1.988-5—Section 988(d) hedging transactions.
(a) Integration of a nonfunctional currency debt instrument and a
(1) In general.
This paragraph (a) applies to a qualified hedging transaction as defined in this paragraph (a)(1). A qualified hedging transaction is an integrated economic transaction, as provided in paragraph (a)(5) of this section, consisting of a qualifying debt instrument as defined in paragraph (a)(3) of this section and a § 1.988-5(a) hedge as defined in paragraph (a)(4) of this section. If a taxpayer enters into a transaction that is a qualified hedging transaction, no exchange gain or loss is recognized by the taxpayer on the qualifying debt instrument or on the § 1.988-5(a) hedge for the period that either is part of a qualified hedging transaction, and the transactions shall be integrated as provided in paragraph (a)(9) of this section. However, if the qualified hedging transaction results in a synthetic nonfunctional currency denominated debt instrument, such instrument shall be subject to the rules of § 1.988-2(b).
(2) Exception.
This paragraph (a) does not apply with respect to a qualified hedging transaction that creates a synthetic asset or liability denominated in, or determined by reference to, a currency other than the U.S. dollar if the rate that approximates the Federal short-term rate in such currency is at least 20 percentage points higher than the Federal short term rate (determined under section 1274(d)) on the date the taxpayer identifies the transaction as a qualified hedging transaction.
(3) Qualifying debt instrument—
(i) In general.
A qualifying debt instrument is a debt instrument described in § 1.988-1(a)(2)(i), regardless of whether denominated in, or determined by reference to, nonfunctional currency (including dual currency debt instruments, multi-currency debt instruments and contingent payment debt instruments). A qualifying debt instrument does not include accounts payable, accounts receivable or similar items of expense or income.
(ii) Special rule for debt instrument of which all payments are proportionately hedged.
If a debt instrument satisfies the requirements of paragraph (a)(3)(i) of this section, and all principal and interest payments under the instrument are hedged in the same proportion, then for purposes of this paragraph (a), that portion of the instrument that is hedged is eligible to be treated as a qualifying debt instrument, and the rules of this paragraph (a) shall apply separately to such qualifying debt instrument. See Example 8 in paragraph (a)(9)(iv) of this section.
(4) hedge—
(i) In general.
A § 1.988-5(a) hedge (hereinafter referred to in this paragraph (a) as a “hedge”) is a spot contract, futures contract, forward contract, option contract, notional principal contract, currency swap contract, similar financial instrument, or series or combination thereof, that when integrated with a qualifying debt instrument permits the calculation of a yield to maturity (under principles of section 1272) in the currency in which the synthetic debt instrument is denominated (as determined under paragraph (a)(9)(ii)(A) of this section).
(ii) Retroactive application of definition of currency swap contract.
A taxpayer may apply the definition of currency swap contract set forth in § 1.988-2(e)(2)(ii) in lieu of the definition of swap agreement in section 2(e)(5) of Notice 87-11, 1987-1 C.B. 423 to transactions entered into after December 31, 1986 and before September 21, 1989.
(5) Definition of integrated economic transaction.
A qualifying debt instrument and a hedge are an integrated economic transaction if all of the following requirements are satisfied—
(i)
All payments to be made or received under the qualifying debt instrument (or amounts determined by reference to a nonfunctional currency) are fully hedged on the date the taxpayer identifies the transaction under paragraph (a) of this section as a qualified hedging transaction such that a yield to maturity (under principles of section 1272) in the currency in which the synthetic debt instrument is denominated (as determined under paragraph (a)(9)(ii)(A) of this section) can be calculated. Any contingent payment features of the qualifying debt instrument must be fully offset by the hedge such that the synthetic debt instrument is not classified as a contingent payment debt instrument. See Examples 6 and 7 of paragraph (a)(9)(iv) of this section.
(ii)
The hedge is identified in accordance with paragraph (a)(8) of this section on or before the date the acquisition of the financial instrument (or instruments) constituting the hedge is settled or closed.
(iii)
None of the parties to the hedge are related. The term “related” means the relationships defined in section 267(b) or section 707(b).
(iv)
In the case of a qualified business unit with a residence, as defined in section 988(a)(3)(B), outside of the United States, both the qualifying debt instrument and the hedge are properly reflected on the books of such qualified business unit throughout the term of the qualified hedging transaction.
(v)
Subject to the limitations of paragraph (a)(5) of this section, both the qualifying debt instrument 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 debt instrument and the hedge whether or not such corporation is a member of an affiliated group of corporations that files a consolidated return.
