Hedging Regs Should Be More Comprehensive, Attorneys Assert.
Hedging Regs Should Be More Comprehensive, Attorneys Assert.
- AuthorsGordon, Stephen L.Paul, Deborah L.
- Institutional AuthorsCravath, Swaine & Moore
- Cross-ReferenceFI-46-93; FI-54-93
- Code Sections
- Subject Area/Tax Topics
- Index Termshedging transactions, capital assets
- Jurisdictions
- LanguageEnglish
- Tax Analysts Document NumberDoc 94-1130
- Tax Analysts Electronic Citation94 TNT 21-45
Stephen L. Gordon and Deborah L. Paul of Cravath, Swaine & Moore, New York, on behalf of the International Swaps and Derivatives Association, Inc., have submitted comments on the temporary and proposed regulations relating to the tax treatment of financial hedges.
Gordon and Paul commend the Service "for the practical and concise approach to financial hedges" in the regulations. The regs, they say, "neatly solve many problems that have troubled taxpayers for several years." However, the authors think that the regulations should be more comprehensive. In their comments, they describe additional types of transactions that they believe should be covered by the definition of "hedging transaction" and, therefore, be eligible for ordinary treatment. In addition, Gordon and Paul ask for clarification of the Service's views on the applicability of the portfolio interest exception to deemed interest payments on notional principal contracts.
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MEMORANDUM
HEDGING REGULATIONS
January 19, 1994
This letter is written in response to the Notices of Proposed Rulemaking published in the Federal Register on October 20, 1993, in which the Internal Revenue Service (the "Service") requested comments on the Temporary Regulations and Proposed Regulations (the "Regulations") released on October 18, 1993, concerning the Federal income tax treatment of financial hedges.
On behalf of the international Swaps and Derivatives Association, Inc. ("ISDA"), we commend the Service for the practical and concise approach to financial hedges in the Regulations. The Regulations neatly solve many problems that have troubled taxpayers for several years. We believe, however, that the Regulations should be more comprehensive. As described below, certain additional types of transactions should be covered by the definition of "hedging transaction" and therefore eligible for ordinary treatment. In addition, we would appreciate clarification of the Service's views on the applicability of the portfolio interest exception to deemed interest payments on notional principal contracts.
1. HEDGES OF ORDINARY INCOME AND EXPENSE STREAMS THAT RELATE TO CAPITAL ASSETS. Certain hedges of ordinary income or expense streams are not "hedging transactions" under the Regulations because they do not relate to "ordinary assets" or "ordinary liabilities". Accordingly, such a hedge may still create the Arkansas Best problem -- capital loss on the hedge and ordinary income on the underlying transaction. At least two types of hedges of ordinary income or expense streams are commonplace business activities and should be addressed by the Regulations.
CONSUMABLE SUPPLIES. A hedge of the expense stream generated by a service provider's use of consumable supplies, such as fuel used by an airline or trucking company, will not be covered by the Regulations. Because service providers generally do not treat such supplies as inventory for tax purposes, they are not described in Section 1221 and may produce capital gain or loss if sold rather than consumed. Such supplies are therefore not "ordinary property" within the meaning of the Regulations. Accordingly, the Regulations do not apply to a hedge of such consumable supplies. Moreover, the Regulations' claim of exclusivity (see Regulations Section 1.1221- 2T(a)(3)) suggests that ordinary treatment for hedges of such supplies could not be supported on a common law basis outside the Regulations.
We believe there is no reason to exclude from ordinary treatment all hedges of consumable supplies. In fact, the Regulations' exclusion of such hedges from ordinary treatment is at odds with Corn Products, which involved hedges of raw corn supplies, not finished corn syrup or other products. Perhaps the technical distinction is that the taxpayer in Corn Products was a manufacturer, not a service provider, but it is difficult to identity a sensible policy that treats manufacturers and service providers so differently with respect to hedges of consumable supplies. If the Service is concerned that service providers will whipsaw it by claiming ordinary hedging losses and then selling the underlying supplies and claiming a capital gain, surely it could fashion a rule aimed at such an abuse without imposing a character mismatch on all hedges of such supplies.
ORDINARY INCOME IN RESPECT OF CAPITAL ASSETS. The Regulations, when finalized, should generally provide that hedges of ordinary income streams on capital assets will result in ordinary income or loss, in order to clearly reflect income. It is common for investors that hold fixed income securities to hedge the rate risk on such securities. For example, many insurance companies that hold large amounts of debt securities enter into interest rate swaps or forward contracts to hedge the exposure of those securities to changes in interest rates. Since such an insurance company would not normally be a dealer in such securities, the securities would not be "ordinary property" in the insurance company's hands, and the gains or losses from the sale or exchange of a hedge of those securities would therefore be excluded from ordinary treatment under the Regulations.
