Foreign currency hedging transactions under Section 988 temporary regulations.by Kaepplinger, Peter
TRA 86's addition of Subpart J (i.e., Secs. 985-89) to the IRC was intended to provide guidance with respect to such issues as the timing, character and source of foreign currency transactions. Sec. 988(d), in particular, permits both legs of such hedging transactions to be integrated and treated as part of the same transaction. In order for a hedging transaction to qualify for integration, one leg must be a "Sec. 988 transaction," as defined, which in turn must be a part of a "Sec. 988 hedging transaction." This latter term is defined as a transaction which is primarily intended to reduce the risk of currency fluctuation with respect to current or future property holdings, borrowings or lending. Temp. Reg. 1.988-5T has been issued to provide guidance for taxpayers entering into hedging transactions. This regulation provides guidance for three common types of hedging transactions: 1) hedged borrowings and lendings; 2) hedged executory contracts for the sale and purchase of goods and services; and 3) hedges of certain publicly traded securities transactions by cash basis taxpayer. The regulations do not cover all offsetting foreign currency positions. For example, they, do not apply to hedges of equity investments in foreign branches and subsidiaries (e.g., "Hoover hedges"). The following is a discussion of the rules pertaining to the three covered types of transactions.
Hedged Borrowings and Lendings
Temp. Reg. 1.988-5T(a) provides integrated treatment for "qualified hedging transactions" ("QHTs") which consist of qualifying hedged borrowings and loans. These borrowings and lendings are to he distinguished from executory contracts for the sales and purchases of goods and services that are subject to "hedged executory contract" provisions discussed later. While these hedged borrowing and lending provisions are based on Notice 87-11, there are important differences, especially regarding hedges entered into after the hedged transaction, related party hedges and the method for identifying hedged transactions.
The consequences of qualifying as a QHT are that the hedge is ignored and the economic package, consisting of the two legs of the hedging transaction, is treated as a synthetic debt instrument denominated in the foreign currency that the taxpayer pays (under a liability hedge) or receives (under an asset hedge). Thus, the denomination of the synthetic debt is determined by reference to the denomination of the hedge. For example, a Swiss franc borrowing and a U.S. dollar-franc currency swap agreement that together qualify as a QHT would be treated as a synthetic U.S. dollar liability. The amount borrowed is considered equal to the amount of dollars received under the swap. The principal and interest paid would be considered equal to the amount of dollars paid under the Swap to acquire the francs necessary to make the principal and interest payments under the borrowing.
If a transaction qualifies as a synthetic borrowing or lending under these rules, the interest expense or income will be determined under the OID rules of Secs. 1272-75 and 163(e). If the QHT is a synthetic liability, the interest expense would be subject to allocation and apportionment under the Sec. 861 regulations. If the QHT is a synthetic asset, then the interest income would be sourced under Secs. 861 and 862.
A QHT is defined to consist of a qualified debt instrument," a "Sec. 988 hedge" and an "integrated economic transaction," all of which are defined in the regulations. A qualified debt instrument is any debt instrument other than accounts payable, accounts receivable, and similar items of income or expense. (These items are covered under the hedged executory contract provisions discussed below.) A hedge max include a spot foreign currency, contract, futures contract, forward contract, currency swap contract or combination thereof that permits the calculation of a yield to maturity for the synthetic instrument. Options will not qualify, for this purpose since then, do not permit the calculation of a yied to market.
To qualify as an integrated economic transaction, all nonfunctional currency payments must be fully hedged on the date that the transaction is identified, the hedge must be identified as part of the QHT on the day it is entered into, and both legs of the QHT must be held by the same taxpayer (e.g., the same qualified business unit, U.S. branch of a foreign taxpayer or U.S. taxpayer). As part of the identification process, certain information concerning the hedging transaction must be maintained by the taxpayer as provided in Temp. Reg. 1.988-5T(a)(8). These identification requirements include a description of the hedge and the hedged transaction (including the dates on which they were entered into), the date on which the two legs were identified as a hedging transaction and a summary of the cash flow resulting from the integrated treatment of the two legs.