(vi)
With respect to a foreign person engaged in a U.S. trade or business that enters into a qualifying debt instrument or hedge through such trade or business, all items of income and expense associated with the qualifying debt instrument and the hedge (other than interest expense that is subject to § 1.882-5 ), would have been effectively connected with such U.S. trade or business throughout the term of the qualified hedging transaction had this paragraph (a) not applied.
(6) Special rules for legging in and legging out of integrated treatment—
(i) Legging in.
“Legging in” to integrated treatment under this paragraph (a) means that a hedge is entered into after the date the qualifying debt instrument is entered into or acquired, and the requirements of this paragraph (a) are satisfied on the date the hedge is entered into (“leg in date”). If a taxpayer legs into integrated treatment, the following rules shall apply—
(A)
Exchange gain or loss shall be realized with respect to the qualifying debt instrument determined solely by reference to changes in exchange rates between—
(1) The date the instrument was acquired by the holder, or the date the obligor assumed the obligation to make payments under the instrument; and
(2) The leg in date.
(B)
The recognition of such gain or loss will be deferred until the date the qualifying debt instrument matures or is otherwise disposed of.
(C)
The source and character of such gain or loss shall be determined on the leg in date as if the qualifying debt instrument was actually sold or otherwise terminated by the taxpayer.
(ii) Legging out.
With respect to a qualifying debt instrument and hedge that are properly identified as a qualified hedging transaction, “legging out” of integrated treatment under this paragraph (a) means that the taxpayer disposes of or otherwise terminates all or a part of the qualifying debt instrument or hedge prior to maturity of the qualified hedging transaction, or the taxpayer changes a material term of the qualifying debt instrument (e.g., exercises an option to change the interest rate or index, or the maturity date) or hedge (e.g., changes the interest or exchange rates underlying the hedge, or the expiration date) prior to maturity of the qualified hedging transaction. A taxpayer that disposes of or terminates a qualified hedging transaction (i.e., disposes of or terminates both the qualifying transaction and the hedge on the same day) shall be considered to have disposed of or otherwise terminated the synthetic debt instrument rather than as legging out. If a taxpayer legs out of integrated treatment, the following rules shall apply—
(A)
The transaction will be treated as a qualified hedging transaction during the time the requirements of this paragraph (a) were satisfied.
(B)
If the hedge is disposed of or otherwise terminated, the qualifying debt instrument shall be treated as sold for its fair market value on the date the hedge is disposed of or otherwise terminated (the “leg-out date”), and any gain or loss (including gain or loss resulting from factors other than movements in exchange rates) from the identification date to the leg-out date is realized and recognized on the leg-out date. The spot rate on the leg-out date shall be used to determine exchange gain or loss on the debt instrument for the period beginning on the leg-out date and ending on the date such instrument matures or is disposed of or otherwise terminated. Proper adjustment to the principal amount of the debt instrument must be made to reflect any gain or loss taken into account. The netting rule of § 1.988-2(b)(8) shall apply.
(C)
If the qualifying debt instrument is disposed of or otherwise terminated, the hedge shall be treated as sold for its fair market value on the date the qualifying debt instrument is disposed of or otherwise terminated (the “leg-out date”), and any gain or loss from the identification date to the leg-out date is realized and recognized on the leg-out date. The spot rate on the leg-out date shall be used to determine exchange gain or loss on the hedge for the period beginning on the leg-out date and ending on the date such hedge is disposed of or otherwise terminated.
(D)
Except as provided in paragraph (a)(8)(iii) of this section (regarding identification by the Commissioner), that part of the qualified hedging transaction that has not been terminated (i.e., the remaining debt instrument in its entirety even if partially hedged, or hedge) cannot be part of a qualified hedging transaction for any period subsequent to the leg out date.
(E)
If a taxpayer legs out of a qualified hedging transaction and realizes a gain with respect to the terminated instrument, then paragraph (a)(6)(ii)(B) or (C) of this section, as appropriate, shall not apply if during the period beginning 30 days before the leg-out date and ending 30 days after that date the taxpayer enters into another transaction that hedges at least 50% of the remaining currency flow with respect to the qualifying debt instrument which was part of the qualified hedging transaction (or, if appropriate, an equivalent amount under the § 1.988-5 hedge which was part of the qualified hedging transaction).
(7) Transactions part of a straddle.
At the discretion of the Commissioner, a transaction shall not satisfy the requirements of paragraph (a)(5) of this section if the debt instrument making up the qualified hedging transaction is part of a straddle as defined in section 1092(c) prior to the time the qualified hedging transaction is identified.
(8) Identification requirements—
(i) Identification by the taxpayer.