The exclusion of such hedges from ordinary treatment may result in a serious character mismatch. If the insurance company has hedged with forward contracts, it will recognize capital gain or loss on each forward expiration date. Such gain or loss will be economically attributable to an offsetting decrease or increase in the "premium value" of the ordinary interest income realized from holding the debt securities. Interest rate movements that cause an increase in the value of the ordinary income on the securities and a loss on the forward will result in the classic Arkansas Best problem: no economic income, but substantial taxable income because the capital loss from the hedge cannot be used to offset the ordinary income on the debt securities.
We recognize that an unlimited ordinary income rule for hedges of ordinary income streams on capital assets may result in a character mismatch in certain cases. For example, if the insurance company we have described were to sell its debt securities, its gain or loss would generally be treated as capital (except as provided by the market discount rules); there would be no reason to treat the termination of the corresponding hedge as ordinary in that case. Accordingly, we suggest that the ordinary income rule apply to gains or losses from sales or exchanges of hedges of such assets as follows. To the extent that the hedging gain or loss is attributable to the portion of an ordinary income stream that has been accrued or otherwise recognized as ordinary income, the hedging gain or loss would be treated as ordinary. To the extent that the hedging gain or loss is attributable to the portion of the ordinary income stream that has not yet been accrued or otherwise recognized, it will tentatively be treated as ordinary income or expense, but will be recharacterized as capital gain or loss if the underlying asset is disposed of at a capital gain or loss before the accrual or recognition of that ordinary income stream. In view of the fact that the proposed timing rules of the Regulations would generally result in the recognition of the hedging gain or loss and the income, gain or loss on the underlying investment in the same taxable period, it would not be difficult to suspend the determination of the character of the hedging gain or loss until that period.
EXAMPLE. Corporation A, which is not a dealer in
securities, owns a debt security that pays a fixed rate of
interest on December 31 of each year and matures on December 31,
1999. In order to hedge its interest rate risk with respect to
that security, on January 1, 1995, Corporation A enters into a
five-year interest rate swap with an unrelated counterparty.
Under the swap, on December 31 of each year Corporation A pays a
fixed rate of interest on a notional principal amount and the
counterparty pays LIBOR on the same notional principal amount.
Corporation A complies with applicable identification
requirements to identify the swap as a hedge of the debt
security.
During 1995 interest rates fall, and on December 31, 1995,
Corporation A makes a net payment under the swap. That payment
is treated as an ordinary expense because there is no sale or
exchange of the swap. (This result does not turn on the use of
the swap as a hedge.)
On December 31, 1996, Corporation A makes another net
payment on the swap. In addition, the counterparty agrees to
terminate the swap on that date in exchange for Corporation A's
agreement to make a lump sum termination payment on that date to
the counterparty. On January 1, 1998, Corporation A sells the
debt security which the swap had hedged.
The scheduled net swap payment made by Corporation A on
December 31, 1996, is an ordinary expense because it does not
arise from a sale or exchange of the swap. The loss attributable
to the lump sum termination payment by Corporation A is
tentatively treated as an ordinary loss; however, under the
method of accounting adopted by Corporation A in response to the
proposed timing rules in the Regulations, the recognition of
that loss is deferred until Corporation A recognizes the income
or loss on the underlying debt security. Under that method of
accounting, the accrual of interest income on the debt security
by Corporation A during 1997 results in the recognition of a
portion of Corporation A's deferred loss on the terminated swap;
such portion of the loss is treated as ordinary. The sale of the
debt security by Corporation A on January 1, 1998, results in
the recognition of the remaining portion of Corporation A's
deferred loss on the terminated swap. Because that recognition
of the deferred loss on the swap is triggered by the sale or
exchange of the debt security, a transaction resulting in
capital gain or loss, the deferred loss on the swap recognized
in 1998 is treated as capital, not ordinary.
We do not intend that the ordinary treatment of hedges of ordinary income streams change the result in Hoover Company v. Commissioner, 72 T.C. 206 (1979). In that case, the court held that transactions in sterling by a U.S. parent corporation to offset a change in value of its investment in a U.K. subsidiary did not give rise to ordinary income or expense under Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955), because those transactions did not relate to any income or loss that the U.S. parent expected to realize in respect of its investment. Consistent with Hoover, iSDA is not recommending ordinary treatment for a hedge of a parent corporations's net investment in the stock of a subsidiary. Whether a particular transaction is a hedge of an expected dividend stream or of the underlying investment in the stock of a subsidiary would depend on the applicable facts and circumstances. In that regard, the treatment of a hedging transaction for financial accounting purposes would be relevant but not dispositive, as the applicable accounting standards may not correlate with the relevant tax standards.
