Volume 6 Issue 3 2007

Interest Rate Hedging Considerations for Corporate Taxpayers

By William R. Pomierski

William Pomierski describes the requirements for, as well as the expected tax consequences resulting from entering into, qualifying interest rate hedging transactions relating to current or anticipatory borrowings by a corporate taxpayer. It is imperative that these taxpayers know of potential tax character and timing mismatches before they enter into such transactions.
Introduction
Corporate p taxpayers entering into interest rate hedging transactions tra ans sac ctio on relating g to current or anticipated borrowings need to be aw aware of pote potential tax character and i n ne ngs eed dt are o timing tim imin ing mismatches. mi ism i m tches If interest interest rate hedging losses are treated losses, for example, they would not eat ted d as capital ll be deductible against gai st ordinary ord dinary business busine s pro prots. ts. Timing Tim ming mismatches are also al possible possib ble in interest i te est rate rate hedging hedgin transactions. For example, an interest rate hedge that meets the denition of a section 1256 contract under Code Sec. 1256(g) could be subject to markto-market taxation, whereas the liability being hedged thereby would not be marked to market.1 Hedging transactions that are intended to manage interest rate risk with respect to a taxpayers U.S. dollar denominated borrowings may avoid potential tax character and timing mismatches by taking advantage of the hedging rules of Code Sec. 1221(a)(7), or under the hedge integration rules of Reg. 1.12756.2 To qualify for the special tax rules that apply to qualifying hedging transactions, however, a number
William R. Pomierski is a Partner in the international law rm of McDermott Will & Emery LLP, resident in its Chicago ofce. He is a former Editor-in-Chief of the JOURNAL OF TAXATION OF FINANCIAL PRODUCTS.

of requirements must be satised. The balance of this article describes the requirements for, as well as the expected tax consequences resulting from entering into, qualifying interest rate hedging transactions relating to current or anticipatory borrowings by a corporate taxpayer.3

Hedging H d i Under Code Sec. 1221(a)(7)

Code Sec. 1221(a)(7) assures ordinary gain or loss treatment for qualied hedging transactions by carving them out of capital asset treatment. A qualied hedging transaction is dened for purposes of Code Sec. 1221(a)(7) as a transaction that a taxpayer enters into in the normal course of its trade or business primarily to manage the risk of (1) price changes or currency uctuations with respect to ordinary property that is held or to be held by the taxpayer, or (2) interest rate or price changes or currency uctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer.4 It is worth noting that the ordinary income or loss assurances of Code Sec. 1221(a)(7) are relevant to the extent that gains or losses from an interest rate

W.R. Pomierski

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Interest Rate Hedging Considerations

a specied share of stock or an equity index. If the hedging transaction would, in the absence of Code issuer hedges its risk relating to this contingent interSec. 1221(a)(7), be considered capital gain or loss. For est payment with a derivative (nancial) instrument, example, if a taxpayer hedges a current or anticipated the hedge should meet the denition of a hedge for borrowing by entering into a futures contract that is purposes of Code Sec. 1221(a)(7).9 considered a section 1256 contract, gain and loss from such contract would, absent Code Sec. 1221(a)(7), Code Sec. 1221(a)(7) allows taxpayers to hedge be capital under Code Sec. 1256(a). Certain forms an expected (or anticipatory) issuance of debt. By of interest rate hedging transactions, however, result contrast, the integrated hedge rules of Reg. 1.1275in ordinary income or 6, which are described deductions in their own below, are more restrictive Under the regulations, the general in the case of anticipatory right. For example, if a taxpayer manages interest test for risk management is a macro hedges. rate risk with respect to Finally, Reg. 1.1221-2 testthat is, does the transaction a borrowing by entering makes it clear that a taxmanage risk after considering the into an interest rate swap payer may hedge all or transaction that meets the part of its risk for all or part taxpayers overall risk prole? denition of a notional of the period over which principal contract under the taxpayer is exposed to Reg. 1.446-3, periodic and nonperiodic payments that risk.10 For example, if a taxpayer issues a $100 made or received with respect to such swap would million debt instrument that calls for the entire prin5 be ordinary irrespective of Code Sec. 1221(a)(7). cipal balance to be paid at maturity in 10 years, a notional principal contract with a notional principal Risk Management amount of $40 million and a term of ve years could, even though it hedges less than the entire principal Reg. 1.1221-2(c)(4) states that whether a transaction amount for less than the entire period of the debt, manages a taxpayers risk is determined based on qualify as a hedging transaction under Code Sec. all of the facts and circumstances surrounding the 1221(a)(7). By contrast, the availability of the intetaxpayers ta axp paye ers s business and the transaction. A taxpayers grated hedge rules of Reg. 1.1275-6 is limited in the practices pr rac ctic tices and an proceduresas proce edure as reected in its minutes case of partial hedging transactions. other or r ot the her business bu ness recordsare b bus recordsare evidence of whether a he hedging edg ging transaction manages risk.6 Consolidated n Group Considerations Under the regulations, ul ions, th the eg general eneral test est fo for rr risk isk ma m mannagement is a macro is, d does transaction acr testthat est tha at is oe the e tra nsactio As s a general r rule, a risk management transaction manage risk after considering the taxpayers overall is a qualied hedging transaction under Code Sec. risk prole? This is often referred to as the enterprise 1221(a)(7) only if the taxpayer manages its own risk. risk reduction requirement. Notwithstanding this Managing the risk of a related taxpayer generally general rule, a hedging transaction that relates to does not qualify as a hedge for purposes of Code a particular asset or liability generally is treated as Sec. 1221(a)(7). An exception is provided, however, managing overall risk if it is undertaken as part of a in the case of taxpayers that are members of a U.S. program reasonably expected to reduce the overall consolidated federal income tax group. risk of the taxpayers operations.7 Under Reg. 1.1221-2(e)(1), all of the members of a U.S. consolidated group are generally treated as If a taxpayer borrows money and agrees to pay if they were divisions of a single corporation. This stated interest at a xed (oating) rate, a risk managesingle-entity default rule effectively means that any ment transaction whereby the taxpayer synthetically member of a consolidated federal income tax group converts the interest rate to a oating (xed) rate may hedge the risks of any other member of the group, would qualify as a hedging transaction for purposes and the hedge is eligible to be treated as a Code Sec. of Code Sec. 1221(a)(7).8 Code Sec. 1221(a)(7) also 1221(a)(7) hedge.11 For example, if members of a U.S. extends to hedging of interest rate risk with respect to a contingent debt instrument governed by Reg. consolidated group engage in their own borrowing 1.1275-4. For example, consider a debt instrument transactions, a designated member of the group could that provides for contingent interest payable at maenter into interest rate hedging transactions with turity based on the increase, if any, in the value of third parties on behalf of members of the group that

