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SERVICE PROVIDES TEMPORARY GUIDANCE RELATING TO CERTAIN FULLY HEDGED FOREIGN CURRENCY TRANSACTIONS.

JAN. 2, 1986

Notice 87-11; 1987-1 C.B. 423

DATED JAN. 2, 1986
DOCUMENT ATTRIBUTES
  • Institutional Authors
    Internal Revenue Service
  • Cross-Reference

    Part III--Administrative, Procedural, and Miscellaneous

    Guidance Is Provided Under Section 988(d) of the Internal Revenue

    Code With Respect To Certain Fully Hedged Foreign Currency

    Transactions
  • Subject Areas/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Electronic Citation
    1987 TNT 1-20
Citations: Notice 87-11; 1987-1 C.B. 423

Notice 87-11

SECTION 1. INTRODUCTION

The Internal Revenue Service announces that it will issue regulations under section 988(d) of the Internal Revenue Code regarding certain fully hedged foreign currency transactions. Section 988(d) provides that to the extent provided in regulations, if any section 988 transaction is part of a 988 hedging transaction, all transactions which are part of such 988 hedging transaction shall be integrated and treated as a single transaction or otherwise treated consistently. The regulations to be issued will set forth the consequences of integrating and treating as a single transaction all transactions that comprise a fully hedged section 988 hedging transaction that is an integrated economic package. The regulations generally will follow the provisions of sections 2 through 6 of this notice and will integrate a section 988 hedging transaction only with respect to the taxpayer that enters into the transaction. Until such regulations are issued, taxpayers may rely on this notice with respect to transactions entered into after December 31, 1986, that occur in taxable years beginning after December 31, 1986.

SECTION 2. TRANSACTIONS TO WHICH THIS NOTICE APPLIES

(a) QUALIFIED HEDGING TRANSACTION--(1) IN GENERAL. This notice applies only to qualified hedging transactions as defined in this section 2. A qualified hedging transaction is an integrated economic package, as provided in paragraph (d) of this section, consisting of a qualifying transaction, as defined in paragraph (b) of this section, and a section 988 hedge, as defined in paragraph (c) of this section, provided that--

(i) the interest rate (fixed or floating) on the qualifying transaction is set and all exchange rates on the section 988 hedge are fixed on the same calendar day (the trade date, as defined in paragraph (e)(7) of this section) such that the cost or return with respect to such qualified hedging transaction is not affected by movements in exchange rates after the trade date, and

(ii) all transactions that comprise the qualified hedging transaction are entered into on or before the settlement date (as defined in paragraph (e)(8) of this section).

(2) EXCEPTIONS. This notice shall not apply with respect to--

(i) A qualified hedging transaction that creates a synthetic asset or liability denominated in a currency other than the dollar if the rate that approximates the Federal short- term rate in such currency is at least 20 percentage points higher that the Federal short-term rate (determined under section 1274(d)) on the trade date, or

(ii) A transaction that would be a qualified hedging transaction but for the fact that a component transaction is terminated prior to maturity.

(3) SERVICE SOLICITS COMMENTS. The Service solicits comments on the application of section 988(d) under the rules prescribed in this notice. The Service also solicits comments as to the possible application of section 988(d) to transactions not described in this notice, including:

(i) Transactions in which the interest rate with respect to the qualifying transaction is set and the exchange rates with respect to the hedge are fixed on different calendar days,

(ii) Transactions in which either the hedge or the qualifying transaction is terminated prior to maturity,

(iii) Transactions that are partially hedged.

(b) QUALIFYING TRANSACTION--(1) DEFINITION. A qualifying transaction is a borrowing under a debt instrument or the purchase of a debt instrument if the entire amount which the taxpayer (or qualified business unit of the taxpayer) is required to pay or is entitled to receive as a result of the transaction--

(i) Is denominated in terms of a functional currency, or

(ii) Is denominated in terms of a nonfunctional currency.

(2) EXCEPTIONS. A qualifying transaction does not include a borrowing under a debt instrument or the purchase of a debt instrument if the payment or receipt of interest and principal is denominated in more than one currency.

(c) DEFINITION OF A SECTION 988 HEDGE. A section 988 hedge (hereinafter referred to as a "hedge") is a spot contract, a swap agreement or agreements, forward contract, series of forward contracts or combination thereof that fixes the cost or return with respect to a qualifying transaction (or transactions) in terms of a currency other than the currency in which such qualifying transaction is denominated such that the cost or return is not affected by movements in exchange rates after the trade date (as defined in section 2(e)(7) of this notice).

(d) DEFINITION OF INTEGRATED ECONOMIC PACKAGE. (1) IN GENERAL. For purposes of this notice, a qualifying transaction and a hedge are an integrated economic package if--

(i) The qualifying transaction and the hedge are a package as defined in paragraph (d)(2) of this section, and

(ii) The qualifying transaction and the hedge make up one of the economically integrated transactions enumerated in paragraph (d)(3) of this section.

(2) DEFINITION OF A PACKAGE. A qualifying transaction and a hedge are a package if all the requirements of this section 2(d)(2) are satisfied as follows--

(i) The interest rate (fixed or floating) on a qualifying transaction that is a borrowing under a debt instrument or the rate of return (fixed or floating) on a qualifying transaction that is the purchase of a debt instrument is set, and the exchange rates on the hedge are fixed, on the trade date.

(ii) None of the parties to the qualifying transaction or hedge are related as defined in section 2(e)(4) of this notice.

(iii) The identification requirements of section 3 of this notice are satisfied.

(iv) Except with respect to a transaction described in section 2(d)(3)(vi), the total initial amount borrowed under a debt instrument or the total initial amount paid to acquire a debt instrument that is the qualifying transaction is hedged at an exchange rate determined on the trade date.

(v) All subsequent interest and principal amounts paid with respect to a qualifying transaction that is a borrowing or all subsequent interest and principal amounts received with respect to a qualifying transaction that is the purchase of a debt instrument are hedged throughout the term of the qualifying transaction at an exchange rate determined on the trade date.

(vi) The qualifying transaction matures on the same day the hedge expires. (A hedge expires on the last day a payment is made or received under the terms of the hedge.)