A taxpayer must establish a record and before the close of the date the hedge is entered into, the taxpayer must enter into the record for each qualified hedging transaction the following information—
(A)
The date the qualifying debt instrument and hedge were entered into;
(B)
The date the qualifying debt instrument and the hedge are identified as constituting a qualified hedging transaction;
(C)
The amount that must be deferred, if any, under paragraph (a)(6) of this section and the source and character of such deferred amount;
(D)
A description of the qualifying debt instrument and the hedge; and
(E)
A summary of the cash flow resulting from treating the qualifying debt instrument and the hedge as a qualified hedging transaction.
(ii) Identification by trustee on behalf of beneficiary.
A trustee of a trust that enters into a qualified hedging transaction may satisfy the identification requirements described in paragraph (a)(8)(i) of this section on behalf of a beneficiary of such trust.
(iii) Identification by the Commissioner.
If—
(A)
A taxpayer enters into a qualifying debt instrument and a hedge but fails to comply with one or more of the requirements of this paragraph (a), and
(B)
On the basis of all the facts and circumstances, the Commissioner concludes that the qualifying debt instrument and the hedge are, in substance, a qualified hedging transaction,
then the Commissioner may treat the qualifying debt instrument and the hedge as a qualified hedging transaction. The Commissioner may identify a qualifying debt instrument and a hedge as a qualified hedging transaction regardless of whether the qualifying debt instrument and the hedge are held by the same taxpayer.
(9) Taxation of qualified hedging transactions—
(i) In general—
If a transaction constitutes a qualified hedging transaction, the qualifying debt instrument and the hedge are integrated and treated as a single transaction with respect to the taxpayer that has entered into the qualified hedging transaction during the period that the transaction qualifies as a qualified hedging transaction. Neither the qualifying debt instrument nor the hedge that makes up the qualified hedging transaction shall be subject to section 263(g), 1092 or 1256 for the period such transactions are integrated. However, the qualified hedging transaction may be subject to section 263(g) or 1092 if such transaction is part of a straddle.
(B) 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 paragraph (a)(5)(vii) of this section 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 paragraph (a)(5)(vii) of this section shall be allocated and apportioned under § 1.882-5 of the regulations.
(C) 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 person, for purposes of sections 871(a), 881, 1441, 1442 and 6049, the provisions of this paragraph (a) shall not apply and such sections of the Internal Revenue Code shall be applied separately to the qualifying debt instrument and the hedge. To the extent relevant to any foreign person, if the requirements of this paragraph (a) are otherwise met, the provisions of this paragraph (a) shall apply for all other purposes of the Internal Revenue 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 paragraph (a)).
(ii) Income tax effects of integration.
The effect of integrating and treating a transaction as a single transaction is to create a synthetic debt instrument for income tax purposes, which is subject to the original issue discount provisions of sections 1272 through 1288 and 163(e), the terms of which are determined as follows:
(A) Denomination of synthetic debt instrument.
In the case where the qualifying debt instrument is a borrowing, the denomination of the synthetic debt instrument is the same as the currency paid under the terms of the hedge to acquire the currency used to make payments under the qualifying debt instrument. In the case where the qualifying debt instrument is a lending, the denomination of the synthetic debt instrument is the same as the currency received under the terms of the hedge in exchange for amounts received under the qualifying debt instrument. For example, if the hedge is a forward contract to acquire British pounds for dollars, and the qualifying debt instrument is a borrowing denominated in British pounds, the synthetic debt instrument is considered a borrowing in dollars.
(B) Term and accrual periods.
The term of the synthetic debt instrument shall be the period beginning on the identification date and ending on the date the qualifying debt instrument matures or such earlier date that the qualifying debt instrument or hedge is disposed of or otherwise terminated. Unless otherwise clearly indicated by the payment interval under the hedge, the accrual period shall be a six month period which ends on the dates determined under section 1272(a)(5).
(C) Issue price.
The issue price of the synthetic debt instrument is the adjusted issue price of the qualifying debt instrument translated into the currency in which the synthetic debt instrument is denominated at the spot rate on the identification date.
(D) Stated redemption price at maturity.
In the case where the qualifying debt instrument is a borrowing, the stated redemption price at maturity shall be determined under section 1273(a)(2) on the identification date by reference to the amounts to be paid under the hedge to acquire the currency necessary to make interest and principal payments on the qualifying debt instrument. In the case where the qualifying debt instrument is a lending, the stated redemption price at maturity shall be determined under section 1273(a)(2) on the identification date by reference to the amounts to be received under the hedge in exchange for the interest and principal payments received pursuant to the terms of the qualifying debt instrument.
(iii) Source of interest income and allocation of expense.
