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 temporary regulations are effective on September 6, 2012—the scheduled date of their publication in the Federal Register.
Text of the regulations: T.D. 9598 [PDF 105 KB]; REG-138489-09 [PDF 90 KB]
Reason for regulations
Under Reg. section 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.
According to the preamble to the temporary regulations, the IRS and Treasury 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 Reg. section 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 have claimed to achieve this result by hedging nonfunctional currency debt instruments with multiple financial instruments and selectively disposing of less than all of these positions, and have taken the position that Reg. section 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 Reg. section 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 Treasury believe that these results are inappropriate under the legging-out rules because the claimed loss is largely offset by unrealized gain on the remaining component of the hedging transaction. Therefore, today’s regulations are intended to clarify the rules regarding the consequences of legging-out of qualified hedging transactions that consist of multiple components.
With today’s release, Reg. 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) will 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) will be treated as sold for its fair market value on the leg-out date of the terminated hedge.
Comments, hearing date requests
Written comments and requests for a public hearing with respect to the proposed regulations are due by 90 days after their publication in the Federal Register on September 6, 2012.