Regs. issued on integrated hedging transactions of qualifying debt.

• Author: Jimenez, Julio

On Sept. 6, 2012, the IRS published final and temporary regulations (T.D. 9598) and proposed regulations (REG-13848909) under Sec. 988(d) addressing certain integrated transactions that involve a foreign currency denominated debt instrument and multiple associated hedging transactions. The regulations provide that if a taxpayer has identified multiple hedges as being part of a qualified hedging transaction (which is referred to as "legging into" integrated treatment), and the taxpayer has terminated at least one but fewer than all of the hedges (which is referred to as "legging out" of a transaction), the taxpayer must treat the remaining hedges as having been sold for fair market value on the date of disposition of the terminated hedge. (The final and proposed regulations contain only a cross-reference to the temporary regulations.)

The temporary regulations apply to leg-outs that occur on or after Sept. 6, 2012. Under Regs. Sec. 1.988-5(a)(6)(ii), leg-outs mean that a taxpayer disposes of all or a part of the qualifying debt instrument or hedge before the maturity of the qualified hedging transaction or changes a material term of the qualifying debt instrument or hedge. This results in "legging out" of integrated treatment.

Background

Sec. 988 and its regulations generally provide that foreign currency gain or loss with respect to a "Sec. 988 transaction" is (1) recognized at the time established by the recognition provisions of the Code that apply to the sale or other disposition of property; (2) characterized as ordinary gain or loss; and (3) sourced based on the residence of the holder. The definition of a Sec. 988 transaction includes acquiring or becoming the obligor under a nonfunctional currency--denominated debt instrument and entering into or acquiring any nonfunctional currency--denominated forward contract, futures contract, option, or similar instrument. Under these general rules, a taxpayer who hedges foreign currency exposure arising from issuing or holding a debt instrument would have to separately account for the hedge and the hedged item and could face mismatches in character, source, and timing of income (of which the last is likely to be the most significant).

To provide certainty of tax treatment for foreign currency hedging transactions that were fast becoming commonplace (such as fully hedged foreign currency borrowings) and to ensure that those transactions were taxed in accordance with their economic substance...