Interest income from a synthetic debt instrument described in paragraph (a)(9)(ii) of this section shall be sourced by reference to the source of income under sections 861 (a)(1) and 862(a)(1) of the qualifying debt instrument. The character for purposes of section 904 of interest income from a synthetic debt instrument shall be determined by reference to the character of the interest income from qualifying debt instrument. Interest expense from a synthetic debt instrument described in paragraph (a)(9)(ii) of this section shall be allocated and apportioned under §§ 1.861-8T through 1.861-12T or the successor sections thereof or under § 1.882-5.
(iv) Examples.
The following examples illustrate the application of this paragraph (a)(9).
Code of Federal Regulations
Example 1.
(i) K is a U.S. corporation with the U.S. dollar as its functional currency. On December 24, 1989, K agrees to close the following transaction on December 31, 1989. K will borrow from an unrelated party on December 31, 1989, 100 British pounds (£) for 3 years at a 10 percent rate of interest, payable annually, with no principal payment due until the final installment. K will also enter into a currency swap contract with an unrelated counterparty under the terms of which—
(a) K will swap, on December 31, 1989, the £100 obtained from the borrowing for $100; and
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(b) K will exchange dollars for pounds pursuant to the following table in order to obtain the pounds necessary to make payments on the pound borrowing:
| December 31, 1990 |
8 |
10 |
| December 31, 1991 |
8 |
10 |
| December 31, 1992 |
108 |
110 |
(ii) The interest rate on the borrowing is set and the exchange rates on the swap are fixed on December 24, 1989. On December 31, 1989, K borrows the £100 and swaps such pounds for $100. Assume x has satisfied the identification requirements of paragraph (a)(8) of this section.
(iii) The pound borrowing (which constitutes a qualifying debt instrument under paragraph (a)(3) of this section) and the currency swap contract (which constitutes a hedge under paragraph (a)(4) of this section) are a qualified hedging transaction as defined in paragraph (a)(1) of this section. Accordingly, the pound borrowing and the swap are integrated and treated as one transaction with the following consequences:
(A) The integration of the pound borrowing and the swap results in a synthetic dollar borrowing with an issue price of $100 under section 1273(b)(2).
(B) The total amount of interest and principal of the synthetic dollar borrowing is equal to the dollar payments made by K under the currency swap contract (i.e., $8 in 1990, $8 in 1991, and $108 in 1992).
(C) The stated redemption price at maturity (defined in section 1273(a)(2)) is $100. Because the stated redemption price equals the issue price, there is no OID on the synthetic dollar borrowing.
(D) K may deduct the annual interest payments of $8 under section 163(a) (subject to any limitations on deductibility imposed by other provisions of the Code) according to its regular method of accounting. K has also paid $100 as a return of principal in 1992.
(E) K must allocate and apportion its interest expense with respect to the synthetic dollar borrowing under the rules of §§ 1.861-8T
through 1.861-12T.
Code of Federal Regulations
Example 2.
(i) K, a U.S. corporation, has the U.S. dollar as its functional currency. On December 24, 1989, when the spot rate for Swiss francs (Sf) is Sf1 = $1, K enters into a forward contract to purchase Sf100 in exchange for $100.04 for delivery on December 31, 1989. The Sf100 are to be used for the purchase of a franc denominated debt instrument on December 31, 1989. The instrument will have a term of 3 years, an issue price of Sf100, and will bear interest at 6 percent, payable annually, with no repayment of principal until the final installment. On December 24, 1989, K also enters into a series of forward contracts to sell the franc interest and principal payments that will be received under the terms of the franc denominated debt instrument for dollars according to the following schedule:
| December 31, 1990 |
6.12 |
6 |
| December 31, 1991 |
6.23 |
6 |
| December 31, 1992 |
112.16 |
106 |
(ii) On December 31, 1989, K takes delivery of the Sf100 and purchases the franc denominated debt instrument. Assume K satisfies the identification requirements of paragraph (a)(8) of this section. The purchase of the franc debt instrument (which constitutes a qualifying debt instrument under paragraph (a)(3) of this section) and the series of forward contracts (which constitute a hedge under paragraph (a)(4) of this section) are a qualified hedging transaction under paragraph (a)(1) of this section. Accordingly, the franc debt instrument and all the forward contracts are integrated and treated as one transaction with the following consequences:
(A) The integration of the franc debt instrument and the forward contracts results in a synthetic dollar debt instrument in an amount equal to the dollars exchanged under the forward contract to purchase the francs necessary to acquire the franc debt instrument. Accordingly, the issue price is $100.04 (section 1273(b)(2) of the Code).
(B) The total amount of interest and principal received by K with respect to the synthetic dollar debt instrument is equal to the dollars received under the forward sales contracts (i.e., $6.12 in 1990, $6.23 in 1991, and $112.16 in 1992).