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would still qualify under Code Sec. 1221(a)(7). Note, however, that because consolidated group members are treated as divisions of a single corporation for this purpose, a risk management transaction between members of a consolidated group will not be treated as a qualied hedging transaction for purposes of Code Sec. 1221(a)(7).12 This is because of the fact that in an intercompany transaction, the risk being hedged does not leave the group unless and until one of the members shifts the risk outside of the group by entering into a transaction with a third party (in which case the third-party transaction would be eligible to be treated as a qualied hedging transaction). Notwithstanding the single-entity default rule, a consolidated group may elect to treat each member of the group as a separate taxpayer for purposes of Code Sec. 1221(a)(7).13 This separate-entity election is made by ling an appropriate statement on a timely led federal income tax return for the rst taxable year for which the election is to apply.14 Once made, a separate-entity election may only be revoked with the consent of the IRS. If a separate entity election is made, a risk management transaction will be eligible to be treated as a Code Sec. 1221(a)(7) hedging transaction only if the risk being hedged is the taxpayers own risk. Special rules are provided for intercompany hedging transactions entered into among members he edg gin ng t tr consolidated of f a co ons so ated group that has made a separate entity election. en ntit ity ele e l ct tion.15 where the adoption of an aggregate tax hedge policy replaces the requirement of specically identifying each hedged item.19

Method of Hedge Identication

Reg. 1.1221-2(f)(4) provides limited guidance regarding the manner in which the hedge identication requirements can be met. The regulations require that the hedge identication be made on, and retained as part of, the taxpayers books and records. To qualify, an identication must be clear and unambiguous. The regulations also indicate that identication of a hedging transaction for nancial accounting or regulatory purposes will not satisfy this requirement unless the taxpayers books and records indicate that the identication is also being made for tax purposes. Note that hedge identications under Code Sec. 1221(a)(7) need not be led with the IRS, but are simply retained as part of the taxpayers books and records. Reg. 1.1221-2(f)(4)(iv) provides that a taxpayer may either separately make each identication or, so long as the identication is unambiguous, may establish a system pursuant to which the identication is indicated either by the type of transaction or by the manner in which the transaction is consummated or recorded. The hedging regulations offer three examples of permissible forms of identication: (1) hedge accounts, (2) a designation in the taxpayers books and records and (3) stamped trade records.20 In n add a addition itio on to identifying the hedging (risk management) transaction, the regulations also provide for ment tr ansact identication of the hedged item (e.g., the liability being hedged). With respect to hedges of existing debt, the taxpayer should specify the issue and, if the hedge is for less than the full issue price or the full term of the debt, the amount of the issue price and the term covered by the hedge.21 If a taxpayer hedges anticipatory debt,22 the identication should include all of the following information: Expected maturity or maturities of the debt Total expected issue price of the issue Expected interest provisions If the hedge is for less than the entire expected amount of the issue price of the debt or the full term of the debt, a taxpayer must identify the amount being hedged and/or the term being hedged, as appropriate. The identication of anticipatory debt may indicate a range of dates, terms and amounts instead of specic dates, terms and amounts.

Identication Req Requirements qui ir ts

Code Sec. 1221(a)(7) 21 (7) states sta ates that a hedging he edging (risk (ris management) transaction must be clearly identied before the close of the day on which it was acquired, originated or entered into, or at such other time as the Treasury may determine by regulations.16 There are two components to the identication requirement. First, Reg. 1.1221-2(f)(1) provides that a taxpayer must identify the hedging transactionmeaning the futures contract, option, forward, swap or similar transaction that manages riskon the same day that the hedging transaction is entered into. In addition to identifying the hedging (risk management) transaction, the asset, ordinary obligation or borrowing being hedged thereby (the hedged item) must also be identied.17 The hedged item must be identied substantially contemporaneously with the hedging transaction, but in no event more than 35 days later.18 The only exception to the requirement that the hedged item be specically identied is in the context of aggregate or macro hedging activities,

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as a general rule, both gains and losses from such If a taxpayer enters into infrequent interest rate transactions are to be determined without regard to hedging transactions, a common practice is to idenCode Sec. 1221(a)(7), meaning that the character of tify both the hedging (risk management) transaction gains and losses would be determined under the genand the debt being hedged thereby pursuant to a eral rules for the particular same-day identification type of transaction. form/memorandum that The regulations then set describes (1) the terms of [T]he regulations include an antiout two exceptions to this the hedging transaction abuse rule for transactions that characterization rule. The (including the type of risk meet the denition of a qualied rst exception is referred management transaction to as the inadvertent er( e.g., futures contract, hedging transaction, but are not ror exception. 26 Under option, swap contract), identied as such. the name of the taxpayers Reg. 1.1221-2(g)(2)(ii), if counterparty in the case a taxpayer does not idenof an over-the-counter transaction or the exchange on tify a qualied hedging transaction, the taxpayer which the risk management transaction is traded in maybut is not required to 27treat gain or loss from the case of an exchange-traded position, the notional the transaction as ordinary income or loss if each of amount or number of contracts, maturity date, cash the following requirements are satised: ows, etc.) and (2) the terms of the borrowing (such (1) The transaction qualies as a hedging transacas the principal amount, interest rate, payment dates tion within the meaning of Code 1221(b)(2). and maturity). If, however, a taxpayer enters into nu(2) The failure to identify the transaction was due merous interest rate hedging transactions or enters to inadvertent error. into hedging transactions on an aggregate (or macro) (3) All of the taxpayers qualied hedging transbasis such that the hedging transactions cannot be actions in all open years are being treated on associated with any particular borrowing, another either original or, if necessary, amended returns form of hedge identication may be required. as qualied hedging transactions. Unfortunately, there is limited guidance regarding Misidenti M Mis sid den nti cation nti cation Issues Issues the meaning of inadvertent error.28 Finally, the regulations include an anti-abuse rule Code C od de S Sec. ec c. 1221(b)(2)(B) 221(b b)(2)(B) aut authorizes the Treasury for transactions that meet the denition of a qualied Secretary ecr reta ary to prescribe regulations to properly charhedging but are not identied as such. acterize any income, gain, expense arising ncome, gai g n, exp e pens or loss oss ar ising hedg ng transaction, transa Under rule, the regulations authorize from a transaction either quali hedging on that hat is ei ther a q ali e ed hed gin Under this th his anti-abuse an nti the IRS to treat gains from such transactions as orditransaction that is not identied as such, or that is nary.29 The anti-abuse rule applies, however, only if not a qualied hedging transaction but is identied as a hedge. the taxpayer has no reasonable grounds for treating Reg. 1.1221-2(g) includes two separate provisions the transaction as other than a hedging transaction. 23 for misidentied hedging transactions. First, in the The reasonableness of the taxpayers failure to identify a transaction is to be determined by taking into accase of nonqualifying transactions that are identied count not only the requirements of Reg. 1.1221-2(b), as Code Sec. 1221(a)(7) hedging transactions, the but also the taxpayers treatment of the transaction regulations state that the identication is binding for other purposes, as well as by taking into account with respect to any gain resulting from the transaction the taxpayers identication of similar transactions as (meaning that gain will be ordinary), whereas losses hedging transactions. from the particular transaction will be characterized under the general rules for the type of transaction.24 Hedge Timing Considerations Note that there is an inadvertent error exception that may be applicable in certain cases to avoid this If a taxpayer enters into a qualied hedging transaccharacter mismatch potential.25 tion within the meaning of Code Sec. 1221(b)(2), regardless of whether the transaction is identied A second misidentication provision potentially as such, the timing of any gains and losses from the applies to transactions that meet the denition of a hedge must be accounted for under Reg. 1.446-4. qualied hedging transaction, but are not identied Note that the hedge timing rules of Reg. 1.446-4 as such. In such cases, the regulations provide that,