(vii) In the case of a qualified business unit with a residence, as defined in section 988(a)(3)(B) of the Code, outside of the United States, or a qualified business unit resident in the United States with a functional currency other than the dollar, both the qualifying transaction and the hedge are entered into by the same qualified business unit and the interest income or expense from the qualified hedging transaction is properly reflected on the books of such qualified business unit throughout the term of the qualified hedging transaction.

(viii) Subject to the limitations of section 2(d)(2)(vii) of this notice, both the qualifying transaction and the hedge are entered into by the same individual, partnership, trust, estate, or corporation. With respect to a corporation, the same corporation must enter into both the qualifying transaction and the hedge whether or not such corporation is a member of an affiliated group of corporations that files a consolidated return.

(ix) With respect to a foreign person engaged in a U.S. trade or business that enters into a qualifying transaction or hedge through such trade or business, all items of income and expense associated with the qualifying transaction and the hedge, would have been effectively connected with such U.S. trade or business throughout the term of the qualified hedging transaction had the provisions of this notice not applied.

(3) ECONOMICALLY INTEGRATED TRANSACTIONS. A qualifying transaction and a hedge are economically integrated if--

(i) The hedge effectively converts a qualifying transaction that is a nonfunctional currency borrowing into a functional currency borrowing. A nonfunctional currency borrowing is effectively converted into a functional currency borrowing if--

(A) The entire principal amount of nonfunctional currency received from the borrowing is sold or exchanged for functional currency on the settlement date at a rate fixed on the trade date, and

(B) The terms of the hedge provide for the acquisition of the borrowed nonfunctional currency, in exchange for functional currency, on the calendar day when interest and principal payments are due on the borrowing and in an amount which equals such interest and principal payments.

(ii) The hedge effectively converts a qualifying transaction that is a borrowing in one nonfunctional currency (first nonfunctional currency) into a borrowing in a second nonfunctional currency. A borrowing in one nonfunctional currency is effectively converted into a borrowing in a second nonfunctional currency if--

(A) The entire principal amount of the first nonfunctional currency received from the borrowing is sold or exchanged for a second nonfunctional currency on the settlement date at a rate fixed on the trade date, and

(B) The terms of the hedge provide for the acquisition of the borrowed nonfunctional currency (i.e., the first nonfunctional currency), in exchange for the second nonfunctional currency, on the calendar day when interest and principal payments are due on the borrowing and in an amount which equals such interest and principal payments.

(iii) The hedge effectively converts a qualifying transaction that is a functional currency borrowing into a nonfunctional currency borrowing. A functional currency borrowing is effectively converted into a nonfunctional currency borrowing if--

(A) The entire principal amount of functional currency received from the borrowing is sold or exchanged for nonfunctional currency on the settlement date at a rate fixed on the trade date, and

(B) The terms of the hedge provide for the acquisition of the borrowed functional currency, in exchange for that nonfunctional currency on the calendar day when interest and principal payments are due on the borrowing and in an amount which equals such interest and principal payments.

(iv) The hedge effectively converts a qualifying transaction that is the purchase of a nonfunctional currency denominated debt instrument into a functional currency denominated debt instrument. The purchase of a nonfunctional currency denominated debt instrument is effectively converted into the purchase of a functional currency denominated debt instrument if--

(A) In exchange for functional currency, the purchaser acquires on the trade date (at a rate set on such date), for delivery on the settlement date, an amount of nonfunctional currency equal to the purchase price of the debt instrument and exchanges such nonfunctional currency for the debt instrument on the settlement date, and

(B) The terms of the hedge provide for the sale or exchange of the nonfunctional currency denominated interest and principal payments received under the debt instrument for functional currency, at a rate fixed on the trade date, on the calendar day when such payments are received.

(v) The hedge effectively converts a qualifying transaction that is the purchase of a debt instrument denominated in one nonfunctional currency into the purchase of a debt instrument denominated in a second nonfunctional currency. The purchase of a debt instrument denominated in one nonfunctional currency (first nonfunctional currency) is effectively converted into a debt instrument denominated in a second nonfunctional currency if--

(A) In exchange for functional currency, the purchaser acquires on the trade date (at a rate set on such date), for delivery on the settlement date, an amount of the first nonfunctional currency equal to the purchase price of the debt instrument and exchanges that nonfunctional currency for the debt instrument on the settlement date, and

(B) The terms of the hedge provide for the exchange of the first nonfunctional currency denominated interest and principal payments received under the debt instrument for a second nonfunctional currency, at a rate fixed on the trade date, on the calendar day such payments are received.

(vi) The hedge effectively converts a qualifying transaction that is the purchase of a functional currency denominated debt instrument into a nonfunctional currency denominated debt instrument. The purchase of a functional currency denominated debt instrument is effectively converted into the purchase of a nonfunctional currency denominated debt instrument if--

(A) The purchaser acquires the functional currency denominated debt instrument for functional currency, and

(B) The terms of the hedge provide for the sale or exchange of the functional currency denominated interest and principal payments received under the debt instrument for nonfunctional currency, at a rate fixed on the trade date, on the calendar day when such payments are received.

(e) OTHER DEFINITIONS.

(1) FUNCTIONAL CURRENCY. For the definition of functional currency, see section 985 of the Code.

(2) NONFUNCTIONAL CURRENCY. A nonfunctional currency is any currency other than a functional currency.

(3) QUALIFIED BUSINESS UNIT. For the definition of qualified business unit, see section 989(a) of the Code.

(4) RELATED. The term "related" means the relationships defined in section 267(b) and section 707(b)(1) of the Code.

(5) SWAP AGREEMENT. A contract in which two parties agree to exchange simultaneously one currency for another at a predetermined rate, in which each party's obligation to perform is contingent upon the other party's performance.

(6) SPOT CONTRACT. A contract for the purchase or sale of currency which requires delivery in two business days or less.

(7) TRADE DATE. The one calendar day on which both--

(i) The interest rate (fixed or floating) on a qualifying transaction that is a borrowing under a debt instrument or the rate of return (fixed or floating) on a qualifying transaction that is the purchase of a debt instrument is set, and

(ii) All exchange rates on the hedge are fixed.

(8) SETTLEMENT DATE. The first calendar day on which--

(i) With respect to a qualifying transaction that is a borrowing, proceeds of the borrowing are credited to the taxpayer's account, otherwise made available so that the taxpayer may draw upon such proceeds at any time, or actually received by the taxpayer, or

(ii) With respect to a qualifying transaction that is the purchase of a debt instrument, the debt instrument is available for delivery to the taxpayer or is credited to the taxpayer's account.