(C) The synthetic dollar debt instrument is an installment obligation and its stated redemption price at maturity is $106.15 (i.e., $6.12 of the payments in 1990, 1991, and 1992 are treated as periodic interest payments under the principles of section 1273). Because the stated redemption price at maturity exceeds the issue price, under section 1273(a)(1) the synthetic dollar debt instrument has OID of $6.11.
(D) The yield to maturity of the synthetic dollar debt instrument is 8.00 percent, compounded annually. Assuming K is a calendar year taxpayer, it must include interest income of $8.00 in 1990 (of which $1.88 constitutes OID), $8.15 in 1991 (of which $2.03 constitutes OID), and $8.32 in 1992 (of which $2.20 constitutes OID). The amount of the final payment received by K in excess of the interest income includible is a return of principal and a payment of previously accrued OID.
(E) The source of the interest income shall be determined by applying sections 861(a)(1) and 862(a)(1) with reference to the franc interest income that would have been received had the transaction not been integrated.
Code of Federal Regulations
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648
Example 3.
(i) K is an accrual method U.S. corporation with the U.S. dollar as its functional currency. On January 1, 1992, K borrows 100 British pounds (£) for 3 years at a 10% rate of interest payable on December 31 of each year with no principal payment due until the final installment. The spot rate on January 1, 1992, is £1 = $1.50. On January 1, 1993, when the spot rate is £1 = $1.60, K enters into a currency swap contract with an unrelated counterparty under the terms of which K will exchange dollars for pounds pursuant to the following table in order to obtain the pounds necessary to make the remaining payments on the pound borrowing:
| December 31, 1993 |
12.80 |
10 |
| December 31, 1994 |
12.80 |
10 |
| December 31, 1994 |
160.00 |
100 |
(ii) Assume that British pound interest rates are still 10% and that K properly identifies the pound borrowing and the currency swap contract as a qualified hedging transaction as provided in paragraph (a)(8) of this section. Under paragraph (a)(6)(i) of this section, K must realize exchange gain or loss with respect to the pound borrowing determined solely by reference to changes in exchange rates between January 1, 1992 and January 1, 1993. (Thus, gain or loss from other factors such as movements in interest rates or changes in credit quality of K are not taken into account). Recognition of such gain or loss is deferred until K terminates its pound borrowing. Accordingly, K must defer exchange loss in the amount of $10 [(£100×1.50)−(£100×1.60)].
(iii) Additionally, the qualified hedging transaction is treated as a synthetic U.S. dollar debt instrument with an issue date of January 1, 1993, and a maturity date of December 31, 1994. The issue price of the synthetic debt instrument is $160 (£100×1.60, the spot rate on January 1, 1993) and the total amount of interest and principal is $185.60. The accrual period is the one year period beginning on January 1 and ending December 31 of each year. The stated redemption price at maturity is $160. Thus, K is treated as paying $12.80 of interest in 1993, $12.80 of interest in 1994, and $160 of principal in 1994. The interest expense from the synthetic instrument is allocated and apportioned in accordance with the rules of §§ 1.861-8T
through 1.861-12T. Sections 263(g), 1092, and 1256 do not apply to the positions comprising the synthetic dollar borrowing.
Code of Federal Regulations
Example 4.
(i) K is an accrual method U.S. corporation with the U.S. dollar as its functional currency. On January 1, 1990, K borrows 100 British pounds (£) for 3 years at a 10% rate of interest payable on December 31 of each year with no principal payment due until the final installment. The spot rate on January 1, 1990, is £1 = $1.50. Also on January 1, 1990, K enters into a currency swap contract with an unrelated counterparty under the terms of which K will exchange dollars for pounds pursuant to the following table in order to obtain the pounds necessary to make the remaining payments on the pound borrowing:
| December 31, 1990 |
12.00 |
10 |
| December 31, 1991 |
12.00 |
10 |
| December 31, 1992 |
162.00 |
110 |
(ii) Assume that K properly identifies the pound borrowing and the currency swap contract as a qualified hedging transaction as provided in paragraph (a)(1) of this section.
(iii) The pound borrowing (which constitutes a qualifying debt instrument under paragraph (a)(3) of this section) and the currency swap contract (which constitutes a hedge under paragraph (a)(4) of this section) are a qualified hedging transaction as defined in paragraph (a)(1) of this section. Accordingly, the pound borrowing and the swap are integrated and treated as one transaction with the following consequences:
(A) The integration of the pound borrowing and the swap results in a synthetic dollar borrowing with an issue price of $150 under section 1273(b)(2).
(B) The total amount of interest and principal of the synthetic dollar borrowing is equal to the dollar payments made by K under the currency swap contract (i.e., $12 in 1990, $12 in 1991, and $162 in 1992).