2. HEDGING RISKS OF RELATED PARTIES. A "hedging transaction" is defined by the Regulations as a transaction that reduces certain risks of a party to the transaction. We believe that the definition of "hedging transaction" should include transactions entered into with third parties to hedge the risk of a related party. At a minimum, transactions entered into with third parties by one member of an affiliated group of corporations filing consolidated returns to hedge another member's risk should be covered. Although any member of the consolidated group may be subject to business risk, it is common to concentrate the group's hedging activities in one group member for practical or financial reasons. Although intra-group swaps or other transactions may "transfer" the business risk to the hedging center and thus make the business risk the hedging center's risk, there is no apparent policy reason to require each member of an affiliated group to enter into such intra-group transactions. Further, a rule disqualifying hedges of another member's risk will disqualify a hedge of net aggregate group risk entered into by a member, since such a hedge could not be identified with any particular member, including the member that enters into the hedge.
Certain nonconsolidated related parties are subject to full or partial flow-through regimes and are therefore in a similar position to consolidated groups. For example, a partnership hedging a partner's risk, a partner hedging a partnership's risk, a U.S. shareholder hedging its controlled foreign corporation's risk and a trust hedging a beneficiary's risk are analogous to a consolidated group member hedging its consolidated affiliate's risk. In such cases, sale or exchange of the hedge should give rise to ordinary income or loss for the reasons described above.
3. COMPLEX RISK MANAGEMENT STRATEGIES. The Regulations require that a hedging transaction "reduce" risk. The Regulations should clarify that transactions that are part of an overall risk management strategy are covered, regardless of whether the particular transaction in question reduces risk. For example, a taxpayer may purchase a put option on inventory to reduce the taxpayer's risk relating to decreases in the price of the inventory, and sell a call option to finance the cost of purchasing the put option. Although the call option does not "reduce" the taxpayer's risk -- in fact, the call option arguably increases the taxpayer's risk by giving the buyer of the call option upside in the inventory -- it is part of an overall strategy to reduce risk. One or more transactions that, as a package, are reasonably expected to offset, at least in part, the possible economic results of one or more underlying transactions should be covered.
A transaction should not be part of a hedging transaction, however, to the extent that the economic result it is reasonably expected to produce in response to changes in prices, currency rates or interest rates is significantly greater than the contrary economic result reasonably expected to be produced by the remainder of the hedging transaction (including both the underlying transaction or transactions and all elements of the hedging transaction with respect thereto) taken as a whole.
4. APPLICATION OF "PORTFOLIO INTEREST" EXCEPTION TO DEEMED INTEREST PAID TO NON-U.S. Bank. Under Treasury Regulation section 1.446-3(f), a significant nonperiodic payment under a swap is treated as a loan by one party to the swap to the other party with the consequence that the party receiving the nonperiodic payment (the "borrower") is generally deemed to repay the loan, with interest, over the term of the swap, and the other party (the "lender") is deemed to make larger periodic swap payments that offset the deemed principal and deemed interest payments on that loan.
The recharacterization that results in "interest" payments to the "lender" applies for all purposes of the Code. If the "borrower" is a U.S. entity but the "lender" is a non-U.S. entity, this recharacterization could result in the imposition of U.S. withholding tax on the deemed interest payments if the "lender" is related to the "borrower" or, perhaps, is a bank. This risk is attributable to the fact that "portfolio interest" (which is generally exempt from U.S. withholding tax) does not include interest received by certain non-U.S. related parties (Sections 871(h)(3) and 881(c)(3)(B), (C) of the Code) or by a non-U.S. bank on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business (Section 881(c)(3)(A) of the Code).
It is unclear whether the deemed loan arising from the recharacterization of a significant nonperiodic swap payment should be treated as such a loan agreement, although there are strong arguments to support the treatment of the deemed interest on such a deemed loan as portfolio interest. We would appreciate clarification of the IRS' view on this point.
Please feel free to call either of us at the numbers listed above if we can be of any further assistance.
Stephen L. Gordon
Deborah L. Paul
Cravath, Swaine & Moore
New York, New York
Internal Revenue Service
1111 Constitution Avenue, N.W.
Room 5228
Washington, DC 20224
Attention: CC:DOM:CORP:T:R (FI-54-93)
CC:DOM:CORP:T:R (FI-46-93)
235A
Copy to:
Jo Lynn Ricks, Esq.
Office of the Assistant Chief
Counsel (Financial Institutions and Products)
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, DC 20224
Attention: CC:DOM:FI&P
- AuthorsGordon, Stephen L.Paul, Deborah L.
- Institutional AuthorsCravath, Swaine & Moore
- Cross-ReferenceFI-46-93; FI-54-93
- Code Sections
- Subject Area/Tax Topics
- Index Termshedging transactions, capital assets
- Jurisdictions
- LanguageEnglish
- Tax Analysts Document NumberDoc 94-1130
- Tax Analysts Electronic Citation94 TNT 21-45