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only apply to the hedging (risk management) transaction; the hedge timing rules do not, however, affect the timing of income, deduction, gain or loss with respect to the hedged item. Accordingly, in the case of a hedging transaction relating to a borrowing, the hedge timing rules do not alter the tax accrual principles that apply to determine the timing of the issuers interest deductions with respect to the debt instrument itself. application of those rules would not otherwise result in the matching needed to satisfy the clear reection requirement of Reg. 1.446-4.32 For example, if a notional principal contract hedges a debt instrument, the method of accounting for periodic payments described in Reg. 1.446-3(e) and the methods of accounting for nonperiodic payments described in Reg. 1.4463(f)(2)(iii) and (v) generally satisfy the clear reection requirement of the hedge timing regulations. The methods described in Reg. 1.446-3(f)(2)(ii) and (iv), however, generally do not clearly reect the taxpayers income in that situation.

General Matching Requirement

No particular hedge timing method is prescribed under Reg. 1.446-4. Instead, the hedge timing rules simply require that hedge gains and losses be accounted for under a method that clearly matches the timing of income, deductions, gains, or losses attributable to the item being hedged. As a general rule, the hedge timing provisions of Reg. 1.446-4 trump the timing rules that would otherwise apply to the risk management (hedging) transaction. Special timing rules are provided for hedges of debt instruments.30 Under Reg. 1.446-4(e)(4), gain or loss from transactions that hedge a debt instrument must be accounted for by reference to the terms of the debt instrument and the period or periods to which the hedge g applies. This regulation further provides that hedges he edg ges s of f debt instruments that provide for xed or oating rates interest generally accounted for oat o t g ra ting ti at t of int erest are ge using constant yield principles, which effectively us sin i g const on nt yie eld pr incip require equ uire e a taxpayer to take k hedging gains or losses into account over the e same ame periods p periods in in which w ch they hey would would be taken into account the hedging gains losses co nt as if th e he dging ga ains or l osse were to adjust the yield of the debt instrument. In the case of hedges of anticipatory borrowings, the constant yield principles of Reg. 1.446-4(e)(4) require taxpayers to take gains and losses from hedges of anticipatory borrowings that are consummated into account as if the hedge adjusted the issue price of the debt instrument. Under Reg. 1.446-4(e)(8), gains and losses from hedges of anticipatory borrowings that are not consummated, however, are generally taken into account when realized.31 A taxpayer consummates an anticipatory borrowing when it issues either the anticipated debt or a different but similar transaction for which the hedge serves to reasonably reduce risk. Under special rules for hedges involving notional principal contracts, the rules of Reg. 1.446-3 will generally continue to govern the timing of income and deductions with respect to a notional principal contract that qualies as a hedging transaction unless the

Identication
The hedge timing rules of Reg. 1.446-4 automatically apply to any risk management transaction that meets the denition of a qualied hedging transaction set out in Code Sec. 1221(b)(2). In other words, application of the hedge timing rules is not dependent on identication of the transaction as a hedging transaction under Code Sec. 1221(a)(7).33 Reg. 1.446-4, however, includes its own identication requirements. Specically, a taxpayers books and records are to include a description of the accounting method used for each type of hedging transaction. This description must be sufcient to show how the clear reection requirement of Reg. 1.446-4 is being satised. In addition, a taxpayers books and records should contain additional information sufcient to verify that the taxpayers hedge method accounting is being used for the particular metho hod of ac co transaction This identication is to be tra ansact on n or or transactions. t made on or before the date the hedging transaction is entered into, and is made on, and retained as part of, the taxpayers books and records.34 If a taxpayer does not timely identify its hedge method of tax accounting, the IRS may be more likely to challenge the taxpayers hedge accounting method.

Legging in
A taxpayer legs in to a hedging transaction in situations where the risk management transaction and the hedged item are not entered into on the same day. For example, if a taxpayer issues a debt instrument and subsequently enters into an interest rate hedging transaction intended to manage interest rate risk with respect to the borrowing, the taxpayer would be viewed as having legged in at the time the risk management transaction is entered into. Under Reg. 1.446-4, no special timing rules are provided for a legging-in transaction where the taxpayer incurs

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a borrowing and subsequently engages in a related hedging transaction.35 The absence of a legging-in rule under those circumstances is consistent with the notion that Reg. 1.446-4 does not alter the timing of income, deduction, etc., with respect to the hedged item itself (e.g., the liability being hedged). the same taxable year. In this ruling, the taxpayer terminated its interest rate hedge agreement and its lender nancing agreement (borrowing) in the same tax year. Thus, the IRS concluded that the taxpayers termination of the hedging transaction should be taken into account in the same tax year as the termination of the hedged borrowing. In LTR 9706002, the IRS addressed the application of the hedge timing rules of Reg. 1.446-4 to an anticipatory hedge with respect to a borrowing.39 Specically, the taxpayer planned to issue xed-rate debt. To protect itself from an increase in interest rates, and to lock-in its interest rate obligation on the anticipated borrowing, the taxpayer entered into a Treasury lock agreement. A Treasury lock agreement is essentially a forward rate agreement that provides that if the interest rate on Treasury notes upon the maturity of the rate lock agreement is greater than a threshold amount, the taxpayer will receive money from the counterparty. If rates decrease, on the other hand, the taxpayer will pay money to the counterparty. The taxpayers rate-lock agreement was to mature at or around the time that the related borrowing was to be incurred by the taxpayer. The IRS concluded that under Reg. 1.446-4(e)(4), the taxpayer was required to account for income or loss from the anticipatory debt hedge in a manner that treats such gain (or loss) as if it decreased (or increased) the issue price of the debt instrument. As a result, the gain or loss from the hedge was to be spread out over the term of the debt instrument. nstrumen FSA 199932012, the IRS disallowed a taxpayers In F SA 19 9993 attempt to take hedging losses into account before the taxpayer realized gains or losses from the hedged item.40 In this ruling, the taxpayer was in the business of leasing equipment to end-users. As part of its business operations, the taxpayer pooled its leases and sold securities that were collateralized by the pool of leases. The protability of these transactions depended on the market rate of interest when the taxpayer offered these securities to the public. Prior to the issuance of the collateralized securities, the taxpayer entered into hedging transactions intended to lock-in an interest rate. The IRS disallowed the taxpayers attempt to deduct losses from these hedging transactions in the year realized because the IRS believed that such accounting treatment would violate the clear reection of income standard of Reg. 1.4464(b). The IRS concluded that the taxpayers hedging gains or losses must be accounted for by reference to the terms of the debt instrument and the period to