(C) The stated redemption price at maturity (defined in section 1273(a)(2)) is $150. Because the stated redemption price equals the issue price, there is no OID on the synthetic dollar borrowing.
(D) K may deduct the annual interest payments of $12 under section 163(a) (subject to any limitations on deductibility imposed by other provisions of the Code) according to its regular method of accounting. K has also paid $150 as a return of principal in 1992.
(E) K must allocate and apportion its interest expense from the synthetic instrument under the rules of §§ 1.861-8T
through 1.861-12T.
(iv) Assume that on January 1, 1991, the spot exchange rate is £1 = $1.60, interest rates have not changed since January 1, 1990, (accordingly, assume that the market value of K's bond in pounds has not changed) and that K transfers its rights and obligations under the currency swap contract in exchange for $10. Under § 1.988-2(e)(3)(iii)
, K will include in income as exchange gain $10 on January 1, 1991. Pursuant to paragraph (a)(6)(ii) of this section, the pound borrowing and the currency swap contract are treated as a qualified hedging transaction for 1990. The loss inherent in the pound borrowing from January 1, 1990, to January 1, 1991, is realized and recognized on January 1, 1991. Such loss is exchange loss in the amount of $10.00 [(£100×$1.50, the spot rate on January 1, 1990)−(£100×$1.60, the spot rate on January 1, 1991)]. For purposes of determining exchange gain or loss on the £100 principal amount of the debt instrument for the period January 1, 1991, to December 31, 1992, the spot rate on January 1, 1991 is used rather than the spot rate on the issue date. Thus, assuming that the spot rate on December 31, 1992, the maturity date, is £1 = $1.80, K realizes exchange loss in the amount of $20 [(£100×$1.60)−(£100×$1.80)]. Except as provided in paragraph (a)(8)(iii) (regarding identification by the Commissioner), the pound borrowing cannot be part of a qualified hedging transaction for any period subsequent to the leg out date.
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Code of Federal Regulations
Example 5.
(i) K, a U.S. corporation, has the U.S. dollar as its functional currency. On January 1, 1990, when the spot rate for Swiss francs (Sf) is Sf1 = $.50, K converts $100 to Sf200 and purchases a franc denominated debt instrument. The instrument has a term of 3 years, an adjusted issue price of Sf200, and will bear interest at 5 percent, payable annually, with no repayment of principal until the final installment. The U.S. dollar interest rate on an equivalent instrument is 8% on January 1, 1990, compounded annually. On January 1, 1990, K also enters into a series of forward contracts to sell the franc interest and principal payments that will be received under the terms of the franc denominated debt instrument for dollars according to the following schedule:
| December 31, 1990 |
5.14 |
10 |
| December 31, 1991 |
5.29 |
10 |
| December 31, 1992 |
114.26 |
210 |
(ii) Assume K satisfies the identification requirements of paragraph (a)(8) of this section. Assume further that on January 1, 1991, the spot exchange rate is Sf1 = U.S.$.5143, the U.S. dollar interest rate is 10%, compounded annually, and the Swiss franc interest rate is the same as on January 1, 1990 (5%, compounded annually). On January 1, 1991, K disposes of the forward contracts that were to mature on December 31, 1991, and December 31, 1992 and incurs a loss of $3.62 (the present value of $.10 with respect to the 1991 contract and $4.27 with respect to the 1992 contract).
(iii) The purchase of the franc debt instrument (which constitutes a qualifying debt instrument under paragraph (a)(3) of this section) and the series of forward contracts (which constitute a hedge under paragraph (a)(4) of this section) are a qualified hedging transaction under paragraph (a)(1) of this section. Accordingly, the franc debt instrument and all the forward contracts are integrated for the period beginning January 1, 1990, and ending January 1, 1991.
(A) The integration of the franc debt instrument and the forward contracts results in a synthetic dollar debt instrument with an issue price of $100.
(B) The total amount of interest and principal to be received by K with respect to the synthetic dollar debt instrument is equal to the dollars to be received under the forward sales contracts (i.e., $5.14 in 1990, $5.29 in 1991, and $114.26 in 1992).
(C) The synthetic dollar debt instrument is an installment obligation and its stated redemption price at maturity is $109.27 (i.e., $5.14 of the payments in 1990, 1991, and 1992 is treated as periodic interest payments under the principles of section 1273). Because the stated redemption price at maturity exceeds the issue price, under section 1273(a)(1) the synthetic dollar debt instrument has OID of $9.27.
(D) The yield to maturity of the synthetic dollar debt instrument is 8.00 percent, compounded annually. Assuming K is a calendar year taxpayer, it must include interest income of $8.00 in 1990 (of which $2.86 constitutes OID).