(9) DEBT INSTRUMENT. The term debt instrument means a bond, debenture, note, certificate or similar financial instrument but does not include--

(1) Accounts payable, accounts receivable or similar items of expense or income, or

(2) A debt instrument issued as part of a transaction subject to sections 483 or 1274 of the Code. For purposes of applying sections 483 and 1274, currency (functional or nonfunctional) shall not be considered property.

(10) PURCHASE. The term purchase includes an extension of credit.

SECTION 3. IDENTIFICATION REQUIREMENTS

(a) IN GENERAL. In order to satisfy the identification requirements of this section, a taxpayer must:

(1) Identify a qualified hedging transaction on its books and records in accordance with paragraph (b) of this section before the close of the trade date, and

(2) Verify in accordance with paragraph (c) of this section that the interest rate on the qualifying transaction was set and the exchange rates on the hedge were fixed on the trade date.

In the case of an individual, the close of the trade date is midnight (local time) in the location of the individual's principal residence. In the case of any qualified business unit of a taxpayer, the close of the trade date is midnight (local time) in the location of such unit's principal place of business.

(b) IDENTIFICATION ON BOOKS AND RECORDS OF THE TAXPAYER OR QUALIFIED BUSINESS UNIT. A taxpayer, or qualified business unit of a taxpayer, must establish a separate account on its books and records designated "Qualified Hedging Account." Before the close of the trade date, such person must enter into the account--

(1) A description of the qualifying transaction including the interest rate and the date such rate was set,

(2) A description of all elements of the hedge including the exchange rates and the date such exchange rates were fixed, and

(3) A summary of the cash flows resulting from the qualified hedging transaction.

(c) VERIFICATION THAT THE INTEREST RATE WAS SET AND THE EXCHANGE RATES WERE FIXED ON THE SAME DAY--

(1) PRESUMPTION. A taxpayer is presumed to have verified that the interest rate on the qualifying transaction was set and the exchange rates on the hedge were fixed on the trade date if the taxpayer receives independent verification as defined in paragraph (c)(3) of this section from one or more persons with respect to all of the information identified on its books and records pursuant to paragraph (b) of this section.

(2) CORROBORATING EVIDENCE. If the presumption of paragraph (c)(l) of this section does not apply, the burden shall be on the taxpayer to establish that the interest rate on the qualifying transaction was set and the exchange rates on the hedge were fixed on the trade date. If the taxpayer fails to provide evidence other than the information entered on its books and records in accordance with paragraph (b) of this section and its own testimony, the identification requirements of this section shall not be satisfied unless the taxpayer shows good cause for such failure.

(3) INDEPENDENT VERIFICATION. Independent verification means:

(i) A written confirmation received from the person or persons (including an underwriter in a firm commitment underwriting) with respect to whom the qualifying transaction or the hedge is entered into, or

(ii) A written contract (e.g., a swap contract) signed and dated by the parties to the transaction.

(d) IDENTIFICATION BY THE COMMISSIONER. If--

(1) A person enters into a qualifying transaction and a hedge but fails to comply with one or more of the requirements of sections 2 and 3 of this announcement, and

(2) On the basis of all the facts and circumstances, the Commissioner concludes that the qualifying transaction and the hedge are, in substance, a qualified hedging transaction,

then the Commissioner may treat the qualifying transaction and the hedge as a qualified hedging transaction for all purposes of this notice. The Commissioner may identify a qualifying transaction and a hedge as a qualified hedging transaction even though the qualifying transaction and the hedge are entered into by different related corporations (as defined in section 2(e)(4) of this notice), or by a domestic corporation and a qualified business unit with a residence outside the United States. With respect to a qualifying transaction and a hedge that are treated by the Commissioner as a qualified hedging transaction under this section 3(d), the qualifying transaction and the hedge each remain, at the discretion of the Commissioner, subject to the rules of sections 1092 and 263(g).

SECTION 4. TAXATION OF QUALIFIED HEDGING TRANSACTIONS

(a) IN GENERAL--(1) GENERAL RULE. If a transaction constitutes a qualified hedging transaction as defined in section 2 of this announcement, the qualifying transaction and the hedge are integrated and treated as a single transaction with respect to the taxpayer that has entered into the qualified hedging transaction. Except as provided in section 3(d) of this notice, neither the qualifying transaction nor the hedge that make up the qualified hedging transaction shall be subject to section 263(g), 1092 or 1256.

(2) SPECIAL RULE FOR INCOME OR EXPENSE OF FOREIGN PERSONS EFFECTIVELY CONNECTED WITH A U.S. TRADE OR BUSINESS. Interest income of a foreign person resulting from a qualified hedging transaction entered into by such foreign person that satisfies the requirements of section 2(d)(2)(ix) of this notice shall be treated as effectively connected with a U.S. trade or business. Interest expense of a foreign person resulting from a qualified hedging transaction entered into by such foreign person that satisfies the requirements of section 2(d)(2)(ix) of this notice shall be allocated and apportioned under section 1.882-5 of the regulations.

(3) SPECIAL RULE FOR FOREIGN PERSONS THAT ENTER INTO QUALIFIED HEDGING TRANSACTIONS GIVING RISE TO U.S. SOURCE INCOME NOT EFFECTIVELY CONNECTED WITH A U.S. TRADE OR BUSINESS. If a foreign person enters into a qualified hedging transaction that gives rise to U.S. source interest income (determined under the source rules for synthetic asset transactions as provided in this section) not effectively connected with a U.S. trade or business of such foreign persons, for purposes of sections 871(a), 881, 1441, 1442 and 6049, the provisions of this notice shall not apply and such sections of the Code shall be applied separately to the qualifying transaction and the hedge. To the extent relevant to any foreign person, if the requirements of this notice are otherwise met, the provisions of this notice shall apply for all other purposes of the Code (e.g., for purposes of calculating the earnings and profits of a controlled foreign corporation that enters into a qualified hedging transaction through a qualified business unit resident outside the United States, income or expense with respect to such qualified hedging transaction shall be calculated under the provisions of this notice).

(b) INCOME TAX EFFECTS OF INTEGRATION. The income tax effects of integrating and treating a transaction as a single transaction are determined under paragraphs 1 through 6 of this section 4(b).

