[Federal Register Volume 77, Number 173 (Thursday, September 6, 2012)]
[Rules and Regulations]
[Pages 54808-54811]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-21986]


=======================================================================
-----------------------------------------------------------------------

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.

-----------------------------------------------------------------------

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