(E) The source of the interest income is determined by applying sections 861(a)(1) and 862(a)(1) with reference to the franc interest income that would have been received had the transaction not been integrated.
(iv) Because K disposed of the forward contracts on January 1, 1991, the rules of paragraph (a)(6)(ii) of this section shall apply. Accordingly, the $3.62 loss from the disposition of the forward contracts is realized and recognized on January 1, 1991. Additionally, K is deemed to have sold the franc debt instrument for $102.86, its fair market value in dollars on January 1, 1991. K will compute gain or loss with respect to the deemed sale of the franc debt instrument by subtracting its adjusted basis in the instrument ($102.86—the value of the Sf200 issue price at the spot rate on the identification date plus $2.86 of original issue discount accrued on the synthetic dollar debt instrument for 1990) from the amount realized on the deemed sale of $102.86. Thus K realizes and recognizes no gain or loss from the deemed sale of the debt instrument. The dollar amount used to determine exchange gain or loss with respect to the franc debt instrument is the Sf200 issue price on January 1, 1991, translated into dollars at the spot rate on January 1, 1991, of Sf1 = U.S.$.5143. Except as provided in paragraph (a)(8)(iii) of this section (regarding identification by the Commissioner), the franc borrowing cannot be part of a qualified hedging transaction for any period subsequent to the leg out date.
Code of Federal Regulations
Example 6.
(i) K is a U.S. corporation with the dollar as its functional currency. On January 1, 1992, K issues a debt instrument with the following terms: the issue price is $1,000, the instrument pays interest annually at a rate of 8% on the $1,000 principal amount, the instrument matures on December 31, 1996, and the amount paid at maturity is the greater of zero or $2,000 less the U.S. dollar value (determined on December 31, 1996) of 150,000 Japanese yen.
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(ii) Also on January 1, 1992, K enters into the following hedges with respect to the instrument described in the preceding paragraph: a forward contract under which K will sell 150,000 yen for $1,000 on December 31, 1996 (note that this forward rate assumes that interest rates in yen and dollars are equal); and an option contract that expires on December 31, 1996, under which K has the right (but not the obligation) to acquire 150,000 yen for $2,000. K will pay for the option by making payments to the writer of the option equal to $5 each December 31 from 1992 through 1996.
(iii) The net economic effect of these transactions is that K has created a liability with a principal amount and amount paid at maturity of $1,000, with an interest cost of 8.5% (8% on debt instrument, 0.5% option price) compounded annually. For example, if on December 31, 1996, the spot exchange rate is $1 = 100 yen, K pays $500 on the bond [$2,000−(150,000 yen/$100)], and $500 in satisfaction of the forward contract [$1,000−(150,000 yen/$100)]. If instead the spot exchange rate on December 31, 1996 is $1 = 200 yen, K pays $1,250 on the bond [$2,000−(150,000 yen/$200)] and K receives $250 in satisfaction of the forward contract [$1,000−(150,000 yen/$200)]. Finally, if the spot exchange rate on December 31, 1996 is $1 = 50 yen, K pays $0 on the bond [$2,000−(150,000 yen/$50), but the bond holder is not required under the terms of the instrument to pay additional principal]; K exercises the option to buy 150,000 yen for $2,000; and K then delivers the 150,000 yen as required by the forward contract in exchange for $1,000.
(iv) Assume K satisfies the identification requirements of paragraph (a)(8) of this section. The debt instrument described in paragraph (i) of this Example 6 (which constitutes a qualifying debt instrument under paragraph (a)(3) of this section) and the forward contract and option contract described in paragraph (ii) of this example (which constitute a hedge under paragraph (a)(4) of this section and are collectively referred to hereafter as “the contracts”) together are a qualified hedging transaction under paragraph (a)(1) of this section. Accordingly, with respect to K, the debt instrument and the contracts are integrated, resulting in a synthetic dollar debt instrument with an issue price of $1000, a stated redemption price at maturity of $1000 and a yield to maturity of 8.5% compounded annually (with no original issue discount). K must allocate and apportion its annual interest expense of $85 under the rules of §§ 1.861-8T
through 1.861-12T.
Code of Federal Regulations
Example 7.
(i) R is a U.S. corporation with the dollar as its functional currency. On January 1, 1995, R issues a debt instrument with the following terms: the issue price is 504 British pounds (£), the instrument pays interest at a rate of 3.7% (compounded semi-annually) on the £504 principal amount, the instrument matures on December 31, 1999, with a repayment at maturity of the £504 principal plus the proportional gain, if any, in the “Financial Times” 100 Stock Exchange (FTSE) index (determined by the excess of the value of the FTSE index on the maturity date over the value of the FTSE on the issue date, divided by the value of the FTSE index on the issue date, multiplied by the number of FTSE index contracts that could be purchased on the issue date for £504).