Legging out
Once a hedging transaction is established, a taxpayer may leg out of the hedge by disposing of or terminating either the liability being hedged, the hedging (risk management) transaction itself, or both. The hedge timing rules set out two separate legging-out provisions. First, if the taxpayer disposes of or terminates the liability being hedged, but does not dispose of or terminate the related hedging (risk management) transaction, Reg. 1.446-4(e)(6) requires that the taxpayer match the unrealized (built-in) gain or loss on the hedging transaction to the gain or loss on the hedged item (liability) being disposed of. To meet this requirement, Reg. 1.446-4 provides that the taxpayer may mark the hedging transaction to market on the date it disposes of or terminates the liability being hedged.36 After the legging-out transaction, the hedging g transaction would no longer be governed by Reg. 1.446-4 it is recycled to serve as a hedge 1 14 1.4 446 6 4 unless 6-4 u y with with h respect re espec to o another ano other hedged hedge item.37 Second, S e ond eco d, a taxpayer d axpay yer m may ay en engage in a legging-out transaction ans sac ctio by b terminating the hedging (risk management) transaction disposing or terminating n without ithou ut d sp posin ng of fo erm mina ating the liability being ng hedged. hedged In n that that case, ase the the hedge hedg timing rules do not require that the taxpayer take any income, deduction, gain or loss into account with respect to the liability being hedged. Instead, the taxpayer is required to account for any gain or loss resulting from the disposition (termination) of the hedging transaction in a manner that matches such gain or loss to the income, gain, loss or deductions to be realized in the future with respect to the liability being hedged. In LTR 199951038, the IRS considered whether a taxpayers payments to terminate a hedging agreement could be deducted in the year paid.38 In its analysis of Reg. 1.446-4(b), the IRS stated that, under certain circumstances, taking gains and losses from hedging transactions into account in the period in which they are realized may clearly reect income. As explained in LTR 199951038, such an accounting result would clearly reect income if the hedge and the hedged item are disposed of in

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matically treated as an offset (reduction) to interest which the hedge relates, meaning the hedge losses expense for foreign tax credit calculation purposes. were to be deferred and matched to the income or Temporary Reg. 1.861-9T(b)(6)(iv)(B) allows taxdeductions on the collateralized securities. payers to use gains from such nancial products to Finally, Rev. Rul. 2002-71 deals with the applicareduce total interest expense, but only if the nancial tion of the hedge timing rules of Reg. 1.446-4(e) to products are properly identied as hedges. In order to a legging-out transaction involving an early terminatake advantage of this rule for gains from interest rate tion of an interest rate swap.41 In Rev. Rul. 2002-71, hedges, Temporary Reg. the taxpayer issued a debt 1.861-9T(b)(6)(iv)(C) instrument with a 10Unfortunately, gains from nancial provides that taxpayers year term that provided must identify a nancial for interest to be paid products that alter the effective cost annually at a xed rate. of a borrowing are not automatically product as a hedge on the same day as it enters Contemporaneously with treated as an offset (reduction) to into the hedging transacthe issuance of the debt tion. Taxpayers have up to instrument, the taxpayer interest expense for foreign tax 120 days to identify anentered into an interest credit calculation purposes. ticipatory debt hedges.44 rate swap (the Swap) with a ve-year term that A taxpayer can satisfy the converted the xed rate payments under the debt rules of Temporary Reg. 1.861-9T(b)(6)(iv)(C) by instrument into oating rate payments. The taxpayer meeting the debt hedge identication requirements then terminated the Swap on the last day of Year 2. of Reg. 1.1221-2. According to Rev. Rul. 2002-71, prior to its terminaCoordination with Straddle Rules of tion on the last day of Year 2, the Swap would have Code Sec. 1092 continued to hedge interest payments on the debt instrument during Year 3 through Year 5, and the taxAlthough a taxpayers own debt instrument is generpayer would have been required to take into ally not viewed as a position in personal property y generally g account the that is potentially considered part of a tax straddle ac cco oun nt th he remaining g income, , deduction, gain or loss under Code Sec. 1092, the IRS has recently taken the on n the th he Swap Sw wa over ver the th he period per od from fro Year 3 through Year Since payment made or received position that, in limited circumstances, a taxpayers 5. 5 . Si inc ce any any termination ermin nation paym by the taxpayer upon termination of the Swap repreown debt may be considered part of a tax straddle.45 y th he tax sented the present the extinguished rights and Even own debt is not considered nt value alue of th he ex tin ng shed r ghts sa nd Even n if a taxpayers taxp obligations under part tax straddle, a risk management (hedging) er the e Swap Sw wap p for for Year Year 3 through through Year Year 5, 5 pa art of of a ta ax st the IRS ruled that the taxpayer should amortize the transaction entered into with the intent of managing gain or loss resulting from terminating the Swap over interest rate risk on a borrowing could potentially the period from Year 3 through Year 5.42 be matched up with some other offsetting position of the taxpayer and therefore be considered part of Coordination with a tax straddle. Fortunately, an exception to the apTemporary Reg. 1.861-9T plication of the straddle rules is provided in the case of hedging transactions that meet the denition of a For foreign tax credit calculation purposes, in deterhedge under Code Sec. 1221(b)(2). mining how to allocate or apportion interest expense Code Sec. 1092(e) provides a hedge exception between U.S. source and foreign source income, a to the application of the straddle rules. Code Sec. taxpayer must rst determine whether a given item 1092(e) provides simply that the straddle rules will of income or expense is interest. Temporary Reg. not apply in the case of any hedging transaction as 1.861-9T automatically treats certain losses from dened in Code Sec. 1256(e). Code Sec. 1256(e), in nancial products that alter the effective cost of borturn, denes a hedging transaction as any transaction rowing as an item of interest expense for purposes of that meets the denition in Code Sec. 1221(b)(2)(A), the apportionment and allocation rules. This includes if before the close of the day on which such transaclosses from swaps, options, forwards, caps, collars, 43 tion was entered into (or at such earlier time as the and similar nancial instruments. Secretary may prescribe by regulations), the taxpayer Unfortunately, gains from nancial products that clearly identies the transaction as being a hedging alter the effective cost of a borrowing are not auto-

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transaction. This means that a hedging transaction that satises the Code Sec. 1221(b)(2) denition of a hedge, and is identied in a manner that satises the requirements of Reg. 1.1221-2(f), is exempt from the straddle rules of Code Sec. 1092. Note further that the regulations issued under Code Sec. 1256(e) provide that a hedging transaction that is identied under Code Sec. 1221(a)(7) is automatically treated as an identication for purposes of Code 1256(e) and Reg. 1.1256(e)-1.46 The straddle exemption provided for qualied hedging transactions under Code Sec. 1256(e) is twofold. First, the hedging transaction and the hedged item (borrowing) are not considered straddles with respect to each other. Second, neither the risk management (hedging) transaction nor the hedged item can be considered part of a tax straddle with respect to any other potentially offsetting positions of the taxpayer.

