F
IRS has issued final and temporary regs providing guidance
regarding certain integrated transactions that involve a foreign currency
denominated debt instrument and multiple associated hedging transactions. The
regs apply to “leg-outs” under Reg.
§ 1.988-5(a)(6)(ii) occurring on or after
Sept. 6, 2012. The text of the temporary regs also serves as that of proposed
regs. T.D. 9598, 09/05/2012; Reg. § 1.988-5; Reg. § 1.988-5T
Background. A “qualifying debt instrument” can be integrated with a ”Reg. § 1.988-5(a) hedge” (see below), and treated as if a
synthetic debt instrument were created, if certain requirements are met. (Reg. § 1.988-5) If a taxpayer
enters into a qualified hedging transaction (i.e., an integrated economic
transaction consisting of a qualifying debt instrument and a Reg.
§ 1.988-5(a) hedge) and meets the
regs' requirements, 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).
A qualifying debt instrument is a debt
instrument described in Reg.
§ 1.988-1(a)(2)(i), regardless of
whether denominated in, or determined by reference to, nonfunctional currency
(including dual currency, multi-currency, and contingent payment debt
instruments). The term does not include accounts payable, accounts receivable
or similar items. A Reg.
§ 1.988-5(a) hedge is a spot,
futures, forward, option, notional principal, or currency swap contract, or
similar financial instrument (or series or combination of such instruments),
that when integrated with a qualifying debt instrument permits a yield to
maturity to be calculated in the currency in which the debt instrument is
denominated. (Reg. §
1.988-5(a)(4))
A taxpayer that disposes of all or part of the
qualifying debt instrument or hedge before maturity of the transaction, or that
changes a material term of the qualifying debt instrument or hedge, is viewed
as “legging out” of integrated treatment. (Reg. §
1.988-5(a)(6)(ii)) If a taxpayer legs out of integrated treatment,
gain or loss on the instrument that was not disposed of is realized and
recognized at the time of legging out (the leg-out date). The spot rate on that
date is used to compute exchange gain or loss on the remaining instrument upon
its disposition. 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. (T.D. 9598)
Reason for change. IRS has 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 Reg.
§ 1.988-5(a)(6)(ii)(B) as allowing them to
recognize loss on the debt instrument without recognizing 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, asserting that Reg.
§ 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.
IRS believes 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. The new regs are intended to clarify the rules regarding the
consequences of legging-out of qualified hedging transactions that consist of
multiple components. (T.D. 9598)
New guidance. The new regs 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) will be treated as sold for their fair market value (FMV) on
the leg-out date of the terminated hedge. (Prop
Reg § 1.988-5T(a)(6)(ii)(B)) Similarly, if a
part of any component of a hedge has been disposed of, the remaining part(s) of
that component still in existence, as well as the qualifying debt instrument,
will be treated as sold for its FMV on the leg-out date of the terminated
hedge. (Prop Reg § 1.988-5T(a)(6)(ii)(C))
References: For section 988 hedging transactions, and the
integration of hedge with nonfunctional currency debt instrument, see FTC 2d/FIN ¶ G-7038 et seq.; United
States Tax Reporter ¶ 9884.02 et seq.; TG ¶ 30611 .
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