(ii) Also on January 1, 1995, R enters into a contract with a bank under which on January 1, 1995, R will swap the £504 for $1,000 (at the current spot rate). R will make U.S. dollar payments to the bank equal to 8.15% on the notional principal amount of $1,000 (compounded semi-annually) for the period beginning January 1, 1995 and ending December 31, 1999. R will receive pound payments from the bank equal to 3.7% on the notional principal amount of £504 (compounded semi-annually) for the period beginning January 1, 1995 and ending December 31, 1999. On December 31, 1999, R will swap with the bank $1,000 for £504 plus the proportional gain, if any, in the FTSE index (computed as provided above).
(iii) Economically, both the indexed debt instrument and the hedging contract are hybrid instruments with the following components. The indexed debt instrument is composed of a par pound debt instrument that is assumed to have a 10.85% coupon (compounded semi-annually) plus an embedded FTSE equity index option for which the investor pays a premium of 7.15% (amortized semi-annually) on the pound principal amount. The combined effect is that the premium paid by the investor partially offsets the coupon payments resulting in a return of 3.7% (10.85%−7.15%). Similarly, the dollar payments under the hedging contract to be made by R are computed by multiplying the dollar notional principal amount by an 8.00% rate (compounded semi-annually) which the facts assume would be the rate paid on a conventional currency swap plus a premium of 0.15% (amortized semi-annually) on the dollar notional principal amount for an embedded FTSE equity index option.
(iv) Assume R satisfies the identification requirements of paragraph (a)(8) of this section. The indexed debt instrument described in paragraph (i) of this Example 7 constitutes a qualifying debt instrument under paragraph (a)(3) of this section. The hedging contract described in paragraph (ii) of this Example 7 constitutes a hedge under paragraph (a)(4) of this section. Since both the pound exposure of the indexed debt instrument and the exposure to movements of the FTSE embedded in the indexed debt instrument are hedged such that a yield to maturity can be determined in dollars, the transaction satisfies the requirement of paragraph (a)(5)(i) of this section. Assuming the transactions satisfy the other requirements of paragraph (a)(5) of this section, the indexed debt instrument and hedge are a qualified hedging transaction under paragraph (a)(1) of this section. Accordingly, with respect to R, the debt instrument and the contracts are integrated, resulting in a synthetic dollar debt instrument with an issue price of $1000, a stated redemption price at maturity of $1000 and a yield to maturity of 8.15% compounded semi-annually (with no original issue discount). K must allocate and apportion its interest expense from the synthetic instrument under the rules §§ 1.861-8T
through 1.861-12T.
Code of Federal Regulations
651
Code of Federal Regulations
Example 8.
(i) K is a U.S. corporation with the U.S. dollar as its functional currency. On December 24, 1992, K agrees to close the following transaction on December 31, 1992. K will borrow from an unrelated party on December 31, 1992, 200 British pounds (£) for 3 years at a 10 percent rate of interest, payable annually, with no principal payment due until the final installment. K will also enter into a currency swap contract with an unrelated counterparty under the terms of which—
(A) K will swap, on December 31, 1992, £100 obtained from the borrowing for $100; and
(B) K will exchange dollars for pounds pursuant to the following table:
| December 31, 1993 |
8 |
10 |
| December 31, 1994 |
8 |
10 |
| December 31, 1995 |
108 |
110 |
(ii) The interest rate on the borrowing is set and the exchange rates on the swap are fixed on December 24, 1992. On December 31, 1992, K borrows the £200 and swaps £100 for $100. Assume K has satisfied the identification requirements of paragraph (a)(8) of this section.
(iii) The £200 debt instrument satisfies the requirements of paragraph (a)(3)(i) of this section. Because all principal and interest payments under the instrument are hedged in the same proportion (50% of all interest and principal payments are hedged), 50% of the payments under the £200 instrument (principal amount of £100 and annual interest of £10) are treated as a qualifying debt instrument for purposes of paragraph (a) of this section. Thus, the distinct £100 borrowing and the currency swap contract (which constitutes a hedge under paragraph (a)(4) of this section) are a qualified hedging transaction as defined in paragraph (a)(1) of this section. Accordingly, £100 of the pound borrowing and the swap are integrated and treated as one synthetic dollar transaction with the following consequences:
(A) The integration of £100 of the pound borrowing and the swap results in a synthetic dollar borrowing with an issue price of $100 under section 1273(b)(2).
(B) The total amount of interest and principal of the synthetic dollar borrowing is equal to the dollar payments made by K under the currency swap contract (i.e., $8 in 1993, $8 in 1994, and $108 in 1995).