Qualifying Transactions
Reg. 1.1275-6 provides for integration of a qualifying debt instrument (a QDI) and a qualifying hedging transaction (hereinafter a section 1275-6 hedge). The regulation denes a QDI to include all debt instruments subject to three enumerated exceptions.47 This can include QDIs issued by a taxpayer, as well as QDIs held as an asset by the taxpayer.48 A section 1275-6 hedge is broadly dened to include any financial instrumentsuch as spot, forward, or futures contracts, options, swaps, debt instruments or combinations thereof49that, when combined with the QDI, will permit the calculation of a yield to maturity or would qualify as a variable debt instrument under Reg. 1.1275-5. In order to qualify as a section 1275-6 hedge, the resulting synthetic debt instrument must have the same term to maturity as the remaining term of the QDI.50 By contrast, Code Sec. 1221(a)(7) simply requires that the hedging transaction manage the taxpayers risk. As such, Reg. 1.1275-6 requires a high degree of correlation between the terms of the hedging transaction and the terms of the QDI being hedged thereby. A transaction is eligible for integrated treatment under Reg. 1.1275-6 only if the QDI is issued or acquired by the taxpayer on or before, or substantially contemporaneously with, the date of the rst payment on the hedging transaction.51 Unlike Code. Sec. 1221(a)(7), this means that anticipatory hedging is limited under Reg. 1.1275-6. under Reg. 1.1275-6, a QDI As stated stated d above, ab cannot be hedged for less than its entire remaining ca nn not o b he ed term. However, an instrument that hedges only a portion of the principal amount of a QDI can qualify for integration under Reg. 1.1275-6 as long as the proportional hedge is for the entire remaining term of the QDI.52 By contrast, Code Sec. 1221(a)(7) and Reg. 1.1221-2 make it clear that a taxpayer may hedge all or part of its risk with respect to a borrowing for all or any portion of the period that it is subjected to such risk.53

Integrated Hedge Treatment Under Reg. 1.1275-6

As described above, the hedging rules of Code Sec. 1221(a)(7) and Reg. 1.446-4 generally provide for matching of the tax character and timing of income, gains, , deductions, and losses from a qualied hedging transaction to the character and timing of the in ng tra t nsa ac income, i n ome nco e, gains, ga s, deductions g ded ductio ons or losses resulting from the Although Code th he liability li b liab bili ity y being eing hedged hedged thereby. the Sec. 1221(a)(7) and Reg. 1.446-4 provide for conec 12 221 sistent treatment hedging transaction the nt of o the he dging tr ra act on and dt he liability being hedged he ed thereby, the ereb by the he income, ncome gains, gain ns deductions and losses from the hedging transaction would need to be reported separately from the liability being hedged. By contrast, Reg. 1.1275-6(a) provides for tax integration of a qualifying debt instrument and a hedge or combination of hedges that meet the requirements of that regulation. The integration rules of Reg. 1.1275-6 trump other federal income tax rules that would otherwise govern the tax character and timing consequences of each individual component of the hedge. In other words, if a qualifying debt instrument and a qualifying hedge are integrated under Reg. 1.1275-6, during the period of integration the taxpayer ignores the separate existence of the hedging transaction and accounts for the qualifying debt instrument on a synthetic basis, meaning that the debt instrument is treated for all tax purposes as the combination of the debt instrument being hedged in combination with the hedging transaction itself.

Requirements
In addition to the basic rules described above, a taxpayer may take advantage of Reg. 1.1275-6 only if the following requirements are met: There must be same-day identication under Reg. 1.1275-6(e). The parties to the hedge are not related, or, if they are related, the party proposing the hedge uses a mark-to-market method of accounting for the

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hedge and all similar or related transactions. The same taxpayer enters into both the hedge and the QDI. If the taxpayer is a foreign person engaged in a U.S. trade or business, all items of income and expense (other than interest expense subject to Reg. 1.882-5) are effectively connected with the U.S. trade or business for the period of the QDI had Reg. 1.1275-6 not applied. Neither the hedge or the QDI nor any other debt instrument that is part of the same issue as the QDI was part of an integrated transaction with respect to the taxpayer or otherwise legged out of in the 30 days preceding the issue date of the QDI. The taxpayer issues the QDI on or before the date on which the taxpayer makes or receives the rst payment on the section 1275-6 hedge.54 Neither the hedge nor the QDI may have previously been a part of a Code Sec. 1092 straddle. Note that the third requirement, which is that the same taxpayer must enter into both the hedge and the QDI, effectively precludes Reg. 1.1275-6 integrated hedge treatment in situations where one member of a consolidated group directly hedges a QDI of another member of the group. The related-party hedging rule set out above also makes it difcult to qualify for integrated in nteg gra ated d treatment if the issuer of a QDI enters into a hedge he edg dge with wi a related w rela ated taxpayer. taxpay retained as part of the taxpayers books and records. The common practice is for taxpayers to identify both the QDI and the qualifying section 1275-6 hedging transaction pursuant to a same-day identication form/memorandum that satises the requirements of Reg. 1.1275-6.

Misidentication Issues
Unlike Code Sec. 1221(a)(7), Reg. 1.1275-6 does not include misidentication rules. Reg. 1.1275-6(c)(2), however, provides that the IRS may, in limited circumstances, integrate a QDI and a section 1275-6 hedge where the taxpayer has not elected to do so.56 The circumstances under which integration may be imposed by the IRS include (1) a failure by a taxpayer to identify an otherwise qualifying transaction, (2) a related party entering into a section 1275-6 hedge and the taxpayer holding a QDI, (3) a taxpayer holding a QDI and entering into a hedge with a related party, or (4) a taxpayer legging out of an integrated transaction and entering into a new section 1275-6 hedge within 30 days with respect to the same QDI or another QDI that is part of the same issue. The IRS may deem a taxpayer to have made an integration election under Reg. 1.1275-6, however, only if (1) the QDI is subject to the rules of Reg. 1.1275-4 (relating to contingent payment debt instruments), or (2) the QDI is subject to the rules of Reg. 1.1275-5 (relating to variable rate debt instruments) and the QDI pays interest at an objective rate.

Identi Id de ent ent ti tica c cation ion

To integrate a section cti n 1275-6 127 75-6 6 hedge hedge e with w th a QDI QDI under under Reg. 1.1275-6, a taxpayer must identify the xpayer mu m ust i de ify th he resulting esultin synthetic debt instrument by entering the required information in its books and records on or before the day that it enters into the section 1275-6 hedge.

Consolidated Conso olidat Group Considerations

As noted above, one of the requirements for integrated treatment under Reg. 1.1275-6 is that the same taxpayer must enter into both the section 1275-6 hedge and the QDI. This limitation denies integrated treatment under Reg. 1.1275-6 in a situation where one member of a consolidated group enters into a hedge with respect to a QDI held or entered into by another member of the group. As a result, Reg. 1.1275-6 is more restrictive than the rules under Code Sec. 1221(a)(7), which generally allows members of a consolidated group to hedge the risks of other members.