The temporary regulations permit legging in" (i.e., entering into a hedge after the date that the debt is assumed or acquired) and "legging out'. (i.e., disposing of the debt or the hedge before maturity). Legging in is only permitted for preexisting debt. A taxpayer who "legs in" to a QHT is treated as if it sold the existing debt and bought a replacement debt obligation at fair market value on the identification date. The recognition of gain or loss on the deemed sale is deferred until the debt obligation matures or is otherwise disposed of Legging out is permitted with respect to the disposition of either leg of a pre- existing QHT. If a taxpayer "legs out" of a QHT, the gain or loss on the disposition is recognized. in addition, the remaining leg is marked to market and the resulting gain or loss is recognized. Although the hedged borrowing or lending may be due to or from a related party the hedge itself must be entered into with an unrelated party. Although partial hedging is permitted for hedged executory contracts, QHTs must be fully hedged. Finally, the IRS reserves the right to impose QHT treatment on nonqualifying transactions that in substance constitute a QHT.
Hedged Executory Contracts
Temp. Reg. 1.988-5T(b) provides rules for the integrated treatment of contracts for the purchase and sale of goods and services along with an associated hedge ("hedged executory contracts" or "HEKS"). The effect of such integration is that the amount of foreign currency paid or received under the hedge is treated as the income or sales price received or the expense or purchase price paid for the underlying property or service, Thus, for example, a taxpayer that has the U.S. dollar as its functional currency and that orders a machine whose sale price is in Swiss francs could "lock in" the dollar price of the machine at the time of the order using an authorized hedging instrument, such as a forward contract, for the delivery of francs at the time of delivery. The purchase price for the machine would be the amount of dollars paid under the contract regardless of the exchange rate at the time of sale.
To qualify for integration under these provisions, a transaction must satisfy the definition of an HEK which in turn consists of an executory contract and a hedge. The executory contract and the associated hedge must be identified on the day the hedge is entered into. A hedge man only be entered into on or after the date of the executory contract (i.e., only pre-existing executory contracts can be hedged). Both legs of the HEK must be held by the same taxpayer.
An executory contract is an agreement to pay or receive nonfunctional currency in the future for the sale or purchase of goods or services in the ordinary course of the taxpayer's business. Such purchase and sale agreements will only qualify as executory contracts prior to the date of accrual for tax purposes. After that date, the sale or purchase agreement is considered an account payable or receivable. Sec. 988 transactions (e.g., a forward contract to buy foreign currency) are excluded from the definition of executory contracts. A hedge is defined under these provisions to include a forward contract, futures contract, segregated bank account, or combination thereof, which reduces the risk of exchange rate fluctuations with respect to nonfunctional currency denominated executory contract transactions.
In contrast to the provisions for QHTS, the HEK rules permit partial hedging. Also, the hedge amount can be adjusted during the life of the transaction. However, the hedge can only be increased, since a decrease in the hedge is considered a termination of the HEK. Rolling hedges are permitted as well, provided the taxpayer enters into a successor contract on the next business day.
Legging in is permitted for a pre-existing executory contract at any time until the accrual date. The consequences of legging out depend on whether the disposition of a leg of an HEK occurs before or after the accrual date. If an executory contract is terminated before the accrual date, the associated hedge is treated as if sold for fair market value and the resulting gain or loss is recognized. If an identified hedge is disposed of prior to the accrual date, the resulting gain or loss is not recognized but, instead, is treated as an adjustment to the amount paid or received under the executory, contract. if the hedge is disposed of after the accrual date (i.e., during the receivable or payable period), no gain or loss on the disposition is recognized. The taxpayer continues to use the functional currency amount previously established for the receivable or payable, and exchange gain and loss is recognized on the receivable or payable for the period between the hedge disposition date and the payment date for the hedged obligation.
Cash Basis Taxpayer Hedging of Publicly Traded Securities Transactions
Temp. Reg. 1.988-5T(c) provides integrated treatment for the narrow class of transactions in which a cash basis taxpayer hedges the currency risk of a securities transaction on an established securities market between the trade and settlement dates. Thus, any gain or loss on the hedge is treated as an adjustment to the sale or purchase price of the stock. These provisions complement the rule of Temp. Reg. 1.988- 2T(a)(2)(iv) which provides that the foreign currency amounts paid or received in connection with such purchases and sales are translated on the settlement date.
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