(1) QUALIFIED HEDGING TRANSACTION THAT EFFECTIVELY CONVERTS A NONFUNCTIONAL CURRENCY BORROWING INTO A FUNCTIONAL CURRENCY BORROWING. The income tax effects of integrating a qualified hedging transaction described in section 2(d)(3)(i) of this notice are as follows--

(i) DEEMED FUNCTIONAL CURRENCY BORROWING. The integration of the nonfunctional currency denominated borrowing and the hedge results in a deemed functional currency borrowing with respect to the borrower. The amount deemed to be borrowed equals the total amount of functional currency received under the terms of the hedge in exchange for the total amount of the nonfunctional currency borrowed. The total amount of interest and principal deemed to be paid equals the total amount of functional currency paid under the terms of the hedge to acquire the nonfunctional currency necessary to make interest and principal payments on the nonfunctional currency borrowing.

(ii) DETERMINATION OF INTEREST EXPENSE OF THE BORROWER. The interest expense deductble by the borrower shall be determined as follows--

(A) The issue price and stated redemption price at maturity of the deemed functional currency borrowing shall be determined under the provisions of section 1273 and the regulations thereunder in units of the functional currency.

(B) If the deemed functional currency borrowing has original issue discount (OID) within the meaning of section 1273(a)(1), then the rules of section 163(e) and the regulations thereunder shall govern the manner in which such discount is deductible by the borrower.

(C) Any interest expense other than OID with respect to the deemed functional currency borrowing shall be deductible from gross income under section 163(a) (subject to any limitations on deductibility contained in other sections of the Code) in accordance with the borrower's regular method of accounting.

(iii) ALLOCATION AND APPORTIONMENT OF INTEREST EXPENSE. The interest expense determined pursuant section 4(b)(1)(ii) of this notice shall be allocated and apportioned under sections 1.861-8 and 1.882-5 of the regulations as the case may be (subject to section 864(e) of the Code).

(2) QUALIFIED HEDGING TRANSACTION THAT EFFECTIVELY CONVERTS A BORROWING IN ONE NONFUNCTIONAL CURRENCY INTO A BORROWING IN A SECOND NONFUNCTIONAL CURRENCY. The income tax effects of integrating a qualified hedging transaction described in section 2(d)(3)(ii) of this notice are as follows--

(i) DEEMED BORROWING IN THE SECOND NONFUNCTIONAL CURRENCY. The integration of the nonfunctional currency borrowing (i.e., first nonfunctional currency) and the hedge results in a deemed borrowing in the second nonfunctional currency. The amount deemed to be borrowed equals the total amount of the second nonfunctional currency received under the terms of the hedge in exchange for the total amount of the first nonfunctional currency borrowed. The total amount of interest and principal deemed to be paid equals the total amount of the second nonfunctional currency paid under the terms of the hedge to acquire the first nonfunctional currency necessary to make interest and principal payments on the first nonfunctional currency borrowing.

(ii) DETERMINATION OF INTEREST EXPENSE OF THE BORROWER. The interest expense deductible by the borrower shall be determined as follows--

(A) The issue price and stated redemption price at maturity of the deemed borrowing in the second nonfunctional currency shall be determined by applying the provisions of section 1273 and the regulations thereunder directly to the units of the second nonfunctional currency used to make the interest and principal payments under the deemed borrowing.

(B) If the deemed borrowing in the second nonfunctional currency has original issue discount (OID) within the meaning of section 1273(a)(1), then the rules of section 163(e) and the regulations thereunder shall govern the manner in which the amount of such discount denominated in units of the second nonfunctional currency is determined. The amount of discount deductible by the borrower in his functional currency shall be the amount determined in the manner described in the preceding sentence, translated into the borrower's functional currency using the weighted average exchange rate for the accrual period. Any amounts of qualified periodic interest (as defined in section 1.1273-1(b)(1)(ii) of the proposed regulations) shall be translated into the borrower's functional currency at the spot rate on the date of payment and deducted from gross income in accordance with the borrower's regular method of accounting.

(C) Any interest expense other than OID with respect to the deemed second nonfunctional currency borrowing shall be determined under section 163(a) in units of the second nonfunctional currency (subject to any limitations on deductibility contained in other sections of the Code). The interest expense deductible by the borrower in his functional currency shall be the amount determined in the manner described in the preceding sentence, translated into the borrower's functional currency at the spot rate on the date of payment and deducted in accordance with the taxpayer's regular method of accounting.

(iii) ALLOCATION AND APPORTIONMENT. The interest expense determined pursuant to section 4(b)(2)(ii) of this notice shall be allocated and apportioned under sections 1.861-8 and 1.882-5 of the regulations as the case may be (subject to the section 864(e)).

(iv) DEEMED BORROWING IN THE SECOND NONFUNCTIONAL CURRENCY IS A POSITION UNDER SECTION 1092. The deemed borrowing in the second nonfunctional currency referred to in this section (4)(b)(2) is a position as defined in section 1092(d)(2).

(3) QUALIFIED HEDGING TRANSACTION THAT EFFECTIVELY CONVERTS A FUNCTIONAL CURRENCY BORROWING INTO A NONFUNCTIONAL CURRENCY BORROWING. The income tax effects of integrating a qualified hedging transaction described in section 2(d)(3)(iii) of this notice are as follows--

(i) DEEMED NONFUNCTIONAL CURRENCY BORROWING. The integration of the functional currency borrowing and the hedge results in a deemed nonfunctional currency borrowing. The amount deemed to be borrowed equals the total amount of nonfunctional currency received under the terms of the hedge in exchange for the total amount of functional currency borrowed. The total amount of interest and principal deemed to be paid equals the total amount of nonfunctional currency paid under the terms of the hedge to acquire the functional currency necessary to make interest and principal payments on the functional currency borrowing.

(ii) DETERMINATION OF INTEREST EXPENSE OF THE BORROWER. Interest expense deductible by the borrower shall be determined in the manner described in section 4(b)(2)(ii) of this notice by substituting the phrase "nonfunctional currency" for the phrase "second nonfunctional currency."

(iii) ALLOCATION AND APPORTIONMENT. The interest expense determined pursuant to section 4(b)(3)(ii) of this notice shall be allocated and apportioned under sections 1.861-8 or 1.882-5 of the regulations as the case may be (subject to section 864(e)).

