IRS Clarifies Hedge Termination ‘Legging Out' in Final Rules

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By Laura Davison

Sept. 3 — Taxpayers who terminate some hedges in integrated transactions involving qualifying debt instruments must treat remaining hedges as having been sold for fair market value on the date of the disposition, the IRS said in final rules.

The final regulations (T.D. 9736, RIN 1545-BK98) clarify the rules for foreign currency debt instruments with multiple hedges where a taxpayer terminates a hedge prior to maturity of the debt instrument, an arrangement commonly known as “legging out” under tax code Section 988.

The rules are intended to stop taxpayers who are attempting to take losses but avoid gain in transactions with multiple hedges tied to foreign currency.

The final rules issued Sept. 3 remove temporary rules (T.D. 9598) issued in 2012, the Internal Revenue Service said, making minor changes to the language to improve clarity.

Sufficient for Income Reflection

“When some of the hedge components of a qualified hedging transaction are disposed of on a leg-out date, deeming a disposition of all remaining components is sufficient to achieve a clear reflection of income,” the rules said.

The government received one comment, from the New York State Bar Association Tax Section, on the temporary rules that said the regulations were unnecessary because they were inconsistent with the purpose of Section 988(d) and the economic substance of the transaction.

The NYSBA Tax Section suggested that the regulations should be integrated with Section 1275, which allows integration of a debt instrument with a combination of hedges if the combined cash flows are equivalent to the cash flow on a fixed or variable rate debt instrument. The IRS and Treasury Department, however, ultimately deemed the approach to be out-of-scope for this regulatory project.

Financial hedges on currency risks can't be integrated as a hedge under Section 1275.

IRS Reasoning

“[T]he temporary regulations are useful in clarifying the section 988(d) integration rules—as well as in preventing unintended approaches to legging out under those rules—and thus should be adopted as final,” the final regulations said.

Legging rules under Section 1275 allow a taxpayer to terminate one hedge without disposing of others. After a leg-out of one hedge, adjustments are made to reflect any difference between the fair market value of the qualifying debt instrument and its adjusted issue price. The Section 988 rules require taxpayers to dispose of any remaining hedges if one is terminated.

The government will continue to mull whether the hedge integration rules under Sections 988 and 1275 should be aligned more closely, the rules said.

The final regulations, due to appear in the Federal Register Sept. 8, apply to leg-outs that occur on or after Sept. 6, 2012, the IRS said.

To contact the reporter on this story: Laura Davison in Washington at ldavison@bna.com

To contact the editor responsible for this story: Brett Ferguson at bferguson@bna.com

Text of T.D. 9736 is in TaxCore.