Method of Hedge Identication

No particular form of identication is required under Reg. 1.1275-6. However, the identication should indicate that it is being made for purposes of Reg. 1.1275-6, and should include the following information: The issue date of the QDI and the date that the hedge was entered into A description of the QDI and the section 1275-6 hedge A summary of the cash ows and accruals that result from integration of the QDI and the section 1275-6 hedge55 Note that hedge identications under Reg. 1.12756 need not be led with the IRS, but are simply

Consequences of Integration Under Reg. 1.1275-6

If an integration election is made with respect to a QDI and a qualifying section 1275-6 hedge, the result is that the QDI and the hedge are generally treated as a single transaction by the taxpayer for all

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Interest Rate Hedging Considerations

of a legging-out transaction relating to a QDI that is federal income tax purposes during the period that a liability of the taxpayer, the transaction may result the transaction qualies as an integrated transaction. in the taxpayer being able to take an interest expense This means that while a QDI and a qualifying hedge deduction as if the synthetic debt instrument were are part of an integrated transaction, neither the QDI retired at a premium.60 If nor the hedge will be subject to the rules that the taxpayer retains the By reason of the integrated would otherwise apply on QDI after legging out of ina separate basis, includtegrated treatment, it must treatment resulting from Reg. ing but not limited to, the make appropriate adjust1.1275-6, the taxpayers interest straddle rules of Code Sec. ments to the QDI to reect expense from a QDI that is part 1092.57 Note, however, any differences between of a qualifying section 1275-6 the fair market value and that an issuers election issue price of the debt to integrate a QDI and a hedge would be determined on a instrument. Any losses or qualifying hedging transsynthetic basis. deductions arising from action has no impact on legging out are disallowed holders of the QDI. if a taxpayer legs out of a Reg. 1.1275-6 hedge During the period of integrated treatment, the within 30 days of legging in to the transaction. resulting synthetic debt instrument is subject to the The legging-out rules of Reg. 1.1275-6 should general rules for debt instruments under Code Sec. be contrasted to the legging-out provisions of Reg. 163(e) and Code Sec. 1271 through 1275. The terms 1.446-4, as it relates to a Code Sec. 1221(a)(7) hedgof the resulting synthetic debt instrument, such as the ing transaction. As described above, the legging-out issue date, issue price, etc., are determined under rules of Reg. 1.446-4 are one-sided, meaning that if Reg. 1.1275-6(f)(2) through (13). a taxpayer legs out of a Code Sec. 1221(a)(7) hedge Legging in by terminating or disposing of the risk management transaction itself, the legging-out will have no impact A taxpayer p y may leg in to a Reg. 1.1275-6 hedge with on the debt instrument being hedged thereby. respect which means that the re espect t to o an a outstanding g QDI, Q taxpayer t a axp paye er can ca enter into c nto the the hedge hed at any time after the Coordination with date In order to leg in, da d ate e on n which wh whic h h the QDI is s issued. issu Temporary Reg. 1.861-9T a taxpayer tax xpa aye must ensure that all of the integration re58 quirements described above met. T cri ed da ab bov ve are a me m The he synthetic synth hetic By yr reason easo on of the th integrated treatment resulting from instrument would Reg. ld become com me eligible e igib e for fo Reg. Reg g 1.1275-6 1 1275 Re eg 1.1275-6, 1 1275 5 6 the taxpayers interest expense from treatment from and after the leg-in date. The taxpayer a QDI that is part of a qualifying section 1275-6 would account for the separate debt instrument under hedge would be determined on a synthetic basis. applicable interest and original issue discount rules As such, during the period a section 1275-6 hedge prior to the leg-in date, and would account for the is integrated with a QDI, no separate gains or losses resulting synthetic debt instrument under the integrafrom nancial products that alter the effective cost tion rules of Reg. 1.1275-6 thereafter. No income, of borrowing would arise for purposes of the rules deduction, gain or loss is generally recognized with under Temporary Reg. 1.861-9T. respect to the QDI upon a legging-in transaction.59

Legging out
A taxpayer may also leg out of a Reg. 1.1275-6 hedge by disposing of one or both of the components of the hedging transaction. A legging-out will also occur if any of the integration requirements of Reg. 1.1275-6 are no longer met. Immediately before legging out, a taxpayer is treated as having disposed of the synthetic debt instrument for its fair market value, and is required to take into account any gain or loss resulting from the deemed disposition. In the context

Coordination with Straddle Rules of Code Sec. 1092

As noted above, during the period that a QDI and a qualifying hedge are part of an integrated transaction under Reg. 1.1275-6, the QDI and the related section 1275-6 hedge cannot be considered offsetting positions with respect to each other for purposes of the straddle rules of Code Sec. 1092. However, in contrast to the consequences resulting from a qualied hedging transaction under Code Sec. 1221(a)(7) and Code Sec. 1256(e), the resulting synthetic debt

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instrument could potentially be part of a straddle under Code Sec. 1092 to the extent the synthetic debt instrument is considered an offsetting position with respect to another position of the taxpayer. of the QDI and the offsetting hedging transaction than would be required under the risk management standard of Code Sec. 1221(a)(7). Other differences between these hedging provisions exist. For example, Code Sec. 1221(a)(7) allows taxpayers to hedge an expected (or anticipatory) issuance of debt. By contrast, the integrated hedge rules of Reg. 1.1275-6 are more restrictive in the case of anticipatory hedges. Further, Reg. 1.1221-2 makes it clear that a taxpayer may hedge all or part of its risk for all or part of the period over which the taxpayer is exposed to that risk.62 By contrast, the integration rules of Reg. 1.1275-6 are more restrictive in the case of partial hedging transactions. Further, identication of a hedging transaction under Code Sec. 1221(a)(7) results in the hedging transaction and the hedged item being exempt from application of the straddle rules, both relative to each other and relative to other positions of the taxpayer. By contrast, in the case of an integrated hedging transaction under Reg. 1.1275-6, although the QDI and the section 1275-6 hedge will not subject to the straddle rules relative to each other, the resulting synthetic instrument could be subject to application of the straddle rules in relation to other offsetting positions of the taxpayer. Finally, differences between the results under Reg. 1.1275-6 versus Code Sec. 1221(a)(7)/Reg. 1.446-4 may arise in the context of a leggingout transaction. As described above, if a taxpayer legs debt instrument under Reg. le gs out out of a synthetic s 1.1275-6, but retains the QDI being hedged, the 1 1275 6 bu b taxpayer would be treated as having sold or disposed of the synthetic debt instrument immediately prior to the legging-out transaction. By contrast, if a taxpayer legs out of a Code Sec. 1221(a)(7) hedge by disposing of the hedging transaction and retaining the debt instrument being hedged, no gain or loss would be taken into account with respect to the debt instrument upon the leggingout transaction, and any resulting gain or loss on the termination of the hedge would generally be deferred and taken into account over the remaining term of the debt instrument. Since it is impossible to predict whether and to what extent a legging-out transaction may occur in the future, it is difcult to judge whether the legging out rules of Reg. 1.1275-6 would provide an advantage or a disadvantage, relative to Code Sec. 1221(a)(7)/Reg. 1.446-4, depending on which side of the transaction is retained and which is terminated early.

