Source: http://thefederalregister.com/2012/09/06/2012-21986.html
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Federal Register | Integrated Hedging Transactions of Qualifying Debt
[TD 9598]
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 theFederal Register.
DATES: Effective Date.These regulations are effective on September 6, 2012.
Applicability Date.These regulations apply to leg-outs within the meaning of SS 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).
Section 1.988-5 provides detailed rules that permit the integration of a qualifying debt instrument with a § 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 § 1.988-5(a)(9). A qualified hedging transaction is an integrated economic transactionconsisting of a qualifying debt instrument and a § 1.988-5(a) hedge. See § 1.988-5(a)(1). A qualifying debt instrument is any debt instrument described in § 1.988-1(a)(2)(i) regardless of its denominated currency. See § 1.988-5(a)(3). A § 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 § 1.988-5(a)(4).
Under § 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 § 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 § 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 § 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 § 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.
The regulation applies to leg-outs within the meaning of § 1.988-5(a)(6)(ii) which occur on or after September 6, 2012.
PART 1—INCOME TAXES Paragraph 1.The authority citation for part 1 continues to read in part as follows: Authority:
Par. 2.Section 1.988-5 is amended by: 1. Revising paragraph (a)(6)(ii). 2. AddingExample 11in paragraph (a)(9)(iv).
§ 1.988-5 Section 988(d) hedging transactions.
(ii) [Reserved]. For further guidance see § 1.988-5T(a)(6)(ii).
Example 11.[Reserved]. For further guidance see § 1.988-5T(a)(9)(iv).
Par. 3.Section 1.988-5T is added to read as follows:
§ 1.988-5T Section 988(d) hedging transactions (temporary).
(a) through (a)(6)(i) [Reserved]. For further guidance see § 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:
(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 § 1.988-2(b)(8) shall apply.
(a)(7) through (a)(9)(iv)Examples 10[Reserved]. For further guidance see § 1.988-5(a)(7) through (a)(9)(iv)Example 10.
(A)Swap #1, Currency swap.On January 1, 2013, K will exchange £100 for $100.
(B)Swap #2, Interest rate swap.On December 31 of both 2013 and 2014, K willpay LIBOR times a notional principal amount of $100 and will receive 8% times the same $100 notional principal amount.
(a)(10) through (g) [Reserved]. For further guidance see § 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).