(iv) DEEMED NONFUNCTIONAL CURRENCY BORROWING IS A POSITION UNDER SECTION 1092. The deemed nonfunctional currency borrowing referred to in this section 4(b)(3) is a position as defined in section 1092 (d)(2).

(4) QUALIFIED HEDGING TRANSACTION THAT EFFECTIVELY CONVERTS THE PURCHASE OF A NONFUNCTIONAL CURRENCY DENOMINATED DEBT INSTRUMENT INTO A FUNCTIONAL CURRENCY DENOMINATED DEBT INSTRUMENT. The income tax effects of integrating a qualified hedging transaction described in section 2(d)(3)(iv) of this notice are as follows--

(i) DEEMED FUNCTIONAL CURRENCY DENOMINATED DEBT INSTRUMENT. The integration of the nonfunctional currency denominated debt instrument and the hedge results in a deemed functional currency denominated debt instrument with respect to the holder. The purchase price of the deemed functional currency denominated debt instrument is the amount of the functional currency paid to acquire the nonfunctional currency used for the purchase of the nonfunctional currency denominated debt instrument. The total amount of interest and principal deemed received by the holder equals the total amount of functional currency received under the terms of the hedge in exchange for the nonfunctional currency interest and principal payments received pursuant to the terms of the nonfunctional currency denominated debt instrument.

(ii) DETERMINATION OF INTEREST INCOME. The interest income of the holder shall be determined as follows--

(A) The issue price and stated redemption price at maturity of the deemed functional currency denominated debt instrument shall be determined under section 1273 and the regulations thereunder in units of the functional currency.

(B) If the deemed functional currency denominated debt instrument has OID, then the interest income includible by the holder shall be determined pursuant to the provisions of section 1272 and the regulations thereunder.

(C) If the deemed functional currency denominated debt instrument does not have OID, then the interest shall be includible in gross income under section 61 in accordance with the holder's regular method of accounting.

(iii) SOURCE. The source of the deemed interest income shall be determined by reference to the source, as determined under sections 861(a)(1) and 862(a)(1), of the interest income that would have been received under the terms of the qualifying transaction had such transaction not been integrated pursuant to sections 2 and 4 of this notice.

(5) QUALIFIED HEDGING TRANSACTION THAT EFFECTIVELY CONVERTS THE PURCHASE OF A DEBT INSTRUMENT DENOMINATED IN ONE NONFUNCTIONAL CURRENCY INTO THE PURCHASE OF A DEBT INSTRUMENT DENOMINATED IN A SECOND NONFUNCTIONAL CURRENCY. The income tax effects of integrating a qualified hedging transaction described in section 2(d)(3)(v) of this notice are as follows--

(i) DEEMED PURCHASE OF A DEBT INSTRUMENT DENOMINATED IN THE SECOND NONFUNCTIONAL CURRENCY. The integration of the debt instrument denominated in the first nonfunctional currency and the hedge results in a deemed debt instrument denominated in the second nonfunctional currency (referred to as deemed second nonfunctional currency debt instrument) with respect to the holder. The purchase price of the deemed second nonfunctional currency denominated debt instrument is the amount of the first nonfunctional currency used to purchase the first nonfunctional currency denominated debt instrument on the settlement date translated into the second nonfunctional currency at the forward exchange rate between the two currencies (as determined on the trade date) with respect to the period between the trade date and the settlement date. The total amount of interest and principal received by the holder of the deemed second nonfunctional currency denominated debt instrument equals the total amount of the second nonfunctional currency received under the hedge in exchange for the first nonfunctional currency interest and principal payments.

(ii) DETERMINATION OF INTEREST INCOME. The interest income of the holder shall be determined as follows--

(A) The issue price and stated redemption price at maturity of the deemed second nonfunctional currency denominated debt instrument shall be determined by applying the provisions of section 1273 and the regulations thereunder directly to the units of the second nonfunctional currency to be received in exchange for the interest and principal payments to be received under the debt instrument.

(B) If the deemed second nonfunctional currency denominated debt instrument has OID, then the rules of section 1272 and the regulations thereunder shall govern the manner in which the amount of such discount denominated in units of the second nonfunctional currency is determined. The amount of discount includible by the holder in his functional currency under section 1272 shall be the amount determined in the manner described in the preceding sentence, translated into the holder's functional currency at the weighted average exchange rate for the accrual period. Any amounts of qualified periodic interest (as defined in section 1.1273-1(b)(1)(ii) of the proposed regulations) shall be translated into the holder's functional currency at the spot rate on the date of payment and included in gross income in accordance with the holder's regular method of accounting.

(C) Any interest income other than OID with respect to the deemed second nonfunctional currency denominated debt instrument shall be determined in units of the second nonfunctional currency. The interest income includible by the holder in his functional currency shall be the amount determined in the manner described in the preceding sentence, translated into the holder's functional currency at the spot rate on the date of payment.

(iii) SOURCE. The source of the deemed interest income shall be determined by reference to the source, as determined under section 861(a)(1) and 862(a)(1), of the interest income that would have been received under the terms of the qualifying transaction had such transaction not been integrated pursuant to sections 2 and 4 of this notice.

(iv) DEEMED DEBT INSTRUMENT IS A POSITION UNDER SECTION 1092. The deemed debt instrument referred to in this section 4(b)(5) is a position as defined in section 1092 (d)(2).

(6) QUALIFIED HEDGING TRANSACTION THAT EFFECTIVELY CONVERTS THE PURCHASE OF A FUNCTIONAL CURRENCY DENOMINATED DEBT INSTRUMENT INTO A NONFUNCTIONAL CURRENCY DENOMINATED DEBT INSTRUMENT. The income tax effects of integrating a qualified hedging transaction described in section 2(d)(3)(vi) of this notice are as follows--

(i) DEEMED PURCHASE OF A NONFUNCTIONAL CURRENCY DENOMINATED DEBT INSTRUMENT. The integration of the functional currency denominated debt instrument and the hedge results in a deemed nonfunctional currency denominated debt instrument. The purchase price of the deemed nonfunctional currency denominated debt instrument is the amount of functional currency used to purchase the functional currency denominated debt instrument on the settlement date translated into nonfunctional currency at the forward exchange rate between the two currencies (as determined on the trade date) with respect to the period between the trade date and the settlement date. The total amount of interest and principal received by the holder equals the total amount of nonfunctional currency received under the terms of the hedge in exchange for the functional currency interest and principal payments.