Comparison
If a taxpayer borrows money and agrees to pay interest at a xed (oating) rate, a risk management transaction whereby the taxpayer synthetically converts the interest rate to a oating (xed) rate may qualify under the integration rules of Reg. 1.1275-6, as well as under the hedging rules of Code Sec. 1221(a)(7). If an interest rate hedging transaction hedges the entire remaining life of a debt instrument and both the hedge and the debt instrument remain in place through their originally scheduled maturity dates, there may be little practical difference between the integrated transaction rules of Reg. 1.1275-6, and the coordinated hedge character and timing rules of Code Sec. 1221(a)(7)/Reg. 1.446-4. In each case, the net effect should be a matching of the character and timing of income, gain, deduction and loss resulting from the hedge to the interest expense deduction on the debt instrument being hedged thereby. In fact, the differences between the two approaches may be limited lim mit ted d to o slight timing g differences and the manner in which the transactions i n whic w hich h th ransactions are reported.61 If i integrated treatment adopted, no separate nt teg gra at d tre atment is a gain ain n or r loss lo is reported d with respect to the hedging transaction itself, lf, and the the interest nteres st expense xpe ense deducdeduction resulting from fro the e synthetic syn nthet c debt ebt instrument nstrumen must be determined and reported as a single item. By contrast, in a Code Sec. 1221(a)(7) hedging situation, the timing and amount of interest expense deductions with respect to the debt being hedged remains unchanged, and the income or loss with respect to the hedging transaction is separately reported. As a result, separate reporting of the hedge gain or loss under Code Sec. 1221(a)(7)/ Reg. 1.446-4 may necessitate a separate hedge identication for foreign tax credit purposes under Temporary Reg. 1.861-9T. Although the consequences under Reg. 1.1275-6 and Code Sec. 1221(a)(7) may be similar, the requirements for integrated treatment under Reg. 1.1275-6 are, as described above, potentially more difcult to satisfy than the denition of a hedging transaction under Code Sec. 1221(a)(7). In particular, integrated treatment under Reg. 1.1275-6 requires a higher degree of correlation between the combined cash ows

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Interest Rate Hedging Considerations ENDNOTES

1

6 7 8

10 11

All references to the Code are to the Internal Revenue Code of 1986, as amended. This article assumes that the taxpayer issues debt in its functional currency. A detailed discussion of the issues associated with hedging of nonfunctional currency denominated debt under Code Sec. 988(d) and Reg. 1.988-5(a) is beyond the scope of this article. This article does not address the special tax issues that arise in the case of taxpayers that are dealers in securities for federal income tax purposes. Code Sec. 1221(a)(7); Reg. 1.1221-2(b). Code Sec. 1221(a)(7) is effective for hedging transactions entered into after December 17, 1999. Except as otherwise specically noted, all references to Reg. 1.12212 are to the regulations that were nalized in 2002 under Code Sec. 1221(a)(7). The 2002 version of Reg. 1.1221-2 is effective for hedging transactions entered into on or after March 20, 2002. See Proposed Reg. 1.162-30 (2004) and Proposed Reg. 1.212-1(q) (2004). Reg. 1.1221-2(c)(4). Reg. 1.1221-2(d)(1)(ii)(A). See Reg. 1.1221-2(d)(2) ([a] transaction that economically converts an interest rate from a xed rate to a oating rate or that converts an interest rate from a oating rate to oa xed xed d rate manages risk). Under the 1994 19 994 4 version ver rsi of Reg. 1.1221-2, 1.1221-2, the regulations la ation ns also also made de it clear ea that a hedge of a borrowing bo orro owin ng met the denition of f a quali qua ed hedging he h edg d i ing transaction t ans without h t regard d to t the use of the proceeds of the borrowing. w See Reg. 1.1221-2(c)(6) )(6 (1994). 994). See Reg. 1.1221-2(d)(5)(i), 21 )(5 ) h however, providing that except as otherwise determined by published guidance or private letter ruling, the purchase or sale of a debt instrument, an equity security or an annuity contract is not a hedging transaction even if the transaction limits or reduces the taxpayers risk with respect to ordinary property, borrowings or ordinary obligations. This provision reects the IRSs view that certain traditional investment positions generally may not serve as tax hedging transactions for purposes of Code Sec. 1221(a)(7). Reg. 1.1221-2(d)(1). This exception does not extend to related entities that are outside of the consolidated federal income tax group even if such related entities are 100 percent owned by members of a group. For example, if two subsidiaries that are part of a consolidated federal income tax group are each 50-percent members of a state law limited liability company that is treated as a partnership for federal income tax purposes, a direct

12

13

14 15

16

17

18 19

hedge of the risks of the limited liability company by either such member would not qualify under Code Sec. 1221(a)(7). Reg. 1.1221-2(e)(1). However, the transaction would be recognized by both members as an actual transaction, subject to the consistency requirements of Reg. 1.1502-13. Note that the separate entity election is effective solely for purposes of determining hedge status under Code Sec. 1221(a)(7). See Reg. 1.1221-2(e)(2). See Reg. 1.1221-2(e)(2)(ii). An intercompany transaction is a hedging transaction with respect to a member of a consolidated group if and only if it meets the following requirements: (1) the position of the member in the intercompany transaction would qualify as a hedging transaction with respect to the member if the member had entered into the transaction with an unrelated party, and (2) the position of the other member (the marking member) in the transaction is marked to market under the marking members method of accounting. If an intercompany hedging transaction meets the above requirements, the character and timing rules of Reg. 1.1502-13 will not apply to the income, deduction, gain or loss from the intercompany hedging transaction and, subject to the identication requirements, the marking members gain or loss from the transaction is ordinary. It should be noted that an identication that satisfies the requirements of Reg. 1.1221-2(f) is treated as an identication f for purposes of Code C Sec. 1256(e) and Reg. 1.1256(e 1.1256(e)-1. 1. An id identi entic cation ation of at transaction as a h hedge d f for purposes of f Code Sec. 1256(e) avoids the potential application of the straddle rules of Code Sec. 1092, as well as the mark-to-market rules for section 1256 contracts that are entered into as part of a qualifying hedging transaction. The only exception to the requirement that the hedged item be identied is in the context of aggregate or macro hedging activities, where an aggregate tax hedge policy replaces the requirement of identifying the hedged item. See Reg. 1.1221-2(f)(3)(iv). Reg. 1.1221-2(f)(2). See Reg. 1.1221-2(f)(3)(iv). If a transaction hedges aggregate risk, by denition the taxpayer is unable to identify the ordinary asset or borrowing/ordinary obligation being hedged with sufcient detail to satisfy the requirements of the regulations. In that case, the identication requirements for the hedged item(s) or risk(s) can be met by placing in the taxpayers books and records a description of the hedging program and

