Terminating debt instrument hedges.

• Author: Sair, Edward A.
• Position: Gains & Losses

Rev. Rul. 2002-71 clarifies when to account for gain or loss from a termination of a swap used to hedge a debt instrument. It generally provides that when the swap hedges the entire term of the underlying debt instrument, the gain or loss should be spread over the remaining term of the hedged debt. If the swap hedges only a portion of the debt's term, however, the gain or loss is spread over the remaining portion of the term hedged, that was the remaining term of the swap--not over the entire remaining debt term.

Many taxpayers enter into interest-rate swaps to hedge debt instruments. For instance, a taxpayer with a floating-rate borrowing may enter into a swap that essentially converts the borrowing into a fixed-rate borrowing. Under the swap, the taxpayer makes fixed-rate payments to its counterparty in return for receiving the floating rate under the swap; in practice, however, the payments ate typically netted.

If market interest rates rise, the taxpayer will have a built-in gain on the swap. If the taxpayer terminates the swap at that time, the taxpayer will receive a payment from its counterparty, representing the present value of anticipated future payments under the swap. Under the normal rules for accounting for swaps under Regs. Sec. 1.446-3, the termination payment would be recognized on the termination of the swap. The hedge timing rules, however, preempt the normal rules and would require the spread of gain over the term that the debt was hedged.

Under Regs. Sec. 1.446-4(e)(4), gain or loss from a hedging transaction "must be accounted for by reference to the terms of the debt instrument and the period or periods to which the hedge relates." Generally, the gain or loss is properly accounted for under constant-yield principles, as though it adjusted the yield of the debt instrument over the term to which the hedge relates.

Rev. Rul. 2002-71 addressed a situation in which an interest-rate swap hedged only a portion of the debt instrument's entire term. It provided two examples involving five-year swaps used to hedge debt instruments with a 10-year term. In both...