(ii) DETERMINATION OF INTEREST INCOME. Interest income shall be determined in the manner described in section 4(b)(5)(ii) of this notice by substituting the phrase "nonfunctional currency" for the phrase "second nonfunctional currency."

(iii) SOURCE. The source of the deemed interest income shall be determined by reference to the source, as determined under sections 861(a)(1) and 862(a)(1), of the interest income that would have been received under the terms of the qualifying transaction had such transaction not been integrated pursuant to sections 2 and 4 of this notice.

(iv) DEEMED NONFUNCTIONAL CURRENCY DEBT INSTRUMENT IS A POSITION UNDER SECTION 1092. The deemed nonfunctional currency debt instrument referred to in this section 4(b)(6) is a position as defined in section 1092 (d).

c) EXAMPLES.

EXAMPLE (1). SYNTHETIC FUNCTIONAL CURRENCY LIABILITY (NONFUNCTIONAL CURRENCY BORROWING HEDGED WITH A SWAP). X, a U.S. corporation, has currency A as its functional currency. (The term "currency A" is used to designate a functional currency which, subject to the limitations of section 985, can be the United States dollar or any other currency.) On December 24, 1987 (the trade date), X agrees to close the following transaction on December 31, 1987 (settlement date). X will borrow from an unrelated party on December 31, 1987, 100 units of currency B for 3 years at a 10 percent rate of interest, payable annually, with no principal payment due until the final installment. X will also enter into a swap agreement with an unrelated counterparty under the terms of which--(1) X will swap, on December 31, 1987, the 100 units of currency B obtained from the borrowing for 100 units of currency A, and (2) X will exchange currency A for currency B pursuant to the following table in order to obtain the units of currency B necessary to make payments on the currency B borrowing:

DATE CURRENCY A CURRENCY B

 

____ __________ __________

 

 

December 31, 1988 8 10

 

 

December 31, 1989 8 10

 

 

December 31, 1990 108 110

 

 

The interest rate on the borrowing is set and the exchange rates on the swap are fixed on December 24, 1987.

On December 31, 1987, X borrows the 100 currency B units and swaps such units for 100 currency A units. Assume X has satisfied the identification and verification requirements of section 3 of this notice.

The currency B borrowing (which constitutes a qualifying transaction under section 2(b) of this announcement) and the swap agreement (which constitutes a hedge under section 2(c)) are a qualified hedging transaction as defined in section 2(a). Accordingly, the currency B borrowing and the swap are integrated and treated as one transaction with the following consequences: (1) The integration of the currency B borrowing and the swap results in a deemed currency A borrowing in an amount equal to the 100 currency A units received on December 31, 1987 in exchange for the 100 units of currency B. Accordingly, the issue price under section 1273(b)(2) is 100 currency A units. (2) The total amount of interest and principal paid by X with respect to the deemed currency A borrowing is equal to the currency A payments made by X under the swap agreement (i.e., 8 currency A units in 1988, 8 currency A units in 1989 and 108 currency A units in 1990). (3) The stated redemption price at maturity (defined in section 1273(a)(2) and section 1.1273-1(b)(l) of the proposed regulations as the amount payable at maturity other than a payment of qualified periodic interest) is 100 currency A units. Since the stated redemption price equals the issue price, there is no OID on the deemed currency A borrowing. (4) X may deduct the annual interest payments of 8 currency A units under section 163(a) (subject to any limitations on deductibility imposed by other provisions of the Code) according to its regular method of accounting. X has also paid 100 currency A units as a return of principal in 1990. (5) X must allocate and apportion its interest expense under section 1.861- 8 of the regulations (subject to section 864(e) of the Code).

EXAMPLE (2). SYNTHETIC FUNCTIONAL CURRENCY LIABILITY (NONFUNCTIONAL CURRENCY BORROWING HEDGED WITH FORWARD CONTRACTS)-- HIGHER INTEREST RATE CURRENCY. X, a U.S. corporation, has currency A as its functional currency. (The term "currency A" is used to designate a functional currency which, subject to the limitations of section 985, can be the United States dollar or any other currency.) On December 24, 1987 (the trade date), when the spot rate is one unit of currency A equals one unit of currency B, X agrees to close the following transaction on December 31, 1987 (settlement date). X will borrow 100 units of currency B from an unrelated party on December 31, 1987 for three years at 10 percent interest, payable annually, with no principal payment due until the final installment. X also enters into a series of contracts with a bank to: 1) sell forward the 100 units of currency B for 99.96 units of currency A on December 31, 1987, and (2) buy forward for currency A, the amount of currency B required to make the interest and principal payments due under the currency B borrowing according to the following schedule:

DATE CURRENCY A CURRENCY B

 

____ ___________ __________

 

 

December 31, 1988 9.81 10

 

 

December 31, 1989 9.64 10

 

 

December 31, 1990 104.07 110

 

 

The interest rate on the borrowing is set and the exchange rates on the forward contracts are fixed on December 24, 1987.

On December 31, 1987, X borrows 100 currency B units and exchanges such units for 99.96 currency A units. Assume X satisfies the identification and verification requirements of section 3 of this notice.

