation of Provisions
Section 1.988-5(a) is amended to provide that if a hedge with more
than one component has been properly identified as being part of a
qualified hedging transaction, and at least one but not all of the
components of the hedge that is a part of the qualified hedging
transaction has been terminated or disposed of, all of the remaining
components of the hedge (as well as the qualifying debt) shall be
treated as sold for their fair market value on the leg-out date of the
terminated hedge. Similarly, if a part of any component of a hedge
(whether a hedge consists of a single or multiple components) has been
disposed of, the remaining part of that component (as well as other
components in the case of a hedge with multiple components) that is
still in existence (as well as the qualifying debt instrument) shall be
treated as sold for its fair market value on the leg-out date of the
terminated hedge.
Effective/Applicability Date
The regulation applies to leg-outs within the meaning of Sec.
1.988-5(a)(6)(ii) which occur on or after September 6, 2012.
Special Analyses
It has been determined that these regulations are not a significant
regulatory action as defined in Executive Order 12866. Therefore, a
regulatory assessment is not required. It has also been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
does not apply to these regulations, and because these regulations do
not impose a collection of information on small entities, the
provisions of the Regulatory Flexibility Act (5 U.S.C. chapter 6) do
not apply. Pursuant to section 7805(f) of the Internal Revenue Code,
these regulations will be submitted to the Chief Counsel for Advocacy
of the Small Business Administration for comment on their impact on
small business.
Drafting Information
The principal author of these regulations is Sheila Ramaswamy,
Office of Associate Chief Counsel (International). However, other
personnel from the IRS and the Treasury Department participated in
their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Amendment to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
0
Par. 2. Section 1.988-5 is amended by:
0
1. Revising paragraph (a)(6)(ii).
0
2. Adding Example 11 in paragraph (a)(9)(iv).
The revision and addition read as follows:
[[Page 54810]]
Sec. 1.988-5 Section 988(d) hedging transactions.
(a) * * *
(6) * * *
(ii) [Reserved]. For further guidance see Sec. 1.988-5T(a)(6)(ii).
* * * * *
(9) * * *
(iv) * * *
Example 11. [Reserved]. For further guidance see Sec. 1.988-
5T(a)(9)(iv).
Example 11.
* * * * *
0
Par. 3. Section 1.988-5T is added to read as follows:
Sec. 1.988-5T Section 988(d) hedging transactions (temporary).
(a) through (a)(6)(i) [Reserved]. For further guidance see Sec.
1.988-5(a) through (a)(6)(i).
(ii) Legging out. With respect to a qualifying debt instrument and
hedge that are properly identified as a qualified hedging transaction,
``legging out'' of integrated treatment under this paragraph (a) means
that the taxpayer disposes of or otherwise terminates all or any
portion of the qualifying debt instrument or the hedge prior to
maturity of the qualified hedging transaction, or the taxpayer changes
a material term of the qualifying debt instrument (for example,
exercises an option to change the interest rate or index, or the
maturity date) or the hedge (for example, changes the interest or
exchange rates underlying the hedge, or the expiration date) prior to
maturity of the qualified hedging transaction. A taxpayer that disposes
of or terminates a qualified hedging transaction (that is, disposes of
or terminates both the qualifying debt instrument and the hedge in
their entirety on the same day) shall be considered to have disposed of
or otherwise terminated the synthetic debt instrument rather than
legging out. If a taxpayer legs out of integrated treatment, the
following rules shall apply:
(A) The transaction will be treated as a qualified hedging
transaction during the time the requirements of this paragraph (a) were
satisfied.
(B) If all of the instruments comprising the hedge (each such
instrument, a component) are disposed of or otherwise terminated, the
qualifying debt instrument shall be treated as sold for its fair market
value on the date the hedge is disposed of or otherwise terminated (the
leg-out date), and any gain or loss (including gain or loss resulting
from factors other than movements in exchange rates) from the
identification date to the leg-out date is realized and recognized on
the leg-out date. The spot rate on the leg-out date shall be used to
determine exchange gain or loss on the debt instrument for the period
beginning on the leg-out date and ending on the date such instrument
matures or is disposed of or otherwise terminated. Proper adjustment
must be made to reflect any gain or loss taken into account. The
netting rule of Sec. 1.988-2(b)(8) shall apply.
(C) If a hedge has more than one component (and such components
have been properly identified as being part of the qualified hedging
transaction) and at least one but not all of the components that
comprise the hedge has been disposed of or otherwise terminated, or if
part of any component of the hedge has been terminated (whether a hedge
consists of a single or multiple components), the date such component
(or part thereof) is disposed of or terminated shall be considered the
leg-out date and the qualifying debt instrument shall be treated as
sold for its fair market value in accordance with the rules of
paragraph (a)(6)(ii)(B) of this section on such leg-out date. In
addition, 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. To the extent relevant, the spot rate
on the leg-out date shall be used to determine exchange gain or loss on
the remaining components (or parts thereof) for the period beginning on
the leg-out date and ending on the date such components (or parts
thereof) are disposed of or otherwise terminated.
(D) If 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. Accordingly, the
hedge (including all components making up the hedge in their entirety)
that is part of the qualified hedging transaction shall be treated as
sold for its 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. To the extent relevant, the spot rate
on the leg-out date shall be used to determine exchange gain or loss on
the hedge (including all components thereof) for the period beginning
on the leg-out date and ending on the date such hedge is disposed of or
otherwise terminated.
