Thursday, September 6, 2012

inal regs clarify loss consequences from “legging out” of integrated hedging transactions

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, 09/05/2012Reg. § 1.988-5Reg. § 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  . (212) 588-1113

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