The currency B borrowing (which constitutes a qualifying transaction under section 2(b) of this announcement) and the series of forward contracts (which constitute a hedge under section 2(c)) are a qualified hedging transaction under section 2(a). Accordingly, the currency B borrowing and the forward contracts are integrated and treated as one transaction with the following consequences: (1) The integration of the currency B borrowing and the forward contracts results in a deemed currency A borrowing in an amount equal to the 99.96 currency A units received on December 31, 1987 for the 100 units of borrowed currency B. Accordingly, the issue price under section 1273 (b)(2) is 99.96 currency A units. (2) The total amount of interest and principal paid by X with respect to the deemed currency A borrowing is equal to the currency A payments made by X under the forward purchase contracts (i.e., 9.81 currency A units in 1988, 9.64 currency A units in 1989 and 104.07 currency A units in 1990). (3) The deemed currency A borrowing is an installment obligation within the meaning of section 1.1273-1(b)(2)(i) of the proposed regulations and its stated redemption price at maturity (defined in section 1273(a)(2) and section 1.1273-1(b)(2)(ii) of the proposed regulations as the sum of all payments to be made under the borrowing other than qualified periodic interest) is 99.96 currency A units (i.e., under section 1.1273-1(b)(1)(ii), 8.00 units of the currency A payment in 1988, 7.86 units of the currency A payment in 1989, and 7.71 units of the currency A payment in 1990 are treated as qualified periodic interest payments). Since the stated redemption price at maturity is equal to the issue price, under section 1273(a)(1) there is no OID on the deemed currency A borrowing. (3) The yield to maturity (as defined in section 1.1272-1(f) of the proposed regulations) of the deemed currency A borrowing is 8.00 percent, compounded annually. (4) Therefore, assuming X is a calendar year taxpayer, it may deduct as interest expense under section 163(a) (subject to any limitations on deductibility imposed by other provisions of the Code) 8.00 currency A units in 1988, 7.86 currency A units in 1989, and 7.71 currency A units in 1990. The remainder of each payment is a return of principal. (5) X must allocate and apportion its interest expense under section 1.861-8 of the regulations (subject to section 864(e) of the Code).

EXAMPLE (3). SYNTHETIC FUNCTIONAL CURRENCY LIABILITY (NONFUNCTIONAL CURRENCY BORROWING HEDGED WITH FORWARD CONTRACTS)-- LOWER INTEREST RATE CURRENCY. The facts are the same as example 2, except the interest rate on the currency B borrowing is 6 percent, payable annually, and the amount of currency A units received in exchange for the proceeds of the currency B borrowing pursuant to the terms of the forward contract is 100.04. X purchases currency B forward, in exchange for currency A, pursuant to the following schedule:

DATE CURRENCY A CURRENCY B

 

____ __________ __________

 

 

December 31, 1988 6.12 6

 

 

December 31, 1989 6.23 6

 

 

December 31, 1990 112.16 106

 

 

The currency B borrowing (which constitutes a qualifying transaction under section 2(b)) and the series of forward contracts (which constitute a hedge under section 2(c)) are a qualified hedging transaction under section 2(a). Accordingly, the currency B borrowing and the forward contracts are integrated and treated as one transaction with the following consequences: (1) The integration of the currency B borrowing and the forward contracts results in a deemed currency A borrowing in an amount equal to the currency A units received on December 31, 1987 for the 100 units of borrowed currency B. Accordingly, the issue price under section 1273(b)(2) is 100.04 currency A units. (2) The total amount of interest and principal paid by X with respect to the deemed currency A borrowing is equal to the currency A payments made by X under the forward purchase contracts (i.e., 6.12 currency A units in 1988, 6.23 currency A units in 1989, and 112.16 currency A units in 1990). (3) The deemed currency A borrowing is treated as an installment obligation within the meaning of section 1.1273-1(b)(2)(i) of the proposed regulations, and its stated redemption price at maturity (defined in section 1273(a)(2) of the Code and section 1.1273-1 (b)(2)(ii) of the proposed regulations as the sum of all payments to be made under the borrowing other than qualified periodic interest) is 106.15 currency A unite (i.e., under section 1.1273-1(b)(1)(ii), 6.12 units of the currency A payments in 1988, 1989 and 1990 are qualified periodic interest payments). Since the stated redemption price at maturity exceeds the issue price, under section 1273(a)(1) the deemed currency A borrowing has OID equal to 6.11 currency A units. (4) The yield to maturity of the deemed currency A borrowing is 8.00 percent, compounded annually. Assuming X is a calendar year taxpayer, it may deduct as interest expense 8.00 currency A units in 1988, (of which 1.88 currency A units constitutes OID), 8.15 currency A units in 1989, (of which 2.03 currency A units constitutes OID), and 8.32 currency A units in 1990, (of which 2.20 currency A units constitutes OID). The amount of the final payment in excess of the total interest expense is a return of principal and a payment of previously accrued OID. (5) X must allocate and apportion its interest expense under section 1.861-8 of the regulations (subject to section 864(e) of the Code).

EXAMPLE (4). SYNTHETIC FUNCTIONAL CURRENCY ASSET (NONFUNCTIONAL CURRENCY DENOMINATED DEBT INSTRUMENT HEDGED WITH FORWARD CONTRACTS)-- HIGHER INTEREST RATE CURRENCY. X, a U.S. corporation, has currency A as its functional currency. (The term "currency A" is used to designate a functional currency which, subject to the limitations of section 985, can be the United States dollar or any other currency.) On December 24, 1987, (the trade date) when the spot rate is one unit of currency A equals one unit of currency B, X enters into a forward contract to purchase 100 units of currency B forward from a bank in exchange for 99.96 units of currency A for delivery on December 31, 1987. The 100 units of currency B is to be used for the purchase of a currency B denominated debt instrument on December 31, 1987. The instrument will have a term of 3 years, an issue price of 100 currency B units, and will bear interest at 10 percent, payable annually, with no repayment of principal until the final installment. X also enters (on December 24, 1987) into a series of forward contracts to sell the currency B interest and principal payments for currency A according to the following schedule:

DATE CURRENCY A CURRENCY B

 

____ __________ __________

 

 

December 31, 1988 9.81 10

 

 

December 31, 1989 9.64 10

 

 

December 31, 1990 104.07 110

 

 

The rate of return on the currency B denominated debt instrument and the exchange rates on the forward contracts are fixed on December 24, 1987. On December 31, 1987, (the settlement date) X takes delivery of the 100 units of currency B and purchases the currency B denominated debt instrument. Assume X satisfies the identification and verification requirements of section 3 of this notice.