(E) Except as provided in paragraph (a)(8)(iii) of this section
(regarding identification by the Commissioner), the part of the
qualified hedging transaction that has not been terminated (that is,
the remaining debt instrument in its entirety even if partially hedged,
or the remaining components of the hedge) cannot be part of a qualified
hedging transaction for any period subsequent to the leg-out date.
(F) If a taxpayer legs out of a qualified hedging transaction and
realizes a gain with respect to the disposed of or terminated debt
instrument or hedge, then paragraph (a)(6)(ii)(B), (C), and (D) of this
section, as appropriate, will not apply if during the period beginning
30 days before the leg-out date and ending 30 days after that date the
taxpayer enters into another transaction that, taken together with any
remaining components of the hedge, hedges at least 50 percent of the
remaining currency flow with respect to the qualifying debt instrument
that was part of the qualified hedging transaction or, if appropriate,
an equivalent amount under the hedge (or any remaining components
thereof) that was part of the qualified hedging transaction. Similarly,
in a case in which a hedge has multiple components that are part of a
qualified hedging transaction, if the taxpayer legs out of a qualified
hedging transaction by terminating one such component or a part of one
or more such components and realizes a gain with respect to the
terminated component, components, or portions thereof, then paragraphs
(a)(6)(ii)(B), (C), and (D) of this section, as appropriate, will not
apply if the remaining components of the hedge (including parts
thereof) by themselves hedge at least 50 percent of the remaining
currency flow with respect to the qualifying debt instrument that was
part of the qualified hedging transaction.
(a)(7) through (a)(9)(iv) Examples 10 [Reserved]. For further
guidance see Sec. 1.988-5(a)(7) through (a)(9)(iv) Example 10.
Example 11. (i) K is a U.S. corporation with the U.S. dollar as
its functional currency. On January 1, 2013, K borrows 100 British
pounds ([pound]) for two years at a 10% rate of interest payable on
December 31 of each year with no principal payment due until
maturity on December 31, 2014. Assume that the spot rate on January
1, 2013, is [pound]1=$1. On the same date, K enters into two swap
contracts with an unrelated counterparty that economically results
in the transformation of the fixed rate [pound]100 borrowing to a
floating rate dollar borrowing. The terms of the swaps are as
follows:
(A) Swap #1, Currency swap. On January 1, 2013, K will exchange
[pound]100 for $100.
(1) On December 31 of both 2013 and 2014, K will exchange $8 for
[pound]10;
(2) On December 31, 2014, K will exchange $100 for [pound]100.
(B) Swap #2, Interest rate swap. On December 31 of both 2013 and
2014, K will
[[Page 54811]]
pay LIBOR times a notional principal amount of $100 and will receive
8% times the same $100 notional principal amount.
(ii) Assume that K properly identifies the pound borrowing and
the swap contracts as a qualified hedging transaction as provided in
paragraph (a)(8) of this section and that the other relevant
requirements of paragraph (a) of this section are satisfied.
(iii) Assume also that on January 1, 2014, the spot exchange
rate is [pound]1:$2; the U.S. dollar LIBOR rate of interest is 9%;
and the market value of K's note in pounds has not changed. K
terminates swap 2. K will incur a loss of ($.91) (the
present value of $1) with respect to the termination of such swap on
January 1, 2014. Pursuant to paragraph (a)(6)(ii)(C) of this
section, K must treat swap 1 as having been sold for its
fair market value on the leg-out date, which is the date swap
2 is terminated. K must realize and recognize gain of
$100.92 [the present value of [pound]110 discounted in pounds to
equal [pound]100 x $2 ($200) less the present value of $108
($99.08)]. The loss inherent in the pound borrowing from January 1,
2013 to January 1, 2014 is realized and recognized on January 1,
2014. Such loss is exchange loss in the amount of $100 [the present
value of [pound]110 that was to be paid at the end of the year
discounted at pound interest rates to equal [pound]100 times the
change in exchange rates: ([pound]100 x $1, the spot rate on January
1, 2013) - ([pound]100 x $2, the spot rate on January 1, 2014)].
Except as provided in paragraph (a)(8)(iii) of this section
(regarding identification by the Commissioner), the pound borrowing
and currency swap cannot be part of a qualified hedging transaction
for any period subsequent to the leg-out date.
(iv) Assume the facts are the same as in paragraph (iii) of this
section except that on January 1, 2014, the U.S. dollar LIBOR rate
of interest is 7% rather than 9%. When K terminates swap 2,
K will realize gain of $0.93 (the present value of $1) received with
respect to the termination on January 1, 2014. Fifty percent or more
of the remaining pound cash flow of the pound borrowing remains
hedged after the termination of swap 2. Accordingly, under
paragraph (a)(6)(ii)(F) of this section, paragraphs (a)(6)(ii)(B)
and (C) of this section do not apply and the gain on swap 1
and the loss on the qualifying debt instrument is not taken into
account. Thus, K will include in income $0.93 realized from
termination of swap 2.
(a)(10) through (g) [Reserved]. For further guidance see Sec.
1.988-5(a)(10) through (g).
(h) Effective/applicability date. This section applies to leg-outs
that occur on or after September 6, 2012.
(i) Expiration date. This section expires on September 4, 2012.
Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
Approved: August 17, 2012.
Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2012-21986 Filed 9-5-12; 8:45 am]
BILLING CODE 4830-01-P