20 21 22 23

24 25 26 27

28

29 30

31 32 33

34 35

36 37

by establishing a system under which individual transactions are identied as being entered into pursuant to the hedging program. This program is commonly referred to as an aggregate hedge policy statement. Reg. 1.1221-2(f)(4)(iv). Reg. 1.1221-2(f)(3)(iii)(A). Reg. 1.1221-2(f)(3)(iii)(B). See Note 4, above, relating to the effective date of Reg. 1.1221-2(g). Reg. 1.1221-2(g)(1). Reg. 1.1221-2(g)(1)(ii) Reg. 1.1221-2(g)(2)(ii). See TAM 200510028 (Dec. 17, 2004). (Where a failure to identify a hedging transaction is inadvertent and certain specied requirements have been satised, a taxpayer may, but is not required, to treat gain or loss from a hedging transaction as ordinary income or loss under section 1.1221-2(a)(1) and (2). (Emphasis added.)) Limited guidance is found in letter rulings relating to Code Sec. 1221(a)(7), but none of these rulings includes a specic conclusion by the IRS as to the availability of the inadvertent error exception. See, e.g., LTR 9706002 (Oct. 24, 1996); and LTR 200052010 (Sept. 25, 2000). See also LTR 200051035 (Sept. 26, 2000) and LTR 200051033 (Sept. 25, 2000), which are nearly identical except for the fact that LTR 200051035 deals with tax years governed by the 1994 hedging regulations. Reg. 1.1221-2(g)(2). To the extent an integration election is made under Reg. 1.1275-6, the hedge timing rules of Reg. 1.446-4 will not apply. Reg. 1.446-4(e)(8). Reg. 1.446-4(e)(5). The IRS has confirmed in Rev. Rul. 2003-127, IRB 2003-52, 1245, that, for purposes of the hedge timing rules under Reg. 1.446-4, the denition of a hedging transaction under Reg. 1.1221-2(b) is not modied by Reg. 1.1221-2(g)(2), dealing with income mischaracterization. Reg. 1.446-4(d)(1) and (2). If, however, a taxpayer legs in to a hedging transaction by rst entering into the hedging transaction and then incurring a borrowing, such a transaction would be covered by the anticipatory hedging rules of Reg. 1.446-4(e)(4). Reg. 1.446-4(e)(6). Even though a hedging transaction is no longer governed by the hedge timing rules of Reg. 1.446-4 following a legging-out transaction, the hedging (risk management) transaction should still be governed by the tax character provisions of Code Sec. 1221(a)(7) and Reg. 1.1221-2.

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38 39 40 41 42

43 44 45

46 47

LTR 199951038 (Sept. 24, 1999). LTR 9706002 (Oct. 24, 1996). FSA 199932012 (May 4, 1999). Rev. Rul. 2002-71, IRB 2002-44, 763. Rev. Rul. 2002-71 also provides an alternative example in which the Swap is terminated at the end of Year 2, and that the debt instrument being hedged is then terminated at the end of Year 4. The ruling concludes that, upon the termination of the debt instrument at the end of Year 4, any remaining unamortized gain or loss with respect to the early termination of the Swap has to be taken into account at the time the debt is extinguished. Temporary Reg. 1.861-9T(b)(6)(i). Temporary Reg. 1.861-9T(b)(6)(iv)(C). See, e.g., TAM 200541040 (Oct. 14, 2005); TAM 200530027 (July 29, 2005); and TAM 200509022 (October 6, 2004). In each of these TAMs, the IRS concluded that debt instruments issued by the taxpayers were positions in personal property subject to the straddle rules of Code Sec. 1092, thereby resulting in capitalization of interest deductions with respect to such debt instruments under Code Sec. 263(g). See also Proposed Reg. 1.263(g)-3(c)(3), issued on January 18, 2001. See Reg. 1.1256(e)-1. Reg. 1.1275-6(b)(1). The enumerated

48

49

50 51 52

exceptions are (1) Code Sec. 1275(a)(3) tax exempt obligations, (2) Code Sec. 1272(a)(6) instruments (such as mortgages held by REMICs), and (3) certain contingent debt instruments issued for nonpublicly traded property. Although either of Reg. 1.1275-6 or Code Sec. 1221(a)(7) potentially applied to hedging transactions relating to a taxpayers own debt, Reg. 1.1275-6 may have broader application in the case of a taxpayer that hedges a debt instrument that it owns as an asset in light of the fact that integration treatment under Reg. 1.1275-6 is not contingent on the debt instrument qualifying as an ordinary asset in the taxpayers hands. By contrast, a taxpayer intending to hedge a debt instrument held as an asset would be eligible to utilize Code Sec. 1221(a)(7) only if the debt instrument is an ordinary asset in the taxpayers hands. Stock is not a financial instrument for purposes of Reg. 1.1275-6(b)(3). Reg. 1.1275-6(b)(2)(i). See Reg. 1.1275-6(c)(1)(vi). For example, if a taxpayer entered into a $1 million borrowing for a term of 10 years, the taxpayer would not be permitted to elect integrated treatment under Reg. 1.1275-6 for a hedge with a term of less than 10 years. However, the taxpayer

53 54

55 56

57 58 59

60 61

62

could enter into a hedge with respect to $500,000 of the $1 million amount of the liability provided that such hedge was for the full 10-year term of the debt instrument. See Reg. 1.1221-2(d)(7)(i). This provision effectively limits a taxpayers ability to engage in anticipatory hedging under Reg. 1.1275-6. However, the QDI may be entered into substantially contemporaneously with the hedge if it is acquired or issued after the date of rst payment on section 1275-6 hedge. Reg. 1.1275-6(e). Reg. 1.1275-6(c)(2). See, e.g., Rev. Rul. 2000-12, 2000-1 CB 744, pursuant to which the IRS deemed integration of two offsetting bull-bear bonds. Reg. 1.1275-6(f)(1). Reg. 1.1275-6(d)(1). Reg. 1.1275-6(d)(1). Special rules are provided for abusive legging-in transactions. See Reg. 1.163-7. There may be slight differences in timing resulting from the application of the OID principles under Code Secs. 1271 through 1275 as applied to the resulting synthetic debt instrument under a section 1275-6 hedge, in contrast to the application of the hedge timing rules of Reg. 1.446-4. Reg. 1.1221-2(d)(1).

This article is reprinted with the publishers permission from the JOURNAL OF FINANCIAL PLANNING, a quarterly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publishers permission is prohibited. To subscribe to the JOURNAL OF FINANCIAL PLANNING or other CCH Journals please call 800-449-8114 or visit www.CCHGroup.com. All views expressed in the articles and columns are those of the author and not necessarily those of CCH.

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