The purchase of the currency B denominated debt instrument (which constitutes a qualifying transaction under section 2(b) of this announcement) and the series of forward contracts (which constitute a hedge under section 2(c)) are a qualified hedging transaction under section 2(a). Accordingly, the currency B denominated debt instrument and the forward contracts are integrated and treated as one transaction with the following consequences: (1) The integration of the currency B denominated debt instrument and the forward contracts results in a deemed currency A denominated debt instrument in an amount equal to the currency A units exchanged under the forward contract to purchase the units of currency B necessary to acquire the currency B denominated debt instrument. Accordingly, the issue price is 99.96 currency A units (section 1273(b)(2) of the Code). (2) The total amount of interest and principal received by X with respect to the deemed currency A denominated debt instrument is equal to the currency A units received under the forward sales contracts (i.e., 9.81 currency A units in 1988, 9.64 currency A units in 1989, and 104.07 currency A units in 1990). (3) The deemed currency A denominated debt instrument is an installment obligation within the meaning of section 1.1273-1 (b)(2)(i) of the proposed regulations, and its stated redemption price at maturity (defined in section 1273(a)(2) of the Code and section 1.1273-1(b) (2)(ii) of the proposed regulations as the sum of all payments to be made under the debt instrument other than qualified periodic interest) is 99.96 currency A units, (i.e., under section 1.1273-1(b)(1)(ii) 8.00 units of the currency A payment in 1988, 7.86 units of the currency A payment in 1989, and 7.71 units of the currency A payment in 1990 are treated as qualified periodic interest payments). Since the stated redemption price at maturity is equal to the issue price, under section 1273(a)(1) there is no OID on the deemed currency A denominated debt instrument. (4) The yield to maturity (as defined in section 1.1272-l(f) of the proposed regulations) of the deemed currency A denominated debt instrument is 8.00 percent, compounded annually. Assuming X is a calendar year taxpayer, it must include interest income of 8.00 currency A units in 1988, 7.86 currency A units in 1989 and 7.71 currency A units in 1990. The remainder of each payment received is a payment of principal. (5) The source of the interest income (stated in (4) above) shall be determined by applying sections 861(a)(1) and 862(a)(1) with reference to the currency B denominated interest income that would have been received had the transaction not been integrated.

EXAMPLE (5). SYNTHETIC FUNCTIONAL CURRENCY ASSET (NONFUNCTIONAL CURRENCY DENOMINATED DEBT INSTRUMENT HEDGED WITH FORWARD CONTRACTS)-- LOWER INTEREST RATE CURRENCY. The facts are the same as in example 4, except the interest rate on the currency B denominated debt instrument is 6 percent, compounded annually, and on December 24, 1987 (the trade date), X enters into a forward contract to purchase 100 units of currency B in exchange for 100.04 units of currency A for delivery on December 31, 1987. X sells forward the amount of currency B that will be received under the terms of the currency B denominated debt instrument according to the following schedule:

DATE CURRENCY A CURRENCY B

 

____ __________ __________

 

 

December 31, 1988 6.12 6

 

 

December 31, 1989 6.23 6

 

 

December 31, 1990 112.16 106

 

 

The currency B denominated debt instrument (which constitutes a qualifying transaction under section 2(b) of this announcement) and the series of forward contracts (which constitute a hedge under section 2(c)) are a qualified hedging transaction under section 2(a). Accordingly, the currency B denominated debt instrument and the forward contracts are treated as one transaction with the following consequences: (1) The integration of the currency B denominated debt instrument and the forward contracts result in a deemed currency A denominated debt instrument in an amount equal to the currency A exchanged under the forward contract to purchase the units of currency B necessary to acquire the currency B denominated debt instrument. Accordingly, the issue price of the deemed currency A denominated debt instrument is 100.04 currency A units (section 1273(b)(2) of the Code). (2) The total amount of interest and principal received by X with respect to the deemed currency A denominated debt instrument is equal to the currency A units received under the forward sales contracts (i.e., 6.12 currency A units in 1988, 6.23 currency A units in 1989, and 112.16 currency A units in 1990). (3) The deemed currency A denominated debt instrument is an installment obligation within the meaning of section 1.1273- 1(b)(2)(i) of the proposed regulations, and its stated redemption price at maturity (defined in section 1273(a)(2) of the Code and section 1.1273-1(b)(2)(ii) of the proposed regulations as the sum of all payments to be made under the debt instrument other than qualified periodic interest) is 106.15 currency A units (i.e., under section 1.1273-1(b)(1)(ii) of the proposed regulations, 6.12 units of the currency A payments in 1988, 1989, and 1990 are qualified periodic interest payments). Since the stated redemption price at maturity exceeds the issue price, under section 1273(a)(1) the deemed currency A denominated debt instrument has OID of 6.11 currency A units. (4) The yield to maturity of the deemed currency A debt instrument is 8.00 percent, compounded annually. Assuming X is a calendar year taxpayer, it must include interest income of 8.00 currency A units in 1988 (of which 1.88 currency A units constitutes OID), 8.15 currency A units in 1989 (of which 2.03 currency A units constitutes OID), and 8.32 currency A units in 1990 (of which 2.20 currency A units constitutes OID). The amount of the final payment received by X in excess of the interest income includible is a return of principal and a payment of previously accrued OID. (5) The source of the interest income (stated in (4) above) shall be determined by applying section 861(a)(1) and 862(a)(1) with reference to the currency B denominated interest income that would have been received had the transaction not been integrated.

SECTION 5. TREATMENT OF A QUALIFYING TRANSACTION AND A HEDGE THAT FAIL TO QUALIFY AS A QUALIFIED HEDGING TRANSACTION

APPLICATION OF SECTIONS 263(q), 1092 AND 1256. Sections 63(g), 1092 and 1256 of the Code and the regulations thereunder apply to a qualifying transaction and a hedge that fail to qualify under section 2 of this announcement as a qualified hedging transaction.

SECTION 6. APPLICATION OF SECTIONS 1441 AND 1442

The provisions of this notice do not affect the obligation of any person to withhold under sections 1441 and 1442 with respect to actual interest payments on a qualifying transaction.

SECTION 7. CONTACT PERSONS

For further information, contact Jeffrey Dorfman or Alice Armitage Neff at the Office of the Associate Chief Counsel (International), Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224 (Attn: CC:INTL:Br5); Telephone 202-566- 3407 (not a toll free call). For information regarding the application of the original issue discount rules to transactions described in this announcement, contact Theresa Bearman at the same address and phone number.

SECTION 8. PAPERWORK REDUCTION ACT

The collection of information in this notice has been submitted to the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 and has been approved by O. M. B.(Control No. 1545-0983).

DOCUMENT ATTRIBUTES
  • Institutional Authors
    Internal Revenue Service
  • Cross-Reference

    Part III--Administrative, Procedural, and Miscellaneous

    Guidance Is Provided Under Section 988(d) of the Internal Revenue

    Code With Respect To Certain Fully Hedged Foreign Currency

    Transactions
  • Subject Areas/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Electronic Citation
    1987 TNT 1-20
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